March 1st, 2017
The Department of Industry, Innovation and Science and the Australian Taxation Office (ATO) have recently released joint taxpayer alerts on a range of R&D Tax issues.
The alerts have highlighted issues identified by the ATO and AusIndustry, such as:
- Activities registered being ordinary business activities that are not eligible for the R&D Tax Incentive;
- Expenses included in the calculation of claims that are not for amounts that relate to eligible R&D activities;
- Expenses included in the calculation of claims that relate to expenditure specifically ineligible under the R&D Tax Incentive, such as building construction costs;
- Software development activities that use existing software development knowledge and expertise to achieve the required technical outcomes, rather than generate new technical knowledge;
Swanson Reed supports the ATO and AusIndustry’s efforts to affirm the boundaries of the R&D Incentive and encourages all participants of the programme to review the alerts.
Companies should also note, that the alerts do not contain any changes to the R&D Tax Incentive or any new reporting requirements. Companies who have carefully assessed their eligible activities and expenditure should not be alarmed at the alerts and should continue to document and register their activities in line with the programme’s requirements.
The ATO and AusIndustry update for companies claiming the R&D Tax Incentive on Software development projects applies to companies who exhibit some or all of the following features:
- Develop new software
- Modify, customise or upgrade existing software
- Acquire and modify off-the-shelf software
The review is also applicable to companies part taking in software development projects, such as:
- Activities using existing software development knowledge and expertise to achieve technical outcomes.
- Undertaking activities involving business risk opposed to technical uncertainty.
- Undertaking activities to replace manual work processes using software technologies that are available in the market and adapted to the requirements of the company.
- Using existing software technologies as they were intended to be used.
Companies who self claim should consider reviewing their R&D Tax Incentive claim, if some or all of the registered R&D activities are broadly described and non-specific; or if all or the majority of the project is registered as an R&D activity. Where a company includes all or a large proportion of their expenditure on the software development project in the calculation of their R&D Tax Incentive claim, this should be reviewed to ensure eligibility requirements are satisified.
The ATO has noted an increase in companies claiming the R&D Tax incentive on software development projects where expenditure has been incurred on ineligible activities. These may include:
- Activities that do not satisfy legislative requirements of the R&D Tax Incentive.
- Expenditure claimed does not relate to eligible R&D activities.
- Taxpayers may not be applying adequate levels of governance and review to the registered activities and the claims made for the R&D Tax Incentive.
Typically companies that undertake software development projects assume software development activities are by nature eligible R&D activities. However, whilst a project may involve experimental activities, this does not qualify the entire project as an eligible R&D activity.
The processes of developing, modifying or customising software can appear superficially similar to the process of performing eligible R&D activities. They are by definition systematic and can be iterative and cyclical and almost always involve testing. However, the application of a software development life cycle does not automatically mean that eligible experimental activities are taking place, nor that the outcome of any technical issues being solved are not using existing knowledge, information or expertise.
A test or trial that does not set out to test causal relationships between technical variables to experimentally resolve an outcome that cannot be determined with existing knowledge or expertise, will not be an eligible core R&D activity under the R&D Tax Incentive. Examples of these types of activities include, but are not limited to:
- Bug, beta and system testing;
- Requirements and user acceptance testing;
- Data mapping and data migration testing;
- Testing the efficiency of different algorithms already known to work;
- Testing websites in operation by measuring the number of hits.
The following activities listed above, however, may be eligible as supporting R&D activities if they are directly related to core R&D activities.
The ATO has observed a number of cases where companies have registered software development activities with AusIndustry which are ineligible. Reasoning for ineligibility include:
- The software development project has been registered on a whole of project basis, without distinguishing eligible R&D activities from ineligible activities. For example, developing and rolling out a new online customer platform may be incorrectly identified as a single eligible R&D activity.
- The activities do not have the purpose of generating new knowledge. The purpose of generating new knowledge must be substantial enough to characterise the activity as being conducted for that purpose.
- The activities are not undertaken to prove or disprove a hypothesis or hypotheses through experiments.
- There is no clearly identified technical uncertainty being addressed by the activity. The software development lifecycle can be complex and highly technical. While this complexity poses risks, it does not mean that all activities involve a specific technical knowledge gap that requires the formulation of a hypothesis and the undertaking of experimental activities to test that hypothesis.
- Project management, commercial or economic risks are mistaken for technical risks. For example, a bank develops a mobile banking application and the delivery of the application is quite certain on the basis of current knowledge, information and experience. There is, however, a risk that existing or future customers may not embrace the application. This risk is commercial in nature only and hence the relevant activities do not constitute eligible R&D activities.·
- The activities involve the purchase of ‘off-the-shelf’ software and subsequent modification to integrate it into the existing environment. Most or all of the activities involve the application of existing knowledge and expertise rather than the generation of new knowledge through experiments.
- The activities are not directly related to experimental activities or do not have a dominant purpose of supporting such activities.
The ATO has observed that in many cases the expenses included in the calculation of the R&D Tax Incentive claim are not correct because:
- Expenditure incurred acquiring the right to use technology cannot be claimed as a notional deduction.
- The expenditure is not for amounts incurred on one or more eligible R&D activities.
- Expenditure is being apportioned between R&D activities and ineligible business activities unreasonably.
- Expenditure is incurred on R&D activities that have been ‘conducted for’ another entity.
- Where the company undertaking the activity is recompensed by another entity under a contract, the expenditure may also not be at risk as required by legislation.
- Expenditure is claimed twice as a notional deduction as R&D and an actual deduction in the calculating taxable income.
It is expected that companies distinguish eligible R&D activities from ineligible ordinary business activities at the time of registration and throughout the conduct of the activities. Contemporaneous records must be kept to support the registration application. It is of significant importance that companies apply adequate levels of governance and review to the R&D activities that have been registered and to the claims that are subsequently made for the R&D Tax Incentive on their behalf.
Actions taken by ATO
The ATO will be contacting companies directly to advise them of concerns with their registered activities and their R&D Tax Incentive claims if:
- The registration of R&D activities continues with the use of broad descriptions that fail to distinguish them from ordinary business activities
- The level of expenditure claimed for the R&D Tax Incentive is high for the industry or stage of business
Actions to be taken by R&D Tax incentive claimers
It should be considered whether the listed concerns apply to your application. The responsibility is upon the individual to ensure that the R&D registration is correct. It is encouraged to:
- Review registrations and ensure they are for eligible R&D activities.
- Ensure claims are correct and that no claims are made for ineligible expenditure related to ordinary business activities.
- Keep all records to demonstrate the R&D activities undertaken in support of the R&D Tax Incentive claim
It is important to note that penalties may apply for incorrectly claimed R&D claims, however these penalties will be significantly reduced if a voluntary disclosure is made.
Swanson Reed provides specialist expertise across a wide range of industries and has assisted many clients attain tax cash savings under the R&D regime. Contact one of our specialist R&D Tax consultants to find out more about the scheme.