Legal precedents establish new benchmark for R&D software eligibility
Claiming benefits under the R&D Tax Incentive is highly contestable. As the program is based on self-assessment all claimants should take proper care to fully understand the legal requirements relative to all aspects of eligibility and the requirement to substantiate claims by contemporaneously tracking R&D activities using the scientific method.
The latest version of the Guide for Interpretation is by far the best explanatory document ever produced by AusIndustry as it attempts to breakdown and explain the 4 pillars of eligibility in plain English and the records required to underpin a claim if and when as audit or review is called for by either of the 2 scheme administrators (AusIndustry or the ATO).
The one word repeatedly used in the Guide (mentioned 30 times) is the need to plan your project before you begin your R&D activities taking into account the unique requirements of the scheme, which requires a claimant to:
- articulate the business reason for undertaking the project
- identify the technical or scientific challenge/s requiring experimental activities that are subject to the R&D Tax claim.
- research the current state of knowledge to determine to prove that the knowledge you are trying to generate is not freely available in the world.
- design the experiment/s you intend to undertake by describing the variables to be tested and the desired performance benchmark you are attempting to achieve.
- formulate the hypothesis which the experimental activities seek to prove or disprove.
- establish that your R&D Manager or CTO is a “competent professional in the field” by documenting their qualifications and/or industry experience.
- break down your project into discreet activities called core, supporting, and ineligible activities.
- identify the staff/ contractors to be involved with each of the activities.
- budget the expected cost over the life of the project.
Despite the positive announcement by Government to enhance the program in the October budget, the new integrity measures announced in Chapters 5 and 6 in the new Explanatory memorandum will allow AusIndustry much greater flexibility to determine eligibility whereby we expect to see far greater scrutiny over a much larger number of claims, so the onus is on claimants and their advisors to get it right.
AusIndustry now has much greater power to make determinations by engaging experts in the field from other Government departments including far greater use of IP Australia to research the knowledge gap that existed at the time of the project commencement. Innovation and Science Australia (ISA) has also engaged an independent contractor to provide AusIndustry with additional resources so it can review more claims before registrations are approved or within a far shorter period after which claims are registered and paid thus addressing the concerns and recommendations made in the Ombudsman Report into the Administration of the R&D Tax Incentive released on 12th December 2019.
It must be recognised that most technology companies and/or start-ups will try and use existing technologies or methods to deliver their new business model whereby costly and complex software development work is required. This however does not necessarily mean that these projects meet the eligibility criteria.
Two new legal precedents have recently been established in the software space.
1. Royal Wins Pty Ltd:
The Administrative Appeals Tribunal’s recent decision in the Royal Wins Pty Ltd (a gaming platform software developer) case found that the activities registered were not Core or Supporting R&D activities as the taxpayer had applied existing mathematical knowledge and models to attain its outcomes and did not demonstrate that:
- the activities were experimental
- the outcome of the activities could not be known or determined in advance based on current knowledge, information, or experience
- a technical knowledge gap existed that could only be resolved by experimentation as part of a systematic progression of work
- a systematic progression of work had been undertaken, based on principles of established science, proceeding from hypothesis to experiment, observation and evaluation and leading to logical outcomes
- that it held relevant hypotheses at the commencement of the project
- that the activities were carried out for the purposes of generating new knowledge.
It further reinforced the fact that documentation for R&D needs to be contemporaneous and should follow a systematic progression of work. Furthermore, the abundance of the word “plan” emphasises that the R&D nature of these activities should be contemplated in advance of their initiation and that contemporaneous documentation should reflect this.
2. Camalic Pty Ltd:
In the other decision, the AAT heard that Camalic Pty Ltd registered a core activity called “Development of an algorithm to predict shareholder value increases” along with the following three supporting activities – Acquisition of a supporting framework and database for the predictive tool, Literature, and technology review and Project planning.
The core activity hypothesis was “that through utilising a Bayesian statistical approach, a predictive tool algorithm can be developed to accurately predict the increase in shareholder value that will result from improvements to various multi-dimension variables aspects of board governance.”
Based on the evidence, including statements from Camalic Pty Ltd, the AAT concluded the applicant never intended to build a bespoke machine learning algorithm. Instead, the objective of the project was deemed “to train an existing machine learning algorithm, using the functionality inherent in the algorithm, to adapt itself to predict increases in shareholder value from board governance variables”. The AAT was not convinced the claimed activities were intended to generate a bespoke algorithm or new, previously unknowable, functionality in an existing algorithm. Accordingly, the AAT affirmed it was not a core R&D activity for the purposes of the R&D Tax Incentive scheme.
The AAT further added that the collection and analysis of board governance data for the purpose of determining relationships between board governance variables and increases in shareholder value came within the “management studies” exclusion and was, therefore excluded from being a core R&D activity. Finally, as there were no core R&D activities deemed to have been undertaken or planned by the applicant, none of the claimed supporting activities were considered supporting R&D activities for the purposes of the R&D Tax Incentive Scheme.
As we can see from these two negative AAT software decisions the devil is in the detail and unless claimants undertake a deep dive and understand both the scheme eligibility criteria’s and the reality around the generation of new knowledge from their own project activities they have not properly self-assessed their participation in the program.
I often say to my clients that they should dedicate the same amount of resources to substantiating their R&D claims as they would to running their own business, the analogy is – how many sales would a claimant need to make to generate the same net after-tax return they expect to achieve from claiming an R&D Tax benefit?
If your company is undertaking Research & Development activities in any industry sector, our professional team of consultants can scope your eligibility and potential benefit, prepare and lodge your applications and establish compliant record-keeping processes to underpin the defensibility of your claim.
We also offer R&D Tax prepayment loans against future R&D cash refunds to assist you with funding your ongoing R&D activities without diluting equity at an early stage.
In addition, we will also review your ability to claim other available grants on offer from either State or Federal Government.