Chapter 3 - Problem definition

3.1 Current tax provisions delay the ability of loss-making businesses to use their deductions as they are required to carry the losses forward. This provides an important integrity measure in the tax system to mitigate the creation of artificial losses. However, these current tax settings create a cashflow problem for certain companies in an ongoing tax loss position.

3.2 This cashflow bias is particularly significant for companies undertaking R&D. This is because:

• The natural profit cycle for innovative projects tends to have a longer period of tax loss before making a profit.
• Many R&D-intensive companies are carrying on high-risk investment which may never be profitable.
• The ultimate cash return may not arise until the resulting capital asset is sold.

3.3 This can increase the cost of investing in R&D rather than in other assets.

3.4 Problems can be compounded for start-up companies undertaking R&D who are already likely to suffer from broader capital constraints as a result of, for example:

• Lack of collateral – R&D-intensive start-up companies typically have fewer fixed tangible assets and the intangible R&D assets being created can be difficult to value upfront. This means there is often little in the way of collateral that can be used for debt financing.
• Information asymmetry – This arises when lenders have less knowledge than the R&D start-up company about the value of the R&D assets being created and the level of risk associated with their creation. This is especially prevalent for R&D-intensive start-up companies given the novel and/or experimental nature of R&D, and they have no proven track record in successfully developing R&D assets. Consequently, this can lead to less lending to or investment in R&D-intensive start-up companies.

3.5 Empirical evidence shows that small R&D firms have a significantly lower probability of being successful with long-term loan applications than other businesses,[3] and that the probability of success decreases as R&D intensity increases.[4] Venture capital can address some of these problems, but evidence from different countries indicates that small and medium businesses tend to rely on internal equity financing, and prefer to seek bank loans if external financing is required. However, recent evidence indicates that banks in New Zealand are not necessarily well engaged with the financing needs of small start-up businesses and have relatively high levels of risk aversion compared with UK and US banking models in supporting early stage companies or projects.[5]

3.6 These factors, and the cashflow problems noted above, may lead to fewer R&D-intensive start-up companies being established and less R&D being undertaken by existing R&D-intensive start-up companies.

3.7 Current tax provisions can also penalise businesses that engage in R&D that ultimately turns out to be unsuccessful. This is because current tax provisions state that losses, in this case from unsuccessful R&D, can only be used going forward if the original owners subsequently engage in a profitable business. The current rules therefore make the use of previous tax losses contingent upon successful innovation or future income earning by the same group of investors. The risk of incurring this potential additional sunk cost is likely to discourage investment in marginal R&D projects further.

Summary

3.8 Current tax loss rules increase the cashflow constraint experienced by companies in a tax loss position. However, for R&D-intensive start-up companies, this bias is compounded as a result of longer periods of tax loss for innovative projects, broader capital constraints and difficulties in securing lending or investment. On the other hand, when successful innovation is sold there is generally no taxation impact.

3.9 Other businesses do not normally expect to make significant ongoing losses, nor do they face the same difficulties when seeking lending. Therefore there are strong grounds for continuing the existing treatment for other firms in tax losses, both as a buttress and also because the existing rules do provide a mechanism for losses when there is also taxable income.

3 Freel, M. S. (1999), The Financing of Small Firm Product Innovation Within the UK, Technovation 19, 707–719.

4 Freel, M. S. (2007), Are Small Innovators Credit Rationed?, Small Business Economics 28, 23–35.

5 Boven, R., Harland, C., and Grace, L. Plugging the Gap: An Internationalisation Strategy. (Auckland: The New Zealand Institute, 2010).