House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Josh Frydenberg MP)

Chapter 5 - Enhancing the integrity of the R & D Tax Incentive

Outline of chapter

5.1 Schedule 5 to the Bill enhances the integrity of the R & D Tax Incentive by ensuring that R & D entities cannot obtain inappropriate tax benefits and by clawing back the benefit of the R & D Tax Incentive to the extent an entity has received another benefit in connection with an R & D activity.

Context of amendments

Recoupments

5.2 Where an R & D entity benefits from a government recoupment (such as a grant or reimbursement) in relation to expenditure that is also eligible for the R & D tax offset, a clawback applies to reverse the double benefit that arises (Subdivision 355-G). In this context, only the 'incentive component' of an R & D tax offset is intended to be clawed back.

5.3 The clawback takes the form of an additional tax on the recoupment (and any other expenditure required as a condition of the recoupment) at a rate of 10 per cent (sections 12B and 31 of the Income Tax Rates Act 1986). The 10 per cent rate was initially selected as a simplicity measure by making the assumption that the R & D entity obtained the initial lower offset rate of 40 per cent (now 38.5 per cent) rather than the higher rate of 45 per cent (now 43.5 per cent). The 10 per cent tax rate also assumes a fixed 30 per cent corporate tax rate for all R & D entities.

Example 5.1 Recoupments

Cross Innovations is committed to spending $2 million to undertake R & D activities, regardless of whether it is successful in obtaining a grant.

During the 2020-21 income year Cross Innovations receives a $1 million grant to undertake R & D activities. In addition to the grant, Cross Innovations must spend an additional $1 million of its own money as a condition of the grant. Cross Innovations receives an offset of $870,000 (applying the 43.5 per cent offset rate to the $2 million expenditure). Cross Innovations would have otherwise been entitled to a deduction worth $520,000 at the 26 per cent corporate tax rate. Therefore, the incentive component of the offset is the difference of $350,000.

In the same income year, the recoupment rules clawback only 10 per cent of the total $2 million spent under the terms of the grant, which is $200,000. Cross Innovations keeps the remaining $150,000 of the offset incentive. However, the grant alone is intended to constitute sufficient incentive without the additional $150,000 from the R & D tax incentive.

5.4 The recoupment rules also apply where an R & D entity receives a recoupment for expenditure incurred by another entity to which it is connected or affiliated (subsection 355-450(4)). In these situations, the R & D entity receiving the recoupment is subject to the clawback tax even though the other entity obtained the financial benefit of the R & D tax offset.

Feedstock adjustments

5.5 Feedstock adjustments apply to recoup the benefit of the R & D Tax Incentive to the extent it relates to goods, material or energy used to produce marketable products sold or applied to the R & D entity's own use (Subdivision 355-H).

5.6 The intended net outcome is that the R & D Tax 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.

5.7 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.

5.8 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.

5.9 The adjustment is implemented by including one third of the lesser of feedstock expenditure or feedstock revenue in the R & D entity's assessable income (subsection 355-465(2)). As with the recoupments in Subdivision 355-G, the one third formula is intended to recoup 10 percentage points of the R & D Tax Incentive (based on a standard 30 per cent corporate tax rate).

5.10 In contrast to the recoupment provisions, feedstock adjustments are incorporated into the income tax equation in section 4-10 and do not create a new tax.

Example 5.2 Feedstock adjustments

In the 2020-21 income year, Wayland Enterprises, a large R & D entity, spends $100,000 on the development of a new product, producing one tangible product, which it then sells for $110,000. Wayland Enterprises is entitled to a $38,500 offset (with an incentive component of $8,500).

$33,333 is included in Wayland Enterprises' assessable income (one third of the feedstock expenditure). After applying the corporate tax rate to the amount included in assessable income, the feedstock adjustment would claw back 10 per cent: $10,000, which is more than the incentive component.

However, if Wayland Enterprises was a small R & D entity in the same position, it would claim an offset of $43,500 (with an incentive component of $17,500).

The $33,333 would be included in assessable income and taxed at the 26 per cent corporate tax rate. The feedstock adjustment would claw back just 8 ⅔ per centage points of the offset: $8,666.58.

5.11 The feedstock rules also apply where an R & D entity receives feedstock revenue in relation to an R & D tax offset obtained by another entity to which it is connected or affiliated (section 355-75). However, in these situations, the R & D entity originally entitled to the R & D tax offset is subject to the feedstock adjustment rather than the entity receiving the feedstock revenue. This represents a further inconsistency between the tax treatment of feedstock revenue and recoupments.

Balancing adjustments

5.12 Balancing adjustment events occur when an entity stops holding a depreciating asset, for example when the entity sells the asset (section 40-295). Balancing adjustment events require an entity to compare the economic value of the asset (its termination value (section 40-300)) with its written-down tax value (its adjusted value (section 40-85)).

5.13 If an asset's termination value exceeds its adjusted value, the difference (the balancing adjustment amount) is included in the entity's assessable income in the income year in which the balancing adjustment event occurs. If an asset's adjusted value exceeds its termination value, the entity is allowed a deduction for the difference. As such, the balancing adjustment ensures an entity's overall tax position reflects the true decline in value of the asset (section 40-285).

5.14 R & D entities can obtain an R & D tax offset for the decline in value of depreciating assets held for R & D purposes (an R & D asset) (section 355-305). This necessitates additional consequences arising from a balancing adjustment for the R & D asset:

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for an R & D asset held only for R & D purposes where the balancing adjustment amount is included in the R & D entity's assessable income - the amount is generally increased by one third (subsection 355-315(3));

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for an R & D asset held only for R & D purposes where the balancing adjustment amount is allowed as a deduction - the deduction is included in the R & D entity's R & D tax offset calculation (subsection 355-315(2));

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for an R & D asset held partially for R & D purposes where the balancing adjustment amount is included in the R & D entity's assessable income - the part of the amount attributable to the asset's R & D use (the R & D component) is generally increased by one third (subsection 40-292(4)); and

•

for an R & D asset held partially for R & D purposes where the balancing adjustment amount is allowed as a deduction - the R & D component of the amount is generally increased by one third or (for small R & D entities) or one half (subsection 40-292(3)).

5.15 Similar rules apply to R & D assets held by R & D partnerships (sections 40-293 and 355-525).

5.16 Transitional rules apply in a similar way to R & D assets acquired prior to the introduction of the R & D Tax Incentive in 2011. These transitional rules further increase certain balancing adjustment amounts to reflect old 1.25 rate deductions available for R & D assets under the pre-2011 law (subsections 40-292(3), 40-293(3), 355-20(4) and 255-25(4) of the Income Tax (Transitional Provisions) Act 1997 (the ITTP Act)). These transitional rules do not apply to deductible balancing adjustment amounts in respect of R & D assets used only for R & D purposes.

5.17 As with the feedstock and recoupment adjustment rules, these R & D balancing adjustment rules rely on rough approximations of the incentive component of an R & D entity's R & D tax offsets.

Summary of new law

5.18 Schedule 5 to the Bill improves the integrity of the R & D Tax Incentive by:

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extending the general anti-avoidance rules in the tax law to R & D tax offsets directly;

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making the rate at which the offset is recouped more accurate in situations where the offset would otherwise result in an additional or double benefit; and

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making that rate at which deductible balancing adjustment amounts incorporate the R & D Tax Incentive more accurate.

Comparison of key features of new law and current law

Detailed explanation of new law

Schemes to obtain an R & D tax benefit

5.19 Part 1 of Schedule 5 to the Bill explicitly extends the concept of tax benefits in the general anti-avoidance rule in Part IVA of the ITAA 1936 to include the R & D tax offset. These amendments ensure that the Commissioner can apply Part IVA to prevent R & D entities from being able to obtain tax benefits by entering into artificial or contrived arrangements to access a non-refundable or a refundable R & D tax offset. [Schedule 5, items 2 to 10, paragraphs 177C(1)(bd) and (h), 177C(2)(f), 177C(3)(cc) and (i), 177CB(1)(f), 177F(1)(f), 177F(3)(g) and subsection 177C(3) of the ITAA 1936]

5.20 Part IVA of the ITAA 1936 applies in situations where a scheme or arrangement is entered into in order to obtain a tax benefit. These rules allow the Commissioner to cancel the relevant tax benefit where the conditions under Part IVA are satisfied. For example, this can include situations where an R & D entity enters into an arrangement with a dominant purpose of securing a tax benefit that is an R & D tax offset. It can also include situations where an entity enters into an arrangement with a dominant purpose to enable it to obtain a refundable R & D tax offset, where it would have, or might reasonably be expected to have, obtained a non-refundable R & D tax offset if the scheme had not been entered into or carried out.

The uniform clawback rule

5.21 Part 2 of Schedule 5 to the Bill remakes and consolidates Subdivisions 355-G and 355-H of the ITAA 1997 (about the clawback of R & D recoupments and feedstock adjustments respectively) into a new Subdivision 355-G. This Subdivision also introduces a new uniform clawback rule that applies for recoupments, feedstock adjustments and balancing adjustment amounts that are included in an R & D entity's assessable income. The amendments ensure that an R & D entity must disgorge the entire benefit of an R & D tax offset to the extent it (or a connected entity or an affiliate entity where appropriate) receives a recoupment amount, feedstock adjustment or assessable balancing adjustment because of the offset. [Schedule 5, item 29, section 355-430 of the ITAA 1997]

5.22 Current Subdivisions 355-G and 355-H, and the various balancing adjustment rules, only partially reverse the benefit of an R & D tax offset in some circumstances. In light of the amendments discussed in Chapter 4, the current clawback rules would produce more anomalous outcomes if they are not amended. The amendments ensure the full benefit of the R & D tax offset is reversed, to remove the unintended benefits that arise in such situations.

Clawback amounts

Recoupment amounts and feedstock adjustment clawback amounts

5.23 Current Subdivision 355-G is remade into a single section and reference to the payment of extra income tax (a recoupment tax) is removed. Instead, the remade provision identifies an amount (a clawback amount) that represents the amount of notional deductions an R & D entity received or is entitled to receive in relation to a recoupment. [Schedule 5, item 29, section 355-440 of the ITAA 1997]

5.24 Current Subdivision 355-H is remade into a single section and the reference to the inclusion of an amount in assessable income is removed. Instead, the remade provision identifies an amount (a clawback amount) that represents the amount of notional deductions an R & D entity received or is entitled to receive in relation to a feedstock adjustment. The clawback amount is the lesser of the feedstock revenue received or the notional deductions attributable to the feedstock output. [Schedule 5, item 29, section 355-445 of the ITAA 1997]

Example 5.3 Clawback amounts

In a previous example, Contrast Industries had the following amounts for the 2021-22 income year (the offset year):

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aggregated turnover in excess of $50 million;

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expenditure of $1 billion;

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notional deductions of $160 million; and

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a non-refundable R & D tax offset of $71.15 million.

Further to this example, in the 2023-24 income year, Contrast Industries sells a tangible product developed during its 2021-22 income year R & D activities. The tangible product is sold for $20 million but cost $25 million to develop. All of the costs were included in Contrast Industries' notional deductions for the 2021-22 income year.

The clawback amount is the lesser of the market value of the tangible product on sale (feedstock revenue) and the tangible product's cost. Here, Contrast Industries has a clawback amount of $20 million.

Balancing adjustment clawback amounts

5.25 There are four clawback amounts that relate to assessable balancing adjustments. The primary clawback amount applies for R & D assets held only for R & D purposes. The clawback amount is the balancing adjustment amount capped at the level of the asset's total decline in value (its tax cost less its adjusted value). The cap ensures the clawback does not apply to the extent an R & D asset's has appreciated in value while held. [Schedule 5, item 29, section 355-446 of the ITAA 1997]

5.26 If the R & D asset was only held partially for R & D purposes, a different clawback amount applies. This clawback amount is calculated in a similar way to the primary clawback amount but it is reduced in proportion to its non-R & D use. [Schedule 5, item 29, section 355-447 of the ITAA 1997]

5.27 Different clawback amounts arise if the R & D asset is held by an R & D partnership. These two clawback amounts reflect the first two balancing adjustment clawback amounts: one for R & D assets used only for R & D purposes and one for assets held only partially for R & D purposes. These rules are necessary to ensure the clawback amount arises for the individual R & D entities that are partners in the R & D partnership. [Schedule 5, item 29, sections 355-448 and 355-449 of the ITAA 1997]

5.28 The four clawback rules outlined above apply in a modified way where the R & D asset was acquired before the introduction of the R & D Tax Incentive in 2011. [Schedule 5, items 41 to 45, 48 to 50, 53 and 54, subsections 40-292(3) and (3A), 40-293(3) and (3A), 355-320(4) and (4A), and 355-325(4) to (4D), and Note 1 to subsections 355-320(1) and 355-325(1) of the ITTP Act]

5.29 The clawback amount rules replace existing rules that estimated the incentive component of the R & D tax offset that need to be clawed back. [Schedule 5, items 17, 20, 28 and 32, subsections 40-292 (3) to (5), 40-293(3), 355-315(3), and 355-525(3) to (7) of the ITAA 1997]

Changes from the current law

5.30 The clawback amount is relevant for working out the amount that must be included in an R & D entity's assessable income to disgorge the benefit of an R & D tax offset. The clawback amount reflects the amount of R & D expenditure (notional deductions) tainted by the operation of the recoupment, feedstock or R & D balancing adjustment rules. The amendments calculate the amount of R & D tax offset tainted by the tainted expenditure. The incentive component of the tainted R & D tax offset, in turn, is the benefit to be clawed back.

5.31 The clawback amount picks up the amount worked out under each of Subdivisions 355-G and 355-H, and the balancing adjustment rules, in the current law immediately before adjustments are made to bring it to account: applying tax to it in the case of recoupments and including a third of the amount in assessable income in the case of feedstock and balancing adjustments. It is primarily these adjustments in the current law that are producing inappropriate outcomes and are subject to the amendments.

5.32 Except as outlined in this chapter, the remaking of Subdivisions 355-G and 355-H, and the R & D balancing adjustment rules, is not intended to alter the way recoupment amounts, feedstock adjustments or assessable balancing adjustments (a clawback amount in these amendments) are calculated. For further information on the operation of these provisions, refer to the Explanatory Memorandum to the Tax Laws Amendment (Research and Development) Bill 2011, and existing guidance materials and rulings issued by the Commissioner.

5.33 The table below outlines the provisions of the new law as amended that correspond with provisions of the current law.

Table 5.1 Remaking the clawback rules

5.34 For balancing adjustments, sections 40-292, 40-293, 355-315 and 355-525 (and section 40-285) continue to operate where appropriate to clawback the deduction component of the R & D tax offset (i.e. the amount of the offset that reflects the R & D entity's corporate tax rate). Similarly, feedstock revenue and government grants are generally assessable as ordinary income (section 6-5). The new provisions clawback the incentive component of the R & D tax offset.

The taxing point

5.35 Consistent with the existing law, the uniform clawback rule will include an amount in assessable income in the year the clawback amount arises (the present year). The underlying offset entitlement, whether in the same year, one or more earlier years or one or more later years (each an offset year) is unchanged. [Schedule 5, item 29, section 355-435 of the ITAA 1997]

5.36 The entity receiving a recoupment or feedstock revenue could be the R & D entity entitled to the R & D tax offset or an entity affiliated with or connected to the R & D entity. [Schedule 5, item 29, subsections 355-440(5) and 355-445(5) of the ITAA 1997]

5.37 The amendments unify the taxing point in cases involving related entities: where one entity has the R & D tax offset entitlement and the other entity receives the recoupment or feedstock revenue. The R & D entity that has received or is entitled to receive the R & D tax offset is the entity with the clawback amount and must include an amount in its assessable income. [Schedule 5, item 29, section 355-435 and subsections 355-440(1), (2) and (5), and 355-445(5) of the ITAA 1997]

Example 5.4 Related entities and clawbacks

It would not change the outcome in Example 5.3 if, instead of Contrast Industries selling the tangible product itself, the tangible product was sold by a related entity. Contrast Industries would be subject to the clawback amount.

5.38 For R & D assets of an R & D partnership that are partially used for R & D purposes, the clawback rule now includes an amount in the partner's assessable income rather than the partnership's assessable income. This aligns the taxing point with the taxing point for R & D assets held by an R & D partnership that are used wholly for R & D purposes. [Schedule 5, item 29, section 355-449 of the ITAA 1997]

The amount included in assessable income

5.39 When the clawback applies, the R & D entity entitled to the R & D tax offset includes an amount in assessable income in relation to each offset year in which it claimed an offset related to the clawback amount. [Schedule 5, item 29, section 355-450 of the ITAA 1997]

5.40 The amount included in assessable income is worked out as follows:

5.41 Each of the components of this formula is explained below.

Calculating the offset portion subject to the clawback

5.42 The first step in applying the formula is to calculate the portion of the R & D tax offset the R & D entity received that relates to the clawback amount. If the R & D entity received the R & D tax offset in multiple offset years in relation to the clawback amount that arises in the present year, the formula must be applied in relation to each offset year.

5.43 The primary way of working out the portion of the offset to be clawed back in an offset year is to compare the actual amount of the R & D tax offset in that year (the starting offset) with the amount of the offset (the adjusted offset) the R & D entity would have received if its notional deductions were reduced by the portion of the clawback amount that relates to the offset year. [Schedule 5, item 29, subsection 355-450(1) (definitions of 'adjusted offset' and 'starting offset') of the ITAA 1997]

5.44 This targets the clawback to the highest tiers of the R & D entity's offset entitlement (i.e. those received for the highest intensity expenditure, the last dollars the entity spent) for an offset year. If an R & D entity had notional deductions in excess of the $150 million expenditure threshold, the excess deductions would be reduced first, limiting the difference between the starting and adjusted offset. This, when combined with the operation of the deduction amount, is equivalent to the outcome achieved under table items 2 and 3 in subsection 355-720(2) in the current law.

Example 5.5 The starting offset and the adjusted offset

Further to Example 5.3, the portion of Contrast Industries' 2021-22 R & D tax offset that is subject to the clawback is worked out by subtracting the entity's adjusted offset from its starting offset.

Contrast Industries has a starting offset of $71.15 million, the amount of the offset it received for the 2021-22 income year.

Contrast Industries has an adjusted offset calculated as if its notional deductions for the 2021-22 income year were reduced from $160 million to $140 million by the value of the clawback amount. The entire clawback amount is included in the reduction because the entire amount relates to the 2021-22 income year.

The adjusted offset is calculated as follows:

Tier	Intensity range	R & D premium	Notional deductions applied	Offset amount
Tier 1	0-2%	8.5%	$20m	$7.7m
Tier 2	>2%	16.5%	$120m	$55.8m
Excess	NA	Nil	Nil	Nil
		Totals:	$140m	$63.5

The adjusted offset amount reflects that $10 million has been removed from the excess tier and $10 million has been removed from tier 2, the highest tier Contrast Industries reached on its level of R & D intensity.

The difference between the two offset amounts is $7.65 million.

Recursive calculations for multiple clawback amounts

5.45 The situation is more complex where an R & D entity's offsets in a particular offset year are clawed back multiple times because the entity receives multiple clawback amounts in relation to it or also receives a catch-up amount (see paragraph 5.59). In these circumstances, the clawback rule works in a recursive manner.

5.46 In recursive applications of the rule, the R & D entity must compare the offset amount that could have been claimed under the last counterfactual calculated and the amount that could have been claimed under a new counterfactual. In calculating the new counterfactual, the R & D entity must incorporate all previous adjustments to the notional deduction amount and make a further reduction for the new clawback amount. [Schedule 5, item 29, subsection 355-450(2) of the ITAA 1997]

Example 5.6 Recursive clawback

Flying Fox Innovations has an R & D tax offset entitlement based on $100 million of notional deductions. The entity receives two recoupment amounts: one of $10 million and one of $20 million.

For the first recoupment, the clawback is calculated by reference to the difference between the starting offset calculated on $100 million of notional deductions and the adjusted offset calculated on $90 million. For the second recoupment, the clawback is calculated by reference to the difference between the starting offset calculated on $90 million and the adjusted offset calculated on $70 million.

Allowing the benefit of the deduction

5.47 Regardless of whether the primary or recursive rule is applied in calculating the difference, once the difference is identified, it is not appropriate to bring the entire difference to account as an increased tax liability. Only the incentive component (or premium) is brought to account. Therefore, the second step of the above formula requires that the difference between the starting offset and the adjusted offset be reduced by the product of the portion of the clawback amount that relates to the offset year and the R & D entity's corporate tax rate in the offset year. This allows the R & D entity to retain the benefit of the R & D tax offset for the clawback amount to the extent it replaced the benefit of a deduction for the same expenditure. [Schedule 5, item 29, subsection 355-450(1) (definition of 'deduction amount') of the ITAA 1997]

Example 5.7 The deduction amount

Further to Example 5.5, Contrast Industries has a deduction amount equal to its clawback amount ($20 million) multiplied by its corporate tax rate in the offset year (30 per cent): $6 million. This is because while the expenditure is no longer eligible for the R & D Tax Incentive as a notional deduction, the expenditure would have been an eligible deduction.

The $7.65 million figure reached in Example 5.5 is reduced by the $6 million deduction amount to complete the numerator of the formula at paragraph 5.40. The resulting $1.65 million difference represents the additional amount of tax Contrast Industries must pay to reverse the incentive component of the R & D tax offset associated with the development of the tangible product.

Bringing the amount to account

5.48 The R & D entity must bring the amount to account as assessable income in the year in which the entity received the clawback amount. The amount calculated up to this point represents the full dollar-value of the incentive component of the R & D tax offset the R & D entity obtained in connection with the clawback amount. The amount of tax the R & D entity is required to pay equals this amount. As such, this amount is grossed-up by dividing it by the R & D entity's corporate tax rate for the present year to ensure its value is maintained when taxed.

Example 5.8 The denominator

Further to Example 5.7, Contrast Industries must divide the $1.65 million by its current corporate tax rate (30 per cent).

The resulting $5.5 million is included in the assessable income of Contrast Industries for the 2023-24 income year. Disregarding other assessable income and deductions, this will increase the income tax liability of Contrast Industries by the appropriate $1.65 million once the corporate tax rate applies to the entity's taxable income.

5.49 Bringing the amount to account as assessable income (rather than through a standalone tax) allows R & D entities to apply deductions from the current year and carried-forward losses against the clawback. Loss-making R & D entities that only obtained a non-refundable R & D tax offset in the offset year can apply the carried-forward offset against the amount included in assessable income. This ensures the clawback rule recovers the correct amount but does not have an unintended negative cash flow impact on R & D entities.

Catch-up rule for R & D balancing adjustments

5.50 The amendments introduce a new catch-up rule for R & D assets. This rule provides an additional deduction to R & D entities when a deductible balancing adjustment amount arises for an R & D asset. [Schedule 5, item 29, sections 355-455 and 355-460 of the ITAA 1997]

5.51 The catch-up rule mirrors the uniform clawback rule but operates in reverse, providing a deduction in lieu of an amount of R & D tax offset forgone rather than including an amount in assessable income. [Schedule 5, item 29, section 355-475 of the ITAA 1997]

5.52 As with the clawback amounts for balancing adjustments (see paragraphs 5.25 to 5.28), there are four different catch-up amounts to cover R & D assets either wholly or partially used for R & D, assets held by R & D entities and those held by R & D partnerships. The catch-up amounts reflect the amount an R & D entity can ordinarily deduct for the balancing adjustment event. [Schedule 5, item 29, sections 355-465, 355-466, 355-467 and 355-468 of the ITAA 1997]

5.53 These catch-up amounts are calculated in a modified way where the R & D asset was acquired before the introduction of the R & D Tax Incentive in 2011. [Schedule 5, items 41 to 44, 46, 47, 49, 51, 52 and 54, subsections 40-292(3) and (3A), 40-293(3) and (3A), 355-320(3) and (4A), and 355-325(3) and (4A) of the ITTP Act]

5.54 The catch-up amount rules replace provisions of the current law that either sought to estimate the value of the R & D tax offset forgone or replace it with a new R & D tax offset entitlement, neither option giving rise to an accurate catch-up. [Schedule 5, items 18, 20 to 26, 30 and 31, sections 355-105 and 355-300, subsections 40-292(3) and (5), and 40-293(3), paragraphs 355-100(1)(c) and (f), the heading to Subdivision 355-E, the headings to subsections 355-315(2) and 355-525(2), the notes to subsections 355-315(2) and 355-525(2) of the ITAA 1997]

5.55 It remains a condition for accessing the incentive component of the balancing adjustment (now the deduction for a catch-up amount) that the R & D entity be registered for R & D activities in the income year in which the balancing adjustment event occurs. However, for simplicity it is no longer a requirement that the R & D entity have $20,000 of notional deductions in that income year.

5.56 For R & D assets of an R & D partnership that are partially used for R & D purposes, the catch-up rule now makes each partner entitled to a deduction rather than the partnership. This mirrors the amendment outlined in paragraph 5.38. [Schedule 5, item 29, section 355-468 of the ITAA 1997]

5.57 The table below outlines the provisions of the new law as amended that correspond with provisions of the current law.

Table 5.2 Remaking of catch-up amount rules

5.58 Sections 40-292, 40-293, 355-315 and 355-525 (and section 40-285) continue to operate where appropriate to provide a catch-up for the deduction component of the R & D tax offset (i.e. the amount of the offset that reflects the R & D entity's corporate tax rate). The new provisions provide an additional catch-up for the incentive component of the R & D tax offset.

5.59 The amount allowed as a deduction for a catch-up amount for an offset year is worked out as follows:

5.60 This formula mirrors the formula discussed in paragraphs 5.40 to 5.48 with two important distinctions. Firstly, the initial operation requires the starting offset to be subtracted from the adjusted offset (rather than the reverse). Secondly, the adjusted offset is defined as the R & D tax offset the R & D entity would have received if its notional deductions for the offset year included the portion of the catch-up amount that is attributable to the offset year. [Schedule 5, item 29, section 355-475 of the ITAA 1997]

Example 5.9 Deductible balancing adjustment amounts

Spark Transformations is an R & D entity with an annual turnover of between $20 million and $25 million for the 2019-20 to 2021-22 income years. Spark Transformations is subject to the corporate tax rate for a base rate entity.

On 18 April 2020, Spark Transformations acquires a depreciating asset for $80,000. It has an effective life of five years. Spark Transformations used the asset entirely for R & D purposes.

Spark Transformations sells the asset on 1 July 2022 for $34,800.

Decline in value notional deductions

Spark Transformations uses the prime cost (straight line) method in section 40-75 to work out the asset's decline in value as follows:

Decline in value
Income Year	Days asset used	Decline in Value	Adjusted Value
2019-20	73	$3,200	$76,800
2020-21	365	$16,000	$60,800
2021-22	365	$16,000	$44,800

Spark Transformation is entitled to notional deductions for the asset's decline in value in each income year.

The R & D tax offset

For the 2019-20 income year, Spark Transformations is entitled to an R & D tax offset at the current 38.5 per cent rate. In relation to the depreciating asset, Spark Transformations is entitled to an R & D tax offset of $1,232. Spark Transformations has total notional deductions in excess of $20,000 (so subsection 355-100(2) does not apply) but it is not necessary to quantify them.

In the 2020-21 income year, Spark Transformations is entitled to an R & D tax offset of $6,160 in relation to the depreciating asset.

For the 2021-22 income year, it is necessary to consider the total R & D tax offset entitlement of Spark Transformations.

In the 2021-22 income year, Spark Transformations has notional deductions of $350,000 (inclusive of the decline in value notional deductions) and total expenses of $7.35 million. Therefore, Spark Transformations has an R & D intensity of 4.76 per cent. As it is subject to the corporate tax rate of 25 per cent in this income year, its R & D tax offset entitlement is worked out as follows:

2020-21 starting offset
Tier	Intensity range	R & D premium	Notional deductions applied	Offset amount
Tier 1	0-2%	8.5%	$147,000	$49,245
Tier 2	>2%	16.5	$203,000	$84,245
		Totals:	$350,000	$133,490

The catch-up amount portions

When the asset is sold, there is a balancing adjustment event. Because the asset's adjusted value ($44,800) exceeds its termination value ($34,800), Spark Transformations is entitled to a deductible balancing adjustment amount of $10,000. This amount is allowed as a deduction but is not a notional deduction and does not contribute towards the entity's R & D tax offset entitlement.

This gives rise to a catch-up amount of $10,000 that relates to the three income years (each an offset year) in which Spark Transformations claimed the R & D tax offset in relation to the asset's decline in value. It is necessary to work out the portion of the $10,000 catch-up amount that relates to each offset year. To do this, it is necessary to work out the decline in value recorded in each offset year as a proportion of the total decline in value of the asset ($35,200):

Spark Transformations has the following catch-up portions in the 2022-23 income year:

•

$909.09 for the 2019-20 income year; and

•

$4,545.45 for each of the 2020-21 and 2021-22 income years.

The adjusted offsets

The adjusted offset for each offset year is calculated by adding the catch-up portion to the R & D entity's notional deductions. This also impacts the calculations for total expenditure and R & D intensity.

It is not strictly necessary to calculate the adjusted offset for the 2019-20 or 2020-21 income years because the flat 38.5 per cent R & D tax offset rate applies.

The adjusted offset for the 2021-22 income year is calculated as follows:

2021-22 adjusted offset
Tier	Intensity range	R & D premium	Notional deductions applied	Offset amount
Tier 1	0-2%	8.5%	$147,090.91	$49,275.45
Tier 2	>2%	16.5%	$207,454.54	$86,093.63
		Totals:	$354,545.45	$135,369.08

Note that the R & D intensity for the adjusted offset calculation is 4.82 per cent in the 2021-22 income year. This incorporates the increase in notional deductions being included in total expenses.

The offset differential

The difference between the starting offset and the adjusted offset for the 2019-20 and 2020-21 income years can be simply calculated as the catch-up portion multiplied by the flat R & D tax offset rate of 38.5 per cent.

For the 2021-22 income year, the difference is derived by comparing the outcomes of the tables above.

Spark Transformations has the following offset differentials:

•

$349.99 ($909.09 multiplied by 38.5 per cent) in the 2019-20 income year;

•

$1,749.99 ($4545.45 multiplied by 38.5 per cent) in the 2020-21 income year; and

•

$1,879.08 ($135,369.08 less $133,490.00) in the 2021-22 income year.

The deduction amount

The deduction amount is the catch-up portion for an offset year multiplied by the corporate tax rate that applied in that year (27.5 per cent for the 2019-20 income year, 26 per cent for the 2020-21 income year and 25 per cent for the 2021-22). Spark Transformations has the following deduction amounts totalling $2,568.18:

•

$249.99 for the 2019-20 income year;

•

$1,181.81 for the 2020-21 income year; and

•

$1,136.36 for the 2021-22 income year.

These amounts are not available as deductions but are included in the 'deduction amount' in the catch-up rule formula (see paragraph 5.59).

Gross-up

The total of the differences between the adjusted offsets and the corresponding starting offsets is reduced by the deduction amounts and then grossed-up by the entity's current corporate tax rate (which in the 2022-23 income year, it is 25 per cent). Spark Transformations is entitled to a deduction for the result of the following equation:

The deduction will reduce the income tax liability of Spark Transformations by $1,410.91 once the current corporate tax rate is applied. This puts the entity in the position it would be in had the decline in value of the asset for tax purposes kept pace with the actual decline in value of the asset.

This reduction of the tax liability reflects that Spark Transformations is separately entitled to a $10,000 deduction for the balancing adjustment event under subsection 355-315(2). This balancing adjustment amount will result in Spark Transformations reducing its income tax liability by $2,500 for the 2022-23 income year.

Consequential amendments

5.61 Definitions of 'non-refundable R & D tax offset' and 'refundable R & D tax offset' linked to Division 355 of the ITAA 1997 are inserted into the dictionary in Part IVA of the ITAA 1936. [Schedule 5, item 1, subsection 177A(1) (definition of 'non-refundable R & D tax offset' and 'refundable R & D tax offset') of the ITAA 1936]

5.62 Consequential amendments are made to the remaking of the recoupment, feedstock and balancing adjustment provisions, and the introduction of the uniform clawback rule. This includes removing redundant provisions associated with the recoupment tax and repealing section 355-720, which dealt with the interaction between the expenditure threshold and the old recoupment, feedstock and R & D balancing adjustment rules. These functions are now consolidated in the new clawback rule. [Schedule 5, items 11 to 14, 33 to 36, 38 to 40, and 55, sections 4-25, 10-5, 355-530 and 355-720, table item 4A in subsection 9-5(1), table item 10 in section 20-5, subsections 355-715(2) and 995-1(1) (definition of 'feedstock revenue'), and Note 2 to subsection 355-715(2) of the ITAA 19997, and subsection 12(7), and sections 12B and 31 of the Income Tax Rates Act 1986, and section 355-720 of the ITTP Act]

5.63 Notes are added to explain the interaction between the R & D balancing adjustment provisions and the clawback and catch-up rules. [Schedule 5, items 15, 16, 18, 19, 27, 28, 31 and 32, notes to subsections 40-292(1), 40-293(1), 355-315(2), 355-315(3), 355-525(2) and 355-525(3) of the ITAA 1997]

5.64 As part of the remaking of Subdivision 355-G, the cap on recoupment amounts is amended to clarify the meaning of the numerator in the formula. [Schedule 5, item 29, subsection 355-440(4) (definition of 'R & D expenditure') of the ITAA 1997]

5.65 An amendment is made to the tax incentive for early stage investors to prevent the inclusion of clawback amounts in an R & D entity's assessable income denying the status of an early stage innovation company. [Schedule 5, item 37, subsection 360-40(2) of the ITAA 1997]

Application and transitional provisions

5.66 The amendments commence on the first day of the first quarter following Royal Assent. [Clause 2 of the Bill]

5.67 The amendments to Part IVA of the ITAA 1936 apply in relation to R & D tax benefits obtained on or after 1 July 2021, regardless of when the relevant scheme was entered into or carried out. [Schedule 5, subitems 56(1) and (2)]

5.68 The amendments to the recoupment, feedstock and R & D balancing adjustment rules, and the new clawback and catch-up rules, apply in relation to income years starting on or after 1 July 2021. The new clawback and catch-up rules may apply in an income year starting on or after 1 July 2021 in relation to an R & D tax offset received in an income year starting before that date (see Example 5.9 as it applies in relation to the 2019-20 income year). [Schedule 5, subitem 56(3)]