Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)Chapter 7 - Research and development amendments
Outline of chapter
7.1 This chapter explains some amendments needed to ensure that the income tax laws existing provisions for R & D deductions interact properly with the consolidation provisions and preserve the policies behind both regimes to the greatest extent possible.
Context of reform
7.2 The income tax law contains a number of provisions that aim to encourage companies to invest in R & D activities. The amendments are intended to ensure that this aim is not frustrated because a company is a part of a consolidated group or because it joins or leaves such a group.
Summary of new law
7.3 The amendments make a number of changes to the ITAA 1936 to preserve the operation of the R & D provisions for situations involving consolidated groups. They ensure that:
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- a head company qualifies for the R & D deductions while any of its subsidiary members do;
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- the expenditure history needed to access some R & D deductions is not affected by the consolidation history rules;
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- clawing back the concessional part of an R & D deduction when expenditure is recouped is still possible even though the deduction was claimed by the head company of a consolidated group but the recoupment was received by a company that left the group; and
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- simply consolidating does not allow 2 concurrent deductions for one amount of R & D expenditure. This is done by setting off one deduction against the other.
| New law | Current law |
|---|---|
| A head company of a consolidated group, that does not otherwise qualify for R & D deductions for particular activities, will still be able to claim them if one of its subsidiaries is incorporated in Australia and registered for those activities. | A company can only claim R & D deductions if it is incorporated in Australia and, usually, only if it is registered for particular R & D activities. |
| For the purposes of working out entitlements to the extra R & D incremental expenditure deduction, a subsidiary members expenditure history from before it joined a consolidated group and, when it leaves, from while it was in the group, are exclusively attributed to the head company or the subsidiary member. |
Both a company and the head company of its consolidated group can count the companys history before it joined the group. Similarly, both a company that has left a consolidated group and its former head company can count the history of its time in the group. |
| Claw back of the deduction for R & D expenditure to 100% can be applied against a consolidated groups assessments for earlier years if a subsidiary member recoups the expenditure after it has left the group. | The deduction for R & D expenditure that is recouped is clawed back from 175% or 125% to 100%. This can involve amending a companys assessments from earlier years. |
| Deductions that can now be claimed under other provisions (because joining a consolidated group has broken the link to the original R & D expenditure) are reduced by the amount of the deduction that is claimed under the R & D provisions. | Deductions for an amount of R & D expenditure can only be claimed under the R & D provisions. |
Detailed explanation of new law
Registration and eligible companies
7.4 A pre-requisite for the operation of the R & D provisions is that the company is an eligible company. This is defined to mean a company incorporated under Australian law. Such a company could join a group that has a head company not incorporated under Australian law. This would mean that the subsidiarys activities would not be covered by the R & D provisions while it was in the consolidated group.
7.5 Similarly, a requirement for most of the R & D provisions is that the company is registered in relation to its R & D activities under section 39J of the Industry Research and Development Act 1986 . If a registered company joins a consolidated group, the head company usually will not be registered for its activities and so will not be covered by the R & D provisions.
7.6 These problems are addressed by an amendment that applies the R & D provisions as if the head company of a consolidated group was both an eligible company and registered in relation to particular activities for so long as are any of its subsidiaries. [Schedule 11, item 7, section 73BAB of the ITAA 1936]
7.7 Some R & D expenditure is eligible for an extra 50% deduction on top of the normal 125% R & D deduction. To access the extra 50%, an R & D group must have incurred eligible expenditure (called incremental expenditure) for the previous 3 years and must have spent more in the current year than it spent on average over those 3 previous years.
7.8 That excess is then distributed amongst the members of the R & D group in proportion to their current years increase in incremental expenditure. Each can claim the extra 50% on its share of the distribution, or on the amount of incremental expenditure that it deducted at 125%, if that is less.
7.9 If a company joins or leaves a consolidated group, its ability to access the extra 50% could be affected by:
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- the consolidation entry and exit history rules (which would allow the entity to count its incremental expenditure while it was in a consolidated group even though the head company of the group was already counting it); and
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- the fact that it would not have deducted its R & D expenditure at 125% while it is in a consolidated group because it would have been deducted by the groups head company.
7.10 These outcomes would usually reduce access to the extra 50% deduction. To address that issue, the amendments aim to put the entity in the same position for the purposes of working out access to the extra 50%, that it would have been in if it had never been in a consolidated group.
7.11 The amendments do that by, for those purposes, treating the incremental expenditure incurred and deducted by a company that joins a consolidated group as instead having been incurred and deducted by the groups head company. [Schedule 11, item 7, subsection 73BAC(1) of the ITAA 1936]
7.12 Similarly, for those purposes a company that leaves a consolidated group is taken to have incurred the incremental expenditure that it actually incurred while in the group and to have deducted the amounts that the head company deducted for that expenditure. [Schedule 11, item 7, subsection 73BAD(1) of the ITAA 1936]
7.13 The R & D provisions already contain rules about the history of incremental expenditure. To ensure that those history rules continue to operate as intended, the amendments provide for the order in which the various history rules apply.
7.14 When a company joins an R & D group and a consolidated group at the same time, the R & D rules about its increment history will apply first. If those rules bring that history into the R & D group, the amendments will then attribute it to the consolidated groups head company. [Schedule 11, item 7, subsection 73BAC(2) of the ITAA 1936]
7.15 When a company leaves an R & D group and a consolidated group at the same time, the amendments will apply first to attribute the relevant increment history to the company. The existing R & D rules about increment history will then apply to work out whether the history stays within the R & D group or goes with the company. [Schedule 11, item 7, subsection 73BAD(2) of the ITAA 1936]
7.16 Sometimes a company will claim deductions at the 125% or 175% level for R & D expenditure that is reimbursed by a grant or other recoupment from a government body. In such cases, the existing law claws back the deduction to just 100%. The claw back is directed first at the current year but can affect assessments of earlier years.
Claw back against former group
7.17 There can be cases where the head company will claim the 125% or 175% deduction for expenditure made by a subsidiary but the subsidiary will recoup that expenditure after it has left the consolidated group. Because the subsidiary did not have an assessment for the time it was in the group, the claw back will not be able to target its assessments for those years.
7.18 To address that, the amendments allow the extra 25% or 75% to be clawed back from the head company to the same extent that it would have been clawed back from the subsidiary if it had never been in the consolidated group. [Schedule 11, item 7, subsection 73BAE(1) of the ITAA 1936]
7.19 The head company may not be aware of the amount of the recoupment that its former subsidiary has received or even that it received the recoupment at all. The amendments solve that by requiring the subsidiary to notify the head company of the amount that it will have to use for its claw back calculation. It must do so within 60 days of the end of the financial year of the recoupment. By that time the subsidiary will be in a position to calculate the information it must supply to the head company. [Schedule 11, item 7, subsection 73BAE(2) of the ITAA 1936]
7.20 Failing to notify the head company of the relevant amount for its claw back calculation could constitute a taxation offence under section 8C of the TAA 1953 and, on conviction, that could result in a fine of up to $2,200 (or more for repeat offences).
7.21 The amendments make it possible for an administrative penalty to also be imposed for failing to notify the head company. The amendments do that by expanding an existing penalty provision about failing to supply the Commissioner with required information so that it also covers failing to notify the head company of the relevant amount for its claw back calculation. [Schedule 11, items 14 and 15, subsections 286-75(3) and 286-80(2) of Schedule 1 to the TAA 1953]
7.22 The amount of the administrative penalty is 1 penalty unit (currently $110) for each 28 days that the failure continues (to a maximum of 5 penalty units). However, that penalty is multiplied by 2 for medium sized taxpayers and by 5 for large taxpayers (see subsections 286-80(3) and (4) of Schedule 1 to the TAA 1953).
7.23 The existing provisions that allow deductions for R & D expenditure (e.g. for core technology expenditure) also provide that no other deductions are allowed for that expenditure. When a company enters a consolidated group, its depreciating assets are taken to have been acquired by the groups head company for a new payment (see paragraph 701-55(2)(a) of the May Consolidation Act). Because that new payment is not the original R & D expenditure, the existing provisions that prevent double counting would not apply.
7.24 To stop any double counting, the amendments reduce any depreciation deduction under Division 40 of the ITAA 1997 and any notional Division 40 deduction under section 73BC of the ITAA 1936 by the amount that is deductible under section 73B of the ITAA 1936. [Schedule 11, item 7, subsections 73BAF(1) and (2) of the ITAA 1936]
Example 7.1: Depreciation deduction reduced
Formaldehyde Ltd spends $1 million to buy the patent to a drug for the purposes of researching an improved drug. It then joins a consolidated group and the cost setting amount for the patent becomes $1.2 million. In year 1, Formaldehyde spends $600,000 researching the improved drug and, because of the single entity rule, the groups head company, Benzedrine Ltd is taken to have spent that money. Because of the entry history rule, Benzedrine is also taken to have spent $1 million buying the patent, so it can deduct $200,000 of it under the core technology provisions (i.e. a third of the $600,000 research expenditure) (see subsections 73B(12A) and (12B) of the ITAA 1936).
The notional Division 40 deduction for the patent is $60,000. The amendment will reduce that to nil because of the core technology deduction. The patents adjustable value will still decline to $1.14 million even though the depreciation deduction was reduced to nil.
7.25 If the deduction under section 73B of the ITAA 1936 exceeds the depreciation deduction, the excess is carried over to reduce future years depreciation deductions. [Schedule 11, item 7, subsection 73BAF(3) of the ITAA 1936]
Example 7.2: Carry forward of reduction amount
Continuing the previous example, Benzedrine spends $75,000 on research in year 2, so it can deduct a further $25,000 of the cost of the patent under the core technology provisions. That will reduce year 2s notional Division 40 deduction from $60,000 to $35,000. However, $140,000 of the reduction amount was unused from year 1, so that unused amount will reduce the notional Division 40 deduction to nil and the remaining $105,000 will carry forward to future years.
7.26 The amendments add an objects clause for the new R & D provisions. It explains that their purpose is to ensure that the R & D concession interacts properly with the consolidation regime. [Schedule 11, item 7, section 73BAA of the ITAA 1936]
7.27 Objects clauses have no direct operation. However, by explaining the underlying purpose of other provisions, they can influence the interpretation of the law towards aligning with that purpose.
Attaching history to activities
7.28 The existing exit history rule (section 701-40 of the May Consolidation Act) provides an entity which leaves a consolidated group with the history of the things that happened to any asset, liability or business that the entity takes with it.
7.29 Although unlikely, it is possible in the R & D case that a company could leave without any of these things but in circumstances where some history should attach to it. For example, it might leave a group with a registration for activities, where the registration is not an asset and the activities do not amount to a business but it still needs the history of those activities so that the R & D provisions can apply to it. Therefore, an amendment adds registration under section 39J of the Industry Research and Development Act 1986 for particular R & D activities to the list of things that history attaches to when an entity leaves a consolidated group. [Schedule 11, item 11, paragraph 701-40(2)(d) of the ITAA 1997]
Consequential amendments
7.30 A number of definitions are added to the ITAA 1936 to ensure that terms used in the amendments have the same meanings as they do in the consolidation provisions. Each of the definitions provides that the term has the same meaning as it does in the ITAA 1997. The terms are:
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- consolidated group ;
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- head company of a consolidated group or MEC group;
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- MEC group ;
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- member of a consolidated group or MEC group;
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- subsidiary member of a consolidated group or MEC group; and
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- tax cost is set .
[Schedule 11, items 1 to 6, subsection 6(1) of the ITAA 1936]
7.31 Some notes are added to the consolidation history rules to draw readers attention to their modified operation when the R & D history rule applies. [Schedule 11, items 8 to 10, section 701-5 and subsection 701-40(1) of the ITAA 1997]
7.32 Some minor changes are made to the guide material and objects clause for Division 286 of Schedule 1 to the TAA 1953 to reflect the fact that the amendments expand the administrative penalty provisions to cover a company failing to inform its former head company of relevant claw back amounts. [Schedule 11, items 12 and 13, sections 286-1 and 286-25 of Schedule 1 to the TAA 1953]