R&D tax incentives: Customised basketball shoe not eligible

In our R&D tax incentives: Integrity rules and taxpayer alerts, we explored the ATO’s Research and Development Tax Incentive Program and provided guidance on tax transparency. In this article, we take a look at a case study which explores the rigorous approach to compliance of R&D tax regulators.  

Case study: Active Sports Management Pty Ltd and Industry Innovation and Science Australia [2023] AATA 4078

The Administrative Appeals Tribunal (AAT) decision of senior member Polak in Active Sports Management Pty Ltd and Industry Innovation and Science Australia was handed down on 6 December 2023. The senior member was not satisfied the claimed activities involved a systematic progression of work based on principles of established science and which proceeded from hypothesis to experiment, observation and evaluation, leading to logical conclusions.

Back in May 2019, AusIndustry determined that none of the claimed activities relating to the development of a customised basketball shoe were eligible R&D activities under the Industry Research and Development Act 1986 (Cth). That decision was confirmed by an internal review decision in November 2019 by AusIndustry and was upheld by the AAT. Active Sports Management (ASM) has appealed the decision of the AAT to the Federal Court.

Relevant activities

ASM is an Australian company that imports and sells sports apparel, footwear, accessories, hoodies and tracksuits. It also designs and develops products with unique Australian features and styles for the Australia market.

ASM lodged applications in both 2015–16 and 2016–17 for registration of two activities: 

• activity 1.1 – prototyping for tests and experiments

• activity 1.2 – tests and experiments.

In 2016-17 it lodged an application for registration of activity 1.3 – other tests and experiments.

The senior member found there was a significant degree of overlap between the claimed activities and how they are described in the registration forms and considered all the activities collectively.

The claimed activities related to the development of a customised basketball shoe, referred to as the “Delly1”, to suit the personal requirements and playing style of Matthew Dellavedova (Delly), an Australian professional basketball player who played in the NBA. The activities involved the manufacture of six prototypes by Quanzhou Peak Shoes Co Ltd (Peak) in China ranging from a bespoke shoe to modifications being made based on testing and feedback given by Delly from training and camps.

ASM stated they were testing the prototypes to see if it would meet Delly’s requirements and set out various aspects they wanted to test to see if they could be done in relation to the upper, flexibility, traction, heel counter and cushioning of the shoe and whether the production versions performed in the same way as the handmade prototype.

AAT decision

The tribunal found:

• although specific data produced by the work undertaken could not have been known in advance, the activites were not ones in which an outcome could not have been known or determined in advance based on current knowledge, information and experience
• it was unclear precisely what unknown outcome ASM was seeking to determine other than to create a basketball shoe which satisfied Delly’s specific requirements. The outcome was not directed to a technical or scientific uncertainty. It was a subjective outcome and one outside the control of ASM
• it was unclear what modifications took place between the various prototypes and to what degree as the descriptions of modifications were general and vague
• there was no evidence to establish that the outcomes of the specific modifications made to the prototypes could not have been known in advance
• there was also no evidence about how Delly actually tested each prototype, other than that he wore each one either in training conditions or during play. The testing undertaken by Delly did not consist of repeatable, verifiable tests capable of isolating the effects of each of the design modifications actually being tested. His feedback was not technical in nature
• there was no evidence given of the work undertaken by PEAK or whether it was attempting to formulate any scientific or technical hypothesis in relation to each prototype. The available evidence suggests PEAK was simply responding to instructions from Delly directly or via Mr Bickley, a director of ASM
• the evidence also did not demonstrate how each ‘hypothesis’ was formulated and then tested on each iteration of prototype and how the outcomes were recorded and observed. Delly’s feedback on certain prototypes did not relate to the asserted hypothesis
• sm Polak agreed with the evidence of Dr Sterzing, a scientist in the field of athletic footwear and R&D, that the hypotheses were actually objectives and description of what was done and were not hypothesis in the way that can postulate a certain fact to be verified
• there was no evidence that the outcome of any of the asserted hypotheses was uncertain or unknown to the applicant or to a competent professional in the field. In fact, there was evidence that Mr Bickley was able to anticipate and predict whether certain features and modifications were not going to meet Delly’s requirements
• while there was some uncertainty around whether the modifications would satisfy Delly’s requirements, the uncertainty was not an unknown outcome in the context of developing a hypothesis
• the nature of the testing done was not documented with any precision
• the development of Delly 1's design was likely through trial and error, as opposed to a scientific process
• the evidence does not demonstrate that the knowledge sought by the claimed activities went beyond validating a simple progression from what was already known and went beyond merely implementing existing knowledge in a different context
• the development and manufacture of the mesh upper was plainly undertaken by PEAK. There was no evidence to demonstrate that ASM was involved in the actual design or development of the upper mesh or that its development involved a systematic progression of work based on principles of established science nor formed part of the claimed activities, which consisted of the modification of previously known athletic shoe design features to meet Delly’s preferences or requirements.
• None of the claimed activities were core R&D activities and therefore none were supporting activities.

The decision is being appealed to the Federal Court and we await the outcome. It is a definitive decision and makes it clear that the tribunal expects that there is not only a scientific and systematic approach taken to R&D but that approach is recorded in writing at the time. SM Polak stated:

“Contemporaneous written evidence detailing the process of each activity will be highly persuasive because the recording of such information is an indication that the activity was carried out in a manner consistent with a systematic progression of work”.

It is clear that contemporaneous written evidence is the best evidence to confirm what has been done and why. However, it is important to consider the 2020 Federal Court decision of
Commissioner of Taxation v Bogiatto [2020] FCA 1139, where Thawley.J had to determine whether promoter penalties should be imposed on the respondent in relation to tax exploitation schemes that involved R&D claims.

As part of the decision, it was necessary for Thawley.J, in the context of ATO expenditure, to determine whether a taxpayer had to maintain relevant records. His honour accepted that a failure to have such records might be a matter from which inferences might be drawn including that certain activities did not take place or certain expenditure was not incurred. He found however, at paragraph 100, that the entitlement to the tax offset is not dependent on keeping records to “substantiate that the claimed R&D expenditure was incurred on R&D activities that have been registered with AusIndustry”. He stated that entitlement to the tax offset depends on whether the taxable facts are such that the R&D claims were available. Whether those taxable facts can be proved or established is a different issue. A taxpayer who kept inadequate records but who was able to substantiate the various matters required by the statutory scheme would still be entitled to the tax offset. At paragraph 101 of the judgment he stated:

“It is a misconception that documentary evidence is the only kind of evidence which can substantiate the relevant taxable facts. This might be done through witness statements, statutory declarations or the giving of oral testimony. Such material might or might not be supported by documentary evidence. The absence of documentary evidence does not mean the testimony would have to be rejected or was incapable of proving or establishing the relevant asserted facts.”

While it is not the only available evidence to support what has been done, written contemporaneous evidence is the best and recommended form of evidence.

What can you do

We recommend companies adopt good governance, strictly document evidence of a systematic progression of work based on principles of established science and which proceeded from hypothesis to experiment, observation and evaluation, leading to logical conclusions and identify risks as early as possible.

If you have any questions about this update and how it may affect you, please get in touch with a member of our team below.

Disclaimer
The information in this article is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, we do not guarantee that the information in this article is accurate at the date it is received or that it will continue to be accurate in the future.

Published by:

Megan Bishop

Ross Hocking

Christian Febbraro

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