Contributed by Muhunthan Kanagaratnam, Partner and Chris Merjane, Lawyer, Gilbert + Tobin
Last week, Treasurer Scott Morrison revealed that the Australian Government will “relaunch” the research and development (R&D) tax incentive. It is his view that the government is currently “writing blank cheques to everyone that has a good idea”, and that the programme has to change so that it is no longer “a tax incentive for business as usual”.
The “relaunch” will likely include an overhaul of the types of activities and expenditure that are eligible, and tweaks based on findings of recent reviews of the R&D tax incentive. However, the government must ensure that the process creates certainty for claimants in Australia, as many claimants have been doubting the merits and cost-benefit of the programme following increased risk reviews, taxpayer alerts and insufficient binding guidance, exacerbated by (in some cases) a poor understanding of both the burden of proof for claims and the role of R&D tax advisors and tax agents in reviewing that proof.
The road to change
An “overhaul” to the R&D tax incentive follows substantial new registrations over six years — from 8,753 applicants in 2010–11 to 15,321 applicants in 2016–17 (a 75% increase).
The increased number of R&D applicants has not been welcomed with open arms by the administrators (being AusIndustry and the ATO). The Commissioner of Taxation has released five taxpayer alerts regarding “higher tax risk” R&D matters (taxpayer alerts are only issued when there is a pattern of high-risk positions being adopted by taxpayers). Both AusIndustry and the ATO have heavily increased their review activity. Legal action has been taken against a number of R&D tax advisors (including criminal and promoter penalty cases).
With this backdrop, a review of the R&D tax incentive is not a new blip on the government’s radar. Many commentators — including G+T — were anticipating changes to the R&D tax incentive as part of last year’s Budget following the “Review of the R&D Tax Incentive” (largely headed by Australia’s Chief Scientist Alan Finkel) (the Finkel Review). The findings of the Finkel Review were clear: “the programme falls short of meeting its stated objectives of additionality and spillovers”. In other words, the programme did not sufficiently encourage additional R&D (additionality) that benefits others (spillovers).
In addition, the government has received 130 submissions as part of its “Australia 2030: Prosperity Through Innovation” report (the 2030 Report), which considers the broader strategy of the Australian Government in respect of science, research and commercialisation.
What will be the changes?
Although the Finkel Review only recommended small changes to the programme, the 2030 Report and Mr Morrison’s comments reveal more will be on the table.
- Reducing overall benefits available under the R&D tax incentive: The 2030 Report indicates that Australia has a “heavy reliance on ‘indirect’ funding measures, such as the [R&D tax incentive]”, and that there is a concern about the extent to which the programme generates genuine “additionality” in R&D activity. The 2030 Report notes that “there is emerging evidence in the international literature questioning the impact of R&D tax incentives on productivity growth”.
- Software R&D will likely be tightened: The 2030 Report specifically targeted software development as an area of exploitation, noting only a small part of software projects may be innovative.
- “Ordinary business expenditure” as R&D will likely be tightened: Under the current programme, applicants can claim R&D expenditure on core and supporting R&D activities at the same offset rate. Supporting R&D activities include any activities “directly related” to core R&D activities (certain supporting R&D activities have a stricter test). This is an area of focus by the ATO — businesses claiming administrative, business and general costs on the proviso that they “support” the conduct of R&D. It is a case of how long you can draw a bow — and the Commissioner has been cracking down.
The government will likely adopt the specific recommendations of the Finkel Review and 2030 Report. From a policy perspective, these recommendations are sound and are designed to ensure the R&D tax incentive achieves “additionality”:
- Scale back the general R&D tax incentive: a cap of $4m in cash refunds per year (with a maximum cumulative refund of $40m), and an intensity threshold in the order of 1% of total annual expenditure (ie at least 1% of total expenditure must be incurred on R&D in order for a company to be entitled to claim).
- Increase the R&D tax incentive for key areas: a collaboration premium for R&D expenditure undertaken with publicly-funded research organisations, and increasing the expenditure threshold from $100m to $200m (to complement the R&D intensity threshold).
- Better administration: developing plain English guidance and public rulings, and improving administration from the current two-agency delivery model.
The rationale is right, but the above may attract exploitation. Claimants might be incentivised to claim additional expenditure to meet the 1% intensity threshold, or claim R&D via multiple companies to exceed the $4m per year/$40m cumulative cash refund amounts. Draft legislation may (and should) address this.
The “elephant”: documentation
In our experience with the existing R&D tax incentive, documentation and evidence is the cause of most R&D disputes. However, documentation remains “the elephant in the room”.
When the R&D tax incentive was first implemented (replacing the old R&D tax concession), the government removed requirements for claimants to maintain “R&D Plans” and the ATO removed the “Guide to the R&D Tax Concession — Part C” (a highly prescriptive guide on self-assessing R&D expenditure). Businesses started to rely upon ordinary business documentation to document their R&D activities and expenditure. The problem is that ordinary business documentation is often insufficient for discharging a taxpayer’s onus of proof in respect of the R&D tax incentive, especially as the ATO has continued to expect the same — or more — information as in Part C.
This led to repeated, frustrating arguments between claimants and the ATO/AusIndustry. In our experience, during reviews, ATO case officers continually rejected documentation maintained by taxpayers, but also would not prescribe what is required.
Advisors are often no help here. Many R&D tax advisors conveniently exclude a documentation review from their scope of work. This is a serious issue as documentation is the biggest source of disputes and advisors do not often draw this limitation in scope to the attention of their clients. It is all well and good for claimants to undertake R&D, but if they cannot prove the nexus between their expenditure and the R&D activities, they are not eligible to claim that R&D expenditure.
Prescriptive documentation requirements which are binding on the Commissioner, and guiding for taxpayers, are absolutely necessary as part of a re-write of the R&D tax incentive.
The R&D tax incentive is due for a review following its implementation from 1 July 2011. It is important to weed out the bad actors as part of this process — including aggressive claimants and advisors — and better target government funding.
However, the government must ensure it creates certainty for companies undertaking legitimate R&D. The additional scrutiny under the programme, coupled with the lack of binding guidance or requirements on documentation, means that many legitimate companies are being penalised or simply not choosing to claim the R&D tax incentive.