AusIndustry’s refreshed guide to the R&D Tax Incentive

In brief

In late 2020, AusIndustry released a ‘refreshed’ version of its ‘Guide to Interpretation’ on the Research and Development (R&D) Tax Incentive. This guide provides further clarity on AusIndustry’s expectations of R&D Tax Incentive claimants. While much of the refreshed Guide restates previous guidance in clearer language, it also provides a more nuanced interpretation of some criteria, notably the “hypothesis” and “new knowledge” requirements of the core R&D activity definition. This article explores AusIndustry’s refreshed interpretation of these criteria, in addition to a sample of the core activity exclusions in the context of exploration, software and manufacturing.

In detail

AusIndustry’s refreshed Guide to Interpretation uses simpler language to explain concepts relating to R&D activity eligibility. This guidance is useful for all potential claimants of the R&D Tax Incentive to assess whether their particular activity is eligible for the R&D Tax Incentive. 

Start with the hypothesis

The concept of a hypothesis is a requirement for determining whether there is a core R&D activity. Where previously the hypothesis was defined as testing causal relationships between variables, in this latest guidance AusIndustry has expanded this to include ‘an idea or proposed explanation for how you could achieve a particular result and why that result may or may not be achievable’.

This can be expressed as a statement or a set of statements that will guide experimentation.

A critical factor to the eligibility of a core activity is the knowledge gap that existed. This is relevant to the hypothesis because it must be clear that it is a proposition that may or may not be true; that is, the outcome of experiments undertaken to test it cannot be known or determined in advance on the basis of existing knowledge.

AusIndustry makes it clear it expects records to show how background research helped to identify the knowledge gap and formulate the hypothesis. Records could include:

• Literature reviews

• Internet searches

• Patent searches

• Expert advice.

Importantly, records need to show that the hypothesis was formed before experiments commenced. AusIndustry highlights this and it has also been emphasised in a number of recent decisions considered by the Administrative Appeals Tribunal, most recently in the Royal Wins matter (see this Tax Alert for background).

Generate new knowledge

The refreshed guide also gives welcome clarity on the scope of the new knowledge created as a result of conducting the core experimental activity.

The new knowledge can be of an applied or general nature. For example, it can include a ‘new theoretical or practical understanding of a subject’, which further clarifies AusIndustry’s interpretation of the words in the law, ‘including… in the form of new or improved materials, products, devices, processes or services’. Significantly, AusIndustry states that ‘in most cases, your R&D activities will meet the new knowledge aspect... if they meet the unknown outcome aspect’, however, the reverse is less likely to apply.

In addition to the ‘form’ of new knowledge, companies must also demonstrate with evidence that they had a substantial purpose to generate new knowledge that did not already exist at the time. Evidence of the knowledge gap identified from research conducted at the outset can help in demonstrating that the purpose was to create new knowledge.

Core activity exclusions

Whilst the refreshed Guide outlines the full list of eight excluded core activities, we explore the application of the following three exclusions, with examples involving exploration, manufacturing and software:

• Prospecting, exploring or drilling for minerals or petroleum for the purposes of one or more of the following:

  • Discovering deposits

  • Determining more precisely the location of deposits

  • Determining the size or quality of deposits.

• Management studies or efficiency surveys

• Any activity related to the reproduction of a commercial product or process:

  • By a physical examination of an existing system; or

  • From plans, blueprints, detailed specifications or publicly available information.

Note that where an activity is excluded from being a core R&D activity, it may be a supporting R&D activity if it is directly related to the core activity and the dominant (‘prevailing or most influential’) purpose of conducting the activity is to support the core activity.

Example 1: Exploration

If your activities involve prospecting, exploration or drilling to discover, determine the precise location of, or determine the size or quality of minerals or petroleum deposits, then these activities cannot form a core R&D activity.

However, if you are conducting experiments to test the design of a new or improved mineral refining process, this may be included in the core experimental activity if other eligibility criteria are met. Where you need to drill for mineral samples for the purpose of testing the new mineral refining process, this drilling activity may be included in the supporting R&D activities if the dominant purpose is to support the core experimental test work and it is directly related to testing the new process.

By contrast, if your activities involve determining the optimal extraction method using established mineral refining processes, then this is not an eligible core R&D activity and associated drilling for samples will not be an eligible supporting R&D activity.

Example 2: Software

Management studies and efficiency surveys cannot be core R&D activities. This can include studies or surveys to measure or evaluate the energy efficiency of a business, employee productivity, management capability or cost savings for a business. For example, where a company develops a software application to collect data for analysing relationships between management performance and shareholder value, this may be considered a management study and therefore excluded from being a core activity.  

However, if the activity involves developing and experimenting with a new algorithm functionality that does not currently exist, this may be included in a core R&D activity, if other eligibility criteria are met.

Conducting a management study to acquire data for use in the experiment may be included in the supporting R&D activity if the dominant purpose is to support the core experimental test work and it is directly related to testing the new software functionality.    

Example 3: Manufacturing

The reproduction of an existing product or process based on existing information (such as plans, blueprints and other available information) or know-how, cannot be a core R&D activity. However, producing a product or process in a new way, or developing a new product or process that differs from an existing one, can be a core R&D activity if other eligibility criteria are met. 

For example, a manufacturing company developing a new process that improves upon an existing process must distinguish the new and experimental aspects of the process from the replication of any existing processes. 

In other words, the testing of a new step in an industrial process that is not commercially or publicly available may be included in the core activity. 

The replication of any existing processes to integrate with and test this new process may be included in the supporting R&D activities if their dominant purpose is to support the core experimental test work and it is directly related to testing the new process.    

The takeaway

The refreshed Guide to Interpretation provides clear and practical language on the interpretation of the R&D activity eligibility requirements.  However, many nuances remain.

A few key takeaways:

• Ensure records of background research and the knowledge gap identified are prepared and retained, as this can help demonstrate the formation of the hypothesis and purpose of generating new knowledge.

• Be aware of activities that are excluded from being core R&D activities.

• Carefully distinguish between core and supporting R&D activities.

• Refer to the full guide for all eligibility criteria and record-keeping requirements. 

If you would like to discuss any of these matters further, or require assistance in regards to your R&D documentation, please reach out to your PwC R&D contact.