Two New Taxpayer Alerts Issued on R&D Tax Incentive Claims

In brief

In December 2023, the ATO released two new taxpayer alerts to raise awareness of its concern about issues under risk assessment:

• R&D activities delivered by associated entities (TA 2023/4)
• R&D activities conducted overseas for foreign related entities (TA 2023/5).

The ATO intends the taxpayer alerts to highlight fact profiles in which specific provisions of Division 355 of the Income Tax Assessment Act 1997 (ITAA 1997) may be triggered to prevent R&D expenditure from being eligible for notional deduction because either:

• The activities were not conducted for the R&D entity, or were conducted to a significant extent for another entity, or
• The expenditure was not ‘at risk’ for the R&D entity, for the purposes of section 355-405 of the ITAA 1997. 

The ATO considers entitlement to the R&D Tax Incentive may be affected in whole or part under the arrangements of concern. The general anti-avoidance provisions in Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) may also apply to deny an offset if the arrangement was entered into or carried out for the purpose of obtaining a tax offset, even where an arrangement is effective under the substantive provisions.

In detail

Taxpayer Alert TA 2023/4

TA 2023/4 addresses R&D claims for expenditure incurred under an agreement with an ‘associate’. The term ‘associate’ is defined by section 318 of the ITAA 1936. It is a complex definition, in which, among other things, an entity can be a company’s associate if it ‘sufficiently influences’ the company.

The ATO is concerned with arrangements that:

• Incorrectly purport that the R&D entity has incurred or paid (or both) the relevant expenditure under an agreement with an associate, or
• Have the effect of obtaining for the R&D entity a tax offset for expenditure on R&D activities purportedly conducted for the R&D entity's own benefit but which are instead in substance conducted wholly, or to a significant extent, for an associate.

The ATO outlines that the associate is typically an entity that has historically conducted the group's trading and research activities. However, the associate is not itself an entity that would be entitled to claim an offset were it to conduct the activities for its own benefit, or if it were entitled, would only be entitled to a lesser benefit under the R&D Tax Incentive. By contrast, the R&D entity may have few or no employees and conduct limited or no activity other than the R&D-specific arrangements under the service agreement entered into with the associate. The R&D entity may purport to pay the associate via a loan with the associate as lender, or set-off arrangement against a licencing agreement or intra-group sales.

TA 2023/4 further outlines the structure and conduct common to arrangements of concern to the ATO.

Taxpayer Alert TA 2023/5

TA 2023/5 addresses arrangements where Australian-resident R&D entities claim a tax offset under the R&D Tax Incentive rules for expenditure incurred on R&D activities conducted overseas. The ATO highlights instances where an R&D entity purported that the R&D activities were conducted for its own benefit, where those activities were conducted wholly, or to a significant extent, for a foreign entity that is connected with, or is an affiliate of, the R&D entity.

Arrangements of concern to the ATO are typified by the foreign entity:

1. Owning pre-existing IP
2. Creating an Australian-incorporated entity as an R&D entity
3. Licensing the R&D entity to use and develop its existing IP
4. Securing primary rights to exploit any developed IP, know-how or other results (including data) from the R&D entity's overseas activities, upon creation of that IP
5. Providing funds to the R&D entity to conduct its R&D activities.

In these arrangements, the Australian R&D entity:

• Has limited assets, minimal staff and negligible industry research experience or expertise, requiring it to contract out the conducting of its R&D activities, whether those activities are conducted in Australia or overseas
• Has limited ability to itself commercially exploit the developed IP
• Obtains an overseas finding under paragraph 28C(1)(a) of the Industry Research and Development Act 1986, and
• Claims a notional deduction for the expenditure it incurred, and thereby a tax offset under the R&D Tax Incentive.

In TA 2023/5, the ATO states that upon objective review of the financing, licensing, service, corporate or other arrangements between the Australian R&D entity and the foreign entity, it appears that the foreign entity is the sole or major beneficiary of the Australian R&D entity's overseas activities. Such arrangements would fail to satisfy the requirement of section 355-210 of the ITAA 1997 that R&D activities conducted outside Australia be conducted ‘for’ the R&D entity. 

The ATO is concerned that such R&D entities may be incorrectly claiming the R&D tax offset irrespective of whether:

• The R&D entity has an overseas finding covering the R&D activities being conducted – on the contrary, the ATO has identified the existence of a positive overseas finding as a characteristic of these types of arrangements
• Under the contractual arrangements between the R&D entity and the foreign related entity, the R&D entity purportedly has an interest in any developed IP, know-how or other results from the R&D entity's expenditure on the R&D activities.

TA 2023/5 provides considerably more detail about these arrangements of concern.

Summary

Where an arrangement is covered by either of these taxpayer alerts, the ATO is concerned that R&D entities do not qualify for an R&D tax offset for expenditure incurred by them, because either:

• The activities were not conducted for the R&D entity, or were conducted to a significant extent for another entity, or
• The expenditure was not ‘at risk’ for the R&D entity, for the purposes of section 355-405 of the ITAA 1997.

Where the conditions for entitlement to an R&D tax offset are satisfied, the general anti-avoidance provisions in Part IVA of the ITAA 1936 may still apply to deny that tax offset.

The release of these taxpayer alerts indicates a continued focus from the ATO on incorrect R&D tax offset claims. In a recent findings report on its Top 1000 income tax and GST assurance program, the ATO noted that R&D expenditure typically has lower assurance ratings than other areas reviewed, suggesting that this focus is likely to continue into the foreseeable future.

If you would like to discuss any of the topics mentioned above, please contact PwC’s R&D and Government Incentives team.