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R&D Tax Credits

On the Road to Innovation

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For the last decade, Russia has been trying to will its industrial policy into a dramatic new direction—transitioning from a traditionally heavy dependence on natural resources (especially oil and gas) to technology– and knowledge-based innovation. With oil and gas responsible for between a third and a half of total revenues in its federal budget in recent years (and a large majority of the country’s exports)—and the country’s less-than-stellar reputation around openness and transparency—it’s a goal that can charitably be called an uphill battle.  

Thirty years after the collapse of the Soviet Union (1991)—a tumultuous event that led to 20 years of R&D neglect and the evaporation of an entire generation of scientists and potential innovators—Russia’s brain drain has not been replenished, and its reputation as an R&D powerhouse has not been reestablished. Russia today barely cracks the top 50 in the UN’s Global Innovation Index—little wonder when you consider that its R&D culture may be better known for weak IP protections, plagiarism, political interference, red tape, and massive government spending than for its rich legacy of scientific and technological accomplishment. 

A close look at OECD statistics illustrates the issue. Like China, the Russian Federation has a top-down culture and spends heavily on R&D (both rank in the top 10 in absolute numbers—along with the United States, Japan, and other global powerhouses). But unlike China, whose share-of-GDP R&D spending has tripled in the last 30 years (currently at 2.2%—and on a path to close the gap with the U.S., at 2.8%), Russia’s has languished around 1% for well over a decade—a low rank that places it in 30th place among other nations (noteworthy given its high ranking on total spending). Equally telling is the ratio of state-to-business financing of that R&D: In China, as in the United States, the government finances less than a quarter of total spending, with much of the rest coming from businesses. In Russia, the opposite holds true.  

Russia has also lagged other countries in producing marquee brands (with some notable exceptions in natural resources and, of course, vodka). While Russia has profitable tech companies—the most prominent are Russian Silicon Valley-style powerhouses Yandex, Mail.ru OOO and VK—outside of cybersecurity firm Kaspersky Lab, few have much name recognition or penetration beyond the borders of Russia and its former satellite states.  

Russia is hardly an upstart when it comes to scientific power, and while tens of thousands of its best and brightest did abandon their careers in the chaotic 1990s, the country’s R&D workforce is still the world’s fifth-largest. And, as evidenced by a decrease in direct funding and a corresponding increase in the proportion of support spent on R&D tax incentives, the Russian government appears to be moving toward incentivizing activities by private industry (and attracting foreign talent and capital) as the best way to reach its stated goal of transitioning to an innovation nation. 

Inching Forward 

President Putin has committed to reforming his country’s neglected science ecosystem to make it both more competitive on the world stage and more attractive to foreign talent. In 2018, he announced a six-year research strategy calling for significant new funding, including support for early-career scientists as well as new research facilities and labs focused on cutting-edge work in quantum computing, mathematics, robotics, materials research, and genomics. He also promised to update the aging equipment in Russia’s existing elite scientific institutes and to fund once neglected, now hot-topic, areas such as climate and environmental science.  

Since innovation requires a degree of openness and collaboration, there are bound to be headwinds. International political tensions have impacted scientific exchanges with other countries (although Russia and Germany have an especially robust partnership, with some 300 joint research projects currently underway), and Russia’s notoriously sclerotic bureaucracy has been a significant buzzkill for both native and visiting scientists seeking to conduct the very cutting-edge R&D the country so desires.  

Still, with the government increasingly focused on R&D tax incentives—and making them increasingly generous—there are signs that Russia may finally be getting traction in its quest to rebuild its reputation as a place where innovation can take root and grow.  

What Constitutes R&D?  

The Russian Federation defines R&D as activities and expenditures connected to the improvement or creation of products, services, or production processes. Basic research, applied research, and experimental development can all qualify. Compared to the U.S.’s four-part qualification test, Russia’s criteria (on paper, at least) appear relatively loose. 

Qualifying expenses include labor and contractor costs for those directly involved with the R&D, cost of input materials, depreciation of equipment used for R&D, and certain other expenses (with the provision that those “other” R&D expenses do not exceed 75% of payroll costs for employees involved with R&D for certain incentives). For certain incentives, taxpayers may also consider contributions to certain scientific and innovation funds an eligible expense, providing they don’t exceed 1.5% of sales.  

What’s Available, and Who’s Eligible? 

To entice those desirable R&D actions and expenditures, the government offers a cornucopia of incentives—from super-deductionsreduced tax rates (including payroll tax) and VAT exemptions, to investment-tax creditsaccelerated depreciation, tax holidays, and grants. Beyond the general rules of the road laid out above, the particularities of these incentives vary. Here’s how it all plays out: 

R&D Tax Allowance: Taxpayers can take a 150% super deduction on R&D expenses for qualifying R&D activities—a long list that includes advanced scientific areas such as nanotechnologies, biotech, nuclear power, and space technologies—with any unused expenses eligible for carryforward (up to a limit of 50% of corporate income tax, known locally as profits tax). As a measure of how much the Russian government values this kind of frontier research, this super deduction is applicable even if the activities are not successful. (While the U.S. R&D incentive program also offers a super-deduction, it is not as generous.) The cost of acquiring outside IP is also eligible for the super deduction, subject to certain limitations. 

Unlike in many other countries, Russia’s tax-allowance incentives don’t come with specific rules on whether the R&D must take place only in Russia, or whether foreign R&D contractors may be involved (that said, a contractor itself may not claim the incentive). There’s also no cap on the amount of potential R&D expenditure—or on the potential tax relief ensuing. Russian courts have held that the R&D should not only lead to the creation of new products, processes, or services but that more broadly it must also yield something of value within Russia: For example, if a company works to customize a piece of software, that new software must have commercial value beyond the specific needs of the company to qualify for the benefit. 

Taxpayers are allowed to accelerate depreciation deductions on depreciable fixed assets used exclusively for scientific and technical R&D, with a carryforward limit of 10 years. The depreciation is claimed on the annual profits tax return; supporting documentation must be made available on demand. 

The tax authorities require that an R&D report be submitted for each qualifying project and attached to the annual profits tax return (which is due on March 28 of the following year). Pre-approval is not required: R&D reports are examined along with the return. 

R&D Tax Credits, Reductions, and Exemptions 

An investment tax credit enables the taxpayer conducting qualifying R&D activity to reduce its tax payments by up to 50% for a given period (generally, one to five years)—with the balance (plus accrued interest) paid later. The credit cannot, however, exceed 100% of the acquisition value of fixed assets used in the R&D activity. Though called a credit, the arrangement is more akin to a tax deferral, given the repayment requirement. 

Unused credits are neither refundable nor applicable to future years if the company’s tax liability is insufficient in that tax year. Like Japan, Russia employs a “use it or lose it” scheme. 

Advance permission by the tax authorities is required. 

Accredited IT companies can apply for a reduced payroll tax from 14% to 4% (rates are graduated but all improve upon the headline rate of 30%) through 2023. To qualify, the company must earn no less than 90% of its income from direct R&D IT activities, have at least seven people on payroll for most of the qualifying year, and hold a state accreditation certificate. (Supporting documentation must be provided on request.)  

Patent box: Russian IT companies meeting the above criteria for reduced payroll tax can also—under a set of conditions set by the government in 2021—benefit from a reduced 3% profits tax rate (instead of the standard rate of 20%) and a 7.6% rate for payroll-tax contributions (instead of the IT reduced rate of 14% or the standard rate of 30%). And unlike the IT-payroll tax benefit, which expires in 2023, this one is permanent. 

Educational and medical R&D companies can apply for a 0% profits tax rate, under a host of conditions. 

To be eligible for VAT exemption, the R&D activity must involve at least one of the following: (a) developing new production processes and technologies; (b) transferring IP rights for software (approved by the government), databases, inventories, and know-how; (c) financing activities from special scientific funds; (d) importing certain technologies and equipment that are otherwise unavailable in Russia. IP ownership requirements and other restrictions exist. 

Other Special and Regional Incentives 

The Russian Federation is vast—and so is the range of additional or special incentives available across many of its regions. A host of generous incentives—including reduced federal and/or regional profits and property tax reductions, VAT and customs exemptions, and payroll tax cuts—apply in so-called Special Economic Zones, Innovation Centers, “tax regime territories,” “technoparks,” and other priority areas. Each program and each territory has its own rules and limitations. 

Also, both the federal and regional governments offer grants toward R&D expenses. 

Small Business, Big Impact 

Many countries are making special efforts to support small businesses or startups in their R&D eligibility. Russia shows little evidence of doing so. The marginal tax subsidy rate for profitable small- and medium-sized enterprises (SMEs) in the Russian Federation is well below the OECD median (11% vs 20%)—and as unused credits are not refundable or otherwise usable, SMEs, which tend to carry losses before being profitable, have a built-in disadvantage. The one area where SMEs and startups might be indirectly favored is via government support for its highly touted special innovation zones. 

Although the government lowered the payroll tax rate for SMEs, in the midst of the pandemic, to 15%, and took a variety of other measures to help them stay afloat, its support packages for all its businesses—and especially SMEs—have been far from generous. (At 2-3% of GDP, Russian packages were an order of magnitude less than Japan’s, at 20%.)  

With an economy that skews heavily to resource-extraction activities (read: gigantic companies), SMEs have largely been neglected for largesse. This attitude has led to a blind spot where other countries have found opportunities: SMEs and the R&D they perform are the drivers of tomorrow’s economic growth—potentially a costly oversight. 

The Takeaway 

Russia is making a concerted effort to be known once again for its scientific prowess—and to nurture the kind of R&D and innovation that have currency today. But old habits die hard. Fairly or unfairly, Russia’s technological impact today is often more associated in the public mind with malign activities like IP theft, hacking, and election-meddling than with historic achievements like the Sputnik program—not exactly a fertile field for innovation. And the astonishing effectiveness of some of its cyber-disruption and disinformation campaigns may disguise the backwardness of its abilities and the persistence of its heavy-handed bureaucratic culture.  

As is the case with its competitors, the success of Russia’s R&D programs is as much a factor of culture as it is dollars (or rubles). But one thing is clear: It takes more than pronouncements from on high to enable real cultural change. Innovation, like all creativity, can only come from the ground up.