Edited version of private advice

Authorisation Number: 1051642786002

Date of advice: 13 March 2020

Ruling

Subject: Early stage innovation company

Question

Does the Company qualify as an Early Stage Innovation Company for the year ended 30 June 2018 pursuant to subsection 360-40(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

This ruling applies for the following period:

Year ended 30 June 2018

The scheme commences on:

During the year ended 30 June 2018

Relevant facts and circumstances

The Company is an Australian incorporated private company, incorporated in the year ended 30 June 2018.

The Company is not listed on any stock exchange.

The Company had income of less than $200,000 and expenses of less than $1 million in the year ended 30 June 2018.

The Company does not have any subsidiaries.

The Company is developing technology to test software on a large scale.

The Company provided information detailing the development of the technology and financial model projections depicting its expansion plan to scale its business.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 360-A

Income Tax Assessment Act 1997 section 360-40

Income Tax Assessment Act 1997 section 360-45

Reasons for decision

Subsection 360-40(1) outlines the criteria for a company to qualify as an ESIC at a particular time in an income year.

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.

Early stage test

A company qualifies as an ESIC if it satisfies the early stage test and one of two 'innovation' tests which are the 100-point innovation test or the principles-based innovation test.

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

The early stage test requirements are specified in paragraphs 360-40(1)(a) to (d) and are outlined below.

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

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:

incorporated in Australia within the last three income years (the latest being the current

year) or

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

registered in the Australian Business Register within the last three income years (the latest

being the current year).

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.

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

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

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)

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)

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

If the company satisfies the early stage test, it must also satisfy one of two innovation tests being:

1. The objective (100 point) test; or

2. The principles-based test.

The Company does not satisfy the 100 point test and seeks this Ruling in relation to the principles-based test.

'Principles-based test' - paragraph 360-40(1)(e)

To satisfy the principles-based test, the company must meet the 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.

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.

The five requirements of the principles-based test in subparagraphs 360-40(1)(e)(i) to (v) are:

(i)            the company must be genuinely focused on developing one or more new or significantly

improved innovations for commercialisation,

(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.

The five requirements in paragraph 360-40(1)(e) are outlined below.

(i) Developing new or significantly improved innovations for commercialisation

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...'

The innovation being developed by the company must either be new or significantly improved for an applicable addressable market.

The company's addressable market is identified by making a realistic and objective assessment of the company's intended market for its innovation. It includes identification of the immediately accessible market to which the innovation will initially be introduced, or a new market which may be created by the innovation. Factors in identifying the addressable market may include the location of the company's potential customers, the type of industry to be served and the geographical area it will serve. The addressable market must be objective and realistic.

A 'new' innovation means novel or introduced to the addressable market for the first time. It must be compared to the products, services, processes or methods that may or may not exist in the intended market for the innovation.

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, changes to pricing strategies or changes to goods resulting from seasonal change are examples of improvements that would not be considered significant.

The OECD Oslo Manual (paragraphs 124 and 151) defines innovations as significant changes, with the intention of distinguishing significant changes from routine minor changes. However, it is important to recognise that an innovation can also consist of a series of smaller incremental changes that together constitute a significant change.

The company must be genuinely focused on developing the 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. This requirement draws the distinction between simply having an idea and commercialising an idea.

The EM does not define the meaning of the term 'genuinely focussed' within the context of subparagraph 360-40(1)(e)(i). 'Genuine' is defined in the online Macquarie Dictionary as "Being truly such; real; authentic." 'Focus' is defined as "3. a central point, as of attraction, attention, or activity. ... 8. to concentrate; to focus one's attention." In essence, the phrase 'genuinely focussed' is looking to what the company is truly concentrating and focussing their attention on or, put another way, what is the real central point of the company's activities. That is, the central activities of the company must be truly concentrated on developing their innovation for a commercial purpose. Developing an innovation for commercialisation in relation to a new innovation refers to the process of creating that innovation, and it includes a range of activities such as proof of concept activities, market research, prototyping, pilots and user testing, and other activities to prepare for the launch of the new innovation.

(ii) High growth potential

The company must be able to demonstrate that it has the potential for high growth 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.

(iii) Scalability

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

(iv) Broader than local market

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.

(v) Competitive advantages

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 of subsection 360-40(1) to the Company

Test time

For the purposes of this ruling, the test time for determining if the Company is a qualifying ESIC will be a particular date during the income year ending 30 June 2018.

Current year

For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 2018 (the 2018 income year).

For clarity, in relation to the particular requirements within subsection 360-40(1), the last three income years will include the years ending 30 June 2018, 2017 and 2016, and the income year before the current year will be the year ending 30 June 2017 (the 2017 income year).

Early stage test

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

The Company was incorporated within the last three income years, therefore paragraph 360-40(1)(a) is satisfied.

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

The Company was incorporated in the 2018 income year and does not have any subsidiaries. The Company incurred expenses of less than $1 million in the prior income year (i.e. the 2017 income year). Paragraph 360-40(1)(b) is satisfied.

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

The Company was incorporated in the 2018 income year and had no assessable income in the prior income year. It has no subsidiaries. Paragraph 360-40(1)(c) is satisfied.

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

The Company is privately owned and is not listed on any stock exchange in Australia or a foreign country, therefore paragraph 360-40(1)(d) is satisfied.

Conclusion on early stage test

The Company satisfies the early stage test for the 2018 income year, as each of the requirements in paragraphs 360-40(1)(a) to (d) have been satisfied.

100-point test

The Company has not provided evidence of satisfying the 100-point test under section 360-45 for the year ending 30 June 2018. For it to be a qualifying ESIC it will therefore need to satisfy the principles-based test.

Principles-based test

To satisfy the principles-based test, Machine QA must meet the five requirements in paragraph 360-40(1)(e). Each of these is discussed below.

Genuinely focussed on developing new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i)

The Company's plan is to develop a computer-based mechanism to test software on a large scale to provide a wide range of quality assurance services to the local technology and games industry.

The Company intends to include an internally developed automated testing suite within the computer-based mechanism.

As no other known competitors have incorporated automated testing as part of their QA services the first to successfully commercialise automated testing will introduce a new innovation into the market.

Should the Company be the first to bring an automated testing process to market they will be introducing an improvement to the expensive and time consuming manual testing/labour process.

The Company hopes its computer-based mechanism will be successful in Australia, and, if so, the potential is there to expand internationally. The Company has demonstrated that it has taken tangible steps to identify a gap in the market, to create an innovative product to fill the gap in the market and to commercialise the innovation to generate revenue. The Company is genuinely focussed on developing its computer-based mechanism which includes the development of a significantly improved process for a commercial purpose. Subparagraph 360-40(1)(e)(i) is satisfied.

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

The Company's market includes the game development industry in Australia with potential for expansion into markets overseas.

The game development industry is bigger than the film industry worldwide and testing is required when each game is being developed.

Should they successfully develop a reliable automated system then the cost and time savings over manual testing should result in enough game developers choosing the Company over other providers to achieve high growth.

Therefore, subparagraph 360-40(1)(e)(iii) is satisfied.

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

The Company's innovation relates to developing a computer-based mechanism to test software on a large scale which if successful in Australia's technology and games industry, could quite easily be adapted for expansion into overseas markets.

By removing the need for manual testing the Company's revenue can increase without having to increase employment costs, allowing it to leverage the development costs against the costs of maintaining the computer-based mechanism.

Subparagraphs 360-40(1)(e)(iii) and (iv) will be satisfied.

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

The Company will initially apply the technology to limited markets in Australia and will then expand to further markets in Australia.

The Company intends to eventually gain global market presence.

The Company has demonstrated the potential to address a broader market than just the local market. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied.

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

The computer-based mechanism being developed is a new innovation for the local technology and games industry. The innovation is 'new' because there are no other known competitors providing these particular improvements to an App of this nature in the local technology and games industry.

The first to successfully commercialise a computer-based mechanism that incorporates an automated testing process will have an advantage over those who test manually.

Should that be the Company then they will have that first mover advantage and therefore demonstrated the potential for it to have competitive advantages within the market, satisfying subparagraph 360-40(1)(e)(v).

Conclusion on principles test

The Company satisfies the principles-based test because it satisfies the requirements in subsection 360-40(1)(e) for the period commencing 1 July 2017 until 30 June 2018.