R & D Tax Break : A new Proposal
The cry is for the New Zealand to move from a commodity to a research and development based economy. There are some signs that this is happening (see the latest Research and Development Survey from Statistics New Zealand (www.stats.govt.nz). Although they are often lumped together, research and development (R & D) are different concepts, research being in the nature of a discovery and development being its pre-commercial “polishing”. R & D is driven by demand for new products and services and to prevent obsolescence.
R & D is expensive. Who should do it and who reaps its benefits is sometimes controversial. In practice, governments recognise that when businesses spend money and create private R &D benefits they enter the knowledge pool through disclosure or the expiry of protection.Therefore, one policy behind R & D incentives is to compensate for those spillover effects.
There are tax incentives for R & D. An example is the deduction of research or development expenditure under s DB 34 of the Income Tax Act 2007 (ITA 2007) using an international accounting standard to define R & D (NZIAS 38). The deduction is only useful if the expenditure is offset by delayed or non-existent income. .This is the usual case for start-up companies.
Another example was the R & D tax credit under subpart LH of the ITA 2007. Broadly it followed Australian, Canadian and United Kingdom models in giving a 15% tax deduction for R & D qualifying expenditure or an equivalent cash payment if income did not exist. Defined eligible activities had to follow the scientific method of hypothesis tested by experiment involving the resolution of a scientific or technological uncertainty or novelty and resulting in a new product or service. Some supporting activities were included. Other activities were expressly excluded.
The tax credit was only in force for a short time and was discontinued, apparently, for fiscal reasons and disquiet about the underlying policy of incentivising R & D on a broad basis.
The government then moved back to direct funding models through government agencies. They require applicants to pre-apply for and justify R & D funding rather than applying for assistance after R & D costs have been incurred.
Very recently, the government has floated a new mode “all comers” model (see www.taxpolicy.ird.govt.nz, officials’ issues paper, R & D Tax Losses, July 2013).The key points of the proposal are:
- It applies only to so-called “R & D intensive start-up companies” resident in New Zealand. Sole traders and other entities are excluded on the basis that companies are the usual vehicle for R & D.
- It recognises that they will incur losses in the early stages. It allows them to “cash out” those losses in the income years earlier rather than having to carry them forward.
- The R & D definition is based on s DB 34 of the ITA 2007. As noted above, it uses NZIAS 38.
- The cashout proposal uses an R & D “wage intensity threshold”: 20% of total wage and salary expenditure must be on R & D. This targets start-ups who have no other activities.
- The approach is fiscally conservative. There is a cap on the cash out of the lesser of 1.5 times the eligible wage and salary expenditure in the relevant year, the total qualifying R & D expenditure in that year (which extends beyond wage and salary costs) and total tax losses in the relevant year. There is a further incremental cap of $500,000rising to a maximum cap of $2million in the relevant year. Because the criterion is specific (wage and salary expenditure) it can be monitored through PAYE returns and the risk of datamining past expenditure for eligible items is reduced.
- If the company derives a later return from the sale of its intellectual property or shares the tax loss cash out is clawed back (so in a sense the cash out is in the nature of a contingent loan).
Rules around how the R & D definition is applied link back to the older tax credit scheme which excluded certain expenditures and activities.
Some expenditure (such as interest) is excluded for the purposes of determining total qualifying R & D expenditure. Likewise, some activities are also excluded such as research in social sciences, arts or humanities, marketing activities, compliance related work and cosmetic or stylistic product changes, to give only a few examples. However, even though the proposed R & D activity is based around a wider NZIAS standard, as with supporting activities under the previous tax credit, there still could be a problem in determining whether wage and salary expenditure truly relates to R & D.
Notably, the new proposal excludes “the late stages of software development (for example coding)”. This is important given current emphasis in New Zealand upon developing “weightless” businesses based on software rather than the exploitation of natural resources. Software R&D has caused serious issues in overseas tax jurisdictions and this is probably the reason for referring to coding as non-core research activity.
Software development wage and salary expenditure that comes within the R & D definition would still seem to qualify. The extent to which wage and salary expenditure on computer science or information technology that supports qualifying R & D might be an issue (as for the previous tax credit around core and supporting activities).
The proposal is intended to be simple. But any scheme will require the applicant to provide significant validating information to the IRD. The direct and indirect costs of doing so are high. Chapter 6 of the proposal outlines a screening process.
However, this is after the event. Should a precondition to screening and accessing the cashout be evidence of significant planning and record-keeping disciplines? These are key indicators of real R & D using standard scientific methodologies.