Incentivising Ireland’s innovation activity

This year marks the 20th anniversary of Ireland's R&D Tax Credit. Ken Hardy, who leads KPMG's R&D Incentives Practice, looks back at the scheme's successes and what more could be done to improve the scheme, incentivise more R&D activity, and ultimately help Ireland become the knowledge island it aspires to be.

Ireland’s R&D Tax Credit is now 20 years old having come into being on January 1^st, 2004. It has evolved and been improved in many ways since then and continues to incentivise billions of euro worth of R&D activity every year.

The tax credit was introduced to fill a clear gap in Ireland’s support proposition for both FDI and indigenous industry. Direct grants for R&D activity were available but there were no incentives available through the tax system. Competitor jurisdictions already had such schemes in place. Canada introduced theirs shortly after the Second World War, the US has had one for a long time, and the UK introduced its scheme in 2000.

The introduction of the tax credit was certainly not before time. The Tax Credit was introduced in the Finance Act 2003 and eligible expenses from January 1, 2004, onward were covered.

The success of the scheme over the years can be measured in terms of the number of claimants and the R&D expenditure supported. The total budget for the cost to the exchequer in the first year was €50 million. That was effectively accounted for by one project – the Wyeth (now Pfizer) biopharmaceutical facility investment at Grange Castle, in Dublin.

Since then, the scheme has grown from not much more than a handful of claimants in 2004 to 1,629 in 2021 with total eligible R&D expenditure of €3.47 billion. Total cost to the exchequer was just €753 million. It is estimated that those figures grew to over €4 billion and almost €1 billion in 2023.

The scheme has clearly been outstandingly successful by any measure. While some look on it as a cost to the exchequer, it should be seen as an incentive that generates very significant capital investment by claimants. 

Having said that, Ireland still lags behind competitor countries in terms of overall spend on R&D so where would Ireland be without the benefit of the tax credit over the past 20 years?

The scheme has seen a number of changes over the years, the majority of them for the better. The first highly impactful change was the abolition of the base year threshold for claims. When the tax credit was first introduced, firms could only claim for amounts over and above their 2003 R&D expenditure. The logic behind this was to ensure the scheme only applied to new expenditure, not to spending that would have happened anyway.

However, it was clearly inequitable as it meant that a company that had only started up or located in Ireland for the first time in 2004 or subsequently could claim for the entirety of their R&D expenditure while other companies in the same field could not.

Arguments were made for many years for the removal of this iniquitous rule, and it was eventually removed on a phased basis from 2012. No threshold amount has applied since January 1^st, 2015.

The next important change saw the credit become encashable. Initially, the credit could only reduce tax for claimant companies and many indigenous businesses and startups simply don’t have taxable profits. They are innovative companies at the early to mid-stages of growth and cash is king to them, a tax credit is not much use. They could carry the credit forward to a time when they would make profits but that was not much help to them in the here and now when they need the money to spend on growth and development.

The Government introduced a refundable mechanism similar to that of competitor countries in order to give companies the cash benefit when they need it most.

Another very significant change was the increase in the value of the credit from 20 percent to 25 percent of eligible expenditure. That has an immediate impact on the number and value of credit claims as a result of industry responding to the improved incentive with increased investment.

The value was increased again to 30 percent last year. That change was necessitated by several factors. The government had attempted to introduce an enhanced R&D Tax Credit regime for smaller companies some time ago but couldn’t get approval from the European Commission.

As a result, the last Finance Act introduced a new rate of 30 percent across the board for all claimants. This had the effect of incentivising smaller companies at one end of the scale and compensating larger companies for the erosion in the value of the tax credit brought about by OECD tax reform measures.

On a somewhat less positive note, there has been an unfortunate reinterpretation by Revenue over time of what is and is not eligible expenditure. The legislation has not changed in any material way, but Revenue has changed the way it operates through guidance.

At the outset, items of expenditure like rent, overheads, and administrative costs and all the things required to run the portion of the business dedicated to R&D were claimable. If 50 percent of the site costs was for R&D, that portion was claimable.

At present, almost none of that with the exception of light, heat and power is eligible. The lack of certainty that has created is most unwelcome. As is the lack of a logical explanation behind the changes. It means that companies contemplating future R&D expenditure cannot be sure that it will be eligible for the tax credit.

For multinational companies, that may make the difference between carrying out the activity in Ireland or in another jurisdiction where they enjoy greater certainty.

The restrictive nature of the Revenue guidance also fails to acknowledge the changed nature of R&D activity which can take place in offices or in the cloud and not just in a laboratory environment. Revenue authorities in other jurisdictions recognise the importance of R&D Tax Credits as incentives and have put in place appropriate definitions of eligible expenditure.

The thinking here needs to change in line with that and to reflect the reality of the constantly changing digital world we live in today.

Another area where change would be beneficial is the current restriction on expenditure on outsourcing R&D activities to 15 percent of the claim. This may have been justified at one time but makes no sense now.

The nature of products in areas like medical devices has changed out of all recognition, for example. Medical devices have moved from metal stents 20 years ago to drug-eluting metal stents with embedded software that controls them and communicates with external devices. That requires expertise in pharmacology, materials science, software, electronics and much else besides.

Individual companies can’t be expected to have deep expertise in all of these areas, and they have no choice but to outsource a significant proportion of their activities. Outsourcing R&D is now integral to product development for many companies. The 15 percent cap needs to be revised upwards lest companies relocate the main R&D activity to jurisdictions where the limit is higher. That could result in a significant loss to the exchequer and the economy.

Consideration should also be given to providing a super credit to certain strategically important sectors such as green energy or sustainable technologies. Ireland has the potential to be a world leader in offshore wind, energy storage, hydrogen manufacture and transport, and sustainable aviation fuel, and agritech. Offering enhanced credits to businesses in these areas could accelerate innovation and propel Ireland to the front rank in this critically important space.

Furthermore, we have learned from experience that the factory tends to follow the R&D activity. This means that not only would the country gain from the high-quality jobs in R&D but would also benefit from the corporation taxes paid by the collocated manufacturing operations.

Ireland’s R&D Tax Credit has been hugely successful and continues to play a key role in incentivising innovation activity. However, Ireland has fallen out of the world’s top 20 most innovative countries in recent years and was ranked 22^nd last year having been as high as 10^th in 2017. R&D expenditure must increase if we are to arrest this fall and make up for lost ground.  

A good place to start would be to make changes to the R&D Tax Credit legislation to provide certainty around eligible expenditure, increase the cap on outsourced expenditure, and the provision of an enhanced super credit for companies in sectors of national importance.