The Senate Economics Legislation Committee (the Committee) released its Report into the R&D Tax Credit Bills (the Bills) yesterday. The Report sets up the debate in the Senate as to whether the Bills should become law prior to the proposed commencement date of 1 July 2010.

Overall, MJA is disappointed by the recommendations made by the Government in the Report and submits that the Dissenting Report of the Coalition Senators should be taken into account by the Senators on the cross-benches when the legislation comes to the vote.

When looked at in detail, the Government has recommended a series of minor changes to the Bill but has not undertaken any detailed analysis of most of the key concerns raised by so many of the stakeholders during the consultative process.

This is best illustrated by the Committee’s response to concerns raised regarding the proposed feedstock provisions which appeared for the first time when the Bills were read into Parliament on 13 May. At pages 61-63 of the Report, the proposed changes are outlined, followed by only one generally expressed concern made at the recent Senate hearings. The Committee goes on to note the concerns about the provisions without providing any details and then indicates that it “…does not believe this will be a problem for large companies.” It proceeds to recommend an advisory group be established to advise the administration on any “unforeseen consequences that emerge as the bill is implemented.”

Rather than dwell on whether this is a case of buck-passing of the highest order, we submit that it is a compelling example of the fact that the Committee simply didn’t have the time to absorb and analyse the feedstock issues in the same way that stakeholders were not afforded any time to undertake a similar process. Yet the new provisions stand to have a huge impact on eligible R&D for all claimants going forward. The same can be said for so many of the other concerns that have been raised regarding the Bills.

The content of the Report, spread very thinly over its 110 pages, underlines the rushed nature of the drafting process and the fact that the implications of the Bills in their current form have not been subject to anywhere near the requisite degree of scrutiny required for the making of good law.

Before setting out the recommendations and providing some further preliminary assessment of the Report, it is worth making particular note of the fact that the Government has recommended that the dominant purpose test be removed for companies with a turnover of less than $20 million. This would establish two distinct programs with separate definitions of R&D as well as levels of benefit. This takes the legislation even further away from the Government’s own announced policy, let alone the original position taken by the Cutler Report of a system that supported the same type of R&D within all organisations, large or small. It goes without saying that more compliance complexity and administrative uncertainty will follow.

We urge the Government to reconsider the passage of the Bills in the form recommended by the Committee. Policy on the run suits nobody and stakeholders have simply run out of time to consider the impact of the latest round of recommendations and amendments before the Bills need to be passed by 25 June.

The Government’s Recommendations

The Government Senators have made the following recommendations:

Recommendation 1
The Committee recommends that subsection 355-5(2) of the objects clause be
amended to clarify the reference to ‘new knowledge or information in either a
general or applied form’ by adding ‘new knowledge in an applied form  includes
new or improved materials, products, devices, processes or services’.

Recommendation 2
The Committee notes that many of the concerns were raised by organisations
who want to maintain the status quo. Nevertheless, given the concerns raised, but
acknowledging the need to ensure that public support is targeted appropriately,
the Committee recommends that the definition of ‘core R&D activities’ in section
355-25 be amended to remove the word ‘about’ from paragraph 355-25(1)(b) so
that the paragraph reads as:
[talking about experimental activities] that are conducted for the
purpose of generating new knowledge (including about the creation of
new or improved materials, products, devices, processes or services).

Recommendation 3
Given the  scope of the changes proposed, the Committee is of the view  that the
amended provisions,  including  the effect of the ‘dominant purpose’ test,  be
reviewed  after two years to ensure that the  legislation is operating consistently
with the Government’s intent.

Recommendation 4
The Committee recommends that companies with revenues under $20 million be
exempt from the dominant purpose test.   
 
Recommendation 5
The Committee recommends that a broad–based working group including small
business and union representatives be established to advise Innovation Australia
and the Department of Innovation, Industry, Science and Research about any
unforeseen circumstances  that emerge as the bill is implemented. This working
group would also inform the two year review of the bill (Recommendation 7).

Recommendation 6
The Committee notes the claim of drafting errors.  The Committee notes that
minor drafting errors are common when framing new legislation.  The
Committee does not believe that these minor errors are of sufficient magnitude to
delay passage of the bill but considers it preferable that they be dealt with before
the bill is enacted.

Recommendation 7
The Committee recommends that the Senate pass the bill, with the amendments
proposed in the earlier recommendations, before the end of June 2010. The
operation of the bill should be monitored on an ongoing basis and reviewed after
two years.

The Dissenting Report of the Coalition Senators 

The Coalition Senators have made the following recommendations:

Recommendation 1:
The Coalition recommends that the start date for these Bills be amended to 1
July 2011.

Recommendation 2:
The Coalition recommends that the passage of the Bills be delayed in order to
rectify the issue of drafting errors.

Recommendation 3:
The Coalition recommends that the definitions of core and supporting R&D be
reconsidered to be more closely aligned to the Frascati model of R&D.

Recommendation 4:
The Coalition recommends that the dominant purpose test be removed and be
reconsidered.

Recommendation 5:
The Coalition recommends that the Object clause be amended to ensure that
both research and development are given equal tax benefits.

Our Preliminary Assessment

The spectre of the 2007 Productivity Commission Report (the PC Report) looms large over the Committee’s Report. In the opening to Chapter 6, the Committee states that:

“The bill will introduce aspects of the recommendations that came out of the Productivity Commission’s 2007 review;” (page 59).

This is a stunning admission given that the PC Report was so directly contradicted by the Cutler Report and it is Cutler that the Government has repeatedly quoted as the basis of its R&D tax policy. Again, remember that the PC Report advocated the closure of the basic concession for all but the smallest companies, leaving most with an incremental option only. Cutler advocated the polar opposite – enhance the basic incentive and close the incremental option and that is exactly what the Government announced in last year’s Budget.

The Committee is in the thrall of the additionality and spillover arguments of the PC Report and repeats much of the debate that had already been resolved in the Cutler Report. From MJA’s perspective, it is clear that the Committee could not follow the arguments we put forward regarding additionality involving the need to focus support on generating additional R&D activities from the R&D projects that companies do undertake rather than designing a subsidy aimed at getting otherwise marginal projects across the line.

The Government’s recommended amendments do very little to allay the concerns expressed by so many stakeholders since the consultation process began towards the middle of last year.

The changes to the Object Clause and the definition of core R&D activities appear designed to more explicitly acknowledge the eligibility of applied R&D but do nothing to address the restrictive impacts of the dominant purpose test and the new feedstock provisions. The express inclusion of new or improved products, processes, devices, materials and services in the definition of new knowledge actually doesn’t make grammatical sense. How is it that new knowledge includes the creation of new and improved products and processes as the Committee suggests?Traditionally, new knowledge has been seen as the output of basic and applied research whilst the creation of products and processes results from experimental development ie. the application of existing knowledge. The recommendation to equate the two is very confusing.

In discussing the extent of the restrictions associated with the definitional changes, the Committee indicates that these changes are really only seeking to limit ‘business as usual’ activities and ‘whole of project’ concerns. This is giving voice to some of Treasury’s recent defences of the changes but will offer no comfort to those faced with assessments of their production-based R&D claims in the new regime.

The discussion of the concerns regarding the dominant purpose test is perfunctory and, tellingly, avoids grappling with the conclusion expressed at the Senate hearings by the current Chair of Innovation Australia’s Tax Concession Committee that determining dominant purpose under the new legislation will be entirely a matter of judgement as opposed to a question of fact. At no time is any consideration given to the power of the current ‘directly related’ definition to regulate excessive claims but the impact of the change to dominant purpose is tacitly acknowledged by the Committee’s recommendation regarding the test and SMEs.

The removal of the dominant purpose test for SMEs is, in one sense, welcome but it does establish two distinct programs by legislating two different definitions of R&D. This feels like an innovation that we could all do without as it adds yet more complexity and uncertainty, particularly for taxpayers whose turnover is in the vicinity of $20 million. What such a change does do, is reinforce the notion that the dominant purpose test is a restrictive one that will see larger companies unable to receive support for an uncertain range of R&D activities that would have otherwise qualified had the organisation simply been smaller.

Many of the major concerns raised in the recent round of consultations – beyond feedstock, these included the splitting of core and supporting R&D activities; the quality of the Explanatory Memorandum, particularly its example projects used to demonstrate the operation of the new definition of R&D; the ‘expenditure not at risk’ provisions; the greatly enhanced administrative powers; the increased complexity of the compliance regime – did not result in any specific recommendations by the Government. Like all the other parties, the fact that the timeframe for considering all the issues has been so condensed has meant that it is apparent that the Committee did not have the opportunity to actively turn its mind to many of the concerns raised.

We are very concerned that the Government accepts the Treasury’s modelling without having seen it. As we pointed out in our last Update, it appeared from the Senate hearings that Treasury’s admitted reduction of claims by 15-20% did not take into account the closure of the 175% Premium Concession which we had demonstrated previously would save 30-35% of the current cost of the program. In the absence of any published modelling, the Committee steps into the breach and offers up its own “back-of-the-envelope” calculations in support of Treasury’s estimate (page 75).

In some breathtaking assumptions, the Committee suggests that the new regime will increase current program costs by one third to one half of current levels by the combination of higher rates and new program entrants and the savings associated with the combination of the changed definition and the closure of the Premium Concession will roughly offset these costs. We wish to strenuously challenge these assumptions, particularly as they are partially based on a submission we made regarding the impact on program participation back in 1996 where the number of registrants was no more than half the current number and when participation rates fell from around 4,000 to below 3,000. It is unreasonable to assume that program uptake by new entrants will be of a similar dimension given the user base now involves roughly 8,000 Australian companies.

Of course, there is no opportunity to do this prior to the vote and the Committee appears happy with its published back-of the-envelope numbers standing in the place of any need to publish Treasury’s elusive modelling. This is not acceptable.

Finally, we remain absolutely dumbfounded by the following statement on Page 1 of the report:

 ”It is neither sustainable nor in the national interest that 60 per cent of the total government support is consumed by 100 firms out of Australia’s two million enterprises”.

You will be growing tired of us pointing out that this figure is consistent with ABS statistics on the profile of Australia’s corporate innovation activity and is in line with international practice. We have continued to emphasise throughout the consultative process that large corporates are prepared to negotiate some limits on their R&D tax benefits provided they continue to be acknowledged as performing legitimate R&D on the same basis as their smaller cousins.

However, once more, we feel compelled to point out in the strongest manner possible that the R&D tax incentive is not a finite pie, 60 per cent of which is consumed by 100 firms. Rather, it is a self-assessment program in which 60 per cent of claims are currently made by the top 100 firms. Smaller firms are not crowded out by the claims of the top 100 firms. All firms claim their entitlements against the prevailing rules. No firm’s access to the available benefit is impacted in any way by the claiming behaviour of any other company. In 25 years of consulting on the R&D Tax Concession, MJA has never met a company that does not claim or has a reduced claim because of a claim being made by another company of any size.

If this is the justification for the gutting of the incentive as the Coalition describes it, then it should be shown for the fallacy that it is. The Cutler Report called for reform to R&D taxation support for all Australia’s corporate citizens in the National Innovation System. It never intended for this reform to be the ushering in of an era where large corporates are seen as doing a lesser class of R&D when serving Australia.

What Next?

The Bills need to get through the Senate by 25 June. The Coalition appears ready to vote against the legislation so the focus now shifts to the standpoints of the Greens and the Independents.

Keep an eye out for MJA Updates in the next few days regarding the impending vote as well as any additional issues that emerge from a closer consideration of the report.

As always, 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.

Last week’s announcement that changes were being made to the draft legislation and explanatory materials associated with the New R&D Tax Credit (the Credit) was very welcome.

MJA has expressed its concern that the Bill’s attempt to legislate additionality and spillover in the Object Clause (something the Government publically assured stakeholders would not happen) creates a fundamentally flawed platform from which all the identified problems flow. These problems include the expenditure not at risk provision, the augmented feedstock rule, the severely restricted definition of R&D, the software changes and the radically changed compliance framework. Further details about these concerns are contained in our submission to the Treasury.

However, what gets lost somewhat in the debate about the impact of the changes is a clear understanding of why the changes need to be made in the first place.

This MJA Update wants to review some aspects of the debate with a view to contributing to a rational discussion when the revised legislation and associated materials appear. A future Update will tackle the numbers issue around the need to maintain revenue neutrality in the program.

It’s Blockbuster Time

Students of popular culture know that the onset of the Northern hemisphere summer heralds a new wave of “tentpole” or blockbuster movies. These days, you can count on a comic book movie or two to be among them. This is, of course, a good and bad thing. For every “Iron Man” to enthral us, we can be sure to be burdened with an “X-Men Origins: Wolverine” (Sorry, Hugh). Looking ahead, “The Mighty Thor” is in the pipeline and you can bet that there will be a role for his half-brother and arch nemesis, Loki, the God of Mischief. And if we are to believe the Federal Government, Loki has been wreaking his handiwork amongst the R&D Tax Concession (the Concession).

Throughout the recent consultations, government representatives repeatedly highlighted that the restrictive changes to the program were necessary because of various mischiefs.

Well, what are some of the mischiefs associated with the Concession and are they really, in fact, myths that shouldn’t be put forward as justification for the sweeping changes that have been attempted?

Mischief 1 – The current Concession facilitates bogus, illegitimate claims against the taxpayer

All incentive schemes may be subject to misuse and the Concession is no different. That is why the legislation includes a number of checks and balances including penalty regimes. Audit programs are in place to ensure that taxpayers do the right thing. In fact, all the evidence over the history of the program is that it is responsibly used by the vast majority of users and very few risk assessments proceed to prosecutions. Removing benefits from all taxpayers for the inappropriate behaviour of the few is not a rational response to the issue of alleged misuse.

Mischief 2 – The Concession provides assistance to non-genuine R&D

This was a can of worms that was opened up by the Cutler Report on the National Innovation System which raised concerns about “whole of mine” claims which were characterised as large, one-off claims made by mining and civil engineering companies involving significant operating costs.

The inference that has emerged in the consultative process is that these claims do not involve genuine R&D and should be stopped or severely limited in the new Credit. These sentiments fit in with a world view that certain types of R&D (e.g. biotech, medical performed by SMEs) merit support and others have a weaker case (e.g. large company resources and engineering projects).

This is not what Cutler said. Cutler stated that the so-called “whole of mine” projects were R&D but that they were expensive and that the government might look at putting some reasonable limits on the amount of support that goes to these legitimate R&D activities.

The real mischief here is when one starts to import a moral dimension to what is genuine R&D. The strength of the current Concession is that it delivers an internationally-competitive definition of eligible industrial R&D. The proposed definition in the Credit, in seeking to narrow the definition to limit assistance to “genuine R&D”, manages to disqualify the vast majority of R&D actually conducted by Australian businesses, large or small.

Mischief 3 – The criticism of the Credit has come from those with a vested interest in the status quo

The initial observation to be made here is that responses such as the recent public submissions to the Treasury will always come in the main from those with a vested interest. That is the usual driver for a party to respond at all.

If a submission comes in arguing for the status quo, does it automatically follow that the submission can be discounted because it is designed to protect a vested interest?

Speaking for MJA, our February submission to the Treasury essentially argued for the status quo. Further, we believe that the proposed Credit was not going to be good for our business. But that did not form the basis of our submission. We have always approached our submissions from a primary standpoint of what will deliver good program outcomes.

As recently as the Cutler review, we campaigned vigorously for the closure of the 175% Premium on the grounds that it was a high cost element of the Concession that did little to influence R&D behaviour. Yet every month we billed clients to prepare premium claims. We were happy to see this business go if the result was a simpler, more effective R&D tax incentive. We were pushing for a major change to the status quo.

Our views have been echoed by many other advisers, industry groups and taxpayers and the closure of the 175% Premium has raised nary a voice in protest.

So why is it that our critiques can now be dismissed as being hostile and reflecting vested interests? Is the real mischief here the fact they don’t concur with the views of the Government?

Mischief 4 – 80% of the Concession goes to 100 companies

For decades, Australian Bureau of Statistics on R&D have indicated that the vast majority of innovation spend is incurred by a handful of Australian companies. This is, and will always be, a matter of fact. The current trends in the Concession simply reflect this fact. Given that the Concession is open-ended, the share of those 100 companies will be determined by the prevailing rules and the amount they identify and claim. When added to the spend and claim of the other 7,900 firms in the program, the proportions will then be determined as a matter of mathematics.

There is not a finite amount of claims and assistance available. The proportions are only determined after the claims are identified and made against the rules.

The thinking behind the restrictions in the new Credit is that the rules can be changed to alter these proportions. This is entirely possible. You can rewrite the rules so that the proportion of assistance accessed by the other 7,900 is a much larger figure. The problem comes in when the rules are so restrictive that the proportion is larger but the overall value of the assistance to those 7,900 companies falls.

This is exactly the concern being reflected by the commentators regarding the Credit. We are being offered a program that wipes out assistance across-the-board. A larger slice of the cake might go to SMEs but so what if we are now cutting up a cup cake as opposed to a passionfruit sponge.

So, has Loki got something to answer for?

A recent editorial in the Australian Financial Review called for the draft Bill to be withdrawn or thrown out on the basis that the Government’s arguments for the major restrictions could not be made out. MJA agrees wholeheartedly. The mischiefs aren’t real. They are really more akin to myths (perhaps like the Treasury modelling that shows the changes to be revenue neutral?!) and Loki is off the hook on this one.

So don’t expect Thor to be wielding his mighty Uru hammer against the Credit in a multiplex anywhere near you soon. Not enough legs in that plot.

Looks like it’s up to us mere mortals to keep up the fight as we await the revised legislation.

If the suspense is too much in the interim and you would like to discuss the issues, feel free to contact  Kris Gale directly on (02) 9810 7211 or using our contact form.

The past week has been a predictably intense one. The Treasury consultation paper, “The new research and development tax incentive”, has attracted widespread comment, concern and criticism. Some have seen the paper as the harbinger of the end of effective government support for R&D. Others believe that the consultation process is illusory and that the decisions have already been made. MJA has a more tempered view. And it’s a view based on direct dealings with government over the past week.

Kris Gale, Managing Director of MJA, has met with the Treasury and Innovation, Industry, Science and Research officials nominated as the contact points for the consultation process. He is booked in to meet with Senator Carr’s office on Monday, 28 September. He has presented on the topic to three conferences in the last 7 days. Contact has been made with several industry advisory bodies and all members of MJA have been canvassing client companies and other interested third parties for their reactions and views. The month of October will see this program of active engagement continue apace.

Has any good news emerged?

The answer is yes.

The Government officials will reassure stakeholders at the announced public consultation sessions (see details below) that the paper is truly a discussion paper and that the exposure draft of the legislation will take submissions and commentary into direct account.

They have acknowledged that the delay in issuing the paper has placed pressure on the timetable for the delivery of the new legislation and allowances will need to be made. They indicated that the main source of the delay was the fact that the paper spent considerable time in the offices of Senator Carr, Mr Swan and Mr Rudd and that this is a reflection of real ministerial engagement.

Assurances were also given that the ‘additionality and spillovers test’ referred to in Paragraph 48 of the paper will not translate into a legislative requirement and that this will be confirmed at the consultation sessions. Further metrics around the issues raised such as the meaning of a revenue neutral program over the next 4 years will also be provided.

Finally, it is now clear that the Refundable Tax Credit will be available to foreign-owned R&D in contrast to its announced preclusion in the May Budget.

So what is the Big Issue in the paper?

Without doubt, the main concern raised by the paper was the announcement of the fact that the definition of R&D will be changed in order to reduce the expenditure available to be claimed against the Credit. This was deemed necessary to achieve budget outcomes and justified on a policy basis of focusing support on the areas of highest net benefit and redirecting support to the SME sector.

In announcing the changes, the paper curiously made use of the “old school” terminology of core (cf. SIE) and supporting (cf. directly related) activities. It was indicated that core activities will need to contain innovation AND technical risk, rather than just one of these elements. Further, limitations are to be brought in with respect to supporting activities and the paper sought responses to a suggested list of possible restrictions.

In the next fortnight, MJA will circulate its draft response to the paper which will analyse our concerns with this ‘Big Issue’ in detail. However, we would like to take this opportunity to sound the alarm now.

The Government announced on Budget night that the R&D Tax Credit will replace the “complex and outdated” R&D Tax Concession with a

“…simplified R&D Tax Credit which cuts red tape and provides a better incentive for business to invest in research and innovation.”

The Issues Paper makes the case for the Credit delivering a simpler program by highlighting the following:

 “Paragraph 9.….Companies will no longer need to distinguish between their base and incremental expenditure on R&D in working out their claim.”

Yet, under the proposed changes, companies will have to distinguish between their core and supporting activities in working out their claim with the direct result of a restricted level of support for supporting activities.

So much for a simpler R&D tax program. Changing the definition of R&D will, by the few strokes of a pen, introduce an unprecedented level of complexity, attendant uncertainty and compliance burden into the program.

The case for definitional change is simply not made out in the paper. No concrete evidence is given. The very thin examples in Attachment A are misleading in their conclusions. No modelling is being offered up to amplify the cost concerns. Given these factors, MJA believes that the Big Issue needs to be thoroughly explored with relevant stakeholders as soon as possible.

If cost control is the political outcome required, MJA believes that the real focus needs to be on reviewing expenditure provisions. Changing the well understood, internationally competitive definition of business R&D will cruel the prospects of all companies involved, whatever industry they are in and whatever their size. In fact, it will be the technology-intensive SMEs who will be hit the most as they are the companies that spend large proportions of their operating budgets on R&D compared with the mature sectors who have the largest claims in numerical dollars but modest claims in terms of proportions of  overall operating cost.

It is well known that Australia currently sits on the lower end of OECD Business Expenditure on Research and Development (BERD) comparisons. Changing the definition of claimable R&D along the lines proposed means that we should be expecting snakes not ladders in our BERD future.

MJA will continue its campaign of direct liaison with the Government to explore the issues raised and work towards a negotiated result that promotes a sensible outcome for business innovation policy.

But what can I do?

Make time to attend the upcoming public consultations. Details are below and bookings can be made through the following link Bookings

Make a submission. It doesn’t have to be a treatise. It does need to express the concerns that you have and it should set out how the proposed changes would affect you, both good and bad. The aim is to be  constructively critical, not destructively so.

In both these matters, don’t rely on your advisers and industry bodies to make all the running this time. You are the Credit’s proposed customers. Your voices are the most influential ones.

And keep talking. Dialogue generates ideas that can then be translated to workable solutions. Please include us in your conversations. We are passionate about effective innovation policy and we would love to hear what you are thinking.

To keep the dabate moving, contact Kris Gale directly on (02) 9810 7211 or using our contact form.

How are we doing?

It’s always helpful to have your feedback on the articles we prepare, and the approach we’re taking in dealings with the government. You can help us by filling out a comment below this post on our website, and giving us any feedback you have on how we’re performing, or how we could improve.