House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Treasurer, the Hon Wayne Swan MP)

Chapter 2 - Meaning of research and development activities

Outline of chapter

2.1 This chapter sets out what will qualify as research and development (R & D) activities for the purpose of attracting a tax offset under the new R & D tax incentive.

2.2 The new R & D tax incentive retains some elements of the framework for R & D activities that currently applies to the R & D Tax Concession located in sections 73B to 73Z of the Income Tax Assessment Act 1936 (ITAA 1936). (For example, the distinction between core and supporting R & D activities continues.) However, these elements have been refined so that the new scheme better aligns with the rationale for providing a general subsidy for business R & D as described in Chapter 1.

Context of amendments

2.3 The Government announced in the 2009-10 Budget that it would replace the existing R & D Tax Concession with a new, more streamlined R & D tax incentive from 1 July 2010.

2.4 Accompanying a tighter definition of 'eligible R & D activities', the two core components of the new incentive are:

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a 45 per cent refundable R & D tax offset for R & D entities with an aggregated turnover of less than $20 million; and

•

a non-refundable 40 per cent tax offset for larger R & D entities.

2.5 The Government issued a consultation paper titled The new research and development tax incentive in September 2009 and released exposure draft legislation and explanatory material in December 2009.

2.6 A second exposure of revised draft legislation and explanatory material was released for public comment in March 2010.

Comparison of key features of new law and current law

Detailed explanation of new law

Object of new law

2.7 The rationale of the new R & D tax incentive lies in the potential for R & D activities to generate new information that benefits the wider Australian economy, while the risk of scientific and technological uncertainty may discourage them from taking place. A tax incentive that induces such R & D activities to proceed may provide a public benefit (in the form of the spread of additional knowledge) that ultimately exceeds the cost of the incentive. [Schedule 1, item 1, subsection 355-5(1)]

2.8 Accordingly, the definition of R & D that is eligible for the tax incentive entails the activities that are most likely to produce economy-wide benefits that, in the absence of the incentive, might not go ahead because of uncertain returns. [Schedule 1, item 1, subsection 355-5(2)]

Meaning of R & D activities

2.9 The legislation makes a key distinction between 'core' and 'supporting' R & D activities. For R & D to be recognised as occurring there must be an activity - or more typically a set of related activities - that satisfies the criteria for core R & D. Once core R & D has been identified, certain supporting activities may also become R & D activities. [Schedule 1, item 1, section 355-20]

2.10 The following sections discuss the criteria for activities to qualify as R & D as either core or supporting activities. Examples of how the tests apply are consolidated in the final section of this chapter.

Core R & D activities

2.11 The existence of core R & D depends on establishing that an experiment (or set of related experiments) is taking place. An experiment entails investigating causal relationships among relevant variables to test a hypothesis or determine the efficacy of something previously untried. Experiments may take place in a range of settings, from a separate laboratory to an otherwise normal production run. [Schedule 1, item 1, subsection 355-25(1)]

2.12 To qualify as core R & D activities, experiments will not merely confirm what is already known, or have an outcome that can be known or determined in advance. Rather, they will be activities whose outcome can only be determined by employing a systematic progression of work based on scientific principles and using an approach that proceeds from hypothesis to experiment, observation and evaluation and leads to logical conclusions. This approach is generally known as the scientific method. [Schedule 1, item 1, paragraph 355-25(a)]

2.13 The requirement for the scientific method establishes a threshold for the knowledge gap and the degree of uncertainty that an eligible experiment must seek to address. The threshold will not be met if the knowledge of whether something is scientifically or technologically possible, or how to achieve it in practice, is deducible by a competent professional in the field on the basis of current knowledge, information or experience.

2.14 Further, the nature of the eligible experiment is such that there will be a clear risk that the outcome of the experiment will not be the desired one. The potential for this risk to deter firms from undertaking knowledge-generating R & D underpins the rationale for the R & D tax incentive.

2.15 Less rigorous knowledge discovery and problem solving techniques, such as 'trial and error' alone will not be sufficient to qualify as eligible experimentation. However, trial and error may form part of an eligible experiment where the conditions for core R & D are met. Trial and error can also qualify as a supporting activity where it forms part of a decision to proceed to activities that qualify as core R & D.

2.16 Experimental activities that qualify as core R & D must be for the purpose of acquiring new knowledge or information. This requirement reflects the R & D tax incentive's object of generating the knowledge benefits that arise from conducting R & D - rather than merely subsidising the application of the knowledge produced by R & D. This is particularly relevant where trials are repeated or prolonged, especially if carried out in a production context. The distinction between conducting R & D and applying the results of it (other than in further R & D) is a question of fact. 'New knowledge' in this context means knowledge not already available in the public arena at the time the activities are conducted, in the relevant technology, on a reasonably accessible world wide basis. [Schedule 1, item 1, paragraph 355-25(b)]

2.17 The requirement can be met by the purpose of acquiring or generating knowledge in the practical form of knowledge or information about the creation of new or improved materials, products, devices, processes or services. Where experimental activities occur in the context of normal production activities, the experiments may entail the direct production or use of an actual material, product, device, process or service.

2.18 The need to employ the scientific method also reflects the degree of novelty in the ideas being tested. That is, the knowledge being sought must go beyond validating a simple progression from what is already known and beyond merely implementing existing knowledge in a different context or location. Rather, the gap between existing knowledge and the hypothesis being investigated will be significant enough to require application of the scientific method.

Scope of core R & D

2.19 Core R & D activities are part of the eligible experiment, rather than being merely related to it. These are the activities whose outcome is being determined in the context of applying the scientific method. However, not all of the steps in the scientific method will constitute experimental activities. Nor will an activity fall within the scope of the experiment merely because the experiment cannot take place without it.

2.20 The scope of eligible core R & D activities might be narrower than what the firm views as its R & D 'project'. However, 'non-core' activities can still qualify as an eligible R & D activities if they meet the criteria for supporting R & D.

Supporting R & D activities

2.21 Activities that are directly related to core R & D activities, in that they have a direct, close and relatively immediate relationship with the experimental activities (but without being part of the experiments themselves), can be supporting R & D activities. Supporting R & D activities can occur before, at the same time as, or after the experimental activities and at either a proximate or remote location. [Schedule 1, item 1, subsection 355-30(1)]

2.22 As a general rule, activities directly related to core R & D activities can be eligible for the R & D tax incentive along with their associated core R & D activities. This reflects the fact that supporting activities will usually be required in order for the targeted core R & D activities to take place. However, where supporting activities would have been undertaken anyway for normal operational reasons, they do not impose an additional cost on the company that arises from its R & D activities and so the R & D tax incentive is not intended for them. In particular, it is not intended that the R & D tax incentive cross-subsidise normal production activities. Accordingly, production activities will only be eligible where the dominant (or sole) purpose for conducting them is to support core R & D. Production activities are those that produce goods and services, along with their directly related activities. Production activities can range from a once-off activity to mass production. [Schedule 1, item 1, paragraphs 355-30(2)(b) and (c)]

2.23 This dominant purpose test also applies to activities that are on the exclusions list (see below). [Schedule 1, item 1, paragraph 355-35(2)(a)]

2.24 Dominant purpose means the prevailing or most influential purpose. Implicit in the dominant purpose test is the acknowledgment that activities can serve, or be conducted for, more than one purpose. Accordingly, the fact that an activity serves a commercial objective as well as being directly related to R & D does not preclude it from qualifying as supporting R & D.

2.25 Conversely, the fact that certain activities are necessary in order for core R & D to occur is not sufficient to show that those activities are undertaken for the dominant purpose of supporting core R & D. Nor will the test be satisfied merely because the activities occur in close proximity (either time or location) to the experimental activities. These qualifications can be particularly significant where core R & D is conducted in the context of normal production.

2.26 In discerning the purpose for undertaking an activity, regard must be had to the overall circumstances within which the activity is conducted. Being a purpose test, it is possible that activities that are similar in appearance might qualify as supporting activities in one context, but not in another. A critical consideration will be the extent to which the activities in question also achieve outcomes (particularly production or other commercial goals) over and above assisting the conduct of the core activities, and the importance of those outcomes.

2.27 Activities required to support an experiment that are in addition to routine activities - such as additional monitoring or output inspections - would normally be considered to be undertaken for the dominant purpose of supporting the experiment. Factors such as the extent to which normal production practices are disrupted or the risk that production outcomes will be significantly compromised will be relevant in determining whether the experimental activities are taking advantage of an essentially normal production run, or whether the production run is being conducted for the dominant purpose of facilitating the experiment. The examples appended to this chapter illustrate the considerations that can be relevant in various contexts.

Exclusions list and core and supporting R & D

2.28 Certain activities continue to be excluded from being considered as core R & D. [Schedule 1, item 1, subsection 355-25(2)]

2.29 However, the range of activities comprising the exclusions list has been significantly rationalised on the basis that the clearer, more robust definition of core R & D operates to appropriately target the scope of the incentive.

2.30 Activities remaining include those undertaken for the purpose of discovering and/or quantifying mineral and petroleum deposits; are required to be undertaken to comply with statutory requirements or relate to reproducing an existing product or process; as well as research in social sciences, arts or humanities.

2.31 Other activities continue to be excluded on the basis that they would not satisfy the core R & D definition due to them normally not occurring as part of an experiment. These include market research, market testing and market development activities; the undertaking of management studies or efficiency surveys; and activities related to the commercial, legal and administrative aspects of patenting and licensing.

2.32 An activity undertaken by an R & D entity that is excluded from being core R & D can still qualify as a supporting R & D activity if it is undertaken for the dominant purpose of supporting core R & D. [Schedule 1, item 1, paragraph 355 35(2)(a)]

Software

2.33 Software is subject to the same eligibility tests as other forms of R & D, with the exception of certain 'in-house' software.

2.34 The existing exclusion for 'in-house' software comprising a 'multiple sales' requirement, has been removed, reflecting the fact that ongoing developments in e-commerce and software distribution methods have meant it no longer adequately reflects the original policy intent.

2.35 A new software core R & D exclusion is incorporated into the exclusions list. The exclusion clarifies that activities related to the development, modification or customisation of software are not eligible core R & D where the software is developed for the dominant (or sole) purpose of internal business administration by the entity (or connected entities) for which it was developed, modified or customised. [Schedule 1, item 1, paragraph 355-25(2)(h)]

2.36 The exclusion encompasses software that is for use in the day-to-day administration of the business such as business application, management information system and enterprise resource planning software. The exclusion reflects the fact that such software activities are site-specific, can usually be expected to be undertaken by the relevant business without an incentive, and that, consequently, the additional public benefit from subsidising such activities is limited.

2.37 The exclusion does not extend to software developed in-house that is of an applied nature, forming an integral part of an electrical or mechanical device, such as home appliances or industrial equipment. Similarly, the exclusion does not apply to software activities undertaken to support a larger R & D project, and which may qualify as supporting R & D activity.

Examples illustrating the R & D activities tests

2.38 The following examples use a range of fictitious technology and business scenarios to illustrate the application of the tests for core and supporting R & D. Not all elements of the tests are comprehensively discussed in each example. Neither are the activities that fall into core and supporting R & D exhaustively listed.

EcoStartup

2.39 The following series of EcoStartup examples illustrates a straightforward application of the core R & D and supporting R & D tests in a non-production context.

EcoStartup I

2.40 Example 2.1 illustrates a pure R & D activity that precedes commercial production and has no by-products.

Example 2.1 : EcoStartup I

EcoStartup was formed to investigate the potential for a chemical known as C23 to be added to petrol to reduce greenhouse gas emissions. The company devises an R & D plan and systematically conducts documented experiments to investigate this idea, by measuring exhaust emissions produced from a range of engines by different amounts of the additive for fuels across a range of octane values. The test batches are consumed in these experiments. EcoStartup's project proves successful and the company then decides to manufacture and sell the fuel additive.

Core R & D activities

The idea has a scientific basis, as C23 has several analogous properties to a compound K32 - which is known to reduce greenhouse gas emissions in cars but is only available in limited quantities - so the hypothesis has a scientific basis. C23 is widely available but normally used as a paint additive; that it can serve as a fuel additive to target greenhouse gas emissions would be new knowledge. The related chemistry is complex and underdeveloped, such that whether C23 can be used in this way cannot be determined in advance from current knowledge.

EcoStartup is addressing a knowledge gap that can only be resolved by applying the scientific method. The experimental activities are conducted for the purposes of acquiring new knowledge. The activities do not fall within the scope of any items on the exclusions list. EcoStartup's experimental activities are core R & D.

Supporting R & D activities

EcoStartup can also claim as supporting R & D activities those that are directly related to core R & D. EcoStartup's directly related activities include researching the properties and applications of C23 and K32; mixing and measuring the ingredients for the test batches; constructing apparatus to capture and record exhaust emissions; and developing a computer model to assist in interpreting the results. These activities have a direct, close and relatively immediate relationship with the actual experimental activities that constitute the core R & D.

EcoStartup does not need to subject its supporting activities to the dominant purpose test, as the supporting activities are not activities on the core exclusions list and are not of a kind that produces goods or services. Nor do they contribute to activities that produce goods or services. It is not relevant that the activities contribute to experiments that, by their success, could lead to subsequent production.

EcoStartup II

2.41 Example 2.2 illustrates the supporting activities test in relation to incidental by-products.

Example 2.2 : EcoStartup II

As a variation on EcoStartup I , assume that the number of tests needed for each particular fuel batch is uncertain prior to the experiments. Accordingly, each batch is made sufficient to accommodate the maximum number of tests that might be required. EcoStartup sells the leftovers to a nearby oil refinery to blend away in its general production.

Supporting R & D activities

EcoStartup's supporting activity of blending the test batches would be a production activity. Accordingly, that activity will only qualify as a supporting R & D activity if conducted for the dominant purpose of supporting the experiments.

EcoStartup is not in the business of producing or selling fuel. The quantities of fuel blended for the test batches were justified by the analysis in the experimental plan and the actual amounts that would be left over were uncertain and incidental. Accordingly, the activity of preparing the test batches was for the dominant purpose of supporting core R & D.

Smartread

2.42 Example 2.3 illustrates the scope of the purpose test for core R & D activities within the overarching commercial purpose of R & D and the impact of using production facilities for supporting activities.

Example 2.3 : Smartread

Smartread manufactures tyres. It also conducts an ongoing research program testing new compounds with a view to developing improved products that it can exploit commercially. The test tyres are produced using Smartread's normal production facilities (which only allow one compound to be used in a given production run). The production aspects of the compounds (such as how they function during the moulding process) were not at issue for Smartread's tests. Smartread's research program does not produce any marketable outputs.

Core R & D activities

Although the research has an overriding commercial objective, the relevant purpose of Smartread's experimental activities is to create knowledge in the form of product improvements. Accordingly, Smartread's experimental activities can satisfy the tests for core R & D if they are part of a valid application of the scientific method to address a knowledge gap.

Supporting R & D activities

The cost of the activities involved in actually manufacturing the test tyres (such as running the production line) will be determined in the same way as a normal production run, using normal accounting principles. That is, plant costs, floorspace rent, labour and corporate overheads will be attributed to the cost of the activity of manufacturing the test tyres.

This activity of manufacturing the test tyres is directly related to the experiments but constitutes a production activity, so the dominant purpose test applies. In the context of Smartread's experimental plan, the manufacture of the test tyres does not have the prospect of producing commercial outputs. The dominant purpose test is satisfied so the activity is a supporting R & D activity and Smartread is eligible for a tax offset on the costs attributable to the activity.

Boulevard Mining

2.43 The following series of Boulevard Mining examples illustrates the distinction between conducting and applying R & D in a production environment.

Boulevard Mining I

2.44 Example 2.4 illustrates how the tests apply where existing technologies are modified to apply in a novel application, adjacent to normal production, with the experimental activities supported by otherwise normal production activity.

Example 2.4 : Boulevard Mining I

Boulevard Mining commences work on a previously unmined fork in a coal seam at its Evans Range mine. It decides to use the new fork to undertake an R & D project aimed at allowing it to use wider tunnels, to increase the amount of coal that can be safely and economically extracted from future tunnels.

The project utilises existing knowledge about a new truss design developed elsewhere for cantilevered stadium roofs along with existing knowledge about safe tunnel widths for black coal. The project investigates the extent to which using the new truss design in various scales with various modifications will allow tunnels to be widened, using measurements of the forces being generated in the supported tunnel structure.

Boulevard's mine plan indicates that the seam will be mined regardless of the outcome of the experiments. The coal extracted in the activity of creating the tunnel used for the experiments is mixed and sold with the other output of the mine.

Core R & D activities

The experimental activities pertain to addressing the uncertainty over how the truss will function as a tunnel support, rather than a cantilever roof support, to allow significantly wider tunnels. The experiments are conducted for the purpose of acquiring new knowledge.

The truss will be subject to forces of a significantly different nature to those in its previous applications. Further, how the truss design interacts with tunnel widths and shapes cannot readily be determined using existing knowledge of the properties of trusses and tunnels. Rather, application of the scientific method is required in this instance to address the gap in knowledge.

The experimental activities are core R & D activities.

Supporting R & D activities

In order for the experiments with the truss to take place, tunnelling of various widths and shapes needs to be undertaken into the coal seam. This tunnelling has a direct, close and relatively immediate relationship with the actual experimental activities. Accordingly, it is a directly related activity.

However, in addition to creating a tunnel, the tunnelling also produces coal, so the dominant purpose test applies. In this instance, it is clear from the mine plan that the dominant purpose of undertaking the tunnelling activities is to allow the seam to be mined, rather than to support experimental activities. Accordingly, the tunnelling activity does not qualify as a supporting R & D activity. This outcome would apply were Boulevard to sell the coal or use the coal itself (for example, as fuel or as an input to a coking oven) or stockpile it for later use.

Boulevard Mining II

2.45 Example 2.5 illustrates the tests where the knowledge gained from experiments incorporating production activity is implemented in subsequent customised applications that involve trial and error that is systematically conducted and monitored.

Example 2.5 : Boulevard Mining II

The project in Boulevard Mining I is successful and the technique is applied throughout the Evans Range mine. Due to the shape of the coal seam, the preferred tunnel width varies throughout the mine. The optimal combined specification of truss and tunnel shape for each preferred tunnel width can only be finalised as the work is in process. This work is systematically logged for future reference.

The scope of core R & D activities at Evans Range only extends to the amount of experimentation necessary to acquire the new knowledge to create the improved process - not to the determination of all of the various combinations of truss scale and tunnel width used in the mine.

In this instance, it was found that the Boulevard Mining I experiments with 10 combinations proved sufficient to ascertain the relationship between the two factors and prove the hypothesis that the truss can function as a tunnel support to allow significantly wider tunnels. When using the technique in other tunnel widths at the Evans Range mine, the experimental results can be interpolated and, by monitoring forces as the work is in progress, the structure 'fine tuned' by adding reinforcing segments or adjustments to the tunnel shape.

Although these implementation activities entail a degree of trial and error in applying the knowledge gained from the Boulevard Mining I activities, they do not demand the application of the scientific method.

Also, these subsequent activities are conducted for the purpose of applying knowledge, rather than acquiring knowledge.

Consequently, the implementation of the technique developed in Boulevard Mining I does not constitute R & D activities.

Mimic Mining

2.46 Example 2.6 illustrates how the tests apply where the knowledge gained from experiments incorporating production activity is applied in a different location. Although unique circumstances will be faced in different contexts, resolving how to apply known technology in the face of those circumstances will not, of itself, constitute R & D activities.

Example 2.6 : Mimic Mining

Mimic Mining learns of the technique developed at the Evans Range mine and wishes to apply it to a mine it owns in the Oates Range that is of similar geological structure. Boulevard Mining offers to sell its data and designs for a commercially reasonable sum. Mimic Mining declines the offer and instead replicates the experiments that had been undertaken by Boulevard Mining.

Mimic Mining's experimental activities are not undertaken for the purpose of generating new knowledge. The experiments at Evans Range by Boulevard Mining have proven the hypothesis that it is feasible to use the new truss design to significantly widen tunnel sizes and have established the relationship between truss and tunnel. This information is available to Mimic Mining on a reasonably accessible basis.

Consequently, Mimic Mining is not undertaking eligible R & D activities. Rather, the adoption by Mimic Mining of the Evans Range technique at Oates Range - along with similar adoption by other mining companies - exemplifies the shared benefits that the R & D tax incentive seeks to foster.

Boulevard Mining III

2.47 Example 2.7 illustrates, by way of contrast with Mimic Mining, that resolving how to apply known technology in a fundamentally different location can potentially constitute R & D activities.

Example 2.7 : Boulevard Mining III

Boulevard Mining also has a mine in the Bowers Valley, where, based on current knowledge, the coal is considered too crumbly for the approach developed at the Evans Range mine to be usefully applied. However, Boulevard Mining conducts further experiments that discover the truss can, with modification, still permit significant increases in tunnel widths for crumbly coal seams.

This outcome could not be determined from the Evans Range experiments and its feasibility could only be ascertained by application of the scientific method. Although applying existing knowledge from earlier R & D, the Bowers Valley activities were conducted for the purpose of producing knowledge, rather than merely to resolve routine problems in applying knowledge.

As with the implementation of the approach at the Evans Range mine in Boulevard Mining II , the scope of the Bowers Valley mine R & D activity (including any supporting R & D activity) would only extend to the extent necessary to establish whether the truss could be used to significantly increase tunnel width in crumbly coal seams and to ascertain the relationship between truss and tunnel width. It would not extend to determining the actual specifications when applying the approach throughout the mine, which has similar geological characteristics.

Boulevard Mining IV

2.48 Example 2.8 illustrates the dominant purpose test for supporting activities where production activities are contingent upon the outcome of the experimental activities and there is no 'Plan B'.

Example 2.8 : Boulevard Mining IV

As a variation on Boulevard Mining I , Boulevard Mining decides instead to conduct the tunnel support experiments (which constitute R & D activities) at Marginal Prospect, a new mine it is about to commence, rather than at Evans Range. Should the experiments fail, the Marginal Prospect Mine will not proceed at currently foreseeable coal prices.

In order for the experiments to occur, roads and access tunnels need to be built, which will be used for ongoing mining operations should the mine proceed. The company banks on the experiments being successful, and builds the roads to the standard necessary to service the mine over its expected 10-year production life, and with numerous passing bays to accommodate movement of significant output when the mine is in full production. The company also commences constructing a lengthy railway spur line to the mine and coal train loading facilities.

Supporting R & D activities

The road and access tunnel construction activities are directly related to the experimental activities. However, because they are activities directly related to producing coal, the dominant purpose test applies.

In discerning the dominant purpose for these supporting activities, regard would be had to their place in the company's overall activities and plans in relation to the Marginal Prospect site.

In this instance, it is evident that, although the road and access tunnel will initially be used for the experiment, the company mainly envisaged them as infrastructure for future mining operations. Accordingly, the construction activities were not for the dominant purpose of supporting the core R & D and so do not constitute supporting R & D activity. Activities that maintain the road and supply light and ventilation to the tunnels would qualify during the experimental period.

Grandheap Mining

2.49 Example 2.9 illustrates applying the core R & D and supporting R & D tests where the experimental activities are linked to live production activities.

Example 2.9 : Grandheap Mining

Grandheap Mining learns of new ground vibration sensors developed for vulcanology. Grandheap undertakes reasonable inquiries, but is unable to resolve whether and how it might be practical to apply the technology to assist in optimising slope angles for overburden heaps. Grandheap decides to conduct experiments on the ability of this technology to reliably identify incipient heap instability prior to a collapse occurring.

Grandheap Mining conducts the experiments in the course of its disposal of overburden at a working mine site, Compact Gorge. Grandheap will apply the findings to minimise the land area lost to overburden heaps at a range of open cut mines it operates, by allowing slope angles to safely approach more closely the actual angle at which the heap would fail. Due to the restrictive geography of the Compact Gorge site, minimising the number of overburden heaps will be a key factor in maximising access to the minerals there.

Core R & D activities

At the initial stages it would be fairly straightforward to demonstrate that the activities are being undertaken to test the hypothesis that the new sensor technology can reliably identify incipient heap instability.

As the number of experiments progresses, closer scrutiny would be expected as to whether further heaps were still part of the R & D activities related to resolving technological uncertainty, or were more appropriately considered to be the application of that technology to resolve routine uncertainty about the optimal slope angle for a particular heap. That is, whether the state of knowledge had reached the point where, using the innovative sensor technology, a competent professional in the field could determine when the appropriate slope angle had been reached.

Regard would be had to factors such as Grandheap's original plan ^[1] for the R & D activities, the results obtained and the evidentiary basis for the number of trials considered necessary. Although Grandheap conducted all of the 'tests' at Compact Gorge in a similar manner, it was found that the state of knowledge had reached the point that the hypothesis had been established. Accordingly, those latter activities, despite their form and appearance, did not satisfy the purpose test for core R & D.

The experimental activities would include 'incremental' building of overburden heaps beyond the known safe slope angle, along with clearing of overburden from collapsed heaps.

Supporting R & D activities

Testing the vibration sensors at Compact Gorge requires a supply of overburden. The activity of extracting overburden and delivering it to the site of the experiments has a sufficiently direct, close and relatively immediate relationship with the experimental activities to be considered directly related.

However, removing the overburden and carting it away from the open cut contributes to mining activities, which are production activities. Accordingly, the dominant purpose test applies to the activities of removing and carting overburden.

It is clear from Grandheap's mining plan that the overburden would be removed regardless of the experiments with the sensors, in order to access mineral deposits. Further, there is no apparent difference between the activity of removing overburden used in the experiments and removing overburden subsequent to the experiments. In the context of Grandheap's activities at Compact Gorge, the dominant purpose of removing and carting the overburden is to access mineral deposits rather than supporting the core R & D activities. Accordingly, removing and carting the overburden do not qualify as supporting R & D activities.

Similarly, basic heap building, which is not part of the experimental activities, would fail the dominant purpose test for supporting activities.

Matryoshkoala

2.50 The following series of Matryoshkoala examples illustrates the tests where experimental activities occur within a normal production run. The extent of the experiment relative to the normal production activities can be a guide to the purpose of activities.

Matryoshkoala I

2.51 Example 2.10 illustrates the tests for a small scale experiment conducted in conjunction with a factory production run.

Example 2.10 : Matryoshkoala I

Matryoshkoala operates a factory manufacturing koala-shaped Russian dolls from wood. The production line produces the seven sizes of doll halves in sets of bare forms, which it then paints, glazes, assembles in the nested form and packages. The speed of the production line is constrained by the need to allow the paint on the dolls to dry before the set of dolls can be coated in glaze, dried and nested inside each other, prior to moving to the packaging stage of the production line.

Matryoshkoala has learned of a new fast drying permeable polymer glaze that is used to protect leather from scratching while still allowing it to breathe. Matryoshkoala conducts experiments on whether, in a production line context, using this glaze might allow the dolls to be glazed and nested before the paint has fully dried, such that the paint does not smudge and does finish drying in storage. Because the glaze serves to protect the design painted on the dolls, the experiments will also investigate the maximum thickness of glaze that will be permeable enough to allow the paint beneath to dry.

A production line diversion is fitted with a spare glazing unit and glaze tank, to allow several sets of test doll to be coated with the permeable glaze in various formulations and thicknesses in conjunction with a normal production run. The diversion also contains a spare nesting machine to allow the test doll halves to be nested at an earlier than usual stage of the production line and set aside for examination.

The test dolls will not be sold with the firm's normal output, as they will be inconsistent due to the range of glaze formulations and thicknesses being tested. Also, they will be subject to considerable handling during the inspections. Those not retained for future reference are to be donated to a local preschool or destroyed.

These experiments had been preceded by removing several dolls from a normal production run as they approach the glazing machine, and spray coating them by hand with the polymer glaze. The results were ambiguous, but suggested the glaze might work as intended.

Core R & D activities

The experimental activities are for the purpose of acquiring new knowledge about the drying and permeability properties of the glaze - specifically the effect of nesting the doll halves before the glaze has dried - for varying formulations and thicknesses of glaze. The outcome of the experiment cannot be determined from existing knowledge about the glaze, and the application of the scientific method is required to address the knowledge gap. Further, the hypothesis can only be tested by replicating how the materials would be handled in a production line context.

The experimental activities qualify as core R & D.

Operating the diversionary stage of the production line where the test dolls are coated with the glaze and assembled would form part of the experiment.

The less formal manual trial prior to the experiments proper would also form part of the core R & D activities.

Supporting R & D activities

Matryoshkoala's experiment on an alternative glaze can only be done on a production line, so activities involved in the production run that have a direct, close and relatively immediate relationship with the actual experimental activities will be activities directly related to the core R & D. However, being production activities, the dominant purpose test applies.

The main production line is operated for the dominant purpose of conducting the normal production run rather than supporting the experiment. Consequently, its operation per se will not fall within the scope of eligible supporting R & D activities.

However, producing the painted doll halves used in the glazing experiment would be eligible as a supporting activity (as would acquiring the painted doll halves were they sourced externally). Normal cost attribution rules would be used to determine the cost of producing the test dolls.

Matryoshkoala II

2.52 Example 2.11 illustrates the tests for an experiment conducted in the midst of a full scale production run.

Example 2.11 : Matryoshkoala II

Due to concerns over the viscosity and curing properties of the test glaze, the experiment is next run at full scale, to also test whether the glaze will clog the lengthy ducts leading to the glaze applicator over the duration of a typical production run. A range of formulations that proved acceptable for the dolls in the first experiment will be tested, for their feasibility with respect to the ducts.

The dolls produced in the experiment will again not be a consistent product that can be sold through normal distribution channels. However, Matryoshkoala agrees a 'job lot' price with an exporter that will ensure a satisfactory margin over the cost of materials and running the full production line.

Core R & D activities

The hypothesis being tested is that the various formulations of glaze will remain sufficiently fluid over the duration of a normal production run. The core R & D will therefore include the processes from the glaze storage tanks through to the nozzles on the glazing unit - these are the activities whose outcome cannot be determined in advance.

Supporting R & D activities

The production line supplies and removes the dolls that the test nozzles apply the glaze to, which has a direct, close and relatively immediate relationship with the experimental activities, and so running the production line is a directly related activity. Because it is also a production activity, the dominant purpose test applies.

In determining the dominant purpose for the production run, several considerations are relevant. Running the production line to some extent is necessary to supply dolls and move them away from the glazing unit to a place where they can be inspected, so there is a purpose of supporting the experiment. However, that production run goes beyond the needs of the experiment by also nesting the dolls and packaging them - but the design of the production line makes it impractical to not also perform those integrated activities. A further important consideration is that conducting the production run along with the experiment is profitable in its own right - such that it would be done regardless of whether necessary for the experiment - so there is a commercial purpose.

In this instance, the determinative factor lies in the reason why the production line needs to be run and the related consequences. The requirements of the experiment could not be met simply by running the nozzles into a bucket for the duration of a normal production run. Glazing the dolls is a part of the experiment itself, to test whether the glaze has retained the necessary fluidity when exiting the nozzles to apply evenly without flecking. The production run differs significantly from a normal commercial run due to the inconsistent glazing outturns that the experiment anticipates, together with the risk of flecking.

Together, these factors indicate that the dominant purpose for running the production line is to support the experiment, rather than to make commercial use of the available glaze. Profitably disposing of the resulting dolls is incidental to this dominant purpose.

Accordingly, the directly related activities in relation to running the production line are for the dominant purpose of supporting the experiment, so they qualify as supporting R & D activities.

Matryoshkoala III

2.53 Example 2.12 illustrates the tests for an experiment conducted on a portion of a production line that is run at full scale.

Example 2.12 : Matryoshkoala III

Matryoshkoala adopts the experimental glaze, allowing it to considerably shorten the paint and glaze drying sections of its production line to free up floorspace for other activities. A resulting tight turn causes recurring problems for the chain that drives the conveyor belt through this 10 metre section of the production line.

Matryoshkoala hypothesises that the optical recognition device it uses in the quality control section of the line can be modified to reliably detect chain movement anomalies and trigger a mechanical jolt to set the chain back on its cogs.

Modifications are devised and made to the optical recognition device and related software and the mechanical 'kicker' designed and fabricated.

The system is brought up to satisfactory performance in offline tests, but a lengthy test in the actual production line is required to prove the hypothesis. Conducting the test while undertaking a full production run ensures that the test section of the production line is subject to realistic loads.

Core R & D activities

The lengthy test with the production line running is a part of the experiment, as its outcome cannot be determined in advance. However, although running the production line as a whole might be necessary for the experiment, only running the 10 metre section encompassing the tight turn would form part of the experiment.

The cost of the experiment would include a reasonable apportionment of the cost of running the production line. Matryoshkoala apportions on a 'length in metres' basis, plus a loading for the extra power costs and maintenance this section gives rise to because of the extra drag caused by the tight turn.

Supporting R & D activities

Although running the full production line is, to some extent, necessary for the experiment, it also serves the commercial purpose of producing standard dolls. In determining the dominant purpose for the production run, regard would be had to the perceived likelihood that the run would be normal from a production standpoint and the implications for production costs were the line to be subject to interruptions. Also relevant would be whether actual doll production was necessary in order to provide a realistic test load.

It was found that interruptions from the test equipment not working as intended would be comparable with those that had been experienced from the chain jumping off in the period prior to the experiment. It was not credible that Matryoshkoala would attempt a full production run if serious delays were likely, due to the cost of the glaze that would need to be pumped to waste out of the lengthy ducts. A realistic test load could have been achieved without the risk of painting and glazing doll halves, by using available halves that had the correct weight but had been rejected at quality control due to paint imperfections.

Accordingly, in the circumstances, it was found that the dominant purpose of conducting a full production run was commercial, rather than to support the experiment. That is, Matryoshkoala, quite sensibly, took the economic opportunity to piggyback the experiment onto a production run.

Hayk Hockey Stix

2.54 Example 2.13 illustrates the tests where the experimental activities are a subset of a long production run.

Example 2.13 : Hayk Hockey Stix

Hayk Hockey Stix produces field hockey sticks in large numbers for supply to a world market. Hayk experiments with integrating a multi-axial scanner with an existing numerically controlled laser guided cutting and rasping machine. If successful, this will allow real time detection of output that is outside of tolerances, allowing faulty adult sticks to be recut - if necessary to a junior specification - prior to leaving the machine.

Statistical analysis determines that in a production run of 1,000 sticks the cutting and rasping machine would generate sufficient out-of-tolerance sticks to test, to the 95 per cent confidence level, whether the scanner can accurately identify them.

Hayk has a large order, so it integrates the experiment into a production run of 5,000 sticks. The production stage itself consists of little more than the machine in question, which accepts pre-cut lengths of timber and produces the cut forms, which are rested for curing prior to further processing.

Core R & D activities

Cutting and rasping the first 1,000 sticks of the 5,000 stick production run would be part of the experiment. The cost of the experiment would include a reasonable apportionment of the cost of running that production stage over the 5,000 stick production run. Hayk apportions on a 'per stick' basis, plus a loading for stopping the line to check for false positives.

Supporting R & D activities

The remainder of the 5,000 stick production run is undertaken for the dominant purpose of commercial production.

Tabby Marine

2.55 The following linked examples for Tabby Marine illustrate the tests where R & D activities are conducted through the production of a marketable product. In all three stages, the experimental activities are conducted on prototypes that are intended for sale.

Tabby Marine I

2.56 Example 2.14 illustrates the tests where normal production components are unsuccessfully matched with experimental ones, increasing the overall cost of what ultimately turns out to be a normal production unit.

Example 2.14 : Tabby Marine I

Tabby Marine manufactures catamarans. Generally four boats are under construction at any one time. Tabby experiments with a novel combination of steering rudder and propeller screw, in the hope of achieving increased speed without sacrificing steering control. Trials with scale models were considered, but found not to be an economical or reliable option. Tabby constructs a prototype catamaran using its usual design, but with the test rudder-screw assembly fitted. The boat is otherwise fully fitted out as usual for eventual sale. Trials are then conducted on open water.

The experiment fails and the vessel is refitted with a conventional rudder and screw and sold for the usual price. Tabby retains the rudder-screw assembly for possible further experiments.

Core R & D activities

The experimental activities are deemed to satisfy the tests for core R & D with respect to the need to apply the scientific method to test a hypothesis about the test rudder-screw assembly for the purpose of generating knowledge about the creation of new/improved products.

The experimental activities principally entail developing and testing the design using a computer model and, separately, testing the fabricated assembly in sea trials. These are the activities whose outcome cannot be determined in advance.

Fabricating the rudder-screw assembly from the computer-tested design was, in this instance, a routine step. Consequently, it is not a core R & D activity, but may qualify as a supporting R & D activity.

Supporting R & D activities

As the experiments pertain to testing how the rudder-screw assembly operates with Tabby's standard hull design, constructing the hull (and other boat elements that are necessary for the experiments) would be directly related activities and so potentially be eligible as supporting activities. However, because they are production activities, the dominant purpose test would also apply.

Although earmarked for the experiment, the conventional hull was predominantly constructed with a view to the commercial sale of a finished boat. The experiments would only affect whether that boat would be sold with the experimental rudder-screw assembly or a regular rudder and screw. Had the R & D not been undertaken, the hull would have been constructed as part of Tabby's normal business activities. The dominant purpose of its construction was commercial and so constructing the hull is not a supporting R & D activity.

Fitting out the catamaran has direct, close and relatively immediate relationship with the experimental activities, by aiding crew comfort. However, in the context of Tabby's activities, the dominant purpose of the chosen fit out is to assist completing the boat for eventual sale and so it does not qualify as a supporting R & D activity.

Fabricating the rudder-screw assembly was a directly related production activity that was only undertaken to support the experiments on the design. As there would be no obvious alternative use for the assembly (should it fail to perform as hoped) the dominant purpose for constructing it was clearly to support the experiments. Accordingly, along with installing and removing the test rudder-screw assembly (to allow a conventional rudder and screw to be fitted for the ultimate sale), fabricating the test assembly would qualify as a supporting R & D activity. This would still be a qualifying supporting activity had the experiment been successful and the boat sold with the test assembly.

Tabby Marine II

2.57 Example 2.15 illustrates the tests where modified production components are matched with experimental ones in a follow-up experiment that produces immediate commercial rewards.

Example 2.15 : Tabby Marine II

In the following year, Tabby Marine attaches the removed rudder-screw assembly to a second prototype catamaran with modified hull segments. The tests are successful. The prototype is sold at a premium and the modified catamaran design, with the novel rudder-screw assembly, is put into full production.

Had the modified hull segments been unsuccessful, it would have been impractical to replace them with conventional segments.

Core R & D activities

These experiments test a different hypothesis about the test rudder-screw assembly and are still for the purpose of generating new knowledge about the rudder-screw assembly design.

The experimental activities principally entail developing and testing the design for the modified hull segments using a computer model ^[2] and testing, in sea trials, the performance of the resulting catamaran hull in combination with the rudder-screw assembly.

Fabricating the modified hull segments from the design proved problematic due to tight curves in the design and the need for joints accommodating segments entering at varying angles. Tabby's boatbuilders tried several approaches, consulted colleagues and researched boatbuilding articles to overcome the challenges. These were not experimental activities because the uncertainty was of a kind that could be resolved by a competent professional in the field on the basis of current knowledge, information or experience.

Supporting R & D activities

Although the modified catamaran incorporated mainly conventional catamaran hull segments, it would not have been a practical option to rebuild the boat with purely conventional segments - all of the hull construction was committed to the experimental design. Further, there was significant uncertainty as to how marketable the finished boat would be. Accordingly, constructing all of the hull (not just the experimental segments) was for the dominant purpose of supporting the experiment and so would qualify as supporting R & D activity (inclusive of the failed attempts to fabricate the modified segments).

Tabby Marine III

2.58 Example 2.16 illustrates the tests where a prototype fails and is made from overspecified materials.

Example 2.16 : Tabby Marine III

Tabby then experiments with applying the novel rudder-screw assembly design to a similarly modified monohull boat. With an eye to the luxury market, Tabby uses expensive timbers when building this boat. Being optimistic, Tabby also completes the fit out to a high standard, gold plating numerous interior surfaces, prior to commencing sea trials.

The results for the monohull boat are disappointing and the experiment is discontinued. The unsuccessful monohull prototype is sold at a loss as being usable but with performance limitations.

Core R & D activities

Again, these experiments test a different hypothesis about the test rudder-screw assembly and, although applying results from previous R & D, are still for the purpose of generating new knowledge about the rudder-screw assembly and modified hull segments. In this instance, application of what is still only proven as catamaran hull technology to a monohull is a significant step that requires scientific experimentation to assess its feasibility.

Translating the catamaran hull modifications to the existing monohull design, along with related computer testing, would be included in core R & D as experimental activities for which the outcome could not be determined in advance.

Supporting R & D activities

Constructing the modified monohull is a supporting R & D activity as it was undertaken for the dominant purpose of supporting the experiment. It is not relevant that the materials used in the experimental activities (such as the planking for the hull) were of a higher standard than necessary to conduct the experiment.

The luxury fit out will not qualify as a supporting R & D activity, as it was clearly conducted for the dominant purpose of the commercial sale of the prototype. It is not relevant that the experiment failed and the boat was sold at a loss.

Whist Constructions

2.59 Example 2.17 illustrates the rules where experimental activities are an integral part of an inherently one-off production task under a fixed price contract.

Example 2.17 : Whist Constructions

Whist Constructions enters into a fixed price contract to construct a bridge across River Gorge. Whist tendered on the basis of using a suspension bridge.

The type of rock to which the suspension cables must be anchored has known weaknesses. Whist hopes to address this weakness by an innovative approach to anchoring that would only need holes drilled to a narrow diameter and would spread the forces along the depth of the drill hole.

The anchor design is tested in situ at the point in the construction schedule that anchors would normally be inserted. As it was not economical to halt construction and wait for load test results, the identical non-test anchors were also fabricated in advance and installed as soon the installation and activation procedure had been verified. As usual, the anchors are closely monitored as the load increases throughout construction of the remainder of the bridge.

Core R & D activities

The hypothesis being tested is that the modified anchor design - in conjunction with its installation and activation method - will hold in this rock type when subjected to the design forces of the bridge. In this instance, the scientific approach is needed to determine whether this is so. Further, significant uncertainty remained after computer simulations.

Whist's experimental activities include developing and finalising its original conception for the design using a computer model, and installing the necessary number of test anchors into the drill holes while closely monitoring their activation. The experimental activities would also include monitoring the test anchors as they were subjected to load.

However, the experimental activities do not extend to installing and testing all of the anchors - only to the extent necessary to acquire the new knowledge about the improved product and related process (the new anchor design and its installation). Beyond this, installing and routinely testing anchors is part of the non-experimental activities involved in building the bridge using the knowledge gained from the experiment.

Supporting R & D activities

The core R & D activities (including final load testing on the test anchors) can only be fully conducted by building a complete bridge at a site such as River Gorge. However, building the River Gorge bridge is not, for the most part, a supporting R & D activity. The dominant purpose of the normal bridge building activities is building a bridge in order to fulfil Whist's contractual obligations.

Fabricating (or sourcing) the anchors would be directly related to the experiment, as all of the anchors will either be used in the experiment or contribute to the bridge's completion, which allows the test anchors to be tested to the full load. Fabricating sufficient test anchors to conduct the experiment would be for the dominant purpose of allowing the experiment to take place, and so would qualify as a supporting R & D activity.

Anchors beyond those used in the actual experiment contribute to finalising the bridge, and so facilitate the full load test on the test anchors. They also, through routine monitoring, provide a supplementary source of data. However, as with the rest of the bridge (which also serves to assist the full load test) the dominant purpose for fabricating and installing the non-test anchors is the commercial purpose of completing the bridge.

Two Wheels, E C Plus, and Sanctuary

2.60 The following examples illustrate the application of the rules in relation to software development projects, including the application of the software core R & D exclusion.

Example 2.18 : Two Wheels

Two Wheels Ltd, undertakes a project to develop a new gearbox for motorcycles. The project involves investigating the potential for using multiple lay shafts within a gear box in order to reduce its overall size without compromising effectiveness. Such an approach has not been attempted before and it is not known whether it will succeed.

Computer-aided engineering and simulation software is used to explore how such a gearbox might be designed and developed. While the software needs to be adapted for the project in question, this is achieved using existing application program languages, and is within the design capabilities of the software used.

Core R & D activities

The outcomes of the software activities are not uncertain and are not intended to achieve new knowledge in relation to computer science as the adaptation is based on existing knowledge. The software activities, by themselves, would not constitute core R & D activities. However, assuming for the example that the larger gearbox project itself constitutes an eligible R & D project, the software activities may constitute eligible supporting activities.

Supporting R & D activities

While developed for in-house use, the software is applied in nature rather than related to the administration of the business, and consequently would not have fallen within the software exclusion were it core R & D. As such, under the supporting R & D rules, Two Wheels only need demonstrate that the software activity was directly related to the core R & D project. The software activities are eligible as supporting R & D activities.

Example 2.19 : E C Plus

A software company, E C Plus Ltd, wants to develop a new computer language that will simplify and streamline the coding of on-line software applications without impacting on functionality. E C Plus intends to release the language as open-source in order to promote its uptake and thereby support E C Plus's longer term business strategy. As the proposed language differs significantly from those currently used, a series of development, evaluation and testing activities needs to be systematically undertaken to ascertain whether its idea is workable, and if so, how it performs relative to existing software applications.

Core R & D activities

Considerable uncertainty exists regarding the project, which needs to be addressed through a structured series of activities. These activities are conducted for the purpose of generating new knowledge in relation to computer science and information technology. The activities are core R & D.

Core R & D software exclusion

The software is not being developed for use by E C Plus or a related or connected entity for internal business administration purposes. The exclusion does not apply to the project activities.

Example 2.20 : Sanctuary

Sanctuary Ltd, a financial institution, intends to reengineer its disparate systems for managing customer accounts into one customer focused system.

As part of the project, Sanctuary also intends to build a secure payment system that operates by providing customers with a single-use encryption 'key' via a mobile device, allowing them to access their accounts in a secure manner over the Internet. Developing such a system will require an experimental process to develop and effectively utilise the advanced cryptographic algorithms and protocols such a system will require.

During testing of the payment system, Sanctuary discovers that a modification will need to be made to the new customer accounts system for the payments system to operate in a secure manner.

Core R & D activities

The outcome regarding the proposed new secure payment system cannot be determined in advance, as it is dependent on the successful development and operation of the envisaged new secure algorithms and protocols. To address this uncertainty, a systematic process involving design, evaluation and testing is undertaken. The software is being developed to provide a new service for customers, and not for Sanctuary's internal administration, and so the core R & D exclusion does not apply. The activities related to the development of the secure payment system are core R & D.

The activities related to the re-engineering of customer account software involve developing and/or modifying software for the dominant purpose of use by Sanctuary for its internal administration, and so are excluded from being core R & D.

Supporting R & D activities

The activities related to customer accounts are software activities for Sanctuary's internal administration and so are subject to the dominant purpose test. That is, they may be eligible as supporting R & D activity if the dominant purpose for undertaking them was to support the core R & D activities. In this case, the dominant purpose for the integration of the disparate systems was to streamline Sanctuary's customer accounts system. These activities are not supporting R & D.

However, the additional modification made to the customer accounts system following the testing of the payments system was undertaken for the dominant purpose of supporting the core R & D project. The modification activities qualify as eligible supporting R & D activities.