Cash out of research and development tax losses

Overview

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 research and development is a key element in the innovation process.

High up-front costs associated with undertaking research and development mean that relative to other investment projects, the profit cycle for research and development projects tends to be much more heavily skewed towards early losses.  This can pose a particularly significant barrier to undertaking research and development for innovative start-up companies.  Larger firms generally have the ability to use those losses earlier, setting them off against existing streams of income.

Current tax provisions delay the ability of loss-making businesses to use their deductions as they are required to carry the losses forward.  This provides an important integrity measure in the tax system to mitigate the creation of artificial losses.  However, these current tax settings create a cashflow problem for certain companies in an on-going tax loss position.

This cashflow bias is particularly significant for companies undertaking research and development, and this can increase the cost of investing in research and development rather than in other assets.

Problems can be compounded for start-up companies undertaking research and development who are already likely to suffer from broader capital constraints.

Current tax settings can also penalise businesses that engage in research and development that ultimately turns out to be unsuccessful.  This is because current tax provisions state that losses, in this case from unsuccessful research and development, can only be used going forward if there is a subsequent profitable business.  The current rules therefore make the use of previous tax losses contingent upon successful innovation or future income earning by the same group of investors.  The risk of incurring this potential additional sunk cost is likely to discourage investment in marginal research and development projects further.

The proposed changes focus on start-up companies engaging in intensive research and development, and are intended to reduce their exposure to market failures and tax distortions arising from the current tax treatment of losses.  The timing that those companies can access their losses will be brought forward, provided they meet certain criteria.  This will help to reduce the bias against investment in these firms from current tax settings.

PROPOSALS FOR THE “CASH OUT” OF RESEARCH AND DEVELOPMENT TAX LOSSES

Summary of proposed amendments

The bill proposes to allow loss-making research and development start-up companies to “cash out” their tax losses arising from research and development expenditure.

The measures are intended to be as simple as possible.  That intention and the focus on start-ups means that the proposed changes are not aimed at taxpayers with complex or unusual tax arrangements.

Under the proposals, research and development start-up companies will be able to claim up to 28 percent (the current company tax rate) of their tax losses from research and development expenditure in any given year.

The main eligibility requirements are that the company must be a loss-making company resident in New Zealand, with a sufficient proportion of expenditure on research and development.

The amount of losses that can be cashed out will be capped at $500,000 for the 2015–16 year, increasing by $300,000 over the next five years to $2 million.  The amount that can be cashed out in any year is the smallest of that cap, the company’s net loss for the year, the company’s total research and development expenditure for the year, and 1.5 times the company’s labour costs for research and development for the year.  Because the cash-out is administered through the tax system, it is delivered in the form of a tax credit.

Research and development expenditure as defined for the initiative will be more restricted than expenditure that is subject to the income tax deductibility provisions for research and development.  Expenditure on certain activities and some types of expenditure are excluded.

A cashed-out loss can be thought of as an interest-free loan from the Government to be repaid from the taxpayer’s future taxable income; it is intended to provide a temporary cash flow timing benefit.  When businesses make a return on their research and development, they will be required to repay some or all of the amounts cashed out.  New deductions will reinstate corresponding losses that will be available to offset future income.  Triggers for the repayment of amounts cashed out include the sale of research and development assets, liquidation or migration of the company, or the sale of the company.

Application date

The amendments will apply to income years beginning on or after 1 April 2015.

Key features

Eligibility

(Clauses 192 and 213)

The proposed eligibility requirements, as set out in new sections MX 1 and MX 2 of the Income Tax Act 2007, are intended to target the initiative to start-up firms engaging in intensive research and development.  The initiative is not intended to apply to highly structured research and development companies or those who are not meeting their tax obligations.

The applicant must be a company that is resident in New Zealand for the whole year and not be one treated, under a double tax agreement, as a resident of a foreign country or territory.  A company incorporated part-way through the year will be eligible as long as it meets all the requirements for the part of the year that it is in existence.

A company that is owned by the Crown, or a special corporate entity as defined, or one that is publicly listed will not be eligible.  The company must have a net loss for the relevant tax year, and meet the wage intensity criteria.  It must have research and development expenditure, and intellectual property that results from the research and development must vest, at least partially, in the company.  It must also have complied with all tax law obligations.

A company that is part of a group of companies that includes a foreign company or a company that is treated, under a double tax agreement, as a resident of a foreign country will not be eligible.

Similarly, if a company is part of a group of companies, the group must meet the requirement to have a net loss (in aggregate), meet the wage intensity requirement, and have complied with all tax law obligations.  These features are important for the integrity of the initiative.

Look-through companies and qualifying companies are excluded.

Wage intensity criteria

In order to target the initiative to research and development start-ups, expenditure on labour is used as a proxy to gauge the intensity of research and development.  Evidence indicates that loss-making research and development-intensive businesses, particularly smaller and younger businesses, tend to spend a greater proportion of their wage and salary costs on research and development than other businesses.  The wage intensity criteria are set out in new section MX 3 and, to be eligible, the company must have a wage intensity calculation of 0.2 or more.

The intensity calculation is:

total research and development labour expenditure

total labour expenditure

 Total research and development labour expenditure is defined as the total of:

  • salary or wages paid to employees for carrying out research and development;
  • amounts paid to shareholder-employees as income for carrying out research and development; and
  • the costs of research and development carried out by a contractor multiplied by 0.66 (the multiplier is intended to reduce profit and non-wage cost components of the contract price).

Research and development labour expenditure does not include labour employed on activities that are excluded from eligibility.

Total labour expenditure is the total of:

  • salary or wages paid to employees;
  • amounts paid to shareholder-employees as income; and
  • the costs of research and development carried out by a contractor multiplied by 0.66 (as in the numerator).

Amount of the cash-out

(Clauses 192 and 213)

Because the cash-out is administered through the tax system, it is delivered in the form of a tax credit.  Similarly to other tax credits, the amount will be cashed out only for the relevant year.  That means that it will not be possible to cash out a loss in a year subsequent to when the loss arose.

New section MX 4 sets out the amount of tax credit for a year.  It is the smallest of:

  • $500,000 multiplied by the corporate tax rate;
  • the company’s net loss for the year multiplied by the corporate tax rate;
  • the company’s research and development expenditure for the tax year multiplied by the corporate tax rate; or
  • the company’s total research and development labour expenditure for the year, multiplied by 1.5 and also multiplied by the corporate tax rate.

It is proposed that the $500,000 cap on eligible losses will be increased to $2 million over five years (by increments of $300,000 per year).

New section MX 5 proposes to extinguish tax losses that are cashed out.

Research and development expenditure

(Clauses 213, 217 and schedule 1)

The definition of “research and development” is similar to that which applies to provisions that govern deductibility of research and development expenditure in the income tax rules.  Using the existing definition is simpler for taxpayers already familiar with it for accounting purposes.  However, to ensure that the initiative stays targeted, qualifying expenditure is limited.

Expenditure on certain activities will be excluded because they generally take place in a post-development phase, are related to routine work or there is an indeterminate relationship between the activity and economic growth.  Many of the activities are likely to take place when the company is less likely to be capital and cashflow-constrained.

Excluded activites

An activity performed outside of New Zealand.

Acquiring or disposing of land, and related activities, except if the land is used exclusively for housing research or development facilities.

Acquiring, disposing of, or transferring intangible property, core technology, intellectual property, or know-how, and related activities (for example: drafting sale and purchase agreements for patents).

Prospecting for, exploring for, or drilling for, minerals, petroleum, natural gas, or geothermal energy.

Research in social sciences, arts, or humanities.

Market research, market testing, market development, or sales promotion, including consumer surveys.

Quality control or routine testing of materials, products, devices, processes, or services.

Making cosmetic or stylistic changes to materials, products, devices, processes, or services.

Routine collection of information.

Commercial, legal, and administrative aspects of patenting, licensing, or other activities.

Activities involved in complying with statutory requirements or standards.

Management studies or efficiency surveys.

Reproduction of a commercial product or process by a physical examination of an existing system or from plans, blueprints, detailed specifications, or publicly available information.

Pre-production activities, such as a demonstration of commercial viability, tooling-up, and trial runs.

Similarly, some items of expenditure are excluded on the basis that their inclusion could create an economic distortion, inequity between taxpayers in a similar position or risk compromising the integrity of the initiative.  A notable exclusion is for expenditure that is not deductible.

Excluded expenditure

Expenditure for goods and services to the extent to which they relate to an activity that is an excluded activity (see the table above).

Expenditure on goods and services used to provide a service of research or development to an external contractee, or used to further another person’s research or development activities.

Expenditure that corresponds to a payment for which the person has made an election under section CX 47(4) (Government grants to business).

Expenditure for which no deduction is available for the income year.

Expenditure for or under a financial arrangement.

Expenditure for the acquisition or transfer of intangible property, core technology, intellectual property, or know-how.

Reinstatement of losses

(Clauses 99, 117, 192, 194, 195 and 213)

A cashed-out loss can be thought of as an interest-free loan from the Government to be repaid from the taxpayer’s future taxable income; it is intended to provide a temporary cashflow timing benefit when the company is in tax loss.

If the company or the shareholders make an untaxed return on their investment before they have repaid the value of the cashed-out loss, this will lead to an outcome that is concessionary to the taxpayer.  In addition to the untaxed receipt, they also retain the benefit of the remaining cashed-out losses that have not yet been repaid.  This also creates a fiscal risk.

If the company is able to sell intellectual property or if the company is sold, it is highly likely the research and development company will no longer be constrained to the same degree by the market failures and cashflow constraints affecting small research and development-intensive start-up companies.  In this situation, the original policy rationale will no longer apply, as the company will have funds available to pay back the value of the cashed-out loss.  New section MX 6 sets out the rules required to recover the value of any remaining cashed-out loss to ensure the correct policy outcome.

 It is proposed that the cashed out payments should be repaid (and corresponding losses reinstated) when:

  • the company makes a return on their investment by disposing of or transferring research and development assets;
  • the company migrates;
  • if the company is liquidated;
  • the company amalgamates with another company; or
  • if more than 90 percent of the company has been sold since the company first cashed-out research and development tax losses.

It is proposed that the company will have deductions corresponding to the repayments in order to reinstate the losses.  New section DV 26 and new subsection EJ 23(1)(ab) reinstate the loss and should allow the deduction to be carried forward in line with other deductions for expenditure on research and development.

In the case of the sale of research and development assets, the repayment amount (research and development repayment tax) will be capped at the market value of the consideration for the disposal or transfer multiplied by the tax rate.  However, if both the sale of research and development assets and one of the other triggers occurs in the same year, all of the cashed out amounts will need to be repaid that year.

In all five cases the repayment amount will be reduced by income tax paid by the company from the time that losses were cashed out.  The payment of income tax is a repayment of the cashed-out amount (because the company does not have the use of losses that have been extinguished to set off against that income).  No further repayments will be required if the company has already derived sufficient taxable income to repay the balance of the cashed out amounts before one of these events occurs.

Example

R&D Bio is incorporated in May 2015.  It cashes out losses of $150,000 and $300,000 for the 2015–16 and 2016–17 income years respectively.  It receives tax credits of $42,000 and $84,000.  It carries forward other losses of $50,000.  In the 2017–18 year the company enters a manufacturing phase selling trading stock to earn net income of $150,000.  It has taxable income of $100,000 and pays income tax of $28,000.  In the 2018–19 income year it sells know-how for $250,000 and also has taxable income of $80,000.  That year R&D Bio has to pay research and development repayment tax of $70,000 ($250,000 * 0.28) as well as income tax of $22,400.  In the 2019–20 income year R&D Bio has taxable income of $150,000 and pays income tax of $42,000.  Unless R&D Bio cashes out further losses, no further repayments will be required from that time.  Repayments and income tax payments made since the 2017–18 income year ($28,000+$70,000+$22,400+$42,000=$162,400) exceed the tax credits paid for the 2015–16 and 2016–17 income years ($42,000+$84,000=$126,000).

Imputation

No credit balance will arise in an imputation credit account of a company that has cashed out a loss until that company has repaid the cashed-out amounts.  This is to maintain neutrality with taxpayers who are not able to cash out losses.  The rules are set out in new section OB 47B

Example

In the example above, R&D Bio will not have a credit balance in its imputation credit account for either the 2017–18 year, nor for the 2018–19 income year.  It will have a credit balance of $36,400 for income tax paid for the 2019–20 income year (income tax of $42,000 - loss cash-out balance of $5,600).

Effect on deductions

It is proposed that a deduction mechanism is used to reinstate the losses.  Those deductions will be available to be allocated to a future income year.

 Administration

(Clauses 180, 181, 187, 230 and 238)

Companies will need to apply to cash out their tax losses.  Applications will need to be made at the same time companies file the corresponding income tax return.  The income tax return and the application will need to be in electronic form.  Electronic filing will also be required when a company pays research and development repayment tax.

Like other tax credits, cashed out amounts may be offset against tax payable by the company.

The rules governing the administration of the initiative are set out in sections LA 7, LB 4B and MA 1 of the Income Tax Act 2007, and new sections 70C and 97C of the Tax Administration Act 1994.

Consequential amendments

(Clauses 88 and 267)

Consequential amendments are being made in section DF (1BA) of the Income Tax Act 2007 and to the GST Order in Council 1992.