Edited version of private ruling

Authorisation Number: 1011655288648

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Ruling

Subject: Subsection 73B(9) of the Income Tax Assessment Act 1936

Question

Are the research and development activities undertaken by the rulee that are registered with Innovation Australia in the income year, carried on by or on behalf of the rulee as specified in the definition of research and development expenditure in subsection 73B(1) of the Income Tax Assessment Act 1936 (ITAA 1936) and the meaning of the notional Division 40 deduction in subsection 73BC(2) of the ITAA 1936 and not on behalf of another for the purposes of subsection 73B(9) of the ITAA 1936?

Answer

Yes, the research and development activities undertaken by the rulee that are registered with Innovation Australia in the income year, are carried on by or on behalf of the rulee and not on behalf of another.

Relevant facts and circumstances

Background

The rulee is an Australian proprietary company limited by shares.

The rulee lodged an application for registration under section 39J of the Industry Research & Development Act 1986 (IR&D Act) with Innovation Australia (the Board) for the year of income. The applicant was advised that the delegate of the Board had approved registration for the period.

Research and Development Activities

There is only one entity conducting the research and development activities. The everyday business of the rulee is research and development.

The applicant has advised that the research and development activities registered with Innovation Australia meet the requirements of the definition in subsection 73B(1) of the ITAA 1936.

The applicant advised that the principal intention of the R&D conducted by the rulee is to develop products for use by third parties, including Company A. The rulee is confident that despite the risks, it will eventually be able to manufacture products developed out of its R&D activities. However, as this has not yet been achieved on the desired scale, funding has been achieved by providing knowledge to Company A pursuant to the licence agreement.

Company A does not provide the rulee with specifications for products prior to the rulee starting an R&D project for these.

The rulee selects the R&D projects based on its own knowledge of the industry and based on the trends in general. Company A has little or no involvement in selecting the projects or development of products by the rulee, and does not request that the rulee undertake particular product development. The rulee does not tender to develop any products for Company A.

Licence Agreement

The applicant has stated that the rulee has entered into a licence agreement with Company A whereby Company A is able to use the information and data generated out of the R&D activities. The licence fee is negotiated annually and only paid upon the provision of data and information arising from the successful completion of nominated R & D activities.

The Licence Agreement provides that the Licensor is the rulee and the Licensee is Company A.

The Licence Agreement provides that the rulee grants to Company A the licence and the rulee undertakes to do all acts and provides all assignments, transfers and licences as may be legally permissible and appropriate to ensure that Company A is licensed in respect of all rights which the rulee had immediately prior to this agreement.

The Licence Agreement provides that the 'licence' is the use of the information and data generated out of the research and development activities.

The Licence Agreement states that the rulee warrants that to the best of its knowledge, information and belief it is the legal and beneficial owner of proprietary rights.

Under the Licence Agreement, Company A will pay the rulee a licence fee negotiated annually based upon the provision of technical data and information arising from the successful completion of nominated research and development activities. Company A has the right to negotiate the cessation of the payment for the technical data and information if they deem that there is no benefit derived.

Company A does not have any right to assign, in whole or in part, its rights or obligations under this agreement without the rulee's written consent.

The applicant has advised that the licence agreement does not include an exclusivity clause as it is a non-exclusive licence. The rulee continues to own the intellectual property and has the ability to licence the same information to other parties without any restrictions.

Company A may use the knowledge obtained from the rulee as a basis to build products which may be modified. If Company A chooses to use the information provided by the rulee to create a new product, they do not need to produce this product in house. Further, Company A can contract another person to produce products based on the information without breaching the licence agreement.

Financial Risk

The everyday business of the rulee is R&D. The applicant has advised that income is derived from the licensing of the intellectual property gained and the sale of prototype parts. The R&D activities have not yet been successful enough to warrant manufacture of products for use by third parties.

The rulee does not advertise its products for sale.

A copy of the R&D plan results (excluding financial data) is made available to Company A in late July/early August each year and the fee is negotiated in accordance with the licence agreement.

Control

The applicant has advised that the research and development activities undertaken during the year were determined by the sole director of the rulee, in conjunction with his senior engineers. The applicant further advised that the involvement of Company A was limited and of a general nature only.

There are no written agreements between the rulee and other parties regarding the conduct of the research and development activities.

The applicant provided that the rulee has total control over the ability to choose, change, stop, follow up or end its R & D activities.

Intellectual property

The applicant has stated that the rulee legally owns all intellectual property developed as a result of undertaking the R & D activities and provided copies of letters from Company A confirming this.

The applicant has stated that there are no registered patents, however the rulee owns the intellectual property for the technology developed and has the ability to sell products developed as part of the R&D activities. The results of the R&D are commercially available to any party.

The applicant provided a sample of invoices which they advised were for various products sold to unrelated third parties.

Reasons for Decision

On own behalf

An eligible company cannot claim a deduction under subsections 73B(13), 73B(14) or section 73BA of the ITAA 1936 for its expenditure under the R&D tax concession unless that expenditure is incurred in respect of research and development activities carried out by or on behalf of that eligible company. This requirement is set out under the definition of 'research and development expenditure' in subsection 73B(1) and the meaning of 'notional division 40 deduction' in section 73BC of the ITAA 1936.

In addition, under subsection 73B(9) of the ITAA 1936, an eligible company generally cannot claim a deduction at the concessional rate in respect of expenditure incurred for the purpose of carrying on research and development activities on behalf of any other person. It is not necessary that the company be acting as agent of the other, the question is whether, in all circumstances, the R&D is to be carried out in substance for the other. This will be a question of fact in each case.

The requirements in section 73BC and subsections 73B(1) and 73B(9) of the ITAA 1936 (collectively referred to as the 'on own behalf' requirement) effectively prevent companies making double deductions in respect of the same research and development activities by restricting entitlement to the concessional deductions to the company that:

§ bears the financial risk associated with a R&D project

§ has control over the R&D project, and

§ effectively owns the project results.

Arrangements which in substance abdicate either ownership, financial risk or control could compel the conclusion that research and development activities were not being carried out by or on behalf of a company.

The tests of when a company has research and development activities carried out by it or on its behalf, and when it incurs expenditure for the purpose of carrying on research and development activities on behalf of another, are tests which are determined on the facts.

Financial risk

Where research and development activities are carried out on behalf of a company, it would generally be expected that the company would bear the financial risk of the activities undertaken. A deduction would not necessarily be prevented in circumstances where a company does not bear the financial risk of an R&D project, but effectively owns the results and controls the conduct of the R&D project. The requirement that the eligible company bear the financial risk for the research and development activities does not preclude the company from contracting out some or all of the company's R&D work.

Where an eligible company performs research and development activities under contract for another person and does not bear the financial risk and does not have any entitlement to the results of that R&D, that company would not be entitled to claim a deduction under section 73B of the ITAA 1936 for the expenditure incurred in fulfilling its obligations under the contract.

Generally a company would bear the financial risk in relation to research and development activities where these activities are merely incidental to the supply of a saleable product for a fixed price that bears no relationship to the extent of research and development activities the company may need to conduct in order to produce this product.

The rulee has advised that they received in income in relation to the research and development activities. Of this amount approximately half was received from Company A with the remainder being received from sales of components to other third parties. The total income received was quarter of the amount shown as expenditure under the R&D tax concession in the rulee's tax return. This shows that the amount received from third parties in respect of the rulee's research and development activities bears no relationship to the cost of the research and development activities being conducted.

Where an eligible company in a non-consolidated group (for income tax purposes), incurs research and development expenditure which is reimbursed by another entity in the group that suggests this company is not bearing the financial risk in relation to the associated research and development activities.

The rulee was not reimbursed for the expenditure incurred as a result of its R&D program. The amounts paid by Company A were agreed after the year in which the research and development activities were completed and based on the knowledge gained out of the R&D program rather than a reimbursement of expenditure incurred.

It is considered that the rulee bears the financial risk of the activities undertaken in the year.

Control of the research and development activities

A company seeking to claim the concession under sections 73B and 73BA of the ITAA 1936 (except under subsection 73B(14C)) in relation to particular research and development activities must be able to demonstrate an appropriate degree of control over the conduct of the activities. When research and development activities are carried out by or on behalf of a company, it would be expected that the company should exercise proper control over the conduct of those activities.

Essential elements of control of the conduct of research and development activities are:

§ the ability to choose the project of R&D;

§ the capacity to decide on major changes of direction in those activities;

§ the ability to stop an unproductive line of research;

§ the scope to follow up (or not) an unexpected result; and,

§ the power to end a project.

The rulee states they have 'total control over the ability to choose, change, stop, follow-up or end' its research and development activities and there are no written agreements between the rulee and other parties regarding the conduct of the research and development activities. The director and senior engineers prepare an R&D plan for each product.

On this basis it is considered that the rulee has demonstrated an appropriate degree of control over the conduct of the research and development activities.

Ownership

A company seeking to claim the concession under sections 73B and 73BA of the ITAA 1936 (except under subsection 73B(14C)) in relation to particular research and development activities must have effective ownership of the results of those activities.

This does not necessarily mean that the company must be the proprietor of a piece of intellectual property in any formal sense. First, the relevant formal regimes of intellectual property-copyright, patent, or registered design-may be unavailable to protect the results. Second, it is possible for the formal owner of any resulting intellectual property to hold it on such terms that the company has all the advantages of ownership.

No patents have been registered as a result of the research and development activities, however the applicant has advised that the rulee owns the intellectual property for the technology developed and has the ability to sell products developed as part of the R&D activities.

Some theoretical rights of ownership may be given to others without denying this effective ownership to a claimant. For instance, a company having R&D carried out on its behalf might completely control commercial use of the results of that R&D, including further development of those results for commercial purposes, yet permit the researcher certain exclusive rights of scientific publication. The company would nevertheless be the effective owner of the results in the ordinary case. Similarly, actual use of particular results may only be possible in limited ways or for limited purposes, so that apparently limited rights can really amount to full effective ownership. For instance, exclusive rights of commercial use and development for only a few years might amount to full ownership in a particularly ephemeral area of R&D.

The rulee, rather than Company A, controls the commercial use of the results of the research and development activities.

Although Company A is permitted to use the results of the research and development activities as agreed in the Licence Agreement, Company A has confirmed that the rulee owns all intellectual property. Each invoice relating to third party sales contains a disclaimer indicating that the intellectual property in relation to the goods sold remains the property of the rulee.

There might be pre-arrangements between companies seeking to claim deductions under section 73B of the ITAA 1936 and other parties involving a sale, option, or irrevocable and exclusive commercial licence of the results of a program of research and development activities, entered into before those results are known. Where a price or royalty percentage is fixed in advance, research and development activities are carried on for the benefit of the buyer, option-holder or licensee because the company's reward does not reflect the value of the actual R&D results; even in the percentage royalty example, the fixing of the percentage may not reflect the bargaining power of the holder of successful R&D results.

The licence granted to Company A is non-exclusive and the rulee sells products to third parties. The applicant has advised that the amounts paid by Company A for the year were based on the knowledge gained out of the R&D program.

It is considered that the rulee has both the effective and legal ownership of the results from its research and development activities.

Conclusion

The rulee satisfies the on own behalf requirements under section 73BC and subsections 73B(1) and 73B(9) of the ITAA 1936 as it bears the financial risk associated with a research and development project, has control over the research and development project, and effectively owns the project results.