Edited version of private advice

Authorisation Number: 1051941792575

Date of advice: 21 January 2022

Ruling

Subject: Early stage innovation company

Question

Does THE COMPANY satisfy the requirements for qualifying early stage innovation companies (ESICs) contained in section 360-40 of the Income Tax Assessment Act 1997 to enable eligible investors that acquire newly issued shares in the company to receive the tax offset and capital gains tax exemption provided by Subdivision 360-A?

Answer

Yes

This ruling applies for the following period:

1 July 20XX to 30 June 20XY

Relevant facts and circumstances

1.            THE COMPANY is a proprietary company incorporated in Australia.

2.            The four individual founders are also the directors and shareholders of the company. All four are Australian residents.

3.            THE COMPANY's equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country, and will not be listed prior to 30 June 20XY.

4.            THE COMPANY is not part of a tax consolidated group.

5.            THE COMPANY is a start-up company in the early stages of a program designed to establish a new platform, called 'The Product', to advertise a product for sale.

6.            The company's goal is to materially improve the process of advertising and selling discreetly, reducing costs associated with both selling and acquiring assets, creating more sales volume and removing barriers for purchasers.

7.            THE COMPANY will generate income from subscription fees.

8.            THE COMPANY will be seeking equity investment to fund its design, implementation, and commercialisation program.

9.            User testing and App store verification was undertaken. The App was launched on Apple and Android App Stores. Roll-out in local markets has occurred, broader roll-out is yet to occur.

10.         THE COMPANY's priority is to successfully commercialise the model in the Australian market after which it plans to address a broader market overseas.

Information provided

11.         You have provided a number of documents containing detailed information in relation to THE COMPANY's product, we have referred to the relevant information within these documents in applying the relevant tests to your circumstances. These documents include:

•           Private Binding Ruling ('PBR') Application.

-       ASIC Certificate of Registration of a Company

-       Company Profile

•           Response to further questions

-       Draft Accounts

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

Reasons for decision

All legislative references in the reasoning section are to the Income Tax Assessment Act 1997 unless otherwise stated.

Qualifying Early Stage Innovation Company

12.         Subsection 360-40(1) of the ITAA 1997 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', and is the time immediately after the relevant shares are issued in the year (subsection 360-15(1)).

13.         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

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

15.         To meet the requirement in paragraph 360-40(1)(a), at the test time 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).

16.         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.

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

18.         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.

19.         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.

20.         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.

THE 'INNOVATION' TESTS

21.         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.

The '100 point test' - paragraph 360-40(1)(e) and section 360-45

22.         Section 360-45 of the ITAA 1997 sets out various innovation criteria with point values assigned to each criteria. To satisfy the '100 point test' in paragraph 360-40(1)(e), the company must have at least 100 points under section 360-45. If a company satisfies this test it does not need to satisfy the principles-based test.

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

23.         To satisfy the 'principles-based test', the company must meet five requirements provided in subparagraphs 360-40(1)(e)(i) to (v), these are outlined below:

            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.

24.         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.

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

25.         In relation to the definition of innovation 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:

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...

26.         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 from the business relating to the innovation. The addressable market must be objective and realistic (EM paragraph 1.79).

27.         '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 making minor changes, such as updates to existing equipment or software, changes to pricing strategies or seasonal changes to goods are examples of improvements that would not be considered significant (EM, paragraph 1.80).

28.         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."

29.         The company must be genuinely focussed on developing the innovation for commercialisation - 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. The central activities of the company must be truly concentrated on developing their innovation for commercialisation. '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)

30.         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 is distinct from typical small to medium enterprises such as cafes, local retail stores, local service providers that service a single local market. The addressable market for the innovation, within which the company can expand, must be broad (EM, paragraph 1.82).

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

31.         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 its existing revenues can be multiplied with a reduced or minimal increase in operating costs as it increases its market share or enters into new markets (EM, paragraph 1.83).

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

32.         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 national, multinational or global scale in the future (EM, paragraph 1.84).

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

33.         The company must be able to demonstrate that it has the potential to have competitive advantages for the business related to the innovation. Competitive advantages are conditions or circumstance that puts a company, when compared with its competition, in a favourable or advantageous business position, 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.

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

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

RELEVANT TIMES FOR THE PURPOSE OF THIS RULING

35.         For the purposes of this ruling and determining if THE COMPANY is a qualifying ESIC:

•         the 'test time' is the time immediately after the issue of qualifying shares on a particular date or dates after 1 July 20XX and on or before 30 June 20XY.

•         the 'current year' is the year ending 30 June 20XY (the 20XY income year).

•         the 'last 3 income years' will be the years ending 30 June 20XY, 20XX and 20XZ, and

•         the 'income year before the current year' will be the year ending 30 June 20XX (the 20XX income year).

THE 'EARLY STAGE TEST' - PARAGRAPHS 360-40(1)(a) - (d) ITAA 1997

36.         The facts show that THE COMPANY:

a)    Was incorporated in Australia within the last 3 years (including the current year);

b)    In the 20XX year, being the year before the current year, incurred expenses of less than the maximum $1 million;

c)    In the 20XX year, being the year before the current year, earned less than maximum $200,000; and

d)    Was not listed on either the Australian or any overseas stock exchange.

37.         THE COMPANY satisfies the early stage test for the relevant test time, as each of the requirements within paragraphs 360-40(1)(a) to (d) of the ITAA 1997 have been satisfied for the period 1 July 20XX to 30 June 20XY.

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

38.         THE COMPANY has not provided sufficient evidence of satisfying the '100 point test' in section 360-45 of the ITAA 1997 for the year ending 30 June 20XY. THE COMPANY are electing to seek eligibility by satisfying the 'principles-based' test under paragraphs 360-40(1)(e)(i)-(v).

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

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

39.         In applying the requirements of subparagraph 360-40(1)(e)(i), THE COMPANY must be developing an innovation which is either new or significantly improved for an applicable addressable market. THE COMPANY must be genuinely focussed on developing an innovation for a commercial purpose in order to generate economic value and revenue for the company.

40.         THE COMPANY's innovation is in developing a digital platform to enable the marketing of assets with discretion. This product will retain the level of discretion required by the vendor and make knowledge of these assets widely accessible to purchasers, hence increasing sales volumes for this method of sale.

41.         THE COMPANY's innovation is also an improvement on the traditional marketing platforms currently available in Australia, which do not meet the needs of discreet sale.

42.         The Product platform will be available on a subscription basis.

43.         THE COMPANY will initially roll out their product to the local market, then the rest of the city and subsequently the rest of Australia.

44.         Considerable development has already been undertaken by THE COMPANY in developing The Product.

45.         User testing and App store verification was undertaken. The App was launched on Apple and Android App Stores. Live listing and buyer roll-out in local markets. A broader roll-out is expected in future.

46.         THE COMPANY is genuinely focussed on developing an innovation which is significantly improved for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the period 1 July 20XX to 30 June 20XY, or the date when the Product has been fully developed and is ready for client use, whichever occurs earlier. Once the Product 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) ITAA 1997

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

48.         THE COMPANY has extremely high growth potential as the Product will initially be available in Australia but can be expanded into global markets.

49.         In addition to growth potential in expanding the geographic market, the Product aims to increase sales volume in Australia. Greater sales volume in this market will attract more subscriptions to the platform.

50.         THE COMPANY has demonstrated a high growth potential for their product, so subparagraph 360-40(1)(e)(ii) is satisfied for the period 1 July 20XX to 30 June 20XY.

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

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

52.         THE COMPANY's product is a software product, naturally allowing for rapid scaling.

53.         Provided the Product is successful in Australia, it will be scaled to foreign markets that operate similarly to Australia. The ability to scale up the business to include national and international markets can be done without large increases in operating costs as the product is digital and does not require a physical presence in the market in which it operates.

54.         This demonstrates THE COMPANY has the potential to successfully scale up its business, so subparagraph 360-40(1)(e)(iii) is satisfied for the period 1 July 20XX to 30 June 20XY.

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

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

56.         The Product will be initially be rolled out to the local market. A broader roll out across the city will occur before the service is rolled out across Australia. Although laws and guidelines are state based in Australia, they run in a similar manner to one another. The Product is able to be rolled out across Australia as its features will apply across the country.

57.         There are a number of foreign countries in which the market operates in a similar manner to Australia. The Product can also be rolled out to these countries with minor changes made to the platform to accommodate jurisdictional differences.

58.         THE COMPANY 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 1 July 20XX to 30 June 20XY.

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

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

60.         THE COMPANY will operate a business model that offers competitive advantage over traditional advertising services as it is catering specifically to the needs of that market, which is not a service currently offered on other platforms.

61.         The features of the Product will reduce the cost to vendors to advertise assets. The Product will also avoid costs potential purchasers incur. This cost reduction will also be a competitive advantage to THE COMPANY.

62.         THE COMPANY has demonstrated that it has competitive advantages over its competitors, so subparagraph 360-40(1)(e)(v) is satisfied for the period 1 July 20XX to 30 June 20XY.

CONCLUSION FOR PRINCIPLES-BASED TEST

63.         THE COMPANY satisfies the principles-based test as it has satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period 1 July 20XX to 30 June 20XY, or the date when the Product has been fully developed and is ready for client use, whichever occurs earlier.

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

64.         As THE COMPANY was incorporated in Australia, it is not a Foreign Company and paragraph 360-40(1)(f) is satisfied for the period 1 July 20XX to 30 June 20XY.

CONCLUSION

65.         Based on the ruling facts, THE COMPANY meets the eligibility criteria of an ESIC under section 360-40 for the period 1 July 20XX to 30 June 20XY, or the date when the Product has been fully developed and is ready for client use, whichever occurs earlier.