R&D Tax Incentive. The new feedstock rules. NSW Division 25 October 2011 Swissotel, Sydney

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1 R&D Tax Incentive The new feedstock rules Written and presented by: Paul van Bergen, ATIA Partner KPMG NSW Division 25 October 2011 Swissotel, Sydney KPMG 2011 Disclaimer: The material and opinions in this paper are those of the author and not those of The Tax Institute. The Tax Institute did not review the contents of this paper and does not have any view as to its accuracy. The material and opinions in the paper should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests.

2 CONTENTS 1 Overview Comparison of old and new PROVISIONS Impacts on claims for 2012 and later income years Tax return and R&D application disclosure How ATO Fact Sheet follows law Ongoing terms reliance on ATO ID? Conclusion OVERVIEW The research and development (R&D) Tax Incentive applies to entities claiming R&D for the year of income commencing on or after 1 July The R&D Tax Incentive contained in division 355 of the Income Tax Assessment Act 1997 (1997 Act) replaces the R&D Tax Concession contained in sections 73B 73Z of the Income Tax Assessment Act 1936 (1936 Act). The feedstock provisions are contained in sub-division 355H of the 1997 Act and contain four sections. In addition, the Australian Taxation Office (ATO) has issued a Fact Sheet R&D Tax Incentive - feedstock adjustments that provides worked examples of the new feedstock provisions. The new feedstock provisions create the following changes that impact R&D claimants: Including in assessable income one-third of the lesser of feedstock revenue and notional deductions attributable to feedstock input (compared to netting off feedstock output from feedstock input under the 1936 Act). Companies eligible for the 45 percent R&D offset rate will benefit by a net tax saving of a minimum of 5 percent of the feedstock input (where the feedstock revenue is greater than feedstock input). SME s therefore have an incentive to record all feedstock inputs even if the output is profitable! There may be timing advantages where feedstock is not saleable until after year end. Feedstock rules apply to one or more tangible products bringing certain prototype claims within the ambit of the new feedstock rules. The terms of the new provisions in subdivision 355H are summarised in the slide presentation (refer Appendix to this paper) which should be read with and forms part of this paper. This paper will focus on some of the key terms and phrases used in the provisions, especially having regard to pronouncements by the ATO in guidance issued under the superseded R&D Tax Concession. KPMG

3 2 COMPARISON OF OLD AND NEW PROVISIONS The following table summarises the differences between the old and new legislation: Feedstock rules Old law New law Feedstock expenditure Feedstock input Feedstock output Expenditure in acquiring materials or goods to be the subject of processing or transformation in R&D activities, including cost of energy. Feedstock expenditure (above) re acquiring or producing materials or goods that were the subject of processing or transformation in R&D activities [value $] of product obtained during the income year from the processing or transforming of feedstock inputs Sale proceeds or sale price/ market value N/A Expenditure in acquiring or producing goods or materials transformed or processed during R&D activities Tangible products from the transforming or processing of feedstock inputs Supplied to another entity Applied to own use Feedstock revenue N/A Market value of marketable product Eligible feedstock expenditure Residual feedstock expenditure R&D expenditure Excess of feedstock input re R&D activities over feedstock output re those activities [s73b(1a)] Lesser of feedstock input and feedstock output [100% deductible s73b(14b)] Excludes feedstock expenditure. Includes eligible feedstock expenditure (ie. Excess) 125% concessional deduction s73b(14)] N/A N/A treated as assessable income on sale/applied to own use Includes [all] feedstock expenditure (notionally deductible for 40%-45% tax offset calc s ) Feedstock adjustment N/A 1/3 lesser of feedstock revenue and (feedstock exp + energy + decline in value of assets to produce inputs) -assessable income s (2) KPMG

4 2.1 Impacts on claims for 2012 and later income years The new provisions have the effect for taxpayers subject to the 45 percent credit, that they receive a 5 percent permanent tax saving on feedstock inputs. Under the new R&D rules, it is important for all taxpayers (including large companies subject to the 40 percent tax offset rate) to measure the feedstock inputs and feedstock outputs because: A tax saving arises if the feedstock revenues are less than feedstock inputs Where there is no sale or goods applied for own use during a year of income the assessable income is deferred until a later year The application of the feedstock rules is governed by specific clauses in the legislation. Following the new rules is good tax governance in ensuring that a company s systems are designed in such a way to comply with legislation. It also enables a company to capture feedstock input claims leading to tax savings. 2.2 Tax return and R&D application disclosure There will changes to the tax return disclosure because of the inclusion of assessable income amounts where feedstock is claimed. It is likely that this will require an additional label to include the assessable income component. The data-matching between AusIndustry and the ATO leads to the likelihood of the application for registration also requiring disclosure of the feedstock inputs, outputs etc. Given the announced intention to focus on core and supporting activities, this may create challenges for taxpayers involved in trials and prototyping. Taxpayers will need good record keeping practices to ensure correct timing and quantum of feedstock claims for long running projects and those involving multiple stages of production. An example may be wine or cheese production where maturation of products often means sales occur in one or more subsequent years of income. Where feedstock travels between affiliated companies, the feedstock rules in sec need to be considered. The feedstock rules apply to a supply or use of the marketable product by an entity connected with, or an affiliate of, the R&D entity as if it was by the R&D entity. Extrapolating the example of the gravel crushing company if the secondary processing were by another related company in the group, the feedstock adjustment also applies where an affiliate or an entity connected with the R&D entity claiming the R&D Tax Incentive supplies or uses the marketable product as if the primary company had done so. This may raise record keeping questions where the ownership of the companies is not a consolidated group under tax or corporations law (eg 40 percent shareholdings). Projects involving prototype expenditure should be examined carefully from the point of view of the feedstock provisions. At the same time, taxpayer s need to consider other aspects of the R&D Tax Incentive provisions, including sec (2) (if the activity is conducted to a significant extent for one or more entities not covered under the conditions for eligibility under subsection (1) (similar to the on behalf of test )), and sec ( expenditure not at risk ). These issues have been a focus of the ATO and AusIndustry under the old R&D Tax Concession rules and taxpayers can expect that this situation will continue under the new R&D Tax Incentive. KPMG

5 3 HOW ATO FACT SHEET FOLLOWS LAW The Fact Sheet on the feedstock rules issued by the ATO follows the legislation. In general terms the Fact Sheet provides support for those taxpayers whose circumstances follow that described in the Fact Sheet. Going through the eleven substantive clauses in the Fact Sheet, the components of the law follow suit 1. How the feedstock rules work / why we have them, etc: The R&D Tax Incentive has feedstock rules consistent with the previous R&D Tax Concession. This is true, although they now expressly extend to one-off items. Under the R&D Tax Incentive, the feedstock adjustment works by increasing assessable income (Sec ), rather than by reducing the deductions or offset claimed. The feedstock rules effectively adjust the R&D Tax Incentive benefit received for expenditure on certain 'inputs', reflecting the value of the related 'outputs'(sec ). 2. When is a feedstock adjustment triggered? The Fact Sheet follows the provisions set out in sec (1)(b), the timing in sec (1)(c) and sec (3). The Fact Sheet discusses connected entities and affiliates, it makes clear that the feedstock adjustment can trigger assessable income in a future income year. 3. The Fact Sheets provide guidance generally helpful to taxpayers, that where there are multiple feedstock outputs, reasonable attribution (see sec (2)(b)) can be applied to each output: 1. If substantially identical, those outputs can be treated as a single feedstock output for practical purposes; or 2. If similar items of variable quality, the faulty items can be separately treated from the successful ones. The worked examples are discussed in the slide presentation and seem to also follow the R&D legislation. 3.1 Ongoing terms reliance on ATO ID? Despite the approximate 15 year life of the feedstock provisions, the R&D Tax Concession Guide to Benefits (in its various forms) contained limited information on the nature of inclusions in feedstock beyond reiteration of the key terms and some straightforward examples. In 2007, over a decade after enactment of the old feedstock provisions, the ruling contained in ATO ID 2007/122 provided significant guidance on key definitions in the 1936 Act supported by a significant body of case law. To the extent that the phrases are the same as the new law, ATO ID 2007/122 provides useful material for taxpayers to consider in their individual circumstances.. The conclusions of ATO ID 2007/122 are summarised thus: KPMG

6 The company has incurred expenditure on the acquisition of product ingredients, and the manufacture and storage of the product. The product is manufactured, stored and sold in the course of the company's usual commercial activities. The product and its constituent ingredients are 'materials or goods' for the purposes of the definition of 'feedstock expenditure' in subsection 73B(1) of the ITAA The purpose and scheme of the feedstock provisions therefore does not support a narrow meaning being given to the terms 'processing' or 'transformation'. Rather, the meaning to be given to them should be one that recognises the many and varied types of activities than can come within the definition of 'research and development activities'. Such activities by their nature, can take many different forms, and may often involve the analysis of changes in the composition of substances that are not visible to the naked eye. The ordinary meanings of these terms, as obtained from the dictionary definitions referred to, conform with the purpose and context of the feedstock provisions. Reading between the lines, in the example referred to in the ATO ID, it appears that expenditure on storage materials was caught by the feedstock provisions. Similar outcomes could also apply to consumables/aids to manufacture, etc. R&D claims involving feedstock expenditure should become more prevalent even where profits would be expected to be made from the resultant feedstock outputs, given the 5 percent tax benefit for small companies. Assuming we see more focus on feedstock claims by taxpayers, the ATO may update its guidance to confirm the validity of old terms as well as some clarity around other terms not specifically defined in the new law. KPMG

7 4 CONCLUSION The new feedstock rules provide a more reliable basis to claim R&D on feedstock inputs and record the assessable income arising from successful R&D. It especially benefits those entities qualifying for the 45 percent R&D offset rate (ie groups/affiliates with turnover less than $20 million). The stepby-step approach to the provisions also enables claimants the opportunity to structure their project costing systems to capture R&D feedstock in real time. For example, the ability to treat faulty items separately from successful increases the tax benefit from a claim for feedstock. The subtle changes of definition do create some challenges for taxpayers: Compliance burden of making calculations, perhaps on individual faulty items is it worth the benefit? Adjustments needing to be made to assessable income rather than netting off the residual feedstock creates compliance burden for sales/use post the year incurred The inclusion of tax depreciation creates record keeping issues. There is also the additional compliance burden if an adjustment balance occurs on the later disposal of any assets used to produce inputs. Overall, the provisions broaden the extent to which feedstock adjustments impact on R&D claims but seem consistent with the intent of the feedstock legislation as set out in KPMG, an Australian partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. KPMG