It’s not often that one thinks of Shakespeare and the R&D Tax Incentive (the Incentive) at the same time but there is little doubt that intended claimants are going through similar existential conundrums to those that found Hamlet and Yorick “conversing” so intently a few years back.

As will be outlined in this MJA Update, it’s not hard to point to inconsistencies in the material published by the Government to date causing many to stress about what is the correct box (core or supporting) in which to register their R&D activities. A decent amount of mental energy is being expended by all stakeholders dealing with this issue and it could easily become an overwhelming concern for claimants, particularly SMEs.

However, we would argue that most of this exertion can be easily avoided and there is light at the end of the tunnel. We will advocate that, as is often the case in great drama, getting the right answer is usually the product of asking the right questions in the right order. If only someone had given Hamlet the same advice, the Black Prince could have averted disaster and a huge dry cleaning bill for what was left of the Danish Royal Family.

ICT Guidance Has Fogged Up the Windscreen

As highlighted in the last MJA Update, AusIndustry released its ICT Guidance product last September. The document covers eligible software R&D in areas such as new algorithms, specific software modules and cloud computing.

Overall, we believe that the document provides a good introduction to the eligibility of ICT activities under the new regime. We agree with the following statement in the Guidance – “In practical terms the new R&D eligibility requirements are not greatly different from the Concession.”

We further support its heavy emphasis on the maintenance of contemporaneous records to support any claims made. This is a message that builds on the recent court cases about this issue in the context of the former R&D Tax Concession (the Concession):

• RACV Sales and Marketing Pty Ltd and Innovation Australia [2012]

• NaughtsnCrosses Pty Ltd and Innovation Australia [2012]Willox

However, the Guidance does start to get confusing at the granular level when it describes specific activities as being core or supporting.

For example, in the four case studies provided, literature reviews are discussed under headings relating to both core and supporting activities. Theoretical modelling for algorithm development is excluded from being core on the unusual assumption that such a model would never be subject to testing and is therefore a supporting activity. Systems integration is referred to in Appendix A as being core or non-core depending on ”business and project specific issues” and that this cannot be said to be “a black-and-white issue”.

As a result, the Guidance appears to blur the distinction between core and supporting activities leaving taxpayers with a fogged windscreen as they head down the ICT registration road.

AusIndustry Workshop Not the Demister Hoped For

The potential for confusion is certainly not confined to ICT R&D. This was borne out at a recent AusIndustry R&D tax advisers workshop held in Canberra.

The workshop was a well-received event providing useful information and updates on a range of issues including the 2012/13 AusIndustry Guidance & Education Agenda, Record Keeping & Compliance, Consolidated Group Registration and Advance & Overseas Findings (where AusIndustry noted that applications prepared with the assistance of R&D tax agents were presenting less issues than self-prepared applications).

However, there were several areas of contention around the correct delineation of R&D activities. There was debate over the level of disaggregation of activities required for the AusIndustry registration application. Another unresolved matter was whether the acquisition of goods or materials for use in an R&D activity was a separate activity requiring registration. The appropriate characterisation of activities as core and supporting was the subject of much conjecture.

It seems that all R&D tax registrants are fumbling for the switch for that demister.

How Can We See Clearly Now?

The disaggregation issue will not be resolved overnight. We recommend that this will need careful consideration by all taxpayers and their advisers, involving AusIndustry where appropriate. The registering of the claim will need to embrace the twin requirements of legislative compliance and technical sense while remaining administratively workable. No doubt this will be the subject of a number of future MJA Updates as we all learn more.

However, we contend that the following approach can help right now in the successful preparation of your claims.

The distinction between core and non-core R&D activities is not the critical one. The key distinction is between those activities subject to the dominant purpose test (excluded activities and production-related activities) and those that are not (core activities and supporting activities NOT subject to dominant purpose).

As a result, we submit that determining eligible R&D activities under the Incentive should follow this progression:

1. Establish the R&D project to be claimed.
2. Identify all potentially eligible activities involved in the R&D project under consideration.
3. Determine which of the identified activities are on the excluded list or involved with production.
4. Excluded activities can’t be core but can be claimed as supporting if they meet the dominant purpose test.
5. Production activities can be core or supporting. First, see if they meet the core R&D definition. If yes, claim accordingly. If no, only then turn to consider whether they meet the dominant purpose test and can be claimed as supporting.
6. Claim all other activities as core or supporting based on the facts, legislation and precedent material.

What emerges from the above framework is that the immediate priorities for AusIndustry guidance are how to identify excluded and production activities and how to apply the dominant purpose test. Exact categorising of eligible activities as core and supporting is a secondary consideration.

Applying this approach is something we are working hard with AusIndustry to get acknowledged in their subsequent releases of guidance material. Having taxpayers agonising over whether activities such as literature searches, theoretical modelling and systems integration are core or supporting is unproductive and adds to the compliance burden and associated cost. Whatever category such activities best belong to, they are ultimately eligible and the box in which they are registered shouldn’t be a cause for endless deliberation and concern.

We will report back soon on our progress in this regard. For now, we hope that AusIndustry focuses on the right questions going forward.

Of course, key in all of this is achieving a consensus as to how the dominant purpose test actually works. AusIndustry has yet to commit on this fundamental question.

MJA will be endeavouring to ensure that the ultimate view on dominant purpose supports the Government’s stated innovation aims and does not become a tragedy of Shakespearean proportions.

Watch this stage…er, space.

Should you wish to discuss this update any further, please do not hesitate to contact Kris Gale directly on (02) 9810 7211.