Edited version of private advice

Authorisation Number: 1052218868705

Date of advice: 16 February 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:

xx October 20XX

Relevant facts and circumstances

Company Background

1.    Company X was incorporated in Australia on DD MM 20XX. Its equity interests are not listed for quotation in the official list of any stock exchange.

2.    Company X has no subsidiaries and has expenses of less than $1 million in the previous income year, i.e. the year ended 30 June 20XX. It has not yet generated any revenue / assessable income and as such it's assessable income is less than $200,000.

The Innovation

3.    Company X is developing a xx that aims to significantly accelerate the collation of information and automate recommendations in a particular industry. The xx significantly speeds up the decision process. Company X's product enhances the accuracy is of the decision process. The xx is currently undergoing rigorous development and testing in collaboration with various stakeholders within the particular industry and the technology sectors.

4.    By offering a solution that streamlines processes and reduces associated costs, Company X is positioned as a unique and valuable tool in the particular industries landscape. The xx scalability and adaptability make it a viable solution not just for large operators in that industry but also for smaller operators as well.

5.    This novel approach offers unparalleled speed, accuracy, and transparency compared to existing methods, empowering operators and businesses with decisive strategic advantages in their industry. The innovation eliminates human error, and improves accuracy and efficiency, which will have benefits to the broader industry and public who use those services, and related services.

6.    This XX offers several advantages:

•         Precision

•         Bias mitigation

•         Continuous learning

•         Simplified processes

•         Data security

•         Social impact

•         Transparency and trust

7.    While the potential emergence of future xx solutions in this sphere is acknowledged, Company X's first-mover position and commitment to ongoing xx development through advanced xx ensure its continued relevance and potential to remain at the forefront of this industry and service offering.

Commercialisation Strategy

8.    In a landscape where operating can be expensive, Company X seeks to xx in that industry. At the same time, it aims to xx, ensuring they remain competitive and efficient in an ever-evolving industry.

9.    Company X seamlessly integrates with existing systems, offering a significant improvement over other solutions.

10.  Company X plans to continue refine its innovation, incorporating the latest advancements in xx. The focus will be on enhancing the xx. Further development activities include expanding the innovation to new markets.

11.  Company X's commercialisation strategy is integrated into its development process. By working closely with professionals and xx, the product is being designed to meet specific market needs. From the onset, feedback from testing with businesses is being used to develop the product, ensuring that it aligns with the practical requirements of its market.

12.  Company X has engaged with various businesses and other industry stakeholders who have expressed interest in the innovation. Collaborations have provided valuable insights into the needs and expectations of potential customers.

Market & Growth Potential

13.  Company X has high growth potential given its potential to solve an issue in an industry in a novel way. The innovation will exceed the ability of others providing the same service, because of its xx.

14.  Company X's high growth potential stems from its ability to address the users needs with xx.

15.  Company X has interest from users in all sectors of the industry, from small users though to global business.

16.  The industry is vast and constantly evolving, with increasing demand for innovative solutions. Company X directly addresses several pain points within this market, such as xx. This positions it to capture a significant share of a growing market.

17.  The factors it has identified that will drive this growth include:

•         The market is experiencing significant global growth, driven by a need for more efficient, cost-effective processes.

•         Company X's solution is well-positioned in this expanding market, offering xx that caters to a growing demand for xx in the market.

•         There's a rising trend in the market towards leveraging xx for various purposes, including separate steps. Company X's product, with its advanced capabilities, aligns with the market trend, indicating a substantial market opportunity.

•         Company X's xx significantly improves upon traditional, slower, and less accurate methods, offering a more efficient alternative.

•         Company X's commitment to continuously improving and updating its innovation ensures the product remains at the forefront of innovation, further driving its growth potential.

•         Company X's strategy of partnering with business/users for testing and feedback provides it with early market penetration opportunities and valuable insights for product refinement.

•         Company X has identified other providers/services that it compliments and is intending to offer the product initially through other platforms to ensure users are aware of the product.

18.  The company's market segmentation strategy includes primary targets such as small businesses, large businesses, government departments, and other xx firms. Secondary targets encompass academic institutions, consultants, and individuals.

Global Expansion

19.  Company X will launch into Australian markets on the back of those relationships, referrals and with testing with users that continue to expand across the industry. In the future it will also adapt to international jurisdictions.

•         Expanding Market: The market is rapidly growing, with more businesses recognising the advantages of digital solutions.

•         Government Collaboration: Potential to assist governments in streamlining the current process.

•         Global Expansion: Opportunity to cater to international markets facing similar issues in the industry.

•         Continuous Development: Stay ahead by regularly updating and enhancing the innovation for even better operation.

Sales Channels

20.  Company X's approach to product sales is multifaceted to reaching all potential customers across various sectors. The company implements a multi-channel sales strategy that includes direct sales and online sales. This dual approach caters to different customer preferences and maximises market reach.

21.  Company X can effectively distribute its product to its target customers, ensuring widespread adoption and use through a mix of these channels:

a.    Direct Sales:

b.    Online Platform:

c.     Partnerships:

d.    Digital Marketing and Advertising:

e.    Conferences and Seminars:

f.      Referral Programs:

g.    Government Liaisons:

h.    Distributors & Resellers:

i.      Training and Certification Programs:

j.      Feedback and Continuous Development:

Pricing model

22.  Tiered Pricing:

23.  Subscription Model:

24.  Pay-As-You-Go:

25.  Introductory Offers:

26.  Partnered Pricing:

27.  Volume Discounts:

28.  Licensing for Governments:

Scalability

29.  Company X has the potential to scale rapidly as the large upfront cost component in building the innovation is upfront, and supported by the founders, network, and advisory team. Thereafter operational costs as operations grow will be quite small compared to projected income due to the high value to customers.

30.  Company X's growth potential in the rapidly expanding market is significant. The company's scalability, enabled by its innovation, positions it well to handle increasing demand efficiently.

31.  The innovation can learn and adapt to different markets and it makes the innovation scalable across various markets or jurisdictions. No additional costs are required to tailor the innovation across different markets.

32.  The platform's versatility in handling different types of markets and adapting to various jusrisdictions positions it to capture a broad range of market segments within the industry.

33.  Company X boasts high scalability for several key reasons:

•         xx

•         xx

•         xx

•         Collaborative approach

Competitive advantage

34.  The combination of first mover advantage, xx innovation, rapidly evolving technology, low technology incumbents and significant need for the solution help lay the ground for an opportunity that Company X is uniquely placed to convert.

35.  Company X promises to provide a shift in service to the market, regardless of xx. The innovation is unique in that it offers the potential of;

•         xxxx

•         xxxx

•         xxxx

•         xxxx

•         xxxx

•         xxxx

36.  Company X is seeking to build and exploit structural competitive advantages including;

•         Development of a xx

•         Integration of advanced xx

•         Development of a xx process

•         Rare and unique insights

•         Significant customer benefits to existing methods

•         Implementation by quality, experience and determined professionals

•         Advanced xxxx

•         Advanced xxxx

•         First mover advantage

37.  Company X is aware of overseas applications that are similar and is aware that it has first mover advantage because the technology is not yet developed for this aspect of this industry. As such the industry knowledge and contacts of the founders have been important to ensure that they take advantage of the ability to develop the innovation and further develop the innovation here in Australia for this particular application.

38.  There are no known innovations being developed in Australia similar to this innovation.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subdivision 360-A

Income Tax Assessment Act 1997 section 360-40

Reasons for decision

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

Summary

Company X meets the eligibility requirements of an ESIC under subsection 360-40(1) of the ITAA 1997.

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.

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); 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 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).

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 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)

7.     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)

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 is genuinely focused on developing for commercialisation one or more new or significantly improved products, processes, services or marketing or organisational methods; and

                ii.       the business relating to those products, processes, services or methods has a high growth potential; and

               iii.       the company can demonstrate that it has the potential to be able to successfully scale that business; and

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

Developing new or significantly improved innovations for commercialisation

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

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

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

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

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.

27.      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

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

Current year

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

Early stage test

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

30.      As Company X was incorporated on 5 October 2022, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) / (iii) is satisfied.

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

31.      As Company X had expenses of $1 million or less in the prior income year (the 20XX income year) paragraph 360-40(1)(b) is satisfied.

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

32.      As Company X's assessable income in the prior income year (the 20XX income year) is $200,000 or less paragraph 360-40(1)(c) is satisfied.

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

33.      Company X is not listed on any stock exchange in Australia or a foreign country, therefore, subparagraph 360-40(1)(d) is satisfied.

Conclusion on early stage test

34.      Company X 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 innovation test

35.  Company X has not provided any evidence of satisfying the 100 point test under section 360-45 for the year ending 30 June 20XX. For Company X 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.  Company X is an innovator of the world's first innvoation.

37.  While initially launching in the Australian market, Company X's global aspirations are evident, as its scalable and adaptable for all users in it's market. With a clear roadmap for commercialisation and ongoing development, Company X is able to grow on a global scale.

38.  In regard to "new" innovations:

•         xx

•         xx

•         xx

•         xx

39.  In regard to "significantly improved" innovations:

•         xx

•         xx

•         xx

•         xx

•         xx

40.  Key differences and enhancement to processes:

•         xx

•         xx

•         Enhancing xx

•         Transforming xx

Conclusion

41.  Based on the facts presented, we consider that the product will be a new, or significantly improved product compared to current traditional services commonly used within the initial target markets.

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

42.      Company X's innovation xx.

43.      Market-focused commercialisation drives development. Close collaboration with xx guides product development.

44.      A strategic market segmentation targets xx to specific needs.

45.      With a strategic focus on initial market penetration in Australia followed by global expansion, Company X is poised to make a significant impact in the xx industry.

46.      Starting in Australia, Company X has a clear strategy to expand into other xx globally.

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

47.  Based on the facts presented, we consider that the product will be a new, or significantly improved product compared to existing xx commonly used within the initial target markets.

48.  Based on the facts presented, we consider that Company X has satisfied the 'genuinely focussed on developing for commercialisation' requirement under subparagraph 360-40(1)(e)(i).

49.  Therefore, Company X satisfies subparagraph 360-40(1)(e)(i) for the period during the test time.

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

50.  Company X's growth potential stems from three key factors:

a.    xx

b.    xx

c.     xx.

51.  Company X's has demonstrated its capability of providing xx is well-positioned in this expanding market, offering xx that caters to a growing demand for xx.

52.  Company X's commitment to continuously improving and updating its xx ensures the product remains at the forefront of xx further driving its growth potential.

53.  Company X has demonstrated that its product has high growth potential from launching in key Australian markets to setting sights on global expansion.

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

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

55.  Company X's business model projects significant revenue growth with the adoption of its xx. This growth is driven by:

•         High customer value

•         Growing market

•         Global reach

56.  Company X's flexible xx enable robust domestic and global scalability.

57.  Company X's ability to generate increased revenue with minimal operational cost growth due to scalability creates significant operating leverage:

•         Subscription model

•         xx services

•         Low marginal costs

58.  By combining projected sales growth, domestic and global scalability, and a revenue generation strategy with strong operating leverage, Company X demonstrates its capacity to successfully scale up its business. This operating leverage affords Company X the potential to successfully scale up its business. Therefore, subparagraph 360-40(1)(e)(iii) of the ITAA 1997 will be satisfied

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

59.      While Company X initially targets key Australian markets, its xx is built for worldwide use, designed to scale seamlessly across diverse xx frameworks and jurisdictions. Initial traction in Australia serves as a springboard for global expansion, opening doors to xx for innovative solutions.

60.      Company X transcends geographical boundaries. Its xx features offer immense value to any business facing xx challenges, regardless of location.

61.      Company X's commitment to continuous development ensures its global applicability. It's future impact is not limited to Australia but throughout the global landscape.

62.      Company X has demonstrated the Innovation has the potential to address a broader market than just the local market, including international markets. Therefore subparagraph 360-40(1)(e)(iv) will be satisfied.

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

63.      The combination of first mover advantage, rapidly evolving xx, low xx incumbents and significant need help lay the ground for an exceptional opportunity that Company X is placed to convert.

64.      Company X's Unique Value Proposition:

• xx.
• xx.
• xx.
• xx.
• xx.

65.  Being the first of such the Innovation, Company X has the first mover advantage. The Company has demonstrated the potential for the Innovation to have competitive advantages within the 'addressable market'. Therefore subparagraph 360-40(1)(e)(v) will be satisfied.

Conclusion on principles base test

66.      Company X 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 Innovation has been fully developed and is ready for sale, whichever occurs earlier.

Conclusion

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

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

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