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Understanding the Commercial Production Rules in Research and Development (R&D) Tax Incentive
In 2019, the New Zealand government introduced the R&D Tax Incentive (RDTI) program, replacing the earlier Growth Grants initiative. The primary aim of RDTI is to encourage Research and Development (R&D) activities within New Zealand by offering financial support to eligible businesses. This support is intended to promote a more diverse and productive national economy.
To qualify for RDTI funding, businesses must meet specific eligibility criteria outlined by Inland Revenue. Conversely, some activities fall under the ineligible criteria listed in the Income Tax Act 2007 Schedule 21. These exclusions are applied for various reasons, such as when the required knowledge to resolve uncertainty is publicly available, or the fiscal cost associated with the activity is deemed too high. Additionally, if the government believes that other incentives are more suitable for encouraging specific activities, those activities may also be excluded from RDTI. Among these determinants of ineligible R&D expenditure, R&D activities carried out in the course of commercial production are listed due to the nature of the uncertainty that has been resolved.
‘The commercial production’ means producing products or services for sale. ‘In the course of’ refers to time and location. If an R&D activity occurs in the course of commercial production, only specific expenses related to that R&D are eligible for tax credits. This rule is essential to ensure that costs associated with regular business operations do not qualify for R&D tax credits.
The exception is listed in the Commercial production rule, which is stated in the Income Tax Act 2007 Section LY 5(1)(c) that, if an R&D activity takes place in the course of commercial production, the expenses eligible for tax credits are limited to:
- Expenditures relating to the contribution of employees to the R&D.
- Additional expenses incurred due to the R&D.
The eligible expenditure does not include expenditure or loss that would have been incurred in the absence of the research and development activity, if it:
- Is performed in the course of commercial production, and
- Is not in relation to an employee’s contribution to a R&D activity.
In essence, expenses not directly tied to R&D are ineligible. To determine if these expenses are directly linked to R&D, a test can be applied:
- Consider whether these expenses would exist if R&D activities were absent.
- Examine if removing support from these overhead costs would hinder R&D activities.
For instance, overhead expenses like rent, insurance, administrative personnel, and cleaning costs may or may not be eligible as R&D expenses, depending on their direct association with R&D activities.
To decide if these activities are directly related to R&D, two components should be considered:
- If these expenses would still exist if R&D activities did not occur, such as rent for premises specifically used for R&D or administrative support solely for R&D.
- If removing this overhead support would prevent R&D activities from continuing.
If either answer to these tests is negative, the expenses are likely ineligible for consideration. A crucial requirement for these expenses is maintaining records demonstrating the application of reasonable apportionment methods, as they often serve multiple purposes. This helps identify the portion of expenditure related to eligible R&D activities versus other business activities.
It is not uncommon for businesses involved in R&D to become confused about the eligibility of expenses linked to commercial or pre-commercial production. This complexity is often encountered in businesses conducting ongoing R&D projects with the intention of eventually selling them as final products or services. Conversely, businesses might already have revenue-generating products/services while concurrently pursuing supplementary R&D projects using the same product or service.
In summary, these scenarios require careful analysis to distinguish between R&D expenditure and segments generating revenue. The latter does not require additional R&D funding and is therefore excluded from R&D tax credit eligibility.
Should your business be applying for the R&D Tax Incentive and require guidance on navigating the complexities of the commercial production rule and other issues, please contact us for assistance.