Research and Development Tax Deductions Reduced
01 September 2011
Posted by: Author: David Warneke
Research and Development Tax Deductions Reduced
Section 11D of the Income Tax Act, the provision that grants taxpayers a deduction in respect of research and development (R&D)activities conducted in South Africa, is set to undergo fundamental changes if the recently-released Draft Taxation Laws Amendment Bill becomes law. Many of these changes are confusing, and they are by no means all taxpayer-friendly.
One of the requirements of the proposed provision is that in order to qualify for any deductions, expenditure on R&D would have to be incurred solely in respect of R&D. Under the current provision, this requirement is not explicitly stated, and it is therefore possible to argue for an apportionment of a deduction where an expense is incurred both for R&D and for non-R&D purposes.
In the case of individuals and trusts that undertake R&D, no deductions may be claimed unless the R&D expenditure passes the tests of being both ‘in the pursuance of the production of income’ and‘in the carrying on of any trade’. In the case of companies that undertake R&D, only the ‘in the pursuance of the production of income’ test needs to be passed. In the case of individuals and trusts,the ‘trade’ test seems to imply that the taxpayer would have to be trading in R&D in order to qualify for deductions. It would seem that in respect of revenue R&D expenditure, 150% of the amount may be claimed where the taxpayer is a company that does the R&D, as opposed to individuals or trusts that do R&D.It is not certain why individuals and trusts will no longer qualify for the additional 50% deduction, and this is something that BDO has criticised in its submission to Treasury on the Bill.
The proposed provision is confusing in that it does not comprehensively deal with capital R&D expenditure. One has to refer to other provisions in the form of proposed amendments to Sections12C and 13(1) for the proposed treatment of certain capital expenditure. In my view it would have been better to have housed these provisions within Section11D.
If one examines the wording of Section 11D in isolation, it would seem that both revenue and capital expenditure (provided that the latter does not attach to an ‘R&D facility’) will potentially qualify for a full deduction of cost and an additional 50 per cent deduction of cost in the year of incurral.This is in contrast to the current 150 percent deduct ion for revenue expenditure and a 50/30/20 per cent deduction regime over three years for capital expenditure.
However, when one examines the proposed amendments to Sections 12C and 13(1), it would seem that this is not the intention and that the 150 per cent deduction in Section 11D is by implication meant only to cover revenue R&D expenditure.Assuming that this is the case, it would greatly assist with the interpretation of the provision if it were made clear that the deductions referred to only relate to revenue expenditure.
In respect of deductions for capital R&D expenditure, proposed amendments to Section 12C grant an allowance for new and unused buildings or parts thereof, or machinery or plant owned by a taxpayer and first brought into use by that taxpayer for purposes of R&D.The allowance is based on the cost of the assets and is granted over four years at the rate of 40 percent in the first year, followed by 20 per cent allowances over the remaining three years.Proposed amendments to Sect ion 13(1) also contain allowances for buildings used in R&D activities.This allowance would not be claimable in addition to that under Section 12C, and it is uncertain in many instances which of the two allowances would apply. The proposed amendments to Section 13(1) all relate to buildings which are ‘wholly or mainly’ used for R&D.It is considered that this implies more than 50 per cent by floor area.The buildings must either have been built by the taxpayer or purchased. If purchased then they either have previously have been unused or else purchased from a seller who was entitled to claim a Section 13(1) allowance themselves.
Where the building is a laboratory or similar structure, an incentive allowance in the form of an additional 50 per cent of cost(over and above the Section 12C or 13(1) allowances) is deductible in the year in which the laboratory is first brought into use.Technically the proposed provision refers to a‘research and development facility’,which is defined to mean a laboratory or similar structure which is expected to be used on a regular or continuous basis and is designed solely for carrying on R&D activities.To qualify for the additional 50 per cent allowance,the laboratory must:
• Be used on a regular and continuous basis;
• Designed solely for carrying on R&D activities;
• Be approved by the Minister of Science and Technology (see below); and
• Be contracted for on or after the date of the approval.
One has to question the wisdom of the pre-approval requirement, as inordinate delays in the process could entirely scupper projects with severe time constraints.Perhaps a process whereby tax assessments incorporating Sect ion 11D deductions would not be issued prior to the obtaining of approval would have been preferable to the proposed pre-approvals process.Some of the factors that have to be considered by the Minister of Science and Technology for purposes of the approvals process are skills development, job creation,and the provision of synergies with other R&D or economic activities undertaken within the Republic.
It is not clear why approval of a research project should be necessarily linked to job creation or other activities undertaken within the Republic. Why, for instance,should a non- resident be discouraged from setting up a research project in South Africa merely because few jobs will be created in South Africa? It can be argued that the mere undertaking of such a project in South Africa would be a boon.
Then within 12 months after the close of each tax year, the taxpayer would have to report to an adjudication committee, in respect of the progress of the project.The adjudication committee would consist of five employees of the Department of Science and Technology, one employee of National Treasury, and two employees of SARS.Where a taxpayer funds expenditure of another person that conducts R&D, the taxpayer would only be able to claim the additional 50 per cent deduction if the person that conducted the R&D were one of a number of listed public research bodies or a company in the same group as the taxpayer,provided that in the latter case such fellow group company did not itself
claim the additional 50 per cent deduction.
With respect to taxable government grants received, under the proposed provision tax payers will be better off than under the current provision.Under the proposed provision, the additional 50 per cent deduction is not available on R&D expenditure up to the amount of the grant, but it is claimable on the balance.For example, if a grant of R100 were received and qualifying R&D expenditure were R300, then only R200 of the expenditure would qualify for the 150 per cent deduction, while the remaining R100 of the expenditure would only qualify for 100 per cent deduction.
Total deductions would therefore be R400.Under the existing regime,only 100 per cent of the expenditure qualifies for deduction up to twice the amount of the government grant, with the 150 per cent deduction applicable to the remainder of the expenditure.Total deductions in the example above would therefore amount to only R350.
The proposed provision explicitly does not allow any R&D overheads to be deducted.Under the current provision, it would appear that direct overheads qualify for deduction, but not indirect overheads.This is because the wording of the current provision allows a deduction of ‘expenditure actually incurred … directly in respect of [ research and development] activities undertaken in the Republic directly for the purposes of [qualifying R&D activities]’ (emphasis added).The first use of the word ‘directly’ implies that indirect costs may not be deducted. This would appear to represent a major change.
In terms of the proposal, certain other types of expenditure would be added to the current list of non qualifying expenditure. These are expenditure in respect of:
• Routine testing, analysis, the collection of information and quality control;
• The creation or development of financial instruments or financial products; or
• The acquisition or use of preexisting inventions, designs or computer programs.
In addition, ‘financing and legal costs in respect of R&D’ may not be claimed.On the other hand,there would be a slight relaxation in the current blanket prohibition on the deduction of expenditure relating to ‘exploration or prospecting’.This prohibition would, in terms of the proposal, be confined to oil and gas or mineral exploration or prospecting only.Taken in its entirety, the proposal may be described as a curate's egg.One welcome aspect of the proposal is the concept of an independent approval of R&D projects.This should create certainty for taxpayers in their dealings with SARS.
However, there are many potential pitfalls elsewhere, and taxpayers should take careful note of the wording of the proposal in relation to their specific circumstances.One of the more significant consequences of the proposal, if it were enacted, is that we would doubtless see significant numbers of individuals ,partnerships, and trusts that undertake R&D incorporating in order to derive benefits in future.
Source: By David Warneke (Tax breaks)