The R&D Tax Incentive – Like the Footy Finalists, Take It One Week at A Time

4:29 pm by Kris Gale · 2 Comments

A few weeks ago, we were chatting with the tax manager of a large engineering firm about the proliferation of briefing sessions currently being offered regarding the new R&D Tax Credit, to be known from today as the R&D Tax Incentive (the Incentive). We agreed that the whole thing seemed a little early as the Bills hadn’t yet passed and the views of the Government were yet to be heard.

From our perspective, we had attended two Government workshops about the Incentive in August and nothing substantive could be said by the authorities about matters of interpretation as the law was not yet in place. The tax manager went on to say that if the company’s technical staff heard that you may not have a claim if your predominant purpose was commercial, not R&D, a number of them would grab hold of this red card being offered and send themselves off so they didn’t have to help claim an R&D project ever again. We concluded that it would be best to learn a little more about the Incentive rulebook before we launched a whole new strategy for winning in the R&D game.

As we write this MJA Update, the Incentive is waiting patiently for Royal Assent. The word on the street is that this will be achieved around the middle of next week.

The understandable reaction from companies after such a long wait would be to get cracking and attend any briefing session on offer; start assessing what R&D now qualifies and begin installing new identification and costing systems. How else do you win the Grand Final?

Well, as any coach will tell you, you don’t get ahead of yourself, you play each game on its merits, you take the season one week at a time, and a litany of other sporting clichés in devising a successful approach.

And so we believe it should be with your response to the Incentive. Right now, we think that the best thing you can do is keep on doing what you’ve been doing with regards to the R&D Tax Concession. Keep identifying and tracking the same projects and the same costs.

And here’s why.

To Know the Rules, You Must Know the Umpire

You would be aware that the Incentive is to be jointly administered by AusIndustry, the Innovation Australia Board and the ATO. They are the refs and umpires and we all know that we need to work cooperatively with these bodies to achieve an effective transition to the Incentive regime. Right now, it is their views of the operation of the new legislation that we need to reference and understand before we can meaningfully respond as to how the Incentive affects taxpayers. The fact of the matter is that they have yet to publish their interpretations of the rules, let alone blow their whistles. Until they do, MJA believes it is way too premature to be attempting to determine a finalised approach to successfully claiming the Incentive.

As such, we advocate that you retain your current approach to identifying and documenting R&D that is currently eligible under the R&D Tax Concession (the Concession). Ultimately, the narrower definitions of the Incentive will mean that some of your R&D activities and costs that you track may not be eligible, but this can be reconciled towards the end of the first year of the Incentive, by which time the views of the administrators will be much better understood. Remember that nothing substantive about the interpretations of the new rules has been tabled by Government since the second Explanatory Memorandum back in the first half of 2010. If you speak directly to AusIndustry and the ATO at the moment, they can only respond with the fact that they can’t comment as the Bills are not yet law. All the rest of us can do right now is speculate on the impact of matters such as dominant purpose and feedstock and how the Government will interpret these new concepts.

What Is the Schedule for the Rest of the Season?

Through MJA’s membership of the R&D Tax Incentive National Reference Group (NRG), we have come to understand that the planned Government roll out will go along these lines:

A national series of AusIndustry/ATO information briefing sessions which have just been announced for each of the capital cities from mid-September. Click on the link for the dates and to register your attendance. Initial guidance material will accompany these sessions.
A discussion paper entitled “R&D Tax Incentive Guidance Discussion Paper” will be released in late October 2011 and a period of active feedback and comment will follow.
Following the passage of the Regulations and Decision-making Principles, application forms for Advance and Overseas Findings will be released. This should occur before Christmas.
In the first half of 2012, detailed guidance material will be published including sectoral guidelines covering manufacturing, mining, information technology, biotechnology, agribusiness and construction.
The Registration application form is most likely to appear in the New Year.

As you can see, there will be several months to digest the Government’s viewpoints and requirements and the great unanswered questions will finally start to receive some useful answers.

Keeping Your Eyes on the Prize

At the appropriate time, MJA will run a series of free seminars to assist you in preparing to make your first claim. But we only intend to do that when we have something meaningful to discuss. In the interim, we will keep you posted courtesy of this Update. Remember, we want all of your team out there on the R&D paddock with everyone fully committed and enthused. Don’t get them looking for those red cards right now so they can risk taking you out of the game for the ultimate R&D prizes.

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: ATO, AusIndustry, Dominant Purpose Test, Feedstock Offset, R&D Tax Concession, R&D Tax Credit, R&D Tax Incentive

R&D Tax Credit finally passed through the Senate

4:14 pm by Kris Gale · Comments Off

At 1 pm today, 23 August 2011 the Bills to replace the R&D tax concession with the R&D tax credit finally passed through the Senate. The only successful amendments were those to provide for a quarterly rather than an annual refundable R&D tax credit for SMEs from 1 January 2014, and to amend the start date of the new incentive to 1 July 2011. These amendments will have to be considered by the House of Representatives before receiving Royal Assent.

We do not expect there to be any impediment to the amendments being accepted. Outstanding issues such as the unworkability of the Feedstock provisions remain but MJA will continue to work for a workable solution or amendment.

More information on the details of the new R&D incentive will follow shortly.

Filed under: MJA Update Articles
Tagged: AusIndustry, Feedstock Offset, R&D Tax Credit, The new research and development tax incentive

So what if the proposed R&D Tax Credit only supports failed R&D? Is that such a bad thing?

3:55 pm by Kris Gale · Comments Off

In this edition of the MJA Update, we examine the ways in which the major changes proposed in the R&D Tax Credit (the Credit) reduce the eligibility of R&D where it is done in a production environment. We contend that the changes are driven by a philosophical position that the only production-based R&D that is worthy of being encouraged is R&D that is unsuccessful or otherwise fails to produce something.

We ask whether this in line with announced Government policy and query whether the reforms are logical or even desirable?

It is Government policy to increase profitability by the R&D Tax Credit

The R&D Tax Credit Bill (the Bill) proposes to replace the current 125% and 175% R&D Tax Concessions, split by growth in R&D expenditure, with 40c and 45c R&D Tax Credits, split by company turnover.

The objective of the Bill is to implement the Government’s policy in Powering Ideas, especially with respect to industrial R&D including R&D in a production environment. This policy seeks to substantially increase the number of businesses undertaking R&D activities in Australia for the benefit of the economy, jobs and the environment.

According to the policy, it is supposed to achieve this by being simpler, more certain and by providing benefits “with the added advantage that companies can access the credit whether they are in tax profit or tax loss”. It seeks to overcome the market failure that businesses are too reluctant to invest enough in R&D in Australia to sustain our future economy.

The policy is explicit in that it wants more businesses to succeed and be more profitable as result of their R&D activities:

“The empirical evidence is clear: Australian businesses that innovate are more than twice as likely to report increased productivity and 63 per cent more likely to report increased profitability than businesses that don’t. Innovation makes them more competitive by enabling them to differentiate their products and services, target niche markets at home and abroad, and participate effectively in global supply chains.”
Powering Ideas, Chapter 5

It is Government policy to encourage successful, commercially-based R&D

It is also explicit Government policy that it wants businesses to come here, stay here and do R&D here so that it is commercialised here. This makes perfect sense. The Government cannot achieve its goals in securing our future by encouraging R&D that does not result in profitable outcomes.

If the Government only encourages research that does not improve business performance then this will change the program from one that, by every measure, creates more economic growth and tax revenue than it costs to one that drains revenue by rewarding failure and turning the program into an R&D insurance policy of last resort.

Should R&D in a production environment be supported?

Despite this, the question regularly arises about whether the Government should provide an advantage to businesses that will also make a profit on the output of the R&D. To a layman, this question makes sense; however, it is counterintuitive.

The objective is to make Australian businesses more profitable, more efficient and better able to commercialise technologies developed in Australia; that is, to make more money by doing more R&D so the economy benefits and the Government collects increased tax revenues. No business does R&D for the tax benefit. They do it for the commercial benefit. However, businesses do not carry out enough R&D in Australia so we need an internationally competitive R&D incentive system to encourage this behaviour and overcome the market failure.

Both the current and proposed legislation have caveats to restrict this encouragement to just the R&D activities. For example, the benefit can only be received by the business that bears the risks and costs of the R&D. The definitions seek to limit the programs to only the necessary activities to do the R&D. So far, so good.

Does the Credit’s collar match the cuffs?

However, the Credit’s addition of a dominant purpose test and the expansion of the feedstock provisions seek to withdraw the benefit from otherwise legitimate and necessary R&D activities in the mistaken belief that R&D performed in a production environment is not as worthy of support. This is a poor outcome and does not match the stated Government policy. It assumes that making a profit from your R&D is undesirable when the whole idea of the program is make Australian businesses more profitable. It introduces horizontal inequities. It discourages R&D focused on process improvements and discourages R&D for environmental purposes.

What are the horizontal inequities?

Different treatment of tax payers who otherwise share identical capacity and responsibility to pay tax is a horizontal inequity. If the only difference between two taxpayers is that one is able to perform R&D offline and one is required to do its R&D whilst making saleable product and both will generate the same net economic benefit from the successful completion of the R&D, then both should be able to access the same R&D tax benefit. However, the Explanatory Memorandum accompanying the draft Bill suggests that only the business that is able to conduct all its R&D offline will not be subject to either the dominant purpose test or the expanded feedstock clawback provisions.

This inequity reduces the R&D incentive for two main types of businesses – those where the scale of the project requires that the R&D be done on production facilities and those where the business does not have spare assets to do the R&D separately from the other activities of that business. The former discourages experimental development and the steps necessary to develop something sufficiently to allow it to be commercialised. The latter may have a larger impact on SMEs and may encourage inefficiency in capital asset utilisation.

What are the adverse impacts on manufacturing and environmental projects?

Process improvements are a large part of R&D especially in the embattled manufacturing sector. With established products, this is where the majority of R&D will occur. Even with new products, R&D is frequently required to developing new manufacturing processes to bring the new product to market. Undertaking process developments on existing production lines frequently requires the use of the production line whilst it is making saleable product. This is especially true for significant improvements in processing efficiency and for projects aimed at reducing greenhouse gases, water or other inputs consumption or to increase production from the same or improved inputs.

The expanded feedstock and dominant purpose tests will apply more pervasively to the manufacturing sector than to many other sectors. The nature of the Credit will add to the emerging viewpoint of many Australian businesses that our tax system is less favourable than overseas alternatives. As a result, rather than encouraging more businesses to do more R&D in Australia, the introduction of the Credit may instead be the last straw encouraging them to move production and related R&D offshore.

Our Conclusion

In conclusion, the simplistic notion that a business does not deserve encouragement to undertake R&D in Australia just because they can sell the immediate output from an R&D activity that was necessarily done in a production environment is illogical and undesirable:

It assumes that businesses do not do R&D for the commercial benefit if that benefit is not received from the direct sale of the product made during the experimental development and that businesses do not deserve an R&D credit if they get a commercial benefit. This is counter to the clearly-stated objective of the Credit to make Australian businesses more profitable by encouraging them to do more R&D for commercial benefit.
It assumes that businesses are more likely to undertake experimental development by their own volition if they are forced by circumstances to do it on production equipment than other businesses that have dedicated R&D equipment or are able to do R&D offline so that the first type of businesses deserve less encouragement than the second.
It assumes that industrial R&D, which is primarily Development, is less worthy of being encouraged than lab R&D, which is primarily Research. This is despite Australia’s research achievements frequently outstripping our ability to extend and complete this research so that we can commercialise it here.
It is also counter to the policy objective to see more R&D done in Australia for the benefit of the Australian economy.

Where to from here?

The debate about the contentious aspects of the Bill continues apace.

The Bill could go before the Senate anytime from 28 February through to the first session of the new Senate in July. It is unlikely that the Credit will be introduced retrospectively. The most likely commencement date for the program is 1 July 2011.

This gives us three potential outcomes:

The Bill passes before 1 July 2011 with issues like the expansion of feedstock and dominant purpose tests corrected by way of upfront Government, Opposition or Minor Party amendments. This is the best possible solution for business R&D in Australia;
The Bill passes as is but the Government considers and passes amendments to correct for these issues before the expected 1 July 2011 start date. This would be a good solution but it is a high risk strategy reliant on the majority of Parliament finally being responsive to the concerns expressed by stakeholders; or
The Bill passes as is and is operational from 1 July 2011 with all its fundamental flaws. This option includes the possibility that the Bill will apply retrospectively if it is passed by the new Senate. Corrections will need to occur on the fly to limit damage to the economy and Australian businesses wishing to conduct R&D. This will result in significantly higher levels of uncertainty and risk than with either of the other alternatives.

MJA will keep you informed of all major developments with the Credit legislation as they occur.

Filed under: MJA Update Articles
Tagged: Cutler Review, Dominant Purpose Test, Feedstock Offset, Government Consultation, Industrial R&D, National Innovation System Review, Powering Ideas, R&D Tax Concession, R&D Tax Credit

If We’re Turning Up The Heat, Let’s Put Feedstock Into The Furnace

10:36 am by Kris Gale · Comments Off

As calls continue for the R&D Tax Credit Bills to be put into an independent consultation process as soon as possible so that a workable new R&D Tax Credit can be in place and open for business by 1 July 2011, it is worth remembering that all parties need to appreciate that hammering out a workable definition of R&D activities will mean little unless the concerns regarding the eligibility of feedstock expenditure (along with other issues we have highlighted previously) are resolved at the same time.

The principal concern is that the new provisions are a major extension of the concept of feedstock offsets and, when combined with the narrower definition of R&D activities, result in a drastic reduction in support for any operations-based R&D that generates a commercial value.

Feedstock is a tough one. It’s a bit of a reach for the politicians. The technical bodies – Department of Innovation, Industry, Science and Research; AusIndustry; Innovation Australia Board – all seem to adopt a “not my pigeon, guv” approach. The Senate Committee ran out of puff before it got to feedstock in its report back in May. Financial journos glaze over when you try and explain it to them.

Yet, if we are to believe the Government, feedstock is a non-issue as nothing has supposedly changed regarding the feedstock offset contained in the current R&D Tax Concession and that proposed for the R&D Tax Credit. Bill Shorten, the Assistant Treasurer, in his Lower House speech on November 22 on the Bills said: “The feedstock provisions in the bills have the same scope as the feedstock rule in the existing legislation.” Paul McCullough from Treasury said in his appearance before the May Senate Economics Legislation Committee that he was “aghast” at suggestions that the real problem with the Bills was the feedstock provisions “…because the feedstock provisions are not changing.”

Simply put, MJA disagrees with these two statements. 100%.

The proposed provisions are materially different and their potential scope has greatly expanded.

In summary, the two main differences are as follows:

Scope

Concession – The adjustment applies to the cost of all goods or materials transformed or processed in R&D activities if they are inputs made into saleable goods.

Credit – The adjustment applies to the cost of all goods or materials transformed or processed in R&D activities.

Calculation Methodology

Concession – Exclude feedstock inputs on production trials and only add back the loss if the production trial fails to make profitable outputs via a single adjustment at the conclusion of the trial.

Credit – Always include feedstock inputs but make multiple adjustments to exclude the inputs based on each and every final sale connected with the production trial whenever they occur.

The credit process is a reversal of the current calculation methodology and is vastly more complicated. The adjustments may be required years after the R&D occurs and at points that may be several additional production steps after the trial. Further, relevant sales may include several R&D trials which require taxpayers to undertake a form of product cost tracking that is far in excess of current IFRS accounting standards or tax law requirements.

In addition, the design of the legislation contains a serious flaw in that the proposed provisions can be used to make multiple deductions for the one cost as you are obligated to include feedstock input costs for each trial even if you have already included these costs in prior trials duplicating the deduction and yet you can only adjust this once for the final sale of finished product.

You Can Easily Glaze Over In This Particular Furnace But A Solution Is At Hand

Hopefully, you haven’t glazed over like a Krispy Kreme and you are still with us.

If we can get the Bills into the consultation process, this program-crippling cause of concern can be readily fixed. The proposed changes should be dropped and replaced with a set of better-drafted provisions that more clearly spell out the operation of the current legislation. And, in late-breaking news, MJA has drafted a set of revised provisions which we believe will see everyone on the same page. You are more than welcome to a copy of them and need only reply to this email with ‘Please Send Provisions’ in the Subject line and they will be heading to your inbox.

Filed under: MJA Update Articles
Tagged: AusIndustry, Bill Shorten, Feedstock Expenditure, Feedstock Offset, Government Consultation, R&D Tax Concession, R&D Tax Credit, Senate Economics Legislation Committee

R&D Tax Credit –The Clock Is Ticking, The Engine Is Revving

4:17 pm by Kris Gale · Comments Off

As the proposed commencement date of 1 July 2010 draws ever nearer, the process by which the Federal Government is seeking to kick start the new R&D Tax Credit (the Credit) continues to accelerate at an alarming rate. You can hear the clock ticking and the engine revving from here.

Following the 19 April close date for public submissions regarding the Second Exposure Draft, the Bills and Explanatory Memorandum (EM) were introduced into Parliament on 13 May in advance of any submissions appearing on the Treasury website. The Bills and EM contained the new feedstock provisions which were not made available in the Second Exposure Draft along with some significant changes in areas such as the examples used to explain the definition of R&D and the rules surrounding the grouping provisions. The EM also contained several erroneous technical references to the Bills.

Main Issues With the Proposed Legislation

The majority of the legislation and the EM was consistent with the Second Exposure Draft but, as indicated above, there were some significant changes. Of greatest concern are the feedstock provisions. Treasury is maintaining that there has been a simple rewrite and consolidation of the existing provisions. This is patently not the case as the new provisions extend the notion of feedstock inputs in an uncertain manner, apply the offset to depreciating asset expenditure for the first time and change the point of required calculation from the feedstock output to an assessment of the value of the contribution of the R&D to the marketable output. This last point transforms the calculation from a single year to a multiple year process and introduces a level of potential complexity that may not be able to be resolved in some circumstances. The overall impact of the new provisions is not far from the deleterious impacts on claims associated with the ‘augmented feedstock rule’ abandoned following the outcry after the release of the First Exposure Draft.

The other major problem lies with the final version of the examples used in the EM to explain the definition of R&D. A series of alterations and omissions have been made to the examples in comparison to the revised versions that appeared in the Second Exposure Draft, presumably in response to some of the criticisms received. The result is a series of examples that are internally inconsistent, contradictory and that bear little connection to the real world practicalities of commercial R&D.

MJA has gone to great lengths to detail the problems associated with the above issues in our written submission that has been lodged with the Senate Standing Committee on Economics (the Committee) and our submission is available on request.

Having A Say In The Senate

The Committee was formed rapidly in response to the introduction of the legislation and its public hearings were conducted a mere week later on 20 and 21 May. These hearings actually preceded the closing date for written submissions (28 May) which is unusual in our experience and another likely reflection of the tight turnaround being attempted by the Government.

Kris Gale (20 May) and Melanie Reen (21 May) appeared in front of the Senators. The hearings also provided an opportunity for interested parties to share views more informally over the course of the two days.

The Senators focused on the impact of the changes to the definition of R&D with a particular emphasis on the dominant purpose test and on the issues surrounding the feedstock provisions. Other substantive matters discussed included the existence of so-called “rorts” under the current R&D Tax Concession, the rushed timetable for the introduction of the new legislation and the quality of the consultation process to date.

One key theme to emerge at the hearings was the fact that the proposed restrictions will extend beyond the claims of miners and civil engineers. A series of manufacturing companies appeared in front of the Committee and all argued that they would no longer be able to claim much of their production-based R&D under the proposed rules. One major company estimated that its claims would be reduced by around 80%

Consistent with the written submissions made available at previous stages of the consultative process, there was a strong coincidence of expressed viewpoints amongst the companies, industry bodies and advisers. All those who appeared pointed to real concerns surrounding the negative impacts that would flow from the introduction of the Credit in its current form. And these views were consistently at odds with the views expressed by the Government’s administrative bodies in the hearings that all the real problems with the Credit had been fixed and the balance of concerns stemmed from misunderstandings.

The Senate needs to resolve the polarised positions by 15 June when it has to deliver its report to the Parliament.

At the heart of this resolution will be assessing the true extent of the restrictive effects of the changes that the Government now admits will occur under the Credit. Treasury made a first-time admission to the Committee that 15-20% of currently-eligible R&D expenditure would be eliminated under the Credit. They did not offer any modelling to assure stakeholders that this shortfall would be made up by new entrants and claims to keep the program revenue neutral. Of course, many other commentators have estimated that the restrictive effect will be much larger. This matter must be resolved before the Credit becomes law.

The Engine Is Revving But Will The Lights Go Green On 1 July?

In order for the Credit to become law, it needs to be passed by 25 June which is only 10 days after the Committee delivers its report. Given the wide range of concerns raised in the Senate hearing, we would be surprised to imagine that the Committee will recommend that the Bills be passed in their current form. In fact, we hear that the Opposition has indicated that it would seek to block passage of the Bills as they currently stand.

MJA has maintained its position that the issues associated with the eligibility of activities and expenditure should be made the subject of a real consultation and that the package should be deferred for a year. Due consideration can be given to sensible constraints on large production-based claims in such a consultation. In the interim, the Government could still introduce the credit regime including the new rates, adjust the software provisions and maintain fiscal restraint by closing the 175% Incremental Concession on 1 July of this year.

We will keep you posted regarding all developments.

In the meantime 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: Feedstock Offset, Government Consultation, Kris Gale, National Innovation System Review, R&D Tax Concession, R&D Tax Credit, The new research and development tax incentive, Treasury