Repeal of the tax credit
Issue: Feedstock rule
Clause 424
Submission
(68A – Corporate Taxpayers Group)
The feedstock rule should be amended to make it clear that where a valuable output is produced as part of an R&D testing process, only the cost of the inputs is potentially denied the credit.
Comment
This issue was raised by the Corporate Taxpayers Group with officials before the repeal of the tax credit. The government announced on repeal that the feedstock rule would be reviewed.
The feedstock rule operates to restrict the availability of the R&D tax credit when, as part of an R&D process, a valuable output is produced. For example, a paper manufacturer might be developing a new process, and produce saleable quality paper during testing. If the costs incurred in the testing process were $10 of materials and $40 of other costs, and the end product was worth $60, some or all of the costs may be denied the credit. While the original intention of the provision was to deny the credit for the materials only ($10 above), the legislation has been interpreted as denying the credit for all costs ($50 above).
The legislation should be amended to make the original intention clear.
Officials also recommend that other minor amendments be made to address matters such as the scope of the application of the provision (it should not, for example, apply to the construction of prototypes) and remove an unnecessary duplication in the drafting.
This proposal has been discussed with the Corporate Taxpayers Group, which agrees it is consistent with the policy intent of the credit and supports the amendment. We have also consulted in detail with the New Zealand Institute of Chartered Accountants, Ernst & Young and KPMG. They all support the proposed amendment.
Recommendation
That the submission be accepted, and that the feedstock rules be limited in application only to inputs of items and materials that are the subject of testing.
Issue: Eligibility of labour R&D costs for the credit
Submissions
(35 – PricewaterhouseCoopers, 68A – Corporate Taxpayers Group)
The credit should be available in full on capitalised labour R&D costs (such as design and testing), whatever the ultimate use of the underlying asset. (PricewaterhouseCoopers)
That an upfront credit should be available for design labour costs. (Corporate Taxpayers Group)
Comment
This is another issue that was raised before repeal of the R&D tax credit, and which the government undertook to review to ensure the legislation conformed to the original policy intent.
Complex rules apply when capital expenditure is incurred as part of an R&D project. If the capital expenditure is incurred in developing a depreciable intangible asset or a tangible asset which is intended to be solely used in R&D, the credit is available in full. If capital expenditure is incurred in developing a non-depreciable tangible asset which is not solely intended to be used in R&D, the credit is available (if at all) only on the depreciation which arises when the asset is used in R&D (for example, for testing).
This is not the right outcome when the expenditure is incurred on something like the labour costs of design or testing. This is R&D expenditure under the narrowest definition, and limited eligibility for the credit is not consistent with the original policy intent. Moreover, it is not consistent with the approach indicated during consultation when the credit was being developed.
Accordingly, officials recommend that the credit be available in full for the labour R&D costs of design and testing, which are capitalised, whatever the ultimate purpose of the underlying asset. Care should be taken, however, to ensure that labour costs which are incurred in constructing these assets are not automatically given the credit. We also propose a requirement for capital expenditure, that replicates the effect of the deferred salary expenditure rule so that firms can claim the credit only in relation to salaries that are paid out.
This change has been discussed with the Corporate Taxpayers Group and is supported. It considers that the change is consistent with what the Group and officials consider is the policy intent of the rules when introduced. We have also consulted in detail with the New Zealand Institute of Chartered Accountants, Ernst & Young and KPMG. They all support the proposed amendment.
Recommendation
That the submissions be accepted.
Issue: Costs capitalised after R&D is completed
Submission
(68A – Corporate Taxpayers Group)
In certain circumstances, no credit is available for R&D costs because there is no depreciation on the asset being developed while the R&D is being done. An amendment should be made to allow a deemed depreciation calculation to apply for the purposes of the tax credit in these circumstances.
Comment
There are circumstances in which no tax credit is available because of the way the credit is designed. If the credit were ongoing, these would be reviewed and, where appropriate, recommendations made for change. As the tax credit is now repealed, and any change can only be retrospective, officials do not support the amendment proposed in the submission.
Recommendation
That the submission be declined.
Issue: Removal of internal software development cap
Submission
(68A – Corporate Taxpayers Group)
The $3 million internal software development cap should be removed.
Comment
The internal software development cap is a base protection measure intended to reduce fiscal risk associated with the tax credit. Its removal would likely expose the government to high cost but potentially low-value R&D claims. Other jurisdictions, such as Canada, have experienced very large internal software development claims, such as from banks and insurance companies. A discretion to raise the cap is available if a case is made to the Minister of Finance.
As the tax credit is now repealed, to change this retrospectively would also have no incentive effect and provide a windfall gain.
Recommendation
That the submission be declined.
Issue: Scope of internal software development cap
Submissions
(68A – Corporate Taxpayers Group)
The internal software development cap should apply only where the purpose of the R&D activity was wholly or mainly the development of software. Where the software development is only a facet of a wider project the cap should not apply.
The internal software cap grouping rules should be less restrictive. A 66 percent commonality of shareholding should be required for a group to be an internal software development group.
The boundary between external and internal software development is uncertain and the cap should not apply to software developed for selling or leasing when it is also used internally.
Comment
The $3 million software development cap applies to all internal software development. Grouping rules ensure that the cap cannot be avoided by spreading internal software development expenditure over multiple companies or other entities.
Officials do not support the loosening of these restrictions as this would apply only retrospectively to the 2008–09 year and have no incentive effect on taxpayers.
Also, in the case of the first submission, our concern is that it may also be relatively easy to recharacterise software developed mainly for an independent project as software developed as part of a wider project. Our understanding is that such behaviour has occurred in Australia.
Our concern with weakening the grouping rules is that it may allow internal software development to be structured in a way which by-passes the cap. The potential revenue risk if the cap is not successful could be significant.
In relation to the third submission, we do not support relaxing the rule that software used in-house is internal software development even if it is also sold or licensed to third parties. Without this rule a financial institution, for example, could provide an implicit licence to customers to use its internal back-office software and charge a small fee for the use of those systems. The software would then be seen as licensed to all the institution’s customers and therefore an argument presented that the software was not internal-use software and therefore eligible for the tax credit. We received advice that this type of situation could be a problem, so the rules were extended to cover it at the Select Committee stage of the introduction of the R&D provisions.
Recommendation
That the submissions be declined.
Issue: Grant funding – third party co-funding
Submission
(68A – Corporate Taxpayers Group)
Third party contributions that are a condition of a grant should be eligible for the tax credit.
Comment
The rationale for providing government subsidies for R&D activities is to compensate firms for benefits that accrue to society (spillover benefits) rather than to the firms. Generally, firms are unable to capture all the benefits of the R&D that they undertake.
This matter was debated at the time the credits were introduced. Expenditure met with funds that are required as a condition of a grant is not eligible for a tax credit. This is because the R&D project is already subsidised by the grant. Required co-funding (whether it is funded directly by the grant recipient or by a third party) is part of the contribution that the government expects from the relevant private sector firms towards the work. Providing both forms of subsidies for the same R&D activity would therefore be a double subsidy.
While in principle the double-dipping concern could be dealt with by contemporaneous changes to grant funding and R&D tax credit rules, as the changes would be only retrospective this option is not recommended.
Recommendation
That the submission be declined.
Issue: Repeal of the tax credit
Clauses 245 and 246
Submission
(Matter raised by officials)
A number of technical amendments, including removal of clauses 245 and 246, are required to the bill and the Tax Administration Act 1994 as a consequence of the repeal of the R&D tax credit.
Comment
Clauses 245 and 246 amend the timing rules for the tax credit so that R&D salary expenditure that is paid out in a year after the R&D is performed would be eligible for the tax credit in the year in which the salary is actually paid. Similarly, overseas expenditure that has been carried forward to a subsequent income year would be eligible for a tax credit at the time there is sufficient local expenditure to make a claim.
These amendments are no longer necessary because the tax credit only applies to R&D performed in the 2008–09 income year and it was explicitly stated as part of the repeal that expenditure that would otherwise become eligible for a tax credit after the 2008–09 year, in relation to R&D activities performed in that year, would not be eligible for the concession. Officials therefore recommend that the clauses be removed.
Other minor technical amendments are also necessary to the rules for administering the credit as a consequence of its repeal.
Recommendation
That the submission be accepted.
Issue: Timing adjustments
Clauses 245 and 246
Submissions
(35 – PricewaterhouseCoopers)
The proposed changes to the timing rules for deferred employee remuneration and overseas expenditure should be rationalised to make them easier for taxpayers to follow.
The proposed exclusions from the timing rules should also apply to bonus entitlements determined after the income year in which the R&D activity occurs.
The $20,000 minimum expenditure requirement should not apply to deferred employee remuneration in the year in which it is paid out
Comment
Officials recommend above that clauses 245 and 246 be removed as the tax credit will be claimable only for the 2008–09 income year. These submissions are therefore no longer relevant.
Recommendation
That the submissions be declined.
Issue: Petroleum mining development expenditure
Clauses 245 and 246
Submissions
(35 – PricewaterhouseCoopers, 68A – Corporate Taxpayers Group)
The proposed exclusions from the timing rules should also apply to deferred petroleum development expenditure. (PricewaterhouseCoopers, Corporate Taxpayers Group)
“Offshore” petroleum mining, which is subject to New Zealand income tax, should be treated as R&D performed in New Zealand. (Corporate Taxpayers Group)
Comment
While petroleum mining exploration expenditure is not eligible for the tax credit, expenditure on R&D activities which are included in petroleum mining development expenditure is eligible.
However, the combination of the requirement that the expenditure be deductible and the seven-year spreading rule for petroleum mining development expenditure means that the credit is available for only 1/7th of the revenue expenditure for each year. This does not apply to capital expenditure. All capital expenditure that meets the requirements of the rules will be eligible As the tax credit will be available only for one year, this means that only 1/7th of the R&D expenditure that is on revenue account and that is incurred in the 2008–09 year in petroleum mining development will be entitled to a tax credit. The first submission seeks an amendment so that all the expenditure incurred in a year will be eligible.
It is not clear that the current law provides the right outcome. The intention of the tax credit was to encourage R&D expenditure, and there is no reason why the specific petroleum mining timing rule should apply to limit its availability. However, the only sensible amendments that can now be made are those which have retrospective effect to the date of commencement of the tax credit. An amendment which is retrospective and unanticipated by those entitled to it cannot have an incentive effect, and will purely be a windfall gain to recipients.
Officials have discussed the influence of the availability of the tax credit on the petroleum mining sector with a number of advisers, and none have suggested that petroleum miners have taken into account the availability of the credit, either on a 1/7th or a full-year basis, in their decisions on whether to carry out R&D activities. Also, we have been told that the amendment in relation to capital design costs, discussed earlier, will significantly reduce the amount of expenditure that is not eligible for the credit.
We therefore do not recommend any change be made in this area.
The same argument applies to the second submission. As the tax credit is now repealed, other than the changes signalled at the time of the repeal, we do not support changes that retrospectively broaden the scope of the credit as this has no incentive effect and creates a windfall gain to taxpayers.
Recommendation
That the submissions be declined.
Issue: Eligible expenditure
Submissions
(68A – Corporate Taxpayers Group)
An amendment is required to ensure that a tax credit is available for supporting R&D expenditure (such as feasibility studies) incurred in a year before the main R&D activity.
Consideration should be given to a new “other” class of expenditure for expenditure that is currently not eligible (for example, compensation for the opportunity cost of participating in a trial).
Pre-business expenditure on R&D should also be eligible for a tax credit.
Comment
R&D can be either a “core” activity (that is, an experimental activity) or a support activity (an activity that, while not experimental in itself, is required to conduct the core activity).
The tax credit rules do not require expenditure on supporting R&D to be incurred in the same year or before expenditure on core R&D, although they do require that the core activity takes place. Therefore officials do not consider that an amendment is needed to clarify this point.
Given the repeal of the tax credit from the 2009–10 income year, amendments to extend the types of expenditure eligible for a tax credit in the 2008–09 year would have no incentive effect and result in windfall gains. Therefore we do not support them.
Recommendation
That the submissions be declined.
Issue: Claw-back of imputation credits
Submission
(68A – Corporate Taxpayers Group)
There should be no claw-back of tax credits paid to a company when the company makes distributions to shareholders.
Comment
This matter was debated at the time the tax credit was introduced. There is a partial claw-back of tax credits paid to a company when the company makes distributions to its shareholders. To remove the claw-back would move more entities away from the economically correct position and involve significant fiscal cost. Officials do not support any change to this position, especially as now any change would be retrospective only and have no incentive effect.
Recommendation
That the submission be declined.