Edited version of private advice

Authorisation Number: 1051597832717

Date of advice: 21 October 2019

Ruling

Subject: Early stage innovation company

Question:

Does Company A satisfy the criteria of an Early Stage Innovation Company (ESIC) pursuant to subsection 360-40(1) of the Income Tax Assessment Act 1997 ('ITAA 1997')?

Answer:

Yes

This ruling applies for the following periods

X XX 20XX to y YY 20YY

The Scheme commences on

X XX 20XX

RELEVANT FACTS AND CIRCUMSTANCES

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

1.       Company A is an Australian based unlisted public company, incorporated on x XX 20XX.

2.       Company A's directors are Taxpayer A, Taxpayer B, Taxpayer C, Taxpayer D and Taxpayer E.

3.       Company A wholly owns Company B which is also an Australian based unlisted public company, incorporated on x XX 20XX.

4.       Company A and Company B have elected to form an income tax consolidated group effective from x XX 20XX and notified the ATO of the formation of the consolidated group on y YY 20YY.

5.       For the financial year ending x XX 20XX, Company A and its subsidiaries incurred and earned the following:

a.       Total expenses of $xx

b.       Total income of $yy

6.       Company A is an unlisted public company and its equity interests are not listed for quotation in the official list of any stock exchange in Australia or a foreign country.

7.       Company A is developing both a process and a product - an automated business process, a core IT infrastructure that will significantly improve the particular business process, data sourcing and models supporting the decision-making process and an innovative business product.

8.       Company A is genuinely focused on developing their Process/Product. Company B will only use the innovative technology developed by Company A to operate a business. Investor capital is raised through Company A.

9.       Upon being granted a restricted license, Company A will commence the build of this system. Key technologies that demonstrate significant improvement include various applications, forms and state-of-the-art data protection.

10.    Competitors currently use limited technology to source and package information to support decision making for business transactions. Company A's Process is a significant improvement to the existing process in the particular business.

11.    Company A is developing their Process/Product to address a number of discrete markets and is continuing to develop their Process/Product.

12.    There are a number of steps which are required to be completed into the future, before the Process/Product is considered to be fully developed for commercialisation.

13.    Company A demonstrates it has high growth potential by focusing on providing customers faster turnaround through the increased use of the core IT infrastructure and digitisation of the process which will include all major cities in Australia.

14.    Company A's Process/Product has been identified as having an international addressable market.

15.    Company A has quantified a detailed cash flow forecast for the period from XX 20XX to YY 20ZZ. Based on the assumptions and model built, Company A expects that existing revenues can be increased with a reduced or minimal increase in expenses.

16.    Company A's expansion strategy considers all Australian capital cities potentially being available to Company A and a significant opportunity for Company A to gain market share.

17.    Company A's business model focuses on solving pain points arising from traditional product offerings by competitors in the market.

Information provided

18.    You have provided a number of documents containing detailed information in relation to Company A's Product, including:

a.       Private Binding Ruling ('PBR') Application, dated x XX 20YY

b.       Response to further questions provided

c.        Further information provided during phone call-up on x XX 20YY

d.       Updated response to further questions provided

19.    We have referred to the relevant information within these documents in applying the relevant tests to your circumstances.

20.    You issued new shares in Company A to various investors during 20XX to assist in funding the continued development and commercialisation of the Product.

Assumption(s)

Not applicable.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 360-A

Income Tax Assessment Act 1997 section 360-15

Income Tax Assessment Act 1997 section 360-40

Income Tax Assessment Act 1997 section 360-45

Further issues for you to consider

Not applicable.

REASONS FOR DECISION

All legislative references are to the Income Tax Assessment Act 1997 ('ITAA 1997') unless otherwise stated.

SUMMARY

Company A meets the eligibility requirements of an ESIC pursuant to subsection 360-40(1).

DETAILED REASONING

Qualifying Early Stage Innovation Company

21.    Subsection 360-40(1) outlines the criteria required for a company to qualify as an Early Stage Innovation Company (ESIC) at a particular time in an income year. This time is referred to as the 'test time'. The criteria are based on a series of tests to identify if the company is at an early stage of its development and it is developing new or significantly improved innovations to generate an economic return.

'THE EARLY STAGE TEST'

22.    The early stage test requirements are outlined in detail within paragraphs 360-40(1)(a) to (d).

Incorporation or Registration - paragraph 360-40(1)(a)

23.    To meet the requirement in paragraph 360-40(1)(a), at a particular time (the test time) in an income year (the current year) the company must have been either:

             i.            incorporated in Australia within the last three income years (the latest being the current year); or

            ii.            incorporated in Australia within the last six income years (the latest being the current year), and across the last three of those income years the company and its 100% subsidiaries incurred total expenses of $1 million or less; or

          iii.            registered in the Australian Business Register (ABR) within the last three income years (the latest being the current year).

24.    The term 'current year' is defined in subsection 360-40(1) with reference to the 'test time'; the 'current year' being the income year in which the company issues shares to the investor.

25.    A company that does not meet any of these conditions will not qualify as an ESIC.

Total expenses - paragraph 360-40(1)(b)

26.    To meet the requirement in paragraph 360-40(1)(b), the company and its 100% subsidiaries must have incurred total expenses of $1 million or less in the income year before the current year.

Assessable income - paragraph 360-40(1)(c)

27.    To meet the requirement in paragraph 360-40(1)(c), the company and its 100% subsidiaries must have derived total assessable income of $200,000 or less in the income year before the current year.

No stock exchange listing - paragraph 360-40(1)(d)

28.    To meet the requirement in paragraph 360-40(1)(d), the company must not be listed on any stock exchange in Australia or a foreign country.

INNOVATION TESTS

29.    If the company satisfies the early stage test, the company must also satisfy one of two innovation tests: the objective (100 point) test or the principles-based test.

'100 POINT TEST' - PARAGRAPH 360-40(1)(E) AND SECTION 360-45

30.    To satisfy the 100 point test the company must obtain at least 100 points by meeting the innovation criteria in the table within section 360-45. The criteria are tested at a time immediately after the relevant shares are issued. If a company satisfies this test it does not need to satisfy the principles-based test.

'PRINCIPLES-BASED TEST' - SUBPARAGRAPHS 360-40(1)(E)(I) TO (IV)

31.    To satisfy the principles-based test, the company must meet five requirements in paragraph 360-40(1)(e). This is tested at a time immediately after the relevant new shares are issued to the investor.

32.    The company can demonstrate that it meets each requirement through existing documentation such as a business plan, commercialisation strategy, competition analysis or other company documents. The company must be able to show that tangible steps have been or will be taken in relation to each of the requirements.

33.    The five requirements of the principles-based test, as outlined in paragraph 360-40(1)(e) are:

             i.            the company must be genuinely focussed on developing for commercialisation one or more new or significantly improved products, processes, services or marketing or organisational methods

            ii.            the business relating to that innovation must have a high growth potential

          iii.            the company must demonstrate that it has the potential to be able to successfully scale up the business relating to the innovation

          iv.            the company must demonstrate that it has the potential to be able to address a broader than local market, including global markets, through that business, and

           v.            the company must demonstrate that it has the potential to be able to have competitive advantages for that business.

Developing new or significantly improved innovations for commercialisation

34.    For the purposes of Subdivision 360-A, the Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 ('EM') provides the following at paragraph 1.76 in relation to the definition of innovation:

"Implicit in the definition of innovation is the requirement that the company is developing a new or significantly improved type of innovation such as a product, process, service, marketing or organisational method. This list of various types of innovations provides flexibility for innovation companies and is adaptable to current and future innovations. The Oslo Manual, published by the Organisation for Economic Co-operation and Development (OECD) provides a description of these different types of innovations..."

35.    The innovation being developed by the company must either be new or significantly improved for an applicable addressable market.^[1] The company's addressable market is the revenue opportunity or market demand arising from the innovation or the related business. The addressable market must be objective and realistic.

36.    Improvements must be significant in nature to meet this requirement. Significant is defined in the online Macquarie Dictionary as "important; of consequence." Customising existing products or minor changes resulting from software updates, pricing strategies or seasonal changes are examples of improvements that would not be considered significant.

37.    The OECD Oslo Manual, in relation to defining innovative services, states at paragraph 161 that "innovations in services can include significant improvements in how they are provided (for example, in terms of their efficiency or speed), the addition of new functions or characteristics to existing services, or the introduction of entirely new services."

38.    The company must be genuinely focussed on developing the innovation for a commercial purpose in order to generate economic value and revenue for the company. This requirement draws the distinction between simply having an idea and commercialising an idea.

39.    For a company to qualify as an ESIC under the principles based test, the company must be "genuinely focussed on developing for commercialisation" their innovation. That is, the central activities of the company must be truly concentrated on developing their innovation for a commercial purpose. 'Commercialisation' includes a range of activities that involve the implementation or sale of a new or significantly improved innovation that will directly lead to the generation of economic value for the company.

High growth potential

40.    The company must be able to demonstrate that the business relating to the innovation has a high growth potential within a broad addressable market. This refers to the company's ability to rapidly expand its business. Companies that are limited to supplying local customers will not meet this requirement.

Scalability

41.    The company must be able to demonstrate that it has the potential to successfully scale up the business relating to the innovation. The company must have operating leverage, where as it increases its market share or enters into new markets, its existing revenues can be multiplied with a reduced or minimal increase in operating costs.

Broader than local market

42.    The company must be able to demonstrate that it has the potential to address a market that is broader than a local city, area or region. The company does not need to have a serviceable market at a national, multinational or global scale at the test time. However, it does need to show that the business is capable of addressing a market that is broader than a local market and that the business can be adapted to a broader scale in the future.

Competitive advantages

43.    The company must be able to demonstrate that it has the potential to have competitive advantages, such as a cost or differential advantage over its competitors which are sustainable for the business as it expands. The company can analyse what competitors in the market offer, and consider whether the company has a differentiating advantage that would allow it to outperform these competitors.

APPLICATION TO YOUR CIRCUMSTANCES

TEST TIME

44.    For the purposes of this ruling, the 'test time' for determining if Company A is a qualifying ESIC, is upon the issue of qualifying shares on or after x XX 20XX, and on or before x XX 20YY. Company A issued shares at various dates during 20XX and each date will be a "test time" for the purposes of this ruling.

Current year

45.    Therefore, for the purposes of subsection 360-40(1) ITAA 1997, the current year will be the year ending x XX 20YY (the 20YY income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last 3 income years will include the years ending x XX 20YY, 20XX and 20WW, and the income year before the current year will be the year ending x XX 20XX (the 20XX income year).

THE 'EARLY STAGE TEST' - PARAGRAPHS 360-40(1)(A) - (D) ITAA 1997

Incorporation or Registration - paragraph 360-40(1)(a) ITAA 1997

46.    Company A was registered in the Australian Business Register (ABR) on x XX 20XX, which is within the 3 income years outlined above, therefore the requirements of subparagraph 360-40(1)(a)(iii) are satisfied.

Total expenses - paragraph 360-40(1)(b) ITAA 1997

47.    In applying the requirements of paragraph 360-40(1)(b), Company A and any of its 100% subsidiaries must have incurred total expenses of $1 million or less in the 20XX income year, being the income year before the current year.

48.    Company A and its subsidiary Company B did not incur any expenses in the 20XX income year. Consequently, paragraph 360-40(1)(b) is satisfied.

Assessable income - paragraph 360-40(1)(c) ITAA 1997

49.    In applying the requirements of paragraph 360-40(1)(c), Company A and any of its 100% subsidiaries must have derived total assessable income of $200,000 or less in the 20XX income year, being the income year before the current year.

50.    Neither Company A nor its subsidiary Company B earned any assessable income in the 20XX income year. Consequently, paragraph 360-40(1)(c) is satisfied.

No Stock Exchange listing - paragraph 360-40(1)(d) ITAA 1997

51.    In applying the requirements of paragraph 360-40(1)(d), Company A must not be listed on any Stock Exchange in Australia or a foreign country at the test time.

52.    Company A is not listed on any Stock Exchange in Australia or a foreign country at the test time, so paragraph 360-40(1)(d) is satisfied.

CONCLUSION FOR EARLY STAGE TEST

53.    Company A satisfies the early stage test for the 20YY income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied.

THE '100 POINT TEST' - PARAGRAPH 360-40(1)(E) AND SECTION 360-45

54.    Company A has not provided sufficient evidence of satisfying the 100 point test under section 360-45 for the year ending x XX 20YY. Company A are electing to seek eligibility by satisfying the Principles based Innovation test under section 360-40(1)(e)(i)-(v), in order to be issued with a Private Binding Ruling.

THE 'PRINCIPLES-BASED TEST' - PARAGRAPH 360-40(1)(E) ITAA 1997

Developing new or significantly improved innovations for applicable addressable market - subparagraph 360-40(1)(e)(i) ITAA 1997

55.    In applying the requirements of subparagraph 360-40(1)(e)(i), Company A must be developing an innovation which is either new or significantly improved for an applicable addressable market.

56.    Company A has identified an opportunity in the Australian market to provide a niche offering to business customers through the provision of an essential product.

57.    Company A is developing both a process and a product - an automated business process and an innovative business product.

The Process

58.    Company A is developing an automated business process, a core IT infrastructure that will significantly improve the business process.

59.    Company A's target customers are small to medium businesses that require fast business processes with minimal investment.

60.    Key technologies that demonstrate significant improvement include smart forms, business process automation, automatic sourcing of data for analytics, and state-of-the-art data protection.

61.    Company A is developing the technology to automate and integrate the above such that the final stage is reached within 48 hours of initial application.

62.    This reduces the number of questions required to be asked and allows Company A to provide pre-approval or rejection on the spot. For customers that have been pre-approved, the expectation is that a majority will proceed straight to full approval and those referred will be subject to a more thorough assessment.

63.    Company A will adopt a digital approach to the application process. Increased digitisation is an added function which will provide benefits such as improved synergies with customer's existing document processes, reducing the time and effort required by customers.

The Product

64.    Company A is also developing an innovative business product.

65.    Competitors currently use limited technology to source and package information to support decision making for business transactions. Company A's Process is a significant improvement to the existing process in the traditional business.

66.    Company A is genuinely focused on developing their Process/Product, so subparagraph 360-40(1)(e)(i) is satisfied for the period x XX 20XX to x XX 20YY.

Genuinely focussed on developing for commercialisation - subparagraph 360-40(1)(e)(i) ITAA 1997

67.    In applying the requirements of subparagraph 360-40(1)(e)(i), Company A must be genuinely focused on developing an innovation for a commercial purpose in order to generate economic value and revenue for the company.

68.    Work already undertaken to develop Company A's Process/Product between XX 20XX and XX 20YY is as follows:

a)     August 20XX - Design proof of concept, comparative analysis prepared / documented

b)       September 20XX - Testing with external feed

c)       November 20XX -Licensing process began

d)       December 20XX - IT strategy formalised

e)       January 20YY - Meetings with an organisation for continued development

f)         February 20YY - Engaged Open Analyticals for benchmarking of product and IT infrastructure

g)       March 20YY - Engaged Company X as external consultant for product and competitor analysis

h)       April 20YY - Engaged Company X as external consultant for market analysis and surveying

i)         May 20YY - Sourcing the data feeds that the IT infrastructure requires

j)         June 20YY - Vendor meetings continuing

69.    Company A is currently in the process of obtaining a Restricted licence. The Restricted licence is required for Company A to build, test and use the product with a commercial purpose. While Company A is waiting for the Restricted licence, they are to date refining IT Architecture. Company A is also sourcing the data feeds that the IT infrastructure will require.

70.    There are a number of steps which are required to be completed into the future, before the Process/Product is considered to be fully developed for commercialisation:

a)     The Process/Product will be built for commercialisation within the first quarter after the Restricted licence is granted.

b)       During the Restricted licence phase, Company A will build the products, build the assessment systems, set up a business system and will test, audit and refine the IT Infrastructure.

c)       During this time, Company A will build the framework so that Company A can comply with all prudential standards once they become a full licence holder.

d)       Company A intends its IT infrastructure be fully operational within a year of the granting of the Restricted licence.

71.    Company A is genuinely focused on developing their Process/Product, for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the period 1x XX 20XX to x XX 20YY.

High growth potential - subparagraph 360-40(1)(e)(ii) ITAA 1997

72.    In applying the requirements of subparagraph 360-40(1)(e)(ii), Company A must be able to demonstrate that it has the potential for high growth within a broad addressable market.

73.    Company A has developed a detailed commercial plan. The plan addresses funding, licencing, compliance with prudential requirements, products, HR, marketing, and their IT and platform building.

74.    Company A has outlined an expansion strategy in its business plan to a governing organisation. This plan was developed based on the first-hand experience of the founders.

75.    Company A demonstrates it has high growth potential by focusing on providing customers faster turnaround through the increased use of the core IT infrastructure and digitisation of the process which will include all major cities in Australia.

76.    Company A's target location will be commercial (as opposed to industrial) locations in key centres such as capital city CBD locations.

77.    Company A has high growth potential as the Process/Product is easily and infinitely scalable to a global audience.

78.    Company A has demonstrated a high growth potential for their Process/Product, so subparagraph 360-40(1)(e)(ii) is satisfied for the period x XX 20XX to x XX 20YY.

Scalability - subparagraph 360-40(1)(e)(iii) ITAA 1997

79.    In applying the requirements of subparagraph 360-40(1)(e)(iii), Company A must be able to demonstrate that it has the potential to successfully scale up the business.

80.    Company A has quantified a detailed cash flow forecast for the period from XX 20YY to XX 20ZZ. Based on the assumptions and model built, Company A expects that existing revenues can be increased with a reduced or minimal increase in expenses.

81.    Company A expects that approximately $xxM of post-tax profit could be achieved by issuing around xyz guarantees. This is supported by the nature of the business plan to offer a limited suite of products, which would ensure operating costs per unit should be reduced or minimally increased.

82.    Company A's business model seeks to ensure that it can self-generate free-cash flow, due to the projected primary income source being generated through ongoing fees.

83.    Company A has conducted analysis into their forecasted business growth based on analysis undertaken on the size of the market. Scalable growth in business size is expected on conservative market share estimates.

84.    This leverage ensures that Company A has the potential to successfully scale up its business, so subparagraph 360-40(1)(e)(iii) is satisfied for the period x XX 20XX to x XX 20YY.

Broader than local market - subparagraph 360-40(1)(e)(iv) ITAA 1997

85.    In applying the requirements of subparagraph 360-40(1)(e)(iv), Company A must be able to demonstrate that it has the potential to be able to address a broader than local market, including global markets.

86.    Company A will initially conduct business focusing primarily on the XX CBD and YY CBD locations, as well as satellite capital city CBD locations such as ZZ and TT. Company A's expansion strategy considers all capital cities potentially being available to Company A and a significant opportunity for Company A to gain market share.

87.    As the business grows and as the model is proven in the initial target locations, the footprint will expand to provide coverage of other CBD locations. Once Company A is comfortable with the risk profile, Company A has identified that there is the option to add the market which is approximately xx% additional market potential.

88.    On granting of the conditional license, the business of Company A will not change but Company A may expand their target market across Australia.

89.        Company A will have relationship managers employed to build the referral channel, as well as online and phone support for customers.

90.        This structure is conducive to future expansion outside of the initial target markets to all CBD locations and beyond.

91.        Company A has demonstrated that it has the capacity to address a broader than local market, so subparagraph 360-40(1)(e)(iv) is satisfied for the period x XX 20XX to x XX 20YY.

Competitive advantages - subparagraph 360-40(1)(e)(v) ITAA 1997

92.        In applying the requirements of subparagraph 360-40(1)(e)(v), Company A must demonstrate that it has potential to be able to have competitive advantage for that business.

93.        Company A business model focuses on solving pain points arising from particular product offerings by competitors in the market. The two innovations as described above aim to provide a differential advantage over Company A's competitors as follows:

The automated integrated process (Process)

a)       Company A's Process increases convenience and ease to customers by providing their products through IT infrastructure developed with front end processes, and automated technology used to source and integrate the necessary information.

b)       This means that minimal customer time and effort is required.

The innovative business process product requiring significant lower deposit (Product)

a)       Company A has identified that competitors offer similar products that require 100% cash deposits. Company A's Product offering only requires a 10% deposit.

b)       This allows the freeing up of working capital and makes it easier for customers to source funds.

94.    Additionally, Company A has a competitive advantage with the following:

a)       Niche market - Company A plans to offer a limited suite of products to a niche market. Company A will develop its product based on meeting the unique niche market customers' needs more effectively through both application process and allowing clients greater access to their working capital.

b)       XYZ experience- Company A's founders have extensive experience building a successful xyz company from the ground up.

95.    Company A has demonstrated that it has competitive advantages over its competitors, so subparagraph 360-40(1)(e)(v) is satisfied for the period x XX 20XX to x XX 20YY.

CONCLUSION FOR PRINCIPLES BASED TEST

Company A satisfies the principles based test as it has satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period x XX 20XX to x XX 20YY.

CONCLUSION

Company A meets the eligibility criteria of an ESIC under section 360-40 for the period x XX 20XX to x XX 20YY.

[1] Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.79.