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Government incentives – do they give businesses more bangs for the buck?

Author: Leon Harris

Government incentives are big business for big and small businesses. Incentives may be claimed for R&D, patents, industry, employment, environmentally friendly energy generation, etc. Here is our take.

Following is an overview of what is sometimes on offer

Motivation:

  • Governmental motive: Governments usually want to encourage employment and economic activity. Sometimes a government wants its tech sector to catch up with Silicon Valley in California. 

But the US government wants to restore its industrial capacity – there are incentives for companies for companies that “onshore” non-US activities to the US. There is still a threat of tariffs from the Trump administration for industrial exports from outside the USA.

  • Companies’ motives: Companies usually want to reduce the risk that an investment in R&D, equipment or factory premises doesn’t work out by using incentives to lower their own cost of investment or tax rate.

Types of incentive include:

  • Preferential tax rate: Many countries offer preferential tax rates for certain activities. For example, 12.5% corporation tax rate for trading income in the Republic of Ireland. Many US groups run part of their operations through Ireland.
  • Accelerated depreciation for tax purposes. Timing advantage only.
  • Cash grants or tax credits for investments: Start-ups rarely pay tax before sales take off, so tax incentives are often lost on them. Therefore, many start-ups prefer to receive cash grants. 
  • R&D or energy refundable grants: refundable grants are a hybrid – they may reduce the tax bill or be paid out (“refunded”) if the tax bill is insufficient. Refundable grants may on occasion be paid out by tax officials who don’t fully understand whether the technical (R&D etc.) conditions have been met. But refundable grants are favored by the OECD in its “Pillar 2” (15% minimum global tax rate) recommendation regarding groups with annual revenues exceeding EUR 750 million.
  • Notional interest deduction: Some countries such as Cyprus and Portugal may allow the deduction of notional interest on shareholders’ capital (as if it were a loan) from taxable profits. This reduces the tax bill.
  • Tax deferral until profits are distributed: Some countries (e.g. Estonia) may defer corporate tax on profits until the profits are distributed as a dividend 
  • Free trade agreements: Customs duties on imported goods may be reduced or eliminated under free trade agreements. Such agreements may be bilateral or multilateral such as the EU single market.

M&A implications:

  • A potential buyer should ascertain at the due diligence stage whether the potential seller has ever enjoyed governmental grants (or other incentives). 
  • If so, under what conditions. In particular, are there any limitations on a change in ownership e.g. foreign ownership? 
  • Or is there a price to pay upon changed ownership? 
  • Can such issues be legitimately be avoided e.g. by supporting the local economy? If so, what are the detailed conditions? 
  • Is the seller in full compliance with all grant/incentive rules? Can any infringements be fixed? Will the incentives need to be returned? 
  • Also, is the valuation/price of the seller company affected? Suppose a multiple of annual earnings after tax is used and the tax bill was reduced by non-recurrent tax incentives. A potential buyer may consider reducing the value by using profits after a normal (higher) tax charge. If so, the seller may seek to claim the tax breaks are recurring. 
  • Can the potential buyer step into the shoes of the seller and continue enjoying such government incentives? Would this necessitate a share purchase deal rather than an asset purchase deal? If so, is the deal attractive for the potential buyer (hidden liabilities could perhaps be assumed)?

In conclusion:

Government incentives can give businesses and M&A deals more bangs for the buck, but check the conditions and implications.

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