Glasshouse Advisory reports on proposed changes to R&D Tax program to benefit foreign multinationals over Australian based multinationals.
When Treasurer Scott Morrison announced his intention to overhaul the current R&D Tax Incentive program in the recent Federal Budget, he cited a need to restore integrity to the current program and to reward those companies that invest heavily in R&D activities. Given the scant detail within the budget papers as to how this objective was going to be achieved, it was initially difficult to assess its impact on a company's R&D program, despite the Treasurer indicating the changes to the program will come into effect from 1 July 2018.
On Friday, the 29th June, Treasury released its draft R&D legislation, along with a 28-day public comment and consultation period. While the draft legislation has taken the opportunity to address a number of inconsistencies in the current R&D legislation, (primarily around the mismatch in the treatment of feedstock and clawback as a result recent changes in the corporate tax rate), it also became apparent that the proposed changes to the R&D program will primarily benefit subsidiaries of overseas multinationals conducting R&D in Australia, compared to subsidiaries of Australian based multinationals conducting R&D in Australia.
Given how the proposed R&D legislation will deliver an R&D benefit to overseas multinationals that are not available to locally headquartered multinationals, it is difficult to reconcile why, on the one hand, the Federal Government is implementing a suite of legislation to ensure multinationals are paying their 'fair share' of tax in Australia (via stringent transfer pricing and related integrity provisions), but at the same time, it is preferentially providing multinationals with a higher R&D Tax benefit that is simply not available to Australian based multinationals conducting R&D in Australia in the same set of circumstances.
The reason for this inequity (and why the proposed changes to the current R&D Tax program will preferentially benefit overseas based multinational groups conducting R&D in Australia, compared to Australian based multinationals) comes down to how the new legislation requires a company to calculate its 'R&D intensity'.
When Treasurer Morrison announced that he intended to change the current R&D program in order to reward companies who invest a higher proportion of their expenditure on R&D activities, his idea was based on increasing the percentage of R&D benefit as a company's R&D intensity increased.
For businesses with an aggregate turnover of more than $20 million, the new program proposes 4 tiers of benefit, as outlined in the following table.
|R&D Tax Incentive Rate||Level of intensity (eligible R&D expenditure as a percentage of total expenditure)|
|4%||0% – 2%|
|6.5%||>2% – 5%|
|9%||>5% – 10%|
While limited detail was provided in the initial Budget papers as to how a company's 'R&D intensity' percentage would be calculated, the recently released draft legislation provides this detail, detail that creates further confusion and uncertainty regarding the application of the new program. For example, in the draft legislation, a company's 'R&D intensity' will be assessed by comparing the 'R&D entity's' (a defined term in the legislation) eligible R&D expenditure over the R&D entity's total expenditure (according to accounting principles). Whilst this seems a straightforward concept, this methodology will significantly disadvantage Australian multinational companies conducting R&D in Australia.
Financial advantage provided to Overseas Based Multinationals
In understanding the inequity within the proposed R&D legislation, consider a scenario whereby a German multinational has $4billion in global expenditure and has an Australian subsidiary engaged in R&D activities. The local Australian subsidiary (i.e. the 'R&D entity' which is the entity that lodges its R&D application with AusIndustry) has a turnover of $50 million, total expenditure of $40million and spends $3million on R&D activities. In calculating this company's R&D intensity percentage, the proposed legislation requires only the expenditure of the Australian based entity to form the denominator in the calculation (i.e. is not required to include the nearly $4 billion of expenditure incurred worldwide by the rest of the German multinational Group). This is because the 'R&D entity' only encompasses the Australian based subsidiary. In this example, the Australian subsidiary of the German multinational will have an R&D intensity level of 7.5% (despite having global expenditure of $4 billion), which will provide it with an R&D Tax benefit of $200,000.
|German Multinational R&D Tax Benefit Calculation|
|Percentage||R&D Tax Benefit Rate||R&D Tax Benefit Amount|
|0% – 2%||$ 800,000 @ 4%||$ 32,000|
|>2% – 5%||$1,200,000 @ 6.5%||$ 78,000|
|>5% – 10%||$1,000,000 @ 9%||$ 90,000|
|Total Tax Benefit||$200,000|
Why are Australian Based Multinationals disadvantaged?
Now consider the same scenario, but with an Australian multinational with an Australian subsidiary engaged in R&D activities. Same turnover, same expenditure, same level of R&D spend as in the previous example and same global expenditure for the Australian multinational Group of $4 billion.
In this scenario, it would be reasonable to expect that the Australian subsidiary of an Australian based multinational would receive the same R&D benefit (i.e. $200,000) as previously calculated for the subsidiary of the German multinational conducting R&D in Australia.
However, due to the fact that the head entity of the Australian multinational tax consolidated group would be deemed to be the 'R&D entity' in any R&D claim (i.e. the entity that lodges its R&D application with AusIndustry), the proposed new legislation requires the 'R&D entity' to include all expenditure to be taken into account when calculating its R&D intensity which, in the case of the Australian subsidiary of an Australian based multinational, would include global expenditure of $4 billion. This inconsistency is due to the operation of Section 355-115 of the Income Tax Assessment Act 1997 ('ITAA 1997'), which defines an R&D entity's expenditure as: –
- An R&D entity's expenditure for an income year is the sum of the amounts covered by subsection
- The following amounts are covered by this subsection: –
- the expenditure incurred by the R&D entity for the income year worked at in accordance with the accountancy principle;
- any amount the R&D entity can deduct for the income year as mentioned in sub paragraph 355-100(1) to the extent the amount is not covered by paragraph (a).
This definition and its impact on calculating a company's R&D intensity has generated a significant level of uncertainty in how to apply the proposed new R&D legislation, specifically around how broad the net is cast when it comes to calculating total expenditure for the R&D entity. However, given section 355-35 of the ITAA 1997, defines an 'R&D entity' to include, "a body corporate incorporated under Australian law.", it is reasonable to interpret that a body corporate incorporated under Australian law (that lodges an R&D claim under the proposed new provisions) will need to include total global expenditure in calculating its R&D intensity percentage.
If we interpret the proposed legislation to include the global expenditure of the Australian multinational (given the head entity of this Australian based group would be considered the 'R&D entity') and we assume the same figures from the previous example (i.e. global expenditure of $4 billion), the R&D intensity for the Australian subsidiary of the Australian based multinational would be 0.00075% (i.e. $3 million in R&D expenditure over $4 billion of the R&D entity's expenditure). In this example, as the R&D entity's R&D intensity falls between 0% – 2%, the Australian subsidiary of an Australian based multinational would only have access to a total R&D benefit of $120,000 under the proposed new R&D tax legislation. This is despite undertaking the same level of R&D activities in Australia and despite investing the same level of R&D expenditure in Australia as the Australian subsidiary of a German multinational. Given the Australian subsidiary of the Australian based multinational has an R&D intensity level of 0.00075%, the disparity in R&D benefit is demonstrated in the table below.
|Australian Multinational R&D Tax Benefit Calculation|
|Percentage||R&D Tax Benefit Rate||R&D Tax Benefit Amount|
|4% uplift (0-2% intensity)||$ 3,000,000 @ 4%||$ 120,000|
|6.5% uplift (>2-5% intensity)||$ –||$ –|
|9% uplift (>5-10% intensity)||$ –||$ –|
|12.5% uplift (>10% intensity)||$ –||$ –|
|Total Tax Benefit||$ 120,000|
This appears to be an unacceptably unfair outcome that provides multinationals based in other countries with a higher benefit than is available to the Australian multinationals investing the same level of expenditure on R&D in Australia. In effect, the proposed legislation will penalise Australian based multinationals conducting R&D in Australia, including some of our most innovative and iconic companies, including CSL, Ramsey Health Group, Brambles, and Bradken.
Inequity of R&D benefits between Consolidated and Unconsolidated Groups
The inequity in the proposed legislation (i.e. Australian and overseas based multinationals) also extends to consolidated tax groups, when compared to non-consolidated tax groups. Under the proposed new legislation, if R&D is conducted by a company within a tax consolidated group, given that the head entity is deemed to be the 'R&D entity', the R&D intensity (and therefore its available R&D Tax benefit) of that R&D entity will be reduced, compared to R&D conducted in an unconsolidated group.
The source of the inconsistent treatment and the reason for the reduced benefit available for R&D conducted within tax consolidated groups compared to unconsolidated groups is due to the requirement to include the expenditure of the entire consolidated group as the denominator in the calculation of R&D intensity, whereas an unconsolidated entity only has to take its own expenditure into account when calculating their R&D intensity.
As drafted, the proposed legislation provides unconsolidated entities with the potential to access a materially higher R&D tax benefit than the benefit available to entities within a tax consolidated group. This outcome therefore provides an incentive to structure a Group's tax affairs in a way that enables the R&D entity to sit outside the tax consolidated group where possible. This obviously creates an integrity issue, in a regime where the Treasurer indicated he was seeking to restore integrity to the program.
One of Treasurer Morrison's stated objectives for introducing a '4-tiered' R&D premium was to provide an increased benefit for those companies that invest more of their expenditure on R&D activities. From the examples provided (which primarily relate to companies with an aggregate turnover of more than $20 million), it is clear that the proposed legislation will never be able to deliver on this primary stated objective, due to the introduction of complex concepts that will disadvantage genuine R&D Innovators and encourage creative tax planning structuring to circumvent specific limitations associated with the legislation. What the proposed new R&D program does however deliver is access to an increased R&D tax benefit to multinational groups conducting R&D within Australia, compared to Australian based multinationals conducting R&D in Australia. The proposed new R&D legislation will also deliver increased R&D benefits to entities outside the consolidated tax regime, compared to entities within, in comparable circumstances.
As drafted, the proposed new R&D legislation has significant flaws in that it;
- does not achieve its primary stated objective of rewarding businesses who engage in increased levels of R&D activity
- provides access to increased R&D benefits to multinational groups compared to Australian based multinationals investing in R&D activities in Australia
- provides increased access to higher tax benefits for companies engaged in R&D activities outside tax consolidated group, compared to entities that are within a consolidated group, and
- is poor tax policy that creates more integrity related issues than it was designed to resolve.
What can we do to ensure this flawed legislation is never enacted in its current form?
- Take advantage of the 28-day public consultation program (https://treasury.gov.au/consultation/c2018-t289033/ ) to explain to the Federal Government the impact the proposed legislation will have on your business.
- Write to the local member of Parliament where your company has facilities located, to explain the impact of the proposed R&D changes on your ability to continue to fund R&D activities, its impact on profitability and the potential knock on effect in employment (often linked to reduced profits).
- Alternatively, contact any of Glasshouse Advisory's Innovation and Incentives team, who will be happy to assist formulate and implement the strategy that is relevant to your company.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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