Under the envisaged revised Netherlands innovation box regime, qualifying income is determined per qualifying intangible asset or per coherent group of qualifying intangible assets (tracking-and-tracing). If it is not possible to apply the tracking-and-tracing method, the method for determining the qualifying income will be established by taking into account the nature of the business enterprise and the R&D activities of the taxpayer. It is expected that the main methods used under the current innovation box regime to determine qualifying income will remain applicable to a certain extent. This includes, in particular, the commonly used profit split method. Although the new law does not shed much light on the implementation, it is expected that this will increase the administrative burden for companies, as well as the Netherlands tax authorities. It however also creates opportunities for companies to prepare detailed supporting documentation, which may increase benefits. In this respect we have listed a number of comments.
The initial stage in performing a profit allocation can be complex. In addition, the method of allocating the profits and any assumptions made in doing so need to be documented, which may absorb significant resources in terms of time and costs. Internal data may be helpful where the profit allocation factor is based on a cost accounting system, e.g. headcounts involved or time spent by a certain group of R&D employees on certain tasks. Typically however the profit allocation should be based on some kind of value chain or functional analyses. This should determine where and how value is created in the business and also determines the level of integration between products (which may determine the level at which profits or revenues should be allocated) and the economically relevant contributions (which may determine the factors to use to allocation of profits). Interestingly we often see that excess profits (of what the market would otherwise allow) related to certain products or products groups that are associated with unique intangibles are captured in this kind of analysis (i.e. first mover advantages, unique R&D contributions, protection due to barriers to entry to potential competitors et al). This often is an unexpected benefit of any value chain or functional analyses.
Subsequently the financial data will need to be segregated and allocations need to be made so that the profits solely relating to the R&D activities can be identified. Any company will need to segregate its financial data in a way that reflects the revenues, costs, and profits in relation to R&D investments and R&D capital employed. The choice of the measure of profits to be allocated will depend on the nature of the products and the extent to which these products are integrated. For example, company Q produces two products, A and B. Both products are the result of innovative, complex R&D activities performed by the company.
Company Q shares the production of A and B and the risks associated with the success of the products. However, the selling and other expenses are largely unintegrated. Product A needs significant selling support and product B does only require limited after sales service. Using a profit allocation based on combined operating profits (including production and selling expenses) would have the potential result of sharing selling expenses that are unrelated. In such a case, an allocation of gross profits (before selling expenses) may be more appropriate and reliable for A and B since this level of profits captures the outcomes of R&D investments, market and production activities that the products share together with the associated risks.
It should be noted that we expect that in a number of day-to-day cases asset-based or capital-based factors can be used to allocate profits especially where there is a strong correlation between R&D assets or capital employed and creation of value. In order for a profit allocation factor to be meaningful, it should be applied consistently to all the products of a company. Identification of R&D assets can sometimes be difficult because not all valuable intangibles are legally protected and registered and not all valuable intangibles are recorded in the accounts. In this case an essential part of the analysis is to identify what intangibles are contributed to the production of each product or product group.
A significant issue for the reliability of any allocation factor is the determination of the relevant period of time in relation to the appropriate allocation key (e.g. assets, costs, or others). A difficulty arises because there can be a time lag between the time when expenses are incurred (especially R&D expenses) and the time when value is created. It is also sometimes difficult to decide which period’s expenses should be used. For example, in the case of a cost-based factor, using the R&D expenditure on a single-year basis may be suitable for some ICT-related cases, while in some other cases it may be more suitable to use accumulated R&D expenditure (net of depreciation or amortization) incurred in the previous as well as future years.
Depending on the facts and circumstances of the case, the determination of the appropriate allocation factor may have a significant effect on the allocation of profits between the products / product groups.
We, NovioTax, being a research based advisory firm, are continuously working on increasing our knowledge base, and its consequences for companies doing business globally. Through research, we develop our intellectual capital. Every member of NovioTax is for instance required to participate in research activities. We believe that through the use of research we will discover new ideas and opportunities that support our clients. We are currently working on several Research Papers that will be released via our website.
