Edited version of private ruling

Authorisation Number: 1011566964820

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Ruling

Subject: R&D tax offset

Question 1

Is the rulee eligible to claim a deduction under subsection 73B(13) of the Income Tax Assessment Act 1936 (ITAA 1936), for amounts invoiced to it from a Registered Research Agency (RRA) in the year ending 30 June 2008?

Advice/Answers

No.

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

Company A is an Australian proprietary company limited by shares.

For the year ending 30 June 2008, Company A registered R&D activities under section 39J of the Industry Research and Development Act 1986 for the first time.

In its income tax return for the year ending 30 June 2008, Company A included a claim for the R&D tax offset. In the R&D schedule accompanying Company A's income tax return, Company A included an amount at part A, label 1, 'contracted expenditure to a Registered Research Agency'. This amount was determined under an R&D Services Agreement (the Agreement) executed between Company A and an RRA.

Execution of the Agreement

Company A entered into the Agreement after attending information sessions where available Government grants, including R&D funding and the export market development grant (EMDG) were discussed. These talks initiated discussions between Company A and a representative of Company B.

At the offices of Company B, Company B provided an R&D proposal to Company A, and introduced the RRA's director to Company A. The R&D Services Agreement between the RRA and Company A was executed.

The Agreement

The Agreement is for the provision of Research and Development Services. Under the Agreement, the RRA is appointed Company A's preferred R&D contractor, and will undertake the following Project Management Overhead (PMO) activities:

§ provision of the project management system;

§ reporting in regard to project expenditure and resource application;

§ contract third party sub-contractors by agreement with Company A;

§ financial management of sub-contractors, invoice and payments relating to the R&D activities;

§ convene monthly project meetings with Company A to report on issues related to the health of the R&D activities;

§ ensure reporting compliance of funded activities with the requirements of the R&D Tax Concession;

§ take all reasonable steps to ensure Company A receives the full benefits of contracting the R&D activities through the RRA.

In providing the services, the RRA will enter into sub-contractor agreements with third party entities approved by Company A, however the RRA will remain responsible for all subcontracted functions. The Agreement outlines that the relationship is to work as follows:

Initiation of Project

1) Client enters into 12 month contract for R&D outcomes with RRA

2) RRA issues invoice for 12 month contract.

3) RRA contracts subcontractor to undertake services for the period of the contract, in accordance with the Work Breakdown Structure.

Billing cycle management

4) Client authorises RRA to undertake services for the work period of the contract, in accordance with the Work Breakdown Structure.

5) RRA authorises subcontractor to undertake services for the work period of the contract, in accordance with the Work Breakdown Structure.

6) Subcontractor issues an invoice and work progress documentation for work completed to RRA during a billing period

7) RRA verifies invoice with contract, and work done documentation. RRA secures approval of work done from Client. RRA issues progress claim to Client, including RRA Project Management Overhead fee.

8) Client makes progress payment to RRA.

9) RRA makes progress payment to subcontractor.

10) Subcontractor issues payment receipt advice to RRA.

11) RRA issues payment receipt advice, account statement and project financial report to Client.

12) Client issues varied Work Breakdown Structure to RRA.

Repeat billing cycle

Under the Agreement, Company A will pay the RRA a PMO fee for the provision of the above services, which is equal a percentage of the Project Value. The RRA may provide additional specialist services on an hourly basis, including, inter alia, R&D tax concession preparation and R&D project plan preparation.

At its option, The RRA may charge interest on the daily balance of overdue cash accounts, and retains the rights to recover any overdue amounts.

The Agreement also stipulates that Company A may 'pre-contract' The RRA to commit to undertake future specific R&D activities for a period of more than 12 months. Where this occurs, The RRA has the right to invoice Company A for that work for a period of up to and including a future 12 month period.

In relation to the payment of monies, the Agreement states that at the end of each month, The RRA shall be entitled to make a project progress payment claim to Company A. The claim shall be an aggregate of monthly invoices from the sub-contractors, the RRA's PMO fee and any other approved disbursements and work that is performed by The RRA for Company A.

The Agreement states that Company A is to make full payment of monies due in accordance with the terms set out in the Agreement. Those payment terms include full payment of invoices within 14 days of the date of a progress payment claim by the RRA, or as otherwise mutually agreed in writing between the parties. The RRA will disburse payments to sub-contractors within 7 days of receiving payment from Company A.

The Agreement further provides that The RRA reserves the right to request Company A to pay the next month's forecast project costs to The RRA in advance of work being undertaken in that month.

Sub-contractor Agreements

The Agreement provided that the RRA would execute sub-contractor agreements with Company C, Company D and Company E. The RRA in face executed subcontractor agreements with Company C and Company D but not with Company E.

The agreements are substantially the same and relevantly they provide that sub contractors are to provide a tax invoice made out to the RRA, as fee for the sub-contractor services they undertook the previous calendar month, by the 5^th of the following month. If the invoice is received after the 5^th, payment of the invoice may be delayed until the next calendar month.

The RRA will pay the invoices subject to Company A's approval of the quality of the subcontracted services. The RRA will withhold payment of any amount that it disputes in good faith until the dispute is resolved.

Company A is grouped according to section 73L of the ITAA 1936 with Company C.

A subcontracting agreement was not executed with Company E because the project that was to be performed by Company E was initially delayed and then subsequently cancelled.

Company C and Company D have confirmed they have been paid for all invoices they presented to The RRA.

Invoices rendered to Company A by the RRA

The RRA provided a document titled 'tax invoice' to Company A for 'Research and Development Services Contract Per Services Agreement but subject to contract variation'. The amount of the invoice was for the entire cost of the services outlined under the Agreement. Payment terms were listed as '14 days from approved progress claim'.

During the years ending 30 June 2009 and 30 June 2010 the RRA presented Company A with 6 invoices/progress claims. Each document contained a total which was required to be paid within 14 days of receipt, and a running total of the entire amount under the agreement, minus the amount due, that is, a project balance that reduced with each invoice presented to Company A.

Company A paid the amounts due within terms. The final invoice/progress claim presented to Company A showed that there was an outstanding project balance. The RRA has never presented Company A with an invoice/progress claim for this amount. The subcontractors have not performed any further work under the subcontracting agreements.

No interest has been charged by the RRA on the outstanding amount and has not commenced any debt recovery action in relation to this amount.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 73B

Income Tax Assessment Act 1936 Section 73I

Income Tax Assessment Act 1936 Section 73J

Industry Research and Development Act 1986 Section 39J

Reasons for decision

The legislation cited in this ruling is that which applies to assessments for years of income commencing after 30 June 2007.

Subsection 73I(1) of the ITAA 1936 provides that an 'eligible company' can choose a tax offset instead of a deduction under section 73B (except subsection 73B(14C)), 73BA, 73BH or 73QA for a year of income, if it is eligible to make that choice. The eligibility criteria are contained in section 73J of the ITAA 1936.

Subsection 73I(4) of the ITAA 1936 prevents an eligible company also claiming a deduction where it has chosen the tax offset. This section says that an eligible company cannot deduct any amount under section 73B, (except subsection 73B(14C)), 73BA, 73BH or 73Y of the ITAA 1936 for the tax offset year if it chooses the tax offset for that year.

Subsection 73J(1) of the ITAA 1936 provides that an eligible company can choose the tax offset for the tax offset year if:

(a) it could, apart from subsection 73I(4), deduct an amount under section 73B (except subsection 73B(14C)), 73BA, 73BH or 73QA for that year; and

(b) either:

(i) all or part of the amount that the company could, apart from subsection 73I(4), have deducted is contracted expenditure; or

(ii) its aggregate research and development amount for the tax offset year exceeds $20,000; and

(c) the aggregate research and development amount for the tax offset year of the company and of persons with which it is grouped (while they are grouped in that year) is not more than $2,000,000; and

(d) the R&D group turnover of the company for that year is less than $5,000,000.

Note that subsection 73J(2) of the ITAA 1936 contains an exception to eligibility to choose the tax offset. However, as this exception is not relevant to the circumstances of this case, it will not be discussed.

The first legislative requirement is that Company A is an 'eligible company', as defined by subsection 73B(1) of the ITAA 1936. As it is a body corporate incorporated under a law of the Commonwealth or of a State or territory, Company A is an 'eligible company'.

The next requirement of subsection 73J(1) of the ITAA 1936 is that Company A must be eligible to deduct an amount under section 73B, (except subsection 73B(14C)), 73BA, 73BH or 73Y of the ITAA 1936.

On the facts, the relevant deduction provision to consider is subsection 73B(13) of the ITAA 1936. Subsection 73B(13) allows a deduction at the rate of 125% where, subject to section 73B, an eligible company incurs 'contracted expenditure' during a year of income.

'Contracted expenditure' is defined in subsection 73B(1) of the ITAA 1936 as expenditure incurred by an eligible company:

(a) on or after 1 July 1985 - to the Coal Research Trust Account;

(b) during the period commencing on 1 July 1985 and ending on 30 June 1988 - to an approved research institute; or

(c) on or after 20 November 1987 - to a body (not being an associate of the eligible company) that was, or is taken to have been, registered under section 39F of the Industry Research and Development Act 1986 when the expenditure was incurred as a research agency in respect of the class of research and development activities on which the expenditure was incurred;

in consideration for that Trust Account funding the performance of, or that institute or agency performing, on or after the date concerned, or during the period concerned, as the case may be, research and development activities on behalf of the company.

Subsection 73B(1B) of the ITAA 1936 limits what is 'contracted expenditure' as follows:

Expenditure referred to in paragraph (c) of the definition of contracted expenditure in subsection (1) does not constitute contracted expenditure for the purposes of this section unless, when the expenditure was incurred, the eligible company that incurred the expenditure was capable of utilising, or had formulated a plan to utilise, any results of the research and development activities directly in connection with a business that that company carried on or proposed to carry on.

Relevantly, in relation to the expenditure Company A claimed at label A, item 1 of the R&D schedule accompanying its income tax return for the year ending 30 June 2008, 'Contracted exp RRA', Company A will be entitled to such deduction if, inter alia, it incurred the expenditure to a research agency registered under section 39F of the Industry Research and Development Act 1986 (IR&D Act), in accordance with paragraph (c) of the definition of 'contracted expenditure' (an RRA).

Section 73B of the ITAA 1936, also contains other requirements which must be satisfied before an eligible company is entitled to a deduction under that section. These include:

§ registration with the Board under section 39J of the IR&D Act (subsection 73B(10) of the ITAA 1936);

§ activities must be carried out by, or on behalf of, the eligible company, in accordance with a plan that complies with any guidelines formulated by the Board under section 39KA of the IR&D Act (an R&D plan) (subsection 73B(2BA) of the ITAA 1936);

§ expenditure must not be incurred by the company for the purpose of carrying on research and development activities on behalf of any other person (subsection 73B(9) of the ITAA 1936); and

§ expenditure must not be incurred by the company in the capacity of a trustee or nominee other than expenditure incurred by the company on or after 1 July 1988 in the capacity of a trustee of a public trading trust (subsection 73B(3) of the ITAA 1936).

The company must also be able to substantiate the amounts claimed as a deduction. Section 262A of the ITAA 1936 says that a person carrying on a business must keep records that record and explain all transactions and other acts engaged in by the person that are relevant for any purpose of this Act. Therefore, companies intending to claim the R&D Tax Concession must maintain adequate contemporaneous records which substantiate the carrying on of the claimed R&D activities and the incurring of expenditure in relation to those activities.

Paragraph 30 of IT 2552 provides that where a company cannot comply with the substantiation guidelines:

it is open to demonstrate to the Commissioner that an alternative accounting and reporting system or basis for calculating an R&D deduction produces,… accurate claims consistent with the law and its interpretation. A claim for R & D expenditure which cannot be substantiated by reference to reliable source documents cannot be allowed.

Meaning of 'incurred'

The first question to consider is whether Company A has incurred an amount of expenditure within the meaning of paragraph (c) of the definition 'contracted expenditure' (contained in subsection 73B(1) of the ITAA 1936 for the purposes of subsection 73B(13).

The term 'incurred' is not defined in the ITAA 1936, and there have not been any judicial decisions on its meaning in the context of subsections 73B(1) or 73B(13) of the ITAA 1936. However, there has been judicial consideration of the meaning of 'incurred' in the context of former subsection 51(1) of the ITAA 1936. From these decisions a number of principles emerge, which are summarised in Taxation Ruling TR 97/7 and Taxation Ruling TR 94/26. We consider that the views outlined in these Taxation Rulings are also relevant to determining whether any expenditure is 'incurred' for the purposes of section 73B.

ATO Interpretative Decision 2006/238 Income Tax Research and Development: unpaid wages also provides relevant guidance on when an amount is 'incurred' for the purposes of section 73B of the ITAA 1936.

Taxation Ruling TR 97/7 provides that, as a broad guide, an outgoing is incurred at the time you owe a present money debt that you cannot escape. This ruling also summarises general rules settled by case law which assist in determining whether a loss or outgoing is incurred. These general rules include:

§ a taxpayer need not actually have paid any money to have incurred an outgoing provided the taxpayer is definitively committed in the year of income. Accordingly, a loss or outgoing may be incurred within subsection 51(1) even though it remains unpaid, provided the taxpayer is 'completely subjected' to the loss or outgoing. That is, subject to the principles set out below, it is not sufficient if the liability is merely contingent or no more than pending, threatened or expected, no matter how certain it is in the year of income that the loss or outgoing will be incurred in the future. It must be a presently existing liability to pay a pecuniary sum;

§ a taxpayer may have a presently existing liability, even though the liability may be defeasible by others;

§ a taxpayer may have a presently existing liability, even though the amount of the liability cannot be precisely ascertained, provided it is capable of reasonable estimation (based on probabilities);

§ whether there is a presently existing liability is a legal question in each case, having regard to the circumstances under which the liability is claimed to arise;

§ in the case of a payment made in the absence of a presently existing liability (where the money ceases to be the taxpayer's funds) the expense is incurred when the money is paid;

§ it is sometimes not enough that a loss or outgoing has been incurred. It must also be properly referable to the year of income in which the deduction is sought.

Paragraph 18 of TR 97/7 refers to Justice Dixon's judgement in New Zealand Flax Investments Ltd v. FC of T (1938) 61 CLR 179 at 207, where he stated that although it is 'unsafe to attempt exhaustive definitions of a conception intended to have such a various or multifarious application', incurred 'does not include a loss or expenditure which is no more than impending, threatened, or expected'. It is therefore clear that an expense will not be 'incurred' in a year of income where it is no more than pending, threatened or expected no matter how certain it may be in the year of income that the loss or expenditure will occur in the future.

Paragraph 18 of TR 97/7 also refers to Justice Gibbs' judgement in Nilsen Development Laboratories Pty Ltd & Ors v. FC of T (1981) 144 CLR 616 at 624 where he states, in relation to when an expense is incurred, 'what is clearly necessary is that there should be a presently existing liability'. Further, the ruling refers to the joint High Court judgement in FC of T v. James Flood Pty Ltd (1953) 88 CLR 492, at 506, as precedent for the proposition that a liability is not presently existing if it is contingent. It is therefore also clear that for an expense to be incurred it must be a presently existing liability that is not contingent.

In determining whether an outgoing is a presently existing pecuniary liability, regard can be had to the terms of the contract or other arrangements giving rise to that liability. However the rights and obligations provided for in the contract or arrangement must be viewed in the context of the subsequent action of the parties. ATO ID 2006/238 refers to Equuscorp Pty Ltd v. Glengallan Investments Pty Ltd, 57 ATR 556, [2004] HCA 55 (Equuscorp), where the High Court referred at [34] to the proposition that 'the legal rights and obligations of the parties turn upon what their words and conduct would be reasonably understood to convey, not upon actual belief or intentions'.

Accounting evidence is relevant in identifying the year of income to which expenditure is properly referable, but it is not relevant to the question of whether an outgoing has been incurred. Therefore, treating an amount as a liability for accounting purposes is not determinative of whether that amount has been incurred. This is a legal question, answered by referring to the relevant circumstances, including the terms of any relevant contract(s) and arrangements giving rise to the relevant liability.

Hence it is central to identify whether Company A had a presently existing pecuniary liability in the year ending 30 June 2008, having regard to the terms and conditions of the relevant contract or arrangement, and to what Company A and the RRA's subsequent conduct would be reasonably understood to convey.

The Terms of the Agreement

The Agreement executed between Company A and the RRA explains the relationship between the parties and the subcontractors. It describes The RRA as the provider of professional research, development and technology consulting services and Company A as its client. The general obligations of the RRA are described as the provision of 'Project Management Overhead (PMO) activities.'

To provide these services, the RRA will enter into sub-contractor agreements with third parties, who will perform the R&D activities that Company A has requested. Invoicing and payment under the Agreement is a two step process.

First, the Agreement provides that the RRA will invoice Company A for the full amount under the Agreement, but terms which provide that payment will be made within 14 days of receiving a progress claim. Then a billing cycle begins where:

§ Company A authorises the RRA to undertake activities;

§ the RRA authorises the subcontractor to undertake activities;

§ subcontractor issues an invoice to the RRA for work performed during a billing cycle (a month);

§ the RRA issues a progress claim to Company A including the PMO fee;

§ Company A pays the amount of the progress claim to the RRA within 14 days, and

§ the RRA pays the subcontractor within 7 days of receiving payment from Company A.

The critical question is whether the execution of the Agreement between Company A and The RRA, and/or the rendering of an invoice to Company A on the same date, gives rise to its having a presently existing pecuniary liability to the RRA for the entire amount under the Agreement in the year ending 30 June 2008.

An objective assessment of the Agreement

In construing the Agreement between the parties, all the relevant facts must be looked at objectively in order to identify the true terms of the Agreement; in particular, whether or not the Agreement includes a term that the full project amount is due and payable by Company A at the time the Agreement was executed.

The following factors support the contention that Company A is definitively committed and completely subjected to the full amount under the Agreement in the year ending 30 June 2008:

§ the RRA presented Company A with a document titled 'tax invoice' for the full amount of the Agreement;

§ Company A's detailed profit and loss statement for the year ending 30 June 2008 shows expenses which include the full amount under the Agreement, and

§ in the notes to Company A's Financial Statements, Company A has included the full amount under the Agreement as a current liability for 'unsecured trade creditors' for the year ending 30 June 2008.

The following factors do not support the contention that Company A is definitively committed and completely subjected to the amount set out in the Agreement in the year ending 30 June 2008:

§ the Agreement provides that payment of monies is to be made by Company A within 14 days of the date of a progress payment claim by the RRA, unless as mutually agreed;

§ the invoice provided by the RRA to Company A provides that payment terms are '14 days from approved progress claim';

§ Company A did not pay any money to the RRA until it had been invoiced with a progress claim in the year ending 30 June 2009 or 30 June 2010;

§ the RRA only presented Company A with progress claims when sub-contracted parties had themselves provided the RRA with an invoice for work they had performed - where projects were cancelled or did not go ahead, Company A was only invoiced a correspondingly reduced amount;

§ the final invoice the RRA rendered to Company A showed an outstanding project value balance, in relation to which no progress claim has been issued, and

§ in relation to the outstanding amount, the RRA has taken no debt recovery action, nor has it applied any interest.

Although there are some factors in support of Company A's contention that the Agreement and consequently issued invoice gives rise in the 2008 income year to an obligation to pay the RRA the full amount under the Agreement, it is considered that greater weight should be placed on the subsequent conduct of the parties, which is inconsistent with this contention.

The fact that Company A did not have to make payment to the RRA until the RRA provided Company A with a progress claim, means that at the time of execution of the Agreement, Company A's liability to pay these amounts was contingent on receiving a progress claim from the RRA. This is further evidenced by the fact that the RRA has not applied any interest, or undertaken any debt recovery action on the outstanding project balance amount, which, if a pecuniary liability for the entire amount under the Agreement existed as at 30 June 2008, would be currently outstanding. Instead, the action of both parties shows that liability to pay this amount is contingent on receiving a progress claim for this amount. In line with the High Court case FC of T v. James Flood Pty Ltd (1953) 88 CLR 492 at 506, a liability is not a presently existing liability if it is contingent.

The fact that Company A has recognised the full project amount in its financial statements for the year ending 30 June 2008, does not support the conclusion that Company A has incurred the liability in that year, as per Taxation Ruling TR 97/7.

At the time of entering into the Agreement, there was additionally no certainty as to what amounts Company A would be obligated to pay the RRA in respect of future progress payments. The entire amount under the Agreement was an estimated project cost in respect of R&D activities that the RRA expected to possibly perform for Company A in the future.

This leads to the conclusion that objectively, the true relevant term of the Agreement is:

§ only that portion of the project amount which is invoiced to Company A as a progress claim is due and payable to the RRA within 14 days of the date of its issuance.

As no progress claims were issued in the year ending 30 June 2008, no amounts became due and payable in that year.

As outlined earlier, for an expense to be 'incurred' it must be more than pending, threatened or expected no matter how certain it is in the year of income that the expenditure will occur in the future. Whether the expenditure has been 'incurred' is dependent on whether or not the liability has been made subject to a condition.

The relevant term of the Agreement between Company A and the RRA, as construed above, provides that Company A is only definitively committed to pay amounts invoiced to it as part of a progress claim, subsequent to the subcontracting companies performing R&D activities. Company A had not 'definitively committed itself' to payment of the entire project amount during the 2008 income year.

The effect of this finding is that no amount under the Agreement was a presently existing liability of Company A in the year ending 30 June 2008, as payment of portions of this amount were contingent on progress claims being issued by the RRA in respect of the R&D activities ultimately performed by it or its sub-contractors. No progress claims were issued by the RRA during the 2008 income year.

Conclusion

An objective examination of the relevant terms of the Agreement indicate that Company A does not have a presently existing liability to the RRA for the full project amount in the year ending 30 June 2008. Company A has therefore not 'incurred' this amount, and it is not eligible as a deduction under subsection 73B(13) of the ITAA 1936 in the year ending 30 June 2008. Accordingly, this amount cannot be included in calculating an amount for the R&D tax offset due to paragraph 73J(1)(a) of the ITAA 1936.

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