House of Representatives

Tax Laws Amendment (Research and Development) Bill 2010

Income Tax Rates Amendment (Research and Development) Bill 2010

Explanatory Memorandum

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

Chapter 3 - Tax offsets for research and development

Outline of chapter

3.1 Schedule 1 to the Tax Laws Amendment (Research and Development) Bill 2010 (Bill) amends the Income Tax Assessment Act 1997 (ITAA 1997) and the Income Tax Assessment Act 1936 (ITAA 1936) to introduce new research and development (R & D) tax offsets, which have the following main features:

·
the types of entity that are eligible for the offsets (called an R & D entity in the new law) are a corporation that is an Australian resident, a foreign corporation that is carrying on R & D activities though a permanent establishment in Australia and a public trading trust with a corporate trustee;
·
an R & D entity is entitled to a tax offset if the total of its notional R & D deductions is at least $20,000;
·
the main notional deductions are for:

-
expenditure on registered R & D activities during the income year; and
-
the decline in value of a depreciating asset used for registered R & D activities during the income year (if certain other conditions are satisfied);

·
the offset that an R & D entity is entitled to is a refundable tax offset if the annual turnover of the entity (and certain related entities) for that income year is less than $20 million (and one or more exempt entities do not own or control more than 50 per cent of the entity). Otherwise, the R & D entity is entitled to a non-refundable tax offset; and
·
the quantum of the refundable tax offset is equal to 45 per cent of the total of notional R & D deductions while the quantum of the non-refundable tax offset is equal to 40 per cent of the entity's total notional R & D deductions.

3.2 Amendments to the Income Tax Rates Act 1986 necessary for rules about recoupment from government of R & D expenditures are contained in the supporting Bill, the Income Tax Rates Amendment (Research and Development) Bill 2010.

3.3 Part 1 of Schedule 3 to the Bill contains related amendments to the tax offset rules in the ITAA 1997. Part 3 of Schedule 3 contains consequential amendments to the ITAA 1997, most of which are explained in this chapter because they are important to the overall operation of the new R & D tax incentive. Other consequential amendments in Part 3 of Schedule 3 are explained in Chapter 4. The concept of R & D activities is discussed in detail in Chapter 2 of this explanatory memorandum.

3.4 In this chapter, legislative references are to the ITAA 1997, except where indicated.

Context of amendments

3.5 The existing law contains extensive and complex provisions (sections 73B to 73Z of the ITAA 1936) dealing with R & D expenditure. These deliver an array of deductions and a tax offset, in different circumstances, which can be summarised as follows:

·
a base 125 per cent R & D tax concession that provides an increased tax deduction for certain expenditure on registered Australian-owned R & D activities;
·
a 175 per cent premium R & D tax concession that provides an additional deduction to the base concession for expenditure that exceeds the average of the corporation's previous three years of Australian-owned R & D expenditure;
·
an R & D tax offset that allows small corporations to cash out the value of deductions relating to Australian-owned R & D, which is of benefit if they are in a tax loss situation:

-
the tax offset is (broadly) available to corporations with an annual group turnover of less than $5 million and whose aggregate R & D expenditure is greater than $20,000 and whose group aggregate R & D expenditure is not more than $2 million per year;
-
eligible corporations can choose to receive the tax offset in lieu of deductions available to them under both the base concession and the 175 per cent premium; and

·
a foreign incremental tax concession that provides deductions for foreign-owned R & D is as follows:

-
100 per cent deduction for the base expenditure amount; and
-
an additional 75 per cent deduction for additional expenditure over the three-year average.

3.6 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.

3.7 The two core components of the new incentive are:

·
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. Accompanying this is a tighter definition of 'R & D activities'.

3.8 The Government issued a consultation paper titled The new research and development tax incentive in September 2009.

Summary of new law

3.9 Under the new R & D incentive the main benefits are available as tax offsets. The types of entity eligible for the offsets (called an R & D entity in the new law) are a corporation that is an Australian resident, a foreign corporation that is carrying on R & D activities though a permanent establishment in Australia and a public trading trust with a corporate trustee. An entity that is exempt from income tax is not an R & D entity.

3.10 An R & D entity is entitled to a tax offset if the total of its notional R & D deductions is at least $20,000. It is also entitled to a tax offset for certain R & D expenditure incurred to a Research Service Provider, regardless of the level of its notional deductions. A notional deduction is an amount that an entity cannot actually deduct because it is a step in working out the entity's entitlement to a tax offset. (If the entity could actually deduct the amount it would obtain a double benefit for the same amount of expenditure or depreciation.)

3.11 An R & D entity is entitled to notional deductions for the following (if certain other conditions are satisfied):

·
expenditure on R & D activities during the income year;
·
the decline in value of a depreciating asset used for R & D activities during the income year; and
·
a balancing adjustment for depreciating assets used for R & D activities.

3.12 The R & D entity is entitled to a refundable tax offset if the annual turnover of the entity (and certain related entities) for that income year is less than $20 million (and one or more exempt entities do not own or control more than 50 per cent of the entity). Otherwise, the R & D entity is entitled to a non-refundable tax offset.

3.13 The quantum of the refundable tax offset is equal to 45 per cent of total notional R & D deductions while the quantum of the non-refundable tax offset is equal to 40 per cent of the entity's total notional R & D deductions.

Comparison of key features of new law and old law

New law Current law
The two core components of the new incentive are:

·
a non-refundable 40 per cent R & D tax offset; and
·
a 45 per cent refundable R & D tax offset for (broadly) R & D entities with an aggregated turnover of less than $20 million.

An array of deductions and a tax offset (summarised in paragraphs 3.5 to 3.8) are available for eligible corporations.

The primary benefit is an increased tax deduction equal to 125 per cent of certain expenditure on registered Australian-owned R & D activities.

The types of entity eligible for the tax offsets (called R & D entities) are:

·
a corporation that is an Australian resident;
·
a foreign corporation that is resident of a country with which Australia has a double tax agreement and carries on business through a permanent establishment in Australia; and
·
a public trading trust with a corporate trustee.

An entity that is exempt from income tax is not eligible for the tax offsets.

The types of entity eligible for the R & D concession are Australian corporations and public trading trusts.
An R & D entity is entitled to a tax offset if the total of its notional R & D deductions is at least $20,000.

It is also entitled to a tax offset for certain R & D expenditure incurred to a Research Service Provider, or as a monetary contribution to a Cooperative Research Centre, regardless of the level of its notional deductions.

Entitlement to a tax offset or a 125 per cent deduction is generally limited to corporations whose aggregate R & D expenditure is greater than $20,000. There is an exception for certain R & D expenditure to a registered research agency.

Entitlement to a tax offset is limited to a corporation with an annual group turnover of less than $5 million and whose group aggregate R & D expenditure is not more than $2 million per year.

An R & D entity can notionally deduct amounts under the R & D provisions for the income year for:

·
certain expenditure on registered R & D activities;
·
a decline in value of depreciating assets used for registered R & D activities;
·
a balancing adjustment for those depreciating assets used only for R & D activities;
·
R & D expenditure incurred to an associate in an earlier income year and paid in the current income year;
·
a decline in value of R & D partnership assets; and
·
a monetary contribution to a Cooperative Research Centre.

125 per cent deductions are available for:

·
expenditure on R & D activities;
·
a decline in value of depreciating assets used for R & D activities;
·
a balancing adjustment for depreciating assets used for R & D activities;
·
R & D partnership expenditure; and
·
a decline in value of R & D partnership assets.

An R & D entity is entitled to a refundable tax offset if the annual turnover of the entity (and certain related entities) for that income year is less than $20 million.

It is also necessary that one or more exempt entities do not control more than 50 per cent of the entity.

Otherwise, the R & D entity is entitled to a non-refundable tax offset.

A corporation is (broadly) entitled to choose a refundable tax offset if it has an annual group turnover of less than $5 million and its group aggregate R & D expenditure is not more than $2 million per year.

An entity cannot choose that offset if one or more exempt entities own or control more than 25 per cent of the entity.

The quantum of the refundable tax offset is equal to 45 per cent of the notional R & D deductions.

The quantum of the non-refundable tax offset is equal to 40 per cent of the entity's notional R & D deductions.

Where a corporation chooses to convert a 125 per cent deduction to a tax offset, that is equivalent to a tax offset worked out as 37.5 per cent of relevant amounts.
The deductions under the R & D provisions are notional deductions. They are worked out as a step in calculating an entitlement to an R & D tax offset. A corporation can obtain actual R & D deductions. However, where a corporation chooses a tax offset instead of a deduction, it cannot actually deduct any amount under the R & D provisions for that income year.
The tax offset entitlements are not reduced for government grants or amounts recouped from government.

Instead, an entity must pay extra income tax in relation to a recoupment from an Australian government of (or a grant for) expenditure on R & D activities for which it obtains an R & D tax offset.

The extra income tax is equal to 10 per cent of the total of certain amounts spent on R & D activities (subject to a cap).

A corporation's R & D deductions for expenditure on R & D activities forming part of a project are reduced to 100 per cent where the corporation (or certain related entities) receives:

·
an Australian government grant in respect of the project expenditure on R & D activities; or
·
a recoupment of the expenditure from an Australian government.

The tax offset entitlements are not reduced for feedstock.

Instead, an amount is included in an R & D entity's assessable income if it obtains R & D tax offsets for expenditure on goods, materials or energy transformed or processed during R & D activities to produce:

·
marketable products; or
·
products applied to the R & D entity's own use.

Where goods or materials are produced or acquired in order to be the subject of processing or transformation in R & D activities, a feedstock adjustment (to 125 per cent R & D deductions) applies to reflect the extent to which the value of the outputs from the processing or transformation offsets the cost of the goods or materials.

Detailed explanation of new law

3.14 An R & D entity is entitled to a tax offset if the total of its notional R & D deductions for an income year is at least $20,000.

3.15 If the aggregated turnover of the R & D entity for that income year is less than $20 million (and one or more exempt entities do not control more than 50 per cent of the entity), the entity is entitled to a refundable tax offset equal to 45 per cent of the notional R & D deductions. Otherwise the entity is entitled to a non-refundable tax offset equal to 40 per cent of the notional R & D deductions.

3.16 The main notional deductions are for certain expenditure on registered R & D activities and the decline in value of a depreciating asset used for registered R & D activities (if certain other conditions are satisfied).

3.17 An R & D entity is also entitled to a tax offset for certain R & D expenditure incurred to a Research Service Provider, or as a monetary contribution to a Cooperative Research Centre, regardless of the level of its notional deductions. Whether that offset is a refundable 45 per cent offset or a non-refundable 40 per cent offset also depends primarily on whether the aggregated turnover of the entity is less than $20 million.

Types of entity that are eligible for R & D tax offsets

3.18 The following types of corporation, called an R & D entity in the new law, are eligible to obtain an R & D tax offset if they satisfy the following relevant conditions:

·
a corporation incorporated under an Australian law;
·
a corporation incorporated under foreign law that is an Australian resident for income tax purposes; and
·
a corporation incorporated under foreign law that:

-
is a resident of a country with which Australia has a comprehensive double tax agreement; and
-
carries on business in Australia through a permanent establishment (within the meaning of the term 'permanent establishment' in that agreement).

[Schedule 1, item 1, section 355-40]

3.19 A public trading trust that has a body corporate acting as trustee is also eligible for an R & D tax offset. Public trading trusts are broadly taxed like a company for income tax purposes. [Schedule 1, item 1, section 355-40 and Schedule 3, item 46, subsection 102T(9)]

3.20 Corporate limited partnerships are not eligible for an R & D tax offset because they can have a partner other than a corporation. [Schedule 3, item 45, section 94J of the ITAA 1936]

3.21 This Bill extends the types of entity eligible for the new R & D tax offset compared with the existing R & D Tax Concession. Eligibility under the existing R & D Tax Concession is limited to Australian corporations and public trading trusts. The primary reason for extending eligibility is so that the R & D provisions do not discriminate against foreign corporations from a country with which Australia has a comprehensive double tax agreement where that corporation is an Australian resident or has a permanent establishment in Australia. A tax information exchange agreement, an agreement signed in conjunction with a tax information exchange agreement that only allocates taxing rights over a few, limited categories of income or an airline profits agreement is not a comprehensive double tax agreement.

3.22 The Organisation for Economic Co-operation and Development Model Tax Convention on Income and on Capital (OECD Model) contains a Non-Discrimination Article. That article prevents discrimination on the grounds of nationality by providing that nationals of one country may not be treated less favourably, with respect to taxation, than nationals of the other country in the same circumstances. It also prevents more burdensome tax treatment of tax residents of one country who have a permanent establishment in the other country who are carrying on the same activities as tax residents of that other country. Since 2003, Australia has generally included Non-Discrimination Articles in its comprehensive double tax treaties with 'carve outs' for certain Australian laws (mainly anti-avoidance provisions and R & D).

3.23 From an R & D perspective, the broader eligibility in this Bill includes only corporations that have a permanent presence in Australia in that they are an Australian resident (regardless of where they are incorporated) or have a permanent establishment here through which that corporation carries on its business.

Entities ineligible for R & D tax offsets

3.24 An exempt entity, which is an entity all of whose income is exempt from income tax, is not an R & D entity. The new R & D incentive is not designed to deliver subsidies to exempt entities, which may be eligible for grants under Government grant programs. [Schedule 1, item 1, section 355-40]

3.25 For a consolidated or multiple entry consolidated group (MEC group), any purported registration by a subsidiary member is of no effect (see detailed explanation in Chapter 5). Even without this rule, in a consolidated or MEC group the head company (and not a subsidiary) would get the R & D tax offset.

Entitlement to a tax offset and amount of the tax offset

To work out the total of notional deductions

3.26 To work out whether an R & D entity is entitled to an R & D tax offset it is necessary to add up all the amounts that the entity can notionally deduct under the R & D provisions for the income year for:

·
R & D expenditure;
·
decline in value of R & D assets;
·
balancing adjustment for R & D assets;
·
R & D expenditure to an associate in an earlier income year;
·
decline in value of R & D partnership assets (where the entity is a partner in certain partnerships);
·
a balancing adjustment for R & D partnership assets; or
·
as a monetary contribution to a Cooperative Research Centre.

[Schedule 1, item 1, section 355-100]

When the total of notionally deductible amounts is at least $20,000

3.27 An R & D entity is entitled to a tax offset if the total of its notional R & D deductions is at least $20,000. If the aggregated turnover for the entity is less than $20 million, its tax offset is equal to 45 per cent of the total deductions.

R & D entity controlled by exempt entities

3.28 If one or more exempt entities control the R & D entity in a way described in section 328-125 (which is about where an entity is connected with another entity) the entity's tax offset is equal to 40 per cent of the total deductions. In working out whether one or more exempt entities control the R & D entity in a way described in section 328-125, it is necessary to apply that section as if the 'control percentage' were 50 per cent, instead of 40 percent.

3.29 The 50 per cent threshold is double the 25 per cent cap that exists under the current R & D tax offset. This will encourage collaboration between exempt entities (such as universities) and small firms while still providing some protection against the R & D tax offset being used to fund non-business R & D (that receives public support through other programs).

3.30 If the aggregated turnover for the entity is at least $20 million, its tax offset is equal to 40 per cent of the total deductions.

3.31 Whether the tax offset is a refundable tax offset depends primarily on the aggregated turnover of the entity and is explained in paragraphs 3.41 and 3.42. [Schedule 1, item 1, section 355-100]

3.32 The existing law also contains a rule requiring an aggregate R & D amount of at least $20,000. This threshold rule reflects that, in general, a small amount of R & D expenditure is less likely to result in significant innovation outcomes. Small claims also have the potential to impose disproportionate administrative costs relative to the benefit afforded to the claimant and the community.

Aggregated turnover

3.33 'Aggregated turnover' is already defined in the income tax law in the small business entity provisions (Division 328). Here, it is the sum of the annual turnovers of the R & D entity, any entity connected with the R & D entity and any entity affiliated with the R & D entity, excluding any dealings between those entities.

3.34 'Turnover' is also defined in the existing small business entity provisions. The general rule is that an entity's annual turnover for an income year is the total ordinary income that the entity derives in the income year in the ordinary course of carrying on a business. Therefore, if the R & D entity is not carrying on a business at any time during the income year, its annual turnover is nil. However, it would still be necessary to take into account the annual turnover of any entity connected with the R & D entity and any entity affiliated with the R & D entity.

Example 3.1 : Entitlement to a tax offset where notional deductions are at least $20,000 In the 2011-12 income year New Thingummies Pty Ltd, a corporation incorporated in Australia, carries on a business in Australia that includes R & D activities that it conducted wholly in Australia. Its aggregated turnover for the income year is $250,000.New Thingummies incurs expenditure on R & D activities for which it is entitled to a notional deduction of $180,000 (under section 355-205). It is also entitled to a notional deduction of $20,000 for decline in the value of depreciating assets (under section 355-305) but to no other notional deductions under Division 355.As the aggregated turnover of New Thingummies is less than $20 million, it is entitled to a tax offset equal to $90,000 (45 per cent of $200,000). Also, as its aggregated turnover is less than $20 million, the offset is a refundable tax offset (see paragraphs 3.41 and 3.42).

When the total of notionally deductible amounts is less than $20,000

3.35 If the total of the amounts that the entity can notionally deduct under the R & D provisions for the income year is less than $20,000, it can only obtain a tax offset in the limited circumstances explained below. [Schedule 1, item 1, section 355-100]

Expenditure incurred to a Research Service Provider

3.36 An R & D entity can obtain an offset, regardless of the level of its notional R & D deductions, for expenditure incurred to a Research Service Provider (that is not an associate of the entity) for the provider to provide services within a research field for which the provider is registered under the Industry Research and Development Act 1986 (IR & D Act). [Schedule 1, item 1, section 355-100]

3.37 The amount of the offset is equal to 45 per cent or 40 per cent (depending primarily on the entity's aggregated turnover) of the amount of expenditure satisfying these conditions. [Schedule 1, item 1, section 355-100]

3.38 Research Service Provider has the same meaning it has in the IR & D Act. In that Act the term means any body of persons, whether or not incorporated, registered to provide services in one or more specified research fields to registered R & D entities. [Schedule 1, item 1, section 355-100]

3.39 There is a similar exception in the current law. The continuance of the exception is intended to encourage entities that expend only small amounts on R & D activities to use Research Service Providers. [Schedule 1, item 1, section 355-100]

Example 3.2 : Entitlement to a tax offset where notional deductions are less than $20,000 In the 2011-12 income year Novel Methods Pty Ltd, a corporation incorporated in Australia, carries on a business in Australia and has an aggregated turnover for the income year of $150,000.Novel Methods is entitled to a notional deduction of $15,000 for expenditure it incurred to Ace Research Agency, a Research Service Provider (that is not an associate of the entity) for Ace Research Agency to provide a service in a specified research field for which Ace Research Agency is registered under the IR & D Act. It is not entitled to any other notional deductions under Division 355.Novel Methods is entitled to a tax offset of $6,750 (45 per cent of $15,000), even though its total notional R & D deductions are less than $20,000.

Expenditure incurred as a monetary contribution to a Cooperative Research Centre

3.40 An R & D entity can also obtain an offset, regardless of the level of its notional R & D deductions, for expenditure incurred as a monetary contribution to a Cooperative Research Centre. (These contributions are explained further in paragraphs 3.180 to 3.189.) The amount of the offset is equal to 45 per cent or 40 per cent (depending primarily on the entity's aggregated turnover but also on whether the entity is controlled by exempt entities) of the amount of expenditure satisfying these conditions. [Schedule 1, item 1, subsections 355-100(1) and (2)]

Is the offset refundable or non-refundable?

3.41 Whether the tax offset to which an R & D entity is entitled is a refundable tax offset depends on the aggregated turnover of the entity (see paragraphs 3.33 and 3.34). If the aggregated turnover for the income year is $20 million or more, the offset is a non-refundable tax offset. If the aggregated turnover is less than $20 million, the offset is a refundable tax offset, provided that the entity is not (broadly) owned or controlled by one or more exempt entities (with their affiliates). [Schedule 3, item 4, section 67-30]

3.42 The rules applying to refundable tax offsets and non-refundable tax offsets are explained in paragraphs 3.104 to 3.110.

R & D deductions are notional only

3.43 An R & D deduction to which an entity is entitled under the R & D provisions in Division 355 is a notional deduction in that it is a step in calculating an entity's tax offset entitlement. The entity cannot actually deduct the relevant amount in working out its taxable income (under section 4-15 of the ITAA 1997) because that would result in a double benefit - a deduction and a tax offset - for the same amount of expenditure or depreciation. [Schedule 1, item 1, section 355-105]

3.44 Although deductions under Division 355 are not taken into account in working out an entity's taxable income, those notional deductions are treated as deductions for many purposes of the income tax law. It is important to attract various rules in the income tax law that apply in relation to deductions because there is no similar legislative infrastructure for tax offsets. Thus, an amount that an entity can deduct under the R & D provisions is treated as an actual deduction for:

·
a provision that prevents some or all of an amount being deducted, for example:

-
Division 26 (about some amounts that an entity cannot deduct, or cannot deduct in full);
-
Division 27 (effect of input tax credits on deductions);
-
the forgiveness of commercial debt provisions (currently in Schedule 2C to the ITAA 1936 but the Tax Laws Amendment (Transfer of Provisions) Bill 2010 proposes to transfer these provisions to Division 245 of the ITAA 1997);
-
Subdivision 57-G (denial of certain deductions) in Schedule 2D (tax exempt entities that become taxable) of the ITAA 1936; and
-
the general anti-avoidance provisions in Part IVA of the ITAA 1936;

·
a provision that changes the income year in which an amount can be deducted (for example, the prepayment rules in Subdivision H of Division 3 of Part III of the ITAA 1936);
·
a provision that includes an amount in assessable income wholly or partly because an amount has been deducted (for example, the rules about recoupment of deductible amounts in Subdivision 20-A);
·
the cost base rules in the capital gains and losses provisions (commonly known as capital gains tax (CGT)) in Parts 3-1 and 3-3;
·
applying the R & D provisions to work out a tax offset entitlement; and
·
other provisions that refer to an entitlement to a tax offset under the R & D provisions (for example, the balancing adjustment provisions in sections 40-292 and 40-293).

[Schedule 1, item 1, section 355-105]

3.45 Where one of those provisions requires or permits the Commissioner of Taxation (Commissioner) to do a thing (for example, hold an opinion, form a judgment, or make a determination), the Commissioner can do that thing as if the R & D notional deduction is an actual deduction. [Schedule 1, item 1, section 355-105]

3.46 For the avoidance of doubt, where the prepayment rules (in Subdivision H of Division 3 of Part III of the ITAA 1936) apply to work out the amount of an R & D deduction for expenditure, the amount is treated as deducted under the deduction provisions for R & D expenditure (section 355-205 or 355-480), not under the prepayment rules. [Schedule 1, item 1, section 355-115]

Example 3.3 : Application of prepayment rules to R & D deductions In the 2011-12 income year Upfront Payments Pty Ltd, a corporation incorporated in Australia, carries on a business in Australia that includes R & D activities. Its aggregated turnover for the income year is $800,000, which means that it is a small business entity for the purposes of the income tax law.On 1 June 2012 Upfront Payments incurs expenditure of $150,000 for services to be provided by a contractor over three years (1,095 days). That expenditure satisfies the conditions for a notional deduction for R & D expenditure set out in section 355-205. For the purposes of Subdivision H of Division 3 of Part III of the ITAA 1936 the deduction under section 355-205 is treated as an actual deduction (section 355-110).Section 82KZM applies to the deduction under section 355-205 because:

·
Upfront Payments is a small business entity (and has not chosen not to apply section 82KZMD to the expenditure);
·
the expenditure is not 'excluded expenditure' (as defined in section 82KZL);
·
the eligible service period for the expenditure is longer than 12 months; and
·
a deduction under section 355-205 would, apart from section 82KZM, have been allowed in the year Upfront Payments incurred the expenditure.

The effect of section 82KZM is that the deduction under section 355-100 is spread over the service period. In the 2011-12 income year Upfront Payments is entitled to a deduction for the expenditure under section 355-205 of $4,110 ((30 / 1,095) x $150,000).

Example 3.4 : Application of Part IVA to R & D deductions During the 2012-13 income year Big Claims Pty Ltd incurs expenditure of $10 million on an R & D activity in a way that satisfies section 355-205 (when notional deductions for R & D expenditure arise). Big Claims lodges its income tax return for the 2012-13 income year, and thus self assesses, on the basis that it is entitled to an R & D tax offset equal to $4.5 million (45 per cent of $10 million).However, the notional deduction of $10 million was obtained by Big Claims under a scheme that Big Claims entered into for the dominant purpose of obtaining the notional deduction. The notional deduction of $10 million is a tax benefit obtained by Big Claims in connection with a scheme to which Part IVA of the ITAA 1936 applies. For the purposes of Part IVA, including the definition of 'tax benefit', a notional R & D deduction is treated as if it were an actual deduction (section 355-105).Under section 177F (cancellation of tax benefits etc), the Commissioner determines that the whole of the amount of $10 million is not a notional deduction allowable to R & D and amends the assessment of Big Claims so that it is not entitled to any tax offset for the income year.Big Claims might nevertheless be able to establish an entitlement to deduct the $10 million (or part thereof) under section 8-1, assuming none of it is capital or of a capital nature. Alternatively, the Commissioner might decide that he should make a compensating adjustment to permit a section 8-1 deduction under paragraph 177F(3)(b) of the ITAA 1936.

Conditions applying to R & D expenditure, decline in value of R & D depreciating assets and balancing adjustment for depreciating assets

Registration

3.47 To be eligible for an R & D notional deduction for expenditure on R & D activities, the R & D entity must be registered under section 27A of the IR & D Act for an income year for the activities on which it incurs the expenditure. To be eligible for an R & D notional deduction for a decline in value of a depreciating asset, the R & D entity must be registered for the income year it holds the asset for the purpose of conducting R & D activities. The registration rules are discussed in more detail in Chapter 5. [Schedule 1, item 1, sections 355-205 and 355-305]

3.48 For the balancing adjustment for depreciating assets used only for R & D activities, it is necessary that the R & D entity be registered for the income year in which the balancing adjustment event happens (see paragraphs 3.92 to 3.96). [Schedule 1, item 1, section 355-315]

Where activities must be conducted

3.49 An R & D entity is eligible for notional deductions in relation to R & D activities it conducts solely within Australia or an External Territory. [Schedule 1, item 1, paragraphs 355-210(1)(a) , 355-215(a) and (b) and 355-220(a) and (b)]

Overseas activities

3.50 An R & D entity is also eligible for notional R & D deductions for an overseas R & D activity conducted for the R & D entity while a finding by the Innovation Australia (the Board) under section 28C of the IR & D Act is in force for the R & D activity. [Schedule 1, item 1, paragraphs 355-210(d) and (e)]

3.51 A number of conditions must be satisfied before the Board issues a positive finding under section 28C in relation to an activity conducted, or to be conducted, outside Australia and its External Territories. The activities:

·
must be R & D activities covered by positive findings under section 28A;
·
must have a significant scientific link to core R & D activities conducted in Australia;
·
must not be able to be conducted in Australia;
·
must incur less expenditure than the related activities conducted in Australia.

[Schedule 2, item 1, sections 28C and 28D of the IR & D Act ]

R & D expenditure that can be eligible for a notional R & D deduction

The standard case - activities conducted by or for the R & D entity

3.52 Generally, an R & D entity is only entitled to a tax deduction in relation to R & D activities conducted for the entity (whether by the R & D entity for itself or by another entity for it). Also, an entity cannot deduct its expenditure on R & D activities if it conducts those activities to a significant extent for another entity. [Schedule 1, item 1, section 355-210]

3.53 This retains a key rule from the existing law commonly known as the 'on own behalf' rule. This rule is intended to limit eligibility for a notional R & D deduction to where an R & D entity is the major benefactor from the expenditure it incurs on the R & D activities. In certain situations, the rule also prevents duplication of claims by different R & D entities. [Schedule 1, item 1, section 355-210]

3.54 Determining the major benefactor of expenditure on R & D activities involves examining the extent to which R & D activities are carried out for the R & D entity compared to the extent to which they are carried out for any other entity. This is tested by weighing up three key criteria, namely who:

·
'effectively owns' the know-how, intellectual property or other similar results arising from the R & D entity's expenditure on the R & D activities;
·
has appropriate control over the conduct of the R & D activities; and
·
bears the financial burden of carrying out the R & D activities.

In short, the question of whether an R & D activity is conducted for an R & D entity is a question of fact, determined by whether the activity is conducted in substance to provide the majority of knowledge benefits resulting from the activity, such as access to intellectual property, to this entity.

3.55 Whether an R & D entity has effective ownership involves reviewing all the circumstances surrounding the conduct of the relevant activities and the ownership and control of, and/or ability to utilise, the intellectual property or similar results obtained from the expenditure on the R & D activities.

Example 3.5 : Operation of 'on own behalf' rule A Pty Ltd and B Pty Ltd are both R & D entities. They both enter into a contract under which B Pty Ltd is to carry out specified services that qualify as R & D activities under Subdivision 355-A. A Pty Ltd has no expertise in the particular R & D field, but has given broad direction to B Pty Ltd in the contract about the specifications it wants achieved by the work. A Pty Ltd is obliged to pay B Pty Ltd for the cost of those services, irrespective of the results obtained.A Pty Ltd is the major benefactor of the R & D expenditure it has incurred, through being the only entity which can access intellectual property arising from the R & D activities, for its own commercial purposes. B Pty Ltd does not benefit at all in relation to this intellectual property or any other knowledge benefits gained. B Pty Ltd conducts the R & D activities for A Pty Ltd, and not to any extent for itself.

Example 3.6 : Operation of 'on own behalf' rule where activities conducted jointly X Pty Ltd and Y Pty Ltd both operate in the same industry and decide to pool their resources and undertake R & D activities jointly in a field of common interest. They both contribute equally to a pool of funds to fund the R & D activities, on the understanding that they will both have the same right to use the results of those activities in their respective businesses on completion of the activities.Despite conducting R & D activities jointly, X Pty Ltd and Y Pty Ltd are not partners for income tax purposes. They do not carry on a business in common and are not in receipt of any income jointly.The interests of X Pty Ltd and Y Pty Ltd in the know-how developed from the expenditure on the R & D activities are the same and commensurate with their respective expenditures. So both entities have effective ownership of the results arising from their own expenditures. Further, the expenditure of each of X Pty Ltd and Y Pty Ltd is not a recoupment or reimbursement of the other's expenditure, so X Pty Ltd and Y Pty Ltd each bear their share of the financial burden of the R & D activities. While the R & D activities might be said in one sense, to be conducted for them both, their joint input into what activities are carried on, their sharing of the financial burden and the nature of their respective interests in the results, where neither can fetter use by the other, means that their separate expenditures are not on R & D activities conducted to a significant extent for the other.The conclusion is that X Pty Ltd and Y Pty Ltd each conducts R & D activities for itself and neither conducts R & D activities to a significant extent for another entity.

Permanent establishments

3.56 Under Australia's comprehensive double tax treaties, the business profits attributable to a permanent establishment of a foreign resident are calculated as if the permanent establishment were an entity that was separate and independent of the foreign corporation (that is, the profits of the permanent establishment are determined on the basis of arm's length dealings).

3.57 Where the R & D entity is a foreign corporation carrying on its business through a permanent establishment in Australia and incurs expenditure for the benefit of that permanent establishment, and not to a significant extent for other parts of the body corporate or another entity, the 'on own behalf' rule is satisfied. [Schedule 1, item 1, paragraph 355-210(1)(a) and subsection 355-210(2)]

R & D activities conducted for foreign corporations

3.58 The new incentive also retains an exception to the 'on own behalf' rule that currently exists for certain activities conducted by the R & D entity for one or more foreign corporations that are related to the R & D entity (called foreign-owned R & D in the existing law). Each of the foreign corporations for whom the activities are conducted must be a resident of a country with which Australia has a comprehensive double tax agreement. [Schedule 1, item 1, subsection 355-210(1) and section 355-220]

3.59 Also, the R & D activities must be conducted under a written agreement between the R & D entity and each foreign corporation for the activities to be performed by:

·
the R & D entity; or
·
another entity directly or indirectly under another agreement to which the R & D entity is a party.

[Schedule 1, item 1, section 355-220]

3.60 The written agreement(s) will identify the one appropriate eligible R & D entity that is entitled to the offset. [Schedule 1, item 1, paragraph 355-220(d)]

3.61 Finally, R & D entities conducting the activities as a subcontractor under a contract with a related R & D entity are ineligible for a tax offset. In this way, double deductions under the new concession for the same expenditure will be prevented. [Schedule 1, item 1, paragraph 355-220(e) and subsection 355-20(2)]

R & D activities conducted by a permanent establishment for other parts of the foreign corporation

3.62 The new R & D incentive has an exception to the 'on own behalf' rule for a permanent establishment of a foreign resident corporation that corresponds to the above exception for R & D activities conducted for a foreign corporation. [Schedule 1, item 1, subsection 355-210(1) and section 355-215]

3.63 It applies where the permanent establishment incurs expenditure for R & D activities conducted for the body corporate, but not for the purposes of that permanent establishment. There must also be written evidence of that. [Schedule 1, item 1, subsection 355-210(1) and section 355-215]

Expenditure that is not eligible for a notional R & D deduction

3.64 The following types of expenditure are expressly excluded from eligibility for a tax offset:

·
expenditure incurred for interest (within the meaning of interest in the withholding tax rules) payable to an entity;
·
expenditure that is not at risk; and
·
expenditure on core technology.

[Schedule 1, item 1, section 355-225]

3.65 These types of expenditure do not warrant the enhanced tax benefits available under the R & D tax offsets. They all need to be considered under the normal deduction provisions of the income tax law. [Schedule 1, item 1, section 355-225]

3.66 In the current law, these types of expenditure are eligible for 100 per cent deduction under the R & D provisions (except for core technology expenditure which has a special treatment). Allowing normal tax rules to apply to these expenditures is much simpler than bringing the expenditures into the R & D regime and applying a different rate of benefit. It also ensures that capital expenditures, that under normal tax principles should be written off over a number of years, do not receive the anomalous treatment of being immediately deductible.

3.67 Expenditure that is not at risk is discussed in paragraphs 3.164 and 3.167.

Interest

3.68 Here, interest has the same broad meaning as it has in the withholding tax rules in Division 11A of Part III of the ITAA 1936. This includes an amount in the nature of interest (for example, a discount on a security) and a dividend on a non-equity share.

Core technology expenditure

3.69 Expenditure is excluded from an R & D deduction if it is incurred in acquiring technology for the purpose of R & D activities directed towards obtaining new knowledge based on that technology or creating new or improved things (for example, materials, products, devices) based on that technology. This exclusion is aimed at expenditure incurred by an R & D entity in 'bringing in' technology that is already developed and does not extend to expenditure that the entity incurs in developing technology itself.

Cost of a depreciating asset

3.70 Expenditure included in the cost of a depreciating asset (except an intangible asset) for the purposes of working out notional decline in value of the asset under the new R & D provisions is also excluded from the R & D expenditure provision. This simply reflects the priority of the R & D depreciating asset rules over the expenditure rules. [Schedule 1, item 1, section 355-225]

Buildings

3.71 Expenditure incurred to acquire or construct a building (or part of a building or an extension, alteration or improvement to a building) is also ineligible for a notional R & D deduction. These expenditures are considered under the normal rules applying to buildings, especially Division 43. This accords with current treatment of expenditure on buildings under the definition of 'research and development expenditure' in subsection 73B(1) of the ITAA 1936. [Schedule 1, item 1, section 355-225]

3.72 There is an exception for expenditure on a building, or part of a building, that is plant. That expenditure is specifically excluded from Division 43 and so a building (or part thereof) that is plant is subject to the depreciating asset rules in Division 40. Consequently, an R & D entity may be able to obtain a notional R & D deduction for the decline in value of a building, or more commonly part of a building, that is plant. [Schedule 1, item 1, sections 355-225 and 355-305]

Entitlement to notional R & D deduction for R & D expenditure

3.73 An R & D entity is entitled to a notional R & D deduction for expenditure to the extent that:

·
the entity satisfies the conditions (about registration and where activities must be conducted) applying to both R & D expenditure and decline in value of R & D depreciating assets (explained above);
·
the expenditure is of a kind eligible for an R & D deduction (also explained above); and
·
the entity incurs expenditure during the income year (other than an amount it incurs to an associate but does not pay until a later income year) on one or more registered activities.

[Schedule 1, item 1, section 355-205]

3.74 Thus, the general rule is that expenditure on R & D activities is deductible for the income year it is incurred. There are exceptions to this rule where:

·
an amount of expenditure is incurred to an associate (which has its normal broad meaning in the income tax law); or
·
the rules about prepayments of expenditure for services to be provided over a period apply (explained further in paragraphs 4.31 to 4.33).

3.75 Also, an R & D entity's entitlement to a notional deduction does not arise until the entity is registered for the income year in which it conducts the activities on which the entity incurs the expenditure. However, the year of registration does not, of itself, affect the income year for which the R & D entity is entitled to a notional deduction. That is, once registration occurs, the entitlement is for the income year in which the expenditure is incurred, subject to the associate and prepayment rules referred to above. [Schedule 1, item 1, section 355-205]

3.76 The words 'to the extent that' in the expenditure rule permit the apportionment of undissected amounts of expenditure between R & D activities and other activities. For example, where an R & D entity incurs expenditure on salary and employer superannuation contributions for an employee who works partly on R & D activities (that satisfy the tests explained in Chapter 2) and partly on other unrelated activities. [Schedule 1, item 1, section 355-205]

Expenditure incurred to an associate

3.77 If the R & D entity incurs an amount of expenditure to an associate and pays the amount in the same year, that amount is deductible in that year (assuming other conditions are satisfied). Payment has its general legal meaning in the income tax law, which includes constructive payment. Therefore, in working out whether an R & D entity has paid an amount to another entity, and when the payment is made, the amount is taken to be paid to the other entity when the R & D entity applies or deals with the amount in any way on the other's behalf, or as the other directs. [Schedule 1, item 1, section 355-205]

3.78 However, if the R & D entity does not pay the amount incurred until a later income year, the entity has a choice. The entity can choose to deduct an amount (or, if relevant, obtain a non-R & D tax offset) under the normal income tax provisions (for example, the general deduction provision, section 8-1). The entity must make the choice by the time it lodges its income tax return for the most recent income year before the income year in which it paid the amount.

3.79 It would usually do this by claiming a deduction (or a non-R & D tax offset) in its income tax return (although it could also do so by requesting an amendment of an assessment to deduct the expenditure in the income year it was incurred). Having claimed the deduction (or obtained a tax offset) for this expenditure, the R & D entity foregoes any entitlement to a notional R & D deduction in the year of payment. This cannot be reversed, for example, by later requesting an amendment of the assessment to disallow the deduction claimed. [Schedule 1, item 1, sections 355-205 and 355-480]

3.80 If the entity does not choose to deduct the amount under the normal income tax provisions and pays the amount to the associate in an income year after it was incurred, the entity is entitled to a notional R & D deduction in the year of payment. [Schedule 1, item 1, section 355-480]

Example 3.7 : Expenditure incurred to an associate but not paid until a later income year Ingenious Plans Pty Ltd, a corporation incorporated in Australia, carries on a business in Australia that includes R & D activities. In the 2011-12 income year Ingenious Plans incurs expenditure of $20,000 to an associate for the associate to carry out R & D activities on its behalf. However, Ingenious Plans does not pay the $20,000 until the 2012-13 income year.Ingenious Plans is registered for the activities for the income year in which they were conducted. The expenditure also satisfies the various conditions in section 355-205 for the expenditure to be deductible. Nevertheless, Ingenious Plans cannot deduct the expenditure to the associate in the 2011-12 income year because the amount was not paid in that income year.In lodging its income tax return for the 2011-12 income year Ingenious Plans did not take the expenditure to the associate into account in working out the amount of a deduction under any provision outside Division 355 or any entitlement to a tax offset.Ingenious Plans is entitled to a notional R & D deduction for the expenditure of $20,000 for the 2012-13 income year.

Entitlement to notional deduction for the decline in value of R & D depreciating assets

3.81 An R & D entity is entitled to a notional R & D deduction for the decline in value of a depreciating asset if:

·
the entity satisfies the conditions (about registration and where the activities are conducted) applying to both R & D expenditure and decline in value of R & D depreciating assets (explained above);
·
the entity used the asset during the income year for conducting R & D activities; and
·
the entity would be entitled to deduct an amount under the depreciating asset provisions (Division 40) if those provisions applied with certain changes.

[Schedule 1, item 1, section 355-305]

3.82 The entity cannot deduct an amount if the asset has been pooled with other assets for working out deductions for depreciating assets. Conversely, the entity cannot allocate a depreciating asset to a low value pool or one of small business pools after the R & D depreciating asset provisions have applied to the asset. [Schedule 1, item 1, paragraph 355-305(d); Schedule 3, item 24, subsection 40-425(8); Schedule 3, item 99, subsection 328-175(9) of the ITAA 1936]

Notional application of depreciating asset provisions

3.83 Working out whether the entity would be entitled to deduct an amount under the depreciating asset provisions (Division 40) if those provisions were applied with certain changes is called the notional application of Division 40. This notional application is for the purposes of working out the notional R & D deduction for the decline in the value of a depreciating asset and any balancing adjustment for a depreciating asset used only for R & D activities (and also amounts excluded from deduction as R & D expenditure). [Schedule 1, item 1, section 355-305]

Purpose of conducting R & D activities

3.84 The main change made in working out the notional Division 40 deduction is that references to the purpose of producing assessable income or a taxable purpose are replaced with references to the purpose of conducting one or more R & D activities (except in limited specified cases). The object of this change is to work out the notional Division 40 deduction based on its use for R & D activities. The notional deduction is reduced to the extent that the asset is used for a purpose other than R & D activities. The R & D entity may be entitled to an actual Division 40 deduction for that other use (for example, the other use is in carrying on a business for the purpose of producing assessable income). [Schedule 1, item 1, section 355-310]

Buildings and capital works other than buildings

3.85 The second change is to assume that Division 40 does not apply to a building (or an extension, alteration or improvement to a building) for which the entity can deduct an amount under the capital works provisions in Division 43. Nor does it apply to a building (or an extension, alteration or improvement to a building) for which the entity could have deducted an amount under Division 43 if the entity had started work before a particular date or used the building for R & D activities. The object of the change is to replace the rule in Division 40 that excludes capital works for which you can get deduct amounts under Division 43. The result is that an R & D entity can get an R & D deduction (and therefore, a tax offset) for the decline in value of capital works that are not buildings that it uses in R & D activities. [Schedule 1, item 1, section 355-310]

Uses to ignore

3.86 In working out the notional deduction for decline in value of a depreciating asset, it is necessary to ignore uses of the asset that would not satisfy the various conditions. In particular, it would be necessary to ignore uses for R & D activities that:

·
were not registered for the income year in which they were conducted;
·
did not meet conditions about where activities must be conducted; or
·
did not satisfy the 'on own behalf' test.

[Schedule 1, item 1, sections 355-305 and 355-310]

Effective life

3.87 In working out the effective life of a depreciating asset it is necessary to estimate the period that the asset can be used by an entity for one or more of these:

·
a taxable purpose;
·
the purpose of producing exempt income or non-assessable non-exempt income; or
·
the purpose of conducting R & D activities, assuming that this is reasonably likely.

[Schedule 3, items 18 to 20, subsections 40-95(9) , 40-100(4) and 40-105(1) to (3)]

3.88 This applies both for a taxpayer self assessing effective life and for the Commissioner making a written determination of effective life. [Schedule 3, items 18 to 20, subsections 40-95(9) , 40-100(4) and 40-105(1) to (3)]

3.89 Where it is reasonably likely that an asset will be used for the purpose of conducting R & D activities, it is also necessary, in having regard to the period within which the asset is likely to be scrapped or abandoned, to disregard reasons attributable to technical risk in conducting R & D activities. [Schedule 3, items 18 to 20, subsections 40-95(9) , 40-100(4) and 40-105(1) to (3)]

3.90 There are similar rules about effective life, so far as they relate to R & D activities, in the existing R & D provisions (section 73BG of the ITAA 1936). Those rules apply for working out both notional and actual deductions. In the new law, those provisions are located in Division 40. Locating the rules about effective life in one place should assist readers. As the rules apply for working out actual Division 40 deductions as well as notional deductions for the R & D provisions, there is no strong reason to locate the rules in the R & D provisions.

No change in decline in value method

3.91 A taxpayer generally has a choice of two methods - the prime cost method and the diminishing value method - in working out the decline in value of a depreciating asset and cannot change methods. If an R & D entity has previously worked out actual deductions under Division 40 for an asset, it must use the same method in working notional deductions under Division 40, and vice versa. [Schedule 3, item 17, subsections 40-65(6) and (7)]

Balancing adjustment for depreciating assets used only for R & D activities

3.92 Where an R & D entity has used a depreciating asset only for R & D activities; it is or has been entitled to R & D decline in value deductions; and a balancing adjustment event happens (for example, the entity sells or scraps the asset), a balancing adjustment is worked out. This is necessary so that a taxpayer's income tax position over time reflects the actual decline in value of the assets, rather than the estimates on which depreciation deductions have been based. The balancing adjustment results in a further ('catch-up') notional R & D deduction or an uplifted amount being included in assessable income (to claw back excessive deductions). [Schedule 1, item 1, section 355-315]

3.93 For this balancing adjustment to apply, it is also necessary that the R & D entity be registered for the income year in which the balancing adjustment event happens. Where an entity has ceased R & D activities in a previous income year and scraps an asset in the current income year, it is not appropriate for the entity to obtain the enhanced benefits of the R & D provisions for the decline in value that may have occurred (in whole or part) after R & D activities ceased. Nor will an uplifted amount be included in assessable income. [Schedule 1, item 1, section 355-315]

3.94 If the R & D entity would have been entitled to a balancing deduction under the standard balancing adjustment provision of section 40-285 (assuming the changes discussed in paragraphs 3.83 to 3.91), the entity is entitled to an R & D deduction of an equivalent amount. That R & D deduction is included in the calculation of the entity's tax offset. [Schedule 1, item 1, section 355-315]

3.95 Conversely, if an amount would have been included in assessable income of the R & D entity under the standard balancing adjustment provision of section 40-285 (assuming the changes discussed in paragraphs 3.83 to 3.91), the sum of that amount (the section 40-285 amount) plus an additional amount is included in the entity's assessable income. The additional amount is included to reflect that the R & D entity has obtained enhanced benefits in the form of an offset at 40 or 45 per cent on the decline in value. [Schedule 1, item 1, section 355-315]

3.96 The additional amount is equal to one third of so much of the section 40-285 amount as does not exceed the total decline in value. The factor of one third is based on an offset rate of 40 per cent (rather than the higher 45 per cent rate that generally applies to R & D entities with an aggregated turnover of less than $20 million). [Schedule 1, item 1, section 355-315]

Example 3.8 : Balancing adjustment for depreciating assets used only for R & D activities B Pty Ltd was incorporated in Australia and carries on a business in Australia that includes R & D activities that it conducts wholly in Australia. Its aggregated turnover for each income year is under $20 million. B Pty Ltd has a standard income year ending on 30 June.On 1 July 2011, B Pty Ltd purchases a mass spectrometer for use in carrying on its R & D activities. The unit costs $30,000. B Pty Ltd assesses the effective life of the unit as five years and chooses the prime cost method for calculating its decline in value.During the 2011-12 and 2012-13 income years, B Pty Ltd uses the unit only in carrying on its R & D activities. It sells the unit on 31 December 2012 for $15,000.As B Pty Ltd only ever used the unit for undertaking R & D activities, it will work out a balancing adjustment under section 355-315. It is entitled to a notional deduction equal to the amount calculated under subsection 40-285(2), which is equal to the termination value less the adjustable value. The termination value is $15,000. The adjustable value is equal to the opening adjustable value less the decline in value during the 2012-13 income year. The opening adjustable value is $24,000. The decline in value is $3,000. Accordingly, the adjustable value is $21,000.B Pty Ltd is entitled to a notional deduction of $6,000 ($21,000 ? $15,000) under subsection 355-315(2). Assuming B Pty Ltd has total notional R & D deductions over $20,000 for 2012-13, B Pty Ltd is entitled to an offset of $2,700 (45 per cent of $6,000) in respect of the sale of the unit.

Balancing adjustment for assets used partly for R & D activities

3.97 A balancing adjustment must also be worked out where an R & D entity has used a depreciating asset partly for R & D activities and partly for another purpose that is a taxable purpose (for example, the purpose of producing assessable income) under the capital allowance provisions.

3.98 The existing balancing charge provision that covers this case, section 40-292, is replaced by a similar provision that reflects the new R & D provisions.

3.99 In working out reductions in the balancing adjustment amount for non-taxable use, use for the purpose of conducting R & D activities is assumed to be use for a taxable purpose. [Schedule 3, item 24, section 40-292]

3.100 If the R & D entity is entitled to a balancing deduction under the standard balancing adjustment provision of section 40-285, the amount of the balancing deduction is increased. The amount is increased by half if the R & D entity's aggregated turnover is less than $20 million and one third in other cases. The factors by which the deduction amount is increased are equivalent to the 45 per cent and 40 per cent rates at which the R & D tax offsets are calculated. [Schedule 3, item 24, section 40-292]

3.101 If an amount is included in the R & D entity's assessable income under section 40-285, the amount assessable is increased by one third of an amount worked out under a formula. The factor of one third is concessional for those R & D entities with an aggregated turnover of at least $20 million but is used for simplicity reasons. [Schedule 3, item 24, section 40-292]

3.102 The formula adjusts the amount worked out under section 40-285 so that it does not exceed the asset's total decline in value. It then applies a factor so that the amount being clawed back reflects that proportion of the decline in value of the asset represented by total notional R & D deductions. [Schedule 3, item 24, section 40-292]

Example 3.9 : Balancing adjustment for assets used partly for R & D activities C Pty Ltd was incorporated in Australia and carries on a business in Australia that includes R & D activities that it conducts wholly in Australia. Its aggregated turnover for each income year is under $20 million.On 1 July 2011, C Pty Ltd purchases a mass spectrometer for use in its business. The unit costs $30,000. C Pty Ltd assesses the effective life of the unit as five years and chooses the prime cost method for calculating its decline in value. C Pty Ltd uses the unit 50 per cent of the time for carrying on ordinary business activities and 50 per cent of the time for carrying on R & D activities.During the 2012-13 income year, C Pty Ltd sells the unit on 31 December 2012 for $15,000. C Pty Ltd is entitled to a deduction under subsection 40-285(2) which is equal to the termination value less the adjustable value. The termination value is $15,000. The adjustable value is equal to the opening adjustable value less the decline in value during the 2012-13 income year. The opening adjustable value is $24,000. The decline in value is $3,000. Accordingly, the adjustable value is $21,000. C Pty Ltd is entitled to a deduction of $6,000 ($21,000 ? $15,000) under section 40-285.C Pty Ltd is also entitled to an additional deduction because of section 40-292. As a result of the use of the asset in R & D activities for 50 per cent of the time it has been held by Company A, Company A has been entitled to notional deductions of $4,500 (1/2 x ($6,000 + $3,000)) under section 355-305. Subsection 40-292(2) requires the company to calculate an amount under subsection 40-292(5) as follows:

[Sum of R & D deductions x adjusted section 40-285 amount] / Total decline in value
[$4,500 x $6,000 = $3,000] / $9,000

Subsection 40-292(3) provides that a company is entitled to increase its section 40-285 deduction by the amount worked out by multiplying the amount worked out under subsection 40-292(5) by one half (because it has an aggregated turnover of less than $20 million).C Pty Ltd is entitled, under subsection 40-292(3), to increase its section 40-285 deduction by 1/2 x $3,000 = $1,500. Its total section 40-285 deduction is $7,500 ($6,000 + $1,500).

Relationship between R & D depreciating asset rules and R & D expenditure rules

3.103 The R & D depreciating asset rules have priority over the R & D expenditure rules where an R & D entity incurs an amount of expenditure that is included in the cost of a depreciating asset for working out notional deduction for decline in value under Subdivision 355-D. The object is that the notional deduction for the expenditure and, therefore, the R & D tax offsets, should be spread over the effective life of the assets. [Schedule 1, item 1, sections 355-225 and 355-305]

Application of the tax offset rules

Refundable tax offsets

3.104 If the offset is a refundable tax offset the normal income tax rules for refundable tax offsets apply. These include the priority rules about how a taxpayer's tax offsets must be applied against their basic income tax liability (subsection 63-10(1)). A refundable tax offset is applied after all other tax offsets, except the tax offset that arises from the payment of franking deficit tax. If there is an excess the taxpayer is entitled to a refund, subject to the rules in Divisions 3 (Treatment of payments, credits and RBA surpluses) and 3A (Refunds of RBA surpluses and credits) of Part IIB of the Taxation Administration Act 1953 , which cover how the Commissioner must apply credits, including refunds. Under those rules the Commissioner may allocate the credit to a running balance account or apply a credit against a particular tax debt (for example, a goods and services tax debt).

3.105 The new refundable tax offset provision is included in Division 67, which covers refundable tax offsets. [Schedule 3, items 2 to 4, sections 67-23 and 67-30]

3.106 This Bill has been prepared on the basis that, to the extent the refundable tax offset provides for the payment of refunds of unused tax offset amounts, the offset is supported by the Commonwealth's executive power. Nevertheless, specific savings rules have been included to safeguard the refundable tax offset provisions if, in a constitutional challenge, the High Court were to find that the executive power did not support the payment of refunds in the circumstances described.

3.107 The savings rules rely primarily on the Commonwealth's corporations power in paragraph 51(xx) of the Constitution because it is corporations (including a corporate trustee of a public trading trust) that are entitled to a refundable tax offset. This is done by providing that the application of the refundable tax offset rules to an R & D tax offset also has effect as if references to an R & D entity were to a constitutional corporation. Constitutional corporation is already defined in the income tax law to mean a corporation to which the corporations power applies or a body corporate incorporated in a Territory. [Schedule 3, item 4, subsection 67-30(2)]

3.108 The savings rules also rely on the Territories and external affairs powers in respect of:

·
an R & D entity incorporated in a Territory;
·
an R & D entity with a registered office or principal place of business in a Territory;
·
R & D activities conducted solely in a Territory;
·
R & D activities conducted solely outside Australia; or
·
activities conducted solely for the dominant purpose of supporting core R & D activities conducted (or to be conducted) solely in a Territory.

[Schedule 3, item 4, subsections 67-30(2) and (3)]

3.109 Similar constitutional savings provisions are included in the IR & D Act to safeguard Part III (functions relating to the R & D tax offset) of that Act against constitutional challenge. [Schedule 2, item 1, section 32C of the IR & D Act]

Non-refundable tax offsets

3.110 If the offset is not a refundable tax offset, it is applied before refundable tax offsets but after all other tax offsets (such as a foreign income tax offset). An R & D entity may carry forward a non-refundable tax offset to a later year, provided that it satisfies the standard rules about the carry-forward of tax losses (Division 65). [Schedule 3, item 1, subsection 63-10(1)]

An R & D entity obtains a grant or other recoupment from an Australian government

3.111 Subdivision 355-G adjusts the overall benefit an R & D entity receives where activities eligible for the R & D tax incentive also benefit from a government grant or other recoupment.

3.112 Where the recoupment essentially reimburses the entity for a specific expenditure on an R & D activity, the entity could, in the absence of a clawback adjustment, also enjoy the R & D tax incentive on that expenditure, resulting in a double benefit.

3.113 The other case of interest is where an R & D entity spends its own money on R & D activities along with a matching (often equivalent) amount that is funded by a recoupment in the form of a grant. Without a clawback adjustment, the R & D entity could enjoy both a tax incentive and a matching grant in relation to the spending of its own money, along with a tax incentive in relation to the spending that was funded by the grant, resulting in a 'triple benefit' accruing to the R & D entity's self-funded outlay.

3.114 In both cases, the clawback adjustment reduces the benefit from the recoupment to reflect the extent to which it has been duplicated by the R & D tax incentive. In this context, only the 'incentive component' of an R & D tax offset is taken to provide a benefit. The incentive component is the extent to which the tax offset rate is greater than the company tax rate.

3.115 For simplicity, this clawback adjustment is effected by imposing 'extra income tax' on the recoupment (rather than actually adjusting the grant or offset). As a further simplicity measure, the incentive component of an R & D tax offset is taken to be 10 percentage points; that is, the R & D entity is taken to have received the tax offset at the standard rate of 40 per cent, rather than a possible 45 per cent.

3.116 Accordingly, clawback takes the form of extra income tax on the recoupment, at the rate of 10 per cent, on an amount equal to the amount related to the recoupment on which an offset is received.

Example 3.10 : Matching grant spent wholly on R & D activities Oulixeus Ltd receives a $1 million grant in relation to eligible R & D activities that it conducts. The grant requires Oulixeus to spend a total of $2 million (including the grant money) on specified R & D activities, which it does during the income year the grant was received. Oulixeus has a turnover greater than $20 million.Oulixeus receives an R & D tax offset of $800,000 on its $2 million of project spending (40 per cent of $2 million). However, to claim the offset, Oulixeus forwent a $2 million tax deduction that would have provided a tax benefit worth $600,000 (30 per cent of $2 million). The incentive component of the tax offset is therefore $200,000 (10 per cent of $2 million).Oulixeus's $1 million outlay has given rise to a government grant of $1 million and a $200,000 R & D tax incentive. The grant is therefore worth more to Oulixeus than the R & D tax incentive. [3] The tax incentive is clawed back by a 10 per cent tax on an amount equivalent to the project expenditure for which an R & D tax offset was claimed. The extra income tax on the grant is $200,000 (10 per cent of $2 million), which is equivalent to the incentive component of the tax offset. The project as a whole is left with an effective government subsidy equivalent to the value of the grant.

When clawback applies

3.117 A clawback adjustment arises where an R & D entity receives, or becomes entitled to receive, a recoupment (including a grant) from an Australian government agency or State/Territory body that relates to R & D activities. Recoupments received under the Cooperative Research Centre program are exempt from clawback adjustment. (Subdivision 355-K addresses how the R & D tax incentive applies to Cooperative Research Centres.) [Schedule 1, item 1, sections 355-435 and 355-440]

3.118 The first way a recoupment can be considered to relate to R & D activities is where the recoupment explicitly relates to expenditure that has been incurred on or in relation to certain activities. This form of recoupment will be retrospective, typically a reimbursement. A 'partial reimbursement' will be treated as a recoupment of expenditure equal to the amount of the recoupment. [Schedule 1, item 1, subparagraph 355-445(b)(i)]

Example 3.11 : Reimbursement of R & D activities Burgundy Bagasse Ltd conducts R & D activities in relation to a new machine that pulls out grape vines and then shreds, crushes and bales them. The activities for which the firm receives the R & D tax incentive include trials on a vineyard that it has been using to produce table wine. The firm also receives a $500,000 reimbursement under a government vine-pull scheme for specified costs that it incurred in removing those vines, of which $400,000 were for expenditures notionally deducted under the R & D tax incentive.Clawback of $40,000 (10 per cent of $400,000) will apply in relation to the R & D expenditures that are reimbursed under the vine-pull scheme.

3.119 The other way a recoupment can be considered to relate to R & D activities is where a condition of the recoupment is that a specified amount (the mandated 'project expenditure') is spent on (possibly a menu of) specified activities, and some of the specified activities on which the mandated project expenditure is ultimately spent are eligible R & D activities. This form of recoupment is often referred to as a grant (see Example 3.10). [Schedule 1, item 1, subparagraph 355-445(b)(ii)]

3.120 Grants are often made on a matching dollar-for-dollar basis, whereby the mandated project expenditure is double the amount of the grant. However, a recoupment can be treated as being of this grant type whether the mandated project expenditure is equal to, greater than, or less than the grant. Further, grants can be made in an income year before, at the same time as or after the actual project expenditure on R & D activities occurs.

3.121 Whether a retrospective recoupment is of the reimbursement or grant type will depend on the relationship between the recoupment and the past expenditure. Where a recoupment is given because a specified amount has been spent on a specified activity, it will be a reimbursement, including where the entitlement to a reimbursement if the amount was spent was known in advance. Where a recoupment is given on the condition that a specified amount is spent on one or more specified activities, it will be a grant - including where that condition had been partly or completely satisfied prior to the R & D entity becoming entitled to the grant. [Schedule 1, item 1, paragraph 355-445(b)]

3.122 To the extent that grant conditions allow, it is up to the grant recipient to decide how to apply the mandated project expenditure. This means that the recipient is free to apply the mandated project expenditure against non-R & D activities first. Where the recipient chooses to spend more on their 'project' than the grant mandates, they are free to apply their 'extra' expenditure to R & D activities first.

3.123 Whether either type of recoupment actually relates to R & D activities will depend on whether the expenditure reimbursed or required to be incurred is expenditure that results in an R & D tax offset. That is, a tax offset arising from notional deductions made under the R & D tax incentive arrangements for either the expenditure itself or the decline in value of a depreciating asset. This means that clawback cannot arise where the R & D entity does not receive the R & D tax incentive for expenditure (or decline in value) related to the recoupment. [Schedule 1, item 1, paragraphs 355-450(1)(a) and (b)]

How to apply clawback

3.124 Clawback takes the form of extra income tax on the recoupment, by reference to the expenditure that resulted in an R & D tax offset (or by reference to the decline in value where the expenditure was for a depreciating asset). The rate of extra income tax is specified as 10 per cent in the Income Tax Rates Act 1986 (see below). [Schedule 1, item 1, subsection 355-450(1)]

3.125 The extra income tax on a recoupment is payable for the year in which the recoupment is received (the trigger year), regardless of whether the related R & D tax offsets are received in the same, earlier or later income years. This may result in retrospective amendment of past income tax assessments. [Schedule 1, item 1, paragraph 355-445(a) and subsection 355-450(1)]

3.126 Logically, clawback cannot exceed the incentive component of R & D tax offsets received in relation to the recoupment, because the rate of extra income tax is 10 per cent and the incentive is at least 10 per cent of the same amounts. Similarly, clawback on a reimbursement cannot logically exceed 10 per cent of the reimbursement, because the reimbursement will always equal the expenditure being reimbursed.

3.127 A cap applies to ensure that clawback cannot exceed the amount of a grant that, on a pro-rata basis, is deemed to relate to R & D activities on which the mandated project expenditure is ultimately spent. This ensures that, in relation to R & D activities, a grant recipient effectively receives the R & D tax incentive, rather than the grant, where the R & D tax incentive is worth more than the grant. [Schedule 1, item 1, subsection 355-450(3)]

3.128 Where a grant is to some extent repaid, this will reduce the cap, potentially reducing the extra income tax in relation to the year the grant was received. Grant amounts might be repaid due to a breach of the grant conditions, or because the grant becomes repayable in certain eventualities (such as successful commercialisation of R & D). [Schedule 1, item 1, subsection 355-450(3)]

Example 3.12 : Grant clawback cap and repayment Ulixestyle Pty Ltd applies to a competitive grants scheme that provides 'top up' funding, and receives $1 million toward its proposal to spend $10 million on final stage R & D activities during 2010-11. The grant is repayable at 10 cents for every dollar on any sales over $5 million the project generates within three years. Ulixestyle has a turnover of $26 million from other products. Subsequently, Ulixestyle attracts a further $2 million of equity.In 2010-11 Ulixestyle spends $12 million on otherwise deductible R & D activities for its project, including the mandated $10 million. In relation to the mandated project expenditure, Ulixestyle receives a $4 million R & D tax offset of which $1 million is the incentive component. Ulixestyle pays extra income tax of $1 million (10 per cent of $10 million).After clawback, Ulixestyle is effectively left with a benefit equal to the grant. The net amount of the recoupment at the end of 2010-11 is $1 million and the ratio of R & D expenditure to mandated project expenditure is one. The cap on clawback is therefore $1 million ($1 million x 10/10) and the maximum level of clawback has been reached for this project.Ulixestyle also received a further $800,000 R & D tax offset in relation to the extra $2 million of non-mandated project expenditure (40 per cent of $2 million) of which the incentive component was $200,000 (10 per cent of $2 million) - but this is not relevant for the clawback calculation or the cap.In 2011-12 Ulixestyle achieves sales of $6 million arising from the project and so repays $100,000 of the grant. The net amount of the recoupment is now $900,000. The mandated project expenditure and the amounts notionally deducted in relation to R & D expenditure are unchanged, so the cap is now $900,000 (($1 million - $100,000) x 10/10). Ulixestyle's 'extra income tax' payable on the recoupment for 2010-11 (the trigger year) is reduced to the new cap, resulting in a potential tax refund of $100,000 in relation to 2010-11 (depending on outstanding tax liabilities).Had the grant conditions required Ulixestyle to spend $12 million, and that amount been spent on otherwise deductible R & D activities, Uliexestyle would have received a $4.8 million R & D tax offset in 2010-11, of which $1.2 million would have been the incentive component. The R & D tax incentive related to the grant would therefore be worth more to Ulixestyle than the $1 million grant. In that scenario, the clawback cap would have limited the extra income tax to $1 million ($1 million x 12/12) at the end of 2010-11, rather than a potential $1.2 million (10 per cent of $12 million). After clawback, Ulixestyle would effectively have been left with a benefit equal to the R & D tax incentive.Alternatively, had Ulixestyle instead received a $4 million equity injection and so spent $2 million of the $12 million mandated project expenditure on early stage commercialisation activities (also allowed under the grant conditions), the cap at the end of 2010-11 would have been $833,333 ($1 million x 10/12). This reduction in the cap has the effect of pro-rating the grant amount across the mandated project expenditure and reducing the grant amount considered to relate to R & D tax incentive amounts.

3.129 Where a reimbursement is to some extent repaid, the recoupment will be taken to be of an expenditure that is smaller than the expenditure that was originally recouped. The expenditure considered to have been recouped is reduced by the amount of the repayment. This would have the effect of reducing the extra income tax for the year in which the recoupment was originally received. [Schedule 1, item 1, subsection 355-450(2)]

Example 3.13 : Reimbursement repaid Further to Example 3.11, Burgundy Bagasse Ltd is audited on its compliance with the vine-pull scheme requirements. Its claim for fuel costs is disallowed because the ethylene content was not sourced from grapevines. Burgundy Bagasse has to repay $50,000.Clawback in relation to the reimbursement would be $35,000 (10 per cent of ($400,000 - $50,000)), rather than $40,000. This would be the outcome whether the repayment was made in the same year as the R & D tax offset is received, or a later year.

Recoupment obtained by related entity

3.130 The clawback rule's main operation is where the entity that receives, or becomes entitled to receive, the recoupment is the R & D entity that obtains the R & D tax offset. However, the rule also applies where an entity receives, or becomes entitled to receive, a recoupment of expenditure taken into account in working out tax offsets obtained by certain related entities. [Schedule 1, item 1, subsections 355-450(1) and (4)]

Relationship with core income tax rules

3.131 The extra income tax increases the basic income tax liability on the entity's taxable income beyond the amount that is worked out by simply applying the income tax rates to the entity's taxable income. After that basic income tax liability is worked out, in accordance with the normal rules, total tax offsets are subtracted from the basic income tax liability. The requirement to pay extra income tax operates in the same way as the requirement for primary producers to pay extra income tax as an averaging adjustment under Subdivision 392-C. [Schedule 1, item 54, section 4-25]

Amendments to the Income Tax Rates Act 1986

3.132 The supporting Bill, the Income Tax Rates Amendment (Research and Development) Bill 2010 amends the Income Tax Rates Act 1986 to provide that the rate of additional income tax payable under Subdivision 355-G of the ITAA 1997 on all or part of a recoupment is 10 per cent. [Schedule 1 to the supporting Bill, the Income Tax Rates Amendment (Research and Development) Bill 2010, items 1 to 3, subsection 12(7) , sections 12B and 31 of the Income Tax Rates Act 1986]

Feedstock adjustment

3.133 Subdivision 355-H adjusts the R & D tax incentive that is effectively afforded in relation to certain inputs, to reflect the value of related outputs. The feedstock adjustment does not affect whether an activity is an R & D activity eligible for the R & D tax incentive.

3.134 The feedstock adjustment applies in relation to goods or materials (feedstock inputs) that are transformed or processed during R & D activities that produce one or more tangible products (feedstock outputs). [Schedule 1, item 1, paragraph 355-465(1)(a)]

3.135 The feedstock adjustment also applies in relation to any energy that is input directly into the transformation or processing. [Schedule 1, item 1, subparagraph 355-465(1)(b)(ii)]

3.136 Expenditure on the energy and expenditure (along with decline in value of depreciating assets) on acquiring or producing the feedstock inputs is claimed in the same way as other amounts in relation to eligible R & D activities. The resulting R & D tax offsets will stand, despite any feedstock adjustment in the same or a different income year. A feedstock adjustment cannot arise in relation to amounts for which no R & D tax offset is obtained. Here, 'obtains ... tax offsets' means tax offsets that are actually assessed, either in a self assessment or an assessment made by the Commissioner, rather than merely being entitled to a tax offset under the law. [Schedule 1, item 1, paragraph 355-465(1)(b)]

3.137 The feedstock adjustment is triggered by selling (or otherwise supplying to another entity) the feedstock output or a downstream product. The adjustment can also be triggered when the entity applies the feedstock output (or downstream product) to its own use. However, a feedstock adjustment will not be triggered if the use is for the purpose of transforming that product for supply. [Schedule 1, item 1, paragraph 355-465(1)(c)]

Feedstock revenue

3.138 The feedstock adjustment involves a comparison of the amounts claimed for feedstock inputs and energy with the 'feedstock revenue' associated with related feedstock outputs. Where the feedstock output is immediately sold, the figure used for 'feedstock revenue' will be the market value at that point.

3.139 Where amounts are absorbed into the feedstock output's cost between the R & D activity that produced it and the point of sale, the related 'snapshots' of the product's cost will be used to derive the feedstock revenue figure from the market value of the 'marketable product' that is sold. Such additional cost amounts could arise from transforming the feedstock output in some way, or simply reflect holding costs. 'Marketable product' is a term used in the feedstock provisions to mean the product when the firm sells it or applies it to its own use (regardless of how 'marketable' it might appear at that or an earlier stage).

3.140 The proportion of the market value at sale that is deemed to be feedstock revenue will be the same as the proportion of the cost of the marketable product that was included in the product's cost at the feedstock output stage. A feedstock output that is immediately sold without absorbing further costs will also be a marketable product (in which case feedstock revenue will equal market value). Feedstock revenue will be similarly derived where the feedstock adjustment is triggered by a supply other than a sale, or by the firm applying the feedstock output to its own use. [Schedule 1, item 1, section 355-470]

The feedstock adjustment

3.141 The feedstock adjustment is done by including an amount in assessable income for the income year in which the adjustment is triggered. This accommodates the 'feedstock expenditure' on feedstock inputs and energy being notionally deducted in the year it is incurred and, where the marketable product does not arise in that year, the feedstock adjustment being made in a later year (without having to amend prior year tax assessments or make problematic year-end valuations of outputs that might not be of marketable form).

3.142 The feedstock adjustment is intended to 'claw back' the incentive component of the R & D tax offset that is enjoyed on the recouped feedstock expenditure. The incentive component is the excess of the tax offset over the company tax rate - that is, the excess over the tax benefit that would otherwise have been obtained from normal tax deductions without the incentive.

3.143 The intended net outcome is that the R & D incentive is effectively enjoyed on feedstock expenditure to the extent that it is not offset by feedstock revenue. This is achieved by basing the adjustment on the lesser of feedstock expenditure and feedstock revenue.

·
Where feedstock revenue exceeds the feedstock output's related feedstock expenditure, the feedstock adjustment will be based on the feedstock expenditure - because the effective net cost of the feedstock inputs and energy was nil.
·
Where feedstock revenue is less than the feedstock output's related feedstock expenditure, the feedstock adjustment will be based on the feedstock revenue - because the effective net cost of the feedstock inputs and energy was reduced by that amount.

3.144 For simplicity, the feedstock adjustment only seeks to recover 10 percentage points of the R & D tax incentive enjoyed on the feedstock expenditure claim. This means that a firm receiving the 45 per cent refundable tax offset (rather than the standard 40 per cent non-refundable tax offset) on the feedstock expenditure will effectively retain at least 5 percentage points of incentive on all feedstock expenditure.

3.145 Also for simplicity, the feedstock adjustment is included in the firm's assessable income. This means that the impact of the adjustment will be deferred where a firm is in tax loss, including where a refundable tax offset is or was received on the feedstock expenditure.

3.146 Accordingly, the feedstock adjustment works by including in assessable income an amount equal to one-third of the lesser of feedstock expenditure and feedstock revenue. When multiplied by the prevailing 30 per cent company tax rate, this will result in a 'negative tax benefit' equivalent to the 10 per cent tax benefit from the incentive component of a 40 per cent tax offset in relation to the feedstock expenditure (( x 30 per cent = 10 per cent). [Schedule 1, item 1, subsection 355-465(2)]

3.147 Feedstock output can only lead to one feedstock adjustment. For example where a feedstock adjustment is triggered by an R & D entity applying a feedstock output to its own use - but not for the purpose of transforming it for supply - and it is later sold (with or without transformation), the sale will not trigger a further feedstock adjustment. Similarly, where the entity applies a feedstock output to its own use on a recurring basis, only the first use can trigger the feedstock adjustment. [Schedule 1, item 1, paragraph 355-465(3)(b)]

3.148 The feedstock provision applies in relation to both core and supporting R & D activities that transform or process material inputs, and is not confined to mass production activities.

Example 3.14 : Feedstock output a marketable product Lisowski Crushing Pty Ltd acquires granite boulders from an adjacent quarry and crushes them into small stones for sale to landscapers. Lisowski identifies a significant potential market for 'mock dirt' that will not blow away. Lisowski engages consultants to research and design a diorite stamping head that will crush the granite to fine grains, and has a set of the heads fabricated and fitted to a stamping machine that has been suitably modified. It conducts experiments on 10 tonnes of granite to test the effectiveness of the diorite heads. The resulting granulised granite is sold shortly after to the trade at a special introductory price.Feedstock expenditure of $10,000 is included in the $22,000 of notional deductions claimed by Lisowski for the R & D activities. Lisowski Crushing has a turnover of $100,000 per annum and receives a non-refundable tax offset of $8,800 (40 per cent x $22,000). The potential for the granite granules to be sold in either that or a subsequent income year has no bearing on the size of this tax offset.The 10 tonnes of granite granules are sold for $900 per tonne. As this is an arm's length price the feedstock revenue is $9,000. Because the feedstock revenue of $9,000 is less than the feedstock expenditure of $10,000, the feedstock adjustment is based on the $9,000 feedstock revenue figure. In addition to the $9,000 received from the sale, a feedstock adjustment of $3,000 ($9,000 ? 3) is included in Lisowski Crushing's assessable income. This feedstock adjustment is made for the income year in which the granite granules are sold, which might be the same year as the R & D activities that produce them, or a later year.The sale occurs in the same income year as the R & D activities. Allowing for the $10,000 tax deduction forgone in order to receive a 40 per cent tax offset on the feedstock expenditure, the incentive component of the tax offset was $1,000 ((40 per cent - 30 per cent) x 10,000), which reduces Lisowski Crushing's income tax liability by that amount. Including the feedstock adjustment in taxable income increases Lisowski Crushing's income tax liability by $900 (30 per cent x $3,000). The net 'tax benefit' of $100 (1,000 - 900) is equivalent to only allowing the 10 per cent incentive on the $1,000 (10,000 - 9,000) 'net' feedstock expenditure.

Example 3.15 : Feedstock output subject to additional costs As a variation on the preceding example, Lisowski Crushing Pty Ltd is a medium sized business in tax loss with a $19 million turnover. Also, instead of selling the granulised granite to the trade for $9,000, Lisowski eventually sells it to a new interstate resort for $20,000 delivered, with the sale taking place early in the income year following the year in which the R & D activities occurred. At the end of the R & D activities that produced it, the granulised granite had a cost of $12,000, which had increased to $15,000 by the time it was delivered and sold.Because Lisowski has a turnover below $20 million it qualifies for a 45 per cent refundable R & D tax offset. The $22,000 of notional deductions results in a refundable tax offset of $9,900 (45 per cent x $22,000). After being applied against $1,900 of unrelated outstanding tax liabilities that Lisowski Crushing had, a tax refund of $8,000 cash was received.The $12,000 cost of the granules when at the feedstock output stage is eight-tenths of the $15,000 cost of the granules when sold (12,000 ? 15,000 = 0.8). Therefore the feedstock revenue for the feedstock output is deemed to be $16,000 (0.8 x $20,000). As the feedstock revenue of $16,000 is more than the feedstock expenditure of $10,000, the feedstock adjustment is based on the $10,000 feedstock expenditure figure. In addition to the $20,000 received from the sale, a feedstock adjustment of $3,333 ($10,000 ? 3) is included in Lisowski Crushing's assessable income.Because Lisowski Crushing is in tax loss, the feedstock adjustment has the effect of reducing the firm's carryforward losses by $3,333, but has no immediate impact. Lisowski retains the full $9,900 refundable tax offset (and resulting $8,000 cash refund) that it had received in the previous year, of which $4,500 (45 per cent of $10,000) arose from the feedstock expenditure. When Lisowski Crushing later becomes profitable, the feedstock adjustment causes Lisowski's tax liability to be $1,000 more than it otherwise would have been ($3,333 x 30 per cent). This $1,000 is equivalent to a 10 per cent incentive component that the standard 40 per cent R & D tax offset would have afforded the $10,000 feedstock expenditure. In fact, Lisowski had enjoyed a $1,500 incentive component under the 45 per cent refundable R & D tax offset.

Multiple feedstock inputs and outputs

3.149 A single feedstock output can result from the transformation or processing of a number of feedstock inputs, and one feedstock input can be transformed or processed into multiple feedstock outputs.

3.150 Where there are multiple feedstock outputs from an R & D activity, the feedstock adjustment applies on an output by output basis. The relevant feedstock expenditure for a specific feedstock output would be the amount of feedstock expenditure that is reasonably attributable to that feedstock output. This need not entail feedstock expenditure being evenly attributed across disparate joint outputs [Schedule 1, item 1, paragraph 355-465(2)(b)] :

·
Treating each feedstock output separately has the effect that, where R & D activities 'turn a profit' with respect to one feedstock output, the surplus of that output's feedstock revenue over related feedstock expenditure will not carry across to net off amounts relating to other feedstock outputs (if any).
·
In practical terms, where an R & D activity produces a number of substantially identical feedstock outputs (such as ingots of gold produced by a processing experiment), those outputs can be treated as if a single feedstock output. [4]
·
On the other hand, where multiple outputs of similar items are of variable quality, the claimant is able to treat faulty production units separately from successful production units.

Sequential R & D activities

3.151 Where feedstock output from one R & D activity is feedstock input for a subsequent R & D activity, no feedstock adjustment will apply in relation to that feedstock output - the feedstock adjustment will apply in relation to the feedstock output from the final R & D activity in the chain. [Schedule 1, item 1, paragraph 355-465(3)(a)]

3.152 Where by-products arise as feedstock outputs prior to the final R & D activity in a chain of activities, feedstock adjustments can apply in relation to those by-products:

·
The relevant feedstock expenditure would be the amount of feedstock expenditure that (if any) is reasonably attributed to the by-product.
·
A feedstock adjustment would not occur if the by-product is itself a feedstock input to a subsequent experiment.

Feedstock revenue accruing to a related entity

3.153 The feedstock adjustment also applies where an entity related to the R & D entity supplies (or applies to own use) the marketable product, as if that were done by the R & D entity. This would, for example, cover cases where a related entity (instead of the R & D entity that incurs expenditure in acquiring the feedstock inputs) is entitled to the marketable product. [Schedule 1, item 1, section 355-475]

Integrity rules

3.154 Integrity rules apply to the following:

·
expenditure incurred while not at arm's length [Schedule 1, item 1, section 355-400];
·
disposal of R & D results [Schedule 1, item 1, section 355-410];
·
expenditure reduced to reflect group mark-ups [Schedule 1, item 1, section 355-415]; and
·
expenditure not at risk [Schedule 1, item 1, section 355-405].

3.155 These rules correspond to similar integrity rules in the existing R & D provisions.

Expenditure incurred while not at arm's length

3.156 If the expenditure incurred in a non-arm's length transaction or in a transaction with an associate is greater than the market value of the R & D activities, the expenditure is instead taken to have the market value. [Schedule 1, item 1, section 355-400]

Relationship with international transfer pricing provisions

3.157 Section 136AB of the ITAA 1936 is amended to clarify the relationship between the proposed non-arm's length transaction section (section 355-400) and the international transfer pricing provisions in Division 13 of Part III of the ITAA 1936. If section 355-400 and Division 13 could otherwise apply, the potential operation of section 355-400 is to be disregarded. This leaves Division 13 to apply comprehensively in the international area, subject to the terms of any relevant double tax treaty. [Schedule 3, item 44, subsection 136AB(2) of the ITAA 1936]

3.158 The result is that the relationship of section 355-100 with Division 13 is the same as that of section 70-20, the non-arm's length rule for trading stock.

Disposal of R & D results

3.159 The assessable income of an R & D entity includes an amount if:

·
it is entitled to a notional deduction for expenditure on R & D activities or for using a depreciating asset for R & D activities; and
·
it receives, or becomes entitled to receive, an amount:

-
for the results of any of the activities;
-
from the grant of access to, or the right to use, any of those results;
-
attributable to the entity having incurred the expenditure or having used the asset for R & D activities (including an amount that it is entitled to receive irrespective of the results of the activities); or
-
from disposing of a CGT asset, or from granting a right to occupy or use a CGT asset, where the disposal or grant resulted in another entity acquiring a right to access or use any of those results.

[Schedule 1, item 1, section 355-410]

3.160 The amount assessable is generally the amount received or receivable. However, where the amount is from disposing of a CGT asset that is a depreciating asset, or from granting a right to occupy or use such an asset, the assessable income amount is the amount received or receivable less the cost of the asset (just before the disposal or grant). Where the amount is from disposing of a CGT asset that is not a depreciating asset, the amount assessable is the amount received or receivable less the cost base of the asset (just before the disposal or grant). [Schedule 1, item 1, section 355-410]

Reducing deductions to reflect mark-ups within groups

3.161 If one or more entities connected with the R & D entity incur R & D expenditure for which the R & D entity can notionally deduct an amount and that expenditure was incurred when those entities were connected or affiliated with the R & D entity, then the amount that the R & D entity can notionally deduct may be reduced. [Schedule 1, item 1, section 355-415]

3.162 The amount notionally deducted by the R & D entity is reduced to the extent that R & D expenditure paid to the connected entity or affiliate exceeds the actual cost of the R & D goods or services to the connected entity or affiliate (that is, the goods or services are 'marked-up'). [Schedule 1, item 1, section 355-415]

3.163 Expenditure that is not notionally deductible because of the operation of this 'mark up' rule may be deductible under the ordinary deduction provisions of the law.

Expenditure not at risk

3.164 Expenditure that is not at risk (for example, if there is guaranteed return under a financing arrangement or an indemnity) is not eligible for a notional R & D deduction but the ordinary deduction rules may apply. [Schedule 1, item 1, section 355-405]

3.165 Expenditure is not at risk to the extent that, when the expenditure is incurred, the R & D entity (or an associate) could reasonably be expected to receive an amount of consideration:

·
as a result of the expenditure being incurred or because of anything that happened before then; and
·
irrespective of the results of the activities on which the entity incurs the expenditure.

[Schedule 1, item 1, section 355-405]

3.166 The inclusion of the requirement that the entity reasonably expects to receive the amount of consideration irrespective of the results of the activities on which the entity incurs the expenditure is consistent with the way the Commissioner has administered the existing law about expenditure not at risk. For example, the Commissioner would not apply the existing law where the expectation of receiving consideration under a contract for the development and sale of a product was based both on the terms and conditions of that contract and also the entity's experience and technical capability concerning the degree of confidence about successfully performing that contract. Where this product development involved R & D activities it cannot be said that the expectation of receiving consideration under this contract exists irrespective of the results of these activities. [Schedule 1, item 1, section 355-405]

3.167 As under the existing law, the rule about expenditure not at risk does not apply to R & D activities conducted by the R & D entity for one or more foreign corporations that are related to the R & D entity. Nor does it apply to the corresponding permanent establishment case - where activities are conducted by a foreign corporation though a permanent establishment in Australia for other parts of the corporation. [Schedule 1, item 1, subsection 355-405(4)]

R & D partnerships

3.168 The proposed rules contain a group of rules (Subdivision 355-H) that set out in detail how the tax offset rules apply to certain partnerships called R & D partnerships.

3.169 An R & D partnership is a partnership in which each of partners is an R & D entity. Here, partnership has its normal defined meaning, which includes a general law partnership and an association of persons in receipt of ordinary or statutory income jointly. [Schedule 1, item 1, subsection 355-505(1)]

3.170 Similarly to the existing law, the partnership provisions have the effect that the R & D tax offset is available to an R & D entity that is a partner in an R & D partnership. Rather than being taken into account in determining a partner's individual interest in the net income or partnership loss of a partnership (under Division 5 of Part III of the ITAA 1936), the benefits are directly available to the individual partners that are R & D entities. [Schedule 1, item 1, sections 355-100 and 355-545]

3.171 A central concept in applying the R & D partnership provisions is the partner's proportion of various amounts (for example, expenditure, turnover or recoupment) attributable to the R & D partnership that each partner is treated as entitled to, or bearing. The proportion is the partner's interest in the net income or partnership loss of the R & D partnership, unless the partners have agreed that the partners should bear or be entitled to a different proportion. [Schedule 1, item 1, subsection 355-505(2)]

R & D partnership expenditure

3.172 An R & D entity that is a partner in an R & D partnership is treated as incurring that entity's partner's proportion of the expenditure incurred by the partnership. This deeming rule enables the R & D entity to get a notional deduction for that proportion of the partnership's R & D expenditure if the other conditions for the notional deduction (about registration, where the activities are conducted, the 'on own behalf' rule (and its alternatives in section 355-210) and excluded expenditure) are satisfied. [Schedule 1, item 1, section 355-510]

3.173 An important condition that must still be met by the individual partner is registration - the registration rules in the IR & D Act do not provide for a partnership to register.

Activities conducted by the partnership treated as conducted by each partner

3.174 To facilitate the R & D tax offset being available to each R & D entity that is partner in an R & D partnership, there is also a set of deeming rules that treat:

·
a thing done by, or in relation to, a R & D partnership as done by, or in relation to, the partner;
·
R & D activities conducted by or for the R & D partnership as if they were conducted by or for the partner (but not the partnership) in a corresponding way;
·
relationships that the R & D partnership has with other entities in relation to the R & D activities as if the partner had corresponding relationships with those other entities; and
·
such other changes as having been made to the R & D provisions as are appropriate having regard to that partner's proportion of amounts attributable to the R & D partnership.

[Schedule 1, item 1, section 355-515]

A partner's aggregated turnover

3.175 Under the existing aggregated turnover rules (in Division 328 of the ITAA 1997), if an R & D entity is a partner in an R & D partnership the entity's aggregated turnover can include the whole of the annual turnover of the partnership (for example, if the partner controls the partnership in the way described in section 328-125). If an R & D entity's aggregated turnover does not so include the whole of the annual turnover of a partnership, for the new R & D provisions it includes the partner's proportion of the R & D partnership's annual turnover. [Schedule 1, item 1, section 355-530]

Example 3.16 : R & D partnership A Pty Ltd is in a general law partnership with B Pty Ltd and C Pty Ltd. A Pty Ltd, B Pty Ltd and C Pty Ltd were all incorporated in Australia. As part of the partnership's business, the partnership incurs expenditure of $150,000 during the 2012-13 income year on R & D activities. The partnership conducts those R & D activities in Australia for the partnership (and not for one or more other entities). Each of A Pty Ltd, B Pty Ltd and C Pty Ltd registers for those R & D activities for the 2012-13 income year.The annual turnover of the partnership for that income year is $6 million and, apart from the partnership, the aggregated turnover of A Pty Ltd would be nil.The partnership of A Pty Ltd, B Pty Ltd and C Pty Ltd is an R & D partnership because each is an R & D entity (being a body corporate incorporated under an Australian law). The aggregated turnover of A Pty Ltd for the 2012-13 income year is $2 million (1/3 of $6 million).A Pty Ltd is treated as incurring expenditure of $50,000 (1/3 of $150,000) during the 2012-13 income year on the R & D activities for which A Pty Ltd is actually registered (section 355-505). The R & D activities are also treated as conducted by or for A Pty Ltd in Australia (section 355-515). Therefore, A Pty Ltd is entitled to a notional deduction of $50,000 for the 2012-13 income year (assuming that no other provision applied to limit or exclude the notional deduction).As the aggregated turnover of A Pty Ltd is less than $20 million, it is entitled to a tax offset equal to $22,500 (45 per cent of $50,000), assuming A Pty Ltd is not entitled to any other notional R & D deductions.

Other partnership rules

3.176 The partnership rules also contain special rules about:

·
notional deductions for a decline in the value of depreciating assets of R & D partnerships [Schedule 1, item 1, section 355-520];
·
balancing adjustments for R & D partnership assets only used for R & D activities [Schedule 1, item 1, section 355-525];
·
balancing adjustments for R & D partnership assets used both for general tax purposes and R & D activities [Schedule 3, item 24, section 40-293];
·
disposal of R & D results for R & D partnerships [Schedule 1, item 1, section 355-535]; and
·
recoupment of expenditure incurred by an R & D partnership [Schedule 1, item 1, section 355-540].

3.177 Where an association of persons is in receipt of income jointly but is not a general law partnership (commonly called a tax law partnership), the Australian Taxation Office (ATO) interprets the decline in value provisions in Division 40 as applying to the individual persons, not the tax law partnership.

Associations of persons that are neither general law partnerships nor tax law partnerships

3.178 Under the existing law, in determining whether a relationship between persons for the purpose of engaging in R & D activities is a partnership, the engaging by those persons in R & D activities is treated as carrying on a business with a view to profit (subsection 73(3B) of the ITAA 1936). This deeming rule is stated as applying 'for the purposes of this Act' (for example, the rule applies for the purposes of Division 5 (Partnerships) of Part III of the ITAA 1936).

3.179 It is not clear that the rule in subsection 73(3B) does anything useful. The R & D expenditure is effectively attributed to the individual partners anyway (under subsection 73(3A)). Subsection 73(3B) effectively requires persons to lodge a partnership return (for non-R & D deductions) even though they are neither general law partners nor in receipt of income jointly. Accordingly, the new law does not contain a provision equivalent to subsection 73B(3B).

Cooperative Research Centres

3.180 The Cooperative Research Centre program is a program administered by the Commonwealth that links researchers with industry to focus R & D efforts on addressing major challenges and progressing towards utilisation and commercialisation. A Cooperative Research Centre is an incorporated or unincorporated organisation, formed through medium to long-term collaborative partnerships between publicly funded researchers and end users. Cooperative Research Centres must comprise at least one Australian end-user (either from the private, public or community sector) and at least one Australian higher education institution (or research institute affiliated with a university).

3.181 Taxpayers and the ATO have encountered difficulties in applying the existing partnership rules to Cooperative Research Centres because of the complexity of the existing law. In particular, difficult issues have arisen in relation to determining the true nature of the structure adopted and on whose behalf the activities are carried out within that structure, as well as in ascertaining the timing of any available R & D deductions. These issues are compounded because Cooperative Research Centres are not all required to adopt the same structure, so each one needs to be considered on its own facts.

3.182 This Bill contains a new simpler treatment for entities participating in a Cooperative Research Centre. The key change is that notional deductions arise when monetary contributions are made under the program rather than when those contributions are actually expended on the R & D activities of the centre.

3.183 An R & D entity is entitled to a notional R & D deduction for a monetary contribution it incurs under the program if the entity is registered for the activities on which the contribution is spent. The notional deduction does not arise until the entity is actually registered, which in some cases could be for an income year after the R & D entity incurs the contribution. However, the notional deduction for the monetary contribution still applies to the income year in which the contribution was incurred. [Schedule 1, item 1, subsection 355-580(1)]

3.184 An R & D entity's entitlement to a tax offset in relation to a notional deduction for an amount contributed to a Cooperative Research Centre is (like certain R & D expenditure incurred to a Research Service Provider) regardless of the level of its total notional deductions. [Schedule 1, item 1, subsection 355-100(2)]

3.185 The Commonwealth's contributions to a Cooperative Research Centre do not qualify for an 'up front' notional R & D deduction for a monetary contribution. Although a contribution by the Commonwealth would not ordinarily be considered to be expenditure incurred by an R & D entity under the Cooperative Research Centre program, a specific rule is included to rule out any possible technical argument to the contrary. A company operating a Cooperative Research Centre under the incorporated model would be eligible for a notional deduction for a monetary contribution out of its own funds but not for the contribution of Commonwealth funds. [Schedule 1, item 1, subsection 355-580(2)]

3.186 It is intended that program conditions be used to limit Cooperative Research Centres to spending contributions by R & D entities on R & D activities eligible for a tax offset.

3.187 To prevent double benefits in respect of the same amounts, an R & D entity cannot obtain a notional R & D deduction for:

·
a monetary contribution, other than under the specific rule about monetary contribution to a Cooperative Research Centre;
·
expenditure incurred under the Cooperative Research Centre program out of monetary contributions of an R & D entity; or
·
decline in value of an R & D depreciating asset whose cost includes expenditure incurred under the Cooperative Research Centre program out of monetary contribution that is notionally deductible.

[Schedule 1, item 1, subsections 355-580(3) and (4)]

3.188 Where an entity makes a non-monetary contribution (for example, a depreciating asset or the work of an employee) to a Cooperative Research Centre, the normal R & D provisions would apply. In practice, it is tax-exempt entities that commonly make non-monetary contributions and those entities are not eligible for an R & D tax offset.

Example 3.17 : Incorporated Cooperative Research Centre Company A is a participant in an incorporated Cooperative Research Centre. In the 2012-13 income year Company A incurs a liability of $100,000 under the participant agreement to Company O, which operates the Cooperative Research Centre. Company O spends the $100,000 on R & D activities during the income year. The Board registers Company A for those R & D activities two months after the end of the 2012-13 income year.When Company A lodges its income tax return five months after the end of the 2012-13 income year, it is entitled to a notional deduction of $100,000 for its monetary contribution. It incurred the monetary contribution during the 2012-13 income year and is registered for the R & D activities on which the contributions were spent.

3.189 Expenditure under the Cooperative Research Centre program out of Commonwealth funding (including as part of the cost of a depreciating asset) is not eligible for the R & D tax offset. The reasons are:

·
the availability of a second benefit (in the form of the tax offset) for spending Commonwealth funds is not justified in principle (the Commonwealth is giving generous assistance in the form of the Cooperative Research Centre grant and the 'up front' tax offset to the participants); and
·
if an offset were available, the simplification benefits of providing access to the R & D tax offset at the contribution stage would not be realised because it would be necessary to trace all the actual expenditures by the Cooperative Research Centre to each eligible R & D activity - this would add significantly to the compliance burden.

[Schedule 1, item 1, subsections 355-580(3) and (4)]

Consolidated groups

3.190 Under Part 3-90 of the ITAA 1997 subsidiary members of a consolidated group or MEC group are treated as part of the head company of the group for income tax purposes.

3.191 Therefore, as is the case under the existing law, Division 355 will apply to a consolidated group or MEC group as if it were a single entity. This means that, for example:

·
expenditure incurred by the subsidiary on R & D activities is taken to be incurred by the head company;
·
R & D activities conducted for the subsidiary by a third party are taken to have been conducted for the head company; and
·
R & D activities conducted by one member of the group for another member of the same group are taken to have been conducted by the head company on its own behalf.

3.192 If an entity joins a consolidated group or MEC group part way through an income year, the joining entity must work out the amount of income tax payable on its taxable income for the period before the joining time as if it were an income year (section 701-30). The joining entity will be entitled to R & D tax offsets that relate to R & D activities undertaken before the joining time provided that it is a registered R & D entity for the income year.

3.193 The head company of the group will be entitled to R & D tax offsets that relate to R & D activities undertaken after the joining time provided that it is a registered R & D entity for the income year.

3.194 The head company of the group must be a registered R & D entity for the income year as the joining entity's status as a registered R & D entity is not imputed to the head company. In this regard, any purported registration by a subsidiary member of a consolidated group or MEC group is of no effect (subsection 31(1) of the IR & D Act). Similarly, any finding under Part III of the IR & D Act (about registrations etc.) on application by an entity is of no effect to the extent that the finding is for an activity conducted when the entity was a subsidiary member of a consolidated group or MEC group (subsection 31(2) of the IR & D Act). For a detailed explanation, see Chapter 5.

3.195 The existing R & D law contains rules to ensure they operate effectively for consolidated groups and MEC groups (sections 73BAA to 73BAG of the ITAA 1936). Insofar as they remain relevant, these provisions are replicated in the new law.

3.196 The new law replicates the existing provisions that clarify the history that is taken into account for the purposes of working out the aggregated turnover of:

·
the head company after a subsidiary member has joined its consolidated group or MEC group; and
·
an entity after it ceases to be a member of the group.

[Schedule 3, item 105, sections 716-505 and 716-510]

3.197 Section 355-220, which is about R & D activities conducted for a foreign entity, applies if, so far as is relevant, the R & D activities are conducted under a written agreement which is binding on the R & D entity and each foreign corporation. A new provision is being inserted to clarify that the section applies to the head company of a consolidated group or MEC group as if the head company were bound by an agreement during any period that a subsidiary member of the group is bound by the agreement. [Schedule 3, item 105, section 716-500]

Imputation

3.198 Generally, a franking debit arises in an entity's franking account when, so far as is relevant, the entity receives a refund of income tax (item 2 in the table in section 205-30 of the ITAA 1997). A refund of income tax includes the amount of any tax offset which the entity is entitled to under Division 355, to the extent that the tax offset is refunded to the entity. [Schedule 3, items 94 and 95, section 205-35]

3.199 If a company's franking account is in deficit at the end of an income year, the entity is liable to pay franking deficit tax (section 205-45). A company's franking account could be in deficit at the end of an income year because a franking debit arises when the entity receives a refund of a tax offset which the entity is entitled to under Division 355. This would have the effect of immediately clawing back the tax offset that is refunded.

3.200 To prevent this outcome, a franking debit will not arise in an entity's franking account under item 2 in the table in section 205-30 to the extent that a refund of income tax is attributable to the refund of a tax offset which the entity is entitled to under Division 355. The franking debit is effectively deferred. [Schedule 3, item 93, subsection 205-30(2)]

3.201 Generally, a franking credit arises in an entity's franking account when, so far as is relevant, the entity pays a pay as you go (PAYG) instalment or income tax (items 1 and 2 in the table in section 205-15). However, where a debit has not been made to an entity's franking account because a refund of income tax is attributable to the refund of a tax offset which the entity is entitled to under Division 355, a franking credit will not arise in respect of the payment of a PAYG instalment or income tax until these deferred franking debits are recovered. [Schedule 3, items 91 and 92, subsections 205-15(1) and (4)]

Example 3.18 Radical Innovations Pty Ltd is an R & D entity.In year 1, Radical Innovations Pty Ltd incurs $100,000 R & D expenditure, has no taxable income and is entitled to a refundable tax offset under Division 355 of $45,000. Consequently, the company receives a refund of income tax of $45,000. Paragraph 205-30(2)(b) ensures that a debit does not arise in its franking account under item 2 in the table in subsection 205-30(1) as a result of the refund.In year 2, Radical Innovations Pty Ltd does not incur any R & D expenditure and its taxable income is $100,000. The company pays income tax of $30,000, which gives rise to a credit in its franking account of $30,000 less any amount worked out under the method statement in subsection 205-15(4). The steps in that method statement are worked out as follows:

Step 1:
Identify any income years before the payment of tax was made for which the company received a refund of income tax - year 1.
Step 2:
Add up the part of the refund that is attributable to a tax offset that is subject to the refundable tax offset rules - $45,000.
Step 3:
Subtract any reduction under subsection 205-15(4) of a franking credit for any earlier payment by the entity - nil.

The result after applying the method statement for year 2 is $45,000. Therefore, the franking credit of $30,000 is reduced, but not below zero. Consequently, no franking credit arises in Radical Innovations Pty Ltd's franking account in year 2.In year 3, Radical Innovations Pty Ltd does not incur any R & D expenditure and its taxable income is $120,000. The company pays income tax of $36,000, which gives rise to a credit in the company's franking account of $36,000 less any amount worked out under the method statement in subsection 205-15(4). The steps in that method statement are worked out as follows:

Step 1:
Identify any income year before the payment of tax was made for which the company received a refund of income tax - year 1.
Step 2:
Add up the part of the refund that is attributable to a tax offset that is subject to the refundable tax offset rules - $45,000.
Step 3:
Subtract any reduction under subsection 205-15(4) of a franking credit for any earlier payment by the entity - $30,000.

The result after applying the method statement for year 3 is $15,000. Therefore, the franking credit of $36,000 is reduced by $15,000. As the deferred franking debits are now fully recovered, a franking credit of $21,000 arises in Radical Innovations Pty Ltd's franking account in year 3.

Other matters

Assessments and objections

3.202 The primary meaning of assessment is the ascertainment of the amount of taxable income (or that there is no taxable income) and the tax payable thereon (or that there is no tax payable) (subsection 6(1) of the ITAA 1936).

3.203 Under the core provisions of the income tax law, section 4-10 governs how to work out how much income tax you must pay for an income year. In subsection 4-10(3), step 3 is working out your tax offsets for the income year. Working out the amount of tax offsets, including any refundable tax offsets, is a step in working out your income liability and, therefore, part of the assessment process.

3.204 That means that, under the existing law, the amount of a refundable tax offset is covered by a notice of assessment. If a taxpayer is dissatisfied with the amount of a tax offset under an assessment for the taxpayer, the taxpayer may object against the assessment under section 175A of the ITAA 1936. However, subsection 175A(2) prevents a taxpayer objecting against a 'nil assessment' unless the taxpayer is seeking an increase in its liability.

3.205 This Bill amends the law so that an R & D entity can object against a nil assessment in relation to the amount of an R & D refundable tax offset. This is in addition to the existing objection rights. [Schedule 1, item 1, section 355-699]

Findings of the Board which are binding on the Commissioner

3.206 The Commissioner is bound by the following findings of the Board where the finding is set out in a certificate given by the Board to the Commissioner and the finding is made within four years after the end of the income year (or the last of the relevant income years):

·
a finding under section 27J of the IR & D Act about an R & D entity's registration;
·
a finding under section 27B of the IR & D Act about an R & D entity's application for registration;
·
an advance finding under section 28A of the IR & D Act about the nature of activities; or
·
a finding under section 28E of the IR & D Act about whether particular technology is core technology.

[Schedule 1, item 1, section 355-705]

3.207 For a finding about an R & D entity's registration, the Commissioner is bound for the purposes of an assessment of the entity for the income year(s) for which the finding is made. For a finding about activities yet to be completed, the Commissioner is bound for the purposes of an assessment of the entity for the income year in which the entity applied for the advance finding and the next two income years. For a finding about an activity completed in the income year an R & D entity applies for the finding, the Commissioner is bound for the purpose of an assessment of the application year. [Schedule 1, item 1, section 355-705]

Amendment of assessments

3.208 Currently the Commissioner has an unlimited period to amend an assessment to increase the liability of a taxpayer to give effect to existing R & D provisions in the ITAA 1936. The unlimited period is repealed, which is consistent with the principles in the Treasury discussion paper titled Review of Unlimited Amendment Periods in the Income Tax Laws . [Schedule 3, item 48, subsection 170(10A)]

3.209 In the new law, the Commissioner generally has a period of four years to amend an assessment to give effect to the R & D provisions. To achieve this for all types of an R & D entity, it will be necessary to amend the Income Tax Regulations 1936 after the new R & D provisions are enacted.

3.210 The Board effectively has a time limit of four years from the end of the relevant income year to make a finding about registration under Division 2 of Part III of the IR & D Act. [Schedule 1, item 1, sections 355-705 and 355-710]

3.211 There are also special contingent amendment periods, allowing the Commissioner to amend an assessment outside the normal periods set out in section 170 of the ITAA 1936, where:

·
The Board gives the Commissioner a certificate setting out a finding about registration, activities outside Australia or core technology (and that finding was made within four years after the end of the income year or the last of the relevant income years); or
·
a decision about an R & D entity is made on internal review (under section 30D of the IR & D Act), or by the Administrative Appeal Tribunal (including under subsections 34D(2), 42C(2) or 43(1) or section 42D of the Administrative Appeal Tribunal Act 1975), or a court.

3.212 Where a certificate setting out a finding is given to the Commissioner, the Commissioner has a period of two further years to amend an assessment if giving effect to the certificate increases the R & D entity's liability. However, the Commissioner may amend an assessment at any time to give effect to the finding by reducing the R & D entity's liability. [Schedule 1, item 1, section 355-710]

3.213 Where a decision is made on review, by the Administrative Appeal Tribunal or by a court, the Commissioner may amend the R & D entity's assessment at any time to give effect to the decision. This is consistent with the general approach for decisions on review or appeal (in item 6 of the table in subsection 170(1) of the ITAA 1936). [Schedule 1, item 1, section 355-710]

Relationship of R & D provisions to other income tax provisions

3.214 The R & D provisions in Division 355 have priority over other offset and deduction provisions, except where specifically indicated. So, where an entity's expenditure (or use of a depreciating asset) satisfies the conditions for a notional R & D deduction and also another deduction (or tax offset), the entity is entitled to the R & D deduction but not the other deduction or tax offset. This is consistent with the general scheme of the income tax law (for example, under the 'no double deduction rule' in section 8-10) that taxpayers are not entitled to a double benefit for the same amount of a loss, outgoing or other detriment. [Schedule 1, item 1, section 355-715]


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