Chapter 2 - Background
2.1 The Government’s Business Growth Agenda emphasises the importance of innovation to help grow New Zealand’s economy. Innovation creates new sources of economic growth by delivering new products and generating improvements in the quality and cost of existing products. Encouraging business innovation is one of the seven key initiatives of the Government’s Building Innovation workstream, which recognises that R&D is a key element in the innovation process.
2.2 High up-front costs associated with undertaking R&D mean that relative to other investment projects, the profit cycle for innovative projects tends to be much more heavily skewed towards early losses. This can pose a particularly significant barrier to undertaking R&D for innovative start-up companies.
Current tax settings for R&D
2.3 The tax system in New Zealand is based on the principle of broad-base, low-rate taxation, as set out in the Government’s Revenue Strategy. This means that alternative forms of income and expenditure are taxed as evenly as possible, to ensure that overall tax rates can be kept low, while also minimising the influence that taxation has over economic decisions. This policy means that the current tax treatment of R&D expenditure in New Zealand is largely consistent with the tax treatment of other forms of business expenditure.
Tax deductibility of R&D expenditure
2.4 Expenditure on R&D that is regarded as an expense for accounting purposes is generally deductible for tax purposes. Section DB 34 of the Income Tax Act 2007 allows a person a deduction for expenditure they have incurred on research or development if that expenditure is expensed under paragraph 68(a) of NZIAS 38 Intangible Assets.
2.5 Under section DB 34 of the Income Tax Act 2007 and NZIAS 38, expenditure on an intangible item is immediately deductible for tax purposes until the NZIAS 38 asset recognition criteria are met. The intangible asset recognition criteria require an entity to demonstrate all of the following:
- the technical feasibility of completing the intangible asset so that it will be available for use or sale;
- its intention to complete the intangible asset and use or sell it;
- its ability to use or sell the intangible asset;
- how the intangible asset will generate probable future economic benefits. Among other things, the entity can demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset;
- the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset; and
- its ability to measure reliably the expenditure attributable to the intangible asset during its development.
2.6 Once all of these asset-recognition criteria are satisfied under NZIAS 38, any further development expenditure is capitalised rather than immediately deducted. In certain circumstances, this expenditure can be deducted as depreciation over the life of the asset for tax purposes.
Timing of deductions
2.7 The Income Tax Act 2007 also grants special treatment for the timing of deductions for R&D expenditure. Sections EJ 22 and EJ 23 can permit taxpayers to allocate all or part of this deduction granted under section DB 34 to later income years, provided that the relevant taxable income would not have been derived but for the R&D expenditure. There is no limit to the amount of losses that taxpayers can allocate to future income years under this provision.
2.8 This provision was introduced to recognise that many R&D firms introduce additional equity during the R&D process. Without the provision described above, a breach of shareholder continuity would result in the accumulated losses carried forward being extinguished. Instead, taxpayers can allocate the expenditure (that gives rise to the losses) to an income year after the shareholder continuity breach (if any) takes place.
Sale of successful output from R&D
2.9 The current tax settings tend not to tax the profits from the sale of successful R&D. This is because the sale of companies (which own the successful R&D) is considered to be a sale of capital and therefore outside the scope of the tax base. The exception to this is income from royalty payments or the sale of patents, which is taxable.
Current treatment of tax losses
2.10 The current approach to the treatment of tax losses is to allow loss offsets between companies with a 66 percent common shareholding. Without this rule, losses would be effectively quarantined in the individual company concerned, and income would have to be earned in that company before the tax benefit of the losses could be realised. In reality, this could involve a significant time period.
2.11 Alongside the loss offset rules for “traditional” companies, changes have been made more recently to allow flow-through treatment for limited partnerships and eligible companies that elect to do so. Under these rules losses pass through to their partners and shareholders, thus allowing the tax benefit of the losses to be realised to the extent the partners or shareholders have other taxable income.
2.12 It can be argued that as losses are the inverse of profits, they should be treated symmetrically. In other words, just as profits are liable for a tax payment, losses would be eligible for a negative tax payment (that is, a receipt from the Government). In practice, this is generally achieved through the mechanisms of intra-group loss offsets or loss pass-through provisions.
2.13 Allowing what amounts to a refund inherently involves an element of risk to the tax base as it incentivises the creation of artificial losses as a mechanism for sheltering otherwise taxable income of group companies or partners/shareholders. Under current tax settings, however, this risk will always be capped at the level of the otherwise taxable income. Without this limit there would be greater pressure on other buttressing rules such as shareholder continuity or general anti-avoidance rules.
2.14 The only set of losses that are not used immediately are those where the loss-making company does not have a profit-making company in its group or the partners/shareholders do not have sufficient taxable income to absorb the loss.
2.15 This paper explores whether, in certain circumstances, the Government should allow R&D start-up companies earlier access to tax losses arising from R&D expenditure when no offsets are possible. This would reduce the distortions created when there is an asymmetric tax treatment of tax losses (given wider exacerbating factors affecting these companies noted in Chapter 3). As the current stock of losses for all firms was approximately $45 billion in May 2013, any change from the status quo must be approached with a high degree of caution.