An R&D renaissance through smart taxation

The European Commission has proposed reforms in an action plan to fight Base Erosion and Profit Shifting. These are to be adopted by all member states.

For example, it imposes a one size fits all rule of CFC (controlled foreign companies) in an effort to combat hybrid mismatches whereby profit is left in limbo between two countries and is not taxed anywhere. This is the classic double non-taxation syndrome. These rules can prevent profits being shifted to a hybrid structure in the EU or between an EU country and a third country. However, the current draft directive refers exclusively to hybrid mismatches between two EU member states, while such mismatches do also occur between an EU member state and a third country. It is therefore expected that this directive is extended to include rules to counteract hybrid mismatches between a member state and a third country in order to ensure that third countries react to prevent profit being shifting from or to developing countries.

Does this shower of antiavoidance legislation encroach on our tax code? The answer is yes. Malta is one of the few countries in Europe granting a full imputation option (FIS). Under the FIS, the tax incurred by the company is fully imputed to the shareholder as a tax credit when profits are distributed. The distributed dividend is grossed up with the tax incurred by the company and is taxable at the level of the shareholder. However, a credit equivalent to the tax paid by the company on taxed profits distributed by way of dividends is allowed against the shareholder’s tax liability on the said dividend.

In addition, in terms of Article 68 of the ITA no further tax is imposed on such distributions. The full imputation system is extended to all companies affording them the same advantage without any discrimination. This unique scheme is operative across Malta’s Financial Services Centre, which enjoys the advantage of having net effective tax reduced, through an eligibility to access the refund mechanism. Here one can mention sectors which qualify such as aviation, remote gaming, insurance and the captive industry as well as investment services including Collective Investment Schemes.

Our tax system is fair and transparent. It is fully compliant with OECD rules and has helped the island attract quality inward investment. Deprived of such tax revenue the exchequer will have no option but to raise taxes on consumption, increase VAT rates and eventually reduce welfare payments. This in turn will increase the growing gap between the rich and the rest. Surely there is a legitimate alternative.

The Dutch have attracted substantial foreign direct investment by introducing clever incentive legislation. This year saw the inaugural launch of the new “Innovation Box” tax rules in The Netherlands, which was fully approved after the OECD put some pressure on it to change the old scheme which has been successfully running since 2007. The old scheme attracted many R&D companies that set up base in The Netherlands and claimed tax exemptions, reducing the rate of corporate tax to a preferential rate. This meant that instead of taxing the full amount of such profits at the general corporate income tax rate of 25 per cent, only one-fifth of such profits were taxed at that rate, an effective tax rate of five per cent.

Of course, this year there are new rules to prevent any misuse of the scheme but the lower rates are still available. The incentive applies to self-developed (meaning in-house) technology and creation of other intangible assets, such as the expertise for a new product or for a new production process. The new scheme, which has been styled “the nexus approach”, allocates development expenditures into qualifying expenditures and non-qualifying expenditures.

What are qualifying expenditures?

These are expenditures exclusively incurred for the development of the intangible fixed asset, with the exception of costs incurred for the outsourcing of R&D to group companies and indirect costs such as accommodation and financing costs. Expenses for contract R&D activities performed by third parties are considered qualifying expenses since, a company is expected to only outsource ‘non-fundamental’ R&D activities to third parties. Another bonus in this Innovation Box scheme (which was never introduced in our tax code) is the treatment of losses in the start-up period.

In my opinion, this is a clever way to attract multinational companies to set up R&D centres in our country to support a dynamic economy buttressed by cuttingedge technology. Simply put, the Innovation Box allows losses to be generally tax deductible at the general tax rate of 25 per cent (ours at 35 per cent), not at the reduced effective tax rate of five per cent. The cherry on the cake is that initial losses incurred before business operations have been started are also deductible at a 25 per cent tax rate.

At this stage, readers may ask – what does this piece of tax legislation have to do with us, a small island on the periphery of Europe? It is shameful that our contribution to R&D is a mere 0.7 per cent of GDP.

The answer is that unlike The Netherlands, we lack the presence of multinationals conducting their own R&D. Having attracted foreign manufacturing companies to our industrial estates not conducting own R&D is a risky scenario.

The Anti-Tax Avoidance Directive lays down rules against practices which adversely affect the functioning of the internal market. It contains five legally binding anti-abuse measures all member states should apply against common forms of aggressive tax planning. These are mandatory as from 1 January 2019. The reform includes use of country-by-country tax reporting (CBCR), which means full disclosure of CBCR information to tax authorities with the aim of ensuring further compliance of multinational enterprises (MNE) with national tax laws. It applies to companies reporting a consolidated turnover above EUR750 million. The information should be broken down by EU Member State and aggregated for the rest of the world. The type of information to be disclosed would include income tax paid and accrued, as well as other contextual information: the nature of the activities, turnover, number of employees, and profit before tax.

The above-mentioned initiatives are part of a reform which started seven years ago to combat tax avoidance and aggressive tax planning. It mirrors recommendations from the European Parliament and the outcomes of the studies conducted by OECD’s and G20 to combat alleged Base Erosion and Profit Shifting (BEPS). This directive (as recently approved) when fully enforced will require amendments in our tax code starting in 2019. There will have to be new thin-capitalization rules or similar that will introduce controlled foreign company rules; insert a rule to counter a mismatch in tax qualification of domestic partnership. A new rule is expected to counter a mismatch in tax qualification of a domestic company; there will also be a withholding tax on dividends (unless regulated by DTA) and a reduced deduction allowed for intra-group interest costs. Again, there will be taxation of capital gains introduced upon transfer of IPA, whereas a tax deduction for intra-group royalty costs is no longer permitted.

Another novelty which is absent from our domestic code is the introduction of new legislation catering for exit taxes imposed when an investor decides to repatriate his/her investment. The reform is targeted to fight abuses by member states which offer hostage to multinationals by signing ‘sweetheart’ deals as was the case when Apple Inc. was found to have profited from such deals in Dublin.

But should the punishment be meted out to all and sundry? Malta has unquestionably built a reputable centre for financial services through a combination of robust legislative frameworks. We honestly merit a better deal.