Labor Senators' remarks on the consequences of the 2020-21 Federal Budget for the Treasury Laws Amendment (Research and Development Tax Incentive) Bill 2019
In his Budget speech on 6 October 2020, the Treasurer announced that the Government would introduce changes to the Research and Development Tax Incentive (RDTI) that negate many of the measures included in the bill considered by this committee.
Instead of a $1.8 billion cut to the value of the Incentive, it will now be increased by $2 billion. The Government will no longer proceed with the proposed $4 million cap on refunds for firms with an annual turnover of less than $20 million, and the number of tiers in the intensity scale for calculating the tax offsets of firms with a turnover of more than $20 million will be reduced from three to two.
These changes essentially mean that the bill considered by the committee has been superseded, and the fact that the committee chair's report contains no recommendation implicitly acknowledges this. The new measures announced by the Treasurer are contained in schedules 4, 5 and 6 of the Treasury Laws Amendment (A Tax Plan for Covid-19 Economic Recovery) Bill 2020, which was introduced into the Parliament on the day after the Treasurer's speech and passed two days later
Labor Senators are profoundly concerned, however, that the Government has retained the most damaging element of its 2018 and 2019 bills to restructure the RDTI: an intensity scale for calculating the non-refundable tax offset for larger firms. The reduction in the number of intensity tiers eliminates the 2019 bill's 4.5 per cent tier, which would have halved the rate for most businesses claiming the RDTI. That is an improvement, but it does not change the fact that intensity scales are a fundamentally flawed means of assessing the value of R&D activities.
Intensity scales measure a firm's commitment to R&D by expressing its R&D expenditure as a proportion of its total operating costs. For manufacturers, the bulk of operating costs comprise wages, purchase of raw materials and equipment, and investments in the supply chain. Specific R&D activities will always be a small proportion of the total operating costs for these manufacturers, but that is no indication of the inherent value of the R&D they undertake.
The manufacturing sector is the most innovation-intensive in the economy, and manufacturers spend four times the national average on R&D. In submissions and evidence to the committee many of them warned that the introduction of an intensity scale would force them to move either their R&D or their manufacturing offshore. The elimination of the 4.5 per cent tier might make it less likely that they will face such a choice, but the intensity scale continues to discriminate against Australian companies that conduct both R&D and manufacturing in Australia. Multinationals that can manufacture offshore and conduct R&D here will be better placed to claim the premium rate.
The costs typically incurred by large manufacturers mean that they will also be unfairly disadvantaged by the $150 million cap on what can be claimed under the RDTI. The Government had an opportunity to lift this cap in the new measures announced this week but did not take it.
Under the impact of the severe recession brought about by the COVID-19 pandemic, putting R&D activities and manufacturing jobs at risk is hardly a prescription for recovery. Labor Senators urge the removal of the intensity scale from the RDTI. A far better approach to improving the RDTI would be to introduce a premium rate for collaboration between industry and research institutions, as recommended in the following report.
Labor Senators' remarks on the Treasury Laws Amendment (Research and Development Tax Incentive) Bill 2019
Overview
The Treasury Laws Amendment (Research and Development Tax Incentive) Bill 2019 reintroduces, with only minor changes, measures relating to the RDTI that were included in the Treasury Laws Amendment (Making Sure Multinationals Pay Their Fair Share of Tax and other Measures) Bill 2018. The earlier bill was with withdrawn after a bipartisan recommendation of the Senate Economics Legislation Committee that further consultation be undertaken with industry stakeholders, who had overwhelmingly opposed the changes to the RDTI. The stakeholders' opposition remains unchanged to the present bill, which would severely disadvantage businesses that manufacture and conduct R&D in Australia, creating a strong incentive for them to send either their R&D or their manufacturing operations offshore.
Under either outcome, Australian jobs would be lost, the skills base of the workforce would be eroded and the prospect of building a more diverse and complex economy would fade. Further, none of the stakeholders were consulted by the Treasury and/or the Department of Industry, Science, Energy and Resources (DISER), as the committee inquiry into the 2018 bill had recommended. The Government appears to have persisted in seeking changes to the RDTI solely to create budget savings, despite the overwhelming evidence that the changes would undermine the most important measure in the nation's innovation toolkit—a measure of vital importance as Australia seeks to rebuild its economy in the wake of the COVID-19 pandemic.
What is more, there is strong evidence that the projected saving could be achieved without the changes introduced in the bill. The $1.8 billion the Government is seeking to cut from the RDTI over the forward estimates is being saved through improved integrity measures and a decline in the estimated cost of the RDTI. The 2016 Review of the R&D Tax Incentive estimated the cost of the RDTI for 2017–18 to be $3.48 billion, but Department of Industry figures (cited in Research Australia's submission to this inquiry) show that the actual cost for 2017–18 was $800 million less, at $2.57 billion. The Department's estimate of the cost for 2018–19 is $2.05 billion.
The official cost estimates are also questioned by industry, which argues that Treasury's modelling of the cost does not take account of the 'timing' benefit, in which the cost is recouped through taxes paid when businesses are profitable, or of flow-on reductions to franking credits, taxes paid later as a result of R&D spending, amounts recovered through tax paid by smaller companies in tax-payable position, and amounts 'clawed back' under the feedstock and grant-clawback provisions. On this basis, KPMG estimates that the net cost of the RDTI program is $1 billion a year less than the Government's official figures.
For all these reasons, Labor Senators believe the bill should be withdrawn. If enacted, it would undermine Australia's innovation system and profoundly hamper long-term economic recovery.
Intensity measures
The strongest criticism of this bill, shared almost unanimously by industry stakeholders who made submissions to the committee and gave evidence at the hearing, is that the proposed intensity scale for calculating the non-refundable R&D tax offset will be a disincentive for businesses and especially manufacturers to conduct R&D in Australia. At present, the 38.5 per cent non-refundable offset for companies with a turnover of more than $20 million, which do the bulk of private-sector R&D in Australia, provides either an 8.5 per cent or 11 per cent benefit depending on the corporate tax rate. It is understood that a large percentage of these companies are actually small to medium sized businesses (SMEs).
The bill changes the offset for these businesses to their corporate tax rate plus a premium based on their incremental R&D intensity, calculated as a proportion of overall annual expenditure. The bill provides for a three-tiered intensity scale and most businesses claiming the non-refundable offset will fall within the lowest tier—4.5 per cent—effectively halving the rate for many businesses and reducing the rate by almost 60 per cent for SMEs with a turnover between $20 million and $50 million. As numerous industry submissions point out, since R&D intensity is calculated as the company's spend over its total expenses for the year, and this cannot be determined until the end of the income year, the measure does not create an incentive for companies to undertake more R&D. The intensity measure is fundamentally flawed and would create a disincentive to Australian companies trying to innovate in the wake of COVID-19.
The consequence of introducing the intensity premium will be to force many companies to choose between sending either their R&D or their manufacturing operations offshore. The urgency of that choice will be heightened by the fact that other R&D regimes in the region are becoming increasingly competitive (e.g. New Zealand has introduced a 15 per cent R&D tax offset). As Mr Benjamin Eade, CEO of Manufacturing Australia, told the committee hearing:
Fundamentally, intensity measures are bad for local manufacturing. The reasons for that is they measure your commitment to R&D as your percentage of total expenditure on R&D as a proportion of your overall operating cost base. If you're an Australian-based manufacturer, the vast majority of your cost base is made up of employing Australians, using Australian raw materials and investments in an Australian supply chain.
For a large-enterprise Australian manufacturer it is almost impossible to clear those intensity hurdles, and indeed, the way they've been designed in this bill does make it impossible for most companies to clear those intensity hurdles.
What you're going to see is that the combined impact of those intensity measures will drive R&D investment offshore or drive manufacturing production offshore—I think the former is more likely than the latter but the net outcome is that you will have less R&D expenditure being undertaken by companies that actually manufacture here, because they will be severely punished for making a decision to allocate their production to this country.
Other industry witnesses made similar criticisms. Ms Sandra Boswell, a partner at Grant Thornton who gave evidence for the Lighting Council of Australia, said:
You'll see projects go offshore or projects close. All projects have elements of R&D and have elements of process and operations…in that manufacturing environment, it's required for experimentation to test the hypothesis of the R&D, so it's not all done in commercial R&D; it's very much done in that operational environment. I think we will either see projects move offshore, or now with COVID, projects close—they won't go anywhere. Either way, jobs will be lost in Australia.
Ms Boswell also emphasised that changing the present offset would deter foreign companies from investing in Australia:
I would often get calls once or twice a week from offshore entities looking to understand the program here—so it brings investment into Australia—and also making decisions about where to locate projects. I think the other thing about this program is that it makes Australia competitive on a world stage, so it does drive investment in the economy here.
Retrospectivity
The measures in the bill would be retrospective: they are intended to operate from 1 July 2019. As noted by almost all 93 written submissions, this means the measures would have an immediate impact on R&D activities already commenced by companies on a legislative expectation. The stakeholders do not report having received any advice or assistance from the Australian Tax Office or DISER on the problem created by this retrospectivity.
Labor Senators note that, in a return to a question on notice, DISER claims that e-bulletins have been used to inform businesses and agents of the retrospective nature of the bill. But on analysis of the bulletins the advice to the sector is confusing and understated. Companies are effectively being asked to operate with two sets of books—it is not only a calculation that companies are being asked to do.
Note: If the bill is enacted with retrospective effect, decisions made since 1 July 2019 would essentially be invalidated. And since labour costs are the primary cost of R&D, a company's labour cost for employees engaged in R&D would retrospectively increase by 4 per cent—the rate reduction from 8.5 per cent to 4.5 per cent under the intensity measure.
That is a real cost of doing business and it is likely that companies would have taken different decisions, such as hiring fewer people, if they had known that the rate was halved. This is not just a tax calculation. The effect is that decisions made on whether to employ staff, their hours of work and their salary levels would be retrospectively invalidated.
Labor Senators remain highly concerned that the retrospective nature of the bill will see businesses burdened with a tax liability they weren't expecting at the time they invested in the R&D.
COVID-19 and economic recovery
As many stakeholders have noted, the Morrison Government's declared aim of reviving Australia's manufacturing sector as a key to post-pandemic economic recovery is not consistent with the bill's almost certain consequence of discouraging R&D investment in this country. As Ms Elizabeth De Somer, CEO of Medicines Australia, said:
The Prime Minister said recently that in emerging from the COVID-19 crisis he wants Australia to build its economic sovereignty to ensure we have a prosperous and healthy community…A healthy research and development sector will be critical to meet the Prime Minister's aspirations. Growing investment in R&D will be one of the keys to providing the essential jobs for this new cohort of highly skilled researchers and scientists.
It will also attract much-needed foreign investment, strengthen Australia's expertise and international connections in the development of medical treatments, and open up opportunities for advanced manufacturing for homegrown discoveries.
To achieve this, the Government must reverse the tide of recent history. Investment in R&D in Australia has been falling for decades, and implementing this bill would only accelerate the downward trajectory…the proposed changes in this bill would be detrimental to Australia's health and productivity at the best of times, but especially so when we are faced with the unprecedented challenge of COVID-19.
Research Australia (RA) argued in its submission that the lack of diversity in Australia's economy places our long-term future at risk, and that COVID-19 has highlighted the dangers in Australia's over-reliance on one major export partner, China, a reliance without parallel in the developed world. Overcoming this will require:
…supporting the companies in Australia, both small and large, that engage in research and development, creating new jobs and opportunities and diversifying our economy. These are the companies that utilise the RDTI and which will be disadvantaged by the proposed changes.
Research Australia points out that the complexity of a country's economy, measured in terms of the diversity of its international trade, is a good measure of the economy's strength and resilience, and its capacity for continued innovation and growth. The RA submission cites Harvard University's Atlas of Economic Complexity as evidence of the lack of complexity in the Australian economy. According to the Atlas, Australia has only the 93rd most complex economy, placing it behind Morocco, Uganda and Senegal. RA cites this comment from the Atlas:
Compared to a decade prior, Australia's economy has become less complex, worsening by 22 positions…Australia is less complex than expected for its income level. As a result, its economy is projected to grow slowly. The Growth Lab's 2027 Growth Projections foresee growth in Australia of 2.2 per cent annually over the coming decade, ranking in the bottom half of countries globally.
The dismal picture of Australia's economic future set out in the Atlas was drawn before the COVID-19 pandemic wreaked its havoc on the Australian and global economy. The future now is even more bleak. If greater economic complexity is to be achieved, and if excessive dependence on fragile global supply chains—especially those emanating from China—is to be reduced, changes to the RDTI that create incentives to send R&D or manufacturing offshore would be counter-productive.
Collaboration premium
As well as their unanimous rejection of the bill's intensity measures, most stakeholders urged the adoption of a recommendation in the 2016 Review of the R&D Tax Incentive that was not included in either the 2018 bill or the present bill. This was a proposal for a premium rate of the RDTI to be available to businesses that conduct R&D activities in collaboration with universities or public research agencies. The ALP's 2019 election platform included the introduction of 10 per cent collaboration premium, but several stakeholders, including Science and Technology Australia, called for a 20 per cent collaboration premium in their evidence or submissions.
Mr Eades, of Manufacturing Australia (MA), urged the adoption of a collaboration premium when asked during the hearing about the consequences of COVID-19 for the changes set out in the bill and MA's submission:
If I were preparing this submission in a post-COVID environment, I think I would lean further into the concept just discussed around a premium rate for R&D that drives local production. I am increasingly asked, in discussions more broad than today's, about ways that governments can incentivise manufacturing. I think we are all on a unity ticket around the idea that manufacturing is more than just production, but we need to incentivise the production…
I'd be allocating a premium rate for R&D tax incentives where it was demonstrably linked to domestic manufacture, where you can demonstrate as a company that your manufacturing R&D is directly fuelling innovation that allows you to make more in Australia, to hire more and to invest more in production. I'd be applying a premium rate such as we've discussed in the university partnership area.
Mr Eades agreed with the Parliamentary Budget Office's observation in 2019 that the premium rate announced in Labor's election platform would not necessarily add to the cost of the RDTI program, but would promote a shift from non-collaborative to collaborative expenditure. And he added:
Collaboration is how we get more manufacturers that are currently in a small-to-medium enterprise to scale up in Australia…I'd like to see more Duluxes and Blue Scopes, and to see more SME manufacturers have the capability and the opportunity to scale up their production here in Australia, rather than prove a technology and then be forced, for a range of other reasons, to offshore the production component of that. So the opportunity to collaborate, to form alliances with university partnerships, is primary to that.
Smaller businesses, start-ups and integrity problems
Most businesses registered for the RDTI—generating 80 per cent of the cost of the program—have turnovers of less than $20 million and are therefore eligible for the refundable component. They include many start-up enterprises, especially in the bio-tech sector, and support for these businesses is one of the reasons for the existence of the program. It is a myth propagated by critics of the RDTI that the program exists to benefit large businesses only: its reach is economy-wide and that is one of its key strengths
Unfortunately, many of the integrity issues connected with the operation of the program have arisen in connection with unscrupulous agents and advisers who have sought to take advantage of both the businesses and the program. The rorts have been surveyed in a December 2019 report by the Small Business Ombudsman, Ms Kate Carnell, who also proposed various measures to counter shonky practices, thereby saving money for the RDTI program. Anecdotal reports of these practices include claims for website and app development that do not comply with the definition of R&D, gym equipment and even hair dressing salons.
These problems have been brought to the Government's attention on numerous occasions but it has done nothing to address them. It has not even commissioned an independent review—for instance the Australian National Audit Office has only recently listed the RDTI as a potential area for audit in FY21, possibly in response to Ms Kate Carnell's scathing review of its administration. If the Government really wanted to save money for the program—money that could be reinvested in genuine R&D activities—tackling these integrity and administrative problems should be a priority, and it would not require damaging changes to the structure of the program through intensity measures for larger SMEs and 'big' business.
The R&D Tax Incentive and Australia's declining global competitiveness
Taxation is one of the most powerful levers available to governments to influence investor behaviour, and the RDTI has accordingly become the chief measure integrating Australia's taxation and innovation systems. The Morrison Government, citing assertions in the 2016 Three Fs Review of the RDTI, claims that the present structure of the RDTI does not sufficiently encourage additionality—investment that would not occur in the absence of the program—or spillover investment that benefits the wider economy.
The Government maintains that this is why the changes set out in the bill are needed, but it has not been able to demonstrate how measures such as the intensity premium would create greater additionality and spillovers. Stakeholders, on the contrary, overwhelmingly expect that the changes would do the opposite. Research Australia's submission to the committee warns that:
The currently proposed amendments to the RDTI risk destroying the additionality and spillover benefits the program is designed to create, simply because there is not a sufficient understanding of where and how the additionality and spillover benefits are being created and where this is not being achieved.
Research Australia's warning is especially important because of the decline in Business Expenditure on Research and Development (BERD) in Australia in recent years. The most recent Science, Research and Innovation Tables reveal that BERD has fallen by 32 per cent since 2015, and DISER annual reports show a comparable decline of 30 per cent.
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2015/16
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$2.18 billion
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$824 million
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$3.00 billion
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2018/19
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$1.69 billion
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$358 million
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$2.05 billion
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32% reduction
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2015/16
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$17.32 billion
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2018/19
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$11.92 billion
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30% reduction
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This decline has taken place during a period of decline in Government support for innovation programs since 2013, including the axeing or defunding of programs set in place under the previous Labor government. A net $2 billion has been cut from innovation support, and the changes introduced by this bill would only accelerate the decline further by creating disincentives to invest in R&D in Australia.
A 2019 International Monetary Fund report, cited in KPMG's submission to the committee, found that R&D tax incentives have a strong positive effect on stimulating investment in R&D by business—in the UK, R&D investment has increased by an average of 33 per cent as the UK's R&D tax credit has become more generous. The contrast between countries such as the UK and New Zealand, which have increased the value of tax offsets for business investment in R&D, and Australia is stark. Australia's RDTI is already globally less competitive than it was at the time of its inception in 2011, and the changes introduced in schedule 1 of this bill—that is, the intensity measures—will make Australia even less attractive to business considering whether to conduct their R&D here.
As Emeritus Professor Roy Green, of the University of Technology Sydney, noted in an interview with Geoff Chambers, Australia has been lagging in terms of the manufacturing proportion of our economy for some time. We are down to 6 per cent. Other economies are around 15–20 per cent. Professor Green is quoted in the article saying that the weaknesses in domestic manufacturing should be used as an opportunity to:
…identify niches in the world economy where we can be globally competitive…
There's a big opportunity there. It's going to require big investments both by the public and private sectors in lifting our R&D performance, which is lamentable…
We're down to 1.79 per cent of GDP. The rest of the world average [for OECD nations] is 2.4 [per cent]. Korea, Japan, Switzerland, Germany are all over 3 per cent now.
…Germany has just invested $80 billion in digital manufacturing, digital transformation. Britain has just committed $40 billion to lift their R&D performance. Even Singapore has committed $20 billion. Joe Biden…in his new program is committing to more than $400 billion.
The declining international competitiveness noted by Professor Green reveals the hollowness of Morrison Government rhetoric about reviving Australia's manufacturing sector in the wake of the COVID-19 pandemic. The Government has rightly commended the achievements of manufacturers that have adapted to the immediate needs created by the pandemic, such as the production of personal protective equipment or hand sanitizer. The Government's rhetoric does not, however, recognise that reviving a manufacturing sector requires more than short-term support for end-stage producers.
Building a strategic reserve of personal protective equipment, for example, relies on the existence of chemicals and plastics industries, and for these materials Australia is still over-dependent on fragile global supply chains. Reducing that dependence and increasing the size of the manufacturing sector will require substantial public and private investments of the kind proposed by Professor Green. Maintaining an effective and globally competitive RDTI will be crucial to that, but the Morrison Government is intent on cutting the value of the RDTI at this time when it is crucial to economic recovery and to ensuring prosperity in the longer term.
The overwhelming evidence is that this bill would create significant disincentives for business investment in R&D in Australia, at a time when the Australian Government should be taking every opportunity to increase incentives for business both to conduct R&D and to manufacture here. Labor Senators therefore make the following recommendations.
Recommendation
Labor Senators recommend that this bill be withdrawn.
Recommendation
Labor Senators recommend that the Australian Tax Office and the Department of Industry, Science, Energy and Resources conduct proper consultations with industry stakeholders, as recommended by the committee's inquiry into the 2018 bill.
Recommendation
Labor Senators recommend that any future bill to reform the RDTI should not operate retrospectively.
Recommendation
Labor Senators recommend that any future bill intended to make the RDTI work more effectively in encouraging innovation in Australia should include a premium rate for collaboration between industry and universities or public research agencies.
Deputy Chair
Committee Member