Federal Court dismisses H2O Exchange’s appeal from AAT R&D decision

Articles Written by Kathryn Bertram (Partner)

On 22 January 2021, Stewart J decided H20 Exchange Pty Ltd (H2O) v Innovation and Science Australia (ISA) [2021] FCA 11 in favour of ISA. For an appellant to be successful in an appeal of a decision of the Administrative Appeals Tribunal (AAT), they must be able to satisfy the Court that the AAT has erred on a question of law. In this case, H2O was unable to satisfy the Court that the AAT had so erred in respect of each of the three grounds of appeal raised by H20. His Honour held that:

a) the AAT’s decision to accept the expert evidence of ISA was not irrational or illogical in circumstances where the expert had relevant work experience but no relevant tertiary qualifications;

b) there was no denial of natural justice by the AAT making the presence or absence of research involving artificial intelligence (AI) a relevant issue in the proceeding without advising the parties that the AAT would do so; and

c) there was no denial of procedural fairness by the AAT to proceed with the hearing in circumstances where H2O had filed an application to vary the relevant registration definitions and ISA had failed to deal with the variation request.

Accordingly, this case shows that taxpayers will need a strong ground of appeal that is supported by the evidence, such as demonstrating the AAT has incorrectly interpreted legislation, in order to convince the Court the AAT has made an error of law and the decision ought to be overturned.


This case was an appeal from an earlier decision of the AAT (H20 Exchange Pty Ltd and Innovation and Science Australia [2019] AATA 4195) which had affirmed ISA’s internal review decision not to register certain activities in the 2013-14 and 2014-15 income years as core R&D activities (as defined in s 355-25 of the  Income Tax Assessment Act 1997 (Cth) (ITAA97)) or supporting R&D activities (as defined in s 355-30 of the ITAA97), a prerequisite for accessing the R&D tax incentive.

H2O undertook a project to establish an online water exchange that would allow the sale and purchase of water rights in the Murray-Darling Basin within New South Wales (NSW), Victoria and South Australia (SA).

H2O sought to have Activity 1.1 and Activity 1.2 registered by ISA as core R&D activities. Activity 1.1 involved the following elements:

  1. the creation of a web-based trading platform;
  2. membership database and CRM;
  3. binding legal framework;
  4. real time settlement and payment of fees; and
  5. complete automation of the conveyancing and registration process.

Activity 1.2 involved the following elements:

  1. creation and incorporation of a rules matrix for the trading of water rights in NSW, Victoria and SA; and
  2. ongoing monitoring of changes to the rules and updating of the rules matrix.

ISA determined in 2016 that Activity 1.1 and Activity 1.2 were not core R&D activities. This decision was affirmed by ISA on internal review and H2O then sought review of that decision by the AAT. The AAT also concluded that Activity 1.1 and Activity 1.2 did not satisfy the requirements in s 355-25 of the ITAA97. In particular the AAT found:

a) in relation to Activity 1.1, the outcome of the activity was known to be achievable and could be determined in advance on the basis of current knowledge, information or experience. In relation to the automation of the conveyancing and registration process, the AAT held that this was not achievable because NSW and SA did not offer online registration of transfers. Accordingly, the outcome of this depended on governments changing their conveyancing requirements, which was not the type of uncertainty of outcome that was able to be determined only by applying a systematic progression of work; and

b) in relation to Activity 1.2, the AAT found that this activity “may have been achievable using AI software but probably not otherwise”. However, the AAT found that the application for registration did not mention AI software was to be used for any activity and no information was provided by H2O about what experimental activities using AI software were embarked upon, whether those activities were based upon the principles of established science, whether a systematic progression of work was involved and what hypotheses were considered. 

Federal Court decision

H2O lodged a notice of appeal on the basis that the AAT had made 38 independent errors of law. The Court noted at [20] that during the hearing counsel for H2O reduced that number to just three grounds of appeal.  Stewart J concluded that all three grounds of appeal must fail. We briefly summarise the Court’s reasons below.

Ground 1 – the evidence of Mr Harding

H2O objected to the AAT’s acceptance of the evidence of ISA’s expert, Mr Harding, on the basis that he was not an expert in software development. The Court considered the relative experience of Mr Harding and concluded at [28] that the fact Mr Harding had a Bachelor of Finance and had worked in finance and investments “did not in any way shake his experience relevant to software development as outlined in his report. That experience provided a proper basis for Mr Harding to have specialised knowledge on which the opinions expressed by him with regard to software development were based. The fact that he had not formally studied software design, had never been hired as a software engineer and had never written a line of code did not detract from that”. Accordingly, Stewart J held at [29] that the AAT was “entirely justified in accepting Mr Harding’s expertise on the questions on which he expressed an opinion”. It concluded there was no basis “even if questionable or in error, [that] rises to the level of illogicality, irrationality or unreasonableness so as to amount to error of law”.

Ground 2 – denial of natural justice with regard to AI

H2O had argued that no notice had been given that the presence or absence of research involving AI would be a relevant issue and as such it was denied the opportunity to present any evidence or make submissions on this issue.

The Court noted at [35] that it was H2O, through the evidence of Mr Daley (H2O’s chief executive officer) who actually introduced the concept of AI. The Court also found that both H2O and ISA’s experts referred to AI as a means to achieve the second identified element of Activity 1.2. The AAT then relied upon H2O’s expert, Dr Fearn, in reaching its conclusion. Stewart J found at [36] “[i]n the circumstances, it is not apparent that [H2O] was in any way taken by surprise by the [AAT]’s reference to AI or that there was any unfairness with regard to the [AAT]’s references to AI”. His Honour continued at [37] that “even if there was some surprise or unfairness it could not have been material to the outcome of the decision”.

Ground 3 – application to vary the registrations

H2O argued that it had sought to vary its registrations by a letter to ISA dated 21 March 2016 but ISA had not treated the letter as an application for variation. During the course of the hearing before the AAT H2O sought an adjournment in order to enable the application for the variation to be considered or so ISA could undertake an internal review of its failure to approve the variation. This was denied by the AAT and H2O argued this amounted to a denial of procedural fairness.

The Court found at [45] there was no procedural unfairness by the AAT “even adequately identified never mind established” because:

a) it was not clear that the letter of 21 March 2016 was an application for variation. On its face it was a response to a request from ISA for H2O to provide further information or documents;

b) H2O only sought to characterise the 21 March 2016 letter as an application to vary the registrations during the AAT hearing. If H2O had intended for the letter to be an application for a variation, it could have done that at an earlier time; and

c) H2O ultimately accepted that once the decision of ISA was under external review in the AAT, it was too late to vary the registration.

Accordingly, none of the matters raised by H2O in this case satisfied the Court that the AAT had made an error of law in its original decision.

Important Disclaimer: The material contained in this article is comment of a general nature only and is not and nor is it intended to be advice on any specific professional matter. In that the effectiveness or accuracy of any professional advice depends upon the particular circumstances of each case, neither the firm nor any individual author accepts any responsibility whatsoever for any acts or omissions resulting from reliance upon the content of any articles. Before acting on the basis of any material contained in this publication, we recommend that you consult your professional adviser. Liability limited by a scheme approved under Professional Standards Legislation (Australia-wide except in Tasmania).

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