Edited version of private advice

Authorisation Number: 1051988264963

Date of advice: 14 July 2022

Ruling

Subject: Technology early stage innovation company

Question:

Does Company A meet the criteria of an Early Stage Innovation Company (ESIC) under subsection 360-40(1) of the Income Tax Assessment Act 1997 ('ITAA 1997') for the period XX XXX 20XX to XX XXX 20XX?

Answer:

Yes

This ruling applies for the following periods

XX XXX 20XX to XX XXX 20XX

The Scheme commences on

XX XXX 20XX

Background information

Company A is a proprietary company incorporated in XYZ on XX XXX 20XX.

Company A's directors are Taxpayer A and Taxpayer B.

Company A's registered office is situated at XXX.

Company A's principal place of business is situated at XXX.

Company A has no wholly or partly owned subsidiaries, and is not part of an income tax consolidated group.

For the financial year ending XX XXX 20XX, Company A incurred and earned the following:

•           Total expenses of $XX

•           Total income of $XX

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.

Development of technology

Company A is developing a technology (the 'Product') to classify various products at various points through the supply chain. The aim of this technology is to replace subjective inspections carried out by people, with objective testing driven by the artificial intelligence of their technology.

This technology is designed to be used on a software as a service basis, with minimal hardware requirements, allowing it to be used at all points in the supply chain.

There is no existing technology which can be applied to this particular industry in a cost effective manner. Currently, the grading of various products is carried out through a visual inspection carried out by people. This inspection is subjective, dependant on the skill and judgement of the inspector, resulting in inconsistency of results.

Company A 's technology uses a small amount of hardware and is intended to be used at all points within the supply chain.

Company A intends to offer its technology on a software as a service basis, with tiered subscriptions, which will include the lease of proprietary hardware. This significantly reduces the capital expenditure requirements for users.

The hardware component used with Company A's technology will be leased to users as part of their subscription to the technology, significantly reducing the users' capital commitment when compared to other products being developed.

The technology is intended to be used for a wide variety of products.

Company A's technology also has potential use for grading other products.

Currently, this hardware costs a fraction of the selling price of existing competitor products and will reduce in cost once commercial production commences.

Commercialisation strategy

Company A has significant industry networks and is collaborating with members of the supply chain to gain input and feedback on product development, with the aim of being able to commercialise the technology.

As well as collaborating with industry partners in Australia, Company A has established professional networks with another 2 international companies.

Company A is developing their technology to address a number of discrete markets and is continuing to develop their technology, which has been identified as having an international addressable market.

Information provided

You have provided a number of documents containing detailed information in relation to Company A's Product, including:

•           Private Binding Ruling ('PBR') Application, dated XX XXX 20XX

•           Response to further questions provided

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

You are currently in discussions with potential investors and propose to issue new shares in Company A to assist in funding the continued development and commercialisation of the Product.

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 are to the Income Tax Assessment Act 1997 ('ITAA 1997') unless otherwise stated.

SUMMARY

Company A meets the eligibility requirements of an ESIC under subsection 360-40(1) for the period XX XXX 20XX to XX XXX 20XX.

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 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 any 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).

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 any 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 any 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.

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

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)

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 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

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.[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.

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.

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 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.

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

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

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

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

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 (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

TEST TIME

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 XX XXX 20XX, and on or before XX XXX 20XX.

Current year

Therefore, for the purposes of subsection 360-40(1) ITAA 1997, the current year will be the year ending XX XXX 20XX (the 20XX income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last 3 income years will include the years ending XX XXX 20XX, 20XX and 20XX, and the income year before the current year will be the year ending XX XXX 20XX (the 20XX income year).

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

Incorporation or Registration - paragraph 360-40(1)(a) ITAA 1997

Company A was incorporated in XYZ on XX XXX 20XX, 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

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 20XX income year, being the income year before the current year.

Company A incurred expenses of $XX in the 20XX income year. Consequently, paragraph 360-40(1)(b) is satisfied.

Assessable income - paragraph 360-40(1)(c) ITAA 1997

In applying the requirements of paragraph 360-40(1)(c), Company A and any of its 100% subsidiaries must have derived total assessable income of $200,000 or less in the 20XX income year, being the income year before the current year.

Company A earned assessable income of $XX in the 20XX income year. Consequently, paragraph 360-40(1)(c) is satisfied.

No Stock Exchange listing - paragraph 360-40(1)(d) ITAA 1997

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.

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

Company A satisfies the early stage test for the 20XX 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

Company A has not provided sufficient evidence of satisfying the 100 point test under section 360-45 for the year ending XX XXX 20XX. 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

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.

Company A is developing a technology (the 'Product') to classify various products at various points through the supply chain. The aim of this technology is to replace subjective inspections carried out by people, with objective testing driven by the artificial intelligence of their technology.

This technology is designed to be used on a software as a service basis, with minimal hardware requirements, allowing it to be used at all points in the supply chain.

There is no existing technology which can be applied to this particular industry in a cost effective manner. Currently, the grading of these products is carried out through a visual inspection carried out by people. This inspection is subjective, dependant on the skill and judgement of the inspector, resulting in inconsistency of results.

Company A's technology uses a small amount of hardware and is intended to be used at all points within the supply chain.

Company A intends to offer its technology on a software as a service basis, with tiered subscriptions, which will include the lease of proprietary hardware. This significantly reduces the capital expenditure requirements for users.

The hardware component used with Company A's technology will be leased to users as part of their subscription to the technology, significantly reducing the users' capital commitment when compared to other products being developed.

Company A's technology also has potential use for grading other products.

Currently, this hardware costs a fraction of the selling price of existing competitor products and will reduce in cost once commercial production commences.

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

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.

Company A has significant industry networks and is collaborating with members of the supply chain to gain input and feedback on product development, with the aim of being able to commercialise the technology.

As well as collaborating with industry partners in Australia, Company A has established professional networks with two international companies, allowing access to the large global market.

Company A is developing their technology to address a number of discrete markets and is continuing to develop their technology, which has been identified as having an international addressable market.

The shareholders of Company A have been developing the novel algorithm since XX XXX 20XX. The scope was then expanded to include custom hardware in XX XXX 20XX. The development of the algorithm and hardware was then transferred to Company A upon its incorporation in XX XXX 20XX.

In XX XXX 20XX, the software interface Minimal Viable Product ('MVP') commenced.

There are a number of steps which are required to be completed into the future, before the Product is considered to be fully developed for commercialisation.

Company A is currently finalising the MVP to commence initial laboratory trials with a particular product classification. The laboratory trial will be used to build up the accuracy of the artificial intelligence model, and to refine the prototype hardware and software where necessary.

This process will include feedback from our target customers to ensure 'product market fit'. This will then lead to a commercial trial as per the Development Plan. Customer surveys and feedback sessions will be undertaken at this time to ensure the user interface ('UI') offers the core functions valuable to our target market.

Company A will consider its product to be fully developed when it is released for full commercial use. Currently, the Australian commercial release of the Type X module is expected to occur in the first quarter of the year ended XX XXX 20XX, followed by the Type Y module in the fourth quarter of that year.

Following the release of each module in Australia, the technology will be tailored for international settings.

The objective is to train the model to an accuracy of greater than 98% for each commodity group.

Company A is genuinely focussed on developing their technology for a commercial purpose, so subparagraph 360-40(1)(e)(i) is satisfied for the period XX XXX 20XX to XX XXX 20XX, or the date when their technology has been fully developed and is ready for client use, whichever occurs earlier. Once the technology has been fully developed, Company A will no longer be 'developing' the technology for commercialisation.

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

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.

Company A has high growth potential as their technology is easily and infinitely scalable to a global audience.

Currently there are approximately X million tests carried out in Australia each year to grade particular commodities at various points in the supply chain. When other overseas countries are included, this figure increases to XX million tests per annum.

Company A has significant industry networks and is collaborating with organisations at various levels in the supply chain, both in Australian and overseas. This collaboration not only assists with the development of the technology, it will also provide access to the market.

Additional expansion will be possible into other overseas countries.

Company A has demonstrated a high growth potential for their technology, so subparagraph 360-40(1)(e)(ii) is satisfied for the period XX XXX 20XX to XX XXX 20XX.

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

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.

The directors of Company A have significant experience in business, and the particular commodity sectors.

Company A has significant industry networks and is collaborating with members of the supply chain to gain input and feedback on product development.

Company A's technology is to be offered on the basis of a software as a service, which will be hosted in the cloud. New subscribers to the software can be added without a significant increase in running costs.

Cloud hosting costs will increase as the number of subscribers increase, but through economies of scale, the hosting costs per subscriber will decrease.

The hardware component will be leased to subscribers as part of their subscription.

The prototypes of this hardware have been constructed using single components purchased at full retail price. Once commercial production commences, these components will be purchased in bulk at wholesale rates, significantly reducing their costs.

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 XX XXX 20XX to XX XXX 20XX.

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

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.

The grading of particular commodities is a worldwide issue, with no widely available alternatives to the visual inspections. As noted above, XX million tests are carried out in Australia and overseas. Based on this, the potential market is large.

Company A has identified potential users of their technology at various points in the supply chain.

The directors of Company A have significant experience in the business, and related industries, and have established a network of contacts with many of the potential users in Australia.

Company A also have established professional networks with two international companies, which will provide an entry point into the overseas market.

Company A have reviewed the grading standards which apply in the overseas markets, as well as those which apply in Australia. The software used for the AI will include the relevant standards for the user's local market.

The AI will be trained to recognise the varieties of those commodities grown in each market.

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 XX XXX 20XX to XX XXX 20XX.

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

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.

Company A 's technology is designed to be applied at all points in the supply chain, unlike the products being developed by other competitors.

The hardware used as part of Company A's technology is significantly cheaper than that used by competitors, with costs expected to further reduce, once commercial production commences.

By offering its technology on a software as a service basis, with the related hardware included in the subscription, the capital cost to users will be significantly less than the products being developed by Company A's competitors.

Company A has demonstrated that it has competitive advantages for its business, so subparagraph 360-40(1)(e)(v) is satisfied for the period XX XXX 20XX to XX XXX 20XX.

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 XX XXX 20XX to XX XXX 20XX, or the date when their technology has been fully developed and is ready for client use, whichever occurs earlier.

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

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 XX XXX 20XX to XX XXX 20XX, or the date when their technology has been fully developed and is ready for client use, whichever occurs earlier.

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