Government To Clarify R&D Tax Treatment
"All research expenditure and most development expenditure will be available for an immediate tax deduction under changes now being considered by the Government," Finance and Revenue Minister Michael Cullen announced today.
Dr Cullen told the Business - Government Forum in Auckland that the Government was preparing a discussion paper on the issue to put out to the public for wider consultation.
"I said after the 2000 Budget that my door was open to anyone who could come up with a mechanism to create a more supportive R&D regime without significant risk to the revenue.
"Since then I have been canvassing the matter with private sector tax practitioners and accountants. One of the issues accountancy firms in particular raised was that, while in most cases R&D was being deducted, there were concerns that the boundary between deductible and non-deductible was unclear and that the Inland Revenue Department was adopting an aggressive pro-revenue approach.
"The initiative the Government is announcing today arose directly out of those discussions. Essentially the proposal is that the tax laws be brought into conformity with Generally Accepted Accounting Practice in terms of what qualifies as R&D expenditure," Dr Cullen said.
"Currently the 'Eureka point' at which an idea is judged to have become an asset and to no longer automatically qualify for immediate R&D deductibility as a business expense is a grey area in tax law.
"The definition for accountancy purposes is much clearer, and tends to occur further on in the product development process. The effect, therefore, of bringing the two codes into alignment will be to introduce more certainty into the system and, in most cases, to support a more generous tax treatment.
"No-one will be disadvantaged. Those wishing to continue with the status quo will have that option. There should, however, be compliance cost savings for many taxpayers in applying the same regime across both their accounting and their tax treatments.
"This latest move will complement the $12 million R&D grants programme in the budget. Response to this has been strong, and has enabled the Government to give private sector R&D an early and much-needed boost," Dr Cullen said.
RESEARCH AND DEVELOPMENT PROPOSAL
The aim of the proposal is to reduce uncertainty in the tax treatment of research and development (R&D) expenditure by clarifying when R&D expenditure is immediately deductible.
Summary of Proposal
Broadly, the proposal permits taxpayers immediately to deduct for tax purposes R&D costs that are treated as an immediate expense for accounting.
In essence, all R&D would be immediately deductible for tax unless the expenditure gives rise to an identifiable and valuable asset under paragraph 5 of the accounting standard for R&D.
Details of Proposal
These will be discussed in a discussion paper which will be released for public consultation.
R&D expenditure that is treated as an immediate expense under paragraph 5 of FRS-13 in the year it is incurred will be immediately deductible for tax purposes provided the link with the income earning process is satisfied.
This means that all expenditure on research will be immediately deductible for tax purposes. Expenditure on development will be immediately deductible unless and until all of the following criteria contained in paragraph 5 are satisfied –
(a) the product or process is clearly defined and the costs attributable to the product or process can be identified separately and measured reliably;
(b) the technical feasibility of the product or process can be demonstrated;
(c) the entity intends to produce and market, or use, the product or process;
(d) the existence of a market for the product or process or its usefulness to the entity, if it is to be used internally, can be demonstrated;
(e) adequate resources exist, or their availability can be demonstrated, to complete the project and market or use the product or process.
Only development costs incurred after all the criteria are satisfied will not be automatically immediately deductible for tax. (They may be deductible under existing provisions.)
Taxpayers will need to comply with paragraph 5 of FRS-13 in relation to R&D costs (including costs that are immaterial for accounting) in order to obtain the benefit of the proposal. Existing provisions will continue to apply to taxpayers who are not required to comply with paragraph 5 and who choose not to. This means that no one will be disadvantaged by the proposal relative to current treatment.
Normal tax treatment would apply to costs that are not immediately expensed under FRS-13.
QUESTIONS AND ANSWERS
What R&D expenditure do accounting standards allow to be expensed immediately?
This is covered by paragraph 5 of Financial Reporting Standard 13 (the accounting standard for R&D). Paragraph 5 requires research expenditure to be expensed immediately for accounting. It requires development expenditure to be expensed immediately for accounting unless and until all the following criteria are satisfied:
(f) the product or process is clearly defined and the costs attributable to the product or process can be identified separately and measured reliably;
(g) the technical feasibility of the product or process can be demonstrated;
(h) the entity intends to produce and market, or use, the product or process;
(i) the existence of a market for the product or process or its usefulness to the entity, if it is to be used internally, can be demonstrated;
(j) adequate resources exist, or their availability can be demonstrated, to complete the project and market or use the product or process.
Development costs incurred after all the criteria are satisfied are not expensed immediately for accounting, rather they are capitalised and amortised over the economic life of the asset.
What is the change from current law?
In many cases, it is currently not clear whether a particular item of R&D expenditure will be immediately deductible. This will depend upon the application of case law principles that determine whether the expenditure is capital or revenue. Broadly, expenditure is capital if it gives rise to an enduring benefit to the taxpayer. Otherwise, it is on revenue account. There is little New Zealand case law on whether R&D expenditure is on capital or revenue account that helps taxpayers in making this distinction.
There is therefore some uncertainty about how much R&D expenditure is immediately deductible. This proposal reduces this uncertainty by permitting R&D that is expensed when it is incurred under paragraph 5 of FRS-13, to be deducted immediately for tax. In essence, the proposal allows taxpayers to use the accounting standard, instead of case law on the capital/revenue boundary, to determine when R&D expenditure is immediately deductible.
This means that research expenditure will be immediately deductible for tax purposes. Development expenditure will also be immediately deductible unless all of the paragraph 5 criteria are met.
Can anyone be disadvantaged?
The proposal will not disadvantage any taxpayers, relative to existing tax treatment. It will operate as a “safe harbour”.
If taxpayers comply with paragraph 5 of FRS-13 in relation to their R&D expenditure (including expenditure that is not material for accounting purposes) they will obtain the benefit of this proposal. If they are not required to comply with that paragraph, and they do not want to incur compliance costs in complying with it, the existing tax treatment will continue to apply to them.
If taxpayers capitalise and amortise R&D expenditure for accounting because the criteria in paragraph 5 are satisfied, they may nevertheless argue that such expenditure is on revenue account for tax purposes.
Accounting standards are uncertain so what is the benefit?
The criteria in paragraph 5 are flexible. For example, it is a matter of judgement when technical feasibility is demonstrated. Taxpayers will be in the best position to make those judgements. Such judgements are likely to be challenged by Inland Revenue only when they are clearly not sustainable. The proposal will therefore in practice provide greater certainty to taxpayers than they currently have.
Won’t this increase compliance costs?
No. Many companies already have a legal requirement to apply FRS-13 when reporting to shareholders. They will use the same rules when reporting income to Inland Revenue. Taxpayers who do not currently have to comply with paragraph 5 of FRS 13 will have the choice of applying existing law, or complying with paragraph 5 and obtaining increased certainty.
How does this affect software?
The Commissioner of Inland Revenue set out his views on the tax treatment of software development costs in 1993 (Tax Information Bulletin Vol. 4 No. 10). That item includes a discussion on the deductibility of the costs of developing software for in-house use. Broadly, pre-development costs are immediately deductible, and development expenses are capitalised until the project is completed and then depreciated over three years.
Under this proposal, if software development costs fall within the definitions of research and development under FRS-13, and are expensed immediately under paragraph 5, they will be immediately deductible for tax.
What is the estimated fiscal cost?
The fiscal cost of the proposal is difficult to estimate. The Government understands that almost all R&D is immediately deducted for tax purposes. If this is the case, it is likely that the measure will not have a significant fiscal cost.
The exception is likely to be in relation to software development costs that are capitalised and amortised over three years. It is not clear how much software development that is currently depreciated would become immediately deductible. Treasury has provided its best estimate of the cost by making assumptions about the amount that would become immediately deductible. It estimates a one-off revenue cost of $12.4 million over two years (not taking future growth in software development expenditure into account).
Is this a tax concession?
No. However, in legislating for a capital/revenue boundary in this area the Government is proposing a rule that is likely to be more generous than existing tax law.
Is this going to be reconsidered by the McLeod Tax Review?
The McLeod Review will report on the structure of the tax system including whether taxes should be used to encourage worthwhile activities such as R&D. Following that report, the Government will consider specific tax issues. That may include further changes to the tax treatment for R&D.
Why is the Government proposing this change?
By clarifying the distinction between expenditure that is immediately deductible from what is not and by aligning tax and accounting treatment in this area, there should be more certainty for taxpayers and fewer disputes between taxpayers and Inland Revenue. That should allow businesses to focus more on their business and less on their tax affairs. Discussions with tax practitioners identified uncertainty and risk of tax disputes as a significant problem in the R&D area. The proposal addresses that concern.
When will the proposal be in legislation?
The Government will issue a Discussion Paper on the proposal. In accordance with the normal tax policy process, it will consult on that. The result of those consultations could result in legislation next year.
Will the R&D grants scheme announced in the Budget continue?
Yes. This proposal aims to reduce tax problems encountered with R&D but is not a tax concession. The grants scheme is specific targetted Government assistance to increase the level of R&D in New Zealand.
What proportion of R&D will be immediately deductible?
That is not clear. All research expenditure will be immediately deductible. Discussions with private sector accountants suggest that most development expenditure will be immediately deductible.