Changes to the Tax Depreciation Rules

2005 changes to the tax depreciation rules including treatment of patents, additions to depreciable intangible property, and deductibility for losses on buildings.

The tax depreciation rules have been changed to improve their operation. They include changes to the tax depreciation treatment of patents, additions to the list of depreciable intangible property, extending deductibility for losses on buildings and the special tax depreciation rate rules.

Patents

Sections CB 26, DB 31, EE 27, EE 27B, EE 27C, EE 27D, EE 52(4), FF 8, OB 1 and Schedule 17 of the Income Tax Act 2004

Tax depreciation of patent costs will be allowed to begin from the date a patent application is lodged with a complete specification, for applications lodged on or after 1 April 2005.

For patent applications lodged before 1 April 2005 that are granted in the 2005-06 or a subsequent income year depreciation will be allowed from the date of grant. Depreciation for the period the patent is pending will be allowed as a "catch-up" deduction in the year of grant.

Background

Depreciation of patents was previously allowed only from the date a patent was granted. However, the legal life of a patent - 20 years (or 240 months) - applies from the date the application for a patent was lodged with a complete specification, once a patent is granted. The change originally proposed was to recognise depreciation for the period a patent application was pending as a "catch-up" deduction in the year a patent application was granted.

Submissions put forward the view, however, that the economic life of a patent effectively begins when an application is lodged as this is when the underlying invention is typically commercialised. Also, the date of filing an application is important as it has implications for the legal priority given to competing patents.

The application first filed has legal priority and enables its owner to both generate revenue from commercialisation of the invention and prevents others from operating in the same field.

Therefore, on the recommendation of the Finance and Expenditure Committee, tax depreciation for patent costs will begin from the date a patent application with a complete specification is lodged. This change will apply to patent applications with a complete specification lodged on or after 1 April 2005. As a patent application is now being treated as a depreciable item, on the recommendation of the committee, any gain on the sale of a patent application will be taxable (as is currently the case with the sale of a patent).

As a transitional measure, the committee recommended that patent applications lodged before 1 April 2005 that are granted in the 2005-06 or a subsequent income year be allowed a depreciation "catch-up" (for the period the patent application was pending) in the year of grant. The changes that were originally proposed have therefore been retained for patent applications lodged before 1 April 2005.

Key features

Section EE 27B applies to patent applications lodged before 1 April 2005, that are granted in the 2005-06 or a subsequent income year. This section allows depreciation for the period a patent is pending to be allowed as a "catch-up" when the patent is granted (for the first income year of use). The formula for the first income year of use comprises the catch-up deduction plus the annual rate for the year. In each subsequent year, the annual rate applies. An adjustment to the formula is required where a patent is granted to a person other than the person who originally filed the patent application.

Section EE 27C applies to patent applications lodged on or after 1 April 2005 and allows depreciation from the income year of application with a complete specification. Section EE 27C applies for the period between when a patent application is lodged and when it is granted (or refused or withdrawn). The section provides an annual rate to be applied in each income year in the relevant period. To allow for these items to be depreciable intangible property, patent applications with complete specifications that are lodged on or after 1 April 2005 have been included as depreciable intangible property in Schedule 17 of the Income Tax Act 2004.

Section EE 27D applies to patent applications lodged on or after 1 April 2005, once those applications have been granted (when a patent exists). This section provides an annual rate to be applied in the income year a patent is granted, and in every subsequent year until the patent expires.

In both sections EE 27C and EE 27D, an adjustment to the respective formulas is required where the person holding the patent application (in the case of section EE 27C) and the person to whom the patent is granted (in the case of section EE 27D) are not the same as the person who originally filed the patent application.

Section CB 26 has been amended to deem any gain on the sale of a patent application (with a complete specification) to be taxable. On the recommendation of the Finance and Expenditure Committee, this change will apply only to the sale of a patent application with a complete specification where the patent application was lodged for the first time (with a provisional specification) on or after the date of enactment.

A number of consequential amendments have also been made to sections DB 31, EE 27, EE 52(4), and FF 8. In addition, a definition of "patent application date" has been included in section OB 1.

Application date

The changes to allow depreciation of patent costs, from the date a patent application is lodged with a complete specification, applies to patent applications with complete specifications lodged on or after 1 April 2005. The changes to allow a depreciation "catch-up" when a patent is granted will apply to patent applications with complete specifications lodged prior to 1 April 2005 that are granted in the 2005-06, or subsequent income years. The changes to tax gains on the sale of patent applications will apply to patent applications that were lodged for the first time on or after the date of enactment, 21 June 2005.

The above changes will apply to patent applications lodged with the Intellectual Property Office of New Zealand or a similar office in another jurisdiction.

Example 1: Patent application lodged after 1 April 2005

A Co files for a patent on a new type of printing press. It lodges an application in New Zealand with a complete specification of the invention on 1 June 2005. The patent is granted on 15 February 2008. The depreciation rate for the patent application and the patent (once granted) would be calculated as follows:

Depreciation rate for the patent application (for the period the application is pending) under section EE 27C
2005-06 income year (1 April 2005 to 31 March 2006) = 10 months divided by 240 months = 0.04 [June 2005 to March 2006]  
2006-07 income year (1 April 2006 to 31 March 2007) = 12 months divided by 240 months = 0.05  
2007-08 income year (1 April 2007 to 31 March 2008 = 10 months divided by 240 months = 0.04* [period up to grant date - April 2007 to January 2008]
Depreciation rate for the patent (for the period after the patent application is granted) under section EE 27D
2007-08 income year (1 April 2007 to 31 March 2008) = 2 months divided by 240 months = 0.01* [period from date of grant - February 2008 to March 2008]
2008-09 income year (1 April 2008 to 31 March 2009) and subsequent years = 12 months divided by 240 months = 0.05  
* the total depreciation rate for the 2007-08 income year would be 0.05 (0.04 + 0.01)  

 

Example 2: Patent application lodged prior to 1 April 2005

Z Co filed for a patent with a complete specification on a new type of cutting device on 15 January 2003. The patent is granted on 9 June 2006. The depreciation rate for this patent would be calculated as follows, under section EE 27B:

First income year of use (2006-07)
Depreciation "catch-up": 41 months divided by 240 months = 0.17 [January 2003 to May 2006]
Annual rate for the year: 10 months divided by 240 months = 0.04 [June 2006 to March 2007]
Subsequent income years (2007-08 +)
Annual rate for the year: 12 months divided by 240 months = 0.05  

Plant variety rights

Sections CC 9(2)(a), EE 27, EE 27E, EE 52(4), OB 1 and Schedule 17 of the Income Tax Act 2004

Plant variety rights granted and rights to use plant variety rights acquired in the 2005-06 or a subsequent income year have been made depreciable intangible property.

Background

A grant of plant variety rights gives the holder the exclusive right to produce for sale and to sell propagated material of the plant variety for a period of 20 or 23 years, depending on the plant material (under New Zealand legislation). Legal life begins from the date of grant.

Under the previous rules, plant variety rights and the right to use plant variety rights were not depreciable intangible property. Plant variety rights have now been listed in Schedule 17 of the Income Tax Act 2004 and will be fixed-life intangible property with depreciation over the property's legal life. The right to use plant variety rights has also been included on Schedule 17.

On the recommendation of the Finance and Expenditure Committee, a number of improvements were made to the provisions as originally introduced. They include:

  • allowing a "catch-up" of depreciation for the period an application of plant variety rights is pending (the provisional protection phase) in the income year of grant; and
  • clarifying that intellectual property protection granted in foreign jurisdictions that effectively provides protection over plant varieties (but are not explicitly called plant variety rights) falls within the scope of the change.

The legislation also clarifies that royalties from the use of plant variety rights and rights to use plant variety rights are taxable.

Key features

Schedule 17 of the Income Tax Act 2004 has been amended by inserting plant variety rights (or similar protection offshore) and the right to use plant variety rights as paragraphs 11 and 12. A definition of "plant variety rights" has also been included in section OB 1 of the Income Tax Act 2004.

New section EE 27E of the Income Tax Act 2004 allows a depreciation "catch-up" for plant variety rights that have been given provisional protection that are granted in the 2005-06 or a subsequent income year. The "catch-up" relates to the period the plant variety right has been given provisional protection. Consequential amendments have been made to sections EE 27 and EE 52(4).

The "royalty" definition in section CC 9(2)(a) has been amended to include a reference to "plant variety rights".

Application date

The changes to allow depreciation in respect of plant variety rights and the right to use plant variety rights will apply to plant variety rights granted, and rights to use plant variety rights acquired, in the 2005-06 and subsequent income years.

Example

Fruit Co files for a plant variety on a new type of apple on 1 April 2006. The plant variety right is granted on 1 January 2008. The plant variety right has a legal life of 20 years (240 months) beginning from the date of grant. During the consideration of the application the new variety of apple has provisional protection.

First income year of use (2007-08)
Depreciation "catch-up": 21 months / (240 months + 21 months) = 0.08

Annual rate for the year: 3 months / (240 months + 21 months) = 0.01

Subsequent income years (2008-09 +)
Annual rate for the year: 12 months / (240 months + 21 months) = 0.05

Losses on buildings

Sections EE 32(1) and EE 41(2) of the Income Tax Act 2004

A deduction is to be allowed for losses on buildings when a building is irreparably damaged and rendered useless for the purposes of deriving income and, the damage is not caused by the owner or a related party (or their failure to act). This new provision applies if the building is irreparably damaged in the 2005-06 or a subsequent income year.

Background

No deductions were previously allowed for losses on buildings (except when the building was a temporary building or when a building was destroyed as the result of a "qualifying event" - for example, the central New Zealand floods of early 2004).

The policy intent of this change is for a loss to be allowed when an unexpected event results in a taxpayer's building being irreparably damaged and rendered useless, when the damage is not caused by the actions of the person or failure to act (or the actions or inaction of the taxpayer's agents). The unexpected event could be a natural disaster such as an earthquake, or an event like a fire. It does not include changes to regulation (for example, health and safety) that make a building obsolete and require it to be knocked down. The event must have caused damage to the building. What is meant by "irreparably damaged" and "rendered useless" is that the building has no continuing economic value for the taxpayer. When a building is irreparably damaged and rendered useless, a deduction arises irrespective of whether the building is still standing and needs to be disposed of by the taxpayer or whether the taxpayer chooses not to dispose of the building.

Key features

Sections EE 32(1) and EE 41(2) of the Income Tax Act 2004 have been amended to allow a deduction for losses on buildings when a building is irreparably damaged and rendered useless for the purpose of deriving income and the damage occurs in the 2005-06 or a subsequent income year.

Application date

The changes apply to buildings that are irreparably damaged in the 2005-06 or a subsequent income year.

Examples

Example 1: Floods

Joe owns a warehouse that is used in his import/export business. On 1 July 2006 extreme climatic conditions cause flash flooding which results in significant damage to the warehouse. An independent assessor concludes that Joe's warehouse cannot be salvaged. In this circumstance, Joe would be able to claim a deduction for the remaining book value of the building (the loss) under section EE 41.

Example 2: Fire

Anne owns a rental property. On 7 October 2005, a fire which started on neighbouring premises spreads to her property, resulting in significant damage. The insurance company finds that Anne's premises cannot be salvaged. In this circumstance, she would be able to claim a deduction for the remaining book value of the building (the loss) under section EE 41. [Note: any insurance proceeds would be deemed consideration.]

Example 3: Fire (negligence on part of building owner)

Martin owns a workshop that is used to manufacture wooden furniture. Fire safety regulations require that the workshop be fitted with fire safety devices such as sprinklers, smoke alarms and fire extinguishers. A safety check of the premises on 30 November 2005 reveals that the sprinklers are not in working order. On 5 December 2005 a fire that is started by an electrical fault causes significant damage to the workshop. The insurance assessor concludes that the damage would not have been irreparable if the sprinklers were in working order. In this situation, Martin would not be able to claim a deduction for the loss as he has not taken reasonable care in ensuring the workshop is safe. The likelihood of the workshop being irreparably damaged is not unexpected as his inaction in not getting the sprinklers in working order had contributed to the result.

Example 4: Failure to maintain a building

John owns a building that for a long time has housed high-end apartments that have been let on short-term leases. However, owing to a combination of changing tastes for high-rise living and changes to the surrounding neighbourhood, John has recently struggled to let a majority of the apartments. The land on which the building is situated is, however, relatively valuable and John sees other opportunities for use of the land. However, he recognises that voluntary demolition of the building would result in the remaining tax-book value being lost (as no deduction is allowed generally on disposal of a building). Instead, he chooses to let the building fall into a state of disrepair. The City orders that the building be demolished for health and safety reasons. In this scenario, John would not be able to claim a deduction for the loss on demolition of the building because his inaction has contributed to his building requiring to be demolished for health and safety reasons.

Special depreciation rates

Sections EE 12 and EE 28 of the Income Tax Act 2004 and sections 91AAG(2), 91AAG(3), 91AAG(5B) and 91AAM(2) of the Tax Administration Act 1994

Changes to the special tax depreciation rules:

  • extend the rules to apply to fixed-life intangible property (such as patents);
  • clarify that the Commissioner may have regard to a range of factors in determining the estimated useful life of an asset;
  • allow the Commissioner to prescribe a special tax depreciation rate using a straight-line formula in addition to the diminishing value formula;
  • allow the Commissioner to prescribe a single special tax depreciation rate for items of the same kind that are subject to the same circumstances that underlie a special tax depreciation rate; and
  • allow the Commissioner to prescribe a special or provisional tax depreciation rate outside the six-month time limit if the taxpayer involved agrees to this.

Background

Under the special tax depreciation rules, taxpayers can apply for depreciation rates that are higher (or lower) than those prescribed by Inland Revenue if they consider the prescribed general depreciation rate is substantially different from the rate that should apply. This may arise, for example, if depreciable property is being used in a way that is different from that considered by Inland Revenue when determining a general economic depreciation rate for the property.

The changes allow the Commissioner greater flexibility in considering special tax depreciation rate applications if he is reasonably satisfied that, in the circumstances, a more accurate estimate of economic life, to the estimate of economic life used to prescribe the general tax depreciation rate (estimated useful life), is applicable.

One of the main changes is to extend the availability of special tax depreciation rates to what is currently fixed-life intangible property (that is, depreciable intangible property which must currently be depreciated over its legal life, such as patents). Taxpayers are now able to approach the Commissioner for a special tax depreciation rate for these assets.

Another change allows the Commissioner to consider a broad range of factors when determining what an accurate estimate of economic life should be. This change in particular is designed to make it easier for the Commissioner to consider the impact of events outside a taxpayer's control which may curtail an asset's useful life (and result in the asset not being able to be salvaged or used). Examples include when the regulatory environment changes so an asset can no longer be used lawfully (for example, environmental legislation which outlaws the use of a particular type of machine) or when the raw materials that are used as an input into the asset are expected to run out. Another example is when the rate of technological obsolescence for an asset is significantly higher than was originally envisaged.

It is worth noting that the Commissioner's general view (TIB Vol 10, No 1 January 1998) is that the "whole of life" approach for determining the estimated useful lives of assets is the appropriate benchmark for setting tax depreciation rates. This view was supported by the Finance and Expenditure Committee and will continue to be the case under the changes to the special tax depreciation rates.

Other changes ensure that the Commissioner can prescribe a special tax depreciation rate using the straight-line method from the outset if a taxpayer requests this. Under the previous rules, the Commissioner was required to issue a special tax depreciation rate using the diminishing value formula (with a straight-line equivalent then having to be calculated).

On the recommendation of the Finance and Expenditure Committee, the legislation has been amended to allow the Commissioner to prescribe a single special tax depreciation rate for a group of identical assets that are all subject to the same special circumstances. For example, a set of five printing presses that because of special circumstances are all expected to last less than their prescribed economic life. Previously, taxpayers had to lodge a separate application for each press, even though the rate allowed would be the same for each item. Now the taxpayer needs to only lodge a single application for the group of assets.

Finally, changes have been made to allow the Commissioner to prescribe a special or provisional tax depreciation rate outside the six-month time limit for issuing such rates, if the taxpayer agrees to this. This change recognises that certain special and provisional tax depreciation rate applications are complex and may require a period longer than six months to be resolved (for example, if they require the input of expert valuers). One of the concerns raised in submissions to the Finance and Expenditure Committee with this change was the status of tax assessments where a special or provisional rate has been applied for and the taxpayer agrees to an extension of time, but such an extension results in a tax assessment being made before the issue of a rate. In these circumstances, taxpayers should use the relevant Commissioner-prescribed rate for the purposes of the assessment. Then, if the application for a special or provisional deprecation rate is granted, and it covers the income year at issue, taxpayers can make a request to the Commissioner under section 113 of the Tax Administration Act 1994 for an amendment to that assessment.

Key features

Section EE 28 of the Income Tax Act 2004 has been amended to extend the special tax depreciation rules to apply to fixed-life intangible property such as patents. Section EE 12(1) has been amended as a result.

Section 91AAG(2) of the Tax Administration Act 1994 has been amended to clarify that the Commissioner may have regard to a range of factors in determining the estimated useful life of an asset.

Section 91AAG(3) has been amended to allow the Commissioner to prescribe a special tax depreciation rate using a straight-line formula in addition to the diminishing value formula.

On the recommendation of the Finance and Expenditure Committee, section 91AAG(5B) has been added to allow the Commissioner to prescribe a single special tax depreciation rate for items of the same kind that are subject to the same circumstances that underlie a special tax depreciation rate.

Section 91AAM(2) has been amended to allow the Commissioner to prescribe a special or provisional tax depreciation rate outside the six-month time limit if the taxpayer agrees to this.

Application date

The amendments will apply to applications for special tax depreciation rates that are made in the 2005-06 and subsequent income years. The amendment to the six-month time limit also applies to provisional tax depreciation rate applications made in the 2005-06 and subsequent income years.

Costs associated with failed or withdrawn resource consents

On the recommendation of the Finance and Expenditure Committee, section DB 13B of the Income Tax Act 2004 has been amended to treat the costs incurred on a failed or withdrawn resource consent application as deductible if those costs would have formed part of the cost of depreciable property, or would otherwise have been allowed as a deduction, if a resource consent had been granted. Section DJ 14B in the Income Tax Act 1994 has also been amended accordingly.