One of the positive features of the 2013 budget is that it brought in provisions designed to deal with what is called “black hole” expenditure. “Black hole” expenditure is expenditure that is not prohibited from deductibility pursuant to s DA 2 of the Income Tax Act 2007 (ITA) but which never eventuates into a capital asset.
Routine expenditure of a business is deductible under s DA 1 of the ITA. That section is called the general permission. Crudely it provides that a person is allowed a deduction for an amount of expenditure or loss to the extent that it is incurred by them in deriving assessable income or incurred by them in the course of carrying on a business for the purpose of deriving assessable income. Thus in principle all expenditure incurred by a business that is being carried on for the purpose of deriving assessable income is deductible.
However, s DA 2 of the ITA describes specific situations where the general permission is overridden: s DA 2(7). One such overriding situation is where the amount of expenditure or loss is of a capital nature: s DA 2(1). This is called the capital limitation.
While expenditure which is capital in nature cannot be deducted it can be depreciated. Thus the cost of a capital asset whether calculated by reference to its acquisition price or construction price can be depreciated. Depreciation is not as good as a full deduction in the year the expenditure is incurred because it provides for only small annual deductions over the estimated useful life of the asset. Further, if the asset is sold for more than its written down book value, that “excess” depreciation is clawed back as income.
While depreciation is worse than a full deduction in the year the expenditure is incurred it is better than nothing. “Black hole” expenditure is the name given to expenditure that cannot be deducted in the year it is incurred because of the operation of s DA 2(1) but which does not give rise to a capital asset and hence cannot be depreciated over time. Because the expenditure does not give rise to a capital asset the outgoing is not captured in anything that can be depreciated for tax purposes. The expenditure therefore sits in no-man’s land and cannot be deducted. It falls into a “black hole” so to speak.
As a general proposition there is tax symmetry. A revenue account receipt is taxable and revenue account costs are assessable. Conversely, capital gains are not taxable but capital losses are not deductible either. Depreciation recognised the diminution in value of capital assets over their useful working life. It also recognises that the asset will have to be replaced eventually. Black hole expenditure was and is a breach of the symmetry because it falls into a hybrid category being neither truly revenue in nature nor truly capital in nature because no asset has been generated.
Prior to the budget announcements the common law did not allow for a different classification of the expenditure depending on whether its objective was met or not. The law classifies the expenditure by reference to the purpose it had when incurred. The proposal is that now the tax treatment of certain forms of black hole expenditure will be outcome driven.
This phenomenon can arise in all sorts of businesses. For example the case of Milburn NZ Limited is a typical example of what occurs with “black hole” expenditure. The case is reported as Milburn NZ Limited & Anor v CIR (2001) 20 NZTC 17,017. In that case a subsidiary was incorporated to investigate acquiring other concrete businesses and investigating the possibility of developing concrete businesses. This investigation work entailed investigations of 48 different sites as the possible aggregate sites for such businesses. The majority of these investigations were into existing quarries but some investigations were into greenfield quarries.
The immediate purpose of the expenditure incurred in relation to the greenfield sites was to secure consents or licences necessary to develop the sites into quarries of either aggregate or lime for the broader concrete making business of Milburn.
Milburn (and its subsidiary) classified the expenditure as revenue account expenditure and claimed deductions under what is now s DA 1 of the ITA. In fact the expenditure was capital in nature because it was spent in order to establish an asset which was a significant and important addition to Milburn's operating structure. One of the greenfields sites involved the direct replacement of an existing strategic asset. The subsidiary’s expenditure was similar in that it was incurred in investigating a resource alternative to an important existing one which was likely to be circumscribed in the future.
Given the capital limitation the taxpayer was forced to argue that the expenditure was not capital at all but was on revenue account. That was always a very big ask and they unsurprisingly failed. The expenditure was indeed capital in nature but it did not on the facts of that case lead to the creation of any capital asset. Because no capital asset was created the expenditure fell into the black hole and was not able to be deducted.
This has long been a frustration for business. For example, a power company may spend many millions of dollars looking at the feasibility of and seeking various consents for a power generation project. If that project does not see fruition it will not generate a capital asset and hence all the costs will not be deductible. Teams of tax accountants are employed to minutely scrutinise all such expenditure to see what can be justifiably pushed into the revenue account category and be deducted.
Those efforts will diminish now that the Government has announced legislation to deal, partially, with black hole expenditure.
The changes intended are that a person will be allowed an immediate deduction (on abandonment) for legal and administrative costs incurred in applying for patents or plant variety rights, in circumstances where those applications are unsuccessful in terms of creating a tax asset which can be depreciated.
A person will be permitted a deduction in the year in which the resource consent applications are abandoned. This would cover say a power company’s costs associated with an intended but abandoned application for resource consent. The deduction is allowed even for expenditure that has not resulted in an application for resource consent being lodged. Currently the law requires taxpayers had to lodge their application.
As mentioned the deduction is intended to be permitted in the year of abandonment of the project to obtain the patents, plant variety rights or resource consents. Hence there will be no immediate deductibility. The tax treatment will be held in suspense until the outcome is known. The logic here being that if the project is successful then there will be a capital asset and hence the expenditure can be depreciated and will not by virtue of the success be black hole expenditure. The project’s failure will now trigger deductibility. This will comprise a statutory departure from the principle that the tax outcome is determined from the purpose of the expenditure at the date it is incurred.
The motivation from a governmental perspective for these changes is unlikely to have been a desire to improve tax symmetry. It is more likely to have been a desire to remove impediments to obtaining of patents, plant variety rights and resource consents. Those assets are ordinarily associated with positive investment activity, which is something that the government wants to encourage.
These two changes deal explicitly with black hole expenditure as it has been described above. It will be immediately apparent that although the headlines made it look as if the whole conceptual problem with black hole expenditure was benevolently dealt with by the law changes announced on budget night, that is not in fact the case. The changes address only a very small subset of what is comprised within the concept of black hole expenditure.
If one takes the Milburn case as illustrative, the new rules would allow a deduction for Milburn (I will not complicate things by specifying whether it was Milburn or its subsidiary that would benefit) for the costs which were incurred and relate to obtaining resource consents but in respect of which applications which were abandoned before being lodged. However, any costs associated with an investigation of but abandoned acquisition of an existing quarry would not meet the new “anti-black hole” tests. That expenditure would not be for the purpose of obtaining patents of any sort, nor would it be for the purpose of acquiring resource consents. The expenditure would nonetheless be capital in nature.
In this regard the standard capital tests still exist and would be satisfied. The costs of investigation into a failed quarry acquisition would be capital. The objective of the expenditure would correctly be classified as being for the purpose of creating an enduring asset or advantage. While the expenditure would still be capital, no deduction will be allowed in respect of it.
There are some additional taxpayer friendly developments stemming from the budget that have also been categorised as black hole reducing. These changes are as follows:
- Certain fixed-life resource consents granted under the Resource Management Act can now be depreciated. These previously could not be depreciated as they were excluded from the definition of fixed life intangible assets.
- Providing immediate deductibility for all direct costs associated with the payment of dividends to shareholders.
- Providing immediate deductibility for the annual fees for listing on the stock exchange, subject to some qualifications. There is a distinction between the annual fee for listing and the costs of listing. Those costs would include solicitor and other advisor costs associated with the prospectus and other listing documents. Those costs are not deductible and the law is being changed to make that very clear.
- Providing immediate deductibility for the costs of annual general meetings. Special general meeting costs will not be deductible.
These last three items can be seen as aimed at encouraging listing on the New Zealand Stock Exchange. The Inland Revenue policy advice division says that the intention is to have legislation in place for the 2014/2015 tax year.
There is a sister topic to black hole expenditure and that is expenditure incurred prior to a business being established. Manufacturing enterprises for example begin with the building of plant and machinery. This is all capital in nature. The depreciation can only begin to be deducted once the enterprise has commenced business.
With respect to industrial concerns, a period of many years may pass between the first sod being turned to build the plant and the business commencing. The depreciation allowance will start to flow in the year the business starts which will be when the raw materials are ordered for production to commence.
There exists a form of black hole expenditure or timing disadvantage in the case of research and development costs associated with start-up ventures. A rather radical proposal to ameliorate this problem has been announced by the Government in the budget. The announcement was that a public consultation paper will be released in June on a proposal to allow tax losses arising from research and development expenditure to be refunded!
The proposal is embryonic at this stage. The sketchy details are that it will be targeted at “small, innovative businesses that invest heavily in research and development.” Such activity is deemed to be “doing the right thing” and the Government wants more people “doing the right thing.”
The idea seems to drive off the fact that small research and development intensive start-ups tend to endure long periods in tax loss as a result of high risk, upfront investment. The assumption is that start-ups are not swimming in money and that the cost of the research and development can be a real disincentive to undertaking that activity. The Government wants to incentivise that sort of activity and hence is proposing refunds.
To many tax purists who think that tax ought to be broad based and flat such that economic decision making is not distorted, this development although tax payer friendly will remind them of the bad old days of export incentives and the like.