Changes to KDB, R&D and digital games tax credits

What updates were announced in Finance Act 2022?

04 April 2023

17 min read

As published in Issue 1 2023 of Irish Tax Review

The research and development (R&D) tax credit is a key incentive for companies performing R&D in Ireland. The consistency of the rate of Ireland’s R&D tax credit together with the various legislative enhancements to the credit since its introduction in 2004 have helped companies to plan their R&D investment in Ireland. The availability of the R&D tax credit, when combined with IDA Ireland’s R&D-related grants, is often the tipping point in investment decisions when Ireland is compared with other jurisdictions. Damien Flanagan and Cian Smith of our R&D Incentives team explain the changes to innovation tax credits announced in Finance Act 2022.

The regime provides for a credit of 25% on qualifying expenditure on R&D activities. Until the introduction of Finance Act 2022, the credit was first used to reduce a company’s corporation tax liability. Where a company had offset current and previous years’ corporation tax liabilities, the credit was then available as a cash refund and was typically paid out in three instalments spread over three years.

In 2022 the Department of Finance conducted a public consultation on the R&D tax credit, and key stakeholders, including multinational companies, indigenous companies, industry bodies and R&D tax credit practitioners, submitted recommendations for improvements to the regime. The main changes that were recommended sought to ensure that the R&D tax credit regime is aligned and compliant with new international definitions of refundable tax credits with the introduction of the OECD’s minimum tax proposals under Pillar Two.

Finance Act 2022 gives effect to a number of these recommendations, and this article considers the details of the Finance Act changes for the R&D tax credit regime, the Knowledge Development Box (KDB) and the digital games tax credit.

Impact of international tax reform on R&D tax credits

Before discussing the Finance Act 2022 changes for the R&D tax credit regime, it is important to consider the backdrop of international tax reforms that have taken place recently. The main reform is the proposed implementation of the OECD’s Pillar Two.

OECD BEPS Pillar Two

The OECD’s Pillar Two Model Rules introduce a new global minimum effective tax rate of 15% for large multinational groups. EU Member States have now reached agreement on implementing the Pillar Two rules, and it is likely that the 15% minimum effective tax rate for multinational enterprise groups will apply in the EU (including Ireland) from 1 January 2024. Under the new rules, “a qualified refundable tax credit” is treated as income and recognised for the purposes of the calculation of a company’s effective tax rate.

Where the Irish R&D tax credit regime fails to meet the criteria of a “qualified refundable tax credit”, the R&D tax credit would instead be treated as reducing covered taxes. A non-qualifying refundable tax credit will therefore result in a lower effective tax rate (as covered taxes are reduced) for the company than a credit that meets the definition of a qualifying refundable tax credit, resulting in potentially higher top-up taxes payable under the Pillar Two rules.

As a result, jurisdictions that offer qualified refundable tax credits will naturally be more attractive to groups within the scope of Pillar Two than those with non-qualified refundable tax credits.

Before Finance Act 2022, the R&D tax credit regime in Ireland did not meet the Pillar Two requirements for a “qualified refundable tax credit” due to the obligation for taxpayers to use the credit, in the first instance, to reduce the corporation tax liability of a company. The definition of a “qualified refundable tax credit” requires the credit to be implemented in such a way that it must be able to be paid as cash or available as a cash equivalent within four years of satisfying the conditions to receive the relief.

“Available in cash” includes the ability to offset the refundable amount against other tax liabilities (outside of corporation tax) owing to the tax authority. Before Finance Act 2022, the Irish R&D tax credit regime provided that in most instances the tax credit would be refundable within four years. However, certain companies that were loss making with insufficient payroll liabilities, in accordance with the application of s766B of the Taxes Consolidation Act 1997 (TCA 1997), were not eligible to obtain the refund within four years.

The OECD Commentary on Pillar Two provides further detail on the criteria to be a “qualifying refundable tax credit”. These include the requirement that the refund amount is not limited to any “tax liability”. “Tax liability” is not defined in the Commentary. A broad interpretation of the term could include payroll taxes (although should not include a limit based on payroll costs).

The refundable amount previously eligible under s766(4B) TCA 1997 was limited by the amount of corporation tax or payroll liabilities in accordance with s766B TCA 1997. Therefore, there was a risk that the R&D tax credit, as it stood, would not have been considered a “qualified refundable tax credit” under Pillar Two.

Changes to R&D tax credit regime: Finance Act 2022

In the context of the above international tax reforms and following the Department of Finance’s public consultation on the R&D tax credit, Finance Act 2022 included a number of changes to the operation of the regime that seek to future-proof it by ensuring that it meets the requirements of international tax reforms. These changes focus on how companies can claim the benefit of the R&D tax credit.

The new regime, which we discuss further below, applies to accounting periods where the specified corporation tax return date is on or after 23 September 2023 (for companies with a year-end of 31 December, for example, this means that the new regime is being introduced for their accounting period that commenced on 1 January 2022). Transitional rules will apply, allowing companies to make an R&D tax credit claim under the old regime; however, the old regime will not be available in respect of R&D expenditure incurred in an accounting period that commences on or after 1 January 2023. This essentially provides for a one-year transition period to the new regime.

We will now discuss each of the main updates to the R&D tax credit regime.

The most significant change to the R&D tax credit regime included in Finance Act 2022 is that the current method of offsetting the credit against corporation tax (in priority to the credit’s being processed via a cash refund) will no longer be available. Instead, companies will be required to claim the R&D tax credit via a new three-year fixed payment schedule, with no option to offset the full R&D tax credit amount against corporation taxes paid or owing. This will mean that a certain cohort of companies will experience a negative cash-flow impact as those companies that paid more corporation tax than their R&D tax credit claim will no longer be able to get a full refund of the corporation tax paid in “year 1”. Companies will have the option to specify that any part of each instalment be offset against their tax liabilities (not limited to corporation tax).

This amendment to the payable element of the R&D tax credit is designed to enable the regime to align with the new international definitions of refundable tax credits. This has been achieved through substantial structural changes to the way in which companies can access the benefits provided by the credit.

How does the new cash refund system work?

The newly introduced s766C TCA 1997 (R&D expenditure other than a building or structure) sets out the new three-year fixed payment schedule, which will be calculated as follows:

The first payable instalment, in year 1, shall equal the greater of:
- €25,000 or, if lower, the amount of the R&D tax credit and
- 50% of the amount of the R&D tax credit.
The second payable instalment, in year 2, shall be three-fifths of the remaining balance of the R&D tax credit.
The last payment, in year 3, shall be the remaining balance of the R&D tax credit in respect of the accounting period, less the sum of the first and second instalment amounts.

In other words, the tax credit is likely to be received by many companies in a 50:30:20 split over three years.

By way of example, if a company submitted an R&D tax credit claim with a total value of €400,000 for the year ended 31 December 2022 and opts to claim under the new regime, the fixed payment schedule would be as follows:

The first instalment would be €200,000 (i.e. €400,000 x 50%) and claimed in the company’s corporation tax return for the year ended 31 December 2022.
The second instalment would be €120,000 (i.e. €400,000 – €200,000 = €200,000 x 3/5 = €120,000) and claimed in the company’s corporation tax return for the following accounting period.
The third instalment would be the remaining €80,000 (i.e. €400,000 – €200,000 – €120,000 = €80,000) and would be claimed in the further following accounting period.

Section 766D TCA 1997, the second new section introduced, provides for payment of the R&D tax credit over a three-year period in respect of expenditure on buildings or structures used for qualifying R&D activities. The payment schedule is broadly the same as outlined above, i.e. 50:30:20.

The new provisions in s766C and s766D also provide for the payment of the R&D tax credit in full within 48 months from when a “valid claim” is made, i.e. where all conditions to qualify for the R&D tax credit are met, which includes satisfying Revenue in respect of the company’s entitlement to the R&D tax credit by furnishing any information that may reasonably be required. The “valid claim” provision would appear to have been introduced to satisfy the definition of a “qualified refundable tax credit” under Pillar Two (i.e. the credit must be paid as cash or available as a cash equivalent within four years of satisfying the criteria to receive the relief).

The previous limits with respect to the payable/refundable R&D tax credit amount, which were linked to the corporation tax paid by the company in the previous 10 years or the payroll taxes remitted by the company for the relevant periods, have been removed in full from s766B.

This is a positive change as it means that claimants will no longer have any limitation on the amount of their R&D tax credit that is refundable and they will not need to carry out complex calculations to determine the cap that applies to their payable R&D tax credit claims.

The amendment to make the first €25,000 of a claim for R&D expenditure payable in full in “year 1” will provide a cash-flow benefit for companies carrying out smaller R&D projects and as a result will likely encourage more companies to engage with the regime.

Under the old regime, where a company sought a cash refund of an R&D tax credit of €25,000, this would have been split into three instalments over a period of 33 months, with only €8,250 being received in year 1 as the first cash instalment. Under the new R&D tax credit repayment mechanism, it will be possible to claim up to €25,000 in year 1, which is a significant acceleration of the refund for smaller R&D tax credit claims.

In addition, under the new regime, companies that incur R&D expenditure in pre-trading periods will be able to claim a payable credit for this over a three-year period from the year that the company commences to trade.

Under the previous regime, the R&D tax credit on pre-trading expenditure was only available for offset against future corporation tax liabilities, and a company could not avail of the cash refund mechanism for this expenditure. This will benefit small and micro-sized companies and provide a welcome cash-flow benefit for start-ups.

Finance Act 2022 introduces the concept of a “valid claim” for the first time to s766C and s766D TCA 1997. While the concept of a “valid claim” has always existed under the broader corporation tax requirements of s865 and R&D tax credit claims have always been subject to audit or review by Revenue, they also have always been made under our self-assessment regime (i.e. a company claims the R&D tax credit in its full and true corporation tax return, and after the credit is first used to offset fully the company’s corporation tax liability for the current period, a cash refund may be due).

Depending on how it is implemented in practice, this change has the potential to slow the pace at which refunds are made and, indeed, could increase the administrative burden on companies claiming the R&D tax credit. We understand, however, that this is not Revenue’s intention.

Now, based on the amendments in the Finance Act, payments will not be released until Revenue accepts that a “valid claim” has been made. The determination of a “valid claim” appears to be a subjective test to be applied by Revenue in relation to whether sufficient information has been provided by the taxpayer to demonstrate how it is entitled to the R&D tax credit that has been claimed. Depending on how it is implemented in practice, this change has the potential to slow the pace at which refunds are made and, indeed, could increase the administrative burden on companies claiming the R&D tax credit. We understand, however, that this is not Revenue’s intention.

As outlined above, there will be a one-year transitional period to the new regime during which companies can make a claim under the old rules for accounting periods commencing before 1 January 2023.

The transitional rules also permit payable R&D tax credit instalments carried forward from accounting periods that commenced before 1 January 2022 (i.e. payable instalments 2 and 3 from the previous year’s claim and from the pre-preceding year’s claim) to be claimed in the accounting period commencing on or after 1 January 2022. This would appear to indicate that such instalments carried forward under the current regime can be claimed in 2022 tax returns, effectively accelerating the third instalment.

Impact of changes to R&D tax credit regime

As taxpayers can now request payment of the R&D tax credit over a three-year fixed payment schedule without first offsetting it against other tax liabilities, the R&D tax credit would appear to qualify as a refundable tax credit under the current definitions laid out in Pillar Two. It is worth noting that international tax reforms such as Pillar Two are relatively new, and there could very well be additional requirements introduced in the coming months that mean that further updates to the Irish R&D tax credit regime are needed.

Although there is no doubt that ensuring that the R&D tax credit remains attractive to innovative multinational companies is critical, the manner in which Finance Act 2022 seeks to achieve this has a negative cash-flow impact for profitable indigenous companies, in particular.

The introduction of a “fixed three-instalment approach” to the refundable element of the credit means that companies that previously were able to offset their credit in full against their corporation tax liability for the current period will no longer be able to do so.

All claimants will now claim only 50% of the R&D tax credit in year 1, with the balance being paid out in years 2 and 3. This has an obvious impact for companies that have regularly received the full value of the credit in a single tax return where they had the tax capacity – a provision that has been available since the introduction of the R&D tax credit in 2004.

Knowledge Development Box

Finance Act 2022 confirmed that the Knowledge Development Box (KDB) regime has been extended for four years, to include accounting periods commencing before 1 January 2027. Although the extension is welcome, as companies need a long-term view to make investment decisions around R&D, it would be preferable if the Irish KDB regime were similar to those of other, competing jurisdictions, which are not limited by sunset clauses such as that included in the Finance Act. Ideally, the KDB would be a permanent fixture of the tax system.

The KDB in its current form will be significantly impacted by changes in the international tax environment, specifically under OECD Pillar Two if it is introduced. Pillar Two includes a “subject-to-tax rule” (STTR), whereby developing countries may apply a withholding tax on interest, royalties and other defined payments where the recipient jurisdiction applies a nominal corporate tax rate of less than 9% to the payment.

As a result, Finance Act 2022 contained amendments to increase the effective tax rate on KDB profits to 10% from the current 6.25%. The amendments are subject to Ministerial Commencement Order, the date of which will be determined by reference to international progress on the implementation of the Pillar Two STTR.

Despite the deemed tax deduction under Irish domestic rules resulting in the KDB profits’ effectively being taxable at the proposed new rate of 10%, for larger companies (i.e. those with group turnover of more than €750m) these profits will be within scope of GloBE and will be subject to the minimum effective tax rate of 15%. This is likely to give rise to additional top-up tax payable on these profits, thus negating the benefit of the KDB regime for in-scope multinational companies.

The future for the KDB

In terms of the future of the KDB regime, it will be important that it is amended further to ensure it that falls within the definition of a “qualified refundable tax credit” under the Pillar Two rules. This would help to make sure that the KDB remains viable as an incentive, despite the reduced benefit.

For indigenous and other companies that will not be impacted by the proposed minimum effective corporation tax rate of 15% (because they are below the turnover requirements) and will retain a corporation tax rate of 12.5%, the increased tax rate for the KDB of 10% (rather than 6.25%) will significantly reduce the benefit and attractiveness of the KDB. Given the low number of taxpayers that currently avail of the KDB, this change is unlikely to help the uptake of the relief.

Digital games tax credit

The digital games tax credit was introduced by Finance Act 2021 but was subject to approval by the European Commission under EU State Aid rules, which has now been provided. On 16 November 2022 a Commencement Order (SI 571 of 2022) brought this new regime into effect, and on 22 November 2022 supplemental Regulations (SI 593 of 2022) were introduced. It is expected that companies will be able to claim the credit from Revenue from 1 January 2023. At the time of writing, we are awaiting guidelines from Revenue on how the digital games tax credit will operate and be administered in practice. It would be helpful, in order to give taxpayers clarity, if these guidelines were published before the first claims are made.

By way of background, the digital games tax credit will be available for digital games development companies that are resident in the EEA and carry on a business in Ireland that involves investment in the design, production and testing of a digital game. To qualify for the credit, a digital game must receive a “cultural certificate” from the Minister for Tourism, Culture, Arts, Gaeltacht, Sport and Media. When applying for the cultural certificate, a company must include details on the contribution that the digital game is expected to make to the promotion and expression of Irish and European culture.

The tax credit will be available as a refundable corporation tax credit at a rate of 32% on eligible expenditure. Under the current Regulations, “qualifying expenditure” is considered to be expenditure incurred directly by the digital games development company on design, production and testing of a digital game (excluding expenditure incurred on designing the initial concept for the digital game), debugging a completed digital game or carrying out any maintenance in connection with such a digital game, and on sub-contractor payments exceeding €2m.

The total amount of tax credit available over the life of the project is capped at 32% of the lowest of:

80% of the total qualifying expenditure,
100% of qualifying expenditure in Ireland or the EEA and
€25m.

Therefore, the maximum amount of credit that can be claimed is €8m per project (32% of €25m). To the extent that the tax credit exceeds the developer’s tax liability in a tax year, the excess can be refunded in cash or applied against other liabilities.

The digital games tax credit is available in addition to the standard trading tax deduction (at 12.5%) but cannot be claimed on expenditure in respect of which Irish R&D tax credits have been claimed or expenditure that has been met by EU grant assistance.

The digital games tax credit will be claimed in the annual corporation tax return once the taxpayer has obtained either an interim certificate from the Minister or a final certificate at the end of the development process.

Some amendments were made in Finance Act 2022 to the digital games tax credit to ensure compliance with State Aid requirements and correct other, technical points. These included minor amendments to the definitions of “digital games development company” and “qualifying expenditure”. Clarification was provided that a company resident in an EEA State (other than Ireland) must carry on a business in Ireland through a branch or agency in order to make a claim.

This article originally appeared in the Irish Tax Review and is reproduced here with their kind permission.

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If you are a business seeking advice on conducting R&D activity, please contact Damien Flanagan or Cian Smith of our R&D Incentives team. We'd be delighted to hear from you.