Business. The R&DTax Incentive. ICT Guidance FEBRUARY Digital version business.gov.au/taxincentive

Transcription

1 Business The R&DTax Incentive ICT Guidance FEBRUARY 2015 Digital version business.gov.au/taxincentive

2 Commonwealth of Australia 2015 This work is copyright. Apart from any use as permitted under the Copyright Act 1968, no part may be reproduced by any process without prior written permission from the Commonwealth. Requests and inquiries concerning reproduction and rights should be addressed to the Department of Industry and Science GPO Box 9839, Canberra ACT

3 Contents Message from AusIndustry iv Introduction 1 Background 1 About the Case Studies 2 Case Study 1: DataCoAnalytics 3 Business Scenario 3 What documentation did DataCoAnalytics keep? 4 Commentary 5 Case Study 2: ColdTec 7 Business Scenario 7 What documentation did ColdTec keep? 9 Commentary 10 Case Study 3: ewatchmakers 11 Business Scenario 11 Commentary 12 Commentary 14 What documentation did ewatchmakers keep? 14 Case Study 4: Push Through Technologies 15 Business Scenario 15 What documentation did PTT keep? 16 Commentary 17 Attachment A 19 Frequently Asked Questions 21 iii

4 Message from AusIndustry As an important driver of productivity and economic growth, innovation encompasses a wide range of activities, many of which start with research and development (R&D). The R&D Tax Incentive provides a targeted and generous incentive for companies to invest in and grow their R&D capacity. By supporting eligible R&D, the Incentive program will help both individual businesses and benefit the broader Australian economy, making us a cleverer and more globally competitive nation. As a key enabler of business and innovation, ICT R&D is central to services, processes and products across virtually all sectors of the economy. Based on experiences gained from the R&D Tax Concession, AusIndustry anticipates ICT involvement in the new R&D Tax Incentive will be high. This guide has been designed to help clarify the eligibility of ICT-related R&D activities. It contains several hypothetical business case studies that discuss the identification and registration of business R&D activities. The guidance has been developed with input from knowledgeable and experienced businesses, industry bodies and professional advisory firms. Their assistance in this process is gratefully acknowledged by AusIndustry. If your business is incurring expenses to solve problems and generate new knowledge or develop new products or services, you are likely to be undertaking some activities that qualify as R&D under the Incentive program and you should look to register. I encourage you to read this document. David Wilson General Manager, R&D Tax Incentive, AusIndustry iv

5 Introduction The following guidance seeks to highlight for business the relationship of their actual R&D activities with the legislative framework of the R&D Tax Incentive program. It comprises a series of ICT related case studies and commentary. The focus of the various case studies is on eligibility issues associated with R&D activities and how these arise under various business scenarios. This is to assist companies to see how the broad principles of the R&D Tax Incentive apply to ICT-related R&D. The commentary throughout each case study provides additional explanatory information around key concepts including new knowledge and experimental process, core and supporting R&D activities, records management and compliance assurance, excluded activities and activities likely to be ineligible. The examples do not attempt to go into every aspect of a real-life claim, such as the methods for calculating and allocating labour expenses and overheads to R&D activities. Background The R&D Tax Incentive is a self-assessment program which is accessed via a two stage process that involves: Registering your R&D activities with AusIndustry (this can be done online and must be done within 10 months of the end of your income year), and Including a claim for the R&D Tax Incentive activity expenses in your company tax return. The various tax benefits provided under the new R&D Tax Incentive and the process associated with identification, registration and claiming of eligible business R&D activities are described in more detail in other guidance products (available at default.aspx). Briefly in summary, the program provides a tax offset to encourage more companies to engage in R&D. Specifically, the program offers two core components: a 45% refundable tax offset (equivalent to a tax deduction of 150%) for eligible entities with an aggregated annual turnover of less than $20 million a 40% non-refundable tax offset (equivalent to a 133% tax deduction) for all other eligible entities. 1 In the R&D Tax Incentive, business activities, and attributable expenses, must comply with the legislated definition of one of the following: core R&D activities broadly, these are the systematic, experimental activities fundamental to generating new knowledge, or supporting R&D activities broadly, these are activities that are not part of the experimental activities, but support them in a direct way. The legislation provides more detailed guidance than these broad definitions 2. This guidance is intended to assist businesses to apply these definitions in selfassessing their ICT activities. First-time registrants are encouraged to seek assistance from AusIndustry or from tax agents or advisory firms familiar with the registration process and eligibility. At time of registration AusIndustry reviews all applications for timeliness and completeness before they are registered 3.As with all tax-based activities, companies registering and making claims under the R&D Tax Incentive must maintain adequate records to ensure that they can substantiate their activities, if they are selected for a compliance review. 1 The Australian Government has announced its intention to change the rates of assistance to 43.5 and 38.5 per cent respectively. The Government has also committed to target access to the R&D Tax Incentive to entities with aggregated assessable income of less than $20 billion. Both changes require legislation. More information is available from business.gov.au. 2 More information on the R&D Tax Incentive program, including how to apply, can be found on business.gov.au and the ATO website (ato.gov.au). 3 Please Note: Registration of activities does not, by itself, render the activities described in the registration as eligible R&D activities, nor is it an indication of compliance with the requirements of the R&D Tax Incentive. After registration, AusIndustry may examine a registration in detail and this may lead to a formal finding about the eligibility of all or some of the registered activities. 1

6 About the Case Studies The following hypothetical case studies are a guide only. They are not intended to be a definitive, exhaustive precedent that cover every possible component of a claim for companies to follow. The intent of this guidance is to empower companies with an overview and understanding of the key legislative requirements and concepts that they need to self-assess their own claims. The case studies are intended to assist companies in a number of ways including: helping them to see where they might be undertaking eligible R&D that could be registered for the program understanding the documentation and records that need to be kept to substantiate that the activities they register as eligible activities comply with the legislative definition of R&D categorising their R&D activities as either core R&D or supporting R&D activities. The case studies attempt to highlight important issues to take into account in ensuring risk-managed compliance with the program. They explore several different ICTrelated business scenarios in order to provide additional guidance in accessing the new program. These include: understanding the scope, number and type of eligible activities comprising an R&D project; building on knowledge and experience gained through participation in the previous R&D Tax Concession program; aligning eligibility with distinct phases in a business cycle; and the situation where an R&D project has overseas activity. The objective of each case study is to assist the selfassessment of a company s activities by demonstrating how the terms core and supporting R&D activities apply to practical ICT business situations. In relation to any broader issues around company eligibility, exclusions or tax treatment, further information and guidance is available 4. The four case studies (at Table 1) were developed in response to issues typically faced by business undertaking ICT related R&D. They were identified through close consultation, including workshops and face-to-face interviews, with a range of businesses and experienced tax agents. Note: The case studies themselves do not intend to represent the benchmark in new products and services available against existing products and services that are currently used or offered by other companies, both in Australia and overseas. Rather, they seek to provide companies with scenarios to assist them in their selfassessment of activities to help identify and demonstrate those that are innovative and meet the R&D Tax Incentive eligibility requirements. Table 1 List of Case Studies that illustrate various ICT-related R&D activities CASE STUDY DataCoAnalytics ColdTec ewatchmakers Push Through Technologies SCENARIO New algorithm for analysing and displaying big data sets this case study has a detailed rationale for translating the new R&D definition in a practical business situation Cloud computing in a manufacturing environment this study shows how a company draws upon its prior experience with the R&D Tax Concession Software modules for electronic watches this case study attempts to link R&D activities management with events in a 2 3 year business cycle New algorithms for mobile communications system this study shows how a company registers activities in an R&D project that include activities that need to be conducted overseas 4 Guidance in relation to whether you are an eligible entity and the claiming of company R&D expenses is provided by the Australian Taxation Office (ATO). For more information on those aspects of the program, you should visit the ATO website ato.gov.au, or phone the ATO on Guidance in relation to other aspects of AusIndustry s administration of the program, such as registration or seeking Advance or Overseas Findings can be found on the business.gov.au website, or visit the Contact Us page on the website for full details on how to contact us via phone ( ), or web chat. 2

7 Case Study 1: DataCoAnalytics This case study illustrates the application of two key legislative requirements in the definition of core R&D activities: whose outcome cannot be known or determined in advance ; and experimental activities that are conducted for the purposes of generating new knowledge. In this context, the case study presents a business scenario and commentary on how the above concepts impact on the relationship between core R&D activities, supporting R&D activities, listed exclusions and records management. This case study also shows how by keeping good documentation right throughout the project, DataCoAnalytics: is better placed to provide clear and accurate descriptions of its activity in its registration application; reduces its compliance costs and risks if it were to be selected for a review in the future; helps to ensure that its project is well managed, efficiently carried out and knowledge is captured. Business Scenario DataCoAnalytics has received an extremely large data set courtesy of the Square Kilometre Array (SKA), and is contemplating using it to produce a primary school teaching package ( SkyWonder ) which will use the data to create 3D visual depictions of areas of outer space. The company conducted a range of activities in order to research, develop, test and finalise its product. After searching the market place, DataCoAnalytics could not find any existing tools or solutions it could apply to query the SKA data set in the way needed for SkyWonder. This meant that the company needed to develop and then implement a new approach to solving its problem. DataCoAnalytics embarked on a project to create a new algorithm that could search the SKA data set to locate elements necessary to display 3D images based on parameters a user has selected. DataCoAnalytics also proceeded to develop the graphical user interface (GUI) for SkyWonder using the Java and OpenGL programming languages. In order to access the R&D Tax Incentive DataCoAnalytics needed to register self-assessed eligible activities and categorise them as either core R&D activities or supporting R&D activities. In the course of identification and claiming of R&D activities the company deemed that it would register one core R&D activity and one supporting R&D activity. SkyWonder Project Core R&D Activity 1: Development of the new algorithm to the new SkyWonder product suite DataCoAnalytics considered AusIndustry s guidance material on eligible R&D activities and self-assessed that developing the new algorithm, testing it, and implementing and integrating it could be registered as an eligible core R&D activity. In reaching this decision DataCoAnalytics undertook a literature and technology review to search for data search and integration algorithms already available in the market. It documented the weaknesses and limitations of these existing algorithms, in particular reasons why these existing algorithms did not provide any solutions to the problems it faced in developing SkyWonder. This evidence supported DataCoAnalytics s conclusion that the outcome of the experimental activities could not have been known in advance. To be eligible for the R&D Tax Incentive, DataCoAnalytics needed to keep documents explaining what it had done. As part of this process, DataCoAnalytics set out its experimental activities hypothesis and described the unknown variables that were intrinsic to its testing activities. The hypothesis for this activity is in effect, what it was trying to resolve, e.g. an algorithm can be developed to create 3D visual depictions of areas of outer space. Tests are primarily performed in order to develop and implement a novel data searching algorithm that would give an accurate, reliable and relatively speedy output that would display a 3D image based on the sky coordinates a user has selected. As part of the record keeping process, DataCo Analytics recorded the nature and results of these tests. 3

8 SkyWonder Project Supporting R&D Activity 1: Developing the graphical user interface (GUI) While this part of the business solution for SkyWonder was challenging for the business (particularly, those activities conducted to achieve consistent performance and presentation in the GUI) it was decided that the activity was unlikely to meet the threshold tests of two key legislative requirements in the definition of core R&D activities: requiring experimental activities whose outcome cannot be known or determined in advance; and, that is conducted for the purpose of generating new knowledge. DataCo Analytics decided therefore to register the activity as a supporting R&D activity directly related to the development of the new algorithm to the new SkyWonder product suite (core R&D activity). The company s rationale for this decision was based on knowledge that: development of the GUI involved programming work that used well-established methods for their intended purpose with no unique challenges in terms of their assembly or integration (i.e. non-experimental activities); the programming would be fairly standard and not involve anything new or different (i.e. nonexperimental activities); and, the new knowledge obtained in the new algorithm (core R&D activity) is itself displayed in and through the GUI (i.e. a direct relationship exists between the activities) Subsequently, DataCoAnalytics confidently described and detailed the multiple activities involved in developing the GUI as a collective supporting R&D activity in its registration. What documentation did DataCoAnalytics keep? DataCoAnalytics kept appropriate business documentation to verify the eligibility of their activities and substantiate their claim for the R&D Tax Incentive. Their effective management, good planning and robust business systems were fundamental ingredients to their successful innovation. In relation to its R&D activities the company kept a register of all of the relevant technical scoping and business planning documents these could be used to substantiate their claim should they be subject to an AusIndustry compliance assurance review. In relation to the R&D activities themselves, the company was careful to maintain records that demonstrated a systematic progression of work that is based on the principles of established science and proceeded from hypothesis, observation and evaluation and led to logical conclusions. For example they: retained the results of test runs of the algorithm, including failed tests that produced incorrect results, and documented the results of running these prototypes on test data from the SKA. kept version repository logs with sufficiently detailed comments on the prototypes indicating the iterative development, testing and improvement of the algorithm including weaknesses that were identified and rectified in successive versions. managed their R&D using a project plan, including a risk management plan, that set out the business aims and technical hypotheses, explained the design of the experiment to test the hypotheses, described the observations and analysis that resulted from each of the experimental processes they engaged in. The company was also careful to keep a record of failed tests and experiments. This could be powerful evidence of their R&D activities documentation for the R&D Tax Incentive because it shows that there was a clear risk that the outcome of the activities was not desired or may not be the desired one. This is a relevant consideration when demonstrating eligible core R&D activities. Failed tests and experiments, whilst not conclusive, can support other evidence that the outcome of the experimental activities were not knowable in advance. 4

9 Commentary Commentary on self assessment and ICT eligibility considerations in general The following commentary further explores the eligibility of various related ICT activities, concepts and challenges in terms of whether they reasonably comply with the program s definition of core or supporting R&D activities. It is also intended to further guide and inform a company s self-assessment as it relates to listed ICT exclusions and common ICT-related activities. About the Core R&D Activities In establishing compliance with the legislative requirement that their experimental activities involve an unknown outcome, companies should focus on explaining how they determined that existing products, methodologies or technological information did not provide the required outcomes for their project. This establishes the necessary knowledge gap or new knowledge threshold codified in the legislative requirement experimental activities that are conducted for the purpose of generating of new knowledge. Establishing the new knowledge threshold of core R&D activities Core R&D activities are experimental activities that are conducted for the purpose of generating new knowledge, including new knowledge in the form of improved products, devices, processes or services. To satisfy this requirement, ICT participants must demonstrate that the activities being registered as core R&D activities are aimed at developing knowledge or functionality that is not readily accessible. Participants will usually demonstrate this through undertaking and recording the results of a reasonable market analysis or searches outside the company regarding the current state of knowledge. For example, in the ICT sector this could include reports in reputable journals, blogs, wikis, etc. A general principle when establishing the knowledge gap entails that program participants search beyond their direct competitors to demonstrate that functions or methods are new. For example, if a company develops an industrial control system that contains a new visualisation method that does not exist in competing industrial control systems, but the system has been implemented successfully in other applications, it would unlikely be new knowledge. In this situation the company could not claim that development as a core R&D activity unless they could demonstrate some new knowledge (e.g. a new or improved process or method) that is not present in the other applications and could not be known in advance in terms of its application to a control system. In relation to the DataCoAnalytics case study, it should also be noted that if there are algorithms in other areas of technology that could easily be adapted to provide the required outcomes for SkyWonder, DataCoAnalytics s algorithm would not be considered new knowledge. Examples of common ICT-related activities that are unlikely to be eligible core R&D activities include: Solving technical problems where similar problems have been overcome previously, such as on the same operating systems or computer architecture. Post R&D activities such as preparation of user documentation and maintenance of existing systems. Minor adaptation of existing software, materials or products. Adding minor user functionality to existing application programs or devices. De-bugging of production systems and products (although resolution of a significant issue could potentially become an eligible R&D activity). Using the capabilities of existing software (such as application programming languages, graphical user interface builders or report generation tools) as they are intended to be used and within their limitations. System integration where the technical components are known and uncertainty that it could be done is low. Certain activities listed above may be eligible as supporting R&D activities if they are directly related to core R&D activities and if necessary are being undertaken for the dominant purpose of supporting an eligible core R&D activity (see below for more information on the dominant purpose requirement). Establishing the new knowledge threshold in systems integration Resolving system integration complexity (that is, the complexity involved in combining multiple previouslyestablished systems, such as creating interfaces between a database and a user application) would not generally be considered to be a core R&D activity in its own right. However, if the integration is more complex (for example, in scale or diversity) some or all of the activity could still be eligible. In some cases integration may more likely be eligible as a supporting activity if it is directly related to a separate core R&D activity. 5

10 The internal administration ICT exclusion It is important to establish whether development, modification or customisation of software was for the dominant purpose of internal administration by the company or a related or affiliated entity. If this was the case then such activities are specifically excluded from eligibility as a core R&D activity under the R&D Tax Incentive (in the DataCoAnalyitics scenario this is not the case). The core activity exclusion on internal administration refers to the general internal business management functions of a company and can be taken to include, among others, the systems associated with the management of offices and staff, payroll and accounting, information management, and enterprise resource planning (ERP). It is also possible that other internal administration in the form of logistics, warehousing applications, payment processing, CRM software and customer service portals where they are developed for the prevailing purpose of the businesses internal purposes may also trigger this exclusion. It is important to note that this condition does not, however, exclude applied software such as process control systems or firmware that forms an integral part of a home appliance or piece of industrial equipment, even if that software is not intended to be sold or distributed publically. Additionally, internal business administration activities may still be eligible as supporting activities, if they are undertaken for the dominant purpose of supporting an eligible core R&D activity. About the Supporting R&D Activities, the ICT exclusion and dominant purpose Activities which do not form part of the experimental activities may be eligible as supporting R&D activities. This means that, as in the DataCo Analytics example, companies may claim expenditure on supporting R&D activities that are directly related to the core R&D activity. Directly related requires an activity to have a direct, close and relatively immediate relationship with the core R&D activities. There is however, an additional consideration where the activities: produce or are directly related to producing goods or services; or, (as referred to above) involve developing, modifying or customising software for the dominant purpose of internal administration of the developer, their affiliate or a connected entity. In both situations, the activities must also be undertaken for the dominant purpose of supporting core R&D activities. Companies self-assessing should weigh up the various purposes for conducting the activity and then determine which was the dominant (i.e. the ruling, prevailing or most influential purpose) of undertaking that particular activity 5. As the DataCo Analytics example shows, ICT-related activities of a known or common nature (for example that use established methods, processes or data) are not likely to be considered to be eligible core R&D activities. They may however be eligible as supporting activities, if they are either directly related and if necessary are being undertaken for the dominant purpose of supporting an eligible core R&D activity. 5 To assist companies determine whether their activity has the necessary relationship with the core R&D activity, they should weigh up the factors under What is the meaning of dominant purpose in the R&D Tax Incentive Customer Information Guide available on business.gov.au. Additional information on dominant purpose is available on page 20 of the R&D Tax Incentive: A Guide to Interpretation which is available on business.gov.au. 6

11 Case Study 2: ColdTec This case study shows how a company that was familiar with compliance under the previous R&D Tax Concession considers the practical similarities and key differences underpinning its compliance with the new R&D Tax Incentive. It also further illustrates relevant considerations in the identification of core and supporting R&D activities including: the likely eligibility of activities which involve the application of existing technologies to new fields; and due diligence around the new knowledge threshold and establishing that core R&D activities are not determinable in advance by a competent professional in the field. In this context, the case study again presents a business scenario and commentary on the relationship between core R&D activities, supporting R&D activities, the judgement required to group and categorise various R&D activities and the underpinning role of good records management. Business Scenario ColdTec is a small company that develops innovative ICT service products. Over the last 10 years or so, the company s business cycle has moved through successive phases of new product identification, R&D activity and subsequent commercialisation. The company has previously accessed the R&D Tax Concession program. The company recently developed a new refrigerator logistics management technology application Groceryvision. This product takes advantage of ubiquitous internet connectivity to automatically order replacement stock. It has potential commercial applications ranging from supermarket stock management, food service industries through to the domestic market. The technology uses a number of small cameras inside the fridge to identify the number and/or status of products and then order replacements when necessary. As Groceryvision relies on its cameras rather than barcode scanning or manual operation, it must perform processor-intensive computer vision tasks several times a day. The company has opted for a cloud computing solution because it would not be commercially viable to equip each fridge with the required processing power. This means that a fridge with Groceryvision simply uploads images to ColdTec s servers, where the image processing and ordering tasks are handled remotely. Although familiar with the operation of the R&D Tax Concession, in order to register its R&D activities with AusIndustry and access the new R&D Tax Incentive, the company is obliged to re-examine its claim in light of the new definition of R&D as it applies to ICT-related activity. The company is confident that much of its work meets the eligibility requirements of the new R&D Tax Incentive as the activities are about developing a new and novel product line. After reviewing the new program s Customer Information Guide 6 and registration form, the company concludes that: In practical terms the new R&D eligibility requirements are not greatly different from the Concession The definition of R&D activities uses different language and there is now a requirement for R&D activities to be separated into core R&D activities and supporting R&D activities (they will need to separate activities into these categories when they register their activities) supporting R&D activities are now activities directly related to core R&D activities, rather than activities carried on for a purpose directly related to core R&D activities there are also new rules affecting the eligibility requirements for ICT-related activities in the context of internal business administration. The critical importance of record keeping has not changed, although companies are no longer formally required to have R&D Plans for registered activities. ColdTec concludes that this change provides greater flexibility in how companies plan and undertake their research and meet the record keeping obligations under the program. The company decides that in relation to its Groceryvision project that it will register three distinct activities with AusIndustry: two activities involved in setting up and testing Groceryvision as core R&D activities; and a third activity, the development of software for image capture and upload as a supporting R&D activity directly related to these core R&D activities. 6 See business.gov.au 7

12 Groceryvision Project Core R&D Activity 1: Development of the specific image compression algorithm ColdTec considered AusIndustry s guidance material on eligible R&D activities and self-assessed that implementation and testing of this algorithm to be a core R&D activity. The company conducted a literature and technology review to determine whether algorithms existed that could perform the necessary image compression within the space and memory constraints of the low-cost, low-power processors in Groceryvision fridges. It documented the limitations of existing algorithms, including reasons why they were not suitable for use on microprocessors in Groceryvision fridges and why existing methods or technologies could not be adapted for this purpose. The company maintained records of its searches including the analysis and reasons to support its conclusion of the need to develop specific software to enable an algorithm to be implemented on the fridge processors. In this case, the development and testing of the compression algorithm led to new knowledge in terms of how to produce software to enable working image compression firmware for the specific microprocessors used. Groceryvision Project Core R&D Activity 2: Cloud-based application of neural network computer vision techniques to grocery management It is recognised in the industry that computer vision is a well-established field; therefore ColdTec needs to be diligent in establishing how its application in the new Groceryvision product could not be known in advance. To establish this, ColdTec retain a series of s between an engineer and their head of product development. These s record that although neural networks have been used for computer vision in the past and are likely to work in this setting, the outcome of constructing the architecture and training of the neural network for this new application cannot be determined before-hand, and for this reason the precise results and timeframe of this approach are unpredictable. On the basis of an evaluation of their investigations ColdTec decide that the only way to establish how well a neural network will perform in a given application is through experimental investigation. These experiments entail using Groceryvision on a suite of training images of products likely to be encountered, and then testing its ability to correctly recognise products and volumes. They aim to address the hypothesis, after training, the neural network will correctly recognise grocery items in a set of images of a fridge interior. ColdTec also documents how they will know whether the outcome of their experiments will confirm their hypothesis, i.e. in order for the neural network to be classed as recognising the images it must do so with 98% accuracy. On the basis of its research and evaluations, ColdTec self-assesses that testing the candidate methods on a suite of test images is a core R&D activity. ColdTec must generate a series of training and test images to train the Groceryvision neural network. For this, they need to purchase large amounts of groceries and spend considerable time staging fridge interiors. ColdTec s activities in setting up of the testing of Groceryvision are self-assessed as an integral component of the eligible core R&D activities. This decision was based on a professional and pragmatic view of what it means to conduct an experiment. Although ColdTec felt that it could have also categorised these activities as supporting R&D activities as the image generation itself did not involve an experiment, in the end ColdTec s self assessment was that the image generation activities were inseparable from the neural network training and testing experiments (further discussion on this point is found in the case study s Commentary). Groceryvision Project Supporting R&D Activity 1: Image upload firmware for a small microprocessor ColdTec must develop software that can read images from the cameras in the fridge, compress the images, and upload them to ColdTec s servers, all using a low-cost, low-power processor. Literature and market reviews determine that image capture from small cameras is a well known capability and the company is able to adopt an existing method to upload images that does not involve any complex integration of adaption requirements (which would involve any unknown outcomes or uncertainties). Accordingly they self-assess that this work is not eligible as a core R&D activity. However, because it directly supports the testing of the end-to-end operation of the Groceryvision product the company conclude that writing of the firmware is eligible as a supporting R&D activity for both core R&D activities. 8

13 What documentation did ColdTec keep? On the basis of the company s prior experiences with the R&D Tax Concession the company understood that record-keeping was central to their compliance. In the past the company had learnt that their effective management, good planning and robust business systems were fundamental ingredients to their successful innovation. In relation to its R&D activities the company kept a register of all of the relevant technical scoping and business planning documents these could be used to substantiate their claim should they be subject to an AusIndustry compliance assurance review. In this project they paid particular attention to records that would verify their claim that the work undertaken met the new knowledge test. In relation to the R&D activities themselves, the company kept records that demonstrated a systematic progression of work based on the principles of established science (proceeding from hypothesis, observation and evaluation and leading to logical conclusions). For example they: kept an issues log throughout the development of the image compression algorithm, indicating for each issue how the problem was identified, who worked on the solution and for how long, what solutions were tried (including unsuccessful attempts) and a description of the testing undertaken to determine that the issue was resolved kept an experiment log of attempts to train neural networks, recording for each attempt the network architecture and training data used, the results of testing the network on test data (even when those results were poor), and engineers commentary on how the setup may be improved for the next experiment. 9

14 Commentary Further commentary on identifying core R&D activities and supporting R&D activities The following addresses the eligibility of select activities in terms of whether they are core or supporting R&D activities, including the rationale for ColdTec s self-assessment. Two particular themes are covered in the following: the way in which the company capitalised on its corporate knowledge in previously accessing the R&D Tax Concession; and how companies ungroup an R&D project into a manageable activity set (and activity type) for the purposes of registration and compliance. Indentifying Core R&D Activities The R&D Tax Incentive requires core R&D activities to follow a systematic progression of work based on the principles of established science. This means the eligible core R&D activities must proceed from hypothesis through to experiment, observation and evaluation, and lead to logical conclusions. These activities must also be conducted for the purpose of generating new knowledge and involve the process of scientific experimentation. In the above example, ColdTec concluded that in practical terms this is not very different from the Concession which required R&D activities to be systematic, investigative and experimental (SIE), have an appreciable element of novelty and a demonstrable degree of technical risk. In effect the company concludes that the same elements of core R&D activities are present in both programs. However the R&D Tax Incentive s strong emphasis on generating new knowledge influenced the company s self-assessment and compliance outlook. The company conceded that at first blush the various software development and testing activities were seemingly quite routine. This means that where companies are applying new uses of existing technologies, it is particularly important they identify: Why technical problems with the new use cannot be resolved by tailoring existing products, methods or processes, and Why a series of organised experiments are necessary to determine the outcomes of the tests over a range of conditions. In the Groceryvision project the company took special care to establish how it determined that the outcome of its experiments could not be known in advance by a competent professional in the field. The conclusion by its internal expert as to the unknown outcome and need to conduct experimental activities was a reasonably held one. In this example, the engineer had a number of years of experience in the field (10 plus years) which he supplemented with recently undertaken external literature searches. Clarifying the technical scope and number of registered R&D activities In settling upon the number and type of activities to be registered under the Groceryvision project the company made some practical judgements that justified the approach taken. The scope of registered R&D activities is something which will always require subjective judgements. For example, some of the activities to prepare the infrastructure to test the Groceryvision neural network may be supporting R&D activities rather than core R&D activities where they are not immediately part of the experimental activities. (For example, purchasing of the amounts of groceries needed to conduct the experiments.) It is a matter for the judgement of companies as to whether an activity that is closely connected to an experiment forms part of the core R&D activity or whether it would be more correctly classed as a supporting R&D activity. When making these judgements, companies should consider how close the activity is to the experiment, its significance to the experiment and the record-keeping requirements that can substantiate their decisions. 10

15 Case Study 3: ewatchmakers This case study illustrates the identification of core and supporting R&D activities over a hypothetical 3 year business cycle. In this context, the case study illustrates information about core R&D activities useful for registration and some examples of non-experimental activities which are eligible supporting R&D activities. It also highlights some activities likely to be ineligible and the reasons why. This case study shows how the identification and management of eligible R&D activities could link to different points in a company s business cycle: developing a new product or solution improving an existing product or solution R&D funded by a customer early termination of an R&D project. Business Scenario ewatchmakers supplies software modules for electronic watches. They become involved in a step-wise progression of R&D projects in line with their expansion into some new market niches for smart payment devices. Business Year One: Developing a New Product or Solution The founders of ewatchmakers have observed the potential for mobile phones to be used as a payment device by transmitting a signal to a point of sale terminal, using software embedded in the phone and a near field communication (NFC) circuit. Although several international telephone manufacturers are exploring this, the company consider that a potentially successful product would be a smart watch capable of similar functions. After having conducted an analysis that concluded that there are no such products in the market place, ewatchmakers discover that their idea faces a number of challenges that cannot be resolved from existing knowledge. Specifically, whilst there are smart watches on the market that carry a SIM card for phone calls, these do not have the capacity to handle a transmission to a payment terminal. In addition, the small rechargeable batteries in current smart watches all use a design that too quickly drains power during active use. Communicating with an NFC point of sale device is likely to cause the battery to drain much more quickly and lead to the smart watch shutting down prematurely. Because these problems have not yet been solved and it does not appear that the knowledge to do so is available, the company commit to an R&D program to create a smart watch capable of conducting payment transactions. ewatchmakers self-assess that solving how to construct and manage a payment instruction in a smart watch operating system and how to avoid battery draining will meet the core R&D requirements of the R&D Tax Incentive legislation because it requires experimentation in the pursuit of new knowledge. There are several core R&D activities identified by the company: experimenting with various forms of payment instruction coding; ultimately developing a method that puts part of the payment instruction into the memory chip controlling the watch s functions and the rest onto the SIM, where there is more computational capacity. ewatchmakers experimental activities also reveal that by splitting the payment transaction, the power drain on the watch battery can be reduced, because the SIM only needs to transmit for a very short burst. ewatchmakers also encounters a persistent problem in getting the near field sensor connected to the point of sale terminal to recognise transmissions from the SIM if there is any electronic clutter nearby (something that is inevitable in a retail setting). This results in several dead-ends for the project until the problem is narrowed down to the need for stronger shielding of the SIM inside the watch chassis, to prevent interference. In order to progress its R&D project ewatchmakers acquire 20 of the latest smart watches from each of the five main vendors (100 smart watches in total), 1000 SIM modules and a software programming toolkit that can be used to embed financial transaction instructions onto a SIM. The company also buys a commercial point of sale payment terminal and a simple near field communication sensor as part of the R&D project. 11

16 It self assesses these activities as supporting R&D activities as they are directly related to the core R&D activity, because they facilitate the pursuit of new knowledge. It also concludes that the software programming tookit is a supporting R&D activity. It is directly related to the core R&D activities, in that it has direct, close and relatively immediate relationship with the experimental activities, without being part of the experiment itself. It is a commercially available product that is simply being used as an aid to the programming of the SIM. At the end of this period ewatchmakers conclude their experiments and have arrived at a working prototype and specification for a smart watch capable of conducting payment transactions. Commentary R&D Planning At the point at which ewatchmakers began to frame its R&D intentions, it set out its hypothesis and how it planned to attempt to solve the problem(s) identified (the processes of experiment, observation, evaluation), so as to produce a solution (the new knowledge, or logical conclusions) which it hopes to discover by following this systematic progression of work. This planning process and record keeping also allowed the business to assess all activities and make an accurate determination about what are the core R&D activities and what are eligible supporting R&D activities. While R&D planning 7 was involved, it is not unusual for the early versions of an R&D plan to be quite basic. For SME s and new entrants to the program, adopting a systematic R&D planning frame work means that a firm is better able to register for the R&D Tax Incentive and meet its compliance obligations (particularly if the claim is selected for review by AusIndustry). 7 Maintaining formal R&D Plans is not compulsory under the R&D Tax Incentive, however evidence of good planning and governance processes form strong supporting evidence for compliance purposes. Business Year Two: Improving an Existing Product or Solution Twelve months later, ewatchmakers have moved into production and sale of the new smart payment watch. At this point the company has a new idea: programming the watch s display to change colour briefly when a transaction is completed. The idea is discussed with the company s software engineer, who advises that this can be fairly easily achieved, with an extra few lines of code in the watch control module. However the control module is already known to be operating at near capacity (which is why some transactional functions have been transferred to the SIM). In addition, the supplier advises that a new, higher spec module is available however its susceptibility to interference when operated in close conjunction with a SIM in a cluttered electronic setting is unknown. The engineer advises that the only way to find out if the new module can provide the improved functionality and work in the setting is to undertake a series of tests. Although the e-watch has only recently been released to the market, and the proposed new model is similar, the above issue represents a need to experiment to create new knowledge. ewatchmakers therefore undertake to complete a new R&D project. ewatchmakers orders 5000 new higher spec control modules. This is significantly more than is needed for testing, but the supplier offered an attractive price, so ewatchmakers makes a considered decision based on the advice from its software engineer that the testing is likely to be successful and that the modules can be used in subsequent production. When the new modules arrive, ewatchmakers commences an R&D activity to add the additional lines of code, test that the colour screen changes as intended and that the interference levels are within existing electromagnetic screening tolerances. As anticipated by the software engineer, adding the additional lines of code to produce the screen-changing effect proves to be straightforward. Normal production is briefly interrupted to produce a run of 50 smart watches with the new module for testing. After a series of tests the new module is found to be no more susceptible to interference than the old module. As stocks of the old watch control module are starting to run low, a decision is taken to convert across to the new module using the stockpile of 4950 remaining from the recent order, from the next shift. 12

17 Commentary Further commentary ewatchmakers has established that the new module will enable the colour-changing screen feature to be incorporated and it will not have any adverse effect on the smart watch s other performance parameters. This would normally represent the end of the R&D activity. In determining the scope of the core and supporting R&D, it assesses that the testing of the new modules for interference is eligible as core R&D (experimental activities) and the interrupting and running the production line to produce 50 testing samples is supporting R&D activity (because the dominant purpose is to support the core R&D activity). However, only 50 modules were required to establish the new knowledge. Therefore the procurement of the other 4950 modules, which were purchased with a view to production, is not eligible as either core or supporting R&D activity. It cannot be registered under the R&D Tax Incentive. Nor is the programming any of the 4950 new modules eligible as an R&D activity under the R&D Tax Incentive because is not experimental, does not contribute to the generation of new knowledge and does not directly support a core R&D activity. Business Year 2 3: R&D Funded by a Customer The founders of ewatchmakers are now successfully manufacturing a range of smart watches that are capable of being used for financial transactions for domestic and international markets. Observing the trend towards product branding, the founders decide that they will develop a product for the luxury watch market. They successfully approach the world leading GARGA brand with the concept. GARGA agrees to fund the development of an exclusive smart watch, on the basis that it will own the rights to certain aspects of the specialised design. GARGA decides that its watch is to use the rare metal palladium because of its exclusivity and also because it is recyclable. ewatchmakers investigates palladium and finds that it generally has the required metallurgical qualities, except that there is some question about whether the metal will create adverse electronic interference. ewatchmakers develop an R&D plan for the GARGAwatch, focusing on the major area of uncertainty whether a watch made of palladium will alter the shielding required for the SIM. GARGA agrees to fund the development of a prototype smart watch, capable of financial transactions, made out of palladium. In conducting market and internet searches, ewatchmakers learns that palladium is routinely used in electronic components. This is confirmed when they obtain metallurgical advice that no experimental activity will be required and any minor screening modifications could be resolved by a competent professional in the field on the basis of current knowledge, information or experience. ewatchmakers therefore decides to press ahead with developing the new GARGA-watch using existing screening components, with a view to conducting interference testing after the product passes GARGA s design approval stage. However, ewatchmakers also learn during their internet searching that palladium can cause skin allergies. When advised of this during product evaluation meetings, GARGA decides to discontinue the R&D project, meeting agreed termination costs. Commentary Based on this body of work ewatchmakers do not have an eligible R&D Tax Incentive claim, because it is not conducting any eligible R&D activities, since no significant experimental activity will be required and any minor screening modifications could be resolved by a competent professional in the field on the basis of current knowledge, information or experience. 13