The past 18 months have seen increasing uncertainty regarding the R&D Tax Incentive program in Australia. In March we wrote about the R&D Tax Administrative Appeals Tribunal (AAT) decisions to date and how these impact eligibility of R&D activities. Namely, there were a number of decisions that demonstrate AusIndustry and AAT are not afraid to hold claims as ineligible without substantiating documentation.
In a second article, we discussed the four ATO and AusIndustry Tax Alerts released in February relating to definitions of “ordinary business activities” and specific industry activities in Software, Agricultural and Construction R&D. The Alerts, raised a degree of alarm that the Government was moving to rein in the cost of the R&D Tax Incentive by tighter interpretation of the legislation. Most recently however, we noted with relief that the Federal Budget had no negative announcements that would impact the way companies have to date accessed the R&D refund.
Today, we write about two new cases from the AAT. The first, Rix’s Creek Pty Ltd; Bloomfield Collieries Pty Ltd and Innovation and Science Australia (2017) AATA 645, gives good insight into how the AAT has recently treated the eligibility requirement around R&D activities and the need for appropriate supporting documentation and records. The second, DZXP, KRQD and QJJS v Innovation and Science Australia (2017) AATA 573 highlights the importance of ensuring you are claiming under the correct entity. We discuss these cases and conclude with three key lessons.
CASE 1: Rix’s Creek Pty Ltd; Bloomfield Collieries Pty Ltd and Innovation and Science Australia (2017) AATA 645
Rix’s Creek Pty Ltd and Bloomfield Collieries Pty Ltd are two related mining companies which registered and claimed for the years 2008 to 2012 under the previous R&D Tax Concession program. Innovation Australia reviewed their claims and deemed the majority of the activities to be ineligible. An application was then made to the Administrative Appeals Tribunal for an independent review which upheld Innovation Australia’s original decision.
The claimed activities can be grouped into three projects, six in total across the two mines. Each of these projects were reviewed on the eligibility separately:
1. DMS project
This project tested a redesigned prototype sampling device in a coal handing plant aimed at separating coal from ground waste material.
- The design activities were only modest advances involving improvements to the materials, shape and size of known elements of the device.
- The trial and testing activities were “grossly excessive not only in extent but also in time” and unnecessarily highly repetitive.
- There was no record or documentation on the trials or experimental data for the performance of the ‘important variables”.
The Tribunal considered these activities as ordinary business activities and not meeting the definition of R&D.
2. Explosives projects
The project tested the maximum percentage of recycled oil that could be used as a replacement to diesel for explosive projects.
- The experimental methodology was lacking in rigour with minimal or no data recorded throughout the experiment. Trial results were based solely on personal observations and that no documentary evidence was kept detailing any test results. There was also no documented experimental project plan for the methods of trial and testing or project budget.
- There was insufficient evidence of a systematic progression of work from hypothesis to experiment, observation and evaluation, followed by logical conclusion. The AAT found that these activities therefore failed the purpose test through lack of documentation.
- The project seemed to lack novelty and sufficient levels of technical risk. Expert opinion was that the project of replacing a fuel (diesel) with a different type of fuel (refined waste oil) was not effectively novel and that the risks can be managed by relatively simple analysis and testing.
3. Excavator projects
These projects involved the design of new excavator buckets and customising commercially available buckets for specific mine sites.
- The ‘one variable at a time’ (OVAT) method was used on the project, where one variable was changed at a time while holding all others constant and the effects recorded. In this case, the Tribunal found the remaining variables were not controlled and the causal effect of the variables changed could not be established. The Tribunal ruled that this method was not systematic, investigative and experimental in manner, as the interaction between variables are not accounted for and therefore the results cannot be reliably attributed to the single variable being changed.
- The lack of any documentation, i.e. experimental plan, hypothesis, analysis of results also reinforced the lack of systematic and experimental procedure.
Summary of the case
The three projects reviewed failed both in meeting the definition of R&D activities and also lack documentation to evidence the systematic, investigative and experimental nature of the activities. The activities were deemed as ‘business as usual’ activities and did not meet the ‘innovation’ or ‘high levels of technical risk’ benchmark in the R&D Tax Concession legislation.
In 2012, DZXP, KRQD and QJJS entered into an unincorporated joint venture agreement to recover gas in Western Australia and lodged individual applications for overseas findings activities for 2012-2014. Innovation Australia initially found that the activities were ineligible, prompting the companies to appeal the decision to the AAT.
- The AAT decided that further review of the activities was unnecessary as the companies were not eligible to apply in the first place- as subsidiaries of a multiple entry consolidated (MEC) group.
- The companies incorrectly declared that they were individual (non-consolidated) companies and the third declared it was the head entity of the MEC on the Overseas Application. Innovation Australia relied upon the incorrect information in considering their application and making their original finding. As only the head entity in a MEC can apply for an advance/overseas finding, DZXP, KRQD and QJSS were ineligible and therefore the Tribunal decided that further review on the eligibility of the activities would be irrelevant.
Summary of the case
The companies had registered and claimed the R&D Tax Incentive under an incorrect entity. This decision highlights the importance of companies adhering to the registration requirements of the R&D tax incentive. Companies need to be aware of the broader company structure and consider who is the correct claimant.
- Firstly, it is important to establish the correct eligible entity to submit an R&D Application. Individuals, corporate limited partnerships and trusts are not eligible. The head entity is the correct claimant for tax consolidated or Multiple Entry Consolidated (MEC) groups. Ensure that all the information is filled out correctly in the application form as the AAT does not have the power to make corrections.
- Check the eligibility of the R&D activities registered. Core activities should be for the purpose of generating new knowledge and follow the scientific process from hypothesis to experiment, observation and evaluation and lead to logical conclusion. The activities and scientific process should be clearly described in the application form in such a way so that it is easy to follow for any reader without any prior knowledge in the field. Ordinary business activities cannot be claimed and identifying the activities are more than iterative in nature is important.
- Ensure that there are records or supporting documentation around the R&D activities and related costs. While it is not legislated what sort of documentation is required, documentary evidence is an expected feature of an activity that is systematic, investigative and experimental. Documentation is necessary to record the activity undertaken, its purpose, progress, results and analysis. Without such documentation, it is near impossible to establish the progression of the activities undertaken and that the purpose of the activities was to generate new knowledge.