Edited version of private advice

Authorisation Number: 5010081046417

Date of advice: 7 March 2022

Ruling

Subject: Early stage innovation companies

Question

Does X meet the criteria for being an Early Stage Innovation Company under the Principles Based Innovation Test?

Answer

Yes

This ruling applies for the following period:

PU November QOQQ - 30 June QOQR

The scheme commences on:

PU November QOQQ

Relevant facts and circumstances

1.    X was incorporated in Australia on PU November QOQQ (the QOQR income year) and is registered on the Australian Business Register (ABR).

2.    X issued new shares on PU November QOQQ (to A, B, C and D).

3.    X does not have any subsidiaries.

4.    X had nil expenses and nil assessable income in the year ended RO June QOQQ (that is, in the QOQQ income year), as it only came into existence in the QOQR income year (on PU November QOQQ).

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

6.    X is not a foreign company (within the meaning of the Corporations Act 2001 (Cth)).

7.    X is currently in the process of building an online booking website for holiday accommodation around Australia, by replicating some of the technology and learnings from another online booking website - G (at www.G.com.au, for booking holiday accommodation in G only). G is also being operated by current X directors and shareholders, A and B.

8.    The X website will be created to allow guests to make holiday accommodation bookings, for holiday accommodation venue providers (hosts) to list their properties, for money to flow through from guests to hosts, for property bonds to be held/returned and other standard features common to holiday booking websites (such as AirBnB and Bookings.com).

9.    X's investigations and research has revealed that since the onset of Covid-19, there has been an increased trend to support local businesses and to travel within Australia. This has meant X will have the ability to provide a lower cost alternative to the international booking platforms (like AirBnb and Bookings.com), due to its local presence and already established networks with local businesses and connections. This has also provided opportunities for X to collaborate with other Australian micromedia organisations to achieve increased holiday bookings.

X website features

10.  In addition to the features on the G website and other holiday booking websites, X are proposing to include the following new or significantly improved innovations on its online booking website:

a)    Finding a way for the X website to link to local government and/or State government short term accommodation registers, to enable only those accommodation venues compliant with local/State regulations and laws to be listed on the X website

b)    Represent indigenous culture and experiences on the X site effectively (by for example, having different 'welcome to country' recordings which will be accessible to the guests in the appropriate holiday region only)

c)    Develop a system that provides X guests with information specific to the holiday destination/s they are visiting only, based on the type of traveller they are (for example, a family with teenage children would have different needs compared to an older couple with no dependants)

d)    Linking to Property Management Software (PMS) (which allows property managers to put their pricing/rates, minimum duration of stay, availability of holiday accommodation, property description and photos etc in one place) and Channel Managers (which allow holidays accommodation venues to link to holiday booking platforms like X).

Addressable market for innovation

11.  X is initially targeting the domestic Australian market, with plans to expand to global markets. X are pursuing these plans by the following means:

a)  X are in ongoing discussions with local councils and state governments regarding how to link the holiday accommodation venues listed on their X website with the short term accommodation registers.

b)  X have engaged with indigenous business leaders and other indigenous organisations regarding the best means by which to promote indigenous culture and experiences on the X holiday booking website.

X have started conversations with a number of different PMS and are looking to work with Channel Managers Beds24 and Siteminder.

Commercialisation strategy

12.  X has advised that, according to information in the QOQQ Australian Short-term Rental Market Report and other research conducted by X:

a)  there has been a 40% increase in demand for self-contained accommodation due to Covd-19

b)  changes in providers in the international holiday booking platform market (from Stayz to HomeAway, for example) brought about fee increases, decreases in customer service and a general disconnect from the local community

c)   the short term accommodation market's gross annual revenue in Australia was over $Qbillion in QOQQ.

13.  As part of their business projections, X plan to capture 5% of the abovementioned annual short term accommodation revenue (which equates $Tmillion in annual turnover for X). X will utilise the impact from the above factors to roll out the expansion of their Australian website to each of the states and also overseas (to K and H) in future.

14.  X have outlined these future expansion plans and growth forecasts in relation to the short term accommodation market in the X 'Business Plan' as well as the X 'Projections' spreadsheet.

15.  To set up the X business, $S00,000 - $T00,000 in funds will be raised by X from external investment and expended according to the budget outlined in the X 'Business Plan'.

16.  X has employed two IT developers (C and D) to build the X website. Both these developers are also equity holders in X via the purchase of their X shares using 'sweat equity'.

17.  X has purchased the domain names for each of the states in Australia as well as the national domain name, as follows:

a)    X.com.au

b)    G.com.au

c)    M.com.au

d)    N.com.au

e)    I.com.au

f)     V.com.au

g)    W.com.au

h)    L.com.au

i)      J.com.au

18.  X has also purchased the domain names for H and K, as follows:

a)    H.com.au

b)    K.com.au

Market Position

19.  X has stated that it will use affiliate marketing to increase brand awareness. They will use micromedia organisations to market their X website, which will lead to increased sales and market share. This will further assist X in scaling as X will only pay for marketing if X generates revenue in return.

20.  X will have a main contact person in each Australian State to help with guest and host enquires. This will enable X to retain their local touch whilst expanding nation-wide. X will be employing ex-travel agents in these contact person roles (due to their already developed skill set in holiday planning, customer service and travel experience). X also plan to incorporate profit share into the ex-travel agent's salary package, to align their goals with X's success.

21.  X are also planning to link in with PMS and Channel Managers (such as Siteminder and Beds24), to allow for properties to be listed with relative ease across the country and thereby enabling further scaling.

22.  Although X's initial focus will be affiliate marketing (using other micromedia organisations), they are also proposing to utilise the following means by which to engage with the national and/or global market/s:

a)    starting to currently build a social media presence.

b)    using local media such as newspapers (X's first article about expanding nationally using the X website appeared in the G newspaper recently)

c)    targeted Google ads will be used to drive bookings as X expands.

Information provided

23.  You have provided information to us by the following means:

a)    your private ruling application dated QQ November QOQQ

b)    supplementary information provided on PP December QOQQ

c)    our phone conversation with you on P February QOQR

d)    our phone conversation with A and C on V February QOQR.

e)    we have referred to the relevant information within these documents and conversation in applying the relevant tests to your circumstances

f)     you have advised that X is proposing to issue new shares to investors in future, to assist in funding the continued development and commercialisation of their innovation.

Relevant legislative provisions

Income Tax Assessment Act 1997,section 360-40

Corporations Act 2001,section 9

Reasons for decision

Qualifying as an Early Stage Innovation Company

1.     Subsection 360-40(1) of ITAA 1997 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 particular time is referred to as the 'test time'. The ESIC criteria are based on a series of tests to identify if the company is at an early stage of its development and if 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) of the ITAA 1997. To satisfy the early stage test, all of the requirements outlined in paragraphs 360-40(1)(a) to (d) of the ITAA 1997 must be met.

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

3.         To meet the requirement in paragraph 360-40(1)(a) of the ITAA 1997, 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 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 ABR within the last three income years (the latest being the current year).

4.         The 'test time' is the time immediately after new shares are issued to investors. (Please note that the term 'immediately after' means, for example, if a share is issued at 11am on a certain day, the 'time immediately after' will be at 11.01am on that same day.)

5.         The term 'current year' is defined in subsection 360-40(1) of the ITAA 1997 with reference to the 'test time'. The 'current year' is the income year in which the company issues new shares to investors.

6.         A company that does not meet any of the conditions in item 3 (i) - (iii) above will not qualify as an ESIC.

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

7.         To meet the requirement in paragraph 360-40(1)(b) of the ITAA 1997, 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)

8.         To meet the requirement in paragraph 360-40(1)(c) of the ITAA 1997, 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)

9.         To meet the requirement in paragraph 360-40(1)(d) of the ITAA 1997, the company must not be listed on any stock exchange in Australia or a foreign country.

Innovation tests

10.       Once the company satisfies the early stage test requirements in paragraphs 360-40(1)(a) to (d) of the ITAA 1997, the company must also satisfy one of two innovation tests in paragraph 360-40(1)(e) of ITAA 1997 - either the 100 point test in section 360-45 of ITAA 1997, or the principles-based innovation test in paragraph 360-45(1)(e) of ITAA 1997 (PBIT).

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

11.       To satisfy the PBIT, the company must meet the five requirements in paragraph 360-40(1)(e) of the ITAA 1997. This is tested at a time immediately after the relevant new shares are issued to the investor (noting that the term 'immediately after' has the same meaning as in paragraph 4 above).

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 satisfying each of the requirements.

13.       The five requirements of the PBIT, as outlined in paragraph 360-40(1)(e) of the ITAA 1997 are:

                (i)         the company must be genuinely focused on developing for commercialisation one or more new or significantly improved products, processes, services or marketing or organisational methods

               (ii)       the business relating to those products, processes, services or methods 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

14.       For the purposes of Subdivision 360-A of the ITAA 1997, 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..."

15.       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.

16.       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.

17.       The OECD Oslo Manual defines innovations as significant changes, with the intention of distinguishing significant changes from routine minor changes. 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.       The EM does not define the meaning of the term 'genuinely focussed' within the context of subparagraph 360-40(1)(e)(i) of the ITAA 1997. Genuine is defined in the online Macquarie Dictionary as "Being truly such; real; authentic." Focus is defined as "3. a central point, as of attraction, attention, or activity. ... 8. to concentrate; to focus one's attention." In essence, the phrase "genuinely focussed" is looking to what the company is truly concentrating and focussing their attention on or, put another way, what is the real central point of the company's activities.

22.       For a company to qualify as an ESIC under the PBIT, 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.

23.       'Commercialisation' is discussed further at paragraph 1.81 in the EM which states "Commercialisation encompasses a spectrum of activities including those leading to the sale of new or significantly improved product, process or service as well as activities involving the implementation of a new, or significantly improved, process or method, where the process or method directly leads to the generation of economic value for the company."

High growth potential

24.       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

25.       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, 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.

Broader than local market

26.       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

27.       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)

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

29.       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

30.       For the purposes of this ruling, the 'test time' is the time immediately after new X shares are issued to investors on PU November QOQQ.

Current year

31.       For the purposes of subsection 360-40(1) of ITAA 1997, the 'current year' is the income year in which X issued new shares to investors. As new shares were issued by X to investors on PU November QOQQ, the current year is the year ending 30 June QOQR (that is, the QOQR income year).

Income year before the current year

32.       In relation to the particular requirements within subsection 360-40(1) of the ITAA 1997, the 'income year before the current year' will be the year ending 30 June QOQQ (that is, the QOQQ income year).

The early stage test

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

33.       As X was incorporated on PU November QOQQ, which is within the last 3 income years, subparagraph 360-40(1)(a)(i) of ITAA 1997 is satisfied.

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

34.       As X was only incorporated on PU November QOQQ, it did not exist in the 'income year before the current year' (that is, X did not exist in the QOQQ income year).

35.       Therefore, as X has 'nil' expenses in the QOQQ income year (as it did not exist), it will have incurred total expenses of less than $1 million in the 'income year before the current year' and paragraph 360-40(1)(b) of the ITAA 1997 is satisfied.

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

36.       As X was only incorporated on PU November QOQQ, it did not exist in the income year before the current year (that is, X did not exist in the QOQQ income year).

37.       Therefore, as X had 'nil' assessable income in the QOQQ income year (as it did not exist), it will have incurred total assessable income of less than $200,000 in the 'income year before the current year' and paragraphs 360-40(1)(c) of the ITAA 1997 is satisfied.

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

38.       As X is not listed on any stock exchange in Australia or a foreign country, subparagraph 360-40(1)(d) of the ITAA 1997 is satisfied.

Conclusion on early stage test

39.       Therefore, X will satisfy the early stage test for the entire QOQR income year, as each of the requirements in paragraphs 360-40(1)(a) to (d) of the ITAA 1997 have been satisfied.

Principles-based innovation test - subparagraphs 360-40(1)(e)(i) to (iv)

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

New or significantly improved

40.       The X website is a 'significantly improved' innovation as X is currently in the process of devising a method to link local government and/or State government short term accommodation registers to the holiday accommodation listings proposed to be advertised on the X website. This is a feature which is presently not available on the other holiday accommodation booking websites in the market.

Developing for commercialisation

41.       The X 'Business Plan' and 'Projections' spreadsheet explains how X will centrally focus its efforts to implement the above significant improvement, with the main purpose of generating economic value for X.

42.       The X 'Projections' spreadsheet shows how sales revenue will increase and expenses will be maintained or decrease (after the initial start-up phase). The X 'Business Plan' goes into more detail regarding how the sales will be increased and what costs will be expended over time as X expands.

43.       Further, X have participated in the following activities to implement its commercialisation objectives:

a)    had ongoing discussions with local councils and state governments regarding how to link the holiday accommodation venues listed on their X website with short term accommodation registers

b)    engaged with indigenous business leaders and indigenous organisations regarding the best means by which to promote indigenous culture and experiences on the X website

c)    connected with a number of different PMS and are looking to work with various Channel Managers (such as Beds24 and Siteminder).

Genuinely focussed

44.       The following activities undertaken by X indicate that it is 'genuinely focussed' on developing the X website for commercialisation:

a)    incurring significant expenses for its start-up costs ($R00,000 - $S00,000 per the X 'Business Plan')

b)    hiring specialist staff (two IT developers have been retained to build the X website)

c)    taking steps to protect intellectual property rights, by purchasing the domain names for the X website, for each of the Australian states and two countries (K and H).

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

45.       The X website evolved as a result of the increased need for self-contained, short term holiday accommodation due to Covid-19 and the growth in consumer demand for Australian based holidays. Combined with changes in providers in the international holiday booking platform market (from Stays to HomeAway, for example), fee increases, decreases in customer service (due to most booking websites being online only and based overseas) and a general disconnect from the local community, mean that X are in a position to address and capitalise on this gap in the market.

46.       X will utilise the impact from these factors to grow the X (national accommodation) website, expand holiday accommodation booking websites to each of the states and to expand overseas (to K and H) in the future.

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

47.       X are planning to use affiliate marketing by advertising using micromedia organisations, who will only charge a fee if X generates revenue in return.

48.       X plan to incorporate profit share into the ex-travel agent's salary package (when employing these individuals as part of X's expansion to state-based websites), to align their goals with X's success.

49.       The use of PMS and Channel Manager that X are planning to initially use, do not charge ongoing fees or commissions and costs incurred for them will be during the initial development stage (that is, linking to their PMS or Channel Manager system/s).

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

50.       X will engage affiliate marketing and other modes of advertising (social media, newspapers and Google ads) to reach markets external to Australia. Also, X has already engaged with some PMS providers and Channel Managers (such as Beds24) to access a database of holiday accommodation rentals available to be used on the X website.

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

51.       The following competitive advantages have been or can be obtained by X:

a)  collaborating with hyperlocal competitors and micromedia organisations has enabled X to utilise local knowledge, gain significant cost advantages (for example, by only paying for marketing expenses to micromedia organisations if X generate revenue) and increase their brand awareness

b)  when compared with international holiday booking platforms (like AirBnb, Bookings.com), X's local presence will allow:

•                the ability to provide pertinent local information to guests and hosts

•                promotion of tourism that is Australia focused

•                reduced commission rates

•                enhanced customer service due to local contact people engaging with guests

•                promotion of indigenous culture

•                support of local (Australian) communities.

Conclusion on PBIT

52.       Therefore, X will satisfy the PBIT at the test time (being the time 'immediately after' PU November QOQQ), as each of the requirements in subparagraphs 360-40(1)(e)(i) to (iv) of the ITAA 1997 have been satisfied.

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

53.       As X is a body corporate (company) that is incorporated in Australia, paragraph 360-40(1)(f) of the ITAA 1997 has been satisfied.

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

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