Black hole expenditure
Overview
These proposed amendments will give effect to changes to the income tax treatment of certain items of “black hole” expenditure that were announced as part of Budget 2014. “Black hole” expenditure is business expenditure that is not immediately deductible for income tax purposes, and also does not form part of the cost of a depreciable asset for income tax purposes which means it cannot be deducted over time as depreciation.
The amendments are primarily targeted at black hole research and development (R&D) expenditure. Under current tax law, taxpayers are allowed immediate income tax deductions for R&D expenditure incurred up until the point that an intangible asset is recognised under the accounting rules. Any further development expenditure incurred generally must be capitalised.
The problem is that development expenditure incurred subsequent to the recognition of an intangible asset for accounting purposes is potentially never able to be deducted for income tax purposes. This may discourage businesses from undertaking R&D that they would have undertaken in the absence of taxation.
The amendments aim to reduce the cases where tax rules may be discouraging investments that would be undertaken in the absence of taxation, by allowing capitalised expenditure to be deducted or depreciated, as appropriate.
On 7 November 2013, a Government discussion document, Black hole R&D expenditure, was released, which outlined initial proposals to allow tax deductions for black hole R&D expenditure. The proposals were part of the Government’s “encouraging business innovation” initiative under its Business Growth Agenda “Building Innovation” workstream.
Submissions were generally supportive of the intent of the proposals to relieve black hole R&D expenditure. However, many of the submitters wanted the scope of the proposals widened to provide tax deductibility for both successful and unsuccessful capitalised development expenditure towards intangible assets that are not depreciable for tax purposes. In response to these submissions, the scope of the proposals was widened to also provide tax deductibility for these expenditures. Additionally, a number of submitters identified other categories of expenditure that fit within the policy framework in the discussion document (namely, expenditure relating to registered designs and the copyright in an artistic work that has been applied industrially) and the proposals were extended to cover them.
RESEARCH AND DEVELOPMENT EXPENDITURE ON DERECOGNISED NON-DEPRECIABLE ASSETS
(Clause 85)
Summary of proposed amendment
For taxpayers that have developed intangible assets that are not depreciable for tax purposes, an amendment to section DB 34 of the Income Tax Act 2007 will allow a one-off income tax deduction for capitalised development expenditure (incurred on or after 7 November 2013) upon the intangible asset to which it relates being derecognised for accounting purposes.
Application date
The amendment will apply from the beginning of the 2015–16 income year.
Key features
Section DB 34 will allow a taxpayer who has developed an intangible asset (recognised for accounting purposes) that is not depreciable for tax purposes an income tax deduction for capitalised development expenditure they have incurred on the asset. The proposed amendment only applies for expenditure incurred on or after 7 November 2013, the date the discussion document was released.
The deduction will be allowed upon the intangible asset being derecognised (that is, written off) for accounting purposes (other than due to its disposal). The deduction will be allowed irrespective of whether the asset was useful for a period or the R&D was unsuccessful.
The deduction will be allowed in the income year in which the relevant intangible asset is derecognised for accounting purposes.
Background
Taxpayers are currently allowed immediate tax deductions under section DB 34 of the Income Tax Act 2007 for R&D expenditure incurred up until the point that an intangible asset is recognised under the accounting rules. Any further development expenditure incurred must be capitalised. In the event that the R&D project does not create an asset that is depreciable for tax purposes, any development expenditure incurred post-recognition of an intangible asset for accounting purposes is generally non-deductible for tax purposes. This may discourage businesses from undertaking R&D investments that would have been undertaken in the absence of taxation.
It would be inappropriate, from an economic perspective, to allow tax deductibility for expenditure towards creating an asset that would not have been likely to have a finite life if successful. Not allowing a deduction for losses in this situation is the counterpart of not taxing capital gains.
It is recognised, however, that technology tends to move at a relatively fast pace and it is likely that R&D-generated assets will have finite useful lives, even if those lives are not able to be estimated with a reasonable degree of certainty at the time of the asset’s creation.
While capitalised expenditure on successful R&D can lead to an asset that is worth more for a period than the amount of capitalised expenditure, resulting in an untaxed gain, not allowing any deduction for capitalised expenditure on an asset that can only have a finite useful life appears harsh.
Allowing a one-off tax deduction for capitalised R&D expenditure that relates to an intangible asset that is non-depreciable for tax purposes upon the intangible asset being derecognised for accounting purposes (other than due to its disposal) appears the most appropriate solution. This would mean that a deduction would be available irrespective of whether the asset was useful for a period or the R&D investment was completely unsuccessful. Restricting deductions to when an asset has been derecognised for accounting purposes restricts deductions to cases when it is clear that the expenditure is of no on-going value.
Expenditure incurred on or after the date of the 7 November 2013 release of the Government discussion document, Black hole R&D expenditure, should be eligible for deductibility under the proposed new provision. This was signalled as the Government’s preferred option in the discussion document. This was done to ensure that the discussion document’s release did not prompt businesses to defer their R&D expenditure in anticipation of new tax rules coming into effect. Allowing additional historical R&D expenditure to be eligible for deductibility would significantly increase the fiscal cost, but provide only 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.
The proposed change will reduce distortions against investment in R&D caused by the current tax rules.
CLAW-BACK FOR DERECOGNISED NON-DEPRECIABLE ASSETS
(Clause 73)
Summary of proposed amendment
Proposed new section CG 7C of the Income Tax Act 2007 will claw back, as income, deductions that have been taken for capitalised development expenditure on derecognised non-depreciable intangible assets, in the event that the intangible asset is sold or becomes useful again.
Application date
The amendment will apply from the beginning of the 2015–16 income year.
Key features
New section CG 7C is a claw-back provision, which will apply to a taxpayer if:
- they have been allowed a deduction under section DB 34 because proposed new section DB 34(3) applies (that is, a deduction for capitalised development expenditure on a non-depreciable intangible asset that has been derecognised for accounting purposes); and
- the previously derecognised intangible asset:
- is disposed of for consideration that is not income under another provision of the Income Tax Act 2007; or
- is used or available for use.
In the case of a disposal for consideration, the amount that will be clawed back as income will be the lesser of the consideration derived for the disposal and the amount of the deduction previously taken.
In the case of the asset being used or becoming available for use, the entire amount of the deduction previously taken will be clawed back as income. For the purposes of the depreciation rules, the taxpayer will be treated as never having had the deduction. Therefore, if the taxpayer eventually acquires an item of depreciable intangible property to which the expenditure relates, they will be able to depreciate the expenditure.
Any income arising under proposed new section CG 7C will arise in the income year in which the previously derecognised intangible asset is disposed of for consideration, or is used or available for use, as the case may be.
Background
There is risk that, after a taxpayer has taken a deduction for capitalised development expenditure on a derecognised non-depreciable intangible asset, the intangible asset may be sold or become useful.
In the case of a sale, the taxpayer has conceptually derived income. Therefore, a claw-back provision is necessary to preserve a neutral tax treatment by ensuring that a taxpayer does not receive a deduction that is larger than the loss they have suffered.
If a taxpayer was able to receive an early deduction for expenditure that has created what turns out to be a useful asset, they would receive a significant advantage. Therefore, a claw-back provision is appropriate, as it would reduce this advantage and ensure greater economic neutrality and consistency with the treatment of expenditure that has created an asset that has always been regarded as successful.
Without a claw-back provision, there would be a risk of taxpayers manipulating the system. A claw-back provision is therefore an important integrity measure.
DEPRECIABLE COSTS OF CERTAIN DEPRECIABLE INTANGIBLE ASSETS
(Clauses 105, 106, 109 and 110)
Summary of proposed amendment
Proposed new section EE 18B of the Income Tax Act 2007 will enable taxpayers who have created an asset that is depreciable for tax purposes to include capitalised expenditure that relates to the asset as part of the depreciable costs of the asset.
Application dates
The amendment allowing capitalised expenditure relating to an existing item of depreciable intangible property (other than a patent, patent application, or plant variety rights) to be included as part of the item’s depreciable costs will apply from the beginning of the
2011–12 income year.
The amendment allowing capitalised expenditure relating to a patent, patent application, plant variety rights or the new additions to schedule 14 of the Income Tax Act 2007 proposed in this bill to be included as part of the item’s depreciable costs will apply from the beginning of the 2015–16 income year.
Key features
New section EE 18B specifies that the “cost” to a person of an item of depreciable intangible property for depreciation purposes includes expenditure they have incurred on an underlying item of intangible property, if that item gives rise to the item of depreciable intangible property.
In the case of patents, patent applications, plant variety rights, and the new additions to schedule 14 proposed, the person must have incurred the expenditure on or after 7 November 2013, for the expenditure to be included in the depreciable cost of the item of depreciable intangible property.
Consequential amendments are proposed to sections EE 33 and EE 34, which set out how to calculate the annual rate of depreciation for fixed-life intangible property and patents, respectively.
Background
Capitalised expenditure may be rendered non-depreciable, even if a taxpayer is successful in creating an intangible asset that is depreciable for tax purposes (that is, an asset listed in schedule 14 of the Income Tax Act 2007). As explained below, this may occur because, although the expenditure has given rise to an asset that is depreciable for tax purposes, the depreciable costs of the asset have been interpreted to exclude some types of expenditure.
An interpretation statement issued by the Commissioner of Inland Revenue takes the view that the depreciable patent costs (for a taxpayer who has lodged a patent application with a complete specification or had a patent for an invention granted) are limited to the administrative and legal fees incurred in the patent process.[1] According to the Commissioner’s view of the law, capitalised development expenditure relating to the invention that is the subject of the patent (or patent application) is potentially neither deductible nor depreciable for tax purposes.
In reaching this view, the Commissioner considered the policy intent as to the meaning of “patent” in the depreciation provisions, and concluded that:[2]
[T]here is no evidence that the meaning of “patent” was intended to be changed to mean “the patent and the invention” under the current depreciation legislation. Had this been the intention, it would be expected that such change would have been explicitly made. As this is not the case, it is the Commissioner’s view that, in the depreciation rules, the patent costs means the costs of acquiring the patent and not expenditure incurred in devising an invention.
Although the Commissioner’s interpretation statement is confined to patents, it is likely that the depreciable costs of plant variety rights would be interpreted in the same way, given that they are both types of intellectual property rights obtained by registration following an R&D process.
A similar interpretative issue exists in the case of “the copyright in software”, with some doubt having been expressed about whether taxpayers who have developed software for use in their own business are able, under current law, to depreciate all of the capitalised development costs.
However, unlike in the case of patents and plant variety rights, there is a clear statement in a 1993 policy statement indicating that the policy intent was that capitalised expenditure incurred in the development of software by a business for its own use should be depreciable. In outlining the tax treatment of expenditure incurred on in-house software development, the statement says that “when the development is completed capitalised costs will be deductible under the depreciation regime”.[3] It is understood that taxpayers who have developed software for use in their own business, based on the 1993 policy statement, have been depreciating all of the capitalised development costs.
Where expenditure is in economic substance related to the creation of an asset with a finite useful life that can be estimated in advance with a reasonable degree of certainty, the appropriate tax treatment is to allow the expenditure to be depreciated over that life.
The policy framework adopted for resolving issues with the depreciability of capitalised expenditure relating to intangible assets that are depreciable for tax purposes is to:
- make the changes apply from the beginning of the 2015–16 income year, with capitalised expenditure incurred on or after the date of the release of the Government discussion document, Black hole R&D expenditure, (that is, 7 November 2013) to be eligible for depreciation in the case of patents, patent applications, plant variety rights and the proposed new additions to schedule 14 of the Income Tax Act 2007; and
- make the changes retrospective to the statutory time-bar, for intangible assets, when the policy intent was that the expenditure should be depreciable.
NEW DEPRECIABLE INTANGIBLE ASSETS
(Clauses 72, 87, 104, 107, 111 to 116, 213(2), (9), (10) and (12), and 216)
Summary of proposed amendment
Proposed amendments to the Income Tax Act 2007 will make depreciable registered designs, applications for the registration of a design, and copyright in an artistic work that has been applied industrially. Several associated amendments are proposed as a consequence.
Application date
These amendments will apply from the beginning of the 2015–16 income year.
Key features
The proposed amendment to schedule 14 of the Income Tax Act 2007 will make the following intangible assets depreciable:
- a design registration;
- a design registration application; and
- copyright in an artistic work that has been applied industrially (as defined in section 75 of the Copyright Act 1994).
Including definitions of “design registration” and “design registration application” in section YA 1 make it clear that a registration of a design in New Zealand under the Designs Act 1953 and a registration of a design in other jurisdictions, under similar laws and associated applications, are eligible for depreciation.
Section EE 16 defines the cost of these new depreciable intangible assets for the purpose of calculating the annual amount of depreciation allowed. Expenditure incurred before 7 November 2013 is ineligible for depreciation. Section EE 19 reiterates this, making it clear that costs incurred before 7 November 2013 for these new depreciable intangible assets cannot be added to the asset’s adjusted tax value and depreciated.
New section EE 34B sets out how to calculate the annual rate of depreciation for a design registration.
Section EE 67 provides that the legal life of a design registration or application for depreciation purposes commences from when the application was first lodged. Section EE 67 also provides that the legal life of the copyright in an artistic work to which section 75 of the Copyright Act 1994 applies is the length of time, from when the artistic work was applied industrially, that protection against infringement of that copyright is available under that Act.
Section DB 37 will allow a taxpayer a deduction for capital expenditure they have incurred for the purpose of applying for the grant of a design registration if they did not obtain the design registration because the application was not lodged or was withdrawn, or because the grant was refused. The deduction will be allocated to the income year in which the taxpayer decides not to lodge the application, withdraws the application or is refused the grant of design registration.
Section CG 7B ensures that this existing claw-back provision will claw back, as income, deductions that have been taken for aborted or unsuccessful applications for the grant of design registration, if the taxpayer subsequently sells or uses the abandoned application property.
Other minor consequential amendments proposed to sections EE 44, EE 57, EE 60 and EE 61 ensure that the depreciation rules operate appropriately in relation to the new depreciable intangible assets.
Background
An intangible asset can only be depreciated for income tax purposes if it is 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.
A design registered in New Zealand under the Designs Act 1953 has a legal life of 15 years (assuming all rights of renewal are exercised). Designs registered in other jurisdictions are also likely to have finite legal lives. It is therefore appropriate to make registered designs depreciable by adding them to schedule 14.
The 15-year legal life of a registered design generally begins on the date on which the first application is made, rather than the date the registration is granted. Therefore, it is also appropriate to make applications for the registration of a design depreciable, by adding them to schedule 14. This will ensure that depreciation is available during the time that registration is pending.
Section 75 of the Copyright Act 1994 contains a special exception from copyright protection for an artistic work that has been applied industrially. The effect of this exception is that, once an owner of copyright in an artistic work (or a licensee) has applied the artistic work industrially (as defined in the section), within New Zealand or overseas, their copyright protection will only last for a further 16 years (for product designs and casting moulds) or 25 years (for works of craftsmanship). This time limit makes the copyright in an artistic work that has been applied industrially appropriate for inclusion in schedule 14.
These proposed additions to schedule 14 follow feedback from submissions received on the Government discussion document, Black hole R&D expenditure, released on 7 November 2013. To ensure consistency with the proposed amendments on the deductibility of capitalised R&D expenditure, only capitalised expenditure on registered designs (and applications) and copyright in an artistic work that has been applied industrially incurred on or after 7 November 2013 will be eligible for depreciation.
As it is proposed to make registered designs depreciable, it is also appropriate to allow an immediate tax deduction for expenditure incurred for the purpose of applying for registration of a design if registration is not obtained. This will parallel the tax treatment of expenditure incurred for the purpose of applying for a patent when a patent is not obtained.
An existing claw-back provision applies to deductions taken for aborted or unsuccessful applications for the grant of a resource consent, a patent or plant variety rights, if the taxpayer subsequently sells or uses the abandoned application property. Applying this provision to deductions taken for aborted or unsuccessful design registration applications is appropriate to ensure consistency with existing policy settings.
[1] Interpretation statement “Income tax treatment of New Zealand patents”, Tax Information Bulletin Vol 18, No 7 (August 2006), p 51.
[3] Appendix to Tax Information Bulletin Vol 4, No 10 (May 1993).