What R&D expenditure do accounting standards allow to be expensed immediately?

This is covered by paragraph 5 of Financial Reporting Standard 13 (the accounting standard for R&D). Paragraph 5 requires research expenditure to be expensed immediately for accounting. It requires development expenditure to be expensed immediately for accounting unless and until all the following criteria are satisfied:

1. the product or process is clearly defined and the costs attributable to the product or process can be identified separately and measured reliably;

2. the technical feasibility of the product or process can be demonstrated;

3. the entity intends to produce and market, or use, the product or process;

4. the existence of a market for the product or process or its usefulness to the entity, if it is to be used internally, can be demonstrated;

5. adequate resources exist, or their availability can be demonstrated, to complete the project and market or use the product or process.

Development costs incurred after all the criteria are satisfied are not expensed immediately for accounting, rather they are capitalised and amortised over the economic life of the asset.

What is the change from current law?

In many cases, it is currently not clear whether a particular item of R&D expenditure will be immediately deductible. This will depend upon the application of case law principles that determine whether the expenditure is capital or revenue. Broadly, expenditure is capital if it gives rise to an enduring benefit to the taxpayer. Otherwise, it is on revenue account. There is little New Zealand case law on whether R&D expenditure is on capital or revenue account that helps taxpayers in making this distinction.

There is therefore some uncertainty about how much R&D expenditure is immediately deductible. This proposal reduces this uncertainty by permitting R&D that is expensed when it is incurred under paragraph 5 of FRS-13, to be deducted immediately for tax. In essence, the proposal allows taxpayers to use the accounting standard, instead of case law on the capital/revenue boundary, to determine when R&D expenditure is immediately deductible.

This means that research expenditure will be immediately deductible for tax purposes. Development expenditure will also be immediately deductible unless all of the paragraph 5 criteria are met.

Can anyone be disadvantaged?

The proposal will not disadvantage any taxpayers, relative to existing tax treatment. It will operate as a "safe harbour".

If taxpayers comply with paragraph 5 of FRS-13 in relation to their R&D expenditure (including expenditure that is not material for accounting purposes) they will obtain the benefit of this proposal. If they are not required to comply with that paragraph, and they do not want to incur compliance costs in complying with it, the existing tax treatment will continue to apply to them.

If taxpayers capitalise and amortise R&D expenditure for accounting because the criteria in paragraph 5 are satisfied, they may nevertheless argue that such expenditure is on revenue account for tax purposes.

Accounting standards are uncertain so what is the benefit?

The criteria in paragraph 5 are flexible. For example, it is a matter of judgement when technical feasibility is demonstrated. Taxpayers will be in the best position to make those judgements. Such judgements are likely to be challenged by Inland Revenue only when they are clearly not sustainable. The proposal will therefore in practice provide greater certainty to taxpayers than they currently have.

Won't this increase compliance costs?

No. Many companies already have a legal requirement to apply FRS-13 when reporting to shareholders. They will use the same rules when reporting income to Inland Revenue. Taxpayers who do not currently have to comply with paragraph 5 of FRS 13 will have the choice of applying existing law, or complying with paragraph 5 and obtaining increased certainty.

How does this affect software?

The Commissioner of Inland Revenue set out his views on the tax treatment of software development costs in 1993 (Tax Information Bulletin Vol. 4 No. 10). That item includes a discussion on the deductibility of the costs of developing software for in-house use. Broadly, pre-development costs are immediately deductible, and development expenses are capitalised until the project is completed and then depreciated over three years.

Under this proposal, if software development costs fall within the definitions of research and development under FRS-13, and are expensed immediately under paragraph 5, they will be immediately deductible for tax.

What is the estimated fiscal cost?

The fiscal cost of the proposal is difficult to estimate. The Government understands that almost all R&D is immediately deducted for tax purposes. If this is the case, it is likely that the measure will not have a significant fiscal cost.

The exception is likely to be in relation to software development costs that are capitalised and amortised over three years. It is not clear how much software development that is currently depreciated would become immediately deductible. Treasury has provided its best estimate of the cost by making assumptions about the amount that would become immediately deductible. It estimates a one-off revenue cost of $12.4 million over two years (not taking future growth in software development expenditure into account).

Is this a tax concession?

No. However, in legislating for a capital/revenue boundary in this area the Government is proposing a rule that is likely to be more generous than existing tax law.

Is this going to be reconsidered by the McLeod Tax Review?

The McLeod Review will report on the structure of the tax system including whether taxes should be used to encourage worthwhile activities such as R&D. Following that report, the Government will consider specific tax issues. That may include further changes to the tax treatment for R&D.

Why is the Government proposing this change?

By clarifying the distinction between expenditure that is immediately deductible from what is not and by aligning tax and accounting treatment in this area, there should be more certainty for taxpayers and fewer disputes between taxpayers and Inland Revenue. That should allow businesses to focus more on their business and less on their tax affairs. Discussions with tax practitioners identified uncertainty and risk of tax disputes as a significant problem in the R&D area. The proposal addresses that concern.

When will the proposal be in legislation?

The Government will issue a Discussion Paper on the proposal. In accordance with the normal tax policy process, it will consult on that. The result of those consultations could result in legislation next year.

Will the R&D grants scheme announced in the Budget continue?

Yes. This proposal aims to reduce tax problems encountered with R&D but is not a tax concession. The grants scheme is specific targetted Government assistance to increase the level of R&D in New Zealand.

What proportion of R&D will be immediately deductible?