Edited version of private advice

Authorisation Number: 1051878856288

Date of advice: 30 July 2021

Ruling

Subject: Early stage innovation company

Question

Does the Company meet the criteria of an Early Stage Innovation Company (ESIC) under 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 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The Company was incorporated in Australia in the 20XX income year. Its equity interests are not listed for quotation in the official list of any stock exchange.

The Company has no subsidiaries and has expenses less than $1 million in the 20XX income year, i.e. the year ended 30 June 20XX. It did not generate assessable income in the 20XX income year.

The Company was incorporated to commercialise a business performance platform (the Platform), whose intellectual property (IP) it acquired in the 20XX income year.

The Platform is a novel program that integrates management principles.

The Company has further developed the Platform since acquiring the IP.

The Company intends to target SME's both domestically and internationally.

Information provided

You have provided information in a number of documents, including:

a.    your private ruling application.

b.    Market analysis and growth potential.

c.     Competitor assessment.

d.    20XX Profit and Loss Statement.

e.    Supplementary information provided.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 360-A

Income Tax Assessment Act 1997 section 360-40

Reasons for decision

Summary

The Company meets the eligibility requirements of an ESIC under subsection 360-40(1).

Detailed reasoning

Qualifying Early Stage Innovation Company

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'

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)

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 6 income years (the latest being the current year), and across the last 3 of those income years before the current year it and its *100% subsidiaries (if any) 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).

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

'Principles-based test' - subparagraphs 360-40(1)(e)(i) to (v)

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.

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, as outlined in paragraph 360-40(1)(e) 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.

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..."[1]

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 the revenue opportunity or market demand arising from the innovation or the related business. The addressable market must be objective and realistic.

Improvements must be significant in nature to meet this requirement. 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.

The OECD Oslo Manual 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.[2]

In discussing services innovation activity, paragraph 111 of the OECD Oslo Manual states,

"Innovation activity in services also tends to be a continuous process, consisting of a series of incremental changes in products and processes. This may occasionally complicate the identification of innovations in services in terms of single events, i.e. as the implementation of a significant change in products, processes or other methods."

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."

The company must be genuinely focused 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.

'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

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.

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, 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 per unit.

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.

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.

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

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

The dictionary in section 9 of the Corporations Act 2001 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

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 20XX.

Current year

For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20XX.

Early stage test

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

As the Company was incorporated in the 20XX income year, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) is satisfied.

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

As the Company had expenses of less than $1 million in the prior income year paragraph 360-40(1)(b) is satisfied.

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

As the Company's assessable income in the prior income year was nil, paragraph 360-40(1)(c) is satisfied.

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

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

Conclusion on early stage test

The Company will satisfy the early stage test for the entire 20XX income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied.

Principles based test

Developing new or significantly improved innovations for commercialisation - subparagraph 360-40(1)(e)(i)

According to the Company 'The Innovation' is a business performance Platform that integrates best practice management principles.

The Platform's key point of differentiation is its ability to provide effective analysis and control over management behaviours/actions, a function which is not present in competitor offerings.

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

Although the Company acquired the IP from a third entity, it has further developed the Platform:

The Company is still at the pre-commercialisation phase of the development programme.

The Company intends to distribute not only direct to customers but also through platform partners. Platform partners will help the Company to establish enhanced trust and confidence with clients, in turn easing the sale process.

Conclusion on subparagraph 360-40(1)(e)(i)

The Company is genuinely focussed on developing the Platform for a commercial purpose. The Platform will be a significantly improved product compared to existing products.

Therefore subparagraph 360-40(1)(e)(i) will be satisfied for the time period from 1 July 20XX until 30 June 20XX.

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

The Platform is targeting the large addressable global SME market comprising of 100 million small businesses. Locally, the SME market is Australia's largest employer, with 2.15 million small businesses in Australia.

Through its commercialisation / marketing strategy, the Company hopes to foster widespread use of its product by distributing not only direct to customers but also through platform partners

If the commercialisation strategy is successful, this may give the Company the ability to grow its business into the large addressable global SME market.

Therefore subparagraph 360-40(1)(e)(ii) will be satisfied.

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

The Platform's ability to integrate easily with existing technology widely used in the SME market will help facilitate a seamless and speedy market take-up.

As the Company is developing a software platform it is not impacted by factors such as manufacturing capability or size of premises. Ongoing costs would not be expected to increase in a linear fashion alongside its increase in market penetration. As the number of users increases, the Platform's growth can be leveraged against already developed technology.

As a software platform, the Platform can demonstrate the potential to successfully scale up its business. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied.

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

The Company intends to target SME's both domestically and internationally. The Company believes that their holistic solution will have significant benefits and offerings that would apply to a global market.

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

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

The Company has the first mover advantage. The Company has demonstrated the potential for the Platform to have competitive advantages within the 'addressable market' satisfying subparagraph 360-40(1)(e)(v).

Conclusion on principles test

The Company satisfies the principles based test as it satisfies the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period commencing 1 July 20XX until 30 June 20XX.

Foreign Company Test

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

Conclusion

The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20XX until 30 June 20XX.

[1] See Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.76.

[2] OECD Oslo Manual, paragraph 124 and paragraph 151.