“Guilty until proven innocent”: Tax office R&D audits leave startups facing “financial ruin”

Reactive, aggressive and inconsistent.

Those are just some of the words small business ombudsman Kate Carnell has used to describe the administration of the R&D tax incentive by the tax office (ATO) and the Department of Industry, Innovation and Science (AusIndustry).

In a scathing report published Thursday, the Australian Small and Family Enterprise Ombudsman (ASBFEO) directly linked the behaviour of federal regulators to a “scaling down” of research and development efforts by startups in Australia, calling for sweeping changes to the oversight of the Morrison government’s largest private-sector R&D support program.

Twelve months after high-profile startup Airtasker was hit with a multimillion-dollar back payment bill for R&D incentives, the ombudsman has “grave concerns” many others face “financial ruin” from copping tax office audits several years after receiving their refunds and investing.

Speaking to SmartCompany on Wednesday afternoon, Carnell said the ATO and AusIndustry have “changed their attitude” since the inception of the R&D incentive in 2011, moving away from a collaborative approach in what appears as an “attempt to claw back dollars rather than focusing on increasing R&D”.

“It’s guilty until proven innocent,” Carnell says.

The comments come just a week after the Morrison government unveiled a tranche of controversial R&D tax incentive reforms that will rip an estimated $1.8 billion in taxpayer support from the program over four years and create about $26 million in compliance costs for business.

Startups and technology companies report becoming wearier of tax office and departmental R&D crackdowns following the Coalition government’s initial announcement of the cost-cutting measures in 2018.

Airtasker co-founder Tim Fung was asked to pay back millions in R&D incentives.

But Carnell says the screws have tightened so much on the scheme that it’s no longer delivering what it says on the tin: encouraging innovation. 

“You can’t have a situation where you go back three, four, even five years and ask businesses to pay back what can be significant amounts of money,” Carnell says.

“The retrospective approach taken is obviously not fit for purpose.”

Carnell says she’s concerned falling rates of R&D investment are stymying the competitiveness of Australian businesses, revealing startups aren’t applying for the incentive program for fear of clawbacks.

“They’re just too worried that down the track somewhere they’ll end up being audited and having to pay it back,” Carnell says.

Some companies have gone as far as recording R&D tax incentive refunds as liabilities on their books, recognising they may have to repay the money, the inquiry details.

Ombudsman pitches “sweeping changes”

The ombudsman has made 24 recommendations for overhauling how the ATO and AusIndustry regulate the R&D program, including measures to reduce complexity, increase certainty and ensure integrity measures are timely.

There are four broad themes.

1. Where compliance examinations or audits are necessary, they should be done as close as possible to the first year of registration of a project.
2. Guidance material should be comprehensive, clearer, up-to-date and developed in consultation with small business.
3. Agency record-keeping requirements should be simplified to take into account commercial practicality for small businesses.
4. Small businesses should be assisted in identifying and retaining professional and responsible R&D consultants.

A tax office spokesperson said the regulator welcomes the report.

“We are currently in the process of reviewing the report and will be in a position to release a statement about the recommendations made at a later date,” the spokesperson said.

ATO ‘doesn’t understand’ software R&D

The 51-page report details a trend of increasingly stringent regulation of the R&D tax incentive since its inception in 2011, revealing claims against software-based applications —which account for a third of the 13,156 companies registered for the program in 2017-18 — have increased.

Meanwhile, there was a $700 million (13%) reduction in the tax offsets paid out under the tax incentive in 2017-18 from the prior year, even though the number of participating firms increased by 85 (0.7%).

Carnell says software companies have been held back by regulators which “don’t understand” what R&D looks like.

“We’ve had story after story from really innovative companies in this space saying they’ve tried to explain to the ATO, or for that matter AusIndustry, why what they’re doing is innovation,” Carnell says.

“All startups get is blank stares. They [regulators] don’t understand what R&D looks like in the software development space.”

Carnell says the preferred management models of software startups, often based on ‘agile’ or ‘rapid’ business methodologies, are creating conflicts and uncertainty when determining eligible R&D activity.

ATO Commissioner Chris Jordan has said the R&D tax incentive is a “problematic area”.

However, speaking at a small business event in August, commissioner of taxation Chris Jordan implied businesses are making ineligible software applications.

“There are a lot of apps around these days, so you have to be pretty innovative to qualify in terms of new ways of doing things,” he said.

“Adding a new subject matter for an app is not really within the definition of R&D.”

Unreasonable requests and legal grey areas

But the ombudsman’s report finds the ATO has progressively ramped up its compliance hurdles to the point that applicants are now being asked to provide unreasonable levels of documentation.

“The impact of this on R&D entities has been that businesses undertaking eligible R&D activities are having these rejected by both AusIndustry and the ATO,” the report reads.

“The follow on effect of this is that Business Expenditure on R&D in Australia has been declining since this process started.”

“We are aware of a number of software development businesses that have shifted development activities overseas or ceased R&D development completely.”

Further, the ASBFEO says it has reviewed correspondence where the ATO has told companies what R&D activities are not eligible under the program.

But there is “no legislative basis for the ATO to determine whether or not the activities are eligible under the legislation”, the ombudsman’s report reads.

“There would be occasions where an activity is clearly not eligible, such as an excluded activity, and where it would be administratively efficient for the ATO to make that judgement.

“There is however, a problem when the area is grey and where the matter requires investigation. In these cases, the ATO and its officers do not have the authority or the training to make determinations on the eligibility of the R&D activities.”

Regulators change tack

Both the ATO and AusIndustry have told the ombudsman they are changing their approach to administering the R&D tax incentive, amid criticism from Carnell that they’re applying a “one-size-fits-all” philosophy that disadvantages small business.

Late last month, AusIndustry unveiled a revised R&D incentive integrity framework, splitting applications into various risk categories depending on the perceived intentions of businesses.

Similarly, the ATO says it is developing additional guidance material to assist companies in maintaining records of their R&D expenditure.

“The ATO will provide broad guidance on record keeping requirements, but the diversity of companies from start-ups to large multinational companies will result in different record-keeping practices,” deputy commissioner Tim Dyce wrote in a letter to ASBFEO in October.

“In our updated approach to R&D compliance activities, we do work with companies and will seek secondary source documents which may assist in substantiating R&D expenditure where they are unable to provide primary evidence.

“We will also work with the company (and R&D consultant) to educate them [sic] what is required for future claims.”

AusIndustry is also in the process of engaging a third-party contractor to help it carry out R&D tax incentive integrity work, amid complaints businesses aren’t being given enough clarity or guidance about eligibility criteria.

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