Chapter 3 - Black hole expenditure on successful R&D
3.1 This chapter discusses the situation when capitalised development expenditure has given rise to a valuable asset, but the expenditure is unable to be depreciated over time. There are two different scenarios when this might occur. The first scenario is when the expenditure has given rise to an asset that is depreciable for tax purposes, but the depreciable costs of the asset have been interpreted to exclude development expenditure (for example, a patent). The second scenario is when the expenditure has given rise to an asset that is not depreciable for tax purposes (for example, know-how).
Proposed solutions for first scenario
Patents and plant variety rights
3.2 The Government proposes making capitalised development expenditure that relates to an invention that is the subject of a patent or a patent application depreciable. This could be achieved by amending the Income Tax Act 2007 so the depreciable cost of a patent application and a patent expressly includes capitalised development expenditure incurred in connection with devising the invention, for taxpayers who have lodged a patent application or had a patent for an invention granted.
3.3 It is likely that under any proposal to address black hole R&D expenditure on successful assets, the capitalised development expenditure relating to the invention that is the subject of the patent would become part of the depreciable patent costs. This tax treatment is appropriate if the residual value of the know-how (created by the capitalised development expenditure) is nil at the end of the life of the patent. After 20 years, the taxpayer will still have the know-how, but the invention will have been publicly disclosed and the monopoly rights granted by the patent will have expired. The Government is interested in your view on whether ascribing a value of nil to the know-how at this point is a close approximation to commercial reality.
3.4 The Government also proposes making the capitalised development expenditure that relates to a plant variety that is the subject of plant variety rights depreciable.
3.5 Policy options for making capitalised development expenditure on these assets depreciable are discussed in detail on pages 11-12.
3.6 Several policy options exist. Under the first two options described below, depreciation deductions for capitalised development expenditure would be restricted to new assets.
3.7 A third option would allow depreciation deductions for existing as well as new assets.
3.8 The first option is to allow only capitalised development expenditure (that relates to a patent, patent application or plant variety rights, as the case may be) incurred from the date of the release of this discussion document to be eligible for depreciation deductions. This option targets new R&D expenditure.
3.9 The second option is to allow depreciation deductions for assets created (that is, recognised for tax purposes) from the date of the release of this discussion document. This option would allow all of the capitalised development expenditure relating to the asset (whenever incurred) to be eligible for depreciation deductions. This option would reflect the view that the status quo is a poor outcome under tax policy frameworks. However, it would provide a windfall gain to those who have incurred sunk costs on the development of these assets, have a higher fiscal cost for the Crown, and create boundary issues (as the tax treatment of past expenditure would differ between assets recognised for tax purposes before and after the discussion document’s release).
3.10 A third option is to allow depreciation deductions for capitalised development expenditure that relates to existing as well as new assets. By targeting existing assets in addition to new innovation, this option would also reflect the view that the status quo is a poor outcome under tax policy frameworks. This option would have a significantly higher fiscal cost for the Crown. It does, however, offer an additional benefit in that it makes it more attractive for someone who currently holds one of these assets (which they have developed) to continue to hold it rather than sell it. This is because currently a purchaser of one of these assets can depreciate the entire purchase cost, which means that such assets are potentially more valuable to purchasers than to the person who has developed them. However, this option would provide a windfall gain to holders of existing self-developed assets who made an economic decision to proceed with developing the asset in the expectation that development expenditure incurred from the point of asset recognition for accounting purposes would be neither immediately deductible nor depreciable.
3.11 Under this option, a pro-rated amount of the capitalised development costs of an existing asset would be able to be depreciated over the asset’s remaining legal life, as if the asset had been depreciated from the beginning of its legal life. For example, if the capitalised development costs of a patent were $100,000 and there were five years remaining in the patent’s legal life at the date the policy came into effect, the taxpayer would be able to claim a $5,000 depreciation deduction in each of the five years ($100,000 capitalised development costs / 20-year legal life of a patent). This means that, of the $100,000 that was previously black hole expenditure, $25,000 would be deductible over time and $75,000 would remain black hole expenditure.
3.12 Aside from the potentially significant fiscal cost, the reason why the amount of the capitalised development costs able to be depreciated over the asset’s remaining legal life is pro-rated under the third option is because allowing all capitalised development costs of existing assets to be depreciated would create undesirable boundary issues. It would enable a taxpayer who holds a patent which has a year remaining in its legal life to deduct all of the capitalised development costs of the patent, whereas a taxpayer who held a recently expired patent would not be able to deduct any of the capitalised development costs. This does not seem to be an equitable outcome.
3.13 The Government considers that all three options discussed are an improvement upon the status quo. However, the Government favours option 1. It targets new R&D spending only and does not give windfall gains to those who have incurred sunk costs. Therefore, any fiscal cost incurred as a result of the policy change would be more closely aligned with the Government’s objective of increasing new business R&D. The other options provide limited additional benefit in reducing the bias that those who have incurred sunk costs have towards selling the resulting asset over continuing to hold it.
3.14 The Government proposes that the legislation be amended to clarify that capitalised expenditure incurred by a taxpayer in the successful development of software for use in their own business is depreciable. This would clarify the law to be in line with the policy intent and the Government’s understanding of current taxpayer practice. To provide certainty for taxpayers, the Government proposes that this amendment be made retrospective to the statutory time-bar.
3.15 The second scenario where capitalised development expenditure that has given rise to a valuable asset is unable to be depreciated over time is when the asset created is not depreciable (for example, know-how).
3.16 Under tax depreciation policy frameworks, tax depreciation is meant to approximate true economic depreciation. When an asset does not decline in value over time, the appropriate tax treatment is not to allow depreciation deductions.
3.17 Intangible assets are only depreciable if they are listed in schedule 14 of the Income Tax Act 2007. For an item of property to be listed in schedule 14, it must be intangible and have a finite useful life that can be estimated with a reasonable degree of certainty on the date of its creation or acquisition. Although not an explicit requirement, the assets listed in schedule 14 tend to have finite legal lives that are determined under contract or statute. A finite legal life provides comfort that the requirement for the asset to have a finite useful life that can be estimated with a reasonable degree of certainty on the date of its creation or acquisition is met. When an intangible asset does not have a finite legal life (for example, know-how and trademarks) it is difficult to satisfy the finite useful life test. Therefore, the appropriate tax treatment for these assets is that they are not depreciable.
3.18 That a particular intangible asset is non-depreciable for tax purposes should not, however, be taken as an indication that the asset has an infinite useful life. Rather, the asset may have an indefinite useful life. It is this indefinite useful life that presents a problem for determining the basis upon which the capital costs of the asset should be deducted over the asset’s useful life.
3.19 As a result, the Government considers it would not be appropriate to allow depreciation deductions for capitalised expenditure on intangible assets that are not currently listed in schedule 14, as it has not been established that these assets have finite useful lives that can be estimated with a reasonable degree of certainty. New intangible assets can, however, be considered for inclusion in schedule 14 on a case-by-case basis. In deciding whether a new intangible asset should be added to schedule 14, a further relevant consideration is whether there is a low risk of the asset being used in tax avoidance schemes if it is made depreciable.
3.20 At some point in time, the usefulness of a non-depreciable intangible asset may cease. Section EE 39 of the Income Tax Act 2007 allows a person to deduct the remaining undepreciated costs of an item of depreciable property that is no longer used. By contrast, when a non-depreciable asset is no longer used, there is no ability to deduct the capital cost of the asset.
3.21 However, giving a deduction for the capital cost of a non-depreciable asset when its usefulness ceases is akin to giving a deduction for a capital loss. Our tax system generally does not give deductions for capital losses on investments in other types of non-depreciable assets, such as land and shares. As our tax system does not comprehensively tax capital gains, not giving deductions for capital losses generally means that there is a consistent tax treatment. If capital gains were comprehensively taxed, giving deductions for capital losses may be appropriate as this would ensure a consistent tax treatment.
3.22 Additionally, if a deduction were to be given for the entire capital cost of an asset when its usefulness ceases, the deduction for the expenditure would not be matched with the income derived from the asset. This is undesirable from a policy perspective. It is true that in the year that a depreciable asset’s usefulness ceases it is possible that the taxpayer will have derived little or no income from the asset, while being able to potentially deduct a large part of the asset’s cost. However, with depreciable assets there will, at least, be some sort of matching of income derived with related expenditure while the asset is useful.
3.23 Given these arguments, the Government considers that it would not be appropriate to allow deductions for non-depreciable assets that are no longer useful.