Edited version of private advice

Authorisation Number: 1052160871736

Date of advice: 24 August 2023

Ruling

Subject: Early stage innovation company eligibility

Question:

Does Company X 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 DD MM YYYY to DD MM YYYY?

Answer:

Yes

This ruling applies for the following periods:

DD MM YYYY to DD MM YYYY

The Scheme commences on:

1 July 2022

Relevant facts and circumstances

Background facts

1.      Company X is an Australian proprietary company incorporated in XYZ on DD MM YYYY.

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

3.      Company X's registered office and principal place of business are situated in XYZ.

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

5.      For the financial year ending DD MM YYYY, Company X incurred and earned the following:

•                     Total expenses of $xxx

•                     Total income of $yyy

6.      While the business was formally incorporated on DD MM YYYY, the founder maintained external full-time employment whilst initial development and business activities took place. With effect from MM YYYY, the founder was engaged full time with Company X, significantly increasing the active financial and business operations of the company towards developing the core product offerings.

7.      Company X's equity interests are not listed for quotation in the official list of any stock exchange, either in Australia or a foreign country.

Product Development

8.      Company X is developing a unique digital platform, embodied in a software as a service solution (SaaS), to improve the accessibility of particular data and consumer options ('the Product'). Specifically, Company X's Product intends to deliver a single portal for a range of particular focused services.

9.      Company X's app is a centralised solution for product and customer service needs. With a single digital wallet, Company X brings together key services and product information.

10.   Behind the scenes, Company X collaborates with a number of partners.

11.   Specifically, this SaaS intends to provide the first end-to-end digital consumer and product ecosystem targeted at the establishment of a particular economy and acceleration of the transition to specific consumerism.

12.   From an implementation perspective, the following two key features are the focus of development:

•                     Consumer Application

•                     Intelligent product tracking/labelling

13.   A key new and sophisticated characteristic of the core Product, not previously available in the market, will be the integration of all end-to-end services, data and transactions.

14.   One of the novel functions of Company X's core Product is the ability to track, collate and analyse data and metadata from both a product and consumer perspective.

15.   In addition to these functions, Company X's Product will facilitate a marketplace, and integrate service providers.

Product Development Stages

16.   Key milestones completed to date include:

•                     Raised $xxx seed round and established an advisory board of key industry people

•                     Prototype delivered for demonstration purposes to support partner discussions

•                     Brand and logo developed

•                     Registration of name, trademarks and establishment of website

•                     Positive response from brands, NGO's, government and specific service providers

17.   Company X is developing functional prototype applications and building ongoing long-term relationships with both development and pilot partners.

18.   To date, the following development has taken place:

•                     Phase 1 (Initial Research & Scope) - MM YYYY - MM YYYY

•                     Phase 2 (Focussed Feedback and Design + Prototype) - MM YYYY - MM YYYY

•                     Phase 3 (MVP Development) - MM YYYY - MM YYYY

19.   Currently, Company X is finalising the development of the base functionality MVP and associated infrastructure. With this, internal and small-scale community pilots have been conducted for application performance observations and feedback.

20.   Development will continue as follows:

•                     Phase 4 (Pilot and Launch) - MM YYYY - MM YYYY

21.   Company X intends to release the product in a stepwise fashion, with the minimal functionality solution becoming available to users as additional features and infrastructure for expanding target market segments are developed. On this basis, MVP finalisation is expected within the coming months and requires the finalisation of software infrastructure and data management.

22.   The complete solution, however, is anticipated to be complete by MM YYYY, requiring further development, testing and feedback across use case applications.

Commercialisation Strategy

23.   Company X's Product is intended for a profitable purpose, with commercial objectives including customer volume and revenue targets.

24.   Company X had taken the following tangible steps to developing the Product for the purposes of future commercialisation:

•                     Undertaken extensive market research and competitor analysis in respect of the core product offering

•                     Finalised capital raising of $xxx and is currently negotiating additional capital raising commitments as at the time of application

•                     Engaged third-party specialists for the development of the core platform

•                     Participated in accelerator programs and entrepreneurial communities

•                     Engaged commercial, legal, taxation and accounting advisors

25.   The next steps in the commercialisation plan include larger scale user pilots and broader launch with established partners. The commercialisation strategy will then continue with additional expansions, establishment of subscription models and loyalty programs, additional partners, and the development of additional features.

High Growth Potential

26.   As an early mover in the space, Company X expects to achieve significant growth initially within Australia, and globally over time. The nature of the Product and scalability of the revenue streams creates low barriers for geographical expansion to access the broader global market. That is, the subscription-based revenue model is readily scalable with little additional input requirements for customer base expansion, with the platform also holding little barriers to an increased user base.

27.   With the significant level of investment capital that has been raised and which is further planned to be raised, Company X can develop the platform solution intended to be able to apply across a variety of national and global markets.

Scale up the Business

28.   Company X's business model is inherently scalable and leverageable. Scalability will deliver low-cost growth and leveragability will allow the introduction of further consumers, organisations and partners.

29.   Specifically, Company X will have significant operating leverage once the development of the planned product has been fully realised. Company X will incur only marginal increases in operating costs as revenue streams increase. That is, as the base product and relevant functionalities will have been developed, additional users will only incur minimal added costs related to onboarding and hosting, which is outweighed by the additional revenue generated by the subscription model.

30.   With this, Company X has defined multiple recurring preliminary revenue streams, each being scalable at a minimum cost to the business.

31.   Naturally, an increase in platform users directly increases revenue and the availability of capital for further development and business scaling.

32.   Furthermore, whilst initially focusing on the Australian market, the nature of the Product inherently holds low barriers to international expansion and partnership.

33.   Company X is confident that its directors have the experience and access to successfully scale an extended Business model.

Broader than Local Market

34.   Company X's Product has the capability to be adapted to a national, multinational or global scale in the future.

35.   It is clear from the outset, that the core Product offering will be targeted at the national Australian market. The Product will have widespread immediate applicability to a national addressable market, and longer-term to global markets that are not yet saturated with other providers.

36.   The nature of Company X's Product inherently holds low barriers to international expansion and partnership.

Competitive Advantages

37.   Company X has directly sought to evaluate the information publicly available on any market competition and assessed the extent or type of competition faced (if any), and monitors this on an ongoing basis.

38.   Such competitor analysis did not identify any direct competitors to their Product offering. However, a range of platforms with varying degrees of functionality, all seeking to provide a niche capability in an exclusive manner were identified.

39.   In contrast, Company X intends to develop competitive advantages by providing an aggregated platform whereby many such solutions can integrate, allowing a single distribution channel, improved traceability and communications and a single access portal for consumers.

40.   That is, Company X's aggregated platform intends to develop the following competitive advantages over existing solutions:

•                     Allowing organisations to readily co-ordinate and communicate with consumer groups across relevant market segments

•                     Providing consumers with a single point of access for otherwise disconnected services

•                     Provide service providers with a feedback loop via integration with a single distribution channel with integrated digital passport functionality

41.   Based on these factors, Company X recognises that its Product offering differs significantly from what it understands these competitors intend to bring to the market, given the limitations of commercial sensitivities and publicly known information.

42.   Given the level of capital raising achieved and the intended differentiation of their Product under development, Company X will be seeking to achieve key first mover competitive advantages.

43.   Company X further believes that the sophistication and reach of their Product, its developing partnerships and the experience of its directors in the industry will enable the competitive advantages to be sustained over a significant period of time.

44.   Company X is developing their Product to address a number of discrete markets and is continuing to develop their Product.

45.   Company X's Product has been identified as having an international addressable market.

Issue of Shares

46.   Initial investment immediately after incorporation led to a series of initial share issues to a number of shareholders, made by Company X for the purposes of facilitating initial development and necessary business commitments.

47.   Additional share issues to new shareholders were completed on DD MM YYYY, with xxx shares issued for a total investment of $yyy. This funding intends to cover the costs of further development and pilot trial activities.

48.   As at the date of this Private Ruling Application, Company X has issued a total of xxx shares raising capital of $yyy. Company X is negotiating additional capital raising commitments, intending to raise an additional $zzz in capital investment.

Information provided

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

•                     Private Binding Ruling ('PBR') Application, dated DD MM YYYY

•                     Response to further questions provided

50.   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

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

Summary

Company X meets the eligibility requirements of an ESIC under subsection 360-40(1) for the period DD MM YYYY to DD MM YYYY.

Detailed reasoning

Qualifying Early Stage Innovation Company

51.   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'

52.   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)

53.   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).

54.   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.

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

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

56.   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)

57.   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)

58.   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'

59.   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

60.   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)

61.   To satisfy the principles-based Innovation 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.

62.   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.

63.   The five requirements of the principles-based test, as outlined in paragraph 360-40(1)(e) are:

(iv)          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

(v)           the business relating to that innovation must have a high growth potential

(vi)          the company must demonstrate that it has the potential to be able to successfully scale up the business relating to the innovation

(vii)        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

(viii)       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

64.   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..."

65.   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.

66.   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.

67.   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."

68.   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.

69.   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

70.   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

71.   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

72.   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

73.   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)

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

75.   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

76.   For the purposes of this ruling, the 'test time' for determining if Company X is a qualifying ESIC, will be upon the issue of qualifying shares on a particular date or dates on or after DD MM YYYY, and on or before DD MM YYYY. Company X issued shares on 1DD MM YYYY and DD MM YYYY.

Current year

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

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

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

78.   Company X was incorporated in XXX on DD MM YYYY, 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

79.   In applying the requirements of paragraph 360-40(1)(b), Company X and any of its 100% subsidiaries must have incurred total expenses of $1 million or less in the YYYY income year, being the income year before the current year.

80.   Company X incurred expenses of $xxx in the YYYY income year. Consequently, paragraph 360-40(1)(b) is satisfied.

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

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

82.   Company X earned assessable income of $xxx in the YYYY income year. Consequently, paragraph 360-40(1)(c) is satisfied.

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

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

84.   Company X 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

85.   Company X satisfies the early stage test for the YYYY 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

86.   Company X has not provided sufficient evidence of satisfying the 100-point test under section 360-45 for the year ending DD MM YYYY. Company X are electing to seek eligibility by satisfying the principles-based Innovation test under section 360-40(1)(e)(i)-(v), in order to be issued with a Private Binding Ruling.

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

Developing new or significantly improved innovations for applicable addressable market - subparagraph 360-40(1)(e)(i) ITAA 1997

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

88.   Company X is developing a unique digital platform, embodied in a software as a service solution (SaaS), to address a particular market ('the Product').

89.   Company X's app is a centralised solution for product and customer service needs. With a single digital wallet, Company X brings together key services and product information.

90.   Company X is developing their Product to address a number of discrete markets and is continuing to develop their Product.

91.   Company X 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

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

93.   Company X's Product is intended for a profitable purpose, with commercial objectives including customer volume and revenue targets.

94.   The core Product is currently in the early stages of development and the directors are confident that the new platform and products will be well received.

95.   The next steps in the commercialisation plan include larger scale user pilots and broader launch with established partners. The commercialisation strategy will then continue with additional expansions, establishment of subscription models and loyalty programs, additional partners, and the development of additional features.

96.   Company X anticipates that the current programme of development will be completed in the YYYY financial year (approx MM YYYY).

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

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

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

99.      Company X has provided details to satisfy this requirement.

100.    Company X has demonstrated a high growth potential for their Product, so subparagraph 360-40(1)(e)(ii) is satisfied for the period DD MM YYYY to DD MM YYYY.

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

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

102.    Company X has provided details to satisfy this requirement.

103.    This leverage ensures that Company X has the potential to successfully scale up its business, so subparagraph 360-40(1)(e)(iii) is satisfied for the period DD MM YYYY to DD MM YYYY.

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

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

105.    Company X has provided details to satisfy this requirement.

106.    Company X 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 DD MM YYYY to DD MM YYYY.

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

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

108.    Company X has provided details to satisfy this requirement.

109.    Company X has demonstrated that it has competitive advantages for its business, so subparagraph 360-40(1)(e)(v) is satisfied for the period DD MM YYYY to DD MM YYYY.

CONCLUSION FOR PRINCIPLES BASED TEST

Company X satisfies the principles-based Innovation test as it has satisfied the requirements within subparagraphs 360-40(1)(e)(i) to (v) for the period DD MM YYYY to DD MM YYYY, or the date when their Product has been fully developed and is ready for client use, whichever occurs earlier.

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

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

CONCLUSION

Company X meets the eligibility criteria of an ESIC under section 360-40 for the period DD MM YYYY to DD MM YYYY, 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

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