WITH RESEARCH & DEVELOPMENT CLAIMS UNDER INCREASED SCRUTINY FROM THE ATO, NOW IS THE PERFECT TIME FOR COMPANIES TO TAKE A PROACTIVE APPROACH TO DOCUMENTING THESE ACTIVITIES.
The Research and Development (R&D) Tax Incentive provides a cash rebate or cash offsets for companies that engage in activities aimed at creating new or improved products and services. By receiving a portion of their taxes back for the expenditures they put towards these endeavours, companies can invest in innovation and advance their business operations.
Although the government is committed to supporting companies through this scheme, the refund is a significant drain on the tax system and budget resources. Small companies can claim up to 45 cents for every dollar they spend on R&D. For that reason, the Australian Tax Office (ATO) is taking measures to ensure enterprises claiming these credits are actually spending their claimed expenditures on these R&D activities.
How do companies know if their R&D claims are safe? What are the repercussions and how can they take a proactive approach to ensure they’re in the clear? We sat down with Phil Renshaw to learn more.
With more than 36 years experience in indirect tax, Mr Renshaw is a principal at BDO and a member of the National Steering Group for R&D Incentives.
Q. Why do companies need to worry about their R&D claims all of the sudden?
About four to six weeks ago, the Commissioner of Taxation issued a statement saying he’d become aware of some claims prepared by tax agents where the taxpayer could not substantiate either the R&D activities undertaken or the nature and level of expenditure claimed as a deduction. He didn’t go as far as mentioning the word ‘fraudulent’ but I think that term may very much at the back of his mind.
Of those initial audits undertaken by the Commissioner, a number of taxpayers have not been able to substantiate their claims - either because the R&D itself isn’t there, the expenditure incurred doesn’t relate to the activities of those industries, or the reported spend hasn’t been proven by robust record-keeping and as such cannot be substantiated.
Now there’s going to be a fairly significant audit compliance process focussing on claimants across the board, but especially in particular industries that have large claims that may be difficult to substantiate.
Q. How do you think the ATO will target companies for potential audits?
I would be looking at the profit and loss of claimants’ annual financial accounts or company reports.
For some enterprises, particularly startups and junior explorers, there may be no other revenue or income reflected in their accounts, so when you review the financial reports and cash operating statements, the R&D line item stands out because there’s nothing else around it.
From there, it’s a simple extrapolation to see if a taxpayer is claiming a reasonable amount. Say a taxpayer receives a refund of $450,000 and has only a million dollars incurred in expenditure for the full year. This means that the company has claimed every dollar it’s spent in that year as eligible R&D - this might well be accurate but it will also serve as a red flag if it’s not a correct reflection of the industry or that particular enterprise.
Additionally, after a series of audits, the Commissioner may form a view that some advisers may have a greater fail rate than others. And then that will promote the next level of interrogation, to particular clients and cities, or specific advisors to certain industries.
The Commissioner might also look at how companies paid their tax advisors. If you pay on a time and materials basis, such as per hour, that could be viewed more favourably than someone paying on a success fee basis. It’s not uncommon for agents to take 20-30 per cent of the cash rebate as their fee, which the ATO may view as an incentive to boost that claim as much as possible.
Q. What will the ATO be looking for during the audit?
If taxpayers have put in a claim for a million dollars, they’ll need to establish on what activities that amount was spent.
This isn’t something you can estimate. You have to be very, very precise in your calculations and in the documentation that supports it. This includes information like invoices from suppliers, timesheets for people working on R&D, and so on. You’d have to establish the percentage of the time actually spent on these activities.
Q. Are companies generally good about keeping this documentation?
In all fairness, it’s probably the weakest part of the process. The reality is that if an expense can’t be substantiated, no matter how strong it is, it shouldn’t go in the claim.
I think there’s a general sentiment within the ATO that companies aren’t taking this approach. Companies can say they’ve spent the money on R&D but have nothing to prove it, and they’ll put the claim in anyway. If there’s no documentation at all, the Commissioner will look at it as reckless - a more serious offence than simply being negligent or incorrect.
In certain circumstances taxpayers may be either estimating or padding it. Gilding the lily, you could say.
Q. What is the impact on the company from a financial perspective?
There are three levels to it.
If the ATO decides the claim is not eligible, the taxpayer will be required to pay back the cash refund received.
In the example I gave before, the company that spent a million dollars but can’t substantiate it will be required to pay back to the ATO $450,000 in cash, which he may or may not have in his bank account. The Commissioner also has the ability to review taxpayers prior year returns, and may go back three or four years, assessing all previous claims.
In addition, there are penalties starting at 25 per cent of the primary tax payable for a false or misleading statement and as much as 75 per cent for an intentional disregard of the law. It’s not uncommon to see 50 per cent as the base penalty for negligence, including cases where the claim simply can’t be substantiated.
To put this into context, if your cash offset was $500,000 and disallowed in full, and the ATO considered you were reckless in filing your R&D claim, you would be required to pay back the $500,000 plus a $250,000 penalty.
On top of that, there will be a general interest charge at a set percentage per annum, usually at 12 to 14 per cent. Interest is imposed based on the time use of money. If the refund was paid to you two years ago, the interest charge could be as high as $140,000, bringing the total payment to $890,000. And that continues to accrue additional interest over the period of time you aren’t able to repay the debt to the Commissioner.
This would be enough to break many smaller companies in the junior exploration, or technology startup phase, especially if they don’t have a strong financial backing.
Q. Are there any broader implications that companies and directors need to be aware of?
Successive Commissioners have been very vocal in their views on tax governance. The board of a company is responsible for the decisions made by the financial controller or the tax manager, whether they know about those decisions or not.
In the best case, this may result in fines being imposed on the directors in their own capacity.
More importantly however, if the Commissioner determines that an enterprise has acted fraudulently, and I repeat acted fraudulently, I would have every expectation that not only the office holders or executives of the companies be prosecuted, but potentially members of the board as well. This action can affect the individual’s eligibility to hold board positions in the future.
The Taxation and Administration Act has provisions for prosecuting office bearers for tax offences, with set-value fines. However, if the Commissioner believes the company is being fraudulent, he may refer to the Crimes Taxation Offences Act or the Crimes Act. Once you move into those Acts, the fines are a lot higher and a number of those actions can carry a jail sentence.
There have been many occasions in the past where company directors or office holders have been jailed for fraud, so this is something to take very seriously.
Q. How can taxpayers defend themselves if an audit is commenced?
The best form of defence is attack, so be on the front foot, expect what may be coming and put your claim together properly in the first place.
Next, if you’re concerned about something in your claim, you should get an independent review. The Commissioner would most likely look at a company that’s gone through that process quite favourably. He takes great comfort from these results - and that’s across a range of taxes, not just research and development.
At the outset, you should also consider the risks associated with having the work done under a ‘success fee’ arrangement, which can actually reduce your reasonably arguable position.
Q. What can BDO do to assist?
I’ll start by saying that we have a very robust process for how we advise clients on R&D incentive claims. Nobody is bullet proof, but our clients have that sense of comfort that everything is being substantiated properly.
At BDO, not only have we been successful at defending our clients’ claims, we’ve also gone to the next level of building a solid reputation with the regulators as to the quality of the work that we do. That assists us in the audit process when it occurs.
BDO as a firm can bring that reputation to other clients, including in an independent review function. That reputation of doing everything by the book and not having any of our claims overturned - would work well to assist defend a claim where companies engaged BDO for a review and we formed the view that the claim was valid.
For our clients, we also work on building up the appropriate documents and advising on the implementation of internal claim preparation processes. It’s a proactive approach that starts from the very beginning so the proper documentation is in place when tax return preparation rolls around.