Edited version of private advice

Authorisation Number: 1052048846086

Date of advice: 26 October 2022

Ruling

Subject: Early stage innovation company - principles based test

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 XX 20XX to YY YY 20YY?

Answer

Yes

This ruling applies for the following period:

Income year ending YY YY 20YY

The scheme commences on:

XX XX 20XX

Relevant facts and circumstances

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

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

3.      Company A's registered office and principal place of business is situated at XYZ.

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

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

•           Total expenses of $XYZ

•           Total income of $XYZ

6.      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 product

7.      Company A is developing a Product, XXX, which utilises a combination of innovative technologies to provide value for its target audience.

8.      Users can own a technologically advanced product associated with Company A's Product. The ownership of these products would allow users to participate in and use the Product.

9.      Company A's Product provides an accessible landscape for users of any specific group.

10.   Company A's Product provides a realistic technological offering that is unique to the Product.

Executive Team

11.   Company A's Executive Team provide the expert leadership required for the company's success.

Business Model

12.   The technologies that underline Company A's Product, together with the entity's expert leadership team, provide Company A a unique competitive advantage.

13.   Company A's business model allows the entity to produce revenue from three different streams:

•           Sales of XXX;

•           Commission from the use and transfer of XXX and other associated products; and

•           XXX rights.

14.   Company A will also release their own independent contingent product, YYY, which will allow users to access Company A's Product.

15.   If Company A's independent contingent product fails due to market conditions, Company A will adopt an existing version of the contingent product which is more stable.

16.   Company A has prepared a multi-phase promotional plan to introduce the Product.

17.   Company A has a global addressable market.

18.   Company A holds ownership of the intellectual property ('IP') underlying their Product, XXX. Company A's IP is also related to the platform they are developing, which can be replicated across other offerings.

19.   Company A's IP has been registered for commercialisation in XYZ.

20.   Company A's ultimate vision is for the Product to become a global offering in the particular industry.

21.   Company A has issued a number of shares to various shareholders since its incorporation in XX 20XY. Company A hopes to issue new shares in the current period to raise additional funds to assist with development, commercialisation and expansion of their Product, XXX.

Information provided

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

•           Responses to ESIC Criteria under the principles-based innovation test

•           Response to further questions provided

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

24.   You propose to issue new shares in Company A to various investors to assist in funding the continued development and commercialisation of your 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 XX 20XX to YY YY 20YY.

Detailed reasoning

Qualifying Early Stage Innovation Company

25.      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'

26.      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)

27.      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).

28.      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.

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

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

30.      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)

31.      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)

32.      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'

33.      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

34.      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)

35.      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.

36.      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.

37.      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

38.      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..."

39.      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.

40.      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.

41.      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."

42.      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.

43.      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

44.      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

45.      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

46.      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

47.      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)

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

49.      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

50.      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 XX 20XX, and on or before YY YY 20YY.

Current year

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

52.      Company A was incorporated in XYZ on XX XX 20XY, 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

53.      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.

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

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

55.      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.

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

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

57.      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.

58.      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

59.      Company A satisfies the early stage test for the 20YY 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

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

61.      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.

62.      Company A is developing their Product by utilising numerous different technologies.

63.      Users can own a technologically advanced contingent product associated with Company A's Product. The ownership of these contingent products would allow users to participate in and use the Product.

64.      Company A's Product provides an accessible landscape for a diverse group of users.

65.      Company A has undertaken a range of R&D, design and implementation activities to work towards developing their Product for an applicable addressable market.

66.      Company A is genuinely focussed on developing their Product for an applicable addressable market.

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

67.      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.

68.      Company A has undertaken the following work to develop their Product for commercial purposes:

•         Q3 and Q4 20XX - A wide range of R&D activities in order to prepare for the design and implementation phase of development.

•         Q1 20YY - Commencement of the Product's development.

•         Q1 20YY - Development of technological capabilities of the Product.

•         Q1 20YY - Development of the Product's platform.

69.      Presently, Company A is undertaking the following work to develop their Product for commercial purposes:

•         Continued development of the Product's qualities.

•         Continued development of technological capabilities of the Product.

•         Continued development of the Product's platform.

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

•         Q2 20YY - Release and sale of contingent product, YYY, to use in collaboration with the Product.

•         Q2 - Q3 20YY - Completion of development and implementation of the Product's platform.

•         Q2 - Q3 20YY - Completion of design and development of the Product's technological capabilities.

•         Q2 - Q3 20YY - Completion of development of the Product's platform.

•         Q2 - Q3 20YY - Development of the Product's streaming platform.

•         Q2 - Q3 20YY - Development of data capabilities of the Product's platform.

71.      Company A anticipate that a primary version of the platform underpinning their Product will be completed and released by Q1 20YY.

72.      Following the launch of the XXX to the public in Q3 20YY, Company A will focus on further development, product testing, XXX release from Q3 to Q4 20YY.

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

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

74.      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.

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

76.      Upon the completion of the development of the platform underlying the Product, Company A is planning to execute a multi-stage global promotional campaign.

77.      Company A plans to showcase its Product platform to Body X, a relevant professional body in YY 20YY. The entity aims to form an agreement with Body X that involves Body X partnering with Company A in promotions of the Product. If successful, this partnership is predicted to attract a large number of users to the Product.

78.      Company A has existing partnerships with business partner companies. The entity is also exploring partnerships with other influential individuals to assist with promoting the Product.

79.      Company A's platform which underlies their Product, can be replicated to other offerings as well.

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

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

81.      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.

82.      Company A will be able to produce revenue through three different streams and offerings:

•               Sales of XXX;

•               Commission from the use and transfer of XXX and other associated products; and

•               XXX rights.

83.      Company A predicts that greater user participation would result in more revenue which can be enabled through a relatively small increase in expenditure to ensure their Product is suitable to a higher number of users.

84.      After the basic platform is created, Company A will be able to generate a marginal profit through attracting more active users at a fixed cost.

85.      Company A's Executive Team has proven experience with successfully scaling up technology companies. In addition, Company A plans on recruiting additional staff to assist them in further developing their technologies.

86.      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 XX 20XX to YY YY 20YY.

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

87.      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.

88.      Company A's Product's platform has global potential, with interest already shown by relevant professional organisations across the world.

89.      Company A has estimated that the Product has a global audience of up to XX people and estimates that their Product is predicted to have XXX users within its first year of commercialisation from across the world.

90.      Company A plans to showcase their Product's platform to Body X in YY 20XY. The entity aims to form an agreement with Body X that involves Body X partnering with Company A in promotions of the Product. If successful, this partnership is predicted to attract a large number of users to the Product.

91.      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 XX 20XX to YY YY 20YY.

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

92.      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.

93.      The competitors of Company A are companies which provide technologically based specific offerings. Most other competitors do not utilise the advanced technologies that Company A is utilising in their Product.

94.      There are a number of other start-up entities attempting to undertake a similar concept to that of Company A's Product through similar technologies. These competitor entities' offerings span across different offerings. None of these competitor entities have launched their product to the public.

95.      Unlike its competitors, Company A's Product, provides a realistic offering achieved through proprietary tools and highly trained models.

96.      The combination of technologies underpinning Company A's Product, provides the entity a unique competitive advantage, which is one of the first of its kind globally.

97.      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 XX 20XX to YY YY 20YY.

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

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

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

Conclusion

Company A Pty Ltd meets the eligibility criteria of an ESIC under section 360-40 for the period XX XX 20XX to YY YY 20YY, or the date when their Product has been fully developed and is ready for client use, whichever occurs earlier.

Other references (non ATO view)

Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016

Key words

Early Stage Innovation Company

Tax incentives for Early Stage Investors

Early Stage Test

Principles Based Innovation Test

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