Tax reforms

Overview
The Cutler Report notes that tax has a strong effect on all kinds of economic behaviour, including innovation. In this respect the Report observes that in relation to incentives for business to fund R&D expenditure:

• the link between the rate of company tax and economic growth is strong, and although Australia has cut its corporate tax rates, it has not done so as aggressively as other OECD countries so that its corporate tax rate is now above the OECD average;
• the data surrounding the effectiveness of the R&D Tax Concession (consisting of the 125% R&D Tax Concession, the Tax Offset, the 175% Premium Concession, and the 175% International Premium Concession) (Concession) is poor;
• despite the paucity of data, it appears the Concession does not do enough for firms in tax loss, which are often the most innovative – many start-up firms are too large to qualify for the Tax Offset, yet are not successful enough to access other aspects of the Concession for years (if at all);
• the Concession is typically accounted for “below the line” (and so does not influence a range of business decisions);
• the effective value of the Concession has decreased over time as the corporate tax rate has fallen; and
• accordingly, the Report recommends that the Concession be replaced with a simplified tax credit, described in more detail below.

Corporate tax rate
The Report notes that there is a strong negative correlation between growth rates and corporate tax rates. Reductions in corporate tax help to stimulate foreign investment and, some studies have shown, increase entrepreneurialism. While Australia has lowered corporate tax rates, it has not done so as aggressively as other OECD countries, with the effect that Australia’s corporate tax rates are now above the OECD average.

The Report acknowledges that lowering the corporate tax rate will have a negative impact on revenue collection, but notes that there have been recent proposals for a revenue neutral reduction in the company tax rate funded by the abolition of dividend imputation, which evidence suggests are not fully valued by the market.

The Report states that appropriate forum for considering these issues is the Australia’s Future Tax System Review, chaired by Dr Ken Henry.

R&D Tax Concession
The Report notes that the Concession is the largest single government innovation outlay.

It notes that data relating to the success of the scheme is poor, and that analysis of what data is available is complicated by outside factors which likely played a large part in influencing R&D expenditure. For example, data shows that there have been upturns in business expenditure on R&D on introduction of the R&D Tax Concession in 1985, and a downturn when the concession rate was reduced from 150% to 125% in 1997. However, the growth may also have been driven by the need for Australian companies exposed to the international market in the 1980s to become more competitive, while the downturn may be explained by the abolition of the ability to syndicate rather than the reduction in the concession rate.

It was noted that the nature of business investment in R&D had changed over time – in 1985 the prevailing model of business research centred around in-house corporate laboratories, but the prevailing model today is open innovation – which suggests that a review of tax incentives designed to stimulate R&D expenditure is timely.

Aside from the fall in the effective value of the Concession (which had been reduced by 3 times since 1985 as a result of a reduction in the concession rate and the lowering of the corporate tax rate), the Report questioned the success of the scheme in incentivising companies to spend more on R&D because eligibility criteria meant that many companies were not able to access any element of the scheme.

Companies in tax loss – which are most crucial to innovation – were particularly disadvantaged to the extent they were too large to access the Tax Offset, because anti-avoidance measures meant the natural attractiveness of tax losses to an acquirer often could not be exploited. The Report acknowledged that while such anti-avoidance measures are necessary, such measures have a dampening effect on investment in start-up companies.

Finally, the Report notes that even if eligibility criteria are met, it may not positively influence firms’ behaviour. The Concession is accounted for “below the line” and so does not factor sufficiently into decision-making, reducing the impact that the Concession can have on decisions relating to R&D expenditure. Further, delays in accessing the benefits have an adverse impact firms’ behaviour – paying benefits in the year post-expenditure may not be soon enough to positively influence behaviour.

Instead, the Report proposes:

• a non-refundable tax credit of 40% to support all R&D activity undertaken in Australia; and
• a refundable 50% tax credit for smaller firms (with a tenfold increase in what is considered a small firm – from $5 million to $50 million),
  which in each case apply to any research activity carried out in Australia, regardless of firm ownership.

A tax credit is accounted for “above the line” in firm budgets and so will have a more direct effect on firms’ decision-making. The simpler rules will also make it easier for firms’ to assess the impact of the credit, and take appropriate decisions.
The Report emphasises that tax-based entitlement measures are not suited to supporting large joint or collaborative projects and that additional programs more directly suited to these areas be maintained.

Scope of R&D activities
The Report notes that the scope of R&D supported by tax-based incentive schemes should be broadened beyond R&D entailing substantial technical risk. If it is impractical to do this with either the Concession or the tax credit, alternative programs should be developed. Specific recommendations include:

• R&D on open source programs should qualify for the multiple sale test and potentially benefit from relaxed requirements in relation to the degree of “technical risk” required, since development of open source software generates clear spillovers for the rest of the community;
• the ability of “whole of mine” and similar claims to access the Concession, or the proposed credit, should be constrained.

Recommendations
In summary, the Report calls for:

• a return to a classical tax system with a lower corporate tax rate and the abolition of dividend imputation;
• changing the incentive system from a tax deduction to a tax credit – specifically a 40% non-refundable credit available to large firms and a 50% refundable tax credit available to small firms, redefined to be firms with turnover under $50 million;
• all R&D undertaken in Australia which meets relevant definitions be eligible for the tax credit;
• further work should be undertaken to determine the feasibility of expanding the scope of R&D eligible for the tax credit; and
• managing the timing of payment of the tax credit (but having regard to the likely benefit versus the administrative and compliance costs and the need to manage risk).