The R&D Tax Incentive provided by the Australian Government to encourage businesses to invest in research and development. By subsidising the development of new products and ideas, the government hopes to encourage business growth through innovation.
The R&D Tax Incentive ultimately means you get money from the government for research and development costs you’ve incurred. You currently get this as cash back or a reduction in tax. The incentive and appropriate use of the incentive by businesses is a great funding mechanism to help grow an innovative business in Australia.
There are two problems commercially with the R&D Tax Incentive. One is the false sense of business performance it can give. The other is the problems it creates when selling your business.
These primarily stem from the R&D Tax Incentive being classified as a form of revenue.
How the R&D Tax Incentive Works
For businesses doing innovative work, such as developing new products or software, the R&D Tax Incentive, as at the time of writing, provides a tax offset for amounts you spend on “eligible R&D activities”.
If your revenue is under $20 million then you get the offset back in the form of cash. If your revenue is over $20 million then it just reduces your tax payable.
The R&D Tax Incentive gets recorded on your profit and loss statement under Income, near the top. This filters down and increases EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation).
Here is an example of a simplified Profit and Loss statement from the fictitious SaaSCo to show you where the R&D Tax Incentive shows up in your financials and the impact it has:
| Revenue from Customers | $2,800,000 |
| Other Income | |
| R&D Tax Incentive | $600,000 |
| Total Income | $3,400,000 |
| Expenses | $2,700,000 |
| EBITDA | $700,000 |
This seemingly harmless position on the P&L, supported by accounting standards and various whitepapers, masks problems for the business owner.
Actual Business Performance
EBITDA, which stands for Earnings Before Interest, Tax, Depreciation, and Amortisation, is usually a good indicator of Operating Profits. Operating Profits are the earnings that an owner of a business can expect to get from the underlying business before any external factors, debts or technical accounting treatments (like depreciation) are applied to their numbers.
Business is about providing a solution to customers that they pay you for, so you can ultimately make a profit. This is what EBITDA is really meant to reflect.
The inclusion of the R&D Tax Incentive makes business performance harder to understand because it is warping our EBITDA. Money from the R&D Tax Incentive isn’t really income, not income like the revenue you receive from customers.
Going back to the SaaSCo example, look at what happens if we just look at earnings from operations, or Operating Profits:
| R&D as Income | R&D as Tax Offset | |
| Revenue from Customers | $2,800,000 | $2,800,000 |
| Other Income | ||
| R&D Tax Incentive | $600,000 | $0 |
| Total Income | $3,400,000 | $2,800,000 |
| Expenses | $2,700,000 | 2700000 |
| EBITDA | $700,000 | $100,000 |
If you just look at Operating Profits then SaaSCo is breakeven and not really profitable. A more accurate summary of this business financially is that it’s running at breakeven and is being supported by tax incentives.
Flow on impact on decisions and key metrics
The problem with using the accounting standard Profit & Loss when the R&D Tax Incentive is heavily skewing your key financials is that your key metrics can be skewed if you aren’t careful.
You might take the Total Income (which is inflated from the incentive) by accident when looking at overall revenue growth or churn (it happens more often than you think). You might factor it into your profitability when looking at other SaaS benchmarks.
On benchmarking, if you want to compare your performance or potential exit multiples to companies globally then you need to be aware that many other countries treat R&D schemes as tax credits, appearing after or below EBITDA.
Finally, the R&D Tax Incentive in the short term could be likened to spending $1 to get a $1 back. This isn’t a great equation. Most of us are in business to spend $1 and ideally make at least $2 back if not $10.
You can argue that R&D is an investment in future returns but, by its very definition, it’s experimental and innovative which may or may not pay off at all.
Differing Impact Based on Size
The size of the business affects the amount you can claim and the way you receive benefits from the R&D Tax Incentive. Smaller businesses get the incentive in the form of cash sometime after they’ve submitted their tax return. Larger businesses (> $20m turnover) receive a reduction in tax payable or a sort of credit to offset future tax payable. That is, larger businesses aren’t receiving additional cash.
This matters because the benefit to you may not be the same for an acquirer who is larger.
Risks
Differing views on what can be claimed
An acquirer may take differing views on what can be claimed. They aren’t alone in this, different managers, accountants and R&D consultants will each have a different opinion on what is worthy and what is not.
This throws uncertainty into the quantum of claim that might be possible in future years.
Audit risks
There is a chance that what has been claimed was not claimable. If the company is audited then it will need to repay some or all of the claims made.
In the sale of a business there are different ways to deal with this. One is to add warranties or similar mechanisms that make the sellers responsible if an R&D claim needs to be repaid. Another is to escrow an amount related to a claim. The other is to reduce the price by the doubtful claim.
Changes to legislation
Another risk with the R&D Incentive is that the legislation changes. By counting the R&D Incentive in the value of the business under today’s regime you are making the assumption that it will continue to operate as it has. However, the incentive has changes made to it every year.
These changes are as small as requesting more documentation, through to changing the amounts that can be claimed, the types of activities that can be claimed and the size of business it is relevant for.
Commitment to continued spend
The R&D Incentive is an incentive to keep spending, that is to keep costs high. The general goal of most businesses and shareholders is to turn a profit. A forecast relying on the R&D Incentive is a forecast that is relying on further spending. But the return on spending may not be as good as you can get from operating and growing the business more effectively.
Estimating the R&D Incentive
Forecasting earnings that include R&D means forecasting and estimating your technology roadmap. You are forecasting that you will be doing work that requires R&D.
On one hand, it is good discipline to define your technology roadmap, estimate the effort involved and then estimate the R&D Incentive that can help enhance your cashflow.
On the other hand, however, most businesses have difficulty (a) defining a technology roadmap in detail more than 3 months out, (b) it’s generally not best practice to do long-range detailed roadmaps, and (c) most effort and cost estimates for this range of roadmap are usually significantly off.
This gives rise to the challenge of estimating the amount of R&D you will receive. If you can support your R&D Incentive estimate with a breakdown of the tasks and activities, as well as evidence that you have strong discipline with development estimates, then you can make a case for a well supported R&D Incentive amount. However, if you don’t have this detail and you’re forecasting future claims based on past-claims or simply headcount, then the forecast R&D Incentive becomes less reliable.
R&D Incentive When Selling Your Business
So, when you’re selling your business and it makes use of the R&D Incentive, there are a few things that will help you and potential buyers:
- Separate out the R&D Incentive: show the R&D Incentive clearly and, ideally, after operating profits. Don’t try to hide it under Other Income and don’t pretend it’s revenue from customers.
- Substantiate future claims: If you want the buyer to believe it’s an ongoing incentive that they can use then make sure you provide supporting documentation and evidence that explains why further claims can be made and details how the total amount is being estimated.
- Be prepared to take on R&D related risks: as the beneficiary of past R&D claims, you will likely need to take responsibility for any problems with them. Additionally, if you’re trying to use the R&D Incentive to increase the value of the business, then you will likely need to take some responsibility for the future as well.
- Be aware of the buyer’s context: if the buyer is larger or requires a lower cost base then the value and timing of the R&D Incentive will change. This will impact how they see value in your business.