ATO investigates companies spending R&D Tax Incentive on software development

The Australian Taxation Office (ATO) and AusIndustry are currently reviewing the arrangements of companies that are claiming the Research and Development (R&D) Tax Incentive on software development projects, in particular where expenditure is incurred on activities not eligible for the incentive.

At its core, the R&D Tax Incentive allows companies to claim a tax break for the money they spend on internal R&D. However, eligibility under the incentive is based on specific R&D activities rather than on entire projects, the ATO said, and in order to be eligible, there must be at least one experiment being carried out for the purpose of generating "new knowledge".

"The outcome of the experiments cannot be able to be known or determined in advance by a competent professional in the field," the ATO explained. "The experiments being carried out must be based on principles of established science, and must seek to prove whether specific technical hypotheses are right or wrong to resolve specific technical issues or risks."

According to the ATO, companies undertaking software development projects sometimes assume that software development activities are by their nature eligible R&D activities. However, the tax office said it is extremely unlikely that all of the work involved in a software development project will meet the legislative criteria for eligible R&D activities.

Under the criteria, developing new software; modifying, customising, or upgrading existing software; and acquiring and modifying off-the-shelf software are not eligible for the government-funded incentive.

"While a project may involve some experimental activities, that does not qualify the entire project as an eligible R&D activity," the ATO explained.

The ATO noted that the processes of developing, modifying, or customising software can appear superficially similar to the process of performing eligible R&D activities, as they are by definition systematic and can be iterative and cyclical, and almost always involve testing.

However, it argued that the application of a software development lifecycle does not automatically mean that eligible experimental activities are taking place, nor that the outcome of any technical issues being solved are not using existing knowledge, information, or expertise.

Such testing activity deemed inappropriate for R&D bonus spend is bug, beta, system, requirements, user acceptance, data mapping and data migration, as well as testing the efficiency of different algorithms that are already known to work, and testing websites in operation by measuring the number of hits.

The R&D Tax Incentive is jointly administered by Innovation and Science Australia -- supported by AusIndustry within the Department of Industry, Innovation and Science -- and the ATO.

The ATO warned that it will be contacting companies directly as a result of its review if: Advisors applying high-risk practices are involved in the preparation of the registration application and/or claim; broad descriptions are used in the registration of R&D activities; and the level of expenditure claimed for the R&D Tax Incentive is flagged as too high for the particular industry or stage of business.

A review into the R&D Tax Incentive was undertaken in September by chair of Innovation and Science Australia Bill Ferris, Australia's Chief Scientist Alan Finkel, and Secretary to the Treasury John Fraser, after Prime Minister Malcolm Turnbull tasked the trio with "identifying opportunities to improve the effectiveness and integrity of the R&D Tax Incentive, including by sharpening its focus on encouraging additional R&D spending".

The review into the program that handed out AU$2.95 billion in 2013-14 found that the R&D Tax Incentive falls short of meeting its stated objectives of "additionality and spillovers", and that it could do more to encourage additional research and research spillovers into other sectors, and recommended the federal government focus more on encouraging research or it will impact the program's long-term continuation.

In total, the trio made six recommendations to the government, with three focused on encouraging research into "additionality" -- activities that would otherwise not take place -- which includes providing extra incentives for businesses to hire PhD graduates and to work closely with Australia's research institutions.

The other three recommendations sought to strengthen the effectiveness of the program, including through reducing compliance costs for companies.

In February 2015, Parliament passed legislation that limits the amount for which companies can claim R&D tax breaks to AU$100 million.

The following March, the Senate then voted against the Tax & Superannuation Laws (2014 Measures No. 5) Bill 2014, which included a proposal to introduce a 1.5 percent cut to the current R&D tax offset rates of 40 percent and 45 percent from July 1, 2014.

It was pitched by former prime minister Tony Abbott at the time as a move that would result in savings of AU$550 million in underlying cash balance terms over the four-year forward estimates.