Boosting Investment in R&D in Australia via the tax system

1. Boosting Investment in R&D in Australia via the tax system Dept presentation 24 June 2011 Nance Frawley

2. Using the tax system for purposes beyond revenue raising Our tax system contains many provisions that aim to stimulate certain behaviour or alternatively provide benefits/support for certain taxpayers Tax expenditures – not for revenue raising; in fact reduce potential revenue (similarities to direct govt spending, but administered thru tax system) 2010/11 year estimates- $243 billion will be raised in taxes; approx. $49 billion will be forgone in tax expenditures (v. difficult to accurately measure)

3. types of tax expenditures Income tax payable = taxable income x tax rate – tax offsets (ie assessable income- deductions) A tax expenditure connected to income tax* can be considered as any tax provision that reduces the amount of income tax payable. Ie Income exemptions (ie making certain types of income non-assessable either because of category of income or category of tax payer) Concessional deductions (ie allowing greater than 100% deductions for certain expenditures- limited benefit for t/ps in tax loss position) Providing tax offsets/tax credits (apply directly to reduce tax liability - can be refundable or non-refundable; decoupled from the tax rate) Applying a lower tax rate to certain tax payers

4. Tax expenditures for R&D Currently Australia provides R&D tax deductions ( either 125% or 175% ) for eligible R&D. Effective from 1 July 2011 ->R&D tax Credits NOT deductions -SMEs (grouped t/o less than $20m) -> 45% refundable tax credit (to be paid quarterly from 2014). -Larger companies -> 40% non-refundable tax credit. Note: importance of grouping rules as integrity measure

5. Some stats current estimate of cost of R&D tax concession for 2010/11 financial year- $1.563 billion Approx. 8000 claimants Most of the $ goes to large companies Small number of very large claims- particularly from mining & construction industries

6. Parliamentary Process & the new R&D tax credit 2009-10 budget Rudd govt announced the change to R&D tax credits in (to take effect from 1 July 2010) – consequence of several years of investigations & reports The new R&D Bill has twice been passed by the House of Representatives BUT not yet passed by the Senate (Coalition opposed) Last week (15/6/11) - joint media release by Treasury & DIISR- crossbench support achieved (ie a deal done with the Greens; some conditions imposed) ; change in Senate composition 1/7/11 R&D credit will become law by second half of year; retrospective to 1 July 2011

7. Basis for govt support of business R&D R&D stimulates generation of new knowledge, new technology & new processes spillover benefits to community Market forces alone result in suboptimal levels of business R&D Only one part of innovation theory Tax incentives only one form of govt support for R&D

8. How does Australia perform on the world stage? BERD intensity- important measure of R&D performance Latest available figures 08/09- Australia’s BERD was $16,858. BERD : GDP was 1.34% ( OECD average is 1.63%) Australia currently 11th out of 30 OECD countries (08/09- now 34 countries in OECD) Large businesses accounted for 71% of BERD Note: OECD Frascati Manual – internationally accepted definition of R&D-covers pure basic research, strategic basic research, applied research & experimental development- most of Australia’s BERD relates to experimental development and applied research. In 08/09 basic research only accounted for 5.7%

9. BERD & the R&D tax concession BERD in 70s & 80s- very low & declining- upward trend in most OECD nations 1986- R&D tax concession introduced BERD = Strong upward trend from 1991 to 1996 1996 – R&D tax concession rate dropped from 150% to 125% BERD= substantial decline between 1996 to 2000 (dropped to 0.64%) 2001- changes to R&D tax concession, particularly intro of R&D tax offset for small companies BERD- steadily rising since 2001 BUT BERD figures should not be viewed in isolation- in some instances Australia’s productivity growth was growing rapidly even though BERD intensity was low

10. A bit more detail on our current R&D tax incentives 4 elements: Basic 125% tax deduction 175% incremental premium deduction- introduced in 2001; aimed at encouraging companies to increase their R&D expenditure above a rolling 3 year average; modelled on OS systems. Not very successful 175% international premium- introduced 2007; multinationals with Australian subsidiaries; to encourage choice of Australia as location for R&D. Not very successful. Refundable tax offset for small coys (t/o < $5m, R&D spend limited to $2m)- introduced 2001; very successful but very restricted access.

11. Administration of the R&D tax concession Self assessment; but high use of specialised consultants Jointly administered by ATO and Innovation Australia interesting issues re compliance, division of powers etc ATO tends to deal with costs issues; Innovation Australia tends to deal with technical issues. Applicants can be audited by either or both Registration of R&D activities with Innovation Australia, compulsory- must be registered within 10 months of end of financial year after R&D activities carried out. NOTE: New R&D Bill- gives significantly greater powers to Innovation Australia than currently exist

12. What is the govt saying about the new R&D tax credit? The benefits are more generous, especially for SMES More robust & stable incentive with greater certainty for business Budget neutrality- clearer definition of R&D activities & simpler for claimants Will deliver more support to more businesses Expanded access to foreign companies who undertake R&D in Australia & who hold IP offshore Will align with international best practice WILL COME BACK TO THIS…….

13. Brief background Hawke Govt introduced 150% (deduction) R&D tax incentive in May 86 (initially temporary measure)- political economy at time- shift away from heavily protectionist policies to integration with global economy First review 1987- lead to intro of syndication –> rorting ; abolished 1996 (also retrospective claims abolished in 1996) Howard Govt cut rate to 125% in 1996, then made significant changes in 2001 (‘Backing Australia’s Ability’) including introduction of 175% incremental premium & refundable tax offset for small companies; plus requirement to prepare R&D plan (based on 3 significant Evaluation Reports) Over the years other major changes to: feedstock rules, R&D building expenditure; R&D plant; interest payments; core technology; expenditure considered ‘not at risk’

14. Lead up to the new R&D tax Credit Number of Evaluation Reports prepared most significant: 2007 Productivity Commission Report (‘Public Support for Science and Innovation’) 2008 Cutler Review (Review of the National Innovation System- Venturous Australia ‘Building Strength in Innovation’)

15. 2007 Productivity Commission Report (‘Public Support for Science and Innovation’) Key Findings: • The R&D tax concession did not screen out R&D that would have occurred regardless • Net benefits to community would substantially increase if the base incentive (ie 125%) was accessible only by small companies & large companies could only claim 175% premium

16. 2008 Cutler Review (Review of the National Innovation System- Venturous Australia ‘Building Strength in Innovation’) Suggestions on R&D tax concession: change to R&D tax credits with refundable 50% tax credit for companies with t/o less than $50m and non-refundable tax credit of 40% for larger companies Allow access to benefits to multinationals who carry out R&D in Australia Note govt response ‘ Powering Ideas’ (2009) expressed support

17. The Consultation Process Public submissions invited for PC Report & Cutler Review Public Consultation Paper on proposed new R&D Tax Credit released Sept 09; public forums First Draft of Legislation released- 18 Dec ‘09(just before Christmas)- harsh criticisms of proposed substantially reduced eligibility of many currently claimed R&D activities Second Draft of Legislation released 31 March ’10 (just before Easter!)- feedstock rules removed- promise that new feedstock rules would be the same as existing rules; eligibility criteria softened slightly; significant change to language & terminology

18. What elements of the new R&D tax Credit have attracted the most support? Tax credit better than tax deductions Greater access to refundable tax credit than currently exists (providing stricter eligibility criteria are satisfied) Removal of incremental 175% premium has attracted very little negative comment Greater access for multinationals & relaxing of IP rules Biotechnology & Pharmaceutical sectors v. happy (basic research) Removal of requirement to prepare an R&D Plan

19. What elements of the new R&D tax Credit have attracted the most criticism? Substantially increased restrictions on eligibility of R&D activities Introduction of new test ‘ dominant purpose test’ for R&D supporting activities- adds to complexity & compliance burden plus ignores commercial realities & prejudices small companies who cannot afford to carry out R&D in isolation from commercial activities Favours basic research over research and development (or applied research)- prejudices mining & construction sectors & probably manufacturing sector Generally increases compliance burden Feedstock rules

20. Response to govt claims about the new R&D tax credit The benefits are more generous, especially for SMES- Only at one level-need to consider impact of restricted eligibility More robust & stable incentive with greater certainty for business–Maybe but time will tell; uncertainty re application of dominant purpose test; feedstock rules & increased powers of ‘Innovation Australia’ Budget neutrality-Cost Cutting instead ?? Why no modelling??

21. Response to govt claims about the new R&D tax credit cont. clearer definition of R&D activities & simpler for claimants- But loss of 25 years of claimant understanding & jurisprudence Will deliver more support to more businesses- Only if the business meets new stricter eligibility reqs; more support probably available from ‘Innovation Australia.’ Will this reduce use of consultants? Expanded access to foreign companies who undertake R&D in Australia & who hold IP offshore -Yes, Agreed 7. Will align with international best practice – Not sure- further comparative research required.

22. Time will tell The government promises it will carry out a comprehensive review of the new R&D Tax credit in the next few years