R&D tax credits – where are we now?
Tax Alert - April 2019
By Greg Pratt, Aaron Thorn and Robyn Walker
As we have clocked over into April and the 2019/20 tax year, most taxpayers are now potentially eligible to apply the new, but as yet not enacted, Research and Development (“R&D”) tax credit regime. In this article we explain some of the key aspects of the rules, some significant proposed improvements made to the regime following the submission process, and things taxpayers should be considering as they undertake R&D.
Status of legislation
The Taxation (Research and Development Tax Credits) Bill (“the Bill”) has been considered by the Finance and Expenditure Committee and improvements have been made. The Bill will now be heading back to Parliament to complete its remaining legislative steps. We expect, subject to the priorities within Parliament, that the Bill will be enacted by mid-May 2019.
Draft guidelines to help taxpayers understand and apply the legislation were released for consultation in February and we expect these to be updated and released once the legislation is enacted. These guidelines will be a living document and will continue to be updated as issues or gaps in the guidance are identified. It is also expected that over time the guidelines will be expanded to include specific guidance on a sector-by-sector basis. The draft guidelines currently cover the software development, primary production, food and beverage and manufacturing sectors.
R&D tax credit – Facts
- Applies from the 2019/20 income year
- 15% tax credit, with imputation credits also received
- Non-refundable tax credit in most cases in year 1 (further work is being done in this space)
- Minimum spend required is $50,000; maximum level of claim is $120million of expenditure (with the ability to have this increased on application)
- Focus is primarily on R&D conducted in New Zealand (but some supporting activities can be undertaken outside New Zealand)
- Costs which are eligible for the credit include employee costs, depreciation on assets used in R&D, cost of goods and services used as part of the R&D
- Specific activities and costs are excluded from eligibility
- Internal software development has specific rules and an eligible expenditure cap of $25million
The R&D tax credit regime will provide a 15% tax credit for eligible expenditure incurred on eligible R&D activities undertaken in the 2019/20 and later tax years. This means that if you have a March balance date, the regime will apply to expenditure incurred from 1 April 2019; a December balance date can apply the rules from 1 January 2019 and a June balance date can apply the rules from 1 July 2019 for example.
What is (or is not) R&D?
The key thing taxpayers need to understand is what is R&D which may qualify for the regime. This is something which needs to be carefully considered based on the definitions contained within the Bill. The concept of R&D can also often run counter to the approach taken in business documentation, where personnel may understate the risks or uncertainties of particular activities in order to get a project approved.
R&D activities are made up of core and 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.
- Activities undertaken outside New Zealand will not be eligible as a core R&D 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. Some supporting R&D activity may be undertaken outside of New Zealand.
Both core and supporting activities will have certain activities which will be legislatively excluded from qualifying. For more information about what is excluded from the regime, reference should be made to proposed Schedule 21 of the Income Tax Act 2007.
What is or is not an eligible R&D activity will really come down to the facts of each particular case, but some examples of the types of activities which may qualify include:
- The creation of new or more efficient algorithms based on new techniques or approaches
- Machine learning and robotics development
- New approaches or concepts aimed at addressing software security related issues
- Development of new devices and related software
- Plant variety development through genetic evaluation and experimentation
- Advanced animal breeding technique development
- The development of new or enhanced primary products
- Developing packaging techniques or products that improve the shelf-life or stability of products
- Manufacturing process development (e.g. scale up, process improvement, overcoming technical challenges and improving manufacturing efficiency)
- The design, development and trialling of medical devices
- The development of complex health based IT products and apps (e.g. the development of unique algorithms for analysing and displaying complex health related data)
- New product and process development from lab and bench scale development, through to larger scale trials
- Process improvement projects driven by the need to reduce costs, increase throughput or improve product quality
- Introduction of new, or significantly modified manufacturing processes to overcome major problems encountered with an ‘established’ process
- Development of new automated processes to improve quality consistency and competitiveness
- Investigations into the suitability of alternative raw materials and components for existing production processes
- Development of new equipment or process designs to meet emerging safety or environmental requirements
Major changes resulting from submissions
Following the consideration of the Bill by the Finance and Expenditure Committee, many aspects of the original Bill remain unchanged, however there have been some improvements, most notably:
- There are now part-year continuity rules, meaning that some R&D tax credits can still be used or carried forward in the event of a shareholding change.
- It is made clear that joint ventures will be able to be eligible for the regime. Under the regime, the eligibility will be tested at the joint venture level (including whether the $50,000 minimum spend is satisfied), with R&D credits disseminated to joint venturers in proportion to their interest in the joint venture.
- The original Bill included a requirement that the party claiming the R&D tax credits needed to hold sole controlling rights to the R&D. This requirement has been removed.
- There has been an improvement to the rules which will allow certain companies to obtain a refund of R&D tax credits if they are in a loss position. The ability to obtain refunds remains very restricted, however this will be improved over time as these rules are subject to further policy consideration.
- The original Bill contained rules which removed 20% of the cost of eligible outsourced R&D from being eligible expenditure, as this was considered a proxy for the profit margin of the party performing the R&D services. This requirement has been removed.
- The cap on internal software development expenditure has been significantly increased from $3million to $25million.
- Additional employment costs beyond salary and wages will be eligible, for example employee share scheme benefits, bonuses, fringe benefits, recruitment and relocation costs.
- Existing Callaghan Innovation Growth Grant recipients with late balance dates will be able to claim R&D tax credits for the remainder of the 2021 income year after the expiry of final Growth Grants on 31 March 2021.
Points 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, aside from being able to apply the definitions of what is R&D and what is (or is not) an eligible activity or type of expenditure. We set out below some details of some of the trickier aspects of the regime.
Specifically listed as ineligible expenditure is “expenditure or loss to the extent to which it contributes to the cost of depreciable tangible property, if the depreciable tangible property is not used soley in performing a research and development activity”. What this means is that if 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. The stated rationale for this treatment is that if expenditure has been capitalised this can indicate that any scientific or technological uncertainty has been resolved.
While a similar approach is adopted in Australia, a key difference between the two countries is the approach taken to capitalising expenditure for tax purposes. In New Zealand we treat expenditure as being “capital” in nature much earlier than may be the case in Australia – refer to our March 2017 Tax Alert for a summary of the New Zealand treatment of feasibility expenditure.
This rule may turn out to be problematic for some taxpayers and will put some pressure on the boundary between capital and revenue expenditure.
To the extent R&D is directed towards intangible property (e.g. software) or assets which are being created solely for R&D purposes (e.g. a prototype) any capitalised costs may still be eligible for the R&D tax credit.
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.
The draft guidelines prepared by Inland Revenue devote a number of pages to explaining how the rules apply to software development, including examples of software activities which may be eligible. Once finalised, these guidelines will be a useful resource for taxpayers.
From a software perspective, it is also important to be aware that there are separate rules for software which is developed for sale and software which will be used for internal purposes. Internal software development is subject to an overall cap on eligible expenditure of $25million and has specific activities directed towards the internal administration of the taxpayer being ineligible for the tax credit.
R&D collaborations / outsourced R&D
The R&D tax credit regime contemplates that businesses can work together with others when undertaking R&D, this includes outsourcing R&D to another party. The regime has specific rules which are designed to ensure that multiple taxpayers can’t claim an R&D tax credit for the same item of R&D (obviously partners in partnerships and joint venturers can each claim their respective shares of R&D).
If your business works with others, it will be important to consider your contractual arrangements to make sure it is clear which party will be eligible for the tax credit, and also to ensure that rights and obligations are not split between parties in a way which results in nobody being eligible for an R&D tax credit.
Anyone wanting to claim R&D tax credits will need to keep records to demonstrate that the activities they undertook met the definition of an R&D activity. The type of records that must be kept include records which show:
- Basic eligibility criteria are met (i.e. that there was R&D and the taxpayer is carrying on business in New Zealand)
- The purpose of the R&D;
- The scientific or technological uncertainty the R&D intends to resolve;
- Why the scientific or technological uncertainty could not be resolved by information that is publicly available or deducible by a competent professional;
- The systematic approach that was undertaken to try to resolve the uncertainty; and
- The nature of any supporting activities, and evidence to show they were integral to the core R&D activity.
Records should be kept contemporaneously, rather than being documentation created after the fact for tax purposes.
Year one of the regime will operate slightly differently to future years. From year two onwards there will be rules which will require taxpayers to either get “in-year approval” from Inland Revenue that an activity is an eligible R&D activity, or will require “significant performers” of R&D to obtain external certification of R&D activities.
Now is the time to get prepared for the R&D tax credit regime. Get talking within your business to start to determine whether some of your activities may be eligible for a tax credit. Check existing documentation processes to see whether adequate information is currently in place to enable your business to identify eligible projects and expenditure. Documentation will be very important, as will the ability to separate eligible and non-eligible expenditure.
If you need any help in understanding the new rules and getting ready for them, contact one of us or your usual Deloitte advisor.