The ATO has recently released Taxpayer Alerts TA 2023/4 and TA 2023/5 regarding Research & Development (R&D) activities delivered by associated entities and R&D activities conducted overseas for foreign related entities.

Associated entities

The ongoing assessment of R&D claims under the Research & Development Tax Incentive (RDTI) reveals a focus on entities engaging with associates, particularly “service providers”, conducting R&D activities. Their scrutiny is directed at arrangements that either inaccurately represent the R&D entity as incurring or paying the relevant expenditure, or result in, the R&D entity claiming a tax offset for R&D activities purportedly conducted for its benefit but, in reality, serving the interests of the service provider.

Typically, these concerning arrangements involve a service provider, historically responsible for the group’s trading and research activities, causing the creation of a special-purpose company as the R&D entity. The service provider, as a contractor, conducts R&D activities and maintains control over strategic decisions, possessing primary rights to commercially exploit intellectual property developed through these activities. The R&D entity, limited to R&D-specific arrangements, relies on the refundable tax offset as its sole receipt, used exclusively to fulfill payment obligations to the service provider.

These arrangements may take various forms, including those involving related entities, share issuances, circular fund flows, or long-term funding posing as general working capital. Potential impacts on RDTI entitlement arise from uncertain payment obligations, non-compliance with payment conditions, and R&D activities not being conducted for the R&D entity’s primary benefit.

Foreign-related parties

The Australian Taxation Office (ATO) is also investigating instances where Australian-resident R&D entities claim a tax offset under the RDTI for expenditure related to R&D activities conducted overseas. Concerns arise when R&D entities claim the tax offset, despite the activities being conducted for (or significantly benefiting) a foreign-related entity.

In these scenarios, arrangements are structured to benefit the foreign-related entity, with ownership rights in the developed intellectual property granted to them. The foreign-related entity may assume financial and operational risks, control strategic decisions, and even be contracted to conduct R&D activities. The R&D entity, lacking a physical presence in Australia, has limited ability to itself commercially exploit the developed IP and often incorporated shortly before claiming the RDTI, will not meet the eligibility criteria.

An essential eligibility requirement for the RDTI involves establishing a formal and legally binding agreement between the foreign parent company and Australian subsidiary company. This agreement must explicitly define the relationship between the parties and outline the mechanisms through which the Australian company has the potential to generate future income proportionate to the risks it assumes within the RDTI program. The specifics of this agreement may differ based on the ownership status of the IP. Given the intricacies involved with this kind of structure, and it being a complex area of the RDTI, a comprehensive discussion with your R&D tax adviser is recommended.

Entities are advised to ensure compliance with RDTI legislation, objectively evaluate the commercial substance of their arrangements, and stay vigilant to avoid potential disqualification or scrutiny under anti-avoidance provisions.

The ATO is committed to upholding the integrity of the RDTI program and preventing misuse of tax incentives which is also shown in their release “Clarifying R&D program integrity rules” in late October 2023, and the ATO and AusIndustry Joint Review Program which is currently selecting 200 companies, at random, for review of both the R&D activities and R&D expenditure.

As always when claiming the R&D Tax Incentive, supporting records are essential to demonstrate to the ATO that any arrangements and payments between multiple entities are commercial, arms- length and legitimate for R&D claims.

Please contact your HLB Mann Judd adviser if you would like to discuss your company’s eligibility for the R&D Tax Incentive.