Made in China: Generous R&D Incentives4th August 2021
You may be aware that the iPhone in your pocket was likely assembled in China, the world’s largest manufacturer of smartphones by a wide margin. But did you know that China is also home to the world’s largest video game maker (Tencent), local-delivery platform (Meituan), and social shopping company (Pinduoduo)? China also claims three of the world’s four largest e-commerce companies: Alibaba, JD.com, and Suning.com.
In addition to these digital champs, Chinese companies hold leading positions in Information Age fields like drone technology, quantum computing, and electric vehicles. China’s evolution from manufacturing workhorse to digital thoroughbred is well underway and now the government is putting its foot on the (electric) accelerator: The digital economy accounted for 36% of China’s GDP in 2019 and the government expects to raise that share to 50% by 2027. How are they going to get there? In part, by ramping up incentives for research and development.
Super Duper Deduction
First introduced in 1996, the cornerstone of China’s research and development (R&D) incentive regime is the super deduction: 175% of qualifying R&D expenses can now be deducted from corporate income, up from an already generous 150% in 2018. Previously available only to small and mid-size companies (SMEs), the 175% deduction was expanded to any company that conducts “systematic activities with clear goals” to acquire, improve, or creatively use new scientific and technical knowledge in an eligible industry. Which expenses qualify? Labor, materials, depreciation, amortization, and fees paid for design and testing, among others. You’ll also want to keep receipts for some less commonly eligible expenses: R&D insurance, IP application fees, and other costs directly related to the R&D are deductible, although the benefit is capped at 10% of total qualifying spend. Even your outsourced R&D is eligible, albeit with a cap of 80% of costs.
Claiming your R&D benefit in China has gotten notably easier. Previously, you’d have had to get your R&D expenses pre-approved in order to later claim the deduction. Compounding the administrative burden, approval at that time was governed by unwritten rules, making for an opaque process that discouraged investment. In 2016, however, the government simplified matters by making the super deduction available to any company excluded from a list of low-priority sectors: tobacco, lodging, retail, real estate, entertainment, and commercial services. If you don’t see yourself on that list, you’re eligible. Note, however, that documentation is still required to be filed.
Despite all the talk of digital transformation, if your China-based entity is engaged in manufacturing, you needn’t feel neglected. China knows that its manufacturing sector is key to dominating high-tech fields like solar panels and electric vehicles. To encourage those efforts, the government offers manufacturing companies an even-more-super deduction of 200% for qualifying R&D expenses. As is common with China R&D incentives, these benefits sunset, in this case in 2023. But the government tends to extend—and often enhance—the benefits when they come up for renewal.
The Road Ahead: Technology
To know a person, as the saying goes, watch what they do, not what they say. In the case of China, to know the government’s economic priorities, you could read its latest five-year plan, which weighs in at a page-turning 35,000 words. But if that’s not your preferred way to spend a Friday evening, just have a glance at the tax incentives it offers.
While China encourages innovation across a wide swath of the economy, if you are a domestically owned technology company, expect to receive special attention. That most-favored category is split into two designations: HTNEs and TASEs. HTNEs (high and new technology enterprises) and TASEs (technologically advanced service enterprises, also sometimes seen as TASCs, or technologically advanced service companies) are both eligible for a reduced corporate income tax (CIT) rate of 15%, down from the standard 25%. TASEs also qualify for a zero VAT rate on qualified revenue from offshore services.
You can see the government’s priorities for economic growth most directly in the eligibility criteria for HTNE status. To qualify, your core product or service must fall into one of the following categories: electronic information; biological and medical; aviation and space; new materials, high-technology services; new-energy and energy conservation; resources and the environment; and advanced manufacturing and automation.
Within those sectors, qualifying activities include the development of new technology, new products, and new production techniques. The government prefers to see those activities take place at home in mainland China but allows up to 40% of expenses to be incurred abroad. Once approved, your HNTE status is good for a three-year period and is reviewed annually.
To earn TASE status, a company must be registered in Mainland China and engaged in at least one qualified outsourcing activity that requires advanced technological and R&D capacities—e.g., IT outsourcing (ITO), or business or knowledge process outsourcing (BPO or KPO)—and have a highly educated workforce (at least 50% of graduates with an associate degree or above). There are also revenue requirements: at least half must be derived from qualified, technologically advanced services, and 35 percent from qualified offshore outsourcing services. TASEs generally aren’t entitled to the R&D super deduction.
But Wait, There’s More!
China is not afraid to get creative in its drive for innovation. In addition to favorable tax rates and generous deductions, the government offers several other R&D incentives.
If you are a China-based technology or software company, your tax rate on income derived from your intellectual property (IP) may be lowered via a patent box: Your first RMB5 million of annual income from IP technology transfers is exempt from enterprise income tax (EIT). Income above that level is taxed at just 50% of the standard EIT rate. Software companies may also be eligible for preferential VAT treatment and exemption from import duties on equipment. If your entity is a startup, you may also be granted tax holidays.
The Chinese government has recognized the role of early stage investing in fostering innovation. China-based entities or individuals investing in startup tech companies may be able to deduct 70% of the investment from the taxable income derived from that investment—provided the startup is based in mainland China and devotes at least 20% of its total expenses to R&D. The investment must be held for two years, and any unused balance can be carried forward.
China’s R&D game plan has a geographic element as well. The country has designated a number of National Economic and Technological Development Zones (NETD Zones, or ETDZs) and Special Economic Zones (SEZs), each of which offers its own mix of incentives and its own rules and regulations which must be met in order to receive them.
Over the past three decades, R&D investment in China has risen by nearly a factor of 40. By comparison, U.S. R&D spend over the same period is up less than 2x. The U.S. still leads in absolute terms with $613 billion of annual R&D spend vs. China’s $515 billion (2019 data). And the U.S. still invests more as a percent of GDP: 3.07% vs. China’s 2.24%. Generous R&D incentives, however, are expected to close that gap and supercharge China’s transformation into a digital powerhouse. In the future, it won’t just be your iPhone that’s made in China. The robot carrying your bags, the quantum computer in your pocket, and the self-driving minivan in your driveway may be as well.