​Why Australia's R&D tax break cap could drive innovation

Traditional wisdom would have it that any cuts to company R&D tax breaks could hamper innovation, yet the Australian government's latest move to cap domestic R&D incentives may in fact help drive the development of new technology in the country.

Australia's Shadow Minister for Higher Education, Research, Innovation, and Industry Senator Kim Carr this week slammed the government's move to put a cap on what companies can claim under the federal Research and Development (R&D) Tax Incentive.

The R&D Tax Incentive allows companies to claim a tax break for the money they spend on internal R&D, but on February 10, parliament passed new legislation limiting the amount for which companies can claim R&D tax breaks to AU$100 million.

The federal government struck a deal with the Palmer United Party and independent Senator Nick Xenophon in a bid to see the new Tax Laws Amendment (Research and Development) Bill 2013 pass the Senate.

The deal saw a number of amendments, including the reduction of the tax offset rate for companies with R&D expenditure above AU$100 million, and a move to backdate the new legislation to July 1 last year, leaving the laws to apply retrospectively.

In a statement, Carr reiterated concerns that industry stakeholders had previously raised in submissions to the committee charged with inquiring into the legislation.

"Some of Australia's biggest R&D investors, including companies such as Telstra and Caltex, made it clear that new R&D investments and the associated jobs could go offshore if the government's measure was passed," said Carr. "Universities like the University of New South Wales said their business research partnerships would be placed at risk if access to the R&D Tax Incentive was cut.

"It will have the same disincentive on R&D investment as the original measure," he said. "The only difference is that it will impact a different list of companies, with the added problem of retrospectivity."

The "original measure" refers to the Bill as it was first introduced by the previous Labor government in 2013, when it passed through the lower house. The original proposal was to reduce the tax offset by 1.5 percent and remove R&D incentives for companies with a yearly turnover of more than AU$20 billion.

Carr said that the original measure was intended to exclude only "very large" Australian companies from claiming the R&D Tax Incentive, and that the Bill, as it is now, "raises serious concerns about sovereign risk for innovative companies considering new R&D investment in Australia".

Despite these concerns, however, there is a chance that the new legislation could in fact provide many of Australia's technology industry players with a compelling incentive to ramp up their R&D activities.

Treasurer Joe Hockey has said that he expects fewer than 25 companies in the country to be affected by the new measure, with the "vast majority" of companies claiming the R&D Tax Incentive remaining unaffected by the changes.

"These changes represent a fair and sensible outcome, providing a concession for small and medium-sized companies, which are typically more responsive to tax incentives for innovation while at the same time ensuring that important savings in the [federal] Budget are realised," said Hockey in a joint statement with Finance Minister Senator Mathias Cormann.

Chris Ridd, managing director for the Australian operations of cloud accounting software provider Xero, agrees with Hockey's assertion that the new changes will likely see local small and medium-sized companies respond to the R&D Tax Incentive.

In fact, Ridd believes that by restricting the amount that very large companies in Australia can claim as part of the scheme, smaller players may well ramp up their innovation activities in a bid to leverage the moderately flatter playing field that the new measures allow.

"I think that what the government's done with the capping is not a bad thing, because the bigger vendors, the big guys that are spending that sort of money on R&D, you'd argue that they don't really need those sorts of R&D incentives," Ridd told ZDNet. "Anything the government can do to encourage that low end is a good thing.

"This is all about democratising IT," he said. "You don't want the masses of technology sitting with the few; the big guys. It's actually good for the IT [industry] in terms of choice and competition to have small vendors coming through, and those tax incentives obviously encourage those smaller players to grow."

Although Xero is headquartered in New Zealand, the company's almost 200-strong Australian team includes an increasing number of engineers and developers working on several activities classed as R&D projects.

While the Australian R&D Tax Incentive was not the primary impetus behind Xero's move to build a large development team in Australia, it has encouraged the company to carry out more innovative work locally than it may have otherwise done.

"We're now at well over 50 developers in Melbourne, and our global development team is at around 400. That comes under R&D and innovation investment," he said. "So, we definitely fall in that category, where those R&D grants really helped us to look at Australia to build product, and that's been an incentive."

First and foremost in the decision to build a strong development team in Australia, according to Ridd, was the requirement to tap into a larger talent pool than was available in the company's hometown of Wellington, but the R&D Tax Incentive has been a bonus that has helped that team grow.

"What it has meant is that as we've grown our development core, and as we think about building product in Australia, those incentives certainly help us and encourage us to continue to invest. So, it's a bonus," he said.

According to Xero's FY14 financial results, the company incurred NZ$18.4 million (AU$17.65 million) in costs related to product design and development. While that figure is not broken down into R&D specifically, it is clear that the company would spend just a fraction of the capped AU$100 million amount stipulated in the new laws.

In fact, most of the companies populating Australia's technology landscape would probably have never come close to such an R&D budget.

It is more likely that the cap's impact will be restricted to a handful of the top-tier companies in high-revenue sectors such as mining and resources, or health and pharmaceuticals.

Anglo-Australian mining leviathan BHP Billiton, for example, recorded $43 million (AU$55.64 million) in research and development costs before crediting-related grants during the financial year ending 2014.

Meanwhile, Australian-listed healthcare giant CSL reported $466.4 million (AU$602.35 million) in R&D expenses for FY14, although it is not clear how much of this figure was spent in Australia.

Australia's largest telecommunications provider, Telstra, which said in its submission to the committee reviewing the legislation that the R&D Tax Incentive "has been one of the reasons behind Telstra's commitment to undertake the majority of our R&D work onshore," reported (PDF) that it accrued just AU$4 million in research and development expenses for the financial year ending 2014.

By contrast, the company's annual results for FY14 showed that it accumulated AU$346 million in promotion and advertising expenses for the same period.

While Google Australia did not explicitly reveal how much it spent on R&D in Australia in its submission to the Senate Economics References Committee Inquiry into Corporate Tax, the internet giant's Australian arm said that it spends around $300 million on local operations each year.

However, it went on to say in its submission that of its entire Australian team, around 500 were employed as engineers -- representing about half of the company's Australian employee base.

"Some of the areas our engineers work on are claimable through the Australian R&D credit," Google said in its submission, adding that for the past six years, it has applied for and received a tax benefit from the tax office for projects being undertaken by its engineers.

However, the company was quick to point out that despite making use of it, the incentive is only one factor taken into account when it set up its engineering hub in Sydney.

Importantly, Google added that the scheme could have a greater focus on the smaller end of the market -- a move that could, in turn, drive more innovation among a larger number of companies.

"We do believe the measure could have more focus by embracing smaller players taking those initial risks when starting up a new business. Google would welcome a discussion on how the credit could be better used to drive innovation and support the startup community," the company said in its submission.

This is precisely what the new measures are likely to help achieve, according to Mark Randall, chief commercial officer for local cloud services provider Bulletproof.

Randall believes that the cap will not only provide an added incentive for smaller companies to invest more in R&D, but may also provide those smaller companies with greater access to the local talent pool necessary for such projects.

"Part of the commentary has been around the fact that the tax incentives here are less generous, and those larger companies will be tempted to do more of that R&D offshore," Randall told ZDNet. "If that's the case, then the guys that are performing that R&D for those large companies [in Australia] are going to come onto the market and become available to smaller companies.

"That's why I think that the overall impact will probably be fairly muted. Certainly, those who are directly impacted are going to probably cite very valid examples of where they have undertaken less R&D or moved it offshore as a result of the cost-benefit equation having changed. But that doesn't take into account the flow-down effect elsewhere in the labour market and the economy," he said.

From Bulletproof's perspective, the new legislation will not have much of an impact. The company will continue to invest in R&D projects as it always has, with the aim of creating long-term competitive advantages. Like Xero, the R&D incentives are a bonus.

"Whether it's going to have a material impact? I'd be unsure of that. Most organisations that undertake R&D do it because it adds value to their business. But when it comes to tax benefits, large companies particularly often have many other options available to them," he said.

The Australian government came under fire last year for shedding a projected AU$845.6 million from programs aimed at fostering local innovation from startups or smaller companies, as part of a host of government funding cuts in the 2014-15 Federal Budget.

At the time, industry stakeholders voiced concerns that the cuts would see some of the country's most innovative companies -- specifically technology startups -- move overseas to take advantage of more attractive benefits in other markets.

It was not known at the time how well the government's introduction of its AU$484.2 million Entrepreneurs' Infrastructure Program would replace the work that had been done by the several programs that were scrapped. Indeed, the new program's long-term effectiveness is yet to be clearly determined by the local startup sector.

However, between the capping of the R&D Tax Incentive, and the passing in the Senate on February 9 of new legislation aimed at simplifying elements of Australia's intellectual property (IP) system, the country's small and medium-sized technology innovators may have been handed enough of an incentive to ramp up internal R&D.

The government's new Intellectual Property Laws Amendment Act 2015, which passed the Senate on Monday, is intended to make it easier and, importantly, cheaper for companies to protect and enforce certain intellectual property.

"This new legislation will streamline business between Australia and New Zealand by simplifying the process for innovators seeking to patent the same invention in both countries," said Parliamentary Secretary to the Minister for Industry and Science Karen Andrews. "It allows for a single patent attorney regime and a single patent application and examination process, making it easier for businesses to protect their IP in both countries."

This move could be interpreted as a sign that the government is starting to show greater support for local science and technology innovators, after cutting AU$111 million in funding to Australia's largest science and technology research organisation, the CSIRO, last year.

While the new IP laws may benefit the big players as well as the smaller players, the intention of the legislation seems to be tied in with the federal government's desire to facilitate the commercialisation of innovation resulting from local R&D.

In October, Minister for Industry and Science Ian Macfarlane announced the launch of the final part of the new Entrepreneurs' Infrastructure Program -- its Accelerating Commercialism stream.

"Australia has some of the best researchers, inventors, and entrepreneurs in the world," he said at the time. "But our track record of turning great ideas into commercial products is not as good as it could be or as good as it should be if we are to keep pace in evolving global markets.

"Accelerating Commercialisation will drive business growth and competitiveness and achieve nationwide economic benefits by helping to ensure that more of Australia's wealth of intellectual property resource is effectively commercialised," he said.

According to Randall, the move to cap the R&D Tax Incentive could be viewed as an additional step the government has taken to help lower the barriers for smaller technology companies to generate returns from their R&D activities.

"Smaller companies can get access to resources that traditionally only large organisations would have," he said. "There's a lot of democratisation of smaller companies in this move."