Coalition’s R&D tax break ‘unworkable,’ ‘uncompetitive’

A clutch of innovators and investors like the general direction of Megan Woods’ new R&D policy but find at least four major problems with its current form.

Punakaiki Fund director Lance Wiggs goes as far as saying the current tax break proposal is “unworkable” but, like the others, he’s relatively optimistic that it can be improved during the 60-day consultation period that kicked off yesterday.

The research, science and technology minister has proposed reintroducing a 12.5% tax break for research and development, capped at $15 million a year per company, from April 1 this year.

The quid pro quo would be that $155m in Callaghan Innovation Growth Grants would be axed (something the coalition is more sheepish about; the measure is first mentioned on page 31 of the discussion paper released yesterday. And although the paper stresses that options are up in the air, an accompanying Q&A is more blunt, saying “The Growth Grant scheme will be closed to new applicants on March 31, 2019.” Smaller Callaghan project grants and the Crown agencies' research role will remain.).

Problem 1: Gaming the system
Ms Woods wants R&D spending to increase from today’s 1.28% of GDP to 2% (the OECD average is 2.38%).

Punakaiki Fund manager Lance Wiggs says it’s a given that R&D spending will soar because firms will financially incentivised to reclassify as much spending as possible a research and development.

And here’s the first issue.

National says a 12.5% tax break failed to be effective during the Clark-Cullen government. That’s not really fair, given the policy was barely in place for six months before being wiped by the incoming John Key government in favour of the establishment of Callaghan Innovation

But former finance minister Steven Joyce’s wider point – that companies will try to game an R&D tax break, and that it will be hard to police what is being classified as research – is trickier to rebut.

Callaghan Innovation has had the same issue, notably with the Trends Publishing case that saw the Serious Fraud Office drafted in but two wrongs don’t make a right.

The industry experts consulted by NBR had no killer ideas on this one, though investor Ralph Shale notes that Inland Revenue, which has a track record of charges that have led to fines and jail time, will be more feared by potential rule-breakers than Callaghan Innovation, violations of whose terms have resulted in "a slap with a wet bus ticket" (Callaghan did bring in the SFO in the instance of Trends Publishing, it should be noted. That case is also notable for the difficulty in determining when software development is in the cause of R&D, and when it is being used for business-as-usual – often it's a grey area or both).

For Ms Woods, it’s one of the reasons the policy has entered a six-week consultation period over the discussion paper.

And the paper does acknowledge mistakes were made with the last implementation.

Fixes will have to be found this time around, Mr Wiggs says, because "As it stands, I don't think it's a workable system."

Andy Hamilton says it's not competitive.

Problem 2: Not competitive
Asked if a 12.5% tax break is competitive, Icehouse chief executive Andy Hamilton has a simple answer: “No.”

As a number of readers pointed out after NBR’s story yesterday, Australia offers a much more generous R&D tax break.

As ever, we’re in something of a war of incentives.

During the election campaign, Jacinda Ardern told NBR National’s move to eliminate the Clark-Cullen 12.5% tax break pushed companies offshore. Asked to name an example, she said LanzaTech, which decamped from Auckland to Chicago where the state government offered better tax breaks.

But Mr Wiggs says LanzaTech shifted to the US because its largest investors were Americans, who wanted it closer.

And another company that threatened to move offshore if the 12.5% tax break was eliminated, big data star Wherescape, did not.

Regardless, tech startups are always looking for the most attractive landscape, and Mr Hamilton notes that in terms of R&D tax breaks, 12.5% is not world-beating.

Problem 3: Getting SMEs to the party
Mr Hamilton – who calls Callaghan Growth Grants a “distortion” – says big companies have a relatively poor track record in R&D. He puts this down to half of them doing most of their business locally, where they enjoy a lazy monopoly.

And he adds that the reality is that New Zealand is largely an angel-backed rather than venture-backed economy, given our relative dearth of large investors (and it’s notable that it's looking as though The Big Two – the Super Fund and ACC – are going to sit out NZVIF’s latest fund).

Thus he thinks small to medium enterprises (SMEs) must be incentivised to do more R&D. And while he backs the tax break, he says 12.5% or even 20% probably won’t be enough to get SMEs involved.

So how do you do that? That’s another one where everyone’s hoping the six-week consultation process will throw up some bright ideas.

Both Messrs Wiggs and Hamilton agree part of it will be keeping things the tax system simple as possible, including the new tax break, and to ensure New Zealand is an attractive place to do business overall with a minimum of red tape (though the problem can be where this clashes with the need to identify those attempting to rort the system).

Having said that, the Icehouse boss is also concerned that all companies aren’t treated the same. A large company has a quite different approach to R&D from the likes of a Xero, or an early-stage business, he says. So there must be a degree of nuance in the policy.

Problem 4: Not big enough
Closely related to problem 2. Aussie independent director Dr Anna Lavelle says the evidence points to the fact that, to be effective, an R&D tax credit has to be substantial.

In Australia, a company with under $A20m annual revenue can claim – cashback – 45c on every dollar spent on research and development.

Companies with over $A20m turnover can claim 38c in every R&D dollar back.

Problem 5: Unprofitable startups can’t claim a tax break
Entrepreneur Doug Hastie (the man behind businesses ranging from high-tech air quality detection company Syft to Chanui Tea), highlights a key problem: Most startups don’t make a profit – so there’s nothing to claim a tax break against.

Emailing NBR from Germany, where he’s geeing up sales for the Christchurch-based Syft, Mr Hastie adds, “Effectively [R&D tax breaks like the one proposed] only support large, profitable businesses. We all know that these don’t tend to be the real innovators. In the case of Syft, we would get no value from this grant. This is in contrast to the R&D growth grant that we are currently on, which has resulted in us adding 50 new employees over the past four years.”

The discussion paper comprehensively acknowledges the problem raised by Mr Hastie.

“The government recognises that it is important to support R&D businesses that are in tax loss or which have insufficient taxable income to use their tax credits. R&D intensive firms, in particular, typically spend their early years in a tax loss position,” it says.

“They also have a lower probability than other businesses of becoming profitable, so may never be able to use their R&D tax credits to improve their cash position.”

However, it posits no answers. Officials are looking at the problem.

Meanwhile, others have suggested alternatives.

Sam Morgan says companies should be able to expense the cost of software developers.

Investor Ralph Shale favours tax breaks for high net worth individuals who invest in the companies that drive R&D.

Mr Wiggs would like eligible companies to receive tax rebates early.

And Mr Hamilton would like to see a cashback against payroll scheme – or at least, some kind of programme that delivers cold hard cash to startups (but, unlike Callaghan funding, is a scheme that applies universally).

The Icehouse boss also has an eye on the Tax Working Group, and its possible changes to the way capital gains are addressed — which will also factor in, he says.

What about the Sam Morgan argument?
The Trade Me founder has continually railed on social media, and at times in NBR, on various government attempts to give startups a leg up.

His broad thesis is that, if a startup has a good enough idea, it will find backing in the private sector.

Mr Wiggs' response is that it might find backing but not necessarily in New Zealand.

If New Zealand wants more companies to stay onshore, and more R&D to happen here, then the Crown does have to come to the party in some fashion.

A continuing role for Callaghan?
Ms Woods has earned "tax hero" status from the Taxpayers Union for her plan to gut Callaghan, which the lobby group sees as saving not just $155m or so a year in grants but another $86m with attendant staff and costs cuts.

However, the minister stresses Callaghan has played a key role in developing the discussion paper, and posits a role for the agency in helping to administer the proposed tax break.

Has it earned the right to play that role, given its patchy performance, a recent tightening up and change of CEO notwithstanding?

"Many would argue that they have not," Mr Wiggs says.

"Callaghan is a vexed issue. They're trying to do the right thing, and there are some people in there who have produced some results that are absolutely excellent."

"[But] at the same time, it's structurally set up to have a series of bad stories because they will make mistakes. At the very beginning, it was a bit of a hodge-podge where you took a bunch of scientists and a bunch of funders and a bunch of business people and tried to blob all of these things into one organisation and put a great man's name on it – and the jury is still out on whether Callaghan is viable."

(NBR has extended an invitation to Callaghan Innovation chief executive Victoria Crone to discuss the R&D tax break proposal and Callaghan's role from this point. We hope to have her on NBR View soon.)

Watch the full video on Doug Hastie's NBR Radar profile by pressing the play button

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