Chapter 4 - Black hole expenditure on unsuccessful R&D

4.1 This chapter discusses capitalised development expenditure that has not given rise to a valuable asset – either an asset that is depreciable for tax purposes, or an asset that is non-depreciable for tax purposes because it does not have a finite useful life that can be estimated with a reasonable degree of certainty (for example, know-how).

4.2 Conceptually, unsuccessful expenditure should be tax deductible when it would have led to a depreciable asset if the project had been successful.

4.3 Where the expenditure would have led to a non-depreciable asset if the project had been successful, allowing a tax deduction for unsuccessful capital expenditure would bias investment decisions in favour of these kinds of assets.

4.4 An alternative view is that all such expenditure should be deductible as the capital expenditure has not created any value or enduring benefit. However, this is akin to giving a deduction for a capital loss. As mentioned above, our tax system does not generally provide deductions for capital losses, which generally means that there is a consistent tax treatment, given that our tax system generally does not tax capital gains either.

4.5 As previously discussed, New Zealand’s current R&D expenditure deductibility rules are linked to the accounting rules. Expenditure on R&D is generally deductible for tax purposes up until all the criteria for recognition of an intangible asset in the accounting rules have been met. Once an intangible asset has been recognised under the test in the accounting rules, all further development expenditure is capitalised. The tax rules follow this treatment.

Proposed solution

4.6 As well as a test for recognising an intangible asset, the accounting rules contain a derecognition test for an intangible asset. This test is found at paragraph 112 of NZ IAS 38, which provides that:

An intangible asset shall be derecognised:
(a) on disposal; or
(b) when no future economic benefits are expected from its use or disposal.

4.7 The Government proposes allowing a person a tax deduction for capitalised development expenditure they have incurred if the following three conditions are met:

• The intangible asset to which the expenditure relates has been derecognised under the accounting rules (other than due to its disposal) before it is used or available for use—
  • in deriving income; or
  • in carrying on a business for the purpose of deriving income.
• The person intended that the expenditure would lead to an item of “depreciable intangible property” (that is, an asset listed in schedule 14 of the Income Tax Act 2007) of the person.
• No deduction has been allowed for the expenditure under any other provision.

Timing of deductions

4.8 There are two main options for the timing of deductions for unsuccessful capitalised development expenditure:

• allow an immediate deduction for the unsuccessful capitalised development expenditure; or
• depreciate the unsuccessful capitalised development expenditure over the estimated useful life of the asset the development expenditure was aimed at creating.

4.9 Depreciating the unsuccessful capitalised development expenditure over the estimated useful life of the unsuccessful asset is, theoretically, an economically neutral treatment. By contrast, an immediate deduction (or spreading it over a shorter period than the asset’s estimated useful life) is non-neutral to the taxpayer’s advantage.

4.10 Depreciating the unsuccessful capitalised development expenditure over the estimated useful life of the asset the development expenditure was aimed at creating is therefore, in theory, preferable. However, in practice, there are a number of reasons why allowing an immediate deduction may be preferred, including the following:

• Allowing an immediate deduction is consistent with the current treatment for depreciable assets that are written off, where the remaining undepreciated costs are deducted on write off. If the proposed rules did not match this treatment, there would be an incentive to develop uneconomic assets to the depreciable asset stage in order to write them off and obtain the immediate deduction.
• Solutions implemented for other black hole expenditure problems have involved allowing an immediate deduction. There is a strong case for consistency of approach.

4.11 For these reasons, the Government proposes allowing an immediate deduction for unsuccessful capitalised development expenditure.

4.12 However, the case for allowing an immediate deduction for unsuccessful capitalised development expenditure becomes less compelling the longer the period that the asset would have been valuable, had it been successfully created.

4.13 In 2012, an amendment was made to the Income Tax Act 2007 allowing an immediate deduction for capitalised expenditure incurred in unsuccessful software development. The period that software is expected to be valuable generally ranges between one and four years, depending upon whether the software is designed for a single-year application or longer. It was considered that the relatively short life of software made allowing an immediate deduction for expenditure on unsuccessful software development the appropriate policy.

4.14 By comparison, patents have a legal life of 20 years, and plant variety rights have a legal life of 20 years in the case of non-woody plants and 23 years in the case of woody plants.[5] The longer life of these assets means that allowing immediate deductibility for unsuccessful expenditure would create a greater bias in favour of investing in these types of assets, at the margin. This bias would be strongest in the case of allowing immediate deductibility for unsuccessful expenditure incurred in developing an asset that would not have declined in value over time had the development been successful.

Integrity measures

4.15 In the event that a failed asset from an abandoned R&D project (which has had capitalised development expenditure deducted) becomes useful, the Government proposes that the capitalised development expenditure previously allowed as a deduction should be clawed back as income. Where the useful asset is depreciable, the clawed-back amount should then be able to be depreciated over the estimated useful life of the asset.

4.16 In the event that a failed asset from an abandoned R&D project (which has had capitalised development expenditure deducted) is sold, the Government proposes that the capitalised development expenditure previously allowed as a deduction (or the sale proceeds, if this amount is lower) should also be clawed back. The exception would be when the sale of the failed asset would otherwise give rise to assessable income. In such instances, the Government proposes that the entire sales proceeds should continue to be treated as assessable income.

Policy options

4.17 The Government has considered two options for allowing deductions for black hole expenditure on unsuccessful R&D.

Option 1

4.18 The first option is to allow deductions only for capitalised development expenditure incurred from the date of the release of this discussion document.

Option 2

4.19 The second option is to also allow deductions for capitalised development expenditure incurred before the date of the release of this discussion document, when the asset to which the expenditure relates is derecognised after the date of the release of this discussion document.

4.20 The Government proposes that the policy option chosen to address the issue of black hole expenditure on successful R&D should guide the choice of policy option for addressing the issue of black hole expenditure on unsuccessful R&D. If only capitalised development expenditure incurred from the date of the release of this discussion document is to be eligible for depreciation deductions in the case of successful R&D, then the Government considers that, for consistency reasons, it would make sense to allow deductions only for capitalised development expenditure incurred from the date of the release of this discussion document in the case of unsuccessful R&D.

Issues and risks with allowing deductions for black hole expenditure on unsuccessful R&D

4.21 The Government is aware that there are various issues and risks with allowing deductions for unsuccessful capitalised development expenditure that do not arise in the case of successful capitalised development expenditure. These are outlined below.

Eligibility for the deduction

4.22 Allowing deductions for unsuccessful capitalised expenditure raises the question of how to test whether the expenditure would have led to an item of “depreciable intangible property” had the project been successful (given that no depreciable asset for tax purposes will have been created). The Government proposes that an intention test could be used, even though this may create practical difficulties as intention is often difficult to prove or disprove.

4.23 An alternative option would be not to limit the deduction to expenditure that would have led to an item of “depreciable intangible property” if the R&D project had been successful – in other words, allowing a deduction for all unsuccessful R&D expenditure. If the reason for giving a deduction for capitalised R&D expenditure that has not given rise to a valuable asset is that the taxpayer only incurred the capitalised R&D expenditure because they recognised an asset under the accounting rules “prematurely” (that is, they never got to the point where they had a valuable asset at all), then it is arguable that it should not matter whether the taxpayer intended that the expenditure would lead to an item of “depreciable intangible property” or not. To illustrate this argument, consider the counter-factual situation where the taxpayer had not prematurely recognised an asset under the accounting rules. In this situation the same R&D expenditure would not have been capitalised – it would have been expensed for accounting purposes and deductible for tax purposes, whether or not the taxpayer intended that the expenditure would lead to an item of “depreciable intangible property”.

4.24 On the other hand, as a general tax principle, the classification of a particular expense as being of a capital nature is not based on whether it actually produces an enduring benefit but, rather, on whether the expense was intended to produce an enduring benefit. Development expenditure that is intended to create an asset is capital in nature. Section DB 34 is concessionary in that it overrides the capital limitation, giving immediate tax deductions for R&D expenditure that is treated as a revenue expense for accounting purposes.

4.25 In reality, the risk of recognising an intangible asset prematurely may be small. R&D expenditure is only capitalised for tax purposes after the taxpayer has demonstrated that all of the intangible asset recognition criteria in the accounting rules are satisfied, as noted in Chapter 2. These criteria are rigorous, which implies that a conservative approach is taken to intangible asset recognition for accounting purposes. Having rigorous asset recognition criteria in the accounting rules makes sense because, generally speaking, the incentive is to recognise an asset as soon as possible. A taxpayer knows in advance that once they recognise an intangible asset for accounting purposes, concessionary tax treatment under section DB 34 will cease, and that any further development expenditure on the asset must be capitalised. This tax treatment is appropriate because the intent of any further development expenditure after the point of asset recognition will be to produce an enduring benefit.

Residual know-how

4.26 When an R&D project is abandoned after the point of intangible asset recognition under the accounting rules but before an intangible asset that is depreciable for tax purposes is created, there is a question around how Inland Revenue would know that the taxpayer does not still have valuable know-how (and therefore conceptually should not be allowed a deduction). It would be unsatisfactory for the integrity of the tax system if taxpayers were able to receive deductions for capital expenditure that has created valuable know-how. It would also increase the fiscal cost for the Crown.

Perverse incentives for marginal projects

4.27 Allowing immediate deductibility of unsuccessful capitalised development expenditure would create a perverse incentive for taxpayers not to complete marginal projects because, when the value of exploitation is low or uncertain, immediate deductibility of unsuccessful capitalised development expenditure may be preferred by the taxpayer over depreciation of successful capitalised development expenditure.

Re-labelling incentives

4.28 Allowing deductions for unsuccessful capitalised development expenditure would increase incentives for taxpayers to re-label expenditure in order to obtain a deduction. The risk of taxpayers re-labelling non-R&D expenditure as R&D expenditure is one of the major concerns associated with providing tax incentives for R&D expenditure. However, there is reason to believe that re-labelling risks would be much lower in the case of providing immediate deductions for unsuccessful capitalised development expenditure compared with R&D tax incentives (such as an R&D tax credit). This is because the treatment that would be accorded to any expenditure re-labelled as unsuccessful capitalised development expenditure under this proposal (that is, immediate deductibility) would be no more favourable than that which is accorded to most other non-capital business expenditure. By contrast, in the case of say, an R&D tax credit, a taxpayer could benefit from re-labelling any non-R&D expenditure as R&D expenditure.

4.29 Therefore, under the Government’s proposed solution to the problem of black hole expenditure on unsuccessful R&D, the only business expenditure that it would benefit a taxpayer to re-label as capitalised development expenditure would be expenditure that is not immediately deductible (such as expenditure that is of a capital nature).

Risk of breaking up R&D projects

4.30 If deductions for unsuccessful capitalised development expenditure are allowed, there may be a risk that taxpayers break up R&D projects to get immediate deductibility of capitalised development expenditure on failed aspects of what is really a single project.

5 Technically, for tax purposes, the legal life of plant variety rights includes the number of whole calendar months during which the person owns the plant variety rights application in relation to which the rights are granted, in addition to the 20 or 23-year term for which the plant variety rights are granted.