Although New Zealand taxation rules have been developed with a view to encourage innovative research and development, tax deductibility for such has traditionally been fraught with difficulties.
Having abandoned the failed Tax Credit regime that applied for one tax year (2009), we are now left simply with enhanced deductibility. There is now a three-step inquiry to achieve greater deductibility than may otherwise be allowed under the Act.
First, we need to prove that the expenditure has been incurred in carrying on business to earn income. If, for example, you had a company that specialised in the manufacture of car parts, and work expenses were incurred on developing a new and innovative exhaust system, those expenses are most likely incurred in carrying on business to earn income.
Secondly, the activities involved in the research and development component must be systematic, investigative, and experimental. The business must demonstrate that the R&D process followed a planned, logical progression of work involving hypothesis, experiment, observation and evaluation in a scientific way.
This must involve acquiring new knowledge that achieves an advance in science or technology by resolving scientific or technological uncertainty or involves an appreciable element of novelty. Guidance as to what qualifies is found in the International Accounting Standards as applied in New Zealand to the extent that if expenditure is an expense for accounting purposes, then generally it is deductible for tax purposes.
Interestingly, even though there is a Tax Act definition of R&D, this is not actually relevant for determining deductibility, but rather reliance is placed upon the correct accounting treatment. Relying on accounting standards in this way is a little unusual for the Income Tax Act.
Furthermore, supporting activities that are wholly or mainly for the purpose of, required for, and integral to the carrying on of the systematic, investigative, and experimental activities, but that on their own are not systematic, investigative and experimental, may be eligible for R&D taxation treatment.
If the expenditure meets these definitions, then the third and final hurdle is crossed in that the capital limitation that would most like apply to expenditure of this enduring, long-term nature is deemed not to apply, and thus a tax deduction is allowed.
It is possible to either claim the expense in the year it is incurred or to carry forward the deduction to future years when income is earned as a result of the R&D effort or still has losses carried forward.
There are rules about how much can be carried forward and what amounts must be claimed in each future year, but it does allow a business to match its claim with its income. This provision is useful as it means that a company that has R&D expenditure can choose not to "convert" such into tax losses that may be breached upon a major shareholding change (e.g. if an angel investor comes on board).
If the project is unsuccessful, a claim can be made for the expenses incurred (including failed software development projects). If the project is successful, at the point at which it has created an "asset", then deductibility will cease, and a depreciable asset is created.
This is a complex area in reality, and we would always recommend the seeking of specialist tax advice should such expenditure be undertaken.
• Scott Mason is tax principal at accounting firm WHK, Dunedin.
