Research and development: unpaid wages

Can an eligible company claim a deduction for certain 'unpaid wages' under subsection 73B(14) of the Income Tax Assessment Act 1936 (ITAA 1936)?

No. The company cannot claim a deduction under subsection 73B(14) of the ITAA 1936 in respect of the 'unpaid wages' that have not been incurred by the company.

The company is an 'eligible company' which undertakes on its own behalf 'research and development activities', as defined by subsection 73B(1) of the ITAA 1936.

The company's 'research and development activities' are registered with the Industry Research and Development Board (IRDB) under section 39J of the Industry Research and Development Act 1986 (IR&D Act), as required by subsection 73B(10) of the ITAA 1936, and the company has an 'R&D Plan' in respect of the relevant income year(s), in accordance with subsection 73B(2BA) of the ITAA 1936.

The company has entered into an oral contract for services with an entity, the express terms of which include: • the company will pay the entity $500 per week • the entity will perform 'research and development activities' for the company; and • the $500 will be due to the entity at the end of each week in respect of 'research and development activities' performed during that week.

Over several years, the entity performed 'research and development activities' for the company in accordance with the oral contract. However, at the end of each week the company determined it could not afford to pay the entity $500 and so paid only $50 per week. To be able to pay the balance the company would require sufficient funds to be able to do so, which it did not have, and it would need to decide that making payment would not jeopardise its operations.

The entity accepted the payment of $50 per week and continued to perform its side of the oral agreement. Further, the entity did not make any demand for payment of the 'unpaid wages' of $450 each week and did not otherwise attempt to enforce the payment terms of the oral contract.

Neither the company nor the entity sought to bring the oral contract to an end.

The company treated the 'unpaid' wages as current liabilities in its books of account. However, at no time was it in a position to pay the 'unpaid wages', as it derived no income and was continually in a loss position.

For deductions to be allowable under section 73B of the ITAA 1936, a number of eligibility requirements must be satisfied. These eligibility requirements include that the company is an 'eligible company' and that 'research and development activities' are undertaken and are registered with the IRDB under section 39J of the IR&D Act (see subsection 73B(10) of the ITAA 1936). The terms 'eligible company' and 'research and development activities' are defined in subsection 73B(1) of the ITAA 1936. The company must also incur expenditure that is deductible under section 73B of the ITAA 1936 and meet any associated eligibility requirements for that expenditure.

Taxation Ruling TR 97/7 sets out the general principles which apply in determining whether a particular outgoing has been 'incurred'. Broadly, an outgoing is incurred when you owe a present money debt which you cannot escape. Although an amount need not actually be paid to be 'incurred', it must be a presently existing pecuniary liability to which you are 'definitively committed' and 'completely subjected' in the year of income ( Federal Commissioner of Taxation v. James Flood Pty Ltd (1953) 10 ATD 240 at p 244; (1953) 88 CLR 492 at p 506). It must also be more than 'contingent, pending, threatened or expected', no matter how certain it is in the year of income that the loss or outgoing will be incurred in the future ( Federal Commissioner of Taxation v. James Flood Pty Ltd (supra); Hooker Rex Pty Ltd v. Federal Commissioner of Taxation (1988) 88 ATC 4392 at p 4400; (1988) 19 ATR 1241 at p 1249). See also Merrill Lynch International (Australia) Limited v. Federal Commissioner of Taxation (2001) 113 FCR 79; [2001] FCA 1127.

Treating an amount as a liability for accounting purposes is not determinative of whether that amount has been incurred. This is a legal question, answered by referring to the relevant circumstances, including the terms of any relevant contract(s).

It is not disputed as between the company and the entity (the parties to the oral contract) that their agreement includes terms to the effect that the entity is to be paid $500 per week to undertake research and development, and that this amount falls due at the end of each week. However, as stated by the High Court in Equuscorp Pty Ltd v. Glengallan Investments Pty Ltd (2005) 218 CLR 471; [2004] HCA 55, it is not the belief or intention of the parties that defines their legal rights and obligations.

In construing the oral agreement, all the relevant facts must be looked at objectively in order to identify the terms of the contract ( Re Combined Security Systems & Designs Pty Ltd; Hawthorne v. Harris (Unreported, QG 3026 of 2994, Federal Court of Australia, Drummond J, 28 February 1995); Handbury v. Nolan (1977) 13 ALR 339). In particular, it must be determined from all the relevant evidence and the objective framework of facts whether the agreement includes a term that the sum of $500 per week is owing to the entity at the end of each week ( Codelfa Constructions Pty Ltd v. State Rail Authority of NSW (1982) 149 CLR 337 at 353).

Although there are some factors in support of the contention that $500 per week is owing at the end of each week, it is considered that, in line with the decision in Green v. Wilden Pty Ltd [2005] WASC 83, greater weight should be placed on the subsequent conduct of the parties. This leads to the conclusion that objectively, the relevant terms of the oral contract in the relevant years are:

the company was and is only liable for the amounts of salary actually paid ($50 per week) or, in the case of future years, actually to be paid; and

the balance said to be owing to the entity ($450 per week) will only be owing if the company concludes that it has sufficient funds to do so, and that making payment will not jeopardise its operations.

As it is not a true term of the oral contract between the company and the entity that the amount of $500 is owing at the end of each week, there is no debt at the end of the week for the $450 which has not been paid. Consequently, there is no presently existing liability in respect of the unpaid amounts and they will not be expenses 'incurred' by the company according to the principles set out above.

In the alternative, where an objective construction of the contract does uphold the payment term asserted, the enforceability of that term may be affected by estoppel by convention. If the entity is estopped from demanding payment of the full amount promised, such that the unpaid amounts are only owing at the election of the company when it determines it has sufficient funds to do so, the liability for the unpaid amounts is contingent. Consequently, such an amount will not be 'incurred' at the end of each week.

The principle of estoppel by convention was described by Lord Denning MR in Amalgamated Investment & Property Co. Ltd v. Texas Commerce International Bank [1982] 1 QB 84 at 120 and by Gillard J in Powercor Australia Ltd v. Pacific Power [1999] VSC 110 at [450]-[451]. In general, if parties to a contract put a particular interpretation upon its terms by their course of dealing, and conduct their mutual affairs in reliance upon that interpretation, then they may be bound by their interpretation where it is contrary to the express terms of the contract.

The unpaid amounts of salary or wages represent at best, only contingent liabilities, and not presently existing liabilities to which the company is definitely committed in the years of income in question. Therefore, the company has not incurred the unpaid salary and a deduction is not available under subsection 73B(14).