Cutler Review Green Paper: The Good, The Bad and The Ugly for the R&D Tax Concession
After months of submissions, consultation, deliberations, and writing, Dr Terry Cutler delivered his Green Paper on the National Innovation System to Senator Kim Carr last week. At 2.30pm today, it became public.
This MJA Update will address the aspects that touch on R&D tax concessions.
From Green Paper to Policy, and Policy to Legislation
Today marks the start of a journey towards positive reform of R&D tax benefits. There is a long and potentially difficult path to be negotiated to the formulation of the Minister’s policy response to the Green Paper. Then, as we have witnessed in the recent past (such as the 175% international premium), implementation of policy through legislative drafting, debate, and parliament can be a process fraught with controversy, complexity and contradictions.
The Good
The Green Paper acknowledges the point made by MJA’s Kris Gale during the consultation process that the current R&D tax concession is “underpowered and overcomplicated”. It is resoundingly positive in its acceptance of the mechanism to stimulate activity in the economy, and reflects some of the changes in the innovation environment between 1985 and 2008.
The biggest single change is to abolish the current range of concessional deductions and refundable tax offsets at 125% and 175% and to introduce an income tax credit model. This would help disconnect the benefit of the program from the tax rate (which may be further reduced after the Henry Review of Australia’s Future Tax System) and provide an opportunity to relaunch the program as a credit, bringing it into greater focus within corporate decision-making and planning.
Small Australian-owned companies (meaning those with a group turnover of less than %50 million, a tenfold increase over the current $5 million cap) benefit from the opportunity to access a 50% refundable credit, higher rate than the present 125% concession (an effective 166% R&D concession). Of course, it will be unfortunate if you cross from $49,999,999 to $50 million annual turnover as the effective marginal tax rate on that $1 of revenue is 5,000,000% based on average business expenditure on R&D (1% of revenue).
Recommended changes to allow eligible activities to be claimed regardless of where the resultant intellectual property (IP) is owned is a positive and internationally competitive change. It makes us competitive with the program in the United Kingdom, among others, and recognises that where the activity occurs is of primary relevance to policy makers, even if the major benefits from exploitation may reside elsewhere.
The Green Paper’s approach to software is odd. Whilst recommending that open source software R&D be taken to “qualify for the multiple sale test”, it suggests that “relax[ing] … the degree of technical risk required” might also be possible. Yet the Green Paper apparently approves of the multiple sale test limiting claims for large firms. This is an odd distortion, and does not take account of the realities of software, process and product development in 2008. Moreover, the wording of the multiple sale test in the legislation is an ongoing source of uncertainty and tension in the compliance fabric of the concession and would have benefited from commentary in the Green Paper as it was emphasised in the consultation process.
The Bad
In all of the positives there are some potential downsides. At the core is the risk that replacement of the 125% and 175% programs by the credit may see fundamental changes to the definition of R&D and the established expenditure concepts and mechanisms. This would be the risk of starting from a blank piece of paper rather than from the relative certainty among companies and advisers on the concepts in the existing programs. Of course there may be a concomitant reduction the complexity of the legislation, but the risk is greater on the downside.
For large companies (where turnover is greater than $50 million) and foreign-owned corporations, the rate of the credit at 40% is only equivalent to a 10% after tax benefit, or an R&D tax concession of 133%. Whilst this restores core program value to pre-1996 levels, there are two major problems with this rate. The first is that the rate is considerably lower than the return they can generate under the current complex 175% program (up to 22.5 cents per dollar invested), making it an unfair trade off to ask large corporates to make. Second, the rate nominated remains below the cost of capital and will contribute only marginally to project economics.
The Ugly
Perhaps the worst feature of the Green Paper is its handling of the issue of what it terms “large one-off projects like mines and civil engineering”. It has recommended that the definition of R&D (or, failing that, directly related expenditure or the use of government guidelines) limit claims in order to “protect the revenue and continued viability of the R&D Tax Concession”.
Unfortunately, this point cannot be sustained based on the reasoning in the Green Paper and may be the single largest issue with the government’s adoption of the Green Paper as R&D tax policy.
With exceptions such as software and “processing” R&D, the R&D tax concession operates as a market driven program that is technology agnostic. It provides (in general) the same rate of support to small and large projects, regardless of whether the company expends its effort on what the Green Paper terms “worthwhile innovation” or not: what matters is that the activities are eligible. Where the eligibility of activities and expenditure can be established, it does not matter whether projects receive concessional treatment for 8% or 80% of the investment expenditures.
The Green Paper is at risk of distorting the commercial reality attaching to this analysis by its focus on mining and civil engineering projects. You could rewrite the section of the Green Paper to address large one-off projects in the biotechnology or software sectors, where 80% or more of the invested expenditure may be eligible for concessional treatment, and the analysis would look the same. This is exactly as it should be.
It is a feature of a market-based program that no one sector or project benefits disproportionately, and the case for such a sectoral distortion has not been made by the Green Paper. Instead, it introduces the spectre of uncertainty and complexity to the definition of R&D at a time where the tenor of the Green Paper is resoundingly in favour of expanding the existing mechanism.
This is most disappointing when large companies are considering fundamental technology shifts associated with leadership and compliance around sustainability. At the very least, any program changes should exempt these activities from the proposed constraints.
Finally, it does the innovation community a great disservice when the process of consultation could have explicitly engaged and addressed this point rather than simply handballing it back to government to deal with in a relative vacuum.
Stay tuned for further developments on this point.
Conclusion
Overall, the Green Paper presents a positive future for the use of R&D tax mechanisms to stimulate, reward and incentivise the conduct of innovative and risk-based activities in Australia.
What will be of critical importance to Australian industry is how the journey from Green Paper to Policy is achieved, and beyond that how effectively the Policy is turned into practical, workable and actionable legislation.
The Government is taking responses to the Green Paper until 23 September 2008 and will announce its policy response to the program before Christmas.
