08 January 2019
Incentivizing private sector R&D in India
Source: By Gaurav S. Ghosh: Mint
In recent years, many countries have experimented with tax and economic policies to stimulate home-grown innovation. These include cash grants and other types of financial support; tax credits, deductions, exemptions and holidays; and accelerated tax depreciation rates. One policy that has been rapidly gaining popularity is the ‘patent box’. While specifics may vary, all patent boxes have one common feature: they offer concessional tax rates for income accruing to patents. There are two intentions behind a patent box. The first is that it will lead to more home-grown research and development (R&D) and thus local innovation. Second, it will reduce erosion of the income tax base.
The economic rationale is straightforward. Because of the tax cost advantage conferred by the patent box, the relative cost of local R&D production is lowered. This means that local companies are incentivized to expand their R&D and patent-generation activity, meeting the first intention. Likewise, corporate groups are disincentivized from shifting intellectual property (IP) ownership abroad—and perhaps incentivized to transfer ownership of foreign IP to the home country—because the ratio of the tax rates on IP-sourced income is tilted in favour of the home country. This meets the second intention.
The appeal of the patent box vis-à-vis other R&D-related incentives lies in the second intention. Incentives like tax credits may incentivize local R&D generation, but do not incentivize in-country retention of IP ownership. As a result, corporate groups have a record of using transfer pricing mechanisms like contract R&D and cost sharing to avail of local R&D tax incentives, while maintaining IP ownership abroad in a low-cost jurisdiction. Under such an arrangement, IP income collects in the foreign jurisdiction, while the R&D cost is incurred in the home jurisdiction. The home jurisdiction loses the tax income generated by the asset that it subsidized through its tax breaks.
India introduced its own patent box in the Finance Bill (2016) by inserting Section 115BBF into the Income Tax Act. By doing so, it joined Brazil, Turkey, Singapore and a host of European countries in having patent-related incentives. Under Indian rules, royalty income from patents developed and registered in India is taxed at a concessional 10% rate (plus applicable surcharges). The concessional rate is applied to gross income or revenue.
Indian patent box rules are beneficial for the first intention, i.e. to stimulate home-grown R&D. This is because its concessional rate applies to gross income instead of net income, as is the case in most other jurisdictions. At first glance, the gross income rule seems a negative: it leads to the concessional rate being applied to a larger base, in turn leading to a larger tax payment. However, a closer look shows that the rule is beneficial, and leads to greater tax savings for the firm undertaking R&D.
To see why this is so, we need only note that since R&D costs are not deducted from IP income, they will be deducted from the firm’s other income, to which the standard corporate income tax rate applies. In general, a unit reduction to the tax base reduces taxes paid by the applicable tax rate. Hence, a deduction applied to ‘other income’ reduces taxes paid in proportion to the statutory corporate income tax (CIT) rate, while a deduction applied to royalty income reduces it only in proportion to the patent box rate. Since the patent box rate is lower than the CIT rate, the gross income rule is beneficial to the taxpayer.
Indian patent box rules may not be as effective in satisfying the second intention, i.e. preventing base erosion. The main reason for this is that eligibility rules are quite restrictive, more restrictive than those in other jurisdictions. One restriction is that only royalty income is eligible for patent box treatment. This means that a firm can only use this rate when it licenses out its IP. If, on the other hand, it uses its self-developed IP on its own products and services, then no explicit royalty payments are made and the patent box does not apply. Other countries do not have this restriction because they include “embedded” royalty payments in their patent boxes: hypothetical payments that would have accrued to the IP owner, if the IP were licensed to outside parties instead of being used internally.
Another restriction is that the patent box does not apply to IP that is developed in other countries, but then transferred to India. This removes the incentive for corporate groups to transfer existing foreign IP to India, as happens in jurisdictions without this restriction.
A third restriction is that the patent box is only available for Indian patents. It does not apply to Indian patents-in-progress or to Indian R&D that has resulted in US, European or other foreign patents. Apart from these restrictions, the Indian patent box rate is higher than in other jurisdictions. Despite the gross income rule, total taxes paid on R&D activity may therefore be lower in other countries, leading to India suffering a cross-country tax cost disadvantage.
In summary, the patent box is an important step in making India an attractive destination for R&D investment. It shows that the Indian administration is cognizant of the latest trends in tax policy and seeks consistency with global practice. The gross income rule is a positive step in providing tax benefits for R&D production. However, eligibility criteria remain restrictive and the overall tax burden on R&D is higher than in some other countries. These factors may militate against India establishing itself as an attractive R&D destination.
This analysis must be caveated because the international tax environment is in flux. Of particular importance is Action 5 (Countering Harmful Tax Practices More Effectively, Taking Into Account Transparency and Substance) of the OECD’s BEPS Plan. Countries are already changing their IP treatment rules with major consequences for India’s efforts to develop into an R&D powerhouse. But this is a topic for a separate analysis.