The intersection of taxation and innovation in Australia

The subject of Venture Capital has been debated widely over the past few years in Australia. The current debate surrounding changes to the Capital Gains Tax (CGT) regime in Australia to encourage the development of a venture capital industry is commendable. There are however, arguments that other more elegant mechanisms could be used to encourage investment in high potential ventures. This is not arguing against reform of the CGT, but research in the US by Professor Poterba from the Massachusetts Institute of Technology pointed to reductions in the US Capital Gains Tax in 1978 and 1981, not having the stimulation effect on venture capital that many believed. Professor Poterba argued the strong growth in the venture capital industry in the US may have had more to do with issues such as the relaxation of investment rules for pension funds, than with reductions in the CGT rate. Therefore alternative or complementary mechanisms to the reform of the CGT should be investigated when determining how the venture capital industry in Australia should be stimulated.

Whilst the venture capital industry in Australia is small in comparison to other countries, it is also limited in its geographical spread. An example of this is the Innovation Investment Fund (IIF) initiative, which has five licensed funds. All funds are located on the East Coast and the experience is that these funds are in the main not willing to consider investments outside their immediate geographical area. This fact is not so much a criticism of the funds - they are making investment decisions based on proven commercial experience - rather it is an indication of a need for government to do more as a catalyst of the development of resources and expertise in venture capital in areas other than two or three of the major population centres.

Our preferred position in relation to Government assistance for innovative companies is for open access programs such as the 125 per cent Tax Concession for R&D (the concession). This is the preferred route over discretionary schemes such as the R&D Start program which places the Government in the position of picking winners. A discretionary system lacks certainty from a taxpayer’s perspective, can take a significant amount of company resources both internally and externally to present the company case, and can be subject to various political influences beyond the control of the taxpayer.

However we have focused our efforts on examining the concession and its shortfalls. We have put forward a suggestion in relation to how the concession could form part of the new GST regime.

Shortfalls in the effective delivery of the concession

Historically, the concession has been an effective incentive that has been embraced by business over a long period. Business has generally found the incentive effective notwithstanding the somewhat cumbersome administration process. It is widely accepted that the concession has achieved the aim of encouraging R&D in Australia.

In 1996, the concession was reduced from 150 per cent to 125 per cent together with a number of legislative changes in specific areas of R&D expenditure. These moves effectively halved the tax benefit whilst simultaneously increasing the administrative burden to claimant companies.

With the reduction in the concession, companies have looked at the costs and benefits of:

1. undertaking R&D;
2. undertaking the R&D in Australia; and
3. claiming the concession.

Larger companies will often benefit more from the concession as a consequence of the nature and size of the R&D undertaken whilst also having the resources to more adequately deal with the compliance burden.

The converse is often true for smaller companies. The reduced benefit available may delay R&D activities, restrict the scope of activities or lead to a decision not to proceed at all. The cost of preparing a claim may seriously erode any taxation benefit arising. This has been alleviated in recent times with a move to reduced reporting requirements for smaller claims.

For start-up companies and those in tax losses, there is a cost incurred in preparing a claim for the concession with no immediate cash benefit. There is of course a deferred benefit by way of carry forward tax losses, but the ability to utilise these may not arise for a number of years. One way around this is to implement the Bureau of Industry Economics recommendation of paying the tax benefit of 9 cents in the dollar.

It is this feature of the concession we urge further consideration of and offer our ideas below as a potential solution.

Incorporation of the concession within the GST as an Indirect Tax Concession

There have been a number of areas receiving concessional treatment with the introduction of the GST legislation as follows:

1. Wine Equalisation Tax ;
2. Diesel Fuel Rebate;
3. Luxury Car Tax;
4. GST Free for supplies of health and education;
5. Some food GST free; and
6. Student book subsidy.

Each of these GST treatments or GST adjustments represent examples where the Government has been prepared (or was obliged) to make changes to the standard GST treatment for reasons based broadly on social equity, national health or environmental grounds.

R&D directed to accelerating national wealth creation through commercialisation of innovations stands, we believe, on par with the above listed examples as a public and economic good. We believe that the existing Concession under the Income Tax Assessment Act 1936 ("ITAA") should be brought under the GST legislation as follows:

• introduce a concessionary input tax credit based on eligible R&D expenditure identical to the current concession;
• include a notional credit for R&D salary & wages (currently outside GST scope); and
• ensure the value of the concession is maintained, if not bettered.

The benefits are as follows:

1. likely retention of the existing legislative framework;
2. continued application of the case law and precedents;
3. immediate cash flow benefits for both profitable and loss companies;
4. "merged" compliance costs. All enterprises must in the future comply with the GST. Those who conduct R&D would make R&D input taxed concession claims as allowable adjustments, applying similar administrative requirements;
5. flow on benefits of improved "real-time" R&D accounting in order for companies to claim any adjustment in a timely manner. This would improve their project management skills and be of cumulative national benefit;
6. provide comprehensive means of near real time measure of national R&D expenditure (limited to amounts claimed);
7. provide an option to be an either/or concession with companies electing which scheme they will claim under (ITAA or GST); and
8. eligibility could be confined to companies/public trading trusts and thereby exclude public sector enterprises. The latter would then be at a competitive disadvantage if they do not proceed to incorporate (this may act as a flow on benefit to force universities and the CSIRO to have a more commercial outlook).

Finally, we note that the outcomes of the Ralph submission may alter the company tax rate and/or the basis of taxing (profit or a cash flow surrogate), and this outcome may drive further need for change to the current Concession.

Administrative Implications

It is proposed that the existing process of registration be maintained. We are of the view that it is important that some formal registration process be maintained as it serves an important purpose of assisting to ensure the integrity of the concession.

Under the above periodic claim process, taxpayers would effectively be claiming the concession throughout the year. Currently, companies can only submit an Application after the end of their financial year. There is a risk therefore that companies may claim a concession during the year for activities that may be ineligible. Whilst there is currently an advance registration process, taxpayers using this process must still submit an Application, which is a duplication of effort.

As the information required for an Advance Registration is similar to that required for an Application. Advance Registration might act as the formal registration of activities, doing away with the current post year end Application. This requires forward planning of R&D activities but will not cover activities commenced during the year that were unplanned. A mechanism to allow such activities to become registered would be required.

Incorporation of the concession within the PAYG system

If the concession remains under the Income Tax Assessment Act, the concepts expressed above can also be applied to the proposed new Pay As You Go system albeit with some modifications.

By allowing a periodic claim for the concession through the PAYG system, profitable companies are able to offset any tax payable against the concession thereby achieving a reduced periodic tax bill. However, modifications to the legislation would be required to allow cash refunds for R&D expenditure by taxpayers in loss situations. This might be limited to particular criteria such as:

• taxpayers determined to be "small" by reference to their "likely tax" (as currently calculated);
• only taxpayers with a likely tax less than a specified threshold;
• only taxpayers with a likely tax less than zero; and
• by level of R&D expenditure.

The references to registration made above apply equally here as do the list of benefits provided.