House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Josh Frydenberg MP)

Chapter 4 - Enhancing the R & D Tax Incentive

Outline of chapter

4.1 Schedule 4 to the Bill reforms the R & D Tax Incentive to help businesses that invest in R & D manage the economic impacts of the Coronavirus pandemic while providing incentives for businesses to undertake additional investments in R & D.

Context of amendments

The R & D Tax Incentive

4.2 The R & D Tax Incentive was introduced in 2011. The R & D Tax Incentive is intended to encourage R & D activities that might not otherwise be conducted in cases where the new knowledge gained is likely to have a wider Australian economic benefit. That is, the Incentive is intended to support additionality in R & D activities and spillover benefits to the broader economy.

4.3 Division 355 of the ITAA 1997 provides R & D tax offsets to R & D entities for a range of expenses and depreciation costs incurred on R & D activities. There are currently two R & D tax offsets available:

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a 43.5 per cent refundable tax offset available to most small R & D entities - those with an aggregated turnover of less than $20 million. The refundable offset can be refunded as a cash payment to an R & D entity if the offset exceeds the entity's income tax liability; and

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a 38.5 per cent non-refundable tax offset available to larger R & D entities and R & D entities controlled by one or more exempt entities. A non-refundable tax offset may be used to reduce an R & D entity's income tax liability for an income year but any remaining excess must be carried forward to be applied in future income years.

4.4 The basis for calculating R & D tax offsets is the concept of a notional deduction. A notional deduction is generally recognised for expenditure (Subdivision 355-D) on R & D activities and depreciation on assets held for R & D purposes (Subdivision 355-E) subject to conditions. These deductions are referred to as notional because they are only used to calculate an R & D entity's entitlement to the R & D tax offset and for some other discrete purposes (section 355-105). That is, the entitlement to the R & D Tax Incentive for a notional deduction replaces any entitlement to an underlying tax deduction.

4.5 The value of the R & D Tax Incentive (the 'incentive component') is generally the difference between the R & D entity's corporate tax rate and the R & D tax offset rate (plus the benefit of refundability where it applies). For example, the incentive component of a large R & D entity receiving the 38.5 per cent non-refundable offset and paying the 30 per cent corporate tax rate is generally 8.5 per cent.

4.6 Under the Government's reforms to corporate tax rates, the tax rate for companies with an aggregated turnover of less than $50 million has been reduced to 26 per cent and will be further reduced to 25 per cent from 1 July 2021. As the corporate tax rate has been lowered from 30 per cent for some taxpayers, the value of the incentive component of the R & D tax offsets has increased for these entities.

The $100 million expenditure threshold

4.7 The R & D Tax Incentive is subject to a $100 million expenditure threshold, sometimes referred to as an expenditure cap. Expenditure on R & D activities (notional deductions) in excess of $100 million is not eligible for the full rate of the relevant R & D tax offset. Rather, these notional deductions give rise to an offset at the R & D entity's corporate tax rate. That is, excess notional deductions give rise to the same benefit as if the expenditure had instead been claimed as an ordinary tax deduction, without any incentive component.

4.8 The $100 million expenditure threshold and some associated provisions are legislated to sunset on 1 July 2024 under Part 2 of Schedule 1 to the Tax Laws Amendment (Research and Development) Act 2015.

Review of the R & D Tax Incentive and impact of the Coronavirus

4.9 The Government's reforms are made in response to the economic impact of the Coronavirus pandemic, but also have regard to the recommendations of the 2016 Review of the R & D Tax Incentive (the Review).

4.10 The Review of the R & D Tax Incentive was commissioned as part of the Government's National Innovation and Science Agenda. The Review Panel was chaired by the then Chair of Innovation and Science Australia (ISA), Mr Bill Ferris AC, Australia's Chief Scientist, Dr Alan Finkel AO, and the then Secretary to the Treasury, Mr John Fraser. The Review Panel was asked to identify opportunities to improve the effectiveness and integrity of the program, including how its focus could be sharpened to encourage additional R & D activities in Australia.

4.11 The Review of the R & D Tax Incentive found that the Incentive was failing to fully achieve its objectives of generating additional R & D activities and was not well targeted, providing benefits for R & D activities that would have been undertaken without the R & D Tax Incentive.

4.12 The Review of the R & D Tax Incentive made recommendations to improve the integrity and effectiveness of the program. The Review of the R & D Tax Incentive also made recommendations to improve the administration of the R & D Tax Incentive. The ISA 2030 Strategic Plan, published in January 2018, made alternative recommendations informed by feedback provided on the Review of the R & D Tax Incentive's report. A number of the Review's recommendations were adopted by Government in the 2018-19 Budget.

4.13 The Treasury Laws Amendment (Research and Development Tax Incentive) Bill 2019 was introduced into the Parliament in December 2019. The former Bill proposed to make a number of changes to retarget support under the R & D Tax Incentive from 1 July 2019. The former Bill also proposed amendments to improve the integrity of the R & D Tax Incentive and improve the administration and transparency of the R & D Tax Incentive.

4.14 In light of the continuing economic consequences of the Coronavirus pandemic, further refinements to the R & D Tax Incentive are needed to support Australian firms that invest in R & D. The refinements are intended to provide business with greater support and certainty, and in doing so support a strong economic recovery.

Summary of new law

4.15 Schedule 4 to the Bill supports companies that invest in R & D through the following changes:

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increasing the R & D expenditure threshold from $100 million to $150 million and making the threshold a permanent feature of the law;

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linking the R & D tax offset for refundable R & D tax offset claimants to claimants' corporate tax rates plus a 18.5 percentage point premium; and

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increasing the generosity of the R & D Tax Incentive for larger R & D entities with high levels of R & D intensity.

4.16 In particular, large R & D entities with aggregated turnover of $20 million or more for an income year are entitled to an R & D tax offset equal to their corporate tax rate plus one or more marginal intensity premiums.

4.17 The intensity premiums apply to notional deductions within a range of R & D intensity where the R & D entity's R & D expenditure (notional deductions) are expressed as a proportion of the entity's total expenses.

4.18 In addition, Schedule 5 to the Bill makes a number of amendments to improve the integrity of the R & D Tax Incentive and Schedule 6 to the Bill makes a number of amendments to improve the administration and transparency of the R & D Tax Incentive. See Chapters 5 and 6 of this Explanatory Memorandum for more information.

Comparison of key features of new law and current law

Detailed explanation of new law

Increasing the expenditure threshold

4.19 The $100 million expenditure threshold is increased to $150 million per annum. [Schedule 4, item 9, subsection 355-100(3) of the ITAA 1997]

4.20 The increase allows R & D entities to claim additional amounts of concessional R & D tax offset on R & D activities. The purpose of this amendment is to increase the incentive for large R & D entities to continue to engage in R & D activities when their R & D expenditure exceeds $100 million.

4.21 The current law provides that the expenditure threshold will no longer apply from 1 July 2024 and requires the Government to conduct a review of the threshold after 5 March 2020. In light of the Review of the R & D Tax Incentive and the changes to the threshold adopted by the Government, the requirement for the review is repealed and the increased threshold is made a permanent feature of the law. [Schedule 4, items 11, 12 and 13, section 355-750 of the ITAA 1997, table item 3 in subsection 2(1) of the Tax Laws Amendment (Research and Development) Act 2015 and Part 2 of Schedule 1 to that Act]

The refundable R & D tax offset for small R & D entities

4.22 An R & D entity with aggregated turnover of less than $20 million for an income year is generally entitled to a refundable R & D tax offset equal to their corporate tax rate plus 18.5 percentage points. [Schedule 4, item 4, table item 1 in subsection 355-100(1) of the ITAA 1997]

4.23 This refundable offset does not apply to an R & D entity controlled by one or more exempt entities. These R & D entities are instead entitled to the non-refundable R & D tax offset available to R & D entities with aggregated turnover of $20 million or more. [Schedule 4, item 5, table item 2 in subsection 355-100(1) of the ITAA 1997]

Example 4.1 The refundable offset

In the 2021-22 income year, Aperture Research has aggregated turnover of $15 million. Without taking into account its R & D activities, Aperture Research has an income tax liability of $500,000.

Aperture Research has incurred $20 million on R & D activities.

Aperture Research is entitled to an R & D tax offset of $8.7 million, which is $20 million multiplied by the entity's R & D tax offset rate of 43.5 per cent (where the offset rate is comprised of the entity's corporate tax rate of 25 per cent plus a 18.5 percentage point premium).

For the 2021-22 income year, Aperture Research is able to apply the refundable tax offset to obtain a cash refund of $8.2million.

Intensity-based R & D tax offset for large R & D entities

4.24 R & D entities with aggregated turnover of $20 million or more for an income year are entitled to an R & D tax offset equal to their corporate tax rate plus marginal intensity premiums determined with reference to the R & D intensity of their R & D expenditure on an incremental basis. [Schedule 4, items 5 and 7, table item 3 in subsection 355-100(1) and subsection 355-100(1A) of the ITAA 1997]

4.25 The intensity premiums in the table below apply to notional deductions within a range of R & D intensity for R & D expenditure where notional deductions are expressed as a proportion of the R & D entity's total expenses:

Table 4.1 R & D tax offset intensity premium

4.26 Example 4.2 demonstrates the R & D tax offset for large R & D entities.

Example 4.2 The R & D tax offset for large R & D entities

Contrast Industries has notional deductions of $160 million in the 2021-22 income year, exceeding the $150 million expenditure threshold. In the same income year, Contrast Industries had expenditure of $1 billion. Its aggregated turnover exceeds $50 million, meaning it is subject to the 30 per cent corporate tax rate.

Contrast Industries has an R & D intensity of 15 per cent ($150 million divided by $1 billion). The portion of the R & D expenditure in excess of the $150 million expenditure threshold ($10 million) is calculated separately (see below).

Contrast Industries' R & D tax offset for the income year is calculated as follows:

Tier	Intensity range	R & D premium	Notional deductions applied	Offset amount
Tier 1	0-2%	8.5%	$20m	$7.7m
Tier 2	>2%	16.5%	$130m	$60.45m
Excess	NA	Nil	$10m	$3m
		Totals:	$160m	$71.15m

R & D intensity

4.27 To calculate the R & D tax offset, a large R & D entity must determine its R & D intensity. The R & D intensity is the proportion of the R & D entity's total expenses spent on R & D expenditure for the income year:

4.28 This is intended to provide a higher rate of support for incremental R & D expenditure to R & D entities that devote a significant portion of their overall operations to R & D eligible for support under the R & D Tax Incentive.

Notional deductions

4.29 Notional deductions in excess of the $150 million expenditure threshold do not attract an intensity premium and are not counted for the purposes of calculating an R & D entity's R & D intensity (see Example 4.2). [Schedule 4, item 9, paragraph 355-100(3)(a) of the ITAA 1997]

4.30 If an R & D entity's notional deductions for an income year are less than $20,000, the entity's notional deductions for the purposes of calculating the entity's R & D tax offset only includes the notional deductions that satisfy the criteria in subsection 355-100(2): that the expenditure was incurred to a research service provider registered under Division 4 of Part III of the IR & D Act or was incurred under the Cooperative Research Centre Program. [Schedule 4, item 8, subsection 355-100(2) of the ITAA 1997]

Total expenses

4.31 An R & D entity's total expenses are reported in their company tax return. The expenses reported at item six of a company income tax return are the expense amounts taken from the company's financial statements. [Schedule 4, item 10, section 355-115 of the ITAA 1997]

4.32 The Australian Accounting Standards Board's Framework for the Preparation and Presentation of Financial Statements defines 'expenses' (at paragraph 70(b)) as:

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decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.

4.33 For companies that prepare a financial report for the income year in accordance with the accounting standards and other pronouncements issued by the Australian Accounting Standards Board, those standards and pronouncements apply. For other entities, total expenses are worked out in accordance with other commercially accepted principles relating to accounting. [Schedule 4, item 10, paragraph 355-115(2)(a) of the ITAA 1997]

4.34 An R & D entity's notional deductions are always included in its total expenses. If an amount of notional deductions is not otherwise included in an entity's total expenses, an adjustment is made to nevertheless include it. [Schedule 4, item 10, paragraph 355-115(2)(b) of the ITAA 1997]

4.35 Rules apply to prevent any double counting of amounts recognised at different times as notional deductions and total expenses. [Schedule 4, item 10, subsection 355-115(3) of the ITAA 1997]

Example 4.3 Total expenses

On 1 July 2021, Ace Designs acquires an asset for $20,000 that it uses exclusively in its R & D activities. The R & D entity claims an up-front notional deduction of $20,000 in the 2021-22 income year (section 355-205).

For its financial accounts, Ace Designs uses the straight line method to work out the asset's depreciation records. The asset has a useful life of four years. Ace Designs records an expense of $5,000 in each of the 2021-22 to 2024-25 income years for the asset (for simplicity, the effect of a leap year is ignored in this example).

An adjustment is required when the entity's total expenses are calculated for R & D purposes in the 2021-22 income year. $5,000 is included as an accounting expense under paragraph 355-115(2)(a). However, an adjustment is made to add a further $15,000 to the total expenses, under paragraph 355-115(2)(b). This reflects the additional amount of notional deductions that are claimed in the 2021-22 income year.

No amount is included in Ace Designs' total expenses for R & D purposes in the later income years in relation to the asset. In each of these years, the $5,000 accounting expenses would initially satisfy paragraph 355-115(2)(a). However, the amounts are disregarded because a corresponding amount was included under paragraph (2)(b) in the 2021-22 income year (applying paragraph (3)(a)).

Consequential amendments

4.36 A cross-reference to the expenditure threshold is amended to reflect the increase of the threshold from $100 million to $150 million. [Schedule 4, item 3, the heading to subsection 355-100(1) of the ITAA 1997]

4.37 A number of amendments are made to section 355-100 of the ITAA 1997 to accommodate and explain the introduction of R & D intensity premiums to the calculation of the non-refundable R & D tax offset. [Schedule 4, items 6 and 8, Note 2 to subsection 355-100(1) and subsection 355-100(2) of the ITAA 1997]

4.38 Similarly, subsection 355-100(3) is amended to reflect both the increased expenditure threshold and the changes to subsection 355-100(1). In turn, a consequential amendment is made to subsection 67-30(1). [Schedule 4, item 2, subsection 67-30(1) of the ITAA 1997]

Application and transitional provisions

4.39 The amendments commence on the first day of the quarter following Royal Assent. [Section 2 of the Bill]

4.40 The amendments in Schedule 4 apply to income years starting on or after 1 July 2021. [Schedule 4, item 14]