BIO 2024

R&D Tax Incentive legal/IP issues for offshore early-stage life sciences companies

The Australian R&D Tax Incentive (R&D Incentive) scheme can help offshore early-stage life sciences companies progress development in a cost-effective manner. A number of legal/ intellectual property (IP) complexities must be considered to achieve an optimal outcome for your business.

The R&D Incentive is intended to provide the following three benefits to Australia. Legal/IP complexities arise when one considers the third of these benefits.

1. The immediate benefit of economic activity from having development activities conducted in Australia.
2. The strategic benefit of fostering development expertise for use by Australian businesses.
3. The longer term benefit of extracting local value from outcomes of the R&D Activities undertaken using the claimed expenditure, including clinical data IP, know-how, materials and equipment (Activity Results).

R&D Incentive overview

The R&D Incentive provides a tax offset at an effective rate of ~ $0.185 up to $0.435 for each $1.00 spent on Eligible Activities in Australia, depending on which of the two models outlined below is adopted. For an entity with an aggregated group turnover < AU$20m, the offset is paid in cash.

The maximum effective rate of $0.435 is available where the Australian entity (AU Co) undertakes the Eligible Activities “on its own behalf”, meaning that it must own all rights in the Activity Results.

The effective rate is reduced to ~ $0.185 where AU Co undertakes the Eligible Activities as a service provider (eg on behalf of another entity, usually its offshore sole shareholder, Parent Co). However, under this model it is not necessary for AU Co to own rights in the Activity Results, and it is possible for Parent Co to do so.

Thus, a critical threshold question is to decide whether it is more important to:

1. access the higher rate (Option 1: “On own behalf” Ownership Model); or
2. ensure Activity Results are not owned by AU Co (Option 2: “On Parent Co’s behalf” Services Model).

Eligible R&D Entity

To qualify for the R&D Incentive, an eligible “R&D Entity” must incur expenditure undertaking R&D Activities in Australia “on its own behalf“, having regard to whether that entity:

• effectively owns any IP, know-how or other rights arising from the R&D Activities
• has control over how the R&D Activities are conducted
• bears the financial burden of the R&D Activities

The most common form of eligible R&D Entity for international life science development companies under Option 1 is an Australian “Pty Ltd” company, wholly owned by Parent Co, and having at least one Australian resident director.

Under Option 2, Parent Co is usually the eligible R&D Entity.

Eligible R&D Activities

R&D Incentive can be claimed on R&D Activities undertaken in Australia which are either Core Activities or Supporting Activities.

1. Core Activities, are experimental activities:
   1. whose outcome cannot be known or determined in advance on the basis of current knowledge, information or experience, but can only be determined by applying a systematic progression of work that is based on principles of established science and proceeds from hypothesis to experiment, observation and evaluation, and leads to logical conclusions; and
   2. that are conducted for the purpose of generating new knowledge (including new knowledge in the form ofimproved materials, products, devices, processes or services).

Examples – Pre-clinical and toxicology, clinical trials, prototype development or testing.

2. Supporting Activities, are experimental activities directly related to, and, as a general rule, undertaken for the dominant purpose of supporting, Core Activities.

Examples – Patent searches, project planning, management, administration, preliminary research, clinical trial site selection or monitoring, conference attendance.

FAQs

What’s the catch?

As noted above, the R&D Incentive’s longer term benefit is to extract local value from outcomes of the R&D Activities undertaken using the claimed expenditure. This is achieved by requiring, under Option 1, that the rights in Activity Results are owned by AU Co, such that AU Co receives (and pays tax on) the fruits of any commercialisation of those results.

It is not necessary for AU Co to hold these rights in perpetuity. For example, it can readily assign or license them to Parent Co if it is desired to have all IP owned by a single entity and to thus streamline future commercialisation of the underlying asset. However, any such dealing must comply with transfer pricing rules, and thus take place at market value, which will result in AU Co receiving (as prima facie assessable income) revenue equivalent to the then market value of the Activity Results.

What are Activity Results?

Activity Results are anything that arise from the conduct of R&D Activities in respect of which R&D Incentive is claimed, and it is not necessary for registrable IP to be produced to be eligible for the R&D Incentive. If AU Co undertakes a Phase I study, then the data obtained from that study will be Activity Results.

If AU Co undertakes product or process development, then the resulting product/process will also be Activity Results. This may cause AU Co to have an ownership interest in rights inherent in the drug asset per se (eg the manufacturing or formulation process) rather than, say, early stage clinical data which is generally not inventive or patentable per se but rather demonstrative of the inherent characteristics of the previously invented (and patented) drug asset.

How can AU Co’s Activity Results be accessed?

The longer term benefit of extracting local value from outcomes of the R&D Activities undertaken using the claimed expenditure, means that any disposal (eg licence or assignment) to Parent Co for commercial use must take place at arm’s length. This ensures that AU Co receives market value, and generates taxable income in Australia (noting, of course, that international tax treaties may apply to reduce the net impact of that tax to the group).

In general terms, this can be done in at least the following three ways.

• By AU Co assigning its rights in the Activity Results to Parent Co at the then market value, and then computing and remitting any tax payable on income received for that assignment.
• By AU Co licensing its rights in the Activity Results to Parent Co on arm’s length terms and then computing and remitting any tax payable on income received under that licence.
• Under a cross-licence arrangement whereby AU Co licenses its rights in the Activity Results to Parent Co on arm’s length terms for use outside Australia and Parent Co in return licenses its pre-existing underlying IP in the asset to AU Co, so that AU Co commercialises the asset in AU and Parent Co commercialises it in the rest of the world (RoW). AU Co would then pay arm’s length royalty to Parent Co for the Australian rights in the preexisting underlying IP in the asset and AU Co would receive an arm’s length royalty from Parent Co for the RoW rights to the Activity Results. AU Co would then compute its net tax position under the cross-licence and also any income it receives from its own commercialisation in Australia, and then be liable for any resultant tax.

When should AU Co dispose of the Activity Results?

This can be left open and assessed at regular intervals, noting that:

• if the asset ultimately fails, the Activity Results will be worthless and any tax paid by AU Co on an earlier assignment/licence will not be recoverable; and
• whilst deferment risks increasing the absolute value in dollar terms of AU Co’s rights in the Activity Results, the proportion of the value AU Co holds in the overall asset will reduce over time as later clinical development is undertaken without AU Co participation and even more extensive and valuable phase Il & Ill data is added to the overall asset package.

The pro’s and con’s of an immediate assignment of Activity Results to Parent Co should be assessed if:

• there is a possibility that AU Co may have an ownership interest in rights inherent in the drug asset per se; or
• transacting the drug asset is contemplated (eg a divestment or out-licence to a third party), so that the third party can be presented with a simper ownership structure, rather than acquiring/licensing different components from Parent Co and AU Co. Alternatively, AU Co can be left in place for the acquirer to inherit and manage, and this may be useful if the acquirer intends to undertake further Eligible R&D Activities in Australia.

For what value should AU Co dispose of the Activity Results?

Market value at the time. This can be assessed by a valuer applying appropriate valuation principes at the relevant time, noting that the value of AU Co’s rights in the Activity Results may depend on the extent (if any) to which AU Co has commercial rights to the pre-existing underlying IP in the asset.

If commercial revenue is received from a third party on arm’s length terms in respect of the drug asset (eg a divestment or out-licence to a third party) whilst AU Co retains its ownership interest in the Activity Results, then AU Co will be expected to receive as income the proportion of that consideration corresponding to the proportionate value that AU Co’s Activity results bear to the value of drug asset as a whole.

Is the R&D Incentive repayable?

The R&D Incentive is not repayable. However, if a recipient is found to have received R&D Incentive to which it is not entitled, it can be required to repay those funds, and may also be liable for penalties and interest in certain circumstances.

Are there any other things to note?

New IP – As noted above, if AU Co’s R&D Activities go beyond generating early stage clinical data and extend to generating rights inherent in the drug asset per se (such as formulation development, CMC, proof of concept etc), then a risk arises of AU Co having an ownership interest in the underlying asset. This may require Parent Co to, among other things:

• involve AU Co (directly or via a pass-through licence) in disposals or commercialisation dealings with third parties;
• attribute to AU Co a greater share of the value of the underlying asset, and/or pass on a greater share of commercialisation proceeds;
• include AU Co as a co-owner on patent applications.

Late-stage activities – If AU Co is involved in later stage development activities (eg pivotal or Phase Ill studies) and owns rights in the resulting data that adds significant value to the drug asset, then AU Co may have a comparatively large proportionate share of value of the total drug asset. This in turn increases the market value AU Co is required to record as received on any disposal of the Activity Results, or as a proportionate share of commercialisation revenue.

In-licensed IP – Generally, to allow AU Co to undertake the anticipated R&D Activities, Parent Co grants it an enabling licence to the relevant underlying IP of the drug asset. However, if Parent Co has in-licensed that underlying IP from a third party (eg an Institution), then Parent Co’s grant to AU Co will be a sub-licence and care must be taken to ensure that it complies with all relevant provisions of Parent Co’s in-licence.

Offshore work – R&D Incentive is generally limited to Activities conducted in Australia. It is not available for activities conducted offshore, unless certain strict requirements are met before the activities commence.

Service provider terms – Where AU Co engages a third party to assist in undertaking the R&D Activities, care must be taken to ensure that AU Co obtains ownership of all relevant Activity Results so that it can either:

• claim R&D Incentive on the “On own behalf” basis; or
• on-assign those rights to Parent Co.

AU Co should also ensure that the service provider:

• performs all services in Australia (including any that the service provider may customarily undertake offshore, such as data analysis and call centre operations) unless AU Co provides prior written consent; and
• does not itself claim R&D Incentive for any activities that AU Co intends to claim for.

Grant funds of Parent Co – Parent Co should not use grant funds for funding AU Co’s R&D Activities unless either:

• the grant terms allow AU Co to own rights in outcomes from the R&D Activities conducted with those funds; or
• the grant terms allow Parent Co to own those rights, and the lower R&D Incentive rate is acceptable.