The superior man, when resting in safety, does not forget that danger may come. When in a state of security he does not forget the possibility of ruin. When all is orderly, he does not forget that disorder may come. Thus his person is not endangered, and his States and all their clans are preserved.
When one considers the efficacy of R&D tax incentives in the context of a sluggish and slowing Chinese economy (at least in comparison to China's stellar growth over the past two decades), it is important that such incentives generate benefits greater than the outgoing cost to tax revenue. In this way R&D policy outcomes may help to preserve the State to minimise the impact of a potentially more severe economic downturn in China.
The innovation and economic growth nexus
Thinking and planning ahead to minimise disorder and enhance China's economy is obviously both fundamental and critical in this 21st century age of disruption, and innovation is widely considered to be a dominant factor in stimulating economic growth. The Economist Intelligence Unit identified a number of key innovation indicators:
- innovation is beneficial to both national economies and corporate performance;
- innovative companies tend to outperform their peers;
- firms connected to high-tech clusters tend to outperform their peers;
- technical skills of the workforce and IT/telecommunications infrastructure are critical to innovation;
- small countries have an advantage; and
- return on investment (ROI) is higher in middle-income countries than in rich countries.
(Innovation: Transforming the way business creates" Report: Sponsored by Cisco, 2009)
A major factor concerning a country's ability to drive innovation is its capability and opportunity to actually undertake the work. When R&D investment by companies is encouraged and rewarded, this 'innovation capability' and opportunity is thought to increase exponentially. Technical capability is a strong attraction for local Chinese and foreign companies looking to establish or expand operations in China, and, when combined with effective R&D incentives, such a combination may lead to stronger economic growth and innovative technologies and outcomes.
Inclusive economic growth and the impact of technology and education
The World Economic Forum (WEF) in The Inclusive Growth and Development Report 2015 highlighted friction around economic growth and the need to ensure such growth reaps benefits for a broad spectrum of society, including the unskilled and uneducated (and not just the Hurun Rich List (The Hurun Research Institute: Hurun Rich List 2015, October 15 2015, Shanghai)). In this context, the WEF reported that:
Technological change can be an important driver of economic growth: in developing countries, a 10% increase in high-speed internet connections is associated with an increase in growth by an average of 1.4%. Yet, whether it tends to create inclusive growth in the absence of supportive public policies is hotly debated…
World Economic Forum: The Inclusive Growth and Development Report 2015 – Box 5: Technology and Inclusive Growth
The WEF noted that technological progress may be linked to unequal global distribution of income by increasing the premium paid to high skilled workers while potentially shifting medium skilled activities to lower skilled workers or moving such work offshore at reduced cost. The question is often raised as to whether redundancies resulting from technological advancement will be offset by opportunities in the modern technological realm of artificial intelligence and robotics.
So the challenge for China is how to manage its transition from a 'manufacturer for the world' to a capable and technologically advanced and inclusive global economic leader. Geographic regions and individuals with access to knowledge delivered via the internet and technological innovations will more likely prosper economically than those without. Indeed, modern technologies can encourage successful establishment of small businesses and entrepreneurs:
One study in Niger found that farmers increased their income by 29% when technology gave them better access to information. Online work offers opportunities for people who face barriers to working outside the home, whether due to geographical remoteness, physical disability, or cultural barriers (such as those against women's work in patriarchal cultures).
World Economic Forum, Ibid
It is encouraging to note that the Chinese government's Internet Plus national strategy seeks to integrate internet and mobile technology efficiencies into the country's retail, transport, health, finance and housing sectors. Given that access to start-up finance is absolutely critical to a growing economy, it is clear that advancements in mobile payment systems and online lending platforms that provide access to transparent financial services (including reputable loan products and other forms of funding such as crowd sourcing) will play a fundamental role in the success of budding start-ups and small to medium sized enterprises in China. This is particularly important to the Chinese economy in the context of the government's crackdown on underground banking and illegal foreign exchange trading.
Another key metric for inclusive economic growth is community access to education. Once again, technological advancement and capability is key to enhancing the accessibility of quality education to a broad spectrum of society–this is now possible through the provision of educational courses and qualifications via so-called open education universities and online technical courses across the world.
Innovation capability and knowledge based capital – a shift in focus
But the OECD notes that "where innovation comes from is changing… Strong knowledge based companies invest in a wider range of intangible assets, such as data, software, patents, designs, new organisational processes and firm specific skills. Together these non physical assets make up knowledge based capital."(OECD Multilingual Summaries: Supporting Investment in Knowledge Capital, Growth and Innovation: Beyond R&D – considering 'knowledge capital' and its ability to drive growth and innovation?) In many countries, business investment in knowledge based capital has been increasing faster than investment in physical capital such as equipment, buildings and hard assets.
Moreover, McKinsey & Co in its report: Playing to Win: The New Global Competition for Corporate Profits, highlights that for the past three decades many companies have enjoyed reduced input costs, significant profit growth and new market opportunities. But these historical market growth highs have mostly ended, especially for those in mature economies and markets – and new rivals are putting traditional leaders at risk. Consistent with the OECD perspective, McKinsey & Co highlight that companies with an asset-light footprint can avoid stagnation and disruption and, should plan ahead for resilience (as Confucius would also recommend). McKinsey stress the need for companies to focus on intangibles and new business armaments such as software, data and R&D.
Indeed this is playing out in the marketplace, as the 2015 KPMG M&A Outlook survey of 738 US based finance and M&A professionals found that nearly half of respondents said technology will be the most active industry for M&Ain 2015. This is followed by pharmaceuticals / biotechnology (33%). The primary motivators for technology deals are access to intellectual property and/or talent (50%), bolt-on acquisitions to enhance new products (42%), the acquisition of innovative technologies or products (41%), the desire to enter into markets (41%), and the desire to expand existing technology platforms (40%) (KPMG LLP Four Hot Trends Driving Technology M&A Growth In 2015: KPMG Survey).
It is clear that innovation capability and knowledge-based capital will drive a company's ability to succeed across many industries and countries.
Knowledge based capital: services sector in China
The services sector is a key component of knowledge-based capital innovation. However, until recently, China's prevailing focus on manufactured exports (combined with barriers to trade and investment in the services sector) has limited development of the services sector in China: "The Services Sector in China still accounts for a smaller percentage of GDP than the global average for developing countries… The sector has grown strongly in China in recent years, but it is arguably still smaller than it should be for an economy at China's stage of economic development." (Intracen.org: China Services Sector Analysis: page 2)
It is anticipated that a cut in GDP growth (potentially to 6.5% from 7% (China Daily, November 3 2015, GDP Growth targeted at 6.5% to 7% through 2020, Chen Jia)) for China's 13th Five-Year Plan (2016 to 2020) may facilitate reform and the switch to a services-driven economy. Indeed, Yu Bin, an economist with the State Council Development Research Centre (government think-tank) believes a slowdown is logical because the "service industry is comprising an increasing share of the economy. The service industry generally has a lower demand for capital investment than manufacturing industry, and inevitably when translated in terms of GDP growth, you get a smaller figure".(China Daily October 21 2015 Business Economists favor reducing GDP target to 6.5%, Chen Jia)
Importantly, in China's 12th Five-Year Plan (2011to 2015) the government highlighted services, and specifically Trade in Services (TIS), as strategic focal points. As such, China is opening-up commerce in sub-sectors such as logistics, finance, tourism, healthcare and education. This includes supporting activities in a broad range of service areas such as renewable energy, online trading and financial technology products, and high technology services (including software development and information systems improvement).
Not inconsistent with such forecasts is the 2015 Hurun Rich List which indicates that many billionaires were made in emerging service oriented industries. The list shows that technology was the fastest-growing source of significant wealth, and that almost all self-made individuals under 40 years of age made their fortune in the information technology sector.
Knowledge based capital: value-added manufacturing, agricultural modernisation and green technology in China
Nonetheless, traditional sectors such as manufacturing and agriculture comprise a significant portion of China's GDP. As a result, the Chinese government proposed the Made in China 10 year action plan earlier this year and policy makers are keen to emphasise value-added production and intelligent manufacturing. The aim is to upgrade the industrial sector and set targets for innovation, green and smart manufacturing. An important policy initiative within the Made in China plan is for R&D expenses in the manufacturing sector to double, with 40 manufacturing innovation centres to be created and carbon dioxide emissions to be reduced by 40%. President Xi in a written interview with Reuters on Sunday October 18 2015 stated: "The new type of industrialisation, urbanisation and agricultural modernisation and IT application that is in full swing has generated strong domestic demand and great potential for future growth."
Maintaining economic growth is a key policy consideration for the Central Committee of the Communist Part of China and its 13th Five Year Plan (2016 to 2020), and economists believe that key goals of the next plan will include promoting innovation and rapidly improving the environment across China. This will include a focus on new green technologies and the allocation of special funds to tackle pollution on a coordinated basis. Sectors where China plays a global lead include solar photovoltaic manufacturing and deployment of wind turbines. One would expect the focus for the next plan would be toward reducing the cost of solar and wind energy, linking energy to IT (for example, the internet of things), electric transportation, and increased investment in smart grid and energy storage.
The link between traditional industries' modernisation, technology and China's knowledge and capability to execute transformative projects of this nature could not be clearer.
How innovation and knowledge based capital drive growth
The World Bank suggests that technological innovation can help drive industrial growth and raise living standards, and China is a major driver of global R&D, doubling spending on R&D over 2008 to 2012, despite an economic slowdown in growth compared to 2001to 2008 (OECD Multilingual Series: OECD Science, Technology and Industry Outlook, 2014, p1). China's National Bureau of Statistics: Economic and Social Development Report 2014 states "that expenditures on R&D activities was worth Rmb 1,331.2 billion in 2014, up 12.4% over 2013, accounting for 2.09% of GDP" (Statistical Communiqué of the People's Republic of China on the 2014 National Economic and Social Development, National Bureau of Statistics of China, February 26, 2015). This statistical information supports recent comments by China's Vice–Premier Zhang Gaoli on November 1 2015 that innovation was the key to driving development (China Daily, November 3 2015, GDP Growth targeted at 6.5% to 7% through 2020, Chen Jia) and the Minister of Finance, Lou Jiwei's, statement that China is making innovation a focus for economic growth and is increasing its capacity to innovate (China Daily, October 22 2013).
The OECD knowledge capital report also provides evidence of the economic value of knowledge based capital and how it can boost economic growth and productivity in technology and manufacturing process improvement. For example, studies for the EU and the US show that "business investment in knowledge based capital contributed 20% to 34% of average labour productivity growth" (OECD Multilingual Summaries: Supporting Investment in Knowledge Capital, Growth and Innovation: Beyond R&D – considering 'knowledge capital' and its ability to drive growth and innovation?). It stands to reason that the services sector and value-added manufacturing / agricultural modernisation in China have tremendous potential to increase employment prospects for a fast-growing labour force, increase trade and exports and generally help achieve economic growth in China. And despite the slowdown in China's growth, the government's goal for jobs creation in urban areas remains at 10 million a year. Dr Dollar from the Brookings Institute states that job creation is important in boosting China's service sector and overhauling the economy: "Service sectors are going well. That is where most of the job creation is. So I think it makes sense to the government to focus on job creation that means paying more attention to the service sector." China's 2015 GDP Target Means Healthier Growth: Experts 2015-03-05; Crienglish.com)
R&D tax incentive policy rationale and characteristics
If one accepts the nexus between innovation – R&D – and a country's ability to achieve inclusive and sustainable economic growth, it seems logical that tax incentives to encourage R&D spending will help achieve this aim. In some countries and regions, such as the EU, a key priority for governments is that business investment in R&D should reach at least 3% of gross domestic production by 2020.
It is thought that government intervention to stimulate R&D is justified because R&D activity generates spillover benefits for society that outweigh the cost of the R&D subsidy. From a policy perspective it is commonly held that R&D incentives can:
- promote R&D activities that would not be performed in the absence of incentives;
- stimulate the creation and direct use of intangible assets in the production of goods and delivery of services, which may in turn induce spill-over benefits; and
- attract highly mobile capital by reducing the effective tax rates applicable to the income stemming from such capital.
Source: Innovation through R&D Tax Incentives: Some Ideas for a Fair and Transparent Tax Policy; Paolo Arginelli, World Tax Journal February 2015
Therefore, R&D incentives are considered to enhance innovation and decrease the cost of domestic R&D. This helps to retain R&D activities onshore where they will be undertaken in a tax effective location. A major factor in this equation is also capability to undertake the work.
An increasing number of countries favour tax incentives as opposed to direct grants or subsidies to support R&D. This is because tax incentives are usually broad brushed and do not attempt to pick winners. Across the world, the rate of R&D tax benefits (that is, the net tax benefit accruing to the applicant company resulting from the R&D incentive) is rising, especially within the EU and parts of Asia. For example, Thailand is in the process of increasing the R&D incentive from 200% to 300%.
R&D incentives are generally grouped into two categories. The first category refers to input incentives, which include expenses incurred in conducting the R&D activities. These incentives are often in the form of tax credits, super-deductions, offsets, and accelerated depreciation for R&Drelated activities. Output incentives include benefits related to income generated from eligible intangible assets – these are often referred to as patent boxes.
Including within industry and academia, R&D is undertaken at various levels. For R&D tax incentive purposes, the focus is mainly on business expenditure on R&D as opposed to academic research. As such, definitions of R&D for tax purposes generally include references to process improvement, product development, new knowledge and innovation. Tax systems for R&D are geared toward facilitating industrial / applied R&D as well as pure research. This is, by definition, iterative and evolutionary in nature, where businesses discover and develop new and improved processes, technologies, services and methodologies, having accumulated know-how and expertise over the years. Such a definition of eligible R&D is broader than the traditional laboratory or academic concept of blue sky R&D. Of course, R&D activities inclined towards revolutionary development (that is, where a breakthrough in technology and knowledge occur) is also clearly applicable to R&D tax incentives across the world.
Global R&D tax incentives landscape – a snapshot
If one concludes that innovation, knowledge-based capital and technological advancement intertwine to generate and support inclusive economic growth, what R&D tax incentives exist and how do such R&D tax incentives support economic objectives?
First, it is important to understand the R&D tax incentive landscape. KPMG has issued regional R&D incentive reports (KPMG: R&D Incentive Guides: Asia Pacific 2015; Europe Middle-East and Africa 2013; Americas 2014),which provide an update on available R&D tax incentive schemes around the world. Specifically, these reports contain country by country information on the design, scope and benefits associated with R&D tax incentive support. Generally, KPMG has found that many countries are introducing or reforming their R&D incentives; some are enhancing R&D benefits while others are tightening audit protocols to manage revenue leakage.
A 2014 OECD R&D report(OECD: Measuring R&D Tax Incentives: Summary description of R&D tax incentive schemes for OECD and selected economies, 2013, which wasbased on the results of a 2013 questionnaire conducted by the OECD Working Party of National Experts on Science and Technology Indicators) provides R&D tax incentive details for relevant jurisdictions. Key OECD data, trends and issues in a number of different areas related to R&D incentives include:
- as of 2015, 28 of the OECD's 34 countries offer R&D incentives for eligible R&D expenses – more than double the number in 1995.
- Some countries are making their incentives more generous (for example, UK, France, Thailand, Singapore, www.oecd.org/sti/rd-tax-stats.htm. OECD Report: Measuring R&D Tax Incentives; & OECD Science Technology and Industry Scoreboard 2015) while others are increasing R&D incentives but expanding audit activities to better manage compliance.
- Between the years 2006 and 2011, the OECD data indicates that direct support from R&D incentives increased for about 12 of 23 countries. However, direct R&D funding support dropped in some countries due to difficult economic conditions. Lower profitability during the global financial crisis limited some companies' opportunity to access various R&D incentives, especially incentives linked to profit.
- Australia, UK, Norway, Austria, France and some other countries allow companies to cash out R&D deductions if in a tax loss position. This tends to be available for SMEs but UK has extended this to large companies too.
- Australia, Singapore, Canada, France, Korea, the Netherlands and Portugal offer more generous tax savings to SMEs as compared to large companies.
- Some countries allow tax deductions to be carried-forward to allow companies to benefit from tax incentives when they are not profitable.
Large companies and R&D activities
Large companies traditionally undertake large-scale transformational or nation-building projects, with elements of R&D. They are linked to broader supply chains and create spin-off benefits, such as employment. The Dyson Report in the UK (Dyson, J, Ingenious Britain: Making the UK the leading high tech exporter in Europe, March 2010), found that large companies are likely to engage with universities and smaller companies to work together to undertake R&D and support innovation.
Large companies also have the resources to undertake significant, high risk R&D projects which other smaller companies may be unable to execute. Large companies employ a significant number of people involved in R&D, both directly and through contracts with companies and research entities. As these companies may typically have a global presence, decisions as to where to undertake R&D activities may be considered with every project.
As a consequence of the intrinsic direct and indirect value attributed to large companies' R&D activities, many jurisdictions around the world offer enhanced R&D tax benefits to large companies.
Small and medium sized enterprises (SME) and R&D activities
The SME company lifecycle often begins with (1) early stage innovation, and moves to (2) implementation/applied development, and onto (3) incremental innovation, potentially building on the original core innovation. As the company matures it may (4) expand its technical capability and increase its core technology and products or platforms for further growth.
The empirical evidence suggests SMEs have revolutionised entire industries (Business R&D in SMEs; Raquel Ortega-Argilés Peter Voigt 2009 IPTS, IPTS working paper on corporate R&D and innovation 07/2009). Early-stage startups, entrepreneurs,and university spinoffs have produced major technological break throughs that have collectively changed society. Such companies also generate spill-over benefits since their technology and know-how is often purchased or relied upon by larger corporations (KPMG M&A report). This is despite the fact the small companies have limited capabilities, resources and income. They often incur tax losses and derive no benefit from R&D incentives that cannot be cashed out if the company has tax losses.
It is thought that smaller companies may therefore be at a competitive disadvantage (relative to MNEs) in undertaking and exploiting R&D. On this basis, improved design of R&D tax incentives, such as greater targeting of benefits to SMEs, is often implemented.
SMEs and entrepreneurship continue to be a key source of dynamism, innovation and flexibility in advanced industrialised countries, as well as in emerging and developing economies. Therefore it is crucial to consider SMEs, and in particular their attitude to both R&D, and common trends (growth patterns, sector composition/trends), and the problems they face, in order to achieve an understanding of the EU economy's positioning in terms of business R&D.
Business R&D in SMEs; Raquel Ortega-Argilés Peter Voigt 2009 IPTS working paper on corporate R&D and innovation 07/2009
As such, policy makers may be willing to stimulate small business R&D spending by introducing tax incentives specifically targeting those companies. This may reduce financing constraints faced by SMEs and stimulate inbound M&A of small R&D companies (KPMG LLP Four Hot Trends Driving Technology M&A Growth In 2015: KPMG Survey). This M&A activity is thought to generate spill-over advantages resulting from R&D performed elsewhere around the world, and attract foreign investment and improved products and processes for the local market.
As a consequence, some jurisdictions have implemented higher R&D tax benefits for SMEs as compared to large companies, also allowing SMEs to cash out benefits if the SME has tax losses.
Since introducing its R&D assistance regime, the UK has increased support for small companies; extended the programme to large companies; enabled all large companies to report R&D assistance as an above the line benefit; and provided refundable benefits to both large and small companies.
Interestingly, a 2010 to 2012 review of the UK R&D regimes resulted in a change to the large company regime from a super-deduction to a credit. The above the line credit can provide increased visibility for technical teams undertaking R&D activity to drive investment decisions since the benefit is accounted for as income and can be owned by the engineering/science department rather than the tax function, since it is not technically a tax deduction.
The definition of an SME for UK R&D purposes is wider than the normal EU definition and is a company, organisation or group of linked or partnered companies with fewer than 500 employees and either of the following:
- an annual turnover of not more than €100 million ($107 million); or
- gross assets on the balance sheet not more than €86 million.
In the UK, SMEs access a higher R&D rate of 225% (230% after April 1 2015), which can be surrendered for a cash credit if in tax losses (at a rate of 14.5% by 225%). This amounts to a cash refund of £32.63 cash back for every £100 of qualifying expenditure incurred on or after April 1 2014 (increasing slightly after April 1 2015). However, a company may not be considered to be an SME if it is part of a larger enterprise that taken as a whole would fail these tests.
This expansion of its R&D programme has occurred during a tough economic period for the UK, however the promotion of R&D assistance across all sectors is considered as beneficial to the economy.
Singapore introduced its R&D regime in 2009 and has since increased the level of benefit to all companies in a bid to encourage further investment in Singapore by multinationals and local operations. The programme was built upon the framework of existing, well established programmes already available throughout the world. In particular, the Singapore R&D incentive has a number of similarities to the requirements of the Australian R&D tax system.
A tax deduction of 400% of qualifying expenditure on the first SG$400,000 ($283,000) is available for R&D carried out in Singapore or overseas. A tax deduction of 150% of qualifying expenditure applies to the remainder for R&D carried out in Singapore only.
As an added tool to support SMEs in Singapore, a tax deduction of 400% of qualifying expenditure on the first $600,000 instead of $400,000 (that is, additional $200,000) is available to SMEs for R&D carried out locally or overseas.
Unused deductions may be carried forward indefinitely subject to the satisfaction of the shareholder continuity test or transferred to other related entities under the group relief system
In response to concerns over funding business as usual activities, the Australian R&D tax incentive scheme replaced the long-standing R&D tax concession in 2011. The R&D tax incentive includes a modified definition of eligible activities, narrows the scope of supporting activities; but raises the benefits for small companies in particular.
A tax offset of 45% (equivalent to a 150% deduction for comparison purposes) applies to SMEs with a turnover under A$20 million ($14 million) (this is much lower than the SME threshold in the UK). It equates to 15% net benefit for every eligible dollar, and 45% cash refund if the company has tax losses.
A tax offset of 40% (equivalent to a 133% deduction for comparison purposes) applies to larger companies. This equates to 10% net benefit per eligible dollar. With effect from July 1 2014, a $100 million threshold applies to R&D expenses. Clearly this cap will limit the benefit for some large local and global companies.
The tax deductions may be carried forward indefinitely.
Research indicates that the R&D tax incentive has had a positive impact on business expenditure on R&D (BERD) in Australia, with BERD as a percentage of GDP generally increasing over time. This can be attributed to more companies taking advantage of the tax benefits provided by the R&D incentive. (Australian data comes from ABS cat. no. 8104.0 (various issues) and OECD data from MSTI 2013/1.)
Asia Pacific region
Table 1 (KPMG ASPAC R&D Incentives Guide 2015) highlights the nature and value of R&D tax incentives available to small and large companies in the Asia Pacific region.
We note that Thailand, Malaysia and Sri Lanka offer the highest net benefits per eligible R&D spend across Asia.
|Jurisdiction||Enhanced Tax Benefit|
|Typical SME benefits||Typical large company benefits|
|Australia||Corporate tax rate: 30% |
Benefit: 45% refundable offset
|Corporate tax rate: 30% |
Benefit: 40% non-refundable offset
|China||Corporate tax rate: 25% |
Benefit: 150% deduction
|Corporate tax rate: 25% |
Benefit: 150% deduction
|India||Corporate tax rate: 33.99% |
Benefit: 200% deduction
|Corporate tax rate: 33.99% |
Benefit: 200% deduction
|Japan||Corporate tax rate: |
Benefit: 12% credit
|Corporate tax rate: |
Benefit: 8% credit
|Malaysia||Corporate tax rate: 25% |
Benefit: 200% deduction
|Corporate tax rate: 25% |
Benefit: 200% deduction
|Singapore||Corporate tax rate: 17% |
Benefit: 400% deduction on first SGD 600,000 then 100% deduction on remainder
|Corporate tax rate: 17% |
Benefit: 400% deduction on first SGD 400,000 then 100% deduction on remainder
|South Korea||Corporate tax rate: 24.2%|
Benefit: 25% credit
|Corporate tax rate: 24.2% |
Benefit: 4% credit
|Sri Lanka||Corporate tax rate: 28%|
Benefit: 200% deduction
|Corporate tax rate: 28% |
|Taiwan||Corporate tax rate: 17%|
Benefit: 15% credit up to 30% of tax due
|Corporate tax rate: 17% |
Benefit: 15% credit up to 30% of tax due
|Thailand||Corporate tax rate: 20%|
Benefit: 200% deduction
|Corporate tax rate: 20% |
Benefit: 200% deduction
Patent box regimes offer enhanced income tax treatment for profits derived from eligible intangible assets. These are usually in the form of tax relief on royalty and licence income. The tax incentive/benefit is often extended to capital gains realised on the disposal of eligible IP assets. Patent box regimes take the form of a partial exemption or a notional deduction of the relevant eligible income.
Patent boxes are therefore output based in the sense that the tax incentive usually applies after the core R&D activities have ceased, when income is derived. As a consequence, patent boxes are sometimes considered to be less effective at promoting R&D activities than input-based R&D incentives.
Patent boxes have sprung up in many EU member states in an attempt to protect their tax base since some companies were moving their IP offshore notwithstanding that the R&D activity originally occurred onshore.
Commentators therefore contend that some patent boxes can generate unintended tax leakage because multinational groups may seek to locate the IP in jurisdictions with lower effective tax rates for related royalty, profits and capital gains. It is possible, if the patent box is not carefully designed, that the substance and economic value of the R&D activity may occur in one country (where tax deductions and incentives may be derived) but that the income to be gained from the R&D results is transferred to a lower tax jurisdiction with an attractive patent box regime. Such preferential tax rates on royalties and licence fees can be between 15% and 0% in certain countries.
China's R&D Super Deduction and recent changes
In China, the R&D super deduction is an input incentive that offers companies a 150% tax deduction for eligible activities. This provides companies with a net tax saving of 12.5% for every eligible expense. To be eligible, a company's technological activity must itself involve, new knowledge applied in a creative way, and result in an improved product or process. For example, if a company spends Rmb10 million on eligible R&D expenses that involve new knowledge, improved products and/or processes and achieve an advancement in science and technology, such expenditure will generate a tax saving of Rmb1.25 million. This definition is very broad and can include improvements to products and technologies in many industry sectors such as financial services (usually software development), IT, logistics, agribusiness, manufacturing, engineering and mining – as well as more typical R&D industries such as pharmaceuticals and automotive.
China's net saving of 12.5% is on the low-side in comparison to some other Asian countries such as Thailand and Malaysia. However, it is also important to consider a company's ease of access to the relevant R&D programme. It's fair to say that some countries, while offering healthy R&D tax savings on paper, may make such savings difficult to access in reality. On the ease of access metric, China's R&D Super Deduction application process is reasonably competitive – perhaps not as transparent or consistent as some Western countries, but better than some Asian neighbours.
R&D Super Deduction: Improvements issued on November 2 2015
On November 2 2015 the Chinese government released Notice on Policy Improvement of Research and Development Expenses Super Deduction Cai Shui  No. 119, which includes the following key changes:
From January 1 2016:
The scope of eligible R&D activities and R&D expenditures will expand. The adjusted policy will apply a Negative List method. This means that companies will need to satisfy the definition of R&D activities but will no longer need to match the activity to one of eight High New Technology categories. This is a significant policy change and consistent with global benchmarks. It suggests that all R&D activities shall be eligible for the R&D Super Deduction, unless specifically listed as ineligible.
In the future, companies will be able to deduct previously unclaimed R&D expenses for the preceding three year period. In the global landscape for R&D incentives, this is curious policy that rewards prior R&D activity. Some economists and academics may prefer to see additional funds allocated to current or future projects in the form of higher net benefits (for example at 200% rate) rather than reward companies for R&D previously undertaken.
The allocation and accounting of R&D expenses will be simplified. According to the original policy, special account management for R&D expenses was required. The new policy will allow companies to use auxiliary or supplementary accounts to support the relevant R&D expenses. This initiative should be applauded and it is consistent with other jurisdictions where a separate R&D account to track expenses is not required. For example, in the UK and Australia, activities that constitute R&D for tax purposes are those which meet the definition of R&D activities, even where the project itself may not be separately treated as R&D in the company's accounts.
Companies will experience streamlined R&D validation procedures, adopt post-filing management for the R&D Super Deduction, and may apply updated accounting methods regarding deductible R&D expenses. This is another significant improvement as the Chinese compliance process can be unduly complex. It suggests a move toward self-assessment which is consistent with many other R&D incentive programmes globally. However, contemporaneous and post-filing recordkeeping will be a critical step to managing tax compliance as the tax authorities aim to audit 20% of R&D applications and may retrospectively undertake audits of prior year R&D claims.
In addition to expenses listed in the previous Guo Shui Fa  No116 and Cai Shui (2013) No70, additional expenses such as trial product testing and inspection fees, consulting fees, cooperative or contract R&D related costswill be eligible R&D Super Deduction expenses. Once again, such changes should be applauded and are consistent with global benchmarks.
However, the government has listed a number of ineligible industry categories:
1) Tobacco manufacturing
2) Accommodation and catering industry
3) Wholesale and retail business
4) Real estate
5) Leasing and business services
6) Entertainment businesses
7) Other industries as prescribed by the Ministry of Finance and State Administration of Taxation
So even if a company in these sectors is undertaking highly innovative activities, it is possible such companies will not be eligible to claim the Super Deduction. Of the regulation changes issued on November 2, this particular provision is at odds with the general move in China, and globally, toward a services-consumption driven economy.
Otherwise, the R&D Super Deduction in China should, in principle, be applauded. We are expecting more detailed R&D Super Deduction guidance materials to be released to clarify specifically how the above initiatives will work in practice, and, as usual, the devil is often in the detail.
A key success factor to consider is how the many local Chinese tax bureaus will actually implement and interpret the abovementioned policy improvements.
Recommended enhancements to China's R&D Super Deduction
In the context of the global R&D tax incentive and economic landscape mentioned in this paper, we consider that the following enhancements to the R&D Super Deduction regulations may help achieve government innovation policy objectives:
'Rule of law' interpretation of the R&D regulations and creation of specialist national R&D audit teams to review selected R&D Super Deduction applications
It is important to attempt to ensure that government officials follow a 'rule of law' interpretation of R&D Super Deduction regulations. In this regard, regulatory guidelines should be clearly drafted and both companies and tax authorities must adhere to them. It is also important that the various local tax authorities across China apply a consistent interpretation of the R&D regulations. This can be difficult considering the decentralised nature of the SAT and various science and technology bureaus. In this vein, the government should consider creating: a national R&D sub-group within the SAT to conduct any applicable R&D tax expense audits; and a national R&D sub-group within the Science and Technology Bureau to conduct any applicable R&D technical audits across China.
'Cash out' and higher R&D benefit rate for SMEs in tax losses
The global trend in R&D incentives is to encourage and reward SMEs for undertaking R&D activities. This has taken the form of cash out benefits (usually at a higher rate than those available to large companies) to the extent that the company has tax losses, that is, the R&D benefit can be crystallised in the current year rather than carried forward.
We would recommend that the Chinese authorities investigate how this cash out policy might apply in the context of the Chinese economy. Policy makers might also consider whether a similar scheme should apply to large companies, such as the UK R&D relief scheme.
'Above the line' treatment of the R&D benefit
As mentioned above (refer UK section), the Chinese R&D regulations should be amended to allow the R&D Super Deduction benefit to be reflected above the line in corporate accounts, that is, the benefit may be booked as income in the profit and loss statement of the company. This would result in minimal loss to tax revenue but encourage greater participation in R&D.
Higher R&D Super Deduction rate to encourage business collaboration with universities
Countries such as Australia are examining how to encourage greater collaboration between business and universities (Australian Financial Review: Christopher Pyne seeks to fortify business science bonds with tax breaks, October 26 2015). This may take the form of R&D incentives directly linked to collaboration with universities to commercialise ideas successfully and traverse the technology/innovation valley of death, that is, help bridge the gap between an innovative product or process and full-scale implementation. As highlighted by the WEF:
Technological change is the result of conscious decisions taken by scientists, investors, governments, and consumers, and its nature and direction can be influenced by public policies and market incentives. There is a role for public-private collaboration in mitigating the social and economic risks presented by technological change, and for maximizing benefits to produce more widespread stability and prosperity.
World Economic Forum: The Inclusive Growth and Development Report 2015 – Box 5: Technology and Inclusive Growth
This policy initiative appears to have merit given that science, technology and access to education are fundamental to innovation.
Charge to expense of R&D costs usually capitalised for accounting purposes
Some countries provide that costs incurred in intangible asset creation can be expensed through the profit and loss statement, notwithstanding that accounting principles may require capitalisation of such costs. This tax treatment provides a cash flow benefit by "creating a mismatch (only for tax, not accounting purposes) between the accrual of revenues and the accrual of related costs" (P. Palazzi, Taxation and Innovation, OECD Taxation Working Papers, no 9, OECD Publishing (2011), p10). If the R&D Super Deduction rate of 150% could also be applied to the relevant expense in China, then a permanent tax benefit of 12.5% would be derived by the eligible entity. In terms of increasing investment in innovation, from a policy perspective this makes sense for China and may enhance China's existing R&D incentive programme since intangibles are increasingly relevant to expanding knowledge based capital.
R&D expenses charged to cost of goods sold
An approach by some Chinese tax authorities is that expenses allocated to Cost of Goods Sold (COGS) are considered routine in nature and ineligible for the R&D Super Deduction. While the R&D regulations do not prohibit such expenses, the COGS treatment is occasionally used by some Chinese tax authorities to limit the scope of eligible expenses. It is hoped that the new updated R&D regulations (refer above) clarify this issue to ensure that R&D COGS expenses are no longer deemed ineligible. This would be consistent with R&D incentive programs globally.
Accelerated depreciation/amortisation of assets used in R&D input activities is encouraged in certain countries. This provides a cash flow benefit by increasing the present net value of depreciation/amortisation deductions. The regulations suggest that Chinese entities may deduct such costs but accelerated depreciation/amortization is not permitted since the depreciation rate for R&D assets is the standard 10 years.
In terms of increasing investment in innovation, from a policy perspective it is logical for China to modify the regulations to allow accelerated depreciation and amortisation for R&D related assets since asset acquisition and construction is inherently relevant to expanding R&D capability.
It would also be prudent to clarify the Chinese regulations to confirm that companies can pro-rate the deduction for the asset to the extent it is used for R&D purposes rather than to require exclusive use of the asset for R&D purposes.
Indefinite carry forward of R&D deductions
Indefinite carry forward of R&D deductions for companies with losses is regarded as best practice. In China, carry forward deductions expire after five years. We recommend that the regulations in China be amended to allow indefinite carry forward.
Outsourcing R&D activities
Whenever there is more than one entity undertaking an R&D project (for example, where R&D activities are contracted out to another party), a key issue to resolve is which entity should claim the R&D incentive for the cost incurred.
MNE cost-plus or contract R&D expenses
In recent years, countries such as Australia have modified the R&D regulations to allow resident companies within a multinational group to obtain R&D incentive relief even though the R&D expenses are reimbursed by a related offshore entity and where the IP is owned by the offshore entity. In this situation the policy objective is clearly to attract actual performance of the activity to Australia.
In China it is very common for MNEs to engage local Chinese subsidiaries on a cost-plus basis to undertake R&D on behalf of the global group. If the policy intent behind the R&D Super Deduction is to encourage greater R&D activity in China, then it is appropriate for policy makers to consider the Australian precedent and allow cost-plus R&D expenses to be deductible under the R&D Super Deduction.
R&D activities contracted out to other local unrelated companies
Where all the R&D activity for a project occurs within the one country, and is contracted to one or more unrelated entities, then R&D incentive policy must determine which entity should claim the deduction. The purpose of legislative provisions in this regard is to ensure that the same R&D expense is not claimed by multiple entities. In this context some jurisdictions apply an 'on own behalf test' which involves awarding the R&D benefit to the entity that (1) owns the IP, (2) controls the activity, and (3) bears the financial risk. Other jurisdictions deem that the entity that pays for the work is entitled to the deduction.
In China the recent Cai Shui (Notice on Policy Improvement of Research and Development Expenses Super Deduction Cai Shui  No. 119 'Entrusting party allowed deduction') states the latter approach applies, but in practice the authorities may require that the IP is also owned by the claimant company. This is a point of uncertainty for Chinese taxpayers and requires clarification.
Given the global focus on base erosion and profit shifting it may be prudent to defer implementation of any potential patent-box-type incentive in China.
Some countries are currently reviewing patent efficacy, and considering patent box systems which more effectively link the R&D activities to downstream income benefits.
This paper suggests that knowledge based capital and innovation are dominant factors in generating inclusive economic growth and influencing patterns of world trade. In China the R&D Super Deduction(and other incentive programmes such as High New Technology Enterprise Status and Advanced New Technology Enterprise Status) encourages and rewards investment by Chinese companies and MNEs to create new or improved products or processes. The R&D Super Deduction may be seen as a tool to grow China's knowledge capability and increase business expenditure on R&D. This increased technical capability itself is a strong motivating factor to drive foreign and local investment into China.
The various initiatives undertaken by the PRC government (including those described in this paper such as the 12th Five Year plan, Internet Plus national strategy, Made in China 10-year action plan, and R&D Super Deduction) – combined with broader structural economic reforms – may coalesce to achieve steady and stable growth for China in the midst of technological change and disruption.
Klaus Schwab, founder and executive chairman of the WEF, recently stated that countries will soon no longer be described as "emerging" or "advanced" but rather "innovation-rich" or "innovation-poor" and China is well on the way to being an "innovation-rich" country. With careful government planning and collaboration with key community stakeholders, this may be achieved and sustained in the context of a potential structural slowdown in the economy.
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Alan Garcia is a partner, R&D tax, Asia Pacific regional R&D leader & leader, Centre of Excellence, R&D Incentives, China. His ASPAC R&D regional role involves assisting companies to access and understand various R&D incentive programmes around Asia, including China, Singapore, Australia, Malaysia and Thailand. He has 18 years R&D consulting experience with big four firms.
In China, Alan focuses on the R&D Super Deduction and HNTE / ATSE. He deals with State Administration of Taxation (SAT) / Ministry of Finance (MOF) regulators regarding interpretation of R&D incentive rules and regulations, and liaises with government regarding issues such as incentive policies and audit defence. Alan specialises in identifying all material R&D activities and associated R&D expenditure. This includes the provision of tailored knowledge transfer workshops and extensive analyses and processing of financial data – including understanding IP location issues, cross-charge/reimbursement across jurisdictions and associated financial risk.
Across ASPAC, he has extensive experience in undertaking R&D reviews for global and local companies. In particular, Alan manages high value R&D audits and inland revenue reviews and appeals and provides advice on legal R&D issues, including strategy and R&D planning.
Key areas of experience include the following: automotive, process and materials engineering; chemical engineering; banking and finance; information technology; energy and natural resources; manufacturing process, including automation; recycling process development; environmental sustainability projects; pharmaceuticals, and food and beverage development and processing efficiency.
Alan also assists companies to identify potential government grant opportunities and preparation of competitive grant and subsidy applications. He has extensive experience in tracking the changing funding priorities of governments across Asia and assists companies to access appropriate funding opportunities, particularly for the innovation or commercialisation of new technologies and/or for projects that deliver environmental benefits.
He has a Bachelor of Laws degree, Bachelor of Arts, and is an affiliate of the Institute of Chartered Accountants.
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Bin Yang worked for the Guangdong government and a multinational foreign investment company for 14 years before he joined KPMG. When working for the government, he was responsible for regulations consultation and project management regarding foreign investment to PRC.
Since joining KPMG in 2006, Bin has been mainly responsible for regulatory and company structuring advisory and implementation.
Bin is knowledgeable in business laws and regulations, and has a deep understanding of enterprise investment practice; he is also familiar with the business environment in China. He has plenty of experience in enterprise set-up, advisory and implementation of corporate restructuring and has successfully assisted many multinationals as well as medium and small companies from manufacturing, trading, property, and service industries to enter the PRC market and improve their company structure.
Bin also has in-depth knowledge of R&D incentives in China and has been actively assisting multinational companies as well as China domestic enterprises in R&D planning, R&D incentive application and R&D audits.
Bin has an MBA.
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Dylan is the domestic tax leader for KPMG Central China which is responsible for developing the market strategy for PRC based companies, particularly for outbound investments in the US and nationally for the ASC 740 service. Dylan also has been supporting multi-national enterprises' China tax related issues including R&D, cross-border restructuring, due diligence reviews, general tax advice and outsourcing services.
Before joining KPMG China in April 2012, he led the US China practice for the Western Area with KPMG US. Working from KPMG's New York and Silicon Valley offices, he has more than 12 years of experience providing various US federal tax services in the consolidated returns area, the outsourcing service of ASC 740 tax provision (FAS 109), US tax compliance services and tax outsourcing engagements for public and privately held US multinational clients.
Dylan is a frequent speaker for various US and PRC corporate related tax topics for PRC SAT, business associations and PRC companies and provides training in the ASC 740 area and investment in the US
Dylan is a certified public accountant of New York and Colorado, a member of the American Institute of Certified Public Accountants, a member of the New York State Society of Certified Public Accountants and a former chairperson of the New York State Society of CPAs' consolidated returns committee. He holds bachelor's and master's degrees in taxation from Long Island University.
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State Shi is our lead partner for R&D tax and international tax in Northern China. State has been practising tax in various jurisdictions including China and Australia for almost 12 years.
State started with the KPMG China Tax practice and has been actively involved in providing international tax and M&A tax services to both multinational companies and domestic Chinese clients. In particular, he has extensive experience in advising clients on creative and practical solutions with respect to tax efficient investment structures and cross-border funding considerations. His industry specialisation covers mainly technology, media and telecommunications (TMT) and energy and natural resources.
State was seconded to KPMG Australia in October 2010. He focused on advising Chinese clients on their investment and operational activities in Australia as well as Australia clients investing to China. Over five years in Australia, State has been involved in a number of high-profile transactions between China and Australia and is well recognised by the market as the tax man in the corridor.
State is a frequent speaker on topical tax issues in the China-Australia business and investment corridor. He also teaches Chinese international taxation for the master of taxation students at the University of Sydney.
State has a master's degree in taxation from University of Sydney and is a certified public accountant.
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