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Authorisation Number: 1012759551365

Ruling

Subject: R&D activities conducted for a foreign resident

Question

Is Company A, as head entity of the Company A tax consolidated group (Company A TCG), entitled to a notional deduction under section 355-205 of the Income Tax Assessment Act 1997 (ITAA 1997) for R&D expenditure incurred by Sub Co, a subsidiary member of the Company A TCG, on R&D activities undertaken by Sub Co for Foreign Co pursuant to the R&D Agreement?

Answer

Yes.

This Ruling applies for the following period:

1 December 2012 to 30 November 2016

Relevant facts and circumstances

Overview

Company A is incorporated under the Corporations Act 2001 and is the head company of the Company A TCG. The Company A TCG undertakes, through its subsidiary member, Sub Co, various R&D activities.

Additionally, Company A is a wholly owned member of the Overseas Group. The ultimate holding company of the Overseas Group is Overseas Inc which is an overseas based company with headquarters located in Country Z.

Foreign Co is located in Country Y and is also a wholly owned member of the Overseas Group.

Overseas Inc owns 100% of the equity interest in both Company A and Foreign Co.

This Ruling does not apply for any relevant years of income in which the equity interests within the Overseas Group are varied to such an extent that the condition in subparagraph 355-220(1(c)(i) is not met.

R&D Activities

The R&D activities undertaken by the Company A TCG can be effectively separated into two distinct areas, namely:

• R&D activities conducted for the purposes of the local Australian market with the resulting intellectual property being retained exclusively in Australia - there is no external involvement from or recharging to overseas group members in this instance.

• R&D activities undertaken by Sub Co for Foreign Co pursuant to the R&D Agreement between Foreign Co and Sub Co. These activities can also extend to any activities approved by Foreign Co and agreed to by the Company A TCG.

These R&D activities are undertaken solely in Australia.

R&D Agreement

Pursuant to the R&D Agreement, Sub Co undertakes, effectively on behalf of the Company A TCG, the R&D activities for Foreign Co. As head entity of the Company A TCG, Company A is responsible for registering all R&D activities undertaken by either itself or subsidiary members of the Company A TCG, and for claiming all the R&D tax entitlements available to the Company A TCG under the ITAA 1997.

Under the terms of the R&D Agreement, Sub Co undertakes the R&D activities for Foreign Co with the resulting Intellectual Property (IP) remaining the exclusive property of Foreign Co. Similarly, all legal and beneficial rights are solely and exclusively owned by Foreign Co as from the date of their creation.

Sub Co is paid a service fee by Foreign Co for the R&D services which is equal to all the internal and external costs plus 10% (all service fee income will ultimately be returned by Company A as head entity of the Company A TCG).

The R&D activities will be undertaken by Sub Co at the direction and supervision of Foreign Co with Foreign Co retaining the power to cancel the project or change the agreed parameters settled on from time-to-time as and when required.

IP generated by the Company A TCG as a result of Sub Co undertaking R&D activities for Foreign Co is subject to reallocation to other entities under subsequent and separate commercial arrangements. Specifically, the reallocation includes the transfer of IP to Overseas Inc under a separate written service agreement between Foreign Co and Overseas Inc.

Following the reallocation of IP from Foreign Co, all IP and associated findings are retained within the broader Overseas Group structure. Specifically, IP is retained by another entity within the Overseas Group, Overseas Inc 1 that is based overseas and that is also a wholly-owned subsidiary of Overseas Inc and part of the Overseas Inc tax group.

The IP is utilised for product development and/or may provide the basis of further research activities by the group. Where group members other than Overseas Inc 1 utilise the relevant IP they do so under intra-group license agreements.

Company A is registered with Innovations Australia under section 27A of the Industry Research and Development Act 1986 for the activities to which the expenditure relates pursuant to a Notice of Registration, thereby satisfying sub-paragraph 355-205(a)(i).

This Ruling does not apply to Company A if they do not obtain registration with Innovation Australia, in accordance with the requirements of subparagraph 355-205(1)(a)(i), for the relevant years of income.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 355-35

Income Tax Assessment Act 1997 Paragraph 355-35(1)(a)

Income Tax Assessment Act 1997 Section 355-205

Income Tax Assessment Act 1997 Subsection 355-205(1)

Income Tax Assessment Act 1997 Paragraph 355-205(1)(a)

Income Tax Assessment Act 1997 Section 355-210

Income Tax Assessment Act 1997 Subsection 355-210(1)

Income Tax Assessment Act 1997 Subsection 355-210(2)

Income Tax Assessment Act 1997 Section 355-220

Income Tax Assessment Act 1997 Paragraph 355-220(1)(a)

Income Tax Assessment Act 1997 Paragraph 355-220(1)(b)

Income Tax Assessment Act 1997 Subparagraph 355-220(1)(c)(i)

Income Tax Assessment Act 1997 Subparagraph 255-220(1)(d)(i)

Income Tax Assessment Act 1997 Subparagraph 255-220(1)(d)(ii)

Income Tax Assessment Act 1997 Paragraph 355-220(1)(e)

Income Tax Assessment Act 1997 Subsection 255-220(2)

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997.

Relevant R&D entity for the purposes of the ITAA 1997

Paragraphs 3.190 and 3.191 of the Explanatory Memorandum to the Tax Laws Amendment (Research and Development) Bill 2010 states:

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

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

• expenditure incurred by the subsidiary on R&D activities is taken to be incurred by the head company;…

This is the practical effect of the single entity rule for consolidated groups under section 701-1. Accordingly, although Sub Co has entered into the R&D Agreement, as Company A is the head company of the tax consolidated group, under section 701-1 Company A is taken to be the relevant R&D entity for the purposes of this Ruling. Any reference to Sub Co throughout this Ruling should therefore be taken to be a reference to Company A when considering whether the relevant R&D entity meets the applicable legislative R&D provisions.

When notional deductions for R&D expenditure arise

Subsection 355-205(1) states:

(1) An *R&D entity can deduct for an income year (the present year) expenditure it incurs during that year to the extent that the expenditure:

(a) is incurred on one or more *R&D activities:

(i) for which the R&D entity is registered under section 27A of the Industry Research and Development Act 1986 for an income year; and

(ii) that are activities to which section 355-210 (conditions for R&D activities) applies; and……

Paragraph 355-35(1)(a) requires the R&D entity (including a body corporate incorporated under an Australian law - paragraph 355-35(1)(a)) to be registered under section 27A of the Industry Research and Development Act 1986. Company A is a company incorporated in Australia and is registered under section 27A of the Industry Research and Development Act 1986 for the activities to which the expenditure relates pursuant to a Notice of Registration, thereby satisfying sub-paragraph 355-205(a)(i).

Having therefore satisfied paragraph 355-205(1)(a), Company A will be able to claim, as head entity of the Company A TCG, notional deductions for R&D expenditure for activities undertaken and incurred by Sub Co for Foreign Co provided they are activities to which section 355-210 applies.

Subsection 355-210(1) states:

(1) An *R&D activity covered by one or more of the following paragraphs is an activity to which this section applies:

(c) the R&D activity is conducted for one or more foreign residents who are each:

(i) incorporated under a *foreign law; and

(ii) a resident of a foreign country for the purposes of an agreement of a kind described in subsection 355-35(2);

and the conditions in section 355-220 (activities conducted for a foreign entity) are met for the R&D activity;

For the purposes of paragraph 355-210(1)(c), Foreign Co would be classified as a foreign resident given it was incorporated overseas and retains no central management or major shareholders in Australia.

The term 'foreign law' in subparagraph 355-210(1)(c)(i) is defined in section 995-1 as meaning a 'law of a foreign country'. The term 'foreign country' is then further defined as '…any country (whether or not an independent sovereign state) outside of Australia and the external Territories'. As Foreign Co is also a body corporate incorporated under the laws of another country, subparagraph 355-210(1)(c)(i) is satisfied.

An agreement of the kind described in subsection 355-35(2) is a double tax agreement which applies to Australia and the relevant foreign entity. A comprehensive double tax agreement presently exists between Australia and the country in which Foreign Co is incorporated overseas. Subparagraph 355-210(1)(c)(ii) is also therefore satisfied.

Subsection 355-210(2) states:

However, an *R&D activity is not an activity to which this section applies if the activity is conducted, to a significant extent, for one or more other entities not covered by any paragraph of subsection (1).

Note: An entity would not be covered by, for example, paragraph (1)(c) if the conditions in section 355-220 were not met for the R&D activity in relation to that entity.

Sub Co will not be conducting any R&D activities to a significant extent, for one or more other entities not covered by any paragraph of subsection 355-210(1) - Sub Co will in fact be conducting R&D activities only for an entity covered by subsection 355-210(1) (that is, an entity covered by paragraph 355-210(1)(c)). Subsection 355-210(2) will therefore not apply to prevent subsection 355-210(1) from applying to any of the R&D activities undertaken by Sub Co for Foreign Co.

Given that the preliminary conditions in subparagraphs 355-210(1)(c)(i) and (ii) have been satisfied and that subsection 355-210(2) will not apply, Company A will be able to claim notional deductions for R&D expenditure in respect of activities conducted by Sub Co on behalf Foreign Co (a foreign entity) provided the conditions in section 355-220 are met.

Section 355-220 states:

355-220(1) For the purposes of paragraph 355-210(1)(c), the conditions for an *R&D activity conducted for one or more foreign residents are as follows:

(a) the R&D activity is conducted solely within Australia or an external Territory;

(b) if the R&D activity is a *supporting R&D activity, each corresponding *core R&D activity must be:

(i) an activity conducted, or to be conducted, solely within Australia or an external Territory; and

(ii) an activity for which the *R&D entity is or has been registered under section 27A of the Industry Research and Development Act 1986, or could be registered for an income year if that core R&D activity were conducted during the income year;

(c) when the R&D activity is conducted:

(i) each foreign resident is *connected with the R&D entity; or

(ii) for each foreign resident - either the foreign resident is an *affiliate of the R&D entity or the R&D entity is an affiliate of the foreign resident;

(d) the R&D activity is conducted:

(i) in accordance with a written agreement binding on only the R&D entity and each foreign resident; and

(ii) either directly by the R&D entity, or indirectly by another entity under an agreement binding on the R&D entity;

(e) the R&D activity is not conducted in connection with an agreement covered by subsection (2).

355-220(2)

An agreement is covered by this subsection if:

(a) the agreement is binding on the R&D entity (the first entity) and an R&D entity that:

(i) is *connected with the first entity; or

(ii) has the first entity as an *affiliate, or is an affiliate of the first entity;

while the *R&D activity is conducted; and

(b) the R&D activity is to be conducted under the agreement by the first entity or by an entity:

(i) who is not bound by the agreement; and

(ii) who is to conduct the R&D activity directly or indirectly under another agreement to which the first entity is, or will become, bound.

Paragraph 355-220(1)(a) - the R&D activity is conducted solely within Australia

This condition is satisfied as Sub Co undertakes the R&D activities (on behalf of the Company A TCG) solely in Australia, and no R&D activities are conducted outside Australia or its Territories.

Subparagraphs 355-220(1)(b(i) and (ii) - supporting R&D activity

The Company A TCG engages in pharmaceutical based activities including the testing and development of animal vaccines. These activities are categorised as core activities given they include scientific experimentation for the purpose of generating new knowledge. Therefore, so long as these supporting activities continue to be directly related to, or for the dominant purpose of supporting the core activities and are undertaken solely within Australia, they will be considered to be supporting R&D activities in satisfaction of paragraph 355-220(1)(b)..

Subparagraph 355-220(1(c)(i) - foreign resident (Foreign Co) is *connected with the R&D entity (Company A)

For the purposes of subparagraph 355-220(1(c)(i), the relevant 'foreign resident' is Foreign Co.

Pursuant to paragraph 328-125(1)(a) an entity is connected with another entity if:

(a) either entity controls the other entity in a way described in this section; ..….

Pursuant to paragraph 328-125(2)(b)

An entity (being the first entity) controls another entity if the first entity, its *affiliates, or the first entity together with its affiliates:…

(b) if the other entity is a company - own, or have the right to acquire the ownership of, *equity interests in the company that carry between them the right to exercise, or control the exercise of, a percentage (the control percentage) that is at least 40% of the voting power in the company

An affiliate is defined in section 328-130(1) as follows:

An individual or a company is an affiliate of yours if the individual or company acts, or could reasonably be expected to act, in accordance with your directions or wishes, or in concert with you, in relation to the affairs of the *business of the individual or company.

Company A is an affiliate of Overseas Inc as based on Overseas Inc's 100% ownership of Company A, Company A `...could reasonably be expected to act… in concert with Overseas Inc.

Paragraph 328-125(2)(b) is therefore satisfied as an entity (the first entity, being Company A) controls another entity (Foreign Co) as Company A's affiliate (Overseas Inc) owns an equity interest in Foreign Co that between Company A and Overseas Inc gives them the right to exercise a control percentage that is at least 40% of the voting power of Foreign Co (in this case, the control percentage is 100% as Overseas Inc currently owns 100% of Foreign Co).

Accordingly, as Foreign Co is controlled by Company A, it is connected with Company A and accordingly satisfies subparagraph 355-220(1(c)(i).

Subparagraphs 355-220(1)(d)(i) and(ii)- how the R&D activity is conducted

Ultimately, pursuant to the R&D provisions of the ITAA 1997, it is Company A as head entity of the Company A TCG that is taken to conduct R&D activities for Foreign Co pursuant to the R&D Agreement. The R&D activities undertaken in accordance with the agreement are conducted solely by Sub Co (on behalf of Company A, the relevant R&D entity) without additional delegation.

Paragraph 355-220(1)(e) - R&D activity is not conducted in connection with an agreement covered by subsection 355-220(2)

The R&D Agreement identifies Sub Co and Foreign Co as the two parties subject to the terms and conditions contained within the agreement. No other parties have been identified and could not be deemed to be subject to the contents of the agreement. None of the R&D activities undertaken by Sub Co are subcontracted away. In these circumstances, the Commissioner does not accept that the R&D Agreement is of a kind covered by subsection 355-220(2).

Conclusion

As the conditions in section 355-220 have been satisfied, Company A, as head entity of the Company A TCG, is entitled to a notional deduction under section 355-205 for R&D expenditure incurred by Sub Co, a subsidiary member of the Company A TCG, on R&D activities undertaken by Sub Co for Foreign Co pursuant to the R&D Agreement.

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