2 July 2003 Media Statement

Private sector R&D report welcomed

The government today released the preliminary report of the Private Sector Liaison Group on Research and Development, promising to consider seriously the group¡¦s recommendations to improve the R&D rules introduced in 2001.

PricewaterhouseCoopers senior partner, John Shewan, wrote to Revenue Minister Michael Cullen, Research, Science and Technology Minister Pete Hodgson and then Associate Finance and Revenue Minister Paul Swain on 12 May outlining the group¡¦s views prior to a meeting with the ministers on 16 June.

"The report confirms that the 2001 changes have achieved what was intended: providing greater certainty by clarifying the tax treatment of R & D through alignment of tax law with accounting practice," Dr Cullen said.

¡§But it does recommend a number of potential improvements. I want to take this opportunity to thank the members of the group for their work and to assure them that we will give serious consideration to the suggestions they have made.¡¨

These include:

- Changing the law to make it possible to deduct some "black hole" R&D expenditure;
- Looking at the implications for the new rules of the eventual adoption in New Zealand of international accounting standards; and
- Inland Revenue providing more public guidance on how it applies the rules introduced in 2001.

The group advised that some of its members favoured some form of tax incentive for R&D but noted that this issue went beyond their terms of reference.

Attached: The letter from John Shewan to ministers.

Private Sector Liaison Group on Research and Development
P O Box 11342
Wellington

12 May 2003

Hon Dr Michael Cullen Hon Pete Hodgson Hon Paul Swain
Minister of Finance & Revenue Minister of Research, Science Associate Minister of
Parliament Buildings & Technology Finance & Revenue
Wellington Parliament Buildings Parliament Buildings
Wellington Wellington

Dear Ministers

Private Sector Views on current Tax Treatment of Research and Development

In August 2002 you wrote to members of the R & D Private Sector Liaison Group inviting the Group to continue to monitor how the new R & D tax rules were operating with a view to arranging a meeting if and when significant issues arise. The purpose of this letter is to:

„h Update you on the initial views of the Liaison Group based on experience with the new regime since its introduction in 2001.

„h Request a meeting to discuss the key issues outlined below.

Terms of reference for Liaison Group

It is appropriate at the outset to record our understanding of the terms of reference of the Liaison Group. They are to:

„h monitor the application of the R & D tax rules

„h draw issues of concern to Government¡¦s attention.

Some within the Liaison Group consider that R & D is such a critical ingredient to growth in the NZ economy that incentives, possibly in the form of a deduction for an excess of 100% of expenditure on R & D, are essential. That issue is beyond the terms of reference of the Liaison Group. However, it is important to record that the fact that the comments below relate to the existing regime, and modifications required to address issues of concern, and should not be interpreted as indicating that all members of the Liaison Group concur with the current policy position of not providing incentives for R & D expenditure.

The structure of this letter is to set out our understanding of the Government¡¦s policy position of the tax treatment of R & D, and then to comment on changes required to the existing rules to address issues of concern.

The Liaison Group agrees with the Government that R & D plays a vital role in the New Zealand economy. By way of example, Navman NZ Limited estimate that:

„h In their first 5 years of operation their R&D had a multiplier effect on the economy of 9
„h In their second 5 years of operation their R&D had a multiplier effect on the economy of 15
„h In their third 5 years of operation their R&D had a multiplier effect on the economy of 25
„h In the next 2 years of operation their R&D will have a multiplier effect on the economy of 50

Our understanding of the Government¡¦s position on the tax treatment of research and development

Much of the discussion about the tax treatment of research and development expenditure has been based on the difference between the Frascati rules (as contained in the Frascati Manual for R&D) and the boundaries set out in FRS 13. We understand that officials believe that FRS 13 is wider than the Frascati rules, with the exception that Frascati in some instances includes land and buildings whereas FRS13 does not.

We understand that the Government¡¦s intention is to allow 100% deductibility for expenditure on research, and 100% deductibility for expenditure on development except to the extent that an asset is created which requires capitalisation for accounting purposes. In order to allow such deductibility, a definition of ¡§research and development¡¨ is needed. The FRS 13 rules provide that definition.

The introduction of the new R & D legislation in 2001 was followed by the Commissioner giving clear instructions to the operational staff at IRD that 100% deductibility was to be allowed provided the expenditure had been expensed pursuant to FRS 13. If the expenditure falls outside FRS 13, ordinary rules of deductibility apply, with the main issue being the capital/revenue distinction.

Officials have advised the Liaison Group that in their view the FRS 13 rules place a high threshold that must be crossed before expenditure must be capitalised, that is that in most cases the costs can be expensed and claimed as a deduction. This is because all five of the elements in paragraph 5.3 of FRS 13 must be met. For example, under 5.3(b) it is not enough that the taxpayer is confident of technical feasibility; rather, to meet the threshold, the taxpayer must be able to demonstrate technical feasibility.

The Liaison Group¡¦s views on the existing deductibility regime for research and development expenditure

The Liaison Group supports the Government¡¦s commitment to legislating for 100% deductibility for research and most development costs. Although as a practical matter 100% of these costs were already being deducted in most cases prior to the FRS 13 legislation, the Liaison Group endorses the increase in certainty arising from the legislation.

There are a number of issues that the Liaison Group would like to see addressed. These are:

Inability to depreciate/amortise development expenditure
Although in practice the vast majority of development expenditure is likely to be deductible because it is written off under FRS 13, a number of companies will incur expenditure which satisfies the five tests set out in paragraph 5.3 of FRS 13, and will capitalise the associated expenditure. The Income Tax Act is currently deficient in that:

„h There is no legislative basis for depreciating or amortising development expenditure which is capitalised, but which does not constitute depreciable property (either tangible or intangible) in terms of sub-part G of the Income Tax Act.

„h There is no legislative basis for deducting development expenditure which is capitalised on a project but is subsequently written off or written down as a consequence of that project being abandoned or less successful than initially thought .

„h There is no legislative basis for deducting expenditure incurred in deriving patents in circumstances where the expenditure is capital in nature, but the patent is not granted or the application is withdrawn or abandoned prior to grant of the project.

The Liaison Group considers that there is no policy reason why a deduction should be denied in the circumstances set out above.

The expenditure outlined above is sometimes loosely referred to as ¡¥black hole¡¦ expenditure. However, black hole expenditure also extends to matters of expense outside of the R & D regime, such as expenditure on resource management consents in circumstances where a project does not proceed. While that also needs to be addressed from a policy perspective, it is outside the R & D project.

Capitalised Research and Development costs
The Liaison group understands the general rule to be that a deduction cannot be claimed for tax if an expense has not been recorded in the entity¡¦s financial statements .

We are concerned that the Government has not considered the position of a taxpayer that has chosen, for non-tax reasons, to capitalise costs that could have been expensed. This may be the result of a choice by the taxpaying entity or it may be the result of a requirement placed on that entity, for example, by a parent or a lending institution. Where this capitalisation occurs, the effect of using FRS 13 in the legislation is to prohibit a deduction being taken.

We understand that this issue was not considered in any detail at the time that FRS 13 was incorporated into the R & D tax regime. We would like to discuss with you the feasibility of extending the allowable deduction to cover expenditure which has been capitalised but which does not give rise to a recognisable asset and is not land or buildings. If that is not feasible, we would like to discuss a change to the amortisation rules so that any capitalised expenditure (excluding expenditure on land) could be expensed over time, or immediately if the project to which the development expenditure relates is abandoned.

Differential reporting
Not all entities are required to adopt the accounting standards. Most companies are exempt companies, because they are small private companies. Multi-national companies may also be outside the accounting standards.

Where an entity is not using FRS 13 for financial reporting purposes, there is some ambiguity about the way that the legislation is applied. Such entities can only claim R & D expenditure by using the general deduction rules or the special rules allowing deductions for scientific research.

We would like to discuss with you the coverage of entities that are not required to use FRS 13. We believe that such exempt entities should be subject to the same rules for the treatment of R & D, and the same certainty of treatment, as entities that have to use FRS 13 for their financial accounting. While it could be argued that the existing wording in section DJ 9A allows this, the position is not clear and legislative clarification is required.

FRS 13 vs International accounting standard 38 (IAS 38)
Currently Section DJ 9A of the Income Tax Act 1994 explicitly incorporates FRS 13. We understand that it is likely that a New Zealand version of IAS 38 will be introduced as an alternative to FRS 13 from 2005. The New Zealand equivalent of IAS 38 will completely replace FRS 13 from 2007.

We would like to discuss the implications of this change. In particular it is important that the policy objectives outlined above not be undermined by the move to international accounting standards. While the tests in IAS 38 are very similar to those in FRS 13, an exercise will need to be undertaken to confirm that no unexpected tax changes arise from the switch.

Well-run vs poorly run companies
Concern has been expressed by companies involved in undertaking R & D that applying the five criteria in FRS 13 (at paragraph 5.3) for tax purposes may penalise orderly research and development. In practice it will be easier for an entity which is poorly run (in the sense of lacking discipline and approval procedures before R & D is undertaken) entity to show that it does not meet the criteria. A well-run entity will be trying to ensure that it gets some payback for its research and development effort, that it is acting within budget, that there is a market, etc. Thus a well-run entity may find it harder to place itself outside the requirements to capitalise.

This may be an issue that the IRD can address operationally by giving some public guidance on how it sees the criteria in paragraph 5.3 working.

General

The Liaison Group welcomes the opportunity to discuss these issues with you. We appreciate the efforts that the Government has already made to address concerns about the deductibility of research and development. We look forward to working with you in the future on this issue.

Yours faithfully

John Shewan
On behalf of the Private Sector Liaison Group on Research and Development

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