The current R&D landscape and ATO guidance on Australian inbound investment

Background 

The inception of the R&D Tax Incentive (RDTI) regime over a decade ago saw a deliberate policy intent to attract R&D activities onshore in Australia overseas to create additionality and spillover. Broadly to do this, the RDTI regime provides two separate pathways for eligible R&D entities to access the Australian RDTI, the Australian owned R&D (AORD) pathway and Foreign owned R&D (FORD) pathway.

Where certain conditions are satisfied, the FORD pathway allows a foreign entity to undertake R&D activities in Australia via a permanent establishment, or an Australian company that is connected with or an affiliate of it, even if the R&D activities are funded by the foreign entity and the resulting IP is retained by the foreign entity.

To facilitate this policy from a statutory perspective, there are FORD exceptions to the ‘expenditure not at risk’ provisions and the overall ‘by or for’ integrity rule that replaced the ‘on own behalf’ test in the former R&D Tax Concession. 

That said, the claim for the RDTI offset under the FORD pathway must also form a part of the wider Australian company income tax return. This must reflect the transfer pricing position under which the Australian company or PE must receive commensurate consideration or payments from the foreign entity for performing the activities in Australia on behalf of the foreign entity.

Absent other deductions or tax losses, such types of service fee income derived by an Australian company from overseas will naturally absorb some of the R&D tax offset available and reduce any refund available under the refundable offset. 

In contrast, claims under the AORD pathway may avoid such a reduction and maximise an RDTI refund. Such an AORD pathway may be available where an inbound foreign company is seeking to establish a longer-term investment into Australia via a relationship with an Australian company that is not akin to an R&D service model. Should the Australian company’s commercial, financial and legal affairs demonstrate that in substance the R&D is being undertaken by the Australian company ‘for’ itself and not for the foreign entity, the Australian entity would be able to register an AORD claim. 

Where the AORD conditions are satisfied, there would be no expectation of receiving income or payments from an overseas entity for carrying on the R&D activities in question.  This also means that an Australian entity needs to be funded appropriately at the outset for the long-term, with the at-risk integrity rule still applying to AORD activities. 
An eligible AORD structure also has the advantage of enabling expenditures incurred on some linked overseas activities to be included in the RDTI claim where an Advance Overseas Finding (AOF) is obtained. 

Given the significant differences between these pathways, in practice it is critical to understand how these provisions apply in properly registering AORD or FORD activities. Incorrectly setting up the documentation and substance to the business, or incorrect characterisation of the R&D claim when the relevant integrity rules are not satisfied could permanently jeopardise an otherwise eligible R&D claim. 

Relevant ATO guidance 

The proper characterisation of eligible R&D activities must substantively align with the reality of the global structure implemented, and the accompanying transfer pricing positions or commercial rationale, the analysis of which has become more sophisticated over time. 

PCG 2024/1 sets out a detailed analysis of how the ATO will apply its resources to arrangements relating to the Australian development, enhancement, maintenance, protection and exploitation (DEMPE) activities in connection with intangible assets held offshore. This includes examples of Australian R&D service centres. That said, the simple understanding should be that as the value of any DEMPE activities carried out in Australia for another entity increases, so should the commensurate consideration or payments that Australia should receive for performing the activities.

With the elapse of time, the ATO has formed an opinion on the application of the by or for test to global structures, in particular in respect of the clinical trials and biotech industries, where Australian R&D activities can be outsourced and are also relevant to commercialising the underlying drug IP held overseas. 

This culminated in the publication of TA 2023/5 which set out arrangements of ATO concern “where an R&D entity has purported that the R&D activities were conducted for the R&D entity's own benefit, but those activities were instead being conducted for (or to a significant extent, for) a foreign entity that is 'connected with, or is an 'affiliate of the R&D entity (foreign related entity)”.

The remaining part of this article seeks to explore the detailed application of the ‘by or for’ test, including the significant extent limb, and discusses practical factors proposed inbound entities should consider when seeking to carry on and register R&D activities in Australia. 

‘By or for’ test 

The ‘by or for’ test is a critical integrity measure contained in section 355-210 of the Income Tax Assessment Act 1997 (ITAA 1997). The provision is a hybrid test which seeks to determine the entity (or entities) for whom the R&D activities are being conducted, and where if certain legislative conditions are not satisfied, the expenditure related to those activities will not be eligible. Critically, the test contains a perceived negative limb which requires consideration of all the entities the activities are being carried on for.  

Interpreting the term ‘for’

Broadly the provisions containing the by or for test make two separate enquiries: 

• For whom are the R&D activities being conducted; and
• Are the activities being conducted to a significant extent for more than one entity.

Critically, the two limbs do not represent a tiebreaker test, with the alternate postulates contained in the positive limb compellingly anticipating that R&D activities can, and will be, carried out for more than one entity. 

The interpretation of ‘for’ in this context is fairly well understood, being a direct continuation of similar provisions in the former R&D Tax Concession, with the current ATO website guidance detailing the following three factors which must be considered on balance: 

• Which entity has the rights of effective exploitation – who is the major beneficiary of the resulting intellectual property (IP)?
• Control – which entity has day-to-day strategic control of the R&D activities?
• Financial risk – who is the major benefactor taking the financial risks? 

Based on these factors, the positive limb requires that the R&D activities be conducted by the eligible R&D entity or conducted by another entity on its behalf (and anticipates that they may also be carried on for certain ‘covered’ foreign entities if specific conditions are also satisfied).  

However, a common error is to overlook the presence and importance of the negative limb, with the R&D activities being required to both satisfy the positive limb, and not fall foul of the negative limb. 

Analysis of negative limb provision

At its simplest, the negative limb has been perceived as a test to prevent the double claiming of expenditure incurred on a single set of R&D activities by more than one R&D entity. However, an examination of the drafting of the negative limb in ss.355-210(2) is critical, since at law it requires both:

• A consideration of whether the R&D activities are being conducted for more than one entity, and if so, to what extent for each entity; and
• If being conducted to a significant extent for any entity, whether that entity is ‘covered’ by the provisions set out in the positive limb. 
  Overall, the application of these linked provisions anticipates the following outcomes where it is considered that the R&D activities are being conducted for an entity other than the R&D entity itself:
• Should the other entity not be a significant benefactor, controller or beneficiary of the R&D activities in question, then the R&D entity may continue to make a claim for the whole of the relevant expenditure incurred on the R&D activities (as Australian-owned R&D (AORD) activities), subject to the at-risk provisions.
• Should the other entity be a significant benefactor, controller or beneficiary, but is broadly a foreign entity related to the R&D entity, then Australian R&D activities can remain ‘covered’ and therefore the related expenditure eligible – but only if the FORD conditions under ss.355-210(1)(b) and (c) are satisfied and relevant R&D activities are registered as FORD.  
• Should the other entity be a significant benefactor, controller or beneficiary but is an unrelated Australian or foreign entity, such as an overseas third-party, then the positive limb conditions cannot be satisfied, the R&D activities will not be ‘covered’ and the related expenditure will be ineligible (see ATO Private Binding Ruling). 

Importantly, under this statutory analysis, should a related foreign entity be a significant benefactor, controller or beneficiary of Australian R&D activities, but a claim is not made under the FORD provisions, the R&D activities may become wholly ineligible since they are not wholly covered by the postulates in the positive limb. 

Rather, there is a direct legislative expectation that where a related foreign party is a significant benefactor, controller or beneficiary of Australian R&D activities, then the R&D activities must be claimed as FORD activities, assuming that the requisite conditions are satisfied. 

Put another way, there is an intended legislative causality between the outcome of the application of the negative limb and whether R&D activities should be framed at law as either Australian or foreign-owned R&D activities. 

Determining ‘significant extent’ in practice 

In practice, this statutory analysis clearly hinges on the term ‘conducted to a significant extent for’ which must be based on the commercial substance of the arrangements and the extent, if any, to which a foreign entity is funding, controlling or benefiting from the R&D activities under consideration. 

Any conclusions formed must be based on an examination of the following factors in substance and effect; that is which entity:

• ultimately acquires ownership and exploitation rights in the resulting IP
• can impose restrictions on rights to exploit, rights to alienate and rights to manage the resulting IP
• assumes the financial risk in relation to any types of funds committed to the R&D entity for the purposes of financing the R&D activities
• sets the conditions for initial and subsequent funding of the R&D
• assumes the operational risks for the conducting of the R&D activities, or
• controls the strategic decisions regarding the R&D activities, including the instructions given to any outsourced entity as to the way the R&D activities are to be conducted.

In the context of inbound investment, these conclusions will naturally stem from the intellectual property and funding agreements executed, as well as any commercial rationale, transfer pricing documentation, and functional DEMPE analysis aligning with PCG 2024/1. 
Importance of economic substance in Australia 

The sufficiency of independent economic substance of inbound entities in Australia seeking to register AORD activities is currently a focus of regulatory attention. The ATO stated in TA 2023/5 that arrangements may in practice have a legal form that is inconsistent with the actual commercial substance of the arrangement between the entities, especially where there is little independent economic substance in Australia.

For the life sciences and biotech industries, this issue is exacerbated by the global nature of clinical trials, the presence of both the underlying drug IP and the clinical trial data IP, and the common practice of outsourcing local trials to clinical research organisations (CROs).

For effective AORD claims, our understanding of the ATO position is that they may expect to see long-term equity funding into Australia and the presence of strategic decision-makers on the ground, whether as employees or contractors. From the perspective of the effective exploitation factor, a direct correlation could also be expected between the reward or compensation accruing to Australia and whether the R&D activities are AORD or FORD:

• Comparatively low rewards for Australia as compared to a foreign entity, commensurate with its global contribution, are increasingly likely to indicate that the ATO may consider the nature of the R&D activities are foreign-owned. These may encompass limited territorial commercialisation rights, payment of royalties for use of underlying or core IP, or limited revenues from the resulting IP.  
• High global rewards commensurate with its contributions, such as a proportion of global commercialisation rights or revenues would indicate a stronger likelihood that the activities were carried on for the Australian entity.  

Conclusions 

Inbound R&D claimants must ensure that all RDTI claims substantially align with a realistic global analysis of activities, including the transfer pricing positions, and functional DEMPE analysis.  Typically, successful claims would require a team of corporate tax, R&D advisers and transfer pricing experts working together given the complexity and uncertainties of this area. 

Practical ways to obtain certainty at the outset could include applying for a private binding ruling from the ATO, or engaging at an early stage with the ATO, particularly the innovation team, to discuss the particular facts at play. In theory, we understand that the ATO has the view that it is possible for FORD claims to evolve into AORD claims as the inbound investment develops a more substantial presence in Australia over time. 

On a final note, a reminder that although of less potential cash-flow benefit, the ability to access foreign-owned R&D benefits still does remain a substantial tax incentive whilst carrying substantially less compliance risk. 

FOR MORE INFORMATION

If you would like to learn more about the topics discussed in this article, please contact your local RSM office.