ATO ‘U-Turn’ on Tax Offset Sparks Increased Fears of R&D Audits

The R&D tax offset has been a boon to many businesses seeking to innovate. But fears of scammers and false claimants saw a crackdown on this R&D concession last year. Now, in light of budgetary concerns, a major shift in the way the ATO approaches R&D audits has seen firms cut back on R&D tax incentive assistance.

Should you be more cautious about applying for this healthy incentive?

The benefits of the R&D Tax Incentive

Companies at a loss. Companies with profits. Small businesses and large corporations. Companies from almost any industry. The R&D concession is open to you if your entity pays tax and engages in innovation.

If you earn less than $20 million as a company, you receive a 43.5% refundable R&D tax offset rate. For example, if you invest $90,000 into research and development, you will receive $39,150 back.

If you earn more than $20 million, you will receive a 38.5% non-refundable R&D tax offset rate. For example, if you invest $200,000, you will receive a benefit of $77,000.

How do you apply for the cash back?

As you can see, the tax concessions are generous. But the crux of accessing the grant lies in fulfilling criteria for core activities. Does your company engage in activities which look for outcomes that cannot be determined by current knowledge, only by tests or experiments based on the principles of established science? Supporting activities also complement these core activities, but meeting the latter is crucial. These are also the focus for present controversy and debate surrounding the R&D rebate.

The benefit of the R&D tax incentive is generally received as a cash back or through a reduction to tax payable. It has therefore become a serious incentive for businesses of all sizes to invest in innovation and take their fresh products and services to the local and international market. Yet while it has been so welcomed by many businesses and small business advisors, it has also come under attack as an avenue for unscrupulous firms to rort a cash back from the government.

The government voices concern early in 2018…

When confident spending on national innovation and scientific development turned into a perception of wasted spending on those seeking a quick and easy tax concession, the government acted in the 2018 budget.

Both Innovation and Science Australia and the Finkel Review urged new guidelines prior to the 2018 Budget. These included:

  • A $4 million annual cap with a $40 million lifetime cap;
  • An intensity threshold of 1% of total annual expenditure, so at least 1% of total expenditure must be incurred on R&D in order to claim;
  • Tightening of applications for software-based R&D;
  • Closer scrutiny and tighter rules for inclusion of ordinary business expenditure as R&D;
  • A premium for R&D expenditure undertaken in collaboration with publicly-funded research organisations, such as universities; and
  • Public rulings, guidance in plain English, and reform of the current two-agency delivery model.

Review activity increased over the middle of last year. Warnings, R&D audits, and legal action were enacted; a number of R&D tax advisors faced criminal penalties.

The concerns turn into a crackdown… and the scope broadens

In its initial changes to the delivery of the R&D tax incentive, the federal government chose to target primarily big business rather than start-ups in its efforts to save $2.4 billion over the next four years. The scheme, which costs the budget more than $3 billion, has been growing rapidly, with a big take up from the software sector and its start-ups. Yet while this crackdown began with big business, it then began to broaden.

Software companies in particular found themselves under the microscope. Since there is a fine line between building new software that is empirically tested and customizing existing software through beta-testing, the government has been concerned that software companies have been abusing the R&D grant by claiming beta-testing as innovation. It was worried that start-ups have been claiming multiple R&D refunds over a number of years to make up for poor profits, or established firms have been over-claiming on the R&D tax incentive by not properly differentiating R&D activities from normal business.

The government completes a ‘U-turn’ on innovation

As this shift toward increased scrutiny has continued into 2019, many experts would now say that that the government’s generous approach to funding innovation has taken a ‘U-turn’. In addition to simply trying to crack down on rort claims, the Federal Government’s initiative to move the budget into surplus has also come into play. As such the ATO’s position in relation to what constitutes R&D has become even stricter and appears to have an effect which is completely counter to what the legislation was first set out to achieve the first place.

In this current climate, not only might you be unable to continue to claim the R&D rebate, but an R&D audit might mean you have to pay back significant funds for past claims now deemed illegitimate.

How serious an impact could this have? Just ask Airtasker. Airtasker’s claims from 2014 and 2015 were rejected; the highly successful start-up faced the possibility of repaying millions of dollars, as well as a 75% penalty. While Airtasker engaged a professional advisor to claim the R&D incentive, which was done long before the ATO’s alert in 2018, the rejection of its claims has been heralded as marking an end to the usefulness of the R&D tax incentive for software companies.

Some R&D financial advisors have even been laid off as a result of the increased crackdown. PwC let go of an excess of 30 staff as its R&D clients were forced to pay back millions from R&D audits. Questions are not only being asked about how tech firms will manage without this very lucrative grant, but also regarding consultants who charged tens of thousands of dollars for advice that led to ultimately unsuccessful R&D claims and the current risk of audits.

How have the rules tightened?

This ‘U-turn’ essentially involves a significant shift in relation to what constitutes a core activity.

Eligible core activities must meet stringent criteria. A systematic and planned experiment must be designed around a specific hypothesis that proposes a relationship between variables. These are then proven right or wrong by observing and evaluating empirical results. Such activities can take place in software experiments when you aim to develop and test new or improved algorithms, (for example, when using predictive modelling, interrogating large data sets, and testing functionality in firmware).

However, the ATO argues many software companies wrongly believe the following testing activities are eligible core activities, when in fact they are not: bug testing; system testing; data mapping; data migration testing; testing websites hit-rates and CTR; developing customised solutions from an existing commercial software package. Since these are common and necessary activities, and often linked to the launching of new products and technologies, the software industry’s confusion and dismay over the government’s approach is understandable.

As you can see, there is a great deal of uncertainty surrounding the R&D rebate. Is it still worthwhile for you to apply in light of the tightening of the government’s proverbial belt? Are you, as a past or current claimant, at risk of a potential R&D audit?

How you can adjust your R&D strategy

The rebate is still too generous for businesses to dismiss in Australia. If you have claimed it or wish to, the first step is to review your company’s internal R&D documentation. Check it against the recent narrowing of criteria for core activities. Is there any avenue for the ATO to reasonably argue that your activities are not a systematic, investigative, and experimental progression of work to develop new knowledge?

Expert business advisors with success in applying for the R&D tax incentive know that genuine core R&D activity has been dismissed by the government in the past, only to be accepted upon review. Likewise, disputes have occurred in the application process over what constitutes effective documentation. This means there is wiggle room, regardless of the tightening of the rules. But you will need to consider the help of a grant specialist.

You will also need two key resources to tap into this generous cash back without facing a R&D audit. Excellent and accurate R&D documentation, firstly. And secondly, a proven R&D advisor who understands both the grant rules and the scientific evaluation of your R&D activities.

Calibre Business Advisory can not only help you with your R&D application from end-to-end, but has also had proven success in delivering the rebate in the past, to both tech and non-tech firms. We employ adept CFO outsourcing to ensure you have CFO-level assistance at hand that is both expert and cost-effective.

Calibre Business Advisory worked with a client who had set up a manufacturing business in Australia. We were able to demonstrate that while the client was from overseas, the business and the R&D activity made them eligible for the R&D grant. As a result, the R&D tax incentive helped them recover a large percentage of their investment.

Our approach is honest. We still believe in the boon of the R&D tax incentive. In light of the government’s overhaul, we will assess your documentation and R&D activities and give you a clear appraisal of your chances in receiving the cash back, or the odds of you facing an R&D audit of past claims. The R&D rebate is still too vital for innovative companies to ignore wholesale, but a more prudent and deliberate approach, with experienced R&D advice, is most definitely a must.

“We are a start-up technology business developing an App in the education space. Significant funds were invested as a start-up so the R&D tax incentive was critical for our cash flow. However, it was our first claim and we were worried that it might be a difficult and lengthy process. Calibre Business Advisory took the time to sit down with our development team to understand and define the R&D, and helped us document the plans until the forms were submitted. We completed the process in good time and our development team now has a great understanding of what is required for future claims.”