Going Deep on Critical Policy Issues
Going Deep on Critical Policy Issues
Competitive Tax Policy: A Strategic Lever
Few policy tools are more heavily debated within a country than the way in which the tax burden is distributed. A nation’s tax policy informs the choices that individuals and corporations make in how they spend, invest, hire, research and produce. Chief executives – particularly of manufacturing companies – often cite national and local tax policies as a top consideration in assessing a region’s attractiveness and as an influential factor in choosing where to locate or expand. The elements that comprise a nation’s tax policy – rates, incentives, credits and treatment of foreign income, among others – go to the heart of a nation’s economic competitiveness.
Table 1 provides a summary of five key attributes related to tax policy and a snapshot of how the six focus nations compare across dimensions. These are top-of-mind policy considerations for manufacturing companies in evaluating a location’s tax competitiveness. A more detailed version of this matrix is found in the appendix.
Table 1: Comparison of Key Tax Policies across Nations
Source: Deloitte Tax LLP (MacNeil, Ellen; Goldbas, Michael; Zhang, Priscilla), (US analysis conducted in conjunction with The National Association of Manufacturers), © 2013
A corporate tax rate is the rate that corporations pay on their income. The level and stability of corporate tax levels has a tremendous impact on a country’s overall economic competitiveness. An unduly high corporate tax level can inhibit expansion, encourage relocation of productive assets abroad, and discourage the inflow of foreign direct investment.
A territorial or worldwide system refers to the manner in which foreign income is treated for tax purposes. A territorial system means that only the corporate income earned in a home country is subject to that country’s tax laws. A worldwide system subjects all of a given
corporation’s income to the home country’s tax policies, regardless of where it is earned. A worldwide system is often considered a form of “double taxation” in that the income earned by a foreign subsidiary is taxed by both the host country and the home country. As a result, the worldwide system often discourages repatriation of profits earned by foreign subsidiaries as a way for companies to mitigate this kind of double taxation. Also, this system can encourage foreign investment as opposed to bringing profits back to be reinvested domestically.
Value-added tax (VAT) is a method of taxation in which each member of the value chain is taxed based on its economic contribution at each stage of production. A VAT is used commonly throughout the world except in the United States. It is a form of “consumption tax”, though it works differently than a sales tax. Only the end consumer ultimately bears the economic burden of the tax, like a sales tax. Unlike a sales tax, the collection and remittance of the tax to the government takes place at various points along the value chain. What this means is that only the “value-added” of the product is taxed at each point along the value chain, and the government receives taxes on the gross margin that each business along the chain earns.
Treatment of depreciation refers to the way that companies value the use of productive assets for tax purposes. There are several kinds of depreciation tax policies, and each has its own benefits and disadvantages. Companies’ investments in buildings or state-of-the art technology and equipment, which increase their ability to compete, are often influenced by the nature of a country’s depreciation tax policies. This is especially true in the case of capital-intensive manufacturing companies for which the differences in the tax treatment of depreciation can have a significant impact on the bottom line.
R&D Incentives: A Closer Review
R&D spending as a percentage of GDP, annual average 2005-2010. Source: Maplecroft analysis based on data from World Development Indicators: Research and development expenditure (% of GDP), World Bank (http://data.worldbank.org/indicator/GB.XPD.RSDV.GD.ZS), December 2012.
Source: Maplecroft 2012, World Bank 2011
R&D incentives refer to the benefit that federal – and sometimes local – governments give companies related to their research and development activities. Some R&D incentives are directly linked to companies’ tax liabilities while others take the form of grants, loans and other financial vehicles not directly related to tax liability. More recently, governments are showing a stronger focus on attracting research-intensive companies by offering the patent box, or innovation box, as part of the research incentives. A patent box either provides a favourable tax rate to income or allows a deduction from taxable income attributable to R&D projects, patents or other intellectual properties.
Companies rely on these incentives in determining what kind of R&D to perform and at what level. R&D incentives often serve to advance the research and innovation agenda of a country. They can also serve to promote private-sector innovation generally without “picking” winners or deciding the day-to-day manner in which the corporation carries out its R&D activities. It puts the control in the hands of the company and its leadership, allowing the private sector to determine the best investments to make – which is why executives frequently cite long-term R&D tax credits as an important factor in government policy. Because of the role that R&D incentives play in shaping a country’s manufacturing competitive position, a closer review of each focus country helps to uncover some of the complexities associated with R&D incentive policies.
Incentives – and especially R&D tax incentives – play a particularly important role in determining a country’s competitive position in research and innovation. Innovation thrives in an ecosystem. In many cases, competitive companies and countries enable an environment in which scientists, researchers and product designers are in close proximity to where products are actually produced, creating a transparent, adaptive and nimble ecosystem. Having the right incentive structure in place, such as long-term R&D tax incentives, helps innovation to flourish and increases the competitiveness of a country.
Countries offering R&D tax incentives are often regarded as favourable locations for internationally-mobile R&D. Companies can effectively leverage their global R&D infrastructure to develop a portfolio of valuable intellectual property for various consumers and markets. Highly innovative companies that have worldwide reach often view a country’s R&D incentive programme as among the most important factors in deciding whether to expand their research capabilities in a given location or to invest there in the first place. In making that decision, organizations must evaluate how well a given country’s incentive programme aligns with their technical competencies and strategic objectives.
Although the basic definition of “research and development” is similar across many countries, distinctions do exist. Some programmes favour certain industries or technologies while others are neutral in this regard. Some incentive regimes reward increased R&D spending in and of itself, while others reward a basic threshold of R&D spending. Restrictions also vary in terms of what qualifies as R&D expenditures. While many countries provide R&D incentives in terms of tax breaks, others emphasize benefits that are not directly tax related.
The collective array of global R&D incentive programmes is vast and always evolving. Below is a top-level discussion of R&D incentives – mostly tax incentives – for the six focus countries. The appendix includes a more detailed summary of the R&D incentive policies of these countries.
Top five R&D companies by total R&D spend. Source: Maplecroft analysis based on data from UK Department for Business, Innovation and Skills, 2010 R&D Scoreboard (http://webarchive.nationalarchives.gov.uk/20101208170217/http://www.innovation.gov.uk/rd_scoreboard/?p=1), December 2012.
Source: Maplecroft 2012, UK Department for Business, Innovation and Skills, 2010
The country offers a 100% deduction for R&D expenses (other than land) that satisfy a set of basic criteria. However, the government offers a super deduction of up to 200% of qualifying R&D expenses that also favour certain industries and research activities. The R&D facility must be approved by the Department of Scientific and Industrial Research in order to qualify for the super deduction. India also allows a deduction of R&D employee salaries and materials consumed within three years immediately preceding the commencement of the business. Approval of the super deduction also depends on how the research is conducted, including the requirement that the research takes place in a separate facility with staff dedicated exclusively to the research activities. The unused benefits may be carried forward for the next eight years, but cannot be carried back to earlier years. This larger R&D deduction is set to expire in 2017 unless the law is extended.
The US offers two methods to calculate an organization’s R&D tax credit. First, the “traditional credit” is calculated as equal to 20% of the amount of the R&D expenditures exceeding a “base amount”. An alternative computational method (“alternative simplified credit”) is equal to 14% of the excess of the organization’s qualified research expenditures over 50% of the average of the three prior years’ R&D expenditures. The incentive is intended to benefit all industries conducting qualified research. As a result, all industries are eligible for the research credit. R&D costs that qualify for the credit include: wages for in-house labour, 65% of contract labour and supplies used in the research process. Overhead and capital expenditures are excluded. Qualifying activities must be performed within the US, and the related qualifying costs must be incurred by a US taxpayer (although such costs may be reimbursed by a foreign affiliate). Unused research credits can be carried back one year and carried forward 20 years (small businesses with less than US$ 50 million in gross receipts can carry back 2010 credits five years and forward 20 years).
The Chinese R&D incentives are offered in the form of reductions in enterprise income tax rates. A reduced 15% (down from 25%) corporate tax rate is given to companies engaged in R&D activities that are otherwise granted high and new technology enterprise (HNTE) status. The reduced rate of 15% also applies to qualified technology advanced service enterprises in designated cities with over 50% revenue derived from providing qualified technology advanced services outsourced by foreign entities. (This incentive is available from 1 July 2010 through 31 December 2013.)
China offers special tax incentives for technology and software companies, such as the first RMB 5 million of income from qualified technology transfers are exempt from the enterprise income tax (EIT), any income from technology transfers in excess of RMB 5 million is taxed at a 50% reduced EIT rate, and newly established software companies are often granted tax holidays. There is also a business tax exemption for the transfer of qualified technology.
The Chinese government provides the following list of eight state-encouraged industries that are considered in awarding HNTE status:
- Electronic information technology
- Biological and new medical technology
- Aviation and space technology
- New materials technology
- New energy and energy conservation technology
- High-technology service industry
- Resources and environmental technology
- Transformation of traditional industries through high-new technology
HTNE status is granted for three years and must be renewed every three years. To gain and keep HTNE status, the company must satisfy a set of qualifying criteria. Qualified activities include development of new technology, new products and new production techniques. Qualifying expenditures include staff costs, direct costs, supplies, depreciation and amortization, design costs, equipment installation costs, intangible asset amortization and contracted R&D costs.
For both HTNEs and those entities that do not qualify for HTNE status, the government offers a 150% R&D super deduction, provided that certain R&D spending requirements are satisfied. Tax losses attributable to R&D super deduction claims can be carried forward up to five years.
In Japan, the size of an R&D tax incentive is a function of the size of the organization. For companies whose capital value – or parent’s capital value – is under 100 million yen, up to 12% of R&D expenditures are eligible, with a limitation of 20% reduction in tax liability. For larger companies, only up to 10% of R&D expenditures are eligible, with a similar 20% cap on the reduction in tax liability.
Japan offers an additional tax credit (for both SME and large companies) calculated as a percentage of current year research spending as compared to either the prior years’ research spending or prior years’ sales. This portion of the credit is limited to 10% of the company’s national corporate income tax liability before the credit is applied. The additional tax credit is available in relation to fiscal years commencing on or after 1 April 2008 and up to 31 March 2014.
A tax incentive has been introduced for Japanese entities that are exclusively engaged in R&D activities. This incentive cannot be claimed in conjunction with the R&D tax credit. This incentive permits a qualifying entity to deduct 20% of its income that is attributable to the approved business activities for the first five years of receiving the research centre designation.
Generally, unused R&D tax credits may be carried forward one year. The unused R&D tax credits for the fiscal years beginning on or after 1 April 2009 through 31 March 2010 may be carried forward up to three years. Research credits for fiscal years beginning on or after 1 April 2010 through 31 March 2011 may be carried forward two years.
In Japan, research credits are not limited to any specific industry, though the activity must be technological and scientific in nature. Consequently, research conducted in non-technical fields will generally not qualify for the research credit. The expenses must be borne by the Japanese entity; if the funding is from another party (e.g. government agencies, customers, suppliers, etc.), the R&D tax benefit is not available for those funded expenses.
As a general matter, Brazil offers a super deduction of between 160% and 180%, depending on whether the organization satisfies certain labour/headcount requirements. Brazil offers an extra 20% deduction for the qualifying costs incurred in developing a patent, but the super deduction is only allowed when a patent is registered. For corporate income tax purposes only, 100% depreciation is allowed in the year of acquisition for new machinery, equipment and instruments exclusively dedicated to research and development, as well as 100% amortization for intangibles used in research and development. Eligibility is broad and is not limited to particular industries. Activities undertaken to achieve technological innovation qualify for the R&D tax incentives. These activities include designing new products or processes, as well as the aggregation of new functionalities or characteristics to a product or process, resulting in incremental improvements in quality or productivity. Additionally, software development qualifies as an R&D activity as long as it is undertaken to advance scientific or technical goals. R&D expenditures include wages, salaries, and certain payments to third parties (e.g. laboratory tests), directly attributable to the execution of qualified R&D activities.
Companies must have a tax clearance certificate, regarding the whole calendar year in which the incentive is taken, to qualify for the super deduction. Specific accounting controls are also required. Furthermore, Brazil provides additional research incentives, such as equipment, machinery and tools dedicated to R&D receive a 50% reduction of the IPI due.
R&D tax incentives are not yet offered in Germany. Rather, the government offers two kinds of assistance programmes that take the form of grants and loans. R&D grants are non-repayable and are awarded on a “per project” basis, most frequently for collaborative projects. There is no legal claim for R&D funding. Grant rates can reach up to 50% of eligible project costs. Higher rates may be possible for small and medium-sized enterprises. The selection criteria for eligible projects include the levels of innovation, technical risk and economic risk.
R&D loans can be an alternative to R&D grants. R&D loans are not contingent on conducting R&D activities in a specific technology field and there are no application deadlines. R&D loans are provided under different governmental programmes. For instance, the ERP Innovation Program offers 100% financing of eligible R&D project costs up to € 5 million.
Eligibility for grants or loans is not limited to particular industries. However, companies in the following industries typically seek cash grants:
- Biotech and life sciences
- Information and communications technologies
- Energy and utilities
Qualified activities for grants or loans include:
- Fundamental research – experimental or theoretical work aimed at gaining new knowledge
- Industrial research – research with a specific practical objective aimed at developing new products, processes or services, or at improving existing ones
- Experimental research – research aimed at producing draft, plans and prototypes
What Does This Mean for Manufacturing Competitiveness?
Because virtually every aspect of tax policy affects a country’s global manufacturing competitiveness, it touches upon the most important concerns of the manufacturing organization. A relatively high corporate tax rate discourages any organization from investing in that country in the first place. However, since the manufacturing organization often has productive assets in many countries, it is especially concerned with the manner in which the home country taxes money earned abroad. Differences in depreciation treatments among countries are important because manufacturing entities are often highly capital-intensive businesses. R&D incentives are important to manufacturing companies because innovation-based research is the lifeblood of the manufacturing organization. Given the impact to a manufacturer’s bottom line, it is not surprising that chief executives cite tax policy as among the most important criteria in choosing where and how they will make capital investment decisions.