On 8 May 2018, the Australian Government announced its plans to reform the Research and Development Tax Incentive (R&DTI) program to better target the program and improve its integrity and fiscal affordability in response to the recommendations of the 2016 Review of the R&D Tax Incentive (‘the Review’). Changes to the program will apply for income years starting on or after 1 July 2018, i.e. the current financial year just beginning. On 29 June 2018, the government released exposure draft legislation and associated explanatory materials setting out its proposed implementation of the reforms. It is currently seeking stakeholder feedback on these materials, and has published an accompanying consultation paper outlining areas in which specific feedback on the implementation of the reforms is being requested.The R&DTI is the Australian Government’s largest, and most costly, innovation incentive program. In its current form, it provides a tax offset (of 43.5% or 38.5%, depending on annual aggregated turnover) for some of a company's cost of eligible R&D activities. To be eligible, an applicant must be an incorporated company, and be conducting eligible core R&D activities incurring an expenditure of at least A$20,000. The legislation defines eligible activities as being experiments that are guided by hypotheses and conducted for the purpose of generating new knowledge.
The Review found that the R&DTI was failing to fully achieve its objectives of generating additional R&D activities and was not well targeted, in the sense that it provides benefits for R&D activities that would have been undertaken anyway. It also found the cost of the Incentive had exceeded its initial estimates of A$1.8 billion per annum when it was introduced in 2011-12. In 2016-17, it actually cost around A$3 billion. The Review made a number of recommendations to improve the integrity and effectiveness of the program and to promote its objectives. The proposed legislation would implement a number of these recommendations, adopted in the 2018-19 national budget.
If passed, the proposed changes to the R&DTI program will apply a A$4 million cap to the refund available to small companies (although, notably, clinical trials will be exempt from the cap). They will also reduce the incentive available to large companies, and make the corresponding tax offset dependent upon R&D intensity (i.e. cost of R&D relative to total expenditure). Additionally, they will close some ‘loopholes’ and make a number of adjustments to the administration of the program, including enhancing transparency by requiring information about companies’ R&D tax claims to be published.
A consultation process in currently underway, with submissions due by 26 July 2018.
‘Better Targeting’
Provisions in Schedule 1 of the draft amendments bill are intended to adjust the targeting of the R&DTI program, to deliver relatively greater incentives to smaller companies, and to larger companies that spend more of their annual budget on R&D, while also attempting to contain the escalating costs of the program. Since these provisions will directly affect how R&D tax offsets are calculated, and the maximum deductions (or refunds) available, they will most likely be of greatest interest to users of the program.Small R&D entities (i.e. those having an aggregated turnover of less than A$20 million – typically start-ups and SMEs) are currently entitled to a refundable R&D tax offset rate of 43.5%. In the past the corporate tax rate was 30%, meaning that the R&D tax offset included an ‘incentive component’ of 13.5%. That is, a small R&D entity was entitled to a notional deduction this much higher than the benefit that would be obtained simply by claiming R&D expenditure as a tax deduction. Furthermore, unlike a regular tax deduction, the R&DTI program provides for the payment of a refund even if the notional deduction exceeds the tax payable by a company. Thus, for example, an early-stage start-up with no taxable profits may be entitled to a cash payment from the Tax Office of 43.5% of its eligible R&D tax expenditure.
However, under changes to company tax rates that have just been legislated, the rate for small entities has dropped to 27.5%, and is slated to fall to 25% for all companies by the 2026-27 financial year (although if you believe that will actually happen, perhaps I can interest you in the purchase of a nice bridge). As matters now stand, therefore, the incentive component of the R&D tax offset has suddenly risen to 16% for small entities.
Under the proposed law, the incentive component will be fixed at 13.5%, i.e. the R&D tax offset rate will be set at the applicable company tax rate plus 13.5%.
Additionally, the maximum refund will be capped at A$4 million, whereas currently there is no cap. Keeping in mind that this cap applies, by definition, only to companies with turnover below A$20 million, this is still quite a generous program that should continue to serve the interests of innovative start-ups and SMEs. At the same time, the cap will limit larger refunds that, while claimed by only a small number of companies, have been significantly increasing the cost of the program.
Significantly for start-ups and SMEs in the pharmaceutical and healthcare fields, it is proposed that expenditure on clinical trials would be exempt from the A$4 million cap.
A different regime will apply to large R&D entities (i.e. those with aggregated turnover above A$20 million), which are currently entitled to a non-refundable R&D tax offset at a rate of 38.5%, providing an incentive component of 18.5%. Instead of this fixed rate, large entities will be entitled to an R&D tax offset equal to the applicable corporate tax rate (currently 30%) plus a premium based on their R&D intensity, which is essentially the proportion of their total expenditure spent on eligible R&D activities.
The objective here is to encourage larger companies to allocate a greater proportion of their total annual expenditure to R&D. The proposed premium ranges from 4%, for R&D expenditure (or, more accurately, notional deductions) of 2% or less of total expenditure, up to 12.5% if R&D expenditure exceeds 10% of total expenditure.
There will be, additionally, a permanent cap on notional deductions of A$150 million, beyond which a large entity will be entitled only to a ‘normal’ tax deduction in respect of additional R&D costs. (There is currently a cap of A$100 million, legislated to cease in 2024.)
‘Enhancing Integrity’
Provisions in Schedule 2 of the draft amendments bill are designed to further close some ‘loopholes’ in the R&DTI program.Firstly, the powers of the Commissioner of Taxation to deny an R&D tax benefit to a company seeking to use the program as part of a tax avoidance scheme will be extended. Clearly, this should have no impact on legitimate users of the program.
Secondly, adjustments will be made to provisions intended to limit ‘double-dipping’, i.e. where a company seeks to claim an R&D tax benefit in combination with some other benefit connected to the R&D activity. This may be, for example, where a government grant has been received to cover part of the costs of the activity (‘recoupment’), or where the R&D activity itself results in some benefit to the company, such as a saleable product (‘feedstock adjustment’). In such cases, the existing rules already provide for a clawback of the additional benefit, however they use fixed calculation rules that only approximately reflect the true amount of this benefit. Examples given in the explanatory materials suggest that, depending upon their circumstances, companies may end up either better or worse off than they should be under these rules.
Under the proposed changes, the mechanism for assessing the amount of the clawback will be adjusted so as to be based directly on the actual incentive component of the R&D tax offset claimed in any given case, so as to more accurately reflect the true additional benefit resulting from recoupment amounts and feedstock adjustments.
‘Improved Administration and Transparency’
Personally, I am most excited about some of the provisions in Schedule 3 of the draft amendments bill, which are generally intended to improve administration of the R&DTI program by making information about R&D expenditure claims transparent, enhancing the guidance framework to improve certainty, and streamlining processes.I realise that this probably does not sound very exciting, and actually much of it is not (which is not to say that it is not important). However, the particular aspect that interests me is ‘transparency’. As summarised in the explanatory materials, under the proposed legislation:
As soon as practicable after the end of the income year, the Commissioner must publish information about the R&D entities that have claimed notional deductions for R&D activities, including the amount claimed.
Compared to many other countries (including the UK and the US), proprietary companies in Australia are substantially opaque, and are not under any obligation to report publicly, even in respect of those aspects of their operations – such as tax benefits claimed and received – that are effectively funded or subsidised by the public. Publication of information about R&DTI claims will, for the first time, provide insight into the R&D expenditure of Australian companies, to the extent that they are seeking public support via the R&D tax offset.
In addition to allowing taxpayers to see how their money is being spent to enhance Australian innovation, I am confident that there will be many other valuable applications of this data. For example, it may be possible to match the R&D claims made by a company with any applications for patents, or other IP rights, that it may file, enabling correlations (or lack thereof) between R&D and generation of formal IP to be identified and studied. If so, then I for one will be very keen to get my hands on the new data!
Doubtless, some companies will be resistant to making this aspect of their financial records public. However, as I have already noted, it is fairly minimal compared to the requirements in some other jurisdictions (e.g. in the UK, many documents filed by registered companies – including annual accounts – are now available for free viewing). And any company that does not wish information about its R&D expenditure to become public can always choose not to make an R&DTI claim!
Conclusion – Does the Proposed Legislation Get It Right?
Australian taxpayers, via the government, provide financial support to companies engaged in legitimate R&D activities in the expectation this this will, in aggregate, result in innovation that creates economic benefits not only for those companies, but also to the nation as a whole, through enhanced economic activity, creation of new jobs, and the resulting future tax revenues.It is therefore important that we get the balance right. An R&D incentive program that does not make a sufficient investment, or is expensive but poorly targeted, may fail to deliver enough future benefit to justify its cost. Adjustments to the Australian R&DTI program are therefore of considerable potential importance to the nation, as well as to the individual companies that may – or may not – benefit from the changes. This is not an area in which I have much experience, or any expertise. However, I would encourage those who do to review the draft legislation, the explanatory materials, and the Consultation Paper, and consider providing any relevant feedback.
The government is particularly seeking input on the practicalities of the proposed calculation of R&D intensity for large entities, the clinical trials exemption to the refund cap for small entities, and any potential unintended consequences of the changes to clawback provisions. However, comments on other matters in the draft Bill and Explanatory Materials are also welcome.
As noted at the outset, submissions are due by 26 July 2018.
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