Income Tax Act 2007: research and development credits (subpart LH) - tax avoidance (section BG1)

All legislative references are to the Income Tax Act 2007.

We have been asked whether section BG 1 applies where:

1. a group of companies has a member company that performs research and development ("R&D") activities;
2. that member company is not eligible for R&D tax credits because it does not fully satisfy the requirements in section LH 3(1), even though those requirements are fully satisfied by the group as a whole; and
3. the group of companies restructures in order to enable that member company to satisfy fully the requirements of section LH 3(1) and thereby claim R&D credits.

The following example illustrates this question: A, B, and C are a group of companies for tax purposes. Company C carries out R&D activities on its own behalf within the meaning of section LH 3(1)(a) but company B, which provides the finance for the R&D activities, bears the financial risk of the R&D activities within the meaning of section LH 3(1)(c). (It is assumed that company C satisfies all the other requirements in subpart LH.) As a result of not satisfying section LH 3(1)(c) company C is not eligible for tax credits for its R&D activities, because all the requirements in section LH 3 must be satisfied by the person claiming the R&D credit. In order to enable company C to claim R&D credits, the group agrees to restructure so that company C funds its R&D activities and bears the financial risk of its R&D activities within the meaning of section LH 3(1)(c). Company C has adequate staff capability and capital to manage the financial risk assumed, and has genuinely and appropriately incurred all relevant expenditure.

Answer

The following answer necessarily sets out general principles only. The facts of particular cases always need to be carefully considered and, if there are additional relevant facts or circumstances, the conclusion may be different. In some cases it may be necessary for taxpayers to obtain advice from a tax advisor.

Although it is clear that the ability to claim R&D credits is a purpose or effect of the restructuring, section BG 1 does not apply in the scenario outlined in the example because Parliament would not have intended eligibility for R&D credits to be denied in these circumstances.

Analysis

New Zealand businesses are eligible for tax credits for R&D activities that they perform, or which they commission others to perform for them, where the requirements contained in subpart LH are satisfied.

Relevant to the question is section LH 3(1), which provides:

LH 3(1) WHAT IS REQUIRED OF PERSON?

For the purposes of section LH 2, the person must, for the income year or period in the income year,-

1. perform on their own behalf, or have another person perform, research and development activities related to-
   1. the business referred to in section LH 1(1)(a), or an intended business of the person:
   2. for an industry research co-operative, the business of a person who is an industry member under section LH 16; and
2. control the research and development activities; and
3. bear the financial risk of the research and development activities; and
4. effectively own the results of the research and development activities, if any; and
5. have-
   
   1. incurred expenditure described in schedule 21, part A (Expenditure and activities related to research and development) and not excluded under schedule 21, part B, for which they are allowed a deduction in the income year, or would be allowed a deduction if they derived income other than exempt income:
   2. an a of depreciation loss described in schedule 21, part A and not excluded under schedule 21, part B, for depreciable property used in the research and development activities, for which they are allowed a deduction in the income year, or would be allowed a deduction if they derived income other than exempt income.

The effect of section LH 3(1) is that, in order to be eligible for R&D credits, the company performing the R&D activities must by itself satisfy subparagraphs (a) to (e).

In terms of section BG 1, it is clear that the ability to claim R&D credits is a purpose or effect of the restructuring. Prior to the restructuring the company performing R&D activities was not eligible for R&D credits. The restructuring overtly enables the company to satisfy fully section LH 3(1) and thereby claim R&D credits.

It is considered however that section BG 1 would not apply. In enacting the R&D regime, Parliament sought to encourage investment in R&D activities and thereby improve the productivity and international competitiveness of New Zealand businesses: Taxation (Annual Rates, Business Taxation, KiwiSaver, and Remedial Matters) Bill 2007, Explanatory Note, at p3.

The restructuring ensures that eligibility for R&D credits is not lost in circumstances where the company performing R&D activities does not by itself fully satisfy section LH 3(1) but the group as a whole does. After the restructuring the company will incur the economic consequences (i.e., the costs and financial risk of performing the R&D activities) Parliament intended to be incurred in order to qualify for R&D credits. Accordingly the company's receipt of R&D credits would be consistent with Parliament's aim of encouraging R&D activities in circumstances where the company satisfies the eligibility requirements in subpart LH. Moreover the restructuring does not itself involve any undue pretence or artificiality.

For these reasons the Commissioner considers that section BG 1 would not apply so to deny eligibility for R&D credits in the scenario outlined in the question.