The tax issues affecting CRCs and their participants are largely well-known and provide sufficient flexibility to accommodate both participants who are tax exempt (such as research providers) and those which are taxable entities (i.e. industry participants).
The Commonwealth’s preference for a CRC to have a corporate structure, and widespread use of a separate commercialisation entity, impact on structuring decisions. While template documents exist for the constitution of a corporate CRC and the agreement between participants, it is common for participants to customise structures and documents to suit particular objectives which may differ from case to case.
This paper discusses common issues and also addresses recent and proposed legislative changes affecting not-for-profit (NFP) entities.
CORPORATE AND COMMERCIALISATION STRUCTURES
The two most common forms of companies that can be established under the Corporations Act are:
- companies limited by guarantee – these are a form of NFP entity, the features of which are that the members do not have shares in the company and cannot receive distributions of income or capital from the company. Subject to any restriction in the company’s constitution or any agreement between members, shares are transferrable. The liability of members to contribute to the debts of the company on winding up is limited to a nominal amount guaranteed by each member. These companies can be used to create entities which are tax exempt.
- Companies limited by shares – members have shares in the company and can receive distributions of income or capital from the company. The liability of members to contribute to the debts of the company on winding up is limited to the amount which they have agreed to pay for the shares issued to them. These companies are taxable. Dividends to shareholders may be fully franked, i.e. effectively carry a tax credit which resident shareholders can offset against their own tax liabilities.
Additionally, a company may hold certain assets and income on trust for beneficiaries. Where a company acts as trustee, and the beneficiaries (e.g. CRC participants) are absolutely entitled, the assets and income are treated for all purposes (e.g. company law and tax) as held or derived by the beneficiaries directly. It is common for a corporate CRC entity to hold certain IP and commercialisation benefits in trust for participants on this basis.
The duties of company directors and rights of members of companies are set out in the constitution and the Corporations Act. In relation to NFPs, recent and proposed legislative changes locate certain rights and obligations in the Australian Charities and Not-for-profits Commission Act 2012 (Cth) and regulations (see further below).
Common CRC structures may cater for differing corporate functions, which may be carried out by separate companies or combined in one or more companies:
- Receipt of grant funds – commonly the CRC entity will receive the grant beneficially (i.e. in its own right or as trustee for its participants) and manage participant contributions. Grant funds are taxable. If a relevant tax exemption is available, the CRC entity will usually be structured as a tax exempt company limited by guarantee.
- Holding centre IP – commonly this is held in trust for participants in proportion to relative contributions to the centre. This means that, if the participant is a taxable entity, the participant rather than the CRC entity be entitled to any R&D concessions.
- Commercialisation activities – commonly commercial activities are undertaken by a taxable entity rather than an NFP, which may suggest that the CRC entity establish a separate commercialisation entity which would ordinarily be a taxable entity. The ATO has taken the view that the nature and extent of commercial activities, if carried on by an NFP, can cause tax exempt status to be lost. Current and proposed reforms entrench that view (see further below).
TAX IMPLICATIONS OF CORPORATE STRUCTURES
If the proposed research activities of a CRC do not fall within the list of eligible activities for tax exemption purposes, a CRC effectively has no choice but to establish using a taxable structure. Attention needs to be given to the nature and taxing of the activities and expenditure to ensure that the tax exposure on the grant can be managed. It will usually be preferable for centre IP to be held in trust, so that participants that are taxable entitles get the benefit of R&D concessions and participants that are tax exempt derive commercialisation benefits directly and so do not effectively lose that exemption. Where CRC activities are eligible for tax exemption, the availability of the exemption means that the grant, and interest earned from time to time, will unquestionably remain tax free. There are GST and other implications of transactions between a CRC entity, the Commonwealth and participants that need to be addressed, but these are beyond the scope of this paper.
As noted above, a tax exempt CRC entity might wholly own a taxable subsidiary to undertake commercialisation activities. Any dividends which the taxable subsidiary pays out of taxed income can carry franking credits. At present a tax exempt entity can recoup franking credits attached to dividends received. However, the government is giving consideration to withdrawing this concession by legislative amendment (see further below).
The key structuring issue here is that the refundable tax offset of 45% of eligible R&D expenditure applies only if an eligible company is not controlled by a tax exempt entity. If an eligible company is controlled by a tax exempt entity, while it will not be entitled to the refundable tax offset, it would still be entitled to the non-refundable 40% tax offset.
Thus a taxable entity which is established for commercialisation purposes with the intent of claiming R&D concessions, typically a spinout company, must not be controlled by tax exempt entities. In determining whether a tax exempt entity controls a company, the test is whether the tax exempt entity and its affiliates own or have the right to acquire interests in the capital or voting power equal to 50% or more. An individual or a company is an affiliate if the individual or company acts, or could reasonably be expected to act, in accordance with tax exempt entity’s directions or wishes, or in concert with the tax exempt entity, in relation to the affairs of the company entitled to the R&D concession.
For a more detailed paper on R&D tax concessions (click here).
Over recent years the government’s NFP working group has initiated a number of legislative changes affecting the tax treatment of NFPs. Further changes are in the pipeline.
The Australian Charities and Not-for-profits Commission (ACNC) has oversight of registered charities, which must limit activities to their eligible purpose. The ACNC will determine whether the nature and extent of commercial activities carried on by an NFP have strayed sufficiently from the qualifying purpose to cause registration with the ACNC (and hence tax exempt status) to be lost.
At this stage, tax exempt entities qualifying as charities have been transferred to ACNC jurisdiction. Many medical research institutes and some CRCs may be tax exempt under the head “health promotion charities”. The government intends that all NFPs ultimately will come under the jurisdiction of the ACNC. Draft legislation has recently been released to amend the general law definition of “charitable purposes” from 1 January 2014. This re-definition of “charitable purposes” applies only for the purpose of Commonwealth legislation (i.e. the validity and effect of charitable trusts continues to be determined under judge-made laws of the States). The proposed new legislation more specifically defines “other purposes beneficial to the community” by reference to specific sub-categories and sets out the relevant criteria for determining public benefit. To transition to the new categories of charitable purpose, an existing tax exempt entity must notify the ACNC that it meets the relevant description under the new law.
NFP entities may also qualify for DGR status, i.e. a person making a donation to the entity will obtain a tax deduction. The tax legislation sets out a list of eligible activities for this purpose.
“In Australia” requirements
The Tax Laws Amendment (Special Conditions for Not-for-profit Concessions) Bill 2012 is yet to be passed. The ATO website nevertheless confidently states that the following changes will apply from 1 July 2013.
The Bill changes the eligibility criteria for income tax exemption and DGR status to tighten up the requirement that activities be carried out in Australia:
- for tax exempt entities, they must operate principally (i.e. more than 50%) in Australia; and
- for DGR entities, they must operate solely in Australia (but merely incidental and minor activities are allowed outside Australia); there is a transitional provision that allows previously qualified DGR medical research institutes to be grandfathered if they are prescribed by regulation (we understand that the Treasury is consulting with the Department of Health & Ageing with regard to regulations to exempt medical research institutes active overseas).
Regulation by the ACNC
The ACNC Act now sets out conditions which must be complied with to obtain and retain registration (which is a pre-condition to tax exempt and DGR status). There are now regulations setting out “governance standards” (such as that mentioned above regarding qualifying activities) but as yet there are no “external conduct standards” promulgated. The external conduct standards will give effect to the “in Australia” requirements from the perspective of ACNC enforcement. For a more detailed paper on ACNC governance standards (click here).
The High Court in the Word Investments case (2008) held that commercial activities unrelated to a charitable purpose are eligible for tax exempt status because they were carried out in furtherance of a charitable purpose, in that case the advancement of religion. The Word Investments case goes further than the ATO is prepared to accept the current law in Tax Ruling 2011/4, where the ATO states that only commercial activities which are incidental or ancillary to tax exempt activities will be permitted to benefit from an entity’s tax exempt status. If there is a real risk that activities of a tax exempt entity could be characterised as beyond “incidental or ancillary” to eligible core activities then the standard method of addressing this risk has been to establish a “for-profit”, i.e. taxable, wholly owned subsidiary company limited by shares.
The May 2011 Budget announced measures to tax NFPs on income from “unrelated commercial activities” that commence after 10 May 2011, i.e. new activities. The intention is that exemptions for existing unrelated commercial activities will be phased out over time. The removal of tax concessions will not apply to commercial activities that further a NFP entity's altruistic purposes, and small-scale and low-risk unrelated commercial activities. The tax was supposed to commence on 1 July 2011, but that has been delayed, at first until 1 July 2012 and more recently until 1 July 2014 because there is as yet no draft legislation to implement the announcement.
The delay is presumably due to the problematic nature of the announcement and its implementation. For example, if the net result is that a tax exempt entity sets up a wholly owned taxable entity, but would be entitled to a rebate for franking credits on dividends, after the new entity has paid tax on the commercial income, what is the point? In a separate review, the government has a working group reviewing tax concessions, such as the ability of a tax exempt entity to recoup franking credits.
CRCs have available a range of corporate structures, with a variety of tax implications. Currently there are changes to the corporate and tax laws being made and proposed which will impose additional compliance burdens on NFPs. Existing and proposed CRCs will have to consider the potential impact of these changes when reviewing structuring issues.