Since 1 July 2011, the R&D Tax Incentive scheme has provided a 43.5% cash refund on eligible expenses of approved R&D activities for companies with a loss and turnover under $20m with a 38.5% for other companies. The scheme costs the government over$3 billion annually.
The ATO have focused their attention to the R&D Tax incentive claims of companies in the Mining, Property and Construction, Financial Services,Agriculture and Information Technology Industries. In many cases the review can cover claims over the past 4 years.
Theirrecent activity has resulted in several information technology companies being ordered to repay millions of dollars, including high-profile companies Airtasker and Digivizer.
Tim Fung, CEO of Airtasker has confirmed “Airtasker has been asked to repay to the ATO 100 per cent of the R&D incentives provided over a number of years of participation in the program.” This is despite Airtasker’s R&D Claims being prepared by a Tier-one accounting firm.
Airtasker’s R&D involved the unique development of combining two previously separate software languages. It had never been done before. It also developed machine learning and artificial intelligence algorithms to apply to online content moderation and detect undesirable behaviour on its platforms.
It should be noted that new technology or innovation is not necessarily automatically eligible for the R&D Tax Incentive. To be eligible it must also contain a core experimental activity that involves systematic and planned experimentation with technical risk.
Airtasker felt the ATO’s interpretation of the Frascati model required documentation that were more relevant to scientific laboratory experiments, rather than software development methods.
While the R&D Tax Incentive program allows companies to claim eligible information technology development, understanding the requirements is clearly not easy. Even the Frascati Manualraises concerns regarding the identification of R&D in software. It states:
“The basic definitions in this [Frascati] Manual were originally developed for manufacturing industry and research in the natural sciences and engineering.Specific problems therefore arise for applying them to service activities, which often involve software applications and research in the social sciences. “
A new section was created specifically to identify R&D in software. It included:
Software development has since become a major intangible innovation activity with a high R&D content. The tools developed for identifying R&D in traditional fields and industries are not always easy to apply to these new areas.
Software development is an integral part of many projects which, in themselves, may not involve any R&D. Software advances are often incremental rather than revolutionary so identifying the R&D component within software can be difficult.
What does a software project need to contain to be eligible under the R&D Tax Incentive Scheme? Frascati suggests the following:
- The aim of the project must be the systematic resolution of a scientific and/or technical uncertainty.
- The completion of the project must be dependent on a scientific or technical advance.
- The software should be eligible R&D in its own right and as an end product.
- An upgrade, add-on or change to existing software or system may be classified as R&D if it involves scientific and/or technical advances that increase the knowledge base. Software for a new application or purpose is not necessarily an advance.
- Failure of a software development may be R&D where a scientific and/or technical advance is achieved. The failure in itself may be eligible as an “Einstein Event”, knowing what does not work.
Frascati provides examples of eligible software activities which include:
- Producing new theorems and algorithms in the field of theoretical computer science.
- Development of information technology at the level of operating systems, programming languages, data management, communications software and software development tools.
- Development of Internet technology.
- Research into methods of designing, developing, deploying or maintaining software.
- Software development that produces advances in generic approaches for capturing, transmitting, storing, retrieving, manipulating or displaying information.
- Experimental development aimed at filling technology knowledge gaps as necessary to develop a software programme or system.
- R&D on software tools or technologies in specialised areas of computing (image processing, geographic data presentation, character recognition, artificial intelligence and other areas)
- Mathematical research relating to financial risk analysis.
- Development of risk models for credit policy.
- Experimental development of new software for home banking.
- Development of techniques for investigating consumer behaviour for the purpose of creating new types of accounts and banking services.
- Research to identify new risks or new characteristics of risk that need to be taken into consideration in insurance contracts.
- Research on social phenomena with an impact on new types of insurance (health, retirement, etc.), such as insurance cover for non-smokers.
- R&D related to electronic banking and insurance, Internet-related services and e-commerce applications.
- R&D related to new or significantly improved financial services (new concepts for accounts, loans,insurance and saving instruments)
- Analysis of the effects of economic and social change on consumption and leisure activities.
- Development of new methods for measuring consumer expectations and preferences.
- Development of new survey methods and instruments.
- Development of tracking and tracing procedures (logistics).
- Research into new travel and holiday concepts.
- Launchof prototype and pilot stores.
The following are examples of ineligible software-related activities:
- Business application software and information system development using known methods and existing software tools.
- Support for existing systems.
- Converting and/or translating computer languages.
- Adding user functionality to application programmes.
- Debugging of systems.
- Adaptation of existing software.
- Preparation of user documentation
So where did the focus on software R&D start?
In February 2017 the ATO and Department of Industry, Innovation and Science issued details of their concerns regarding R&D tax incentives claimed in the information technology and software development industries. They expressed their concerns as:
- R&D claims were made on the whole of the project not considering each of the activities and applying the relevant legislation to determine which activities are R&D activities.
- The software experiments are not clearly articulated in the R&D registration forms.
- Technical uncertainties are not clearly identified.
- Expenditure is incurred in acquiring, or acquiring the right to use, technology that cannot be claimed as a notional deduction.
- Expenditure is being apportioned between R&D activities and ineligible activities in an unreasonable manner.
They provided examples of activities that are not core R&D unless there is clear evidence they are being done as experiments to test a hypothesis. They were:
- Bug testing
- Beta testing
- System testing
- Requirements testing
- User Acceptance Testing
- Data mapping and data migration testing
- Testing the efficiency of different algorithms that are already known to work, and
- Testing websites in operation by measuring the number of hits.
The main reasons that software R&D claims are found to be ineligible include:
- Registering the full R&D project rather that the specific eligible components. The software development project is included and registered on a whole of project basis, without distinguishing eligible R&D activities from ineligible activities.
- The R&D activities cannot clearly demonstrate generating new knowledge. Generating new knowledge is critical and should be the purpose of the project.
- The activities described are not intended to test a hypothesis through experiments.
- The technical uncertainty is not clearly addressed by the activities.
- The risk of conducting the project is not technical risk but project management, commercial or economic risks. The R&D Tax Incentive program has no interest in whether the software being developed will generate revenue.
- Claiming existing ‘off-the-shelf’ software, which is integrated into an existing platform using existing knowledge and expertise, rather than the creation of new knowledge through systematic experimentation.
- The activities claimed are not directly related to experimental activities or do not have a dominant purpose of supporting those activities.
What do you need if your R&D software claim has been selected for review or audit?
- Provide proof that the intellectual property developed is owned by the claimant. If using a contractor, provide a copy of the contract showing the ownership of the IP.
- Show the claimant has full management and control of the R&D activities.
- Demonstrate the claimant wears the financial risk of the R&D activities.
- Provide documented examples of experiments carried out for your registered core activities. This should include the hypothesis and the experiments that were conducted to test the hypothesis, and a statement of the outcome. If any experiments failed, make sure you include them.
- Provide contemporaneous documentation showing the activities were conducted in a systematic manner from hypothesis to experiment, observation, analysis, and if completed, a conclusions for each core activity.
- Ensure your core activities can demonstrate they used scientific or engineering principles and know how to create the new knowledge.
- Explain why the outcome of each experiment could not be determined in advance. Provide details on the knowledge gap that existed when the project commenced. If you can provide the results of internet or patent searches that will assist.
- With software, development is often incremental. Explain how the new knowledge is more than just a simple progression from existing technology or applying existing knowledge in more than a different context or application.
These cases highlight the intricacies of the R&D Tax Incentive Scheme, the issues of using accountants for claiming grants and the importance of getting all elements of the claim right.
Clearly the activities undertaken by Airtasker and Digivizer were R&D activities, as defined by the Frascati Manual, and would have been eligible if they were part of an eligible project, properly conducted and documented. The ATO released a document “Getting Software Development R&D Tax Incentive claims right”which is available at www.business.gov.au/~/media/Business/RDTI/Research-and-development-tax-incentive-Getting-Software-development-RD-Tax-Incentive-claims-right-PDF.pdf?la=en
For more information contact Bruce Patten from Pattens Group at firstname.lastname@example.org or on 1800 PATTENS
Written by Bruce Patten: With more than 30 years’ experience claiming government grants, Bruce is regarded as the grants expert. He has a passion for helping new business get off the ground and has a long list of successful clients who have received the government funding they needed for research, development, management, commercialisation, exportation, small business support… and the list goes on.