In the Federal budget handed down on Tuesday 8 May 2018, Treasurer Scott Morrison announced major changes to “better target” the research & development (R&D) tax incentive. The Government estimates these changes will result in a net gain to the Budget of A$2.4 billion over the next 4 years. In order to achieve these savings, the Government is tightening the qualifying rules - which will generally reduce the level of R&D tax offsets available - and increasing resourcing for compliance activities. Below, we consider the implications of these changes and suggest how taxpayers can prepare themselves for the new environment.

Existing rules

Companies with an annual turnover less than A$20 million are currently entitled to a 43.5% refundable tax offset in respect of core and supporting R&D activities.

Companies with an annual aggregated turnover of A$20 million or more are entitled to a 38.5% non-refundable tax offset in respect of core and supporting R&D activities. These companies can carry forward unused offset amounts to future income years.

The rate of the R&D tax offset is currently capped at expenditure of A$100 million per year. Any eligible expenditure over that amount generates a tax offset at a company’s ordinary corporate tax rate.

Proposed changes

Under the proposed changes, from 1 July 2018, taxpayers with an aggregated annual turnover below A$20 million will be entitled to the R&D offset rate at 13.5% above their company tax rate (i.e. 43.5% for a 30% taxpayer and 41.0% for a 27.5% taxpayer). Except for clinical trials, cash refunds for these taxpayers will be capped at A$4 million, with offsets that cannot be refunded to be carried forward as non-refundable tax offsets for future income years.

Companies with an aggregated annual turnover of A$20 million or more will be entitled to a non-refundable R&D tax offset at concessional rates (ie above their ordinary company tax rate) based on their “R&D intensity” percentage. This is the R&D expenditure as a proportion of total expenditure for the year. The lower the intensity percentage, the lower the maximum available tax offset.

The intensity percentage incrementally increases as follows:

R&D intensity percentage

R&D offset rate (above company tax rate)

Offset rate for 30% taxpayer1

Offset rate for 27.5% taxpayer2

Between 0 – 2%

4%

34.0%

31.5%

Above 2% to 5%

6.5%

36.5%

34.0%

Above 5% to 10%

9%

39.0%

36.5%

Above 10%

12.5%

42.5%

40.0%

The maximum eligible R&D expenditure threshold for the concessional R&D tax offset will be increased to A$150 million per year (an increase of A$50 million on the existing rules).

The Budget papers also reveal that the Government is introducing several administrative and compliance measures including:

  • increased resourcing for the Australian Taxation Office (ATO) and the Department of Industry, Innovation and Science in relation to enforcement activity and providing improved program guidance to participants;
  • increased transparency of the program, by enabling the ATO to publicly disclose claimant details and the amount of R&D expenditure they have claimed;
  • limiting time extensions to complete R&D registrations; and
  • amending technical provisions, such as the general anti-avoidance rules.

Impact of the changes

The mechanics of potential financial impacts of the changes are illustrated in the examples below.

Example 1 - large R&D taxpayer

In 2018/2019, Big Pharma Co has an aggregated turnover of over A$1 billion and has incurred expenditure in Australia of A$120 million on its eligible core and supporting R&D activities. Its total expenditure is A$6.5 billion per annum. Under existing rules, Big Pharma Co would be entitled to a tax offset of A$44.5 million (A$38.5 million (38.5% x A$100 million expenditure at the R&D tax offset rate) + A$6 million (30% x A$20 million at the ordinary corporate tax rate)).

Under the new rules, Big Pharma Co will have an R&D intensity percentage of 1.85% and will be entitled to a deduction of A$40.8 million (34% x A$120 million). Accordingly, Big Pharma Co’s offsets for its R&D activities have been reduced by A$3.7 million.

However, if Big Pharma Co’s total expenditure was only A$800 million, such that it had an R&D intensity percentage of 15%, it would be entitled to a deduction of A$51 million (42.5% x A$120 million). Accordingly, in this case Big Pharma Co would be entitled to additional tax offsets of A$6.5 million for its R&D activities as compared to the position under the current rules.

Example 2 – small R&D taxpayer

Small Tech Co has an aggregated turnover of A$18 million and has incurred expenditure of A$10 million on its eligible core and supporting R&D activities.

Under the existing rules, Small Tech Co would be entitled to a refundable offset of A$4,350,000 (43.5% x A$10 million). However, under the new rules, Small Tech Co will only be entitled to an offset of A$4,100,000 (41% x A$10 million) because it has an ordinary corporate tax rate of 27.5%. In addition, it will only be entitled to a maximum cash refund of A$4 million and will have to carry over the balance of A$100,000 to the next financial year.

Implications for taxpayers

The examples demonstrate that there will be significant differences to taxpayers’ entitlements to tax offsets under the new laws. Some taxpayers may be better off, but others will be significantly worse off.

When taken together with the increased funding for compliance activities, the net effect of these measures for all taxpayers is that it will likely be more time consuming and costly for taxpayers to access reduced R&D tax offset entitlements.

In relation to compliance activities, our experience is that audits of R&D offset entitlements will usually take place years after the expenditure has been incurred, when it may be more difficult to gather the evidence needed to confirm the validity of the claim. In such circumstances, it is possible that key employees may have moved on, files been lost, or memories faded about why and how certain decisions were made and activities undertaken. Defending a position years later will also mean companies incur significant legal costs in order to gather the necessary evidence to support their positions.

In addition, if AusIndustry (the government agency that registers R&D activities) revokes the registration of a company’s R&D activities, the ATO may require the company to repay the offset before the objection and appeal process with AusIndustry has been completed. This in turn could have significant implications for cash flows and financial reporting in later financial years, depending on the size of the offset that was claimed.

What should taxpayers do?

To put themselves in the best position to qualify for the R&D tax offset and, if necessary, avoid adverse adjustments in an audit, companies should:

  • seek advice from tax professionals with relevant R&D experience in advance of incurring the expenditure, in order to identify the information and documents to be collated that will support their positions;
  • ensure they meet strict registration time limits;
  • consider employing a dedicated resource to manage the R&D registration process (particularly if the company spends a significant amount on R&D); and
  • collate contemporaneous evidence at the time the R&D activities are undertaken and expenditure is incurred to demonstrate the eligibility of all registered activities, including:
    • interviewing and taking statements from key commercial staff about why decisions were taken and what was anticipated to be achieved;
    • collating reports to substantiate technical positions;
    • identifying and collating research papers, reports and journal articles to outline the existing state of knowledge on those activities the subject of the R&D expenditure; and
    • identifying and collating the required contemporaneous internal documents to support decisions made (eg internal memoranda, emails, board minutes and papers).

Failure to do this will likely result in a greater risk of a company’s activities not being registered by AusIndustry or, if initially registered, then being audited and having the activity registrations revoked so that the R&D tax offset is denied.