Edited version of private advice

Authorisation Number: 1051846291202

Date of advice: 31 May 2021

Subject: Qualifying early stage innovation company

RULING

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') for the period x XX 20XX to y YY 20YY?

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 proprietary company incorporated in XYZ on x YY 20XX.

2.      Company A's director is Taxpayer A.

3.      Company A's registered office and principal place of business is situated at XYZ.

4.      Company A is a privately held company consisting of a single entity.

5.      For the financial year ending x XX 20XX (the previous income year), Company A incurred and earned the following:

•           Total expenses of $xyz

•           Total income of $xyz

6.      Company A's equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country.

7.      Company A is developing a software platform called AAA - their focus is on assisting companies to perform certain procedures.

8.      Company A is developing four (4) Products:

•           Product 1

•           Product 2

•           Product 3

•           Product 4

9.      Company A is also developing three (3) Processes:

•           Process 1

•           Process 2

•           Process 3

10.   Company A's core Products and Processes will enable the assessment of specific criteria automatically so that companies can better perform certain procedures.

11.   Company A is developing their Products and Processes to address a number of discrete markets and is continuing to develop their Product and Processes into the current financial year.

12.   Company A will aim to establish the brand within Australia, and by gaining strong traction in the Australian market during 20XX, Company A intends to expand overseas into key markets.

13.   Company A's Products and Processes have been identified as having an international addressable market.

14.   Company A owns all their intellectual property ('IP') and does not licence it to anyone.

15.   Company A submitted an ESIC Company Report on x XX 20XX, which detailed the shares in Company A which were issued to x investors on y YY 20XX (the 'test time'). Company A had self-assessed as an ESIC entity for that financial year.

Information provided

16.   Company A has provided a number of documents containing detailed information in relation to Company A's Products and Processes, including:

•           Private Binding Ruling ('PBR') Application, dated x XX 20XX, submitted on y YY 20YY

•           Various documents including Marketing Plan, Financial Statements, Shareholders' Agreement, Company Plan

•           Response to further questions provided

•           Responses to various emails

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

18.   Company A has issued new shares to various investors in XX 20XX to assist in funding the continued development and commercialisation of their Product/Processes.

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

19.   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'

20.   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)

21.   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 before the current year, 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).

22.   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.

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

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

24.   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)

25.   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)

26.   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'

27.   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

28.   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 (v)

29.   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.

30.   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.

31.   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 - subparagraph 360-40(1)(e)(i) ITAA 1997

32.   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..."

33.   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.

34.   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.

35.   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."

36.   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.

37.   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 - subparagraph 360-40(1)(e)(ii) ITAA 1997

38.   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 - subparagraph 360-40(1)(e)(iii) ITAA 1997

39.   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, whereas 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 - subparagraph 360-40(1)(e)(iv) ITAA 1997

40.   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 - subparagraph 360-40(1)(e)(v) ITAA 1997

41.   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.

Foreign Company test - paragraph 360-40(1)(f)

42.   At the test time, the company must not be a foreign company within the meaning of the Corporations Act 2001 (Cth).

43.   The dictionary in section 9 of the Corporations Act 2001 (Cth) defines a foreign company to mean:

(a) a body corporate that is incorporated in an external Territory, or outside Australia and the external Territories, and is not:

(i) a corporation sole; or

(ii) an exempt public authority; or

(b) an unincorporated body that:

(i) is formed in an external Territory or outside Australia and the external Territories; and

(ii) under the law of its place of formation, may sue or be sued, or may hold property in the name of its secretary or of an officer of the body duly appointed for that purpose; and

(iii) does not have its head office or principal place of business in Australia.

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, will be upon the issue of qualifying shares on a particular date or dates on or after x XX 20XX, and on or before y YY 20YY.

Current year

45.   Therefore, for the purposes of subsection 360-40(1) ITAA 1997, the current year will be the year ending y YY 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 y YY 20YY, 20XX and 20ZZ, and the income year before the current year will be the year ending y YY 20YY (the 20YY 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 incorporated in Australia on y YY 20YY, which is within the 3 income years outlined above, therefore the requirements of subparagraph 360-40(1)(a)(i) 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 2019 income year, being the income year before the current year.

48.   Company A incurred total expenses of $xyz in the 20YY 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% owned subsidiaries must have derived total assessable income of $200,000 or less in the 20YY income year, being the income year before the current year.

50.   Company A did not earn any assessable income in the 20YY 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 y YY 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 is developing a software platform called AAA - their focus is on assisting companies to perform certain procedures.

57.   Company A is developing four (4) Products:

•           Product 1. There is no such existing platform in the world.

•           Product 2

•           Product 3

•           Product 4

58.   Company A is also developing three (3) Processes:

•           Process 1

•           Process 2

•           Process 3

59.   Company A is developing their Products and Processes to address a number of discrete markets and is continuing their development into the current financial year.

60.   Company A is genuinely focussed on developing their Products and Processes, for an applicable addressable market, so subparagraph 360-40(1)(e)(i) is satisfied for the period x XX 20XX to y YY 20YY.

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

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

62.   Company A has a commercialisation focus - Company A has released a first version of AAA during XX 20XX. There have been more than x subsequent releases, all with iterative improvements based on feedback from customers, potential customers and candidates.

63.   Company A has raised a seed round of $xyz AUD during YY 20YY from experienced angel investors.

64.   Company A has conducted extensive market research, meeting with potential buyers from numerous target companies.

65.   There are a number of steps which are required to be completed into the future, before the Products and Processes are considered to be fully developed for commercialisation.

66.   Company A anticipates that the current programme of development will be completed in the 20VV financial year.

67.   Company A is genuinely focussed on developing their Products and Processes, for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the period x XX 20XX to y YY 20YY, or the date when their Products and Processes have been fully developed and are ready for client use, whichever occurs earlier. Once the Products and Processes have been fully developed, Company A will no longer be 'developing' the products and processes for commercialisation and subparagraph 360-40((1)(e)(i) will no longer be satisfied.

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

68.   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.

69.   There are several fundamental drivers of Company A's high growth potential:

•           There are a significant number of analytics professional roles.

•           The number of analytics professional roles is growing rapidly.

•           There are no known direct competitors in any country in the world.

70.   Company A has demonstrated a high growth potential for their Products and Processes, so subparagraph 360-40(1)(e)(ii) is satisfied for the period x XX 20XX to y YY 20YY.

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

71.   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.

72.   Company A's model is fundamentally scalable for the following reasons:

•           The main costs of AAA are the fixed costs of the development of the software, and the creation of the content.

73.   AAA's model also has network effects.

74.   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 y YY 20YY.

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

75.   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.

76.   Company A's platform has the potential to address a global market as:

•           The problem space exists in all countries.

•           There are no direct competitors anywhere in the world.

77.   The Executive team has proven experience and will consist of the following fulltime staff:

78.   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 y YY 20YY.

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

79.   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.

80.   In addition to Product and Process innovations, there are several other underlying sources of competitive advantage:

•           Company A's founder has strong domain expertise.

•           Company A has a strong set of angel investors.

•           Company A has a team of analytics experts who create and peer review each other's content.

•           Company A's Chief Technology Officer has expertise in scaling technology and product teams.

81.   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 y YY 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 y YY 20YY, or the date when their Products and Processes have been fully developed and are ready for client use, whichever occurs earlier.

Foreign Company Test - subparagraph 360-40(1)(f) ITAA 1997

82.   As Company A was incorporated in Australia, it is not a Foreign Company and paragraph 360-40(1)(f) is satisfied.

CONCLUSION

Company A meets the eligibility criteria of an ESIC under section 360-40 for the period x XX 20XX to y YY 20YY, or the date when their Products and Processes have been fully developed and are ready for client use, whichever occurs earlier.

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