"Cash out" of R&D tax losses

By Darren Johnson

The proposals regarding the cashing out of research and development (R&D) tax losses, have finally materialised in the just introduced Taxation (Annual Rates for 2015-16, Research and Development, and Remedial Matters) Bill. A subject of two budgets and an officials’ issues paper, the Government is proposing to allow loss-making R&D companies to “cash out” their tax losses from R&D expenditure. We welcome the finer legislative details on how the rules will operate.

The proposals focus on start-up companies engaging in intensive R&D. The intention is to reduce exposure to market failures and tax distortions arising from the current tax treatment of losses. R&D start-ups face high up-front costs with its profit cycle heavily skewed towards early losses. Currently, companies are required to carry forward losses until they make a profit which is an important integrity measure in the tax system to mitigate the creation of artificial losses. However this creates a cash flow problem for R&D companies which is further compounded by the length of period they are in a loss position, broader capital constraints and difficulties in securing financing or investment.

Under the proposals, R&D start-up companies will be able to claim up to 28% of their tax losses from R&D expenditure in any given year.

Eligibility

• An 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;
• The company must have R&D expenditure relating to research and development activities; and
• It must also have a net loss for the relevant tax year and meet the wage intensity criteria.

The wage intensity criteria help target the proposals to R&D start-ups. Evidence shows loss-making R&D intensive businesses tend to spend a greater portion of their wage and salary costs on R&D. To be eligible, the company must spend 20% of their total labour expenditure on R&D labour.

Amount of the “cash out”
The amount of the cash out is to be delivered in the form of a tax credit administered through the tax system, cashed out for the relevant year. The amount is to be the lesser of:

• $500,000 of eligible losses multiplied by the corporate tax rate;
• The company’s net loss for the year multiplied by the corporate tax rate;
• The company’s R&D expenditure for the tax year multiplied by the corporate tax rate; or
•  The company’s total R&D labour expenditure for the year, multiplied by 1.5 and also multiplied by the corporate tax rate.

The bill proposes the $500,000 cap on eligible losses to be increased to $2 million over a period of five years in increments of $300,000 per annum.

R&D expenditure
R&D expenditure is defined using the current definition used in the existing R&D provisions with reference to NZ IAS 38. The proposals however limit the qualifying expenditure to ensure that it is targeted as intended. Activities that are excluded expenditure generally take place in a post-development phase, related to routine work or where there is an indeterminate relationship between the activity and economic growth. These activities are likely to take place when the company is less likely to be capital and cash flow-constrained, one of the main policy reasons behind the new proposals.

The issues paper had proposed excluding clinical trials and software coding which would have locked out a large proportion of software companies during the most important phase of their R & D investment. It is pleasing to note that Officials have listened to submitters on this point and so such activities have not been excluded. However the caveat is that expenditure on such matters must still fall within the general principles of not being post development, routine work and so on. This is positive news for New Zealand's start-up technology companies, many of whom are software based. The key will be seeing the approach to the caveat in practice.

Reinstatement of losses
As the proposals are intended to provide a temporary cash flow timing benefit when the company is in a tax loss position, it is proposed that the cashed-out payments should be repaid and corresponding losses reinstated (via a deduction mechanism) when:

• The company makes a return on their investment by disposing of or transferring R&D assets;
• The company migrates;
• If the company is liquidated;
• The company amalgamates with another company; or
• If more than 90% of the company has been sold since the company first cashed-out R&D tax losses.
  

The repayment amount will be reduced by the income tax paid by the company from the time the losses were cashed out. No further repayments will be required if the company derives sufficient taxable income to repay the balance of the cashed-out loans before one of the above occurs.

Please contact your usual Deloitte advisor if you would like more information.

March 2015 Tax Alert contents

New Tax Bill introduced

GST and Bodies Corporate

"Cash out" of R&D tax losses

Amending return errors: Taxpayer friendly High Court ruling

Consultation sought on related party debt remission

Tax treatment of life insurance policies

Draft re-issue of rulings for interest deductibility