The R&D Tax Incentive is a great funding opportunity for startups, as it provides refundable tax offsets of as much as 43.5% of expenditure on eligible research and development activities. The entitlement program is open to businesses of all sizes across all industry sectors. About 15,000 companies claim $3.4 billion each year, including an increasing number of smaller enterprises.
The Australian Taxation Office (ATO) and Innovation Australia jointly administer the program with assistance from AusIndustry. There is a joint application process: first registering R&D activities using the AusIndustry registration smart form, followed by claiming expenditures with the ATO using the R&D Tax Incentive schedule.
Innovation Australia first determines whether activities are eligible. The application should show that you have technical issues that cannot be resolved with existing knowledge or expertise, and thus need to conduct systematic experiments or ‘core R&D activities’. The ATO then determines the validity of expenses incurred on those activities.
The ATO and Innovation Australia identified 5 common areas of confusion that result in mistakes among those claiming the R&D Tax Incentive. Groups at higher risk for making these mistakes include startups, small-to-medium enterprises and those making claims related to information and communications technology (ICT), construction, agriculture and software development.
The top 5 mistakes are:
Insufficient record keeping
Documentation that substantiates R&D activities and expenditure, and separates it from regular business activity is crucial. For example, separating R&D activities with specific R&D job codes when entering transactions into the businesses accounting system can help substantiate a claim.
It’s also important to distinguish and document whether an entire project is eligible, as it’s possible that specific activities may qualify even if a broader project does not. AusIndustry offers the example of a large company with a vague application focusing on an entire project.
The original application was not enough to qualify for the incentive. However, the company was able to explain the technical issues that required experiments to resolve, and supported this with records proving the experiments conducted. Importantly, these experiments were hypothesis-driven—not trial and error.
AusIndustry ruled that the experimental activities were eligible even though the entire project was not.
Incorrectly calculating or supporting R&D percentage of costs
It is also important to support your logic when apportioning a percentage of costs to R&D. For example, one staff member may spend 15% of their time on R&D while the other 85% is spent on other job requirements, so this employee’s salary would be apportioned as 15% R&D. The claimant should also maintain records to support the apportionment method used. This may include keeping general ledger entries, invoices and timesheets with job codes specifically for R&D.
Claiming ‘business as usual’ activities
Some organisations incorrectly claim activities that are unrelated to R&D. Generally, those considered internal ‘business as usual’ activities will not qualify. This includes those related to developing software to be used for internal administration purposes including information, HR and employee management systems, as well as enterprise resource planning.
Activities related to delivering services to customers typically do qualify—creating a customer database, for example. The intent must be to sell, lease or hire the systems externally. This means that a system that manages equipment maintenance records does not qualify if only used for internal machinery, but the system likely would be eligible if used to provide contract maintenance services.
Market research, management studies, efficiency surveys and activities associated with regulatory compliance typically do not qualify.
Claiming salary payments incurred in a different financial year
Organisations can only claim costs incurred within the same financial year of the R&D activities. This goes for salary as well, which must be incurred and paid within the financial year of the activities performed to be eligible.
This is particularly relevant for early-stage companies that practice ‘sweat equity’, providing company shares in exchange for services. Because only actual expenses can be claimed, a better option for those claiming the R&D incentive could be to pay the staff member or service provider at usual arms-length terms; then in turn, the service provider buys shares to further assist with funding.
It’s important to keep in mind that the value of the shares will not be eligible for the incentive. However, this arrangement may provide tax advantages to the share purchaser.
Failing to include income from connected entities
Claimants must calculate aggregated turnover for the income year, which includes income earned by ordinary business activities as well as income earned by connected or affiliate entities in Australia if there is 40% or greater shareholder interest. The ATO aggregation rules help determine whether this is applicable.
The Department of Industry, Innovation and Science has outlined a plan to provide better guidance in these areas. Relevant stakeholders have also suggested opportunities to more clearly communicate how to make a claim, including more detailed case studies and guidance on record keeping, a chat function providing tailored advice and an ICT-specific form clearly highlighting risk areas.
Brendan Brown is a Partner with Prime Accounting & Business Advisory Pty Ltd., a division of ASX-listed Prime Financial Group Ltd. (PFG), which provides integrated Accounting & Business Advisory, Wealth Management and Capital services Australia wide. Brendan is an expert in the R&D tax incentive, Export Market Development Grant (EMDG) and other government grants. He works with businesses to navigate the complexities of many government grant programs to ensure they meet eligibility criteria and maximise the potential returns. Brendan’s specialty is helping businesses unlock capital to extend their development, growth and market share.