Federal Court dismisses appeal over R&D claim

The Federal Court has upheld a decision by the Commissioner of Taxation determining that a company did not qualify for research and development (R&D) tax incentives as it had conducted significant R&D activities outside of Australia.

The R&D activities undertaken by the company were not covered by an Overseas Advanced finding as per the IRDA 1986 legislation.

The Federal Court upheld the Commissioner’s denial of the taxpayer’s R&D tax incentive claim, and the application of the penalty in T.D.S. Biz Pty Ltd v Commissioner of Taxation [2023] FCA 710.

The applicant in this case, TDS Biz, designed and developed an electric tricycle in the financial year ending 30 June 2014.

In January, February and May 2018, TDS Biz received three invoices from companies in China totalling $1,613,462. The January and May invoices were for vehicle components and the February invoice for electrical components.

TDS Biz lodged an R&D tax incentive application form to AusIndustry in August 2018 which included a description of its R&D activities and expenditure for the year ended 30 June 2018.

In its application, TDS Biz indicated that the R&D project had been conducted solely within Australia and that no overseas expenses had been claimed under the R&D tax incentive for the income year. It did advise in the application that components for the project had been sourced from overseas.

TDS Biz lodged an income tax return for the year ended 30 June 2018 and its research and development tax incentive schedule for the same year, obtaining a refund of $748,476.23.

Following a review of TDS Biz’s tax return, the Commissioner in July 2019 advised that an amended assessment would be issued whereby $1,613,462 of TDS Biz’s R&D notional deductions would be reclassified as general deductions, being the sum of the three invoices.

The Commissioner noted that TDS Biz did not have a finding under s 28C(1) of the IRD Act in respect of overseas activities conducted during the year ended 30 June 2018.

As a result, an amended notice of assessment for the year ended 30 June 2018 was issued.

The following adjustments were made:

(a) accounting expenditure subject to the R&D tax incentive was decreased from $1,720,635 to $107,173, a decrease of $1,613,462 (being the sum of the three invoices);

(b) refundable tax offsets was decreased from $748,476.23 to $46,620.28, a decrease of $701,855.95;
(c) a notice of assessment of shortfall penalty (penalty notice) for the year ended 30 June 2018 was issued, imposing an administrative penalty 50 per cent of the shortfall amount of $701,855.95 of $350,927.95.

The rate of 50 per cent for the administrative penalty was the base penalty amount provided for making a false statement recklessly, by item 2 of the table in s 284-90(1) of the Tax Administration Act 1953 (Cth) (TAA 1953).

The liability for the penalty arose under s 284-75(1) of the TAA 1953, because TDS Biz claimed amounts in the 2018 income year to which the Commissioner considered it was not entitled, and which the Commissioner considered constituted making a false statement in a material particular for the purposes of s 284-75(1)(b) of the TAA 1953.

TDS Biz prepared and submitted an R&D tax incentive registration variation to AusIndustry, registering its supporting R&D activities, and reclassifying the construction cost of the prototype from a core R&D activity to a supporting R&D activity, making no mention of any supporting R&D activities being conducted overseas to furnish components for the prototype.

AusIndustry approved TDS Biz’s variation request in August 2019 in relation to its R&D tax incentive registration for the year ended 30 June 2018. That registration was taken always to have existed as varied: s 27M(4) of the IRD Act.

TDS Biz objected to the amended notice of assessment by the ATO, both as to not allowing the tax offset claim and as to the administrative penalty.

The Commissioner then issued an objection decision in September 2020 advising that the objection to both the notice of amended assessment and the penalty notice were disallowed.

TDS Biz sought a review of this decision by the Tribunal. The Tribunal affirmed the two objection decisions.

The applicant contended that the Tribunal failed to apply s 27M(4) of the IRD Act, which provides that for the purposes of that Act and the ITAA 1997, the effect of a variation of its registration under s 27A was taken always to have existed as varied.

Justice James Bromwich said this argument cannot be sustained because the Commissioner accepted that TDS Biz’s supporting R&D activities do constitute “supporting R&D activities” for the purposes of s 355-30 of the ITAA 1997, being consistent with the variation request approved on 21 August 2019.

TDS Biz also argued that it did not require a finding under s 28C of the IRD Act because it did not undertake any R&D activities outside Australia, pointing to the distinction between the core R&D activities carried out in Australia, and the purchase of parts and components outside of Australia that were required for the dominant purpose of the Australian activities, which it described as not being R&D activities at all.

This argument involves a misunderstanding of the legislative regime, in part apparently due to a misreading or misunderstanding of an AusIndustry guide to interpretation and of comments made by a senior tax official, neither of which convey this mistaken understanding,” stated Justice Bromwich.

“Reliance upon such secondary sources was, in any event, never any substitute for reading the somewhat complex, but otherwise clear, legislative provisions.”

The regime for R&D tax concessions summarised only applies to expenditure on R&D activities, as defined, which means expenditure on core R&D activities or expenditure on supporting R&D activities that are sufficiently connected to core R&D activities, said Justice Bromwich.

“If an activity does not fall into one of those two categories, there is no basis for claiming any R&D tax offset,” he stated.

“To the extent that expenditure takes place on any overseas activities capable of falling within one of the two categories of R&D activities – core R&D activities or supporting R&D activities – that will only be able to be the subject of a claim for a tax offset if those overseas activities are also covered by a finding in force under s 28C(1)(a) of the IRD Act that those activities cannot be conducted in Australia, meeting all four conditions in s 28D for such a finding.”

“TDS Biz accepted that it could not meet several of the conditions in s 28D, so it could not have obtained the necessary finding.”