Edited version of private advice

Authorisation Number: 1052234272847

Date of advice: 21 March 2024

Ruling

Subject: Early stage innovation companies

Question

Does Company A satisfy the conditions to be 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 periods:

Year ended 30 June 20SS

Year ending 30 June 20YY

Relevant facts and circumstances

Company A was incorporated in Australia in 20SS. Its equity interests are not listed for quotation on any stock exchange.

Company A has no subsidiaries.

In respect of the 20VV income year (i.e. the income year previous to the 20SS income year), Company A had nil expenses and nil assessable income since it was not in existence.

In respect of the 20SS income year (i.e. the income year previous to the 20YY income year), Company A had nil expenses and nil assessable income.

Company A first incurred expenses during the 20YY income year and had not derived any assessable income since its incorporation.

Company A is developing software that uses artificial intelligence technology to wholly automate social media management for businesses on an ongoing basis, and enable businesses to increase sales through effective content creation and promotion.

The software is a significantly improved product compared to that offered by competitors.

Company A has taken steps to commercialise the software and has provided its commercialisation strategy and timeline. The business concept in respect of the software has taken on a number of iterations based on industry analysis and feedback from different stakeholders. The development of the software by external contractors and closed customer testing started in 20SS. The software will begin to be commercialised in 20YY.

Company A's product will initially launch in Australia, its initial target market being small to medium businesses (SMBs) in a select industry, before expanding to SMBs across a wide range of businesses/industries in Australia and other English-speaking countries.

As the product is digital, Company A's growth opportunities are not limited by physical borders or location. Company will be able to service any English-speaking nation and distribute easily through digital platforms.

Company A has raised capital in 20SS and plans to raise further capital via the issue of ordinary shares before the end of the 20YY income year.

Relevant legislative provisions

Income Tax Assessment Act 1997Subdivision 360-A

Income Tax Assessment Act 1997section 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)(i)

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)

Corporations Act 2001 section 9

Reasons for decision

All subsequent legislative references are to the ITAA 1997, unless otherwise stated.

Summary

Company A 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 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 the test time in an income year (the current year) the company must have been either:

1. incorporated in Australia within the last 3 income years (the latest being the current year); or
2. 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 the company and its 100% subsidiaries (if any) incurred total expenses of $1 million or less; or
3. registered in the Australian Business Register within the last 3 income years (the latest being the current income 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 (if any) 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 (if any) 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[1] or the principles-based test.

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

To satisfy the principles-based test, the company must meet 5 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:

1. the company must be genuinely focused on developing one or more new or significantly improved innovations for commercialisation;
2. the business relating to that innovation must have high growth potential;
3. the company must demonstrate that it has the potential to be able to successfully scale up the business relating to the innovation;
4. 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
5. 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 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...

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 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.

'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, whereby it increases its market share or enters into new markets, and 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)

To meet the requirement at paragraph 360-40(1)(f), the company must not be a foreign company within the meaning of the Corporations Act 2001 at the test time.

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 Company A is a qualifying ESIC will be a particular date during the income years ending 30 June 20SS and 30 June 20YY.

Current year

For the purposes of subsection 360-40(1), the current year will be either the year ended 30 June 20SS (the 20SS income year) and the year ending 30 June 20YY (20YY income year).

Early stage test

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

In respect of the 20SS income year, as Company A was incorporated on XX February 20SS, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) is satisfied.

In respect of the 20YY income year, as Company A was incorporated on XX February 20SS, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) is satisfied.

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

In respect of the 20SS income year, Company A had nil expenses in the prior income year (the 20VV income year) since it did not exist, therefore paragraph 360-40(1)(b) is satisfied.

In respect of the 20YY income year, as Company A had expenses of $1 million or less in the prior income year (the 20SS income year) paragraph 360-40(1)(b) is satisfied.

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

In respect of the 20SS income year, Company A had nil assessable income in the prior income year (the 20VV income year) since it did not exist, therefore paragraph 360-40(1)(c) is satisfied.

In respect of the 20YY income year, Company A had nil assessable income in the prior income year (the 20SS income year), so paragraph 360-40(1)(c) is satisfied.

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

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

Conclusion on early stage test

Company A will satisfy the early stage test for the period starting from its incorporation to 30 June 20YY as each of the requirements within paragraphs 360-40(1)(a) to (d) have been satisfied.

Principles based test

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

Company A is genuinely focussed on developing its software for a commercial purpose. Company A's software will be a significantly improved automated social media management tool for SMBs.

Company A has not yet made its first commercial sale to any business or partner.

Therefore, subparagraph 360-40(1)(e)(i) will be satisfied for the period beginning 1 July 20VV until 30 June 20YY or until such date as the product has been fully developed, whichever occurs earliest.

Once the software has been fully developed, Company A will no longer be 'developing' the product for commercialisation and subparagraph 360-40(1)(e)(i) will no longer be satisfied.

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

The software developed by Company A is easily accessible and capable of servicing the majority of SMBs both in Australia and other English-speaking countries via digital platforms.

Company A expects its software to appeal to a wide range of SMBs across many industries. Therefore subparagraph 360-40(1)(e)(ii) is satisfied.

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

Company A has demonstrated that it has the potential to scale up its business.

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

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

The product is entirely digital, able to service any English-speaking nation and will be available through widely used digital platforms such as web browsers. The product therefore has the potential to address international markets and subparagraph 360-40(1)(e)(iv) is satisfied.

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

Company A has demonstrated the potential for its software to have competitive advantages within the addressable market, be it in terms of product offering and quality, cost and time management, thereby satisfying subparagraph 360-40(1)(e)(v).

Conclusion on principles based test

Company A satisfies the principles based test as it satisfies the requirements within subparagraphs 360-40(1)(e)(i) to (v) from incorporation to 30 June 20YY unless the product is fully developed before 30 June 20YY in which case Company A only satisfies the principles based test from its date of incorporation to the date the product is fully developed.

Foreign company test

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

Conclusion

Company A meets the eligibility criteria of an ESIC under section 360-40 from its incorporation to 30 June 20YY unless the product is fully developed before 30 June 20YY in which case Company A only satisfies the criteria of an ESIC from its incorporation to the date the product is fully developed.

[1] The objective (100 point) test is not considered for the purposes of this ruling.

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