AAT decision – JLSP

ATO reminds companies that expenditure on activities that are not conducted for the R&D entity is generally not available for an offset and expenditure that is not at risk does not attract an offset.

The R&D Tax Incentive is jointly administered by Innovation Australia (assisted by AusIndustry) and the Australian Taxation Office (ATO). Broadly, Innovation Australia is responsible for administering the eligibility of R&D activities while the ATO is responsible for the expenditure aspects.

This Administrative Appeals Tribunal (AAT) case considered issues relating to the first set of these responsibilities – Innovation Australia and the eligibility of activities. The AAT did not consider whether the expenditure that was incurred in relation to those activities would attract the R&D tax offset.

JLSP is an Australian-based company carrying out contracted research services for an unrelated foreign company. Under the contract, JLSP was to receive full payment regardless of the outcomes of the contracted activities it undertook. All data and new knowledge generated under the contract were not owned by JLSP, nor did it have any rights to that data or knowledge.

Innovation Australia considered an Advance Finding application from JLSP seeking a determination of whether the contracted activities were eligible R&D activities.

The company was able to provide evidence that substantiated to Innovation Australia's satisfaction that the core activities met the requirements for eligible core R&D activities, other than the question of whether they had 'the purpose of generating new knowledge' required by s355-25 of the Income Tax Assessment Act 1997 ¹.

Innovation Australia, as set out in the R&D Tax Incentive: A Guide to Interpretation (PDF; 1.8 MB), considers that the law requires that the applicant company must hold the purpose of generating new knowledge, and that purpose must be a significant or substantial purpose.

Innovation Australia determined, and affirmed in an internal review, that the evidence that the company provided to it did not substantiate that the company held the required substantial purpose of generating new knowledge, but that rather its purpose was to fulfil contractual obligations.

¹Section 355-25(1) of the Income Tax Assessment Act 1997 provides that:

Core R&D activities

1. Core R&D activities are experimental activities
   1. whose outcome cannot be known or determined in advance on the basis of current knowledge, information or experience, but can only be determined by applying a systematic progression of work that
      1. is based on principles of established science; and
      2. proceeds from hypothesis to experiment, observation and evaluation, and leads to logical conclusions; and
   2. that are conducted for the purpose of generating new knowledge (including new knowledge in the form of new or improved materials, products, devices, processes or services).

The AAT agreed with the interpretation of 'the purpose' set out in the 'Guide to Interpretation'. The AAT found in regards to the meaning of 'the purpose' that:

• The applicant entity conducting the activity must hold the purpose of generating new knowledge;
• It is not enough that the entity merely holds the purpose as one of many;
• The purpose of generating new knowledge must be substantial enough to characterise the activity as being conducted for that purpose; and
• The purpose of generating new knowledge may be a substantial purpose even if an activity is also conducted for other substantial purposes.

While the AAT affirmed Innovation Australia's interpretation of the legislation, the AAT decided that the evidence presented to the Tribunal substantiated that JLSP held the requisite purpose and consequently the relevant activity was an eligible core R&D activity.

Any company considering whether it holds a substantial purpose of generating new knowledge where it is carrying out activities under contract must consider whether it has the necessary records to substantiate that the company itself holds a substantial purpose of generating new knowledge.

While the AAT determined that in this case the company was able to substantiate that it carried out eligible activities, the company will also need to be able to substantiate to the ATO that its expenditure incurred in conducting those activities attracts the R&D tax offset.

The ATO reminds programme applicants and their advisors that:

• Activities for which programme applicants wish to claim expenditure must have been conducted for the applicant to be eligible for the offset. That is, an entity cannot deduct its expenditure on R&D activities if it conducts those activities to a significant extent for another entity; and
• Where activities are conducted by an entity under contract , expenditure that is not at risk - that is, expenditure for which the company is recompensed - will not attract an offset due to the operation of section 355-405 of the Income tax Assessment Act 1997. Accordingly, companies considering the eligibility of activities carried out under contract are advised to consider the effect of s355-405² on their circumstances when self-assessing activities under the R&D Tax Incentive.

²Section 355-405 of the Income Tax Assessment Act 1997 provides that:

Expenditure not at risk

1. An *R&D entity cannot deduct expenditure under section 355- 205 or 355-480 if
   1. when it incurs the expenditure, the R&D entity or its * associate had received, or could reasonably be expected to receive, consideration
      1. as a direct or indirect result of the expenditure being incurred; and
      2. regardless of the results of the activities on which the expenditure is incurred; and
   2. that consideration is equal to or greater than the expenditure.

Note: Section 355- 205 is about deductions for R&D expenditure. Section 355-480 is about deductions for earlier year associate R&D expenditure.

1. If
   1. when an * R&D entity incurs expenditure, the R&D entity or its * associate had received, or could reasonably be expected to receive, consideration
      1. as a direct or indirect result of the expenditure being incurred; and
      2. regardless of the results of the activities on which the expenditure is incurred; and
   2. that consideration is less than the expenditure the R&D entity cannot deduct under section 355- 205 or 355-480 so much of the expenditure as is equal to the consideration.
2. For the purposes of paragraphs (1)(a) and (2)(a), have regard to
   1. anything that happened or existed before or at the time the expenditure is incurred; and
   2. anything that is likely to happen or exist after that time.
3. This section does not apply to expenditure incurred on * R&D activities covered by paragraph 355-210(1)(b) or (c).

Note: Those paragraphs cover R&D activities conducted for foreign residents.