Chapter 4 - Suggested policy changes
4.1 The policy solution set out in this paper is to allow loss-making R&D-intensive start-up companies to cash out (that is, obtain early access to) some or all of their tax losses arising from R&D expenditure in the year in which the expenditure is incurred. This should reduce the market failures and tax distortions that can be a deterrent to investment in R&D, and create a more economically neutral outcome for such companies.
4.2 Under this proposal, eligible businesses would be able to cash out the taxable value of their R&D losses in the year they were incurred. In practice, this means that eligible R&D companies would be able to claim up to 28 percent (the current company tax rate) of their tax losses from the Government in any given year.
4.3 Officials suggest that eligibility be targeted to R&D-intensive start-up companies by restricting the refund to:
- loss-making companies whose R&D intensity (based on a ratio of R&D expenditure on wages and salaries to total wage and salaries expenditure) exceeds a specified threshold; and
- an overall cap on the amount that can be cashed out in any given year.
4.4 We suggest that the threshold for R&D intensity is set at 20 percent, to ensure that the refund is appropriately targeted to highly innovative businesses. Eligible R&D companies would be able to cash out up to 1.5 times their R&D expenditure on salary and wages, provided that this amount does not exceed their total tax losses or total qualifying R&D expenditure in the relevant tax year. In practice, this means eligible businesses would be able to cash out the lesser of:
- 1.5 times the company’s R&D expenditure on salary and wages;
- total tax losses; or
- total qualifying R&D expenditure.
4.5 In addition, there would be an overall cap on the amount of losses that would qualify to be cashed out. This would help ensure that the full benefits of the proposal are targeted principally to smaller companies, given the higher relative cashflow benefit the cash-out would have for these companies. It is suggested this overall cap would initially be set at $500,000, eventually rising to $2 million.
4.6 Any losses cashed out under the proposal would no longer be carried forward to be offset against future income. However, taxpayers would still be eligible to carry forward any losses in excess of the amount cashed out. This means that remaining losses would be accorded the same treatment as losses under the current rules.
4.7 Several aspects of the eligibility criteria are included within the scope of this consultation, including features of the eligibility criteria, the cap on eligible losses, and the appropriate definition of R&D. We will discuss and be seeking your views on these features in Chapter 5.
4.8 To further reduce risks to the tax base, it is also suggested that the value of any remaining cashed-out losses be recovered upon the sale of any developed intellectual property, shares in the company, or sale of the company itself. These integrity measures are set out in more detail in Chapter 7.
4.9 This proposal is expected to:
- provide some relief for the financing and cashflow constraints faced by R&D-intensive start-up companies during the initial loss-making phase of the innovation cycle;
- remove a tax distortion against undertaking innovation, making the tax system more neutral for businesses targeted by the policy change; and
- remove the risk that any accumulated tax losses of an R&D-intensive start-up will be lost in the event of failure.
4.10 These expected benefits are aligned with the underlying policy rationale set out in Chapter 3.
4.11 It is difficult to quantify the benefits from this proposal in terms of its marginal impact on R&D expenditure or the probability of successful innovation. As noted in Chapter 3, however, there is a relatively strong consensus in the academic and tax policy literature that young R&D-intensive businesses are likely to face difficulties in accessing sufficient capital, so are likely to benefit from this proposed policy change.
4.12 The proposal provides a cashflow benefit to eligible companies as it rebalances tax liabilities from periods of loss to periods of profit. It should be noted that it does not alter a company’s overall expected tax liability as any tax deductions that are taken now can no longer be taken in the future.
4.13 Evidence indicates that the proposal should be well targeted to start-ups as those companies that would be eligible for the proposed policy are, on average, younger than other R&D-intensive companies.
4.14 In addition, by restricting eligibility of the cash out to those companies above a specified level of R&D intensity means that any tax benefit will be better targeted towards those businesses incurring tax losses due to intensive R&D activity, rather than for other reasons.
4.15 It is proposed that a cap on the amount of loss able to be cashed out will increase over time. This should help limit the risk that the new policy causes an increase in demand for scientists and engineers, and consequently in their wages, due to the finite supply of these workers in the short term. If that situation arose, part of the potential benefits of the R&D cash-out would be reduced as the cost of carrying out R&D would increase, rather than increasing the amount of R&D performed. A gradual phase-in will therefore help to maximise the potential benefits of the policy change in terms of increased R&D activity.
6 This assertion is conditional on the R&D company being successful. If the company fails to earn income, the cashed out loss will effectively become a grant as the loss-making company is able to use some of their tax losses.