Edited version of private advice

Authorisation Number: 1052020948701

Date of advice: 10 November 2022

Ruling

Subject: Early stage innovation company

Question

Does X meet the criteria of an Early Stage Innovation Company (ESIC) under subsection 360-40(1)?

Answer

Yes.

This ruling applies for the following period:

Year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

1.     X was incorporated in Australia on date X. Its equity interests are not listed for quotation in the official list of any stock exchange.

2.     X has no subsidiaries.

3.     X had expenses of less than $1 million and assessable income of less than $200,000 in the previous income year (i.e. the year ended 30 June 20XX).

4.     X does not own any intellectual property for the year ended 30 June 20XX.

5.     X's goal is to provide a shopping app ('the app').

6.     The app's main income streams are freemium member subscription, affiliate and cashback commissions, a platform fee for brands, and advertising fees. X has identified its ultimate market as being the global market, with its initial target being Australian markets.

7.     In addition to the above, X have highlighted their key differentiator as development of financial technology, being planned payment options to be supported by the app. This development of financial technology is intended to add to the competitive advantage of the app.

8.     X has identified its addressable market as similar to other major platforms with potential to attract a comparable number of users.

9.     X launched version 1 of the app in date X.

10.  X continues to develop the app for greater commercialisation through market and consumer research.

11.  X's commercialisation strategy has been developed to focus on achieving key objectives under several themes which relate to consumers, merchants, markets, partnerships, and category penetration. These have been laid out against a 36-month timeframe.

12.  X's Product Roadmap is designed to achieve high growth potential by expanding into new markets and product categories.

13.  X's Financial Plan and International Product Rollout Snapshot provides projections that demonstrate progressively higher profitability in subsequent financial years that increasingly exceed projected expenses.

Information provided

14. You have provided information in a number of documents and phone conversations in relation to the app, including:

a.     your private ruling application dated X.

b.     our emails with X from date X.

c.     supplementary information provided on date X.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 360-40

Reasons for decision

Qualifying Early Stage Innovation Company

1. 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'

2. 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)

3.      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).

4.      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.

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

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

6. 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)

7. 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)

8. 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

9. 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 (iv)

10.   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.

11.   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. 12. 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

13.       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] "

14.       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.

15.       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.

16.       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.

17.       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."

18.       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."

19.       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.

20.       '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

21. 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

22. 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.

Broader than local market

23. 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

24. 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)

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

26.   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

27. For the purposes of this ruling, the test time for determining if X is a qualifying ESIC will be a particular date during the income year starting 1 July 20XX and ending 30 June 20XX.

Current year

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

Early stage test

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

29. As X was registered as a company on date X, which is within the last 3 income years, subparagraph 36040(1)(a)(i) is satisfied.

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

30.   For the income year ended 30 June 2021, X's expenditure totalled $X.

31.   As X had expenses of $1 million or less in the prior income year (the year ending 30 June 20XX (ie, the 20XX income year)), paragraph 360-40(1)(b) is satisfied.

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

32. As X's assessable income in the prior income year (the 20XX income year) is $200,000 or less, paragraph 360-40(1)(c) is satisfied.

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

33. As X 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

34. X 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 36040(1)(e)(i)

35.   According to X, the app is the shopping app platform. Although it will initially be targeted at the Australian market, the app has been identified as having a wider global addressable market.

36.   While there are many shopping apps, the proposed payment methods to be developed in future would constitute a significant improvement. A 'significant improvement' in relation to a software product may include development that significantly increases the software's functionality. Development of this app to support these payment methods will result in a substantial improvement in the functional characteristic of the platform. Such an improvement is classified as a product innovation.

37.   It appears that the app will be one of the first to offer such a product.

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

38.   X launched version 1 of the app on date X but continues to develop the app for greater commercialisation.

39.   X has taken the following steps in developing the app for commercialisation:

a.     Market research and quantitative consumer research

b.     Established initial monetisation streams though:

i.     Freemium member subscriptions

ii.    Affiliate & cashback commissions

iii.   Brand platform fees iv. Advertising

c.     Planned expansion of monetisation through:

i.     Further advertising/boosting

ii.    Data sharing/segmentation iii. Lookalike audiences

d.     Planned expansion of supported payment options to maximise the apps use

40.   X will enlist further potential customers to increase direct sales. This will be done by planned expansion into new markets and broadening of customer base and demographics through greater variety of product categories.

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

41.   X is genuinely focussed on developing the app for a commercial purpose. The app will be a significantly improved product compared to existing products due to its development of financial technology supporting the proposed range of new payment options.

42.   Therefore subparagraph 360-40(1)(e)(i) will be satisfied at the test time.

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

43.   X expects the app to appeal to a wide range of businesses. This aids decision making and is particularly useful when assessing product or service viability in particular markets.

44.   Through its marketing strategy, X hopes to foster widespread use of its product by adding further developments to the app to make it more consumer friendly, signing on more brands to increase appeal, and expand product categories to enlarge customer base size and demographic.

45.   While X has initially developed the app to address the local market, the app is expected to go through a series of developments focussing on platform and market portability to adapt to bigger international markets including UK and US and expand its product categories to encourage and maintain growth.

46.   If the commercialisation strategy is successful, X will experience substantial growth and profit particularly from the 20XX financial year.

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

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

48.   X's projections provided illustrates the increase in projected sales.

49.   Given that X will be available globally, the app has the potential to successfully scale up its business. According to the 20XX-20XX International Rollout, the projected margins show a greater profitability for each subsequent financial year. This is due to the multiplying revenue from existing streams such as advertising, consumer and brands subscriptions, affiliate fees and sponsorships. This will be further assisted with the introduction of additional monetisation streams planned in the 20XX and 20XX financial years. Although expenses are also likely to increase, they will be exceeded by revenue at an increasing rate which indicates a clear potential to successfully achieve economy of scale and provides requisite operating leverage.

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

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

51.   X's app is initially targeted at the Australian markets but is intended for worldwide use. It will be released in the UK in the 20XX financial year, and the US in the 20XX financial year.

52.   The app can be used worldwide by any business. Thus, the ultimate addressable market is on a global scale and is not confined to a local city, area or region.

53.   X has demonstrated the app 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)

54.   The app has a planned expansion of financial technology to support new and innovative payment methods which may give it a competitive advantage when view in conjunction with a clear and planned path into new international markets and product categories. This expanded ability to accept payment would likely produce greater sales than more limited payment models currently in use.

X may have the first mover advantage in relation to these payment methods, as supported use of these methods is not widespread. X has demonstrated the potential for the app to have competitive advantages within the Australian and international markets satisfying subparagraph 360-40(1)(e)(v).

Conclusion on principles test

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

Foreign Company Test

55.   As X was incorporated in Australia, it is not a Foreign Company (within the meaning of the Corporations Act 2001), and paragraph 360-40(1)(f) is satisfied.

Conclusion

56.   X meets the eligibility criteria of an ESIC under section 360-40 for the period 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.