Proposed Research and Development Tax Credits

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The Labour-led Government recently released the Research and Development Tax Incentive Discussion Document – “Fuelling Innovation to Transform our Economy”.

The discussion document proposes a 12.5 percent research and development (R&D) tax credit on eligible expenditure for all businesses carrying out R&D activity in New Zealand from April 1, 2019.

The Government believes R&D is key in their vision of building a better New Zealand through creating a diverse, sustainable and productive economy. R&D expenditure by businesses in New Zealand is currently 0.64 percent of GPD – compared with the OECD average of 1.65 percent. The Government has affirmed its commitment to encouraging R&D expenditure (with the goal being 2 percent of GDP over the next 10 years) by indicating that this proposed tax credit is likely part of a wider incentive package for R&D focussed start-ups and innovative firms to be developed over the coming years.

The proposed tax credit is a welcome addition to the New Zealand R&D landscape, however as with most significant changes in Government policy and subsequent amendment to legislation there will be winners and losers…

The tax credit will not initially be refundable. The exact mechanics of the tax incentive will be confirmed through consultation and legislative drafting however, this means the value of the tax credit would not crystallise until a business is in a tax paying position (which may be years for an early stage R&D intensive business). This is a clear divergence from our current R&D regime which allows loss-making companies to cash-out a portion of tax losses from eligible expenditure, providing valuable cash flow to start-up companies who generally incur significant losses in the early years of business. The Discussion Document indicates the existing regime will also be reviewed and any amendments would apply after the 2019/2020 income tax year (ie, the schemes will run in parallel for the first year).

Further, the Growth Grants administered by Callaghan Innovation will be phased out over the next two years. This is on the basis that the new tax incentive is funding “a similar type of activity and have a similar purpose”. It is proposed that new Growth Grant applications and extension to existing grants will close on March 31, 2019 and all remaining grants will cease on March 31, 2020 (even if originally agreed they would extend past this date).

The combination of the above could have a detrimental impact on the cash flow of R&D start-ups who may not have access to bank funding or may not want to dilute equity through equity investment. However, the Government has indicated that it will introduce changes to support R&D businesses in tax loss positions from April 2020.

The proposed tax credit applies to eligible R&D expenditure over $100,000 but not exceeding $120 million which equates to a possible $15 million tax credit. All businesses, regardless of legal structure will be eligible for the credit.

A new definition of “R&D” is proposed by the new rules. This may result in additional compliance costs and administration for potentially cash poor businesses. The current definition (for Growth Grants and the loss-cash out rules) is based on the financial reporting definition and is not considered suitable. The proposed definition necessitates the use of “scientific methods” and requires expenditure on R&D activities which resolve “scientific or technological uncertainty”. The purpose of the amendment is to deliver a “clear, robust and practical definition of R&D for New Zealand tax purposes”.

Although the regime is intended to have a broad reach, the proposed definition is arguably too narrow which could limit the scope of eligible R&D activities. For example, the proposed definition may not suit software/ app development because it does not involve traditional scientific methods, does not necessarily solve uncertainty (ie. they are more targeted at a specific creation or result) or address a material problem. The definition needs to be clear and comprehensive so businesses are easily able to understand whether they can apply it or not.

Two approaches for determining eligible expenditure are being considered:
1. The direct R&D labour cost approach where the claim is limited to the labour cost of staff performing R&D activities, or

2. A broader approach capturing both direct and indirect R&D costs (including salary/wages, depreciation on tangible property used in conducting R&D, materials, and other costs incurred indirectly as a result of R&D activities). Additionally, some expenditure will be specifically excluded, for example, interest, donations, and depreciation during the period on an asset that is not being used to carry out R&D activities.

Arguably, the new regime shifts Government support from start-ups to profit making medium to large businesses (with potentially the largest impact on GDP?). Profit making, medium size businesses will benefit from the change as Growth Grant Funding is limited to $5m compared with a $15m maximum tax credit. However, it is likely that the most significant benefit is for New Zealand’s large corporations as there have been suggestions that the cap could be extended with Ministerial discretion or pre-registration of large claims.

Ultimately, the tax credit should stimulate investment in innovation – especially given the Government have indicated that the incentive will not stand alone and the Tax Working Group will continue to examine the New Zealand tax system to ensure structure, balance and fairness of our tax system. Profit making medium and large businesses are likely to be better off, but our emerging innovative businesses will have to wait for further announcements to see how they will be effected.

The comments in this article of a general nature and should not be relied on for specific cases. Taxpayers should seek specific advice.

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Hayden Farrow

Hayden Farrow is a PwC Executive Director based in the Waikato office. Email: hayden.d.farrow@nz.pwc.com