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Tax Laws Amendment (Research and Development) Bill 2010

CHAIR —Welcome. Thank you for coming in this morning. Dr Roberts, do you have an opening statement?

Dr Roberts —Just a very brief one, Senator. Good morning to all of the senators.

Senator CAMERON —Good morning.

Dr Roberts —Good morning, Senator Cameron. On my left is Mr Andrew Chia, who is responsible for our global tax in Cochlear, and on his left is Mr Greg Oliver, who has been many decades in industry policy. He has grey hair like I do! He advises us on our in-house R&D. We have been a party to the Advanced Manufacturing Coalition, which is presenting after us. That group has provided a very, very important submission to you. We absolutely endorse that submission. I think it is extremely well written, pithy and succinct. It hits the key issues. I really want to emphasise the importance of that, but I feel it is relevant to attend and appear in front of you to add Cochlear’s perspective on it.

Cochlear has been a quintessential example of a company that has benefited from long-term bipartisan innovation support of the government. Probably we are here today less about Cochlear and more about emphasising the importance of this legislation. It is probably the single most important piece of legislation in terms of supporting innovation, and innovation, particularly technical innovation, is probably the single most important tool that you have to create wealth in this country. Professor Robert Solow, from MIT, was awarded the Nobel Prize in economics in the eighties for demonstrating that technical progress had a far, far greater impact on driving economic prosperity and growth than, indeed, labour and capital together. Technical innovation is absolutely key.

This legislation has been in place for decades in various forms, and appropriately you are looking at taking this legislation, tweaking it, reforming it and making some improvements. That is to be applauded. It seems, when you stand back and look at it, that there are probably three things that could be addressed in this legislation. No. 1 is: was the incentive appropriate enough for SMEs, given that they did not have taxable income? No. 2 is: was there a particular problem with the way software was dealt with in the legislation? No. 3 is: what is the impact of the large, perhaps excessive, claims being made, and is there a distortion from that?

I think that largely those three issues have been dealt with, in terms of the changes being made for the tax credit system for the SMEs. I think that is to be applauded. It is absolutely excellent and fantastic. But I think the legislation has problems, if I could suggest that, in the way it is dealing with the other two problems it is fixing up. It is probably less about software. I think software has been amended, and we can probably take that off the table. But it seems that the baby is being thrown out with the bathwater in trying to fix up how you deal with these excessive claims so that, to the extent that you are going to give some more money to SMEs, the overall cost of the program is neutral.

I assume that one of the objectives of this legislation is to keep it revenue neutral, and that is fine, but the changes to the definitions of R&D are genuinely problematic in terms of various industries—for example, in manufacturing, the importance of the development side versus the research side in manufacturing. You end up with unintended consequences, such as the consequences of complexity and the like from the dominant purpose test, and I am not sure why. There are other mechanisms of keeping the legislation revenue neutral—for example, capping a claim or capping the multiple supporting R&D could be your core R&D. The piece that puzzles me is the solution for the problem that is being proposed.

I will leave my comments there. To summarise: the legislation is incredibly important, absolutely incredibly important. It does some good things for SMEs, but it is still problematic around the definitions, and it is easy to fix. There are other solutions. It can be done by 1 July, and we do not have to make it as difficult as it seems. I think there is a very common theme in some of the things that I have heard and some of the things that the AiG mentioned. I will leave it there.

CHAIR —I think you are right in stating that there is bipartisan support for research and development. I think the minister sees that as a way of improving and stimulating further research and development in industry. You were talking about other ways of achieving this, including capping, but we have had other submissions that suggest that capping would not be the way to go and that that in itself would cause problems. Where do you see other solutions in this whole thing?

Dr Roberts —I am sorry; I have not heard the argument against capping, but you need something to keep it revenue neutral. If you do not want to cap it, perhaps you could cap the ratio of supporting R&D to core R&D. From my understanding, some of the excessive claims are where the supporting R&D is very, very large relative to the core R&D. You deal with it by a multiple like that. There are other ways of dealing with it, perhaps by pre-approval for the program.

CHAIR —That is indeed part of this. AusIndustry has been given significant additional expenditure both to go out and educate business about the changes and to allow for increased auditing and for pre-approval of programs. That is indeed part of this package.

Senator COLBECK —On your comments relating to the timing of the legislation, I think it is probably fair to say it has been a fairly turbulent six or eight months since the initial proposals in the discussion paper came out in September and the initial draft legislation just before Christmas and then the latest version arrived just before Easter. It has been moving very quickly. The government has responded to some of the initial concerns that came out prior to Christmas. There has been quite a move from that initial approach to where we are today. But it really has pushed us up very hard up against the 1 July commencement date for the legislation.

Yesterday we heard officials from AusIndustry saying that they would be giving information—information sheets and things of that nature—to industry in July. From my perspective, that would have to be quite problematic. Getting information in July about a tax that started on 1 July would create all sorts of difficulties. On the opportunity to effectively introduce this legislation with the obvious improvements that you talked about but also to try to deal with the negatives, you have mentioned placing caps on claims. Do you have any sense of the scale on which that might work? You also mentioned the ratio side of things. From a practical perspective, what are reasonable scales for that sort of thing?

Dr Roberts —I do not have the data. I have never seen the data, which is not public, on how big the big claims are et cetera. My understanding of the number of companies is that there are maybe 8,000 companies registered and perhaps 200 companies claiming more than $10 million, for example. It must be a relatively small number of companies that have very, very large claims. Someone would have access to that information. I do not know the quantum that it needs to be. Someone must have that information.

Senator COLBECK —Let us go back to Cochlear. From your perspective of the new definitions and the difficulties that they create, when you decide whether or not to make a claim under the new regulations or new definitions, you would obviously do a risk analysis of whether something does or does not comply and what it will cost you to go through the consultative process and make a decision, yes or no, about whether to make an application for this R&D and then decide whether or not to do it. Does the legislation as it is worded now tip that in favour of saying it is too risky: ‘Let’s not do the R&D,’ or, ‘Let’s not make a claim’?

Dr Roberts —It certainly adds complexity and cost.

Senator COLBECK —So compliance is up?

Dr Roberts —Compliance cost. From my understanding of yesterday’s evidence, there is an estimate of $30 million to $50 million from Treasury of the extra compliance cost over something like four years—tens and tens of millions of dollars of extra cost that is completely non-productive. For sure, we have to take some of that cost, like a lot of other cuts. Greg, do you have a comment on the complexity?

Mr Oliver —Yes, I can add to that. As you know, under the current R&D regime, there is a requirement for R&D plans. While that requirement will not exist under the new legislation, there will nonetheless be a significant amount of additional planning required by companies so that they can reassess the eligibility under the new definition, on the one hand, and also, importantly, to predetermine, perhaps throughout the annual life of a project, what activities will now be core and what will be support.

We see that preparatory role now as being very significant not only in terms of the additional workload that we have but also for a lot of the smaller companies that do not. While we do not want to ingratiate ourselves here, we have quite a sophisticated R&D planning mechanism, not for the tax concessions but of course because we are in a regulatory regime and we have very specific and detailed plans. For us it is an easier impost, if I can use that expression, to step in and do that. In fact, we have already started. We anticipate somewhere between now and September having in place what we need to do, what projects we will claim and on what basis we will claim them.

Attendant with that we have already commenced new time-recording systems for the up to 300 respondents in an R&D claim so that we can track and monitor their activities so that we will be in a position to register their activities in April 2011. We are not complaining about that; it is part of the regime in which we live. We do this elsewhere in the world. It is quite an onerous task for us but, more importantly, for the smaller mediums.

Senator COLBECK —It appears to me from the evidence so far that it is effectively largely manufacturing and the work that needs to go on in the development of the manufacturing processes that are most significantly hit by the revised definitions because of the dominant purpose test.

Mr Oliver —Yes. That is our reading of it.

Senator COLBECK —That is where the additional compliance cost comes in, and that is where the additional risk comes in as to whether or not these issues will comply. It brings in the risk factors of the self-assessment process and the potential consequences down the track with the additional resources that have been supplied for things like auditing and the approach from government.

Mr Oliver —Correct. Senator, I think we agree entirely that, in the manufacturing or production environment, it will be an additional compliance because of the dominant purpose test, but there is still a significant compliance issue required in the non environment, where most of our R&D happens to be, in order to address the core and supporting activities.

Senator CAMERON —Thank you, Dr Roberts, Mr Oliver and Mr Chia. Can you provide us with an example of where an activity would be excluded by the dominant purpose test, which you believe should be covered by the new tax credit?

Mr Oliver —I will just set the framework here. First let me say that the dominant purpose test is not a major impost for Cochlear because we have very well prescribed test processes and procedures. We are in a regulatory environment. We have to build implants that survive in a person’s head for 75 years and we cannot get it wrong, so we have very well prescribed reasons for doing trials. On some occasions we have output from those trials that is saleable but, generally speaking, because of the saleable output we cannot claim the inputs to the trial under the current feedstock rules.

There would be an impact from dominant purpose because some of the activities that support a trial would be supporting activities. Because of that saleable output, there will no doubt be some disconnection of the eligibility because of that. But you must realise that a lot of the R&D we do in the factory, plant or production area is new tool and process design as opposed to just running a new product design through similar tools. There are two arms to R&D here: one is product development and, importantly, the process development. Recently we spend approximately $90 million on developing a new nuclear—

Senator CAMERON —I am sorry, Mr Oliver; I do not have a lot of time. I would like you to come to the question. What would you be excluded from doing under the new legislation that you can do under the present legislation?

Mr Oliver —It would affect some trial costs.

Senator CAMERON —Why?

Mr Oliver —Because they would fail the dominant purpose test.

Senator CAMERON —Why would it fail the dominant purpose test?

Mr Oliver —Because in many cases, depending on where we are in production, such as a prepilot stage as opposed to a postpilot stage, there will generally be some fortuitous saleable product that will go with that. We can get into this debate and argument about whether we are doing it for the dominant purpose or we are doing it to meet the trials. What I am saying to you is that, as much as we have a very strong regulatory reason to do the trials—we cannot sell a product in the world without them—we still feel there could be some challenge to some of the claims we make in dominant purpose. My opening remark was that, while it is not a significant impost on Cochlear, our production R&D is perhaps less than 20 per cent of our total claim as opposed perhaps to the multiples we see in other areas.

Senator CAMERON —Can I ask you to have a look at the whole context of the proposed legislation? As you aware, you read legislation in its overall context; you don’t just read a part. You have to look at the other areas.

Mr Oliver —Sure.

Senator CAMERON —Can you look at the objects clause and give me some comment on the objects clause, which refers to both research and development. It says:

The object of this Division is to encourage industry to conduct research and development activities …

I ask you also to have a look at the evidence that was given yesterday in my questioning of the department and Treasury on the example of the pea. What would be different between that example and issues that you say are a problem? If others who are producing food can claim for associated activities and development activities, why can Cochlear not do the same thing?

Mr Oliver —We have not been of the view that under the new objectives we cannot continue to claim the R&D that we do. We have not said that. But we do believe there will be some impact in regard to that because of the transition point between when you are doing research and when you are doing development. I am not talking production environment, so let us talk about the D&D workshop, if you like, to remove that. We see that there will be some point at which we have to make determinations as to whether or not we are still learning and as to whether or not we still get an acquisition of knowledge throughout this process. Does that answer the question, Senator?

Senator CAMERON —No, sorry.

Dr Roberts —May I add a comment? Senator Cameron, the objects clause in the draft legislation definitely narrows the definition and has a much greater emphasis on the R rather than the D, compared to the existing situation. Do you not think that?

Senator CAMERON —No. I am just saying that the evidence we have from both Treasury and the department which will be implementing the act is that there is no problem here. The examples they give are that you can conduct research and development. My practical experience in the food industry demonstrates that there is not a problem, given the response that we got yesterday. I would like you to have another look at that and maybe come back with some practical examples.

Mr Chia —In regard to the application of when the taxpayer is audited, they are audited by the ATO as well. From that perspective, it is the greyness and the certainty which Cochlear, as a taxpayer, will face under the scrutiny of a different department, from our perspective. As much as AusIndustry and Treasury say it is nice in intent in terms of the EM and the examples they provide, the legislation is a bit grey, and that uncertainty creates a bit of discomfort.

Senator CAMERON —I know that other senators are waiting to ask questions, but I have just one more issue. I think you are a member of AiG. They indicated that they wanted a self-assessment regime. There is still a self-assessment regime here. They spoke about the inconvenience to business. I suppose what we have to balance against the inconvenience to business is public good and accountability for public expenditure. That is a fundamental issue for us.

I have seen examples where large multinational mining companies with core R&D that is worth $20 million say they are using that in their production processes, and suddenly their claim becomes $500 million. In the construction sector they say they will install new air-conditioning in a building, so they claim the cost of the whole building against the R&D. In the manufacturing sector, people are upgrading a processing plant and claiming the upgrading for the whole processing plant against R&D. I am sure that is not Cochlear’s view of how this should work.

The question I put to you is: how do we balance this effectively to make sure that these types of rorts are out of the system and that companies like Cochlear, which are investing in the national good, are looked after in terms of their R&D? That is the issue for us.

Dr Roberts —Senator Cameron, we are completely aligned in terms of what the problem is. Where I do not think we are aligned is about what the solution is and how we fix the problem. What we are saying is that the way it has been fixed has a whole series of unintended consequences and there are other ways to fix it that must have been looked at and presumably rejected. I guess it is far from intuitive why those other relatively simple solutions have been rejected. Those two examples that you mention could very, very easily be addressed by setting some ratio of supporting versus core R&D or a cap.

Mr Oliver —Or even a cap on the overall size of the project that then drives the need to have an internal review or advance approval.

Mr Chia —Or when trials are run over a period of time, such as when a trial is run over more six months, you get approval for that to become eligible expenditure under the new incentive.

Senator COLBECK —I have a question in relation to Senator Cameron’s question and the evidence that Mr Oliver has just given. In relation to some of the production trials that are associated with the R&D and just thinking back to some of the examples in the explanatory memorandum that talked about revenue from the trials, you make that specific point. I think that is raised as one of the discussions in the examples in the explanatory memorandum.

One of the grey areas that comes out of this whole process is the revenue that might be garnered from the trial itself and the question mark that that places over the trial process as to whether or not it is still R&D. Going back to Senator Cameron’s example of the black pea and the technology that is involved in that, the question mark becomes whether, if the company that is putting that production line into place gets significant revenue out of the trial from selling the product that is made with the new technology, that places a huge question mark over the eligibility of that particular part of the processes from the definitions of the new regulations.

Mr Oliver —Senator, firstly just for the sake of understanding, under the current legislation the costs of running the trial—that is, the overheads and the direct factory costs to the extent of running the trial—are eligible regardless of whether you have saleable output. The magnitude of the saleable output is what affects the feedstock inputs that get into that trial cost. Just to be clear: first of all, just because you run the trial in a production environment does not mean it is ineligible, and whether you are doing core R&D or support R&D on that process is really irrelevant to that. I have to confess that I saw the new feedstock provisions yesterday and did not understand them. I would not comment on them today because in my experience with feedstock is that no-one does understands them for some years after application. Someone in the room may qualify this, but I sensed that the new feedstock rules will now call that centre bit ‘feedstock’—that production cost. Someone in the room might know better, but maybe not. I cannot qualify the exact impact of the new legislation in respect of the new rules in that regard.

Senator COLBECK —That was certainly something that I picked up when I was reading through the examples in the explanatory memorandum. You have mentioned the fortuitous sale of product from a trial and that creating a question mark.

Mr Oliver —Yes.

Senator COLBECK —So I was just looking for some clarification on that particular point because I think it is one of the areas that remains very grey—

Mr Oliver —It is very relevant.

Senator COLBECK —and creates uncertainty as part of the new regulatory wording in the new bill.

Mr Oliver —Absolutely. Yes, I totally agree.

Senator BUSHBY —I note that you are part of the Advanced Manufacturing Coalition, which has put in a submission. As an individual company, have been you been dealing with Treasury as well?

Mr Chia —Absolutely, yes. We have been in the consultation process ever since—

Senator BUSHBY —As part of that, you have raised the concerns that we have heard about today?

Mr Chia —Yes.

Dr Roberts —Yes.

Senator BUSHBY —And they have not been adequately addressed, in your view?

Mr Oliver —No, I would not—

Mr Chia —They have been very cooperative throughout the consultation process. That has been great. There was a first round of the consultation.

Senator BUSHBY —But clearly you have raised concerns that still exist as you sit here before us today, so they have not been fully addressed.

Mr Chia —Not entirely.

Dr Roberts —A lot has happened in that consultation process. I think that there have been some very positive amendments and changes, but there are still some problem areas.

Senator BUSHBY —The definition of R&D is a new change.

Dr Roberts —It is objects, definitions and dominant purpose test. It is the consequences of those three areas and what you can and cannot claim, and then it is the complexity that that introduces, for no obvious good other than fixing the examples that Senator Cameron cited, where there are other ways of fixing it.

Senator BUSHBY —Exactly. There is more than one way to skin a cat, so to speak.

Dr Roberts —You are actually quite close. You could amend this. It would be relatively straightforward.

Senator BUSHBY —While still delivering all the outcomes the government is seeking to deliver?

Dr Roberts —While still achieving what you want to achieve.

Senator BUSHBY —We heard evidence this morning that the Productivity Commission report in 2005 included a breakdown of research and development and showed that experimental development at that time was about 61.6 per cent of the proper R&D activity at the time. From Cochlear’s perspective, what percentage would experimental development be of your research and development as opposed to the other three categories, which were—and I did not get the actual term—initial research at 1.8 per cent, strategic-pure research at 5 per cent, applied research at 31.6 per cent and experimental development at 61.6 per cent of the research and development?

Mr Oliver —A year from now under the new legislation, we could probably answer that. In this last year, 2008-09, for example, we would have had a very high ratio of the research side because we are in a phase of developing quite a lot of new products, so there has been a lot of emphasis there and very little on the production side, if you like, in that same time period.

Senator BUSHBY —But that will change depending on—

Mr Oliver —It changes where you are in the project.

Senator BUSHBY —the level of maturity of the research you are doing.

Mr Oliver —That is exactly right.

Senator BUSHBY —At times you might have to put a lot of effort and resources into the research side of it, and necessarily that then moves on to your experimental development side of it.

Mr Oliver —Yes, exactly.

Dr Roberts —It is the importance of the D as well as the R, and a company like Cochlear is doing more D than R. It is capital D and little r. We call it R&D. It is the recognition that it is an ongoing step-by-step-by-step building on what has gone on before. To give you an example, 30 years after the first implant of our cochlear implant, we are still spending 13 per cent of our revenues on technological innovation—30 years later, 13 per cent of R&D. We are doing that because it is a step-by-step journey, and it is development. I guess that is the difference between, say, devices and drugs. A drug either works or it does not, but with a device you hit it with a hammer or paint it green or make it blue and add a little widget or whatever, and you develop it. It is a development process. It is the successful development of that over the long term that creates substantial competitive advantage and keeps you in business, and that is why the development side is really important. Even if you come up with an emphasis on the R that might help the SME when it starts up, unless it gets in its head that ongoing development it will not be there. It is a really important point.

Senator BUSHBY —I agree that it is a really important point. Given that, and given the way the bill is currently drafted, as opposed to the evidence we have heard from Treasury officials on how it is intended to be interpreted, and given your reading of that, what impact do you think that will have on Cochlear’s ability to continue to invest 13 per cent and to maintain your competitiveness against your competitors in other places, which I believe exist?

Dr Roberts —Less of our activities are claimable, so we are less able to do that, by definition. That is a consequence of it. That is the consequence for Cochlear, but this is more than Cochlear.

Senator BUSHBY —I know.

Dr Roberts —This is what we are doing for Australia.

Senator BUSHBY —You are sitting here before us and you are, in a lot of ways, an iconic company in terms of the way in which Australians view you. One of the reasons that you are an iconic company is because you have been able to invest and develop a product which does great things, and you do it in Australia.

Dr Roberts —Correct.

Senator BUSHBY —I think all Australians would love to see that type of example right across the board with other companies. If this bill has the potential to put that at risk, as I believe you are saying, that is important for the committee to hear about.

Dr Roberts —It is hard to read this stuff and not see a distinction between the R and the D, coming back to the objects test. I am surprised at some of the evidence yesterday, given the way the draft legislation is written.

Senator BUSHBY —Thank you.

Senator EGGLESTON —One of the provisions in this bill is that intellectual property need not be held in Australia. I wonder whether you have a comment on that. Where is Cochlear’s intellectual property held—in Australia, or overseas?

Dr Roberts —It is in Australia.

Mr Chia —Basically, Cochlear’s R&D activities and all the IP are located in Australia. We will continue to be an Australian company in terms of what we continue to develop in products. Initially in our input to the consultation process as part of the Cutler review we suggested looking at the broader picture of how to encourage keeping IP in Australia. It was one of the recommendations that came out of the review, but it was obviously not put on the agenda because of the revenue neutrality of the whole program, which the government wanted to achieve.

Senator EGGLESTON —You thought IP should be kept in Australia. Is that what you just said. I am sorry; I could not quite make that out.

Mr Chia —Yes, sorry. To clarify that point again: yes, IP should be kept in Australia.

Senator EGGLESTON —Briefly, what specific disadvantages do you see in its not being required to be kept in Australia, if any?

Mr Chia —Pardon?

Senator EGGLESTON —What specific disadvantages do you see, if any, in not requiring IP to be kept in Australia? Do you see this as a measure which might disadvantage Australian research and development and industry?

Mr Chia —In terms of international competitiveness, other regimes around the world encourage the return of royalties to be taxed more favourably. There are international incentives that encourage a greater deduction. From the perspective in which I understood the intention of the legislation, it was to keep Australia competitive in terms of the other OECD nations. We are addressing the R&D part, but I think the IP part has been shelved because of the revenue neutrality of the program.

Senator EGGLESTON —Given the time, thank you.

CHAIR —I thank Cochlear for coming in this morning.

Proceedings suspended from 10.20 am to 10.33 am