Increased scrutiny of claims for the R&D tax concession

Background

In the financial year ending in 2007, claims for the R&D tax concession totalled approximately $9.2 billion across all industries. AusIndustry and the ATO have announced that they are stepping up the level of scrutiny of claims for the R&D tax concession, particularly in the energy and resources sectors where the claims are typically for substantial amounts.

The Cutler report on Australia’s innovation system entitled ‘Venturous Australia’ was released in September 2008. Chapter 8 deals with the R&D tax concession. Although much of the chapter is even handed in its consideration of the impact of the concession, one passage rings serious alarm bells:

In recent years several firms have been successful in the aggressive use of the R&D Tax Concession to make claims for a very large share of expenditure in large one-off projects like mines and civil engineering. These claims have demonstrated that some aspect of the project is new and technically risky. This having been done it has been possible, despite the efforts of the Australian Taxation Office, to claim as much as 80 percent or more of all investment expenditures in the project.

The Panel appreciates that such ventures are both risky and innovative. At the same time it is clear that such ‘whole of mine’ claims are gaining for themselves a degree of assistance disproportionate to the benefits available to many other innovative projects. While they are also being undertaken by firms with very good access to capital, it is also true that capital markets are averse to risks in long term technology projects.

The quoted passage is, in itself, quite misleading in a number of respects, namely:

• the ATO has no role in determining whether or not claimed activities qualify as eligible R&D activities. That role is vested in Innovation Australia (formerly known as the Industry Research & Development Board) whose determinations are binding on the ATO
• successful determinations of R&D eligibility have been made by Innovation Australia, the AAT and the Federal Court, and
• notwithstanding the assertion that so called ‘whole of mine’ claims may involve up to 80 per cent of the expenditure in developing a project, in our experience claims described as ‘whole of mine’ typically involve between two per cent and 12 per cent of total expenditures for the period in which the claimed R&D is undertaken.

We are, however, witnessing increasing evidence that AusIndustry and the ATO have developed a view that eligible R&D expenditure somehow becomes aggressive when an undefined expenditure threshold is crossed, or the R&D is carried out by large corporates, particularly in the resources sector. This view is being reflected in the increase in the number of reviews being undertaken in relation to the eligibility of the R&D activities underlying substantial claims in the resources area.

Recent contact with AusIndustry suggests that (notwithstanding that one of its functions is to promote R&D in Australia) it is actively discouraging claims for the R&D tax concession in the resources industry by raising the bar on the nature and quality of the evidence required to demonstrate eligibility to levels not seen before.

In addition, the time taken to conduct assessments of R&D eligibility has increased dramatically. As an example, we are aware of a recent assessment which resulted in an adverse finding, taking over six years to resolve. An internal review of that decision which, by law, should be completed within 60 days, has taken over four months so far, with a decision not expected for at least another two months.

It is also worth noting that the normal time limits for amending assessments do not apply to claims for the R&D tax concession with the result that, if claimed activities are eventually determined not to be eligible R&D activities, the claimant’s tax assessments may be amended at any time to disallow the claimed deductions. This subjects companies claiming the R&D tax concession to an unacceptable level of uncertainty when preparing their financial reports.

The combination of interminable delays and raising the evidentiary bar appears to be part of a campaign to discourage claims for the R&D tax concession in the resources industry, consistent with the philosophy espoused in the passage quoted above.

What is eligible R&D?

Research and development activities are defined in section 73B of the Income Tax Assessment Act 1936 (Cth).

These activities fall into two categories broadly described as core activities and supporting activities. Supporting activities are not eligible unless they can be related to core activities and are carried on for a purpose that effectively enables the core activities to be undertaken.

Core activities are activities that are carried out in a systematic, investigative and experimental (SIE) manner which involves innovation or high levels of technical risk and are carried on for the purpose of acquiring new knowledge or creating new or improved materials, products, devices processes or services. Activities will not involve innovation unless they involve an appreciable element of novelty.

Activities will not involve high levels of technical risk unless it can be shown that the outcome of the activities cannot be determined in advance on the basis of current knowledge or experience and that this uncertainty can only be removed by a program of SIE activities involving scientific methods. This involves progressing from hypothesis to experiment, observation and evaluation followed by logical conclusion.

What is the basis for challenges to the eligibility of claimed R&D activities?

Historically, the majority of claims for the R&D tax concession arise when a company’s tax personnel are trawling through a company’s records in the course of preparing the tax return. In the course of identifying the purpose of expenditure, the penny often drops that some of the expenditure may involve R&D and a claim should be developed.

Claims developed in this way suffer from several difficulties:

• the existing level of innovation is not clearly identified, which leads to difficulties in describing the innovation or novelty involved in reaching a solution to the technology gap
• the technical risks are not clearly articulated, and
• the experimentation is not recorded with sufficient detail or clarity to enable the company to demonstrate that it carried out the activities in a systematic, investigative and experimental manner.

What can be done to ensure that R&D activities are eligible for the tax concession?

Careful preparation is necessary to ensure that R&D activities are properly documented and articulated to ensure the best possible chance of surviving an R&D audit. Ideally this preparation will begin before the activities commence with the adoption of an R&D plan in the approved form.

Throughout the R&D program, contemporaneous records should be kept of the activities and the outcomes.

Consideration may also be given to using the advance registration process available under the Industry Research & Development Act.

More information

For information regarding possible implications for your business, contact