A US tax break Israeli startups can utilize
A tax credit in the US for R&D provides an opportunity for astute Israeli technology companies.As Seen in Globes - Israel's Business ArenaFebruary 19, 2019
One of the key reasons Israel is home to more than 5,000 successful startups, averaging 640 per year since 1999, is an intensive focus on research and development.
At 4.3%, Israel spends more on R&D as a percentage of GDP than any other nation in the world. By comparison, the US ranks 9th and only spends 2.8%. South Korea is the only other country in the world that comes close to Israel, at 4.2%.
Prestigious academic institutions including the Weizmann Institute of Science, Hebrew University of Jerusalem, Technion-Israel Institute of Technology, Tel Aviv University and the Ben Gurion University of the Negev, have been at the forefront of biotech R&D for decades. Leveraging the strengths of its cutting edge Information and Communications Technology (ICT) sector, Israel continues to develop a world-class, state-of-the-art digital healthcare infrastructure seeking to make medicine more customized, personalized and effective.
Many Israeli companies with connections to the United States have benefited extensively from the research and development tax credit, which has recently become significantly more accessible.
In addition to making the R&D tax credit permanent, the Protecting Americans from Tax Hikes (PATH) Act of 2015 made significant changes in application and availability to many small and mid-size business owners. Prior to the PATH Act, startups that were unable to generate enough income to have a federal tax liability could not take immediate advantage of the R&D tax credit.
Changes made in the PATH Act help startups by allowing those with less than $5 million in gross receipts offset up to $250,000 of payroll taxes, providing an immediate benefit. The PATH Act also allowed, for the first time, qualified small businesses, defined as non-public companies with less than $50 million in average annual gross receipts for the previous three years, to use research credits against both regular tax and AMT liability.
The Tax Cuts and Jobs Act (TCJA) of 2017 allows business owners to do long-term forecasting and to put mechanisms in place to ensure they are maximizing their R&D tax credit opportunity. Furthermore, the TCJA reduced the corporate tax rate to 21% and repealed the corporate AMT, this further strengthened the value of the research credit. Prior to the TCJA, the rate at which the R&D tax credit was reduced under Section 280C was 35 percent, directly related to the maximum corporate tax rate under Section 11(b)(1) (Section 280C(c)(3)(B)(II)). Therefore, the final benefit with the reduced credit election was 65 percent of the gross credit amount. As a result of the permanent reduction to the corporate rate, taxpayers electing the reduced credit will see an overall benefit of 79 percent of the gross credit amount starting in 2018-a 21.5 percent increase.
How can Israeli technology companies benefit from the US R&D Tax credit? There are three primary ways:
Relocation: The simplest way is for an Israeli citizen to move overseas and start their new company on US soil. The Israeli entrepreneurial spirit has never been confined to Israel’s borders. When Israelis move to other countries, particularly to the US, they have proven themselves to be among the most likely immigrant groups to launch successful technology companies.
Subsidiary deal: An Israel-based company begins its own operations or acquires an existing US based company to be a subsidiary. Any research or experimental activities performed on US soil, whether direct, in support or in a supervisory capacity, can qualify for US R&D tax credits. Even if most of the hard-core science is being done in Israel, various critical contributions can still be made from the US. These might include identification of product or market requirements, design development and modification, prototype assembly, manufacturing, production and quality assurance testing.
Acquisition: A US company acquires an Israel-based company. In 2017 alone, Israeli companies and startups were acquired for a total of $23 billion in 112 deals, according to a recent report by Israel-based IVC Research Center and law firm Meitar Liquornik Geva Leshem Tal. The number of deals by category were as follows: IT and software field (30), followed by internet (24), communications (18), life sciences (16), and semiconductors and clean-tech with 3 each, and 9 deals for companies in the “miscellaneous tech” field such as hardware, defense and industrial applications. A significant number of these acquisitions were made by large US-based companies, including the largest acquisition of Mobileye by Intel. Several of the acquiring companies including Intel have further established R&D centers or incubators in Israel. These new international partnerships can prove wildly successful as both parent and subsidiary stand to benefit from the collaboration through sharing of intellectual property, sales and distribution networks and production capabilities.
Any R&D tax credits earned for qualifying activities performed on US soil can be used to offset US income tax liability, or payroll tax liability for startups that have not yet reached profitability.
Here’s how it works:
The purpose of the R&D credit is to offset some financial burden that companies assume by undertaking high risk, high reward R&D projects. In addition to “revolutionary” development efforts, the credit is available to taxpayers that have performed “evolutionary” type activities like significantly improving upon performance, functionality, reliability, or quality of existing products and processes.
The R&D tax credit is available to taxpayers who incur incremental expenses for qualified research activities (QRAs) conducted within the US. The credit comprises primarily the following types of qualified research expenses (QREs):
- Internal wages paid to employees for qualified services; this includes those individuals directly performing the experimentation as well as those individuals directly supporting and supervising these individuals.
- Supplies used and consumed in the R&D process or used to build prototypes or pilot models.
- Contract research expenses (when someone other than an employee of the taxpayer performs a QRA on behalf of the taxpayer, regardless of the success of the research).
For activities to qualify for the R&D credit, the taxpayer must be able to show they meet each of the following four tests:
- The activities must rely on a hard science (engineering, computer science, biology, chemistry, physics, etc.);
- The activities must relate to the design or development of new or improved functionality, performance, reliability, or quality of a business component (product or process used in the taxpayer’s trade);
- Technological uncertainty must exist at the outset of the activities. The information available at the outset of the project does not establish the capability, methodology or appropriate design for developing or improving the business component;
- A process of experimentation (e.g. an iterative testing process) must be conducted to eliminate the technological uncertainty. This includes assessing a design through modeling or computational analysis and experimenting to improve performance, yield, or efficacy.
Examples of activities that may qualify for purposes of the R&D tax credit include:
- Design and development of new or improved technology products
- Design and development of new or improved software or system architecture
- Research and experimenting with new technologies for potential use in new or improved products or processes
- Design and development of new or improved assembly, manufacturing, production, or distribution processes, and methods or techniques for improved efficiency, performance or reliability
- Developing unique software applications, industry tools or embedded software
- Design and development of new communication and navigation equipment and systems
- Feasibility analysis and research for integrating automated processes, machines or robotics
- Design and development of prototypes for testing and validation
- Research and process development for ISO or other industry or regulatory certifications
- Experimenting with new materials to optimize strength and minimize weight of equipment or components or to increase durability and performance
Whether your company is Israel-based or US-based, it’s important to work with qualified R&D tax professionals who can assist in evaluating your case and prepare an accurate and sustainable claim. Make sure the professional team’s capabilities include preliminary feasibility analysis to R&D tax credit calculations at federal and state levels, if applicable, and ensuring the proper level of supporting contemporaneous documentation is collected.
In light of the positive changes in the tax credit for entrepreneurs, astute management teams, whether in Israel or the US, will be looking for ways to grow their businesses through innovation, to capitalize on the enormous potential for US-Israeli collaboration, and to claim all of the research credits they deserve.
Yair Holtzman, CPA, MBA, MS, CGMA is Tax Partner and R&D Tax Credits & Incentives Practice Leader at US accounting firm Anchin Block & Anchin LLP. Michael Ganz, BS, MS is a Manager in Anchin’s R&D Tax Credits Practice.