Edited version of private advice

Authorisation Number: 1052200138612

Date of advice: 4 December 2023

Ruling

Subject: Early stage innovation company

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 ended 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

1.            The Company was registered on the Australian Business Register in 20XX. Its equity interests are not listed for quotation in the official list of any stock exchange.

2.            The Company and its 100% subsidiaries had expenses of less than $1 million in the 20XX income year and assessable income below $200,000.

3.            The Company's goal is to bring new technology to a sector of industry.

4.            The Company works with stakeholders to bring about the changes or improvements using products developed and owned by the Company, as well as integrate third party technology using its proprietary integration engine.

5.            All IP related to the Company was assigned to the Company before the investment occurred including all intangible assets.

6.            The technology is in use, with talks underway in national networks. The Company has a strategy to continue commercialisation locally across private and national networks, as well as continue to expand into other organisations.

7.            Subsequently the Company is developing its strategy for market entry into foreign markets.

8.            The sector is a multi-billion dollar market in Australia. With compounding global trends and a lack of skilled resources in the sector, the Company sees high growth potential as the industry moves towards digitisation, digital automation and new service offerings outside of the traditional environment that require deep technology and data management behind the scenes.

9.            The core team has deep experience in building and scaling technology and sales teams locally and internationally, dealing with new markets, identifying channel partners, and localising technology for language and culture. The products and pricing models are designed carefully to enable rapid scalability and low customer acquisition costs.

10.          The Company states that its ethos is to act globally from the outset and is working with a number of partners to actively execute on market entry strategy in a number of geographies.

11.          The Company states that its integration technology and underlying IP is also a key competitive advantage, often reducing technology rollouts from months (or even years) to just weeks. The technology is designed to be modular and flexible, which is a unique differentiator in the market.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 360-A

Income Tax Assessment Act 1997 section 360-40

Income Tax Assessment Act 1997 subsection 360-40(1)

Income Tax Assessment Act 1997 paragraph 360-40(1)(a)

Income Tax Assessment Act 1997 subparagraph 360-40(1)(a)(iii)

Income Tax Assessment Act 1997 paragraph 360-40(1)(b)

Income Tax Assessment Act 1997 paragraph 360-40(1)(c)

Income Tax Assessment Act 1997 paragraph 360-40(1)(d)

Income Tax Assessment Act 1997 paragraph 360-40(1)(e)

Income Tax Assessment Act 1997 subparagraph 360-40(1)(e)(i)

Income Tax Assessment Act 1997 subparagraph 360-40(1)(e)(ii)

Income Tax Assessment Act 1997 subparagraph 360-40(1)(e)(iii)

Income Tax Assessment Act 1997 subparagraph 360-40(1)(e)(iv)

Income Tax Assessment Act 1997 subparagraph 360-40(1)(e)(v)

Income Tax Assessment Act 1997 paragraph 360-40(1)(f)

Income Tax Assessment Act 1997 section 360-45

Reasons for decision

All legislative references are to the ITAA 1997 unless otherwise indicated.

Question

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

Summary

The Company meets the eligibility requirements of an ESIC under subsection 360-40(1).

Detailed reasoning

Qualifying Early Stage Innovation Company

1.            Subsection 360-40(1) outlines the criteria required for a company to qualify as an ESIC at a particular time in an income year. This time is referred to as the test time. The criteria are based on a series of tests to identify if the company is at an early stage of its development, and it is developing new or significantly improved innovations to generate an economic return.

'The early stage test'

2.            The early stage test requirements are outlined in detail within paragraphs 360-40(1)(a) to (d).

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

3.            To meet the requirement in paragraph 360-40(1)(a), at a particular time (the test time) in an income year (the current year) the company must have been either:

                                 i.             incorporated in Australia within the last three income years (the latest being the current year);

                                 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 3 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 2 innovation tests: the objective (100 point) test or the principles-based test.

'Principles-based test' - subparagraphs 360-40(1)(e)(i) to (v)

10.          To satisfy the principles-based test, the company must meet five requirements in paragraph 360-40(1)(e). This is tested at a time immediately after the relevant new shares are issued to the investor.

11.          The company can demonstrate that it meets each requirement through existing documentation such as a business plan, commercialisation strategy, competition analysis or other company documents. The company must be able to show that tangible steps have been or will be taken in relation to each of the requirements.

12.          The 5 requirements of the principles-based test, as outlined in paragraph 360-40(1)(e) are:

                                 i.             the company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation

                                 ii.            the business relating to that innovation must have a high growth potential

                                iii.            the company must demonstrate that it has the potential to be able to successfully scale up the business relating to the innovation

                               iv.            the company must demonstrate that it has the potential to be able to address a broader than local market, including global markets, through that business, and

                                 v.            the company must demonstrate that it has the potential to be able to have competitive advantages for that business.

Developing new or significantly improved innovations for commercialisation

13.          For the purposes of Subdivision 360-A, the Explanatory Memorandum to the Tax Laws Amendment (Tax Incentives for Innovation) Bill 2016 (EM) provides the following at paragraph 1.76 in relation to the definition of innovation:

Implicit in the definition of innovation is the requirement that the company is developing a new or significantly improved type of innovation such as a product, process, service, marketing or organisational method. This list of various types of innovations provides flexibility for innovation companies and is adaptable to current and future innovations. The Oslo Manual, published by the Organisation for Economic Co-operation and Development (OECD) provides a description of these different types of innovations...[1]

14.          The innovation being developed by the company must either be new or significantly improved for an applicable addressable market. The company's addressable market is the revenue opportunity or market demand arising from the innovation or the related business. The addressable market must be objective and realistic.

15.          Improvements must be significant in nature to meet this requirement. Customising existing products or minor changes resulting from software updates, pricing strategies or seasonal changes are examples of improvements that would not be considered significant.

16.          The OECD Oslo Manual defines innovations as significant changes, with the intention of distinguishing significant changes from routine minor changes. However, it is important to recognise that an innovation can also consist of a series of smaller incremental changes that together constitute a significant change.[2]

17.          In discussing services innovation activity, paragraph 111 of the OECD Oslo Manual states:

Innovation activity in services also tends to be a continuous process, consisting of a series of incremental changes in products and processes. This may occasionally complicate the identification of innovations in services in terms of single events, i.e., as the implementation of a significant change in products, processes or other methods.

18.          The OECD Oslo Manual, in relation to defining innovative services, states at paragraph 161 that 'innovations in services can include significant improvements in how they are provided (for example, in terms of their efficiency or speed), the addition of new functions or characteristics to existing services, or the introduction of entirely new services.'

19.          The company must be genuinely focused on developing the innovation for a commercial purpose in order to generate economic value and revenue for the company. This requirement draws the distinction between simply having an idea and commercialising an idea.

20.          'Commercialisation' includes a range of activities that involve the implementation or sale of a new or significantly improved innovation that will directly lead to the generation of economic value for the company.

High growth potential

21.          The company must be able to demonstrate that it has the potential for high growth within a broad addressable market. This refers to the company's ability to rapidly expand its business. Companies that are limited to supplying local customers will not meet this requirement.

Scalability

22.          The company must be able to demonstrate that it has the potential to successfully scale up the business. The company must have operating leverage, 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

23.          The company must be able to demonstrate that it has the potential to address a market that is broader than a local city, area or region. The company does not need to have a serviceable market at a national, multinational or global scale at the test time. However, it does need to show that the business is capable of addressing a market that is broader than a local market and that the business can be adapted to a broader scale in the future.

Competitive advantages

24.          The company must be able to demonstrate that it has the potential to have competitive advantages, such as a cost or differential advantage over its competitors which are sustainable for the business as it expands. The company can analyse what competitors in the market offer and consider whether the company has a differentiating advantage that would allow it to outperform these competitors.

Foreign Company test - paragraph 360-40(1)(f)

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

26.          The dictionary in section 9 of the Corporations Act 2001 defines a foreign company to mean:

(a) a body corporate that is incorporated in an external Territory, or outside Australia and the external Territories, and is not:

(i) a corporation sole; or

(ii) an exempt public authority; or

(b) an unincorporated body that:

(i) is formed in an external Territory or outside Australia and the external Territories; and

(ii) under the law of its place of formation, may sue or be sued, or may hold property in the name of its secretary or of an officer of the body duly appointed for that purpose; and

(iii) does not have its head office or principal place of business in Australia.

Application to your circumstances

Test time

27.          For the purposes of this ruling, the test time for determining if the Company is a qualifying ESIC will be a particular date during the 20XX income year.

Current year

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

Early stage test

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

29.          As the Company was registered in 20XX, which is within the last 3 income years, the requirement in subparagraph 360-40(1)(a)(iii) is satisfied.

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

30.          As the Company and its 100% subsidiaries had expenses of $1 million or less in the prior income year (the 20XX income year), the requirement in paragraph 360-40(1)(b) is satisfied.

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

31.          As the Company and its 100%subsidiaries' assessable income in the prior income year (the 20XX income year) is $200,000 or less, the requirement in paragraph 360-40(1)(c) is satisfied.

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

32.          As the Company is privately owned and is not listed on any stock exchange in Australia or a foreign country, the requirement in paragraph 360-40(1)(d) is satisfied.

Conclusion on early stage test

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

100 point test

34.          The Company has not provided any evidence of satisfying the 100 point test under section

35.          360-45 for the 20XX income year. For the Company to be a qualifying ESIC it will need to satisfy the principles-based test.

Principles based test

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

36.          According to the Company its flagship product allows data to move easily between systems. Current offerings in the market are on premise rather than web based, and do not have user friendly interfaces, whereas the Company is modular and provides user experience lead design and cloud based interfaces, so the platforms work in the browser from any approved device.

37.          In addition, the Company is developing a tool built for the IT team to quickly and easily integrate any new equipment, tool, or system once via a standard drag and drop web interface.

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

37.          The Company has registered in Australia and will own all intellectual property (IP). The technology is in use with talks underway in national networks. The Company has a strategy to continue commercialisation locally as well as continue to expand into other organisations.

38.          Subsequently the Company is developing its strategy for market entry into foreign markets.

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

39.          The Company is genuinely focussed on developing its product for a commercial purpose. It will be a significantly improved product compared to existing products and is a new concept as there are no direct competitors anywhere in the world. It is expected to enjoy first-mover advantage.

40.          Therefore, the requirement in subparagraph 360-40(1)(e)(i) is satisfied for the time period from 1 July 20XX until 30 June 20XX.

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

41.          The sector is a multi-billion dollar market in Australia. With compounding global trends and a lack of skilled resources in the pathology sector, there is a high growth potential as the industry moves towards digitisation, digital automation and new service offerings outside of the traditional environment that require deep technology and data management behind the scenes. The Company's goal is to bring new web, mobile, AI and integration technology to the sector, which feeds directly into this high growth potential.

42.          If the commercialisation strategy is successful, this may give the Company the ability to grow its business into the large addressable global market.

43.          Therefore, the requirement in subparagraph 360-40(1)(e)(ii) is satisfied.

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

44.          The products and pricing models are designed carefully to enable rapid scalability and low customer acquisition costs. Further, as the Company is developing web, mobile, AI and integration technology products, it is not impacted by factors such as manufacturing capability or size of premises. Ongoing costs would not be expected to increase in a linear fashion alongside its increase in market penetration. As the number of users increases, growth can be leveraged against already developed technology.

45.          Given that the products will be initially available domestically before market entry into foreign markets, the Company can demonstrate the potential to successfully scale up its business.

46.          Therefore, the requirement in subparagraph 360-40(1)(e)(iii) is satisfied.

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

47.          The Company's products have initially been targeted at the Australian market but is intended for worldwide use. The Company states that its ethos is to act globally from the outset, with the opportunity in the pathology sector being a global one. The Company is working with a number of partners to actively execute on market entry strategy in a number of geographies.

48.          The products have capacity to be used worldwide. Thus, the ultimate addressable market is on a global scale and is not confined to a local city, area or region.

49.          The Company has the potential to address a broader market than just the local market, including international markets. Therefore, the requirement in subparagraph 360-40(1)(e)(iv) is satisfied.

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

50.          The Company's underlying IP provides a key competitive advantage by reducing technology rollouts within a lab environment from months to just weeks. The technology is designed to be modular and flexible, which is a unique differentiator in the market.

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

Conclusion on principles test

52.          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 20XX until 30 June 20XX.

Foreign Company Test

53.          As the Company was registered in Australia it is not a Foreign Company, the requirement in paragraph 360-40(1)(f) is not satisfied.

Conclusion

54.   The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20XX until 30 June 20XX.

[1] See EM, paragraph 1.76.

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