Oxford CPC, LLC professionals and partners have recognized that more than 30 countries now offer various incentives for research and development (R&D). In many cases, these incentives are offered through the tax system in the form of tax credits or additional deductions. Some of these incentives are refundable in cash to the R&D performer even if the taxpayer has no taxable income in that jurisdiction. In other cases, these incentives can be used to offset payroll or other forms of taxes.
The rationale for these incentives is as follows:
Governments are trying to influence R&D performers either to locate their activities within the country or at least to stop research jobs from leaving the country. Sophisticated R&D performers have systems in place to capture eligible activities and the related expenditure, and to allocate the incentives back to the group that actually performed the work. They will build the incentives into the future planning and budgeting process, and the availability of R&D incentives will be a factor in ranking investment decisions and locating future development.
In evaluating the R&D regime in any jurisdiction, a variety of factors must be considered as follows:
United States
The US incentive system is one of the least generous, with an effective rate of 6.5 per cent on incremental spending. Incremental spend is determined by comparing the current year spend to a base figure that is calculated according to R&D spend between 1984 and 1988 inclusive, and then adjusted for growth in sales. There have been instances of companies with a high percentage of spend to sales in the base period that today are unable to access the credit, despite massive R&D spend, because of the base-period limitation. In addition, the base-period calculation adds a severe compliance burden. Special rules exist for companies that did not exist during the base years.
Eligible expenditures include salaries, materials and 65 per cent of subcontracted R&D. Work is limited to that performed in the United States and any receipts are offset against the R&D expenditures, except those from foreign affiliates.
Canada
The Canadian system is one of the most generous regimes in the world. It features a federal volume-based 20 per cent credit on a wide range of expenditures including R&D salaries, contract payments for R&D, R&D capital, lease payments for R&D equipment, materials consumed or transformed and overheads. The credit can be utilised in the current year, carried back three years or carried forward 10 years. Many Canadian provinces offer additional incentives – for example, the Quebec 17.5 per cent wage tax credit is refundable to all taxpayers if it is not used to offset the payable provincial taxes.
There are additional benefits for small Canadian-controlled private corporations, including an increased rate and refundability of the credits within limits. All work must be performed within Canada’s territorial limits. The system has a series of rules that prevent more than one Canadian company from claiming the incentives on the same piece of work. However, any receipts from foreign companies, although treated as income, are ignored for the purposes of calculating the credit.
France
The French system is both incremental and volume based. The basic rate is a 5 per cent tax credit on all eligible R&D expenditures, which include staff costs, overheads, amortisation of R&D capital equipment and some subcontract costs. The incremental rate is a 45 per cent tax credit on the average increase over the last two years.
Under the new rules up to 25 per cent of the work may be performed outside France. Up to €8 million in credits is refundable if a corporation is in a loss-making position. The government will issue the refund after three years; alternatively, the company can discount the refund at a financial institution for cash.
Australia
The Australian incentive is a 25 per cent additional deduction for most expenditures incurred on R&D. This is effectively 7.5 per cent above the tax rate. The incentive increases to 175 per cent on expenditures over the taxpayer’s average R&D spending. In addition, a refundable tax set-off is available for smaller firms. Eligible expenditures include salaries, subcontracted R&D, overheads, trial costs and plant costs where the plant is used in R&D.
In order to claim the incentives, corporations must file an R&D plan setting out their R&D activities and file the R&D claim within nine months of the year-end. In addition, there are restrictions on claiming activities relating to in-house computer software development. In order to be eligible to claim such activities, a company must sell or license the resulting product to two or more non-associates of the company.
Japan
The Japanese system is both incremental and volume based. The incremental credit is 15 per cent of the greater of the three largest spends in the last five years or the largest spend in the last two years. The alternative credit is 8 per cent of R&D expenditures (10 per cent for 2003 to 2006), which can be used to offset up to 20 per cent of a corporation’s tax liability. Additional incentives are also available.
Eligible expenditures include revenue spend on R&D and depreciation on R&D capital spend. A significant feature of the Japanese system is the ability to claim for R&D expenditures carried out anywhere in the world, provided that it is paid for by a Japanese entity and the intellectual property is owned by that entity.
Spain
The Spanish system contains both a base and an incremental incentive. The base is 30 per cent of qualifying costs, with an additional 20 per cent credit on spending above the average of the previous two years. Eligible expenditures include most R&D costs, including buildings. The credit is capped at 50 per cent of the total taxes payable. However, 15 per cent of unused credits can be carried forward. A percentage of the work may be performed outside Spain. In addition, other R&D incentives are available.
Spain is a good example of a country with a generous regime, but which has previously had problems in the administration of the system, resulting in uncertainty for companies as to whether they could access the incentives. The Spanish government has taken steps to alleviate these problems.
United Kingdom
The current system in the United Kingdom was introduced in April 2002. The authorities have made a considerable effort to make the guidance effective for both taxpayers and tax inspectors. The after-tax rate of the additional deduction is effectively 7.5 per cent for large businesses. If the additional deduction is not used in the current year, it is added to a company’s loss to be carried forward. The benefit is increased for oil and gas companies to the extent that they can offset their R&D expenditures against their petroleum revenue tax. The rate is higher for small and medium-sized enterprises and is refundable to them within limits, provided the additional deduction is not currently used.
Work may be performed anywhere in the world provided that it is performed within a UK corporation. There is an anti-avoidance rule designed to prevent unintended benefits. There are no set-offs for any revenue received. Therefore, for example, a defence contractor performing R&D for the UK government may claim the incentives on its work performed.
Problem issues with the system for large corporations include the limited range of costs available (only salary, materials consumed and transformed are included, as well as very limited subcontracting costs) and the comparatively low rate of the benefit. The restriction on subcontracting costs favours companies that perform R&D in-house as opposed to those that subcontract some of their development. In addition, if the development costs are capitalised, the additional deduction may not be available.
Opportunities to maximise incentives arise from the differences between countries’ territorial restrictions as to where qualifying R&D can be performed and on the treatment of receipts for R&D from outside that country. It is likely that these opportunities will increase. For example, for many European countries the current territorial restrictions are under a cloud. This is as a result of a recent ruling by the European Court of Justice (Laboratories Fournier SA (C-39/04, March 10 2006)) that certain provisions of the French R&D tax credit were contrary to Article 49 of the EC Treaty – the French tax credit restricted the credit to activities carried out in France only. France has subsequently relaxed these rules.
One example of how incentives can be claimed in more than one jurisdiction for the same work occurs when a Japanese manufacturer pays for all R&D carried out on its behalf outside Japan and retains the intellectual property. If the R&D performer is in the United States, both companies can claim the incentives, provided that the two companies are affiliated for tax purposes. Under the US regime all foreign payments from affiliated companies are ignored when determining the US credit.
Regardless of whether R&D incentives are claimed, transfer pricing issues often arise in relation to R&D expenditure. Multinational taxpayers have different IP ownership arrangements in place. For example, the IP ownership may be in the home country, in a tax-advantageous country or where it is developed. Transfer pricing issues arise if, for example, intellectual property is developed in one country and then utilised in another without appropriate compensation. Many companies deal with these issues through R&D cost-sharing arrangements, contract-manufacturing arrangements or royalty payments.
However, such risks are not always identified and dealt with. In one such case a parent company incurred R&D expenditure and claimed the R&D incentives for work on developing a new product. The taxpayer claimed the R&D incentives on the work performed and the tax authorities allowed the incentives.
The technology developed was utilised by the parent company’s subsidiaries around the world, but without compensation to the parent. The tax authorities charged the company 10 times as much as the R&D incentives in transfer pricing adjustments and penalties. Of course, transfer pricing issues arise regardless of claiming R&D incentives. However, it may be convenient to combine work identifying and quantifying R&D expenditure for the purpose of an R&D incentive with work identifying whether any transfer pricing issues arise from the R&D expenditure. This could then help to ensure the company’s corporate tax return correctly deals with any transfer pricing issue that arises.
Not all R&D expenditure leads to a transfer pricing issue. For example, a company develops technology in a given country and exports it to its subsidiaries for a fair market royalty. A subsidiary in another country needs to develop the technology further in order to address the concerns of the local market, or perhaps one of the components of the original technology is banned in that particular country as a carcinogen. The local country performs R&D to replace that component without affecting the overall price or quality of the product. Such development should not provide any transfer pricing exposure as there is only local value in the intellectual property developed.
Over the past few years an increasing number of governments have introduced additional tax relief or enhanced existing tax relief for R&D activities (eg, Hungary, Ireland, the United Kingdom). Governments are using these incentives as a policy instrument to attract R&D facilities and employees. For many companies, the ability to reduce development costs by using these incentives gives them a substantial competitive advantage. Companies planning to build new R&D facilities or deciding where to locate development activities should take these incentives into account in their decision making.
