By Lorraine Smyth and Nicola Quinn

Part 1

This article is the first in a series of two articles on the subject.

The report of the Innovation Taskforce (published in March 2010) entitled “Innovation Ireland” recommends that policy and investment decisions should be centred on supporting and encouraging the entrepreneur and innovative enterprises. To that end it recommends improving a number of existing tax provisions, such as the Research and Development (“R&D”) Tax Credit, to help boost investment in areas key to developing a highly-innovative, export-led enterprise sector.

In this article (the first of a two part series looking at tax incentives for innovation), we will consider the R&D tax credit. We will consider the tax exemption for patent royalties and the tax deduction for capital expenditure on scientific research in the June issue of tax.point.

The R&D Tax Credit

The R&D tax credit was introduced in Finance Act 2004. It has been amended and updated by successive Finance Acts. The highlights of the relief are:

• Incremental R&D expenditure incurred by an Irish company qualifies for a tax credit of 25% (20% for accounting periods beginning before 1 January 2009) in addition to the normal deduction for expenditure. This means a company carrying on a trade in Ireland gets an effective 37.5% corporation tax deduction for R&D expenditure. This applies to R&D expenditure by an Irish company in any EU country, provided a tax deduction is not available for that expenditure in another country.
• The R&D tax credit is available in respect of qualifying expenditure of a revenue nature and certain capital expenditure (plant and machinery and buildings).
• For the purposes of the relief, 2003 is designated as the base year for expenditure and the credit is only available on any R&D expenditure above the level of R&D expenditure in 2003.
• The credit can be offset against current year corporation tax. Any unutilised amount may qualify for group relief, and any residual amount may be carried forward.
• In addition, Finance Act (No. 2) 2008 introduced significant changes to the relief, and in addition to providing a mechanism to use the R&D credit to reduce the prior year corporation tax liability, also provided that a repayment of excess R&D credits is available over a three year period. The repayment is limited to the higher of the total corporation tax payable by the company in the previous ten years or the payroll tax liabilities of the company for the period in which the R&D expenditure is incurred. This was a very welcome change for businesses in a difficult economic climate and resulted in cash refunds to many companies.
• Finance Act 2010 made further changes to the R&D credit. The changes are quite specific and are expected to have limited impact. Where a company has an R&D centre which ceases to be used by the company and that company has another R&D centre (not less than 20 kms away), the base year expenditure may be reduced by the expenditure incurred in the centre that has ceased (subject to certain anti-avoidance measures).

What is Qualifying R&D?

R&D for the purposes of the relief includes basic research, applied research or experimental development. These activities must seek to achieve scientific or technological advancement and involve the resolution of scientific or technological uncertainty. The legislation provides that Revenue may consult with experts to determine whether the expenditure incurred was incurred in the carrying on by the claimant of R&D activities and in practice we understand that Revenue always engage a technical expert when assessing an R&D claim.

The R&D legislation allows for very minimal sub-contracting of R&D by a company. R&D subcontracted to universities or third level institutions in the EEA can qualify but only if the expenditure does not exceed 5% of the total R&D expenditure. A credit will also be available for expenditure sub-contracted to an unconnected company up to a maximum of 10% of the qualifying R&D expenditure.

Revenue has issued guidelines on the R&D credit which contain details on what qualifies as R&D. They also issued an eBrief (No.2/2009) as to what should be submitted when making a claim.

What next for the R&D Credit?

The Commission on Taxation Report published in September 2009 recommended that the tax credit for R&D should continue. The credit is considered important in terms of economic activity and is recognised as important in attracting investment into Ireland. The R&D tax credit is likely therefore to continue to form an important part of the tax code going forward.

The Innovation Taskforce, while recognising that the R&D credit was generous, recommended some enhancements to the credit. They recognise that this might have cost considerations (obviously an obstacle for Government in the current environment) but believe that the changes would help deliver the step change required in the level of R&D being undertaken in Ireland.

The benefits for the economy of increased R&D activity in Ireland should far outweigh any cost associated with enhancing the R&D credit. In order to compete internationally for R&D activity, Ireland needs to ensure that its R&D credit regime is as competitive as possible.

Some areas where changes to the existing regime would be welcomed are:

Base year

The Innovation Taskforce has recommended removing the incremental basis from the credit. They state that retaining an incremental based system continues to penalise companies who undertook R&D in Ireland in 2003. A recent Forfás report (prepared in conjunction with the Advisory Council for Science Technology and Innovation) also recommends that the impact on companies of the 2003 base year be investigated with a view to removing it and making it a more competitive incentive internationally.

The abolition of the base year would give the credit a new impetus and would make it more comparable with the incentives available in other countries such as the UK and France where there is no base year restriction.

Qualifying R&D

One of the impediments to companies claiming the R&D credit is the lack of clarity about what qualifies as R&D. The bar has been set quite high in terms of proving that a company is carrying out R&D for the purposes of the tax credit and the documentation requirements are quite onerous.

A recent survey carried out for KPMG by RedC Research found that while 28% of respondents had applied for R&D grant aid, only 17% had claimed the R&D tax credit. Maybe then more companies could benefit from the R&D credit if there was more clarity as to what qualifies.

The documentation requirements should also be reviewed to ensure that they are not unduly onerous.

Outsourcing

The Innovation Taskforce recommends reviewing the permitted level of outsourcing and this is something which should be seriously considered. Many companies collaborate with other companies or enter joint ventures to carry out R&D and unduly restricting the credit available for outsourcing may limit Ireland's attractiveness for this activity.

Conclusion

The R&D tax credit is a very beneficial tax relief for companies and is a cornerstone of Ireland's measures to encourage enterprise and innovation. There is however clearly identified room for improving the effectiveness of the credit. Let's hope that the recommendations of the Innovation Taskforce are given serious consideration in advance of the next Finance Act.

In the June issue of tax.point, Lorraine Smyth and Nicola Quinn will consider the tax exemption for patent royalties and the tax deduction for capital expenditure on scientific research.

Lorraine Smyth is Head of Group Tax with Bank of Ireland.

Nicola Quinn is Divisional Tax Manager – Retail also with Bank of Ireland.

Email: lorraine.smyth@boimail.com or nicola_m.quinn@boimail.com