Comparing the world’s R&D tax credits

Over the past two years, foreign governments have been fine-tuning their R&D benefits

By David Hearn

*This is an expanded version of a summary originally published in the June/July 2009 issue of CAmagazine.

Canada still has the world’s best R&D tax credit scheme, especially for small and medium-sized companies. But other countries, notably the UK, the Netherlands and France, are not far behind; in fact, France may be ahead of Canada where larger public companies are concerned.

These are just some of the key findings from the most recent edition of Overview of Research & Development Tax Incentives in Selected Global Knowledge Economies, published by Scitax Advisory Partners LLP, a Toronto-based consulting firm specializing in taxation of science and technology companies.

Getting a useful picture of R&D tax incentives around the world is more difficult than it might seem. While there is a lot of data available, much of it is out of date and tends to be presented for economists rather than business owners. Furthermore, the past two years have seen a proliferation of countries offering new R&D incentives and some significant increases in the existing rates.

The study, which is published in the form of a tabular report, covers R&D incentives in Australia, Ireland, Canada, The Netherlands, Spain, New Zealand, United Kingdom, United States, France, Austria, Mexico, South Africa and Germany. For each country, the report shows whether the benefit mechanism is incremental or actual, super-deduction or ITC and whether a cash refund is offered. It also lists what R&D expenditures are eligible and if work done outside that country is considered an eligible expenditure.

The Scitax investigators involved in the study note that tracking these benefits has become a moving target. Over the past two years, foreign governments have been fine-tuning their R&D benefits to attract the high-quality jobs that arise when a new scientific research centre opens.

Tax credit terminology explained
While the term “R&D tax credit” is the common vernacular, the more correct term would be R&D tax incentive.

At the most basic level, any comparison of R&D tax incentive regimes involves consideration of two basic parameters: the eligible expenditure method; i.e. what kinds of expenditures the benefit applies to; and the benefit mechanism; i.e., how the allowed eligible expenditures get translated back into real money for the taxpayer.

There are two basic eligible expenditure methods:

Actual – The benefit applies to the actual eligible expenditures incurred in a given tax year. This is the method used in Canada and in several EU countries.

Incremental – The benefit applies to the change in eligible expenditures from year to year. It is calculated by finding the difference between the current year’s expenditures and some “base” amount linked to expenditures in prior years according to some mathematical formula (e.g., moving average, etc.). The US has historically used this method, but by 2010 may adopt a more simplified approach.

In addition to the actual versus incremental method, there are further considerations around what constitutes an eligible expenditure. Some countries may allow only wages, while others may include equipment, materials, supplies, contract payments and / or overheads.

There are five basic benefit mechanisms:

A. Deduction
Reduces taxable income like any other business expense

$100 spent on R&D = taxable income reduced by $100
Assuming nominal tax rate of 11% = tax payable reduced by $11

B. Super-deduction
Taxable income reduced by more than the R&D expenditure

Assuming benefit rate of 150%
$100 spent on R&D = taxable income reduced by $150
Assuming nominal tax rate of 11% = tax payable reduced by $16.50

C. Immediate write-off or accelerated write-off
Faster depreciation of capital assets such as R&D equipment or purchased intellectual property (IP)

$100 spent on R&D equipment or IP
Taxable income reduced by $100 this year rather than $33.33 per year over a three-year period
Beneficial for research requiring costly capital assets or purchase of IP

D. Investment tax credit (ITC)
Direct reduction of taxes payable by some % of the R&D expenditure

Assuming a 20% investment tax credit and a nominal tax rate of 11%
$100 spent on R&D
Taxes payable reduced by $20 for ITC plus normal business deduction of $11 for those expenditures.
Only useful to companies that are profitable and have tax payable
In most jurisdictions the ITC can be applied in arrears to prior years or carried forward for use in future years. In some cases (e.g., Canada) there is an option to also carry the deduction associated with the R&D expenditure forward to a future year.
Benefit may itself be taxable!

E. Refundable cash benefit
Same as investment tax credit but ….

Assuming a 20% investment tax credit and a nominal tax rate of 11%
$100 spent on R&D
Taxes payable reduced by $20 for ITC plus normal business deduction of $11 for those expenditures

If tax payable is fully reduced (or no tax payable) then cheque for $20
Yields cash even if no tax payable
In most jurisdictions the ITC component can be applied in arrears to prior years or carried forward for use in future years.
Important source of funding for startup companies

Canada in the global perspective
For large public corporations, the global R&D tax credit playing field shifted significantly in December 2008, when France enacted new legislation that allows companies to obtain an immediate cash refund for any ITCs that remain unused from 2005, 2006 and 2007, plus the estimated amount that will be unused in 2008. This change, together with benefit rates ranging from 30 to 50% of the actual expenditures up to €100M, makes France highly attractive to cash-starved science and technology companies with big-budget R&D operations.

Despite these recent changes in France, Canada still holds the edge as the most desirable location for with respect to R&D credits for small- and medium-sized companies, because of the following key points:

It has the best overall treatment of domestic-owned small private corporations, which are often the most vigorous technology innovators.
Canada’s benefits are permanent and statutory, which means companies can count on funding for eligible projects over several years.

Complex undertakings may take more than one year to complete. Unfortunately, some of CRA’s current administrative policies on SR&ED eligibility are working to undermine this strength.

It uses an actual benefit mechanism as compared to the US and Ireland, where the benefit is calculated on the change in spending from one year to the next.
Most Canadian provinces offer their own credits, which supplement the federal benefit. While there are considerable differences in the magnitude of these benefits (from 10% to 37.5%), they are all linked so that eligibility at the federal level automatically triggers provincial eligibility. In the US, one of the few countries that also features both state and federal level credits, the state benefits are not only poorly coordinated with the federal system but are often calculated using a different basis. (Moreover, the US only recently restored its federal R&D credit, which had been inconsistently available since 2005, and not available at all in 2007 or 2008.)
In Canada, at least at the federal level, all types of current and capital R&D expenditures are covered. This includes a generous statutory allowance for overhead. Canadian provinces differ somewhat on expenditure coverage, most notably contract payments and equipment. The one item missing from Canada’s list of eligible expenditures is the cost of acquiring and securing intellectual property. France, Ireland and Mexico all offer some form of coverage for these types of expenditures.

Making the choice
While having all this data is certainly handy, it spawns a whole range of further questions: Which incentive scheme is most useful for the kind of R&D I’m doing? How does the R&D credit scheme fit in with other business and personal taxation issues in that country? If the benefit itself is taxable, how much will I actually get to keep after taxes? How does the R&D tax credit benefit I get this year affect my taxes next year? These questions (and the many others likely to follow) are clearly beyond the scope of this article. We can, however, offer some basic guidance:

SMEs -- many of whom are not profitable in early years of operation -- obviously prefer the refundable cash benefit schemes offered in a few countries, most notably the UK and Canada. Companies with very large capital costs, such as chemical, process, metals and semi-conductors, prefer schemes that allow capital equipment and materials. Software developers, custom machinery builders and the automotive industry all rely heavily on outsourcing, so eligibility of R&D done by subcontractors is a significant consideration in those sectors. And finally, super-deductions are most useful -- and appealing – to larger profitable corporations with significant taxable income.

Choosing a country to place your R&D SME will most likely depend on economics (e.g., availability and rate of labour; rent / real property costs; availability of materials), tax issues (e.g., business tax rates, capital cost allowance and value-added taxes) and country-specific incentives (e.g., enhanced incentives for SMEs; restrictions such as thresholds and sector exclusions). As noted above, R&D incentives can vary greatly, and this is especially obtrusive for businesses operating in neighbouring countries. For instance, Canada has one of the best programs while the US has one of the worst: it has lapsed 11 times since 1981 and was unavailable from 1985 until October 2008. Atypically, the UK and Japan allow research anywhere in the world, while their neighbours do not; Germany provides only grants; and Spain does not have a national program. Each region is responsible for R&D incentives.

Another “geographic” factor is the availability of “state-level” benefits within a given national jurisdiction. At present most Canadian provinces and US states offer their own R&D tax incentives that augment what is available at the national level. In some cases these “state / provincial” level benefits are as good as or better than what is offered nationally. While the number and complexity of these state level benefits preclude their inclusion in the Scitax survey, there are a few generalities worth noting: In the US some states offer a refundable benefit on actual expenditures as compared to the US national system, which is ITC on incremental. Conversely, separate state-level R&D incentives are almost unheard of in Europe.

Although Canada is and has been extremely advantageous for SMEs, the European Union has implemented a policy mandating increased government R&D funding; namely, the Seventh Framework Programme for Research and Technological Development (FP7). This is an agreement between EU member states to increase private sector R&D to 3% GDP from 2% by 2010. It is intended to leverage R&D investments across jurisdiction boundaries, foster collaboration between EU countries and generally contribute to the Lisbon objectives for economic growth, jobs, quality of life and social challenges. The FP7 agreement, which was ratified in 2007, is already having a significant impact on government funding for industrial R&D in the EU and will probably continue to shape member states’ policies on science and technology funding at least until 2013.

Notable recent changes likely stemming from FP7 include the UK’s increase in its R&D tax deduction rate for SMEs to 175% from 150% in August of 2008 and France’s recent increase of the top bracket of its multi-tier benefit to 50%. One of the most proactive FP7 initiatives has been in Ireland, which has sought to cement its position as one of the EU’s leading technology destinations by both raising its subcontracted R&D tax credit to 10% from 5% in 2007 and introducing a €500m simplified research grant scheme in 2008.

A final word of caution: we hope our findings help you understand the differences in R&D tax incentive between countries, but given the dynamic nature of tax legislation, please obtain qualified professional advice for any tax-related business decisions.

David Hearn, a senior expert in the science and technology aspects of SR&ED tax credit filings, is a director of Scitax Advisory Partners LLP.