What Does the ATO Actually Challenge When It Audits R&D Expenditure?

You lodge an R&D claim. The refund lands. Your client is happy.

Then, six months later, the ATO sends a letter. They want to “review” the R&D expenditure claimed in the last financial year. They’re asking for timesheets, contracts, project documentation, and a breakdown of every dollar.

And your client looks to you for guidance.

This article isn’t about whether R&D activities are eligible. It’s about what happens once the ATO turns its attention to the numbers. Because when they audit R&D expenditure, they don’t just look at the headline figures. They pull apart the methodology, the records, the related-party arrangements, and the integrity of the cost allocations.

If you advise on R&D claims, you need to understand where the ATO draws the line on expenditure, what they routinely challenge, and how to prepare so that the bulk of the claim remains intact when tested.

Why the ATO Is Looking Harder at R&D Expenditure

The R&D Tax Incentive is one of Australia’s largest tax concessions. In 2022-23, over $3 billion in refunds and offsets flowed to more than 13,000 claimants. With that scale comes scrutiny.

The ATO now publishes annual transparency reports naming large R&D claimants and the quantum of their claims. That’s not for public interest. It’s a signal: this program is under active supervision.

At the same time, the ATO and AusIndustry have improved their coordination. AusIndustry determines whether activities are eligible R&D. The ATO determines whether the expenditure on those activities is correct, substantiated, and genuinely at risk.

That split creates a trap. You can have AusIndustry accept the activities but the ATO disallow 40% of the expenditure because the cost allocations don’t stack up.

Add to this the integrity focus. Recent ATO guidance and alerts have targeted foreign-affiliate structures, at-risk arrangements, and related-party payments. The message is clear: just because you call it R&D expenditure doesn’t mean the ATO will accept it.

If you’re advising on R&D claims, the compliance environment has shifted. The ATO isn’t passively processing these returns. They’re reviewing them with a more sceptical eye.

What Typically Triggers an ATO Review of an R&D Claim

Not every R&D claim gets audited. But certain patterns light up the ATO’s risk filters.

A sudden jump in R&D expenditure compared to prior years is a common trigger. If your client historically claimed 5% of total expenditure as R&D and suddenly it’s 30%, the ATO will ask what changed. Is it a genuine expansion of activities, or has the methodology shifted to capture costs that were always there but never claimed before?

Large claims in absolute terms also attract attention. If the R&D offset is several million dollars, the ATO has more incentive to dig. The same applies to amended returns claiming additional R&D expenditure after the original lodgement.

Industry plays a role too. Software development, biotech, and life sciences are under particular scrutiny. In software, the ATO knows that the line between building new functionality (potentially R&D) and maintaining or implementing existing systems (not R&D) is easily blurred. In life sciences, they’re alert to clinical trials where the Australian entity is just a contract research organisation for a foreign parent.

Overseas expenditure is another red flag. Claims involving foreign contractors or offshore R&D work face tougher substantiation requirements. The ATO wants to see contracts, invoices, proof of what work was done, and evidence that it meets the overseas R&D rules.

Related-party arrangements stand out. If significant R&D costs flow to associated entities, the ATO will question whether the amounts are genuine arm’s-length expenditure or inflated by transfer pricing considerations.

Finally, repeated refunds year on year, particularly for companies with limited taxable income, draw attention. The ATO sees R&D refunds as cash out the door, and they want to be satisfied the expenditure justifies it.

Can you answer this: if the ATO reviewed your client’s last R&D claim, could you point to clear reasons why the expenditure increased, decreased, or looks the way it does?

If you can, you’re ahead of most. If you can’t, something needs recalibrating.

Where the ATO Challenges the Numbers: Common Expenditure Flashpoints

When the ATO audits R&D expenditure, they don’t challenge everything equally. Certain categories are consistently under fire.

Wages and Time Apportionment

Staff salaries are the largest component of most R&D claims. They’re also the easiest to inflate if apportionment is loose.

The ATO expects you to show how much time each employee spent on eligible R&D activities, not on implementation, project management, business-as-usual work, or general administration. If your client claimed 60% of a senior developer’s salary as R&D, the ATO wants to see evidence that 60% of their time was genuinely spent on experimentation.

Rough estimates don’t cut it. “We think about 50% of the team works on R&D” isn’t evidence. The ATO expects timesheets, work diaries, project logs, or task management systems showing what people worked on and when.

Where those records don’t exist, the ATO will pare back the claim. Often significantly.

Here’s the reality: most businesses don’t keep perfect timesheets. Software developers don’t log every task. Scientists don’t always record how long an experiment took. That doesn’t make the R&D claim invalid, but it does make it vulnerable.

If your client’s wage apportionment is based on year-end estimates rather than real-time tracking, expect the ATO to challenge it.

Contractors and Consultants

The same apportionment issues apply to contractors, but with added complications.

First, the ATO wants to see contracts that clearly describe the scope of work and tie it to R&D activities. A generic IT services contract isn’t enough. They want detail: what experiments, what technical uncertainty, what systematic progression.

Second, they look at whether the contractor was genuinely engaged in R&D or in supporting activities. Project management, training, implementation, and general business consulting are routinely excluded.

Third, if the contractor is offshore, the expenditure must meet the overseas R&D conditions. That means the work must relate to Australian-registered R&D activities, be necessary for those activities, and not be excludable under the rules. Poor documentation of overseas contractor work is a common reason for disallowance.

And if the contractor is a related party, expect even closer scrutiny.

Related-Party and Associate Payments

If your client paid an associated entity for R&D services, the ATO will test whether the arrangement has economic substance or whether it’s a vehicle for inflating deductions.

They’ll look at the pricing. Is it arm’s-length, or is there a markup built in that wouldn’t exist in a third-party arrangement? If there’s a margin, they may limit the deduction to the underlying cost base.

They’ll look at the structure. Does the related entity genuinely provide R&D services, or is it just a conduit? Are the services documented, or is the arrangement loosely described?

And they’ll apply integrity concepts. If the arrangement looks like it’s designed to maximise the R&D benefit rather than reflect commercial reality, the ATO will challenge it.

Overheads and Cost Allocations

General overheads can be claimed as R&D expenditure, but only to the extent they’re incurred in conducting eligible R&D activities.

The ATO accepts that rent, utilities, consumables, and similar costs can be apportioned. But they expect a reasonable and defensible methodology. If your client allocated 30% of total overheads to R&D, the ATO will ask: why 30%? What’s the basis? Is it tied to headcount, floor space, time allocation, or something else?

Where the methodology is vague or the percentage seems disproportionate to the actual R&D effort, the ATO will adjust it.

And some costs are simply not eligible. General administration, marketing, finance functions, HR, and executive salaries (unless directly engaged in R&D) are excluded.

Software Development and IT Spend

Software is a grey zone. Building new functionality that addresses technical uncertainty can be R&D. Refactoring, bug fixes, performance tuning, implementing known solutions, and maintaining existing systems are not.

The ATO knows that software development is iterative and that projects shift between R&D and non-R&D work. They expect you to show which parts of the codebase or which sprints involved genuine experimentation, not just engineering effort.

If your client claimed all development costs as R&D without distinguishing between experimentation and implementation, expect the ATO to push back.

Foreign-Affiliate Structures and Clinical Trials

This is where the ATO has recently sharpened its focus.

If an Australian subsidiary conducts R&D on behalf of a foreign parent, the ATO will ask: who owns the results? Who bears the risk? Who benefits from the IP?

If the R&D is effectively conducted for the foreign group and the Australian entity is just a service provider, the ATO may argue the activities aren’t “Australian-owned” R&D and deny the claim.

This issue frequently arises in clinical trials. An Australian entity runs the trial, but the foreign parent owns the drug IP, directs the protocol, and takes the economic benefit. The ATO applies TA 2023/5 reasoning to challenge the eligibility of the expenditure.

If your client is part of a multinational group and conducts R&D that benefits offshore entities, you need to be ready to defend the ownership and risk allocation.

How the ATO Tests Substantiation and Evidence

The ATO’s view is simple: if you claim it, you need to prove it.

That means contemporaneous records. Timesheets, work diaries, project logs, meeting notes, experiment records, contracts, invoices. Evidence created at the time the work was done, not reconstructed six months later when the ATO asks for it.

Real-time records carry weight. Reconstructed records do not.

Here’s what the ATO expects to see for different cost categories:

For wages, they want time records showing what each person worked on, linked to specific R&D activities. If timesheets don’t exist, they’ll accept task management systems, project logs, or calendar entries, as long as there’s a credible audit trail.

For contractors, they want contracts, statements of work, invoices, and evidence of what was delivered. If the contractor is offshore, they want even more: correspondence, technical reports, and proof the work relates to registered R&D activities.

For overheads, they want the apportionment methodology explained and justified. A spreadsheet showing how you got to 25% allocation is better than nothing, but the ATO will test whether the basis is reasonable.

For equipment and materials, they want invoices and evidence the items were used in R&D, not for general business purposes.

Where records are incomplete or missing, the ATO’s starting position is to disallow the expenditure. That doesn’t mean the claim is dead. It means you need to rebuild the evidence using whatever is available: witness statements, project documentation, correspondence, experiment notes, or oral evidence from the people who did the work.

In disputes, tribunals and courts have accepted that R&D can be proven without perfect timesheets. But starting without credible records makes the path much harder.

AusIndustry’s role also matters. AusIndustry determines whether the activities are eligible R&D. If AusIndustry accepts the activities, that doesn’t automatically mean the ATO accepts the expenditure. The ATO can still disallow costs on substantiation or integrity grounds.

Conversely, if AusIndustry queries the activities, the ATO’s expenditure review may be paused until the activity question is resolved. That can extend timelines and create uncertainty.

The lesson: keep records from the start. Don’t rely on being able to reconstruct them later.

Integrity Rules the ATO Relies on to Deny or Reduce R&D Expenditure

The ATO doesn’t just challenge expenditure on substantiation grounds. They use specific integrity rules to deny or reduce claims where the arrangement doesn’t meet the policy intent.

The At-Risk Rule

The at-risk rule says that if you receive (or can reasonably expect to receive) consideration for the R&D expenditure, regardless of the results, that expenditure is not deductible.

This catches cost-plus arrangements where an overseas group company reimburses the Australian entity’s R&D costs irrespective of the outcome. The ATO’s position is: if you’re guaranteed to be paid back, the expenditure isn’t genuinely at risk.

It also catches success fees and performance payments linked to R&D milestones, where the payment isn’t contingent on the R&D succeeding commercially but on completing the work.

The ATO looks at three things: whether there’s a nexus between the consideration and the expenditure, whether the consideration is contingent on results, and whether there’s a reasonable expectation of receiving it.

If the arrangement fails any of those tests, the expenditure may be denied.

Related-Party Arrangements and Economic Substance

The ATO applies economic substance principles to related-party R&D expenditure. If the arrangement doesn’t reflect what independent parties would do, or if the pricing is inflated beyond arm’s-length rates, the ATO will limit the deduction to the underlying cost base.

They’re particularly alert to arrangements where an Australian entity pays a related-party service company for R&D, and the service company has a high margin but limited substantive activity.

The question the ATO asks is: if this were a third-party arrangement, would the same pricing and structure apply? If not, they’ll disallow the difference.

Australian-Owned vs Foreign-Owned R&D

Under the R&D rules, the activities must be conducted for the Australian entity, not for a foreign group member.

The ATO applies this strictly in foreign-affiliate structures. If the Australian entity is effectively a contract research organisation for a foreign parent, with no ownership of the IP, no control over the R&D direction, and no economic benefit from the results, the ATO will argue the R&D is not Australian-owned.

This is the focus of TA 2023/5, which targets life sciences and clinical trial structures where the Australian entity conducts the work but the foreign parent owns the outcomes.

The ATO looks at legal ownership, economic benefit, control over the R&D activities, and who bears the risk. If the substance points offshore, they’ll deny the claim.

How These Rules Play Out in Practice

Imagine a client runs clinical trials for a foreign parent. The Australian entity is paid a fee for the work, but the parent owns the drug IP, directs the trial protocol, and takes all the commercial upside.

The ATO applies the at-risk rule (the Australian entity is guaranteed payment regardless of trial outcome) and the foreign-affiliate test (the R&D is conducted for the parent, not the Australian entity). They disallow the entire claim.

Or: a client has a cost-plus arrangement with an overseas group company, where all R&D costs are reimbursed. The ATO applies the at-risk rule and disallows the expenditure, arguing there’s no genuine risk to the Australian entity.

These aren’t theoretical. They’re happening now.

What an ATO R&D Review Looks Like in Practice

When the ATO decides to review an R&D claim, it typically starts with a letter.

The letter will ask for information: a breakdown of R&D expenditure by project, a list of contractors and their scope of work, copies of timesheets or time records, details of related-party arrangements, and evidence supporting overseas expenditure.

The ATO often provides a spreadsheet or template and asks you to fill it in. They want numbers, names, dates, and explanations.

You’ll have a deadline. Usually 28 days, sometimes longer if you negotiate.

From there, the process can go one of several ways.

If the ATO is satisfied with the information, they may close the review with no adjustment. That’s rare.

More commonly, they’ll raise further questions. They might query the apportionment methodology, ask for more detail on specific contractors, or challenge whether certain costs are genuinely R&D expenditure.

This back-and-forth can take months. The ATO isn’t in a hurry, and each round of questions often spawns another.

If the ATO remains unsatisfied, they’ll issue a position paper or draft assessment, setting out the adjustments they propose. At that point, you have a choice: agree to the amendments, negotiate a compromise, or contest the adjustments through objection and review.

Throughout the process, the ATO’s approach is procedural. They’re methodical, they ask a lot of questions, and they expect detailed answers. They’re not hostile, but they’re not flexible either.

One important nuance: the ATO’s review is separate from AusIndustry’s oversight. If the ATO queries the expenditure, AusIndustry might still accept the activities. But if AusIndustry starts querying the activities, the ATO’s expenditure review may pause until that’s resolved.

That split can create timing and strategic issues. If AusIndustry is questioning whether the activities are eligible, there’s little point defending the expenditure until the activity question is settled.

Timelines vary. A straightforward review might be resolved in six months. A complex one, particularly where AusIndustry is also involved or where integrity rules are in play, can stretch over a year or more.

If the ATO Disagrees: Practical Options for You and Your Client

Let’s say the ATO has reviewed your client’s R&D claim and they disagree with part of the expenditure. What now?

You have options. The right one depends on the strength of your position, the quantum at stake, and your client’s appetite for dispute.

Option 1: Clarify and Narrow the Issues

Often, the ATO’s position is based on a misunderstanding of the facts or a misreading of the records.

Your first step is to clarify. Write back, explain the methodology in more detail, provide additional evidence if you have it, and try to narrow the disputed issues.

Sometimes the ATO will concede part of their position once they understand the facts better. It’s not common, but it happens.

Option 2: Amend Strategically

If the ATO has identified genuine weaknesses in the claim, and the cost of defending it outweighs the benefit, the pragmatic option is to amend.

Amending doesn’t mean conceding everything. You can amend to remove the expenditure categories the ATO has challenged while preserving the rest of the claim.

The risk with amending is that it can set a precedent for future years. If you concede that a category of expenditure isn’t eligible this year, the ATO will expect you to exclude it in future claims.

So amend carefully, and make sure you’re not undermining your client’s position going forward.

Option 3: Object and Prepare for Review

If the quantum is material and you have a strong case on the facts and the law, objection is the right path.

An objection buys time and keeps your client’s rights open. It also signals to the ATO that you’re prepared to take the matter to the Administrative Appeals Tribunal or Federal Court if necessary.

In objection, you’re not just restating the facts. You’re building an evidence case. That might mean getting witness statements from the people who did the R&D, reconstructing time records from project documents, or obtaining expert reports on the technical work.

The Tribunal and courts have been pragmatic where R&D is genuine but records are incomplete. They’ve accepted oral evidence, witness testimony, and circumstantial evidence to prove both the activities and the expenditure.

But that pragmatism isn’t a free pass. You still need to show that the R&D happened, that the expenditure was incurred, and that it’s eligible under the rules.

Option 4: Accept the Adjustment and Move Forward

Sometimes the best option is to accept the ATO’s position, take the amendment, and ensure the next year’s claim is watertight.

That might feel like losing, but it’s often the most commercial outcome. R&D disputes are expensive, time-consuming, and uncertain. If the cost of fighting outweighs the benefit, and the adjustment doesn’t undermine your client’s business, moving on can be the smart call.

The key is to learn from the review. If the ATO challenged your wage apportionment methodology, improve it for next year. If they questioned contractor documentation, tighten the contracts. Use the review as a diagnostic tool.

Setting Clients Up Now for a Defensible R&D Expenditure Position

If your client hasn’t been reviewed yet, they probably will be at some point. The question is whether their R&D claim will survive.

Here’s how to position them so that, if the ATO comes, most of the expenditure remains intact.

Start with Real-Time Records

This is the single most important step.

Implement a system where time spent on R&D is recorded contemporaneously. It doesn’t need to be perfect. It just needs to be credible.

Timesheets, task management systems, project logs, or even weekly summaries are all acceptable. The format matters less than the consistency and the fact it’s done at the time.

If your client balks at timesheets, explain the cost: without them, the ATO will pare back the claim based on their own view of what’s reasonable. That’s almost always less generous than what you would have claimed with records.

Document the Apportionment Methodology

If you’re apportioning costs between R&D and non-R&D, write down the methodology.

Why did you allocate 60% of this person’s salary to R&D? Why 25% of overheads? What’s the basis?

The ATO doesn’t require a specific method, but they do require it to be reasonable and defensible. A one-page note explaining the approach is enough.

Get Contractor Arrangements Right from the Start

If your client engages contractors for R&D, make sure the contracts clearly describe the work, tie it to R&D activities, and specify deliverables.

Generic IT services contracts won’t survive scrutiny. Neither will invoices that just say “consulting fees”.

The more specific the documentation, the stronger the claim.

Be Clear on Related-Party Arrangements

If your client pays a related entity for R&D services, document the commercial rationale and ensure the pricing is defensible.

The ATO will test whether the arrangement reflects economic substance or whether it’s designed to inflate deductions. If you can show that the pricing is arm’s-length and the services are genuine, the arrangement will hold.

If you can’t, expect it to be challenged.

Separate R&D from Business-As-Usual

This is where most claims go wrong.

R&D is experimentation and systematic progression. It’s not routine development, maintenance, implementation, or project management.

If your client’s R&D claim includes costs that blur the line, the ATO will draw it for you. And they’ll draw it narrowly.

Train your client’s team to distinguish between the two. Not every hour a developer works is R&D. Not every test is an experiment. Be disciplined about what goes into the claim.

Keep AusIndustry and the ATO Aligned

Make sure the R&D expenditure you claim matches the activities registered with AusIndustry.

If AusIndustry has accepted a narrow set of activities, don’t claim expenditure on work that sits outside that scope. The ATO will pick up the inconsistency.

Conversely, if AusIndustry has queried an activity, don’t push forward with claiming the expenditure until the activity question is resolved.

Set Expectations with Your Client

Finally, have the conversation early.

Explain that R&D claims attract scrutiny. Explain that the ATO will test the records, the methodology, and the integrity of the arrangements. Explain that robust claims survive reviews, but loose claims get pared back.

If your client understands that from the start, they’re more likely to invest in the documentation and discipline needed to defend the claim.

And if the ATO does come, they won’t be surprised.

Final Thoughts

The ATO isn’t auditing R&D expenditure to catch fraud. They’re auditing because the program is large, the rules are complex, and compliance varies wildly.

Some claims are meticulously documented, with real-time records, clear apportionment, and defensible methodologies. Those claims survive reviews.

Others are loose: reconstructed records, vague cost allocations, and arrangements that don’t stand up to scrutiny. Those claims get pared back, often significantly.

The difference between the two isn’t luck. It’s preparation.

If you’re advising on R&D claims, your job is to position your client so that, if the ATO reviews the expenditure, the bulk of the claim remains intact. That means real-time records, defensible methodologies, and clear documentation.

It also means knowing where the ATO will push back: wages apportionment, contractor costs, related-party arrangements, overseas expenditure, and integrity rules.

And if the ATO does disagree, it means knowing your options: clarify and narrow, amend strategically, or prepare for objection and review.

The pathway through an R&D audit isn’t always straightforward. But with the right preparation, most of the claim can survive.

Disclaimer

This article is general information only and does not constitute legal or taxation advice. R&D Tax Incentive compliance and disputes involve complex fact-specific questions. If your client’s R&D claim is under review or you need advice on structuring an R&D arrangement, speak to a lawyer experienced in tax disputes and R&D matters.

Aptum Legal specialises in tax disputes, including R&D Tax Incentive reviews, objections, and litigation. If you need help defending an R&D claim or preparing for an ATO audit, contact us.