Research and development (R&D) is a phase of technological development that carries an increased risk for business when compared to the production costs for established products; nevertheless, it is an indispensable activity if technological and medical advances are to continue. For some businesses, on-going R&D activities are necessary to continued prosperity. In an effort to encourage and support new developments, many governments offer a research and development credit for both individual and business taxes.
For tax purposes, a credit is different than a deduction. A tax deduction is an expense that is deducted from income prior to calculating tax liability. For example, if a person or business has an adjusted gross income (AGI) of $50,000 US Dollars (USD) and deductions of $15,000 USD, the deductions are subtracted from the AGI to determine taxable income and tax liability. In contrast, a tax credit is a reduction of the tax liability, so if the tax liability is $5,000 USD and there is a research and development credit of $1,500 USD, then the taxes are reduced to $3,500 USD.
In the United States, the federal government offers a research and development credit for technology R&D activities in many applications, such as energy development, medical advances, and the development of generic prescription drugs. Generic drugs are the bioequivalent of medications already approved by the Food and Drug Administration (FDA) which have an expired patent. This general credit for medications does not apply to the development of new drugs. The US tax code offers a variety of choices in how to apply the credit, and anyone who qualifies for the research and development credit should calculate it using all methods to find out which will be most advantageous.
The US does not generally offer credits for most new drug development, since patent laws allow the pharmaceutical companies exclusive rights to any drugs they develop for a long enough period to recoup the R&D expenses and realize a profit. There is a tendency, however, for companies to only undertake drug research for diseases which are wide spread enough that their risks of not recouping the expenses are negligible. As a result, little research may be attempted to find treatments for rare diseases or conditions. In the US, a rare disease is defined as a condition which affects 200,000 people or less in the country, or a disease which affects more than 200,000 people, but for which it is not reasonable to expect the company to recover their expenses. To support this type of research, a special research and development credit, called the orphan drug credit, has been developed.
Some states within the US also offer a research and development credit for certain designated activities. For example, in Colorado a R&D income tax credit is available for taxpayers who invest in research and experimental activities in one of the state’s enterprise zones. An enterprise zone is an economically depressed area, designated by the state, for which special tax treatment is given to companies who will help develop businesses and create jobs in that area.
In addition to the US, a research and development credit is offered by Australia, Austria, Canada, France, Germany, Ireland, Mexico, the Netherlands, New Zealand, South Africa and the UK. In some cases, these are not actually credits, but take the form of a special deduction or accelerated method of depreciating capital investments made for R&D purposes, while countries offer an actual credit that is applied to the tax liability. In some regions, such as Canada, the most attractive credits go to small- and medium-sized companies. Recent tax law changes in France have resulted in that country offering some of the best R&D credits for large corporations. Other countries, like Brazil, do not offer a national research and development credit, but have R&D credits available at the state or provincial level.