(Clauses 11 and 16)
Summary of proposed amendment
Changes are proposed to codify when businesses can deduct expenditure related to completing, creating or acquiring unsuccessful and abandoned assets or business models. The proposed rules also introduce a new immediate deduction for expenditure that in total is $10,000 or less in an income year that is incurred in developing assets in a business context. Together, the changes are intended to set out the circumstances when expenditure related to business innovation and asset development can be deducted for property that, if completed, created or acquired, would be depreciable property or revenue account property.
The rules complement the current tax depreciation rules in situations when property is not completed and abandoned.
The proposed amendment would apply to qualifying expenditure incurred in the 2020–21 and later income years.
Changes are proposed that affect the operation of the general deduction rules in sections DA 1 and DA 2 of the Income Tax Act 2007.
Specifically, for certain items of expenditure proposed, new sections DB 66 and DB 67 override the limitation for expenditure of a capital nature.
Proposed section DB 66 allows taxpayers to deduct expenditure incurred in completing, creating or acquiring property if:
- that property:
- would be depreciable property, including depreciable intangible property;
- would be revenue account property; and
- progress on the asset is abandoned with the outcome that the property is not completed, created or acquired; and
- no other deduction for the expenditure is allowed under any other provision in the Act.
The deduction does not apply to property that is depreciable at the rate of zero percent.
Deductions meeting the conditions above can be spread in equal proportions over a five-year period from the income year in which progress on the property is abandoned (section DB 66(2)).
Proposed section DB 67 allows an immediate deduction in the income year for expenditure incurred in completing, creating or acquiring property if the total expenditure is $10,000 or less and:
- the expenditure is related to depreciable property or revenue account property; and
- no deduction for the expenditure is allowed under any other provision in the Act.
The expenditure under both sections must be incurred in making progress towards completing, creating or acquiring the property.
The amount of the available deduction is equal to the expenditure the taxpayer incurs related to making progress towards completing, creating, or acquiring property.
For abandoned property that is later completed, new section CH 13 claws back the deductions allowed under section DB 66 by treating the amount deducted as income in the income year the property is completed, created, or acquired. The completed property is then subject to the tax depreciation rules in subpart EE, or deductible under section DB 23 of the Act.
The proposed changes to the tax treatment of feasibility expenditure are part of tax measures the Government is implementing to support its economic strategy.
The changes in the Bill:
- respond to private sector concerns following the 2016 decision by the Supreme Court in Trustpower Limited v Commissioner of Inland Revenue, which limited taxpayer expectations relating to deductibility of expenditure incurred on assets that are subsequently abandoned; and
- ensure tax is not a barrier for businesses seeking to invest in new projects or assets, except when there is an explicit denial of deductions (for example, expenditure related to assets when the taxpayer is not expected to incur an economic loss, such as land and shares).
As a general principle, the economic value of business expenditure that is expected to decline in value should be either immediately deductible or, when it provides an enduring benefit, deductible over time if that benefit declines over time. When the tax system does not provide for that treatment, an economic distortion is created.
An example of this distortion arises with expenditure by taxpayers to determine the practicality of an investment or new proposal: “feasibility expenditure”. In some cases, the Act will deny taxpayers an immediate deduction for such expenditure when it has a connection with an asset that has the potential to yield future economic benefits beyond the current income year. If the asset is not completed, it is not recognised for tax depreciation purposes and is unable to be deducted for tax purposes, resulting in what is referred to as “black hole” expenditure. This creates an incentive for businesses to complete projects that, but for the tax effect, would otherwise be abandoned.
The non-deductibility of this expenditure effectively raises the cost of risky investments in new assets (where the chance of a viable outcome is uncertain) and therefore can act as a barrier to businesses committing resources to developing new assets, business models or processes – which are important to innovation and driving productivity improvements.
The proposed amendments are intended to sit alongside the Act’s rules for tax depreciation and Inland Revenue’s interpretation statement IS 17/01 for businesses that regularly incur feasibility expenditure.
The proposed amendments do not give tax deductions for expenditure related to assets that are not expected to decline in value. While assets that are not expected to decline in value sometimes do, it would only be appropriate to provide deductions for this expenditure if the tax system taxed gains in assets that appreciated. Under current policy settings it would not be correct to allow deductions for expenditure related to property that is not depreciable (or that result in expenditure that would not otherwise be deductible if the property is completed).
The proposed amendments are not designed to alter the rules that exist for:
- tax depreciation;
- company administration costs;
- research and development;
- resource consents;
- unsuccessful software projects;
- patents; and
- plant variety rights.
The amendments also do not affect the application and effect on the general permission test relating to deductions.
The proposed amendments in this Bill are the product of discussions with stakeholders following the release of the Government discussion document Black hole and feasibility expenditure, released May 2017, and further rounds of targeted consultation in October 2017 and November 2019. The Tax Working Group also made recommendations regarding reform to the tax treatment of feasibility expenditure and other non-deductible expenditure. The Bill seeks to implement those recommendations.
Spread deduction rule for feasibility expenditure
Proposed section DB 66 is directed at expenditure incurred by taxpayers in making progress towards completing, creating or acquiring property that is subsequently abandoned. The term property is defined by reference to property that if completed would be depreciable property, including certain types of intangible property, and/or revenue account property.
A deduction is allowed for expenditure related to completing, creating or acquiring the abandoned property. Abandonment is when no further money is applied, or the taxpayer documents a decision to not proceed with the property, whichever happens first.
The expenditure must satisfy the general permission requirements, in that the taxpayer must have an existing income-earning process and to which the expenditure must have sufficient nexus. The capital limitation, however, is overridden.
The amount of the available deduction is equal to the expenditure the taxpayer has incurred in relation to the abandoned property, and is not otherwise deductible under any other provisions of the Act. The proposed amendment is designed to allow a broad concept of what expenditure can be deducted, including direct and indirect expenses. General overhead expenses that have an indirect relationship, or expenses that are later determined to have been connected with the abandoned property are expected to be within scope.
The deduction for the expenditure is spread in equal proportions (one-fifth) over a five-year period, starting from the year of abandonment.
Example 1: When the new sections apply – wind studies
Company A, an electricity generator, is exploring the practicality of establishing a new wind farm. It incurs expenditure over a five-year period associated with measuring wind frequency and speeds (anemology) relevant to the local geography. Anemology expenditure connected with the project is booked against a work in progress account (an asset on Company A’s balance sheet for financial accounting purposes). At the end of year two, the studies regarding the site are inconclusive as to reliability of wind supply and the project is mothballed.
Under current law, the anemology expenditure incurred in developing an asset does not give rise to an immediate deduction under the Act. As the asset is not completed, there is no tax asset to depreciate.
Under new section DB 66, the collective anemology expenditure would, had the project gone ahead, have formed part of a depreciable asset (wind turbine generators). The expenditure will be deductible in equal parts over five years.
Example 2: When the new sections apply – nanotechnology study
Company B, a water management company, is working on ways to meet demand in times of low-aquifer inflows and drought, to prevent water restrictions. It is exploring the viability of desalination. The company carries out a number of studies on the practicality of building and operating a desalination plant, and researches how water from the plant could be connected to the wider network. Work on the project is abandoned after an assessment determines it is uneconomic, in terms of energy needs and water output, for the plant to meet forecast demand. The project is shelved pending future advances in desalination nanotechnology.
Under current law, the expenditure incurred in studying the practicality of desalination would be included as part of an asset and does not give rise to an immediate deduction under the Act. As the asset is not completed, there is no tax asset to depreciate.
Under new section DB 66, the collective desalination study expenditure would, had the project gone ahead, have formed part of a depreciable asset (water treatment plant and reservoir). The expenditure will be deductible in equal parts over five years.
Example 3: When the new rules will not apply – design property rights
Company C, an aeronautics company, has plans to redesign the cockpit and airframe canopy for a model of small single propeller aircraft. The redesign is intended to improve flight performance and pilot visibility for such purposes as aerial crop dusting.
The company incurs expenditure in costing the project and scoping initial airframe designs. The multi-year project is shelved in year two when a competing overseas company brings a comparable (and cheaper) improved aircraft to the market.
Under current law, the design expenditure is incurred in developing depreciable intangible property. The designs are subject to tax depreciation and therefore cannot be deducted under new section DB 66.
Example 4: When the new rules will not apply – acquisition of shares
Company D is seeking to diversify the range of products it provides to commercial clients. It is considering options to either directly acquire the products or acquire the shares in another firm that is offering comparable products. Company D decides to acquire the shares in the firm as it is keen to retain the firm’s existing staff, management and the client list the firm has built up.
Expenditure connected with Company D acquiring the firm are not deductible under new section DB 66 as they relate to the acquisition of shares (which are not depreciable property). If Company D had decided to acquire the products directly but abandoned the idea after working though the implications of distribution and product support, the expenditure attributable to that work would be deductible under DB 66 as the expenditure has a relationship with the acquisition of revenue account property.
Example 5: When the deduction starts
The finance team at Company E is considering the expenditure debited in its work in progress account after balance date for the year 20X1. They decide that a study directed at improving the energy efficiency of the company’s plant won’t proceed due to cash flow constraints. The abandoned work related to a potential refit of the company’s premises for lighting and heating. No further amounts had been spent on the project after balance date and the decision is made in 20X2 that the project has been abandoned for financial reporting purposes.
The expenditure would be deductible under new section DB 66 given its relationship with depreciable property. A deduction of one-fifth of the expenditure can be made in the 20X1 tax return.
Immediate deduction for feasibility expenditure
Proposed section DB 67 works in a similar way to DB 66, with modifications to reflect that DB 67 is a compliance cost saving measure. That is, feasibility expenditure can be immediately deducted by the taxpayer if the total expenditure incurred is $10,000 or less in an income year. There is no requirement that the property be abandoned.
However, like the requirements of section DB 66, the expenditure must satisfy the general permission provisions and not be deductible elsewhere under the Act. Section DB 67 is not a replacement for tax depreciation for low-value assets.
Example 6: When the deduction can be claimed immediately – revenue account property
Retailer F specialises in selling cake decoration supplies, cupcakes and other baked goods, and is considering adding takeaway coffee and other hot drinks. It incurs expenditure in doing a cost-benefit analysis and a survey of foot traffic and customer opinion. During the study a coffee shop opens two doors down and the project finishes. About $1,700 was committed to the analysis.
Under Inland Revenue’s Interpretation statement 17/01, the retailer would not be able to deduct the expenditure as it is not recurrent. Under new section DB 67, as the expenditure is connected with selling revenue account property (trading stock) and a coffee machine (depreciable) and other consumables, it would be deductible. As the expenditure is under $10,000 it would be immediately deductible.
Example 7: When the deduction cannot be immediately claimed – depreciable property
Retailer G incurs expenditure in acquiring a secondhand vehicle to assist with deliveries. The vehicle and associated expenditure totals $8,000.
The cost of the vehicle is not immediately deductible under section DB 67 as the cost of the vehicle is subject to the tax depreciation rules.
Clawback of abandoned expenditure deductions
As an integrity measure, amounts deducted for abandoned property that is later completed, created or acquired are treated as income in the year in which that happens. Under proposed section CH 13, the income equals the direct costs for that property. The requirement to return as income amounts previously deducted does not apply to expenditure that has been immediately deducted under the $10,000 de minimis rule.
This deduction clawback rule is directed at situations where taxpayers may be incentivised to prematurely abandon work on property. For example, property may be partially abandoned to take advantage of the five-year deduction if this would accelerate the deductions that would have been allowed had the property been completed and depreciated.
Example 8: Previous deduction clawed back – example 2 continued
A decade after Company B’s decision not to proceed with a desalination plant, population growth in the region and the need for greater water infrastructure has led Company B to restart its earlier work on nanotechnology. Development of the plant and reservoir begins and seven years later it is operational and connected to the wider water supply network. In the year in which the depreciable property is operational, the deduction claimed 17 years earlier is returned as income, with the expenditure included in the cost of the depreciable property.
Example 9: Previous deduction not clawed back – example 5 continued
Company E’s financial situation improves, and it refits the lighting and heating in its premises three years after the initial study using an alternative model. The earlier deduction taken for the previous study is not clawed back as those expenses do not have a direct connection with the final fitout as it did not use any of the earlier work to complete the fitout.
 Interpretation statement IS17/01: Deductibility of feasibility expenditure. Tax Information Bulletin Vol 29, No 3 (April 2017) available at https://www.taxtechnical.ird.govt.nz/tib/volume-29---2017/download-tib-vol29-no3
 Future of Tax: Final Report Volume I – Recommendations, Thursday, 21 February 2019 https://taxworkinggroup.govt.nz/resources/future-tax-final-report-vol-i-html#section-3, recommendation 33 refers.