Clarifying R&DTI Eligibility: What is the relevance of the "Innovation Test"

Introduction

The Research and Development Tax Incentive (R&DTI) in Australia is a program designed to promote innovation by providing tax incentives to businesses engaged in eligible research and development activities. Unfortunately, there appears to be some misunderstandings from advisers, consultants and government bureaucrats surrounding the "innovation test" and its role in R&DTI eligibility.

This ‘test’ appears to conflate the requirements of another Government grant program and then applying opinions about the legislation instead of applying the legislation. In this blog post, we aim to point out these misunderstandings and provide a clear understanding of what it means to qualify for the R&DTI. The test, as we understand it, has been applied to the R&DTI program to assess whether the R&D activity is conducted for the purpose of generating new knowledge or improving existing knowledge, and it has several key components which we have commented on below in blue.

What is the “Innovation Test” and Why is it Incorrect in Assessing R&DTI Eligibility?

The innovation test is a subjective assessment which is used in determining qualification with the Governments “Early Stage Innovation Company (ESIC)” program, but appears to have been misapplied in some quarters to determine whether a particular research and development (R&D) activity satisfies the new knowledge requirement necessary for compliance with the R&DTI. The test assesses whether the R&D activity is conducted for the purpose of generating new knowledge or improving existing knowledge, and it has several key components when misapplied to the R&DTI program:

1. New Knowledge: The primary focus of the innovation test is to determine whether the R&D activity results in the creation of new knowledge. This new knowledge should extend beyond existing knowledge within the relevant field or industry. It's not sufficient for the activity to merely apply existing knowledge. This understanding of new knowledge is correct in accordance with the R&DTI program’s legislative requirements, but doesn’t recognise that the new knowledge test is actually a purpose test, not an outcome test. Core R&D activities must have a purpose of generating new knowledge, but may still be eligible even if they fail to generate any new knowledge – it is the purpose that is critical.

2. Experimental Activities: To meet the innovation test, R&D activities must involve systematic and experimental activities. This means that the research process should be methodical and follow a structured experimental approach to generate new insights and knowledge. This is correct in accordance with the R&DTI program’s legislative requirements.

3. Technical Risk: The innovation test also considers technical risk as a factor. If an R&D activity involves a level of technical risk, it may be more likely to meet the test. Technical risk implies that there is uncertainty about whether the intended outcome can be achieved using current knowledge or methods. Technical Risk is not a legislative requirement of the R&DTI program. The new knowledge, or the uncertainty of the outcome, is not required to be related to a technical risk.

4. Outcome Focus: The focus of the innovation test is on the outcome of the R&D activity, specifically whether it leads to a significant advancement in knowledge or capability within the relevant industry. Outcome Focus is not a legislative requirement of the R&DTI, but having the purpose of the generation of new knowledge is, as per 1 and 2 above. The R&D activity could fail to deliver any outcome, and it could still be eligible.

5. Applicability Beyond the Business: The knowledge gained through the R&D activity should have potential applications beyond the specific business undertaking the research. In other words, the new knowledge should have broader relevance or applicability within the industry. There is no such requirement within the legislative criteria for the R&DTI.

6. Industry Recognition: It's essential for the R&D activity and its outcomes to be recognized and accepted within the relevant industry or field as a genuine advancement or innovation. There is no such requirement within the legislative criteria for the R&DTI.

To qualify for the R&DTI, businesses must meet specific eligibility criteria as outlined in Section 355-25 of the Income Tax Assessment Act 1997 (ITAA 1997). These criteria primarily focus on the nature of the research and development activities. The key components of R&DTI eligibility are explained in the following R&D Certainty blog post.

Understanding the True Eligibility Criteria

The term "innovation test" is sometimes informally used to encapsulate the concept that R&D activities should lead to the creation of new knowledge or improvements in existing knowledge. However, it is crucial to clarify that the term "innovation test" is not an official or legal requirement for R&DTI eligibility according to the legislation, though it is applicable to the ESIC program (though the conditions are different).

The R&DTI program does not require businesses to prove that their R&D activities result in ground breaking innovations or significant industry advancements. Instead, the focus lies on the systematic, experimental nature of the research, with an emphasis on having a purpose of generating new knowledge. New knowledge could be in the form of a new or improved materials, products, devices, processes or services, but it doesn’t need to be. It could be new knowledge about how a new product or process performs, or about how an existing product performs in a new application. It could be new knowledge that gives you a better understanding of a problem, but doesn't solve it. But in any case, the legislation's test is whether you had the purpose of generating new knowledge from your activities, it does not test what your new knowledge outcomes were.

Conclusion

The R&DTI is a valuable program aimed at fostering business innovation in Australia. To ensure businesses can access this incentive effectively, it is crucial to understand the true requirements for eligibility.

While the term "innovation test" may be used informally to describe R&DTI eligibility, it is essential to acknowledge that the formal eligibility criteria emphasize the nature of research and development activities. By clarifying these criteria, businesses can navigate the application process accurately and access the support they need to drive innovation and growth while complying with legislations requirements.