Wednesday, November 20, 2013

Black hole expenditure

Puppies We each have our own version of a black hole. In my home I'm sure there is a black hole that removes random items from my kids' LEGO sets, last season's garments from my wife's wardrobe, and random socks from my sock drawer.

The Inland Revenue Department (IRD) has yet another version of a black hole. Black hole expenditure is defined in the discussion document as:
'business expenditure that is not immediately deductible for tax purposes and also does not form part of the cost of a depreciable asset for tax purposes, and therefore cannot be deducted over time as depreciation'.

Patents and plant variety rights

There is a proposal to allow depreciation of capitalised development expenditure that:
  • relates to an invention that is the subject of a patent or patent application; or
  • a plant variety that is the subject of plant variety rights.

Capitalised development expenditure will be allowed to be depreciated over the legal life of the asset to which it relates.

It's good that the IRD is consulting on this issue. They seem to have forgotten about registered designs (design patents). Those who work with them know that a significant amount of R&D cost is spent on technology for which registered design protection is obtained, or at least applied for.

Unsuccessful R&D

Some capitalised development expenditure may not give rise to a valuable asset. A valuable asset here is one that is depreciable for tax purposes. Or an asset that is non-depreciable for tax purposes because it does not have a finite useful life that can be estimated with a reasonable degree of certainty (eg know how).

The discussion document outlines a proposal to allow a person a tax deduction for capitalised development expenditure they have incurred if:
  • the intangible asset has been derecognised prior to it earning income;
  • the person intended that the expenditure would lead to an item of depreciable intangible property; and
  • no other deduction has been allowed.

Getting the incentives right

There's a risk of perverse incentives here. The discussion paper notes that:
'allowing immediate deductibility of unsuccessful capitalised development expenditure would create a perverse incentive for taxpayers not to complete marginal projects because, when the value of exploitation is low or uncertain, immediate deductability of unsuccessful capitalised development expenditure may be preferred by the taxpayer over depreciation of successful capitalised development expenditure.'
This has got to be weighed up against the greater risk that:
'businesses may be incentivised to complete projects that (ignoring tax) have been discovered to be inefficient, simply to avoid black hole treatment of sunk capital expenditure'.
My view is that abandoning inefficient projects is a prudent thing to do. It's a hard thing to do. A bit like drowning puppies. But it has to be done. I can't see any perverse incentive in doing that.

Further steps

The IRD is looking for submissions on the proposed reforms by 17 December 2013. I expect that feedback on the reforms will be largely positive from those doing R&D. Supporting business growth and innovation by changing 'black hole' tax treatment of R&D expenditure can't be a bad thing.

Photo courtesy of author Niall Kennedy under Creative Commons license.

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