For roughly the last two decades, Australian support for research and development has grown in a near-steady crescendo—both in absolute (dollars) and relative (share-of-GDP) terms. And then suddenly, the tides seemed to turn: A controversial amendment, proposed in 2019, would have cut nearly A$2 billion from the program over four years (purportedly to make the incentive “more targeted and efficient”). That proposal was roundly criticized in the business community—dismissed as a short-sighted budgetary move that would at best throttle R&D investment in Australia, and at worst force some of Australia’s innovators to move research activities to more welcoming shores.
Then came COVID-19, a delayed budget—and a 180-degree pivot. The FY22 budget, in effect from July 1, 2021, points the tax-incentive weathervane back in the right direction: The government announced it would provide A$2 billion in additional R&D incentives—with a renewed focus on fostering innovation, stimulating the economy out of its pandemic doldrums, and providing “greater certainty for R&D investment,” while rewarding those businesses that invest the most in innovation.
At the dawn of 2021, companies with less than A$20 million in total revenue could qualify for a 43.5% tax credit (refundable in cash) for expenses deemed eligible. Those above that revenue threshold could get a (nonrefundable) 38.5% credit, which can be carried forward indefinitely. Both were subject to a minimum expenditure of A$20,000, and a cap of A$100 million—beyond which they would be subject to normal corporate tax rates.
On the face of it, the U.S.’s federal 20% gross credit rate above qualified research expenditures (QREs)—14% if using the simplified (ASC) credit—would seem to be only half as generous as Australia’s. But that doesn’t tell half the story: you can’t just look at the “headline rate” and move on. You also need to consider eligibility requirements (which are far more stringent Down Under than in the U.S.), how many companies can qualify, the types of incentives available, and even the claiming process.
While Australia’s tax-incentive-only plan does bear some resemblance to the U.S.’s R&D incentive plan, the two diverge in important ways. The U.S. offers a “double-dip” deduction (where the R&D expense can be used twice)—a benefit that does not exist Down Under. Australia allows accelerated depreciation on R&D assets, which the U.S. does not. And unlike in the United States, where 36 states offer their own R&D credits, individual Australian states don’t (although some state governments make special grants and concessional loans in certain strategic sectors).
Bottom line: As anyone familiar with R&D tax credits knows, “generosity” can be an ambiguous term. Figuring out how it all adds up requires extracting the devil from the details. And that’s the crux of the problem: if it’s so complicated that you need traditional, paid-by-the-hour consultants in multiple jurisdictions to tackle it—well, you can say goodbye to a huge chunk of your credit. Good thing there’s an easier, more cost-effective, more modern solution.
Granted, dollar-for-dollar, Australia’s headline rate looks hard to beat, but how does it look in terms of eligibility and compliance? To find out, we put Australia’s R&D tax incentive regime under the microscope.
What Constitutes R&D?
The Australian Taxation Office (ATO) may be known for generous R&D credits, but it’s also known for strict and often intricate compliance rituals. The R&D arena is no different: eligibility criteria are stringent, and the definition of R&D comes with little elasticity.
Unlike in the United States, where the program is the sole province of the IRS, Australia’s R&D program has two regulatory parents: the ATO and AusIndustry (a specialist business-growth division within the Department of Industry, Science, Energy and Resources). As Australian law requires companies to first self-assess their eligibility to claim R&D tax credits, they must begin the process by registering with AusIndustry.
Research and development activities must be classified as either “core” R&D activities or “supporting” R&D activities. Australia defines core activities as experimental activities whose outcome cannot be known, and which are conducted to acquire new knowledge—for example, in the creation of improved materials, products, devices, processes, or services. The work must be done systematically—proceeding from hypothesis to experiment, observation and evaluation, and leading to logical conclusion—using principles of established science.
Supporting activities are defined as those that either directly or predominantly support core R&D activities. In the legal verbiage, this must be their “dominant purpose.” (There are, as always, a few fine-point exceptions to both these classifications.)
These definitions roughly align with the four-part criteria—qualified purpose; elimination of uncertainty; process of experimentation; and technological nature—applicable in the United States, although arguably the U.S.’s regulations are trending toward more leniency.
Incentives and Compliance
Not surprisingly, Australia’s generosity comes with plenty of terms and conditions. Companies are expected to maintain contemporaneous records that can substantiate the undertaking of all R&D activities. Both the ATO and AusIndustry are empowered to review claims that can go back multiple years—and these reviews have been on the upswing for several years.
As is the case with the United States, Australia’s R&D benefits take the form of tax credits, or “offsets,” which in some cases can be refunded in cash if the company is in a loss position. This is a huge strategic advantage to startups, as it can free up cash when they most need the fuel to innovate and grow—and help power a post-COVID economic renewal.
Up to June 30, 2021, companies (including foreign companies doing business in Australia) with aggregated annual turnover of A$20 million or more, were entitled to tax offsets of 38.5% for qualifying activities. SMEs (turnover up to A$20 million) could enjoy offsets of 43.5%. In both cases, the offset got credited if it exceeded the company’s tax liability: for larger enterprises, it could get carried forward indefinitely. SMEs could elect to receive the balance in cash.
For example, if a small R&D entity had eligible R&D expenditure of A$1 million in 2019–2020, it would receive a tax offset of A$435,000 (higher than the standard deduction of A$275,000 at the company tax rate of 27.5%). If the entity had a tax liability of A$300,000, the R&D tax incentive would reduce tax payable to zero—and the company would receive a refund of the remaining A$135,000.
As of July 1, 2021, enhanced reforms to the R&DTI made the program more generous still. The previous upper-level deduction cap of A$100 million was extended to A$150 million. Australian SMEs still have an effective tax offset rate of 43.5% (a premium of 18.5% above the new standard 25% corporate tax rate) that is fully refundable. Larger companies (and qualifying foreign-owned entities) pay the corporate tax rate, with a tax-offset premium based on their “R&D intensity” (broadly speaking, the ratio of the business’s eligible R&D expenditure to its total expenditure). In practical terms, that would yield a premium of between 8.5% and 16.5% above the corporate tax rate, depending on how much the company prioritizes R&D in its business investments. For a company with annual revenue above A$50 million and an R&D intensity premium above 2%, that could translate to a whopping R&D tax incentive rate of 46.5%—well above the previous fixed rate of 38.5%—according to an analysis by the Australian Parliament.
How to Get in the Game
Generally, only R&D activities undertaken in Australia qualify for the new R&D Tax Incentive program—although under certain circumstances, activities undertaken overseas could be considered eligible. (At its discretion, the government may also award special grants to help companies with specific R&D projects.)
Companies resident in countries with tax treaties (including the U.S. and Canada) doing business Down Under are also eligible to participate through a permanent establishment. After registering your R&D activities with AusIndustry, you would claim your tax offset using an R&D tax incentive schedule (and an AusIndustry-specific registration number) on your annual tax return with the ATO. Applying for the R&DTI must be done annually, and eligible R&D activities must be registered within 10 months of the end of the relevant income year.
As in the U.S., the R&D benefit is potentially available to all industries—and used by companies across a wide swath of sectors.
Australia’s R&D Tax Incentive program is based on self-assessment. Before registering, you must self-assess whether: (a) your entity is eligible; (b) your R&D activities are eligible (as defined above); and (c) your R&D expenditure is eligible. (A shrewd move: Not only does this place the taxpayer on firmer ground in terms of compliance, it also frees up ATO resources.)
Eligible expenditures include contractors or consultants (e.g., academic or research organizations), some salaries (only for time spent on eligible R&D activities), raw materials, tax depreciation for certain assets used in R&D, and some overhead that aligns with the “dominant purpose” of being essential to the R&D activities. Give the different tax treatment, it’s essential for companies to draw a bright line between “business as usual” expenses and R&D-related spending—and to be able to document that distinction to the penny under compliance reviews.
Small Business, Big Impact
Many countries are making special efforts to include small businesses and start-ups in their R&D eligibility. Australia has been especially generous with SMEs, which it defines as companies with a turnover below A$20 million. Historically, these firms have accounted for nearly 90% of participants in the R&DTI program.
While many countries, including China and the UK, have special programs aimed at supporting technology-driven innovation, several marquee Australian tech companies have found themselves having to advocate for more support for high-tech startups, suggesting the government may have a tin ear when it comes to understanding the global knowledge economy they compete in—and the role that cutting-edge Australian companies can play in fast-tracking economic recovery. They were particularly critical of the 2019 proposed budget, which they maintain failed to encompass some of the legitimate activities at the heart of digital-native companies—to the point of not explicitly naming software development as an eligible R&D activity.
What’s on the Radar?
It’s likely that as Australia continues to grapple with the longer-term economic effects of the COVID-19 pandemic, R&D incentives will remain a key pillar in its economic policy. In addition to the reforms made to the R&DTI, the new fiscal year (starting July 1, 2021) may well see more important changes, as the government has asked the Board of Taxation to review the administrative framework of the R&D Tax Incentive before the end of 2021.
Among the tea leaves are certain measures that could impact future R&D claimants, including a patent box initiative—special tax rates for life sciences companies on profits from patents arising out of R&D activities in Australia—which does not presently exist in the country. A possible one-year extension of the temporary full-expensing provisions in the FY22 budget, on the cost of R&D assets in qualifying R&D expenditures, is also on the table.
A consortium of 13 of Australia’s biggest tech firms is pushing the ATO to clarify whether software development should be considered eligible for the R&DTI, with one executive lamenting “a lack of mutual understanding and trust between the tax office and the industry.” In response, the Senate’s Select Committee on Financial Technology and Regulatory Technology has published a report recommending the program be amended to allow for different assessment methodologies (especially for software development)—and that successful applicants be able to receive credits in the form of quarterly payments to help with cash flow.
So what’s the verdict on Australia and R&D? Despite its reputation as “most generous” in its R&D tax-credit scheme—and despite its strong focus on economic recovery—getting the full-bore support needed to help drive that recovery is no cakewalk, especially for cutting-edge tech companies. Strict rules, an onerous compliance process—and a slightly outdated view of the high-velocity universe of technology firms—might be unintentionally throttling some of the very innovation energy the government seeks to harness.
Lydia Clowney is a CPA specializing in R&D tax credits. She works as a subject matter expert on CrossBorder Solutions’ R&D tax credit software solution helping enable the future of simpler tax compliance through technology. Before joining CrossBorder Solutions, Clowney worked as an R&D tax credit consultant at BDO USA, LLP.