Edited version of private ruling

Authorisation Number: 1011811915311

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Ruling

Subject: Private ruling in relation to section 73CA of the Income Tax Assessment Act 1936

Question 1

Does section 73CA of the Income Tax Assessment Act 1936 (ITAA 1936) apply to reduce deductions claimed by the Company in respect of expenditure under sections 73B, 73BA or 73BH of the ITAA 1936 due to the existence of an agreement that may allow some of the expenditure incurred under these provisions to be recouped in certain future circumstances?

Advice/Answers

No, the existence of the agreement does not reduce deductions claimed by the Company in respect of expenditure under sections 73B, 73BA or 73BH of the ITAA 1936.

Relevant facts

The Company envisages they will require a program of R&D activities to be conducted.

The Company has asserted that the current activities as well as all future activities that the company wishes to claim expenditure for under the R&D tax concession, are research and development activities as defined in subsection 73B(1) of the ITAA 1936.

A series of subcontractors will perform the activities under either a direct cost reimbursement or a schedule of fees arrangement. Each contract currently executed specifically states that the Company will own all X developed as a result of any studies and that the Company will have an irrevocable license to all background X on which the results are based. It is the Company's policy that future contracts be on the same terms.

If some of the Company's proposed R&D is not successful, depending on the nature of the unsuccessful R&D, the R&D activities may not go ahead to completion. If the R&D activities are not completed, no amount can be received under the agreement.

The Company has entered into an agreement imposing certain contractual obligations. Under the agreement, the company may elect to request money from the others parties if:

· the R&D activities are completed

· the product developed is unable to be used to its full capacity.

Consequently, if the R&D activities cannot be completed, the Company cannot request money from the other parties to recover costs of the partially completed activities.

Even if the conditions of the agreement are met, the Company does not have to request money from the other parties.

Where imposed, the agreement has the effect of recovering the cost of the R&D from current and future customers of the Company.

If imposed, the Company does not have to continue to request the money if its circumstances change. The company must assess its circumstances at the beginning of each year in order to make a new decision.

The Company has stated that it may take years for costs to be recovered through the agreement.

The agreement contains a clause that directs the Company to minimise its use of the levy to recover costs.

The Company anticipates that it will not need to apply the agreement to recover costs.

The Company provided a number of other reasons why the agreement may be unable to be utilised, including being unable to obtain approvals from the appropriate external parties.

If an amount is received under the agreement, it will be received by the Company, not an associate.

Relevant legislative provisions

Section 73B of the ITAA 1936

Section 73BA of the ITAA 1936

Section 73BH of the ITAA 1936

Section 73CA of the ITAA 1936

Reasons for decision

Issue 1

Question 1

Summary

Factors external to the agreement as well as the intention of the parties to the agreement, reflect that at the time that the Company incurs its R&D expenditure, it does not have a reasonable expectation of recovering costs via the agreement. As a result, 73CA does not apply to the Company in these circumstances.

Detailed reasoning

The effect of section 73CA of the ITAA 1936 is to limit the research and development deduction available under sections 73B, 73BA and 73BH of the ITAA 1936 to the extent that an eligible company claiming the deduction is 'at risk' in relation to its research and development (R&D) expenditure.

Under subsection 73CA(2), section 73CA of the ITAA 1936 applies if the Commissioner is satisfied that, when the relevant expenditure was incurred, the company was 'not at risk' in respect of the whole or a part of the expenditure.

In this respect, subsection 73CA(5) of the ITAA 1936 sets out the basis for how the Commissioner is to be satisfied that when the expenditure in question was incurred, the eligible company, was 'not at risk in respect of the whole or a part of' that expenditure. The subsection reads as follows:

For the purposes of the application of this section in relation to any expenditure incurred by a company, the company is taken to have not been at risk at the time when the expenditure was incurred in respect of so much of the expenditure as does not exceed any consideration that, in the opinion of the Commissioner, because of:

(a) any act that occurred, transaction or agreement that was entered into, or circumstance that existed, before or at that time; or

(b) any act that was likely to occur, any transaction or agreement that was likely to be entered into, or any circumstance that was likely to exist, after that time;

the company or any associate of the company could reasonably have expected at that time to receive as the direct or indirect result of the incurring of the expenditure.

While the elements necessary for section 73CA to operate must be satisfied at the time that the expenditure is incurred, subsection 73CA(5) contemplates circumstances that would trigger its operation developing at some future date - not just presently existing. However, it is not necessary to wait to see whether these circumstances in fact eventuate, but only to determine that they are "likely" to eventuate. The word "likely" has various shades of meaning ranging from "material risk" to "probable": Tillmanns Butcheries Pty Ltd v. Australasian Meat Industry Employees' Union (1979) 42 FLR 331 at 339. Ultimately the meaning to be given to the word "likely" where it is used in a statute will depend upon the statute and the context in which the word is used - but it must be more than a bare possibility and, while not probable, an event that could well happen: Transport Ministry v. Simmonds [1973] 1 NZLR 359 at 363.

At paragraph 19 of Taxation Ruling No. IT 2635 (IT 2635) mention is made of the fact that whether or not certain matters 'result in a recoupment should involve a substance approach with regard to the economic realities and not just contractual form: see Dampier Mining Co. Ltd. v. FCT 78 ATC 4237 at 4249; (1978) 8 ATR 835 at 848'.

For subsection 73CA(5) of the ITAA 1936 to apply to the Company, it must be the case that because of the matters specified in paragraphs 73CA(5)(a) and 73CA(b) of the ITAA 1936, the Company (or an associate) could reasonably have expected to receive an amount as a direct or indirect result of the expenditure being incurred.

What matters do paragraphs 73CA(5)(a) and 73CA(5)(b) of the ITAA 1936 cover?

Arguably, paragraphs 73CA(5)(a) and 73CA(5)(b) of the ITAA 1936 could be read as extending to practically all matters, particularly given the references to any 'circumstance' that existed or was likely to exist. However, the Commissioner does not take this view.

The two paragraphs direct attention to the features of the relationship between the parties involved in the arrangements under which the expenditure is incurred. In this respect the paragraphs can extend to any combination of formal contracts, side-arrangements, informal understandings, options and the like. But they do not extend to such matters as the technical, scientific or commercial prospects of the relevant research and development activities themselves.

Therefore, the subsection is attracted if in any event, as a result of incurring the expenditure, some consideration could reasonably have been expected to be received because of the arrangement among those parties, even if, in particular, the expenditure fails to produce the intended technical result. In other words, the question is whether one can predict from the contractual arrangement itself, without regard to other matters of the type referred to above, that the incurrence of the expenditure will result in the receipt of consideration.

By contrast, subsection 73CA(5) of the ITAA 1936 does not apply to a company that, at the relevant time, could not reasonably expect to receive any consideration from any source in the event that the expenditure would result in technical failure. This would be so even if the company reasonably ought to have had a high degree of confidence that the project would succeed technically. That degree of technical confidence is not one of the matters specified in paragraphs 73CA(5)(a) and (b) of the ITAA 1936. Therefore it cannot be taken into account as a possible cause of an expectation of a receipt of consideration resulting from the expenditure.

Section 73CA of the ITAA 1936 could well be attracted by an arrangement of any kind between parties (that is, whether formal or informal) under which it is apparent from the terms and features of the arrangement itself that the investing company is likely to receive money back as a direct or indirect result of incurring expenditure, regardless of whether the technology is successfully developed (subsection 73B(9) of the ITAA 1936 may also potentially apply in such a case).

Application of 73CA to the Company

The levy can only be imposed once the R&D is completed and the product developed is unable to be used to its full capacity.

Therefore, it is considered that at the time that the R&D expenditure is incurred, no amounts will be received in respect of that expenditure as the agreement conditions have not yet been met. As a result, the operation of subsection 73CA(5) in this instance needs to be considered in relation to how likely it is that the scenario described in subsection 73CA(5) will eventuate at some future date. Whether these conditions actually eventuate is irrelevant to the current analysis.

There are a number of reasons why the Company may be unable to impose the levy. If any of the circumstances occur, the Company will receive no consideration as a result of the agreement.

The agreement contains a clause that directs the Company to minimise its use of the levy to recover costs. The Company has advised that it intends to comply with this clause. It is considered that this clause, along with the stated intention of the Company confirming their understanding of this clause, indicates that at the time of incurring the expenditure, the Company does not expect to receive the levy.

Further, economic factors for the industry can substantially affect the ability of the Company to recover costs under the agreement due to pricing pressures.

The cost recovery under the agreement is not compulsory. There is nothing explicit in the agreement that suggests that the Company must recover costs. Further, the agreement itself ensures its use is minimised. Therefore, it cannot be said that because of the agreement consideration will be received by the Company as a recoupment of its R&D expenditure.

Unless the Company has a reasonable expectation of receiving consideration for the expenditure, at the time that the expenditure is incurred and in relation to acts that occurred, transactions or agreements entered into, or circumstances that exist before or at the time of the expenditure being incurred, or likely to occur in the future, section 73CA of the ITAA 1936 will not apply.

Factors external to the agreement as well as the intention of the parties to the agreement, reflect that at the time that the Company incurs its R&D expenditure, it does not have a reasonable expectation of recovering costs via the agreement. As a result, 73CA does not apply to the Company in these circumstances.