INSIGHT: Australia’s R&D Tax Incentive: Pros and Cons

Draft legislation was released on June 29, 2018 addressing these issues. Whilst the proposed changes are not yet law, we summarize the intended changes that are expected to commence from July 1, 2018.

The purpose of the R&D tax incentive is to encourage R&D activities, with a view to obtaining new knowledge that is likely to bring wider benefits to the Australian economy. The R&D tax offset is contained in Division 355 of the Income Tax Assessment Act 1997 (Cth), and provides eligible entities with tax offsets for a variety of eligible expenses and depreciation costs incurred in respect of their R&D activities. Currently there are two offsets available:

43.5 percent refundable tax offset for most small R&D entities (entities with an aggregated turnover of less than A$20 million); and

38.5 percent non-refundable tax offset to larger R&D entities or entities controlled by one or more “exempt entities.”

A refundable tax offset allows entities to receive refunds as a cash payment. A non-refundable tax offset is used to reduce the relevant entity’s income tax liability for an income year. Any excess non-refundable tax offsets can be carried forward and applied in future income years.

The proposed changes from the recent draft legislation center around the following:

increasing the R&D expenditure threshold from A$100 million to A$150 million;
introducing a A$4 million cap on annual cash refunds (excluding clinical trials);
linking R&D refundable and non-refundable tax offsets with the change in corporate tax rate;
introducing an “intensity tier” mechanism for non-refundable R&D tax offsets;
new definitions, including a revised definition of “R&D expenditure”; and
strengthening the anti-avoidance provisions in the R&D space.

The pros and cons of the proposed changes are analyzed further.

Pro: Increasing A$100 million Threshold to A$150 million

Currently, expenditure on R&D activities (notional deductions) that exceeds A$100 million is not eligible for the full R&D tax offset. The rate of offset of notional deductions in excess of A$100 million is instead limited to the R&D entity’s corporate tax rate.

The draft legislation proposes to increase this A$100 million threshold to A$150 million. This will allow R&D entities to claim additional R&D tax offsets on expenditure on eligible R&D activities up to the increased threshold—and is a positive change for larger R&D entities whose R&D expenditure exceeds A$100 million.

Con: A$4 million Per Annum Cap for Small R&D Entities

Bad news for small R&D entities: the draft legislation also seeks to enact an annual cap of $4 million on refundable tax offsets allowed to small R&D entities. Expenditure in excess of this amount will be allowed as a non-refundable tax offset that can be carried forward to future income years.

This change is likely to negatively impact start-up entities with notional cash refunds in excess of A$4 million that are already struggling to obtain initial funding, which is common for long R&D programs.

However, with the aim of recognizing the growth and opportunities in the biotechnology, medical technology and pharmaceutical industries, the Government has excluded R&D activities undertaken as part of clinical trials from the A$4 million cap.

Con: Refundable Tax Rate Linked to Corporate Tax Rate

As noted above, small R&D entities are currently eligible for a refundable tax offset at a rate of 43.5 percent. The draft legislation is proposes limiting the refundable tax offset to a rate which is equivalent to the small R&D entities’ corporate tax rate, plus a 13.5 percent premium.

Although the purpose of this change is to align the incentive with the corporate tax rate (and is no different to the level of incentives available when all companies were subject to a 30 percent corporate tax rate), ideologically this change may decrease the attractiveness of R&D Tax Incentives for entities with a corporate tax rate of 27.5 percent, that will in future “lose” a 2.5 percent R&D tax benefit each year.

Con: Intensity Based R&D Tax Offset for Large R&D Entities

With the goal of encouraging incremental R&D expenditure, the draft legislation also proposes amending the rate of non-refundable tax offsets. Once the legislation is passed, large R&D entities will be entitled to claim a non-refundable R&D tax offset at a rate that is equal to the company’s corporate tax rate, plus a “premium”. The premium is determined by reference to the intensity of R&D expenditure incurred by the company.

This means that large R&D entities will be required to calculate their “R&D intensity” in order to determine the R&D tax offset they are entitled to claim. An entity’s R&D intensity is calculated by reference to the proportion of eligible R&D expenditure to the entity’s total expenditure.

As can be seen from the table below, large R&D entities that devote a greater portion of their overall activities to R&D will be entitled to claim a proportionately higher non-refundable tax offset.

Consistent with the proposed legislative changes, any “notional deductions” that exceed A$150 million will not attract an intensity premium. This means that for any eligible expenditure in excess of A$150 million, the R&D offset premium is nil and such expenditure will only attract an offset at the company’s prevailing corporate tax rate.

Overall, the new proposed non-refundable offset will mean that companies with a high R&D intensity may receive an increased benefits and those with a low R&D intensity, as defined, will receive a reduced benefit moving forward. Although this intensity threshold is not as harsh as initially expected, it will discriminate against companies with high levels of “total expenditure,” e.g. mining, manufacturing and fast-moving consumer goods industries.

Con: Definition of R&D Expenditure

The new legislation also includes (controversially) an amended definition of an R&D entity’s eligible expenditure. Under the amended definition the concept of R&D expenditure that is allowable is that which is “incurred” by reference to “accounting principles”. Linking eligible expenditure to those expenses which have been incurred having regard to “accounting principles” is imprecise and may result in uncertainty (in turn, increasing both complexity and compliance costs).

Con: Strengthened Anti-avoidance Provisions

The general anti-avoidance provisions are contained in Part IVA of the Income Tax Assessment Act 1936 (Cth) (“Part IVA”). Despite the fact that R&D notional deductions are considered deductions for Part IVA purposes, the draft legislation proposes to expressly include and R&D tax offset within the concept of “tax benefit” in Part IVA. This means that the Commissioner can access Part IVA to deny R&D entities from obtaining tax benefits when they enter into “artificial” or “contrived” arrangements purpose of enabling access to the R&D tax offset.

Where to From Here?

Assuming that the draft legislative changes are enacted as announced, the attractiveness of the R&D Incentive is likely to decrease and Australia’s appeal as a place to conduct R&D activities is likely to be weakened—particularly for larger companies, as the non-refundable R&D tax offset is among the lowest when compared with other international jurisdictions.

Nevertheless, the proposed changes are not as blunt as anticipated and particular industries (such as life sciences) with higher levels of R&D intensity will likely benefit from the changes.

Planning Points

Companies that currently claim the R&D Tax Incentive may wish to consider the following in light of the proposed amendments:

for larger R&D entities, undertake a review of the total expenditure to determine the likely impact of the new R&D premium intensity mechanism;

for smaller R&D entities, review planned R&D expenditure and consider that expenditure is likely to exceed the proposed A$4 million annual cap; and

all entities should consider whether expenditure will fit within the revised definition of R&D expenditure.