Elizabeth Gil García

An approach to R&D (&I) tax incentives. Elizabeth Gil García1 University of Alicante Abstract This paper contains some ideas and thoughts associated with the PhD project: “Tax Incentives related to R&D (&I)”, being written at the University of Alicante since 2013. This doctoral thesis puts forward legal arguments in support of the development of fiscal measures to foster R&D (&I) structures in order to make innovation attractive and profitable for firms. From a public finance perspective, direct subsidies and tax incentives may be used to stimulate private expenditure on R&D (&I) activities. The current research focuses on tax incentives and it explores several design issues in light of tax law principles as well as international and European standards. Summary 1. INTRODUCTION 1.1. Research questions 1.2. Outline 2. R&D (&I): CONCEPT & SCOPE 2.1. The concept of R&D (&I): international references A) R&D concept given by Frascati Manual B) Innovation defined by Oslo Manual C) Knowledge-based capital: a new benchmark? 2.2. The tax concept of R&D (&I) at the domestic level. 2.3. Tracing the path for a clear and concise R&D (&I) concept for tax purposes. 3. PUBLIC FUNDING: SCOPE & LIMITATIONS 3.1. Tax policy considerations. A) Tax incentives vs. direct subsidies B) Tax incentives in the light of tax fairness 3.2. Legal constraints. A) State aid & Code of Conduct B) Anti-Avoidance provisions: EU and OECD Action Plans 4. INPUT AND OUTPUT INCENTIVES: DESIGN ISSUES 1

Elizabeth Gil García is Doctoral Researcher (FPU14/00028) at the Tax Law Department of the University of Alicante, and member of the EURIDTAX Group. The author would like to thank Prof. Amparo Navarro and Prof. María Teresa Soler for their valuable comments and suggestions in the development of her research. The author can be contacted at [email protected].

An approach to R&D (&I) tax incentives

4.1. Input incentives. 4.2. Output incentives. A) Qualifying taxpayers B) Eligible IP rights C) IP box bases 5. CONCLUSIONS 1. INTRODUCTION 1.1. Research questions. It is commonly held that Research, Development and Innovation [hereafter R&D (&I)] may play an important role in economic development. Although the socioeconomic and political dimension, the academia contributions to that issue have not been generally made from a juridical, but economic, perspective. On the public expenditure side, it is required the legal analysis of certain type of expenses such as the legal system of direct subsidies addressed to fund R&D (&I) activities. From a tax law point of view, a growing number of scholarly writings deals with legal issues related to tax incentives granted by governments at the corporate tax level as well as the royalties’ taxation at the international scenario. This paper focuses on tax incentives and it explores several design issues in light of tax law relevant principles as well as international and European standards. The OECD considers R&D (&I) key to productivity and growth performance, and the Europe 2020 strategy puts R&D (&I) at its heart with the objective of achieving an overall R&D (&I) spending of 3% of the Gross Domestic Product (GDP). According to Eurostat’s data, some EU Member States are far to reach their objectives for 2020. For instance, in November 2014, R&D (&I) spending in Greece was 0,8% of its GDP2. Objectives 2020

R&D in November 2014 (% GDP)

R&D 2020 (% GDP)

Austria

2,81%

3,76%

France

2,23%

3%

The Netherlands

1,98%

2,5%

Spain

1,24%

3%

Governments are in charge of defining the tax system, but also they can create special measures to attract firms to carry out particular business activity within its territory (extra fiscal goals). Tax incentives are one of the options governments have to encourage investment in R&D (&I). The first step of the implementation of tax incentives to encourage R&D (&I) is what constitutes these kind of scientific and innovative activities for tax purposes. Clarity, 2

Data are available at the Eurostat’s site: http://ec.europa.eu/eurostat/web/science-technologyinnovation/statistics-illustrated (accessed 13 June 2016).

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consistency and predictability are essential to assist companies in making R&D investment decisions partly on the basis of tax incentives 3 . Identifying R&D (&I) concept for tax purposes is not an easy task, due to the existence of several definitions based on different instruments. Conventionally, Frascati and Oslo Manuals have offered accepted definitions on R&D (&I) in the international framework, but now it seems there is a new and broader benchmark. In fact, while investment in innovation has traditionally been proxied by indicators such as spending on R&D (&I), innovationbased growth relies on a much broader range of knowledge-based capital4. Secondly, it is widely understood that tax incentives lead to new goods and services, increasing productivity and higher incomes. However, they may cause distortions, are difficult to administer and open to abuse5. In general terms, tax incentives for business spending on R&D (&I) have traditionally been divided into two main groups: i) fiscal incentives designed to foster investment in R&D (so-called input incentives); and ii) measures that fiscally privilege income from R&D (&I) activities (so-called output incentives). The substantial economic activity is especially debatable in the case of output incentives. In this vein, the Final Report of BEPS Action 5requires substantial activity to IP regimes6; in other case, those fiscal measures may fall into the scope of a harmful preferential tax regime. Concerning the implementation and design of R&D (&I) tax incentives, several supranational and domestic standards must be taken into account, such as EU Fundamental Freedoms (i.e. non-discrimination), EU Soft Law, Constitutional and Domestic Law (i.e. ability to pay, equality, effectiveness, proportionality), among others. For instance, at the EU level, the Commission is in charge of examining Member States’ patent box regimes under the state aid provisions as well as the rules of the Code of Conduct for Business Taxation in order to look at the compatibility of those special measures with the internal market7. 1.2. Outline With all this in mind, the work is organised in 5 sections. Section 2 focuses on the concept and the scope of R&D (&I), proposing a more clear and concise R&D definition for tax purposes. Immediately, the paper deals with public funding issues, such as the scope and the legal constraints. Section 4 is addressed to explore several design issues, including input and output incentives. For this purpose, references to 3

OECD (2002): Tax Incentives for Research and Development: Trends and Issues, OECD Publishing, Paris, p. 27. 4

OECD (2013): Supporting Investment in Knowledge Capital, Growth and Innovation, OECD Publishing, Paris. 5

BAL, A.: “Competition for research and development tax incentives in the European Union: how an optimal research and development system should be designed”, in Bulletin for International Taxation Vol. 66, No. 10, 2012, p. 573. 6

OECD (2015): Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5: Final Report, OECD Publishing, Paris. 7

As an example, see: European Commission, State aid N 480/2007 - Spain - The reduction of tax from intangible assets, [C(2008)467 final] (13 Feb. 2008).

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An approach to R&D (&I) tax incentives

fiscal incentives in selected jurisdictions will be made. The aim of this part is to check the compatibility of such measures with the above-mentioned legal constraints, that is, to consider the use of R&D tax incentives in the light of the tax fairness. Finally, brief conclusions and suggestions will be formulated. 2. R&D (&I): CONCEPT & SCOPE The starting point of introducing tax incentives on R&D (&I) is to answer a question that could initially seem petty: what is R&D (&I) for tax purposes? However, to identify an accurate (tax) concept of R&D (&I) is not an easy task, due to the existence of several definitions based on different instruments. Moreover, it is quite frequently that those names are followed by diverse last names depending on which instrument is based. Indeed, the research could be basic or applied; the development usually will be experimental and the innovation probably will be technological8. Consequently, this lack of clarity appears to constitute a serious obstacle to make firms invest on R&D (&I). If there is no certainty that, for example, a specific project will be qualified for applying the incentive, companies will not probably undertake that project. In fact, clarity, consistency and predictability are essential to assist companies in making R&D investment decisions partly on the basis of tax incentives9. Another relevant point concerns the differences between R&D (&I) and other scientific and technological (S&T) activities, particularly in borderline cases (i.e. industrial activities such as prototypes and pilot plants, among others). 2.1. The concept of R&D (&I): international references. At the international framework, two OECD Manuals provide internationally accepted definitions on R&D (&I) activities. On the one hand, the standard for R&D surveys worldwide is the “Proposed Standard Practice for Surveys on Research and Experimental Development” (so-called Frascati Manual). On the other, in case of technological innovation, we should be noted the “Proposed Guidelines for Collecting and Interpreting Innovation Data” (so-called Oslo Manual). In general, countries offering tax incentives for R&D (&I) follow OECD Manuals definitions. The acceptance of these definitions allows granting incentives to the same kind of activities, regardless of the country where the activity is carried out. However, it is important to underline that Frascati and Oslo Manuals are technical documents and are not providing tax definitions. A) R&D concept given by Frascati Manual. Frascati Manual takes action of a mainly technical nature, because experts in collecting data on R&D elaborated it. Over the years, it has become not only into the standard for

8

GONZÁLEZ SABATER, J.: Financiación de la I+D+i. Incentivos públicos para la innovación tecnológica empresarial, Netbiblo, La Coruña (Spain), 2011, p. 19. 9

OECD (2002): Tax Incentives for Research and Development: Trends and Issues, OECD Publishing, Paris, p. 27.

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the conduction of R&D surveys but also into an international reference for R&D definitions. According to Frascati Manual: research and experimental development (R&D) comprise creative work undertaken on a systematic basis in order to increase the stock of knowledge, including knowledge of man, culture and society, and the use of this stock of knowledge to devise new applications10. The term R&D includes three activities: (i)

basic research, defined as experimental or theoretical work undertaken primarily to acquire new knowledge of the underlying foundation of phenomena and observable facts, without any particular application or use in view;

(ii)

applied research that is also original investigation undertaken in order to acquire new knowledge, but it is directed primarily towards a specific practical aim or objective;

(iii) experimental development, explained as systematic work, drawing on existing knowledge gained from research and/or practical experience, which is addressed to produce new materials, products or devices, to install new processes, systems and services, or to improve substantially those already produced or installed. Apart the notion given above, the Frascati Manual deals with some S&T activities similar to R&D, but excluded from this concept 11 . It is the case of education and training at universities and special institutions of higher and post-secondary education with the exception of research by students at the PhD level carried out at universities. There are also excluded other S&T activities –such as specialized health care, patent and license work or routine software development, among others–, except when they are carried out solely or primarily for R&D projects. Additionally, the raising, management and distribution of R&D funds to performers by ministries, research agencies, foundations or charities is not R&D (so-called purely R&D-Financing activities). Frascati Manual excludes as well industrial activities 12 , distinguishing two types: (i)

innovation activities, defined as all those scientific, technical, commercial and financial steps, other than R&D, necessary for the implementation of new or

10

OECD (2002): Proposed Standard Practice for Surveys of Research and Experimental Development – Frascati Manual, 6th Ed., p. 30. 11

According to Frascati Manual, the basic criteria for distinguishing R&D from related activities is the appreciable element of novelty and the resolution of scientific and/or technological uncertainty. 12

There are some cases at the borderline between R&D and other industrial activities, i.e. pilot plants and prototypes are included in R&D as long as the primary purpose is R&D or to make further improvements, respectively. Trial production is included in R&D if production implies full-scale testing and subsequent further design and engineering, by contrast public inspection control, enforcement of standards and regulations are completely excluded from R&D activities (OECD (2002): Proposed Standard Practice for Surveys of Research and Experimental Development – Frascati Manual, 6th Ed., Rule 110, Table 2.3., p. 42-43).

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An approach to R&D (&I) tax incentives

improved products or services and the commercial use of new or improved processes13; (ii)

production and related technical activities that covers industrial preproduction and production and distribution of goods and services and the various allied technical services in the business enterprise sector and in the economy at large, together with allied activities using social science disciplines, such as market research.

B) Innovation defined by Oslo Manual. On the other side, the Oslo Manual defines innovation (&I) as: the implementation of a new or significantly improved product (good or service), or process, a new marketing method, or a new organizational method in business practices, workplace organization or external relations14. Thus, the common feature of an innovation is the “implementation”15. In addition, it is important to remark that some changes are not considered innovations (i.e. simple capital replacement or extension, changes resulting purely from changes in factor prices, customization and so on). It is as well required a certain level of novelty. The minimum entry level for an innovation is that it must be new to the firm, but it is also possible to be new to the market or to the world (intermediate or maximum level of innovation, respectively). In the first case, an innovation will be new to the market if the firm is the first to introduce the innovation into its market. Secondly, innovations are new to the world when the firm is the first to introduce the innovation for all markets and industries, domestic and international. After the general definition of innovation and these common considerations, it is time to look at the main types of innovations established in the Oslo Manual (3rd ed.): (i)

product innovation, defined as the introduction of a good or service that is new or significantly improved with respect to its characteristics or intended uses;

(ii)

process innovation, explained as the implementation of a new or significantly improved production or delivery method;

13

These include acquisition of technology (embodied and disembodied), tooling up and industrial engineering, industrial design n.e.c., other capital acquisition, production start-up and marketing for new and improved products (OECD (1997): Proposed Guidelines for Collecting and Interpreting Innovation Data – Oslo Manual, 2nd Ed., Rule 79). 14

OECD (2005): Proposed Guidelines for Collecting and Interpreting Innovation Data – Oslo Manual, 3rd Ed., p. 56. 15

A new or improved product is implemented when it is introduced on the market. New processes, marketing methods or organizational methods are implemented when they are brought into actual use in the firm’s operations (OECD (2005): Proposed Guidelines for Collecting and Interpreting Innovation Data – Oslo Manual, 3rd Ed., p. 57).

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(iii) marketing innovation, described as the implementation of a new marketing method involving significant changes in product design or packaging, product placement, product promotion or pricing; (iv) organizational innovation that is the implementation of a new organizational method in the firm’s business practices, workplace organization or external relations. C) Knowledge-based capital: a new benchmark? Conventionally, Frascati and Oslo Manuals have offered accepted definitions on R&D (&I) at the international framework, but the so-called knowledge-based capital (KBC)16 appears as a new and broader benchmark. In fact, while investment in innovation has traditionally been proxied by indicators such as spending on R&D, innovation-based growth relies on a much broader range of knowledge-based capital. This comprises a variety of assets which creates future benefits for firms, being unphysical (i.e. employee skills, organizational know-how, databases, design, brands, etc.). Overall, private R&D stocks generally represent no more than 20-25% of total private stocks of KBC17. This non-tangible form of capital is the largest structure of business investment and a key contributor to growth in advanced economies. This new standard involves three categories or groups: (i)

computerised information (software and database);

(ii)

innovative property (R&D, mineral explorations, patents, trademarks, copyright and license costs, new product development in the financial industry and new architectural and engineering designs);

(iii)

economic competencies (brand-building advertisement, market research, worker’s training, firm-specific human capital, networks of people and institutions, management consulting and organisational capital).

2.2. The tax concept of R&D (&I) at the domestic level. As above-mentioned, a high number of countries has implemented the OECD definitions on R&D&I activities in their legal system. That is, for example, the case of Spain that, in general terms, follows such concepts. There are, however, significant differences among countries, so it is not possible to find a single and general R&D (&I) concept for tax purposes. The Spanish tax legislator makes the difference between R&D and innovation, since the Corporate Income Tax Act18 (hereafter CITA) offers a better tax treatment to the first

16

OECD (2013): Supporting Investment in Knowledge Capital, Growth and Innovation, OECD Publishing, Paris, p. 56. 17

OECD (2013): Supporting Investment in Knowledge Capital, Growth and Innovation, OECD Publishing, Paris, p. 23. 18

Ley 27/2014, de 27 de noviembre, del Impuesto sobre Sociedades (BOE No. 288, 28/11/2014).

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An approach to R&D (&I) tax incentives

kind of activities19. In fact, this is the widespread tendency in the majority of countries. For instance, the French tax credit covers 30% of all R&D expenses up to €100 million, and 5% above this threshold; as of January 2013, innovation expenses incurred by small and medium enterprises (SMEs) are also eligible for the tax credit, at a rate of 20% (up to € 400.000 a year)20. In such a way, article 35.1 of the Spanish CITA defines research as21: an original planned investigation in order to discover new knowledge and greater understanding in the field of Science and Technology(S&T)22. Next, “development” implies: the application of research findings or any other scientific knowledge to manufacture new materials or products or to design new production processes or systems, as well as to obtain substantial technological improvement of preexisting materials, products, systems and processes23. Finally: technological innovation is an activity whose result is a technological advance in getting new products or production processes, or substantial improvements of the pre-existing products or production processes. Both R&D and innovation imply a significant scientific or technological improvement. However, while innovation must be addressed to get some outcomes, it is not required a specific result from R&D activities. Furthermore, the novelty required in R&D activities should be objective24, that is, when the solution to a problem is not readily apparent to someone familiar with the basic stock of common knowledge and techniques for the area concerned25. The definition of novelty used may have implications for the expected impact of an R&D tax incentive; because if R&D is targeted to products that are new to the world, the incentive will promote pure innovation (in other cases may promote

19

GONZÁLEZ SABATER, J.: Financiación de la I+D+i. Incentivos públicos para la innovación tecnológica empresarial, ob.cit., p. 83. 20

BURG, P.: “France – Corporate Taxation sec. 1.”, Country Surveys IBFD (accessed 21 January 2015).

21

All quotations of Spanish law and regulations are author’s unofficial translations.

22

This definition is virtually identical to the research definition given by the Spanish General Accounting Plan and also very similar to the research concept of the International Accounting Standard: “original and planned investigation undertaken with the prospect og gaining new scientific or technical knowledge and understanding” (No. 38). 23

In a similar vein, the Spanish General Accounting and the International Accounting Standard (No. 38) says that development is “the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use”. 24

Vid VIÑES BARGADÁ, O: “El concepto “novedad objetiva” en el contexto de las deducciones fiscales por I+D”. Revista Quincena Fiscal, No. 5-2015, Ed. Aranzadi, Pamplona, 2015. 25

OECD (2002): Proposed Standard Practice for Surveys of Research and Experimental Development – Frascati Manual, 6th Ed., p. 34

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imitation)26. In opposition, technological innovation requires a subjective novelty, that is, when the product or process is new to the firm. In this vein, the German Income Tax Act (Einkommensteuergesetz, EStG)27 underlines the novelty feature when says that R&D assets will be used to acquire new scientific and technical knowledge or general experiences (basic research, grundlagenforschung) as well as to develop new products or processes28. Article 35.1 of the Spanish CITA completes the above definitions stipulating that it will be considered as R&D activities the materialization of new products or processes in plans, schemas or designs; the creation of a first unmarketable prototype; the initial demonstration of projects or pilot projects (with an essential new element); the advanced software; etc. This range of activities is different to the general description, but actually it only implies the realization or materialization of R&D activities. For instance, the Indian Income Tax Act does not provide an exhaustive list of R&D activities. It allows a deduction for any R&D expenditures whether or not they are associated with basic research, applied research or experimental research. Thus, businesses are encouraged to carry out various types of scientific research29. While the majority of governments grants R&D incentives, Spain –as well as France– implements innovation reliefs. As a result, article 35 of the CITA includes definitions for both types of activities. In Australia, the Income Tax Assessment Act (Act No. 38 of 1997) 30 establishes that R&D activities are core R&D activities or supporting R&D activities31. According to Division 355 of the ITAA 97: core R&D activities are experimental activities: (a) whose outcome cannot be known or determined in advance on the basis of current knowledge, information or experience, but can only be determined by applying a systematic progression of work (…); and (b) that are conducted for the purpose of generating new knowledge (including new knowledge in the form of new or improved materials, products, devices, processes or services)32. On the other hand, supporting R&D activities are defined as: 26

EUROPEAN COMMISSION: A study on R&D Tax Incentives. Final Report, Taxation Papers – Working Paper No. 52, Luxembourg, 2014, p. 59. 27

Germany does not offered any type of R&D tax incentives.

28

Sec. 51(1) No. 2(u) EStG.

29

ABDELLATIF, M.: “Looking for Efficient Tax Incentives to Stimulate Research and Development and Economic Growth”, New Zealand journal of taxation and policy, Vol. 15, No. 2, Wellington, 2009, p. 154. 30

Act No. 38 of 1997 as amended, taking into account amendments up to Tax Laws Amendments (Research and Development) Act 2015 (registered on 13 March 2015, online available at: www.comlaw.gov.au/Details/C2015C00068). 31

The superseded ITAA No. 27 of 1936 defined R&D activities such as “systematic, investigative and experimental activities that involve innovation or high levels of technical risk and are carried on for the purpose of: acquiring new knowledge; or creating new or improved materials, products, devices, processes or services; or other activities that are carried on for a purpose directly related to the carrying on of activities of the kind referred above” (Section 73B(1), Division 3, Part III, Vol. 1, ITAA 36) 32

Section 355-25(1), Subdivision 355-B, Division 355, Part 3-45, Chapter 3, Volume 7, ITAA 97.

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activities directly related to core R&D activities33. In other cases, R&D definitions are related to some specific sectors or activities. For instance, the Belgian Income Tax Code (Code des Impôts sur les Revenus, CIR 92) links R&D with environment challenges. Indeed, the deduction shall apply to profits and gains from the taxable period in which the: fixed assets intended to promote research and development of new products and advanced technologies that do not affect the environment or that aim to minimize the negative effects of the environment34. 2.3. Tracing the path for a clear and concise R&D (&I) concept for tax purposes. The establishment of a clear and coherent definition of R&D (&I) for tax purposes, it is not a trivial issue. An increasing number of countries grant tax incentives to several activities and it would be desirable that those incentives were offered to the same type of activities, regardless of the country where the activity is carried out. That is, activities unanimously considered as R&D (&I). This point is fulfilled by OECD documents, because the definitions contained in those Manuals have been internationally accepted. However, Frascati and Oslo Manuals are technical documents and do not provide tax definitions. Moreover, it should be highlighted that each country will define R&D (&I) taking into account their particularities (i.e. political, social and/or economic issues) and even such definition may vary over time. This point makes, first, difficult to harmonize the R&D (&I) concept for tax purposes and, second, the variations over time may provide companies with legal uncertainty. In this sense, predictability of a (tax) policy is crucial for corporations to integrate the tax benefit in their R&D (&I) investment plans, which can span many years. If a policy instrument is changed frequently and on irregular basis, a tax incentive will not be fully taken into account when firms make their investment decisions. This decreases, then, the effectiveness and efficiency of the policy35. Terms and expressions used by jurisdictions may, in certain cases, provide firms with legal uncertainty. In truth, it is very common they are in an undetermined scope about what kind of projects are R&D and what others not. Therefore, the most feature that has to be present in a legal system is the legal certainty provided to all citizens and economic players. Precisely, those inaccuracies may contribute to different interpretations of a tax provision. In this regard, it should be noted that the decision of the Spanish Audiencia Nacional (National Court, AN) of 20 June 2013 (Case No. 2751) highlights the following three issues: (1) the indeterminate nature of the concept of R&D (&I); (2) the overuse of generic formulas and confusing terms to define either the

33

Section 355-30(1), Subdivision 355-B, Division 355, Part 3-45, Chapter 3, Volume 7, ITAA 97.

34

Article 69 pf. 1.2(b) of the CIR 92.

35

EUROPEAN COMMISSION: A study on R&D Tax Incentives. Final Report, Taxation Papers – Working Paper No. 52, Luxembourg, 2014, pp. 79-80.

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concept or its exceptions 36 ; and, (3) the novelty requirement may rise in opposite interpretations due to the use of lax terms, such as an “original investigation” or “new knowledge”, i.e. a narrow interpretation would imply a lack of novelty and, therefore, the denial of the tax incentive, while investment in R&D (&I) would be favoured under a broad approach. Additionally, although the scope is mainly focused on R&D (&I), it could be debatable to extent it to other types of assets. As above-mentioned, there is a great group of intangibles, broader than R&D scope, which allows companies to get a high level of economic benefits as well as scientific progress for the society (i.e. software). Nevertheless, some categories do not necessarily contribute to increase the capital based on knowledge, science and technology (S&T), i.e. brand-building advertisement, networks of people and institutions, etc. Thus, two approaches could be taken. First, if technological progress and scientific development are pursued, the scope should be restricted to non-tangible forms based on S&T, i.e. R&D (&I). Second, if the purpose is to favour business investments regardless the scientific value of assets, then a broader concept (i.e. KBC) should be considered. The previous point rise to another relevant question. As said before, KBC encompasses three groups: (1) computerised information; (2) innovative property, which includes R&D; and, (3) economic competencies. The second category comprises different kind of activities targeted to the technological progress and scientific development. Therefore, the question is whether or not R&D and innovation are different and independent activities. Indeed, it can be argued if they are different activities or diverse phases of the same process. Few tax jurisdictions –i.e. Spain or France– provide with a better tax treatment to R&D activities rather than innovative activities. If R&D and innovative activities are steps within the same process, a different tax treatment would not have sense. In this line, Frascati Manual identifies R&D as one of the activities or stages carried out during the innovative process. It may act not only as the original source of inventive ideas but also as a means of problem solving which can be called upon at any point up to implementation37. In the author’s opinion, research, development and technological innovation are phases of the same process lead to the implementation of technologically new or improved products, services or processes. Furthermore, it is debatable the novelty condition, because it is relevant whether R&D (&I) is primarily intended for true innovation or mainly for learning from other firms. If the “new to the firm” level is required, it could encourage imitation. Thus, the “new to the world” level appears as the way to promote only pure innovation. Nevertheless, this may seem a very tough requirement, in particular for SMEs. The solution can be found in a halfway point, such as to measure the degree of novelty through the concept of the 36

See also: Judgments of the Spanish Audiencia Nacional of 30 May 2011 (Case No. 2703) and of 9 December 2010 (Case No. 5764). 37

OECD (2002): Proposed Standard Practice for Surveys of Research and Experimental Development – Frascati Manual, 6th Ed., p. 18.

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“relevant market”38. From the perspective of the company, R&D (&I) activities are not an end in itself, but only a means towards improving its activity. With all this in mind, it could be noted that S&T are implemented through R&D&I to industrial processes allowing companies to improve its position on the market. In terms of clarity and conciseness, R&D&I may be defined as: the application and materialization of the stock of knowledge obtained from the original planned investigation in order to produce new or significantly improved products, processes or services open to exploitation and/or commercialization. The proposed definition should be complemented by a numerous clausus list with doubtful cases, including only those activities whose high scientific value and profitability benefits not only companies but also society as a whole. Firstly, this definition encompasses a triple dimension: research, development and innovation. Research seeks to acquire new knowledge (basic research) in order to solve specific objectives (applied research). Conclusions and results reached through the original planned investigation will be tested through prototypes or pilot plants (experimental development). The process will conclude with the production of new or significantly improved goods and services with an impact either on the company or on the market (technological innovation). Secondly, this concept refers not only to the implementation but also to the novelty. In this latest case, it is taken the relevant market level. Indeed, research and innovation are about bringing new ideas to the market 39, so the market seems the area to measure the impact of products, processes or services. Finally, the above-mentioned definition implicitly refers to the knowledge transfer. It is essential that scientific activities carried out by research operators “go beyond the walls of the laboratory” and benefit the society as a whole. 3. PUBLIC FUNDING: SCOPE & LIMITATIONS 3.1. Tax policy considerations. It is generally understood that market incentives alone are not enough to produce an adequate supply of R&D (&I) and if there is not an opportunity for profit, R&D (&I) will not be undertaken by firms. As a result, State intervention may be considered essential to stimulate private R&D spending and influence the generation of research 38

See VIÑES BARGADÁ, O.: “El concepto de “novedad objetiva” en el contexto de las deducciones fiscales por I+D”, ob. cit. The definition of the relevant market refers to its both product and geographic dimensions. Firstly, a relevant product market comprises all those products and/or services which are regarded as interchangeable or substitutable by the consumer, by reason of the product’s characteristics, their process and their intended use. Secondly, the relevant geographic market comprises the area in which the undertakings concerned are involved in the supply and demand of products or services, in which the conditions of competition are sufficiently homogeneous and which can be distinguished from neighbouring areas because the conditions of competition are appreciably different in those area [Commission Notice on the definition of relevant market for the purposes of Community competition law (Official Journal C 372 , 09/12/1997 P. 0005 - 0013)]. 39

EUROPEAN COMMISSION: A study on R&D Tax Incentives. Final Report, Taxation Papers – Working Paper No. 52, Luxembourg, 2014, p. 59.

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and knowledge for a sustainable economic growth. As DANON says, “State intervention to stimulate R&D is justified because there is broad agreement that without such intervention undertakings will tend to underinvest in R&D compared to the appropriate level of spillovers that R&D may generate for society”40. The interest in increasing the business spending on R&D (&I) is grounded on its consideration as key factor of productivity and growth41 as well as they can contribute to the social welfare and the technological progress 42 . Indeed, technology and innovation are important drivers of economic development, leading to new products and higher income, among others43. This may justify the policy of subsidizing scientific and entrepreneurial activities that could lead to innovation and, thus, to the accumulation of valuable intangible assets, such as know-how, patents, trademarks or copyrights44. The introduction of special tax measures is based on the existence of constitutional values or other public interests. Article 179 paragraph 1 TFEU praises the R&D (&I) promotion as a common interest objective in the EU when it says that: the Union shall have the objective of strengthening its scientific and technological bases by achieving a European research area in which researchers, scientific knowledge and technology circulate freely, and encouraging it to become more competitive, including in its industry, while promoting all the research activities deemed necessary by virtue of other Chapters of the Treaties. From a domestic perspective, some jurisdictions have introduced R&D activities as values or interests in their Constitutions. It is the case of Spain, Italy, Portugal or Switzerland. The Spanish Constitution (Constitución Española, 1978) considers R&D as a public interest when its article 44.2 highlights the promotion of: science and research for the benefit of the society as a whole. According to BAYONA DE PEROGORDO and SOLER ROCH, public expenditure is considered fair when it is based on social values enshrined in the Constitution. In other

40

DANON, R.J.: “Tax Incentives on Research and Development (R&D). General Report”, Cahiers de Droit Fiscal International, Vol. 100a, Sdu Uitgevers, The Hague, The Netherlands, 2015, p. 19. Also in: BROKELIND, C. & HANSSON, Å.: “Tax Incentives, Tax Expenditures Theories in R&D: The Case of Sweden”, World Tax Journal, Vol. 6, No. 2, 2014, p. 175. 41

OECD (2002): Tax Incentives for Research and Development: Trends and Issues, OECD Publishing, Paris, p. 2; OECD (2013): Supporting Investment in Knowledge Capital, Growth and Innovation, OECD Publishing, Paris, p. 17; EUROPEAN COMMISSION: A study on R&D Tax Incentives. Final Report, Taxation Papers – Working Paper N. 52, Luxemburgo, 2014, p. 38. 42

CORCHUELO MARTÍNEZ-AZÚA, M.B.: “Incentivos fiscales a la I+D en la OCDE: estudio comparativo“, Cuadernos Económicos de ICE, No. 73, Ministerio de Economía y Competitividad, 2007, p. 197. 43

BAL, A. & OFFERMANNS, R.: “R&D Tax Incentives in Europe”, European Taxation, Ed. IBFD, 2012, p. 167. 44

ARGINELLI, P.: “Innovation through R&D Tax Incentives: Some Ideas for a Fair and Transparent Tax Policy“, World Tax Journal, Vol. 7, No. 1, 2015, p. 5.

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words, the constitutional inclusion of certain categories of public expenditures will imply a fair realization of them45. Additionally, the State is exclusively in charge of (article 149.1(15) of the Spanish Constitution): the encouragement and coordination of the scientific and technological research. For this purpose, the Judgment of the Constitutional Court of 11 June 1992 (Case No. 90) points out that this competency encompasses “all measures addressed to the promotion and development of R&D (&I)”. For its part, the Italian Constitution (Costituzione della Repubblica Italiana, 1947) enshrines R&D in its article 9: the Republic will promote the culture development as well as the scientific and technological research46. On the other hand, the Portuguese Constitution (Constituição da República Portuguesa, 1976) points out in article 73.4 that: research and creative activities, as well as technological innovation will be subsidized and supported by the State47. Finally, article 20 of the Swiss Constitution (Constitution fédérale de la Confédération suisse, 1999) declares the freedom of scientific research, and its article 64 states that: the “Confédération [suisse]” should promote scientific research and innovation48. In conclusion, the State intervention in order to promote business spending on R&D (&I) is based, from an economic perspective, on the so-called “market failure”. That is, the lack of market incentives leads to the underinvestment on R&D (&I), so State intervention pursues to make innovation attractive and profitable for firms. Although this is commonly held, it could be debatable the assumption of the “market failure” idea in order to justify fostering R&D (&I) by means of public funding, either subsidies or tax incentives. That is, the consideration that without public expenditure there would be no R&D (&I) activity in the private sector is no clear –especially in some specific sectors, i.e. high-technology–. Actually, competitiveness, excellence, prestige or simply the legitimate expectation of “making money” may play an incentive role in many cases,

45

BAYONA DE PEROGORDO, J.J. & SOLER ROCH, M.T.: Derecho Financiero, Vol. 1, Ed. Compas, 2nd edition, Alicante (Spain), 1989, pp. 481-482. See also: BAYONA DE PEROGORDO, J.J.: El Derecho de los gastos públicos, IEF, Madrid, 1991. 46

The Italian Constitution is available online at: http://www.governo.it/Governo/Costituzione/principi.html (accessed 22 June 2015). 47

The Portuguese Constitution is available online at:http://www.parlamento.pt/Legislacao/Paginas/ConstituicaoRepublicaPortuguesa.aspx (accessed 22 June 2015) 48

The Swiss Constitution is available online at:https://www.admin.ch/opc/fr/classifiedcompilation/19995395/index.html (accessed 22 June 2015).

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irrespective of any tax policy measures. For instance, the Encuesta (survey) Sobre Estrategias Empresariales (ESEE) for the period 1998-2005 shows how the “innovation effort” made by Spanish companies receiving subsidies for the carrying out of R&D (&I) activities was significantly higher than the “innovation effort” made by other firms. However, these data are not relevant, as it has not been demonstrated that without public funding there would have been less “innovation effort”49. From a public finance perspective, the introduction of preferential tax measures is grounded on values enshrined in the Constitutions or on public interests, i.e. the common interest stated in article 179 TFEU. These constitutional values and public interests allow governments, beyond its function of defining the tax system, to create special measures to attract firms to carry out particular businesses within its territory (extra fiscal goals). Consequently, taxation may have a regulatory goal, by incentivizing activities (i.e. tax incentives to foster R&D, such as IP boxes) and by penalizing others (i.e. taxes on the use of fuel oil to reduce the CO2 emissions). In this way, governments are able to influence individual’s behaviour to achieve some valuable objectives50. State intervention –through subsidies, taxes, trade or other policies– may, on the one hand, influence the generation of S&T and, on the other, contribute to the development of a sustainable economic growth. The introduction of tax incentives to encourage R&D (&I) is, therefore, a tax policy decision. In terms of tax competition, countries may introduce special fiscal measures under a defensive or aggressive approach. On the one hand, technology-exporting countries normally introduce measures that are intended to retain intangibles and related intellectual property (IP) rights. Consequently, the objective for these countries is to counter the location of highly mobile capital in low-tax jurisdictions. On the other hand, technology-importing, or developing, countries adopt an aggressive position with the purpose of attracting intangibles and related IP rights, i.e. to encourage entities to undertake certain economic activities in their territories. A) Tax incentives vs. direct subsidies. As above-mentioned, tax incentives are one of the options governments have to encourage investment in R&D (&I). One alternative is to provide companies with grants or cash subsidies. As EASSON and ZOLT say, it is much easier to provide tax benefits than to correct deficiencies in the legal system, and tax incentives do not require an actual expenditure of funds by the government51. According to SURREY and McDANIEL, the tax is composed of two distinct elements. The first one contains the structural provision necessary to the application of a normal

49

GARCÍA QUEVEDO, J. & AFCHA CHÁVEZ, S.: “El impacto del apoyo público a la I+D empresarial: un análisis comparativo entre las subvenciones estatales y regionales”, Investigaciones Regionales. Monográfico, Sección Segunda Parte, 2009, p. 1 50

HANCOCK, D.: An Introduction to Taxation: Policy and Practice, CHAPMAN&HALL, 2nd edition, London, 1995, p. 7. 51

EASSON, A. & ZOLT, E.M.: “Tax Incentives”, World Bank Institute, 2002, p. 10

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income tax, i.e. the definition of net income. The second element consists of the special preferences found in every income tax. These particularities, often called tax incentives, are departures from the normal tax structure and are designed to favour a particular industry, activity or class of persons. Whatever the form they partake, these departures from the normal tax structure represent public spending for the favoured activities or groups made via the tax system rather than through direct grants, loans, or other forms of government assistance52. In these authors’ view, some scholars “disagree with the tax expenditure concept itself, essentially on the rhetorical ground that the concept implicitly and erroneously asserts all income belongs of right to the government decides not to collect, by exemption or otherwise, constitutes a subsidy” 53. Although, to some extent, we can share this view, actually a preferential or special tax treatment may be seen as a “subsidy”, which grants the similar economic support to the one conferred by direct grants or other direct forms of government assistance. Thus, an incentive can be defined as “an offer of something of value, sometimes a cash equivalent and sometimes not, meant to influence the payoff structure of a utility calculation so as to alter a person’s course of action”54. The use of tax incentives is justified by the regulatory function of taxation and it is an alternative to command-andcontrol regulations. While tax incentives and cash grants may be similar economically, for political and other reasons, it is easier to provide tax benefits than to actually provide direct funds to firms55. In BROKELIND and HANSSON view, the advantages of tax incentives are that the market rather than the government decides which projects are worthwhile. Companies are then free to choose the financing that suits them best and what projects to undertake56. In a similar way, SALGADO BARCA and PALLARÉS RODRÍGUEZ are in favour of tax incentives, because they are the best instrument to stimulate R&D investments from SMEs and multinational corporations (MNCs) 57 . On the contrary, CORCHUELO and MARTÍNEZ-ROS consider tax incentives are only effective for MNCs and the high

52

SURREY, S.S. & McDANIEL, P.R.: “The Tax Expenditure Concept and the Budget Reform Act of 1974”, Boston College Industrial and Commercial Law Review, Vol. 17, No. 5, 1976, p. 680. 53

SURREY, S.S. & McDANIEL, P.R.: “The Tax Expenditure Concept and the Budget Reform Act of 1974”, ob. cit., p. 687. 54

GRANT, R.W.: “The Ethics of Incentives: Historical Origins and Contemporary Understandings”, Economics and Philosophy, No. 18, April 2002, p. 111. 55

EASSON, A. & ZOLT, E.M.: “Tax Incentives”, ob. cit., p. 10

56

BROKELIND, C. & HANSSON, Å.: “Tax Incentives, Tax Expenditures Theories in R&D: The Case of Sweden”, ob. cit., p. 177. 57

SALGADO BARCA, M. B. & PALLARÉS RODRÍGUEZ, R.: “El patent box en España: análisis del artículo 23 del LIS”, Quincena Fiscal Aranzadi 19, November I – 2014, p. 68.

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technology sector, with no impact on SMEs when they are arbitrarily granted 58 . In South Africa, for instance, no specific incentives are granted to SMEs and, according to empirical studies, the current deductions on R&D tend to favour big companies, frequently South African MNCs59. From the companies’ perspective, direct subsidies are normally associated with more uncertainty and higher administrative costs which may discourage them for applying. Additionally, in case of tax incentives, there is no obligation to give back the money obtain with the relief, regardless of the success of the R&D project. To sum up, there is an agreement on the need to finance R&D (&I) activities from the public sector. Therefore, tax incentives or directs subsidies may be used for that purpose. In our view, it is not necessary to exclude one of these two instruments. Indeed, both of them could be combined as BROKELIND and HANSSON said60. The point will, therefore, be in funding R&D (&I) that would not otherwise have been undertaken. B) Tax incentives in the light of tax fairness. The consideration of R&D (&I) as a constitutional value or public interest implies a fair expenditure. Nevertheless, tax incentives should be in line with some tax law relevant principles and legal constraints, either at the domestic or supranational level. That is, tax incentives should be grounded on the “extra fiscal goal” pursued (i.e. R&D promotion) and “should be in accordance with the proportionality principle and, in any case, cannot be based on arbitrary decisions”61. Thus, it can be affirmed there is a movement from the prohibition of fiscal privileges legitimated by tax justice criteria (ability to pay and equality) to the compatibility with the “extra fiscal goals” legitimated by constitutional values or other public priorities. In such a way, the requirements of a valid different tax treatment in comparable situations are: i) an objective and reasonable justification, i.e. constitutional values; ii) the proportionality of the measure; and, iii) that tax incentives are checked accordingly, depending on comparability and the type of incentive. In regard of the requirement of proportionality, a special provision for R&D (&I) is considered to be proportional only if the same result could not be reached with a less distortive measure. In particular, the amount and intensity of the measure must be limited to the minimum needed for such R&D (&I) activity to take place62. Therefore, it will be proportional (and reasonable) the measure that keeps a fair balance between the effectiveness in achieving the 58

CORCHUELO, B. & MARTÍNEZ-ROS, E.: “The Effects of Fiscal Incentives for R&D in Spain”, Working Paper 09-23, Business Economic Series 02, Universidad Carlos III de Madrid, 2009, p. 20. 59

GER, B.: “Tax Incentives on Research and Development (R&D). South Africa Report”, Cahiers de Droit Fiscal International, Vol. 100a, Sdu Uitgevers, The Hague, The Netherlands, 2015, p. 663. 60

BROKELIND, C. y HANSSON, Å.: “Tax Incentives, Tax Expenditures Theories in R&D: The Case of Sweden”, ob. cit., p. 177. 61

GUTIÉRREZ BENGOECHEA, M.A.: “Algunas notas sobre la extrafiscalidad y su desarrollo en el derecho tributario”, Revista Técnica Tributaria, No. 107, 2014, p. 153. 62

European Commission: Community framework for state aid for research and development and innovation (2006/C 323/01), 30 December 2006.

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objective (i.e. fostering R&D (&I) activities) and the impact of the measure on the public resources. In this line, at the Spanish level, the Judgment of the Supreme Court of 30 September 1999 (Case No. 718), stated that an excessive tax reduction affects the ability to pay principle (article 31.1 of the Spanish Constitution), being an unreasonable and inappropriate measure for achieving the purpose of promoting an economic activity, i.e. R&D (&I). According to the High Court, this kind of measures can negatively affect the free movement of people, goods and services. 3.2. Legal constraints. A)

State aid & Code of Conduct.

Even if tax incentives are a valuable tool for promoting R&D (&I), fiscal measures on this type of S&T activities may qualify as State aid and fall into the scope of the general ban on granting aid expressed in article 107.1 TFEU. The objective of State aid rules is to ensure that government interventions do not distort competition and trade inside the EU, that is, they seek to provide a balance between activities which are anti-competitive with the need to support activities, which contribute towards a well-functioning and equitable economy63. Then, article 107.1 TFEU pronounces a general prohibition of State aid, but measures can be declared compatible if one of the exemptions of article 107.2 or 107.3 is fulfilled. All criteria pointed at article 107.1 TFEU must be fulfilled, because if one single criterion is missing, the measure granted will not be subject to the State aid rules: i)

The aid must consist of a transfer of public resources –including resources granted by regional or local authorities– to an organization involved in economic activity. Financial transfers that constitute State aid may take different forms such as capital injections, loan guarantees or tax exemptions, among others.

ii)

The measure must confer an economic advantage that the undertaking would not have received in the normal course of business64.

iii)

The measure granted must be selective. A measure is selective if it favours only certain undertakings, it is said, when instead of being a “general measure”, it targets particular business, locations, types of firm and so on.

iv)

The aid must distort or have the potential to distort competition.

Therefore, EU Law contains a general ban on State aids, but this principle expressed in article 107.1 TFEU is a rule with exceptions. In fact, aid to R&D (&I) may be exempted from the general prohibition of State aid under the exception of article 107.3 c) TFEU –

63

PÉREZ BERNABEU, B.: “R&D&I Tax Incentives in the European Union and State Aid Rules”, European Taxation, Vol. 54, N° 5, 2014, p. 182. 64

The European Court of Justice (ECJ) has interpreted the term undertaking in this field in a wide sense as any entity which exercises an activity of an economic nature and which offers goods and services on the market, regardless the legal form and the way of financing of this entity (PÉREZ BERNABEU, B.: “R&D&I Tax Incentives in the European Union and State Aid Rules”, ob.cit., p. 183).

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aid to facilitate the development of certain economic activities– or sometimes under provisions of article 107.3 b) TFEU –projects of common European interest–. In this context, the Commission Regulation No. 651/2014 declares certain categories of aid compatible with the internal market 65 . The so-called General Block Exemption Regulation (GBER) is applicable since 1 July 2014 until 31 December 2020. Section 4 of the GBER refers to “Aid for research and development and innovation” as one of the categories exempted because it “can contribute to sustainable economic growth, strengthen competitiveness and boost employment”. In our view, it is important to consider the effectiveness and proportionality of the R&D (&I) aid, that is, to fund R&D (&I) activities that would not otherwise have been undertaken. The favourable position to R&D (&I) aids should be in their incentive effect, the aim of public interest pursued and, specially, in the proportionality of the measure. Therefore, the area of justification of the measure –even if aids are selective per se– is based on these three elements. Hence, the presence of these “principles” will justify an R&D aid and should be considered compatible with EU Law. On the other hand, the Code of Conduct for Business Taxation concerns those measures –included both laws or regulations and administrative practices– which affect, or may affect, in a significant way the location of business activity within the EU66. According to this Code of Conduct: when assessing if such measures are harmful account should be taken of, inter alia: (...) 3. whether advantages are granted even without any real economic activity and substantial economic presence within the Member State offering such tax advantages, or... This means that the total amount of R&D (&I) activities must be created, developed and exploited in the territory of the country introducing the special tax measure. Due to the globalization and the EU internal market, it seems quite complicate that, i.e., an intangible asset has been created just in an EU Member State. For instance, the previous, and inconsistent, Spanish IP box regime, requires that, at least, the transferor has created the assets or IP rights in a 25% of its cost. It means that the transferor could have celebrated a cost-sharing agreement with other firms located in different EU Member States to create and develop IP rights. Following the Code of Conduct, the regime that benefits this situation –i.e. a patent created by two companies, one resident in Spain and another in France– may be considered as a harmful tax regime. The aspect noted by the Code of Conduct could imply a contradiction with other EU principles. In fact, the limitation of an economic activity to a particular territory could

65

COMMISSION REGULATION (EU) No. 651/2014 of 17 June 2014 declaring certain categories of aid compatible with the internal market in application of articles 107 and 108 of the Treaty. 66

Conclusions of the ECOFIN Council Meeting on 1 December 1997 concerning taxation policy – Resolution of the Council and Representatives of the Governments of the Member States, meeting within the Council of 1 December 1997 on a Code of Conduct for Business Taxation; published on the Official Journal C 002, 06/01/1998 P. 0001-006 [This document is available online at: http://ec.europa.eu/taxation_customs/resources/documents/coc_en.pdf (accessed 16 June 2016)].

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be against EU Fundamental Freedoms. This alleged contradiction between EU principles and the Code of Conduct may make the control of harmful tax practices a thrilling and difficult job. B)

Anti-Avoidance provisions: EU and OECD Action Plans.

As it is commonly held intangibles are highly mobile and drivers of value67. Actually, the nature of those types of activities makes it very easy to shift them from one country to another. Globalisation and technological innovation have further enhanced that mobility68. Consequently, the R&D scope may represent a risk of profit shifting. Base Erosion and Profit Shifting (BEPS) mainly carried out by multinational groups to tax jurisdictions with low or non-taxation is not only a problem of great global dimension that undermines the tax fairness principles, but also constitutes an unfair business competition with other taxpayers that, because of their national dimension, cannot carry out such practices. Indeed, harmful tax practices may lead to shift part of the tax burden to less mobile tax bases, i.e. labour, property or consumption, in order to counteract the revenue loss or to strengthen the tax collection. Such shift in the structure of taxation might aim at making the tax system less efficient in terms of its impact on growth and employment in the long run69. Since 2013, OECD has been promoting its Action Plan on Base Erosion and Profit Shifting (BEPS Action Plan)70, tackling globally the harmful tax practices that allow those multinational groups to carry out this aggressive tax planning. Additionally, in June 2015, the European Commission launched its own initiative to tackle BEPS practices, releasing the Anti-Tax Avoidance (ATA) Package in January 2016 –having been released the proposal for the ATA Directive in June 2016 (ECOFIN Meeting)–. This European initiative suggests the re-launch of the Common Consolidated Corporate Tax Base (CCCTB) and proposes the implementation of specific rules to tackle BEPS practices, i.e. preferential regime rules, limitation on interest deductions, controlled foreign company (CFC) rules or transfer princing rules, among others. There is no doubt of the high economic and technological value of innovate activities. However, at the same time, they can lead to base erosion and profit shifting. Antiavoidance provisions may help to counteract harmful tax practices. But it is important to 67

According to BEPS Action 3, royalties and IP income (among other income categories) are likely to be geographically mobile and therefore are likely to raise base erosion and profit shifting (OECD (2015): Designing Effective Controlled Foreign Company Rules, Action 3: Final Report, pp. 44-45). 68

OECD (2015): Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5: Final Report, p. 11. 69

A sensu contrario, the European Commission considers that, given that some categories of taxes are known to be less detrimental to growth than others (i.e. labour taxes), a growth-friendly tax shift can generate static and dynamic efficiency gains. Therefore, shifting tax away from labour (especially for the most vulnerable groups) would stimulate labour supply by reducing the disincentives to work and would raise labour demand by reducing firms’ labour costs. On the other side, shifting taxation from income to consumption reduces the tax burden on savings –since savings are defined as disposable income minus consumption– (European Commission: Tax reforms in EU Member States, Working Paper No. 38 – 2013, pp. 48-49). 70

OECD (2013): Action Plan on Base Erosion and Profit Shifting, OECD Publishing, Paris.

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highlight the (negative) impact that anti-abuse provisions may have on the encouragement of innovation, such as neutralising their effects. Indeed, even if EU and OECD initiatives are not anti-incentives projects, they are having an indirect impact on the design and implementation of R&D(&I) tax measures. PARENT COMPANY

Royalties

IP-HOLDING COMPANY

Member State A

OPERATING COMPANY

IP license

Member State B

Figure 1: Multinational group scenario In Figure 1, the IP-Holding Co. and the Operating Co. are residents in different Member States and they are associated entities within the multinational group directed by the Parent Co., resident in a third State. Therefore, if Member State A has an IP box regime, royalties will be taxed at a low tax rate. As the Directive 2003/49/EC on Interest and Royalty payments (I+R Directive) applies, non-withholding tax is levied71. Finally, if the third State does not provide with controlled foreign company (CFC) rules, foreign income cannot be attributed to shareholders in the parent jurisdiction. In the general framework, governments may have various weapons in their fight against tax avoidance through the abuse of legal forms: the general anti-avoidance rule (GAAR); specific anti-avoidance rules (SAARs); transfer pricing (TP) rules72; and the already mentioned, CFC rules.

71

Council Directive 2003/49/EC of 3 June 2003 on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States. The I+R Directive is designed to eliminate withholding tax obstacles in the area of cross-border interest and royalty payments within a group of companies by abolishing: withholding taxes on royalty payments arising in a Member State, and withholding taxes on interest payments arising in a Member State. According to the EU Action Plan, it should be amended the I+R Directive so that Member States are not required to give beneficial treatment to interest and royalty payments if there is no effective taxation elsewhere in the EU [COM (2015) 302 final: A Fair and Efficient Corporate Tax System in the European Union: 5 Key Areas for Action, Brussels, 17 June 2015, p. 9]. As a result, the “Working Party on tax Questions – Direct Taxation” of 16 February 2016 has considered the minimum effective tax rate should be 10%. That is, any interest and royalty payment would be exempted from taxes in the Member State where they arise when the effective tax rate resulting from the tax regime applicable to those payments in the Member State of the beneficial owner is at least 10%. 72

Briefly mentioned, transfer pricing rules are intended to adjust the taxable profits of associated enterprises to eliminate distortions arising whenever the prices or other conditions of transactions between those enterprises differ from what they would have been if the enterprises had been unrelated. The OECD Project on BEPS addresses TP rules issues in Actions 8-9 and Action 13 (country-by-country

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a) General and specific anti-abuse rules for counteracting the risk of IP profits shifting. GAARs provide an instrument for the Tax Administration to reclassify a given arrangement by interpreting the tax legislation according to its purpose73. In the R&D (&I) scope, the GAAR may disallow the deductibility of payments such as royalties to tax havens under certain conditions. However, it is difficult to draw the line between wholly artificial structures and genuine activities. As a result, it might be easy for firms to circumvent the application of GAAR. The effectiveness of such a rule depends strongly on the interpretation by the national courts 74 , which leads to considerable uncertainty in the application of Tax Law. Finally, it is important to highlight that tax planning, even if considered as aggressive, is not illegal75. Action 6 of the OECD Project recommends the introduction of a GAAR into tax treaties76. Under the condition of defining “special tax regime”, BEPS Action 6 also states new provisions for article 11 (interest), article 12 (royalties) and article 13 (other income) of the OECD Model Convention. In accordance with the new provision for article 12, “[r]oyalties arising in a Contracting State and beneficially owned by a resident of the other Contracting State may be taxed in the first-mentioned Contracting State in accordance with domestic law if such resident is subject to a special tax regime…”77 This new provision allows the taxation in the Source State when there is a preferential tax regime in the Residence State and this one is defined in the Tax Treaty. Therefore, in Figure 1, Member State B (Source State) would be able to tax the royalties if the IP-Holding Co. (beneficial owner) was subject to a special tax regime defined in the Double Tax Convention (DTC). However, it should be highlighted that in the EU framework (Figure 1 scenario), the I+R Directive applies. In accordance with such proposal, the “special tax regime” means “any legislation, regulation or administrative practice that provides a preferential effective rate of taxation to such income or profit, including through reductions in the tax rate or the tax base (…) However, the term shall not include any legislation, regulation or (CbC) reporting). Some authors do not consider TP rules as anti-avoidance provisions, as they are technical rules related to related-party transactions [see VEGA BORREGO, F.A.: “Las medidas antiabuso en los convenios bilaterales para evitar la doble imposición internacional”, Manual de Fiscalidad Internacional, 4ª Ed., Ministerio de Hacienda y Administraciones Públicas (printing press)] 73

RUIZ ALMENDRAL, V.: “Tax Avoidance and the European Court of Justice: What is at Stake for European General Anti-Avoidance Rules?”, International Tax Review: Intertax, Vol. 33, Issue 12, 2005, p. 565. 74

At the Spanish level, the delimitation of the tax avoidance can be found in several judgments of the Supreme Court, such as Judgments of 19 April 2012, of 17 March 2014, of 30 May 2014 and of 18 June 2015, among others. 75

SPENGEL, C. et al.: “Profit Shifting and “Aggressive” Tax Planning by Multinational Firms: Issues and Options for Reform”, Discussion Paper No. 13-044, ZEW – Centre for European Economic Research, 2013 (this document is online available at: http://ftp.zew.de/pub/zew-docs/dp/dp13044.pdf). 76

See PALAO TABOADA, C.: “OECD Base Erosion and Profit Shifting Action 6: The General AntiAbuse Rule”, Bulletin for International Taxation, Vol. 69, No. 10, 2015. 77

OECD (2015): Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 6: Final Report, pp. 96-98.

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administrative practice” whose application “does not disproportionately benefit interest, royalties or other income, or any combination thereof”. Thus, such definition excludes from the term “special tax regime” when its application implies a proportional benefit. Secondly, the term shall neither include any provision “that satisfies a substantial activity requirement”. Probably, this exception is taking into account those IP box regimes that, following BEPS Action 5, have implemented the nexus approach. In a similar manner, the new U.S. Model Income Tax Convention denies reductions to withholding taxes under the treaty for deductible related-party payments when the beneficial owner of the payment pays little or no tax on the related income as a result of a “special tax regime” 78. Moreover, countries may introduce specific anti-avoidance measures to counteract the risk of profit shifting related to certain items. It can be found, in general, an increasing use of SAARs or special measures to address BEPS concerns derived from IP income79. For instance, in France, article 11 of the Finance Act for 2012 (Loi de Finances pour 201280) restricts the conditions for deducting licensing royalties where the licensor and the licensee are related entities. A full deduction for the royalty expense may only be allowed if the licensee can demonstrate, and properly document, that: i) the use of the licence results in added value for the licensee over the entire licensing period; and, ii) such use is real (i.e. does not consist of an artificial scheme)81. In Austria, for example, since March 2014, royalties paid by an Austrian firm to a foreign recipient are not deductible when royalties are exempted or subject to an effective tax rate (ETR) of less than 10% at the recipient level82. It appears that these new rules were clearly designed to target patent box regimes 83. In this regard, it should be highlighted the proposal for amending the I+R Directive to include a minimum 78

The new U.S. Model Convention has been published in the website of the “U.S. Department of the Treasury” on 17 February 2016 [https://www.treasury.gov/resource-center/taxpolicy/treaties/Pages/treaties.aspx (accessed on 19 February 2016)]. 79

According to FREEDMAN, an increasing use of specific anti-avoidance legislation may produce more litigation and more uncertainty, thus “what we need is not more precise and detailed provisions but a principles or standards approach” (FREEDMAN, J.: “Defining Taxpayer Responsibility: In Support of a General Anti-Avoidance Principle”, British Tax Review, No. 4, 2004, p. 352). 80

Loi nº 2011-1977 du 28 décembre 2011 de finances pour 2012 [available at: https://www.legifrance.gouv.fr/affichTexte.do?cidTexte=JORFTEXT000025044460&categorieLien=id (accessed on 28 February 2016)]. 81

WORLDWIDE TAX SUMMARIES: Corporate Taxes www.pwc.com/taxsummaries (accessed on 28 February 2016)].

2015/16,

p.

675

[available

at:

82

MITTERLEHNER, K. & MITTERLEHNER, M.: “Tax Incentives on Research and Development (R&D). Austrian Report”, Cahiers de Droit Fiscal International, Vol. 100a, Sdu Uitgevers, The Hague, The Netherlands, 2015, pp. 142–144; SCHUCHTER, Y. & KRAS, A.: “Austria - Corporate Taxation (sec. 1.)”, Country Surveys IBFD (accessed on 30 June 2015). 83

DANON, R.J.: “Tax Incentives on Research and Development (R&D). General Report”, Cahiers de Droit Fiscal International, ob. cit., p. 53. It is important to highlight that, from the time being, Austria has not implemented a patent box regime, however indirect effects may arise in its territory from such kind of measures. In this sense, see: LOEPRICK, J.: “Indirect Access to Intellectual Property Regimes – Effects on Austrian and German Affiliates”, WU International Taxation research Paper Series, No. 13, 2015.

23

An approach to R&D (&I) tax incentives

effective taxation (MET) clause. Accordingly, any interest and royalty payment would be exempted from taxes in the Source State when the effective tax rate resulting from the tax regime applicable to those payments in the Residence State is at least 10%84. The proposed clause is, in fact, a specific anti-avoidance provision, which strengthens the effective taxation of interest and royalty payments in the Residence State. The current work on the MET clause is taking into consideration the nexus-compliant IP regimes as Member States may keep the possibility to provide companies effective tax incentives to invest in genuine R&D (&I) in the EU. Therefore, a balance between the R&D (&I) promotion and a minimum level of effective taxation should be kept in this context. On the other side, the Belgian patent income deduction does not apply to income from R&D performed under a development contract or cost-sharing agreement. According to the first paragraph of article 205/3 of the Belgian Income Tax Code (Code des Impôts sur les Revenus, CIR 92), income from IP acquired must be reduced by compensations paid to third parties for getting the IP and the amortizations applied to the acquisition value of the patents. Hence, such anti-abuse provision applies to patents acquired in order to avoid, first, a double deduction of the costs and, second, a double dip because of successive licences and sublicences85. b) The “(modified) nexus approach” as a specific anti-avoidance measure. The OECD sees preferential tax regimes as a key pressure area. In order for a regime to be considered preferential, the regime must, firstly, apply to income from geographically mobile activities –i.e. dividends, royalties or IP income–. Secondly, it must offer some form of tax preference –i.e. tax credit, tax allowance or lower tax rate– in comparison with the general principles of taxation in the relevant country –i.e. ability to pay or equality principles–86. Actually, as above-explained, the introduction of tax incentives implies to move from the general prohibition of granting fiscal privileges legitimated by tax justice criteria (mainly, ability to pay and equality) to the compatibility with the “extra fiscal goals” legitimated by constitutional values. The Action Plan on BEPS called for proposals to develop solutions to counter harmful tax regimes more effectively, taking into account factors such as transparency and substance (Action 5) 87 . Indeed, according to the Deliverable of BEPS Action 5, launched in September 201488, it was analysed that issue and proposed the application

84

Vid Supra Note 71.

85

DE MIL, M. & WALLYN, T: “Tax Incentives on Research and Development (R&D). Belgian Report”, Cahiers de Droit Fiscal International, Vol. 100a, Sdu Uitgevers, The Hague, The Netherlands, 2015, pp. 146 & 161. 86

OECD (1998): Harmful Tax Competition: An Emerging Global Issue, OECD Publishing, Paris, pp. 1935; OECD (2015): Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5: Final Report, pp. 19-22. 87

OECD: Action Plan on Base Erosion and Profit Shifting, OECD Publishing, Paris, 2013, pp. 17-18.

88

OECD (2014): Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5: 2014 Deliverable, OECD Publishing, Paris.

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of a “nexus approach” that aligns R&D expenditures with the conferment of tax benefits. Using such approach as a model, Germany and the United Kingdom issued a joint statement proposing a modified nexus approach (MNA) in November 2014. Under the MNA, which is inspired from existing input incentives and proportionate in nature, the benefits provided by patent boxes are linked to the qualifying R&D expenditure incurred by the taxpayer itself89. According to the Final Report of BEPS Action 5, launched in October 2015, a consensus has arrived on the “nexus approach” as the approach for requiring substantial activity for preferential regimes90. The eligible income for the tax regime is calculated applying the following formula: Qualifying expenditure incurred to develop IP asset Overall expenditure incurred to develop IP asset

x Overall income from IP asset

=

Income receiving tax benefits

In this formula, qualifying expenditures are defined as the expenditures directly connected to the IP asset; in particular, R&D (&I) expenditures incurred by the taxpayer itself and expenditures for unrelated-party outsourcing. By contrast, overall expenditures will include the both mentioned categories, plus acquisition costs and expenditures for related-party outsourcing. Therefore, a taxpayer may benefit from an IP regime only to the extent that he has itself incurred in qualifying R&D expenditures for raising the IP income. However, further aspects on the application of the nexus approach are met in the Final Report of BEPS Action 5 (i.e. qualifying taxpayers, IP assets, etc.). In regard of qualifying expenditures, jurisdictions may allow taxpayers to apply a 30% “up-lift” to expenditures that are included in qualifying expenditures with the purpose to benefit taxpayers undertaking themselves R&D (&I) activities, but without penalizing taxpayers for acquiring IP or outsourcing R&D activities to related parties. As a result, qualifying expenditures will be increased, provided that they do not exceed overall expenditures. Therefore, patent box regimes are now facing a new scenario. The initiatives launched both by the OECD in developing BEPS Action 5 and by the EU within the Code of Conduct, represent a turning point for the existing regimes. A new deadline is in the horizon and as far as the States affected by this process follow the new rules, only those regimes compliant with the new standards will survive in a near future91. Some existing 89

OECD (2015): Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5: Final Report, p. 25; DANON, R.J.: “Tax Incentives on Research and Development (R&D). General Report”, ob. cit., p. 45; SANZ-GÓMEZ, R.: “The OECD’s Nexus Approach to IP Boxes: A European Union Law Perspective”, WU International Taxation Research Paper Series, No. 2015-12. 90

A total of 43 preferential regimes have been reviewed, out of which 16 are IP regimes. In respect of substantial activity the IP regimes reviewed were all considered inconsistent, either in whole or in part, with the nexus approach as described in the Final Report of BEPS Action 5. 91

Accordingly, new entrants will not be allowed in any existing IP regime inconsistent with the “nexus approach” after 30 June 2016. If a new regime in line with the “nexus approach” takes full effect before

25

An approach to R&D (&I) tax incentives

regimes have already been amended in order to be in line with the “nexus approach”, i.e. Italy or Spain (which will be further developed in section 4.2). Thus, the “nexus approach” can be seen as an anti-avoidance measure. As it is commonly held, SAARs usually fix a link between the tax avoidance and the lack of valid economic reasons 92 . This means, a sensu contrario, that the presence of an economic valid justification avoids the application of the SAAR. In the case of an IP box regime, the fulfilment of the “nexus approach” requirement implies there is a substantial and genuine economic activity behind the IP income that will apply to the preferential tax treatment. Hence, only income that arises from IP where the actual R&D (&I) activity was undertaken by the taxpayer itself will benefit from the IP box regime (excluding its consideration as harmful preferential tax regime). c) The coexistence between CFC rules and IP box regimes. The so-called controlled foreign company (CFC) legislation is targeted to prevent tax avoidance via CFCs located in low tax jurisdiction. As it is commonly held, CFCs provide opportunities for profit shifting and long-term deferral of taxation. There is no doubt that a tax credit on R&D or a patent box regime imply a tax advantage, in terms they provide taxpayers carrying out such kind of activities with a better tax treatment. The OECD Action Plan stresses the need to address base erosion and profit shifting using CFC rules. In particular, “OECD wishes to see uniform CFC rules to counter BEPS (…) positive “spill-over” effects of CFC rules due to the result that taxpayers would have a much reduced incentive to shift profits into a low tax jurisdictions” (OECD, July 2013). Indeed, CFC rules lead mainly to income inclusions in the residence country of the parent company, but also they have positive spill-over effects in source countries because taxpayers have no (or much less of an) incentive to shift profits into a third, low tax jurisdiction93. Action 3 of the OECD Project recognizes that corporate groups may create low-taxed non-resident affiliates to which they shift income and that these affiliates may be established in low-tax countries wholly or partly for tax reasons rather than for non-tax business reasons 94 . CFC rules allow counteracting such elusive practices; however, 30 June 2016, new entrants will not be allowed in the existing IP regime after the compliant IP regime has taken effect. It is considered that amendments to bring a regime into line with the “nexus approach” must commence in 2015. That is the case, for instance, of Italy or Spain. Jurisdictions are also allowed to introduce grandfathering rules (i.e. Spain) that will allow all taxpayers benefiting from an existing regime to keep such entitlement until a second specific date (“abolition date”). The period between the two dates should not exceed 5 years (so, 30 June 2021 at maximum). After that date, no more benefits stemming from the respective old regimes may be given to taxpayers (OECD (2015): Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5: Final Report, pp. 34-35). 92

According to SOLER ROCH, at the Spanish level, the majority of SAARs are based on the absence of valid corporate or economic reason different from tax saving (SOLER ROCH, M.T.: “Las normas antiabuso generales y especiales”, VII Jornada Metodológica de Derecho Financiero y Tributario Jaime García Añoveros, Instituto de Estudios Fiscales, No. 12, 2011, from p. 177). 93

OECD: Public Discussion Draft. BEPS Action 3: Strengthening CFC rules, 12 May 2015.

94

OECD (2015): Designing Effective Controlled Foreign Company Rules, Action 3: Final Report, p. 11.

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Elizabeth Gil García

some countries do not currently have CFC legislation (i.e. Figure 1) and others have rules that do not always counter BEPS situations in a comprehensive manner95. In order to establish whether CFC rules apply, several questions must be considered according to Action 3. Firstly, a CFC should be treated as controlled where residents hold, at a minimum, more than 50% control (either direct or indirect). Such control could refer to a legal control (voting rights held in a subsidiary), economic control (rights to the profits, as well as capital and assets of a company in certain circumstances), de facto control (i.e. who takes the top-level decisions regarding the affairs of the foreign company) or control based on consolidation (related to accounting principles). Once a foreign company has been determined to be a CFC, the next question is whether the income earned by the CFC raises BEPS concerns and therefore should be attributed to controlling parties. As a matter of fact, not all CFC income should be attributed under CFC rules. That is, in some cases the set-up of non-resident affiliates could be based on business reasons (i.e. the availability of employees, the nature resources, etc.). So, income that arises from economic and value creating activities should be excluded from the scope of the CFC legislation. In the same vein, the ECJ, in Cadbury Schweppes case (C-196/04), stated that the use of CFC rules is justified when, in order to prevent tax avoidance, they are specifically targeted to wholly artificial arrangements which do not reflect economic reality and whose only purpose would be to obtain a tax advantage. As a result, especially in the EU framework, a substance analysis is required to only subject taxpayers to CFC rules if the CFCs are not involved in genuine economic activities. As above-mentioned, since intangibles are highly mobile, royalties and other IP income can easily be diverted from the location where the value of the intangible was created or developed. 100%

PARENT COMPANY

100%

Country P R&D CENTRE

IP-HOLDING COMPANY

55%

Country C

IP transfer

COMPANY B Country B

IP license

IP license

COMPANY A1

COMPANY A2

Country A

Figure 2: IP structures

95

The first CFC rules were enacted in 1962. Currently, 30 of the countries participating in the OECD/G20 Project on BEPS have CFC rules, and many others have expressed interest in implementing them (OECD (2015): Designing Effective Controlled Foreign Company Rules, Action 3: Final Report, p. 9).

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An approach to R&D (&I) tax incentives

In Figure 2, Country C has a high-technology environment. Therefore, the Parent Co. (located in Country P, which provides with CFC rules) has established an R&D Centre there because of the availability of qualified employees, good facilities and resources. It has also set-up an IP-Holding Co. due to the strong protection through IP rights as well as the preferential tax treatment. Company B, an associated entity resident in Country B, buys the intangibles created by the R&D Centre and held by the IP-Holding Co. for its direct use within its industrial process. Additionally, it licenses patents to Co. A1 and Co. A2, located in Country A. Royalties and IP income could be used to shift purely passive income, that is, income that does not arise from any substantial economic activity. However, IP-derived income is not always addressing BEPS concerns. For example, in Figure 2, the Parent Co. has set-up non-resident affiliates based on business reasons (i.e. innovate environment). Even if the R&D Centre, located in Country C, has created the IP asset, the Parent Co. has been responsible for much of the value creation, as it holds the 100% of its shares. Moreover, Company B is using (and probably further developing) IP acquired for a direct use and exploitation. Thus, behind the income received from the direct use and exploitation there is certain economic activity (i.e. developing new products through the IP acquired). However, Co. B is licensing those patents acquired from the IP-Holding Co. to companies located in Country A. Then, in such case, there is not a real activity, because Co. B is just licensing IP acquired and obtaining royalty income for such nonvalue-creating transaction. Therefore, in a similar way as Action 596, a substance analysis looks to whether or not the CFC is engaged in substantial activities for determining what income is considered as “CFC income”. The mentioned analysis can apply as either a threshold test or a proportionate analysis97. In the first case, under a threshold (or “all-or-nothing”) test, a set amount of activity (as identified through one or more proxies) would allow all income of the CFC to be excluded. A CFC that had not engaged in this amount of activity would have all of its income included in CFC income. Secondly, under a proportionate analysis, CFC income would only exclude the amount of income that was proportionate to the amount of activity that the CFC had undertaken. For example, if the CFC had undertaken 75% of the activity that would have to in fact be performed to earn the CFC’s income, then 25% of its income would be treated as CFC income. In regard of the different ways a jurisdiction may design a substance analysis, BEPS Action 3 provides with a specific option for IP provisions. In such a way, IP income earned by the CFC that met the requirements of the “nexus approach” would not be included in CFC income. In Figure 2, the IP-Holding Co. is a controlled party (100%) whose income will be attributed to the Parent Co., as it does not develop any substantial activity. On the other side, Company B should be as well treated as a controlled entity 96

OECD (2015): Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5: Final Report, from p. 24. 97

OECD (2015): Designing Effective Controlled Foreign Company Rules, Action 3: Final Report, pp. 4749.

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because Parent Co. holds more than 50% control. Thus, once the requirements to be a CFC are met, the following step is whether or not the income earned by the CFC should be attributed to controlling parties. Consequently, if the taxpayer shows that income would qualify for benefits under a nexus-compliant IP regime in the CFC jurisdiction, such IP income would not be attributed and neither subject to CFC legislation. For example, in Figure 2, the IP income of Co. B is based on the direct use of IP acquired and on the IP license of IP acquired. Obviously, in this latter case, there is no kind of substantial economic activity (“passive income”), so royalties would not be eligible for a compliant IP regime and will be treated as CFC income. On the other side, it should be assessed the level of further development of the IP acquired for the direct use and exploitation. That is, whether Co. B has incurred itself or not in qualifying expenditures. To conclude, CFC legislation should not apply to IP income eligible for patent boxes that are in line with the “nexus approach”. Compliant IP boxes imply that are only granting a special tax treatment to IP income generated by genuine activities. So, the risk of profit shifting disappears. On the other hand, it is important to highlight that the “nexus approach” is compulsory, while the Action 3 on CFC rules contains just recommendations for strengthening these mechanisms. 4. INPUT AND OUTPUT INCENITVES: DESIGN ISSUES 4.1. Input incentives. Input incentives are designed to stimulate R&D (&I) investments. The interest of the Tax Law is based on the need of firms to invest in R&D (&I), being an indirect mean of supporting R&D (&I). Input incentives may take different forms, such as: i) a tax credit which reduces the tax liability; ii) favourable tax rates for the enterprise conducting R&D activities or special exemptions from payroll taxes for its R&D personnel; iii) a mere R&D deduction for current and capital expenditures; and iv) a so-called super deduction allowing the eligible taxpayer to deduct more than 100% of his qualified R&D expenses in order to arrive at a lower taxable income. In general, when introducing an input incentive the dichotomy is: tax credit vs. tax allowance. On the one hand, tax allowance or extra amount over current business expenses deducted from gross income to arrive at taxable income, it is said, that leaves untaxed an amount of income. On the other hand, tax credits or amounts deducted from tax liability –that implies a reduction of the tax owed–98. Traditionally, tax credits for R&D expenditures have become more popular than tax allowances. Tax allowances let firms investing in R&D (&I) to deduct more from their taxable income than they actually spend on R&D (&I). Tax credits are a specified percentage of R&D (&I) expenditures which are applied against payable income tax. In

98

OECD (2002): Tax Incentives for Research and Development: Trends and Issues, OECD Publishing, Paris, p. 12.

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An approach to R&D (&I) tax incentives

conclusion, an allowance is a deduction from taxable income, while a credit is a deduction against final tax liability. The OECD also points out two other distinctions between allowances and credits: i) the value of a tax allowance depends on the corporate income tax rate, while a tax credit does not; and ii) unused tax allowances may be carried forward to offset future tax under normal loss carry forward provisions, while the carry forward of unused tax credits requires the creation of a special pool to track unused credits99. Spain, for instance, has traditionally granted a tax credit on R&D expenses for companies carrying out this type of activities. Since 2000, a tax credit on technological innovation is also granted. Thus, article 35 of the CITA provides with a tax credit on R&D&I, allowing the deduction of a percentage of R&D&I expenditures. 4.2. Output incentives. For a few years now, income from certain types of R&D intangibles can benefit from special tax measures that may take the form of tax allowances, exemptions or lower effective tax rates, among others. The asserted aim pursued by governments in the introduction of IP boxes is to make innovation more attractive and profitable for companies 100 . Patent boxes are officially aimed at fostering the creation and development of new R&D intangibles and/or at enhancing the direct use of those intangibles in the carry-on of a business, with a view to increase the positive spill-overs of such creation and exploitation and, as a consequence, the social welfare. Generally speaking, IP boxes provide an incentive on the basis of reduced tax for economic operators to develop new innovate products and processes or to perform services 101. In fact, the aim of the patent box regime is to provide an additional incentive for companies to retain and commercialise existing patents and to develop new innovate patented products102. A debatable point in this regard is the need to fund the results of R&D (&I) processes. That is, intangibles are protected under the IP rights scope, so the question is whether it is necessary an additional protection through the tax system.

99

OECD (2002): Tax Incentives for Research and Development: Trends and Issues, OECD Publishing, Paris, p. 14. 100

Currently, the patent box regime is basically a European tax incentive. In total, twelve Member States are granting an IP box regime: Belgium, Cyprus, France, Hungary, Ireland, Italy, Luxembourg, Malta, Netherlands, Portugal, Spain and United Kingdom. Moreover, in 2011, Liechtenstein and the Swiss canton of Nidwalden introduced the patent box regime. On the other side, Switzerland is performing a tax reform with a strong package of measures to encourage R&D activities, including an IP box proposal based on the nexus approach. For its part, United States launched, in July 2015, a discussion draft for implementing a patent box regime. Finally, in India, the Union Budget, 2016 has advanced the concept of “Make in India” to “Invent in India” by introducing the patent box regime: a concessionary 10% tax rate for income arising out of certain IP developed and registered in India. 101

FELDER, M.: IP Boxes from a European, Liechtenstein and Swiss Perspective, Schulthess Verlag, Zurich, 2013, p. 1. 102

PÉREZ BERNABEU, B.: “R&D&I Tax Incentives in the European Union and State Aid Rules”, ob. cit., p. 181.

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As above-mentioned (section 3.2), IP box regimes are facing a new scenario and only those regimes compliant with the new standards will survive in a near future. This is the case of Spain, which has taken a pioneer position in the alignment of its regime to the nexus approach. In such a way, the regime grants benefits when there is a substantial activity on R&D (&I). The Spanish regime is more restrictive than the OECD’s nexus approach, as it limits the IP scope as well as the formula for calculating the IP box base. For that reason, it will be taken the Spanish case as an example for analysing the structure and elements of IP box regimes. A)

Qualifying taxpayers.

In order to ensure equality of treatment between all potential beneficiaries, patent box regimes shall be extended to all taxpayers developing qualifying R&D (&I) intangibles, irrespective of their legal form (legal entities, partnerships or self-employed) 103. In this vein, the Final Report of BEPS Action 5 states that “qualifying taxpayers” would include resident companies, domestic permanent establishments (PEs) of foreign companies, and foreign PEs of resident companies that are subject to tax in the jurisdiction providing benefits104. In Spain, all types of companies may apply for the patent box regime. It should also be noted that non-resident companies, which derive income in Spain through permanent establishments (PEs), also qualify for the patent box regime105. In addition, the patent box regime applies to group companies. In this vein, the Encourage Entrepreneurs Act introduced into article 23.4 of the CITA the obligation for the companies in a tax consolidation to document all of the transactions associated with the application of the patent box regime, according to the Spanish transfer pricing rules. However, the current CITA (Act No. 27, November 2014) abolishes this provision. Consequently, the question is whether this obligation has really been abolished or is implicitly required. With regard to self-employed individuals, such individuals do not, in practice, apply to use the patent box regime. Self-employed individuals are not considered to be taxpayers for corporate income tax purposes, unless they carry out their economic activities in the form of a legal entity. As a result, individual entrepreneurs are subject to Impuesto sobre la Renta de las Personas Físicas (individual income tax) and, as not being corporate income taxpayers, cannot benefit from article 23 of the CITA. However, the Ley del Impuesto sobre la Renta de las Personas Físicas (Individual Income Tax Law, LIRPF) states that individual entrepreneurs may use the “estimación directa” method, instead of

103

This is recommended by Prof. DANON R.J. in “Avis de droit: La constitutionalité des mesures fiscales proposées par la troisième réforme de l’imposition des entreprises (RIE III)”, published on the website of the Finance Minister of the Swiss Federation [http://www.efd.admin.ch/00468/index.html?lang=fr&msgid=57551 (accesed: 21 June 2015)]. 104

OECD (2015), Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5: Final Report, October 2015, p. 25. 105

Ley del Impuesto sobre la Renta de No Residentes (Law on Income Tax on Non-Residents, LIRNR), art. 5.

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An approach to R&D (&I) tax incentives

the “a forfait” method in calculating the tax base. 106 This means that net profits are calculated according to the provisions of the CITA. As a result, in such cases, selfemployed individuals may be able to access the patent box regime. B)

Eligible IP rights.

The first question that arises when designing an output incentive is the identification of IP rights or IP assets that will benefit from the incentive. In general, there are two possibilities. Under a “narrow approach”, the benefit of the incentive is typically limited to patents, and to expertises, secret formulas, processes, plans and models (trade intangibles). This is the case of Portugal, United Kingdom or France. On the other side, under a “broad approach”, the incentive is also extended to trademarks, domain names and software copyrights (market intangibles). This is the case of Luxembourg or Italy. While trade intangibles often are created through risky and costly R&D activities, marketing intangibles have an important promotional value for the product concerned. In other words, trade intangibles are basically concerned with the production of goods while marketing intangibles are used in promoting the sale of goods or services107. Under the nexus approach, the only IP assets that could qualify for tax benefits under an IP regime are patents and other IP assets that are functionally equivalent to patents if those IP assets are both legally protected and subject to similar approval and registration processes. Marketing-related IP assets can never qualify for tax benefits under an IP regime108. The question is therefore what other IP assets are functionally equivalent. Following BEPS Action 5: i) patents defined broadly (i.e. utility models or supplementary protection certificates; ii) copyrighted software; and, iii) other IP assets that are non-obvious, useful, and novel. As a result, generally speaking, under the expression “patents and other IP assets that are functionally equivalent”, BEPS Action 5 is taking the position of the “narrow approach” for defining the IP scope of such regimes. In Spain, the IP scope is defined from a positive and a negative perspective. That is, the law not only refers to the eligible IP assets, but also expressly exclude those assets, which, in spite of their high creative value, do not benefit from the patent box regime. From a positive perspective, the patent box regime is available in respect of “patents, drawings or models, plans, secret formulas or processes”. This kind of IP assets may access to public registers and its protection is covered by different IP laws. However,

106

According to article 30.1 of the LIRPF, in general, the method for the calculation of the tax base with regard to the net income derived from economic activities is the “estimación directa” method. Article 31 of the LIRPF provides for the “a forfait” method with regard to certain types of activity. In practice, a large number of individual entrepreneurs use this method. The criteria for using one or another method depends on the trade volume and the kind of activities performed. As a result, the “estimación directa” method is compulsory for those individual entrepreneurs who cannot apply the “a forfait” method or for those who, in meeting the relevant the requirements, opt for it. 107

OECD (2010), Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Paris, 22 July 2010, pp. 192-194. 108

OECD (2015), Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5: Final Report, October 2015, pp. 26-27.

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such access is independent for the eligibility of the incentive according to the administrative practice109. On the other hand, “undisclosed information with industrial, commercial or scientific value”, i.e. know-how, formes part of the scope of IP for the patent box regime110. The problem in relation to know-how is, first, the lack of a legal definition in the Spanish system and, second, the difficulties of distinguishing knowhow from technical services111. From a negative perspective, it is explicitly excluded the following items from the application of the patent box regarding the transfer or licensing of: (1) trademarks; (2) literary, artistic or scientific works; (4) industrial equipment; (5) image rights; (6) computer programs. Therefore, the Spanish patent box regime is defined under the “narrow approach” because it refers to “patents and other IP assets that are functionally equivalent to patents”, on the understanding that “functionally equivalent” implies “patents defined broadly”. C)

IP box base.

According to BEPS Action 5, income benefiting from the IP box should be (i) proportionate and (ii) limited to IP income. First, income benefiting from the regime should not be disproportionately high given the percentage of qualifying expenditures undertaken by qualifying expenditures. This means that income should not be defined as the gross income. Second, income should only include income that is derived from the IP asset. This may include royalties, capital gains and other income from the sale of an IP asset112. In general terms, both royalties derived from the licensing of intangibles and capital gains derived from the sale of intangibles may qualify for patent box regimes. Moreover, in some cases, IP box regimes also apply to the so-called “embedded royalties”. These are the hypothetical licence fee payments that a taxpayer would have received had the IP assets been used by the taxpayer itself in the manufacture of patented products. With regard to the determination of the base for the patent box regime, jurisdictions already in line with the nexus approach are following the formula contained in the Final Report of BEPS Action 5. It is the case, for instance, of Ireland, which applies its Knowledge Development Box since January 2016. Thus, in case of Spain, the following formula is used for determining the base of the regime: 109

The Spanish Dirección General de Tributos (General Directorate of Taxes, DGT), Tax Ruling No. V1881-12. 110

According to DGT, Tax Ruling No. V2788-15, know-how, which is considered to be industrial, commercial or scientific information, is not part of the scope of the IP in respect of the patent box regime in article 23 of the CITA. 111

SALGADO BARCA, M. B. & PALLARÉS RODRÍGUEZ, R.: “El patent box en España: análisis del artículo 23 del LIS”,, ob. cit., p. 76. 112

OECD (2015): Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5: Final Report, p. 29.

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An approach to R&D (&I) tax incentives

60% x

Direct expenditures related to the IP creation (increased in a 30%) Overall expenditures related to the IP creation

As the Spanish patent box regime is more restrictive than the OECD’s nexus approach, it does, however, raise the question as to whether or not this is the best regime for Spanish companies in terms of competitiveness. 5. CONCLUSIONS The lack of clarity implies a serious obstacle to make firms invest on R&D (&I). Then, a clear and concise concept is required. The certainty of the concept and the predictability of the measure may highly contribute to the effectiveness and efficiency of the policy. OECD Manuals provide with internationally accepted definitions, but it is important to underline that they are not providing tax definitions. In the author’s opinion, R&D&I are phases of the same process lead to the implementation of technologically new or improved products, services or processes. Hence, the provision of a different tax treatment to R&D and innovation would not have sense. On the other hand, the novelty condition should be measured at the market level, because R&D (&I) activities are not an end in itself, but only a means towards improving the companies’ activity. Finally, it is not only important the promotion of R&D&I, but also the encouragement of knowledge transfer. It is essential that scientific activities carried out by research operators “go beyond the walls of the laboratory” and benefit the society as a whole. The introduction of special tax measures is based on the existence of constitutional values or other public interests. These constitutional values and public interests allow governments to create special measures to attract firms to carry out particular businesses within its territory (extra fiscal goals). From an economic view, it could be debatable the assumption of the “market failure” idea in order to justify fostering R&D (&I) by means of public funding. Indeed, competitiveness, excellence or prestige may play an incentive role in many cases, irrespective of any tax policy measures. Nevertheless, in some cases, the lack of market incentives leads to the underinvestment on R&D (&I), so State intervention pursues to make innovation attractive and profitable for firms. It is, then, necessary to fund R&D (&I) that would not otherwise have been undertaken. Proportionality is required when granting tax incentives. Thus, a measure will be proportional when keeps a fair balance between the effectiveness in achieving the objective (i.e. fostering R&D (&I) activities) and the impact of the measure on the public resources. This point links with the justification of R&D (&I) aids. Indeed, the area of justification is grounded on the incentive effect, the aim of public interest pursued and, specially, on the proportionality of the measure.

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