Government investment in technology: how governments use tax regimes to attract R&D activity

Tax R&D
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A recent survey carried out by the European startup initiative found that 25.9 percent of surveyed high tech startup founders set up their business in a country different from that of their origin. Many factors influence the location of tech startups: the availability of local talent (often boosted by local research institutions) and access to investment capital are significant, but with both capital and talent being so mobile, local tax environments can also be a key driver.

Focusing on the UK, Ireland and Germany, this article considers how tax policy can encourage local tech startups. Three types of policy instruments are in play: (i) tax relief for founders and investors; (ii) incentives for employee talent; and (iii) special rates and relief on the technology trade itself. Only a minority of these incentives are purely aimed at tech companies, but the overall cost to governments in terms of revenue reflects governments' policy in attracting R&D innovation activity to create jobs and deliver growth.

Founders and investors

Founders of and investors in high growth companies desire a tax regime that is beneficial in terms of investment and delivers a low tax rate on returns made. The UK offers a competitive top rate of capital gains tax (CGT) of (generally) 20 percent, but a 10 percent rate is available on share disposals by employees and directors of trading companies who retain at least a 5 percent interest in voting rights and nominal capital in the company throughout a minimum 12-month period prior to disposal (so-called entrepreneur's relief). For non-employee shareholders in unquoted companies, a 10 percent rate also applies, provided the shares are held for at least three years. Ireland also offers a 10 percent rate of CGT to Irish resident entrepreneurs on gains, up to a lifetime limit of €1 million.

Whilst the entrepreneurs' relief regime promises a low 10 percent rate on gains for founders and business angels, the UK also offers the EIS and SEIS schemes which provide an effective rebate of income tax on other income and a capital gains tax exemption. The SEIS is designed for investment in startup companies − gross assets not exceeding £200,000 when the shares are issued. EIS is aimed at larger companies − gross assets before and after the investment of £15 million and £16 million respectively immediately before and after the investment.

Companies whose only activity is carrying out R&D can qualify for EIS and SEIS provided that it is intended that a qualifying trade will be derived from or benefit from that activity, and the money raised must be used wholly for the activity within two years (three years for SEIS) of when it was raised. A company whose trade is that of receiving royalties and licence fees is also a qualifying company for these purposes, provided that the royalties or licence fees are attributable to the exploitation of relevant intangible assets (including IP) where more than 50 percent of the value of the asset was created by the company. "Connected person" tests restrict somewhat the availability of these reliefs to founders (eg, with over 30 percent interest), but the reliefs provide a powerful incentive to risk capital from funds or individuals.

In a further move to boost investment in the high-tech sector, the UK government recently announced relaxations to the EIS and venture capital trust (VCT) regimes to provide more flexibility for knowledge-intensive companies seeking investment under those (tax beneficial) regimes.

Germany provides a tax exemption for subsidies granted upon application by the Federal Office of Economics and Export Control to German tax residents to acquire newly issued shares (other than on incorporation) in certain non-public corporations of up to 20% of the acquisition cost (capped at EUR 100K) subject to certain conditions, including (i) the corporation is not older than 7 years (ii) does have less than 50 employees, (iii) its turnover is less than EUR 10 million per annum and total assets are less than EUR 10 million, and (iv) the shares are held longer than 3 years. If these requirements are met, there is also an exemption in respect of 25% of the capital gain realized on the sale of shares again subject to certain conditions. In addition the usual 40% tax exemption on capital gains realized on the sale of shares in corporations applies.

Many start-ups will be loss-making in the early years, Germany has quite strict loss carry forward forfeiture rules pursuant to which the losses are forfeited if more than 50% of the shares in the corporation are acquired by a single person (or a group of persons with a common interest) within any five year period. The losses are forfeited pro rata if more than 25% but less than 50% of the shares in the corporation are acquired. However, there is a relaxation which may benefit start-ups: the losses will not be forfeited provided that the corporation has since its formation, or for at least for the last three financial years prior to the year in which the shareholders changed, had materially the same business operations, was not head of a fiscal unity, did not hold an interest in a partnership operating a trade or business and did not discontinue its business operation of put its business operations dormant.

Employees

Most jurisdictions will tax employees who work in that jurisdiction on their earnings for work carried out in that country and will also tax their residents on worldwide income. Internationally mobile employees, of whom there are many in the tech sector, therefore need to be aware of potential double taxation and, where appropriate, take mitigation steps. For example, they may claim double tax relief or they may "ring-fence" overseas income (to avoid remitting non-UK income and gains).

The attraction and retention of technically skilled workers is a key issue for technology startups. Revenues are low and costs high for these businesses, and this presents challenges for those seeking to offer a competitive remuneration package.

Offering an equity-based element as part of the remuneration package may help address these issues. Most jurisdictions do not levy tax charges on the award of equity or equity interests, and if structured correctly, gains will fall within the (usually lower) capital gains regimes rather than being taxed as ordinary income.

The UK offers a number of tax advantageous share and share option schemes. Recently published UK government statistics show that for 2015-2016, the total value of shares and options awarded under these schemes was around £4.3 billon, and the total cost of income tax and national insurance contributions relief given for these schemes was £880 million. The most tax-advantageous and flexible type of share option − known as the enterprise management incentive (or EMI) share option − is specifically targeted at small high growth companies. Where the relevant conditions are satisfied (including gross assets not exceeding £30 million, and fewer than 250 employees), there will be no tax or national insurance contributions due on exercise of the option, and CGT on sale of the shares acquired on exercise will be only 10 percent.

In common with other (non-tax-advantaged types of share option), a statutory corporation tax deduction will also generally be available for the employer on exercise of the option equal to the difference between the market value of the shares on exercise, and the exercise price.

Germany does not offer any specific tax incentives on equity-based compensation schemes. However, under German tax law generally these schemes become subject to tax only once the participating employee actually receives a monetary benefit, in case of stock options, for example, upon exercise of the options.

Tax relief and incentives for locally developed IP

One of the key indicators of a government's support for technical innovation and research is its investment through the tax incentives it offers for research and development. The UK government announced in November 2016 an additional £2 billion per year investment by 2020 for research and development to secure the UK's long-term commitment to research and innovation. In November 2017, the UK government announced a further £2.3 billion investment in R&D in 2021/2022 from the National Productivity Investment Fund, as well as announcing its intention to raise total R&D investment to 2.4 percent of GDP by 2027, all part of the government's Industrial Strategy, aimed at making the UK the world's most innovative nation by 2030 (see government article here).

Tax reliefs for technology and innovation trades generally take the following forms: (a) writing down allowances for capital expenditure; (b) enhanced relief for revenue expenditure; and (c) special low rates of tax.

In the UK, capital allowances and writing down allowances for intellectual property provide a mixture of relief based on accounts depreciation and fixed rates, up to 100 percent in some cases. However, a number of schemes embody enhanced rates of relief in excess of 100 percent for revenue expenditure. One of the most important relates to R&D, which may be claimed for a range of activities, including development of computer software. For the 2015-2016 tax year, total R&D support by the UK government amounted to almost £2.9 billion, of which 26 percent was claimed by companies in the "information and communication sector” and 20 percent in the "professional, scientific and technical" sector. Government research shows that each £1 spent on R&D tax credits stimulates between £1.53 and £2.35 of additional investment in the UK: a clear demonstration of why the UK is keen to support the system further.

In the UK, tax credits (including repayable credits) are available in respect of R&D qualifying expenditure. SMEs can claim a corporation tax deduction (in addition to the normal deduction) of 230 percent of the qualifying expenditure, or a repayment of up to 14.5 percent of that amount. Large companies can also claim a corporation tax credit, or repayment, but only at 11 percent (to be increased to 12 percent from January 1, 2018) and cannot claim the enhanced deduction as an alternative. Other relief is aimed at the creative industries that work in a similar way − for example, in the technology sector, Video Games Tax Relief and Animation Tax Relief.

Companies in the Netherlands can apply for a R&D payroll tax credit based on the number of allocated R&D hours, the hourly wage and the company's other (non-wage) R&D expense.

Ireland's 12.5 percent corporate tax rate is attractive for technology companies, and Ireland also offers an R&D credit regime of 25 percent for eligible expenditure. The UK, Ireland and Netherlands (in common with a few other countries),) also offer variations on what is called an IP "box." Under the UK's patent box regime, a corporation tax rate of 10 percent is available in respect of profits derived from the exploitation of (broadly) EU granted patents and certain plant-based and medicinal innovations. Ireland's knowledge box, offering a 6.25 percent tax rate, has led Irish tax resident companies to employ software engineers and other specialists throughout the EU to conduct R&D. Where such R&D leads to patented inventions and copyrighted software, the profits from managing and exploiting the software benefit from the 6.25 percent rate. The Netherlands also offers the so-called "innovation box regime" under which net income from "qualifying IP", such as patents, software and prototypes, is effectively taxed at a corporate income tax rate of 5%.

Germany currently does not offer a comparable tax incentive for locally developed IP.

The UK government’s ambitious Industrial Strategy is the latest manifestation of its long-term policy of promoting R&D innovation. Tax incentives are a key part of the strategy. It will be interesting to monitor the effect of the strategy and incentives on tech sector growth in the coming years.

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This article focusses on the UK, Ireland and Germany. Similar articles will follow focussed on the US and other regions.

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