Private ruling: Income Tax: Research and Development
Published: August 2014
Ruling period: Financial year ended 30 June xxxx | Financial year ended 30 June xxxx
Date scheme commenced: 1 July 20xx

Ruling: Q1: During the income years ending 30 June xxxx and xxxx, will the Company qualify for a notional deduction under Subdivision 355-D of the Income Tax Assessment Act 1997 in respect of expenditure funded from Participants' monetary contributions where those Participants cannot claim a notional deduction under section 355-580 of the Income Tax Assessment Act 1997 in respect of their monetary contributions? | A1: No | Q2: For the income years ending 30 June xxxx and xxxx, are the monetary contributions that are made by the Participants of the research program to the Company 'consideration' for the purposes of section 355-405 of the Income Tax Assessment Act 1997 ? | A2: Yes | Q3: For the income year ending 30 June xxxx and xxxx, is the Company eligible to claim a notional deduction under section 355-580 of the Income Tax Assessment Act 1997 in respect of expenditure that it incurs out of the Participants' monetary contributions? | A3: No

Relevant facts and circumstances: Unless stated otherwise, all legislative references are to the Income Tax Assessment Act 1997 . The Company operates as a research centre (RC) on behalf of the Participants and is responsible for its overall management and governance. In accordance with its agreement with the Participants and its contract with the Commonwealth, the Company expends funds received under the research program (RP) on activities that contribute substantially to Australia's national economic growth and the industrial and commercial growth of Australia's industry. ITAA 1997 contains within Division 355, provisions that govern entitlement to the R&D tax incentives. A participant can claim a notional deduction under section 355-580 if it complies with the registration and activities requirement of Division 355. The Company is registered with AusIndustry under section 27A of the Industry Research and Development Act 1986 for the relevant income years and incurs expenditure on R&D activities as defined in section 355-20 which are covered by section 355-210. The Company's R&D incentive applications for the relevant years have been submitted and approved by AusIndustry. RC is the arrangement between Participants and the Company whereby the Company and the Participants have entered into a Participants Agreement to establish, and for the Company to manage, govern and otherwise participate in, the RC. The program is administered by the Commonwealth under the research program. The Company operates the RC in accordance with the Commonwealth Agreement, the Participants Agreement and the Constitution of the Company. In its capacity as operator and manager of the RC, the Company receives funds from Participants and the Commonwealth. The Company uses those funds to undertake the R&D activities agreed to and specified in the Commonwealth Agreement. Participants voluntarily entered Into the Participants Agreement and agreed to pay to the Company the cash component of their Investment for the purpose of pursuing the activities and to apply to the activities the non-cash component of their investment, as specified in this agreement and Project Agreement. In relation to its R&D activities, the Company incurs expenditure which is funded from the following sources: i. Commonwealth funding under the RC program ii. Contributions from Participants of the RC iii. Interest from bank accounts and other income the Company derives In respect to contributions from Participants, the Participants advise the Company whether they can and will claim a notional deduction under section 355-580 for their expenditure in the form of monetary contributions under the RC program. Accordingly, the Company can identify the amount of the Non-Commonwealth funds it receives for which a notional deduction under section 355-580 has not been claimed by the participant.

Relevant legislative provisions: Income Tax Assessment Act 1936 section 73B | Income Tax Assessment Act 1936 section 73CA | Income Tax Assessment Act 1997 section 355-205 | Income Tax Assessment Act 1997 section 355-210 | Income Tax Assessment Act 1997 section 355-405 | Income Tax Assessment Act 1997 section 355-580 | Industry Research and Development Act 1986 section 27A Anti-avoidance rules | Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable. | We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part. | If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply. | For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax . | Issue 1

Reasons for decision: Summary: Broadly, section 355-205 provides a notional deduction for expenditure that an R&D entity incurs during an income year. Entitlement to that notional deduction is dependent upon the R&D entity incurring the expenditure on one or more R&D activities for which the R&D entity is registered for that income year under section 27A of the Industry Research and Development Act 1986 (IR&DA 1986). Further, such entitlement is only to the extent that such expenditure is incurred on those activities, and those activities must be ones to which section 355-210 applies. | Detailed Reasoning - R&D activities conducted 'for' the R&D entity and not 'to a significant extent' for other entities:: Section 355-210 broadly provides: • that the R&D activities that gave rise to the expenditure are being conducted 'for' the R&D entity (paragraph 355-210(1)(a)); and • that the R&D activities are not being carried out, to a significant extent, for one or more other entities not covered by any paragraph of subsection 355-210(1) (see, subsection 355-210(2)). Therefore, entitlement to a notional deduction under section 355-205 in respect of the Participants' Contributions will only arise if that expenditure is incurred on R&D activities, and those R&D activities are conducted 'for' the relevant R&D entity. Further, the R&D activities which gave rise to that notional deduction under section 355-205 must not be 'conducted, to a significant extent' for any other entity which does not satisfy one of the qualifying conditions in subsection 355-210(1). In explaining how to determine whether expenditure on R&D will give rise to a notional deduction in a particular entity, the EM explains at paragraphs 3.52 - 3.54 that: 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 who has the major benefit of the expenditure on R&D activities 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. The following is a discussion that examines the criteria discussed in the EM in determining the relevant entity for which the R&D activities are carried out. | Detailed Reasoning - Effective ownership: Effective ownership of the results relevant of the R&D activities is one of the identifying criterions in determining whether the R&D activities are being carried out for the relevant entity. However, it is recognised that this does not necessarily require that the entity must be the proprietor of a piece of Intellectual Property (IP), as formal regimes of IP may not be available to protect the results. Further, it is possible that the formal owner of the IP may hold it on such terms that the entity has all advantages of ownership. If a number of entities fund an R&D project together on their behalf, it is necessary that each must have a proper and effective interest in the R&D results. Under the scheme that is the subject of this Ruling, the Company uses contributions made by the Participants to fund the R&D activities. The Participants Agreement governs the rights and obligations of the Participants and the Company with respect to any results of the R&D activities carried out by the Company. It is clear from a reading from the Participants Agreement that the effective ownership of any specific intellectual property vests in the Participants as tenants in common, and are the relevant entities entitled to all income such as royalties, licence fees and other monetary proceeds from the commercialisation of the results produced from the R&D activities. Under the Participant Agreement, the Company only has a residual interest in these proceeds to the extent to cover costs incurred in commercialisation of the results from the R&D activities. | Detailed Reasoning - Control: With respect to this criterion, it is considered that the Participants, as a group, sufficiently control the R&D activities that they have contracted the Company to provide. The Participant Agreement together with each subsequent specific project agreement set the parameters for the R&D activities to be undertaken and the underlying philosophies which the Company is bound to follow. The Participants have effective legal control, as they have the ability to compel the Company to perform in accordance with the Participant Agreement. This is evidenced that the Participants Agreement which provides that "the Company…must not use or licence Project IP for any other research, training and education purposes except with the written consent of all the Project Participants". | Detailed Reasoning - Financial Risk: The final identifying criterion is the degree of financial risk that Participants are assuming when the R&D activities are undertaken. In accordance with the Participants Agreement, the R&D activities are funded through a combination of Participants' contributions, termed an 'Investment' which includes money, assets, personnel and facilities and services and Commonwealth funding. Under the Participants Agreement there is no provision for the contributions to be refunded to the Participants. As Participants' contributions are non-refundable, they bear the financial risk associated with the R&D activities undertaken using their contributions. | Detailed Reasoning - Conclusion: The effect of subparagraph 355-205(1)(a)(i) is that an R&D entity is only entitled to a notional deduction for expenditure incurred in an income year in relation to R&D activities conducted for the R&D entity which registered those activities under section 27A of the IR&D Act. Further, subsections 355-210(1) and 355-210(2) provide that the R&D entity cannot deduct its expenditure on R&D activities if it conducts those activities to a significant extent for another entity not covered by subsection 355-210(1). Having regard to the indicators of financial risk, effective ownership and control of the R&D activities, the Commissioner considers that the R&D activities are carried out for each Participant (contributor) to an extent that is commensurate with their contribution during the income year ended 30 June xxxx. Accordingly, the Company is not eligible to claim a notional deduction for monetary contributions made by Participants who do not satisfy the registration requirement of subparagraph 355-205(1)(a)(i) for the relevant income year, as that proportionate share of R&D activity cannot be said to be carried out for (previously referred to as on behalf of ) the Company, within the context of paragraph 355-210(1)(a). | Detailed Reasoning - Question 2: R&D expenditure which qualify for a notional deduction under section 355-205 is either limited or denied under the integrity provisions contained in Subdivision 355-F in certain circumstances. In respect of the present Ruling, given the conclusion reached under Question1, it is not necessary to consider the application of the integrity provision raised under Question 2. Therefore, the following response to Question 2 is premised on the assumption that the expenditure concerned otherwise meets the deductibility criteria in section 355-205. Section 355-405 in Subdivision 355-F, considers 'expenditure not at risk'. Specifically, section 355-405 provides that: 355-405(1) An R&D entity cannot deduct expenditure under section 355-205 or 355-480 if: a) when it incurs the expenditure, the R&D entity or its associate had received or could reasonably be expected to receive, consideration: i) as a direct or indirect result of the expenditure being incurred; and ii) regardless of the results of the activities on which the expenditure is incurred; and b) that consideration is equal to or greater than the expenditure. 355-405(2) If: (a) when an *R&D entity incurs expenditure, the R&D entity or its *associate had received, or could reasonably be expected to receive, consideration: (i) as a direct or indirect result of the expenditure being incurred; and (ii) regardless of the results of the activities on which the expenditure is incurred; and (b) that consideration is less than the expenditure; the R&D entity cannot deduct under section 355-205 or 355-480 so much of the expenditure as is equal to the consideration. In determining whether the R&D entity or its associate could "reasonably be expected to receive consideration" regard must be had to anything that happened or existed before or at the time the expenditure was incurred, and anything that is "likely to happen or exist" after that time: subsection 355-405(3) | Detailed Reasoning - Consideration as a direct or indirect result of the R&D expenditure being incurred regardless of the results of the R&D activities.: Subsections 355-405(1) and (2) will apply to the Company if, when it incurs the R&D expenditure, it had received or could reasonably be expected to receive 'consideration' as a direct or indirect result of the expenditure being incurred and regardless of the results of the activities on which the expenditure is incurred. The Australian Macquarie Dictionary (online, Multimedia) defines 'consideration' as: • a recompense for services rendered, etc.; compensation. • Law in a contract, or other legal transaction, the promise by which some right or benefit accrues to one party, in return for which the party who receives the benefit promises or conveys something to the other. The EM indicates (at paragraph 3.166) that the Commissioner will apply section 355-405 consistently with the way former section 73CA of the Income Tax Assessment Act 1936 (ITAA 1936) was administered. Section 73CA of the ITAA 1936 limited the deduction available under section 73B of the ITAA 1936 for research and development expenditure based on the extent that an eligible company claiming the deduction is 'at risk' in relation to its research and development expenditure. Taxation Ruling IT 2635 (IT 2635), at paragraph 18 says in respect of section 73CA of the ITAA 1936 that: Where a claimant [company] has received (or become entitled to receive) a recoupment or grant in respect of its R&D expenditure, then to the extent of such grant or recoupment the claimant is not at risk for the expenditure. IT 2635 paragraph 19 endorses the authority in the case of Dampier Mining Co. Ltd. v. FCT 78 ATC 4237 at 4249; (1978) 8 ATR 835 at 848' and states that: whether or not certain matters 'result in a recoupment should involve a substance approach with regard to the economic realities and not just contractual form. In the present case, the Participants Agreement governs the rights and obligations between the Company and the Participants with respect to the activities (including R&D activities) to be undertaken with respect to a specific project under the RC program. The Participants Agreement refers to the contributions made by the Participants as Investments. Centre Funds are broadly defined as the cash investment that the Centre received from Participants. It is clear from a reading of the above clauses that under the Participants Agreement, the costs of the R&D activities are borne by the Participants and not the Company and to the extent that the Company incurs expenditure on R&D activities, these expenses are funded out of the Participants' contributions. Where Participants fail to make a contribution, under the Participants Agreement the Company has a debt due that it could call upon. Therefore, the substance of the arrangement is such that the Company receives a grant or is recompensed in respect of its expenses on the relevant R&D activities. Therefore, the monetary contributions made by the Participants of the RC to the Company would be 'consideration' for the purpose of section 355-405. | Detailed Reasoning - Question 3: Section 355-580 provides a notional deduction for monetary contributions made by an R&D entity under the RC Program. An R&D entity is entitled to a notional deduction under subsection 355-580(1) in an income year: a) for expenditure it incurs to the extent that it is in the form of monetary contributions under the RC program; and b) if the contributions have been or will be spent under the RC program on one or more R&D activities for which the R&D entity is registered under section 27A of the IR&DA 1986 for an income year: It is the making of the monetary contribution in the circumstances described above that give rise to the notional deduction. Paragraphs 3.182 and 3.183 of the EM further explain that: 3.182 This Bill contains a new simpler treatment for entities participating in a research centre. The key change is that notional deductions arise when monetary contributions are made under the program rather than when those contributions are actually expended on the R&D activities of the centre. 3.183 An R&D entity is entitled to a notional R&D deduction for a monetary contribution it incurs under the program if the entity is registered for the activities on which the contribution is spent. The notional deduction does not arise until the entity is actually registered, which in some cases could be for an income year after the R&D entity incurs the contribution. However, the notional deduction for the monetary contribution still applies to the income year in which the contribution was incurred. It is clear from the reading of the above extracts out of the EM that the relevant deduction is in respect of expenditure incurred by way of the monetary contribution to the relevant RC program. In the present case it is a Participant entity that makes a monetary contribution that is registered as an R&D entity which is the relevant entity that is eligible to claim a notional deduction under section 355-580. Accordingly, the Company not being the relevant entity making the monetary contribution is not eligible to claim a notional deduction under section 355-580 in respect of expenditure that it incurs out of Participant contributions.