Edited version of private ruling

Authorisation Number: 1011698075463

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Ruling

Subject: R&D tax offset

Subject

Whether a claim for the R&D tax offset is ineligible where the arrangement is substantially the same as that described in Taxpayer Alert TA2009/21.

This ruling applies to

Company A

Issue 1

Eligibility to claim R&D tax offset in circumstances where the claimant is involved in an arrangement substantially the same as that described in Taxpayer Alert TA2009/21.

Question 1

Is Company A eligible to claim a deduction under subsection 73B(13) of the Income Tax Assessment Act 1936 (ITAA 1936), for amounts contracted to a Registered Research Agency (RRA) in the year ending 30 June 2010 so that it will be eligible to choose the tax offset under subsection 73J(1) of the ITAA 1936 in respect of those amounts for the tax offset year?

Advice/Answers

No. Company A is not eligible to claim a deduction under subsection 73B(13) of the ITAA 1936, and therefore cannot choose to claim the R&D tax offset in respect of those amounts for the year ended 30 June 2010.

This ruling applies for the following period

Year ending 30 June 2010

The scheme commenced on

1 July 2009

Relevant facts

Company A

Company A is an Australian proprietary company limited by shares, incorporated in 2008.

Company A has four directors.

Company A was formed to be a platform to develop renewable energy technology.

As at 25 January 2010 Company A has not lodged a tax return for the year ended 30 June 2010 (pending the result of its application for a private ruling).

Registration of Research and development activities with AusIndustry

For the year ending 30 June 2010, Company A registered R&D activities under section 39J of the Industry Research and Development Act 1986.

The two projects registered in the tax offset year are:

The registration details include information on each project's technical objectives::

The registration details also show total estimate expenditure on the two projects of $Ym with $X expenditure in the year ended 30 June 2010.

Financial statements for year ended 30 June 2010

In draft taxation documents supplied by Company A $X of the expenditure is shown as claimable as a tax deduction at the rate of 125%. This includes contracted expenditure to a registered research agency of $CX and other R&D expenditure of $OX.

R&D Services Agreement with Registered Research Agency

The directors of Company A signed a R&D Services Agreement (the Agreement) with Agency A. Agency A is a registered research agency (RRA) for the purposes of section 39F of the Industry Research and Development Act 1986.

The Agreement is for the provision of Project Management Overhead (PMO) Services by Agency A to Company A in respect of a research and development project (Project A). Schedule 2 of the Agreement gives a commencement date and a completion date, however an addendum to the agreement agrees to extend the term of the agreement for an additional 12 months beyond the contracted completion date.

Contracted services

Under the Agreement, Agency A is appointed Company A's preferred R&D contractor, (not an exclusive appointment, but exclusive as to the activities set out in the Agreement for the project named in the Agreement), and will undertake the following 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 project;

§ 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 the Company receives the full benefits of contracting the R&D activities through Agency A's RRA status.

In providing the services, Agency A is to enter into sub-contractor agreements with third party entities approved by Company A, however Agency A will remain responsible for all subcontracted functions.

Payment arrangements

Under the Agreement, Company A will pay Agency A a PMO fee equal to a fixed percentage of total project costs invoiced by third parties to Agency A. The PMO is inclusive in the gross margin on costs incurred by Agency A equal to a fixed percentage of total project costs. Agency A may also charge for other services, including R&D tax concession preparation and R&D project plan preparation, at an hourly rate. Company A is also responsible to reimburse Agency A for expenses listed in the Agreement.

Company A is to make full payment of monies due in accordance with the terms set out in this agreement. Those payment terms include full payment of invoices within 14 days of the date of a progress payment claim by Agency A, or as otherwise mutually agreed in writing between the parties. Agency A is entitled to charge interest on overdue payments based on the overdraft rate fixed by a major bank plus 3%. Agency A will disburse payments to sub-contractors within 7 days of receiving payment from Company A. Agency A retains the rights to recover any overdue amounts.

The Agreement also stipulates that Company A may 'pre-contract' Agency A to commit to undertake future specific R&D activities for a period of more than 12 months. Where this occurs, Agency A has the right to invoice Company A for that work for a period of up to and including a future 12 month period. In those circumstances pre-contracted work over the next 12 month period is undertaken in accordance with the process set out in figure 1 (see above). Pre-contracted work not undertaken in the financial year is to be credited to Company A's account.

Agency A reserves the right to request Company A to pay the next month's forecast project costs to Agency A in advance of the work being undertaken for that month.

The Agreement (at schedule 2) gives forecast total project costs for the period June 2009 to June 2010 of $Z (excluding GST).

Intellectual property and commercial rights

Background intellectual property to be used in the R&D project is licensed to Agency A by Company A.

Intellectual property created during the term of the R&D project initially vests in Agency A but is assigned to Company A when the corresponding amounts invoiced by and due to Agency A are paid. Company A is given exclusive commercial rights for the exploitation of this intellectual property.

Approved sub-contractors

The agreement contains a list of approved sub-contractors as follows:

§ Company B

§ Entity B

Termination of the agreement

Either party may immediately terminate the Agreement by written notice if the other party

§ is the subject of an Insolvency Event

§ ceases, or indicates it is about to cease, carrying on its business

§ there is a change in the effective control of that party, or

§ is in breach of its confidentiality obligations under the Agreement

Company A may terminate the Agreement by written notice to Agency A if Agency A is in breach of its obligations under the agreement, and it does not remedy the breach for 14 days after receiving written notice of the breach.

Agency A may terminate the Agreement by giving written notice to Company A if the company fails to pay an amount due and payable under the agreement to Agency A within 14 days of the date when the payment is due.

Conduct of the parties to the Agreement

Agency A raised an invoice to Company A for $Z + GST according to the terms of the Agreement. This invoice has not been paid. The term of the Agreement was subsequently extended by 12 months (by an addendum to the agreement signed by the parties).

Agency A sent a statement of claim to Company A for one months forecast project costs of $P + GST (representing ¹/₁₂ of $Z) in accordance with the Agreement. Payment was requested within one month. The taxpayer has stated that it was verbally agreed that no action was to be taken by either party until the question of Company A's R&D tax concession claim was resolved. However, in the event that the ATO decision is unfavourable, Company A expects to be the subject of a claim by Agency A including penalties as described in the Agreement.

Agency A sent a letter to Company A confirming a debt to Agency A of $B.

The amount referred to in the above letter has not been paid by Company A and no formal recovery action has been instituted by Agency A.

To date work on the project under the Agreement has not commenced pending finalisation of funding.

Financing the project

The project was initially envisaged as a collaborative venture between Entity B and Company B/Company A under which each participant would pick up its own costs. However at the time of the global financial crisis the project became a pursuit entirely belonging to Company A.

Company A has an understanding with Company C to provide an investment facility (originally stated to be up to $Rm for the 2010 year of income). Conditions precedent for awarding the support include:

§ that the companies R&D activities are to be contracted through and managed by a professional R&D management company (Agency A was nominated and agreed to by Company C), and

§ receipt of the R&D tax offset from the ATO or an alternative funding source.

To date no financing has been secured.

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.

For the purposes of this ruling 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.

Agency A is a registered research agency for the purposes of paragraph (c) of the definition. Relevantly, in relation to amounts contracted to Agency A for the year ended 30 June 2010 Company A will be entitled to such deduction if, inter alia, it incurred the expenditure to Agency A 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 Taxation Ruling 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.

The meaning of 'incurred'

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 and section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997). From these decisions a number of relevant principles emerge which are contained in Taxation Rulings TR 97/7 Income tax: section 8-1 - meaning of 'incurred' - timing of deductions; and TR 94/26 Income tax: section 8-1 - meaning of 'incurred' - implications of the High Court decision in Coles Myer Finance.

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

TR 97/7 provides that an outgoing is generally incurred at the time you owe a present money debt that you cannot escape. The ruling clarifies that, if an amount remains unpaid at a particular time, then that taxpayer must be 'completely subjected' to the outgoing for it to have been incurred at that time. An expected or contingent outgoing is not incurred no matter how certain it is that it will be incurred in the future (ref New Zealand Flax Investments Ltd v. FC of T (1938) 61 CLR 179 at 207; FC of T v. James Flood Pty Ltd (1953) 88 CLR 492, at 506).

Whether an expense has been incurred is a legal question in each case, having regard to the circumstances under which the liability is claimed to arise. For example in Ogilvy and Mather Pty Ltd v. FC of T 90 ATC 4836; (1990) 21 ATR 841 an advertising agent who reserved advertising space claimed deductions based on the time when contractual 'non-cancellation' periods commenced (from which time orders withdrawn did not relieve the taxpayer from the obligation to pay the price of the advertisement). In denying the claim the Federal Court of Australia held that on the proper analysis the expenditure was not incurred at the commencement of the non-cancellation period because (Per Sweeney and Ryan JJ):

At that time, in our view, the agent had not completely subjected itself to the liability in the sense that ``payment was a matter of commercial certainty and was not subject to any contingency which would be regarded as such in the world of ordinary business affairs'' (Commercial Union Assurance Co. of Australia Ltd. v. F.C. of T. 77 ATC 4186 at p. 4194; (1977) 32 F.L.R. 32 at p. 43). Here payment depended on more than the mere effluxion of time from the commencement of the non-cancellation period.

TR 97/7 also states that, for the purposes of section 8-1 of the ITAA 1997 it may also be a requirement that an outgoing must be properly referrable to the year of income in which the deduction is sought. TR 94/26 elaborates on when an outgoing is 'properly referrable' to a year of income. The ruling does not exhaustively state the types of liabilities where it will be necessary to determine the whether the liability incurred is referrable to a particular year of income. In Coles Myer Finance 93 ATC 4220; 25 ATR 95 the joint judgement (apportioning the expenses) was concerned to avoid the distortionary effects of liabilities which are only to be discharged in the future. This does not require an expense to be matched to any particular assessable income (for the purposes of section 8-1 of the ITAA 1997). However 'properly referrable' is concerned with the period of time during which the benefit from incurring the loss or outgoing is put to 'profitable advantage'. At paragraph 30 of TR 97/7 a number of examples are given. For example in the case of expenditure on advertisements, provided the advertisements are not pre-paid, the liability is to be spread over the period during which the advertisements are run.

Accounting treatment is indicative (but not determinative) of the question of the extent to which a liability is to be regarded as incurred in a year of income. Per TR 94/26 at paragraphs 32 and 33:

32. Support for this view is also found in Australian Guarantee Corporation . In that case the taxpayer had claimed an amount of interest deduction for each year in relation to long term deferred interest debentures. Toohey J stated (84 ATC 4648, 15 ATR 991) that:

'If such an approach was in accord with sound accountancy practice, designed to give a true picture of the taxpayer's earnings and outgoings, I see no reason why the taxpayer should not be allowed a deduction accordingly, unless there is something in the Act that precludes such a course or indicates a different course'.

Toohey J then concluded that the taxpayer's approach was not 'precluded by the language of the Act' (84 ATC 4650; 15 ATR 992).

33. Toohey J also endorsed (84 ATC 4649, 15 ATR 991) Lee J's approach, at first instance in Australian Guarantee Corporation , on the use of accounting evidence. He stated that the use of accounting evidence:

' ... does not mean that accounting practice is being used as a substitute for the true meaning of "incurred" in [the former] subsection 51(1). All it means is that accounting practice is identifying in respect of that liability, which is a present liability to pay the whole of the interest at a future time, the amount which is to be treated as an outgoing "incurred" during each year of income'.

Lee J also stated in Australian Guarantee Corporation that:

In this situation it seems to me that accounting practice can be resorted to identify the extent to which a presently existing liability to be discharged in another year, should be treated as an "outgoing incurred" in the year of income.

Determining the existence of a present liability from the facts

In determining whether there exists, at a particular time, 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 are 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'. ATO ID 2006/338 also refers to Green v. Wilden Pty Ltd [2005] WASC 83 in placing weight on the conduct of the parties in determining the nature of the obligations in that decision.

Conclusion

Company A has, at the time it entered into the Agreement with Agency A, subjected itself to binding contractual obligations. However, as noted in Ogilvy and Mather Pty Ltd v. FC of T 90 ATC 4836; (1990) 21 ATR 841 contractual obligations that preclude a taxpayer from unilaterally avoiding the obligation to pay do not by themselves determine that an expense has been incurred for the purposes of the tax law.

An analysis of the Agreement shows that payment of the amount of the original invoice issued to Company A by Agency A ($Z + GST), and the amount referred to in the letter ($B), depends on more than the mere passing of time.

Payments from Company A to Agency A, under the Agreement, are based on a cycle of monthly progress payment claims on 14 day terms reflecting invoices received by Agency A from sub-contractors, the PMO fee calculated by reference to project costs invoiced by third parties to Agency A, and any other approved disbursements (see paragraph 16). Agency A is not entitled to require payment in advance from Company A for a 12 month period, and is restricted to requesting payment in advance for one months estimated project costs under the Agreement.

As noted in Taxation Ruling TR 97/7, whether an expense has been incurred is a legal question in each case, having regard to the circumstances under which the liability is claimed to arise. The conduct of the parties is also relevant to determining the nature of the obligations. In this case it is relevant that:

§ no payments have been made under the Agreement from Company A to Agency A either during the year ended 30 June 2010 or to date, even the one month in-advance progress payment in the statement of claim from Agency A remains in abeyance by agreement between the parties,

§ no formal recovery action has been taken by Agency A for any payments from Company A,

§ no work through Agency A was done on the relevant project in the year ended 30 June 2010 or to date, and

§ no funding has been obtained to commence the project and Company A does not have sufficient other assets to commence the project.

In these circumstances the fact that Company A has accounted for the total amount contracted to Agency A in respect of the year ended 30 June 2010 as a revenue expense in that year is not sufficient to establish that that amount is expenditure incurred under subsection 73(13) of the ITAA 1936 in the year ended 30 June 2010.

Company A has not incurred the expenditure contracted to Agency A in the year ended 30 June 2010 for the purposes of subsection 73B(13) of the ITAA 1936. Therefore Agency A has not satisfied the conditions of subsection 73J(1) and is not eligible to claim the R&D tax offset in respect of that expenditure for the year ended 30 June 2010.

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