Research and development expenditure: Deja vu?
The reintroduction of a tax based R&D incentive was a key announcement in the recent budget. An officials' issues paper was released on 23 July 2013, entitled R&D tax losses in which Officials have suggested allowing “R&D-intensive start-up companies” (R&D companies) to “cash-out” certain losses related to R&D expenditure.
Current tax setting for R&D
Current tax provisions delay the ability of loss-making R&D businesses to use their deductions as they are required to carry the losses forward until such time as they make a tax profit. This in turn creates cashflow problems for R&D companies who are in a tax loss position. For R&D companies, this bias is compounded by longer periods of losses for innovative projects, broader capital constraints and difficulties in securing lending or investment.
This tax treatment disproportionately adversely affects R&D companies for a number of reasons:
- companies are expected to be in an on-going loss position over consecutive periods through the R&D phase.
- companies generally do not have other sources of income to apply the loss against.
- The high-risk nature of R&D investment increases the risk of failure. The resulting failure would mean losses are never utilised by R&D companies.
- In some cases, R&D companies do not realise any gain on investment until the R&D output is sold.
Suggested policy changes
To address these issues, Officials’ have suggested allowing R&D companies to “cash-out” certain losses related to R&D expenditure. There are three primary facets to these proposals.
Eligible R&D companies
Officials propose certain R&D tax losses will be refundable to eligible R&D companies. R&D companies will be eligible if they meet the following criteria.
- The company must be in a tax-loss position for the applicable income year;
- The company must be resident in New Zealand;
- The company must not be a look-through company, listed company, qualifying company or special corporate entity; and
- The company’s R&D expenditure on wages and salaries must be at least 20% of total group expenditure on wages and salaries.
Of particular importance is the last of these criteria (referred to as “R&D wage intensity”). R&D wage intensity has been linked by Inland Revenue to the innovation life cycle. During the initial loss-making phase of the innovation cycle, R&D companies typically invest a greater proportion of their labour costs in R&D for the initial creation of intellectual property. As the business matures, activities shift towards production and sales which leads to a reduction in the proportion of R&D staff (and therefore expenditure on wages and salaries for R&D). Setting a 20% R&D wage intensity threshold therefore targets this policy towards start-up R&D companies and will generally exclude established businesses.
Eligible R&D companies would be able to cash-out the lesser of:
- 1.5 times the company’s R&D expenditure on salary and wages;
- Total losses;
- Total qualifying R&D expenditure; and
- The total overall cap on eligible losses for the relevant year (initially $500,000 of losses, rising over time to $2 million).
Certain R&D expenditure only
It is important to recognise that the “cash-out” amount is limited to total qualifying R&D expenditure. This means the definition of R&D expenditure is critically important.
Officials suggest using existing definitions of R&D found in NZIAS 38, modified to exclude certain activities and expenditure. Activities excluded from the definition of R&D include:
- Prospecting, exploring or drilling for minerals, petroleum, natural gas or geothermal energy;
- Research in social sciences, arts or humanities;
- Market research, testing, development or promotion;
- Quality control;
- Making cosmetic changes to products;
- Commercial, legal and administrative aspects of patenting, licensing or other activities;
- Activities involved in complying with statutory requirements;
- Clinical trials; and
- Late stages of software development.
Further, expenditure excluded from the definition of R&D includes:
- Determining R&D wage intensity;
- Determining total qualifying R&D expenditure;
- Interest expenses related to
- Purchases of existing R&D assets;
- undertaken offshore; and
- Lease payments.
Readers will recall that these exclusions are broadly consistent with those in the R&D tax credit regime that was repealed by the current Government.
It’s good to see support for R&D in start-ups through this tax-related budget initiative. It’s also important to note that there are other components to Government’s support of R&D as seen in the recent announcement regarding business R&D grants.
It is obvious that the success of start-up R&D-intensive companies is ultimately good for the NZ economy and this policy’s efforts to provide tax support is to be applauded. The proposed policy risks being too narrow however and is in danger of being mere lip service to supporting innovation without actually providing support where it is actually required.
There are some particular exclusions/requirements in the proposal that are particularly worrying:
- Software coding & clinical trials exclusion – this could effectively lock out companies in the important software and biotech industries during the most important phase of their R&D investment.
- 20% labour intensity requirement – it is questionable whether this 20% threshold is realistic or whether it sets the bar too high. This test is the primary targeting mechanism to ensure that this incentive is only available to R&D start-ups. We consider that this may be a missed opportunity to provide R&D tax incentives to established companies or those undertaking R&D but which also have existing revenue streams.
- Listed companies – it seems that this policy would be more effective if it were applicable whether a company is listed or not.
Please contact us if you would like to make a submission on this Issues Paper.
Tax Alert August 2013 contents:
- Tax Alert - August 2013
- Clarity, controversy, or both: Inland Revenue’s finalised guidance on tax avoidance
- Succession and divestment
- Clarifying the tax consequences for deregistered charities
- Research and development expenditure: Deja vu?
- Bloodstock investors finish down the track
- A necessary review of allowances
- Deloitte announces new tax partner