Of tax credits and system abuse

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14 October 2015 | 0

Paul HearnsThe news of both the 6.25% corporate tax rate for innovation and the implementation of the OECD recommended country by country reporting (CbCR) in Budget 2016 is to be welcomed.

Ireland has for too long played a little but too fast a loose when it comes to corporate tax and multinationals.

Finally bowing to both fellow EU members and international best practice, Minister Noonan has closed significant loopholes (the famous ‘Double Irish’) to bring our practices here into line with other regimes, if still at a rate lower than would be seen as reasonable by the likes of the UK, France or Germany, through these and previous budget measures.

“The R&D tax credit scheme and the proposed Knowledge Box rate for profits made from innovation carried out in Ireland is a good thing, but we have a poor record of implementing and policing such schemes”

However, as has been shown in those other regimes too, actual rates of tax are often far lower than the headline rates, due to concessions and credits earned through the likes of innovation, research and development, siting in disadvantaged regions, and measures for a diverse workforce, such as employing older workers or those with different abilities.

There has been much commentary on this from various quarters, about the potential effects of these measures.

PwC in an online report, says of the R&D Knowledge Box scheme, “The much anticipated introduction of the Knowledge Development Box is part of the third pillar in Ireland’s corporate tax regime which includes the 12.5% rate, the R&D tax credit and the intangible asset regime. While Ireland has first mover advantage in introducing the Knowledge Development Box, it is expected that the regime will be of limited benefit to the domestic corporate sector given the significant costs to invest in and generate the qualifying intellectual property and engage in substantive operations that have a high ‘value add’ for the Irish economy.”

PwC goes on to say that the Knowledge Development Box “is a welcome addition to Ireland’s suite of offerings,” but it qualifies it somewhat by adding “while it is compliant with international guidance, it appears that the overall attractiveness of the regime in its current purposed form is likely to be limited from an FDI perspective.”

A more detailed analysis by Harry Harrison, director, international tax practice, PwC Ireland, added that a “company which owns patented (or other specifically defined) IP may qualify for the reduced tax rate on qualifying income from the IP.

“However, in order for all qualifying income to come within the scope of the regime, it will be necessary for a significant majority of the R&D work to be undertaken in Ireland.  The definition of R&D activities is very similar to the definition included in the R&D tax credit regime. Ultimately the attractiveness of the regime for most FDI companies is likely to be limited due to the limited nature of IP which will qualify, and the requirement that a significant amount of the related R&D must physically take place in Ireland.”

Now that term “limited nature” immediately caught my eye. As with the troubled idea of software patents, the definition of what counts as research and development in the area of technology and software in particular, is vexed indeed.

The document referred to, the Revenue leaflet on R&D tax credits, gives some definition of what qualifies as research and development.

It states that this would be “systematic, investigative or experimental activities, in a field of science or technology, encompassing one or more of the following categories of R&D:

  1. Basic research,
  2. Applied research,
  3. Experimental development”

There is an emphasis on documentation of any process expected to qualify. It says that an advance in science or technology means “an advance in the overall knowledge or capability in the field of science or technology (not an advance in the company’s own state of knowledge or capability alone).”

So this appears to say that you cannot just do something a bit clever, it has to be a first and an advance over what exists in the field already, reminding the applicants that it is their duty to acquaint themselves with developments in the field to ensure that they are not submitting what has already been achieved.

While that sounds marvellous, it is really not until such mechanisms and definitions are tested that we get any real idea of what qualifies, and more critically, what does not.

And only then will we see whether this is in actual fact a decent system worthy of the hugely generous tax breaks, or whether it is yet another obvious and facilitating loophole through which multinationals can channel earnings, royalties and massive R&D investments that might otherwise be tough to keep out of the hands of the taxman.

The Revenue document refers to the OECD Frascati Manual which states “for software development to be classified as R&D its completion must be dependent on the development of a scientific and / or technical advance and the aim of the project must be resolution of a scientific and / or technical uncertainty on a systematic basis.”

Now while that might be obvious in the case of a new algorithm that governs storage in solid state drives which increases efficiency, speed, lifetime or power consumption, it may be far less so in the case of a section of code that governs a log-in for a customer on a web application or the handling of cookies and IDs. Because the former is still a relatively niche area with few players and a lot of new developments in contrast to the latter where there is already decades of work done, will the system be robust enough to determine the veracity of a claim of innovation in either?

I have to say, I am deeply sceptical. I feel that the potential benefit is such that it will lead to the very human gambit of submitting every elegant rhyming couplet of code as innovation or advancement, with the system expected to weed out the bogus claims from the genuine. This could lead to either vast sums being channelled through such practises for the huge gain on offer, or a system that collapses due to the sheer amount of work to be done to winnow the wheat from the chaff. There is evidence of this already in a 2013 report that saw significant abuse of the system.

The Revenue document also states that ultimately, success is not necessarily a qualifying criterion. If an organisation can show that it poured resources into a project, well-documented, where either the situation changed as regards the goal, someone else trumped them or ultimately they simply were defeated by physics, then the money spent may still qualify, but again, this would appear to be open to fairly wide interpretation and would lead one to fear that there would be a deluge of applications, with the system, expected to weed out he non-qualifiers.

Overall, the R&D tax credit scheme and the proposed Knowledge Box rate for profits made from innovation carried out in Ireland is a good thing, but we have such a poor record of implementing and policing such schemes that one fears we are closing one set of loopholes merely to open up a set of legitimate avoidance schemes that will make the situation worse.

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