Section 11D of the Income Tax Act – Research & Development (R&D) tax incentive’s proposed amendments

The Government is proposing to extend the Research & Development (R&D) tax incentive beyond 31 December 2023 – likely for a period of 10 years following a consultation process with industry stakeholders including the public. All replies are to be presented to Treasury and SARS by 07 November 2022.

The current R&D tax incentive came into operation on 2 November 2006 and has undergone various design changes to better tailor it to meet its objectives. The most significant of these
changes was the introduction of a pre-approval process in 2012. The pre-approval process is administered by the Department of Science and Innovation (DSI), supported by an adjudication committee that evaluates applications and makes recommendations to the Minister of Higher Education, Science, and Innovation. The R&D tax incentive allows for operating expenses incurred directly and solely for the purpose of conducting R&D to be deductible at 150 percent if the R&D is approved by the Minister of Higher Education, Science, and Innovation. This is the case even if those expenses could be characterized as being capital in nature, such as pilot plants.

On 15 December 2021, a discussion document titled Reviewing the Design, Implementation, and Impact of South Africa’s Research and Development Tax Incentive was published. This review sought to determine whether to extend the R&D tax incentive beyond its sunset date and, if so, in what form. Following the review, the government determined that the R&D tax incentive should continue, but sees it necessary to refine the definition of R&D.

Section 11D(1) of the ITA sets out a definition for “research and development” that determines eligibility for the R&D tax incentive. Currently, the wording “scientific or technological” is only found in the title of the section and in one of the paragraphs of the definition, even though the intention has always been that the incentive should only apply to activities with an aim of solving scientific or technological uncertainty.

The definition contains a purpose test that requires not only an understanding of the concept of R&D but also an understanding of various intellectual property statutes and the associated intellectual property characteristics, such as novelty and non-obviousness. In addition to this, several of the purposes focus on the end result of the R&D, which is difficult for taxpayers to explain or prove upfront and equally difficult for the adjudication committee to evaluate. This stands in contrast to the approach taken by many other countries in the design of their R&D tax incentives.

To enhance the practical simplicity of applying for and adjudicating the incentive, it is considered that it would be more appropriate to move away from an “end-result” or IP statute approach. This is primarily because – while taxpayers may have a certain end goal in mind, the reality of R&D is that it involves uncertainty and risk, and it is not practical to expect taxpayers to have detailed knowledge of how their envisaged R&D will unfold at the time of applying for the incentive.

Many other countries instead rely on the principles outlined in the OECD Frascati Manual (i.e. that activities should be novel, uncertain, systematic and transferable, and/or reproducible) to design their legislation to test whether an activity should be considered R&D or not.

It is envisaged that a revised definition will be simpler to understand and adjudicate, ensuring an easier application process. The proposed changes to simplify the legislation combined with moving to an online process and enhancing support for smaller businesses should enhance the uptake of the incentive.

In line with the government’s stance from the outset, the revised definition is shifted more towards a scientific or technological uncertainty and the systematic investigative or systematic
experimental activities that are to be performed, with an added emphasis on the novelty of products, processes, or services, instead of the intellectual property outcomes e.g. invention or design that may occur after the R&D.

Proposal

Based on the above, the following has been proposed:

A. Adjustments to the R&D definition

It is proposed that changes be made to the current definition of R&D as follows:

i. The definition of R&D should be amended to clarify that the intention has always been that the incentive should only apply to activities with an aim of solving scientific or technological uncertainty. By referring to activities that are aimed at solving a scientific or technological uncertainty in the words of subsection (1) preceding paragraph (a), this intent is made clear. Amongst other things, this requirement will clarify the type of computer software activities that will be deemed to form part of R&D. Further, the words “scientific or technological” should be included before the words “research and development” throughout the section.

ii. The definition should also be amended to clarify that activities will not qualify for the incentive if knowledge to resolve a scientific or technological uncertainty is deducible by a competent professional in the relevant scientific or technological field, having regard to information that is publicly available to such professional. In other words, a test for obviousness (or lack of inventiveness) should be brought into the definition.

iii. The “non-obvious” requirement for scientific or technological knowledge in section 11D(1)(a) should be replaced with “new” in line with the proposal that a test for nonobviousness be included in the definition (to ensure that research and development do not include activity if knowledge to resolve the scientific or technological uncertainty is deducible by a person skilled in the relevant scientific or technological field, having regard to information that is publicly available to such professional).

iv. The intellectual property purpose test in the first part of the definition should be deleted to move away from a focus on the end result at the time of applying to recognize the uncertainty inherent in R&D. The approach will shift to testing for R&D by considering some of the principles in the OECD Frascati Manual. In line with this, it is proposed that s11D(1)(b) and (c) be replaced with a purpose test aligned with the OECD Frascati principles that an R&D activity must be carried on for the purpose of creating or developing new knowledge, or new or improved products, processes or services. The OECD Frascati manual provides an internationally accepted definition of R&D activities based on five core criteria being met; i.e. the activity must be novel, creative, uncertain, systematic and transferable, and/or reproducible. In summary, R&D eligibility should be assessed in the context of the type of activities proposed to be performed; the uncertainty being addressed and the new knowledge being sought; or products, processes, or services being created.

B. Exclusions from the definition of R&D

a. Certain internal business processes
It is proposed that the part of the exclusion for internal business processes relating to the for-sale requirement and granting of right/use to a non-connected party be deleted, so that the activities are measured against the requirements set out in the definition of R&D, rather than whether they are intended for sale / licensing or not. An exclusion will remain for management and administrative business process to ensure clarity that these types of activities are not eligible for this incentive.

b. Agrochemical products
It is proposed to specifically exclude research activities undertaken solely in preparation for the registration of products as required by the Department of Agriculture, Land Reform and Rural Development (DALRRD) from the incentive.

C. Additional administrative issues

a. Introduction of a six-month grace period for receipt of pre-approval applications

It is proposed that applicants be allowed a six-month grace period to submit preapproval applications.

For example, if a company has started spending on exploratory R&D activities on 16 June 2022, they will have up until 16 December 2022 to submit their application if they would like to be eligible to claim the expenditure on qualifying R&D activities.

b. Disclosure of information by the Commissioner of SARS

It is proposed that the circumstances under which the Commissioner of SARS discloses information to the Minister of Higher Education, Science, and Innovation be extended to include anonymized information (data) from tax returns that may require fulfilling of duties insofar as they relate to monitoring R&D approved under the incentive and the consideration of proposed amendments and adjustments to the R&D tax incentive, beyond reporting to Parliament. As such, it is proposed that amendments be made in section 11D(14) by introducing a new subsection ( c) dealing with the requirement.

C. Sanctions for breach of secrecy

With respect to any breaches of secrecy, it is proposed that a sanction in line with those provided under section 12I(23) be included in section 11D. As such, it is proposed that any person who contravenes the secrecy provisions is guilty of an offense and be liable on conviction to a fine or imprisonment for a period not exceeding two years.

D. Sunset clause

It is proposed that the revised R&D tax incentive be extended for a period of 10 years and applied in respect of amounts incurred on or after 1 January 2024 and up to and including 31 December 2033.

Effective date

The proposed amendments will come into effect on 1 January 2024 and will apply in respect of amounts incurred on or after that date.

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