AAT decision cautions R&D Incentive claims involving trust structures

The recent decision in XQDX v Commissioner of Taxation[1] by the Administrative Appeals Tribunal (AAT) illustrates potential risks that may be involved where a Research and Development (R&D) Tax Incentive claimant operates through a trust structure. A company may be ineligible to deduct R&D expenditure if it fails to establish that the R&D expenditure was incurred for itself and not for the major benefit of the trust. The decision reminds claimants to maintain sufficient documentation and practices to establish they are eligible to obtain a tax offset for expenditure incurred on R&D activity conducted.

Case details

The applicant was a company that was also a trustee of a discretionary trust. In its capacity as a company (Company), the applicant claimed R&D expenditure for the 2012 and 2013 financial years. In its capacity as trustee of the discretionary trust (Trust), the Company carried on the business of developing and manufacturing custom shade solutions that required R&D.

The Company’s R&D expenditure was disallowed by the Commissioner on the basis they were not ‘incurred’ by the Company. The Commissioner imposed penalties totalling over $290,000 and the Company’s objection to this assessment was further disallowed. The Company then appealed to the AAT.

The AAT’s decision

The AAT found the Company had not ‘incurred’ expenditure and therefore could not claim an R&D notional deduction for the 2012 and 2013 financial years. The AAT also held that the R&D expenditure was not reasonably arguable.

Notable reasons for the AAT’s decision are highlighted below.

The R&D expenditure was incurred by the Trust

R&D expenditure is ‘incurred’ if a taxpayer has a ‘present existing liability’ to which the taxpayer is ‘definitively committed and completed subjected’[2]. In this case, the Trust funded the R&D activities:

  • While customers would contract with the Company for R&D work, all invoices were issued by the Trust and payment would be received in the Trust’s bank account
  • The Company did not own a bank account, generate or declare any income, or lodge a BAS for the relevant financial years
  • Invoices related to expenditure were made out to the Trust’s ABN
  • The Trust engaged all employees and contractors that worked on R&D, and it also paid their PAYGW.

The loan between the Company and Trust

The Company argued that a loan existed between the Company and Trust such that the company had a present existing liability to the Trust for the R&D expenditure incurred, and which was documented by entries in an inter-company loan account.

The Company also argued there were two contingencies that would trigger an obligation to pay back the loan amount:

  1. A receipt of tax refunds relating to R&D
  2. A final payout of the balance being ‘dependent upon a future sale or licencing of the IP to the Trust or a third party’.

The AAT rejected these arguments on the basis that:

  1. If the obligation to repay is contingent on a receipt of the R&D tax refund, then this expenditure would be incurred after the R&D expenditure is claimed. As such, the Company would not have been ‘definitively committed to the obligation to pay’ at the time of the R&D expenditure was incurred. Instead, it would have been incurred outside the relevant financial year.
  2. While witnesses claimed the Company owned IP related to the R&D work, there was no agreement (written or otherwise) to that effect. There was also no evidence provided that established the existence, the nature or the value of any IP. Thus, the second contingency for an obligation to pay was ‘illusory’.

The R&D expenditure was not reasonably arguable

The AAT was not satisfied the R&D expenditure claim made by the Company were reasonably arguable. The Trust had purchased, owned and operated the business, and employed and supervised personnel who undertook the R&D work. All funds used for the R&D came from the Trust. Accordingly, it was not reasonably arguable that the mere creation of an inter-entity loan account between the Company and Trust meant the Company ‘incurred’ the expenditure under tax legislation.

There was no definite obligation to repay the loan

The Company did not have a definite obligation to repay the loan due to the above contingencies. The AAT held that even if there was some obligation to repay, the two contingencies had ‘infected’ that obligation such that the Company was not ‘definitively committed to it’. Therefore, the R&D expenditure was not ‘incurred’.

The AAT also rejected the Company’s argument the loan between the Company and Trust was analogous to borrowing money from a bank. This was indicated by:

  • Primarily a total lack of any documentation recording obligations attaching the supposed loan and its repayment
  • No interest accruing on the balance of the loan account
  • No security that would attach to the loan.

Accordingly, the usual characteristics of a commercial transaction by which an obligation to pay (or repay) could be implied were absent. As there was no obligation to repay, let alone any documentation to substantiate this, the dealings between the Company and Trust were not carried out ‘on an arm’s length basis.’

BDO comment

The case illustrates some of the major challenges R&D businesses face when operating and conducting R&D activity through a trust structure, as a trust is not an eligible R&D entity.

This, however, should not detract businesses that operate and conduct R&D through a trust structure that has the correct entity structure and supporting documentation and practices in place, from accessing the R&D Tax Incentive.

BDO can assist entities with trust structures determine whether they can meet the legislative requirements to access the R&D Tax Incentive for their R&D activity. If you would like advice in relation to your R&D Tax Incentive claim contact your local BDO R&D adviser.

[1] XQDX and Commissioner of Taxation (Taxation) [2021] AATA 4070.

[2] Nilsen Development Laboratories Pty Ltd v Federal Commissioner of Taxation (1981) 144 CLR 616 at 627; Commissioner of Taxation v James Flood Pty Ltd (1953) 88 CLR 492 at 506.