The Gillard Government’s R&D legislation, which passed through the Senate in late August, is one of the most significant tax reforms since the GST. It’s certainly the most significant change to tax innovation since the original R&D tax concession was introduced in 1986.

In a nutshell, the reforms propose a credit system that gives a 45 per cent refundable R&D tax credit to entities with an aggregated turnover of less than $20 million per annum. All other companies will receive a 40 per cent non-refundable tax credit. The Government expects to hand out $1.6 billion in tax credits annually. Instead of passing on the tax credit in an annual lump, the Greens successfully pushed to have quarterly payments in a bid to improve cash flow for companies.  Strictly speaking, however, the 45 per cent figure is minus the 30 per cent tax deduction which they forego so entities would only pick 10 or 15 per cent. Unless of course they are making losses, in which case they would get the full 45 per cent.

There are a lot of plusses here. The refundable credit will see refunds going to small companies and spreads the R&D incentives more widely across the economy. The new law actually places no limit on the amount of R&D expenditure incurred.  The aim here is simple:  it is designed to encourage start-ups to invest far more in R&D than under the original R&D tax concession. And in a departure from the original R&D tax system, companies will be eligible for the credit even where the intellectual property related to the R&D is held off-shore.

There is an agenda here. This reform was part of Labor’s industry centerpiece for many years and was designed to crack down on big research and development claims by miners and other big corporations. The aim is to send that $1.6 billion R&D kitty to small high-tech companies which some in the government see as the future drivers of Australia’s growth. The legislation favours small companies over larger ones. It redirects it away from more traditional industries such as energy and resources and manufacturing and skews it towards the knowledge based industries such as life sciences and biotech.

This package is important because R&D is costly and often unpredictable. For example, Charles Townes, the alleged inventor of the laser, said the only reason he had developed the technology was to satisfy his desire to split light beams. And that was that. He had no idea that the laser would play a key role in developments such as the compact disc, eyesight correction, microsurgery, data storage and retrieval. Thomas Watson, the founder of IBM, once predicted that there would be no need for more than just a handful of computers. Alexander Fleming discovered a drug that has saved so many lives when he was cleaning up his laboratory and found that penicillium mold had contaminated one of his old experiments. Louis Daguerre discovered the technique that gave us photography in the 1830s, when drops of mercury from a shattered thermometer produced the photographic image.  The microwave was discovered when a scientist with Raytheon, Dr Percy Spender, was testing a new vacuum tube and discovered that the lolly bar in his pocket had melted.  Saccharin was the accidental result of a scientist's work on a treatment for gastric ulcers. 3M researcher Art Fry had no idea he was taking the first steps towards Post-it Notes when he used bits of 3M adhesive paper that could be easily lifted off the page, to replace the scrap paper bookmarks that kept falling out of his hymn book. As Nassim Taleb notes in his book Black Swan:  “Not only have forecasters generally failed dismally to foresee the drastic changes brought about by unpredictable discoveries, but incremental change has turned out to be generally slower than forecasters expected. When a new technology emerges, we either grossly underestimate or severely overestimate its importance.” 

The now-defunct airline Pan Am captured this problem perfectly. After the first moon landing in 1969, it started taking advance bookings for round trips between the earth and the moon. A nice bit of forward planning and R&D that failed to take into account that the airline would be out of business not long after.

The R&D legislation has several parents:Terry Cutler's Review of the National Innovation system in 2008; the Australian Business Foundation’s report by economist Nicholas Gruen, The BERD in the Hand; Labor's desire to redistribute R&D support towards smaller companies and Treasury's insistence that it do so without boosting outlays. Innovation and Industry Minister Kim Carr has argued that 100 large companies get 60 per cent of the $1.6 billion R&D funding pool. He has said that this has been done through claims that sometimes extend to supporting expenditure and "whole project" claims on mining, information technology and manufacturing projects. One of the biggest problems identified in Cutler's review was that firms lacked access to the concession until they turned a profit, whereas “many of Australia's most innovative start-up firms remain cash strapped and in tax loss for many years”. The Cutler report said the concession needed to be replaced with a tax credit. 

According to Gruen, miners here have been able to claim 10 times the level of research and development compared with miners in Canada under the 1986 R&D tax concession. “The current scheme is sufficiently underpowered and so would induce so little R&D that would not occur in any event that, with the likely exception of the small firm tax offset, if one had the choice between the 125 per cent tax concession and nothing at all, nothing at all would probably be the superior policy. For that reason the rates of assistance should be increased to give the scheme some chance of increasing sufficient R&D to outweigh its administrative, compliance and revenue costs,” Gruen writes.
 
He said the old R&D concession scheme only assisted established firms earning profit, rather than start-ups, was steadily eroded with cuts in the company tax rate, and effectively assisted foreign shareholders rather than Australian because of the effect of dividend imputation.
 
The new system turns that around completely by favouring smaller companies by targeting financial assistance to those most likely to apply it to new R&D. A tax credit is generally regarded as a more practical and business-friendly form of assistance than grants which have compliance costs. There is also some anecdotal evidence suggesting that the new program will also allow Australian branches of multinational corporations to bid more effectively for R&D funding within their firm. All this will increase the amount of R&D in Australia.
 
Also, the biggest winners would be R&D intensive companies with grouped turnover between $5 – 20m who are in tax loss.  They get the full 45 per cent.

The crunch issue around the legislation however is the eligibility criteria. It introduces a “dominant purpose” test. Using this test, supporting activities whose dominant purpose is to support the core R&D will be eligible. Supporting activities undertaken for production purposes or future commercial benefit would be excluded. Under the 1986 R&D tax concession, supporting R&D activities were undertaken for “a purpose directly related to conducting core R&D activities”. The new system imposes a much stricter test. The activities are only eligible if the “dominant purpose” is to support core R&D. Activities that were claimed as R&D under the old legislation but which were not strictly speaking R&D can no longer be claimed.

Therefore, a trial of a new product or a feasibility study might not be eligible under the new rules – whereas they would have been before – because the trial or the feasibility could be deemed to be about whether the project would continue, rather than R&D. The aim of the new system is to stop cross-subsidising commercial activities.

By definition, this is more likely to favour smaller companies because smaller companies do not have the same amount of supporting activities.
 
Serg Duchini, a national R&D and tax partner at Deloitte says larger companies will face the issue of operationalising their supporting activities into ones that support core R&D. He says companies will have to work with the two regulators, Ausindustry and the Australian Taxation Office. There were still a number of unanswered questions that need to be worked through.
 
“There is a genuine spirit and good will. At the end of the day, most corporates want to make it work and most corporates don’t want to break the law,” Duchini says.
 
Duchini says the legislation is major step forward but he acknowledges that the transition will require some work. “Compliance around this new framework can be onerous and it definitely onerous on any measure compared to what we currently have,’’ he says. “This is aimed at shifting the support from the big end of town to the small end of town but with that comes a very heavy compliance burden and I don’t think that’s fully appreciated yet by regulators.”

At a time when more details of the legislation’s broad rules are still being sorted through, the onus will be on companies to engage in dialogue with regulators to develop a model that can drive the uncertain, unpredictable but critically important world of R&D.