R&D tax: ending reforms of Australia's R&D tax concession will have far reaching consequences for international competitiveness.
Kris Gale investigates
Australia is in danger of creating a 'class system' in the business research and development community.
It could fall further behind the innovative efforts of other countries unless the Australian Government seizes the opportunity for far reaching reforms in its current green paper on the national innovation system.
While analysing the green paper, known as The Cutler Review, will take time, as will any subsequent legislation, this current reform opportunity could place Australia back in an internationally competitive position, plus enhance our ability to attract the R&D of overseas companies.
The R&D tax concession was reduced from the previous basic rate of 150 per cent to 125 per cent in 1996. As someone who has advised a large number of companies, ranging from start-ups to multinationals, on how to assess industry support programs, I have to conclude that the current R&D tax concession is underpowered and overcomplicated, and this has been acknowledged in the green paper.
The complexities in the system have only been further compounded by subsequent tinkering, to the point of descending to farcical levels. At the same time, we have seen a legacy being built that R&D is largely an industrial support mechanism, whereas innovations in the services sector have run into considerable cultural and administrative barriers. It is time to evaluate this area separately.
The Cutler Review does mark the start of a journey towards positive reform of R&D tax benefits, and the minister for innovation, industry, science and research, Senator Kim Carr, is expected to announce the government's policy response next year.
Overall, the green paper presents a positive future for the use of R&D tax mechanisms to stimulate, reward and incentivise the conduct of innovative and risk-based activities in Australia.
What will be critical for Australian industry is how the journey from green paper to policy is achieved, and then how policy is turned into practical, workable and actionable legislation. At this point in time, the green paper is something of a case of the good, the bad and the ugly.
The good
The green paper is extremely positive in its acceptance of the mechanism to stimulate activity in the economy and it reflects some of the changes that have occurred in the innovation environment between 1985 and 2008.
The largest single proposal is to abolish the current range of concessional deductions and refundable tax offsets at 125 per cent and 175 per cent and to introduce an income tax credit model.
This would help disconnect the benefit of the program from the tax rate and provide the opportunity to relaunch the program as a credit and thus bring it into greater focus within corporate decision-making and planning.
Most developed economies use the tax regime to encourage R&D, and New Zealand recently introduced a 15 per cent tax credit scheme. The green paper promotes a ten-fold increase in the turnover threshold for small Australian-owned companies, from the A$5m cap to less than A$50m in order to access a 50 per cent refundable credit, which is a higher rate than the current 125 per cent concession.
This would mean an effective 166 per cent concession. However, the catch is that if you cross from A$49,999,999 to $50m annual turnover, then the effective marginal tax rate on that $1.00 of revenue is 5,000,000 per cent based on average expenditure on R&D of 1 per cent.
Recommendations to allow eligible activities to be claimed, regardless of where the resultant intellectual property is owned, is a positive and internationally competitive change. It makes us competitive with the program of the UK, among others, and recognises that where the activity occurs is of primary relevance to policy makers, even if the major benefits from exploitation reside elsewhere.
The bad
The green paper does contain some potential downsides. The core risk is that replacement of the 125 per cent and 175 per cent programs by the income tax credit model may see fundamental changes to the definition of R&D and the established expenditure concepts and mechanisms.
This would effectively be the risk of starting from a blank piece of paper, rather than from the relative certainty that companies and advisers have on the concepts in the existing programs. There may be a reduction in the complexity of any new legislation, but the risk is greater on the downside.
For large companies, with turnovers greater than A$50m, and foreign-owned corporations, the proposed rate of credit at 40 per cent is only equivalent to a 10 per cent after-tax benefit, or an R&D concession of 133 per cent. While this restores core program value to pre-1996 levels, there are two major problems with this rate.
Firstly, it is considerably lower than the return they can generate under the current complex 175 per cent program, up to 22.5 cents per dollar invested, making it an unfair trade-off to ask large corporates to make. Secondly, the rate nominated remains below the cost of capital and will only contribute marginally to project economics.
There is a strong need for the relaxation of restrictions on claiming overseas R&D activities, which currently require certification before proceeding. Often, activities are too time critical for companies to wait for pre-approvals, but it has to be recognised that suitable R&D facilities are increasingly located overseas.
The green paper still clings to the notion that small firms tend to be more innovative and carry out more worthwhile R&D than their larger counter-parts. Its recommendations to deliver a comparatively lower level of support to large companies, along with some restrictions on the claims they can make, will result in a 'class system' in the business R&D community.
The ugly
Perhaps the green paper's worst feature is the way it handles 'large, one-off projects like mines and civil engineering'. It recommends that the definition of R&D limit claims in order to 'protect the revenue and continued viability of the R&D tax concession'.
With exceptions such as software and 'processing', the R&D tax concession operates as a market-driven program that is technology agnostic. It provides the same rate of support to small and large projects regardless of whether the company expends its efforts on 'worthwhile innovation' or not. What matters is that the activities are eligible.
Where the eligibility of activities and expenditure can be established, it doesn't matter whether projects receive concessional treatment for 8 per cent or 80 per cent of the investment expenditure.
The green paper is at risk of distorting the commercial reality by focusing on mining and civil engineering projects. It does not address large one-off projects in the biotechnology or software sectors. It is a feature of a market-based program that no one sector or project benefits disproportionately.
Rather, the green paper introduces the spectre of uncertainty and complexity to the definition of R&D at a time when the tenor of the green paper is resoundingly in favour of expanding the existing mechanism. It's disappointing, since large companies are considering fundamental technology shifts associated with leadership and compliance around sustainability. Program changes should exempt these activities.
And the final word has to be that the green paper contains some recommendations that are just plain odd, such as its approach to software. While recommending that open source software R&D qualify for the multiple sale test, it suggests that relaxing the degree of technical risk required might also be possible.
But at the same time, it appears to approve of the multiple sale test limiting claims for large firms. This odd distortion does not take account of the realities of software, process and product development in 2008.
Kris Gale is CEO of R&D advisory company Michael Johnson Associates Pty Limited
