House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Glossary

The following abbreviations and acronyms are used throughout this explanatory memorandum.

General outline and financial impact

R&D tax concession

This Bill amends the ITAA 1936, the ITAA 1997, T(IOEP)A 1983 and the IR&DA 1986 to change and make additions to the R&D tax concession. These amendments are designed to encourage investment in business R&D. The T(IOEP)A 1983 is also amended.

The main amendments to be made to the income tax law include:

•

the inclusion of an objects clause and some changes to the definition of R&D activities;

•

an R&D tax offset, for small companies to have access to the cash equivalent to the R&D tax concession;

•

a premium rate of 175% for additional R&D;

•

the removal of the exclusive use test and the introduction of 125% effective life write-off for R&D plant; and

•

a retrospective change made to the manner in which plant expenditure is claimed.

Date of effect: The changes to the definition of R&D activities and to plant expenditure are to apply from 12.00 pm, 29 January 2001. The R&D tax offset and the 175% premium rate are effective from the first income year commencing after 30 June 2001. The retrospective changes to the claiming of plant expenditure are to apply from 1 July 1985 until noon 29 January 2001.

Proposal announced: The retrospective changes to R&D plant were announced on 26 April 2001. The remaining measures were contained in the Backing Australias Ability package announced by the Prime Minister on 29 January 2001.

Financial impact: The measures will result in a cost to the revenue as set out in the following table:

Compliance cost impact: Minimal.

Summary of regulation impact statement

Regulation impact on business

Impact: The proposed amendments will impact upon companies who are undertaking R&D activities, their advisers and the government agencies who administer the R&D tax concession.

Main points:

•

An aid to users in clarifying the interpretation of eligible R&D activities.

•

Encouraging the use of strategic planning.

•

A fairer and more balanced approach to the treatment of expenditure on plant items used for R&D has been adopted. The removal of the exclusive use test will enable companies to claim the R&D tax concession where plant is only being used partially for R&D.

•

A refundable tax offset will be available to assist small companies in tax loss. This will increase the benefit of the R&D tax concession for small companies and improve their cash flow during their initial growth phase.

•

The model chosen for the 175% premium rate, for companies that undertake additional R&D, will induce additional R&D whilst increasing certainty for R&D decision makers and improving access to the concession for companies.

Chapter 1 - Research and development activities

Outline of chapter

1.1 This chapter explains the changes made to aid interpretation of the R&D tax concession. The amendments include the:

•

addition of an objects clause;

•

amendment to the definition of R&D activities; and

•

requirement for an R&D plan to exist for all R&D activities.

Context of reform

1.2 The definition of R&D activities is a most fundamental aspect of the R&D tax concession. The changes aid in the interpretation of the definition and provide more certainty in the determination of what is an eligible R&D activity.

Summary of new law

1.3 The objects clause is designed to aid courts and users in the interpretation of what are eligible R&D activities. The objects clause is intended to provide a statement which reflects the 1986 objectives of the R&D tax concession, incorporating the changes made to the definition of R&D activities in 1996 and the changes in this Bill. [Schedule 1, Part 1, item 1, subsection 73B(1AAA) of the ITAA 1936; Schedule 1, Part 1, item 2, section 39AA of the IR&DA 1986]

1.4 The change to the definition of R&D activities is to clarify and strengthen the current definition to ensure that activities that are not R&D cannot be supported by the tax concession. To be eligible for the R&D tax concession, the program of activities will require at least one activity to meet both the innovation and high levels of technical risk criteria. This activity is referred to as a core activity. Other activities within the program will be eligible as long as they are carried on for a purpose directly related to the carrying on of a core R&D activity. [Schedule 1, Part 2, item 3]

1.5 Further, there will now be a requirement that activities will not qualify as R&D activities unless there is an R&D plan in existence that covers the activities carried out. The requirements for the plan will be prescribed in guidelines issued by the IR&D Board. [Schedule 1, Part 3, item 5, subsection 73B(2BA) of the ITAA 1936; Schedule 1, Part 3, item 7, section 39KA of the IR&DA 1986]

1.6 A change has also been made to the section which excludes certain activities from being R&D activities. This change is to ensure that activities that relate to the post-R&D production and commercial activities are not eligible R&D activities. [Schedule 1, Part 4, item 8, subsection 73B(2C) of the ITAA 1936]

Detailed explanation of new law

Objects clause

Why is an objects clause needed?

1.7 In interpreting the definition of R&D activities, the AAT and Federal Court have, on occasion, made reference to the objective of the IR&DA 1986 as set out in section 3 of that Act.

The object of this Act is to promote the development, and improve the efficiency and international competitiveness, of Australian industry by encouraging research and development activities.

1.8 This statement is one of general encouragement and has resulted in the courts using this objective as a justification to interpret the definition of R&D activities widely.

1.9 The inclusion of a more precise statement of objectives directed at the particular requirements of the tax concession is considered to provide the AAT and the Federal Court with better guidance. It is also consistent with current legislative practice.

1.10 Companies will also benefit by being in a more informed position to self-assess the eligibility of their activities for the R&D tax concession.

Where has the objects clause come from?

1.11 The objects clause has as its basis the objectives of the R&D tax concession as first publicly stated in the second reading speech for the Income Tax Assessment Act Amendment (Research and Development) Bill 1986. It seeks to incorporate the changes made to the definition in 1996 and those in this Bill. It also seeks to limit the parameters of the concession to expenditures in respect of the defined activities.

Consequential amendments

1.12 The objects clause is inserted into the IR&DA 1986 as the IR&D Board will have a role in determining whether companies satisfy the requirements for the concession. [Schedule 1, Part 1, item 2, section 39AA of the IR&DA 1986]

1.13 A new provision is inserted into the IR&DA 1986 to give the IR&D Board the power to issue guidelines in relation to the making of an R&D plan. [Schedule 1, Part 3, item 7, section 39KA of the IR&DA 1986]

Definition

What are R&D activities?

1.14 The definition of R&D activities has been changed to ensure such activities now involve both innovation and high levels of technical risk. This change has been made to maintain the integrity of the concession by focussing on R&D which involves innovation and high levels of technical risk.

1.15 Past court interpretations of the R&D legislation have established low thresholds for both the innovation and technical risk criteria, such that support under the concession could be extended beyond its policy intent.

1.16 Innovation continues to mean an appreciable element of novelty, where novelty means something new or different. High levels of technical risk continues to mean that activities will not involve high levels of technical risk unless there is uncertainty as to whether the technical or scientific outcome can be achieved, and this uncertainty can only be resolved through a program of systematic, investigative and experimental activities. The change to innovation and technical risk is supported by the Frascati definition of R&D activities, which requires the existence of both innovation and technical risk. Such a change will ensure that the focus of R&D activities is where there is uncertainty of outcome and some original thinking is required to resolve the uncertainty.

Changes to exclusion clause

1.17 The amendment to subsection 73B(2C) will have the effect that those supporting activities which are listed as excluded activities no longer qualify as eligible R&D activities. [Schedule 1, Part 4, item 8, subsection 73B(2C) of the ITAA 1936]

1.18 The activities in the exclusion list, such as, quality control, tooling-up, patent and licensing costs, may be carried on for a purpose directly related to the carrying on of the core activity but relate to the post-R&D production and commercial activities of companies or are activities not otherwise included in the concession.

R&D plans

Why is an R&D plan required?

1.19 Through the introduction of an R&D plan, it is sought to reinforce the importance of planning in R&D. It will also encourage Australian companies to think strategically about their R&D activities as a critical and ongoing part of their business.

What is an R&D plan?

1.20 An R&D plan is a plan detailing the R&D activities that the company is planning. The contents, form and timing of the plan will be prescribed in guidelines issued by the IR&D Board. The requirement to prepare a plan applies to all claimants, irrespective of the level of expenditure on eligible R&D activities.

Application provisions

1.21 The amendments to the definition will apply from and including 12.00 pm, by legal time in the Australian Capital Territory, on 29 January 2001. [Schedule 1, Part 2, item 4; Part 3, item 6 and Part 4, item 9]

1.22 All other amendments will commence from the date of Royal Assent.

Chapter 2 - Research and development plant expenditure

Outline of chapter

2.1 This chapter explains the removal of the exclusive use test for R&D plant/assets and the introduction of 125% effective life write-off for R&D plant/assets; and a retrospective change made to the manner in which plant expenditure is claimed.

Context of reform

2.2 The measures adopt a fairer and more balanced approach to the treatment of expenditure on plant/assets used for R&D, including a more accurate reflection of the value of the plant/assets consumed in the R&D activities. This Bill includes the removal of the exclusive use test and the introduction of 125% effective life write-off for R&D plant/assets. The removal of the exclusive use test will enable companies to obtain the R&D tax concession on plant/assets which are not used exclusively for R&D. Therefore, companies, particularly smaller companies, who cannot dedicate plant for use on R&D activities for a whole year, will be able to receive concessional deductions for the period during which the plant is used for R&D.

2.3 Also, retrospective changes are being made to the manner in which plant expenditure is claimed, which will bring the interpretation of the law into line with commercial practice.

Summary of new law

2.4 From noon on 29 January 2001, deductions for depreciating plant used in carrying on R&D activities will no longer be deductible under section 73B of the ITAA 1936. [Schedule 2, Part 3, items 4, 5 and 7 to 10, definitions of aggregate research and development amount, excluded plant expenditure and research and development expenditure in subsections 73B(1), 73B(15AAA) and (15AAAA)]

2.5 From noon on 29 January 2001, deductions for depreciating plant and certain other items used in carrying on R&D activities will be worked out under section 73BH. Those deductions will be notionally worked out under Division 42 of the ITAA 1997, as modified by section 73BJ. [Schedule 2, Part 3, item 11, sections 73BH, 73BI, 73BJ, 73BL and 73BN]

2.6 From the commencement of the new uniform capital allowance regime on 1 July 2001, deductions for depreciating assets used in carrying on R&D activities will be worked out under section 73BA. Those deductions will be notionally worked out under Division 40 of the ITAA 1997, as modified by section 73BC. [Schedule 2, Part 3, item 54, sections 73BA to 73BC, 73BE and 73BG]

2.7 Balancing adjustments on plant depreciated under section 73BHwill be notionally worked out under Division 42 of the ITAA 1997, as modified by section 73BM. Adjustments to 125% concession entitlement will be made where a balancing adjustment is made [Schedule 2, Part 3, item 11, section 73BM] . Similarly, balancing adjustments on assets depreciated under section 73BA will be notionally worked out under Division 40 of the ITAA 1997, as modified by section 73BF [Schedule 2, Part 3, item 54, section 73BF] .

2.8 Rollover relief on the disposal of plant depreciated under section 73BHand on the disposal of assets depreciated under section 73BAis provided for in section 73EA. [Schedule 2, Part 3, items 19 and 61, sections 73EA and 73EB]

2.9 A retrospective amendment to the definition of plant expenditure in subsection 73B(1) is made to limit the time that R&D plant must be for use exclusively for the purpose of carrying on R&D activities to an initial period of time only. This will bring the interpretation of exclusive use into line with commercial practice. This change only has application until noon on 29 January 2001 because from that time only sections 73BA and 73BH apply and the exclusive use test no longer applies. [Schedule 2, Part 1, items 1 and 2, definition of plant expenditure in subsection 73B(1)]

2.10 R&D pilot plant is removed from the CGT provisions in line with the general removal of plant from the CGT provisions on 21 September 1999, effective from that date [Schedule 2, Part 2, item 3, section 118-24A of the ITAA 1997] . The existing R&D pilot plant provisions in section 73B also cease to have effect from noon on 29 January 2001 [Schedule 2, Part 3, item 5] .

Detailed explanation of new law

Depreciation based notionally on Division 42 of the ITAA 1997

What plant is eligible?

2.11 Plant which can be considered for a deduction under section 73BH (referred to as section 73BH plant) is plant which would have notionally been considered for a deduction under section 42-15 of the ITAA 1997, if Division 42 were amended to:

•

include trading stock (note: for the period that the trading stock is being used in carrying on R&D activities, it loses its character as trading stock). This will ensure that concessional depreciation deductions are allowed on trading stock that is used in R&D activities for experimentation, testing, analysis, etc., for the period of R&D use [Schedule 2, Part 3, item 11, subsection 73BH(5) and paragraph 73BI(1)(a)] ;

•

capital works (other than buildings) as described in Division 43 of the ITAA 1997. This will ensure that, for the period of R&D use, concessional depreciation deductions are allowed on experimental structural improvements used in R&D activities [Schedule 2, Part 3, item 11, paragraph 73BI(1)(b)] ; and

•

only apply to plant acquired, constructed or commenced to be constructed after noon on 29 January 2001 but before 30 June 2001 [Schedule 2, Part 3, item 11, subsection 73BI(2)] .

When is a deduction available?

2.12 A notional Division 42 deduction is available to a company if the company would have notionally been entitled to a depreciation deduction for plant under section 42-15 of the ITAA 1997 if Division 42 were amended to:

•

require that the plant was being used for the purposes of carrying on R&D rather than requiring it to be used for the purposes of producing assessable income [Schedule 2, Part 3, item 11, subsection 73BJ(2)] ;

•

ensure that the effective life and the method of calculating the deduction used for the plant is the same as that which existed before the application of section 73BH, if the company was previously eligible for an actual Division 42 deduction on that plant. Complementary, but opposite, provisions have also been added to Division 42 [Schedule 2, Part 3, items 11 and 33, subsection 73BJ(3) of the ITAA 1936 and subsection 42-25(4) of the ITAA 1997] ;

•

take into account any change resulting from the application of sections 73BK (discussed in paragraph 2.36) and 73BL (treatment of partnership expenditure) [Schedule 2, Part 3, item 11, subsection 73BJ(4)] ; and

•

ignore the depreciation pooling provisions [Schedule 2, Part 3, item 11, subsection 73BJ(5)] .

2.13 No notional Division 42 deduction is available to a company where the company was previously entitled to a deduction under the Division 42 pooling provisions. Conversely, where a notional Division 42 deduction is available to a company under section 73BH, the plant cannot be pooled under the Division 42 pooling provisions. [Schedule 2, Part 3, items 11, 40 and 41, subsections 73BH(3) and (4) of the ITAA 1936 and subsections 42-365(2) and 42-455(4) of the ITAA 1997]

What is the amount of the deduction?

2.14 Where the companys aggregate R&D amount is greater than $20,000, the amount deductible to the company is 125% of the notional Division 42 deduction. Otherwise, the deduction is the notional Division 42 deduction. [Schedule 2, Part 3, item 11, subsection 73BH(2)]

2.15 However, where use of the plant in R&D activities contributes to the production of a saleable product, part of the notional Division 42 deduction relating to that use, which would have otherwise received a 125% deduction, may only receive a 100% deduction. That part (which only receives a 100% deduction) is the amount by which the feedstock output exceeds the feedstock input, where such an excess exists. [Schedule 2, Part 3, item 11, subsection 73BH(6)]

Example 2.1

Manufacturing Co Pty Ltd is developing a new manufacturing process to produce widgets in a revolutionary way. It has constructed an experimental production scale plant to test this process, at a cost of $1,000. This plant has an effective life of 10 years (ignoring any risk that it will not be able to be successfully developed for production use - see paragraph 2.16), and its R&D use of testing, analysis and modification commences on 1 July in Year 1. In the initial stages of the R&D activities carried on, output from the machine was of poor quality and of little resale value. In Year 2, however, modifications and adaptations made to the plant during the course of the R&D activities have resulted in much improved quality and output. As a result, the R&D activities cease at the end of the second year and the plant is used in production from then on.

Year 1
feedstock output	$50
feedstock inputs	$150
depreciation (diminishing value - 15% * $1,000)	$150

As there is no excess of feedstock outputs over inputs in Year 1, the full amount of depreciation remains eligible for deduction at 125% (i.e. deduction is $187.50).

Year 2
feedstock output	$250
feedstock input	$150
depreciation (15% * $850)	$127.50

The excess of feedstock output over input is $100. Consequently, the R&D depreciation amount of $127.50 is deductible in the following way:

deductible at 100%: $100 (i.e. deduction is $100)

deductible at 125%: $27.50 (i.e. deduction is $34.38)

Effective life

2.16 Where it is reasonably likely that a company will use a unit of plant for the purposes of carrying on R&D activities, the plants effective life under Division 42 of the ITAA 1997 will be the longest period for which the plant can be used for R&D purposes, for assessable income purposes, or for exempt income producing purposes. That is, the effective life of the asset will be the longest period of use resulting from any one, or combination of 2 or more, of the purposes. [Schedule 2, Part 3, item 11, paragraph 73BN(2)(a)]

2.17 Further, in determining the effective life, it is to be concluded that the plant will not be scrapped because of the inherent technical risk of the R&D activities. In the event that the technical risk in the R&D activities should result in the early scrapping of the plant, the balancing adjustment provisions will ensure that the appropriate concessional write-off is given (see paragraphs 2.18 to 2.20). [Schedule 2, Part 3, item 11, paragraph 73BN(2)(b)]

Balancing adjustments

2.18 If an amount would have notionally been included in a companys assessable income or would have notionally been deductible from a companys assessable income because a balancing adjustment event notionally arises under Division 42, then that amount is assessable income or a deduction, as the case may be, of the company. [Schedule 2, Part 3, item 11, subsection 73BM(1)]

2.19 However, in working out the balancing adjustment amount under Division 42, Division 42 is taken to:

•

increase the assessable amount to recoup the appropriate proportion of the 125% deduction previously given on the balancing gain on disposal (to the extent that the gain relates to the use of the plant in R&D activities); and

•

increase the deductible amount to allow the appropriate further 125% deduction on the balancing loss on disposal (to the extent that the loss relates to the use of the plant in R&D activities).

[Schedule 2, Part 3, item 11, subsections 73BM(2) and (3)]

2.20 If an actual balancing adjustment event arises under Division 42 (rather than a notional) and an amount has been allowed under section 73BH, that amount will be treated as a depreciation deduction for the purposes of working out the balancing adjustment under Division 42. [Schedule 2, Part 3, item 39, section 42-220A of the ITAA 1997]

Example 2.2

Assume the facts of Example 2.1.

In Year 3 the plant is used in production for the full year. Depreciation under Division 42 of $108 (15% $722) is claimed in Year 3, giving a written-down value of $614. At the end of this year, the plant is sold for $700.

The balancing profit made on the plant of $86, to be included in Manufacturing Co Pty Ltds assessable income, is increased to recoup a portion of the 125% R&D tax concession previously given in respect of the R&D depreciation deductions. The proportion by which it is increased is as per the formula in section 42-220A of the ITAA 1997. That is:

(sum of all 1.25 rate notional deductions / total decline in value) * adjusted amount * 0.25


= ($177.50 / $386) * $86 * 0.25 = $10


The balancing profit to be included in Manufacturings assessable income is $96.

Example 2.3

Had the plant in Example 2.2 been sold for $500 instead of $700, the balancing adjustment on disposal of $114 loss would be allowable as a deduction, increased again under the same formula, as follows:

($177.50 / $386) * $114 * 0.25 = $13


The total additional deduction allowable in respect of this event is therefore $127.

Recoupment

2.21 Where the company receives an amount in respect of the results (or lack thereof) of R&D activities, and the company is eligible for (or would have been eligible if the company had not been exempt from tax) a deduction under section 73BH, the amount is assessable to the company. [Schedule 2, Part 3, item 11, subsections 73BM(4) to (6)]

Depreciation based notionally on Division 40 of the ITAA 1997

What assets are eligible?

2.22 Assets which can be considered for a deduction under section 73BA (referred to as a section 73BA depreciating asset) are assets which would have notionally been considered for a deduction under section 40-25 of the ITAA 1997, if Division 40 were amended to:

•

include trading stock (note: for the period that the trading stock is being used in carrying on R&D activities, it loses its character as trading stock). This will ensure that concessional depreciation deductions are allowed on trading stock that is used in R&D activities for experimentation, testing, analysis, etc., for the period of R&D use [Schedule 2, Part 3, item 54, subsection 73BA(5) and paragraph 73BB(1)(a)] ;

•

capital works (other than buildings) as described in Division 43 of the ITAA 1997. This will ensure that, for the period of R&D use, concessional depreciation deductions are allowed on experimental structural improvements used in R&D activities [Schedule 2, Part 3, item 54, paragraph 73BB(1)(c)] ; and

•

exclude intangible assets [Schedule 2, Part 3, item 54, paragraph 73BB(1)(b)] .

When is a deduction available?

2.23 A notional Division 40 deduction is available to a company if the company would have notionally been entitled to depreciation deduction for assets under section 40-25 of the ITAA 1997 if Division 40 were amended to:

•

only require that the assets were being used for the purposes of carrying on R&D rather than requiring them to be used for the purposes of producing assessable income [Schedule 2, Part 3, item 54, subsection 73BC(2)] ;

•

ensure that the effective life and the method of calculating the deduction used for the asset is the same as that which existed before the application of section 73BA, if the company were previously eligible for an actual Division 40 deduction on that asset. Complementary, but opposite, provisions have also been added to Division 40 [Schedule 2, Part 3, items 54 and 75, subsection 73BC(3) of the ITAA 1936 and subsection 40-65(6) of the ITAA 1997] ;

•

take into account any change resulting from the application of sections 73BD (discussed in paragraph 2.36) and 73BE (treatment of partnership expenditure) [Schedule 2, Part 3, item 54, subsection 73BC(4)] ; and

•

ignore the depreciation pooling provisions [Schedule 2, Part 3, item 54, subsection 73BC(5)] .

2.24 No notional Division 40 deduction is available to a company where the company was previously entitled to a deduction under the Division 40 low-value pooling provisions or entitled to a deduction under Subdivision 328-D (the STS pooling provisions). Conversely, where a notional Division 40 deduction is available to a company under section 73BA, no deduction can ever be available for that asset under the Division 40 low-value pooling provisions, or under the STS depreciation provisions. [Schedule 2, Part 3, items 54, 80 and 84, subsections 73BA(3) and (4) of the ITAA 1936 and subsections 40-425(8) and 328-175(9) of the ITAA 1997]

What is the amount of the deduction?

2.25 Where the companys aggregate R&D amount is greater than $20,000, the amount deductible to the company is 125% of the notional Division 40 deduction. Otherwise, the deduction is the notional Division 40 deduction. [Schedule 2, Part 3, item 54, subsection 73BA(2)]

2.26 However, where use of the asset in R&D activities contributes to the production of a saleable product, part of the notional Division 40 deduction relating to that use, which would have otherwise received a 125% deduction, may only receive a 100% deduction. That part (which only receives a 100% deduction) is the amount by which the feedstock output exceeds the feedstock input, where such an excess exists. [Schedule 2, Part 3, item 54, subsection 73BA(6)]

Effective life

2.27 Where it is reasonably likely that a company will use an asset for the purposes of carrying on R&D activities, the assets effective life under Division 40 of the ITAA 1997 will be the longest period for which the asset can be used for R&D purposes, for assessable income purposes or for exempt income producing purposes. That is, the effective life of the asset will be the longest period of use resulting from any one, or combination of 2 or more, of the purposes. [Schedule 2, Part 3, item 54, paragraph 73BG(2)(a)]

2.28 Further, in determining the effective life, it is to be concluded that the asset will not be scrapped because of the inherent technical risk of the R&D activities. In the event that the technical risk in the R&D activities should result in the early scrapping of the plant, the balancing adjustment provisions will ensure that the appropriate concessional write-off is given (see paragraphs 2.29 to 2.31). [Schedule 2, Part 3, item 54, paragraph 73BG(2)(b)]

Balancing adjustments

2.29 If an amount would have notionally been included in a companys assessable income or would have notionally been deductible from a companys assessable income because a balancing adjustment event notionally arises under Division 40, then that amount is assessable income or a deduction, as the case may be, of the company. [Schedule 2, Part 3, item 54, subsection 73BF(1)]

2.30 However, in working out the balancing adjustment amount under Division 40, Division 40 is taken to:

•

increase the assessable amount to recoup the appropriate proportion of the 125% deduction previously given on the balancing gain on disposal (to the extent that the gain relates to the use of the asset in R&D activities); and

•

increase the deductible amount to allow a further 125% deduction on the balancing loss on disposal (to the extent that the loss relates to the use of the asset in R&D activities).

[Schedule 2, Part 3, item 54, subsections 73BF(2) and (3)]

2.31 If an actual balancing adjustment event arises under Division 40 (rather than a notional) and an amount has been allowed under section 73BA, that amount will be treated as a depreciation deduction for the purposes of working out the balancing adjustment under Division 40. [Schedule 2, Part 3, item 79, section 40-292 of the ITAA 1997]

Recoupment

2.32 Where the company receives an amount in respect of the results (or lack thereof) of R&D activities, and the company is eligible for (or would have been eligible if the company had not been exempt from tax) a deduction under section 73BA, the amount is assessable to the company. [Schedule 2, Part 3, item 54, subsections 73BF(4) to (6)]

Rollover relief

2.33 Rollover relief is available on the disposal of plant or assets subject to sections 73BA and 73BH deductions (and no Division 40 or Division 42 deductions are allowable), where rollover relief would have been available under the capital gain provisions of Subdivision 126-B of the ITAA 1997. [Schedule 2, Part 3, items 19 and 61, subsections 73EA(1) and (2), 73EB(1) and (2)]

2.34 The rollover relief provides that the transferor has no balancing charge, provides that the transferee is entitled to deductions under sections 73BA and 73BH on the same basis as available to the transferor, provides detailed treatment for partnership disposals and provides that the subsequent disposal of the plant/asset by the transferee (or later transferees) will not be denied the ability to obtain rollover relief. [Schedule 2, Part 3, items 19 and 61, subsections 73EA(3) to (5) and 73EB(3) to (5)]

2.35 The rollover relief also requires the transferor to provide the transferee (within 6 months after the transferees year of income, unless the Commissioner extends this time) with sufficient information to allow the transferee to work out the rollover relief. The transferee must keep this information for at least 5 years after the loss or disposal of the asset by the transferee. A penalty of 30 penalty units applies where the information is not kept for the required time. [Schedule 2, Part 3, items 19 and 61, subsections 73EA(6) to (9) and 73EB(6) to (9)]

Special treatment of certain expenditure under section 73BA and 73BH

2.36 Sections 73BD, 73BE, 73BK and 73BL provide for special rules to apply in determining sections 73BA and 73BH deductions:

•

the detailed treatment of plant/asset expenditure by partnerships [Schedule 2, Part 3, items 11 and 54, sections 73BE and 73BL] ;

•

plant/asset expenditure by a company that has not registered under sections 39J or 39P of the IR&DA 1986 is ignored in working out deductions under sections 73BA and 73BH [Schedule 2, Part 3, items 11 and 54, subsections 73BD(1) and 73BK(1)] ;

•

the Commissioner can ignore some or all of the plant/asset expenditure between parties who are not dealing with each other at arms length [Schedule 2, Part 3, items 11 and 54, subsections 73BD(2) and 73BK(2)] ;

•

the Commissioner must ignore the plant/asset expenditure if the IR&D Board gives him a certificate under sections 39M, 39MA, 39N, subsections 39P(4) or 39P(6) of the IR&DA 1986 [Schedule 2, Part 3, items 11 and 54, subsections 73BD(3) to (8) and 73BK(3) to(8)] ;

•

plant/asset expenditure by a company on overseas R&D activities is ignored in working out deductions under sections 73BA and 73BH unless the IR&D Board has given a provisional certificate under section 39ED of the IR&DA 1986 [Schedule 2, Part 3, items 11 and 54, subsections 73BD(9) and 73BK(9)] ; and

•

plant/asset expenditure incurred on behalf of any other person (other than as a partner in a partnership) is ignored in working out deductions under sections 73BA and 73BH [Schedule 2, Part 3, items 11 and 54, subsections 73BD(10) and (11), 73BK(10) and (11)] .

Application provisions

2.37 The retrospective amendment to the definition of plant expenditure in subsection 73B(1) of the ITAA 1936, to limit the time that R&D plant must be for use exclusively for the purpose of carrying on R&D activities, applies to expenditure on plant acquired, constructed or commenced to be constructed on or after 1 July 1985. [Schedule 2, Part 1, item 2]

2.38 The amendment to remove pilot plant from the CGT provisions applies from 11.45 am, by legal time in the Australian Capital Territory, on 21 September 1999. [Schedule 2, Part 2, item 3]

2.39 The amendments to allow a notional Division 42 deduction under section 73BH apply to assessments for the income year in which 29 January 2001 occurs, and for later income years. [Schedule 2, Part 3, item 51]

2.40 The amendments to allow a notional Division 40 deduction under section 73BA apply to assessments for the income year in which 1 July 2001 occurs, and for later income years. [Schedule 2, Part 3, item 92]

Consequential amendments

2.41 There are numerous minor technical amendments which are consequential on the move of depreciation deductions from section 73B to sections 73BA and 73BH. These are:

•

ITAA 1936 - Schedule 2, Part 3, items 6, 12 to 18, 20 to 27, 52, 53, 55 to 60 and 62 to 68;

•

ITAA 1997 - Schedule 2, Part 3, items 28 to 32, 34 to 38, 42 to 44, 69 to 74, 76 to 78 and 81 to 83; and

•

IR&DA 1986 - Schedule 2, Part 3, items 45 to 50 and 85 to 91.

Chapter 3 - Research and development tax offset

Outline of chapter

3.1 This chapter explains the tax offset which provides eligible small companies with access to the cash equivalent of the R&D tax concession.

Context of reform

3.2 The tax offset gives eligible small companies, in cases where the company is not yet profitable, the benefit of the R&D tax concession earlier. It could provide a cash flow when they need it most.

3.3 The grouping rules ensure that large businesses do not receive the tax offset by virtue of their operation being divided into several smaller units.

Summary of new law

3.4 An eligible company can claim a tax offset instead of deductions under sections 73B, 73BA and 73BH of the ITAA 1936. [Schedule 3, item 5, section 73I]

3.5 A company is eligible for the tax offset if its aggregate R&D amount for the year exceeds $20,000 and its grouped aggregate R&D amount for the year does not exceed $1 million. Further, a company will not be eligible for the tax offset where the turnover of the group is $5 million or more. [Schedule 3, item 5, subsection 73J(1)]

3.6 Some companies will not be eligible for the tax offset where they are linked with an exempt person. [Schedule 3, item 5, subsection 73J(2)]

Detailed explanation of new law

What is eligible for a tax offset?

3.7 An eligible company can claim a tax offset instead of deductions under sections 73B, 73BA and 73BH of the ITAA 1936. The choice to claim a tax offset is made by the company in its annual tax return. Once the choice is made to claim a tax offset, no deductions under sections 73B, 73BA and 73BH can be claimed in that year. [Schedule 3, item 5, section 73I]

3.8 The tax offset is paid at the rate of 30 cents for each dollar of deduction that would have otherwise been claimable. This means that where a company gives up a deduction that was 125% of the expenditure incurred, the tax offset would equate to 37.5% of the expenditure incurred. Similarly, where a company gives up a deduction that was 175% of the expenditure incurred, the tax offset would equate to 52.5% of the expenditure incurred. [Schedule 3, item 5, subsection 73I(3)]

Who is eligible for a tax offset?

3.9 To be eligible for the tax offset a companys:

•

aggregate R&D amount (as defined under subsection 73B(1) of the ITAA 1936) for the year must exceed $20,000;

•

aggregate R&D amount and the aggregate R&D amounts of each resident company with which the company is grouped must not exceed $1 million; and

•

R&D group turnover (see paragraph 3.11) must be less than $5 million.

[Schedule 3, item 5, subsection 73J(1)]

Exception

3.10 A company will not, however, be eligible for a tax offset where at least 25% of the voting power or 25% of the right to distributions from the company is held, legally or beneficially by an exempt person (or 2 or more exempt persons), or the affiliates of an exempt person, or any combination thereof. [Schedule 3, item 5, subsection 73J(2)]

What is R&D group turnover?

Meaning of R&D group turnover

3.11 A companys R&D group turnover for an income year is the sum of:

•

the value of the supplies made during the year by the company; and

•

the value of the supplies made by other taxpayers grouped with the company.

The R&D group turnover is reduced by any supplies made between the company and the other taxpayers grouped with the company (including non-resident companies), or between the other taxpayers grouped with the company. [Schedule 3, item 5, subsection 73K(1)]

Meaning of value of the supplies

3.12 The concept of the value of the supplies is based on the terms defined in the GST Act and is defined in subsection 73H(2) of the ITAA 1936.

3.13 The value of the supplies a taxpayer makes during an income year is the sum of the values of the supplies the taxpayer made during the year in the ordinary course of carrying on a business or in the course of carrying on R&D activities and is calculated exclusive of GST payable on supplies. [Schedule 3, item 5, subsection 73H(2)]

3.14 The GST Act explains the method of working out the value of a supply. Basically, it depends on whether or not the supply is a taxable supply.

•

If the supply is a taxable supply (i.e. one on which GST is payable), its value is worked out as 10/11th of the price of the supply. This calculation excludes the GST payable on the supply (the other 1/11th).

•

If the supply is not a taxable supply, the price of all the non-taxable supplies made during the year in the ordinary course of carrying on a business is added to the value of all taxable supplies. The price of a supply is generally the amount of money a person pays for the supply. Supplies that are not taxable include those that are GST-free and input taxed for the purposes of the GST Act.

Gambling supplies

3.15 To maintain consistency between the GST Act and the income tax laws, gambling supplies are accorded the same treatment. As such, the method used for calculating the value of the supplies in respect of gambling is different to that described in paragraph 3.14. Where a taxable supply that a taxpayer makes during the income year includes gambling supplies, an amount equal to 11 times the taxpayers global GST amount, as defined in section 126-10 of the GST Act, is included when working out the R&D group turnover. [Schedule 3, item 5, subsection 73K(2)]

Exceptions

3.16 R&D group turnover does not include:

•

a supply that constitutes an insurance recovery; and

•

things that do not constitute the making of a supply - for example, lending money.

[Schedule 3, item 5, subsection 73K(3)]

When is a persons turnover grouped?

3.17 A persons turnover will be grouped with that of another person and its affiliates where:

•

either person controls the other;

•

both entities are controlled by the same third person; or

•

the entities are STS affiliates of each other.

[Schedule 3, item 5, subsection 73L(1)]

3.18 The grouping rules are designed to ensure that businesses that are part of a larger group do not gain access to the tax offset. However, the grouping rules also ensure that unrelated persons are not inadvertently grouped and that only persons that are related to each other are grouped.

Who is an affiliate?

3.19 A persons affiliate is another person that:

•

acts or could reasonably be expected to act in accordance with the directions or wishes of the person in relation to the affairs of the persons business or R&D expenditure; or

•

acts in concert with the person in relation to the affairs of the persons business or R&D expenditure.

[Schedule 3, item 5, subsection 73M(1)]

3.20 Two or more partners in a partnership are not each others affiliatesmerely because one partner acts or could reasonably be expected to act in concert with the other in relation to the affairs of the partnership business. [Schedule 3, item 5, subsection 73M(2)]

Meaning of control

Companies, sole traders and certain trusts

3.21 A person would be regarded as controlling another person where that person either alone or together with its affiliates can enjoy a certain level of benefit from another person. Such a benefit can arise where the person either alone or together with its affiliates legally or beneficially owns, or has the right to acquire legal or beneficial ownership of, interests in the other person that give between them the right to receive:

•

more than 50% of any distribution of income or capital by the other person; or

•

the right to exercise or control the exercise of more than 50% of the voting power in the other person.

[Schedule 3, item 5, subsection 73L(3)]

Non-fixed trusts

3.22 The tests used to identify the control of a non-fixed trust for the purposes of the grouping rules look at the actual receipt of distributions from non-fixed trusts by the person or its affiliates. This test will only group a person with a non-fixed trust where the person or its affiliates, or the person and its affiliates, have received a distribution from the trustee of the trust of $100,000 or more in any one of the last 4 income years. [Schedule 3, item 5, paragraph 73L(4)(a)]

3.23 The other tests look at whether or not the person or its affiliates have the ability to influence the operation of the non-fixed trust. For example, if a person or its affiliates individually or together are able to directly or indirectly control the management of the non-fixed trust or control the application of the capital or income of the non-fixed trust, the turnover of the non-fixed trust will be grouped with that of the person and/or its affiliates. [Schedule 3, item 5, paragraphs 73L(4)(b) and (c)]

Partnerships

3.24 A person would be said to be controlling a partnership where the person and/or its affiliates between them have the right to receive more than 50% of the partnership net income or have more than 50% interest in assets used by the partnership in its business. [Schedule 3, item 5, subsection 73L(5)]

3.25 A partnership would be said to be controlling another person (namely, another partnership, a trust or a company) where a partner or partners in the partnership have the right to receive between them more than 50% of the partnership net income or have more than 50% interest in the assets used in the partnership business and the same partner or partners:

•

also have the right to receive between them more than 50% of:

-

any distribution of income or capital from a trust;

-

the net income of another partnership, or more than 50% interest in the assets used in that partnership business; or

-

any distribution of income or capital by a company, or have the power to exercise control of more than 50% of the voting power in the company; or

•

if the other person is a non-fixed trust it would be grouped with the trust under subsection 73L(4) for similar reasons as explained in paragraphs 3.22 and 3.23.

[Schedule 3, item 5, subsection 73L(6)]

Indirect control of a person

3.26 The control tests are designed to look through business structures that include interposed entities. However, only controlled persons are taken into account in tracing interests. The indirect control rule has been adopted to avoid complex tracing requirements for a person. If a person directly controls a second person, and the second person controls (whether directly or indirectly) a third person, the first person is also taken to control the third person. [Schedule 3, item 5, subsection 73L(2)]

Grouped expenditure

3.27 Where:

•

a company is part of a group under subsection 73L and can claim a deduction for expenditure under subsections 73B(13) or (14) in a year; and

•

another person in the group incurs expenditure, in that year or an earlier year, relating to the things for which the company can claim a deduction for expenditure under subsections 73B(13) or (14),

the amount of that expenditure which can be claimed at the concessional rate of 125% is reduced by an amount that represents the total group markup. The amount of the companys expenditure which could not be claimed at the concessional rate of 125% may be claimed at 100%. [Schedule 3, item 2, subsections 73B(14AA) and (14AB)]

3.28 For each year of income, the total group markup is obtained by adding all the amounts charged by persons within the group for goods and services relating to particular expenditure claimable under subsections 73B(13) or (14), and then deducting the actual cost to those persons of providing those goods or services. [Schedule 3, item 2, paragraphs 73B(14AC)(a) and (b)]

Example 3.1

XYZ Ltd conducts R&D activities as part of its business as a specialist equipment supplier for search and rescue craft.

XYZ Ltd contracts with its subsidiary, ABC Co, for the supply of a new prototype beacon at $500,000. As a part of that contract, ABC Co orders component supplies through another subsidiary, SUP Co, for $100,000. SUP Co costs were $90,000 (cost of goods, salary and overhead costs). ABC Co costs were $450,000 (labour, component supplies, overheads and plant depreciation). XYZ Ltd registers the R&D activities and is entitled to deduct the expenditure as follows:

total group markup =

($500,000 + $100,000) - ($450,000 + $90,000)

= $600,000 - $540,000

= $60,000

reduced R&D expenditure = $500,000 - $60,000 (total group markup)

claim entitled to concessional rate of 125% = $440,000

claim entitled to concessional rate of 100% = $60,000

Application provisions

3.29 The R&D tax offset is effective for assessments for the first income year occurring after 30 June 2001. The application of the T(IOEP)A 1983 to refundable tax offsets is effective from assessments occurring after 30 June 2001. [Schedule 3, item 19]

Consequential amendments

3.30 Section 73H is inserted to provide the definitions necessary for the interpretation of the R&D tax offset provisions. [Schedule 3, item 5, section 73H]

3.31 Subparagraph 73C(7)(c)(ii) and subsection 73F(2)(b) of the ITAA 1936 are amended, and subsections 82AM(2A), 632(2A) and 642(2A) of the ITAA 1936 are inserted, to take into account that a company will now have the choice of choosing a tax offset. [Schedule 3, items 3, 4, 6, 9 and 10]

3.32 In line with the new general prepayments regime in the income tax law, prepaid R&D expenditure (with the exception of accelerated expenditure as defined in subsection 73B(1)) will now be taken, under Subdivision H of Division 3 of Part III of the ITAA 1936, to have been incurred over its eligible service period. This treatment is similar to how prepaid expenditure was treated under subsection 73B(11) of the ITAA 1936. Accelerated expenditure will continue to access concessional treatment under subsection 73B(11). [Schedule 3, items 7 and 8; Schedule 4, items 6 to 9]

3.33 Section 13-1 and paragraph 43-70(2)(g) of the ITAA 1997 are amended to take into account that a company will now have the choice of choosing a tax offset. [Schedule 3, items 11 and 12]

3.34 The definition of income tax crediting amount in subsection 3(1) and subparagraphs 8E(1)(d)(i) and 8G(1)(d)(i) of the T(IOEP)A 1983 are amended, and subsection 67-25(3) of the ITAA 1997 and notes to subsections 8E(1) and 8G(1) of the T(IOEP)A 1983 are being inserted, to ensure that R&D tax offsets are subject to the refundable tax offset rules. [Schedule 3, items 13 to 18]

3.35 The amendment of assessment provisions of section 170 have been updated to include the tax offset and the deduction for the incremental concession. [Schedule 4, item 10]

Chapter 4 - Research and development incremental tax concession

Outline of chapter

4.1 This chapter explains the incremental tax concession which allows companies to claim a deduction of 175% on certain adjusted amounts of eligible expenditure.

Context of reform

4.2 The incremental tax concession is designed to encourage additional business investment by eligible companies in R&D over and above prior year levels of spending on R&D. The concession is focused on the labour-related aspects of R&D which will provide the greatest benefits for the Australian economy.

4.3 The concession will increase the rate of the R&D deduction by an additional 50% to allow a total deduction of 175% for increases over prior year expenditure. This increase on certain expenditures is based on an average of expenditures taken over 3 years and moderated to account for significant prior year reductions in R&D spending.

Summary of new law

4.4 A company must have incremental expenditure which it is able to deduct under subsections 73B(13) or (14) of the ITAA 1936 in the year in which it is claiming the additional 50% deduction. [Schedule 4, item 5, paragraph 73Q(1)(a)]

4.5 To be eligible to claim the additional 50% deduction, a company must also have been eligible to deduct incremental expenditure under subsections 73B(13) or (14) in each of the 3 prior years or be grouped with companies which have been eligible to deduct incremental expenditure in these years. Subsection 73B(10) makes it necessary for a company to be registered under sections 39J or 39P of the IR&DA 1986 before it can claim an R&D deduction under these subsections. [Schedule 4, item 5, paragraph 73Q(1)(b) and subsection 73Q(2)]

4.6 Generally, a company works out the amount that will be subject to the additional 50% deduction by subtracting its average incremental expenditure over the past 3 years from its current year incremental expenditure. That amount (moderated where expenditure in any of the previous 2 years has fallen below 80% of the previous years expenditure), which represents the additional R&D, receives a further 50% deduction in addition to the 125% deduction allowed under section 73B, providing in total a premium rate of 175%. [Schedule 4, item 5, sections 73S to 73W and 73Y]

4.7 In determining the additional 50% deduction, companies are grouped with other related persons. Where a company is grouped and the other companies in the group also have current year incremental expenditure, the amount subject to the additional 50% deduction is allocated between all eligible companies which contributed to the increase. Special rules apply in determining the amount subject to the additional 50% deduction where companies enter or leave a group. [Schedule 3, item 5, section 73L; Schedule 4, item 5, sections 73R and 73X]

4.8A company which is eligible for the refundable tax offset and is also eligible for the additional 50% deduction may choose to take that deduction as a refundable tax offset. [Schedule 3, item 5, section 73I]

Detailed explanation of new law

What expenditure is eligible for the additional 50% deduction

4.9 The additional 50% deduction is derived primarily from a companys incremental expenditure. Where a company is in a group, it is necessary to sum the incremental expenditures incurred by the group members during their period of group membership (defined as R&D spend). The term incremental expenditure is defined to mean expenditure which is already defined as R&D expenditure in subsection 73B(1), with the exception of plant leasing expenditure and any other expenditure incurred under a contract which is in substance for the provision of plant [Schedule 4, item 5, definition of incremental expenditure in subsection 73P(2)] . The definition of research and development expenditure excludes expenditure on plant, core technology, interest, building and residual feedstock expenditure. Where a contract involves both the provision of plant and services it may be apportioned to exclude the plant expenditure for the purpose of determining incremental expenditure. If it is not possible to apportion the expenditure, no expenditure under the contract can be included as incremental expenditure [Schedule 4, item 5, subsections 73P(3) and (4)] .

4.10 Where a company is in a group, under section 73L, and its expenditure includes an amount of total group mark up as defined in subsection 73B(14AC), that amount is also excluded from incremental expenditure. [Schedule 3, items 2 and 5, subsection 73B(14AC) and section 73L; Schedule 4, item 5, section 73P(5)]

Which companies are eligible to claim the additional 50% deduction?

4.11 To be eligible to claim the additional 50% deduction, a company must be able to deduct incremental expenditurein the year of income under subsections 73B(13) or (14) and, in accordance with section 73B(10), it must be registered under sections 39J or 39P of the IR&DA 1986 for the year of income in which the expenditure is incurred. [Schedule 4, item 5, paragraph 73Q(1)(a)]

4.12 In addition, a company must also have been eligible to deduct incremental expenditure under subsections 73B(13) or (14) in each of the 3 prior years (a 3 year history). [Schedule 4, item 5, paragraph 73Q(1)(b)]

4.13 An exception to the requirement for a company to have a 3 year history arises where a company is in a group under section 73L and there are other companies in that group which have been eligible to deduct incremental expenditure under subsections 73B(13) or (14). Provided that, between those identified companies, there are eligible deductions in the group in each of the 3 prior years the company will have a 3 year history. [Schedule 3, item 5, section 73L; Schedule 4, item 5, subsection 73Q(2)]

Application of grouping rules

4.14 Eligible companies with incremental expenditure, must determine if they are in a group in accordance with section 73L. [Schedule 3, item 5, section 73L; Schedule 4, item 5, subsection 73R(1)]

Working out the prior history for eligible companies in the group

4.15 A method statement is provided to assist in working out which other companies with incremental expenditure should be grouped with the eligible company as group members. The method statement also determines the group membership period for each such company in the group. The incremental expenditure of group members during the group membership period ( R&D spend ) is used in determining the additional 50% amount. [Schedule 4, item 5, subsection 73R(2)]

4.16 Step 1 of the method statement determines which companies are grouped with the eligible company on the last day of the year of income. These companies are called primary group members.

4.17 Step 2 then determines the group membership period of the primary group members. The primary group members group membership period extends from the day their control changed which caused them to come into the group to the last day of the current income year. The group membership period will not commence before the first day of the income year 3 years before the current income year.

4.18 Step 3 then determines which companies were grouped with the primary group members during their group membership period. Any such company is called a secondary group member.

4.19 Steps 4 and 5 then determine the group membership period for each secondary group member. The secondary group members group membership period extends from the day their control changed which caused them to come into the group to the day their control changed which caused them to leave the group. The group membership period will not commence before the first day of the income year 3 years before the current income year.

Viable business exception

4.20 The group membership periods of both primary and secondary group members can change under certain circumstances:

•

where a secondary group member leaves the group with a viable business (see paragraph 4.21), its group membership period is deemed never to exist. As such, its incremental expenditure that was otherwise within its group membership period is no longer available for use in the calculation of the additional 50% deduction [Schedule 4, item 5, subsection 73R(3)] ; or

•

where either a primary group member or a secondary group member enters the group with a viable business, its group membership period is extended to include its group membership period from its previous group. As such, its incremental expenditure from a previous group membership is available for use in the calculation of the additional 50% deduction [Schedule 4, item 5, subsection 73R(4)] .

4.21 A company will join or leave the group with a viable business if all assets (which must include R&D assets) necessary to comprise a continuing business are transferred with the company and the vendor and purchaser agree in writing that they are transferring a viable business and the vendor provides written details of the incremental expenditure that the transferring company incurred while in the former group. The written agreement and details generally need to be provided by the end of the year in which the change of control took place. [Schedule 4, item 5, subsections 73R(5) and (6)]

Example 4.1

Companies A, B, C and D are companies that have made incremental expenditure claims at some stage in the past 3 years. Companies A and B are primary group members in year Y-0 as they are grouped on the last day of that income year (step 1). Companies C and D are secondary group members as C is grouped with B in Y-1 and Y-2 and D is grouped with B in years Y-2 and Y-3. When C became grouped in Y-2, it did not bring a viable business.

Companies	Y-0 ($)	Y-1 ($)	Y-2 ($)	Y-3 ($)
Co A	100	0	0	0
Co B	80	50	20	20
Co C		50	50	0
Co D			20	20

Assume company D was liquidated on 30/6/Y-2 (and thus did not transfer a viable business) and C was sold in Y-1 with a valid transfer of viable business (and thus all incremental expenditure is ignored and the company is deemed never to have had a group membership period). The incremental expenditures that could be grouped to A and B are $50,000 in Y-1, $40,000 in Y-2 and $40,000 in Y-3.

Working out the additional 50% deduction

4.22 Once the incremental expenditure for the current year and the 3 prior years has been ascertained, sections 73S to 73Y determine the premium amountwhich, after apportionment, can be claimed by the eligible company as an additional 50% deduction. [Schedule 4, item 5, sections 73S to 73Y]

4.23 For the purposes of the calculation, incremental expenditure of the eligible company is summed with the incremental expenditure of other group members, where relevant. This amount is defined as the R&D spend . Where a company is not a member of a group, its incremental expenditure equals its R&D spend. [Schedule 4, item 5, definition of R&D spend in subsection 73P(2)]

4.24 A simple guide of how to use the 4 steps of sections 73T, 73U, 73V and 73W is set out below:

Step 1 (section 73T)

Determine the adjustment amount for the current year and the previous year.

Step 2 (section 73U)

Determine the running average for the past 3 years.

Step 3 (section 73V)

Determine the adjustment balance using the amounts determined in Steps 1 and 2.

Step 4 (section73W)

Determine the premium amount. This is the R&D spend less the running average from Step 2 less the adjustment balance from Step 3.

Example 4.2

A company has the following eligible R&D spend history:

current year (Y-0) is 110, Y-1 is 90, Y-2 is 60, Y-3 is 30

Step 1: Adjustment amount for Y-0 and Y-1 = 0 as there is no decrease in R&D spend more than 20% in either of the Y-1 or Y-2 years.

Step 2: The running average for Y-0 = $60 ($90 + $60 + 30 / 3).

Step 3: There is no adjustment balance as there is no adjustment amount.

Step 4: The premium amount = $50 ($110 - $60, that is, the current year eligible incremental expenditure less the running average).

Step 1

4.25 There may be an adjustment amount (AA0) where a companys R&D spend in the prior year decreased to an amount which is less than 80% of the prior year incremental expenditure amount. In order to determine this adjustment amount, the R&D spend in the year of the decrease is subtracted from 80% of the prior year R&D spend [Schedule 4, item 5, subsection 73T(1)] . There can also be an adjustment amount (AA-1) where the R&D spend in the year before the prior year is less than 80% of the R&D spend of the year before that [Schedule 4, item 5, subsection 73T(2)] .

4.26 However, the adjustment amount will be nil where the additional 50% deduction could have been claimed in the previous year and no group member underwent a change of control involving the transfer of a viable business in the current year. Also, the adjustment amount will be nil where the additional 50% deduction could have been claimed in the year before the previous year and no group member underwent a change of control involving the transfer of a viable business in the current year or the previous year [Schedule 4, item 5, subsections 73T(3) and (4)] . The adjustment amount will also be deemed to be nil where the result of the calculation is negative [Schedule 4, item 5, section 73S] .

Step 2

4.27 Step 2 calculates the running average which provides the benchmark amount of expenditure which the current year expenditure must exceed if it is to attract the additional 50% deduction.

4.28 The running average for the current year is the sum of the incremental expenditure amounts in the previous 3 years divided by 3 [Schedule 4, item 5, subsection 73U(1)] . The running average for the previous year is the sum of the incremental expenditure amounts in the previous 2 years divided by 2. Determine if one of the exceptions in step 1 applies [Schedule 4, item 5, subsection 73U(2)] .

Example 4.3

Where Y-0 = 100, Y-1 = $180, Y-2 = $150, Y-3 = $200

There is an adjustment amount of $10 for Y-1 [($200 0.8) - $150]

The running average for Y-1 is $175 [($200 + $150) / 2]

Step 3

4.29 Step 3 adds together any adjustment amounts (AA0 and AA-1) where the prior year R&D spend is less than or equal to the running average (RA-1) for that year. The result is referred to as the adjustment balance . If the prior year R&D spend is more than the running average for that year, it reduces the sum of the adjustment amounts (AA0 and AA-1) by the amount by which the R&D spend exceeds the prior year running average (RA-1). However, if the eligible company or any of its group members were eligible to claim an additional 50% deduction in the previous year, and there were no change of control of the eligible company or its group members during the current year involving the transfer of a viable business, the adjustment balance is deemed to be nil [Schedule 4, item 5, section 73V] . The adjustment balance will also be deemed to be nil where the result of the calculation is negative [Schedule 4, item 5, section 73S] .

Step 4

4.30 Step 4 calculates the premium amount which, once it is apportioned between group members, if any, will be eligible for the additional 50% deduction. The premium amount is the R&D spend less the current year running average and the adjustment balance. [Schedule 4, item 5, section 73W]

Example 4.4

Co A has the following eligible incremental expenditures:

Y-0 is $250, Y-1 is $180, Y-2 is $150, Y-3 is $200

(Assume there was no eligibility to claim the additional 50% deduction in Y-1).

Step 1: adjustment amount in Y-0 = 0; adjustment amount in Y-1 = $10 [($200 * 0.8) - $150]

Step 2: running average in Y-0 = $177; running average in Y-1 = $175

Step 3: adjustment balance = $5 ($175 - $180 + $10 + 0)

Step 4: premium amount = $68 ($250 - $177 - $5)

Apportionment of the premium amount between group members

4.31 Where there is more than one company in the group that has incremental expenditure in its group membership period the premium amount will be apportioned. The premium amount will only be distributed to companies that have individually increased their incremental expenditure in their group membership periods, in the year of income over their prior year incremental expenditure. The premium amount will be apportioned among these companies on the basis of their proportionate share of this increased incremental expenditure. [Schedule 4, item 5, section 73X]

Example 4.5

Company	Prior Year (000s)	Current Year	Change
A	$60	$40	-$20
B	10	15	5
C	30	70	40
D	15	25	10

Assume a premium amount of $50,000 is to be shared. This would be shared between B, C and D on the basis of B: 5 / 55; C: 40 / 55; D: 10 / 55

The additional 50% deduction

4.32 The additional 50% deduction is allowed on each eligible companys share of the premium amount. However, if the provisions of sections 73C, 73CA or 73CB have operated to reduce the eligible companys entitlement to the 125% concession on its incremental expenditure to an amount less than the premium amount, then the 50% deduction is only allowed on that lesser amount. [Schedule 4, item 5, section 73Y]

Anti-avoidance measure

4.33 For the purpose of working out the companys incremental expenditure, and only for that purpose, the Commissioner may disregard any debit amendment which reduces prior year R&D expenditure, where he is of the opinion that the purpose of the amendment is to increase a companys entitlement to an additional 50% deduction. [Schedule 4, item 5, section 73Z]

Application provisions

4.34 The incremental tax concession applies from the first income year occurring after 30 June 2001. [Schedule 4, item 11]

Consequential amendments

4.35 A consequential amendment is made to the clawback provisions of section 73C to ensure that its integrity is maintained where an R&D company is part of a group. The amendment ensures that where an R&D related recoupment or grant is received in respect of an eligible R&D companys R&D activities by a person who was grouped with the eligible R&D company, that recoupment or grant is taken to be received by the eligible R&D company for the purposes of the clawback provisions. [Schedule 4, items 1 to 4]

4.36 A consequential amendment is made to bring prepaid R&D expenditure within the general prepayments regime under the income tax law (Subdivision H of Division 3 of Part III of the ITAA 1936). However, the ability to obtain an immediate deduction for prepaid contracted expenditure under subsection 73B(11) remains unchanged. [Schedule 3, item 1; Schedule 4, items 6 to 8]

Chapter 5 - Regulation impact statement

Policy objective

The objectives of the enhanced R&D tax concession

5.1 This Bill enhances the R&D tax concession which is the Governments prime incentive for business investment in R&D. The R&D tax concession is jointly administered by the ATO and the IR&D Board under the ITAA 1936, the ITAA 1997and the IR&DA 1986 respectively.

5.2 The policy objective of the R&D tax concession is to make eligible companies more internationally competitive by;

•

increasing investment in R&D activities;

•

promoting technological advancement through a focus on innovation and high technical risk in defined R&D activities;

•

encouraging the use of strategic R&D planning; and

•

creating an environment that is conducive to increased commercialisation of new processes and product technologies.

5.3 On 29 January 2001 the Government released its Innovation Action Plan entitled Backing Australias Ability, which includes a detailed package of measures for Innovation and Research and Development. The Innovation Action Plan involves major enhancements to the R&D tax concession, including:

a refundable tax offset, in lieu of an R&D tax deduction, for small companies;

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a premium rate of 175% for additional R&D;

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amendments to the tax deductibility of R&D plant;

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amendments to the definition of eligible R&D; and

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a requirement that companies prepare R&D plans.

Implementation options

Refundable tax offset for small companies

5.4 A refundable tax offset for small companies to have access to the cash equivalent to the R&D tax concession will:

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increase the benefit of the R&D tax concession for small companies in tax loss which cannot obtain immediate support through the concession as they are not part of taxable groups; and

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provide direct and timely support through improving the cash flow for up to 1,300 companies that fall under the eligibility criteria, and currently claim the R&D tax concession (recognising the greater cash constraints of early stage innovative companies), thereby improving their chance of survival. These companies will also be able to access the other measures arising from this Bill.

5.5 This proposal has advantages over a competitive granting program, as it is eligibility based and non-distortive.

5.6 Its broad-based nature also enables support to be given to the whole of a companys R&D activities rather than to specific R&D projects. Grouping rules will apply.

Premium 175% R&D tax concession for additional R&D

5.7 Many options were considered for the implementation of this concession. Based largely on recommendations from the Bureau of Industry Economics, the Productivity Commission and the Innovation Summit Implementation Group, an incremental scheme was determined to be more effective than a simple rate rise to the base R&D tax concession rate, as it focuses on additionality.

5.8 The Innovation Summit Implementation Group recommended an increase in the base rate of the R&D tax concession to 130%. However, a general rate increase of only 5% is unlikely to result in any significant change in the behaviour or expenditure by business on R&D.

5.9 The creation of a Premium rate of 175% will apply for companies that undertake additional investment in R&D. The Premium will only apply to the increase in R&D expenditure above a 3-year base. The Premium will focus on labour-related components of R&D where the greatest economy-wide benefits would occur. Non-current expenditure items on R&D (plant, pilot plant and core technology), leasing and interest will be excluded for the purpose of calculating the Premium.

5.10 There are 2 major options for implementing a scheme for the allocation of the premium 175% R&D tax concession for additional R&D, these are an R&D intensity based model or an R&D expenditure based model.

5.11 The features of the 175% Premium that are critical to its effectiveness in inducing behavioural change and thereby stimulating increased business expenditure on R&D (BERD) are:

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low complexity and compliance costs;

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certainty for industry R&D decision makers in relation to the prospective benefits of investing in R&D; and

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better access by companies, including young growing companies.

5.12 While the use of a research intensity model meets the policy objectives of inducing additional R&D, it does not sufficiently meet these effectiveness features: it makes accessing the Premium difficult to predict; has high compliance costs; and is difficult for fast growing companies to access. Furthermore, it is also susceptible to external factors such as volatility in the value of the Australian dollar.

5.13 Conversely, a Premium based on an R&D expenditure model (without turnover) better meets the effectiveness measures as well as meeting the policy objective of inducing additional R&D. It reduces compliance costs; increases certainty for R&D decision makers; and improves access for companies. This model would reward an increase in R&D expenditure over a companys actual 3 year rolling average R&D expenditure.

5.14 The key to improved effectiveness for the Premium is removing turnover - this simplifies compliance and provides for greater certainty. In addition, it provides support for successful companies, with both growing turnover and growing R&D expenditure, to have greater access to the Premium.

5.15 The disadvantage of a move to an R&D expenditure model is that a small number of companies would no longer qualify, notably those that maintain their R&D expenditure in the face of declining turnover, and those that increase their R&D at a rate less than the threshold, but where turnover rises even more slowly.

Treatment of R&D plant expenditure

5.16 Plant expenditure has historically represented about 12% of reported expenditure under the R&D tax concession. For example, total plant expenditure in 1997-1998 was $552 million (12.7% of total expenditure). However, AusIndustry advises that plant expenditures for 1998-1999 have increased substantially (to about 24% of total expenditure).

5.17 This increase has been attributed to a number of very large claims. While such claims are considered to be anomalous, they could be the beginning of a significant increase in the R&D tax concessions cost to revenue.

5.18 The concessional mark-up for R&D plant under the R&D tax concession should only apply to the value of the plant or tangible items consumed in, or associated with, R&D activities - depreciation for the remainder of the life of the plant used in business rather than R&D activities will be covered by the effective life depreciation of the plant or tangible item. This approach is consistent with that adopted by the Government under the Business Tax Reforms for Capital Allowance write-offs.

5.19 The 2 major elements of the proposed change to the treatment of R&D plant comprise:

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adoption of an effective life write-off for all plant used in R&D activities, with the 25% concessional mark-up applied to the relevant write-off amount; and

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removal of the exclusive use intention test.

5.20 The removal of accelerated depreciation for R&D plant will reduce a significant number of opportunities for seeking unintended benefits from the R&D tax concession while still retaining coverage for the capital expenditure needed to support any eligible R&D activity. This approach once again is consistent with that adopted by the Government under the Business Tax Reforms for Capital Allowance write-offs.

5.21 The removal of the exclusive use requirement will enable companies to obtain support for capital expenditure on items not used exclusively for R&D. Therefore companies, particularly smaller companies who cannot dedicate plant for use on R&D activities for a whole year, will be able to receive concessional treatment of their expenditure on plant for that period of time for which the plant is used for R&D. Accordingly, depreciation deductions, at the 125% concessional rate, will be permitted on a pro rata basis, reflecting the periods of actual R&D usage within a year. Similarly, plant that is used for dual purposes throughout the year, will be permitted proportional concessional depreciation deductions reflecting the extent of the R&D use. The balance of the depreciation relating to non-R&D use will be allowed at normal effective life depreciation rates where its other use qualifies for this.

5.22 Where plant is used concurrently in R&D activities and other activities, it is proposed that a limit on the concessional deductions obtained by claimants for R&D plant depreciation be imposed by reference to the profitability of the plant being operated - thus preventing the tax concession from subsidising production costs.

Re-definition of R&D

5.23 Changes to be made to the definition of R&D activities include:

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a requirement that activities are not taken to be R&D activities unless a program of such activities is set out in a specific R&D plan approved before the commencement of the activities;

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a requirement for both the innovation and technical risk criteria to be satisfied before the activities can qualify as R&D activities;

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a change to the wording of the exclusions paragraph, with the effect that those supporting activities which are listed as excluded activities will no longer qualify as R&D activities; and

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the inclusion of an objects clause to aid users in the determination of what is eligible R&D.

Anti-avoidance measures

5.24 Following the announcement of the Premium in Backing Australias Ability, media reports raised the possibility that the Premium could be subject to manipulation by taxpayers seeking to maximise their benefits under it. Subsequently, this has been confirmed in consultations with industry.

5.25 Broadly, unless action is taken to prevent or minimise such manipulations, these activities would take the form of companies understating, manipulating or shifting real R&D activity across years. This would enable companies to reduce their rolling average R&D expenditure thereby increasing the subsequent years Premium entitlement.

5.26 This could arise through simple behaviours such as companies re-characterising their R&D expenditure as non-R&D related business expenses. In doing this, companies will forego the 125% R&D tax concession on the amount of expenditure not claimed (although the expenditure may still be eligible for 100% deduction as a normal business expense) but gain the 175% premium for that increase above the base amount in the following 2 years.

5.27 Accordingly, anti-avoidance measures are required to address the potential for companies to manipulate their R&D claims to increase their access to the Premium.

5.28 A technical amendment is also required to ensure that companies cannot amend previous year tax returns for the purpose of reducing their R&D expenditure, to enhance their entitlement to the Premium.

5.29 These anti-avoidance measures strike a balance between the risks to revenue and the integrity of the Premium associated with companies manipulating their R&D expenditure against the potential adverse impacts on taxpayers with genuine volatility in their R&D expenditure. It will be necessary to monitor these measures to ensure that they are effective and that the balance is preserved.

Other matters

5.30 Additional measures have been introduced to ensure that the integrity of the concession is maintained. These measures include the introduction of mandatory grouping. The grouping rules will be similar to those being introduced for the Simplified Tax System for small businesses. This measure is necessary to prevent abuse by companies shifting their research to and between subsidiaries.

Assessment of impacts

Impact group identification

5.31 The purpose of the Governments policy with respect to the R&D tax concession is to provide support for business investment in innovation and in particular R&D. Accordingly, the groups to be affected by this measure are:

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companies in Australia eligible to register for the R&D tax concession (based on 1999 data, approximately 3,000 companies - this includes the 1,300 small companies expected to be eligible for the refundable tax offset);

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R&D consultants;

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the ATO and the IR&D Board as joint administrators of the R&D tax concession; and

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DISR and Treasury who have policy responsibility for the R&D tax concession.

Other impacts

5.32 Companies that undertake research in Australia, either themselves or by contract, are likely to benefit from this proposal. In particular:

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all companies that increase the level of R&D expenditure according to the eligibility criteria will be entitled to a Premium 175% deduction in respect of their non-capital expenditures to the extent of the increase in the level; and

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all companies will continue to receive deductions for expenditure on R&D through the continuation of the 125% R&D tax concession.

Analysis of costs/benefits

Compliance costs

5.33 The enhancements to the R&D tax concession are expected to affect approximately 3,000 companies that currently claim the R&D taxation concession.

5.34 An analysis of the compliance costs associated with each measure is now provided. It is noted that the relative impact of compliance costs can be much greater on smaller companies than when applied on larger companies.

R&D plans

5.35 Both the IR&D Board and the ATO has for some time promoted the need to properly document R&D activities and expenditure. The current registration form requires, as part of the declaration, that the company while undertaking the activities has maintained contemporaneous records that substantiate the companys carrying on of the activities. The new requirement for an R&D plan is, in effect, an extension of this requirement to clarify the nature of the records necessary to substantiate R&D claims and to focus on the strategic forward planning of R&D activities.

5.36 It should be noted that R&D plans are necessary to meet IR&D Board requirements, but are not sufficient by themselves to meet the requirement for contemporaneous records. Companies also need to keep documents reporting on the progress of the project against milestones, a report on completion of the project identifying the outcomes and expenditure records that will enable them to substantiate their expenditure to the ATO.

5.37 A written plan should be prepared for each R&D project undertaken by a company. The preparation of an R&D plan should facilitate the preparation (if required) of the Schedule 2 description of claimed R&D activities at the time of registration with the IR&D Board, as the information required in Schedule 2 should already be recorded in the R&D plan.

5.38 Ongoing costs would stem from the production, approval and documentation of the R&D plan. Where companies have a large number of separate R&D projects over a year, the cost of producing individual R&D plans for each project may well be significant if taken cumulatively. In order to maintain the integrity of the tax system these costs cannot be avoided. However, these costs would be balanced by the cost savings expected when many companies begin to use a planning process for their R&D activities for the first time. It should also be noted that companies would not participate in the R&D tax concession if they did not consider the benefits of the concession would easily outweigh the costs.

Refundable tax offset

5.39 Under this aspect of the R&D tax concession, a prospective company will need to incur a number of recurring costs to avail themselves of the tax offset. Included amongst these are:

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determining their eligibility against the definition of R&D activities;

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complying with the definition of turnover used in threshold limits to determine eligibility; and

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work in determining the total turnover of a group they are a part of to ensure they are eligible for the tax offset.

5.40 Some businesses may use the services of a tax agent or an R&D consultant to determine their eligibility for the refundable tax offset. However, as the companies eligible for this tax offset are small and unlikely to be extensively grouped, the costs of compliance associated with the refundable tax offset are expected to be small for both individual companies and when viewed as a group.

R&D plant expenditure

5.41 Under the new R&D plant expenditure rules, where companies switch plant from R&D use to business use and from business to R&D, companies will have to keep records to show the period of time items of plant have been used for R&D purposes. This will enable companies to receive concessional treatment on that plant for the period of time it is used for R&D. This will result in a small compliance cost to the company which should be more than offset by the concessional treatment of the plant items used for R&D.

Premium 175% R&D tax concession

5.42 It is expected that no additional information will be collected from companies registering for the Premium component of this proposal. Existing information, or information necessary for companies seeking coverage by the Simplified Tax System, is expected to meet the requirements for companies registering for the additional benefits.

Administration costs

5.43 The ATO and DISR advise that additional funding will be required to administer the enhanced R&D tax concession. Estimated departmental expenses associated with the proposed measures are outlined in Table 5.1.

Government revenue

5.44 The R&D tax concession will be funded through the savings from the change in treatment of R&D plant expenditure and partly through budget appropriations. These figures, in addition to related departmental expenses, have been provided in Table 5.2.

5.45 The measures are expected to encourage business expenditure on R&D, to lead to a more innovative and productive culture in Australia. In increasing innovation, it offers the key to Australias future economic and social prosperity.

Other issues - consultation

5.46 Consultation meetings have been held with a number of stakeholders following the changes to the R&D tax concession announced by the Prime Minister on Monday, 29 January 2001. On 2 February 2001, consultation meetings were held with tax agents and R&D consultants in both Sydney and Melbourne. On 9 February 2001, further consultation was held with industry representatives based in Canberra. Further consultation meetings were undertaken with stakeholders on 25 and 29 March 2001.

5.47 The major concern resulting from these consultations was the prospect of current eligible R&D being ineligible under the new definition. The lack of prior consultation or justification for this change was also criticised.

5.48 Participants supported the refundable tax offset option. The results of the consultations have been taken into account in the development of the proposals.

5.49 Industry feedback has also demonstrated significant concerns in relation to the use of research intensity in determining the 175% Premium tax concession. Issues raised include:

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complexity and significant compliance costs;

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companies whose turnover grows faster than their R&D expenditure unable to access the 175% Premium as their R&D intensity falls;

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the inability for new R&D performers, young companies and start-ups to access the 175% Premium because of the requirement for companies to have a 3 year registration history (note this will be the same in the expenditure-based scheme);

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the inability of high R&D intensive industries, such as biotechnology and information technology, to increase their R&D intensity given their already high research intensity rate - these industries claim that they are already making a significant contribution to Australias BERD/GERD ratio and should be rewarded; and

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changes in factors outside the control of a company or group such as the value of the Australian dollar, may result in companies being able to access the Premium without any change to the actual level of R&D expenditure (i.e. change in turnover only) or conversely not being able to access the Premium despite increasing R&D expenditure.

Conclusion and recommended option

5.50 It is concluded that the proposal for an enhanced R&D tax concession should be adopted as it is a cost-effective mechanism to provide incentives for business investment in R&D. A summary of the benefits that the enhanced R&D tax concession are expected to attract as outlined in this document are:

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an expected increase in investment in R&D activities;

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an increased use of strategic R&D planning;

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the provision of direct and timely support through improving the cash flow of early stage innovative companies that meet eligibility criteria for the refundable tax offset;

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the selection of an R&D expenditure model for the Premium which results in lower compliance costs over other methods and is more accessible for companies; and

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the inclusion of an objects clause to aid users in the determination of what is eligible R&D.

Index

Schedule 1: Streamlining amendments

Schedule 2: Plant, etc.

Schedule 3: Refundable tax offset

Schedule 4: Incremental tax incentive