R&D tax incentive policies in Mainland China started more than 20 years ago. As the policies have evolved, the Mainland has now established an R&D encouragement regime covering R&D process and ownership of intellectual property (IP).
Meanwhile, the Hong Kong Government recently made moves to use tax policy as a tool to drive economic development. Chief Executive Carrie Lam announced in her Policy Address in October that the Government would introduce enhanced tax deduction for R&D expenditure in 2018 to boost the development of innovation and technology in Hong Kong.
This article briefly introduces the Mainland China R&D encouragement regime and potential issues for Hong Kong’s R&D tax incentive policy formulation.
Mainland China R&D encouragement regime
The Mainland China R&D encouragement regime is generally formed by policies on government cash grants, R&D expense super deduction and IP-based enterprises. Some provincial and city governments also provide financial subsidies on qualifying R&D activities. Technology-driven methodology is the fundamental basis of the encouragement regime.
Government cash grants
The Central, provincial and most city-level governments of Mainland China provide various cash grant regimes where funds are granted to qualified R&D projects in qualified technology areas. Different funds may focus on different technology areas in order to guide development in that area.
Businesses may encounter various difficulties when applying for these funds. This is mainly caused by the following:
1) There are many such funds at the city, provincial or central level and each fund may have its own requirements of eligibility
2) The responsible departments in companies may not have full knowledge of what R&D projects are planned by the R&D/technology departments.
As such, many businesses may not be aware the availability and requirements of such funds.
R&D expense super deduction
An R&D expense super deduction policy was introduced to China’s tax regime more than 20 years ago. In recent years the policy has evolved from one with many limitations to a policy based on international standards which has helped boost investment in R&D by Chinese businesses. On 1 January 2016, the basis of the R&D expense super deduction shifted from a more accounting-driven methodology to a technology-driven methodology. This fundamental change means businesses need to understand what qualified R&D activities and expenses are and efficiently prevent abuse of the policy.
The policy allows a 150% to 175% deduction of qualifying R&D expenses relating to qualified activities. For example, if a company is paying corporate income tax (CIT) at 25% which incurs qualifying R&D expenses of RMB 100 million and is eligible for 50% bonus deduction, the qualifying R&D expenses can bring a tax saving of RMB 12.5 million (i.e. a 12.5% tax benefit rate).
R&D project management in enterprises is not regulated in Mainland China. However, qualified R&D activities and expenses are regulated under R&D tax incentive policies. As such, the gaps between regulated R&D activities under the tax incentive policies and R&D projects as defined within companies should be eliminated when claiming R&D tax incentives. For example, certain activities may be considered as an R&D project by a company, but they may not be considered as qualified R&D activities for incentive purposes. This could be because they lack R&D characteristics, such as technical uncertainty, or are still at an experimental stage.
IP-based enterprises
The results of successful R&D may take the form of technology know-how or IP. The Mainland China R&D encouragement regime provides various CIT holidays or CIT rate reductions to IP-based enterprises in areas including new technology and software. For example, a company that qualifies as a High and New Technology Enterprise is eligible for a reduced CIT rate of 15%, as opposed to a statutory CIT rate of 25%.
While the tax incentives for IP-based enterprises are very generous, qualifying as one is no easy task. Such companies should own the qualified IP, continue investing in R&D and meet various other criteria.
Financial subsidies on qualifying R&D expenses
In order to strengthen encouragement on qualified R&D activities, some provincial or city-level government authorities in China provide financial subsidies to companies engaged in qualified R&D activities. These subsidies are usually granted at a percentage of qualifying R&D expenses for R&D super deduction purposes, which is easier for the government authorities to assess.
Importance of technology-driven methodology
For a long time, businesses in Mainland China considered the application and obtainment of R&D incentives as a financial data accumulation process, where not enough attention was given to the R&D activity identification process. This accounting-driven methodology has been changed under the new R&D encouragement regime since 2016, where technology analysis – i.e. R&D activity identification – is the fundamental basis of all R&D incentives.
In businesses, it is usually a natural decision to rely on technology or R&D personnel to identify qualifying activities. However, without proper training or the ability to combine the necessary technology, finance and tax knowledge, R&D activity identification may become a painful process for both technology and finance personnel, as each lacks knowledge of the other field. This can cause companies to miss out on eligible claims.
To avoid this risk, the right application of technology-driven methodology, which emphasizes the combination of technology and financial knowledge, becomes crucially important.
Hong Kong R&D tax incentive policy formulation
In Hong Kong, Lam announced last year that a 300% tax deduction will be offered to the first HK$2 million of R&D expenditure incurred by enterprises in Hong Kong. A further 200% tax deduction will be available for any remaining expenditure.
In order for the proposed policy to be effective, many issues should be considered. These include:
1) Which technologies/R&D activities should be encouraged
2) What types of R&D activities/expenses should be encouraged
3) Onshore/offshore R&D activities, as well as Hong Kong onshore contract R&D arrangement
4) How to define qualified R&D activities and qualifying R&D expenses
5) Claim assessment procedures as well as claims monitoring and inspection
6) Considerations for SMEs
7) Abuse prevention
Businesses who would like to apply for the deduction should anticipate that the definition of qualified R&D activities may not be very specific. As such, the related qualifying R&D expenses must be accumulated carefully to avoid over-claiming, under-claiming or double-claiming. More importantly, a technology-driven methodology should be adopted to ensure compliance from both technology and finance perspectives.
Leveraging policies in both territories
After Hong Kong implements the R&D expense enhanced deduction, deciding how to leverage the policies in both Hong Kong and Mainland China will become more important for businesses. To maximize the incentive benefits, businesses may consider not only the costs of carrying out R&D in a territory, but also the R&D tax incentives available.
This may lead companies to investigate how to position R&D activities in both territories and design the R&D/technology-related transactions among the entities in both territories. This will eventually affect the revenue, cost structure and profits of the entities concerned.