Frascati Manual and R&D in the software development field

the frascati manual

What is the Frascati Manual and why is it relevant to R&D Tax Incentive claims?

In June 1963, the Organisation for Economic Co-operation and Development (OECD) met with national experts on research and development (R&D) statistics at the Villa Falcioneri in Frascati, Italy. The result was the first official version of the Proposed Standard Practice for Surveys of Research and Development, better known as the Frascati Manual.

Over five revisions later, the Frascati Manual is widely recognised as a cornerstone of internationally accepted definitions of R&D and classifications of its component activities. The Manual contributes to intergovernmental discussions on “best practices” for science and technology policies, and its pertinence to the Australian policy framework was reaffirmed in last year's Review of the R&D Tax Incentive (4 April 2016) authored by Mr Bill Ferris AC, Chair, Innovation Australia, Dr Alan Finkel AO, Chief Scientist and Mr John Fraser, Secretary to the Treasury. In the Review, the panel found that:

"...the definition of [eligible R&D] mirrors the principles in the OECD Frascati Manual which is regarded internationally as setting the benchmark for identifying R&D activities."

Below we set out excerpts taken from the Manual, which may help to elucidate the position of when software development qualifies as R&D. 

…

• ROUTINE SOFTWARE DEVELOPMENT

77. Software-related activities of a routine nature are not considered to be R&D. Such activities include work on system-specific or programme-specific advances which were publicly available prior to the commencement of the work. Technical problems that have been overcome in previous projects on the same operating systems and computer architecture are also excluded. Routine computer maintenance is not included in R&D (see Section 2.4.1 for a more detailed discussion of borderline problems between software development and R&D).

• SECTION 2.4.1 IDENTIFYING R&D IN SOFTWARE DEVELOPMENT

135. For a software development project to be classified as R&D, its completion must be dependent on a scientific and/or technological advance, and the aim of the project must be the systematic resolution of a scientific and/or technological uncertainty.

136. In addition to the software that is part of an overall R&D project, the R&D associated with software as an end product should also be classified as R&D.

137. The nature of software development is such as to make identifying its R&D component, if any, difficult. Software development is an integral part of many projects which in themselves have no element of R&D. The software development component of such projects, however, may be classified as R&D if it leads to an advance in the area of computer software. Such advances are generally incremental rather than revolutionary. Therefore, an upgrade, addition or change to an existing programme or system may be classified as R&D if it embodies scientific and/or technological advances that result in an increase in the stock of knowledge. Use of software for a new application or purpose, however, does not by itself constitute an advance.

2. BASIC DEFINITIONS AND CONVENTIONS

138. A scientific and/or technological advance in software may be achieved even if a project is not completed, because a failure can increase knowledge of the technology of computer software by showing, for example, that a particular approach will not succeed.

139. Advances in other fields resulting from a software project do not determine whether an advance in computer software has occurred.

140. The following examples illustrate the concept of R&D in software.

Should be included in R&D:

– R&D producing new theorems and algorithms in the field of theoretical computer science.

– Development of information technology at the level of operating systems, programming languages, data management, communications software and software development tools.

– Development of Internet technology.

– Research into methods of designing, developing, deploying or maintaining software.

– Software development that produces advances in generic approaches for capturing, transmitting, storing, retrieving, manipulating or displaying information.

– Experimental development aimed at filling technology knowledge gaps as necessary to develop a software programme or system.

– R&D on software tools or technologies in specialised areas of computing (image processing, geographic data presentation, character recognition, artificial intelligence and other areas).

141. Software-related activities of a routine nature which do not involve scientific and/or technological advances or resolution of technological uncertainties are not to be included in R&D. Examples are:

– Business application software and information system development using known methods and existing software tools.

– Support for existing systems.

– Converting and/or translating computer languages.

– Adding user functionality to application programmes.

– Debugging of systems.

– Adaptation of existing software.

– Preparation of user documentation.

142. In the systems software area, individual projects may not be considered as R&D but their aggregation into a larger project may qualify for inclusion. For example, changes in file structure and user interfaces in a fourth-generation language processor may be made necessary by the introduction of relational technology. The individual changes may not be considered R&D if viewed in their own right, but the entire modification project may result in the resolution of scientific and/or technological uncertainty and thus be classified as R&D.

• Examples illustrating differences between basic, applied and experimental research

256. Examples from software development:

– Search for alternative methods of computation, such as quantum computation and quantum information theory, is basic research.

– Investigation into the application of information processing in new fields or in new ways (e.g. developing a new programming language, new operating systems, programme generators, etc.) and investigation into the application of information processing to develop tools such as geographical information and expert systems are applied research.

– Development of new applications software, substantial improvements to operating systems and application programmes, etc., are experimental development.

Table 3.2. Fields of science and technology

• What science field software development belongs to

1. NATURAL SCIENCES

1.1. Mathematics and computer sciences [mathematics and other allied fields: computer sciences and other allied subjects (software development only; hardware development should be classified in the engineering fields)]

…

KEY TAKEAWAYS

Many companies do not understand what qualifies as R&D in the field of software development. The above provides some guidance which may help to clarify certain aspects. Beyond this, AusIndustry and the ATO have published a number of guidance documents drawing upon this.

The key for companies making a software development R&D claim is to identify eligible core R&D activities that outline a specific scientific or technical advance sought as a hypothesis. Secondly, ensuring the scope of those activities is clearly rationalised to avoid claiming for activities without a sufficient nexus. This may involve claiming support R&D activities with a sufficient nexus to enabling/supporting the experimentation, or excluding certain activities.

Talk to us today about your software development projects for a free assessment of R&D opportunities.

Managing your R&D Tax Incentive risk - checklist

aUDITS ON THE r&d INCENTIVE HAS BEEN STEADILY INCREASING

With ATO and AusIndustry audits on the increase in the R&D Incentive space, claimants and their tax advisors are facing additional rigour and controls. Where an R&D claim is outsourced to a 'specialist' R&D Tax consultant, many claimants are not fully aware of the regulatory conditions and their own obligations.

Whilst the realisation of an immediate refund or tax rebate provides a positive short term result, in the long term companies face the very real risk of having entire claims dismissed and needing to refund the benefit, with interest, and potentially penalties applicable.  

Here is a checklist to sense check that your R&D risk is appropriately managed:

X - USING A REGISTERED R&D TAX PRACTITIONER

If you are using a specialist R&D Tax consultant, make sure they are a registered R&D tax practitioner with the Taxation Practitioners Board (TPB). This is a mandatory requirement with any person not registered in breach of the law and clients left exposed to significant risk. Check the R&D Application for appropriate disclosure and with your consultant.

X - HAVE A COPY OF THE ENGAGEMENT LETTER

An engagement letter should be present between you and your R&D Tax consultant. It is important to understand the scope of services being provided and evidence of using a registered R&D tax practitioner can help to mitigate penalties. 

X - AUDIT ASSISTANCE IS PROVIDED AT NO COST

Ideally, an engagement should provide audit assistance at no cost. As the program is self assessment, specialist R&D Tax consultants should stand by the work they have undertaken. This also incentivises high quality work with a focus on reducing the risk of an audit. 

X - R&D TAX PRACTITIONER HAS DOMAIN SPECIFIC EXPERTISE

Your R&D Tax consultant should understand the nature of the scientific/technical activities undertaken and should document your R&D position, rather than asking you to document this. Insufficient understanding of the scientific/technical activities means activities may not be appropriately identified, or adequately documented, increasing the risk of an audit.

X - SUFFICIENT DETAIL IN THE AUSINDUSTRY R&D REGISTRATION FORM

Sufficient detail in the AusIndustry R&D Registration Form is required to enable an assessor to conclude that R&D activities have been undertaken, minimising audit risk. Have you clearly documented a knowledge gap, and the steps involving a falsifiable hypothesis, testing, results and observations towards developing new knowledge?

X - SUPPORTING DOCUMENTATION IS PRESENT, INCLUDING RECORDS OF EXPERIMENTATION, AND EVIDENCE OF TIME/EFFORT SPENT ON R&D ACTIVITIES

Do you have adequate substantiating documentation that links/evidences the R&D activities claimed and expenditure incurred? This is a key audit focus/risk area. This should be in a centralised location and easily accessible in the event of an audit. Please see our separate blog post on this here.

X - ADEQUATE EXPERTISE IN R&D TAX INCENTIVE SCHEME REQUIREMENTS

Have you been asked about your 'aggregated turnover' (group revenue), which is calculated on a group basis and determines the rate of R&D Tax Offset and refundability? A common mistake is considering the revenue of the claimant entity in isolation.

Are you using a simplified approach to defining R&D activities, making whole of project claims? This is a high risk area that AusIndustry and the ATO are focusing on.

Do you have a number of support R&D activities in the AusIndustry R&D Registration Form? AusIndustry has stated that every project should have at least one. Projects without this will present a high likelihood of audit.

Are you claiming for overseas R&D activities without pre-approval from AusIndustry? Minor or incidental amounts informing the R&D activities (e.g. conference travel) are acceptable, however, claiming for a number of R&D activities which have been conducted overseas is not.

IF YOU ARE CONCERNED THAT YOUR R&D CLAIM OR ASSOCIATED RECORD KEEPING MAY NOT BE UP TO SCRATCH, CONTACT US TODAY FOR A NO OBLIGATION DISCUSSION.

R&D Tax Incentive...you are doing it wrong!

common mistakes with the R&D tax incentive

Over the last few months we have worked with a large number of companies that had previously accessed the R&D Tax Incentive program either internally or through external consultants 'specialising' in this space.

We have found that companies/consultants are not getting things right with regards to specific areas within the R&D Tax Incentive.

Here are the top 10 things we have found:

1. Lack of sufficient detail in the AusIndustry R&D Registration Form which would enable an assessor to conclude R&D activities have been undertaken, minimising audit risk. 

2. Confusing experimentation with the product concept/market acceptance with experimentation to address technical or scientific knowledge gaps.

3. Misunderstanding the scope of activities that may qualify as R&D and associated expenditure that is claimable.

4. Not having the right structures or agreements in place to be able to claim the R&D Tax Incentive.

5. No focus on underlying substantiating documentation that links/evidences the R&D activities claimed and expenditure incurred. A key audit focus/risk area.

6. Thinking the current rate of the R&D Tax Offset is 43.5%.

7. Not understanding the definition of 'aggregated turnover', which is calculated on a group basis and determines the rate of R&D Tax Offset and refundability (ATO link).

8. Not understanding the 'for whom' (ATO link) and 'at risk' (ATO link) requirements which can dictate whether a claim can be made and the scope of a claim.

9. Thinking all software development qualifies and/or inappropriately making whole of project claims, a high risk area AusIndustry and the ATO are focusing on. 

10. Not using a consultant that is a registered tax practitioner, or that understands the nature of the scientific/technical activities undertaken.

A recent Innovation Australia update echoes some of these concerns and can be found here.

With great pride I can say we have been successful in tendering against 'Big Four' providers, and incumbent mid-tier firms based on our specialised software and technology industry R&D Tax expertise.

We have been able to significantly improve claim outcomes, efficiency, and minimise risk. Part of this involves applying a 'real time' assessment and substantiation approach. Something which is uncommon amongst R&D Tax consultants who often review/prepare a claim retrospectively. 

We offer existing claimants a no obligation, free "Health Check" review. This can provide you with peace of mind and comfort surrounding existing claims. 

It is carried out at no cost to you.

TALK TO US TODAY ABOUT HOW WE CAN MAKE OUR EXPERTISE WORK FOR YOU: info@rsfconsulting.com

The R&D Tax Incentive, is it time for a Health Check?

The Balanced Risk

To kick off our blog, I thought I would discuss the balanced risk associated with accessing the R&D Tax Incentive program. 

The R&D Tax Incentive program is a tax based program which companies are entitled to claim each year.

It is not a Grant. It is self assessment much like a company's income tax return or an individual's income tax return. A positive is that you have more short term certainty that any funding will be received. However, longer term, claims may be audited, and there is the risk that a company may have to pay back amounts received including interest and penalties, if applicable.

Just because you have been receiving funds under the R&D Tax Incentive for a number of years successfully does not mean that claims made have been accepted as valid. In fact, the longer you have been claiming under the program, the higher the risk of an AusIndustry or ATO review occurring.

AusIndustry reviews are common, with a company typically reviewed once every four years. Greater focus is typically placed on first year claimants, and particular claim types such as software development. ATO reviews are increasing. Key focus areas include refundable R&D Tax Offset claims, software development claims, and legislative integrity provisions such as "payment to associates". 

Contemporaneous substantiating documentation is critical and sought by both regulators.

From successfully passing a review, comes greater comfort. 

SO ARE YOU AUDIT READY?

At RSF Consulting, we offer claimants a no obligation, free "Health Check" review. This can provide you with peace of mind and comfort surrounding existing claims. The review will look at past claims focusing on:

• claim risks and recommendations on how these may be reduced,

• where additional value exists, which may be accessed, and

• where the process of making a claim can be made more efficient.

This is carried out at no cost to you. The process does not require significant input from company personnel, and focuses on reviewing existing claim related documentation.

TALK TO US TODAY ABOUT HOW OUR “HEALTH CHECK” CAN WORK FOR YOU.