Allocation of research and development tax deductions

Sections DB 26, DB 27, EE 1, EJ 20 and EJ 21 of the Income Tax Act 2004

The Income Tax Act 2004 has been amended to allow companies that bring in new equity investors better access to tax deductions for research and development (R&D) expenditure.

The amendments allow taxpayers to allocate certain R&D tax deductions to income years after the year in which the related expenditure is incurred. This means that deductions will not be lost if there is a shareholding change between when the expenditure is incurred and when the deduction is recognised by the taxpayer. This tax treatment is optional. However, those who choose this approach must allocate R&D deductions against income resulting from R&D expenditure.

Technology companies, in particular, often have a long lead-in period in which they incur major expenditure before realising income from it. Under the previous law they could lose R&D tax deductions if they brought in new investors after their initial development stage. The changes better suit the growth cycle of technology companies and remove a barrier to R&D investment by allowing R&D tax deductions to be matched with related income.

Background

This reform is part of the government's economic transformation agenda.

Four private-sector taskforces were established to develop growth strategies for sectors of the economy seen as key to New Zealand's future economic performance. They were: the Biotechnology Taskforce, the Information and Communications Technology (ICT) Taskforce, the Design Industry Taskforce and the Screen Production Industry Taskforce.

As part of their 2003 report, the taskforces made various recommendations, including several on tax-related issues. One tax issue raised by both the Biotechnology and ICT taskforces was the relaxation of the loss carryforward rules. Under those rules, the entry of new equity investors into technology companies could result in any accumulated tax deductions (generally tax losses) being lost because of a breach of the shareholder continuity requirements for carrying forward tax losses.

The tax rules broadly provide that a company can carry forward and offset its tax losses only when the tax benefit arising from the offset is obtained by at least 49% of the individual shareholders who originally bore the loss.

The Biotechnology and ICT taskforces recommended that the government consider changing the tax rules to preserve tax losses if business continuity was maintained even though shareholder continuity was lost.

The government did not favour a general business continuity test to supplement the shareholder continuity test for the following reasons:

• it is contrary to the main policy underlying the loss carry forward rules, which is to prevent the trading of losses between unrelated parties;
• it is the experience of other countries that the test is difficult to apply in practice, creating both complexity and uncertainty;
• a general business continuity test could potentially lock companies into businesses that are only marginally profitable and do not represent the best use of capital; and
• a general business continuity test could have significant revenue implications.

The government continued to explore further options to remove tax barriers to the growth of the technology sector in New Zealand.

The current changes to the tax treatment of R&D expenditure are the outcome of this work.

R&D tax rules

The tax treatment of most R&D expenditure is covered by section DB 26 of the Income Tax Act 2004. That section allows taxpayers a deduction for R&D expenditure if the expenditure does not satisfy all the asset recognition criteria contained in Financial Reporting Standard FRS- 13: Accounting for research and development activities. These criteria are designed to approximate the point at which the R&D expenditure gives rise to a valuable asset.

Although most R&D expenditure is deductible, under the previous rules shareholding changes arising during the normal growth cycle of a technology company could result in the deductions being unable to be used.

Policy issues

The amendments are based on achieving a better match between the timing of tax deductions for R&D expenditure and income resulting from that expenditure. This treatment recognises that taxpayers in the development period of an R&D project are developing assets for the purpose of earning income in future periods instead of incurring economic losses in the initial development stage.

The previous tax treatment could recognise R&D expenditure too early in relation to the income resulting from it. However, these expenses are better viewed as developmental rather than operational expenses.

The previous mismatch in the early recognition of expenditure and the later recognition of income means that a company's deductions for R&D expenditure could be inappropriately lost when there was a shareholding change in the company.

This situation was particularly problematic for the growth cycle of technology companies because these companies typically have a long lead-in period when significant expenditure is incurred before any income is realised. It is part of the normal financing process for such companies to bring in additional equity investors after the initial development work has been successful. If tax deductions for that development work cannot be used because of shareholding changes it can effectively result in technology companies being taxed on their gross income. This is not an appropriate result given that the purpose of the Income Tax Act 2004 is to tax mainly net income.

The new treatment will better suit the growth cycle of technology companies as deductions for R&D expenditure will not be affected by changes in shareholding resulting from technology companies bringing in new investors.

Key features

The amendments better match the timing of deductions for R&D expenditure (including depreciation losses) with income resulting from R&D expenditure. The new treatment means that deductions for R&D expenditure will not be lost when companies bring in new equity investors.

Amounts qualifying for new allocation treatment

Three types of R&D tax deductions qualify for the new treatment and therefore can be allocated to income years after the year in which the related expenditure or depreciation loss is incurred:

• deductions for expenditure covered by the main R&D deduction provision in section DB 26 of the Income Tax Act 2004 (section DB 26(6B) of the Income Tax Act 2004);
• deductions for depreciation losses under subpart EE of the Income Tax Act 2004 for property used in carrying out R&D or for market development for an R&D product (section EE 1(4B) of the Income Tax Act 2004);
• deductions for expenditure incurred on the market development for a product resulting from R&D expenditure. This covers expenditure on investigating or developing a market for the product, which may be a good or a service. This market development expenditure must be incurred before the taxpayer starts commercial production or use of the product – for example, general advertising expenditure incurred after the start of commercial production will not be covered by this rule. The deductions for market development expenditure must already be allowed under the Act – for example, under the general permission in section DA 1 of the Income Tax Act 2004 (section EJ 20 of the Income Tax Act 2004).

The new allocation treatment for R&D expenditure is optional. Taxpayers who wish to continue to deduct their R&D expenditure or depreciation loss or their market development expenditure in the year it is incurred under section BD 4(2) of the Income Tax Act 2004 can do so.

Taxpayers can choose how much of a qualifying deduction will be allocated to a future income year. The amount not allocated under the new treatment will be deducted in the year the relevant expenditure or depreciation loss is incurred.

The new treatment is available to all taxpayers with R&D expenditure and not just those whose main activity is R&D. This is because the principle of achieving a better matching of the timing of deductions for R&D expenditure with income resulting from the expenditure is of general application.

R&D expenditure covered by section DB 26 of the Income Tax Act 2004, and therefore by the new allocation treatment, includes overhead costs (other than interest) such as rent and power. A company whose business is not exclusively R&D must conduct an apportionment on a reasonable basis of overhead expenses between its R&D function and other functions.

Interest expenditure is excluded from this treatment as a tax base-protection measure.

The new provisions use the definitions of "research" and "development" contained in Financial Reporting Standard FRS-13: Accounting for research and development activities. These definitions are already used in section DB 26.

In the case of a start-up technology company, which typically incurs significant expenditure for a long period before any income is realised, most of its pre-commercial production expenditure would qualify for this new deduction allocation treatment.

Allocation of deductions under new treatment

Taxpayers may choose to allocate deductions that qualify for the new treatment to an income year after the income year in which they incur the relevant expenditure or depreciation loss.

If they choose to use the new allocation treatment they must allocate the deductions in accordance with new section EJ 21. This provision generally requires taxpayers to allocate a deduction to an income year in which they derive assessable income they would not have derived but for R&D expenditure or the use or disposal of property used in carrying out R&D.

The assessable income referred to in proposed section EJ 21 includes any amount treated as assessable income under the Income Tax Act 2004 – for example, depreciation recovery income.

The new rules do not differentiate between successful and unsuccessful R&D projects. In particular, deductions income resulting from successful R&D projects.

The amount of qualifying tax deductions (that is, deductions for R&D expenditure and depreciation losses and market development expenditure) allocated to a particular income year under this new treatment is the lesser of:

• the amount of the assessable income that would not have been derived but for R&D expenditure (including depreciation loss); and
• the amount of the qualifying deductions that has not been allocated to earlier income years.

Therefore, taxpayers who choose to use this treatment will be required to allocate the qualifying tax deductions to an income year to the extent of any income derived in that year resulting from R&D expenditure or depreciation loss.

This requirement is necessary as a tax-base protection measure to ensure that taxpayers do not use their R&D tax deductions to shelter their non-R&D income. Accordingly, the relevant R&D tax deductions cannot be deducted against unrelated income. The requirement is also consistent with the underlying policy intent of achieving a better match between the timing of deductions for R&D expenditure and the income resulting from that expenditure.

Example 1: New deduction allocation treatment A start-up technology company incurs $5 million of expenditure on developing biotechnology products in the first five years of its existence. This amount includes deductions for depreciation losses on equipment used in carrying out the R&D and expenditure on surveys to gauge market interest in these products. The company uses the new deduction allocation treatment for R&D (including market development) expenditure. At the end of this period the company has developed several innovative products which have significant commercial potential. The company brings on board new investors to fund the next stage of development leading to the start of commercial production of the products. The company also discontinues its biotechnology projects which do not show promise. Under previous tax rules, introducing new investors in a company could result in deductions for previous R&D expenditure being forfeited. However, under the new deduction allocation treatment for R&D expenditure the company's tax deductions (including those relating to the company's unsuccessful biotechnology projects) are preserved until they can be offset against income resulting from the company's R&D products.

Taxpayers are also able to allocate any deduction to which section EJ 21 applies to the current year if they would have been entitled under Part I of the Income Tax Act 2004 to carry forward to that year a net loss from the year in which they incurred the expenditure (or the depreciation loss arose) to which the deduction relates. In particular, this means that a company must have satisfied for the relevant period the shareholder continuity requirements in section IF 1 of the Income Tax Act 2004. This rule ensures that taxpayers have the same flexibility in using their tax deductions for R&D expenditure as if they had not chosen to use the new allocation treatment.

Taxpayers' decisions on the amount of R&D tax deductions allocated under the new treatment will be reflected in the tax positions they take in their returns of income for each tax year. In line with normal tax rules, these tax positions are binding on the taxpayer unless disputes procedures are initiated within the applicable response periods. The Commissioner will not consider it appropriate, outside a dispute, to exercise the discretion under section 113 of the Tax Administration Act 1994 to amend an assessment to adjust the amounts allocated under the new treatment.

Application date

The amendments apply from the 2005–06 income year.