R&D tax credits – new developments
Tax Alert - July 2019
By Aaron Thorn, Simon Taylor and Brendan Ng
The Government has announced changes to the Research & Development (“R&D”) tax credit regime, which has applyed to standard balance date taxpayers from 1 April 2019. The main change has been to allow for refundability of the tax credit from the 2020-21 income year (the second year of the regime).
This change comes as the Government recognises that the tax credit is of little use to most businesses in a tax loss position (such as many in the start-up phase), as these businesses cannot receive an immediate benefit from the regime through the reduction of their tax bill (by offsetting the tax credit against their tax liability). The change will allow taxpayers to essentially cash out the tax credit earned in a year, subject to a payroll based cap.
As a quick recap, the R&D tax credit regime provides a 15% tax credit for eligible expenditure incurred on eligible R&D activities undertaken in the 2019/20 and later tax years. The key thing taxpayers need to understand is what R&D which may qualify for the regime. R&D activities are either core or supporting R&D activities. A “core R&D activity” is one that:
- Is conducted using a systematic approach; and
- Has a material purpose of creating new knowledge, or new or improved processes, services, or goods; and
- Has a material purpose of resolving scientific or technological uncertainty; but
- Does not include an activity if knowledge required to resolve the uncertainty is publicly available and/or deducible by a competent professional in the relevant scientific or technological field.
- Note also that activities undertaken outside New Zealand will not be eligible as a core R&D activity (although there is a limited ability to include them as a supporting activity).
A “supporting R&D activity” means an activity that has the only or main purpose of, is required for, and integral to, conducting a person’s core R&D activity.
Both core and supporting activities have certain legislative exclusions. Exclusions are listed in Schedule 21 of the Income Tax Act 2007.
Inland Revenue has now released final guidance on the application of the R&D tax credit regime (available here). The guidance (which is 122 pages long), does a good job of explaining how the regime works and includes some examples of what is in and out of the regime.
Proposed changes to the regime
The main change that the Government has announced, in a new tax bill that (the Taxation (KiwiSaver, Student Loans, and Remedial Matters) Bill (the Bill)), is to extend the refundability of the R&D tax credit from the 2020-21 income year. This recognises that the tax credit is not immediately useful to many businesses that are in a tax loss position (although it can be carried forward). This is an issue because for many businesses undertaking R&D activity, particularly those in the start-up phase, the availability of cash flows can make or break the business.
There is currently limited refundability available under the regime, with entities able to get an R&D tax credit refund of up to $255,000 (which equals $1.7m of eligible expenditure) if certain requirements are met, including the R&D tax loss cash-out corporate eligibility and wage intensity criteria. However, these requirements can be difficult to meet for most organisations and so the extension of refundability will allow more taxpayers to access refunds of the tax credit.
While the extension of refundability is a good step forward for the regime, the refundability of the tax credit will be limited to the extent of payroll taxes paid in that year. This includes PAYE, Employer Superannuation Contribution Tax (“ESCT”) and Fringe Benefit Tax (“FBT”) of the entity or of other members in the wholly owned group, as well as of companies that directly or indirectly control the entity. This will include any taxes withheld from contractors. For example, if an entity has paid $1,000,000 of PAYE and contractor withholding taxes and $100,000 of FBT in a year, the maximum tax credit that can be refunded in the year will be limited to $1,100,000 (assuming that the entity has earned and/or carried forward sufficient tax credits in the year).
While for many businesses this cap should not pose too much of a problem, many smaller businesses will have limited PAYE payments (as they may only have a handful of employees). They may instead be using contractors who they may not be withholding any tax from, instead allowing the contractor to deal with their own tax obligations, limiting the amount of tax credit able to be refunded.
Exempt income recipients
Another change that has been introduced in the Bill is to exclude any entities that earn exempt income from the R&D tax credit regime, unless that exempt income relates to dividends derived from foreign companies or from within a New Zealand wholly-owned group. The policy reasoning behind this is essentially to exclude charities and other similar tax exempt organisations from being eligible for the tax credit, as these entities already receive the benefit of a tax exemption. Rather alarmingly, any taxpayer earning any exempt income (other than the dividend exemptions mentioned above) may find themselves unwittingly excluded from the regime. We have a concern that the approach adopted here may have unintended consequences.
Some other minor changes have also been made to ensure that the R&D tax credit legislation aligns with the policy intent, particularly in relation to joint ventures, the timeframe for businesses to dispute R&D tax credit claims, the R&D certifier regime, the definition of internal software development and taxpayers’ ability to challenge decisions of the Commissioner.
What else can we expect from the R&D tax credit regime?
Although the R&D tax credit regime has only been in place for a short period of time, Inland Revenue and the Government are looking ahead and planning the implementation of other enhancements to the regime. One such enhancement is the introduction of an in-year approval process in Year 2 of the regime, requiring taxpayers to get pre-approval from Inland Revenue that an activity is an eligible R&D activity. This process is intended to provide taxpayers with greater certainty over the eligibility of their activities, as well as provide Inland Revenue with comfort that the R&D tax credit regime is being used appropriately.
For larger taxpayers, a ‘significant performer’ regime will be implemented so that taxpayers can get approval of their criteria and methodologies used to determine the eligibility of their R&D activities and expenditure. These ‘significant performers’ will also be required to either obtain the general pre-approval, or have an R&D certifier review their R&D return.
Improvements to the existing R&D tax loss cash out scheme are also being considered, as well as the use of Project Grants (administered by Callaghan Innovation). These two initiatives, along with the R&D tax credit, are intended to work together as a broad package to drive innovation in New Zealand. These last two proposals will be consulted on in due course.
Tips and tricks – what to watch out for
As with most aspects of the tax system, there are some complexities within the regime which taxpayers will need to navigate. As we have been working through the application of the R&D tax credit regime, we have come across a few things that may trip up R&D claimants.
To the extent that expenditure “contributes to the cost of depreciable tangible property” it will be ineligible for the R&D tax credit regime, unless the property is used solely in performing an R&D activity. This means that if the R&D expenditure is directed towards creating a new physical asset (for example, creating a brand new machine to manufacture a new product), if that expenditure is treated as capital expenditure for tax purposes then it will not be eligible for the tax credit.
This is emerging as an issue for many taxpayers, as taxpayers are capitalising costs at a much earlier point than used to be the case, making many genuine R&D costs ineligible for the regime. This issue has arisen partly because of an interpretation statement on the deductibility of feasibility expenditure released by Inland Revenue, following a Supreme Court case on the issue (for more information on this see here). Inland Revenue have been considering this matter, however no decision has yet been reached on a solution.
What the rule does mean though is that expenditure will be eligible where it does not form part of the cost of a tangible asset for tax purposes, or expenditure that is intended to form part of the cost of an asset but the asset subsequently never actually comes into existence. The main issue to be aware of here is when costs have been capitalised in one year, but in a subsequent year the development fails, because the R&D tax credit regime requires the credit to be claimed in the year the expenditure was incurred. Depending on when a taxpayer’s income tax return is due, a taxpayer may need to file a section 113 request or a notice of proposed adjustment to get to the correct position.
From the time the R&D tax credit regime was first mooted by the Government there has been concern that the regime would not allow software to qualify for the tax credit. At a high level this is because it is perceived as being difficult for software to satisfy the “scientific or technological uncertainty” test, based on the inherent nature of software development.
However, that’s not to say that software cannot qualify for the R&D tax credit and there are many examples of genuine R&D in the software space. Inland Revenue’s guidance devotes a number of pages to explaining how the rules apply to software development, including examples of software activities which may be eligible.
Inland Revenue’s guidance also outlines its documentation requirements for being able to claim the R&D tax credit, the most noteworthy of which is the requirement for documentation to be maintained contemporaneously. While this does not necessarily mean that documentation must be kept up to date on a day to day basis, there are some relatively stringent requirements for taxpayers to consider, with an expectation that it cannot be prepared after the event.
Your documentation will need to record both your entity’s eligibility into the regime, as well as the eligibility of your core and supporting R&D activities, and capture eligible costs. Inland Revenue’s guidance provides some detailed comments on what is required.
I’m a tax or a finance person, how do I find out if my business qualifies for the regime?
We recommend first talking to your business and those responsible for R&D-like activities, to gauge whether there is eligible R&D activity occurring within your organisation (i.e. whether there is scientific or technological uncertainty being resolved). As your business may not be used to thinking in this way, it often requires a slightly deeper drilling down into the activities being undertaken to draw out this scientific or technological risk. Deloitte is happy to assist with this stage and our R&D experts have experience with a wide range of new developments.
If you do have an eligible R&D activity, then you will also need to check your documentation processes to see whether adequate information is currently in place to enable your business to identify eligible projects and expenditure.
If the above sounds like it might apply to you, please contact one of us, or your usual Deloitte advisor.