This year the ATO released a checklist for Research and Development (R&D) Tax Incentive claimants. The purpose of this checklist is to assist advisors to self assess their clients and to provide some clarification and advice about the requirements of the program.
In recent years the R&D program has grown in popularity and there has been a corresponding change in the joint administration of the program by AusIndustry and the ATO. AusIndustry is the body that claimants must register with and that will assess whether the claimant is conducting R&D activities. The ATO administers the tax incentive which is claimed in the tax return. In general there are now more types of review and higher levels of interaction between these administrators and R&D claimants.
In this context, this article discusses the various purpose tests that must be satisfied to claim an ‘R&D activity’ and the necessity for contemporaneous records. Case law suggests that these concepts can be problematic for claimants.
Unless otherwise stated all legislative references in this article are to the Income Tax Assessment Act 1997 (Cth).
What is the R&D tax incentive?
The R&D tax incentive provides a targeted tax offset designed to encourage more companies to engage in R&D activities.
What is an R&D activity?
To claim, there must be at least one ‘core R&D’ activity, and there may also be ‘supporting R&D’ activities.
Broadly, core R&D activities are experimental activities whose outcome cannot be known or determined in advance based on current knowledge, information or experience, and that are:
- based on principles of established science, and
- proceed from hypothesis to experiment, observation and evaluation, and lead to logical conclusions, and
- are conducted for the purpose of generating new knowledge (including the creation of improved materials, products, devices, processes or services) (s355-25).
A supporting R&D activity is an activity that is directly related to core R&D activities or, for excluded activities (which are discussed further below), has been undertaken for the dominant purpose of supporting core R&D activities (s355-20).
Section 355-25(2) provides a list of activities that are excluded from being core R&D activities, but can be supporting R&D activities if they satisfy the dominant purpose test. This list includes:
- market research;
- oil or mineral exploration;
- management studies or efficiency surveys;
- research in social sciences arts or humanities;
- commercial legal and administrative aspects of patenting licensing or other activities;
- activities associated with complying with statutory requirements or standards;
- reproduction of a commercial product or process; and
- developing modifying or customising computer software for the dominant purpose of internal administration (excluded activities).
Who can claim?
To be able to take advantage of the R&D tax offsets you must be an R&D entity as defined in s 355-35. In general an R&D entity is either a corporation that is incorporated under an Australian law or, in some circumstances, a foreign corporation.
The purpose of the activity
In JLSP v Innovation Australia  AATA 23 (JLSP) the AAT noted that s355-25 is a definitional provision aimed at identifying core R&D activities (or supporting R&D activities) and is not informed or affected by the operational provisions in Div 355, which are aimed at determining the separate question of whether a tax offset is available.
The R&D entity must be able to show that the relevant purpose of conducting a core R&D activity was the development of new knowledge. JLSP shows that this purpose does not need to be the dominant or prevailing purpose, but it must be sufficiently substantial as to enable the activity to be accurately characterised as conducted for that purpose.
This means that an entity may have other substantial purposes for conducting the activity (eg to obtain a financial benefit) but this will not prevent the activity from qualifying as a core R&D activity provided that the activity has the character of generating new knowledge.
This is consistent with the AAT decision of Mt Owen Pty Limited (aka DBTL) v Innovation Australia  AATA 573 (Mt Owen). That decision confirmed that core activities must be carried on for at least a significant purpose of generating new knowledge. However, the AAT considered that under the old R&D provision in the R&D Tax Concession, dominant purpose was probably the required level (this case dealt with the old R&D provisions). The purpose must be evidenced through the aims and the objectives of an activity. If new knowledge was incidental to the activity then this will not be enough to satisfy the purpose test. This will also apply under the current R&D Tax Incentive.
JLSP has clarified this position and confirmed that the dominant purpose test is not imputed into the s355-25 test when determining the purpose of a core R&D activity.
Supporting R&D activities must be directly related to the core R&D activity, ie they must have a close or immediate relationship to the core R&D activity. A supporting activity will include those activities listed as being excluded from being core R&D activities under s355-25(2). The list includes activities which are usually thought of as ‘soft’ sciences or mining activities. Any of these excluded core activities can be ‘supporting R&D activities’ if undertaken for the dominant purpose of supporting a core R&D activity.
Without a specific ‘dominant purpose’ test in the legislation, the dominant purpose of an activity can only be determined on a case by case basis as applied to the facts. AusIndustry considers that dominant purpose means the prevailing or most influential purpose for conducting an activity. An activity may be conducted for more than one purpose. Again, the fact that an activity has a commercial objective does not preclude it from qualifying as a supporting R&D activity. However the dominant purpose of the activity must be to generate new knowledge.
An example of an activity that has the dominant purpose of supporting a core R&D activity is a data collection phase that is undertaken for the purpose of collecting information from the experiment to evaluate the hypothesis or that might be used to draw conclusions or refine the experimentation process. A supporting R&D activity can occur at any phase of the experiment. That is, it may occur prior to, or concurrent with, or following the experiment.
Contemporaneous records, why do I need these and what are they?
There is one common element in many recent cases: a lack of documentary evidence. In Docklands Science Park Pty Ltd v Innovation Australia  AATA 973 the AAT made it clear that if there is no contemporaneous evidence that the activity in question met all of the eligibility criteria, then that activity is not eligible.
The AAT’s comments at paragraph 63 indicate that the documentation must demonstrate each eligibility requirement of the R&D Tax Incentive, and together the combination of those eligibility requirements should be able to establish that the purpose of the activity was to generate new knowledge. The AAT said that “an applicant cannot succeed in establishing those requirements in the absence of detailed documentation recording the process of each activity as it develops”.
It follows that a claimant will not be eligible to claim the tax offset without contemporaneous records. These records should firstly be able to substantiate that the activity was undertaken, and secondly demonstrate that the activity satisfies all of the eligibility requirements. Therefore although the program is a self assessment program it is necessary that claimants only claim those activities that they can reasonably justify with documentation that was created at the time of undertaking that activity.
Claimants should keep two types of records to substantiate their R&D activities:
- records to substantiate that the activities were actually undertaken; and
- records of the cost of those activities.
Records of the R&D activities should be taken at the time of conducting the R&D activities and might include notes from technical meetings, reports or analysis of results from conducting the activities or observations and technical documents which set out things like the objectives of the project, testing that is to be conducted or project developments. These records should also be contain evidence that the purpose of any activity was to generate new knowledge, or was conducted to support the core experimental activity.
Records of expenditure should be of a similar standard to records that a taxpayer retains to justify an ordinary tax deduction. These records should be able to verify the amount incurred on R&D and so they should include sufficient detail to link the expenditure to each different R&D activity.
Good records will help claimants support their claim in the event of a review or audit by AusIndustry or the ATO. We recommend that claimants implement a systematic record keeping process so that sufficient documents are collected at all phases of an R&D project. This might include holding weekly project meetings or filing out periodic reports to track the progress and findings of each R&D activity.