Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)
Chapter 5 - Regulation impact statement
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;
- a premium rate of 175% for additional R & D;
- amendments to the tax deductibility of R & D plant;
- amendments to the definition of eligible R & D; and
- a requirement that companies prepare R & D plans.
5.4 A refundable tax offset for small companies to have access to the cash equivalent to the R & D tax concession will:
- 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
- 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.
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:
- low complexity and compliance costs;
- certainty for industry R & D decision makers in relation to the prospective benefits of investing in R & D; and
- 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.
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:
- 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
- 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.
5.23 Changes to be made to the definition of R & D activities include:
- 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;
- a requirement for both the innovation and technical risk criteria to be satisfied before the activities can qualify as R & D activities;
- 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
- the inclusion of an objects clause to aid users in the determination of what is eligible R & D.
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.
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.
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:
- 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);
- R & D consultants;
- the ATO and the IR & D Board as joint administrators of the R & D tax concession; and
- DISR and Treasury who have policy responsibility for the R & D tax concession.
5.32 Companies that undertake research in Australia, either themselves or by contract, are likely to benefit from this proposal. In particular:
- 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
- all companies will continue to receive deductions for expenditure on R & D through the continuation of the 125% R & D tax concession.
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.
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.
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:
- determining their eligibility against the definition of R & D activities;
- complying with the definition of turnover used in threshold limits to determine eligibility; and
- 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.
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.
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.
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.
|2001-2002 $m||2002-2003 $m||2003-2004 $m||2004-2005 $m||2005-2006 $m||5-year total $m|
|Refundable tax offset for small companies|
|Premium 175% R & D tax concession|
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.
|2001-2002 $m||2002-2003 $m||2003-2004 $m||2004-2005 $m||2005-2006 $m||5-year total $m|
|Refundable tax offset for small companies||0.0||-6.0||-3.0||-2.0||-2.0||-13.0|
|Premium 175% R & D tax concession||-40||-105||-120||-130||-145||-540|
|R & D plant (savings)||25||95||115||95||85||415|
|Definition of R & D||*||*||*||*||*||*|
|Estimated departmental expenses (above)||-4.335||-3.946||-3.946||-3.946||-3.946||-20.189|
|Impact on underlying cash balance||-19.34||-19.95||-11.95||-40.95||-65.95||-158.14|
|Net impact on underlying fiscal balance||-19.34||-19.95||-11.95||-40.95||-65.95||-158.14|
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.
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:
- complexity and significant compliance costs;
- companies whose turnover grows faster than their R & D expenditure unable to access the 175% Premium as their R & D intensity falls;
- 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);
- 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
- 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.
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:
- an expected increase in investment in R & D activities;
- an increased use of strategic R & D planning;
- 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;
- 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
- the inclusion of an objects clause to aid users in the determination of what is eligible R & D.