Incremental tax credit for R&D (legislative proposals)

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Incremental tax credit for R&D (legislative proposals)

Veronika E. Diumina, Lomonosov Moscow State University

In conditions of limited resources, the government is looking for the most effective way of supporting and innovative development of priority sectors of the economy. Despite the fact that the question of the correlation between direct and indirect methods of stimulating investment and innovation activity remains open, more and more economically developed countries make a choice in favor of tax incentives and preferences. The need of finding the effective mechanisms of stimulating R&D in order to develop knowledge-intensive industries, creation of favorable conditions for innovation activity in the country -- all of these confirm the importance of additional restructuring of the taxation system of the innovation sector of the economy. The most common form of tax incentives for innovation activity is tax credit. Based on the analysis of a wide range of foreign studies on the effectiveness of applying a tax credit for stimulating innovation activity, the article discusses and systematizes the positive and negative aspects of applying incremental and volume tax credits for R&D. In the study were used the method of comparative analysis to confront the experience of using different types of tax credit in different countries, the methods of cause-effect and system analysis to identify the main positive and negative aspects of applying volume and incremental tax credits. Based on dialectical method of knowledge, the directions of improving the mechanism of incremental tax credit were formulated. As the result of the analysis the assessment of applying the incremental tax credit for R&D in the existing tax system of Russian Federation and the recommendations for its transformation for increasing the effectiveness are given.

Key words: tax credit, volume tax credit, incremental tax credit, tax incentives for R&D, innovation economy, innovations, taxation

Introduction

In a financial crisis, with shrinking funding and economic slowdown, businesses need additional capital, own and borrowed, to stay afloat. The government, for its part, seeks to minimize its outgoings by supporting the top-priority industries. In this case, a selective approach to stimulation R&D becomes particularly relevant. The government is then forced to change and improve its policy in stimulating innovation activity to make it more efficient and effective while minimizing its costs. The question of balance between direct and indirect economic incentives is still on the agenda.

The government widely uses fiscal tools, which are classified into direct economic incentives (allocations, subventions, subsidies) and indirect economic incentives (tax reliefs and incentives), in order to promote investment in research and development (Ponomareva, Golubgtsova, 2015:49-54). Both higher public investment and tax incentives have multiplicative effect. However, this effect is lower for tax relief than for direct public funding. This is because the funds made available to entities through tax relief can be either spent in current expenses or invested. The government cannot absolutely control how businesses will spend their additional funds. What is more, lower tax assessments means less money for the public coffers. This makes direct intervention mechanisms look more effective; one cannot ignore, however, that targeted support cannot be massive.

Direct incentives for R&D require more sophisticated administration system, micromanagement and ultimately significant human factor in decision-making. Indirect incentives can also have negative effects due to tax fraud as a result of varying interpretations of tax statutes and higher administrative overheads of an overly complicated system for granting tax reliefs and incentives. The key advantage of indirect support is that decision of how to spend R&D budget is made by firms themselves, because they better know which project is might be success- ful R&D tax credits,.There is no doubt that there should be an effective system that could function to a certain extent autonomously, ensuring the maximum return on the funds that were not received in budget (Volynkina, 2007:26).

Overall most developed economies show a trend towards a wider use of tax incentives for investment and innovation (Melnikova, 2010:89-93). Many researchers concur that indirect incentives have positive results, while noting, however, that the performance of a given incentive is determined by a variety of national features and factors, such as, e.g., the sectoral structure, the specifics of the tax system, the contribution of high-tech and knowledge-intensive industries to the nation's GDP, and the government's R&D promotion policies. Tax credit is emerging as the most popular tax incentive for innovation. Out of the 23 OECD countries that use tax credit, 16, 4 and 3 provide a volume-based, incremental and mixed tax credit for research and development respectively.

The aim of this paper is to develop proposals to improve the performance of incremental tax credit as an incentive and to incorporate it into the tax regime of the R&D sector in the Russian Federation. Drawing on a large body of overseas research focused on the efficacy of tax credits in promoting innovation, the paper reviews the positive and negative aspects of two types of tax credit: incremental and volume- based. The findings of the analysis are used to assess the available opportunities for and constraints on this mechanism in Russia and to give practical recommendations for transforming the incremental tax credit so that it can be accepted in the Russian tax system. In furtherance of the tasks at hand, the study used the comparative method to compare the impact of various tax credits in a number of countries, as well as the cause and effect and systems analysis methods, which made it possible to identify the major positive and negative aspects of volume-based and incremental tax credits. Dialectic methods were used to study economic processes and formulate ways to improve the mechanism to implement the incremental tax credit in the tax system of the Russian Federation.

Despite the widespread use of the tax credit in the OECD member states, there are various studies into its effect on R&D investment that sometimes come to the opposite conclusions. E.g., D. Brown and P. Berger discovered a direct relationship between tax credits and higher investment in R&D, whereas S. Hemphill and R. Eiser arrived at the conclusion that the tax credit, along with the other tax benefits, does not have a significant effect on investments in R&D (Bronwyn, 2011). Recent research has demonstrated, however, that such contradictory results can be due to the fact that the researchers examined companies at different stages of the corporate life cycle in aggregate jointly, without grouping them. Taiwan's researchers S. Chiang and P. Lee ascertained that the tax credit affects the most entities in crisis as well as young start-ups, whilst growing entities are less affected by this tax incentive Chiang S., Lee P., Anandarajan A. (2012), The effect of R&D tax credit on innovation: A life cycle analysis. Department of Accounting, Soochow University, Taipe, Taiwan, 519--523.. The practice of applying this tax benefit in the EU and OECD countries has a long history, however, the tax credit was used most actively after the economic crisis in 2008 (Koroleva, Kandrashkina, 2015:29-39). Tax credit is used to promote certain types of innovation, makes certain R&D costs tax-deductible, and does not require the credit amount to be repaid unlike the investment tax credit. A number of countries grant higher rates of tax credit to small and medium-sized R&D companies. Tax credits can be refundable or non-refundable. With refundable tax credits, in the case that the tax credit exceeds the taxpayer's tax liability, the difference can be carried over to subsequent fiscal periods or refunded. With non-refundable tax credits, the balance cannot be carried over to subsequent fiscal periods (Ermakova, 2015:4-10). For the purposes of tax credit assessment, the following types of R&D costs are identified:

- R&D wages (this incentivizes companies to invest in human capital);

- short- and long-term R&D costs (including the costs of consumables).

There are two types of tax credit:

- volume-based (volume),

- incremental (incremental).

Volume-based tax credit

1. Not susceptible to business cycle fluctuations;

2. Low administrative costs of the incentive;

3. Predictability for companies;

4. Straightforward assessment;

5. All companies with R&D costs are eligible for the incentive.

Despite the fact that volume tax credit for R&D is almost universal mechanism for stimulating innovations, it has several limitations:

1. No correlation between reimbursement of R&D costs and their dynamics;

2. High fiscal costs.

Thus the main con of volume-based tax credit is that it does not encourage companies to increase their R&D costs (Samarskii, Sorokina, 2011:34). A volume- based tax credit is normally used in countries seeking to keep their R&D costs at a given level. What is more, the volume-based tax credit provides a better incentive for companies because it applies to their total R&D costs, but costs more for the government. The European countries with volume-based tax credits use rates differentiated by company's size; a case in point is Norway, where a 20% tax credit was initially only available to small and medium-sized businesses and was later introduced for large businesses at the rate of 18% OECD Innovation Policy Platform. In the Netherlands, companies (start-ups) with R&D costs are eligible for a tax credit at the rate of 32% (40%) and 16% for the first 350,000 euros and subsequent amounts spent on R&D respectively Invest in Holland Canada, Corporate tax incentives and credits. Differentiated rates of volume-based tax credit also apply to different forms of ownership, e.g. in Canada. Canadian-controlled private corporations are eligible for a 35% tax credit for research and development costs of up to 3 mln dlr.; all other companies are eligible for a 15% tax credit¹¹. What is more, Canadian states use an additional volume-based tax credit ranging from 3.5% to 37.5%OECD Innovation Policy Platform.

Incremental tax credit

The incremental tax credit makes deductible a portion of R&D costs actually incurred over a basic period and depends on the ratio between R&D costs in the current period and R&D costs in the basic period. The incremental tax credit was first used in the USA (Guinet, Kamata, 1996:171-183). It is used for income tax deductions and can be claimed as long as the entity has outstanding income tax liabilities; thus an unused tax credit can be carried up to three years back and up to 15 years forward. The US uses 3 different methods for assessing incremental tax credits for research and development: traditional, for start-ups and alternative. The applicable assessment method depends on the year of taxpayer registration, the start date of research and development project for tax purposes, as well as on the taxpayer's ability to provide the required paperwork. The first two methods grant a tax credit at the rate of 20% of R&D costs over the baseline amount.

The alternative method grants a 14% tax credit (Warda, 2002:187-195). Whatever the assessment method, the baseline for assessing the incremental tax credit may not be less than half of the R&D costs incurred in the relevant period. An incremental tax credit for research and development is granted to companies that develop or improve products or manufacture goods using new solutions. A tax credit is also available to companies that have improved the performance, reliability or quality of products, which are already on the market (Holtz- man, 2017). Important changes to R&D incremental tax credits were made in the US tax legislation in 2015. The changes were designed to expand the list of taxpayers that are eligible for a credit, with virtually all the changes affecting small businesses. Today incremental tax credit is mostly used to encourage R&D activity of US startups by lowering their after tax costThe differences between the French and American R&D tax credit. This measure is very important because small enterprises are usually especially in need of additional financial recourses.

Apart from the USA, incremental tax credits for research and development are also available in Ireland and Mexico. Incremental tax credit has its' positive and negative aspects. The positive aspects are the following:

1. Stimulates companies to increase their R&D costs;

2. Lower tax expenses (vs volume-based tax credits).

Despite the fact that the incremental tax credit has a greater influence on innovation processes than volume-based tax credit, it has several negative aspects:

1. Not available to companies under various tax regimes;

2. Not available to companies whose R&D costs in the current period are less than the incremental tax credit baseline in place;

3. High administrative costs of the tax incentive;

4. Procyclical in nature: the tax credit will increase and decrease during a recession and boom respectively;

5. Difficult to assess the tax credit;

Companies receive additional tax relief when inflation is rising without a real increase in their R&D costs.

The incremental tax credit costs less for the government because a limited number of companies are eligible for the incentive, which decreases the shortfall in public income. The main con of R&D incremental tax credit is a complicated, multitier credit assessment system, which drives up the costs of tax administration. A number of studies conducted in the USA after the introduction of the incremental tax credit show that only 52.7% of R&D costs were incurred by companies eligible for an incremental tax credit, whereas 15.3% of the companies failed to increase their

R&D costs beyond the baseline, and 32% of the companies were not eligible for an incremental tax credit because they paid no income tax (Eisner, Albert, 1984:76-88).

Incremental tax credit in Russia

In the Russian Federation, about 200 tax benefits and preferences are currently applied. The introduction of additional tax incentives can significantly increase the costs of tax administration and the risks of tax fraud (Kuklina, 2014:118-128). It is therefore important to develop a tax incentivization policy for the R&D sector and estimate the impact of each specific incentive on R&D in the country. Russia has yet to introduce any form of tax credit; it, however, has a variety of tax deductions, exemptions, tax holidays, as well as an investment tax credit in place. Unlike the volume- based and incremental tax credits used abroad, the investment tax credit has a tax and a credit dimension and constitutes tax payment rescheduling that allows eligible entities within a certain time (5 years) and within certain limits (up to 50% of the payable tax) to reduce their tax liabilities, with the credit amount plus interest payable in instalments.

An investment tax credit is available for both income tax and state and local taxes. Despite the benefits of an investment tax credit in practice, it is clear that most organizations that could qualify for a credit are not ready to take it. First, the five-year credit deadline is especially critical. This time limit is demonstrably too short for production re-equipment, modernization and recovery of the costs. Second, an investment tax credit is subject to the approval of the taxman and state comptroller. State governments are often reluctant to grant a tax credit because it means a shortfall in public income. The involved process of applying for an investment tax credit as well as the role of the human factor in selecting credit beneficiaries gives rise to corruption risks. The example of investment tax credit functioning as part of the system of tax incentives designed to promote investment and innovation demonstrates the inadequacy of the system of mechanisms used in Russia. Still, R&D incremental tax credit has potential, but a number of obstacles need to be overcome first. First, it is important to eliminate the requirements on the baseline for incremental tax credit assessment.

This limitation materially reduces the number of companies (particularly small and medium-sized businesses) that can be eligible for the credit. Second, make the incremental tax credit refundable because many businesses use special tax treatments and pay no income tax. The amount of incremental tax credit could then be paid in the form of a grant. Third, change the unconventional mechanism of baselining for incremental tax credit assessment on a case-by-case basis. It is far more effective to group companies by sector and define the baseline based on changes in R&D costs across the board. To improve the performance of incremental tax credit, it is proposed to group taxpayers by sector for better targeting of support. This will, on the one hand, incentivize priority industries, identify and encourage those entities that consistently increase their R&D spending, produce and export more innovative products, and, on the other hand, save public funds. The author suggests building rankings using the method of principal components to match R&D spending and innovative output.

However, the author believes that an integrated system of volume-based and incremental credits is the best way for promoting R&D investment. Such a hybrid system is used, for example, in Japan, Spain and Portugal, with a tax credit granted for a company's total R&D costs, and where the company's R&D costs exceed the average costs over three preceding years, an incremental tax credit shall also be granted. Additionally, under this method, can be set different credit rates for small and medium businesses, as well as for different forms of ownership, in order to support small businesses, especially those in need of financial resources.

Japan has set its volume-based tax credits at 8-10% for large companies and 12% for small and medium-sized companies, and it also has a 5% incremental tax credit in place OECD Innovation Policy Platform.What is more, during the 2007-2008 crisis Japan used a higher rate of 20% for its R&D incremental tax credit Japan, Corporate tax incentives and credits. It is apt to note here that the majority of the countries with the best indirect incentives in place for research and development use flexible tax regimes, easily adaptable to economic changes.

In Russia, such a hybrid system could be conducive to innovation processes in the country. Volume-based and incremental tax credits provide better incentives for companies in the R&D sector and gives an additional impetus to R&D spending. However, approbation of this mechanism requires a significant restructuring of the existing tax system in Russia, because, firstly, additional difficulties arise with the administration of new benefit, and, secondly, duplication of tax credit and existing tax preferences is possible. This calls for an in-depth performance review of each individual incentive in order to keep the best incentives that encourage companies to increase their R&D spending and produce high-tech equipment, and on the other hand, to maximize public savings.

incremental tax credit

Conclusion

As of this writing, research and development tax credits are available in most OECD countries in one form or another. The countries leading in this field offer a combination of tax credit options to provide the best incentives for companies engaged in research and development. The track record of both incremental and volume-based tax credits shows them to be a major driver of innovation processes in the countries that have adopted them. The paper has identified the positive and negative aspects of R&D volume-based and incremental tax credits, formulated an outlook for an incremental tax credit in Russia and given recommendations for its improvement.

An incremental tax credit can be incorporated into the tax regime of the R&D sector to replace the underperforming investment tax credit. This, as has already been mentioned, requires overcoming a number of limitations of the incremental tax credit. First, it is important to scrap the limitation on the baseline for incremental tax credit assessment. Second, make the incremental tax credit refundable because many businesses use special tax treatments and pay no income tax separately. Third, change the unconventional mechanism of baselining for incremental tax credit assessment on a case-by-case basis. Be that as it may, the comparison between the incremental and volume-based tax credit has identified major benefits of a hybrid system rather than anything else. A hybrid system makes it possible to both reward those entities that spend on R&D and to encourage entities to increase this expenditure.

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