4.1 The following information has been extracted from Tax Office audit and technical files, AusIndustry information, Bureau of Industry Economics and Australian National Audit Office reports, Administrative Appeals Tribunal and Full Federal Court decisions.
4.2 On 20 November 1987, legislation was enacted which effectively provided for syndicates' eligibility to the R&D tax concession. Generally, the IRDB could provide 'in principle' approval, and subsequent 'joint registration' for two or more participating companies (a syndicate) undertaking joint activities.
4.3 In 1988, the Taxation Laws Amendment Act (No.5) 1988 inserted subsection 73B(11) into the Income Tax Assessment Act 1936 (ITAA 1936) allowing accelerated expenditure. Deductibility for core technology expenditure for R&D tax concessions was already provided for by subsection 73B(12) of the ITAA 1936.
4.4 On 1 July 1988, section 39P was inserted into the Industry Research and Development Act 1986. This provision, amongst other things, required at least one of the investors to be unable to use the results of the R&D in their business and to have expended not less than $1 million on the project or projects. This section also restricted syndicates to only those which included financial institutions. (See page 54 of the Explanatory Memorandum to the Taxation Laws Amendment Act 1990.)
4.5 In May 1989, the sunset clause for the R&D tax concession was extended for a limited period.
4.6 On 1 July 1989, the company tax rate changed to 39 per cent.
4.7 On 7 December 1989, the Industry Research and Development Board (IRDB) registered the first syndicate.
4.8 On 7 June 1990, the Taxation Laws Amendment Act 1990 was enacted. Amongst other things it effectively removed the restriction in section 39P of the Industry Research and Development Act 1986 that at least one of the investors in syndicates had to be a financial institution.
4.9 On 9 May 1991, the Tax Office published Taxation Ruling IT 2635. The relevant paragraphs for R&D tax concession core technology issues are the preamble and paragraphs 29-32 and 35-37. Paragraphs 35-37 ask the reader to assume that there is no guaranteed return, that the price is not simply equated with an expert's valuation and that it reflects market realities. Also, paragraphs 3, 4 and 8-10 accept that a syndicate established according to the structure set out in paragraph 4 and the associated diagram is a means by which investors may participate in R&D activities within section 73B of the ITAA 1936 on a 'guaranteed return' basis.
4.10 By letter issued in 1991, the Tax Office provided a ruling on a taxpayer's question on a valuer's methodology used in preparing the valuation of core technology:
[Taxpayer proposition set out in the ruling request]
We seek Rulings on behalf of each of the Syndicate Members from the Commissioner of Taxation confirming the issues set out below. A discussion of each issue is contained in Appendix 1. …
9. That the methodology employed in preparing the valuation of core technology is acceptable. …
APPENDIX 1 …
9. Valuation of Core Technology
In preparing the valuation the valuers were directed to have regard to the statements of the Taxation Office set out in paragraphs 35 to 37 of IT2635.
It is noted that not only does the independent valuation prepared by [the valuers] support the value placed on the core technology by the Syndicate Members, it also demonstrates the following:
- the technical feasibility of the project being undertaken;
- the close proximity to commercial exploitation;
- the competence of [the researcher] based on current resources and a proven track record, to effectively carry out the research to a commercial exploitation phase.
(refer page 21 of the valuation)
In the Executive Summary to the valuation, [the valuers] state that they believe a valuation using historical cost and revenue/profit cash flows projected to the year 2000 of $11 million to $12 million is reasonable.
Given the risks perceived by the Syndicate Members in relation to the project, and the fact that the parties are themselves dealing at 'arm's length', the licence fee for the core technology eventually agreed upon of $8.5 million cannot be said to be anything other than fair and reasonable and, therefore, acceptable to the Commissioner of Taxation.
Dealing specifically with the matters raised in paragraphs 35 to 37 of IT2635 the following comments are made:
- there is clearly a proper commercial reason for acquiring the right to use the core technology. The valuation itself clearly demonstrates that without the core technology a marketable product, being the aim of the R&D syndicate, could not be achieved;
- it is noted that the Commissioner of Taxation is concerned in situations where a valuation of core technology is based on future benefits or the service potential of successfully developed [intellectual property] and where the so-called 'arm's length' price attributes the profit on the core technology component of such sales to the vendor. In the present circumstances one method of valuation which has been adopted by [the valuers] is based upon revenue/profits and cash flow projections to the year 2000. Details of this are set out on the bottom of page 19 of the valuation. This valuation method, however, does not have as its starting point the previous expenditure incurred by [the researcher] on the core technology. As a result, given that the price eventually agreed upon by the parties was actually less than historic cost ($8.5 million v $12.147 million) there cannot, by definition, be in the amount paid any 'profit' element from the subsequent sale of the [intellectual property] attributable to the vendor;
- the valuation has not been done by reference to the existence of the Minimum Royalty Payment. It has been calculated by reference to projected sales to be made of the commercialised product;
- it is submitted that given the [valuers'] knowledge of the product and the market place, the likely commercial success of the product and [valuers'] independence, the choice of discount rate in the valuation based on projected future cash flows cannot be objectively challenged. In addition the valuation method adopted is clearly appropriate given the proximity to commercialisation;
- in conclusion, therefore, it is submitted that the attached valuation clearly:
- reflects market realities in that an independent valuation has produced a valuation in excess of the price eventually agreed to between the parties, ie the Syndicate Members have discounted the price to reflect the perception of the commercial risk;
- the valuation does not depend upon the existence of an MRP.
Given these facts and the extent of the work done in order to produce the independent valuation it is strongly contended that the price paid for the core technology licence of $8.5 million can clearly and objectively be said to represent an 'arm's length' price.
[the Tax Office's response to the applicant:]
We advise that the Commissioner cannot be bound in cases of this nature by opinions given as to the manner in which the law will be applied to transactions. When the time comes to assess or review liability to tax the Commissioner must apply the law then in force to the facts as established at that time …
We note the Commissioner's comments in paragraphs 35-37 of IT2635 in respect of the valuation of core technology and confirm the proposition you advance here.
4.11 With effect from 19 December 1991, subsection 73B(31) of the ITAA 1936 was enacted. That provision provides:
- an eligible company has incurred an amount of research and development expenditure, an amount of core technology expenditure or an amount of expenditure in the acquisition or construction of plant, a building or an extension, alteration or improvement to a building for use by the company exclusively for the purpose of the carrying on by or on behalf of the company of research and development activities; and
- the Commissioner is satisfied that:
- having regard to any connection between the company and the person to whom the expenditure was incurred and to any other relevant circumstances, the company and that other person were not dealing with each other at arm's length in relation to the incurring of that expenditure; and
- the amount of that expenditure would have been less if the company and that other person had dealt with each other at arm's length in relation to the incurring of that expenditure;
so much only of that expenditure as the Commissioner considers reasonable having regard to:
- the connection between the company and that other person;
- the amount of the expenditure that would, in the opinion of the Commissioner, have been incurred by the company if the company and that other person had dealt with each other at arm's length in relation to the incurring of that expenditure; and
- such other matters as the Commissioner considers relevant;
shall be taken into account for the purposes of this section.
4.12 In March 1992, the Tax Office's Strategic Research & Analysis Group identified R&D syndication as a potential high compliance risk.
4.13 In May 1992, the TCC raised with the ANAO concerns with R&D syndicates exploiting the R&D tax concession.
4.14 In July 1992, the Tax Office commenced audits in two R&D syndicate cases as part of its large case audit programme.
4.15 In August 1992, the Treasurer announced that the R&D tax concession was extended to operate indefinitely.
4.16 Section 39EA of the Industry and Development Act 1986 was enacted to enable the IRDB to develop Guidelines to assess whether a finance scheme used to finance R&D was ineligible.
4.17 The Taxation Laws Amendment Act (No. 2.) 1992 was enacted and, amongst other things, excluded public sector tax exempt bodies from the R&D tax concession.
4.18 In November 1992, the Tax Office's National Office Taxpayer Audit area was concerned that syndicated R&D was a substantial compliance issue. It recommended a national project on R&D syndication.
4.19 The Finance Scheme Guidelines were introduced by the Taxation Laws Amendment Act (No. 5) 1992 with effect from 31 March 1993. They enabled the IRDB to exercise greater discretion to prevent exploitation:
The Board will, as stated in the Guidelines, adopt a balanced approach to the determination of whether a finance scheme is eligible. This overall approach recognises that certain features of finance scheme proposals, such as the use of a tax exempt organisation or overseas company as the core technology provider, or the utilisation of unrelated third party tax losses in generating the guaranteed return, would not comply with the Finance Scheme Guidelines if they occur in isolation. In such circumstances, the Board would expect that the commercialisation arrangements for the R&D would be such as to offset any negative aspects of the syndicate finance scheme. In the absence of such evidence it would be unlikely that the finance scheme would satisfy the Board's Guidelines. [p 206] … Recognising the lack of specific details on acceptable structural features of syndicates may cause uncertainty amongst investors and promoters, the Board will liaise with promoters to ensure that syndicate structures are acceptable [p 207] ….
It is recognised that syndication, as a mechanism for raising funding for R&D must compete in a market characterised by a limit on the overall availability of funds and that accordingly finance schemes to fund research and development must be competitive with other forms of structured or tax effective finance.
However, the Government is concerned to exclude those schemes whose arrangements are primarily intended to achieve a guaranteed return for investors as opposed to returns generated as a result of the commercialisation of R&D results ….
The manner in which the R&D results are to be commercialised is a critical element in the determination of whether a syndicate is established for the purpose of undertaking R&D with a realistic prospect of successful commercialisation or whether the scheme is merely an elaborate mechanism for generating a guaranteed return to investors …
In considering the specific details of such schemes the Board will make reference to the following:
- Valuation for core technology;
- The ratio of core technology expenditure to total R&D expenditure; ….
- The manner in which the company generates the tax losses that must exist in order for a syndicate to operate
4.20 On 19 November 1993, the ANAO published the report of its review of the R&D tax concession. Amongst others, it recommended:
The Tax Office and DITRD jointly select and examine a sample of syndication arrangements covering a geographic spread and a number of syndicate promoters involving:
- … Suspected inflated core technology valuations and sinking funds … [Recommendation 17]
4.21 Until the ANAO report, the Tax Office considered the R&D syndication compliance risk as a relatively low priority because the R&D legislation initially had a sunset clause due to expire in 1991.
4.22 In December 1993, the TCC issued a document, Finance Scheme Guidelines — Interpretation. It provided further information to proposed syndicates on the TCC's finance scheme requirements. It placed a limit on allowable core technology expenditure of around 65-70 per cent of total syndication expenditure.
4.23 In 1994, the Department of Industry, Technology and Regional Development published a book called 150% Tax Concession: Guide to Benefits: It's Your Break — Revised Edition 1994 (the 1994 R&D book). The 1994 R&D book stated that the IRDB 'examines the eligibility of the proposed R&D project(s) … and all aspects of the financial and commercial arrangements associated with the syndicate'. The Tax Office 'is responsible for addressing matters relating to tax law' [page 199] and 'is responsible for determining whether expenditure claimed by companies and their financial structures are eligible under the various legislative provisions of the ITAA' [page 16].
4.24 The objective of the R&D tax concession was:
To make Australian companies more innovative and internationally competitive through:
- increasing investment in R&D
- encouraging better use of existing research infrastructure
- improving conditions for commercialising research, and
- developing a greater capacity for the adoption of foreign technology. (R&D Book, 1994, page 12) …
The syndicated provision of the concession intended to contribute to these goals by encouraging R&D projects that are (a) too big or (b) too risky for any one company, to be undertaken by a group of companies (page 194)
4.25 The 1994 R&D book stated:
It is generally accepted that financial institutions will not participate in syndication in the absence of a guaranteed return. [page 207]
4.26 The IRDB issued a guide to core technology determinations, Valuing core technology. It states:
It should be noted that section 39LA does not give the Board power to make determinations in relation to the value of any core technology purchase or licence. The power to make determinations relating to 'core technology expenditure' and 'research and development expenditure' remains solely the jurisdiction of the Tax Office. However, core technology valuation is an issue considered in the context of finance scheme guidelines …
Any valuation of core technology submitted to the Board should be conducted using appropriate expertise. The credibility of any valuation will be prejudiced by the extent of any disclaimers.
The core technology valuation should describe and use an appropriate valuation methodology, and the scope of the valuations should be limited to the core technology described (above). Where the core technology involves publicly available knowledge, the valuation should provide reasons why that technology has particular value in relation to the particular research and development activities.
4.27 From March 1994, the Tax Office observer on the TCC was also the Tax Office's R&D syndication project manager.
4.28 On 1 July 1994, the company tax rates changed to 33 per cent.
4.29 On 30 September 1994, a Tax Office project was approved to implement the ANAO's recommendation 17 with a view to completing 6 to 12 audits by 30 June 1996 with six staff. The project initiation brief referred to a 'proposal to have a Senior Tax Counsel appointed to concentrate on R&D issues on a national basis'. It made the following comments in relation to revenue risk:
Revenue at Risk
Since the introduction of the syndication provisions in November 1987 there have been 115 syndicates registered with the IRDB with the great majority of them commencing in the 1990 or a later income year. Estimated expenditure on R&D activities for these syndicates was $1.75 billion and the cost to revenue has been calculated by AusIndustry as being approximately $370 million.
In the 1993-94 income year 38 syndicates were registered with the IRDB with estimated R&D expenditure of $338 million and a cost to revenue of approximately $96 million. Once again these figures have been provided by AusIndustry.
These figures do not include the interest on borrowings by syndicates which is substantial and will greatly increase the cost to revenue.
AusIndustry has not made any forward projections in respect of syndicate registrations for the 1994-95 income year but it is generally accepted that the risk to revenue from syndicated structures is a significantly escalating risk.
4.30 In October 1994, the Bureau of Industry Economics (BIE) evaluated R&D syndication (Report No. 60 — Syndication R&D — An evaluation of the Syndication Program). The report noted that it was too early to assess the commercial benefits of the program. It also pointed to a number of problems with syndication but recommended that the programme nonetheless be retained because it generated significant net social benefits. It found that considerable uncertainty existed in relation to core technology valuations. It also considered that there were misperceptions that syndication was merely a tax shelter. It made the following recommendations:
The BIE considers that there would be advantages in reduced uncertainty from clarification by the Tax Office and other parties of the treatment of core technology and admissible financial structures. It may be worth removing the requirement for a core technology valuation …
The BIE considers that steps should be taken to correct widespread misperceptions about the nature and benefits of the programme.
4.31 The Tax Office has not publicly responded to the BIE report.
4.32 The BIE report also questioned whether the valuations were a means to ensure an arm's length transaction:
The core technology licence value is subject to independent valuation. This is intended to ensure arm's length commercial transaction. Whether or not this value accurately reflects the market price of the core technology is open to question … (page 37)
The core technology payment has a crucial role as the means by which tax loss benefits are transferred under syndication. Its status under the program is ambiguous because on the one hand it is merely a financing mechanism, while on the other it is perceived as a legitimate valuation exercise which must stand up to Tax Office scrutiny … Notionally, all firms either valued technology by aggregating the historical costs of producing core technology and/or estimating the present value of an after-tax royalty stream … Many firms argued that the point estimate of the core technology valuation was determined by:
- The need to undertake a certain amount of R&D and to set up a core-technology value that was consistent with investors' required rate of return … These firms were called R&D led (RLED) firms.
- The desire to convert lowly valued tax losses into highly valued R&D … In their case, the binding constraint on the possible value of the core technology was the level of their tax losses … These firms were called tax-led (TLED) …
Some firms claimed that they … simply estimated the most defensible valuation of core technology, treating it as a genuine valuation exercise. These firms we called core technology led (CTLED). In their case, if the resulting core-technology valuation could not support the desired R&D or exceeded their tax losses, then they would not use syndication. In contrast, the RLED and TLED firms would engineer core-technology valuations consistent with their commercial aspirations, so long as the valuation still lay within the wide bounds of the original core-technology valuation exercise.
… [of the firms surveyed] 14 of the 25 firms who produced core technology valuations were RLED or TLED with 11 being CTLED. Many firms perceived syndication to be sanctioned tax benefit transfer, but concealed in a confusing parcel involving an artificial core technology valuation which obscured this function. They called for the explicit recognition of this aspect of the programme. [page 48]
4.33 The BIE report also commented on the motivation for excluding private and public tax exempt researchers from the tax concession:
… until their [public sector research infrastructure] elimination from the program, syndication allowed public sector tax sector tax exempt bodies to exploit syndication. There was evidence that the public sector tax exempt bodies tended to employ higher core-technology valuations, relative to the R&D conduct, so as to attract financial investors. There was insufficient data to evaluate whether the public tax exempt entities had conducted high quality research with strong commercial prospects. [page 120] …
Currently, tax public sector research firms are disqualified from participation in syndication. The motivation for their exclusion is the concern that:
- A tax exempt body has no incentive to contain the core technology valuation for any given amount of R&D, so that genuine tax loss firms are at a competitive disadvantage when seeking investors.
- As tax exempt bodies are not giving up valuable tax losses, they do not face the same incentives to undertake commercially orientated high returning research. This is a critical distinction relative to taxable entities. Taxable firms use their tax losses as a means of obtaining finance for R&D, whereas no tax loss transfers take place at all for tax exempts.
The net effect of this is that less worthwhile projects conducted by tax exempt bodies may crowd out those in taxable companies …
The critical issue when considering the role of private or public tax exempt bodies is whether worthwhile R&D with high social spill overs is being conducted, relative to the costs of revenue foregone. If it were possible:
- to eliminate cases where the tax exempt body is able to secure a competitive advantage vis a vis taxable entities (for example, where the core technology valuation was inflated artificially); and
- to discriminate between R&D projects with high social rates of return from those with lower returns,
then there would be some basis for allowing both private and public sector tax exempts to participate under special monitoring arrangements. However, even then, a case would have to be made that syndication was a preferred vehicle for subsidising such R&D relative to other tried mechanisms, such as grants …
… DIST could stipulate notional terms of trade for R&D for tax losses for a public tax exempt body … In this way, core technology valuations or other mechanisms could not be easily exploited to provide the public tax exempt body with any competitive advantage …
Finally, the insuperable difficulty regarding public and private tax exempt bodies is the high revenue costs. The analysis in Chapter 5 suggests an historical effective subsidy rate of about 140 per cent for tax exempt syndicates. Notwithstanding, high inducement rates, the revenue losses are so appreciable that large spill over rates are required to be certain that such syndicates produce net benefits. That certainty is not possible in the face of substantial uncertainty regarding the magnitude of spill over effects. Moreover, a traditional mechanism, such as a direct grant, may well produce a higher bang for buck than syndication for such tax exempt institutions.
Because of the extreme rate of subsidy, the low and uncertain net social return and the general absence of market disciplines for tax exempt bodies, the BIE considers both public and private tax exempts should be barred from the programme. [pages 125-6]
4.34 The BIE report also recognised the R&D syndication tax concession as a sanctioned means to sell tax losses:
Notwithstanding its complex guise, the program is an officially sanctioned mechanism for financing new R&D through the sale of tax losses. (p 8) …
… syndicated R&D is fundamentally a mechanism for the transfer of tax losses from R&D researchers who cannot take full advantage of them to financial investors who can. (p 43)
4.35 In October 1994, the Australian Valuation Office provided the Tax Office with a critique of a syndicate's valuation.
4.36 On 11 October 1994, the Tax Office received independent legal advice on, amongst others, subsection 73B(31) issues. That advice concluded that:
The valuation report behind tab 25 in my brief (critique) does rather suggest that the amount settled between the parties was higher than parties dealing with each other at arm's length would have paid. The valuation also suggests further lines of enquiry which the Commissioner should undertake to ascertain what a willing but not over anxious buyer of the technology would have paid for it. The question is essentially one for a valuer to undertake and it may be that further enquiries would reveal that determining the reasonable expenditure will be quite complicated and difficult.
4.37 On 26 October 1994, an investor in syndicate A lodged a private binding ruling request with the Tax Office.
4.38 In late 1994, syndicate A was rejected by AusIndustry because it did not meet the finance scheme guidelines. Changes were made which satisfied AusIndustry. Registration was provided later in 1994 on the condition that:
… 2. that in all other respects, your proposal will be able to satisfy the requirements of section 73B …
4. that any Australian Taxation Office requirements are satisfied.
4.39 A senior tax technical officer was made available to the R&D syndication audit team from early 1995.
4.40 An audit into syndicate B started around 1 February 1995.
4.41 On 16-17 February 1995, a Tax Office Senior Tax Counsel gave a speech at an industry conference on 'Syndicated R&D'. The notes for his speech referred to the following relevant points:
- general issues for syndicates: see IT 2635 paras 29-37
- Arm's length basis for dealing?
- Nature and commerciality of R&D project
- artificial structure attributes one party's R&D expenditure to another? …
- syndication issues
- guaranteed return ignores value of core and results
- return assured by return of funds to syndicate members
- core technology pricing ignores value and provides fixed tax benefit and return to fund further work
Current topics …
- BIE report …
- Suggest no economic grounds for concern overvaluation of core technology: this depends on analysis of syndication as loss transfer
- No formal Tax Office position on BIE report as yet
4.42 On 23 February 1995, the Tax Office issued a private binding ruling to the investors into syndicate C:
That on the assumption that the R&D Program comes within the definition of 'Research and Development Activities' as defined in Section 73B(1) of the Income Tax Assessment Act: …
- that the amount paid on 30 June 1994 by way of Licence Fee … under the [licensing and marketing development agreement] by the [investors] in respect of the licence of certain existing [core technology] … fall within the definition of 'core technology expenditure' in terms of subsection 73B(1) of the Income Tax Assessment Act;
- That the core technology valuation process (supported by an independent report provided by independent consultants [the valuers]) is consistent with the process required to satisfy the terms of IT2635, para 35;
- Confirmed, subject to the following: …
- Under section 39LA of the IR & D Act, the IRDB has responsibility for determining whether particular technology is 'core technology' in respect of particular R&D activities. The Commissioner would rely on the IRDB in determining whether expenditure constitutes 'core technology expenditure' for the purposes of the R&D provisions.
- It should be understood that the Commissioner makes no determination that the Core Technology Licence Fee is accepted as being an arm's length or commercial price for the licence in question. Such a determination can only be made after a factual investigation of the dealing surrounding the acquisition of the licence. We advise that such an investigation cannot be undertaken as part of a response to a private ruling request; this is as contemplated by subparagraph 14ZAN(j)(i) of the Administration Act.
- Refer 1.(iii) above.
4.43 On 17 March 1995, the Tax Office issued the following ruling to an investor in syndicate A:
That the … following expenditures will be deductible to the Investors under section 73B of the Act: Core Technology Licence fee paid to [abc company] under the … Deed … That the methodology employed in preparing the valuation of Core technology is acceptable to the Commissioner …
It should be understood that the Commissioner makes no determination that the Core Technology Licence Fee is accepted as being an arm's length or commercial price for the licence in question. Such a determination can only be made after a factual investigation of the dealing surrounding the acquisition of the licence. We advise that such an investigation cannot be undertaken as part of a response to a private ruling request.
That the Transactions in the Transaction Documents do not invoke the operation of the provisions of Part IVA of the Act to any aspect of the R&D syndication structure … [and] That the provisions of … Part IVA of the Act have no application to any aspects of the R&D Syndication structure … or to any transactions entered into by any of the parties to the various operative agreements in connection with the R&D Syndication …
There would appear to be no specific features in the arrangement which would call for the consideration of Part IVA. However, the question of the application of Part IVA will ultimately have to be determined having regard to the facts of the legal rights of the parties, the factual outcomes of the Syndication and the manner in which the Transaction Documents are given effect by the parties. To the extent to which the confirmation of this Proposition requires the Commissioner to make assumptions relating to future events we decline … to make the Ruling sought.
4.44 In May 1995, the Government announced that it would act on a BIE recommendation to exclude private sector tax exempt bodies. The Taxation Laws Amendment Act (No. 4) 1995 gave effect to this announcement.
4.45 Around August 1995, the TCC was partially reconstituted. A former Commissioner of Taxation was appointed as Chairman to the TCC. The TCC consulted the public on a draft set of new finance scheme guidelines in August 1995.
4.46 In November 1995, the Finance Scheme Guidelines No. 2 were gazetted.
4.47 The Finance Scheme Guidelines No. 2 increased the at risk component to a minimum of 10 per cent, required 50 per cent of the core technology either to be owned by researchers for at least two years, developed by them or the deduction limited to Australian income tax paid. The primary purpose was to fund and commercialise R&D and not provide profit through tax effective arrangements. The guidelines capped at $15 million each guaranteed investment.
4.48 In November 1995, the TCC Chairman gave a speech to an R&D industry conference saying that these finance guidelines were issued to eliminate potential syndicates using artificial tax structures. They would address concerns with:
attempts to widen the scope of tax saving 'fuel' that has come to evidence the power source of 'guaranteed' R&D syndicates and the question of core technology valuations.
4.49 In November and December 1995, the TCC began pressing syndicates for arm's length valuations of core technology for new applicants:
Last November/December the TCC began pressing for arm's length valuations of core technology, in a way that it had not until then been administrative practice always to do so.
In early January, the background to and reasons for this approach were outlined to representatives of the principal packagers. In subsequent meetings, at both most senior and operative management levels, the Board's and the TCC's considered, determined, stand has been further explained to key people in the industry. (TCC Chairman speech paper to AIS industry conference 20-21 March 1996.)
4.50 By the end of 1995, all Tax Office information gathering in the syndicate B audit was finalised.
4.51 In 1996, the Innovations segment of the Tax Office was tasked with responsibility for coordinating the technical views and compliance strategy for R&D syndication.
4.52 By letter dated late February 1996, the Tax Office asked the manager of syndicate D to answer a questionnaire on the syndicate. It responded eight months later.
4.53 The Government changed in March 1996.
4.54 On 20 March 1996, a Tax Office Senior Tax Counsel publicly stated during an R&D industry conference that the Tax Office was aware of 'early indications of questionable valuations of core technology'.
4.55 At an industry conference on 21 March 1996, the Chairman of the TCC announced the TCC's five particular concerns with core technology valuations and its intention to get its own valuations if need be:
As a result of the scrutiny that has been applied the Committee is concerned to see:
- that the valuation is of a high professional standard and meets the accepted criteria of being both independent and at arm's length …
- that income projections do not appear to high or over-optimistic and that they are made with sufficient supporting evidence …
- that royalty rates … are established on the basis of substantiated industry practice and verified by independent expert statements …
- that the nature and underling rationale of risk and risk factors be clearly identified and factored into the valuation …
- that the form of the disclaimer made by the valuer is not too broad and that there is adequate independent verification of key assumptions and facts …
The five points I have just outlined, together with an understanding of the issues arising from the Australian Valuation Office critiques I referred to earlier, will assist the TCC to make some broad judgements in relation to core technology valuations, in the context of addressing all relevant matters relating to each application. Hopefully, that will be enough to make decisions, but we recognise that it may also be necessary for the TCC to itself commission full-scale valuations in some instance. We stand ready to do that.
4.56 The Chairman of the TCC also commented in relation to the issuing of the guidelines that core technology valuations provided a raft of issues:
One of the things that struck me … was the widespread perception that valuations of core technology were substantially on the too high side.
One gained the clear impression that, too often, the amount of a core technology valuation represented not much more than a set of numbers designed to bring about a desired set of outcomes for the participants.
Last November/December  the TCC began pressing for arm's length valuations of core technology, in a way that it had until then had been administrative practice always to do …
Unfortunately, from our point of view, there has been practically no movement by proponents away from what the Board and the Committee consider may be unsustainable valuations. I say this in the general sense, of course, as each situation is entitled to be decided on its own facts and merits. But in the generality, valuations presented to us cannot, we believe, be sustained (we doubt that they would be accepted as sound by a bank that was asked to lend money on the strength of them) and it is necessary in particular cases to apply approaches which reflect the appropriate level of consistency across all cases.
The TCC is conscious that all of this has disturbed the previous flow of decision-making through the Committee. We regret this but do not accept that the criticism is to be laid at our door.
We have been proceeding actively on the basis of expert legal and technical valuation advice, particularly from the Australian Valuation Office. That Office has provided us with critiques of a number of the valuations that are contended by proponents to be valuations on an arm's length basis.
These critiques have served to confirm the general unease that has developed about valuations, has helped to bring to light common deficiencies in valuations and provides a basis for the establishment of a framework to be used in assessing valuations that come to the TCC [the Chairman then set out 3 key deficiencies and 5 expectations in relation to valuations of core technology] …
4.57 At that conference, the Chairman of the TCC also outlined the TCC's concern with guaranteed returns:
That guaranteed return may, in keeping with policy, be 'fuelled' by tax losses of the researcher but not through a core technology acquisition the licensor in which does not bear Australian tax on the receipt because the recipient is tax exempt or is a non-resident entity not subject to Australian tax or because the asset being disposed of is a pre-capital gains tax asset.
4.58 He also considered that the tax concession operated by trading researchers' tax losses in exchange for investors financing early-stage R&D work:
… the then Minister Senator Cook, provided a formal answer to a question asked in Senate Estimates Committee D, in the course of which he set out what had become the policy of the syndication provisions:
- … The basis of a syndicate is the trade off of tax losses in exchange for R&D finance with the result that the research company reduces the magnitude of carry forward tax losses and thus accelerates the time when the company becomes tax positive …
Syndication was conceived of as a mechanism for providing companies in a tax loss position with access to critical capital. (Trevor Boucher speech to AIC Conference, 20 March 1996.)
4.59 During May 1996, promoters approached the ministers in the new Government to argue for the retention of the R&D syndication tax concession.
4.60 The audit into syndicate E started in early June 1996.
4.61 On 1 July 1996, the company tax rates changed to 36 per cent.
4.62 In July 1996, DITR seconded the author of the 1994 BIE evaluation of syndication to review syndication. The resulting report recommended that R&D syndication should be terminated:
Syndication has a number of virtues — in particular its ability to stimulate new R&D. BIE (1994) also found it produced a number of other less tangible benefits — such as better management and planning of R&D projects in technology driven firms.
But these desirable features of the program are offset by some large drawbacks whose impact has intensified since the BIE's first examination of the programme.
- The quality of some of the R&D and the likelihood of its commercialisation is low because (a) good tax loss companies are more scarce in good times and (b) some of the new structures have avoided taxes on payments made to research companies under syndication both increasing the cost to revenue and reducing the incentives of managers and investors to discriminate on the basis of the quality of R&D. We are sceptical that the new guidelines issued in November 1995 will deal with these problems over the longer term.
- Like a chameleon, the program has continually changed in ways which favour the easy extraction of large tax deductions. In August 1992 the then government barred public sector (tax exempt) organisations from using syndication — because the revenue costs were too high. In the aftermath of that change, private tax exempt syndicates developed. The BIE (1994) strongly recommended the removal of such private tax exempts from participation of the program because of the extreme rate of effective subsidy, the low and uncertain net social benefit and the absence of market disciplines for good R&D. This recommendation was acted on in the 1995 Budget. However, new structures quickly evolved which had an identical impact (such as so-called cost base syndicates). The incentives continued for financial innovation — to use syndication as a vehicle for obtaining large tax deductions — outpace the incentive for real technological innovation. We have little confidence that the program can be made immune to renewed efforts to extract such deductions without excessively complex and continually evolving tax legislation and R&D guidelines, and without substantial resources devoted to careful monitoring of the program …
We do not believe that all syndicates are bad — some involve companies with legitimately acquired losses doing worthwhile R&D which would not otherwise have been funded. There have been some outstanding success stories under the syndication program — some of which were reviewed in BIE (1994). (pages xi and xii.)
4.63 In late July 1996, the Tax Office wrote to an investor in syndicate B advising them of Tax Office delays:
I am writing to you to inform you of the current position of the income tax audit of the above named syndicate. You will recall that in previous telephone conversations I have had with you I indicated that our enquiries were completed and that we were awaiting the valuation of the syndicate's core technology by the Australian Valuation Office.
That remains the present position … When the completed AVO valuation is received we will be in a position to formally conclude the audit … Although the delay in obtaining the core technology valuation has been due to causes largely out of our control, I must nevertheless apologise for any inconvenience the syndicate members have suffered as a result. I assure you that every effort will be made to expeditiously bring things to conclusion once the AVO report is at hand.
4.64 On 23 July 1996, the Treasurer and Minister for Industry, Science and Tourism jointly announced the closure of the R&D syndication programme to new syndicates.
The Government has decided to close off new syndicates qualifying for the R&D tax concession as from 5:00 p.m. this afternoon …
The Government has made this decision because the current arrangements with regard to syndication have become focussed on tax minimisation rather than the provision of genuine R&D.
Tax benefits from R&D syndication commonly exceed the cost of R&D work still to be done. These unintended tax benefits have made it impossible for the Government to allow further syndication of R&D …
Investors under existing syndicates, and under planned syndicates which have already received advance approvals, will not be prevented from seeking the R&D tax concession.
4.65 On 24-25 September 1996, at the R&D Tax Conference, another Tax Office Senior Tax Counsel gave a paper on the Tax Office perspective of the 'new rules'. That paper relevant states:
Notwithstanding the 23 July 1996 announcement to end syndication, the Tax Office is continuing its audits of existing syndicates. I mentioned at an AIC R&D conference in March this year that we had concerns with early indications of questionable valuations of core technology. The work that the valuers we have engaged have done since is supporting the early views of serious over-valuation of the core technology in the cases under review. We are getting close to issuing position papers that are likely to flag amendments based, inter alia, on apparent non arm's length transactions (sebsec.73B(31)) or possible application of the general anti-avoidance provisions in Part IVA.
Another area of concern is syndicate termination arrangements. I mentioned in March the need for syndicates to ensure that any terminations are in accordance with arrangements originally, or subsequently, approved in A Tax Office private ruling.
We plan to continue to examine syndicates to ensure compliance with ruled upon arrangements …
4.66 The Taxation Laws Amendment Act (No. 3) 1996 was enacted in December 1996 to give effect to the BIE's recommendation that syndication should be terminated by effectively barring further guaranteed syndicate R&D registrations.
4.67 At an industry conference on 10 November 1997 the Chairman of the TCC considered the TCC's forward compliance approach to R&D syndicates:
Over the years a key question facing registration decision-makers has been whether each particular syndicate was dominated by a purpose of providing risk free returns out of particular tax advantages (to put it colloquially, a 'tax rort'), or whether the aim was genuinely to carry out the nominated R&D and carry it through to successful and beneficial commercialisation … it is not clear as to the extent to which earlier decisions (particularly those made under Finance Scheme Guidelines No 1) would, under review today, attract the same outcomes. Given the more rigorous approach adopted by the TCC on issues such as the manner in which tax losses were generated, projected commercialisation benefits and the validity of core technology valuations, I suspect that quite a number would not. (Pages 3-4.)
4.68 The Chairman of the TCC outlined at an industry conference on 10 November 1997, the role of the Tax Office:
… In many cases, the claims made about the expected multitude of sales, the projected share of global markets, the absence of competition, and the marketable life of the technology were, in the minds of the TCC, stretching credulity to say the least …
Similarly, many core technology valuations submitted to the TCC as part of the syndicate's proposed finance scheme raised questions as to the independence of the valuations, the appropriateness of the discount rates utilised, the validity of expected royalty rates and the credibility of forecast sales projections. Nevertheless, given the need for the TCC to come to a balanced decision having regard to all the criteria, favourable advance decisions from the TCC on the R&D, the core technology and the finance scheme were generally obtained, although over the last 12 months before syndication was abolished it became harder to get finance schemes approved. [Page 4] …
[The Chairman outlined the TCC's concerns with syndication arrangements ongoing technical progress reporting obligation and efforts to commercialise and the IRDB's review functions in disallowing where no commercialisation].
We are, in all of this, working in close collaboration with the Tax Office, which under its legislation has specific and additional review responsibilities notably in connection with core technology valuations and the anti-avoidance provisions of Part IVA of the ITAA 1936.
It may be that an outcome of the Board and the Tax Office reviews will be that the tax deductions sought to be obtained by syndication arrangements will have to be disallowed, with all the consequences attaching to disallowance. And associated with any disallowances, or Board certificates leading to them, would be the costs of ensuing litigation. [Pages 7-8.]
4.69 The audit into syndicate F started in December 1997.
4.70 On 30 March 1998, the Tax Office's R&D syndication project manager made a speech at an AIC conference. However, a copy of this presentation was not provided to the Inspector-General.
4.71 On 31 March 1998, the TCC Chairman announced at an industry conference the TCC's forward compliance approach to previously registered syndicates. It would not seek to render syndicates ineligible so long as investors did not impede commercialisation:
In approving finance scheme at registration, the Board has generally taken the position that it will not subsequently take action against those schemes unless there has been material change to the finance scheme structure …
Excessive optimism by itself may or may not be viewed as culpable. However, if a high Core Technology Valuation had been based on the promise of a large 'pot of gold' upon successful completion of the R&D, but syndicate investors showed no interest in pursuing that 'pot of gold' through genuine support for commercialisation efforts at the end of a successful R&D project, then there are two possible conclusions which could be drawn — both with legal ramifications.
The first conclusion might be that the promised 'pot of gold' had been a work of fiction — that the Core Technology Valuation had not been a legitimate, arms-length commercial valuation. As Ray Veitch told you yesterday, this can lead to action under section 31(1) of the Tax Act.
The alternative conclusion would be that the investor had never been in the game for the 'pot of gold' after all — that the real primary intent had been to obtain the tax deductions. This would contradict the case made out to the Board at the time of the finance scheme approval. Legally, this might be viewed as a material change to the finance scheme, leading again to action under section 39MA of the IR&D Act. (Pages 5-6) …
In all of this, the Board is following some key principles:
... A second principle is that the TCC will not pursue syndicates just because the current TCC may have come to a different decision than did its predecessors about whether a syndication proposal should have been registered … Syndicates will not be targeted for action purely on the grounds that the Board wishes it could reverse the original decision. (Pages 8-9.)
… it needs to be said that this exercise [ensuring commercialisation not impeded by investors] is not about catching syndicates out and getting back the tax deductions, except as a last resort. (Page 12.)
4.72 On 3 April 1998, the Cash Economy Task Force provided its Second Report to the Commissioner of Taxation. It proposed a theoretical model to improving voluntary compliance:
Without an understanding of the structural influencers it is possible that Tax Office efforts to tackle the cash economy will prove ineffective. An approach which relies simply on detecting non-compliance and imposing sanctions on detected non-compliers will tend to be short term in effect and increasingly resource intensive for the Tax Office. It will also place an unreasonable compliance burden on good compliers. (Page 19) …
An extensive review of the compliance literature by the Tax Office has identified some commonly mentioned factors impacting on a taxpayer's compliance decisions. An appreciation of these factors, and their interrelationships, will help the Tax Office address the structural influencers on the cash economy identified by the Task Force in its first report.
The research to date has revealed that taxpayer compliance decisions can be affected by factors which can be broadly categorised as psychological, sociological, economic and industry. The business profile adopted by the taxpayer can also influence compliance. [BISEP factors] (Page 20) …
… the many competing factors impacting on the taxpayer cause the taxpayer to adopt a particular posture or stance. Underlying each stance are beliefs, values and attitudes which influence the behaviour of a taxpayer. These stances indicate the degree of acceptance or rejection a taxpayer has towards the Tax Office and can be summarised as follows:
- managerial accommodation or initiation: the taxpayer includes the regulatory requirements in their management plans and actively complies, and may encourage others to do so;
- capture or conformity: the taxpayer accepts the regulatory requirements, and has faith in the Tax Office;
- resistance: there is confrontation between the taxpayer and the Tax Office;
- disengagement: withdrawal of the taxpayer from the regulatory process.
Taxpayers in the first and second categories are generally compliant, while those in the third and fourth categories are non compliant. The way an industry approaches its taxation obligations may be determined by the make-up of the participants in that industry. An industry comprising a significant number of disengagers will require a different Tax Office approach to regulation than an industry made up of primarily initiators. (Page 23.)
4.73 In April 1998, the Tax Office obtained an external legal opinion in a syndicate case under audit. In relation to the specific anti-avoidance provision it advised the following:
- There was no one test to determine an arm's length dealing. The closest thing to a test was a judicial suggestion that the outcome of the dealing must be 'a matter of real bargaining'.
- The position paper in the audit did not identify matters supporting the Tax Office's conclusion of no arm's length dealing but the Case Manager's earlier internal report did. The Case Manager's reasons were that:
- there was documentation that suggested the investor was seeking to achieve deductions of an amount near that outlaid for the core technology licence before the researcher was even chosen;
- there was documentation to show that the core technology fee was pre-determined — the investor and packager had agreed on the core technology outlay and also applied for IRDB registration before the licensor had completed its valuation of the core technology;
- there was documentation to show that there was an absence of any real bargaining — the researcher had accepted an increase to the core technology licence by about $1 million so as to incorporate the packager's fee;
- there was documentation to indicate that the researcher was
aware that [the investor's] primary concern was its high tax liability and not the commercialisation of research results. This could provide a basis for concluding that [the researcher] and [the investor] were not dealing at arm's length in relation to the core technology fee but were acting in collusion to achieve a reduction in [the investor's] tax liability. We are aware that the high profitability of the group of [the financial year in question] has given rise to a considerable taxable income and that this is the primary reason for the company considering entering research and development agreements with [the researcher].
- The 'matter of greatest significance' was the value of core technology opined in the AVO valuation:
The marked discrepancy between the two valuations seems to us to be at the centre of the issue as to whether the parties were dealing with each other at arm's length.
- It was surprising, in a commercial context, to find that a company outlaid millions of dollars for a licensing arrangement on reliance of a valuation provided by the licensor. However, the preparedness of [the investors] to do so in the present circumstances is probably explained by the existence of the put option, which effectively eliminated any commercial risk on the part of [the investor] should the valuation prove inaccurate.
- Based on the assumption that the AVO valuation was correct, the Commissioner was entitled to be satisfied both that there was no arm's length dealing and that the value opined by the AVO was reasonable to be allowed as the amount incurred as core technology expenditure for the purposes of paragraph 73B(31)(d) on the basis of the matters referred to in the Case Manager's internal report above and the following conclusions:
- The investor outlaid tens of millions of dollars to acquire core technology rights which had a value of less than half a per cent of the claimed amount.
- The investor never obtained a 'truly independent valuation'.
- The investor was assured of recovering the outlay for the core technology through the put option mechanism, which insulated the investor against any adverse commercial consequence flowing from the inaccuracy of the licensor's valuation.
- The legal advice stressed that it was assumed that the AVO valuations were correct. It noted that the AVO had no expertise in that field of technology and that there was need for further input from independent expert valuers before concluding a view in relation to subsection 73B(31). This was because the Commissioner needed to have a 'high degree of confidence' in the valuations relied upon to amend the assessments.
4.74 In August 1998, the Tax Office started audits of syndicate H, syndicate J and syndicate K.
4.75 Prior to September 1998, the Tax Office had commenced 15 audits of syndicates. Each syndicate may have involved more than one investor.
4.76 In April 1999, the Tax Office issued a position paper to an investor in syndicate G. It recited the relevant facts, issues and findings of the audit and pointed to the relevant law. It then provided conclusions with no reasons that indicated which facts were relied upon for evidence of the conclusions, the weight placed on the evidence in reaching the conclusions or the reasoning process used to reach those conclusions. It then set out the proposed audit adjustments.
4.77 In May 1999, Tax Office auditors presented the investors in syndicate B with proposed adjustments.
4.78 In July 1999, the Tax Office started audits of syndicate A, syndicate L, syndicate M and syndicate N.
4.79 The Part IVA Panel meeting on 2 August 1999 considered the application of subsection 73B(31) and Part IVA to two schemes, both applying to one investor in a syndicate which was entered during the 1992 financial year.
Scheme 1: The Panel was of the view that the deduction for the core technology expenditure claimed by [investor] ought to be reduced to zero (ATO valuation) on the basis of 73B(31). This is on the basis that the core technology was grossly overvalued, and that both parties were well aware of that fact (and hence not trading at arm's length). The Panel noted that the non-arm's length argument might not be so strong if the purchaser was in fact not aware of the overvaluation of the core technology …
The Panel agreed that Part IVA would also apply, but that the application of Part IVA to this scheme would depend, like the application of 73B(31), on the valuation of the core technology being excessive …
Scheme 2: The Panel noted that this scheme represents a commonly-occurring structure in R&D, being a structure that involves either a loss entity or an exempt entity. As such it represents a significant issue for the Tax Office, that ought perhaps to be the subject of a nationally coordinated approach …
The Panel did not reach a conclusion as to whether Part IVA applies to Scheme 2.
4.80 The auditor's submission to the Part IVA Panel on these two schemes stated:
The scheme is a deliberate and calculated use of an inflated CTL [core technology licence] Fee and the portion of the interest deduction that attaches to the borrowings used to fund the CTL Fee to incur losses can be transferred to income companies in the Group. These deductions plus the deductions for the R&D Contract Sum and the balance of the interest paid to [investor parent] would not have been sufficient to guarantee the required guaranteed return of [investor parent] if a commercial arms' length market value had been applied to the CTL Fee. These funds paid by [investor] to [researcher] have been set aside on a deposit with [deposit holder] for the purpose of guaranteeing [researcher's] obligation to [the investor parent]. Only $[xxx] million [approximately one-third of the total R&D expenditure] is permitted to be drawn down to fund the R&D programme. [The researchers] only have rights to access these funds to the extent of the after tax amount of any royalty income received by [investor] from exploitation of the Research Results. [Investor] has obtained a tax benefit within the ambit of paragraph 177C(1)(b). [Paragraph 45.] …
The dominant purpose of the [investor group] for the whole syndicate arrangement was to guarantee [the investor parent] a preconceived tax free rate of return on its investment in [the investor] and incur losses which could be transferred to income companies in the Group irrespective of the true worth of the CTL and the success of the R&D project. [Paragraph 57.]
4.81 In October 1999, the Tax Office issued a position paper to an investor in syndicate P.
4.82 In December 1999, the Tax Office started an audit into syndicate Q.
4.83 Around February 2000, the Tax Office instructed its auditors to discontinue audits of R&D syndicates pending further instructions.
4.84 On 28 March 2000, a decision was made to hold off obtaining independent valuations in some R&D cases. Previously the Tax Office had relied on AVO critiques of the investors' valuations. The decision recognised that unless the AVO critiques were challenged it would be an unnecessary waste of public monies to do so. It also recognised that to delay obtaining independent valuations for the cases and also to await the outcome of other cases would 'compound delays'. In one case the valuation would have potentially cost about $100,000. The core technology value disputed in that case amounted to tens of millions of dollars, not including the interest deductions flowing from that value.
4.85 By 29 March 2000, a senior tax official was involved in developing the litigation strategy for R&D syndication.
4.86 On 3 April 2000, the Tax Office provided to external legal counsel a copy of its proposed position paper to an investor in syndicate B.
4.87 An external legal service provider verbally advised the Tax Office in 2000 that further valuations were needed to bolster the Tax Office's evidence in litigation.
4.88 In April 2000, the Tax Office released its position paper to an investor in syndicate B. The Tax Office asked the investor to respond within a month. The Tax Office states that it is difficult to ascertain in the short term whether any amendments were made to the position paper because all its records of this case are archived. The position paper issued recited the relevant facts and then concluded, amongst others, that:
[the researchers and investors] did not deal at arm's length in relation to the CTL (core technology licence) Fee payable by the Syndicate and the CTL of $[tens of millions] was not at arm's length for the purposes of subsection 73B(31) of the ITAA 1936.
The amount claimed as a deduction under subsection 73B(12) for core technology expenditure does not represent arm's length consideration. The Commissioner considers that the arm's length amount in terms of subsection 73B(31) is zero dollars ($0).
4.89 The position paper then set out the amendments proposed. No reasons were provided for the Commissioner's conclusions.
4.90 In May 2000, a senior Tax Office officer discussed the possibility of mediation with a syndicate investor. However, this mediation was to run parallel to any assessment action. A Tax Office auditor's record of the meeting states:
[Tax official] then suggested that both parties might like to consider whether mediation is warranted and appropriate, and what the process might be.
[Investor representative] said that [the investor] had not thought about that in detail, and will again consider it.
[Tax official] then repeated that the normal assessment process will continue concurrently with any mediation.
[Tax official] then suggested that principles established in relation to this syndicate may be useful in relation to [other syndicates in which [the investor] is [an investor]. However, [the investor's representative] said that the facts are different in each case. [The investor's representative] then stated that limitation to this particular syndicate will reduce the potential of any mediation, and so reduce the usefulness of such an approach.
[Tax official] asked what would be the purpose of mediating in relation to only one syndicate, and [the investor] responded that others may not be so different on their facts.
4.91 By early May 2000, position papers had only been released to investors in 2 out of 15 syndicates undergoing audit.
4.92 During May and June 2000 the investor in syndicate B asked the Tax Office to provide reasoning to support the position paper.
4.93 On considering the effect of the caveats in private binding rulings given to investors before they entered arrangements, the Tax Office's Part IVA Panel reported the following from its 7 June 2000 Part IVA meeting:
The Panel noted that the PBR did not give a 'tick-off' to Part IVA or to section 73B(31) or the valuation. However, the PBR did basically approve the internal financial structures including the put options, which needed to be taken into account. However, because the PBR did not cover Part IVA, valuation or arm's length acquisition, in effect it did not give the taxpayer much comfort, and this could also be taken into account. Overall, the Panel was of the view that the PBR did not mean that Part IVA could not be applied.
4.94 The Part IVA Panel meeting on 7 June 2000 considered the application of subsection 73B(31) and Part IVA to three syndicates registered during the 1994 financial year.
Non-arm's length dealing
The Panel noted that the excessive valuation was the primary indicator of non-arm's length dealing … There was also a chronology point, that suggested that the commercial arrangements may have been entered into before the valuation had been done.
The correct valuation methodology for the core technology was likely to be a significant point.
4.95 The auditor's submission to the Panel stated:
[Syndicates 1 and 2]
Core technology expenditure
The Commissioner takes the view that, in the absence of any real bargaining between the parties and having regard to the valuation provided by the AVO:
- The investors and [the valuer] were not dealing with each other at arm's length;
- The arm's length value of the core technology for the purposes of subsection 73B(31) of the ITAA was between nil and $1 million; and
- It is not considered reasonable to allow any deduction for the core technology expenditure.
Firstly the round robin of funds:
[Parent investor] provided [investor] funds to finance their share of the equity to acquire the licence of the core technology, contract fee for R&D payment, management fee and arrangement fee. The cheques in relation to licence of the core technology and contract fee for R&D payment paid to [investor] were endorsed by [researcher], who endorsed the cheques to [subsidiary of parent investor] which are held in the account of [the researcher]. The cheques were all endorsed [during 1994 financial year]. The funds that were initially loaned to [investor] are then loaned back to [investor parent] in the form of an interest free loan by [subsidiary of parent investor].
The consequence of the above transaction is [parent investor] receives a tax deduction by way of losses transferred from [investor] in terms of s80G of the ITAA without outlaying any funds.
Secondly the put option: …
- When the Put Option notice is given to the Researcher …
- the Researcher must subscribe for the additional shares and pay the subscription amount to the first investor …; and
- the First Investor must issue additional shares to the Researcher,
- At settlement on the Put Option Settlement Date:
- the researcher will pay the subscription amount to the First Investor by authorising and directing the Deposit Holder to pay an amount equal to the subscription amount from the Deposit by cheque to the First Investor who will endorse that cheque in favour of the Parent and deliver it to the parent in repayment of the monies outstanding,
- the Researcher will pay the Put Option price to the Parent by authorising and directing the Deposit Holder to pay balance (if any) of the Deposit to the Parent.
The consequence of this action would extinguish the debt of [investor] to the [parent investor].
4.96 No reason for the Commissioner's view was provided for syndicate 3.
4.97 The researcher in syndicate 3 was a public sector tax exempt organisation. It is not noted on the submissions or Panel report whether the researchers in syndicates 1 and 2 were tax exempt.
4.98 The report for the June 2000 meeting outlined the forward approach to applying Part IVA:
Future dealing with R&D schemes
The Panel considered that it had seen enough representative R&D schemes involving the following features:
- Excessive valuation of core technology by taxpayer
- Our valuation of core technology was zero or negative.
Future schemes involving these factors did not need to return to the Panel, but could be signed off for Part IVA by TCN. R&D schemes involving a change to this standard type (for example, Valuation not zero) would need to come back to the Panel.
4.99 After syndicate-caused delays, the Tax Office first met with syndicate Q in mid-June 2000 to start the audit.
4.100 By July 2000, there was significant internal Tax Office discussion on designing an overarching resolution to the R&D syndication issue.
4.101 One investor asked the Tax Office for an internal review in July 2000. The investor expressed concern at Tax Office suggestions that 'amendments may issue shortly' given that five years had elapsed in the audit. The investor stated:
We have received [senior official's] letter of [late] June 2000 on the status of the mediation proposal and will respond. In the letter he agrees with our suggestion that there be an open exchange of views prior to mediation. We believe that provision of full details of the Tax Office reasoning would be consistent with such an open exchange of views and is necessary before a complete response can be provided on the Tax Office position paper.
4.102 In a follow-up letter the investor stated:
… in the spirit of cooperation we have suggested that the matter be mediated. If this occurs, it should allow an open exchange of views without the need for expensive litigation. Our attempts to progress this mediation have been met with ambivalence from the Tax Office …
We anticipate that the new valuation will be received shortly and we intend to discuss it with you once a mediation agreement has been signed. However, unless you agree to defer the issue of assessments until after the mediation we reserve our right to withhold the material, lodge an early objection, and require you to determine it at an early date. …
In any event, we still believe that we are entitled under the Tax Office's own 'Audit Guidelines' to have a pre-assessment internal review conducted by senior Tax Office officers independent of those … who are part of the team which proposed to raise the assessments.
4.103 An internal review was again requested by the investor later in July 2000.
4.104 A Tax Office report to the TCC dated 24 August 2000 stated:
… 6. Apart from the considerable time and cost of an audit where not prevented by legislative or other constraints, there are limited options available to the Tax Office to compel the termination of syndicates …
[the report discussed three meetings with syndicates]
15. For technical and legislative reasons, the audit option is not available to the Tax Office in relation to any of these syndicates [presumably because the syndicate pre-dated the enactment of the specific anti-avoidance provisions in subsection 73B(31)]. By January 2003 the aggregate potential assessable income of these three syndicates will exceed [hundreds of millions of] dollars, and will double by 2007.
16. As a result of these discussions, the Tax Office is discussing the option of legislative amendment … . [The report then went onto discuss matters to consider in any legislative proposal.]
4.105 According to Administrative Appeal Tribunal reasons for decision, on 11 October 2000 the Tax Office issued amended assessments to Zoffanies Pty Ltd for the Substituted Accounting Period ending on 30 September 1992.
4.106 On 11 October 2000, the Tax Office started joint risk evaluations with AusIndustry.
4.107 In mid-October 2000, an investor wrote to the Tax Office outlining concerns with the audit and position taken:
- We have received fourteen Notices of Amended Assessment in relation to this matter. We are disappointed that that this has occurred without a mediation to allow [the investor] to put its position to the Commissioner. In particular:
- the Tax Office refused to provide the reasoning underlying the conclusions in its position paper, but kept demanding that [the investor] provide it with further information; and
- the apparent ambivalence and equivocation of the Tax Office toward mediation and consequently the time that has now passed since the idea was first raised. It is [the investor's] position that a mediation could have occurred prior to the issue of amended assessments had the Tax Office shown greater interest in it.
- As assessments have now been issued, we suggest that mediation be reconsidered once both parties have lodged their evidence in chief with the Court. At this stage each party should have greater knowledge of the other's position. We note your suggestion that the next steps is to contact [the mediator] to discuss the framework of the mediation. We would welcome [the mediator's] view (and yours) on the specifics of the mediation proposal set out in our [late March 2000 email] to [the Tax Office].
4.108 By November 2000, a senior tax official was involved in 'case reviews' to ensure that progress was made on R&D syndicate audits and to assess whether the R&D syndication issue was still a compliance priority when compared to current issues.
4.109 According to Administrative Appeal Tribunal reasons for decision, Zoffanies Pty Ltd's objections were lodged on 14 November 2000.
4.110 In late November 2000, the Tax Office received a specialist valuation of the core technology in syndicate C, valuing it at $0.
4.111 On 8 December 2000, the Tax Office provides an investor in syndicate F with its position paper. It set out the relevant facts, findings and issues and pointed to the relevant law. It then recited the following relevant Tax Office conclusions, without providing further reasoning for the decisions:
5.1 Neither [abc company] and [xyx company] collectively as 'Investors', nor [third investor], dealt at arm's length with [mno company] as 'Researcher', in relation to the Licence Fee of $x million in the year ended 30 June 1994. As noted, the valuation of [Tax Office's valuer] dated 1 December 1999 determined that the arm's length value of the Core Technology was $Nil, and therefore the Syndicate should be allowed no deduction for the Licence Fee pursuant to s 73B(31) …
5.7 The Syndicate arrangement was a scheme as defined in s 177A of the ITAA 1936, which having to the eight matters set out in paragraph 177D(b), was entered into or carried out by [the investors] for the dominant purpose of enabling the 'relevant taxpayer' … to obtain a tax benefit in connection with the scheme as defined in s 177C of the ITAA 1936.
4.112 An auditor's summary of an 8 March 2001 meeting between senior tax officials stated:
As [a senior tax official] stated, the best action is to push through to court or settlement on those cases most currently advanced. If we get a break through with good outcomes the Tax Office will be in a stronger position to achieve resolution on other cases on an acceptable basis to the Tax Office. A settlement basis acceptable to the Tax Office is unlikely to be able to be achieved until we strengthen our hand in this matter …
Without such a break through it is difficult to progress the other cases and it may not be appropriate to do so. If taxpayers have obtained valuations and the Tax Office has not the Tax Office will not be able to successfully challenge the valuation.
The taxpayer would only be attracted to settlement if they have viewed a valuation obtained by the Tax Office and as a result were led to believe that they have a material risk that the Tax Office will be successful in the court and also successful in recovery. If some high profile cases are successfully dealt with by the Tax Office other taxpayers are likely to more favourably view the external valuations obtained by the Tax Office.
Further, if success is obtained in the lead cases the Tax Office could then explore preparing a generic document outlining acceptable settlement terms rather than the Tax Office embarking on the costly exercise of obtaining valuations and disputing on a case by case basis.
4.113 An internal memo dated 9 March 2001 provided recommendations to senior management for future strategies:
The recommendations include:
- Continue work on leading cases through to litigation with a view to obtaining outcomes which are capable of application across the syndicate population.
- Review other audits with objective of identifying priority cases and adequately resourcing these through to litigation stage.
- Mediation not to be pursued at this point.
4.114 The memo noted that:
The strategy adopted to date has involved audits of a range of syndicates with particular emphasis on progressing 2 of the larger cases with a view to obtaining court decision(s) which will provide leverage in other cases …
There has been some correspondence between the Tax Office and representatives of the 2 leading syndicates around the possibility of mediation. While this is certainly a possible means of bringing forward resolution in some cases, it is highly problematic as to whether mediation will be effective without litigation of at least one case.
4.115 The 9 March 2001 memo considered the broader compliance effect of the Tax Office's compliance treatments. In rejecting an option not to take action against syndicates that had not already been audited:
… its adoption would mean that most syndicates would be 'home free'. This could lead to unfairness complaints by those syndicates audited and a far from desirable outcome in terms of the Tax Office influencing future promoters of tax planning arrangements.
4.116 In proposing the selection of additional audits, it commented that further audits:
… would seem the best way of influencing future compliance and optimising recovery of taxes avoided through these arrangements.
4.117 Alternative settlement options were also considered in the 9 March 2001 memo. It is also recognised that due to the cost and time involved the 'ATO cannot achieve the “ideal” position of auditing all syndicates on a simple cost-benefit basis'. Significant litigation risk was also recognised and that valuation evidence 'will play a critical role':
In order to maximise leverage and maintain costs a review of all cases in progress could be undertaken with a view to identifying the priority cases and directing available resources to them. The remaining cases could be put on hold until there are some outcomes from the initial cases.
4.118 The memo recommended that existing audits be completed, to 'use the results for approaches to all remaining syndicates for settlements along the lines of those achieved' and audit of 'a selection of additional syndicates'.
4.119 As at 9 March 2001, there were 27 audits in progress. Ten audits had position papers prepared or in the process of being prepared. Expert valuations were obtained in seven cases with AVO critiques being obtained for the rest. Amendments were issued in two cases with objections received in both.
4.120 In May 2001 senior technical staff, after reviewing the deliberations of the Part IVA Panel, gave an opinion to compliance staff to only apply 'Part IVA to core technology expenditure (and associated interest) where there is evidence that this has been incurred on a non-arm's length basis' and that 'it seems that the best evidence of non-arm's length dealing is a market value of the core technology as opposed to the value arrived at by the syndicate participants'.
4.121 By way of email dated 10 May 2001, a senior technical officer confirmed the Tax Office's approach to Part IVA in R&D syndication to other senior tax officials:
It might be that [another senior technical officer] and I are being far too cautious in not looking at these arrangements and concluding, reasonably, but OBJECTIVELY that Part IVA applies to all R&D syndicates involving, for instance, a put option and tax exempt participant. However, if we are not caught by a ruling and it is clear that Part IVA applies by application of s177D, without regard to the value of the core technology, then it is unclear whether we can amend to the extent the syndicate's core technology amount varies from the arm's length or market valuation. Inevitably it is the core technology and its financing which is the source of the mischief in R&D syndicates.
4.122 By 10 May 2001, senior technical staff recognised the need for judicial consideration of the Tax Office's approach to the 'interrelationship between inflated core technology and the orthodox syndicate finance techniques' in relation to Part IVA.
4.123 Discussion on whether to re-engage external valuers continued from 28 March 2000 until 5 June 2001 when the Tax Office made a decision to re-engage them.
4.124 From May 2001 until May 2002, the Tax Office developed a position paper for investors in syndicate A.
4.125 In June 2001 the Tax Office issued a position paper to an investor in syndicate C. It provided the following relevant reasons for decision on the subsection 73B(31) issue:
3.2 In determining whether the parties were dealing at arm's length, the Commissioner is in essence considering whether 'the outcome of their dealing is a matter of real bargaining' (Trustee for the Estate of Furse v FCT (1991) 91 ATC 4007) or in fact the product of collusion to achieve a particular result (Granby v FCT (1995) 129 ALR 503).
3.3 The following matters indicate that the Investors and [the researcher] were not dealing with each other at arm's length in relation to the incurring of the [core technology licence fee]:
- when the suite of transactions are viewed as a whole it was in all parties' interests to maximise the tax benefits to the Investors by maximising the [core technology licence fee];
- the Tax Office has been unable to find any evidence of real bargaining on the part of the Investors;
- the core technology valuer was engaged by representatives of the Licensor rather than by the Investors;
- [abc company] holds an interest in [the researcher], which is the parent of [the contracted researcher], and [abc company] holds an interest in some of the Investors;
- the licence of the core technology was part of a suite of transactions marketed to Investors as a package, the terms of which were set prior to the identification of any of the Investors.
3.4 Having regard to these matters the Commissioner is likely to be satisfied that, for the purposes of section 73B(31), the Investors and [the researcher] were not dealing at arm's length in relation to the incurring of core technology expenditure …
3.6 Having regard to the valuation obtained by the Tax Office of the core technology, it is likely that the Commissioner would be satisfied that had the parties been dealing at arm's length the core technology expenditure would have been less and in fact would have been nil.
4.126 According to the Administrative Appeal Tribunal's reasons for decision, the Commissioner disallowed Zoffanies Pty Ltd's objections on 26 July 2001.
4.127 Delays in obtaining critiques were initially due to AVO resourcing. By September 2001 these concerns were resolved to the Tax Office's satisfaction.
4.128 According to Administrative Appeal Tribunal reasons for decision, on 20 September 2001, an application was filed in the Tribunal to have Zoffanies Pty Ltd's application for review heard.
4.129 An internal Tax Office Minute dated 21 September 2001 noted amongst other things, that the audit guidelines for the relevant periods of the R&D syndicate audits required auditors to give taxpayers notice of an intention to audit in writing and allow a reasonable opportunity (usually four weeks) for a reply. It also referred to 'one case' in which the taxpayer's objection had been denied and was listed for directions hearings in the Federal Court.
4.130 On 27 March 2002, the Tax Office received an external legal advice in relation to its audit of syndicate C. Amongst other things it opined:
- that much of the argument between the Tax Office and the taxpayers, and much of the valuation material, had been 'misdirected' in that it sought to address 'arm's length value', amongst other things, rather than addressing questions posed by subsection 73B(31) (page 36);
- that the syndicate investment vehicles (subsidiary companies set up by the investors specifically for the purpose of participating in the R&D syndicate) did not deal with each other at arm's length in relation to the core technology:
[they] did no more than perform a role preordained by them, and that they subjugated their (notional) 'will' to that of the dominant participants in the arrangement: that is to the wills of the investors and the research group (and, in its role as packager). The price paid for the licence, and the fee paid for the research work, were not matters which appear to have been considered by the boards of the [investment vehicles] separately and independently by the investors (Page 42);
- determining an amount that would have been incurred if both parties were dealing with each other at arm's length required the 'circumstances peculiar to the parties … to be taken into account'. (p 44)
- in determining the price for the core technology, the investment vehicles would have been influenced by the tax advantages. However, those vehicles did not benefit it was their parent company which benefited and would have been influenced by the tax advantages:
One factor which undoubted influenced the syndicate members was the tax advantage by way of deduction, to be obtained under sec 73B (page 45) … That is not to say that the 'independent' value of the technology and research work … is irrelevant. The arm's length price between the actual parties is increased by the value of the tax benefit, but it is not created solely by the tax benefit: there must be an underlying substance. …
The effect of the 'guaranteed return' elements of the structure — the deposit of the fees and the put option over the shares in the syndicate [investment vehicles] — is to make it substantially irrelevant to the investors what the underlying value of the technology may be. … (Page 46)
On an arm's length basis they are prepared to pay, in effect, whatever the researchers are prepared to receive. … However, theses elements of the structure do not seem to us to confer any benefit on the syndicate [investment vehicles]. …
In the result, it seems to us that the 'arm's length' expenditure against which must be measured the actual outlay of the syndicate [investment vehicles] to form the opinion called for by sec 73B(31)(b)(ii) … is one to be assessed on the basis that the party making the expenditure is one who can claim, or make effective use of, the tax reduction arising from the sec 73B deduction.' (Pages 46-7)
- the arm's length expenditure was to be assessed by what the actual parties, with their knowledge at the time (without the benefit of hindsight), would have paid if they were dealing with each other at arm's length;
- the Tax Office's case was unlikely to succeed if it found that the valuations obtained were genuinely relied upon in the dealings in relation to the core technology:
- It would be reasonable that to expect that a syndicate member, acting in good faith, would have turned its corporate mind to such matters as the premises and acceptability of the valuation advice. …
- If it is found that a syndicate member obtained valuation advice which was not a sham, sought and given as a mere screen for a transaction which had regard only to the tax consequences and put option exit mechanism, and that it genuinely acted in reliance on that valuation advice in dealings over the technology and research, that syndicate [investment vehicle] will probably, in our view, be found to have acted at arm's length. (Page 48);
- all valuations, the Tax Office's and investors', proceeded on a misconceived and erroneous basis:
- We say this notwithstanding that, as it seems to us, the valuations of all the valuers who have been consulted in this matter proceed on a misconceived or erroneous basis. All of the [Tax Office-engaged valuer's] valuations have proceeded on the basis of assessing a potential return from commercial exploitation of the technology on a variety of assumptions … assessing a level of risk of the potential return not being achieved, and using the assessed risk to fix a discount rate for the purpose of capitalising a discounted cash flow to arrive at a present value. While such a process is appropriate to many investments, we do not think it is appropriate to an investment in experimental technology, that is, technology with a medium to high level of technological risk. The application of a reasonable risk-based discount rate to a reasonable prediction of future return, bearing in mind the time at which the return is likely to emerge in any significant amount, will inevitably produce a present value of a negligible amount …
- The appropriate method of valuation is, it seems to us, one analogous to a comparables basis. While it is unlikely that there will be a transaction involving directly comparable technology, it is not so unlikely that there will have been transactions involving loosely comparable technologies … This involves a wider and more detailed survey of research activity and transactions than has been undertaken by any of the valuers or by those instructing us. (pages 49-50) …
- What the Commissioner is required to have regard to is what the actual syndicate members would, if dealing at arm's length, have paid; and if it is not apparent that the syndicate members took into account, in deciding what to pay, some extraneous consideration, but rather [if] it appears that they relied on expert advice, properly sought and reasonably assessed, as to the market value of the technology, we do not think that the Commissioner can conclude that they paid a price in excess of what they would have paid on an arm's length dealing merely because a different valuer now considers an arm's length value to have been greater. (Page 50.)
- in considering the strength of evidence supporting the Tax Office's case, the legal adviser concludes that:
There are we think a number of matters which would support the formation by the Commissioner of an opinion adverse to the taxpayers. We do not, however, presently think that it can be predicted with any confidence that the taxpayers will be unable to establish that they acted in good faith on the basis of information and valuations supplied to them by putative experts, that they believed that there was a market for the technology if successfully deployed, and that they … were dealing on an arm's length (albeit mistaken) basis with the researchers in agreeing to the [core technology licence fee] and the research contract. (Page 52.)
- further information was needed to determine an arm's length amount for the core technology licence:
… we consider it would be necessary to obtain further evidence as to:
- What the particular companies involved in the … syndicate might reasonably be expected to have done in assessing or ascertaining the amount that each of those companies might have paid for the [core technology licence fee] had they been dealing with each other at arm's length with the researchers; and
- What reasonable value could have been expected to have been attributed to the 'core technology' … by reference to transactions involving loosely comparable technologies.
An expert in venture capital investment would, in our view, be in a better position to opine as to these matters than would an accountant or a person with narrow expertise in intellectual property evaluation … The category of investors most likely to be comparable to the syndicate members are members of a venture capital syndicate, and the place where we would expect the most likely source of useful expert evidence to be is the major market for venture capital, which we understand to be the United States.
4.131 In April 2002, the Australian Innovation Association (AIA) approached the Tax Office to discuss the possibility of alternative resolution of the R&D syndication issue. The AIA describes itself as a group of investors and researchers set up to represent the interests of R&D participants in Australia.
4.132 By May 2002, Tax Office staff recognised that an investor's tax adviser was unlikely to recommend settlement with the Tax Office where the investor had a valuation but the Tax Office did not.
4.133 In May 2002, a position paper for an investor in syndicate A was settled and issued. However, it was authorised to be released to the taxpayer with the express instruction to Tax Office staff that 'no assessments based on such position papers should issue' because 'the overall position in relation to Tax Office strategies on R&D syndicates is being further considered and reviewed'.
4.134 The position paper reached substantively the same relevant conclusions as the position paper in syndicate B. However, it provided two-and-a-half pages of reasons for its conclusions, including the Commissioner's views on which facts led to the conclusions and how they led the Commissioner to these conclusions in applying the law to those facts.
4.135 In July 2002, the AIA first met with the Tax Office. All parties agreed to resolve the issue by mediation.
4.136 In July 2002, the Tax Office issued a position paper to an investor in relation to investments made in syndicates. The position paper provided three pages of reasoning on why the Commissioner proposed to deny the core technology deductions. It set out the source in law of the relevant test to be applied, the particular details on why the Tax Office thought the valuation was incorrect and materially overstated, communications on changes in price, the effect of the financing arrangements, the assertion that the investor did not avail itself of its usual due diligence process, the absence of documents evidencing bargaining on price and the particular pieces of evidence indicating that the investor did not exercise its separate mind and will in fixing the price paid for core technology.
4.137 In July 2002, the Tax Office released its position paper to an investor in syndicate Q in relation to deductions claimed eight to nine years previously.
4.138 The Tax Office re-issued amended position papers to investors in syndicate Q over July and August 2002. The investors were asked to respond within a month. Extensions of time to respond were granted.
4.139 The amended position paper given to an investor in syndicate Q provided reasoning for its view:
… There is no evidence whatsoever that [researcher company], as licensor, and [manager company], as Manager, or [investment vehicles for investors] as syndicate members, engaged in any negotiations at all in respect of determining the amount of Core Technology Licence Fee. On the contrary the evidence available indicates that the amount of the Core Technology Licence Fee was determined independently of [researcher company] and that [researcher company] simply accepted the amount of [$x million] determined by [manager company].
[Manager company] had determined the value of core technology at [$x million] by [date] whereas [the initial valuer's] valuation of the core technology … was not completed until [one month later]. [Researcher company] did not obtain its own valuation of the core technology.
[Tax Office valuer's] valuation of the Core Technology Licence Fee as nil is also significant in demonstrating the lack of arm's length dealing between the … Syndicate and [Research company] in arriving at the amount of the Core Technology Licence Fee. The fact that a company … was prepared to outlay an amount of [$x million] to acquire a licence to the rights to core technology which had a value of nil raises questions about the true purpose of the outlay … The [Investor A] Put Option and the [Investor B] Put Option effectively eliminated any commercial risk on the part of [Investor A] and [Investor B] in respect of their investments in [investment vehicle company] and meant that [Investor A] was assured of obtaining substantial financial benefits originating from income tax deductions being claimed by [investment vehicle company] for core technology expenditure, research and development expenditure and interest. [Investor A] was actually advantaged by [investment vehicle company] paying an inflated amount for the core technology.
In summary, having regard to the fact that:
- [investment vehicle company] outlaid an amount of [$y million] to acquire a licence to the rights to core technology which had a value of nil;
- [Researcher company] did not obtain an independent valuation of the core technology, but merely accepted the Core Technology Licence Fee of [$x million] offered to it by [Manager company] on behalf of the … Syndicate;
- the factual matters described in [section in position paper outlining the relevant facts];
it is considered that the … Syndicate and [Researcher company] were not dealing with each other at arm's length when the Syndicate incurred the Core technology Licence Fee of [$x million] for a [number of years] licence to the … core technology.
[The position paper then went on to provide reasons on other areas of the tax laws. It then gave similar conclusions to those stated in earlier position papers and provided details of proposed amendments.]
4.140 The Tribunal hearing of the Zoffanies matter started on 5 August 2002 and continued for three weeks.
4.141 The Tribunal handed down its decision on 4 September 2002 in favour of the taxpayer.
4.142 The Administrative Appeals Tribunal concluded that the syndicate's valuer, Dr Venning, acted independently in preparing his valuation:
131. The Tribunal finds that Dr Venning acted independently in preparing his valuation. As a matter of common sense, it was necessary for him to have ongoing communication with Dr Smeaton because he was the main source of information about Bresatec required by Dr Venning in the preparation of his report. Dr Smeaton gave evidence that he formed the view, after his meeting with Dr Venning on 17 March 1992, that Dr Venning would take an independent view in making his valuation. Mr Phillips said that in the valuation Dr Venning had prepared for MBL previously in relation to another matter, he had been impressed by, amongst other things, Dr Venning being protective of his independence. Mr Phillips said he would have rejected Dr Venning's report if he had thought it was not independent.
132. Dr Venning also impressed the Tribunal as a person who guarded his independence and sought to form his own independent view. The Tribunal accepts that the assistance he gave Dr Smeaton in looking over the draft IRDB letter and suggesting an additional paragraph from a previous IRDB application, was a separate matter and did not compromise his independence. Ultimately, Dr Venning's valuation was that the core technology was worth between $10 million and $19 million, and that a valuation of $15 million was reasonable. The fact that he amended this figure from $15 million to $15.35 million after discussion with Mr Phillips does not, in the Tribunal's view, compromise his valuation. He said $15.35 million was within his range of values and he considered this reasonable. The Tribunal notes, as the expert witnesses made clear, that valuation is often not a precise science especially where projections for the development and commercialisation of biotechnology are concerned.
133. The Tribunal rejects the Respondent's submission that there was persuasion and cooperation amounting to collusion between the parties. It notes, in passing, that persuasion is part of the normal process of negotiation and that cooperation does not, of itself, indicate that parties fail to exercise their separate minds and wills in reaching a bargain. The Tribunal also rejects the Respondent's submission of indifference on MBL's part. Mr Phillips' evidence and the process of negotiation between the parties indicates that this was not the case.
4.143 Although it was not an issue on which the Tribunal had to base its decision, it did offer its observations on the valuation evidence. In doing so the Tribunal cautioned care substituting one valuer's opinion for another without good reason:
135 … It is also worth noting that the five expert witnesses had the benefit of hindsight and that it is easy to be critical after the event when what was then unknown is now known. In the context of what was no more than an estimate of value, care needs to be taken when substituting one valuer's opinion for another without good reason.
4.144 The Tribunal also commented that in relation to determining a reasonable amount:
136. With regard to s 73B(31)(b)(ii), it should be noted that the relevant question is what would the expenditure have been if these parties had been dealing with each other at arm's length? Would a competent and independent valuer other than Dr Venning have made a different valuation which the parties would have relied on in concluding the terms of transaction so that the amount of the relevant expenditure would have been less?
137. The Tribunal finds that Dr Venning acted bona fide in making an independent valuation. He is a Doctor of Philosophy in Microbiology as well as having a Bachelor of Economics degree. The Tribunal accepts that his scientific background facilitated his understanding of the transgenic technology developed by Bresatec and of the ESC technology developed by the University's research scientists, the intellectual property in which was vested in Luminis. The Respondent's expert witnesses were critical of Dr Venning's assumption of success for the project, of his optimistic projections of future revenue from commercialisation, and of his appreciation of what they considered to be an unrealistically low discount rate, thereby recognising a low level of risk. The Tribunal notes that Mr Lonergan [the Tax Office's valuer] proceeded on the basis that he was assessing the market value of the core technology licence. While he is undoubtedly an experienced valuer, the Tribunal's impression, in terms of his adjustments to the projected revenues and choice of discount rate, is that he was unduly pessimistic about the future of the project. Certainly he did not have the scientific understanding of the technology that Dr Venning had. Mr Lonergan also criticised Dr Venning's projection for penetration of the US market without, apparently, giving credence to Dr Venning having based his projection of 30 per cent penetration on Mr Mooney's figures (transcript, 16 August 2002, page 853) …
139. The conclusion reached by the Tribunal in the light of Dr Smeaton's view of the worth of the technology, and of the value attributable to Bresatec by virtue of Cyanamid's investment in its shares, is that a competent and independent valuer other than Dr Venning might have made a similar valuation. The Tribunal is not satisfied that his valuation, which was conducted using the most widely accepted methodology, was flawed such that the Tribunal should substitute a different valuation. The Tribunal finds, having regard to the matters set out in s 73B(31)(c), (d) and (e), that Dr Venning acted professionally, from an informed scientific and economic background, and that there is insufficient evidence to suggest that the relevant expenditure would have been any less had the valuation been made by a different competent and independent valuer undertaking the valuation in 1992.
4.145 Following the decision of the Tribunal, the Tax Office appealed to the Full Federal Court on the grounds that the Tribunal had erred in relation to Part IVA and subsection 73B(31).
4.146 In December 2002, an investor settled with the Tax Office prior to a Federal Court hearing.
4.147 The investors in syndicate Q responded to the Tax Office's amended position paper in late February 2003.
4.148 In July 2003, the Tax Office sent adjustments sheets to the investors in syndicate Q and issued amended assessments reflecting these adjustments.
4.149 On 25 July 2003, four days before the Federal Court hearing of the Tax Office's appeal in the Zoffanies matter, the Tax Office withdrew the subsection 73B(31) appeal ground because it was of the view that it was a factual matter. There is no avenue of appeal to the Full Federal Court on factual matters.
4.150 On 28 July 2003, the Tax Office and a taxpayer entered an agreement to mediate the dispute and, amongst others:
determine Guidelines for reviewing R&D arrangements, thereby potentially removing the need for detailed syndicate audits and/or litigation.
4.151 The Full Federal Court heard the Zoffanies matter on 29 and 30 July 2003.
4.152 In September 2003, an investor and the Tax Office agreed to settle on the basis of 'economic neutrality'. The effect was that the parties agreed to adjust the original core technology deduction by reducing it to 30 per cent of the original amount claimed.
4.153 Investors in syndicate Q lodged objections in September 2003.
4.154 Judgments were handed down in the Zoffanies case on 24 October 2003. The Full Federal Court commented on the outline of evidence in the Tribunal's reasons:
It may be remarked that the Tribunal's reasons consist substantially of an outline of the evidence given by the various witnesses who gave evidence at the hearing which extended over a period of three weeks. It seems to be the case that the Tribunal accepted all evidence recorded in that outline [per Hill J at paragraph 15].
4.155 The Court held that the Tribunal had erred in its approach to the Part IVA issue and remitted the matter back to the Tribunal for reconsideration on that ground. However, when considering whether the Court should determine the application of Part IVA to the case, Hill J opined:
It would be necessary for the Court on appeal to consider all of the evidence before the Tribunal, from a hearing which extended over some three weeks, before it could be in a position to decide whether only one outcome was possible. This I decline to do for it is clear from the Tribunal's reasons and particularly its factual findings (excluding matters of subjective purpose) that it would be possible to reach either a conclusion favourable to the Commissioner or one favourable to the taxpayer [at paragraph 66].
4.156 Further, Gyles J opined (at paragraph 92):
There is a good deal to be said for the view that the Tribunal did not fully analyse, consider and take into account the tax implications of the scheme for what might be called the Macquarie Group as a whole … [However] An administrative tribunal is not bound to deal with all factual matters proposed by a party as relevant to a topic in the manner put forward to it. Put another way, the statute only requires consideration of the topic, not pieces of evidence relating to it.
4.157 On 30 October 2003, the Tax Office's priority technical issue proposal, PTI 170, notes amongst other things:
Brief outline of the risk mitigation strategy and how resolution of the technical issue relates to it (for example, No Tax Office view exists/education programme cannot proceed until application of law is clarified and published. Explain whether the problem exists because of a difficulty in applying, administering or interpreting the law):
Overvaluation of core technology generates a tax benefit to Investors in the scheme. Subsection 73B(31) requires an arm's length valuation of the core technology but there are practical difficulties in applying this section. The schemes also involve a round robin of funds ensuring a guaranteed return of the investors' funds. Part IVA is also an argument.
4.158 The mediator gave his evaluation of the issues on 10 March 2004 and gave the following opinions:
- A court would not hold that the private binding ruling issued to the investors in this case would be binding on the Commissioner in relation to the issue of arm's length dealing. This was because to do otherwise would disregard the reservations stated in the Commissioner's ruling and the two conditions imposed by DITAC in requiring compliance with section 73B. There was also no basis for a claim of legitimate expectation (paragraphs 121-127).
- An absence of bargaining or indifference to price does not necessarily establish a non-arm's length dealing (paragraph 145).
- The question in each case was whether the parties had dealt with each other as arm's length parties would be expected to do (paragraph 146).
- Directly relevant factors to determining the arm's length issue were how the core technology came to be identified and how the core technology price came to be quantified (paragraphs 147-155).
- There were a number of possible explanations for a departure from what arm's length parties would be expected to do (paragraphs 156-159):
- Lack of risk for investors because of the availability of the concession and the acceptance by the Government of guaranteed returns;
- the 'assurance' that the registration process provided;
- the limited time in which to complete the project;
- the 'inducement' of the tax concession to 'cut corners' by relaxing the insistence that a prudent investor might have in specifying the technology and its valuation;
- The positive rather than zero or negative value the core technology seems to have as the Commissioner argues.
171. I have difficulty with the Commissioner's submission and the approach taken by the experts because they overlook what to me is a fundamental point, namely that government policy as manifested in the Tax Concession, along with the acceptance of guaranteed returns and registration constituted 'in principle' approval was instrumental in creating a demand, if not a market, for core technology which might not otherwise have existed. There were investors who were prepared to invest in projects based on core technology because the tax benefits were a sufficient inducement, even if the projects based on that technology had slim prospects of a successful outcome. …
173. I do not accept that the amount of expenditure on core technology which would have been incurred, had these parties dealt at arm's length, would necessarily have reflected the prospects of technical and commercial success or failure. On the other hand, I do not accept that investors dealing at arm's length with an owner/researcher would have incurred expenditure on core technology without subjecting the proposals to risk assessment, independent valuation or independent expert scrutiny.
4.159 On 15 April 2004, Commissioner of Taxation publicly announced that he would not apply the general anti-avoidance provision, Part IVA, to R&D syndication deductions where the specific anti-avoidance provision did not apply. He also announced that a mediation was underway to help resolve the uncertainty:
In 1997 I stated that there would need to be unusual circumstances before Part IVA could be employed to strike down the benefits available under a specific legislative concession. By unusual circumstances I mean artificial arrangements designed to exploit the concessions. This remains the case. It would be incongruous for Part IVA to apply across the board to deny access to a specifically legislated concession.
This issue has become topical because of our review of Research and Development Syndication arrangements entered into in the 1990's. The reason we opened up enquiries here is quite simple — the Australian National Audit Office recommended we do that.
The reasons for our concern following a review of the arrangements is equally straightforward. The financial arrangements typically associated with the investment in the relevant core technology meant that in the event the venture failed, the investors were entitled to receive back their investment in that technology with interest.
While not fatal in themselves, the effect was that the arrangements created a situation where much of the normal bargaining tensions over price were absent.
Investors had little to lose from the core technology purchase price being overstated. Indeed on one view, they gained from such a result through inflated tax savings. That is not to say that was the result in particular syndicates. However it does explain our interest in verifying the outcome.
As it happens the law specifically provided for this potential abuse.
Under specific anti-avoidance provisions, an arm's length price can be substituted where it is found that the parties were not dealing with each other at arm's length in relation to the acquisition of the core technology.
Given our specific concern with some of the arrangements, the tax outcome for the cost of the core technology will be determined by the application of those specific provisions.
Where the parties are found to be dealing with each other at arm's length, Part IVA will have no application.
To assist in resolving our approach in this area we have been engaged in a lengthy mediation process in the considered hands of Sir Anthony Mason.
We have embarked on this course of action in recognition that this is a particularly difficult area of the law to apply.
For example, how do you determine an arm's length price for core technology that, in the absence of tax concessions, has proved to have no real market?
The mediation process is designed to establish principles to be applied in individual cases to determine whether there are arm's length dealings and, where there are not, the principles to be applied in determining the appropriate arm's length price.
Given the inherent difficulties in determining an arm's length price, we will be looking to pursue only those cases where there is a material gap between the price determined under these principles and the claimed purchase price.
Where the specific anti-avoidance provisions operate to reduce the claim we will also make a pro-rata reduction in any interest claimed on moneys borrowed to fund the purchase of the core technology.
In adopting this course we would be relying on the primary provisions of the law. However, as a back up, we will consider the possible application of Part IVA to support this particular adjustment.
My focus today has been on Part IVA, the income tax anti-avoidance provisions.
However, attempts to artificially generate tax benefits are not limited to income tax …
The significance I place on the use and operation of the general anti-avoidance provisions should be clear.
Because of this I have been concerned to ensure its use is carefully and judiciously guided through a panel comprising senior tax officers and appointments of tax experts from academia and the legal and accounting professions.
To enhance their consideration of particular cases, we will shortly be introducing arrangements to allow taxpayers the opportunity of personally presenting the facts and their position to the panel.
This will extend the present opportunity to have written material considered by the panel.
I want to stress that this is not about introducing quasi-judicial processes: it is not about quizzing the panel.
It is about enhancing our ability to ensure the position ultimately taken by the Tax Office is done with the fullest possible understanding of the circumstances of the particular case. [The Art of Tax Administration: Two Years On, 6th International Conference on Tax Administration, Commissioner of Taxation, 15 April 2004.]
4.160 On 5 May 2004, the Tribunal issued orders in Zoffanies Pty Ltd's favour.
4.161 By July 2004, audits were ongoing in 33 syndicates involving 37 main investors.
4.162 By July 2004, the Tax Office proposed to another investor to settle on the basis of 'economic neutrality'. Following these discussions the Tax Office advised the investor that negotiations were on hold pending the outcome of a mediation. Assurance was given that previously agreed figures would be honoured if the outcome was less favourable. In September 2004, the Tax Office offered a significantly more favourable settlement, generally in accordance with the global settlement offer. This settlement was later concluded.
4.163 On 16 July 2004, the mediator gave an addendum to his 10 March 2004 evaluation. He gave draft guidelines which dealt with the application of private binding rulings and the question of arm's length dealing. He also, amongst other things, gave the following opinions:
- Subparagraph 73B(31)(b)(ii) does not require the Commissioner to specify what the arm's length amount should be to reach a conclusion that the amount claimed should be amended:
20. It is open to the Commissioner, without specifying a particular sum as the arm's length amount, to demonstrate that an arm's length amount is less than the amount paid by showing that the arm's length amount was within a range of figures, the highest of which was lower than the amount paid.
- In ascertaining the arm's length amount it is not permissible to have regard to hindsight. One can only look at what was known or was knowable by the parties when the amount was determined (paragraph 23).
- The discounted cash flow method does not of itself produce the arm's length amount (paragraph 76).
- The arm's length amount should be based on idiosyncratic factors that influenced the parties bargaining position rather than a mere valuation of the technology itself (see paragraphs 78-84, especially paragraph 83 where the valuation methodology which ignored the contractual features and special value that the parties placed on the technology was rejected). The following factors were considered:
78. … the parties acted on the footing that the project had potential for success, notwithstanding the inherent risks. Indeed, a strong criticism of the investors made by the Commissioner is that they, and for that matter [the researcher], underestimated the risks. While this justifiable criticism undermines the value they placed on the project and the core technology, it also has relevance for the amount they would have been prepared to pay for the core technology licence had they been acting at arm's length in that respect. The tax benefits would have inclined them to agree towards the high end of a range of permissible values. Further the investors drew comfort from the registration of the Syndicate by DITAC and appeared to have regarded registration as an indication that the project had significant potential, though any reliance on the registration as evidence of the value of core technology would not have been justified. The investors regarded [the parent of the researcher] as being a leading player in the field (which it was at that time) and possessing very considerable expertise (which it had) …
79. [The researcher], for its part, along with [its parent company], had expended not less than $[just over half of the value of core technology claimed] on the development of the core technology before the Syndicate was established. It would be unrealistic to suggest that [the researcher] was willing to dispose of the core technology for a derisory amount. The materials indicate that [the researcher] had an inflated estimate of the worth of the technology and its potential for development and success, a view which it communicated to the investors through [the packager]. On the other hand, it stands to reason that [the researcher] would have been prepared to accept significantly less than $[the amount expended in developing the core technology before entry into the syndication] had the parties been acting at arm's length and had attention been directed to making an independent assessment of the value of the core technology and the matters relevant to the making of such as assessment. [The researcher] has no other available source of funding and the time frame for potential successful development of the technology was limited.
80. The Commissioner makes the point that the IRD Board was told that, without funds, the research would not have been undertaken. There was not apparent funding available to [the researcher's Australian parent company] as [the overseas parent company's] then policy was that all research was to be locally funded. Australian banks would not provide debt lines for R&D funding and [the overseas parent] could not access the local equity market. It was on this basis that IRD Board approval was sought in order to secure the benefit of the Tax Concession. It may well be that, without the benefit of the R&D funding through syndication, [the researcher] would have been unable to continue its development of the core technology. This possibility would, in all likelihood, have induced [the researcher] to accept an amount significantly less than $[the amount expended in developing the core technology before entry into the syndication] for the core technology.
81. Apart from the [accountant's] assessment, there was nothing to suggest that [the researcher] had developed the technology to a point where its value exceeded the amount expended on it. Nor was there anything else to indicate that the value of the technology was equal to the amount of that expenditure. On the assumption that [the researcher] considered that the Syndicate project had potential for technical and commercial success, it was the expenditure on R&D by the Syndicate that would bring that success about. It seems to follow that, had the investors engaged in a bargaining process with [the researcher], [the researcher] would have been willing to dispose of the core technology for a sum significantly less than the amount [the researcher] had expended in it, in return for the Syndicate's injection of funds for R&D. Likewise, had the investors engaged in arm's length approach to the expenditure to be made on core technology, they would have been unwilling to agree to pay an sum equal to the amount expended by [the researcher] on the core technology. …
… 83. My rejection of the view that the core technology had a negative or nil value involves my rejection of [the Commissioner's valuer] detached valuation methodology, although, as I have indicated, its focus on valuing the technology rather than on valuing the contractual rights is persuasive. At the same time, the [researcher's] sales forecasts are far too optimistic and need to be discounted though I would not discount them to the extent that [the Commissioner's valuer] discounts them.
84. … In what is a difficult, imprecise and hypothetical exercise, my conclusion is that a court or tribunal might well find that the technology had a positive value and that the arm's length amount stands somewhere in a range between $[one-fifth to almost half of the amount claimed].
- Subparagraph 73B(31)(b)(ii)'s 'reasonable amount' may be different to the arm's length amount. It may be within the range of estimated amounts. It may be more than the figures in that range (paragraphs 86-88).
- A 'reasonable amount' is not simply the value of the core technology:
89. Another possible interpretation which I have rejected is to interpret the arm's length amount simply as the value of the core technology to be objectively ascertained without having regard to the particular parties and to their attributes and then to reinstate the particular parties and their attributes in determining the amount of the expenditure that is reasonable. This interpretation does not give effect to the language in which [73B(31)](b)(ii) is expressed.
4.164 In July 2004, the Tax Office estimated the revenue at risk under different scenarios. These estimates were as at 16 July 2004, for 237 syndicates on a range of varying assumptions:
- for the total 237 syndicates, $3.978 billion total tax deductions claimed (comprising $2.21 billion claimed core technology deductions and $1.768 billion claimed interest deduction — assuming 80 per cent of core technology deduction) giving a tax cost (at a 36 per cent rate) of $1.43208 billion;
- for the 66 total post-December 1991 syndicates with $10 million core technology and over where individual investments by investors were more than $3 million (48 investors), $2.18232 billion total tax deductions claimed (comprising $1.2124 billion claimed core technology deductions and $0.96992 billion claimed interest deduction claimed — assuming 80 per cent of core technology deduction) giving a tax cost (at a 36 per cent rate) of $0.78564 billion;
- ratios (tax, penalty and interest: core technology), assuming an effective tax rate of 34 per cent, core technology of $10 million, core technology interest of $8 million, syndicate commenced in 1995, GIC calculations to 31 March 2004 applied to total > $10 million syndicate population where individual investments by investors were more than $3 million (that is, $1212.4 million core technology deductions) in four scenarios.
Tax and Penalty analysis
|Deny all core technology and interest deductions, apply a 50 per cent penalty and full GIC||Deny half core technology and interest deductions, apply no penalty and full GIC||Deny half core technology and interest deductions, apply no penalty and four years maximum GIC||Deny half core technology deductions and no interest deductions, apply no penalty and four years maximum GIC|
|Ratio (tax, penalty and interest: CT)||1.56||0.627||0.444||0.234|
|Ratio applied to total >$10m syndicate population where investments >$3m (that is, $1212.4m) in $m||1890.72||759.92||538.13||283.7|
|Ratio applied to total syndicate population (that is, $2.21b) in $m||3447.6||1385.67||981.24||
(From Tax Office's 'Revenue at Risk – all syndicates' spreadsheet, dated 16 July 2004).
4.165 The Tax Office also estimated that if it denied half of the core technology deductions and no interest deductions, and applied no penalty and six years maximum GIC, then a tax, penalty and interest to core technology ratio of 0.263 would apply. This resulted in an estimated:
- $319.4 million revenue at risk for total over $10 million syndicate population where individual investments by investors were more than $3 million; and
- $582 million revenue at risk for the total syndicate population.
4.166 These amounts also included those investors who settled before the Tax Office announced its global settlement offer. Their core technology deductions initially claimed amounted to $153 million. If these cases are excluded from the last scenario above then the revenue at risk amounts to:
- $279.1 million for the total over $10 million syndicate population where their investment was more than $3 million; and
- $541.7 million revenue at risk for the total syndicate population.
4.167 In August 2004, during its Review of Aspects of the Income Tax Self Assessment system, Treasury reconsidered the issue of unlimited periods for review generally and those relating to the R&D provisions. The report of that review (the ROSA report) stated:
The law sets out over 100 instances where the Tax Office has no time limit on its power to amend. Examples include … research and development expenses. The reasons for these unlimited periods vary. The most common reason is that the primary liability rules contain a condition that might only be satisfied (or cease to be satisfied) outside the normal amendment period. In some cases, the original reason is unclear or no longer relevant.
The Review has concluded that it is undesirable that a taxpayer who is not fraudulent or seeking to evade tax be exposed indefinitely to the possibility that their assessment will be increased to implement a particular provision. [ROSA Report, paragraph 3.2.5]
4.168 Treasury recommended that it conduct a more detailed review of these provisions. At this stage, such a review has not been completed but Treasury has indicated that it will consider the usefulness of these provisions and, if such usefulness is outlived, whether the provisions ought to be repealed.
4.169 The ROSA report also recommended:
The category of PBRs should be expanded to cover matters of administration, procedure, collection, and ultimate conclusions of fact involved in the application of a tax law. However, the Commissioner should not be obliged to rule where to do so would prejudice or unduly restrict the administration of the tax law.
The Tax Office should extend its practice of entering into pre-assessment agreements to a wider range of transactions or circumstances, wherever it is cost-effective to do so.
4.170 In summary and as at 1 September 2004, five investors (company groups) had settled with the Tax Office (investments in 18 syndicates). One investor litigated and had orders awarded in the taxpayer's favour. The Tax Office had released position papers in relation to 14 out of 33 audits. The Tax Office had determined that Part IVA applied in 14 syndicates.
4.171 On 6 September 2004, the Tax Office announced that it would only pursue taxpayers who invested in syndicates where the core technology expenditure for the syndicate was $10 million or more and the taxpayer's share of that expenditure was $3 million or more. It offered terms of settlement to 40 investors. The Tax Office said that it would not pursue the remaining investors. They effectively retained their core technology and associated claims.
4.172 In September 2004, the Tax Office published guidelines which would be used to determine whether core technology deductions were properly allowable. Those guidelines gave practical guidance on when the Tax Office would be bound by a private binding ruling. It also gave practical guidance on what factors should be considered in assessing whether there was an arm's length dealing. It gave general guidance on determining an amount where there was no arm's length dealing. This guidance was contained in 'Part C' of those guidelines:
- If the Commissioner considers that an Investor does not satisfy Part B in relation to core technology expenditure which it has incurred, he may be satisfied, that, in the circumstances, the Investor and the researcher were not dealing with each other at arm's length in relation to the incurring of the core technology licence fee.
- If the Commissioner is so satisfied, then s 73B(31)(b)(ii) requires the Commissioner to be satisfied that the amount paid by the Investor would have been less, had the Investor been dealing at arm's length with the researcher. If not satisfied in this respect, the Commissioner does not meet the requirements of s 73B(31)(b)(ii), and cannot adjust the deduction claimed for the core technology licence fee.
- In order to enable the Commissioner to be satisfied that the amount of the expenditure on the core technology would have been less if the Investor and the researcher had dealt with each other at arm's length in relation to the incurring of that expenditure, there needs to be material to support the Commissioner's conclusion.
- Such material may take various forms. By way of illustration only, it may take the form of:
- a valuation by an independent expert which shows that the value of the core technology was at the time of the R&D transaction less than the amount paid;
- material which establishes, either on its own or in conjunction with other material, that the parties inflated the price above the price which would have been paid had the parties been dealing at arm's length; or
- other material which establishes, either on its own or in conjunction with other material, that the parties paid a price in excess of the price which would have been paid had the parties been dealing at arm's length.
- If the Commissioner is satisfied under section 73B(31)(b)(ii), section 73B(31)(d) requires the Commissioner to arrive at an amount which he considers to be reasonable to allow as a deduction. Prior to his forming this view as to the amount, the Commissioner will consider any material put to him by the Investor.
- In relation to paragraph 2 above, the following propositions are relevant:
- the core technology licence fee is likely to have a positive value (as distinct from a negative or nil value);
- the arm's length amount may be within, and is likely to be within, a range of estimated amounts;
- section 73B(31) contemplates that the amount that the Commissioner considers reasonable will not necessarily coincide with the arm's length amount, but will not be less than the arm's length amount; and
- section 73B(31) enables the Commissioner to reach a conclusion in a given case that a part of the expenditure on the core technology licence fee is reasonable even though it does not correspond to the arm's length amount and may exceed that amount.
4.173 During September to December 2004 the Tax Office wrote to 40 investors (79 syndicates) offering a settlement and attaching the Mediation Guidelines:
It is important that we remind you that in accordance with the attached statement, you are only required to consider the settlement offer if the syndicated R&D arrangements in which you participated or from which you benefited involved:
- core technology incurred on or after 19 December 1991; and
- core technology expenditure of $10 million or more and your share of core technology expenditure of $3 million or more.
As your company or a company in your group has benefited (eg by way of a transfer of losses pursuant to former section 80G of the ITAA 1936) from syndicated R&D arrangements which meet the above criteria, the Tax Office will allow part of the benefit you received based on the following terms [terms of settlement were then set out, amongst other things, to allow 50 per cent of core technology deductions, 100 per cent of interest expenses, 0 per cent shortfall penalties and 50 per cent of GIC at the statutory rate capped at six years]
You have a number of options:
Option 1: Within six (6) months from the date of this letter, you can apply to accept the settlement offer by writing to the Tax Office in the manner described … below. The settlement offer expires six months from the date of this letter.
Option 2: Within six (6) months from the date of this letter, you can inform the Tax Office that you intend to seek to demonstrate to the Tax Office that you satisfy the attached Guidelines because:
- you were dealing with the researcher at arm's length in relation to the incurring of the core technology licence fee; OR
- if not (1), either that the core technology licence fee represented an arm's length price or that some other amount greater than 50 per cent of the core technology licence fee was a reasonable amount.
There is no expectation that the process of a taxpayer demonstrating to the Tax Office that it satisfies the Guidelines will be competed within six (6) calendar months from the date of this letter ...
If you do not either accept the settlement offer within six months or demonstrate to the Tax Office that you satisfy the Guidelines, the Tax Office will take appropriate action to determine the amounts allowable for core technology and associate interest expenditure. Subject to individual circumstances, any future settlement of disputes would be significantly less concessional than the offer outlined in this letter.
4.174 During November and December 2004, the Commissioner reissued its settlement letters making it clear that extensions of time would be granted and that no GIC would accrue during these extensions so long as the investors continued to work with the Tax Office towards resolution.
4.175 On 8 February 2005, the Tax Office conducted an information session on the September 2004 Guidelines at the invitation of a law firm.
4.176 On the 20 October 2005, the Tribunal handed down a decision in The Taxpayer and The Commissioner of Taxation  AATA 1039, 20 October 2005, Sydney. The Deputy President, the Hon R N J Purvis, accepted Venning's valuation in that case. In that case the Commissioner assessed a $2.4 million core technology licence fee as assessable to the researcher. The syndicate was registered in the 1993-94 year. The researcher argued, amongst other lines of argument, that the 'payment to the Applicant of the $2.4 million for the grant of the licence was a sham [and alternatively] the real value of the licence fee was not $2.4 million but significantly less. The amount was paid to maximise claimable tax losses. The additional amount beyond the true value of the licence is not assessable income. It is a windfall.'
Valuation of the licence to the core technology
16. It is maintained on behalf of the Applicant that the licence granted by it to the licensee, Lafoten, of the core technology was worth considerably less than the $2.4 million. The difference, it is said, between the true value and $2.4 million was not paid to the Applicant as consideration for the licence but in order to maximise the claimable tax losses of Lafoten. This additional amount, it is further said, is not assessable in the hands of the Applicant. Indeed it is maintained that the licence agreement was a sham.
17. It is basic to the Applicant's argument that the value attributed to the licensing of the core technology was not a real value and that Dr Venning was influenced in arriving at his valuation by suggestions put to him by AusAsean [the promoter]. If this contention can be maintained, then a factor relevant to the sham argument has been established. It is said that Dr Venning had a relationship with AusAsean in which he provided reports. Whilst not submitting that Dr Venning was entirely 'a pawn' it is contended that he was not wholly independent and that he submitted 'a false valuation and the figures were adjusted to come up with $2.4 million'.
18. The criticism made of Dr Venning's report was based on a number of contentions, each of which it was said, cast doubt not only on its reliability but on it being genuine in the sense of a report and a valuation reached after an objective appraisal of all relevant factors. But even if the Applicant is able to satisfactorily establish that the valuation report was not correct in the sense of being based on a false premise or premises, there is other evidence before the Tribunal as to a proper valuation which may substantiate that of Dr Venning. Discussion is had elsewhere in these reasons as to the meaning that is to be ascribed to the word 'sham'. The valuations and opinion of valuers is relevant only if they are such as to cast sufficient doubt on the genuineness of Dr Venning's report and the $2.4 million valuation. As I have said, it is not sufficient to show, that the valuation was wrong.
19. So in order to establish the falsity of the valuation and the lack of independence on the part of Dr Venning, the Applicant refers to aspects of the report which are said to be faulty and calls in aid the opinions expressed by other valuers and experts who commented upon the report or themselves valued the licence.
20. Material was contained in Dr Venning's report (Exhibit O/58) relating to the 'potential size of the market for the transformer equipment'. This information was provided by the managing director of the Applicant. It was maintained that the 'figures were entirely unrealistic' yet Dr Venning, whilst acknowledging that he could not corroborate what he been told, did say that there was no reason known to him to doubt the estimates made. Again when estimating potential revenue (Exhibit O/59) Dr Venning referred to discount rates reflecting the 'moderate risks' associated with developing the product and introducing it to overseas markets of 20 per cent to 30 per cent (13.4 per cent to 20.1 per cent after tax). Even be it evidence was tendered to the effect that the setting of a discount rate is a subjective exercise, criticism was made of Dr Venning in that the figures used by him were said to have been 'much too optimistic' in that one valuer (Mr Lonergan) had suggested a range of 35 to 50 per cent and another (Mr Banks) approximately 19 per cent. Professor Officer did not carry out a valuation but spoke of a discount figure of 30 per cent. Out of all this arose the contention that Dr Venning was so over optimistic as to the probability of the product's success that a Tribunal of fact could only conclude that the figures he used were influenced by the results he was asked to achieve. This Dr Venning strongly denied.
21. It seems to me that not only did Dr Venning use and rely upon the figures supplied to him by the Applicant but that the explanation given by him in his report for relying on them was open to him. Dr Venning placed a value on the core technology in the range of $2.6 million — $3.6 million stating that it was 'fair and reasonable for the syndicate to attach a figure of $2.6 million to the core technology' (Exhibit O/64). It attached a figure of $2.4 million.
22. Dr Venning in his oral evidence said that he received a letter of instructions (Exhibit P) on 30 May 1994 following which he prepared preliminary material based on information received by AusAsean from the Applicant, attended the Applicant's premises and had a discussion with the Applicant on 24 June 1994 seeking such information for the report on that day as was made available to him. His report was finalised a few days later. A basis for his report was that the transformer embodying the core technology was 'a product that had been and was accepted in the market place'. It was not to be breakthrough research. It was to be only a one year program and the chief researcher, the Applicant, 'knew where he hoped to be. It was design and production. For a one year program a major breakthrough in the area was not needed'. The task, Dr Venning said, was inter alia to 'assess whether the task could be completed in one year at a cost of approximately $1.3 million'. In looking at the commercial risks he noted acceptance in the market, past performance and the way in which the product was widely seen by reason of awards won. He did say that it was not easy 'to get a lot of information out of the Applicant'. Subject to assessing their reasonableness he accepted the figures that were given to him. From his own experience and what he was told, he expected 'the product project to be achieved'. A significant figure, 'a yard stick' in his valuation, was the expenditure incurred by the Applicant in generating the technology and the know how associated with the development of the multipurpose loading platform, the in-house knowledge which was given to him by the Applicant as 'at least $2.15 million'. The amounts spent to date were thus relevant to the valuation.
23. Dr Venning's overall impression of the Applicant and its managing director was that they 'were quite bullish, their expectations were high'. He was also fortified by the fact that the technology had a value by reason of the past success of the Applicant and its managing director.
24. The Tribunal accepts the evidence of Dr Venning. He supported his assertions with rational explanations. The more he was questioned the more persuasive were his answers.
25. It was the report by Mr Lonergan of Price Waterhouse Coopers, Chartered Accountants, of 1 December 1999 assessing the 'fair market value of the Core Technology as at 27 June 1994 to be zero' (Exhibit S) that laid the foundation for an initial submission of the Applicant. Mr Lonergan in his oral evidence before the Tribunal took issue with conclusions drawn by Dr Venning, tending to minimise past success of the Applicant and its managing director and saying that 'value is to be determined by future benefits to be generated'. He spoke of removing 'the optimism of the developer' and criticised various percentages used by Dr Venning. He was aware of reports by Mr John Banks and Professor Officer, which were critical of his own report and in cross examination (page 458 of the transcript) said:
'Mr Quinn: In the business of valuation there are always — there is always scope for alternate views; is there not? — Yes.
And in fact the reports of Professor Officer and John Banks provide alternate views? — Yes
And are you aware as to whether there was a committee formed to consider all reports, including your own, the Banks' report, and the Professor Officer report? — I don't know the answer to that question.
One particular factor would be — in considering valuations would be whether the technology already had a presence in the marketplace? — Yes
And the position of the inventor, say, working in the garden shed on an invention and the position of an inventor who was established in the marketplace, had a track record, had successfully commercialised inventions, they are considerations as well, are they not? — Yes
And if it was — and I think you would agree that if there was a tax break which was available to IMB by reason of deductions, that is a factor which could affect valuations of core technology? — It could.
I think the Banks' report considered that the valuation should fall within a range between a fair market value and a market value where the buyer had special interests? — Yes
And that was a view taken by John Banks? — Yes'
26. Mr John Banks provided two reports (Exhibit 48) on the syndicate and the licence attributable to the core technology. He is a Chartered Account and a consultant with KPMG in Forensic Accounting. In his report of 30 March 2001 he stated:
'… It is my opinion that the value range of $(472,510) to $164,848 determined in the PwC Valuation for the Core Technology acquired by the [Applicant] R&D Syndicate is inappropriate and the conclusion that the Core Technology as at 27 June 1994 had a zero value is significantly flawed.
It is my view, based on the available data, that the valuations should fall within the following ranges for a 'fair market value' ('FM Value') and a fair market value where the market consists of buyers with special interests ('SFM Value') (see Section 5 for detailed explanation of SFM Value) after adopting the PwC market share and the 7 per cent royalty rate:
FM Value SFM Value Tax deductions claimed immediately earned Tax deductions claimed as income available 60 per cent
80 per cent
60 per cent
80 per cent
7 year life Low
(20% discount rate)
500 974 1,166 1,599 High
(16% discount rate)
877 1,438 1,373 1,877 12 year life Low
(20% discount rate)
939 1,559 1,605 2,184 High
(16% discount rate)
1,404 2,149 1,983 2,690
27. It is not necessary for me to do other than note the areas in which Mr Banks differed with Mr Lonergan. This I have done. It is relevant to note that uppermost in Mr Banks' valuation was that 'it is clear that [the Applicant] had the ability to research, develop and commercialise products similar to the subject product'. He further expected 'that a valuer in June 1994 would have assessed the probability of success highly and likely to be greater than 80 per cent' (Exhibit 48, Report 29 April 2002 page 3).
28. Mr Banks noted the commercial success achieved by the Applicant prior to June 1994 with patented products. This would impress him as a valuer he said, and encourage him to pay heed to what he would have been told by the Applicant. The project was to be short term and on the basis of such success and information supplied the probability of further success was enhanced. The product, he noted, put together component parts, which had been developed over a period of time and patented.
29. Professor Officer conducted a critique of the Lonergan Report, mainly restricted to the valuation methodology used, and a commentary on that of Mr Banks. After noting that Dr Venning 'relied heavily' on the managing director of the Applicant for technical advice, Professor Officer noted the advantages accruing to an investor from investment in R&D projects and this undoubtedly being a relevant factor. He was critical of various basis used by Mr Lonergan and queried some of his findings. He concluded by saying that the criticism by Mr Banks of the Lonergan valuation was reasonable. He noted that Mr Banks was influenced by the Applicant's 'position in the market and its clear expertise in the product area for which the Research and Development is to be carried out' (Exhibit 42). He would have sought as much corroboration as was possible. He discussed the use of tax losses (would have increased Dr Venning's valuation), commercialisation, risk factor, discount rates, royalty rates and the reliance that would be placed on the researcher (the Applicant) for the provision of information.
30. On the basis of the material tendered before the Tribunal and after considering the matters above discussed, I am satisfied that the licence of the core technology had a true value and I see no reason for finding that the valuation of Dr Venning was other than one open to him on the basis of the material provided and the conclusions that were properly drawn. The Applicant concurred in the provision of information and was an active participant in it being so provided.
31. The licence agreement was not a sham. Both parties intended for there to be a licensing of the core technology for its use in advancing the project and for a consideration of $2.4 million. A valuation of $2.4 million was a proper and true valuation. This is so even if other valuers would arrive at a different figure either more or less. It was based on information provided to Dr Venning. The assumptions made and conclusions reached in aid of arriving at the valuation were properly available to a competent and objective valuer. There was not a 'windfall gain' to the Applicant.
37. I do not accept a submission made on behalf of the Respondent that the managing director was engaged in acts of duplicity referable to disclosure in the project schedule or he 'falsely allowed' a suggestion as to the stage of development of the retractable platform to remain in the documentation. He may have been overly enthusiastic or optimistic as to the transformer. If there were errors at this time, I am satisfied that the representations were not made with any intent to deceive. Likewise market projections and expectations as to market share taken up by Dr Venning may well have been based on optimistic expectations, but honestly made.
84. It is contended on behalf of the Applicant that the real value of the licence was less than $2.4 million and the difference between the real value and the $2.4 million was paid in order to maximise the claimable tax losses of Lafoten and IMB Limited. The assessable income arising from payment of the licence fee was limited, it is said, to the real value of the licence. The additional amount was not income assessable to the Applicant.
87. This contention is basic to the argument referable to the reasonableness of the Venning valuation. Reliance is placed upon the commentary on the valuation made by Mr Banks (Exhibit 48, pages 2-3) and the cost of capital being adjusted so that any valuation made by Professor Officer would be less than that of Mr Banks (Exhibit 42).
88. It is of note to mention the evidence of the managing director of the Applicant in paragraph 8(b) of his statement of 4 February 2005 (Exhibit J) where he says that 'accordingly I did not consider the amount of $2.4 million extraordinary', this in the context of the Applicant group of companies at that time being involved in 'deals worth millions of dollars' and having sold a patent in 1989 for $3.25 million.
89. For the reasons earlier given when considering the valuation of the licence of the core technology, the Tribunal is satisfied that a valuation of $2.4 million for the technology licence was open to the parties to accept. The real value of the licence was not significantly less than a value of $2.4 million.
4.177 On 13 December 2005, the Commissioner issued PS LA 2005/24 which provided the policy and procedures to implement his 15 April 2004 announcement in relation to providing taxpayers with an opportunity to be heard at the Part IVA Panel. It outlines the procedures that govern the period of time that is given to taxpayers, the material they are provided and the limits of their involvement in the Part IVA Panel meeting.
4.178 On 15 December 2005, the Solicitor-General and Australian Government Solicitor's Chief General Counsel gave a joint opinion to the Tax Office on providing administrative guidance on following judicial decisions:
13. We consider that, in order to resist accusations that the Tax Office is disregarding judicial decisions contrary to the rule of law, it is important that, if the Tax Office considers that a decision is wrong, it should as soon as possible put those affected on notice of this view. It should only seek to challenge an earlier decision where it has legal advice to the effect that the decision is wrong. To avoid criticism it will also normally be appropriate, if the Tax Office launches a challenge to the earlier decision, to fund or organise suitable assistance to bring a test case. Pending the outcome of such a decision, other taxpayers affected should be informed of the proposed course of action. [Inspector-General of Taxation's Report on the Review of Tax Office Management of Part IVC litigation, page 249.]
4.179 On 16 January 2006, the Solicitor-General and Australian Government Solicitor's Chief General Counsel gave a joint opinion to the Tax Office on providing administrative guidance on following judicial decisions:
2. … Clearly, it is not appropriate for the Tax Office to seek to challenge a particular interpretation of the tax laws adopted by a court or tribunal just because, as a matter of policy, it considers it wrong or undesirable. If that is the basis for concern then the appropriate approach is to change the tax law. However, if the basis of the Tax Office's attack on an earlier decision is that as a matter of law it is wrong, then our earlier advice indicated that it was proper for the Tax Office to seek an appropriate vehicle in which to test that issue. However, it should, among other things, before making a decision to do that have legal advice that supports the argument that the decision is legally wrong. …
5. It is important in this regard to distinguish between the policy decision to pursue a challenge to a legal decision and the provision of legal advice to support that decision. Normally, a policy decision will need to be made at an appropriately high level within the organisation reflecting the nature of the decision, the likely impact that the challenge to an earlier decision may have on other tax payers and broader tax policy. In making the policy decision, legal advice supporting a challenge is an important element but not the only element to be considered. The legal advice is concerned only with whether there are reasonable legal arguments for a particular interpretation which justify an attack on a previous decision that, for probably good reasons, was not appealed from at the time. The policy decision needs to consider broader issues. For this reason, it will usually be undesirable for the legal advice to be given by the person making the policy decision.
6. In many ways the decision to challenge an earlier decision is not that dissimilar to the decision that might have been taken when the original decision was handed down as to whether an appeal should be pursued. The Legal Services Directions require that an appeal not be pursued unless an agency believes that it has reasonable prospects for success or that the appeal is otherwise justified in the public interest. For that purpose legal advice is obtained. It may be that at the time of the original decision the factual or other circumstances did not make an appeal appropriate. It seems to me, however, that the same burden needs to be met where an earlier decision is to be challenged in another case. The legal advice obtained for this purpose needs to be sufficiently robust and credible to ensure the decision can be seen as consistent with the same principles as determine whether an appeal is justified. Beyond that it does not seem to me necessary or appropriate to try and be prescriptive as to the precise form that any legal advice to support an attack on an earlier decision should take. [Inspector-General of Taxation's Report on the Review of Tax Office Management of Part IVC litigation, pages 252-255.]
4.180 As at 4 April 2006, 15 investors (investments in 30 syndicates) had settled with the Tax Office or agreed on settlement terms. One investor also had other investments under review. Ten investors (investments in 14 syndicates) had satisfied the September 2004 guidelines. Four investors had other investments under review. One investor also had an investment which was settled. Twenty-two investors (investments in 32 syndicates) had investments subject to an unfinalised review.
4.181 As at May 2006, the Tax Office had only amended assessments in two syndicates without first concluding settlement negotiations.
4.182 In early November 2006, the Tax Office notified an investor representative that it would not pursue a claim. No reasons were given:
Dear [investor's representative]
I refer to the letter which issued from this office [of the kind reproduced to paragraph 4.173 above] and subsequent correspondence in connection with the investment by [the investor] in [the syndicate].
I am writing to advise that the ATO will take no further action in connection with the participation by [the investor] in this arrangement.
4.183 The Tax Office decided not to pursue this claim on the basis that the TCC had scrutinised the core technology valuation during registration.
4.184 The following table provides the status of the Tax Office's review of R&D syndicate claims as at 5 February 2007. It focuses on those 40 investors who had invested in syndicates with $10 million of core technology and invested more than $3 million in any of those syndicates.
|Status of investors' investments||Number of investors||Number of investments|
|All satisfied guidelines or otherwise 'NFA'||11||14|
|All under review||6||7|
|Some settled, some satisfied guidelines||6||23|
|Some satisfied guidelines, some under review||3||10|
4.185 The following table is from DITR and shows the number of syndicates registered and amounts claimed by financial year.
|Period||No. of syndicates||R&D ($m)||Core Technology ($m)||Total ($m)|