TAX RELIEFS AND CREDITS FOR RESEARCH AND DEVELOPMENT

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1 TAX RELIEFS AND CREDITS FOR RESEARCH AND DEVELOPMENT SPECIAL REPORT BY WASHINGTON D.C SEPTEMBER 2011 PKF International is a contributor to the Commonwealth Finance Ministers Reference Report 2011, produced by Henley Media Group. PUBLISHED BY HENLEY MEDIA GROUP LTD IN ASSOCIATION WITH THE COMMONWEALTH SECRETARIAT

2 TAX RELIEFS AND CREDITS FOR RESEARCH AND DEVELOPMENT With many of the developed world s economies still struggling to recover from the global economic crisis, governments are looking at targeted fiscal incentives for high-tech industries as a potential engine for future growth. Some of the most popular measures adopted in many territories are tax reliefs and credits for research and development (R & D) expenditure. In this report, tax experts from PKF International member firms in four of the key Commonwealth nations Australia, Canada, South Africa and the United Kingdom summarise the latest R & D developments in their countries while the Indian firm gives an introduction to transfer pricing legislation in India. AUSTRALIA New definition of R & D brings uncertainty On 24 August 2011 the Australian Parliament approved legislation to change the taxation incentive regime for companies conducting R&D activities in Australia. Effective for income years commencing from 1 July 2011, the new provisions provide an increased level of financial assistance to an expanded range of companies. The downside for existing claimant companies is that the legislation defining what is R&D for tax purposes has been changed considerably and has introduced uncertainty as to how the scheme will be administered. From Tax Deductions to Tax Credits One of the fundamental changes to the R&D tax incentive regime involves changing the nature of the tax benefit from additional tax deductions to a tax credit. Under the existing incentive, companies were allowed a 125 per cent tax deduction on eligible R&D expenditure with up to 175 per cent tax deduction on increased R&D expenditure. For tax loss companies with group turnover under Aus$5 million and R&D expenditure under Aus$2 million, the R&D tax deductions were refundable at the 30 cents in the dollar company tax rate. Under the new credit regime, R&D expenditure will become non tax-deductible but subject to a tax credit at either the 45 per cent or 40 per cent rate. The rate of tax credit will depend on whether group turnover is less than Aus$20 million (45 per cent credit) or more than Aus$20 million (40 per cent credit). This equates to 150 per cent and 133 per cent rates of tax deductions under the current scheme, hence the increased level of headline financial assistance. For sub Aus$20 million group turnover companies, the 45 per cent credit is refundable if the companies are in a tax loss position. Unlike the existing tax concession rules, access to the refundable tax credit is not restricted by a maximum R&D expenditure threshold. Further, there is no limit on the amount of R&D expenditure for which the R&D Tax Credit can be claimed. This will be of particular benefit to start up technology companies that will now be able to effectively cash out their R&D expenditure at the 45 per cent rate. Many of these companies were previously precluded from the refundable benefit because of the previous Aus$2 million R&D expenditure thresholds applied to the refund criteria. Access for Foreign Companies The new regime also expands the range of entities that can access the R&D tax benefit. The concession will be expanded to encompass foreign companies operating in Australia through a permanent establishment. This will bring in foreign companies carrying on R&D through a branch in Australia. Foreign ownership of the results of the R&D activity is specifically accommodated under the new regime. Changes to the R&D Activities Eligibility Criteria While the benefits of the new regime are obvious, there are also a number of areas where the eligibility criteria have been tightened to potentially exclude a range of activities that are currently eligible for the tax incentive. The definition of what constitutes R&D for tax purposes has been completely overhauled with the introduction of new terminology. The previous focus for core R&D on systematic, investigative and experimental activities involving innovation or high levels of technical risk has been replaced with experimental activities for the purpose of creating new knowledge. While there would appear to be little substantive difference in the application of the new terminology, it 1

3 will be in the administrative interpretation where uncertainty is likely to be introduced, with the Government flagging the intent for a tighter interpretation of eligibility. Areas targeted for specific tightening are those where the Government considers the activities to be part of business as usual of certain businesses. Those targeted include businesses engaged in some form of production such as manufacturers and mining companies, together with certain computer software developments. Changes to the definition of supporting R&D in the new R&D Tax Credit will subject companies to a dominant purpose test if they conduct activities that produce or are directly related to producing goods or services. Such activities will need to support core experimental development. Production activities that are core experimental activities will continue to be eligible R&D. New feedstock rules will also be applied to producers where R&D results in the production of goods of value. The new rules do not impact on the deductions for material inputs, however, they may be deemed assessable income, depending on the value of the output of the R&D. There is concern amongst the business community that an unsupportable and narrow interpretation of the new legislation will confine assistance to companies whose R&D is a failure, with limited entitlement for successful R&D conducted by productive companies. While the terms of the legislation are fairly innocuous, according to the Government s stated position in published material associated with the new legislation, there is an intent to move away from supporting applied industry R&D towards supporting more basic and early stage development activities. Computer Software Computer software developers are also subject to a new dominant purpose test applying to their core experimental activities. Computer software development whose main purpose is for performing internal administrative functions, including the administration of business functions, is precluded from eligibility as core R&D activities. This test replaces the multiple sale criterion as a means of excluding development of internal software from the scope of the R&D Tax Incentive. Graham Wakeman, Partner - Government Incentives, PKF East Coast Practice Tax Consulting Group, Sydney, NSW 2000, Australia Tel: Direct Line: graham.wakeman@pkf.com.au CANADA Longstanding program to promote the advancement of technology Canada has a longstanding tax incentive program aimed at promoting the advancement of technology in Canada. Companies making qualified expenditures in connection with Scientific Research and Experimental Development (SR&ED) activities in Canada are entitled to receive a federal investment tax credit. The credits reduce federal tax payable but, for certain entities, the credits are fully refundable where there is no federal tax liability. The refunds assist emerging businesses and others that are not taxable in the year. The federal program is administered by the Canada Revenue Agency (CRA). Most provinces offer parallel programs with tax credits for qualifying activities in the particular province. Available Tax Benefits Qualifying current and capital expenditures are fully deductible in computing taxable income. The federal credit rate and the availability of a cash refund are dependent upon the nature of the entity and, in the case of a corporation, its tax status and associated group s prior year taxable income and prior year taxable capital employed in Canada. A Canadian-controlled private corporation (CCPC) is essentially a private corporation that is not controlled by one or more non-residents of Canada or one or more public corporations or a combination of those parties. A CCPC can earn a federal investment tax credit of 35 pet cent on up to Can$3 million of qualified current expenditures and that credit is 100 per cent refundable. For current expenditures in excess of the Can$3 million limit, the credit rate is 20 per cent and that credit is 40 per cent refundable. The corporation s expenditure limit will be eroded on a prorata basis by the aggregate of its associated group s taxable income over the threshold amount (Can$500,000 in 2010) or the aggregate of its associated group s taxable capital employed in Canada above the threshold amount (Can$10 million in 2010). Slightly different rules apply for capital expenditures relating to computers, equipment and machinery used in SR&ED. A corporation which is not a CCPC will receive a 20 per cent credit on all qualifying expenditures. This credit can only be applied to reduce taxes payable and is not refundable. Individuals, partnerships and trusts carrying out qualifying SR&ED activities will also receive a non-refundable 20 per cent credit. Provincial tax credits are generally at a lower rate than the federal credit. The combined federal and provincial tax credits range from: 2

4 35 per cent to 48 per cent for CCPCs 20 per cent to 32 per cent for non-ccpcs and noncorporate entities. Federal investment tax credits claimed in a particular year reduce the SR&ED expenses used to compute taxable income in the following year. Provincial tax credits and other government assistance generally reduce the SR&ED expenses in the current year. Provincial tax credits on the proxy amount used to substitute for overhead expenses reduce SR&ED expenses in the following year. Qualifying Expenditures and Projects From the CRA s perspective, the particular project must meet three main criteria to qualify for SR&ED incentives: 1. Technological advancement or advancement of scientific knowledge 2. Technological uncertainty 3. Systematic investigation. Work that qualifies for the SR&ED program specifically includes: Basic research where there is no specific practical application in view Applied research where there is a specific practical application in view Experimental development to achieve technological advancement to create new materials, devices, products or processes or to improve existing ones Support work in engineering, design, operations research, mathematical analysis, computer programming, data collection, testing or psychological research but only if the work is commensurate with, and directly supports, the eligible experimental development or applied or basic research. The following activities are specifically NOT eligible for benefits under the program: Market research or sales promotion Quality control or routine testing of materials, devices, products or processes Research in the social sciences (psychology, economics, business, law, history, archaeology, literature, philosophy) and humanities research Prospecting, exploring or drilling for or producing minerals, petroleum or natural gas Commercial production of a new or improved material, device or product, or the commercial use of a new or improved process Style changes to an existing product Routine data collection. Expenditures incurred for SR&ED may include wages, materials, contract services, equipment lease costs, third party payments and certain capital expenditures. Overhead expenses may be claimed either on a specifically identifiable cost basis or by electing to use the simplified proxy method which substitutes the actual overhead expenses with a proxy amount determined by multiplying eligible SR&ED wages by 65 per cent. Bill Macaulay, CA Tax Partner, SmytheRatcliffe LLP, Vancouver, Canada bmacaulay@smytheratcliffe.com Direct Telephone:

5 INDIA An introduction to Transfer Pricing Law in India The law on Transfer Pricing (TP) has evolved in India as a logical consequence of the exponential increase in international transactions post-globalisation. The participation of multinational groups in the economic activities of India has given rise to complex issues, particularly so when it involves transactions between two enterprises belonging to the same multinational group. The Finance Act 2001, which introduced an entire gamut of provisions dealing with TP, came into force on 1 April 2002 and was applicable to the assessment year and subsequent years. The law essentially mandates arm s length pricing of international transactions between associated enterprises, specifies the methods for determining the arm s length price (ALP), details the documentation requirements for companies entering into international transactions, and stipulates penalties for non-compliance. Key Features of Transfer Pricing Regulations The Transfer Pricing law in India requires that pricing of international transactions between two Associated Enterprises (AEs), either or both of whom are non-residents, should be at arm s length, a detailed definition of which has been given in the law. The definition is given based on certain objective parameters to assess the relationship between two entities and include: Share Capital Criterion: When one AE holds 26 per cent or more of share capital in the other or when a third party holds 26 per cent or more share capital in both AEs Loan-based Criterion: Loan advanced by one AE constitutes 51 per cent or more of total assets of another AE Management Control Criterion: More than half of the directors or one or more executive directors are actually appointed by one AE in the other AE. If the TP provisions are applicable, the ALP of the international transaction(s) has to be determined. The pricing at arm s length would need to be established by internationally accepted transfer pricing methods including: 1. Comparable Uncontrolled Price Method (CUP) 2. Resale Price Method (RPM) 3. Cost Plus Method (CPM) 4. Profit Split Method (PSM) 5. Transactional Net Margin Method (TNMM) To date, judicial pronouncements indicate a bias towards the CUP method. Safe Harbour Provisions Safe harbour refers to circumstances in which the tax authorities will accept the transfer price declared by the assessee. The principle is that, where the application of the most appropriate method results in more than one price, a price which differs from the average of such prices within a permissible range may be taken as the ALP. The allowable variation will be such percentage as may be notified by the Central Government. As of now, no percentage has been notified. Penalties for Non-compliance Assessees with international transactions of the value exceeding Rs.1 core are statutorily required to maintain and submit the prescribed documents with regard to the international transactions entered into by them. A report from a Chartered Accountant, as prescribed in Form 3CEB, also needs to be provided before the due date for filing the return of income. Non-compliance with these statutory requirements attracts a levy of penalties under the law. Nature of Default Failure to maintain prescribed information / documents Failure to provide information / documents during audit In case of adjustment to taxpayer s income by AO consequent to determination of ALP and assessee not being able to explain the genuineness (leading to inference of concealment) Failure to provide certificate in Form 3CEB Penalty Prescribed 2 per cent of value of international transaction 2 per cent of value of international transaction per cent of the tax on adjustment amount Rs. 1,000,000 The penalty can be waived if the assessee can prove that the default is due to a reasonable cause. Advance Pricing Agreement (APA) An APA is an arrangement between the taxpayer and the taxing authority whereby the two parties agree on the transfer pricing policy for specified transactions of the taxpayer over a given period of time. Such a ruling would be binding on the taxpayer and the tax authorities. The scheme is intended to bring certainty in the tax 4

6 liability of the transacting parties but, as the concept is not yet in the current law, the provisions are still at the conceptual stage. In summary, Transfer Pricing Law in India is in an evolving stage and, considering the practical issues, there is considerable scope for litigation in this area. Hopefully, in the near future, the law would become streamlined by means of amendments to remove the difficulties in application and also by way of judicial pronouncements. S. Santhanakrishnan PKF Sridhar & Santhanam, Chennai, India Tel: sk@pkfindia.in Website: SOUTH AFRICA R&D incentive to help maintain South Africa s position as economic powerhouse South Africa s (SA) existing R&D incentive aims to promote increased private sector R&D investment in SA, enhance its role as an R&D and innovation location and generally promote R&D and innovation-led industrial development and job creation. The main features of the R&D incentive are: Operational Expenditure A 150 per cent deduction is allowed for operating expenses (for example: salaries, overheads, materials and such like) directly incurred for the purposes of: discovering novel, practical and non-obvious information devising, developing or creation of an invention, design, computer program or knowledge essential to the use of such invention, design or computer program of a scientific or technological nature. Taxpayers must carry on a trade and must either intend to use the information, invention, design, computer program or knowledge in the production of income or such items must be discovered, devised, developed or created by the taxpayer for the purposes of deriving income. Interest and expenditure incurred for the right of use of any property do not qualify for the 150 per cent deduction. It is not a requirement for a person to physically carry out the R&D activities the activities can be contracted to a third party. However, the R&D activities must be undertaken in SA and qualifying expenditure must be directly related to the R&D activity. Where a connected person in relation to the taxpayer carries out the R&D activities on behalf of the taxpayer, the taxpayer can only claim the 150 per cent deduction to the extent of expenditure incurred by the connected person in carrying out qualifying R&D activities. A deduction of only 100 per cent of qualifying operational R&D expenditure may be claimed to the extent that such expenditure is funded by a third party through a fee or a non-government grant paid to the taxpayer. Should the funder not be entitled to claim a R&D deduction in respect of the amount paid, for whatever reason, the taxpayer will be allowed to claim a 150 per cent deduction. Where funding is received in the form of a taxable government grant, the 150 per cent deduction may only be claimed in respect of qualifying operational expenditure that exceeds twice the amount of the government grant received. Should a non-taxable government grant be received, a deduction (equal to 150 per cent) may only be claimed in respect of qualifying operational expenditure that exceeds the amount of the government grant received. Capital Expenditure The cost of any new and unused building or part thereof, machinery, plant, implement, utensil or article or improvement thereto owned by the taxpayer, which is used solely and directly for carrying out qualifying R&D activities is depreciable over three years on a 50 per cent: 30 per cent: 20 per cent basis. Any building or part thereof must be specifically equipped and regularly used for R&D purposes. Excluded Activities Expenditure related to the following activities does not qualify for the R&D tax incentive: exploration or prospecting management or internal business process trade marks the social sciences or humanities market research, sales or marketing promotion. R&D expenditure incurred by any person carrying on any banking, financial services or insurance business falls outside the R&D regime. Proposed Amendments to the R&D Tax Regime No pre-approval is currently required to claim a deduction in terms of the R&D tax incentive. Taxpayers are required to annually submit information about their R&D claims to the Department of Science and Technology and to the South African Revenue Service. In terms of proposed amendments applicable to R&D expenditure incurred on or after 1 April 2012 but before 1 April 2017, a pre-approval process will be introduced. More precise definitions of R&D activities, clarification of qualifying expenditure and streamlining of the calculation of R&D tax deductions are also proposed. 5

7 Conclusion There is a clear link between the intensity of R&D expenditure and competitiveness. SA was ranked 54th out of 139 countries in the 2010/2011 Global Competitiveness Report of the World Economic Forum, the second-highest ranked African country after Tunisia (ranked 32nd). SA s R&D tax incentive not only aims to increase its productivity and competitiveness through increased local innovation, research and technological development but also to maintain its position as the economic powerhouse of Africa. UNITED KINGDOM Eugene du Plessis Director Tax, PKF Johannesburg, South Africa Tel: eugene.duplessis@pkf. co.za Website: Changes proposed to remove current restrictions on qualifying expenditure The UK Government has taken significant measures this year to encourage innovation and research & development activity in the UK through a series of proposed reforms to the corporate tax system. R&D Tax Relief The UK has had a special tax relief for R&D expenditure since Broadly speaking, relief is available to small and medium-sized companies (SMEs) for 175 per cent (130 per cent for large companies) of eligible expenditure (including staff costs, computer software and consumable items) on projects that seek an advance in science or technology through the resolution of uncertainties. Loss-making SMEs are able to claim a payable tax credit instead of claiming an enhanced tax deduction. The rate of relief is increased from 175 per cent to 200 per cent from 1 April 2011 and to 225 per cent from 1 April These increases are subject to EU state aid approval. Further changes, also proposed to apply from 1 April 2012, are intended to remove some current restrictions on qualifying expenditure and to make the rules easier to apply. The changes are expected to be of most benefit to SMEs. The existing requirement for the company to spend at least 10,000 in the year concerned on qualifying R&D expenditure is to be abolished. The current cap on the amount of payable tax credit is to be removed. At present, the credit cannot exceed the income tax and National Insurance payments made by the company in respect of all its employees during the year concerned. The Government is considering how it could implement a system whereby the benefit of the tax relief is recognised above the tax line in the company s accounts. This would probably require the extension of the payable tax credit to large companies. Changes are proposed to the rules for allowing relief for expenditure on sub-contractors and externally provided workers. There is currently uncertainty as to the amount of eligible expenditure where R&D is carried out in the course of production activities. Draft guidance has been published which will hopefully clarify the boundaries in this area. A new upfront clearance procedure has been proposed for smaller companies and new start-ups. If you have any queries regarding the availability of R&D tax relief in the UK, please contact Denise Roberts, PKF (UK) LLP s leading expert in this area (denise.roberts@uk.pkf.com). Patent Box The Government has also proposed that a new patent box regime, based on the Dutch model, will be introduced from 1 April Although all UK resident companies (and UK branches of overseas companies) will be able to apply the regime, it is expected to be of most benefit to larger companies with significant patent and similar income. The regime would apply a reduced rate of tax on income from patents granted by the UK s Intellectual Property Office and the European Patent Office. It may also apply to patents granted by selected national patent offices of some other European countries. In addition, the Government proposes to include other forms of intellectual property (IP) within the regime that have a strong link to R&D and high-tech activity and are subject to examination by an independent authority. These include regulatory data protection and certain plant variety rights. It is proposed that the rate of tax on eligible income will eventually fall to 10 per cent by 2017 but this will be preceded by a gradually reducing rate year-on-year from 2013 onwards. The reduced rate is intended to apply both to the legal owner of the IP and anyone holding an exclusive licence to exploit it commercially. However, the company concerned must have performed significant activity in developing the patented invention or its application. In addition, it must remain actively involved in the ongoing decision making connected with exploitation of the IP. 6

8 Tax experts from around the PKF International network at the Madrid International Tax Meeting in November The regime would cover worldwide income earned by UK businesses from inventions covered by a currently valid qualifying patent. This would include both royalties and income from the sale of any products incorporating at least one of such inventions. Companies will be free to opt in and out of the regime at any time and some companies may choose to remain outside if the prospective tax saving is small and the administration cost in identifying that saving is comparatively high. Jon Hills Partner - Tax services, PKF(UK)LLP, Accountants and business advisers, London, United Kingdom Tel: +44 (0) jon.hills@uk.pkf.com Website: You can find answers to all these questions for the 25 starred Commonwealth Nations on the map by visiting com/publications/tax-guides to download a free PKF Tax Guide. (You can also download the PKF Worldwide Tax Guide 2011 plus country tax guides for a further 74 countries around the world.) PKF International Tax Alerts Keep up with the latest global tax information with the PKF International Tax Alert published three times a year. Written by PKF tax experts across the world, it s a useful free resource for any international business. Just visit publications/tax-alerts to download a free copy. About PKF International Limited A world of tax advice for the Commonwealth of Nations from PKF From Adelaide to Cape Town, Mumbai to Vancouver - wherever you are in the Commonwealth, you are never far from good tax advice. With tax experts in 34 Commonwealth nations, the PKF International network of accounting and business advisory firms can provide you with the answers to your local and international tax questions. PKF Tax Guides for Commonwealth Nations For any business moving into international markets, a key deciding factor will be the target country s tax regime. What is the corporate tax rate? Are there any tax incentives or grants? Are there double tax treaties in place? How will foreign source income be taxed? PKF International Limited (PKFI) administers the PKF network of legally independent member firms. There are over 245 member firms and correspondents in 440 locations in around 125 countries providing accounting and business advisory services. PKFI member firms employ around 2,200 partners and more than 21,000 staff. PKFI is the 10th largest global accountancy network and its member firms have US $2.4 billion aggregate fee income (year end June 2010). The network is a member of the Forum of Firms, an organisation dedicated to consistent and high quality standards of financial reporting and auditing practices worldwide. For further information about PKF International or its member firms, please visit The PKF International network of legally independent firms does not accept any responsibility or liability for the actions or inactions on the part of any individual member firm or firms. 7

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