Japan’s R&D Incentives - Exactera (2024)

Like the U.S.and many other industrialized nations, Japan’s R&D tax regime hasevolved with the times—and in response to shifting economic needs.

Withone ofthe highest effective corporate income tax rates in the world, Japanhas usedR&Dincentivesasacornerstone of its industrial policy—and akey lever in driving economic growth—as far back as1967.

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 hasfound itselfoutpacedbythe collective 27 EU memberstatesover the last two decades.

Butas other countries with storied R&D pasts (likeRussia) have discovered, morespending does notnecessarily lead to more results:Therelationship between R&D expenditure and productivitygainsin Japanese companies hasweakenedconsiderably.

In2020,COVID-19 hitthe world’s third-largest economywith a vicious one-two punch:ItforcedTokyoto postponehostingtheSummer Olympics—temporarily forfeitingboththe prestigeandtheeconomic joltit anticipated—anderasedyears ofeconomicgrowth,triggeringthenation’sworst slowdown since the end of WorldWarII.

The abrupt resignation of longtime prime minister Shinzo Abe inAugust of that year—and the ascension of alow-keyinsider,Yoshihide Suga, to the premiership at a fraught moment—onlyadded tothedisruption.

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 onthe wrong trajectory.

Under Suga, Japanisattemptinga difficult balancing act. It’strying tocatalyze a recoverywithtargeted corporatetax reductions—whilesimultaneouslyadvancing twoambitiousinitiatives:ensuring the country iscarbon-neutralwithin three decadesand promotingthedigital transformation(DX) of both private sectorand the government,which areincreasinglybogged downby legacy infrastructure.

These goalsandJapan’slongstandingsupport forinnovationtogetherare drivingthenewmeasures,which includeincentives togeneratenearly$2 trillion worth of “green growth” investmentby 2050,substantial boosts in digital infrastructureincentives,andmodernization of itstax-administration procedures.

While italsodispenses somegrants acrossvarious sectors,the heart and muscle ofJapan’s R&D incentiveregimeisitssystem oftax credits.

What givesthosecreditsextrapunch is that, likethe bobtail squid,theylive and die withina singleyear—theyare not usableorrefundablewithoutadequate offsetable taxable incomeduring the same fiscal year, and they cannot be carried forwardor back.

Japan hasn’t been shy about usingthoseincentivesto promote investment or productivity in targeted areas, andithas regularly tinkered with headline credit rates, thresholds, ceilings, extensions,and deadlines.

Still, in many ways,Japanhas lagged the go-go startup culture (and cutting-edge tech innovations) of its main rivals.A succession of tax reform billsover the last few yearshave puttemporary measures in place to support investments in Internet of Things (IoT),Big Data, artificial intelligence,5G technology,andnew production facilities,among other priority areas.

Now theswirl of crises of 2020, internal and external,hasgivenbirth toyet another tax reform bill (in place sinceApril 1, 2021). Like its recent predecessors,this bill bringssignificant changes, with a clear push toward more generosity—anda few extra carrots (and sticks)thrown intomotivatecorporations to increase their R&D spending.

What Constitutes R&D?

Similar in many ways to the United States,JapandefinesR&Dasexperiments and researchof a scientific or technical naturefocused onmanufacturingnewproducts, inventingnewtechnologies (or improvingexistingones), ordevelopingnew services. These activities are validatedby the use ofqualified research expenditures,orQREs.

The definition of QREs isfairly broad:Itincludesthe cost of materials and salaries for personnelwith expert knowledge and skillswhoworkexclusivelyonR&D activities, as well as any other expenditure directly involved in conducting the experiments and research—including, forthe first time,outsidecontractors.

The2021reformsalsoliberalizedthe definition ofQREtoincludeinternal softwareused toprovidecloud-basedservices to customers.There’s alsoa depreciation allowance for machinery and equipment usedin the R&Dwork.

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.

YetR&Dactivities may occur within or outside of Japan—part of the government’s push topromoteitscompanieswithininternational markets andforeignacademia.

What’s Available, and Who’sEligible?

Japan hastwopermanentR&Dvolume-basedtax credits:one forgeneral R&D expensesand one forspecial “open innovation” R&D expenses. Each ofthese programshas beenenriched withspecial provisionsthatcanenhance orextendthebenefitsunderspecificcirc*mstances.

On top of these bedrock programs, there are multiple limited-time incentives on offer, targeted at priority areas:

Thegeneral-expenseR&D tax creditis segmented bylarge and small-to-medium-sizedenterprises(SMEs).Large companiescan get a tax creditin the range of2% to14%(thelower limitwasreducedfrom 6% after the 2021 reform)of their totalqualifiedR&D spend—up to a cap of25%of all tax payable(before the credit is applied).

Theratio representedin thattwo-to-14 spreadis determined by thecompany’s increase or decreasein R&D spendin the current fiscal year,relative to the pastthree-year average(the“ratio curve” was sharpened inearly 2021to offer companiesadditional, tailoredincentives to invest).

Large companies must prove that they are investing sufficientlyin R&D—in the form ofwagegrowth 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 creditof between12%and17%(based on the same criteria)of their total R&D spend in thefiscalyear, butwith a cap of35%of total corporate tax.

The basic benefits are even richer for so-calledR&D venture corporations, whose tax creditcapisraised to40%—a temporary benefit that has been extended through FY23.

These companies are defined strictly:among other rules,they musthave beenestablished within theprevious10 years,carrynet operatinglossesforward,andnotbe asubsidiary of a largercorporation.

This incentive makes sense when you consider that Japan has been verylate to the gamein 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 (thenchiefcabinetsecretary)set a goal to double the number of startups by 2024.Along the sameVCtheme, while not an R&D program per se, the government also introduced, as part of 2020’s tax reforms, aspecial 25% deductionfor qualifying companies making capital investments in certain venture companies—available through March 31, 2022.

That’s just for openers—nowforthe sweeteners:

The governmentiskeen to reward companies for spending—and to incentivizethem to spend—relatively more on R&D, despite the pandemic-driven downturn.

So,theyraised the maximumpermissibleR&D taxcreditby5%—from 25%to30%for large enterprises, and35%to40%for SMEs—for companieswhoboth (a)saw theirgrosssales decrease by 2%or more inthe current FYas compared tothe “base year” (the latestFYendingbefore February1,2020)and(b) spentmore onqualified R&D expendituresin 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 to10%.

And then there’s Japan’s otherpermanent,volume-based R&D tax incentive program:special“OpenInnovation”R&Dcredits,meant to supportongoinginnovation in Japan.

Eligibleexpenses are incurred byeither 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%to25%to30%(depending on the counterparty)ofqualified R&Dexpenses.This creditiscappedat10%of corporate tax liability.

The takeaway from the general-expense R&D tax credit? When youput it all together,companies who qualifyfor more than one of these add-on incentivescouldhit the tax-credit jackpot—withup to60%off theircorporate taxbillif all theR&Dstars 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 andapplyto theNational Tax Agency, the body that administers Japan’sR&D incentiveprograms.

To qualify for the Open Innovation credit, taxpayers must filea yearly reportwiththe Ministry of Economy, Trade and Industry about the investments,and get confirmationin advance.

Eligibility for tax creditsis 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 theFY2022tax 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 pillarsofPrime 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,iscapped at20% 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 governmenthas made clear its desiretoleave its dated systems in thedust—andspur investment in cloud-based systems, digital backbone,and more holistic IT strategies,generally. They arealso eagerto promote innovative software R&D forhardware applications such as AIdevicesand self-driving cars.

Acentral componentof the new tax law, Japan’sDX investment incentive planmakesDX-related investmentsof up to¥30 billion (about$300 million)eligible fora30%special depreciation,or atax credit of3%(5%,if that data islinked to an external party).

Allowable areas ofinvestment include software, machinery and equipment that contribute to improved productivity,and marketing development.The incentive is initially expected tobe offeredthrough the end of FY2023.

Carbon Neutralityinvestment incentives

Under this plan,carbon-neutral-related investmentsofup to¥50 billion (about$500 million),areeligible for 50%special depreciation,or a5%to 10%tax credit (depending on how much carbon emission is decreased).

Allowableareas ofinvestment includeequipment focused on reducing greenhouse gas emissionsand accelerating carbon neutrality.The incentive iseffectivethrough the end of FY2024.

Small Business, Big Impact

Like many developed economies, Japan tends to lavishextraattention on its SMEs, which it sees as engines of innovation and growth. The feeling must be mutual:Small and midsizeenterprisesaccounted 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 moremerger and acquisitionactivity among qualified SMEs—the kind that could lead to consolidation of management and other resources—an SME acquiring anotheris nowallowed to deductup 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 inR&D, with its electronics, autos, cameras,and so on.

But the business-government cultural nexus that was so vital to thatdecades-agodominanceseems to have fallen behind the times(if notoffthe side of the road).

Disruption—an overused buzzword nowadays, but onethat still carriesheat—issimplynot 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 freshenergy,new perspectives, new agility—and new incentives—forJapan to regain its innovationedge.The new government seems to recognize this:the fingerprints of change (or at least, wished-for change) are all overthe latesttax-reform bill.

Once again,Japan is looking to itsR&D ecosystem for help in level-setting its economy, updating its infrastructure, and brushing off its stature as a world leader in technological innovation.