Edited version of private advice

Authorisation Number: 1052217330644

Date of advice: 30 January 2024

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 ending 30 June 20XX

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

The Company was incorporated in Australia in 20XX. It does not have any wholly owned subsidiaries and its equity interests are not listed for quotation in the official list of any stock exchange.

The Company had no expenses and no assessable income in the 20XX income year.

The Company is developing technology. The Company utilizes XXXX technology which is a faster, cheaper and more accurate method compared to traditional testing methods. This method of testing is unique to the Company.

The technology will allow various agencies to better execute their functions.

The size of the global market is estimated in excess of $X.

The Company will look to expand its addressable market to include other industries.

The sales and commercialization are intended to be a business-to-business, software-as-a-service (B2B SaaS) business model, where developers build a program and charges a subscription fee to access and use it.

The Company has secured a strategic relationship. The Company also has academic connections with universities.

The Company has entered into a binding Heads of Agreement (HOA) to acquire additional intellectual property (IP) inclusive of trademarks, patents, and copyright in order to further develop the technology in the future. The Company has submitted a patent application for the development of its technology.

The Company has received interest from investors who are interested in the project that the Company is pursuing.

The Company will seek to leverage the development in AI technology to continue to develop a technology that can further evolve.

Although initial cost required will be a major expense for the Company, once the technology is approved by regulatory bodies, the Company will be able to more efficiently develop its technology based on the needs of the consumers.

The Company has identified several differential advantages that their software has over its competitors.

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 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)

Reasons for decision

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

Question

Does the Company meet the criteria of an Early Stage Innovation Company (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

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'

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)

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 3 income years (the latest being the current year).

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.

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

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

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)

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)

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

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 (iv)

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.

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.

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

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]

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.

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.

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]

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.

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.'

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.

'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

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

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

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

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)

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

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

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

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)

As the Company was incorporated 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)

As the Company had no expenses in the prior income year, the requirement in paragraph 360-40(1)(b) is satisfied.

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

As the Company had no assessable income in the prior income year, the requirement in paragraph 360-40(1)(c) is satisfied.

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

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

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

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

According to the Company it is developing technology utilising XXXX technology which is faster, cheaper and more accurate.

The technology will allow diagnostics testing various agencies to execute their functions quickly and affordably.

This method is unique to the Company.

The Company's technology will be able to add new capabilities with minimal machine learning training required.

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

The sales and commercialization are intended to be a business-to-business, software-as-a-service business model, where developers build a program and charges a subscription fee to access and use it.

The Company has entered into a binding HOA to acquire additional IP inclusive of trademarks, patents, and copyright in order to further develop the technology in the future. The Company has submitted a patent application for the development of its technology.

The Company has secured a strategic partnership. The Company also has academic connections with universities such as Harvard.

The Company has secured relationships with universities. These relationship with give the Company the additional platform in commercializing its technology to a global market.

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

The Company is genuinely focussed on developing its platform 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.

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

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

The addressable market identified by the Company is not limited to Australia. The size of the global market is estimated to be in excess of $X. Once fully developed the technology can be readily applied to global markets, with minimal additional development required.

There will be other possible application for the technology. The Company will look to expand its addressable market to include other industries.

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

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

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

As the Company is developing a technology, 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.

The Company will seek to leverage the development in AI technology. Once a product is approved the Company will be able to continue to develop the product without additional increases in expenses as it is expected that the incremental cost to scale the product will be minimal to increase revenue

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

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

The Company is looking to seek approval from regulatory bodies.

Once approved, the chance of its approval in other countries will increase as only minor changes will be needed to meet the requirements of other regulatory bodies in other countries. Thus, the ultimate addressable market is on a global scale and is not confined to a local city, area or region.

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)

The Company's underlying IP provides a key competitive advantage, offering testing solutions that are provided cheaper, faster, and more accurate than current technologies and solutions. The Company is unique in its approach of integrating AI.

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

Conclusion on principles test

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 or the date when the technology has been fully developed, whichever occurs earlier.

Foreign Company Test

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

The Company meets the eligibility criteria of an ESIC under section 360-40 for the period commencing 1 July 20XX until 30 June 20XX or the date when the technology has been fully developed, whichever occurs earlier.

[1] See EM, paragraph 1.76.

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