Determine the tax and the cost with a calculator

Nikita Hora, a final year student at O.P Jindal Global Law School. Working as Reporter and Communication Manager and Assistant Editor for iPleaders Blog.

Research and Development tax incentive is the reduction of the tax liabilities of the companies that are involved in the undertaking of R&D and innovation activities. Tax incentive lowers the cost of R&D hence stimulates the additional investment in innovation activities. Government plays a significant role in encouraging the R&D levels and expenditures.

The choice of R&D tax incentives will depend on country-level variables such as overall innovation performance, perceived market failures in R&D, industrial structure, size of firms and the nature of corporate tax systems.  As of today more than 20 OCED government is providing fiscal tax incentive to sustain business R&D, up from 12 in 1995 and 18 in 2014.

Economic and empirical analysis proved that research and development plays a key role in the economic growth of the country. It is considered that long term economic growth is driven when there is accumulation of knowledge-based factors of production that are R&D and human capital. This prevents the marginal return to physical capital from falling below the profitable levels. Empirical analysis affirms that R&D increases multi-factor productivity[1].

Tax incentives are beneficial for both the developed and developing countries. In the large countries tax incentive helps in increasing the rate of innovation and in the smaller countries it might help to facilitate the transfer of technology from abroad. As per the studies done by OECD the studies suggest that 1% increase in the stock of R&D leads on average rise in the output between 0.05% – 0.15%. The R&D intensity of countries and their growth performance tends to be correlated with the share of research financed by business[2].

REASONS FOR TAX INCENTIVE IN RESEARCH AND DEVELOPMENT

  • Seen as a crucial investment for the long term growth of economies

Multifactor productivity in OCED countries have been a major determinant of economic growth. R&D intensity of countries and their growth performance is correlated with the share of research financed by the business sector.

  • Contribute to national competitive

In the era of gloabalization multinational enterprise are increasingly internationalizing their R&D activities therefore it is becoming necessary for the government as well to be competitive in attracting the companies that spent huge amount in the R&D activities. Generous amount of R&D tax incentives makes a country relatively more attractive location for R&D investments than its competitors.

  • R&D activities are risky therefore R&D tax incentives gives ease to small firm and start up

The biggest hurdles with R&D investment is that they are likely to end up as a marketable new products or processes but mostly after the long – time and uncertain payback periods. Even it s very difficult for the financial institution to judge the quality of the R&D investment, because the outcomes are very uncertain and the firms are reluctant to disclose all the information. Therefore particularly the small firm and the start up faces credit constraints while they invest in R&D. R&D tax credit gives ease to the small firms and start up.

  • R&D activity generates “public” good

The major difficulty with R&D investment is the “knowledge spills over “ to the other firms and that too, to those organization that had not bear the cost of the investment over that research and development. When the investing firms are unable to capture all the benefits on their investment then automatically the company starts investing less on R&D and this even results in “social” optimization (the private rate of return of R&D would be lower than the social rate of return). The knowledge spills over risks contributes to the gap in R&D spending and the lowers the desirable innovations.

PARAMETERS OF THE R&D TAX INCENTIVES

For the accounting purposes, there are two parameters through which R&D tax incentives are involved. These parameters are

  1. Current expenditure
  2. Capital expenditure

While calculating current expenditure, R&D expenditure is included like wages and salaries of the research personnel and the cost of material used. Second way to treat R&D expenditure under current expenditure is to deduct from income in the year they are incurred.

Under capital expenditure, the R&D expenditure is treated like the cost of equipment and facilities. Therefore under capital expenditure, the taxpayer can depreciate over the useful life of an assets. There are two methods for depreciating the R&D expenditure. They are

  1. Declining balance
  2. Straight line

There are few countries for example U.S. that allows the taxpayer to switch over the declining method to the straight line method when the straight line method becomes more beneficial to the taxpayer in present value term.

It differs from country to country the way R&D expenditure is treated under capital expenditure. Some countries allows capital expenditures for R&D purposes to be written off in the year they are incurred, while the other countries require that capital expenditures be depreciated over their economic life (or some fraction thereof). Other things being equal, the net-of-tax cost of R&D will be lower in those countries that allow an immediate or accelerated write-off of expenditures on R&D facilities and equipment.

This clearly proves that current and capital R&D expenditure is treated differently in different tax jurisdictions. The R&D expenditures are usually spilt into current expenses and capital expenses by using the average proportion of 90% and 10% respectively. Capital expenses were then divided equally between machinery and equipment (5%), and buildings (5%). Furthermore, wages and salaries (a component of current costs) are assumed to represent 60% of total R&D expenditures. These proportions have been applied uniformly to all the tax jurisdictions examined.

DISCUSSION AT INTERNATIONAL FISCAL ASSOCIATION CONFERENCE, 2015

In the IFA Conference held this year one of the main topics for the discussion was “Tax Incentive on Research and Development”. There was an immense discussion about the issue that whether tax incentives are an effective tool for promoting R&D? Whether the government should direct subsidy will that be more transparent?

The panel discussed about the importance of neutrality and proportionality principles. Neutrality principle is when R&D credits are available to the all the taxpayers from a subjective point of view viz irrespective of whether the taxpayer can setup as partnership, companies and are individuals. The opinion was that R&D tax incentive should be neutral from a policy perspective as the idea has been to achieve spilt over effects on the economy of the country granting them incentives and that non – residents should also be given benefits and treated as par with residents.  Except India and South Africa, countries extend their R&D incentives to residents as well as Permanent Establishment (PE) of the foreigner enterprises. Australia is one of the exceptions that has enhanced the deduction for R&D restricted to the companies that are incorporated in Australia and wherein R&D has been specifically excluded from the non- discrimination article of tax- treaty.

If there is lack of coordination between the identical incentives and different taxpayers, it might result to “double R&D dipping” [3]especially in cross border situations.

Proportionality principle means that it is on the hand of the government to manage an effectiveness of incentives with positive spillover effects. This principle is important with the respect to coordination of R&D tax policy. It is necessary to have coordination between identical incentives and different taxpayers, between  input and output incentives and between R&D tax incentives and direct subsidies is also required. The penal came up with the suggestion that R&D framework should be one single policy within which all components needs to be consolidated.

The panel also raised the issues that each country needs to give right definition to R&D. It is considered as if the definition of the R&D tax incentives is too wide then it will lead to higher revenue losses but if the definition is too narrow then may loose it’s required effect.

In other phase of the conference there was a discussion about the “Patent Box”. The discussion was about the detailed structure of the Patent Box – such as qualifying the income, applicable tax rates, qualifying the taxpayer and intangibles and different approach to compute income under patent box regime.

The was immense discussion about the OECD’s work under BEPS, in respect of preventing harmful tax practices that deals with the Patent Box regime. OECD proposed ‘ modified nexus’ approach for limiting R&D incentives. The nexus approach approaches requires the IP regime only grant benefit in proportion to existing R&D expenditures incurred by the taxpayer. The nexus approach builds on the principles underlying existing R&D credits and other ‘front-end’ IP regime. The nexus approach also has provision of tracking and tracing of expenditure, IP assets and income. Lastly the ‘qualifying expenditure’ under nexus formula does not include cost incurred for outsourcing to related parties. Thus, the outsourcing to related parties reduces the nexus ratio by increasing overall expenditure.

In the conclusion, the remark given about the Modified Nexus approach is that it tackles harmful tax competition but it does not avoid the risk of double taxation.

WHAT IS PATENT BOX ?

There are many governments that encourage tax incentive in R&D with the aim to correct or alleviate the two markets failure. The market failures are “ underinvestment in innovation, secondly difficulty in finding the external finance in the highly uncertain nature of innovation.

Intellectual property (IP) assets such as trademark or brands, patent, copyrights are highly mobile therefore it is easy for the corporation to locate them away from the research activity that generate them. It is common practice of the multinational to locate their intangibles assets in the lower tax jurisdiction so that it can reduce their tax liabilities hence eroding the revenues of that country with the high tax regime. This phenomenon is called base erosion and profit shifting (BEPS).

Patent box was introduced as a safeguard for the IP tax regime for higher tax mobility of IP assets.  Patent box is the method where the companies benefit from lower effective taxes rates on profit derived from intellectual assets including – patent, know-how (such as formulas, processes and information acquired in the commercial, industrial and scientific field), trademark and eligible for legal protection, only if they require ongoing R&D expenditure for their development and maintenance. The IP regime grants an exemption from the local taxes and corporate taxes on the income derived from qualifying IP assets for an irrevocable (specific) number of years.

In 2001 France introduced patent box then 2003 its was Hungary then Netherlands and Belgium in 2007, followed by Spain and Luxembourg in 2008 and UK finally in the 2013. [4] In 2015 Italy had included Patent Box as one of the fiscal measures for supporting firms investment in R&D in its Budget Bill for 2015.

Patent Box can be considered as the new piece of legislation that is designed in such a that it helps the innovative profitable companies to reduce the burden of Corporation taxes and therefore incentivize them to keep their operation in their own countries. It is extended form of R&D tax credits. Tax Credits are provided for helping the companies to develop product is the countries similarly Patent box is a form of tax incentives for that companies that have successfully developed and innovate a product and is deciding where to locate its operations, Mostly the companies decides to exploits their inventions partly or wholly in the other jurisdiction as the tax breaks are comparatively appealing. Therefore by initiating the Patent Box regime the government wants to reverse this trend. In simple words Patent Box regime provides a lower tax rate on income from the exploitation of patented goods than for other income[5].

Patent box only applies to the only on the proportion of the taxable profit if a company’s trade. If the corporation is involved in more than one trade then Patent Box deduction for each trade will be calculated separately.

This regime incentivize both domestic and foreign manufacturers to set up manufacturing in a country that provides the advantage if lower tax rate on the profit derived from the intellectual property. There are large number of MNC that relocate their intellectual property sourced assets and manufacturing to foreign countries without previously having manufacturing activities in that country related to the intellectual property.[6]

The terms and regulations of a patent box will depend on the way drafter is trying to promote the patent box. For example in Italy, tax exemption is calculated on the income should be in proportion to the R&D activities actually performed by the taxpayer. It is then further adjusted according to the shares of profit generated by the IP asset when IP is directly used by the IP owners and advanced ruling is also required. The legislation also provides that profit earned from the sale of the IP will be also exempted but only in the cases where 90 % of the proceeds received are ploughed back into similar investment before the end of the second fiscal year following the relevant sale.

There are mainly three reasons for tax incentive. First, to incentive the location of intellectual assets currently held abroad by foreign -owned and domestic enterprises in the respective country. Second to avoid the relocation of assets abroad and third to support the investment in R&D.

The biggest challenge after even after implementation of the patent box regime was that whether the patent box will be likely to be effective and represent “value for money”. There were two questioned that still remains are that first whether it is possible to tackle the fundamental market failures of investment in innovation. Secondly in the long run there will be increase in the tax revenue stream or are prone to spur a tax competition that entails a race to the bottom that ultimately results in a fall in tax revenue for all the concerned countries. [7]

LIMITATION OF PATENT BOX

The nature of the patent box is an ex-post reward. It means that Patent box regime only applies to the successful innovators that already have monopoly on their inventions and are tend to receive the income from their innovations. This simply means that patent box regime does not foster experimentation per se hence risky activities still have high rates of failures and spill over effect. Therefore even after the implementation of the Patent Box regime there will be no foster in entrepreneurship, ensuring relocation and learning and frontier growth that involve immense R&D.

Secondly, the Patent box regime pushes the firm to focus on innovations that leads to outcomes that are susceptible to protection by IP rights. This distorts the choice of the firms to focus more on the applied research or products that are closer to the market. This does not result in productive growth enhancing strategy in the long run. There are several innovative firms that do not choose to seek any IP protection.

One of the limitations with the Patent box is that it is related to IP assets and large share of patents are held by a small number of large multinational corporations and skewedness in the patent distribution is likely to be exacerbated when focusing on the high- revenues patents. This simply means that patent box regime can be accrued by the MNCs and these are the firms that find ways if using patent box to shift profit across jurisdiction. For example it is difficult to calculate the income eligible for the tax breaks when firm directly uses IP as it is difficult to identity that the profit is generated by a single patent or multiple patents as they are often identified at different point in time and are used to produce a complex product the income flow will have to be imputed in the absence of an explicit price for the use of IP. This is the major difficulty where the tax authority shares the profit that might allow the firm to abuse the system to shift profits across the jurisdiction.

     BEPS ACTION 5: MODIFIED NEXUS APPROACH FOR IP REGIMES

There were few concerns that were expressed in the Patent box regime. Then Modified Nexus Approach came up with the solution such as the calculation of the qualifying R&D expenditure, transitional arrangements between regimes and time allowed for this through grandfathering provisions, and the tracking and tracing methodology for R&D expenditure that will determine whether it tax exemption qualifies. To reflect the concerned raise by the businesses, the government is planned to qualify expenditure within Modified Nexus Approach.

The Modified Nexus Approach is based on the elements, which seek to address the concerns that have been raised, whilst reinforcing the nexus approach, providing safeguards against profit shifting, and ensuring that there is equal treatment across all sectors and businesses of different sizes. These also aim to ensure that the approach to implementing new rules is consistent with existing OECD rules on the phasing out of harmful regimes.

WHAT IS MODIFIED NEXUS APPROACH?

Modified Nexus Approach is intended to ensure that, in order for a significant proportion of IP income to qualify for benefits, a significant proportion of the actual R&D activities must have been undertaken by the qualifying taxpayer itself. Accordingly, such up-lift needs to be restricted. It may only be granted to the extent that expenditure in the context of outsourcing and acquisitions has actually taken place, and it is in any case limited to a certain percentage of the qualifying expenses of the respective company: 30%. This percentage-based limitation relates to the overall amount of both outsourcing and acquisition.  costs. For the avoidance of doubt, acquisition costs and expenditures for outsourcing to related parties are not included in qualifying expenditures, but are taken into account in determining the limitation described in the preceding sentence [8].

The other suggestion by the OECD BEPS Action Plan 5 is that for the protection for the taxpayer from the existing regime, governments have decided to introduce grandfathering rules. Under such rules, all taxpayers benefiting from an existing regime may keep such entitlement until a second specific date (“abolition date”). The period between the two dates should not exceed 5 years (so the abolition date would be 30 June 2021). After that date, no more benefits stemming from the respective old regimes may be given to taxpayers.

The countries that are choosing to implement Modified Nexus needs to bring the applicable rules in line. This simply means once this rules are brought in line then no new entrants will be in existing regime, after the date that a new regime consistent with the modified nexus approach takes effect.

“New entrants” include both new taxpayers not previously benefiting from the regime and new IP assets owned by taxpayers already benefiting from the regime. Further, the new entrants are only those that fully meet all substantive requirements of the regime and have been officially approved by the tax administration, if required. New entrants therefore do not include taxpayers that have only applied for the regime.

When Patent Box was implemented then it had a limitation of reporting requirement, that is, what is the actual amount to expenditure in R&D activities. Therefore Modified Nexus approach as come up with the solution that there should be tracking and tracing of R&D expenditure. The tax authority and the government should be developed in order to implement the Modified Nexus Approach. Agreement will be needed on transitional provisions to enable companies to transfer IP from existing regimes into new regimes. Practical methodologies for identifying qualifying expenditure that companies and tax authorities will be used in recognising the particular issues regarding qualifying expenditure with respect to expenses incurred prior to the introduction of the Modified Nexus Approach. Failure to do so will mean that no tax benefit may be granted to those companies under the Modified Nexus Approach. Special rules will be developed for this time period to ease the tracking and tracing of such expenditure.

Lastly Under the Modified Nexus Approach the only IP assets that could qualify for benefits under an IP regime are patents and functionally equivalent IP assets that are legally protected and subject to approval and registration processes, where such processes are relevant. The Modified Nexus Approach explicitly excludes from receiving benefits marketing-related IP assets such as trademarks. The FHTP recognises the need for clarity on the definition of qualifying IP assets. The FHTP will therefore produce further guidance on this definition, addressing in particular the exact scope of IP assets, for example, the treatment of copyrighted software or innovations from technically innovative development or technical scientific research that do not benefit from patent protection, always provided of course that such assets have been developed with sufficient nexus.

HOW TAX INCENTIVES IN RESEARCH AND DEVELOPMENT SHOULD BE DESIGNED?

Government plays significant role in designing the R&D tax incentives. The government needs to define the following before coming up with ways it will give tax incentive in R&D.

  1. Target Group

Mostly tax  incentive are  neutral that is it is applicable to all the innovators without differentiating between the region, size of the company, sector or types of innovative activity. But then the government should design tax incentives that it would be beneficial to the particular group such as small and medium enterprise (SMEs). Government can explicitly limit the access to the tax incentives to the companies as per the profit they are earning in the financial year. Other way is to grant higher tax exemptions rates to impose upper limits on the tax credits that are mostly accessed to the large firms. The other method which government can use is to cash refunds for  companies that are making losses.

  1. Eligible Cost

The government should define the “ research and development” to that it could classify about the eligible and ineligible expenditures.[9] There are three approaches of defining eligible R&D. They are turn on wages, current R&D and current and capital R&D.

There are times when government extends their eligible expenditures to include the costs of acquisition of intangibles, such as patents, licenses, know-how, and designs. Therefore the more activities come under the ambit becomes deemed eligible and increases the potential incentive to promote innovation activities. On the other hand larger list increases significant cost on the government. The biggest hurdle that governments faces is that even after defining the expenditure cost there are many companies that tempt to manipulate activities to maximize their potential exemptions.

  1. Base Amount

There are two ways of identity the base amount. They are volume based and incremental assessment[10].

Volume based scheme corresponds to the entire expenditure spent on total eligible R&D in the last fiscal year. The volume-based approach imposes more revenue forgone for the government, but it minimizes the likelihood of firms engaging in opportunistic behavior by changing their R&D strategies to maximize tax gains.[11]It is also relatively easy to implement, although it has its own administrative challenges.

In the incremental assessment, the tax credit is calculated from the increase in R&D. So the fiscal authority establishes the tax amount and tax credit is calculated beyond that tax amount. U.S and Ireland uses incremental assessment approach.

There are countries that use hybrid schemes that involve the combination of both volume and incremental R&D as their eligible expenditure.

  1. Carry-Forward And Refund Option

If firms have no profits, they do not have any company tax obligation, and so cannot benefit from these scheme. Some countries allow firms to request a tax refund be paid in cash, while others allow it to be used in the future when the financial situation of the firm improves. The countries that follow this approach us Canada, France, Spain.

CONCLUSION

The Research and Development (R&D) is an important contributor to economy of any country and hence growth and sustainability of R&D vital for nations. As the pace of technology is accelerating and newer technologies and processes are becoming important, R&D is becoming a crucial factor in success of the companies and economies in a globalised and competitive world. Companies that consistently and persistently invest in R&D outperform others. Though R&D is generally undertaken by industry and academia, the government plays a key role in developing policies that foster R&D and its sustainability.

To encourage the positive externalities of domestic R&D spillover, governments should subsidize R&D activity. This article contends that we should take into account the effect of the tax system on incentives for investment in domestic R&D when designing that subsidy. We should also consider that effect when evaluating the merits of various tax systems and reform proposals. That process is, of course, dynamic. When a change in the tax system occurs, it likely requires an adjustment of the subsidy to keep the subsidy optimal.

Applying these principles in practice is challenging. Many of the questions that arise cannot be easily answered today, due to a lack of empirical evidence and uncertainty in quantifying both the value of spillovers and the effect of tax rules and subsidies on incentives. However, mapping out the required analytical stages and better understanding the co- dependency between the tax system and R&D investment incentives is undoubtedly useful for policy makers and for identifying questions for future research.

 

[1] OECD, 2001b

[2] OECD, Tax Incentives For Research And Development: Trends And Issues

[3] The practice of receiving compensation, benefits, etc. from two or more sources in a way regarded as unethical ; http://www.yourdictionary.com/double-dipping#AvxPzvLqlok8LP0X.99

[4] All of these regimes, including the Italian IP box, will need to be assessed against the substantial activities requirement set out by the OECD Forum on Harmful Tax Practices. The UK government has already announced that its current regime will be closed to new entrants as of June 2016 and phased out by 2021, and the current regime is likely to be replaced by a regime that complies with the OECD requirements.

[5]  See B. Knight & G. Maragani, It is Time for the United States to Implement a Patent Box Regime to Encourage Domestic Manufacturing, 19 Stanford Journal of Law, Business & Finance p. 39 (Fall 2013).

[6]  Countering Harmful Tax Practices More Effectively, Taking Into Account Transparency and Substance, the Organisation for Economic Cooperation and Development (OECD, 2014).

[7] Griffith, et al 2010.

[8] This does not change the effect of note 8 on page 51 of the 2014 Deliverable on Countering Harmful Tax Practices More Effectively (OECD, 2014).

[9] Frascati Manual (OECD 2002)

[10] Correa and Guceri 2013)

[11] (Correa and Guceri 2013)

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