Sibanda & Zantwijk

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Section 11D: R&D Tax incentive

Discussion document

(Based on the June 2007 Amendment)

This section (as amended in June 2007) is deemed to have come into operation on 2 November 2006 and applies in respect of any activities undertaken, or any building, machinery, plant, implement, utensil or article first brought into use on or after that date.

Note: A September Bill was subsequently passed, followed by a November Bill. The November Bill supersedes the September Bill.

Background

The R&D tax incentive was proposed during 2006. It is a living section that is maturing from its adolescent state of flux. The initial draft was proposed in October 2006 … followed by its passing into law in February 2007 .… quickly followed by an amendment in late February .…. followed by a further amendment in June …… followed by two further amendment Bills in September and November 2007. It is therefore important to refer continuously to the Treasury website for the most recent amendments to s11D – see “Legislation”; “Acts” and “Bills”. Copies of these Bills are available on our website.

Sibanda & Zantwijk are proud to have been engaged as consultants to Treasury on this and other recent intellectual property-related sections in our Income Tax Act.

This document is released in furtherance of our firm’s commitment to make intellectual property more accessible. You are free to use, copy and distribute this document, provided that all references to Sibanda & Zantwijk are retained. Workshops on this section are available on request.

This guideline is not an official guideline. It is subject to the disclaimer on our website and does not necessarily reflect the intentions of either Treasury or SARS. Various other guidelines have been published that may conflict with the views expressed in this document. Ultimately, the interpretation of our Courts will prevail.

R&D start

S11D allowances can only be claimed as from the date on which “R&D starts”.

R&D starts when:

(a) one has identified the scientific or technological step that is to be attained;

(b) has the requisite intention to develop something new; and

(c) commences activities to reach that goal.

This excludes “brainstorming” sessions aimed at finding possible solutions.

Required documentation

In determining whether a person conducts R&D, one must have regard to that person’s intention and not to his ultimate accomplishments. Accordingly, it is important at the outset to draft a project plan, clearly detailing the intended outcomes.

Researchers must bear in mind that the onus is on taxpayers to prove that they intended to conduct qualifying work detailed in s11D(1). In practice, this means that the taxpayer must at the commencement of R&D be able to identify the scientific or technological step that qualifies the activities in terms of s11D(1).

Trade and “in the production of income” requirements

Taxpayers claiming deductions in terms of s11D(1) must:

- incur R&D expenditure for the purposes of its trade (i.e. with the intention to make a profit); and

- use the resultant IP in the production of income.

The “use” requirement is discussed later on in this document.

S11D(1) - “Direct”

According to s11D(1):

For the purposes of determining the taxable income derived by a taxpayer from carrying on any trade, there shall be allowed as a deduction from the income of such taxpayer so derived, an amount equal to 150 per cent of so much of any expenditure actually incurred by that taxpayer directly in respect of activities undertaken in the Republic directly for purposes of— …

expenditure actually incurred by that taxpayer directly in respect of activities undertaken …

In this instance, “directly” is associated with the expenditure. All expenditure must be incurred directly in respect of qualifying R&D activities (excluding the purchase of capital equipment, which may only be claimed in terms of s11D(2)).

Examples of expenditure not incurred directly in respect of qualifying activities include:

(a) expenditure incurred to purchase shares in R&DCo;

(b) expenditure incurred to purchase goods or services from R&DCo; and

(c) general grants, i.e. general donations to Universities,

irrespective of whether the receipts are used by R&DCo to finance qualifying R&D activities.

activities undertaken in the Republic …

Taxpayers may only claim allowances in terms of s11D where the activities that lead to a patentable invention, registrable design, etc are undertaken in the Republic. Where a taxpayer conducts activities outside South Africa or engages a foreign University to conduct R&D, no South African tax deductions or allowances may be claimed by that taxpayer in respect of such R&D expenditure. The reason is that R&D expenditure is capital in nature and therefore not deductible in terms of s11(a) of our Income Tax Act.

(activities undertaken in the Republic) directly for purposes of …

This reference is more problematic. To what extent are:

(a) support and administrative activities;

(b) insurance activities;

(c) air-conditioning usage and maintenance activities; and

(d) building maintenance activities,

undertaken directly for the purpose of conducting qualifying R&D activities?

To answer this, we should have regard to the corresponding R&D tax provision in the UK, which defines “qualifying indirect activities” as including:

- scientific and technical information services for R&D support;

- maintenance, security, administration, cleaning, storage, transport, clerical and finance activities undertaken for R&D;

- staff costs, laboratory leases, maintenance of R&D equipment (if used directly for R&D);

- training required to directly support the R&D; and

- feasibility studies to inform the strategic direction of R&D.

Surely, “indirect activities” cannot be regarded as “activities undertaken in the Republic directly for purposes of conducting” qualifying R&D activities. Accordingly, it may be argued that only expenditure relating to:

(a) salaries for researchers engaged directly in qualifying R&D activities; and

(b) consumables used in qualifying R&D activities,

may be deducted in terms of s11D(1).

Other activities that are generally considered indirect include:

- general education and training

- scientific and technical information services

- general purpose data collection

Further exclusions

Irrespective of “directness”, due to the nature of the activities with which it is associated, certain expenditure does not qualify for deduction in terms of s11D. For example, s11D(5) excludes expenditure relating to:

(a) exploration or prospecting;

(b) management or internal business processes;

(c) trade marks;

(d) the social sciences or humanities; or

(e) market research, sales or marketing promotion.

But this list is not exhaustive. Expenditure relating to other activities that are not scientific or technological in nature also falls outside the scope of s11D.

Having regard to the UK and Australian provisions, with the possible exception of software, researchers are expected to discover or develop something that is not available to the public anywhere in the world. In other words, the researcher must intend to: add to the general body of scientific knowledge (i.e. an advance in science or technology) / add something new in the absolute sense. Merely fixing a problem using known means does not qualify as R&D unless it would be considered not obvious to an expert in the field to apply such means previously applied within a different field to the problem at hand.

Activities that are not generally regarded as constituting R&D include:

- specialised (routing) medical care

- policies and studies

- routine computer maintenance or software development

- calibration of standards and routine testing and analysis of materials, components, products and processes

- cosmetic and aesthetic effects

- testing analysis either of equipment or product for the purposes of quality or quality control

- periodic alterations to existing products, services or processes even though these may represent some improvement

- operation research not tied to specific research and development activity

- cost of corrective action in connection with breakdowns during commercial production

- legal and administrative work in connection with patent applications, records and litigation and the sale or licensing of intellectual property resulting from the R&D

- design and construction engineering activities relating to the construction, relocation, rearrangement or start-up of facilities or equipment other than facilities or equipment whose sole use is for a particular research and development product

- pre-production activities, such as demonstrating commercial viability, tooling-up, and trial runs

- preparation for teaching

- activities associated with complying with statutory requirements or standards, such as maintenance of national standards, calibration of secondary standards, and routine testing and analysis of materials, components, products, processes, soils and atmospheres

- any activity related to the reproduction of a commercial product or process by a physical examination of an existing system or from plans, blueprints, detailed specifications or publicly available information

Also see the November 2007 Bill (ss5A(c)), which proposes to exclude “persons carrying on any banking, financial services or insurance business” from claiming allowances under section 11D.

s11D(1) purpose

According to s11D(1), the purpose of the R&D activities must be to:

(a) the discovery of novel, practical and non obvious information; or

(b) the devising, developing or creation of any—

(i) invention as defined in section 1 of the Patents Act, 1978 (Act No. 57 of 1978);

(ii) design as defined in section 1 of the Designs Act, 1993 (Act No. 195 of 1993) that qualifies for registration under section 15 of that Act;

(iii) computer program as defined in section 1 of the Copyright Act, 1978 (Act No. 98 of 1978); or

(iv) knowledge essential to the use of such invention, design or computer program,

if that information, invention, design, computer program or knowledge is of a scientific or technological nature and is intended to be used by the taxpayer in the production of his or her income.

Discovered IP – s11D(1)(a)

“Discovery” presupposes a pre-existing intangible asset not previously in the public domain. This should be contrasted against “developing”, which results in something new.

In practice, R&D expenditure will seldom relate to the “discovery” of pre-existing information. Examples, of “discoveries” include:

- proving a scientific rule or principle (e.g. E=MC²)

- discovering that paracetamol thins the blood in addition to killing pain

- Alexander Fleming discovering that the penicillium mould (Penicillium chrysogenum) kills bacteria and that the active compound was penicillin

Despite its narrow scope, one of the motivations for inserting s11D(1)(a) into the R&D section was s25(2)(a) of our Patents Act, which denies “discoveries” the status of an invention and thereby the benefit of patent protection (and entrance into s11D(1)(b)(i)).

The terms “discovery” (in the “pre-existing” sense) and “novel” are not necessarily mutually exclusive: “Novel” means “strikingly new, unusual, or different”; and “new” is generally defined in our Patents and Designs Acts as information that does not “form part of the state of the art, … [i.e. excluding] all matter which has been made available to the public (whether in the Republic or elsewhere) by written or oral description, by use or in any other way”. As such, although the paracetamol example above may constitute a discovery, it will not necessarily be regarded as novel, whereas both the other examples would satisfy both the discovery and novel requirements.

Developed IP – s11D(1)(b)

Apart from being scientific or technological in nature, the resultant intellectual property intended to be developed must constitute:

(a) a patentable invention;

(b) a registrable functional design; or

(c) software as per the Copyright Act,

However, the researcher need not in fact succeed in achieving the intended goal.

Patentable inventions

For an invention to be patentable, it must be:

(a) new (in the absolute sense, i.e. not previously disclosed to the public anywhere in the world, either orally, in writing or by use);

(b) involve an inventive step (i.e. not obvious to an expert in the field having knowledge of all prior art); and

(c) be capable of use in trade, industry or agriculture.

For a further discussion on what constitutes a patentable invention, see our “File your own provisional patent application” Toolkit available from www.mypatent.co.za.

Registrable designs

In practice, only functional designs fall within the scope of s11D. Functional designs are defined as “any design applied to any article, whether for the pattern or the shape or the configuration thereof, or for any two or more of those purposes, and by whatever means it is applied, having features which are necessitated by the function which the article to which the design is applied, is to perform.”

To be registrable, a functional design must be:

(a) new (in the absolute sense, i.e. not previously disclosed to the public anywhere in the world, either orally, in writing or by use); and

(b) not commonplace in the art in question.

Furthermore, a functional design registration cannot be obtained for a spare part.

A spare part includes those parts that are expected to be replaced during the lifetime of the parent part, as a result of wear from general use (e.g. filters). However, specific aspects of a plant that must be replaced in its entirety (for example, a pipeline linking tank A to tank B; generators; pumps; valve / filter housings) are not considered spare parts.

For a further discussion on what constitutes a registrable design, see our “File your own design application” Toolkit available from www.mypatent.co.za.

Software

Our Copyright Act defines a “computer program” as “a set of instructions fixed or stored in any manner and which, when used directly or indirectly in a computer, directs its operation to bring about a result.”

To qualify for copyright protection, the program must be original and reduced to material form. Our Courts have previously held that “original” means emanates from the author. However, it is unclear whether it is even necessary to satisfy these additional requirements for copyright protection. Whichever way one looks at it, the hurdle that a work must overcome to qualify as a “computer program as defined in section 1 of the Copyright Act” is extremely low.

But this is not the end of the inquiry. Before qualifying for deduction, taxpayers must first circumvent the specific exclusions detailed in s11D(5), which included “management or internal business processes”.

By their very nature, computer programs typically fall within the category “management or internal business processes.” However, Treasury has indicated that where a computer program is developed for more than one sale or licence, this exclusion will not apply. But this is not a legislated test, and it is doubtful whether spinning-off an IT company to service the software requirements of the group will convert expenditure that is otherwise specifically excluded into deductible expenditure.

At this stage, we can safely exclude most computer programs developed for internal use, which leaves us with software developed by bona fide third party developers. For this category of computer programs, the tax incentive continues to appear surprisingly broad. But that is until we inquire into whether the computer program is of a “scientific or technological nature”. At first blush, this does not appear to pose a material obstacle. That is, until we have regard to the corresponding R&D provision in the UK. According to the UK Guidelines on the Meaning of Research and Development, the following software related activities do not qualify as R&D as they do not involve scientific or technological advances:

(a) technical problems which have been overcome in previous projects on the same operating systems and computer architecture;

(b) supporting existing systems;

(c) converting and/or translating computer languages;

(d) adding user functionality to application programmes;

(e) de-bugging of systems;

(f) adaptation of existing software;

(g) preparation of user documentation,

We can therefore conclude that the scope of s11D(1)(b)(iii) is in fact relatively narrow.

As an alternative, taxpayers could theoretically patent computer programs and fall within s11D(1)(b)(i). But is the scope of this subsection wider? Unfortunately, according to s25 of our Patents Act:

25. Patentable inventions

(1) A patent may, subject to the provisions of this section, be granted for any new invention which involves an inventive step and which is capable of being used or applied in trade or industry or agriculture.

(2) Anything which consists of -

(a) a discovery;

(b) a scientific theory;

(c) a mathematical method;

(d) a literary, dramatic, musical or artistic work or any other aesthetic creation;

(e) a scheme, rule or method for performing a mental act, playing a game or doing business;

(f) a program for a computer; or

(g) the presentation of information,

shall not be an invention for the purposes of this Act.

(3) The provisions of subsection (2) shall prevent, only to the extent to which a patent or an application for a patent relates to that thing as such, anything from being treated as an invention for the purposes of this Act.

Although our Courts have yet to decide on the meaning of “as such”, “pure software” is most definitely precluded. Our Courts will most probably follow the interpretation in the EU and require a “technical character” or the production of a “technical effect” (together with the normal requirements of novelty and inventiveness). Alternatively, our Courts could elect to adopt the US concept of “a useful, concrete and tangible result”. Either way, one could reasonable expect the hurdle to be overcome in this “patent” category to be higher than that posed by “scientific or technological nature”.

Specific expenditure

Rentals and interest

In its current form, rental and interest expenditure directly associated with R&D work is arguably deductible in terms of s11D(1) at 150%. However, Treasury is acutely aware of the resultant benefits associated with purchasing equipment through a leasing arrangement. Should it become apparent that taxpayers are opting to deduct rentals through such arrangement in terms of s11D(1) instead of making use of s11D(2), it is likely that rental expenditure will in future be specifically excluded from s11D.

Accordingly, it is strongly advised that the acquisition of equipment should be claimed in terms of s11D(2). Leasing structures, which currently appear more attractive from a tax perspective, should be avoided as the expected long-term tax benefit may ultimately fail to materialise.

For a discussion on this topic, see the article “s11D – Financing R&D Equipment”

In this regard, see the November 2007 Bill (ss5B(b)), which proposes to limit deductions in respect of rental and interest payments to 100%.

Training costs

S11D(1) requires expenditure to relate directly to qualifying activities. Accordingly, there needs to be some connection between the expenditure and simultaneous qualifying activities.

Bursary expenditure incurred to train potential future engineers that will be involved in R&D is not associated with a current qualifying activity. If anything, such expenditure may relate to a qualifying activity that may ultimately be performed after the student eventually becomes employed. Accordingly, such expenditure cannot be claimed in terms of s11D(1). Furthermore, since our Tax Act only permits expenditure to be claimed in the year it is incurred, such expenditure can also not be claimed in terms of s11D(1) in future.

Having said this, where training expenditure is linked to existing qualifying activities, e.g. where a researcher encounters a problem while performing qualifying activities and attends a course to skill-up and hopefully find a solution to the problem, such expenditure would most probably be regarded as directly related to current qualifying activities and be deductible in terms of s11D(1).

Books and periodicals

Expenditure relating to general data acquisition is not deductible in terms of s11D(1). Furthermore, Practice Note 19 suggests a 3-year write-of period for textbooks. As such, where a book is purchased specifically to assist in a current qualifying activity, such expenditure may be claimed in terms of s11D(2). Expenditure relating to periodicals should be claimed in terms of either s11(a) or s11(e) over 1 year.

Acquisition of assets

According to S11D(2):

(2) There shall be allowed as a deduction by a taxpayer in respect of any building or part thereof, machinery, plant, implement, utensil or article which—

(a) is owned by that taxpayer, or acquired by that taxpayer as purchaser in terms of an agreement contemplated in paragraph (a) of the definition of ‘installment credit agreement’ in section 1 of the Value-added Tax Act, 1991 (Act No. 89 of 1991);

(b) is first brought into use by that taxpayer solely and directly for purposes contemplated in subsection (1);

(c) prior to first being brought into use by that taxpayer solely and directly for purposes contemplated in subsection (1), was not used by any person for any purpose; and

(d) is brought into use for purposes contemplated in subsection (1) and the information, invention, design, computer program or knowledge is intended to be used by the taxpayer in the production of his or her income,

an amount equal to 50 per cent of the cost to that taxpayer of that building, part, machinery, plant, implement, utensil or article in the year of assessment that it is bought into use for the first time by that taxpayer and 30 per cent in the first succeeding year of assessment and 20 per cent in the second succeeding year of assessment: Provided that no deduction shall be allowed to a taxpayer under this section in respect of any building, part, machinery, plant, implement, utensil or article if that taxpayer ceased to use that building, part, machinery, plant, implement, utensil or article, solely and directly for purposes contemplated in subsection (1) during any previous year of assessment.

This section provides for an accelerated allowance for the acquisition of buildings, machinery, plant, implements, utensils and articles. For a more extensive list of tangible items falling within this category of assets, we should refer to Practice Note 19 (PN19), which expands on similar wording used in s11(e) (our general allowance section for equipment). According to that Note, other items falling within the scope of s11D(2) include: computers; computer software (which is seldom properly classified as intangible intellectual property); vehicles; fitted carpets; furniture and fittings; laboratory research equipment; staff training equipment; textbooks; and video cassettes.

The dictionary definitions of Articles and Utensils are “an individual thing or element of a class; a particular object or item” and “an implement for practical use”, respectively. It goes without saying that these are very broad terms and should cover most tangible items acquired.

Fortunately for s11(e), paragraph 6 of PN19 states:

Where a taxpayer acquires “small” items (loose tools etc) at a cost of less than R5 000 per item he may write such assets of in full during the year or acquisition. …

As such, in respect of many “small items”, it is largely academic whether they fall within s11(e), since an allowance may in any event be claimed over one year. However, PN19 does not apply to s11D(2).

Accordingly, where assets acquired have a life in terms of PN19 shorter than 3 years (i.e. Computer Software (personal computers): 2yrs), it would be preferable to make an election in terms of s11D(6) to claim allowances in terms of s11(e) instead of s11D(2). However, such election must be made in the year in which allowances first become available.

But, one must be careful of “small items”. Just because they previously used to be treated in the same manner as revenue expenditure in terms of s11(a), does not mean that they are not included within the ambit of “buildings, machinery, plant, implements, utensils and articles”. For the purpose of s11D, this is significant, since according to sub-section 5A (inserted in June 2007):

(5A) Notwithstanding any other provision of this section, no deduction shall be allowed in terms of subsection (1) in so far as that deduction is claimed in respect of expenditure incurred to acquire, install, erect, improve or add to any building, machinery, plant, implement, utensil, article, or to acquire, or for the right of use of, any invention, design, copyright or knowledge.

Irrespective of whether “small items” constitute trading stock or consumables, if such items fall within the ambit of “buildings, machinery, plant, implements, utensils and articles”, related expenditure cannot be claimed in terms of s11D(1) at 150%. The fact that an asset may constitute consumables or trading stock would only be relevant to whether such asset should in the alternative be deducted in terms of either s11(a) or s11(e).

Test tubes may be an example of such an item. Naturally, such an interpretation may have a material effect on the quantum of tax allowances available to the taxpayer.

Furthermore, certain provisos are built into s11D(2). These include:

(1) the person claiming the allowance must use the asset for qualifying R&D activities;

(2) The person must intend to use the resultant information, invention, design, computer program or knowledge in the production of his income;

(3) the person claiming the allowance must acquire ownership of the asset, alternatively, have purchased the asset in terms of a hire-purchase agreement (as defined in the VAT Act);

(4) the asset must be new and unused. Second hand assets are effectively excluded;

(5) the asset must be used solely and directly for qualifying R&D activities for the entire 3-year period (otherwise the full allowance may not be claimed)

(6) the asset must be used in the taxpayer’s trade.

Only when all the above requirements are satisfied, may accelerated allowances be claimed in terms of s11D(2).

Regarding the quantum of allowances available, taxpayers are permitted to claim an amount equal to the sum of: the cost of the asset (assuming that none of the anti-avoidance provisions apply); and the cost to install and erect the asset. Where land is purchased together with a building, allowances are only available for the cost of the building. Accordingly, the purchase price must be apportioned on a reasonable basis.

As with claims in terms of s11D(1), s11D(2) requires the asset to be brought into use directly for purposes of conducting qualifying R&D activities. Does this act to exclude air conditioning systems installed in the offices of the company’s accountant? Most probably. In fact, assets relating to the following activities most probably fall outside the scope of s11D(2):

- scientific and technical information services for R&D support;

- maintenance, security, administration, cleaning, storage, transport, clerical activities undertaken for R&D;

- general education and training;

- scientific and technical information services; and

- general purpose data collection.

Such assets may only be claimed in terms of s11(e).

Furthermore, s11D(2) provides that “the information, invention, design, computer program or knowledge is intended to be used by the taxpayer in the production of his or her income”. It is doubtful whether a “sale” constitutes “use” of the resultant intellectual property. It is therefore arguable that a contractor may not claim allowances in terms of s11D(2).

“Used in the production of income”

According to our R&D tax incentive (both s11D(1) (150% allowance) and s11D(2) (acquisition of assets)), the resultant “information, invention, design, computer program or knowledge [must be] … intended to be used by the taxpayer in the production of his or her income”.

As is evident from the definitions below, “use” is a rather nebulous, vague word or wide import:

- 11^th ed, Oxford University Press, 2004: use take, hold, or deploy as a means of achieving something

- Shorter Oxford English Dictionary: The act of using a thing for any (esp a profitable) purpose; the fact, state, or condition of being so used; utilization or employment for or with some aim or purpose; application or conversion to some (esp good or useful) end … to make use of (some immaterial thing) as a means or instrument; to employ (for a purpose etc) esp. for a profitable end; to turn to account... to employ (a person, animal etc) in some function or capacity, especially for an advantageous end'

- Webster's Third New Int'l Dictionary, 2523-24 (unabridged ed 1993): 2 : to put into action or service : have recourse to or enjoyment of : EMPLOY * * * a : to speak or write in (a language) * * * b : to consume or take (as liquor or drugs) regularly * * * 3 : to carry out a purpose or action by means of : make instrumental to an end or process : apply to advantage : turn to account : UTILIZE * * * a : to spend (time) in some occupation, interest, or activity * * * b : to make an involuntary or concealed means to one's own ends * * * c : to employ a word, phrase, or sentence to refer * * * 4 : to expend or consume by putting to use * * * 6 : to apply or have applied as the usual designation (as a title or surname) of a person * * * USE is general and indicates any putting to service of a thing, usu. for an intended or fit purpose * * *.

- Black’s Law Dictionary 1540 (7th ed 1999): [t]he application or employment of something.

- La Rev Stat Ann 47:301(18): the exercise of any right or power over tangible personal property incident to the ownership thereof…

- Bailey, 516 U.S. at 145: these various [dictionary] definitions of 'use' imply action and implementation (definition of "use" in 18 U.S.C. § 924(c)(1), which concerns using or carrying a firearm in a drug trafficking crime)

- www.wikipedia.org: Use, as a term in real property law of common law countries, amounts to a recognition of the duty of a person, to whom property has been conveyed for certain purposes, to carry out those purposes.

- Thornton Estates Ltd v CIR (1998) 18 NZTC 13,577 (CA): “Use” has a wide meaning.  Its primary meanings are: To employ or make use of for a particular aim or purpose; To use up or consume. 

- Transfield Kumagai Contracting Pty Ltd v. FC of T 41 90 ATC 4960; (1990) 21 ATR 1003: The word "use" is to be understood in its ordinary meaning of purpose served or object or end and is not restricted to any notion of actual physical use.

- State of Oregon v Cornelius Shawndra Harris (98C20767; A98206): [Use] may be employed very generally to refer merely to "put into action." Or it may be employed more narrowly to refer to putting something to service "for an intended or fit purpose." Or it may be employed still more narrowly to refer to some specific way of putting into action or service, such as consuming, taking advantage of, or denominating.

"[M]any of the words in our language have several meanings or shades of meaning. However, it does not follow from the fact that there are several variations of how a word is defined in the dictionary that all of the variations are pertinent whenever the word is used, or that each variation is an arguably plausible description of what the word means as it is used in a particular statute. The subject and purpose of the statute, together with the statutory language that surrounds the word in question, narrow the array of definitional choices that dictionaries alone afford and go far in identifying the intended meaning of the word as used in the statute." (Steele v. Employment Department, 143 Or App 105, 113-14, 923 P2d 1252 (1996), aff'd 328 Or 292, 974 P2d 207 (1999))

“It is abundantly clear from the above cases and the meanings of the word 'use' in the various dictionaries that the word 'use' and the phrase 'made use of' can have the widest connotation. The word 'use' and the phrase 'make use of' may have the widest connotation, but it remains the task of this Court to find the correct meaning of the said words in the context in which they are used … It is clear from the different dictionaries and quoted cases that there must be some element of personal purpose, profit or enjoyment in the meaning of the word 'use' or in the phrase 'make use of': It is true that the concept of 'making use' is not necessarily and not always the result of a voluntary action but in such a case there is still a personal purpose or motive of personal enjoyment.” (Egan v Minister of Defence 1987 (2) SA 264 (NC))

Context

According to the explanatory memorandum on the Revenue Laws Amendment Bill, 2006:

Innovation, research and technological development are key factors for improved productivity (leading to new or improved products, processes or services). This enhanced productivity in turn leads to increased economic growth and international competitiveness. However, R&D is costly, involving high levels of technical risk. Given the high entry costs (and the indirect positive externalities for countries as whole), Governments sometimes provide extra support for local R&D via direct subsidies as well as through tax incentives (i.e. which operate as indirect subsidies). While South Africa offers a variety of direct subsidies for R&D, the South African tax regime for R&D does not provide substantial incentives. South Africa accordingly needs an improved set of R&D tax incentives to ensure that local R&D is not at a global competitive disadvantage.

The clear goal of s11D is to ensure South African taxpayers remain competitive through improved productivity … through the use of the resultant intellectual property in manufacture, processes or provision of services.

At first blush, the intention of the legislature appears to exclude sale of the resultant intellectual property from the ambit of “use”. But, the section and explanatory memorandum also specifically provides for contracted R&D, so the context is not exactly clear.

Can sale constitute “use”?

In certain instances disposal can constitute “use”. In this regard, see the comments in Sloss v Sloss [1989] 3 NZLR 31:

The physical occupation of property is clearly a use of that property. In its ordinary meaning, “uses” is not, however, confined in that way. In its natural meaning it is a word of wide import. The Shorter Oxford English Dictionary gives as the first meaning, “[the] act of using or fact of being used”, and amongst the more detailed definitions is, “utilisation or employment for or with some aim or purpose”. The owner of land may be said to use the land when, without doing anything on that land, he obtains advantages from the land (Newcastle CC v Royal Newcastle Hospital [1959] AC 248, 255), and in R v Heyworth (1866) 14 LT 600, 601, Lush J observed that: “The owner ‘uses’ the place [a slaughter house] by letting it out”. Even the giving away of property may be a “use” of that property (R v Wampole (Henry K) & Co [1931] 3 DLR 754) …“Use” can attract many shades of meaning in the various contexts in which it appears, but one of its primary definitions in the Shorter Oxford English Dictionary relevant to the present inquiry is “employment for or with some aim or purpose”.  The degree of involvement by the user must vary according to the nature of the particular object.  In an ordinary domestic situation, the ability of both spouses to exercise direct physical advantage or control will usually establish whether it is for their common use and benefit,—eg a holiday cottage or the family car.  But other assets may not be capable of such a physical relationship, and this is the case with the commercial property here.  Its functions were to generate income and serve (hopefully) as an appreciating asset .… Those functions make up its “use” to its owner.

Lord Denning in Newcastle City Council v Royal Newcastle Hospital [1959] 1 All ER 734 (PC) at p. 735 went even further and held that “use” does not necessarily require physical use:

Counsel for the city council submitted that an owner of land could not be said to use the land by leaving it unused; and that was all that had been done here.  Their Lordships cannot accept this view.  An owner can use land by keeping it in its virgin state for his own special purposes.  An owner of a powder magazine or a rifle range uses the land he has acquired nearby for the purpose of ensuring safety even though he never sets foot on it.  The owner of an island uses it for the purposes of a bird sanctuary even though he does nothing on it, except prevent people building there or disturbing the birds.  In the same way this hospital gets, and purposely gets, fresh air, peace and quiet, which are no mean advantages to it and its patients.

Accordingly, where the intention is to acquire / develop intellectual property as trading stock, disposal of the property could be regarded as use:

In Lundy the principal purpose in respect of the properties continued to be property development.  The properties were part of the taxpayer’s trading stock and were on the market at all times.  The Court of Appeal considered that the properties were both used and applied for taxable and non-taxable purposes.  Although the court in Lundy did not directly consider the meaning of “use”, the discussion in Lundy makes it clear that the court considered the properties were used for taxable purposes as the principal purpose of sale in the course of the taxpayer’s taxable activities subsisted (paragraph 41).  At the same time the properties were used 100 percent on a time and space basis for residential rental purposes ... Lundy supports the view that when the principal purpose in respect of a property remains unchanged and the principal purpose in respect of the property continues to be the ultimate sale of the property, the property continues to be used for that activity. (IS 07/01: GST Treatment of Sale of Long-Term Residential Properties, Interpretation Note)

To summarise, property could be said to be “used” by the owner where:

- it is physically occupied by the owner;

- it is rented out by the owner;

- It is used for its own special purpose which does not necessary require physical use;

- the owner obtains some advantage from the property without doing anything to it (i.e. holding appreciating assets); or

- the owner acquires and disposes of property as trading stock.

Assignment of future intellectual property

The issue is complicated further where the contractor assigns ownership of future intellectual property to be developed. In such, instances, could the contractor ever be regarded as having intended to “use” the resultant intellectual property? In my opinion, not.

“In the production of income”

Assuming that a taxpayer conducts R&D on contract and assigns the resultant intellectual property (if any) to the funder after it has been developed. Depending on the terms of the R&D agreement, the consideration payable to the contractor could arise from:

- the provision of R&D services;

- the grant of an option to acquire resultant intellectual property (which is a mere spes) - i.e. where the contract price is payable, irrespective of whether intellectual property is in fact developed and assigned; or

- the sale of the resultant intellectual property.

Where the consideration:

- is paid for the provision of services; or

- payable and not refundable, irrespective of whether any intellectual property is in fact developed and assigned,

despite any subsequent disposal by the contractor arguably being regarded as “use”, such use is not linked to the production of income by the contractor.

Accordingly, R&D contracts must provide for an amount to be paid to the contractor for the disposal of the resultant intellectual property to the funder, which payment must be foregone should the contractor fail to create resultant intellectual property.

In conclusion, it is arguable (but not necessarily correct) that the sale of intellectual property by a R&D contractor constitutes “use”. However, even if this is the case, the parties must be careful to draft the R&D agreement to ensure that such disposal:

(a) occurs after the intellectual property has come into existence; and

(b) results in the production of income in the hands of the contactor.

Buildings, machinery, plant, implements, utensils and articles

The cost to acquire, install and erect assets must be claimed in terms of s11D(2).

These costs generally include:

- technical drawings for manufacture of equipment

(However, insofar as the designer intends to add to the body of scientific knowledge in the absolute sense (instead of merely applying known or established patterns, methods or techniques or following routine methods that would generally be acknowledged by a competent professional working in the field as creating trivial improvements), such expenditure would qualify as R&D expenditure in terms of s11D(1) if the result is patentable or design registrable.)

- tuning, tweaking and problem solving necessary to make equipment operational

(If the intention when problem solving is to add to the body of scientific knowledge in the absolute sense, such expenditure would qualify as R&D expenditure in terms of s11D(1). In this regard, the following will not constitute R&D: applying known or established patterns, methods or techniques or following routine methods to solve the problem; improvements, optimisations and fine-tuning that does not materially affect the underlying science; and minor or routine upgrading or fault fixing (using known methods) that would generally be acknowledged by a competent professional working in the field as a trivial improvement.)

- Improvements or additions to equipment used in respect of R&D

Having regard to corresponding UK law, it appears that equipment maintenance expenditure does not qualify for deduction in terms of s11D(1). General maintenance to buildings is most probably similarly excluded from s11D(1).

Deemed cost of equipment

According to s11D(3):

(3) For the purposes of this section, the cost to the taxpayer of any building, machinery, plant, implement, utensil or article shall be deemed to be the lesser of—

(a) the actual cost to the taxpayer in respect of the acquisition, installation and erection thereof;

(b) the cost which a person would, if he or she had acquired, installed or erected that building, machinery, plant, implement, utensil or article under a cash transaction concluded at arm’s length on the date on which the transaction for the acquisition, installation or erection thereof was in fact concluded, have incurred in respect of the cost of such acquisition, installation or erection;

(c) where the building, machinery, plant, implement, utensil or article was acquired by the taxpayer from any other person who is a connected person in relation to the taxpayer, the cost (as contemplated in this subsection) to that connected person in respect of the acquisition, installation or erection of that building, machinery, plant, implement, utensil or article; or

(d) where the building, machinery, plant, implement, utensil or article has been acquired to replace an asset which has been damaged or destroyed, such cost less any amount which has been recovered or recouped in respect of the damaged or destroyed asset and has been excluded from the taxpayer’s income in terms of section 8(4)(e), whether in the current or any previous year of assessment.

Regular use requirement in respect of buildings

According to s11D(4):

(4) Notwithstanding any other provision of this section, any building or any part thereof shall be deemed not to have been used for purposes contemplated in subsection (2) unless such building or part is regularly used for those purposes and is specifically equipped for such use.

Acquisition or licensing of intellectual property

S11D(5A) confirms that taxpayers may not claim expenditure for the acquisition or use of intellectual property in terms of s11D(1). The cost to acquire intellectual property must be claimed in terms of s11(gC) and royalties may only be deducted in terms of either s11(a) (running royalties) or s11(f) (upfront payments / license fees).

R&D end

S11D allowances may not be claimed in respect of activities occurring after the “R&D end date”.

R&D ends when:

- the knowledge is codified in a form usable by a competent professional working in the field; or

- a prototype or pilot plant with all the final functional characteristics is produced.

Limitation of claims

S11D(7) – Funding grants

(7) Where any amount (other than a government grant) is received by, or accrues to, a taxpayer to fund expenditure that is otherwise eligible for deduction under subsection (1), the deduction for that expenditure shall be limited to 100 per cent in lieu of 150 per cent to the extent of that amount;

This provision aims to ensure that only the original funder is entitled to claim the deductions. The contractor: includes the funding in his gross income; claims corresponding R&D expenditure as deductions (at 100%); and is taxed on his profits.

However, this section only applies where the R&D expenditure is either pre-funded or received in the same year in which the R&D expenditure is claimed as deductions.

For example, where Funder pre-pays R&DCo R1m for R&D expenditure in the amount of R1.5m to be incurred equally over two years, and pays the balance at the end of the R&D contract:

(a) deductions that may be claimed by R&DCo in years 1 and 2 are limited to R750,000 per year; whereas

(b) Funder may (depending on the terms of the R&D agreement) claim expenditure in the amount of R1m and R0.5m in years 1 and 2, respectively.

Importantly, the nature of the receipt in this sub-section is not defined. A person that sells goods to raise money to fund R&D activities could thereby limit his s11D(1) allowances by way of ss7. This would have the effect of “switching off” the R&D tax incentive altogether, since the purchaser of the goods is excluded from claiming allowances in terms of s11D(1) as such expenditure is not incurred directly for the purpose of conducting qualifying R&D activities.

S11D(8) – Government grants

(8) Where any government grant is received by, or accrues to, a taxpayer to fund expenditure that is otherwise eligible for a deduction under subsection (1), the deduction for that expenditure shall be limited to 100 per cent in lieu of 150 per cent to the extent of twice that amount (except to the extent that expenditure is disallowed in terms of section 23(n)).

This section is similar to ss7, but by denying deductions to twice the amount of the expenditure, the legislature aims to ensure that the benefit received from the State is limited to matching government grants obtained.

It is submitted that as long as the funding originates from the DST, irrespective of the entity through which such funds are channeled (e.g. the Innovation Fund), such funds will retain their nature as “government grants”.

S11D(9) - Recoupment

(9) Where a taxpayer during any year of assessment-

(a) recovers or recoups any expenditure in respect of which a deduction was allowed in terms of subsection (1) during that year or any previous year, such deduction shall be included in the income of that taxpayer;

Where amounts are reimbursed subsequent to the year in which R&D expenditure is claimed as deductions, related deductions that were previously claimed must be recouped. Normally, recoupment results in the amount being added back as gross income, but since s11D provides for a 150% deduction, the corresponding deduction is recouped.

There is some uncertainty regarding whether the sale or license of resultant intellectual property constitutes a recoupment of R&D deductions previously claimed. A risk exists that our Regulators may regard such receipts as triggering recoupment, but this is not the case in the UK.

Connected person provision

(5B) Notwithstanding the provisions of subsection (1), the deduction to be allowed to a taxpayer in terms of that subsection in respect of expenditure incurred by that taxpayer shall, in so far as that expenditure is incurred to defray expenditure of any other person who is a connected person in relation to that taxpayer, be limited to the amount of that expenditure.

This section “switches off” the 150% “bump-up” where R&D is funded by a connected person. The funder’s deduction in terms of s11D(1) is limited to 100% and, to the extent that expenditure by the R&DCo may qualify for deduction in terms of s11D(1), the funding or recoupment provisions in ss(7) and (9) will limit deductions claimed by R&DCo to 100%.

This is problematic where R&DCo is in an assessed loss position.

However, refer to the proposed amendments to this section in the November 2007 Bill, which amendments are intended to (a) prevent funders from “rolling-up” s11D(1) and s11D(2) expenditure, and (b) claiming 150% deductions in respect of expenditure that constitutes profits in the hands of the research entity. The Bill proposes to treat the funder as if the funder was the person actually conducting the R&D activities. By doing so, funders must fulfill the requirements of s11D(1). But, will funders be entitled to claim s11D(2) allowances to fund the acquisition of equipment and buildings?

Disclosure of information

In addition to general requests for disclosure by SARS, s11D provided for disclosure of information to the Minister of Science and Technology:

(11) In respect of each year of assessment during which any taxpayer is eligible for any deduction contemplated in subsection (1) or (2), whether or not that deduction is limited in terms of this section, that taxpayer must submit to the Minister of Science and Technology such information as that Minister may require in such form and manner (including electronically) and at such place and within such time as that Minister may from time to time prescribe.

(12) The Minister of Science and Technology shall annually and in anonymous form submit to Parliament a report advising Parliament of the direct benefits of the activities contemplated in subsection (1) in terms of economic growth, employment and other broader government objectives and the aggregate expenditure in respect of such activities.

(13) Other than as may be required by subsection (12), the Minister of Science and Technology and every person employed or engaged by him or her in carrying out the provisions of this section shall preserve and aid in preserving secrecy with regard to all matters that may come to his or her knowledge in the performance of his or her duties in connection with those provisions, and shall not communicate any such matter to any person whatsoever other than the Commissioner or the taxpayer concerned or his or her lawful representative nor suffer of permit any such person to have access to any records in the possession of that Minister or person except in the performance of his or her duties as required by the laws of the Republic or by order of a competent court.

(14) Every person employed or engaged as contemplated in subsection (13) shall, before acting under this section, take and subscribe before a magistrate or justice of the peace or a commissioner of oaths, such oath or solemn declaration, as the case may be, of fidelity or secrecy as may be prescribed as contemplated in section 4(2)(a).

(15) The provisions of subsection (13) shall not apply in respect of information relating to any person, where that person has consented in writing that such information may be published or made known to any other person.

(16) Any person who contravenes the provisions of subsection (11) shall be guilty of an offence and liable on conviction to a fine or to imprisonment for a period not exceeding 24 months and any person who has been so convicted shall, if he or she fails within any period deemed by the Minister of Science and Technology to be reasonable and of which notice has been given to him or her by that Minister, to submit the information in respect of which the offence was committed, be guilty of an offence and liable on conviction to a fine of R50 for each day during which such default continues or to imprisonment without the option of a fine for a period not exceeding 12 months.

(17) Any person who contravenes the provisions of subsection (13) shall be guilty of an offence and liable on conviction to a fine or to imprisonment for a period not exceeding 24 months.

(18) Any person employed or engaged as contemplated in subsection (13) who carries out any of the provisions of this section before he or she has taken the prescribed oath or solemn declaration shall be guilty of an offence and liable on conviction to a fine not exceeding R500.

Apportionment

Where a company conducts a trade and 80% of its expenditure relates to R&D activities, the company may not claim 100% of its expenditure in terms of s11D. Our law does not recognize the doctrine of “substantially all”. On the contrary, our Courts have consistently applied the principle of apportionment.

Accordingly, where a technician spends 80% of his time assisting in qualifying R&D activities, only 80% of his salary may be claimed in terms of s11D(1) at 150%. The other 20% must be claimed in terms of s11(a) at 100%.

Further reading

For additional articles on this section, see:

- The various articles available on our website www.zaiplaw.co.za

- Financial Mail: “R&D tax break tightened up” (22 June 2007)

- Finweek: “Invention may mean a thousand things … but legislation could mean a thousand more” (19 July 2007 at p87)

DA van Zantwijk

Sibanda & Zantwijk

November 2007