The R&D Tax Incentive Review: Talk of Blunt Instruments and Wrecking Balls

October 21, 2016 Kris Gale

As we rapidly head towards the closing date for submissions in respect of the current Review of the R&D Tax Incentive (the Review), it is high time we supply this third and final instalment of the MJA Update which seeks to unpack the issues contemplated by Messrs. Ferris, Finkel and Fraser.

Our focus will be on the effectiveness and additionality recommendations (Recommendations 4 and 5) which look at reforms around the terms of access to the Non-Refundable R&D Tax Offset. In terms of Recommendation 2 which suggests a way the Incentive might be leveraged to encourage the private sector to more frequently collaborate with publicly-funded research organisations by introducing a ‘collaboration premium’, we will report back after the submissions closing date of 28 October as we believe other parties are better positioned to analyse the merits of this proposal. We will summarise the tabled views at that time.

We are also pleased to be able to report that MJA was part of a specially convened meeting of the R&D Tax Incentive National Reference Group (NRG) in Canberra earlier this week where members were able to share their views with the Minister for Industry, Innovation and Science, Greg Hunt. We can report back that the Review is feeding into a process whereby direct consultations will occur in the remaining months of 2016 based on the submissions received. Any potential changes to the Incentive will form part of a second National innovation and Science Agenda (NISA) statement that is likely to be released by the Prime Minister in March/April 2017. We are buoyed by the engagement and spirit of consultation reflected at that meeting and look forward to this continuing.

Instruments: Blunt and Blunter

At page 15 of the Review’s report, the Incentive is characterised as a blunt instrument because it is volume-based, accessible to all and “necessarily includes the subsidisation of R&D that would have taken place anyway”. It is this last feature that has clearly driven the Review to recommend a major change to the terms of access for the Non-Refundable R&D Tax Offset as set out in Recommendation 5: Introduce an intensity threshold in the order of 1 to 2 percent for recipients of the non-refundable component of the R&D Tax Incentive, such that only R&D expenditure in excess of the threshold attracts a benefit

The Intensity percentage is proposed to be calculated by dividing group R&D expenditure by group total business expenses.The so-called Intensity Requirement has not found much support in the innovation community since it was first mooted in the Review.

Simply put, the Intensity Requirement means that the Incentive would only pay a benefit on R&D expenditure above the threshold rate. For example, if the rate was set at 2% and the group’s intensity was 3%, only a third of the R&D expenditure would attract the Incentive (3%-2% = 1%).

The essential premise the Review puts forward for the Intensity Requirement is that better R&D outcomes flow from more R&D-intense companies so only those companies of a sufficient intensity should be able to participate in the program. In other words, the Review wants to sharpen the so-called blunt instrument by reducing the number of users and the costs of participation all in the name of effectiveness and additionality. Where we come from, that type of sharpening usually involves a razor and is usually called a budget cut. And we submit a very significant one.

The early returns in the analysis we have been party to suggests that, even at a 1% intensity level, the vast majority of the approximately 3,700 users of the Non-Refundable R&D Tax Offset would drop out of the program. Many would simply fall short of the minimum intensity requirement. Further, of the companies that may technically qualify, the inherent design flaws of the mechanism would see them completely discount the R&D Tax Incentive (the Incentive) as a relevant factor in influencing their R&D investment behaviour.

The criticisms of the proposal being tabled are becoming legion and we will briefly itemise some of them here:

Policy – The Intensity Model will effectively exclude R&D performers who, for a variety of reasons related to their sector, life cycle and expenditure conditions, can never meet even a 1% threshold test. They will become an innovation underclass, unable to access the Incentive for structural reasons with no assistance from the government even in circumstances where they may have dramatically increased their R&D spend.  The Intensity Model rewards some but is punitive to others.

Principles – The proposal obviates two key principles of designing an incentive. A key element of the intensity calculation is a variable not able to be directly influenced by the incentive ie. total business expenses. It is stating the obvious that a range of factors such as global markets and government imposts which are out of a company’s direct control contribute to its annual operating cost and the Incentive has no real influence in that arena. Given that, with all the attendant uncertainties, the Incentive loses the ability to be used as a planning tool, condemning it to be an after-the-fact tax calculation. These matters of principle plagued the R&D Tax Concession Premium program throughout its life and ultimately saw its removal in 2011.
Definitional – As it is set out in the Review, the Intensity Model is justified on the basis of “large” company behaviour in aspects such as they are seen as being better users of basic research and more likely to deliver higher levels of innovation. The Review’s discussion seems to be talking about the very large innovation spenders and this is reinforced by Recommendation 5 to lift the $100 million R&D expenditure threshold to $200 million. Yet, the Non-Refundable R&D Tax Offset kicks in at a group turnover of only $20 million. The proposal becomes a very blunt instrument indeed at that level as R&D conditions are vastly different at the entry level turnover range. Other definitional questions that have quickly emerged relate to the grouping provisions, the exact definition of “total business expenses” and the impact of feedstock expenditure on the Intensity calculations. The net result is more uncertainty and complexity.
Operational – Given that the Incentive only applies to the incremental R&D expenditure over the threshold, what was missed in the Review completely is that companies will only consider claiming the Incentive where they are SUFFICIENTLY ABOVE the prescribed intensity percentage in order to generate a viable return against the compliance cost of the full R&D expenditure that needs to be captured. Returning to the simple example above, the company would get the Incentive on the 1% spend but will need to document the full 3%. In such a scenario, a company currently having its 1% expenditure supported by the Incentive could triple its spend under the Intensity Model (1% to 3%) and end up worse off because, to secure the same level of support for the 1%, the new regime necessitates the incurring of a compliance cost relating to three times the spend. This also inevitably raises questions about how the compliance regime would work in practice where audit processes and costs would need to relate to the 3% to secure the eligibility of the 1% in our example.
Evidence – No modelling has been offered as to the impact of the measure, even on the simplest basis of who would qualify if the measure was applied to the current claiming community. We are certain that the vast majority of company groups would fail the 1% test with even more being effectively excluded because they are not sufficiently above the mark. Interestingly, the Review did not offer any international precedents displaying examples of such a model working successfully. MJA understands that only two regimes – Belgium and Japan – operate an intensity regime but these are opt-in programs that offer a higher level of support than the standard regime available. Intensity does not restrict access in these regimes. Rather, it incentivises exceptional performance.
Given the above discussion, the value of Recommendation 5: If an R&D intensity threshold is introduced, increase the expenditure threshold to $200 million so that large R&D-intensive companies retain an incentive to increase R&D in Australia, is not apparent. Our understanding is that only a handful of the approximately 25 company groups affected by the $100 million limit would gain additional support the expenditure threshold was raised at the same time as the intensity arrangemnets were commenced.

Critiques: Constructive and Destructive

We believe that the discussion will move quickly on from the Intensity proposal to the investigation of other ways of maintaining a viable and vibrant Incentive. Matters we have previously highlighted, such as the veracity of the current program cost being put forward by Treasury, the impacts of the recent offset rate cuts and the proposed cap on the cash aspect of the Refundable R&D Tax Offset, will be front and centre in those discussions.

We urge you to consider the Intensity proposal as a highly provocative conversation starter and to take it in that spirit. There is no value in being overly critical of something that clearly can’t be made to work in any way that would incentivise the vast majority of taxpayers that currently use the Non-Refundable R&D Tax Offset. Instead, we need to move on in an orderly and considered fashion to consider better options than one that would run the risk of being seen, not as a blunt instrument, but as a wrecking ball in the history of government support for Australian innovation.

Should you wish to discuss this matter further, please do not hesitate to contact
Kris Gale on 02 9810 7211 or email kris.gale@mjassociates.com.au