Private ruling: Research & Development
Published: November 2013
Ruling period: 01 January 2012 to 31 December 2012
Date scheme commenced: 01 January 2012

Ruling: Q1: Does expenditure incurred by you on R&D activities projects satisfy the conditions for a notional deduction in section 355-205 of the Income Tax Assessment Act 1997? | A1: No

Relevant facts and circumstances: 1. You are a clinical research organisation based in Australia and are a subsidiary of an overseas parent entity (Parent). 2. You perform clinical trials in Australia and associated services under an Agreement between your Parent, yourself and other overseas subsidiaries of your Parent. 3. Your Parent has entered into Sponsor Contracts with overseas based companies (Sponsors), which are not related to your Parent or any of its subsidiaries, to carry out R&D activities. Under these agreements your Parent has significant control over where and how the R&D activities are carried out provided the trials are always conducted in accordance with good clinical practice and in compliance with all relevant regulatory requirements. 4. Your Parent receives a fee from the Sponsor which is agreed between your Parent and the Sponsor before the clinical trials begin. 5. The agreement between your Parent and the Sponsor provides the following: · The Intellectual Property (IP) pertaining to the R&D results is always owned by the relevant Sponsor and never owned by you. Any additional IP which is created during the trial automatically becomes the property of the Sponsor. You agree to ensure that you do not take any steps which would impact the sponsors ability to legally protect that IP, and to comply with any requests to execute, or cause to be executed any legal agreements etc required in order to allow the Sponsor to legally protect that IP, including agreeing that the Sponsor has the sole right to file patent applications etc in respect of that IP. · The Sponsor shall have the right to terminate any trial or the Agreement for any reason at any time by giving appropriate written notice. · If the Sponsor wishes to change the scope of the Services covered by the Agreement or wishes to obtain additional services not initially covered by the Agreement, the Sponsor can advise of such and submit the required specifications. · Your Parent must abide by stringent requirements of confidentiality and data protection. · The Sponsor agrees to indemnify your Parent against any potential third party claims associated with the conduct of the research. · Your Parent may not publish or disclose any data related to the R&D without the consent of the Sponsor. · The relationship of your Parent to the Sponsor is that of an independent contractor. · The Sponsor acknowledges that the results of the clinical trial are inherently uncertain and that your Parent cannot warrant that the clinical trial results will enable the treatment to receive any approval required from the relevant regulatory authorities. The activities are R&D activities for which you are registered with Innovation Australia under section 27A of the Industry Research and Development Act 1986 for the year of income ending 31 December 2012 Income Tax Assessment Act 1997 Section 328-125 Income Tax Assessment Act 1997 Section 328-130 Income Tax Assessment Act 1997 Section 355-205 Income Tax Assessment Act 1997 Section 355-210 Income Tax Assessment Act 1997 Section 355-220


Reasons for decision: Summary: 1. All legislative references are to the Income Tax Assessment Act 1997 . 2. Entitlement to the R&D tax incentive is based, in part, on you having incurred expenditure on R&D activities that you can notionally deduct. You generally have to satisfy the conditions in section 355-210, which sets out for whom R&D activities can be conducted. In general, you can only claim a notional deduction and, therefore the R&D tax incentive, for expenditures on R&D activities conducted for you and not to a significant extent for some other entity. 3. R&D activities may be conducted for you if you conduct the activities for yourself or if another entity conducts these R&D activities for you. 4. You may also qualify for the R&D tax incentive if your R&D activities are conducted for an associated foreign corporation, that is a resident of a country with which Australia has a comprehensive double tax agreement, if certain conditions are met. 5. Subsection 355-205(1) states: (1) An *R&D entity can deduct for an income year (the present year ) expenditure it incurs during that year to the extent that the expenditure: (a) is incurred on one or more *R&D activities: (i) for which the R&D entity is registered under section 27A of the Industry Research and Development Act 1986 for an income year; and (ii) that are activities to which section 355-210 (conditions for R&D activities) applies; and (b) if the expenditure is incurred to the R&D entity's *associate - is paid to that associate during the present year. 6. Under paragraph 355-35(1)(a) an R&D entity includes a body corporate incorporated under an Australian law. You are a company incorporated in Australia. 7. We assume that you will be registered for the activities to which the expenditure relates with Innovation Australia under section 27A of the Industry Research and Development Act 1986 thereby satisfying sub-paragraph 355-205(a)(i). 8. Sub paragraph 355-205(1)(a)(ii) provides that an R&D entity can deduct expenditure incurred during the relevant income year to the extent that the registered activities meet the conditions for R&D in section 355-210. 9. Relevant to this Ruling, an activity to which section 355-210 applies is contained in paragraph 355-210(1)(c), which requires that: (c) the R&D activity is conducted for one or more foreign residents who are each: (i) incorporated under a *foreign law; and (ii) a resident of a foreign country for the purposes of an agreement of a kind described in subsection 355-35(2); and the conditions in section 355-220 (activities conducted for a foreign entity) are met for the R&D activity; 10. When working out whether the R&D activity is conducted for one or more foreign corporations, you must also consider the extent to which the R&D activity is conducted for the benefit of any other entity to whom the conditions in subsection 355-210(1) do not apply. By virtue of subsection 355-210(2), if the R&D activity is also conducted to a significant extent for such an entity, then it is ineligible for the purposes of the R&D tax incentive. 11. In explaining when expenditure on R&D will give rise to a notional deduction, the Explanatory Memorandum to the Tax Laws Amendment (Research and Development) Bill 2010 explains: 3.52 Generally, an R&D entity is only entitled to a tax deduction in relation to R&D activities conducted for the entity (whether by the R&D entity for itself or by another entity for it). Also, an entity cannot deduct its expenditure on R&D activities if it conducts those activities to a significant extent for another entity. 3.53 This retains a key rule from the existing law commonly known as the 'on own behalf' rule. This rule is intended to limit eligibility for a notional R&D deduction to where an R&D entity is the major benefactor from the expenditure it incurs on the R&D activities. In certain situations, the rule also prevents duplication of claims by different R&D entities. 3.54 Determining the major benefactor of expenditure on R&D activities involves examining the extent to which R&D activities are carried out for the R&D entity compared to the extent to which they are carried out for any other entity. This is tested by weighing up three key criteria, namely, who: · effectively owns' the know-how, intellectual property or other similar results arising from the R&D entity's expenditure on the R&D activities; · has appropriate control over the conduct of the R&D activities; and · bears the financial burden of carrying out the R&D activities. In short, the question of whether an R&D activity is conducted for an R&D entity is a question of fact, determined by whether the activity is conducted in substance to provide the majority of knowledge benefits resulting from the activity, such as access to intellectual property, to this entity. 3.55 Whether an R&D entity has effective ownership involves reviewing all the circumstances surrounding the conduct of the relevant activities and the ownership and control of, and/or ability to utilise, the intellectual property or similar results obtained from the expenditure on the R&D activities. 12. These three key criteria apply to two of the conditions in section 355-210. The first condition concerns whether, in a positive sense, the R&D activities in question have been conducted 'for' the foreign resident described in paragraph 355-210(1)(c)). The second concerns whether, in a negative sense, those R&D activities have been conducted 'to a significant extent, 'for one or more other entities not covered by any paragraph of subsection (1)' (subsection 355-210(2)). Applying these key criteria to a particular case requires weighing them up against the relevant facts and circumstances of this case. Effective ownership 13. A company effectively owning results of the relevant R&D activities is the first identifying criterion in determining whether the R&D activities are being carried out for that company. To work out whether a company has effective ownership of the results we must look at the circumstances in which the R&D activities are conducted and what practical, as well as formal, rights the company has to the results from those activities, such as the intellectual property, the know-how or similar results arising from the R&D activities. This does not mean that the company must be the proprietor of a piece of intellectual property in any formal sense. These rights may not be available, or the formal owner of the resulting intellectual property may hold it on terms such that the R&D entity has all the advantages of ownership. 14. In this case, you have an agreement with your Parent to conduct relevant services including the R&D activities upon your parent contracting with the Sponsor to conduct certain services requiring conduct of those R&D activities. 15. The terms of the contractual relationship between you, your parent and the Sponsor have the effect that all rights (and similar) to intellectual property (and similar) generated by you in connection with the conduct of a clinical trial by you is granted to the Sponsor of that clinical trial by you is granted to the Sponsor of that clinical trial. 16. Additionally, the Sponsor has the exclusive right to file patent applications in connection with the services provided and to apply the results of the research. 17. Under the Services Agreement, without the Sponsor's permission, your Parent may not publicise in any form the results of the R&D activities, nor disclose that the Sponsor has retained your Parent for professional services. 18. The Sponsor does not have rights to the intellectual property already owned by your Parent and used to perform the services. 19. Therefore we consider that examination of the first criterion of effective ownership supports a conclusion that the relevant R&D activities were conducted to a significant extent for the Sponsor. Control 20. The second identifying criterion is the nature and extent of the control that the entities exert over the R&D activities. 21. It is expected that when R&D activities are carried out by or on behalf of an entity, then that entity should have and exercise proper control over the conduct of those activities. 22. Factors demonstrating an appropriate degree of control include: · Choosing the project of R&D activities · Deciding on major changes in direction of those activities · Stopping an unproductive line of research · Deciding whether to follow up (or not) an unexpected result · Deciding whether to end a project 23. The Services Agreement describes the substance of the parties' roles indicating the Sponsor's essential function in research and development of pharmaceutical products and your Parent's role as an R&D service provider. It also highlights that your Parent is an independent contractor. 24. If the Sponsor wishes to change the scope of the Services or obtain additional services not initially covered by the Agreement, the Sponsor must submit specifications to your Parent and your Parent will provide a cost estimate for the changed or additional services. 25. The Services Agreement may be terminated by either party for cause such as a breach, default or insolvency but only the Sponsor has the right to terminate the clinical trial and the agreement without cause. We consider that the ability to terminate the project without cause is indicative of ultimate control of the project. 26. We consider that the ability to set and change the parameters of the R&D activities and to terminate the Agreement without cause gives the Sponsor effective control over the R&D activities supporting a conclusion that the relevant R&D activities were conducted in substance for the Sponsor. Financial risk 27. The third identifying criterion is the degree of financial risk that the entities are assuming when the R&D activities are undertaken. Where R&D activities are carried out for a company, it would generally be expected that it would bear the financial risk of the R&D activities undertaken. There is no guarantee that your Parent will receive consideration equal to or greater than its expenditure from the Sponsor. 28. Whilst due to unforeseen circumstances, some contracts may not prove to be profitable, in an arms-length commercial arrangement between multinationals, it is considered very unlikely that your Parent would intentionally contract to perform its services without profit, or at a loss. Therefore it is expected that, whilst there is no guarantee that every clinical trial will be profitable, your Parent would intend to charge its Sponsors a fee that transfers the financial risk to the Sponsor and therefore would only bear part of the financial risk in exceptional circumstances. 29. Under the Sponsor contracts it is the Sponsor who submits the results for approval and bears the risk of whether the activities will be successful and the results are suitable for the desired purpose. The Sponsor acknowledges that the results of the clinical trial are inherently uncertain and that your Parent cannot warrant that the clinical trial results will enable the treatment to receive any approval required from the relevant regulatory authorities. The Sponsor agrees to indemnify your Parent against any potential 3rd party claims associated with the conduct of the research. 30. These paragraphs indicate that regardless of the results of the R&D activities, where your Parent carries out the services under the conditions set out in the Sponsor Contract, the agreement is complied with and your Parent should receive the agreed consideration. 31. Accordingly it is considered that under the terms of the Sponsor Contracts the Sponsor would normally bear the majority of the financial risk of the R&D activities. Consideration 32. Weighing up the factors of effective ownership, control and financial risk show that your Parent and the Sponsor both satisfy to some extent each of the factors indicating that the R&D activities are conducted "for" them. However, taking into consideration these factors with reference to the benefits that you and your Parent are expected to gain and their individual interests in the results of the R&D activities conducted in connection with the projects to which this Ruling applies, compared to their relative expenditure, leads to the conclusion that the activities are conducted, to a significant extent, for the Sponsor, who receives the majority of benefits arising from expenditure on R&D activities. Subsection 355-210(2) 33. Having determined that the R&D activity is conducted, to a significant extent, for the Sponsor, subsection 355-210(2) will apply if the Sponsor is an entity not covered by any paragraph of subsection 355-210(1). 34. The note to subsection 2 reflects the facts of this case: Note: An entity would not be covered by, for example, paragraph (1)(c) if the conditions in section 355-220 were not met for the R&D activity in relation to that entity. 35. Paragraph 355-210(1)(c) relevantly provides that an R&D activity to which section 355-210 applies is where (c) the R&D activity is conducted for one or more foreign residents who are each: (i) incorporated under a *foreign law; and (ii) a resident of a foreign country for the purposes of an agreement of a kind described in subsection 355-35(2); and the conditions in section 355-220 (activities conducted for a foreign entity) are met for the R&D activity 36. One of the conditions in paragraph 355-220(1)(c).is: (c) when the R&D activity is conducted: (i) each foreign resident is *connected with the R&D entity; or (ii) for each foreign resident-either the foreign resident is an *affiliate of the R&D entity or the R&D entity is an affiliate of the foreign resident; 37. "Connected" is defined in subsection 328-125(1) as follows: An entity is connected with another entity if: (a) either entity controls the other entity in a way described in this section; or (b) both entities are controlled in a way described in this section by the same third entity. 1. "Control" as described in section 328-125, involves ownership, or the right to acquire a percentage of ownership of interests in the other entity which carry rights to receive income or capital or to exercise voting power in the company. 2. In this case the Sponsor and your Parent, including each of its subsidiaries, are independent parties with no connections that meet the definition of "control" in section 328-125. 3. "Affiliate" is defined in 328-130 as follows: (1) An individual or a company is an affiliate of yours if the individual or company acts, or could reasonably be expected to act, in accordance with your directions or wishes, or in concert with you, in relation to the affairs of the *business of the individual or company. (2) However, an individual or a company is not your affiliate merely because of the nature of the business relationship you and the individual or company share. 4. The Sponsor is an independent party to your Parent, and to each of its subsidiaries, and there is no suggestion that either party would act in accordance with the other's directions or wishes, or in concert, in relation to the affairs of the business of the other. 5. Having failed one of the conditions in section 355-220, the Sponsor is an entity not covered by any paragraph of subsection 355-210(1). Therefore as the R&D activities have been conducted to a significant extent for the Sponsor, the activities are not an activity to which section 355-210 applies. 6. It follows that you cannot deduct expenditure incurred on those activities under section 355-205.