France has one of the most advantageous tax regimes in Europe for R&D activities, in addition to being a key player in R&D. However, many foreign groups and private equity investors are missing out on valuable domestic and cross-border opportunities offered by the regime. This article briefly describes the various tax breaks on offer and compares the French R&D tax credit with the R&D tax credit provisions recently introduced in the UK.
The highlights of the French R&D regime are:
up to ?6.1 million ($6.0 million) R&D tax credit is available, per company, per year;
there is a 20% tax rate on patent royalties received (in comparison with the 35% effective corporation tax rate); and
immediate expensing of R&D expenditure is available.
R&D tax credit
The R&D tax credit regime provides for an actual tax credit, which can be offset against the company's (or the group's) corporation tax liability. The regime has been in place, in various forms, since 1983, for limited periods ? although to date, the regime is always renewed following expiry. The present regime applies to the period 1999-2003 inclusive; it is an elective regime available to industrial and commercial companies.
The tax credit is calculated on an incremental basis. It is equal to 50% of the increase, in a given year, of the R&D expenditure incurred by a company (or branch), as compared to the average amount of R&D incurred by the company in the previous two years. The credit is limited to ?6.1 million each year for each company. R&D expenditure taken into account when calculating the credit remains fully deductible (subject to standard deductibility rules). The regime thus effectively allows a double dip within France for such R&D expenditure.
The credit may be used by the company to offset its corporation tax liability for the year during which the expenditure was incurred or the following three years. The credit may also be discounted with a bank. The Treasury refunds to the company (or tax consolidated group) any part of the credit not used at the end of the three-year period. Bank discounts or Treasury refunds are of particular benefit to, among other things, private equity R&D ventures, which are often, initially or structurally, loss-making entities.
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Table 1 briefly summarizes some of the key advantages and disadvantages of the R&D tax credit regime.
Reduced rate on patent royalties received
French law provides for a reduced rate of corporation tax (20%) on royalty income received by a French company from the licensing by that company of patents and know-how (in comparison with an effective corporation tax rate of approximately 35%).
For the reduced rate to apply, the after-tax income must be put into a special reserve and remain undistributed. Any later distribution out of the reserve triggers an additional tax payable, equal to the difference between the effective corporation tax rate and the reduced rate.
As of January 1 2002, the reduced rate also applies to royalties paid for the use of a patent or know-how under licence by a French company to a related French company. However, in this case, as a corollary to the extension of the reduced rate to related French companies, the royalties that are paid are only partially deductible in the hands of the paying company, thus preventing any rate arbitrage. A rate arbitrage may, however, be available on royalty payments between (i) unrelated French companies, or (ii) a foreign and a French company, regardless of whether the companies are related (allowing, for example, a deduction of the royalties at 30% in the UK and their taxation at 20% in France).
Table 2 summarizes some of the key advantages and disadvantages associated with the reduced rate on patent royalties.
Immediate expensing of R&D expenditure
For qualifying research operations, French companies can choose, subject to certain legal/accounting requirements, between (i) treating the research expenditure as a trading expenditure (which would be immediately deductible), or (ii) capitalizing the expense (which would be depreciable over a maximum of five years). Research expenditure can only be capitalized and depreciated if there is a reasonable chance of success. When the company is in a loss-making situation, treating the expenditure as a capitalized asset (when possible) may be advisable, since losses attributable to asset depreciation may be carried forward indefinitely.
The benefits of France's R&D tax regime are illustrated in table 3.
Table 3: Benefits of the R&D regime 
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Comparison between the French and UK R&D tax credit arrangements
France's R&D tax credit regime provides for an actual tax credit, available against the company's corporation tax liability. The perhaps misleadingly named UK R&D tax credit system, as introduced for large companies from April 1 2002, provides for an enhanced deduction from the taxable profits for the R&D expenditure ? to the extent of 125% compared with the normal 100%.
Which country's arrangement is more beneficial cannot be stated in general terms, as this would depend on the particular circumstances of the case. France's arrangement may be seen as more beneficial to the extent it takes the form of an actual tax credit (capped to a generous ?6.1 million per year and per company), whereas the arrangement in the UK only provides for an additional 25% deduction from the tax base. Also, France's tax credit may be discounted with a bank, or, at the end of the three-year period, actually be reimbursed to the company by the state (of particular relevance to companies in a loss-making situation), while such facilities are not available under the UK regime.
At the same time, the UK R&D tax credit provides relief for every £1 of R&D expenditure incurred during the year, not only for the increment, as under France's tax credit arrangement. Also, under the UK regime, the amount of relief is not capped. These aspects, coupled with the UK's unlimited tax losses carried forward regime (and its flexible group relief regime), make the UK regime attractive too.
Potentially, the UK regime reduces the cash cost of qualifying expenditure by 7.5% (25% super deduction x 30% corporation tax), while the French arrangement reduces the cash cost of the qualifying expenditure by as much as 50% (50% tax credit). But such figures are either too simplistic or misleading, to the extent that they assume, with regard to the UK arrangement, that the UK company (or group) is profit making (or will eventually be), and that they ignore, with regard to the French arrangement, that the benefit is calculated on an incremental basis.
There are many more differences between the two regimes, for example regarding the definition of qualifying expenditure and the implications of subcontracting the R&D. Further, in both countries, to qualify, the research operation must be conducted locally, as opposed to abroad, therefore normally preventing a double dip between France and the UK.
Companies' eligibility in 2002
The application of France's R&D tax regime has been renewed for the period 1999-2003 inclusive. With respect to the current year 2002, companies may find themselves in one of three of the most common types of circumstances:
companies that already had R&D expenditure, and had elected in 1999 to benefit from the regime, can continue to benefit for the years 2002 and 2003;
companies newly created in 2002 (or existing companies that are incurring R&D expenditure for the first time in 2002) are also eligible for the credit; and
companies that already had R&D expenditure, but did not elect in 1999 to benefit from the regime, cannot elect to benefit from the regime in 2002 (such companies would have to wait until the start of any newly introduced qualifying period for the regime to apply (perhaps in 2004)). However, there may be ways, when circumstances allow, to circumvent that limitation.
Location of the research
The research operations must actually be conducted in France. However, the outcome of the research may be used outside of France. For example, prototypes or pilot projects that are developed in France may be used abroad as part of a production process.
Intellectual property ownership
The ownership of the intellectual property resulting from the R&D has no impact on the availability of the R&D tax credit. However, to be entitled to the credit, the French entity must be responsible for directing the R&D project, as opposed to acting merely as a dependent agent of another company.
Qualifying research
Qualifying research covers the following three areas:
fundamental research;
applied research; and
experimental development.
The key characteristic to be eligible for the tax credit is innovation. In practice, only R&D projects with "innovative characteristics" may benefit from the credit. For example, the creation of innovative software or, alternatively, the substantial improvement of existing software, should qualify for the credit. It is thus essential that the innovative characteristics of the R&D projects be well documented and thoroughly established. The documentation must be such that both engineers and laypersons may readily understand the characteristics of the research, and the innovative aspects of it.
Qualifying expenditure
Qualifying expenditure includes, among other things:
personnel expenditure (emoluments, social security contributions);
operating expenditure (equal to 75% of personnel expenditure);
equipment depreciation;
expenditure related to patents;
costs of research contracted out to qualifying research institutions; and
expenditure triggered by the normalization of products.
Calculation of the tax credit
The tax credit is determined on a calendar year basis. For new companies (or existing companies that have incurred R&D expenditure for the first time), the tax credit for that first year is equal to 50% of the R&D expenditure. In the following years, the tax credit is equal to 50% of the net increase in the value of R&D expenditure incurred during the year relative to the average R&D expenditure incurred during the prior two years (revalued in accordance with the consumer price index). Any decrease of R&D expenditure in a given year does not trigger a recapture of the R&D tax credit granted in the previous year(s), but is taken into account in future years for a further tax credit to be granted.
Public grants, which finance operations that benefit from the R&D credit, must be deducted from the tax credit base during the year in which the subsidies are granted.
As already mentioned, the ceiling for the tax credit is ?6.1 million per company per year. Specific provisions apply for the R&D tax credit in the textile-fabrics sector.
Use of the tax credit
The tax credit may be offset against the company's (or group's) corporation tax liability, in the year during which the expenses where incurred, or in the following three years. The French Treasury refunds any part of the credit not used by the company at the end of the three-year period. During that three-year period, the company may transfer the credit to a bank; this facility enables the company to obtain a refund of the credit (less a commission fee) in anticipation of the expected refund.
Specific rules apply for consolidated groups, as well as in the context of a group restructuring (for example, merger, partial merger, spin-offs), in particular with respect to any transfer of the tax credit from one company to another.
Revenue control
The French tax authorities systematically audit R&D tax credits. The trigger for an audit of the credit may be the use of the credit against the company's corporation tax liability, its discount with a bank, or its refund by the Treasury. An audit of the credit may also take place if there is an audit of the general tax affairs of the company by the tax authorities.
Conclusion
France has a generous R&D tax regime. Many French subsidiaries of foreign groups do not, or do not fully, take advantage of the regime. It is possible to optimize the use of the R&D tax credit regime, prevent any future discussions with the tax authorities, and more generally save a lot of time and effort, by, among other things, putting into place, from the outset, a specific methodology to identify and properly document the relevant qualifying expenditure.
Kind contributions from Henri Tixier, and Roger Horwood regarding the UK R&D tax credit, of Ernst & Young Paris and London respectively.
Isabelle MacInnes, Tax Manager (imacinnes@uk.ey.com), Pascal D'Hont, Partner (pd'hont@uk.ey.com), Ernst & Young, London.
