Is the R&D tax break really an incentive to innovate?

There is opposition to the proposed withdrawal of R&D tax breaks in India. But did the perk really propel companies to research and innovate?

Sachin Joneja

[Photograph by Alexas_Fotos under Creative Commons]

It never ceases to amaze me just how much misinformation and alarmist propaganda Corporate India can spread whenever it is proposed to withdraw a regulatory perk or a privilege. The fact that, in the global context, they are not alone is cold comfort. The latest round of fear mongering is around the proposed withdrawal of R&D tax breaks in India.

In light of all the heat and dust generated I decided to try and look at various industries in India that have been completely transformed by technology and to look at their successes and failures (as an industry rather than as individual companies) and see what role the tax break on R&D has played or not played in this transformation.

Before I begin, let me clarify that I want to completely avoid talking about the misuse or abuse of this law to claim weighted tax breaks for expenditures on things like quality control, minor—even trivial—process improvements or even training fresh engineers and trainees. For that just a look at the evolution of the various rules that have been framed over the years to implement this provision will suffice.

Let’s just look at two facets. First, industries where India is globally competitive and R&D has some reasonable role to play in that and second, global companies with R&D offices in India. For both, let us see whether the R&D tax deduction had any role in creating their current position.

Paving the road to global competitiveness?

Take the healthcare inputs industry in India—pharmaceuticals, biotech, medical devices, etc. This industry has seen two sharp shocks that influenced it and brought it to where it is. The first came in the form of India’s decision in 1970 to only permit process patents rather than product patents for drugs. That saw every chemical engineer in the country trying to come up with a new process for making existing drugs and their intermediates. These were first for the Indian market and then for the global market. Did this outpouring of creativity require the tax break? Was the tax break even a necessary condition—leave alone a sufficient condition or a tipping point—to make this outpouring happen? Frankly the start-ups could have done nothing with the break since there were no profits to set it off against to start with.

Then, after India entered the World Trade Organization (WTO) in 1994, it changed course and agreed to accept product patents for new drugs from January 2005. Did any of the companies created by the first wave roll over and die or remain confined to generic drugs? Not really. Each in its own way tried to enter pharma R&D and created R&D setups to discover new drugs. Were they worried that, as internationally reported, the cost of finding a new drug was higher than their annual sales?

Ask yourself, did the availability of the tax credit actually contribute to the decision to set up an R&D infrastructure? Today all leading Indian pharma companies are already global. And a pioneer and   leader of the earlier era, Ranbaxy Laboratories, doesn’t even exist anymore, having been eaten up by other players.

Did the tax break help the companies in this case? Yes, to a point, because when they set up new drug discovery units, companies existed and had profits against which this break could be set off. But did it influence the actual activity of doing R&D or even its location? Not really. Will a withdrawal of the break mean that these companies will move their R&D overseas and whatever remains in India will be due to sheer inertia? We’ll look at that a bit later.

Let’s look at automobiles next. This industry too has seen two sharp shocks and one smaller one. First came the shock administered by the entry of Japanese companies, in the first half of the 1980s. You had Maruti, light commercial vehicle makers (remember DCM Toyota, Swaraj Mazda, Eicher Mitsubishi?) and also two-wheeler makers.

Then came the second shock: the complete opening up of the sector to foreign players in 1991. For two-wheeler and three-wheeler makers there was the smaller shock of seeing a change in pollution control norms which effectively ended the life of the two stroke engine-based offering as a viable product.

The response to the first shock (the entry of the Japanese players) was mixed. Carmakers did do some cosmetic changes, but for one, Premier Automobiles, it was the beginning of the end. The other, Hindustan Motors, sort of carved out a retro rugged positioning and somehow survived but finally seems to have hit the end of the road in the previous year. The LCV market saw a better response with Tata Motors creating a viable range. It was helped by a sharp appreciation of the Yen and the consequent rise in prices of the Japanese collaboration offerings, but it did create a credible product.

And then there was Bajaj scooter—a “globally competitive” product even in that era, which was trying to enter the international market and had a 10 year waiting list for its product in India. The motorcycle revolution began in earnest and the various companies with Japanese collaborators redefined the market. Over time, each of the foreign tie-ups either died or evolved. And the Indian partners, including Bajaj—by now in its second global tie up—learned to create new products on their own.

Each of the old automobile companies had an R&D department and did claim the benefit of the R&D tax credit. The Engineering Research Centre in Tata Motors, Pune existed even prior to these shocks. Bajaj Auto was researching two- and three-wheelers with a formal department to do that well before these shocks.

Did the R&D tax credit and the high level of profits that the automobile companies were making in all those years of the closed market incentivise them to develop an R&D base and develop globally competitive products? Today all but two of the firms that have survived from the pre-1991 era have a global footprint. So what exactly was the role of the R&D tax credit in making the companies transform themselves and their continuing willingness to do R&D and develop new products?   

Finally, in the list of globally competitive Indian industries, let’s look at information technology (IT) — the industry that is India’s claim to global fame. This was a new industry that was created in the 1980s as the personal computer, the mini computer and networks (and the internet) all came into their own. Of all the leading Indian software companies today, only Tata Consultancy Services got into software directly because it began life as an in-house software provider to the Tata group. The rest—HCL, Wipro, Infosys—began with or dabbled in computer hardware or hardware applications of some sort and then moved on to software. All the “R&D” that was done to make the original push into hardware would have qualified for this tax credit. Did the tax credit drive decisions either way? Was it perhaps a nice thing to have? Where relevant and beneficial, yes—which company would object to paying a lower tax—but drive the decision, influence the decision?

An incentive to make India an R&D hub?

Now let’s turn our gaze to non-Indian global companies that have R&D setups in India—and I am not referring to business process outsourcing (BPO) setups here. General Electric set up a BPO operation that was spun out as Genpact, but it also has an R&D facility in Bengaluru. Microsoft has an R&D facility in Hyderabad. Did R&D tax credit actually influence the decision to set these up?

A straightforward answer is provided by the research setups of companies that have no other business footprint in India or where the size of the R&D setup is disproportionately large relative to their other India business. And in this category, please include Texas Instruments and even Intel—yes, Intel. Even though Intel chips power most of the computers in India, the chips are sold to the manufacturers of the computers in the country where the computer is assembled, which is not India. So, profits from the sale of chips used in computers that Indian customers buy, is not necessarily available to set off any tax breaks that they would get for their India R&D centre.

So why are their R&D setups in India? Certainly not to benefit from a potential R&D tax credit—they don’t have the profits in India to set it off against. So again, the tax credit is not a driver of the decision. Maybe we need to look at the sheer size of the pool of engineering talent, even globally trained engineering talent, that is available to an India centre at Indian cost of living and salaries for an answer as to why the R&D centres are here? Or maybe, just maybe, the size of the market and need to locate research in close proximity to such a market drive those decisions? Whatever it is, to me at least, it doesn’t appear as if the tax break is a particularly relevant driver.

Will R&D centres shift away from India?

Finally, we come to the fear that if the tax credit were to be withdrawn, these multinational companies or the global Indian companies (that need to remain globally competitive) will walk away from their R&D setups in India over time. Let me make a couple of points in this context.

First, as I have tried to show through the point about non-Indian multinationals, the decision to locate an R&D centre in India is not driven by the tax credit in the first place, so why would its withdrawal be a reason to change course?

Second, for the emerging Indian multinationals, they already do R&D in non-Indian locations. For software it is anyways an article of faith. They set up all operations wherever it makes sense to them and the R&D credit or non-credit will make not an iota of difference to this.

In the automobile industry, Tata Motors is busy modernising R&D in its Engineering Research Centre and also has an R&D centre in London. Its subsidiary Tata Technologies is already a global R&D outsourcing business with a presence in all major automobile manufacturing countries. All this does not even take into account the R&D done in Daewoo trucks and Jaguar Land Rover. Mahindra and Mahindra has two major R&D setups, one in Chennai and the other in Singapore.

In the pharma industry, already some smaller companies have R&D setups in India with leadership provided by staff sitting in Dubai or Singapore. The Indian R&D tax break is not what makes these companies avoid getting their R&D heads to come to India from overseas, nor prevents them from moving the back office out of India.

So, all in all, I for one cannot see where the fire—or potential fire—is. There are many actions that the government can (and should) take to encourage R&D in India, but letting this R&D tax credit stay on the statute book is certainly not one of them.

In fact, this tax credit is an anachronism and needs to go. How I wish Indian industry or individual members within it would grow up and stop walking around with a sense of entitlement, asking for sops to operate in India. I thought that era was behind us.

If this doesn’t quite happen, I hope the government will tell Indian industry and chambers of commerce (actually capital masquerading as industry and enterprise) what I often say in private conversations where talk about “conditions in India” is either dismissive or condescending: “Ticket main katwa doon? Kahan jaiyega?” (Shall I buy you a ticket (to migrate)? Where would you like to go?)  And since it is enterprise and industry that India needs, not capital, they are welcome to take “their capital” with them, thank you. 

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About the author

Sachin Joneja
Sachin Joneja

Independent Consultant

Sachin Joneja has been a part of the Indian equity markets—in one capacity or the other—from when the Sensex was in three digits. His career has grown and evolved with the markets. From 1989 to 1999, he conceptualised and led the creation of equity research departments for two companies—first for Champaklal Investment and Financial Consultancy Ltd, one of the original big four merchant banks of the pre-liberalisation era and then in the post liberalisation era for the stock broking subsidiary of ITC Classic Finance Ltd.

Since then he has been an independent consultant in the venture capital and private and corporate investment areas. Initially, he worked largely with the internal team at Reliance Industries Ltd to help them strategise and evaluate investments in companies in the software domain. Later, he moved to looking at the electric vehicle and alternate energy space and advised high technology start-ups from overseas interested in opportunities in the Indian market.

He is fascinated with the interplay of entrepreneurial ideas and energy on the one hand and capital—including state capital—on the other and how they shape the market for risk capital and control. Sachin has evolved sharp insights into what it would take to develop a strong high-tech entrepreneurship ecosystem and how to remove the current barriers that are preventing it from taking shape. He is also deeply interested in the role that modern corporate venturing models and sovereign wealth fund type investment structures can play in deepening the entrepreneurial ecosystem in India.

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