R&D Tax Credit – The Shock of The New

April 14, 2010 by Kris Gale · Comments Off

Hopefully, in amongst the Easter chocolate blitz and trips with the kids to see “Nanny McPhee And The Big Bang” (the only G-rated movie on these school holidays), you’ve had time to prepare a compelling submission in response to the 2^nd Exposure Draft and Explanatory Materials (the Easter package) detailing the New R&D Tax Incentive. If not, don’t worry. You have until Monday. OK, maybe you can worry just a bit.

Here at MJA, we have had to dispense with our usual practice of circulating our draft response to interested parties well in advance of the submission closing date as only 10 working days were provided to put thoughts together. As a second best alternative, we have decided to make use of the MJA Update to give you a snapshot of the main conclusions that will be contained in our submission.

In a Nutshell

We believe that the Easter package should be treated as though it was the first response to the May 2009 Budget announcement.

We have concluded that the package is legislating a brand new business R&D support program that is a fundamental departure from the established principles and framework of the existing R&D Tax Concession (the Concession) and that 25 years of institutional experience and memory related to the Concession is at real risk of being jettisoned.

We submit that the Easter package is introducing a different type of support for corporate R&D that dramatically narrows the range of eligible activities and expenditures. In doing so, the program has shifted from supporting corporate research and development to corporate research only. This shift is reinforced by the replacement of the current Objects clause with its five promotional objectives with a new Object clause containing one restrictive premise that only business R&D reflecting additionality and spillover merits support.

The eligibility requirements for core and supporting R&D activities have been changed, not clarified, and have added several layers of complexity and uncertainty for program participants. In addition, new legal concepts have been introduced such as ‘production’ and ‘business as usual’ R&D for the first time in the Easter package. The previewed compliance framework shifts the Credit away from the principles of self-assessment to a program controlled by administrators through a range of sectoral guidelines and position statements so that it takes on a form resembling a discretionary grants program delivering support based on the perceived merits, rather than the eligibility, of the R&D.

Further, there are a number of unresolved features of the draft legislation such as expenditure not at risk, overseas expenditure requirements and core technology transition provisions. Critically, the redrafted feedstock expenditure provisions announced in the Easter package have not been made available to stakeholders.

Finally, after a legislative development process that has long been characterised by delay and a lack of true consultation, the Easter package now provides a miniscule amount of response time followed by a rapid timetable by which it becomes operative law on 1 July. For the vast majority of claimants, there will be no transitional process in place for taxpayers to absorb the new legislation and establish new plans and procedures. Rather, there is a hard changeover from the old system to the supposedly brave new world.

Overall, we submit that there is an unacceptable risk that the Easter package will harm Australia’s innovation system by withdrawing critical support for commercially-focused R&D. And remember that it is this aspect of R&D that Australia traditionally lags behind our competitors. There is an urgent need to provide for a comprehensive review of this legislation including a realistic process for its implementation in an orderly fashion. This may well involve a need to delay the introduction of a number of features of the Credit to ensure a smooth transition for taxpayers.

How New is New?

Given the above, it is worth demonstrating as briefly as possible why we agree with the Government that it is a brand new program, rather than a reform of the old one, thereby leading us to conclude that the timetable to convert this draft package into legislation is simply too rushed and likely to involve unintended consequences and outcomes.

Since the consultation process began in earnest, all the Treasury releases have been headed “The new research and development tax incentive”. Recent consultations with Government officials have reinforced the idea that the R&D Tax Credit (the Credit) is being treated as a new program by outlining a different style of administration based upon industry sector-specific guidelines and a compliance framework that will be built from the ground up.

This Government’s emphasis of the fact that the program is a new one stands somewhat in contrast to the policy announcements in last year’s Budget which referred to a tightening of eligibility criteria of the current Concession to better support “genuine R&D”. There was a sense that there would be a significant carryover of the principles and understandings associated with the Concession and the Budget announcement reinforced this notion.

It is now clear that this is not the case. The fact that this is a very brave new world is even more starkly set out in the Easter package than with the 1^st Exposure Draft and Explanatory Materials (the Christmas package).

To demonstrate this, take the new definition of R&D activities contained in the Easter package as an example.

A New Definition of R&D

The Treasury’s consultation guide to the Easter package refers to a “clearer” definition of core R&D activities by its use of clear language in the place of ambiguous concepts such as ‘considerable novelty’ and ‘high levels of technical risk’. What they should go to say is that the intended definition of both core and supporting R&D is fundamentally different to the very stable definition that has been in place since 1985.

As you would be aware, eligible activities have been separated into two categories –core and supporting – with separate qualification tests. Previously, activities qualified as eligible R&D activities collectively through the ‘SIE’ or ‘directly related’ pathways. Now they are split into two distinct baskets.

As Treasury has indicated, the new definition of core R&D requires taxpayers to be seeking new information (to solve problems or develop new or improved products and processes) and to need an experiment to uncover that knowledge.

The concepts of systematic, investigative, innovation and technical risk have all been dispensed with. These are concepts that are useful to taxpayers in qualifying their R&D activities and are well understood as opposed to ambiguous. Ten of the current technical objectives – the creation of new or improved products, processes, devices, material and services – have been eliminated and subsumed into the new knowledge objective.

This is an unequivocal narrowing of the definition of core R&D compared to the current Concession and, in fact, to the one contained in the Christmas package. Add the four new classifications of supporting R&D activities and the new restrictive Object clause and you end up with a very different definition of eligible business R&D.

The September 2009 Treasury Consulation Paper stated that the Government was altering the definition to bring it more in line with the Frascati definition. They could no longer credibly maintain that this is the case. The proposed definition reflects the first two elements of Frascati – basic and applied research – but experimental development has been removed.

The new Explanatory Materials confirm the narrowing of the definition. In paragraph 2.16, they indicate that it is not enough to be doing experimental activities if they “merely confirm what is already known”. As displayed in the example projects provided, the suggestion is that the taxpayer will need to be able to prove in a retrospective assessment that the knowledge did not exist anywhere else. Not only is this highly impractical. It also flies in the face of encouraging an innovation system where several companies in an industry pursue the development of new and improved products and processes and the associated knowledge in parallel.

The guidance given to taxpayers as to how to interpret the definition is very open-ended. The Explanatory Materials indicate that qualifying the eligible purpose of the activities is a question of fact based on the overall circumstances of the conduct of the work (paragraph 2.32) without detailing what the key determining criteria might be. It appears as though the Government is seeking to preserve as much discretion as possible when assessing claims. This is apparent from the statement in paragraph 2.32 that says that “…it is possible that activities that are similar in appearance might qualify as supporting activities in one context but not in another.”

As we have been saying all along, the Credit is seeking to institute a scientific definition of R&D that gives voice to the Productivity Commission’s world view of what is “genuine R&D”. Yet that view was not the one put forward in the Cutler Report, the Government’s Innovation White Paper or the May 2009 Budget announcement which all reflected the existing industrial definition.

Suddenly, we are at ground zero and you’ve been given 10 working days to get your head around what it all means!

More Work For Us All To Do

The proposed Credit is new, uncertain and even a bit scary.

We urge you to use the April 19 response and the highly likely Senate Committee as your last remaining opportunities to elicit the Government to pause and take stock of whether the proposed Credit really aligns with its previously announced policy. Hopefully, we can all then move on in a spirit of true consultation to ensure the right R&D outcomes for Australia’s innovation future.

Should you wish to discuss this matter any further, please do not hesitate to contact Kris Gale directly on (02) 9810 7211 or using our contact form to discuss the matters raised in this MJA Update in greater detail.

Filed under: MJA Update Articles
Tagged: BERD, Cutler Review, Government Consultation, Innovation Australia, National Innovation System Review, Productivity Commission, R&D Tax Concession, R&D Tax Credit, The new research and development tax incentive, Treasury

R&D Tax Credit March 2010 Exposure Draft – A Brief Summary of Features

April 1, 2010 by Kris Gale · 1 Comment

The release of the second Exposure Draft of the R&D Tax Credit Legislation after the close of business on Wednesday 31 March, just prior to the Easter break, is disappointing, with a scant 9 days left in which to prepare a response. Given the tightness of this timetable, coupled with the new legal concepts, as highlighted below, MJA would suggest that the best course of action is to stay the introduction of this legislation until full consideration can be given to its merits. We would not support the timetable currently being mooted by Government for a commencement date effective 1 July 2010. We agree with other advisors and industry groups that rushing this legislation through will ultimately be counter-productive to the program.

Below is a brief overview of the new legal concepts proposed.

Rates of deduction

The R&D Tax Credit (the Credit) is designed to provide a greater incentive for SMEs to undertake R&D by providing a higher tax offset than that available to larger companies. Foreign owned R&D will also be eligible. The rate, and whether it is refundable, will be dependent upon company turnover:

A 45% refundable tax offset (equivalent to a 15% after-tax benefit) will be available to SMEs (companies with an aggregated annual turnover of less than $20 million) undertaking eligible R&D; and
A 40% non-refundable tax offset (equivalent to a 10% after-tax benefit) will be available for companies with an aggregated turnover greater than $20 million undertaking eligible R&D. Unused non-refundable tax offsets can be carried forward.

Changes to the definition of R&D activities

As in the first draft, companies will now need to clearly distinguish between core and supporting activities, identifying not just two but three types of activities, including two subsets of supporting activities. Additionally, the Explanatory Materials appear to indicate the potential for Innovation Australia to differentially apply the definition depending on the circumstances.

(1) Core R&D Activities

Core R&D activities are will now be defined as experimental activities whose outcome cannot be known and are conducted for the purpose of acquiring new knowledge. So it appears that although the words technical risk and innovation will no longer be used, these concepts will still remain, and both elements will be required to be demonstrated. The list of excluded activities will only apply to core R&D activities.

(2) Dominant purpose supporting activities

These dominant purpose supporting activities will be defined as activities that do not meet the definition of core R&D activities and

are for the production of (or directly related to) the production of goods and services; or
would fall under the exclusions list

These activities will need to be undertaken for the dominant purpose of supporting the core R&D activities. Importantly, production activities have not been defined in the ED. This new subset of supporting activity will have the potential to significantly reduce claims across all industries, as the technical and financial risks in demonstrating any technology in a full scale environment are almost always going to be the biggest expense a company incurs in undertaking R&D.

(3) Directly related supporting activities

A directly related supporting activity will be defined as any activity undertaken for a purpose directly related to the core R&D that is not a production activity or one that would fall under the exclusions list. The exclusions list will not apply to directly related supporting activities. It appears that there would be only a small amount of expenditure that would fall under this subset of supporting activities.

Software development activities

Software development will be subject to the same eligibility tests as other types of R&D with the exception of in-house, business administration style software. This exception has been incorporated into the exclusions list, however it will not extend to “applied” software that forms part of a device or equipment, nor to software activities that may qualify as supporting a core R&D activity. The existing multiple sales provision for core R&D software development has been removed.

Feedstock

The feedstock rules will change, however it is not yet known whether there will be any surprise additions to the current definition of “feedstock”. What is clear is that the notion of augmented feedstock introduced in the first draft has been dropped.

Expenditure not at risk

A company will not be able to claim expenditure on activities where the expenditure is not at risk. This will apply where a company has a reasonable expectation that it will receive consideration irrespective of the results ie receive consideration even if the R&D fails to deliver a result or a successful result. Expenditure not at risk will not necessarily apply to all product development projects where a company could receive consideration under a contract for the development and sale of a product. It will only apply if the contract provides that the company will receive consideration, irrespective of whether it delivers a product.

Administrative powers

The Credit will continue to operate on a self-assessment basis for companies. However, Innovation Australia will have “enhanced” powers in registering and assessing eligibility of R&D activities. R&D activities can be unilaterally reclassified and rejected based solely on the detail provided by companies in the registration application. This means companies will not always get the opportunity to meet and discuss with the government on their activities and may only get an opportunity to present their case in a formal appeals process.

Object clause

The new provisions will be interpreted by having regard to the Object clause which will be more restrictive than the promotional Object clause of the existing program. The clause defines the object of the legislation as encouraging industry to conduct R&D where the knowledge gained is likely to have a benefit for the wider national economy and might not otherwise have been conducted without the Credit. As such, this more restrictive clause will lead to a more restrictive interpretation of the Credit provisions.

Filed under: MJA Update Articles
Tagged: Government Consultation, National Innovation System Review, R&D Tax Concession, R&D Tax Credit, R&D Tax Credit Issues Paper, The new research and development tax incentive, Treasury

The New R&D Tax Incentive – Second Exposure Draft Released

April 1, 2010 by Kris Gale · Comments Off

“The Good, the Bad and the…oh, you know the rest.”

The Federal Government released the second Exposure Draft (ED) and Explanatory Materials (EM) in support of the new R&D Tax Credit (the Credit) after the close of business on Wednesday, March 31. In what is arguably emerging as a pattern, the ED and EM have been delivered one working day before the Easter break. This leaves a scant ten working days available before the due date for responses (April 19).

Given that the ED introduces some first time concepts such as a new definition of core R&D activities and ‘business as usual activities’, this is hardly enough time for a considered response. There is a wealth of new discussion material and examples to absorb and interpret yet most of us won’t really turn our minds to this until the middle of next week.

MJA will generate a comprehensive update regarding the changes and circulate this next week. We shall also share our detailed views about what are the next possible courses of action. The Government continues to insist that this Bill will become law prior to July 1 and it proposes to introduce the Bill in the Budget session of Parliament (May 11).

What’s New and What’s Our Gut Feel

Object Clause

The Object clause has removed the reference to spillover but clearly retains the concepts of additionality and spillover in its wording. All the promotional objectives from the current legislation remain removed. The new clause is restrictive in its terminology.

Splitting Core and Supporting R&D Activities

The need to distinguish between these two classes of activities has been retained and this remains a major concern with the Credit. It should be remembered that the need to split these activities is a first-time feature of the new program.

A “Clearer” Definition of Core R&D Activities

The new definition requires that you seek new information and that you need to do an experiment to uncover the knowledge. The concepts of ’systematic’, ‘investigative’, ‘considerable novelty’ and ‘high levels of technical risk’ have all been removed. The Government’s explanation is that this simplifies the eligibility requirements for core R&D. However, we are concerned that the changed definition may have far-reaching impacts on the operation of the Credit. And there is little time allowed to think through those implications and formulate a response.

A Narrower Dominant Purpose Test for Supporting R&D

The dominant purpose test will only be applied to production activities (apparently not defined) and activities on the exclusion list. The ‘directly related’ test will be retained for the balance of supporting activities. This is the single largest concern with the ED and EM. The supplied examples in the EM clearly spell out a desire to restrict the availability of the Credit across a range of necessary, dare we say, genuine R&D activities. The same concerns remain as those stated by so many parties in response to the Treasury September 2009 Consultation Paper. The dominant purpose test stands to remove most of the support from the vast majority of innovation projects conducted by modern Australian companies.

Lifting Exclusions on Supporting R&D

Given the dominant purpose test, it has been decided that the exclusions list no longer applies to supporting R&D activities. This is sensible and focuses our concern on the likely application of the dominant purpose test.

A New Approach to Software R&D

In a pleasing development, most software R&D will be subject to the same rules as all other kinds of other R&D. The multisales test and the broad-based exclusions have gone. Certain in-house software activities will be excluded from core R&D but will be subject to the dominant purpose test for R&D.

Changes Regarding ‘Expenditure Not At Risk’

The ‘expenditure not at risk’ rule has been clarified to align with the Australian Taxation Office’s interpretation of the corresponding existing rule. We support this announcement as being sensible.

Augmented Feedstock Rule

This rule has been dropped and we are happy to see it die a quiet and polite death. A redrafted provision of the existing feedstock provision will be retained. That space will need to be watched as the redrafted provisions are not yet available.

Enhanced Administration Powers

Most alarmingly, all the proposed enhanced powers for the administrative bodies in the first ED have been retained. In short, taxpayer claims prepared under self-assessment can be unilaterally reclassified and rejected by Innovation Australia based purely on the registration application. MJA finds this unacceptable and will vigorously oppose these changes.

So, is this a Win?

Many will be tempted to see the new ED and EM as something of a win for the post-Christmas lobbying effort and this is understandable. However, the harsh reality is that the main positives are around the removal of some of the more extreme elements that appeared for the first time in the Christmas announcements – augmented feedstock; radical changes to software; a naked ‘expenditure at risk’ provision. The current package leaves us back where we all were when the Treasury delivered its September 2009 paper – a restrictive Object clause legislating additionality and spillover (despite the original public assurances to the contrary); a first-time split between core and supporting R&D activities; a wide-reaching dominant purpose test. Remember, 162 of the 165 responses to the Treasury paper published last year opposed such changes. They were a bad idea then and they remain a bad idea now. Six months on and we have made little progress. It’s time to consider whether the best for all concerned is to have this Bill made subject to a Senate review as an urgent priority.

Filed under: MJA Update Articles
Tagged: Government Consultation, Innovation Australia, National Innovation System Review, R&D Tax Concession, R&D Tax Credit, R&D Tax Credit Issues Paper, The new research and development tax incentive, Treasury