Edited version of private advice

Authorisation Number: 1052052550382

Date of advice: 2 November 2022

Ruling

Subject: Early stage innovation company qualification

Question

Does the Company meet the criteria of an Early Stage Innovation Company (ESIC) under subsection 360-40(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

This ruling applies for the following period:

Year ending 30 June 20YY

The scheme commences on:

1 July 20YY

Relevant facts and circumstances

1.            The Company was incorporated in Australia in 20YY.

2.            The Company is a privately owned company and is the head of a tax consolidated group.

3.            The Company has a wholly owned subsidiary. The Company is developing the Product (the Innovation), but the other entity will be the eventual trading company and access the technology through a license fee or similar.

4.            The Company and its subsidiary have expenses of less than $1 million in the previous income year, i.e., the year ended 30 June 20YY. It has not yet generated any revenue and assessable income is less than $200,000.

5.            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.

6.            The Company is not a foreign company.

7.            The Company is developing an information management platform which facilitates and streamlines information sharing to assist the target market.

8.            The Company has identified its ultimate market as being the domestic market, with its initial target being Australian markets. The target market has been identified and once further functions are developed, the target market will expand.

9.            Once the Innovation has been successful within the Australian target market, other jurisdictions have been planned for international expansion. The Innovation can be used worldwide by industries that also share the same target market. Thus, the ultimate addressable market is on a global scale and is not confined to a local city, area or region.

10.         Deploying the Innovation into other jurisdictions would require only minimal changes to the front-end of the Innovation to reflect the nuances of the relevant jurisdiction. The backend is being designed with this in mind.

11.         In addition to the above, the Company has highlighted the key features as being:

•                     Alternatives provide only partial solutions

•                     The Innovation acts as a repository

•                     The Innovation provides access to further support including through additional upcoming features

•                     The Innovation proactively addresses a problem which has traditionally been addressed as it arises

12.         The Company has taken the following steps in developing the Innovation:

•                     Built prototypes

•                     Undertaken a branding exercise

•                     Commenced initial discussions with application developers

•                     Identified potential investors

•                     Had initial conversations with leading members of the relevant industry who have confirmed a gap in the market for the Innovation.

13.         Within the Company there is considerable business experience. The Founder has advised businesses on numerous aspects of their operations for more than X years. There is also considerable experience on the advisory board, with industry experts bringing their experience and networks.

14.         The platform is expected to launch in MM 20YY, with additional functions expected to launch in MM 20YY. The next steps involve:

•                     Completing the Innovation through raising capital, engaging with third party developer and continuing to meet the timetable for deliverables.

•                     Increase subscriber numbers by engaging with adviser partners to communicate benefits for clients, ensure the Innovation is developed to meet user needs and continuous feature addition to improve day-to-day benefits and targeted advertising.

•                     Establish of additional features by commencing discussions with providers and select preferred partner, document scripts and FAQ, expand to a call centre environment.

•                     Develop other additional features by engaging with potential third parties, creating a framework for pricing and communicate offer to the target market.

•                     Hire additional staff by building a culture that attracts and retains talent, focus on training and development, document key HR policies, position descriptions and proactively hire.

15.         The financial projections of the Company show that for the next 5 years there is continued steady growth.

16.         The Company will obtain revenue via:

•                     Wholesale - selling subscriptions ($X a month) - feedback has been received from professional advisers is that they see the benefit to their clients of using the system. The Company would propose to leverage this benefit to have the advisers sign up their clients to the platform.

•                     Website - potential customers who arrive on the website will be able to subscribe to the service via the website.

•                     Online part of website - The Innovation will incorporate third party providers listing products and services which can be purchased using the details of the user. The Company will generate a sales commission from these sales.

17.         The Company will pursue product sales through:

•                     Advisers - Trusted advisers will be used to convey the value of the platform to potential users and keeping that information up to date.

•                     Online - There are a number of keyword search terms which will be relevant to this space. Adverts will be taken out relating to these ads to attract customers who are researching the space.

•                     Conference/industry - Attending industry conferences to explain the benefits for them and their clients

•                     Paid advertising - Recommendations facilitated via networks are anticipated to be a powerful sales channel. Likely to offer discounts to users who refer in people who are known to them.

18.         The Company has engaged with trusted professional advisers, who have expressed their interest in the platform. Advisers recommending the Innovation to their clients will keep the cost of acquiring new users down.

19.         The Company will be seeking further funding. This will be raised in two tranches.

•                     Tranche 1 - this will be used to fund the initial development.

•                     Tranche 2 - this will be used to fund the operational expenses post the beta testing.

20.         The Innovation will be accessed via a web application. This enhances the infrastructure underneath the platform to allow it to scale to service larger volumes of traffic as they arise with limited added cost.

21.         Of the competitors that the Company has identified, some already provide platforms but require input from third parties. However, these approaches do not operate domestically (within Australia) and do not provide any offering similar to the additional upcoming feature. There are much more limited offerings in Australia.

22.         The Company has highlighted the key differentiators as being:

•                     Ability to capture and collate information from a wide variety of sources into a single repository.

•                     Organised and categorised to optimise use

•                     Controlled access changes

•                     Lower price point to increase accessibility

•                     Ongoing subscription fee means desire is to keep customer happy

•                     Other additional offerings

•                     Engagement via professional advisers

•                     Focus on day-to-day benefits

Information provided

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

•                     your private ruling application

•                     our phone conversation with 'The Contact'

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

25.         You propose to issue new shares in the Company to various investors to assist in funding the continued development and commercialisation of the Innovation.

Relevant legislative provisions

Section 360-40of the Income Tax Assessment Act 1997

Reasons for decision

Detailed reasoning

Qualifying Early Stage Innovation Company

26.         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'

27.         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)

28.         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).

29.         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.

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

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

31.         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)

32.         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)

33.         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

34.         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)

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 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

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..."[1]

39.         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.

40.         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.

41.         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.[2]

42.         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."

43.         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."

44.         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.

45.         '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

46.         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

47.         The company must be able to demonstrate that it has the potential to successfully scale up the business. 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 per unit.

Broader than local market

48.         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

49.         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)

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

51.         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

52.         For the purposes of this ruling, the test time for determining if the Company is a qualifying ESIC will be a particular date during the income year ending 30 June 20YY.

Current year

53.         For the purposes of subsection 360-40(1), the current year will be the year ending 30 June 20YY (the 20YY income year). The income year before the current year will be the year ending 30 June 20YY (the 20YY income year).

Early stage test

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

54.         As the Company was incorporated in MM 20YY, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) is satisfied.

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

55.         As the Company and its 100% owned subsidiary, had expenses of $1 million or less in the prior income year (the 20YY income year) paragraph 360-40(1)(b) is satisfied.

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

56.         As the Company and its 100% owned subsidiary, had assessable income in the prior income year (the 20YY income year) of $200,000 or less paragraph 360-40(1)(c) is satisfied.

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

57.         As the Company 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

58.         The Company will satisfy the early stage test for the entire 20YY income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied.

100 point test

59.         As an alternative to satisfying the principle based test for a qualifying ESIC, a company may be a qualifying ESIC if it has at least 100 points for meeting certain objective innovation criteria. The 100 point test is provided as an alternative innovation test providing the company with a self-assessment test. The Company does not satisfy the 100 point test, therefore we rely on the principles based test.

Principles based test

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

60.         In order to meet the requirements of this subparagraph, there are three interrelated elements that need to be addressed:

a.            New, significantly improved, product, process, service or marketing method or organisational method - the Innovation;

b.            Genuinely focussed on

c.             Developing for commercialisation

61.         The Company is developing an information management platform which facilitates and streamlines information sharing.

62.         The Company has highlighted the key features as being:

a.            Alternatives provide only partial solutions

b.            The Innovation acts as a repository

c.             The Innovation provides access to further support including through additional upcoming features

d.            The Innovation proactively addresses a problem which has traditionally been addressed as it arises

63.         The Company has identified its ultimate market as being the domestic market, with its initial target being Australian markets. The target market has been identified as specific group and once further functions are developed, the target market will expand.

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

64.         The Company has taken the following steps in developing the Innovation:

a.            Built prototypes

b.            Undertaken a branding exercise

c.             Commenced initial discussions with application developers

d.            Identified potential investors

e.            Had initial conversations with leading members of the relevant industry who have confirmed a gap in the market for the Innovation.

65.         The timeline provides that the Company expects the Innovation to be launched in MM 20YY. Another function is expected to be launched in MM 20YY.

66.         The Company will develop relationships with trusted advisors who will identify potential customers to increase direct sales.

67.         The Company will pursue product sales through referrals and online sales.

68.         The Company will be the first to offer such a product.

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

69.         The Company is genuinely focussed on developing the Innovation for a commercial purpose. The Innovation will be a new offering of product compared to existing products.

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

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

71.         The Company expects the Innovation to appeal to a specific target market within their target industry.

72.         The financial projections of the Company show that for the next five years there is continued steady growth.

73.         The Company projections provided illustrate the increase in projected sales with intentions that finance will be raised in two tranches:

a.            Tranche 1: to fund the development of the initial platform

b.            Tranche 2: to fund the operational expenses post the beta testing.

74.         Through its commercialisation strategy, the Company hopes to foster widespread use of its product by

a.            Advisers - Trusted advisers will be used to convey the value of the platform to potential users and keeping that information up to date.

b.            Online - There are a number of keyword search terms which will be relevant to this space. Adverts will be taken out relating to these ads to attract customers who are researching the space.

c.             Conference/industry - Attending industry conferences to explain the benefits for them and their clients.

d.            Paid advertising - Recommendations facilitated via networks are anticipated to be a powerful sales channel. Likely to offer discounts to users who refer in people who are known to them.

75.         The Company is contracting stages of the development to third party developers. They will make their revenue through:

a.            Wholesale - selling subscriptions ($X a month) - feedback has been received from professional advisers is that they see the benefit to their clients of using a system. The Company would propose to leverage this benefit to have the advisers sign up their clients to the platform.

b.            Website - potential customers who arrive on the website will be able to subscribe to the service via the website.

c.             Online part of website - The Innovation will incorporate third party providers listing products and services which can be purchased using the details of the user. The Company will generate a sales commission from these sales.

76.         Within the Company there is considerable business experience. The Founder has advised businesses on numerous aspects of their operations for more than X years. There is also considerable experience on the advisory board, with industry experts bringing their experience and networks.

77.         If the commercialisation strategy is successful, this may give the Company the ability to increase sales through referrals and online.

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

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

79.         The Innovation will be accessed via a web application. This enhances the infrastructure underneath the platform to allow it to scale to service larger volumes of traffic with limited added cost.

80.         The Company has engaged with trusted professional advisers, who have expressed their interest in the platform. Advisers recommending the Innovation to their clients will keep the cost of acquiring new users down.

81.         The Company has currently developed two prototypes. The platform is expected to launch in MM 20YY with additional features launching in MM 20YY. The next steps involve:

a.            Completing the Innovation through raising capital, engaging with IT designer and continuing to meet the timetable for deliverables

b.            Increase subscriber numbers by engaging with adviser partners to communicate benefits for clients, ensure the Innovation is developed to meet user needs and continuous feature additions to improve day-to-day benefits and targeted advertising

c.             Establish additional features by commencing discussions with providers and select preferred partner, document scripts and FAQ, expand to a call centre environment

d.            Develop other additional features by engaging with potential third parties, creating a framework for pricing and communicate offer to clients

e.            Hire additional staff by building a culture that attracts and retains talent, focus on training and development, document key HR policies, position descriptions and proactively hire

82.         Given that the Innovation will be available domestically and potentially globally, it is expected that the Innovation has the potential to successfully scale up its business. Therefore, subparagraph 360-40(1)(e)(iii) will be satisfied.

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

83.         The Innovation will initially be targeted at the Australian markets but is intended for worldwide use. It will be released globally once it gains traction in the initial targeted markets.

84.         The Innovation can be used worldwide by industries that share the same target market. Thus, the ultimate addressable market is on a global scale and is not confined to a local city, area or region.

85.         Once the Innovation has been successful within the Australian target market, other jurisdictions have been planned for international expansion. Deploying the Innovation into other jurisdictions would require only minimal changes to the front-end of the Innovation to reflect the nuances of the relevant jurisdiction.

86.         The Company has demonstrated the Innovation has the potential to address a broader market than just the local market, including international markets. There is significant potential for expansion as the product is not country specific. Therefore, subparagraph 360-40(1)(e)(iv) will be satisfied.

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

87.         Of the competitors that the Company has identified, some already provide platforms, but they input from third parties. However, these approaches do not operate domestically (within Australia) and do not provide any offering similar to the additional upcoming feature. There are much more limited offerings in Australia.

88.         The Company has highlighted the key differentiators as being:

a.            Ability to capture and collate information from a wide variety of sources into a single repository

b.            Organised and categorised to optimise use

c.             Controlled access changes are triggered

d.            Lower price point to increase accessibility

e.            Ongoing subscription fee means desire is to keep customer happy

f.              Other additional offerings

g.            Engagement via professional advisers

h.            Focus on day-to-day benefits

89.         Being the first of such Innovation, the Company has the first mover advantage. The Company has demonstrated the potential for the Innovation to have competitive advantages within the addressable market satisfying subparagraph 360-40(1)(e)(v).

Conclusion on principles based test

90.         The Company satisfies the principles based test as it satisfies the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period commencing 1 July 20YY until 30 June 20YY or the date when the Innovation has been fully developed and is ready for sale, whichever occurs earlier.

Foreign Company Test

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

Conclusion

92.         The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20YY to 30 June 20YY or the date when 'The Innovation' has been fully developed and is ready for sale, whichever occurs earlier.

[1] See Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016, paragraph 1.76.

[2] OECD Oslo Manual, paragraph 124 and paragraph 151.