2.1 The R&D tax concession was a major part of the then Government's late 1980s package of measures to encourage innovation in Australian companies. The aim of the concession was to attract investment into early-stage, high-risk R&D — an area where no market previously existed. The concession provided special tax incentives designed to encourage investment in R&D where it was either too big or too risky for one company.
2.2 The main form of syndication was the guaranteed syndicate. In these syndicates a 100 per cent deduction was given for investments, and investors could guarantee themselves a rate of return regardless of the technical or commercial success of the R&D work.
2.3 A 1994 report of the Bureau of Industry Economics' review of R&D syndication commented that:
Notwithstanding its complex guise, the program is an officially sanctioned mechanism for financing new R&D through the sale of tax losses. (BIE report, 1994, page 8.)
2.4 The R&D and finance scheme was scrutinised by the Industry Research & Development Board (IRDB). The IRDB was a Government-appointed body assisted by the Tax Concession Committee (TCC) and AusIndustry in the then Department of Industry, Tourism and Resources (and its predecessors). If all requirements were met, the syndicate was registered and eligible to claim the tax concession.
2.5 The Tax Office was at all times responsible for compliance with the relevant tax laws, including a specific anti-avoidance provision (subsection 73B(31) of the Income Tax Assessment Act 1936) introduced in 1991. It had observer status on the TCC and provided the TCC advice on tax matters.
2.6 A critical factor to the viability of syndicates was the price of the eligible 'core technology' at the heart of the research. The anti-avoidance provision was specifically focused on whether the core technology price was an 'arm's length' amount. This was the core compliance issue.
2.7 In the early 1990s, the R&D tax concession was reviewed by the Australian National Audit Office (ANAO) and by the BIE. The Tax Office commenced audits of some syndicates in 1992 and it took a compliance project approach to syndicates from 1994. In late 1995, the TCC announced that it would increase its scrutiny of proposed syndicates; in particular, it began pressing for arm's length valuations of core technology.
2.8 The concession was closed off to new syndicates by the then Government in 1996 because there were by then widespread concerns that it was being exploited, particularly by means of inflated core technology values. Applications for registration that were already in the pipeline were, however, allowed to proceed.
2.9 The Tax Office was legally able to review core technology deductions without time limits on those periods for review. However, all syndicates incurred core technology deductions and all investors utilised the resulting losses many years ago, in some cases up to 14 years ago.
2.10 Following an expensive but unsuccessful lead case litigation strategy aimed at applying the specific and general anti-avoidance provisions, the Tax Office mediated a case in 2003–04 in order to produce guidelines for reviewing its compliance cases. The mediation rejected the zero or negative value approach to core technology prices that the Tax Office had maintained in previous years.
2.11 Some 245 syndicates were registered during the period the concession was available. At one stage the Tax Office estimated that some $3.4 billion of revenue was involved. This estimate was based on the Tax Office view that core technology values were zero or negative. It also included full interest and penalties.
2.12 In 2004, the Tax Office decided to pursue only 40 or so of the largest investors. The remaining 'smaller' investors (less than $3 million invested) have never been contacted. In late 2006, following discussions with the Inspector-General, the Tax Office also decided that the additional scrutiny undertaken by the TCC from late 1995 would be a determinant factor in whether it would pursue particular cases or not.
2.13 At the time of this report the Tax Office has settled with most of the 40 investors for around $143 million with potential for a further $73 million to be collected from eight investors' investments still under examination, including penalties and interest. Tax Office activity could have cost the community more than what the Tax Office has collected as a result of its actions. Although no formal calculation of the cost to the community has been attempted, the Inspector-General has conservatively estimated that the overall cost to the community of the Tax Office's compliance activity over the 15 years that this issue has so far taken to resolve is between $35 million and $55 million.
The Inspector-General's conclusions
2.14 The review's foremost conclusion is that, had the Tax Office provided early, practical information to make clear its compliance expectations, this issue would never have ballooned into the protracted and expensive problem it became. The Tax Office was aware that core technology valuations were a potential compliance issue at least as early as 1991 when the specific anti-avoidance provisions were introduced. It commenced an audit project specifically on R&D syndication in 1994; but, practical guidelines on its expectations did not issue until 2004; and, as at 2007 it still has a number of cases to resolve (in spite of screening out the vast majority of 'smaller' cases).
2.15 Having noted that the Tax Office missed that opportunity to prevent things going wrong in the first place, the review has found a number of reasons for why the issue then took so long for the Tax Office to resolve. The Tax Office accepts that it took far too long.
2.16 Noting evidence that the Tax Office believed and continues to believe that R&D syndicate arrangements are tax abuse, the conclusion of the Inspector-General is that an unchecked cultural influence of 'hitting tax abuse hard' has been a major contributing factor to why the R&D syndication issue has taken well over a decade to near resolution.
2.17 The Inspector-General also has concerns about what the review has shown about the Tax Office's approach to major compliance issues. These concerns include the Tax Office:
- acting unfairly;
- lacking transparency;
- using litigation purely to strengthen its negotiating position in settlements rather than to test the issues objectively;
- failing to communicate directly with taxpayers on matters that affect them;
- exhibiting an inability to undertake an objective reconsideration of its position until some external 'searchlight' sheds light on it that the Tax Office cannot ignore; and
- not deciding major aspects of its compliance strategy until many years after the matter was identified as a major compliance issue.
2.18 While these behaviours undoubtedly contributed to the excessive timeframes, they have also undermined the Tax Office's relationships with major taxpayers and its own objectives of promoting voluntary compliance into the future. Questions also arise as to whether the Tax Office acted in line with its espoused values and the Taxpayers' Charter in this matter.
2.19 The Inspector-General has concluded that an underlying cause of these behaviours has been the Tax Office's conviction from the outset that R&D syndicates were 'rorts'. The Tax Office was right to be concerned about compliance in this area and exploitation has been identified by the Tax Office in a number of cases (but far from all of them). But compliance concerns should not, in the view of the Inspector-General, get in the way of being a fair and objective administrator.
2.20 Specific conclusions are listed below and expanded upon in Chapter 3. They reflect that this report focuses on issues with the most potential for future tax administration improvements rather than on every aspect of interest or concern in this complex issue. In this context, the review also notes a number of legislative and administrative improvements that would help better to manage issues of this magnitude and complexity.
Specific Inspector-General conclusions
- Aspects of the concession's design and its administration created a high risk of inflated core technology values.
- The Tax Office had good reason to be concerned.
- The Tax Office took far too long to give practical guidance and this caused significant unnecessary compliance costs and extended the resolution's timeframes.
- Investors could have done more to be able to demonstrate compliance, but this was unrealistic in the circumstances especially in the absence of practical guidance from the Tax Office.
- The Tax Office took far too long to finalise its compliance action; it displayed no material sense of urgency for a major period of the timeframe.
- Only when very senior Tax Office executives directly managed the issue did the Tax Office take positive action to speed up its resolution.
- An unchecked cultural influence of 'hitting tax abuse hard' has been a major contributing factor to why the R&D syndication issue has taken well over a decade to near resolution.
- The Tax Office used litigation purely to strengthen its settlement position rather than to test the issues objectively.
- The Tax Office failed to communicate effectively.
- In some specific cases the Tax Office acted unfairly.
Changes to tax administration
2.21 Since these issues arose, there have been a number of changes to tax administration. Amongst those changes the more significant are:
- recent changes to the tax laws to allow the Tax Office to provide private binding rulings on matters of fact, including valuations;
- recent changes to the tax laws placing time limits on the effective unlimited time periods for review of 'nil' assessments; and
- Tax Office use of 'Taxpayer Alerts' to advise taxpayers of potential Tax Office concerns with certain tax arrangements and the reasons for those concerns.
2.22 This review and report are part of a broader study of the Tax Office's management of large complex issues. The Inspector-General plans to issue a fourth report that will make specific recommendations for changes to tax administration that draw on the findings of this case study and on the case studies of living away from home allowances, and service entities. This report signals a number of areas for inclusion in discussions with the Tax Office on the fourth report:
- Providing early practical compliance guidance in matters of complexity and uncertainty. This includes the early publication of guidance and the early communication to relevant taxpayers that their claims may be reviewed in the future.
- Improving the mechanisms to trigger management at an appropriate senior level of those complex issues experiencing delays, without relying on bottom-up escalation processes.
- Providing sufficient reasoning on technical issues to enable an informed understanding of the strengths and weaknesses of each party's case. This could include developing and applying a set of guidelines as to the form, content and purpose of a position paper.
- Introducing circuit breakers to require independent and objective reassessment of the Tax Office's view and compliance approach where significant technical or compliance issues are not being resolved in a timely way.
- Introducing processes (checks and balances) to minimise any risk of potential cultural, or other extraneous, influences getting in the way of administrative objectivity (noting that all organisations, not only the Tax Office, are subject to unconscious influence by their culture).
- Using lead cases to reduce compliance costs of the majority of potential auditees in areas of uncertainty. These lead cases could be representative of the class of cases against which the outcome will be applied. They could be used to reduce uncertainty and provide practical guidance. These cases could be clearly identified as lead cases at the outset.
- Ensuring that there is no basis for allegations of bias in review processes either by implementing sufficient transparency and external assurance in those processes, or by engaging tax officers without a prior history in the matter.
- Ensuring that there is no basis for criticism of settlement offers by ensuring that the alternative action to settlement was not arbitrary or overstated. This could include obtaining appropriate external counsel opinion on the litigation risks (both in terms of the view of the law and an assessment of the evidentiary basis to sustain that view for that case) and likelihood of success. Greater clarity around the weight of factors for adjusting settlement terms could also be given.
2.23 This review has concluded that the Tax Office has acted unfairly towards some R&D taxpayers. The report therefore makes the following recommendation that is specific to the Tax Office's management of R & D syndicate cases.
The Inspector-General recommends that the Tax Office fully reconsider whether it has fairly struck settlements with:
- the 19 investors that the Tax Office did not formally advise that their investments made more than eight years previously would be subject to review; and
- those investors with whom the Tax Office negotiated settlements without telling them that at the same time it was mediating a case to develop guidelines for the resolution of R&D syndicate cases.
Tax Office response
2.24 The Tax Office provided the following response to the above recommendation.
In relation to the 19 investors mentioned in paragraph (a), it should be noted that settlements have been made in respect of only six cases with another three cases yet to be finalised. In the remaining cases, adjustments have not been made to claimed deductions.
The Tax Office accepts that it would have been better if direct contact was made with these investors earlier. However, it is our view that most, if not all, of those investors and their advisers would have been aware of the Tax Office's ongoing review of R&D syndication arrangements.
In the small number of these cases where adjustments have been made, the settlements were entered into in good faith and were based on the fact that the deductions claimed by investors were not fully allowable under the law. To unwind these settlements for the reasons suggested in the report would raise questions of fairness to other taxpayers who have complied with their tax obligations under the law. It would also raise questions of fairness to other taxpayers who have settled or otherwise finalised assessments in circumstances where the Tax Office has reviewed old issues, for example, loss company cases.
It should also be noted that in reviewing these cases the Tax Office did take into account the length of time since the transactions took place in considering our position and the terms of settlement in each case.
In response to the cases settled during the course of the mediation mentioned in paragraph (b), each case was settled at a time when the Tax Office had not contemplated making a general settlement offer. This offer was considered towards the end of the mediation and was announced following the mediation. The cases were also settled before the Commissioner announced in April 2004 that the general anti-avoidance provisions in Part IVA of the Act would not be applied to deny deductions for core technology expenditure. The timing of the events relating to the two cases referred to in the report is set out in the attachment.
While not raised in the report, the overall complex and special circumstances of the R&D syndication issue may warrant that consideration should be given to reviewing any case settled on less favourable terms than the general settlement offer made towards the end of 2004. Although these cases would have been settled in good faith, there is an issue whether such investors have been unfairly disadvantaged compared to other investors simply because they chose to finalise their case in a more timely way. We will review this matter further taking into account all of the circumstances relating to these cases.
Inspector-General's comments on the Tax Office's response
2.25 I am pleased that in the last paragraph above the Tax Office has accepted my recommendation to reconsider the fairness of some of its settlements, albeit not on the basis set out in the recommendation.
2.26 In relation to the 19 investors mentioned in recommendation (a), the Tax Office accepts that it should have directly contacted these investors earlier. But, the Tax Office fails to acknowledge as unfair the fact that it did not. It also fails to acknowledge that apart from the lack of adequate communication there were also other aspects of unfair treatment of these taxpayers. Unlike other loss company cases, it was aware of all the relevant facts before arrangements were entered (including the details of the syndication arrangements and their tax effect), it was aware that this matter was, in its view, a significant compliance issue 12 to 14 years ago and it was aware that the losses were utilised by the investors at least eight years ago. It was aware of these matters many years before it sent them a settlement offer out of the blue (see paragraphs C10.3 to C10.3.5 in Chapter 3).
2.27 The Tax Office agrees that there was no fraud or evasion in these cases. In this context the Tax Office should have acted promptly within normal period-for-review time limits. After those periods it should have moved on, noting that in 2004 it pragmatically chose not to pursue over three-quarters of investors.
2.28 Further dialogue on these recommendations will be undertaken as part of the process leading up to the finalisation of my final and overall report on the Tax Office's ability to deal with major complex issues within reasonable timeframes.
Tax Office's submission to criticisms contained in this report
2.29 As afforded under section 25 of the Inspector-General of Taxation Act 2003, the Inspector-General gave the Commissioner of Taxation an opportunity to make submissions on criticisms in this report. The Tax Office gave a written submission.
2.30 In summary, the Tax Office clearly admits that the finalisation of its compliance action has taken too long and the communication with affected taxpayers could have been better. The Tax Office also fully accepts 7 of the 10 conclusions in the report.
2.31 However, the Tax Office did not fully accept three of the conclusions (conclusion 3, 7 and 10 — see 'specific Inspector-General conclusions' above) and some of the findings relevant to those conclusions.
2.32 Overall, the Tax Office submission does not address the substantive points raised by the conclusions. Its submission does nothing to dispel the conclusions. In some places it even appears that the submission asks the reader to accept propositions which are contrary to the Tax Office's role in a self assessing environment — for example, providing tax certainty in large complex matters.
2.33 The Tax Office submission on these disputed conclusions appears to focus on its later attempts of resolution with a blind eye to the prior 10 years. In an attempt to support its rejection of these disputed conclusions it seeks to dispute one or more references in the conclusions without addressing the range of other behaviours and areas of unfairness found in those conclusions. I assume that by not challenging these other references (neither in its final submission nor during previous discussions) the Tax Office fully accepts those findings.
2.34 The submission also asserts the report contains 'factual errors', 'omissions' and 'misleading inferences'. On closer inspection, however, these assertions are unfounded and clearly do not affect the conclusions on which they are based. I have responded to those assertions in the submission itself in some detail and further substantiated the report where relevant.
2.35 In an attempt to maintain brevity, the Tax Office's submission has truncated the facts to the point of misrepresentation in some places. The Tax Office submission also gives a mis-stated view of the facts in places. For example, the submission appears to take credit for initiating action to remedy identified unfairness. The simple fact is that without my office's strong urging to do so the Tax Office would not have taken the action it now takes credit for initiating. The Tax Office has conveniently omitted these facts from its submission.
2.36 I have reproduced the Tax Office's submission in Appendix 3. In order to reduce the length of this report and prevent duplications I have provided my detailed comments on the Tax Office's submission in the submission itself.