Like the U.S. and many other industrialized nations, Japan’s R&D tax regime has evolved with the times—and in response to shifting economic needs. With one of the highest effective corporate income tax rates in the world, Japan has used R&D incentives as a cornerstone of its industrial policy—and a key lever in driving economic growth—as far back as 1967. The island nation has long loomed large on the global innovation stage—currently ranking at number-two in R&D spending as a percentage of GDP (3.4%). Along with the U.S., Germany, Korea, and France, Japan was one of the biggest R&D performers in the OECD arena in 2019 in terms of gross domestic expenditure—even as it has found itself outpaced by the collective 27 EU member states over the last two decades. But as other countries with storied R&D pasts (like Russia) have discovered, more spending does not necessarily lead to more results: The relationship between R&D expenditure and productivity gains in Japanese companies has weakened considerably.
In 2020, COVID-19 hit the world’s third-largest economy with a vicious one-two punch: It forced Tokyo to postpone hosting the Summer Olympics—temporarily forfeiting both the prestige and the economic jolt it anticipated—and erased years of economic growth, triggering the nation’s worst slowdown since the end of World War II. The abrupt resignation of longtime prime minister Shinzo Abe in August of that year—and the ascension of a low-key insider, Yoshihide Suga, to the premiership at a fraught moment—only added to the disruption.
The humbling losses of the pandemic era have thrown an unfamiliar yet revealing spotlight on the many ways in which Japan’s managerial autopilot may have been on the wrong trajectory. Under Suga, Japan is attempting a difficult balancing act. It’s trying to catalyze a recovery with targeted corporate tax reductions—while simultaneously advancing two ambitious initiatives: ensuring the country is carbon-neutral within three decades and promoting the digital transformation (DX) of both private sector and the government, which are increasingly bogged down by legacy infrastructure. These goals and Japan’s longstanding support for innovation together are driving the new measures, which include incentives to generate nearly $2 trillion worth of “green growth” investment by 2050, substantial boosts in digital infrastructure incentives, and modernization of its tax-administration procedures.
While it also dispenses some grants across various sectors, the heart and muscle of Japan’s R&D incentive regime is its system of tax credits. What gives those credits extra punch is that, like the bobtail squid, they live and die within a single year—they are not usable or refundable without adequate offsetable taxable income during the same fiscal year, and they cannot be carried forward or back.
Japan hasn’t been shy about using those incentives to promote investment or productivity in targeted areas, and it has regularly tinkered with headline credit rates, thresholds, ceilings, extensions, and deadlines. Still, in many ways, Japan has lagged the go-go startup culture (and cutting-edge tech innovations) of its main rivals. A succession of tax reform bills over the last few years have put temporary measures in place to support investments in Internet of Things (IoT), Big Data, artificial intelligence, 5G technology, and new production facilities, among other priority areas.
Now the swirl of crises of 2020, internal and external, has given birth to yet another tax reform bill (in place since April 1, 2021). Like its recent predecessors, this bill brings significant changes, with a clear push toward more generosity—and a few extra carrots (and sticks) thrown in to motivate corporations to increase their R&D spending.
What Constitutes R&D?
Similar in many ways to the United States, Japan defines R&D as experiments and research of a scientific or technical nature focused on manufacturing new products, inventing new technologies (or improving existing ones), or developing new services. These activities are validated by the use of qualified research expenditures, or QREs.
The definition of QREs is fairly broad: It includes the cost of materials and salaries for personnel with expert knowledge and skills who work exclusively on R&D activities, as well as any other expenditure directly involved in conducting the experiments and research—including, for the first time, outside contractors. The 2021 reforms also liberalized the definition of QRE to include internal software used to provide cloud-based services to customers. There’s also a depreciation allowance for machinery and equipment used in the R&D work.
Only tax-deductible R&D expenses incurred by the Japanese entity are eligible for the credit—and detailed documentation (especially around labor costs) substantiating these expenses is required. Yet R&D activities may occur within or outside of Japan—part of the government’s push to promote its companies within international markets and foreign academia.
What’s Available, and Who’s Eligible?
Japan has two permanent R&D volume-based tax credits: one for general R&D expenses and one for special “open innovation” R&D expenses. Each of these programs has been enriched with special provisions that can enhance or extend the benefits under specific circumstances.
On top of these bedrock programs, there are multiple limited-time incentives on offer, targeted at priority areas:
The general-expense R&D tax credit is segmented by large and small-to-medium-sized enterprises (SMEs). Large companies can get a tax credit in the range of 2% to 14% (the lower limit was reduced from 6% after the 2021 reform) of their total qualified R&D spend—up to a cap of 25% of all tax payable (before the credit is applied). The ratio represented in that two-to-14 spread is determined by the company’s increase or decrease in R&D spend in the current fiscal year, relative to the past three-year average (the “ratio curve” was sharpened in early 2021 to offer companies additional, tailored incentives to invest). Large companies must prove that they are investing sufficiently in R&D—in the form of wage growth and adequate capital investment as a percentage of total depreciation—to obtain these credits.
SMEs (defined as companies with capital of ¥100 million or less, though limitations apply) can get a tax credit of between 12% and 17% (based on the same criteria) of their total R&D spend in the fiscal year, but with a cap of 35% of total corporate tax.
The basic benefits are even richer for so-called R&D venture corporations, whose tax credit cap is raised to 40%—a temporary benefit which has been extended through FY23. These companies are defined strictly: among other rules, they must have been established within the previous 10 years, carry net operating losses forward, and not be a subsidiary of a larger corporation. This incentive makes sense when you consider that Japan has been very late to the game in fostering a VC culture—and far, far behind its main rivals, the United States and China, on that score. In 2019, the current PM Suga (then chief cabinet secretary) set a goal to double the number of startups by 2024. Along the same VC theme, while not an R&D program per se, the government also introduced, as part of 2020’s tax reforms, a special 25% deduction for qualifying companies making capital investments in certain venture companies—available through March 31, 2022.
That’s just for openers—now for the sweeteners:
The government is keen to reward companies for spending—and to incentivize them to spend—relatively more on R&D, despite the pandemic-driven downturn. So, they raised the maximum permissible R&D tax credit by 5%—from 25% to 30% for large enterprises, and 35% to 40% for SMEs—for companies who both (a) saw their gross sales decrease by 2% or more in the current FY as compared to the “base year” (the latest FY ending before February 1, 2020) and (b) spent more on qualified R&D expenditures in the current year than they did in that base year.
The government has also extended for another two years a special incremental credit for companies engaging in higher-intensity R&D activities. Large enterprises whose qualified R&D spend is more than 10% of average gross sales over the prior three years are eligible for an additional tax credit of up to 10%.
And then there’s Japan’s other permanent, volume-based R&D tax incentive program: special “Open Innovation” R&D credits, meant to support ongoing innovation in Japan. Eligible expenses are incurred by either engaging in joint R&D with other parties (including national R&D institutions, universities, R&D venture companies, and other private enterprises), or consigning the R&D to such third parties. That allowable ratio varies from 20% to 25% to 30% (depending on the counterparty) of qualified R&D expenses. This credit is capped at 10% of corporate tax liability.
The takeaway from the general-expense R&D tax credit? When you put it all together, companies who qualify for more than one of these add-on incentives could hit the tax-credit jackpot—with up to 60% off their corporate tax bill if all the R&D stars align. Even if they don’t, this amounts to a major shot in the arm for innovation in Japan.
On the compliance front, the R&D tax credit is available to “blue form” tax-return filers—companies that comply with certain record-keeping requirements and apply to the National Tax Agency, the body that administers Japan’s R&D incentive programs. To qualify for the Open Innovation credit, taxpayers must file a yearly report with the Ministry of Economy, Trade and Industry about the investments, and get confirmation in advance. Eligibility for tax credits is scrutinized by tax authorities upon future tax audits. In keeping with the new focus on DX, companies can now file digitally.
Then there are the two non-R&D related incentives in the FY2022 tax reform bill—which, being squarely focused on new and innovative technologies, will likely cross-pollinate with some of the new R&D tax-credit benefits enabled in the same bill. These new measures, twin pillars of Prime Minister Suga’s ambitious post-pandemic plans, are also meant to work in tandem—at least in terms of the total allowable benefit, which, bundled together, is capped at 20% of corporate income tax.
Digital Transformation (DX) investment incentives
Japan’s digital infrastructure weaknesses—a legacy of rigid, scattered systems—came painfully to the fore in 2020, laid bare by the multiple stress points of the pandemic. The new government has made clear its desire to leave its dated systems in the dust—and spur investment in cloud-based systems, digital backbone, and more holistic IT strategies, generally. They are also eager to promote innovative software R&D for hardware applications such as AI devices and self-driving cars.
A central component of the new tax law, Japan’s DX investment incentive plan makes DX-related investments of up to ¥30 billion (about $300 million) eligible for a 30% special depreciation, or a tax credit of 3% (5%, if that data is linked to an external party). Allowable areas of investment include software, machinery and equipment that contribute to improved productivity, and marketing development. The incentive is initially expected to be offered through the end of FY2023.
Carbon Neutrality investment incentives
Under this plan, carbon-neutral-related investments of up to ¥50 billion (about $500 million), are eligible for 50% special depreciation, or a 5% to 10% tax credit (depending on how much carbon emission is decreased). Allowable areas of investment include equipment focused on reducing greenhouse gas emissions and accelerating carbon neutrality. The incentive is effective through the end of FY2024.
Small Business, Big Impact
Like many developed economies, Japan tends to lavish extra attention on its SMEs, which it sees as engines of innovation and growth. The feeling must be mutual: Small and midsize enterprises accounted for 70% of R&D tax-relief recipients in 2018.
Outside of the advantageous terms for qualifying for the R&D tax credits outlined above, most of the generosity built into the 2021 tax-reform bill is in the form of fiscal measures, such as an extension of the corporate tax-rate reduction, from 19% to 15%, for another two years. Another noteworthy incentive: In a bid to stimulate more merger and acquisition activity among qualified SMEs—the kind that could lead to consolidation of management and other resources—an SME acquiring another is now allowed to deduct up to 70% of the acquisition cost in the year of acquisition.
The Takeaway: Can Japan Get Its Innovation Mojo Back?
Nearly synonymous with must-have technology, and innovative design and engineering, Japan once led the world in R&D, with its electronics, autos, cameras, and so on. But the business-government cultural nexus that was so vital to that decades-ago dominance seems to have fallen behind the times (if not off the side of the road). Disruption—an overused buzzword nowadays, but one that still carries heat—is simply not consistent with a corporate culture centered around consensus, planning, and careful attention to detail. And yet disruption is now leading the conversation—to the point of being equated with innovation.
It will take fresh energy, new perspectives, new agility—and new incentives—for Japan to regain its innovation edge. The new government seems to recognize this: the fingerprints of change (or at least, wished-for change) are all over the latest tax-reform bill. Once again, Japan is looking to its R&D ecosystem for help in level-setting its economy, updating its infrastructure, and brushing off its stature as a world leader in technological innovation.
Lydia Clowney is a CPA specializing in R&D tax credits. She works as a subject matter expert on CrossBorder Solutions’ R&D tax credit software solution helping enable the future of simpler tax compliance through technology. Before joining CrossBorder Solutions, Clowney worked as an R&D tax credit consultant at BDO USA, LLP.