Stimulating innovation through better tax policies

KPMG's latest Innovation Monitor reveals high levels of innovation activity in Irish business with 84 per cent of companies either innovating or planning to. The report, which is based on research carried out on behalf of KPMG by RedC, also highlights the importance of the tax regime in encouraging and incentivising R&D activity.

Among the key aims of the report is to establish how effective Government supports are for R&D and innovation. While progress has been made in relation to tax, there is still room for improvement, according to KPMG partner and R&D incentives practice leader Ken Hardy.

“This year 86 per cent of respondents said they think funding is important to the completion of an innovation project,” he says. “However, only a quarter think there is enough information available on funding.”

Until now the primary support for innovation has been the R&D tax credit which allows a 25 per cent tax credit on qualifying R&D expenditure. This is quite generous by international standards and is recognised as such. However, the KPMG research shows it is possibly not working as well as it might. This year only 44 per cent of companies said they had claimed the R&D tax credit with large companies almost twice as likely to claim as their smaller counterparts. That would seem to indicate that the more resources available to a company, the more capable it is of claiming the credit, Hardy says.

Tax rebate

It may also reflect a widespread belief in relation to the existing R&D tax credit regime as it relates to smaller companies. It is often claimed the scheme is only of interest to firms that have developed sufficiently to be in a position to pay tax. However, this is not the case.

“This was an issue some time ago but the Government has taken steps over the years to address it. Initially the R&D tax credit was claimed against tax paid, but there was a change in 2009 when the then government introduced an encashable tax credit. This can be encashed against payroll taxes. Its introduction has made a significant difference to companies not yet paying corporation tax,” Hardy says.

Effectively, that allows a small company to obtain a rebate on payroll taxes even when they are not earning profits to pay tax on.

However, there is a belief more could be done to make the scheme more accessible and thereby more attractive to SMEs with 80 per cent of respondents saying a simplified and more generous SME regime would lead firms to increase R&D and innovation spend. Furthermore, when asked for suggestions on how to improve the innovation ecosystem in Ireland, more than a quarter of respondents want improvements to the R&D tax credit regime, specifically a reduction in administration and the elimination of barriers to claiming.

Hardy says this would put us more in line with our nearest neighbour.

“The UK has a two-tier regime for large and small companies with an enhanced benefit and a more simplified approach for smaller companies,” he says. “I believe this would lead to greater innovation in this country. There is considerable Government support for SMEs as it stands and the sector is acknowledged as the main driver of jobs growth. Changes to the R&D tax credit regime as it applies to SMEs would be very welcome.”

Positive note

On a more positive note, the announcement of the “knowledge development box” (KDB) in the budget has almost certainly improved the environment for innovation. The objective of the KDB is to provide an attractive tax rate for income generated from commercialising R&D and intellectual property.

While new to Ireland, so-called patent box measures have existed for many years in other countries, with, for example, the UK having a patent box rate of 10 per cent. In Ireland, the rate of tax which will apply to qualifying income will be a very attractive 6.25 per cent.

The rate is only part of the story, however. Compliance with new international taxation rules being laid down by the OECD is critical.

“Anyone who has been following international tax developments in recent times will be well aware of the increasing pressure being applied by the OECD to counter harmful tax practices,” says Hardy. “The organisation recently produced its final package of measures to address base erosion and profit shifting (BEPS). These measures set out how patent boxes and their equivalents should operate.”

Fortunately for Ireland, the KDB will be, in the words of Minister for Finance Michael Noonan, the "first OECD-compliant KDB in the world".

The KDB has been designed to comply with the new international guidelines and follows what is known as the modified nexus approach.

“This limits the application of the 6.25 per cent KDB rate by reference to a company’s R&D spend,” Hardy says. “This is on the basis that the R&D activity produces, for example, patented or copyrighted assets which generate income eligible for the reduced tax rate.”

He believes it is likely that other jurisdictions seeking to compete with Ireland as a location for conducting R&D or the development of intellectual property will also need to follow the modified nexus approach. He also believes the KDB could be very beneficial to Irish firms.

“The KDB could be very attractive for Irish indigenous businesses and SMEs that undertake the majority of their R&D in Ireland,” he says. “Perhaps less so for multinational companies where the generation of the qualifying assets is the result of globally dispersed R&D activity.”

‘Track and trace’

There will be hurdles to clear for companies and these will include an obligation to “track and trace” and provide documentary evidence of expenditure incurred, income generated from the IP assets and activity undertaken to generate the IP assets.

“Obviously, larger and more sophisticated organisations are better resourced to track and trace than some SMEs,” Hardy says. “As the KDB will be very important to Ireland’s SME sector, it will be essential that the track and trace regulations do not place an additional administrative burden on potential claimants in that sector.”

Finally, he believes the establishment of the KDB and changes to the treatment of entrepreneurs under both the income tax and capital gains tax regimes will improve the overall climate for entrepreneurship and innovation in Ireland but hopes for further progress in the coming years.

“The CGT rate for entrepreneurs was reduced to 20 per cent, subject to a lifetime limit of €1 million of net gains,” he says. “Although it is significantly less attractive than the equivalent relief in Britain, it is a move in the right direction and it is to be hoped it can be enhanced over time from both a rate and lifetime limit perspective.”