R&D Tax Incentive Review Issues Paper

R&D Tax Incentive Review Issues Paper Introduction The R&D Tax Incentive encourages industry investment in R&D. It is a broad-based programme that is accessible to all industry sectors. The object of the R&D Tax Incentive is to support industry to conduct R&D activities that might otherwise not be conducted because the private benefits to firms may be less than the wider benefit to Australian society. The Government s National Innovation and Science Agenda, launched on 7 December, initiated a review of the R&D Tax Incentive, jointly chaired by Mr Bill Ferris AC (Innovation Australia), Dr Alan Finkel AO (Chief Scientist) and Mr John Fraser (Secretary of the Treasury) under the auspices of Innovation and Science Australia. The Government has asked the Review to identify opportunities to improve the effectiveness and integrity of the R&D Tax Incentive, including by sharpening its focus on encouraging additional R&D expenditure. The review is drawing on stakeholder feedback and expert input. Submissions made to the Re:Think discussion paper issued for the Tax White Paper; the 2014 Senate inquiry into Australia s innovation system; and the Chief Scientist s 2015 consultation paper, Vision for a Science Nation - Responding to Science, Technology, Engineering and Mathematics: Australia s Future will all be considered by the review, and need not be re-submitted. As input to the Tax White Paper, the Department of Industry, Innovation and Science (the department) commissioned The Centre for International Economics (CIE) to conduct an analysis of the R&D Tax Incentive programme looking at its policy rationale, programme design, impact and cost. This study will be incorporated into the Review of the R&D Tax Incentive. Description and Performance What is the R&D Tax Incentive? The R&D Tax Incentive is available to companies that are resident in Australia for tax purposes, and foreign companies in certain circumstances. For eligible R&D, the Tax Incentive provides a: Refundable 45 percent tax offset for companies with turnover of less than $20 million; and Non-refundable 40 percent tax offset available to other companies. Expenses can ordinarily be deducted at the standard company tax rate of 30 percent (excluding small business entities), which implies that the tax offset delivers a total net benefit of 10 cents in the dollar for larger companies. Small profitable companies with turnover below $2 million qualify for the small business corporate tax rate (28.5 percent), implying a net benefit of 16.5 cents in the dollar. For profitable companies with a turnover between $2 million and $20 million the net benefit is 15 cents in the dollar. The refundable tax offset means that where a company s tax liability is smaller than the value of the R&D tax offset they receive the full, benefit as an immediate refund rather than carrying forward the offset as in the non-refundable component. 1

In the 2014 Budget, the Government announced it would reduce the R&D Tax Incentive by 1.5 percentage points to 43.5 and 38.5 percent respectively. This measure is yet to pass into law. In 2015, an annual $100 million R&D expenditure threshold was introduced. From 1 July 2014, companies with eligible R&D greater than the threshold receive a tax offset at the corporate tax rate rather than the Tax Incentive rate for expenditure in excess of $100 million. This limits the benefit per large company group from the Tax Incentive to a maximum of $10 million per annum. Participation in the programme Since its inception in 2011, participation in the R&D Tax Incentive has grown rapidly, particularly by SMEs (a performance indicator for the programme) but with relatively stable business R&D expenditure (Figure 1). Figure 1: Total R&D expenditure and registrations in the R&D Tax Concession and Tax Incentive $bn 25 R&D Expenditure Entities 14,000 Registrations 20 12,000 10,000 15 8,000 10 6,000 4,000 5 2,000 0 2010-11 2011-12* 2012-13 2013-14 0 2010-11 2011-12* 2012-13 2013-14 Turnover >$20m Turnover <$20m Turnover >$20m Turnover <$20m * 2011-12 was a transitional year in which some firms accessed the R&D Tax Concession while others accessed the R&D Tax Incentive. R&D collaboration between industry, universities and research organisations is generally considered an important channel for R&D to benefit the broader economy. For the 2013-14 income year, 9.5 percent (3,033 projects amounting to around $2.7 billion worth of R&D) of total projects registered under the programme indicated they involved collaboration with another organisation. This reflects Australia s low rates of collaboration between research and industry sectors, which is currently the lowest in the OECD. A priority of the National Innovation and Science Agenda is improving collaboration in Australia. 2

$millions Costs of R&D tax support The budget cost of the R&D Tax Concession and Incentive has risen strongly over the past decade. Figure 2 reveals the revisions in the cost of the programme made in the Science, Industry and Innovation budget tables since the introduction of the Tax Incentive in 2011-12, when its expected cost was around $1.9 billion. The consistent upward revisions in cost over time reflect the difficulties in forecasting R&D investment and the enhanced attractiveness of the programme following the 2011-12 amendments. The actual cost has been significantly more than forecast, largely due to growth in the cost of the refundable component for businesses with a turnover of less than $20 million. The Tax Incentive cost more than $2.5 billion in 2011-12 and grew to almost $3.0 billion in 2013-14. Despite a moderation in growth in 2014-15 and 2015-16, which may reflect the introduction of the expenditure threshold and the announced reduction in rates, costs are forecast to grow further to around $3.5 billion in 2017-18. Upward revision in the costs make it important that the effectiveness of the programme is assessed in the context of the broader suite of innovation measures. Figure 2: Cost revisions to the R&D Tax Incentive 4000 3500 3000 2500 2000 1500 1000 Forecast * 2015-16 SRI 2014-15 SRI 2013-14 SRI 2012-13 SRI 500 0 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 * The Forecast uses estimates from the 2015 Tax Expenditure Statement combined with previously unpublished projections from the 2015-16 MYEFO. This mimics the estimates presented in each SRI document, which are based on the expense estimates underpinning the relevant Budget combined with tax expenditure estimates from the relevant Tax Expenditure Statement. Source: Science, Research and Innovation Budget Tables, Department of Industry, Innovation and Science. Estimates by CIE provide an indication of the compliance costs for firms participating in the programme. The estimated total compliance cost to firms in the programme is around $437 million per annum, including fees paid to consultants and tax agents of $199 million. For large firms approximately half of their compliance costs are attributed to consultant fees, with slightly less for smaller firms. While these estimates include the cost of tax returns, they are high relative to the budgeted cost of the programme and the benefit to participants. This may reflect the complexity of the programme design. In 2014-15, the combined administration cost of the Tax Incentive for the department and the Australian Tax Office (ATO) was around $18.5 million. 3

1-B index International experience Most OECD countries have incentive schemes for R&D. Australia and most other countries use tax incentives as part of their public support, but Australia, Canada and the Netherlands are unusual in having tax measures as the principal form of support for business R&D. Countries such as Finland, Germany, New Zealand and Sweden are examples at the other extreme, in that they do not have tax system measures but rather support business R&D through direct measures such as competitive grants. The OECD calculates tax subsidy rates for R&D by firm size and performance for a range of countries (Figure 3). Based on this analysis, Australia s tax subsidy is: 8 cents per dollar of R&D registered for large firms, just below the OECD average of 9 cents per dollar. 20 cents per dollar of R&D registered for small firms, more generous than the OECD average of 15 cents per dollar. Figure 3: Tax subsidy rates on R&D expenditure (by firm size and profitability) 0.5 0.4 0.3 0.2 0.1 0.0-0.1 Large, profitable firm SME, profitable firm Large, loss-making firm SME, loss-making firm Source: OECD. The subsidy rate is defined as 1 minus the B-index which is a measure of the before tax income needed by a representative firm to break even on USD 1 of R&D outlays. The subsidy rate may be negative in countries where the corporate tax rate is greater than the combined net present value of allowances and credits applying to R&D outlays. Along with seven other economies (Canada, France, Italy, Japan, the Netherlands, South Korea and the UK) Australia provides more generous incentives for SMEs. Only Israel provides extra tax breaks for large companies that undertake R&D in Israel. A number of countries restrict eligible expenditures to R&D wages, recognising R&D employees as an important channel for generating spillovers. The OECD (2015) argues that R&D tax incentives should be designed to primarily meet the needs of young innovative firms and stand-alone firms without cross-border tax planning opportunities. Policy Design Issues To assess the economic welfare impact of the programme, any broader benefits from the additional R&D should be weighed against the costs of the programme, including administration, firm-level 4

compliance and economic efficiency costs. If it is possible to reduce either one of these costs without impacting the cost to revenue or the overall benefits, this would improve the programme s effectiveness. Moreover, the process through which firms must register their R&D and claim through the tax system can have important implications for the costs and benefits. Policy rationale R&D activities are a key driving force of productivity and economic growth, in part because a firm s R&D often does not solely benefit the firm itself the benefits frequently spill over to individuals, other firms and the broader Australian society. At the same time, R&D activities generally entail high up-front costs and uncertain returns over long periods of time. It is commonly accepted that the presence of both economy-wide spillovers and the inherent uncertainty of R&D projects leads to underinvestment in private business R&D. The R&D Tax Incentive is part of a mix of innovation policies seeking to improve the quality and quantity of R&D investments in the public and private sectors. The legislation states that the R&D Tax Incentive is to encourage business to conduct R&D activities that: might otherwise not be conducted (additionality); and are likely to benefit the wider Australian economy (spillovers). Like any other government programme that intervenes in the economy, there are efficiency costs. If the policy generated additional R&D without spillovers it would simply be subsidising one part of the economy at the expense of the rest. But if the benefit to the economy the spillover of the additional R&D from the programme is great enough, it can more than offset the associated efficiency cost. Box 1 discusses some evidence on additionality and spillovers for Australia. From this perspective, the challenge is in designing an effective mechanism to support the activities most likely to generate spillovers and be additional to business-as-usual; and to ensure that the administration of the programme facilitates businesses use. This is a difficult policy challenge for an instrument delivered through the tax system (where clear, neutral and unbiased rules are necessary for impartial treatment). Nonetheless, the R&D Tax Incentive attempts to target support at such R&D using differential rates, refundability, expenditure thresholds and through the definition of R&D (see Attachment A). These aspects are highlighted here and discussed in more detail below: Rates and thresholds: the tax offset rates are intended to encourage R&D investment by lowering the price of R&D with a focus on smaller companies through the provision of a higher rate and refundability, while the expenditure threshold limits the maximum benefit per company/group. A minimum threshold of $20,000 reduces smaller claims. Definition of eligible R&D: the definition is intended to filter genuine R&D projects that are likely to deliver spillovers. Timing of administration: because companies register their R&D and claim the benefit after the decision to undertake the R&D project, the registration process may have a smaller impact on R&D project investment decisions and additionality than would otherwise be the case. 5

Box 1. Evidence on Australian additionality and spillovers Additionality: By design, volume-based tax instruments such as the R&D Tax Incentive not only subsidise new R&D but also support the R&D a firm would have done anyway. This limits the level of additionality that can be achieved through the tax system. In its analysis of the R&D Tax Incentive, CIE found additionality of between 0.3 and 1.0 additional dollars of R&D per dollar of tax forgone for large firms, and between 0.9 and 1.5 per dollar of tax forgone for SMEs. This is broadly similar to studies of R&D tax schemes used in other countries. These magnitudes imply that around 10 to 20 percent of the total R&D registered would not be undertaken in the absence of the programme. International studies generally agree that additionality is greater for SMEs than for larger firms. This is borne out in CIE s findings that the R&D Tax Incentive has a higher influence on R&D spending decisions by SMEs 54 percent of R&D decisions were materially influenced by the programme, compared to 34 percent for large entities. Spillovers: Evidence on spillovers is hard to gather. While there is limited information in the international literature, the Productivity Commission (PC 2007) finds that in Australia a one percent increase in market R&D leads to approximately 0.02 percent increase in productivity. This is equivalent to 65 cents of average spillover benefit from each dollar of R&D conducted. The PC (2007) argues spillovers are likely to be greatest for: basic research in science, especially where most governance and funding mechanisms concentrate on the highest quality and most efficient diffusion practices; and novel R&D activities undertaken by business that can be induced by support that either spill over cheaply to others or that trigger cycles of innovation by rivals. Improving the effectiveness of the programme suggests a focus on measures that will lead to greater additionality from R&D, resulting in economy-wide spillovers. However, these improvements should take into account the cost of any complexity introduced. Critical design features and underlying policy issues in relation to the effectiveness and integrity of the programme include the definition of what R&D is eligible for companies to claim; the degree to which the programme influences R&D decision making (including the timing of the registration process with AusIndustry and ATO); the administration of the programme; and the rates and thresholds which determine the size of eligible claims. These are discussed in turn. Definition of R&D activities The R&D Tax Incentive applies to eligible expenditures on experimental activities conducted in a scientific way for the purpose of generating new knowledge or information in either a general or applied form. In general terms, most types of expenses incurred during the financial year are claimable as long as they were directly relevant to an eligible R&D activity. The current definition of eligible R&D, as well as a list of excluded activities, is provided at Attachment A. Under the Tax Concession there was evidence that supporting R&D expenditures were being claimed for business-as-usual activities. New definitions of core and supporting R&D activities were introduced in the change to the Tax Incentive with the aim of being clearer about what activities were eligible under the programme. Evidence to date based on AusIndustry s integrity assurance work indicates a relatively high level of compliance with the programme s eligibility requirements. The proportion of core R&D activities is currently around 80 percent of registered R&D expenditure. 6

The main benefit of a principles based definition of R&D activities is the flexibility it provides to R&D activities changing across time, while still maintaining the original scope of the policy. However, in the absence of case law, this approach relies on interpretation; it can be open to misunderstanding and potential boundary pushing. One alternative approach that could seek to address these issues would be to be more prescriptive in defining eligible activities in order to more clearly target R&D that leads to spillovers that benefit the economy. However, such an approach may increase complexity and require more frequent updates to reflect the changing nature of R&D activities to ensure continued alignment with the policy intent. It is also inherently difficult to prescribe activities that by their nature are new and unknown, hence the current principles-based approach to a definition of eligible R&D. Small variations in the definition can lead to large differences in the scope of eligible R&D. For instance, while the US definition bears close resemblance to Australia s, it is slightly more prescriptive and perhaps clearer in delineating eligible activities. Ultimately, there is a trade-off between flexibility and supporting R&D that is likely to benefit the economy that needs to be considered in the context of the policy objective. The impact of any definitional change also needs to be weighed against the negative impact on programme stability (and participants confidence to rely on the programme when considering their R&D investment decisions in future years). Rates and thresholds Tax offset rates and turnover/r&d expenditure thresholds are set to strike a balance between encouraging firms to undertake additional R&D, and ensuring sustainability of the programme. The size of the tax offset for each dollar of eligible R&D, partly determines the magnitude of additional business R&D conducted in Australia. The expenditure claim threshold of $100 million limits the cost-to-revenue of the programme to some extent, but it removes the incentive for firms to undertake additional R&D in Australia beyond that threshold. The level of additionality and the size of spillovers can depend upon the characteristics of R&D entities (for example, small, young, old, large). Most studies show smaller innovative firms are more responsive to fiscal incentives. Reflecting this, the R&D Tax Incentive offers a higher tax offset rate for smaller firms. These tax offsets are refundable to address the cash flow constraints often faced by smaller firms. More broadly, tax incentive programmes in other countries use various rates and thresholds to specifically target different sectors, new claimants, startup companies, and activities involving collaboration including between industry and research organisations. In each instance the case for targeting includes greater additionality or to tap into an important source of spillovers. Administration and Compliance There are a range of administration and compliance issues that could be addressed to improve both the effectiveness and integrity of the programme. They range from substantive issues which would involve legislative changes through to improvements that administrators could implement. While the review is looking at the full range of such issues, two specific aspects are the timing of registration claims and the two agency administration model. These are discussed in turn. 7

Timing Under the R&D Tax Incentive, a firm has ten months following the end of an income year to register its R&D activities. Only once registered can a firm then receive an offset through their annual tax return process. In some cases, R&D investments are made within a company before decision makers are aware of the programme. In this scenario, the R&D Tax Incentive represents a windfall gain from the firm s first use of the programme (mitigated if the windfall gain is subsequently reinvested in R&D). The growth of R&D tax consultants and marketing of their services could imply that a significant number of firms fall into this category. Expenditures like these may not constitute additionality, but are part of having a broad-based programme accessible to firms of all sizes across all industry sectors (but not all businesses may be aware of their eligibility). This may explain some of the growth in the programme. CIE argue that a pre-registration process is likely to increase the consideration of the Tax Incentive in firms decision making, increasing the likelihood of claims generating additional R&D. This type of approach has been adopted in Norway, whose programme has reported high additionality rates. Two-stage administration Administration of the R&D Tax Incentive involves a separation of administration functions between Innovation Australia (assisted by AusIndustry) having responsibility for promotion, industry education, registration and determining the eligibility of R&D activities, and the Australian Taxation Office (ATO) having responsibility for the eligibility of R&D-performing entities and their R&D expenditure, and the provision of benefits through the taxation system. As a self-assessment entitlement delivered through the tax system, the Tax Incentive is a mechanism for the delivery of large-scale innovation assistance. The scale of the programme and method of delivery does however provide challenges to the programme administrators to strike a balance between providing a positive user experience and ensuring programme integrity. In particular, there may be changes to online administration processes and additional explanatory material that could assist businesses to understand and comply with the programme, reducing the need for external advice. An alternative would be to adopt a single-agency delivery model as in other countries. Despite the strong cooperation between AusIndustry and the ATO, coordination of effort to administer the programme is at times challenging given its size. Points to consider in determining whether programme processes between the two organisations can be improved or whether a single agency delivery model is more appropriate include: The functional expertise required to administer the programme (the assessment of R&D activities and the assessment of expenditure) a single-agency delivery may not reduce the number of functions to be performed; The cultural differences between the two organisations that arise from providing an industry benefit and administering the tax system; Innovation Australia has legislated authority for the administration of the R&D Tax Incentive; a move to single-agency delivery would require consideration of Innovation Australia s role. 8

Attachment A In Australia, the definition of R&D Activities eligible under the Incentive distinguishes between core and supporting, as demonstrated in the table below. Core R&D Activities Experimental activities whose outcome cannot be known or determined in advance on the basis of current knowledge, information or experience, but can only be determined by applying a systematic progression of work that: is based on principles of established science; and proceeds from hypothesis to experiment, observation and evaluation, and leads to logical conclusions; and are conducted for the purpose of generating new knowledge (including new knowledge in the form of new or improved materials, products, devices, processes or services). Supporting R&D Activities Activities directly related to core R&D activities. However, if an activity produces goods or services; or is directly related to producing goods or services; then it is a supporting R&D activity only if it is undertaken for the dominant purpose of supporting core R&D activities. The following activities are excluded as core R&D activities: 1. Market research, market testing or market development, or sales promotion (including consumer surveys). 2. Prospecting, exploring or drilling for minerals or petroleum for the purposes of one or more of the following: a. discovering deposits; b. determining more precisely the location of deposits; or c. determining the size or quality of deposits. 3. Management studies or efficiency surveys. 4. Research in social sciences, arts or humanities. 5. Commercial, legal and administrative aspects of patenting, licensing or other activities. 6. Activities associated with complying with statutory requirements or standards, including one or more of the following: a. maintaining national standards; b. calibrating secondary standards; c. routine testing and analysis of materials, components, products, processes, soils, atmospheres and other things. 7. Any activity related to the reproduction of a commercial product or process: a. by a physical examination of an existing system; or b. from plans, blueprints, detailed specifications or publicly available information. 8. Developing, modifying or customising computer software for the dominant purpose of use by any of the following entities for their internal administration (including the internal administration of their business functions): a. the entity (the developer) for which the software is developed, modified or customised; b. an entity connected with the developer; c. an affiliate of the developer, or an entity of which the developer is an affiliate. 9