R&D Capitalization is here! Are you wondering how this change impacts your business? Join our live Q&A to get answers.
During the rollout of his signature corporate tax cut, the Tax Cut and Jobs Act of 2017, President Donald Trump argued that his plan would stop U.S. companies from offshoring their work overseas. But according to Reuters, it failed to curtail the flow of American jobs abroad:
“During the four years of the Trump administration, [the Labor Department] program certified 2,095 petitions covering 202,151 workers who lost jobs that moved overseas. That’s only slightly less than the 2,170 petitions approved during the last four years of the Obama administration, which covered 209,735 workers.”
Additionally, the TCJA included a provision that changed how R&D deductions can be taken by American companies—rather than being deducted all at once, R&D costs must be amortized over 5 years for domestic spending and 15 years for foreign expenditures. The change threatens to disincentivize American companies to invest in innovation. “In a letter dated Nov. 4, 178 chief financial officers, primarily from large U.S. companies, including Ford Motor Co., Raytheon Technologies Corp., Lockheed Martin Corp. and Boeing Co., said the new rules create a competitive disadvantage for American companies and will lead to job losses and thwart innovation,” an article in the Wall Street Journal explained. “They are asking Congress to move back to immediate deductibility before the end of the year.”
The CFOs argue that the R&D capitalization change will threaten American business and foreign policy interests; they argue that a country that stops prioritizing innovation will fall behind on the global playing field. “On a level playing field, the U.S. can compete for R&D investment with any country in the world,” they wrote. “Unfortunately, the current playing field is tilted against the U.S., and every day this policy continues to be in place makes it harder for the U.S. to remain a global leader in innovation.”
So, how does American R&D policy compare to competitors abroad? And what could we learn from their policies? Ernst & Young’s (EY) 2022 Worldwide R&D Incentives Reference Guide offers a fascinating look.
Since World War II, the United States has functioned as the world’s economic superpower. Prior to that, Great Britain held that mantle, and many believe that China may soon surpass the U.S. and claim that title in the future. It turns out that both the UK and China have committed to a much more robust R&D investment than the current American plan—the two countries have “super deductions” for R&D expenditures, allowing companies there to deduct more than 100% of R&D costs from their taxes. According to EY’s Worldwide R&D Incentives Guide, mainland China-based companies can deduct 175% of qualified R&D expenses for purposes; manufacturing enterprises began deducting up to 200% of qualified R&D expenses starting in 2021!
Until a new R&D policy was announced this month, the UK had a more favorable (or, perhaps, favourable) R&D credit for all businesses, and was especially invested in domestic small-to-medium-sized enterprises (SMEs). SMEs could claim an enhanced deduction of 230% of qualifying R&D spend, as a deduction against taxpayers’ profits. If the deduction was more than the taxes, these SMEs could claim a cash credit at 14.5%, according to EY’s Worldwide R&D Incentives Guide.
The tax code in the UK and China is a demonstration of the way each country works to incentivize R&D, but taxes only tell part of the story. The UK also has a large number of public grants meant to spur innovation. For example, Innovate UK, which gets funding from the Department for Business, Energy & Industrial Strategy (BEIS), works to get academia and industry working towards UK-based patents and products and gives around £1 billion in direct grant funding every year for company-run R&D projects.
The United States has a similar SMB R&D grant called the Small Business Innovation Research program, but most of the R&D spend is done by private industry. As the Wall Street Journal explains: “U.S. companies spent an estimated $532 billion on R&D in 2020, representing the lion’s share of what the U.S. as a country allocates to it, according to the National Center for Science and Engineering Statistics, a statistical government agency. A 2019 report from Big Four accounting firm Ernst & Young forecasts that U.S. R&D spending would be cut by $4.1 billion a year for five years because of the change and then by $10.1 billion annually for the subsequent half-decade.”
The change in R&D capitalization threatens to accelerate that reduction in industrial R&D spending. Without the public grants to buoy American innovation, it could lead America to fall behind in the global race towards innovation.
India is a fascinating case study in R&D tax law and its impact. During its rapid push to liberalize and modernize the economy, the Indian government introduced an R&D tax credit to stimulate innovation. From 2001 to 2010, the R&D tax deductions were worth 150% of any capital and revenue R&D spend by firms in qualifying sectors. Starting in 2010, the R&D tax deduction was increased to 200% and became available to every Indian company. That new structure helped make India one of the most tax-friendly countries in the world in regards to R&D. (Note: in 2020-21, the deduction was reduced to 100% of R&D expenditure.) Researchers at three universities looked at the effects and found a substantial rise in R&D spending and patent applications in both India and in the US due to the changes: “We find that the R&D tax credit scheme and its 2010-11 reform spurred firm innovation,” they wrote in their 2021 journal article R&D tax credit and innovation: Evidence from private firms in India. “In response, such firms became more innovative and more productive.”
The finding is intuitive, but it doesn’t make it any less striking when compared to the US policy toward R&D spending: lowering the cost of R&D through tax credits increases research spending, which leads to more domestic patents.
Canada has an interesting R&D policy that could be a valuable model for making R&D reform more politically palatable in the United States. The country offers a 15% federal R&D credit on all qualifying expenses. However, in addition, they offer an enhanced credit rate of 35% for R&D spend by small Canadian-controlled private corporations (CCPC) on their first $3 million of R&D expenditures each year. That 35% credit is 100% refundable.
The policy is specifically crafted to incentivize domestic small-and-medium-sized businesses run by Canadians. For a company to qualify as a CCPC, it must be privately owned and operated in Canada, and must not be controlled directly or indirectly by a nonresident or a public corporation.
The PATH Act, passed in 2015, is an example of an American law with a similar aim. It amended the R&D Credit so that it could count against payroll taxes rather than just income tax for pre-revenue and early-revenue startups. It meant that the credit could be claimed by the companies that were actually sparking much of American innovation over the last decade: technological startups.
Clearly, as the letter-writing CFOs explained, the change to R&D Capitalization threatens to make America a country that disincentivizes domestic R&D. That could have stark consequences for the next generation of American business and American foreign policy. There seems to be bipartisan support for a change to the law, but it’s unclear if the political climate or economic moment will allow it to be prioritized. According to a recent piece in Marketwatch, the “bipartisan push on R&D tax break looks likely to flop.”
At Neo.Tax, we hope lawmakers will look abroad and realize there is a way to incentivize innovation. Perhaps a “super deduction” is not possible at this moment, but a model that allows SMBs to continue to innovate should be a no-brainer. Either way, we’ll do our part to make sure startups maximize their R&D credits and minimize their R&D tax burden; that’s why we built Neo.Tax, and our mission hasn’t changed.