Edited version of private advice

Authorisation Number: 1051903889700

Date of advice: 30 September 2021

Ruling

Subject: Early stage innovation company

Question

Does the company satisfy 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, the company is an ESIC for the period from 1 July 20XX until 30 June 20XX, or the date when its innovation has been fully developed, whichever occurs earliest.

This ruling applies for the following periods:

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The company was incorporated in Australia in the year ended 30 June 20XX and was registered in the Australian Business Register (ABR) in the year ended 30 June 20XX. The company's equity interests are not listed for quotation in the official list of any stock exchange in Australia or any foreign country.

The company does not have any 100% owned subsidiaries. The company is not part of a consolidated group nor is it planning to join a tax consolidated group.

In respect of the years ended 30 June 20XX to 30 June 20XX the company has total expenses incurred of less than $X million and total assessable income of less than $XXX.

The company designs products that take away the pain of manual and antiquated business processes for a fraction of the cost in time, resources and money. The company have released their 'innovation' for a particular industry.

The company has a primary customer market of various customers and also have a secondary customer market comprising entities who provide services to the same primary customers as the company.

The finalisation of the innovation is ongoing and is expected to take approximately a further 6 months to reach a fully viable stage. The innovation is yet to be developed for any other industry. Development of the innovation for the next industry is likely to take 12-18 months, even with substantial investment.

In relation to the activities being undertaken to commercialise the innovation it is now being tested by paying customers and is growing quickly. Research has indicated the company has a two-level target market, namely the primary market and the secondary market. The company has structured their marketing strategy in this way. The company is building their sales and service team to accommodate these main and ancillary markets with people who are subject matter experts in each area so they fully understand the clients' challenges and can provide the necessary service. The company are building their industry and marketing awareness through their marketing strategy and a specific set of actions set to achieve this strategy and goals/objectives.

Looking to the future for commercialising the company's innovations, the company's development team has commenced the initial work on the innovation for the next industry. Many industry participants have confirmed that they keenly await the completion of the innovation and wish to benefit from the massive simplification of their work that the innovation promises.

The company has already proven the potential for high growth of its innovation by being selected as a finalist for an industry award. An overseas region is showing great interest in the innovation and a subsidiary will be established shortly in that region. The subsidiary will adapt the innovation to ensure full compliance with the local regulatory regime. There is a similar interest from the other overseas regions and further subsidiaries may be established in those regions. Interested investors are researching the market and conducting other inquiries to establish the investment potential.

Projections and feedback from the industry indicate the company's innovation has potential to become an industry standard for the designated market in Australia. This is supported through the company's marketing plan in building relationships with industry participants as well as the company's awareness campaigns and association and active participation with the most influential and respected industry bodies. Once fully developed it will be the most efficient, fastest, most user-friendly and most cost-effective product available which will attract substantial usership and growth.

The innovation already demonstrates rapid expansion through the growth rate of its customers, even before any dedicated marketing has commenced. Month-over-month growth rates of customers are very promising. The company's market activity has been purposefully limited until now to testing of the innovation in the first industry. Financial projections show the number of customers will grow substantially in the coming months. There is also high growth potential by expanding internationally. The company has identified at least 25 viable, compatible and sizable additional jurisdictions whose markets' will benefit from the innovation.

The company's five year strategic growth plan is to reach profitability early in the second year and capture greater than 30% of the available Australian market by end of 20XX. The full potential of market capture is hard to determine but could viably and realistically reach in excess of 60% in Australia. Once the Australia innovation is established, and due diligence in other jurisdictions is complete, the growth strategy is to expand the innovation into international countries/jurisdictions as soon as feasible. The innovation has been developed specifically with this international compatibility and capability as a goal. The company's growth plan will see the company duplicating and scaling the innovation to overseas countries/jurisdictions. This is reasonably expected to provide for an exponential growth and earnings potential. The company's 3-5 year growth strategy will see other innovations being developed.

The innovation presently being developed by the company for the next industry, will likewise address global markets after it has been successfully proven in the Australian market. The next industry is an immense market to address, with unlimited potential. The projections are still work in progress.

Innovations like the company's innovation have extremely high net profit margins. There is no problem with scaling up because the innovation will cope with any demand. Conservative financial projections indicate significant growth of gross revenue, profit and the number of customers from year 1 to year 4.

There is no directly comparable competition that the company is currently aware of in Australia or overseas. The company considers its innovation truly unique and original by offering advantages to its customers that they cannot obtain elsewhere. None of the traditional options allow the flexibility the innovation provides. The company's innovation is a completely new and unique advantage for its users in financial costs, efficiency and time.

The company is unaware of any imitators but recognizes this threat that may arise at any time. To retain its 'first mover' advantage the company must grow very fast and is implementing its strategy to amply fund this critical expansion. By setting up subsidiaries in country after country, and making them self-funding, the company is confident that it will be able to hold its ground as the leader. The company's innovation is very complex and uniquely interwoven with industries that do not normally collaborate. This gives the company distinct operational advantages as well as a longer 'first mover' market advantage. It is very complex for potential imitators to determine what the company are doing.

The private ruling application forms a part of the facts.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 360-A

Income Tax Assessment Act 1997 subsection 360-40(1)

Income Tax Assessment Act 1997 paragraph 360-40(1)(a)

Income Tax Assessment Act 1997 paragraph 360-40(1)(b)

Income Tax Assessment Act 1997 paragraph 360-40(1)(c)

Income Tax Assessment Act 1997 paragraph 360-40(1)(d)

Income Tax Assessment Act 1997 paragraph 360-40(1)(e)

Income Tax Assessment Act 1997 subparagraphs 360-40(1)(e)(i) to (v)

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997 unless otherwise indicated.

Summary

The company is an ESIC for the period from 1 July 20XX until 30 June 20XX, or the date when its innovation has been fully developed, whichever occurs earliest.

Detailed reasoning

Subsection 360-40(1) outlines the criteria required for a company to qualify as an 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.

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.

Early stage test

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 (before the current year)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 test

If the company satisfies the early stage test, the company must also satisfy one of two innovation tests, the 100-point test or the principles-based test. The 100-point innovation test is an objective test and is self-assessed by the company at a time immediately after the relevant shares are issued.

For the purposes of this ruling the principles-based test is considered.

'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.

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.

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.

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 per unit.

(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 (i.e. the time immediately after the relevant shares are issued by the company) during the income years ending 30 June 20XX, 20XX, 20XX, 20XX and 20XX.

Current year

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

Early stage test

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

The company was incorporated in Australia in the year ended 30 June 20XX and was registered in the ABR in the year ended 30 June 20XX. The company does not have any 100% owned subsidiaries. In respect of the years ended 30 June 20XX to 30 June 20XX, the company incurred total expenses of less than $X million.

The company therefore satisfies the requirement in paragraph 360-40(1)(a) as follows:

•         In respect of the 20XX, 20XX, and 20XX income years, the company satisfies the requirement because it was incorporated in Australia within the last three income years.

•         In respect of the 20XX income year, the company satisfies the requirement because it was registered in the ABR within the last three income years. In addition, the company also satisfies the requirement in respect of the 20XX income year because it was incorporated within the last six income years and across the last three of those income years before the 20XX income yearit has incurred total expenses of less than $X million.

•         In respect of the 20XX income year, the company satisfies the requirement because the company was incorporated within the last six income years and across the last three of those income years before the 20XX income yearit has incurred total expenses of less than $X million.

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

To satisfy this requirement the company must have incurred total expenses of $1 million or less in the income year before the current year.

The company satisfies the requirement in paragraph 360-40(1)(b) for each of the income years as follows:

•         In respect of the 20XX income year, the company satisfies the requirement because the company was incorporated in the 20XX income year and therefore incurred no expenses in the prior income year (i.e. in the 20XX income year).

•         In respect of the 20XX, 20XX, 20XX and 20XX income years, the company satisfies the requirement because the company incurred total expenses of less than $X million in each income year prior to the current year (i.e. the 20XX, 20XX, 20XX and 20XX income years).

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

To satisfy this requirement the company must have derived total assessable income of $200,000 or less in the income year before the current year.

The company satisfies the requirement in paragraph 360-40(1)(b) for each of the income years as follows:

•         In respect of the 20XX income year, the company satisfies the requirement because the company was incorporated in the 20XX income year and, therefore, incurred no assessable income in the prior income year (i.e. in the 20XX income year).

•         In respect of the 20XX, 20XX, 20XX and 20XX income years, the company satisfies the requirement because derived total assessable income of less than $200,000 in in each income year prior to the current year (i.e. the 20XX, 20XX, 20XX and 20XX income years).

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

The company 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 20XX, 20XX, 20XX, 20XX and 20XX income years, as each of the requirements in paragraphs 360-40(1)(a) to (d) have been satisfied.

Principles based test

The company must meet the five requirements in paragraph 360-40(1)(e) to satisfy the principles-based test. 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 designs products that take away the pain of manual and antiquated business processes for a fraction of the cost in time, resources and money. At present the company's innovation has been developed for one chosen industry however the company's 3-5 year growth strategy will see innovations developed for other industries. There is no directly comparable product to the innovation in Australia or overseas. The company's innovation is unique and original offering advantages to its customers that they cannot obtain elsewhere. The company's innovation differentiates itself by being a complete product. This is a completely new and unique advantage for its users in financial costs, efficiency and time. The finalisation of the innovation is ongoing.

The company's addressable market includes both the Australian market and overseas markets. The company has a two-level target customer market. This includes its primary market of customers, within Australia and its secondary market of customers who provide services to the same primary customers as the company. Once the innovation is established in Australia and due diligence in other jurisdictions is complete, the growth strategy is to expand the innovation into international countries/jurisdictions as soon as feasible.

The company's market activity has been purposefully limited until now to testing of the innovation in the first industry. Financial projections show the number of customers will grow substantially in the coming months. The company is building its sales and service team to accommodate their main and ancillary markets with people who are subject matter experts in each area so they fully understand the clients' challenges and can provide the necessary service. The company are building their industry and marketing awareness through their marketing strategy and a specific set of actions set to achieve this strategy and its goals/objectives.

The company has commenced the initial work on the innovation for the next industry. Development of this innovation is likely to take 12-18 months, even with substantial investment.

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's innovation is unique and original offering advantages to its customers that they cannot obtain elsewhere. The company is genuinely focussed on developing a new innovation for a commercial purpose.

Subparagraph 360-40(1)(e)(i) will, therefore, be satisfied for the time period from 1 July 20XX until 30 June 20XX or the date when the innovation has been fully developed, whichever occurs earliest. Once the innovation has been fully developed, the company will no longer be 'developing' the product for commercialisation and subparagraph 360-40((1)(e)(i) will no longer be satisfied.

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

The company's addressable market includes both the Australian market and overseas markets. Within both the Australian market and overseas markets the company's innovation has a two-level target customer market. Projections and feedback from the industry indicate the company's innovation has potential to become an industry standard for the designated market in Australia.

The company's five year strategic growth plan is to reach profitability with the innovation early in the second year and capture greater than 30% of the available Australian market by end of 20XX. The full potential of market capture could reach in excess of 60% in Australia. There is no technical problem with scaling up because the innovation will cope with any demand. The innovation already demonstrates rapid expansion. Month-over-month customer growth rates are very promising. Conservative projections show this will grow substantially in the coming months and indicates substantial growth in the number of customers in year 1 to year 4.

Once the Australia platform is established and due diligence in other jurisdictions is complete, the growth strategy is to expand the innovation into international countries/jurisdictions as soon as feasible. The innovation has been specifically designed with this international compatibility and capability as a goal.

At present the company's innovation has been developed for one industry, however the company's 3-5 year growth strategy will see innovations for other industries which likewise address global markets after being successfully proven in the Australian market.

The company demonstrates that its innovation has the potential for high growth within a broad addressable market. Therefore, subparagraph 360-40(1)(e)(ii) will be satisfied.

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

The company's five year strategic growth plan is to reach profitability early in the second year and capture greater than 30% of the available Australian market by end of 20XX. The full potential of market capture could reach in excess of 60% in Australia. Month-over-month customer growth rates are very promising. Conservative projections show this will grow substantially in the coming months and indicates substantial growth in the number of customers in year 1 to year 4.

The company's innovation has extremely high net profit margins. Conservative financial projections indicate significant growth of gross revenue, profit and the number of customers from year 1 to year 4.

Once the innovation is established in Australia and due diligence in other jurisdictions is complete, the growth strategy is to expand the innovation into international countries/jurisdictions as soon as feasible. The innovation has been designed with this international compatibility and capability as a goal.

Given that the company's innovation will be available domestically and globally there is potential to successfully scale the business. Projections indicate increases in projected sales, revenue and profits. The company demonstrates it is able to successfully scale its business, therefore, subparagraph 360-40(1)(e)(iii) is satisfied.

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

The company's addressable market includes both Australian and overseas markets. Once the Australian innovation is established and due diligence in other jurisdictions is complete, the growth strategy is to expand the innovation into international markets.

The company's innovation also has a two-level target customer market. This includes its primary market of customers and its secondary market of customers who provide services to the same primary customers as the company.

The innovation presently being developed by the company for the next industry will also have a two-level target customer market and will likewise address global markets after it has been successfully proven in the Australian market.

The company demonstrates that its innovation has the potential for high growth within a broad addressable market. Its ultimate addressable market is Australian and international markets. the company, therefore, addresses a broader market than just the local market and is not confined to a local city, area or region. Subparagraph 360-40(1)(e)(iv) will therefore be satisfied.

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

There is no directly comparable product to the company's innovation in Australia or overseas. The innovation is unique and original offering advantages to its customers that they cannot obtain in elsewhere.

The company is unaware of any imitators but recognizes this threat that may arise at any time. To retain its 'first mover' advantage the company must grow very fast and is implementing its strategy to amply fund this critical expansion. By setting up subsidiaries in country after country, and making them self-funding, the company is confident that it will be able to hold its ground as the leader. The innovation is very complex and uniquely interwoven with industries that do not normally collaborate. This gives the company distinct operational advantages as well as a longer 'first mover' market advantage. It is very complex for potential imitators to determine what the company is doing. Selection as a finalist for an industry award also provides competitive advantage.

The company is building their sales and service team to accommodate their main and ancillary markets with people who are subject matter experts in each area. The company's marketing plan entails building relationships with industry suppliers, as well as awareness campaigns and association and active participation with the most influential and respected industry bodies.

The company has demonstrated the potential for it to have competitive advantages within the market, satisfying subparagraph 360-40(1)(e)(v).

Conclusion on principles-based test

The company satisfies the principles-based test for the period from 1 July 20XX until 30 June 20XX, or the date when its innovation has been fully developed, whichever occurs earliest.

When the company's innovation has been fully developed, the company will no longer be 'developing' the product for commercialisation and the principles-based test will no longer be satisfied.

Overall Conclusion- ESIC

The company satisfies the early stage test requirements in paragraphs 360-40(1)(a) to (d) and will satisfy the principles-based test in paragraph 360-40(1)(e) until such time that their innovation has been fully developed.

The company, therefore, satisfies the eligibility criteria for an ESIC in subsection 360-40(1) and is an ESIC for the period from 1 July 20XX until 30 June 20XX, or the date when its innovation has been fully developed, whichever occurs earliest.