On Monday 20th February the ATO released its Taxpayer Alert TA 2017/5 warning of review activity being undertaken by ATO and AusIndustry (who jointly administer the R&D tax incentive) targeting R&D tax incentive claims on software development projects where some or all of the expenditure incurred are not eligible R&D activities.
We have broken down the top nine risks in a clear and concise summary with some insight on measures that should be adopted to ensure that R&D claims satisfy the eligibility criteria.
Review Activity
In our view, this is another development in the general trend for increasing review activity for the R&D tax incentive due to perceived abuses of the incentive. Whilst review activities have be ongoing for some time now to ensure the integrity of the system, the ATO alert suggests there is currently a ramping up in the level of compliance activity. Accordingly, the likelihood of current and prior R&D claims being selected for review has increased.
Most review/audit activity actually occur after the R&D refund is received – this is something that people tend to forget – and if any issues arise the company may be liable to pay back the funds plus interest and penalties.
The tech industry is not the sole target of review activity. Earlier this month the ATO released alerts covering construction activities and ineligible ordinary business activities.
Risks Identified
The issues the ATO noted in the alert are all valid, but none of them are new:
RISK ONE
ATO concern
The software development project is being claimed on a whole of project basis.
Explanation
The meaning of R&D is very specific and it cannot be assumed that your entire development expense is automatically R&D eligible.
Risk mitigation measure
It is critical that a company first identifies specific elements of its development work that meets the detailed criteria, and ensure that only expenses relating to such activities are claimed. In doing so, record keeping will be a critical consideration. Azure Group have helped multiple startups put in place disciplined tracking of eligible R&D spend so it becomes a monthly habit of record keeping.
RISK TWO
ATO concern
The activities do not have the purpose of generating “new knowledge”.
Explanation
New software and new code do not automatically mean new knowledge.
Risk mitigation measure
There needs to be some innovation, novelty and meaningful degree of technical risk. A company must perform research to confirm the project satisfies this requirement and clearly articulate this in its R&D application.
RISK THREE
ATO concern
The activities are not undertaken to prove or disprove a hypothesis through experiments.
Explanation
A hypothesis is a supposition made that will be proven or disproved by testing and experimentation.
Risk mitigation measure
A hypothesis is the key starting point of an R&D claim and it must be articulated clearly.
RISK FOUR
ATO concern
There is no clearly identified technical uncertainty being addressed by the activity.
Explanation
The government regards technical risk to be a key ingredient in developing “new knowledge”. Without technical uncertainty, a company would not satisfy the “outcome cannot be known in advance” criteria.
Risk mitigation measure
Extra focus should be placed on articulating the technical uncertainty of the project, including documenting technical failures.
RISK FIVE
ATO concern
Project management, commercial or economic risks are mistaken for technical risks.
Explanation
Commercial and business risks are not relevant to the R&D claim.
Risk mitigation measure
The R&D application must not focus on non-technical risk.
RISK SIX
ATO concern
The activities involve the purchase of 'off-the-shelf' software and subsequent modification to integrate it into the existing environment.
Explanation
Such projects pose a higher risk because the ATO regards most or all of the activities involve the application of existing knowledge rather than the generation of new knowledge through experiments.
Risk mitigation measure
Before costs relating to such projects are claimed, take extra care to ensure the innovation and technical risks of the project are valid and well documented.
RISK SEVEN
ATO concern
The company includes the whole, or a large proportion, of their expenditure on the software development project in the calculation of their R&D Tax Incentive claim.
Explanation
Only “Core” and “Supporting” activities are eligible expenses.
Risk mitigation measure
Ensure appropriate documentation are kept to link expenses with “Core” and “Supporting” activities.
RISK EIGHT
ATO concern
Aggressive inclusion of overhead expenditure in the R&D claim.
Explanation
For example advertising and sales expenses, or overhead expenses are apportioned using a method that allocates an unreasonably large amount to R&D.
Risk mitigation measure
There must be a supportable and reasonable basis for calculating overhead expenses such as rent.
RISK NINE
ATO concern
Ineligible activities are treated as “Core” R&D activities.
Explanation
The following are noted as activities at high risk of being ineligible as Core R&D activities: Bug testing, Beta testing, System testing, Requirements testing, User Acceptance Testing, Data mapping and data migration testing, testing the efficiency of different algorithms that are already known to work, and testing websites in operation by measuring the number of hits.
Risk mitigation measure
Extreme care should be taken if the project is relying on the above activities as their Core activities. However it is entirely possible that they may still be eligible as “Supporting” R&D activities.
On a final note
The ATO “will be contacting companies directly to advise them of our concerns with their registered activities and/or their R&D Tax Incentive claims”.
A safe measure would be to refer any ATO enquiries to your R&D advisor as soon as you receive a call, they can then handle the communication with the ATO on your behalf.
To find out more about how Azure Group can assist with your R&D needs, visit our information page or contact us below.
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