Edited version of private ruling

Authorisation Number: 1011825126340

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Ruling

Subject: Research and development tax concession

This ruling applies to

Company A

Question 1

Are the research and development activities undertaken by Company A in relation to the project "design and development of new claims management system" carried on by or on behalf of Company A as specified in the definition of research and development expenditure in subsection 73B(1) of the Income Tax Assessment Act 1936 (ITAA 1936) and not on behalf of another for the purposes of subsection 73B(9) of the ITAA 1936?

Advice/Answers

No, the research and development activities undertaken by Company A in relation to the project "design and development of new claims management system" are carried on on behalf of Company B and not on behalf of Company A.

Relevant facts and circumstances

Background

1. Company A is an Australian proprietary company limited by shares and meets the definition of an 'eligible company' under subsection 73B(1) of the ITAA 1936.

2. Company A has not yet lodged a registration of research and development activities under section 39J of the Industry Research & Development Act 1986 (IR&D Act) with Innovation Australia (the Board) in respect of its research and development activities that are relevant to this ruling.

3. Company A has asserted that the activities that are relevant to the ruling meet the definition of 'research and development activities' in subsection 73B(1) of the ITAA 1936. The Commissioner provides this ruling on the assumption that this assertion is correct.

4. Company A has not yet lodged a tax return for the income year 1.

5. Company A entered into an agreement (the Agreement) to provide services to and on behalf of Company B.

Research & Development (R&D) activities

6. Company A must have an operational information system that meets the requirements of Company B in order to be authorised by Company B to commence delivery of the services under the Agreement.

7. Company A is undertaking an R&D Project to design and develop these systems over income year 1 and income year 2.

8. The costs incurred by Company A in the R&D Project are not being directly reimbursed by Company B or any other party.

9. Company A is endeavouring to exceed the requirements of the Agreement and deliver a better product in order to achieve a competitive advantage. It is the intention of Company A to develop reusable solutions that can be exploited in providing services to other clients.

The Agreement

10. The Agreement between Company B and Company A is the only agreement concerning exploitation of the R&D results.

Fees

11. Under the Agreement a fixed amount is payable by Company B on the satisfactory completion of the systems that enable the commencement of services within a stipulated time frame. Company A is liable for damages if it is not able to commence delivery of services on time.

Intellectual Property Ownership

12. Under the Agreement legal ownership of the intellectual property created after the date the Agreement commenced in relation to the relevant systems vests in Company B.

13. Any material including software, documentation, information or data created by or for Company A in the course of performing the Agreement may only be used for the purposes of the Agreement. Any such material owned by or licensed to Company B is held by Company A as custodian only. Under the Agreement Company A and its personnel are prohibited from commercially exploiting such material other than directly in providing services under the Agreement and must surrender all copies of such material to Company B on termination of the Agreement.

Control and management of the R&D Project

14. The Company A project manager has the day to day control of the activities and control of the associated budgets in relation to the R&D Project. However under the Agreement the overarching project plan must be developed in consultation with Company B and must be approved by Company B. Any changes to the plan must be approved by Company B prior to implementation.

Personnel

15. Company A is responsible to engage and maintain sufficient personnel that are appropriately skilled in order to meet the Agreement. However, Company B has the power under the Agreement to require Company A to replace any underperforming personnel.

Information Systems

16. Under the Agreement Company A must have in place information systems that meet specified requirements and enable the provision of the agreed services.

17. Company A cannot, without the prior written approval of Company B, make changes to the information systems used in providing the agreed services. Conversely Company A is required, under the Agreement, to make changes to the information systems to meet the requirements of Company B as advised from time to time.

Assumptions

The Commissioner provides this ruling on the assumption that the activities of the R&D Project meet the definition of 'research and development activities' in subsection 73B(1) of the ITAA 1936.

Relevant legislative provisions

Subsection 73B(1) of the Income Tax Assessment Act 1936

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

Subsection 73B(14) of the Income Tax Assessment Act 1936

Subsection 73BC(2) of the Income Tax Assessment Act 1936

Reasons for decision

Issue 1

Question 1

Summary

The research and development activities undertaken by Company A in relation to the R&D Project are carried on on behalf of Company B and not on behalf of Company A.

Detailed reasoning

On own behalf

1. An eligible company cannot claim a deduction under subsections 73B(13), 73B(14) or section 73BA 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.

2. 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 research and development activities are to be carried out in substance for the other. This will be a question of fact in each case.

3. 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.

4. 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.

5. 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

6. 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.

7. 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.

8. 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.

9. In respect of the R&D Project:

· There is currently only one relevant agreement (the Agreement), between Company B and Company A.

· Under the Agreement the amount payable in respect of the part of the Agreement that includes the R&D Project activities is a fixed amount. If Company A was not able to fulfil its requirements it would be liable for damages.

10. The amount received from third parties (Company B) in respect of the research and development activities undertaken by Company A bears no relationship to the cost of the research and development activities being conducted.

11. Where an eligible company incurs research and development expenditure which is reimbursed by another entity that suggests this company is not bearing the financial risk in relation to the associated research and development activities.

12. Company A was not reimbursed by any other party for the expenditure incurred as a result of its R&D Project. The amounts paid by Company B were agreed prior to the R&D Project, and based on the results of the R&D Project rather than a reimbursement of expenditure incurred.

13. As a result the Commissioner considers that Company A bears the financial risk of the activities of the R&D Project.

Control of the research and development activities

14. 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.

15. 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.

16. Company A has the power under the Agreement to engage the personnel working on the R&D Project and decide which personnel are working on the project (although Company B can require that underperforming personnel be replaced). The Company A project manager has the day to day control of the R&D Activities and control of the associated budgets. It is Company A's responsibility to develop and implement the necessary information systems and processes to fulfil the Agreement.

17. However under the Agreement the overarching project plan must be approved by Company B, and once approved, any amendments to the project plan must also be approved by Company B prior to Company A implementing any changes. Company B also has the power under the Agreement to require Company A to revise the plan.

18. Further, Company A cannot, without the prior written approval of Company B, make changes to the information systems used in providing the agreed services. Conversely Company A is required, under the Agreement, to make changes to the information systems to meet the requirements of Company B as advised from time to time.

19. The Commissioner considers that although Company A has the day to day control over the R&D Project it is Company B that has overall control of the direction of the project. On balance the Commissioner considers that Company A has not demonstrated an adequate degree of control over the R&D Project.

Ownership

20. 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.

21. In this case title to, and relevant intellectual property rights vest in or are otherwise assigned or transferred to Company B.

22. However the test does not necessarily require that the company must be the proprietor of a piece of intellectual property in any formal sense. 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.

23. Also 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.

25. Company A has the right, under the Agreement, to exploit the research and development results in accordance with the Agreement over a considerable period and in providing services in accordance with the Agreement. However the Agreement places considerable restrictions of the exploitation of intellectual property rights otherwise than in respect of the legal owner of the rights in accordance with the Agreement.

26. In this case the results of the R&D Project become part of materials on which the Agreement places considerable restrictions in respect of Company A's use of them, for example:

· Company A holds the relevant materials as custodian for Company B only,

· Company A or its personnel cannot use or exploit the relevant materials otherwise than directly in relation to providing the agreed services, and

· if the Agreement is terminated Company A must deliver to Company B all copies of the relevant materials.

27. Where a price is fixed in advance, as is the case here, this is indicative that research and development activities are carried on for the benefit of the buyer because the company's reward does not reflect the value of the actual R&D results.

28. The Commissioner considers that Company A does not effectively own the project results because Company B legally owns the intellectual property resulting from the project and the Agreement does not provide Company A with sufficient advantages to support a view that Company A has effective ownership of the project results.

Conclusion

29. On balance, we consider that Company A does not satisfy the on own behalf requirements under subsections 73B(1) and 73B(9) of the ITAA 1936. While it bears the financial risk associated with a research and development activities, it does not have sufficient control over the research and development activities, and does not have sufficient advantages of ownership of the project results to be able to say that it effectively owns the project results.