R&D Tax Credits - A Step Forward but not a Leap
By Derek Henry, Tax Director and Head of R&D team.
The Minister for Finance, Michael Noonan, in his budget speech re-affirmed his commitment to supporting Irish companies carrying on Research and Development (R&D) activities in Ireland by announcing a range of measures aimed at enhancing the regime and increasing its international competitiveness. While the legislation which was published last Wednesday does include the legislation in support of the announcement, some of the measures have a more limited effect than was hoped for.
By way of background under the R&D Tax Credit Regime, companies are entitled to a tax credit of 25% of the incremental R&D expenditure incurred in excess of the base year spend. The base year is 2003. In simply terms if you spend more on R&D in the current year than you did in 2003 a tax credit is available.
Since this credit is in addition to the normal 12.5% corporation tax deduction for the expenditure, in an effect those who qualify can receive an effective tax deduction of 37.5%. In addition, this credit can be offset against a company’s corporation tax liability or, where the company does not have a corporation tax liability, be claimed as a refund from Revenue over a three year period subject to certain limits.
Packaged together this has been extremely popular since its introduction and has been in certain cases a lifeline to cash strapped start-ups and early stage development companies. Interestingly, R&D is actually broadly defined and in this regard, qualifying activities can be found in a wide range of industries and sector, areas that may not be generally perceived as carrying on R&D.
So what has been changed by Finance Bill 2012 to bring more benefit to the scheme?
Use of Credit to reward employees
The first significant change has been to enable companies claiming the credit to reward employees for their part in the R&D process by passing the benefit of the R&D credit directly to the employees. Thus for the first time an employee involved in R&D can then use the credit to reduce their income tax liability for the year which should result in a refund from Revenue.
In order to qualify the employee must be a “key employee”. To be regarded as a key employee the individual:
- Must not be, or have been, a director of the company or a connected company,
- Must not have a material interest (greater than 5%) of the company or a connected company,
- 75% or more of the individual’s duties must be involved in the conception or creation of new knowledge, products, processes, methods and systems, and
- 75% or more of the employment cost for that individual must be eligible as qualifying R&D expenditure.
There are a number of other conditions that must be met, in particular; the amount of the credit available is limited to the extent that it cannot be used to reduce the individual’s effective tax rate below 23%., the amount which the company may surrender is limited to the amount of corporation tax payable by the company for the period and to claim the relief the employee must submit a tax return.
Any element of the credit unused in a particular year can be carried forward to future periods by the individual until they cease to an employee of the company, at which stage any unused credit is lost.
Importantly, if the relief is found not to apply to the employee any tax relief received may, in certain circumstance, have to be repaid to the Revenue by the employee.
The introduction of this concept into the legislation is welcomed. However, the stringent qualifying conditions means in practice that it will only be an option for rewarding some employees in some of the large multinationals. The problems with the mechanism for SMEs (and indeed some multinationals) are as follows:
- In practice, given resource constraints, key staff in SMEs who are responsible for the R&D element of, for example product design, are also responsible for the post R&D phases, including commercialisation of the product, business development and other management functions. As a result, very few SMEs will have staff members who spend 75% of their time on the pure “knowledge conception and creation” side of the business. Also, it is typical that the key drivers of R&D in SMEs would be at the owner/director level of the organisation.
- Many companies carrying R&D are in the pre-revenue phase of development and are therefore not paying significant corporation tax. The inclusion of the corporation tax related cap on the incentive will mean that many companies will not qualify even if they have qualifying employees.
- The fact that the relief is limited to the extent that the employee’s effective tax rate cannot fall below 23% will also limit the effectiveness of this relief. Running some very quick numbers take a €80,000 salary for a single person (assuming basic personal tax credits), the maximum relief that can be achieved in a year is circa €4,212. If the individual has any tax deductible items such as medical expense, other credits (e.g. married credits) or other tax relief such as film relief or EIIS/BES then the amount of the relief reduces significantly. In order to ascertain the value of the relief for the employee, the employer is going to need to understand the employee’s full income tax circumstances, potentially, including that of their spouse. Some employees may be uncomfortable with sharing this information.
- The idea behind this scheme is that the credit surrender would reward the employee in lieu of a bonus. However, given the fact that the credit could be lost at some stage in the future if Revenue find that the employee was not entitled to the credit it will be hard to convince employees that this is a viable alternative to a cash bonus.
Incremental base relaxation
As discussed above, the Irish R&D Tax Credit Regime is an incremental system. Under the new rules, a full volume base will apply to the first €100,000 of qualifying expenditure with the incremental base applying for amount in excess of €100,000. This will be beneficial to companies who are carrying on R&D activities but have a base year amount either greater or marginally less than current year expenditure. In such instances these companies will now be able to claim a minimum of €100,000 as qualifying expenditure where they would otherwise have been entitled to no credit.
Limit on outsourcing
Under current legislation, where a company outsources some of its R&D activities to third parties or universities, the amount of related costs eligible for the credit were limited to a percentage of internal R&D expenditure- 10% if paid to a third party or 5% if paid to a university. The new legislation provides that these limits will be amended to the greater of €100,000 or 10%/5%. These measures will be particularly important for SMEs who rely heavily on external resources and capabilities to assist their internal R&D functions.
The legislation also includes a requirement that the company outsourcing the R&D activities write to the third party provider to inform them that they will be claiming a credit on the cost. This is to ensure that the third party provider does not also receive a credit in relation to that work.
Expenditure incurred by the company on the management of outsourced R&D activities will not now regarded as qualifying R&D expenditure.
Where R&D activities are funded by EU or EEA grant assistance, the expenditure will not now qualify as R&D expenditure. A similar provision was already in place where companies received grant assistance relating to the activities from the Irish State so these new provisions simply extend this to grants received from other EU/EEA jurisdictions.
Amendments included now permit any unused credits of a dissolved company to be carried forward into a successor company when certain conditions are met.
The new legislation also details various penalty and interest measures aimed at ensuring companies only claim an appropriate level of R&D credit under the regime.
In general, the new legislation is effective for accounting periods commencing after 1 January 2012, however, the increased limit for outsourced R&D applies to accounting periods ending after 1 January 2012.
It is encouraging that the Minister is continuing the focus on this valuable relief for corporate and attempting to enhance the regime. This ongoing commitment is essential to ensuring that the Irish R&D Tax Credit Regime continues to be internationally competitive. The relaxation in the base year and the increase in the limit on outsource activities are very welcomed, however, in terms of the employee reward scheme the legislation needs to be revisited in advance of the Finance Act to make it more broadly applicable, in particular to SMEs.