Global Tax Alert | 18 October 2013

OECD report recommends new approaches to encouraging business innovation via tax incentives

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A new Organisation for Economic Cooperation and Development (OECD) report, Supporting Investment in Knowledge Capital, Growth and Innovation,1 stresses that effective government policies aimed at encouraging business innovation in knowledge-based capital (KBC) – described as a range of intangible assets beyond just research and development (R&D) – are essential for growth in the current global economy.

The report notes that as of 2011, 27 of the OECD’s 34 member countries provided tax incentives to support business R&D, more than double the number in 1995. The report also sets out that “R&D tax incentives have proven popular largely because exemptions from international agreements make R&D subsidies one of the few ways that governments can help domestic firms improve competitiveness without direct state aid” while going on to note that “…potential benefits have led many governments to increase the generosity of R&D tax incentives in recent years. Over the period 2006-2011, about half of the 23 countries for which complete data are available increased their generosity, with R&D tax support rising by almost 25% in some countries.”

KBC investment and the economy

The OECD divides KBC into three key classifications:

1. Computerized information – including software and databases.

2. Innovative property – including R&D, mineral explorations, copyright and creative assets, new financial services product development and new architectural and engineering designs.

3. Economic competencies – including brand-building advertisement, market research, worker training, management consulting and organizational investment.

The OECD notes that business investment in KBC has been consistently increasing in advanced economies. For instance, in the US, data shows that business investment in KBC has been rising continuously for at least 40 years. In fact, in the US and a number of other countries, business investment in KBC now equals or exceeds business investment in traditional tangible property. The report describes how this growth is about more than R&D; many countries show spending on R&D to have held steady in recent years while non-R&D KBC investment has continued to grow. Furthermore, this trend is not limited to advanced economies; some emerging economies are also showing increased business investment in KBC.

The OECD attributes the increased investment in KBC to a number of factors. One such factor is the rising stock of human capital in OECD countries that enables the production of KBC. Another factor is the fact that products themselves are becoming more knowledge-intensive. For instance, in the automotive sector, an estimated 90% of new features in cars have a significant software component. In addition, global integration and deregulation have made innovation based on investment in KBC increasingly important.

The OECD states KBC investment is vital to economic growth, noting that studies show a connection between business investment in KBC and macroeconomic growth. In addition, the OECD notes that in the recent global economic crisis KBC investment was not impacted to the extent that physical capital investment was. Two properties of KBC investment have particularly positive implications for growth: (1) for many forms of KBC investment, the benefits spill over to other parts of the economy and (2) some forms of KBC, once created, can be replicated at a low marginal cost.

OECD policy recommendations

While noting that R&D tax incentives have both proliferated and become more generous, the OECD report makes a number of policy recommendations to encourage business investment in KBC and resulting economic growth.

One particular area of emphasis in the report is that policy makers need to take a view of innovation that is broader than just R&D. Other KBC investments, such as data, new business processes and design, which can drive innovation and value creation, are affected by government policies. The framework of government policies is important. For instance, well-designed frameworks may encourage collaboration between firms and public research organizations and/or offer direct support for areas of KBC investment that offer high social returns.

The OECD also encourages countries to target R&D tax incentives to smaller entities, which may be critical in creating radical innovations. On this point, an OECD summary of the main report2 (issued simultaneously) states that “…firms that are not part of a multinational group of companies – often small and young firms – may be placed at a competitive disadvantage, relative to Multinational Enterprises (MNEs), in undertaking and exploiting R&D.” while going on to note that “Overall tax relief for R&D, when factoring in cross border tax planning by MNEs, could well be greater than governments foresaw when their R&D tax incentives were designed. Countries may be losing tax revenue on the output from subsidized R&D and also losing out on domestic knowledge spillovers associated with production.”

The OECD highlights the importance of the protection of intellectual property rights as a framework condition necessary for KBC investment. It notes evidence of a positive relationship between the strength of patent regimes and the number of patent applicants per capita – although it’s uncertain whether this represents increased innovation or just more frequent patenting. The OECD also raises the importance of design rights, but adds that little is known about the relative efficiency of different frameworks to protect design rights. The OECD states that more analysis is needed and notes that many OECD countries have begun reviews of their intellectual property rights systems.

The OECD urges enhanced corporate reporting of KBC for the benefit of investors, analysts and financial institutions. There is some evidence that industrial sectors more dependent on external finance grow faster in countries with higher quality corporate disclosure regimes. Prevailing accounting standards generally do not require recognition of KBC. As a result, KBC reporting currently depends largely on management’s interest in disclosing this information – which is often done in narrative form without quantitative data.

Given the ever-increasing importance of data, the OECD emphasizes the need for countries to develop sound policies for the collection, transport, storage and use of data. These polices should address such issues as privacy protection, open data access, infrastructure and measurement. The OECD discusses a variety of approaches for the collection of corporate KBC data.

Some other highlights of the OECD’s recommendations include:

  • Due to the importance of human capital for R&D, the OECD states that improving the quality of education should be a priority – with an emphasis on producing skilled workers that companies want to hire.
  • Governments should review their competition policies, with an aim both to eliminate unnecessary, anti-competitive regulations and to effectively enforce competition laws necessary to protect and encourage investment.
  • The OECD also encourages countries to focus on the measurement of KBC investment, because, while it is clear KBC investment is key for growth, the understanding of how to accurately measure it is still in its infancy.

Implications

The use of R&D tax incentives continues to form a key policy focus of governments around the world, and as noted in the report, these incentives have both proliferated and become more generous. At the same time, many legislative developments demonstrate that governments are focusing their funds more narrowly on those sectors and activities they think will provide the greatest levels of support to their long term plans of improved infrastructure, employment, economic and social development. Close monitoring of the direction of policy in key countries to ensure that appropriate opportunities are identified is recommended, and where appropriate incentives are identified, close attention should be paid to the eligibility and ongoing maintenance and reporting requirements.

Endnotes

1. http://www.oecd.org/sti/inno/newsourcesofgrowthknowledge-basedcapital.htm.

2. OECD Multilingual Summaries: Supporting Investment in Knowledge Capital, Growth and Innovation.

For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP, Cleveland, United States
  • Craig Frabotta
    +1 216 583 4948
    craig.frabotta@ey.com
Ernst & Young (Australia), Perth, Australia
  • Robin Parsons
    +61 8 9429 2222
    robin.parsons@au.ey.com
Ernst & Young LLP (United Kingdom), Birmingham, UK
  • Christine Oates
    +44 121 535 2466
    coates1@uk.ey.com

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