Edited version of private advice

Authorisation Number: 1052126474946

Date of advice: 16 June 2023

Ruling

Subject: Early stage innovation company eligibility

Question

Does Company A satisfy the criteria of an Early Stage Innovation Company (ESIC) pursuant to subsection 360-40(1) of the Income Tax Assessment Act 1997 (ITAA 1997) for the year ending 30 June ZZZZ?

Answer

Yes

This ruling applies for the following period:

Year ending 30 June ZZZZ

The scheme commenced on:

DD MM YYYY

Relevant facts and circumstances

All legislative references are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise stated.

Background facts

1.      Company A ('the Company') is an Australian proprietary company which was incorporated in Australia and registered on the Australian Business Register on DD MM YYYY. Its equity interests are not listed for quotation in the official list of any stock exchange in Australia or overseas.

2.      Company A is not a foreign company pursuant to the Corporations Act 2001 (Cth).

3.      On DD MM YYYY, Company B ('the subsidiary company') became the wholly owned subsidiary of Company A.

4.      Company B is an Australian proprietary company which was incorporated in Australia and is registered on the Australian Business Register.

5.      The Board of Directors is of Company A is currently comprised of its two co-founders, Individual 1 and Individual 2.

6.      Company A's registered office and principal place of business is situated in Australia.

7.      None of Company A's current or proposed shareholders are exempt, (under section 66A of the Corporations Act 2001).

8.      Company A's current offering of shares in its current investment round will require a disclosure under section 708 of the Corporations Act 2001 (Cth).

9.      Company A is currently undertaking a capital raise with investors who may wish to access the early-stage investor tax offset.

10.   An intellectual property assignment agreement has been entered into between Company A and its wholly owned subsidiary, Company B, under which Company B has transferred ownership of the intellectual property rights that it owns in respect of and developed for the innovation ('the Product').

11.   A licence/service agreement has been entered into between Company A (as Licensor) and its wholly owned subsidiary, Company B (as Licensee), under which Company A has engaged Company B as its agent to complete the development of the Product on its behalf.

Under the agreement the Licensee:

a)            Assigns to the Licensor all rights, title and interest in the copyright in respect of the Licensed Property created or produced by the Licensee.

b)            Agrees to assign to the Licensor all rights, title and interest in any improvement, modifications or additions to the Licenced Property and all Future Rights which may arise or be created during which may arise or be created during the term and which the Licensee owns.

12.   Company A did not derive any assessable income or incur any expenses during the year ended 30 June YYYY, being the year before the current year.

13.   Company B incurred total expenses of less than $1 million in the income year ended 30 June YYYY.

14.   Company B did not derive any assessable income in the income year ended 30 June YYYY.

Development of new or significantly improved innovations

15.   Company A (through the engagement, under a binding agreement, of the services of its wholly owned subsidiary Company B) is in the process of developing an innovative hardware, software and service solution that merges existing and new technology supported by machine learning to optimise non-invasive monitoring of properties within its industry.

16.   This includes hardware and software components with inbuilt security and sensors components.

17.   The solution's main hardware component is supported by an intuitive app and web platform to suit a variety of users. The app can generate an incident report that shows data to make accountability and insurance claims easier.

18.   The next iteration of the solution once additional capital has been raised will be utilising existing hardware but adapting the software and algorithms for use in a variety of environments.

Genuinely focussed on developing innovations for commercialisation

19.   Company A has prepared a step-plan to develop and commercialise the invention as part of their project plan. The project plan outlines detailed steps towards commercialisation, including prototype designs, validation, testing and extensive customer testing and feedback. These identified steps demonstrate a genuine focus on developing the invention for commercialisation and ensuring it meets the needs of the target market and delivering a solution that provides value to its customers.

20.   Company A has submitted a commercialisation grant application, to assist in expediting the commercialisation of their solution.

21.   Company A's revenue model projects turnover on the back of fees generated from both hardware purchases and a yearly subscription model.

22.   The Company A team has completed the manufacture of the full-scale product and system alpha prototype and it is available for demonstration. Testing of the technology components is currently being conducted.

23.   Company A will be undergoing a capital raise within the year ending 30 June ZZZZ.

24.   Concurrently, Company A is running advertising of the product within its overseas target market with leads generated from this directly funnelled into their planned crowdfunding platform launch. Once an appropriate number of leads have been generated the solution will go live on a crowdfunding platform generating the first sales. Company A intends for its first sales to be generated in its overseas target market.

High growth potential

Market Gaps and Problems

25.   Company A's solution is initially targeting the monitoring of properties within its industry with potential further application across a variety of markets.

26.   Market research indicates that there is a large gap in solutions that provide property monitoring.

27.   Company A's solution solves many of the problems the problems inherent in its industry.

Evidence of Demand for the Product and Addressable Market

28.   Company A's research indicates that significant opportunities currently exist within its industry worldwide, including Australia and its initial overseas target market, and are predicted to substantially increase over the next five years.

29.   Company A plans to capture 10% of the emerging Australian and its initial overseas target market and 2% of the global market with little competition.

30.   Company A's industry has already seen an increasing trend in the use of monitoring devices.

31.   Media coverage for the Company A's solution has occurred with positive responses received across a number of news services.

32.   The initial response to advertising efforts in the Company's overseas target market has been extremely successful with the cost required per lead being less than half of its industry average. Additionally, Company A has received a significant number of registrations of interest from its advertising efforts.

33.   Company A is currently in discussions with an ASX listed company regarding partnering for Company A to be distributed to their customer base (primarily in its initial overseas target market).

34.   Company A is also currently in discussions with an Australian management company that manages multiple buildings.

Scalability

35.   Company A' solution is composed of the hardware apparatus and back-end software (including proprietary algorithms, analytic capabilities, reporting and more) incorporated into the various hardware and a separate mobile application.

36.   Company A has designed its solution such that the application of the inbuilt sensors can be easily adapted, with minor edits to the underlying software, to suit a wide range of applications.

37.   As the solution is cloud-connected and operates autonomously, it can be managed and the software managed remotely, making it infinitely scalable and operable in any country with sufficient internet connection and postal infrastructure.

38.   The software can be easily updated to enable the hardware to provide unique solutions across different industries.

39.   Company A has completed a detailed cashflow analysis which illustrates the scalability of the solution as significant increases in total gross margin are expected as the volume of sales increases.

Broader than local market

Plans for overseas expansion

40.   Company A is planning on achieving a 10% market share in its initial overseas target market and a 2% global market share in the next 5 years.

41.   The solution will be launched in its initial overseas target market with presales occurring on a crowdfunding platform. As such, all current advertising has been targeted to the initial overseas market with leads generated directly funnelling into the crowdfunding platform launch.

42.   After the success of their overseas launch, Company A then aims to penetrate the Australian market. Given the proximity of the local market to the currently engaged manufacturing facilities and the same market gaps similarly present they aim to achieve 10% Australian market share within 5 years.

43.   Company A's solution is cloud-connected and operates autonomously, it can be managed and the software managed remotely, making it infinitely scalable and operable in any country with sufficient internet connection and postal infrastructure.

44.   The system has been designed from the outset to meet the regulatory requirements of overseas markets on the first revision to ensure a quick entry overseas.

45.   Company A is currently in the process of communicating with an ASX listed company in its initial overseas target market in relation to a partnership.

Competitive advantages

First in the World Solution - Unique Technology and Business Model

46.   Company A has lodged a provisional patent regarding their non-invasive monitoring solution.

47.   Unlike other solutions in the market, Company A provide both a comprehensive and affordable smart solution. It offers buyers more options and value than similar brands at a comparable price.

48.   The Company's solution includes several unique selling points and capabilities that are not provided by any other known competitor.

49.   A detailed competitor and unique selling point (USP) analysis was done by an external consultant which clearly identified the limitations of current competitors and as such the key competitive advantage of Company A's product.

Board of Directors and unrivalled experience

50.   Company A believe that it consists of a team of professionals with unrivalled experience who have the know-how, contacts, and influence to ensure that Company A's product and business are successful.

Information provided

1.    You have provided information in a number of documents in relation to Company A's product.

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

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

Summary

Company A meets the criteria of an ESIC under subsection 360-40(1) of the ITAA 1997 for the year ending 30 June ZZZZ or the date when its innovation has been fully developed and is ready for sale, whichever occurs earlier.

DETAILED REASONING

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.

'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 six income years (the latest being the current year), and across the last three of those income years before the current year the company and its 100% subsidiaries incurred total expenses of $1 million or less; or

            iii.                registered in the Australian Business Register (ABR) within the last three income years (the latest being the current year).

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.

'100 POINT TEST' - paragraph 360-40(1)(e) and section 360-45

10.  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)

11.  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.

12.  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.

13.  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 - subparagraph 360-40(1)(e)(i) ITAA 1997

14.  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]

15.  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.

16.  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.

17.      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]

18.      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."

19.      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."

20.  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.

21.  '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

22.  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 - subparagraph 360-40(1)(e)(iii) ITAA 1997

23.  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 - subparagraph 360-40(1)(e)(iv) ITAA 1997han local market

24.  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

25.  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)

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

27.  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

28.  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 1 July YYYY, and on or before 30 June ZZZZ.

Current year

29.  For the purposes of subsection 360-40(1), the current year will be the year ending 30 June ZZZZ (the ZZZZ income year). For clarity, in relation to particular requirements within subsection 360-40(1), the last three income years will include the years ending 30 June ZZZZ, YYYY and XXXX, and the income year before the current year will be the year ending 30 June YYYY (the YYYY income year).

'EARLY STAGE TEST' - paragraphs 360-40(1)(a) - (d) itaa 1997

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

30.  Company A was incorporated in Australia on DD MM YYYY, which is within the last three income years (the latest being the current year). Therefore, the requirements of subparagraph 360-40(1)(a)(i) are satisfied.

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

31.  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 YYYY income year, being the year before the current income year.

32.  Company A did not incur any expenses in the YYYY income year.

33.  On DD MM YYYY, Company B became the sole wholly owned subsidiary of Company A.

34.  Company B incurred total expenses of less than $1 million in the income year ended 30 June YYYY.

35.  Therefore, paragraph 360-40(1)(b) is satisfied.

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

36.  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 YYYY income year.

37.  Company A did not derive any assessable income in the YYYY income year.

38.  On DD MM YYYY, Company B became the sole wholly owned subsidiary of Company A.

39.  Company B did not derive any assessable income in the income year ended 30 June YYYY.

40.  Therefore, paragraph 360-40(1)(c) is satisfied.

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

41.  In applying the requirements of paragraph 360-40(1)(c), Company A must not be listed on any Stock Exchange in Australia or a foreign country at the test time.

Company A was not listed on any stock exchange in Australia or a foreign country at the test time. Therefore, subparagraph 360-40(1)(d) is satisfied.

CONCLUSION FOR EARLY STAGE TEST

42.  Company A satisfies the early stage test for the entire ZZZZ income year, as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied.

'100 POINT TEST' - paragraph 360-40(1)(e) and section 360-45

43.  Company A has not provided sufficient evidence of having satisfied the 100-point test under section 360-45 for the year ending 30 June ZZZZ. 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.

'PRINCIPLES-BASED TEST' - paragraph 360-40(1)(e) itaa 1997

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

44.  In applying the requirements of subparagraph 360-40(1)(e)(i), Company A must be developing an innovation which either new or significantly improved for an applicable addressable market.

45.  Company A (through the engagement, under a binding agreement, of the services of its wholly owned subsidiary Company B) is in the process of developing an innovative hardware, software and service solution that merges existing and new technology supported by machine learning to optimise non-invasive monitoring of properties within its industry.

46.  The next iteration of the solution, once additional capital has been raised, will be utilising existing hardware but adapting the software and algorithms for use in a variety of environments.

47.  Company A has provided details substantiating that it is developing a product that is either new or significantly improved for an applicable addressable market.

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

48.  In applying the requirements of subparagraph 360-40(1)(e)(i), Company A must be genuinely focussed on developing an innovation for commercial purpose in order to generate economic value and revenue for the company.

49.  Company A has prepared a step-plan to develop and commercialise the invention as part of their project plan. The project plan outlines detailed steps towards commercialisation, including prototype designs, validation, testing and extensive customer testing and feedback. These identified steps demonstrate a genuine focus on developing the invention for commercialisation and ensuring it meets the needs of its target market and delivering a solution that provides value to its customers.

50.  Company A's revenue model projects turnover on the back of fees generated from both hardware purchases and a yearly subscription model.

51.  Company A has provided details substantiating that that it is genuinely focussed on developing its innovation for a commercial purpose in order to generate economic value and revenue for the company.

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

52.  Company A is genuinely focussed on developing their product, an innovative hardware, software and service solution to optimise non-invasive monitoring of properties within its industry for commercialisation. The product will be a significantly improved product compared to existing products in their addressable market.

53.  Therefore, subparagraph 360-40(1)(e)(i) is satisfied for the period 1 July YYYY to 30 June ZZZZ. Once the product has been fully developed, Company A 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)

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

55.  Company A has provided details substantiating that it meets this requirement.

56.  Therefore, subsection 360-40(1)(e)(ii) is satisfied.

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

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

58.  Company A has provided details substantiating that it meets this requirement.

59.  Therefore, subsection 360-40(1)(e)(iii) is satisfied.

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

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

61.  Company A has provided details substantiating that it meets this requirement.

62.  Therefore, subsection 360-40(1)(e)(iv) is satisfied.

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

63.  In applying the requirements of subparagraph 360-40(1)(e)(v), Company A must be able to demonstrate that it has the potential to be able to have competitive advantages for that business.

64.  Company A has provided details substantiating that it meets this requirement.

65.  Therefore, subsection 360-40(1)(e)(v) is satisfied.

Conclusion on principles-based test

66.  Company A 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 YYYY until 30 June ZZZZ or the date when its innovation has been fully developed and is ready for sale, whichever occurs earlier.

'FOREIGN COMPANT TEST' - subparagraph 360-40(1)(f) ITAA 1997

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

CONCLUSION

68.  Company A meets the eligibility criteria of an ESIC under section 360-40 of the ITAA 1997 for the period commencing 1 July YYYY to 30 June ZZZZ or the date when its innovation has been fully developed and is ready for sale, whichever occurs earlier.

Other references (non ATO view)

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

[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.