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Dec
15
ragupathyrenganathan
Is the R&D tax break really an incentive to innovate?
Drug Discovery, Formulation Discussion, Regulatory Affairs
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Photo: Bloomberg

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 latest round of fear mongering is around the proposed withdrawal of R&D tax breaks.

In light of all the heat and dust, I decided to 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 the role the tax break on R&D has played or not played in this transformation.

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.

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 it 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 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 set-ups 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. A pioneer and leader of the earlier era, Ranbaxy Laboratories, doesn’t even exist anymore, having been eaten up by other firms.

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 (LCV) 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 companies in 1991. For two-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 firms) was mixed. Car makers 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.

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. The Indian partners, including Bajaj—by now in its second global tie-up—learnt 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 incentivize 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?

An incentive to make India an R&D hub?

Now let’s turn our gaze to non-Indian global companies that have R&D set-ups in India—and I am not referring to business process outsourcing set-ups here. General Electric 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 set-ups of companies that have no other business footprint in India or where the size of the R&D set-up is disproportionately large relative to their other India business.

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 computers are 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 set-ups 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. Maybe we need to look at the sheer size of the pool of engineering talent that is available to an India centre at Indian cost of living and salaries for an answer. 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 set-ups in India over time.

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.

In the automobile industry, Tata Motors is busy modernizing 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 set-ups, one in Chennai and the other in Singapore.

In the pharma industry, already some smaller companies have R&D set-ups 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 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 not tax breaks to seed innovation, then what?

One key assumption behind this entire thought process seems to be that R&D is also something that the government can actively encourage and induce by using tax policy. The thinking assumes that R&D is a good habit that can be encouraged with some carrots, much like exercise or healthy food. Is that an appropriate way to even think about it?

Forget about the government or any external agency, can even the chief executive or a set of individuals within a company’s senior management, with an inherent love for R&D, simply encourage a large company to do R&D that is meaningful and material, given its scale of operations? From whatever I have understood about this, it is extremely difficult and risky.

What a senior management’s love for R&D divorced from the business’s needs and compulsions usually creates is an ivory tower, a vanity project, whose only meaningful and real link with the business is that the profits pay the bills and keep the lights on. Perhaps the most famous vanity project in the world is the Xerox Palo Alto Research Center (PARC). PARC did some revolutionary work and helped give birth to an entire industry, except that the work did nothing much for Xerox. A less successful Indian equivalent would be the Engineering Research Centre at Tata Motors.

The tragedy of these vanity projects is that they are actually initiated by some of the most decent and sincere people. In their individual or even collective capacities they are anything, but vain. These projects result from a very human sentiment that goes: “When we can afford it, we’ll invest in our own R&D.” This is a dream, an aspiration of an individual or perhaps all good technologists at the helm of large companies. It has nothing to do with the needs of the organization at that point of time.

If a CEO does decide to “invest in our own R&D”, in a manner that makes organizational sense, she needs to bring enterprise—organizational enterprise—to the table. Such a move will, in most instances, be game changing and risky enough for the world to notice. R&D tax breaks or their absence will make little difference to this.

A good example is Tata Motors’ move to passenger cars. The original Indica project brought the company to its knees. Even today, despite the technical achievement that the Nano represents, the passenger car division is struggling in the marketplace. By the way, while the company was at it, it had to completely revamp the Engineering Research Centre and its links with the rest of the firm.

With this out of the way, let’s revisit the question and ask what exactly can the government do to encourage large companies to do R&D? The only thing that can work is to increase the competitive intensity of the marketplace. Just keep creating a credible set of threats in the marketplace that ensure that the companies know that R&D and the resulting products will happen with or without the cooperation of the current entities in the industry.

Let the government learn to distinguish between the existing firms (and their relative positions) in the industry and Indian industry as a whole. Companies and their position will change all the time.

At present in India, for all the sectors where there is real R&D, the competitive intensity is coming from global exposure and global integration of businesses. What the government needs to do is enhance Indian science and the ecosystem for early-stage commercialization to the level that it ensures that a credible message goes out that the R&D efforts of the country will keep creating competition whether the existing firms like it or not.

Automatically, the love for R&D will begin to be fostered in an entire sector and its businesses, and the appropriate and healthy linkages between Indian science and (global, including Indian) industry will develop.

Perhaps the only sector where we get to see such a healthy relationship in India is in the pharmaceuticals and biotech sector. Right from the time that India changed the patent laws to allow for process patents, and the public sector unit, Indian Drugs and Pharmaceuticals Ltd (IDPL), Hyderabad, along with the various Indian chemical laboratories did the early research, this link has been strong, so much so that to date Hyderabad is the capital of the Indian pharma industry though IDPL is long gone.

The key driver for such an integration between Indian science and the sector is not quite understood. It is the mutual respect between the leaders of the industry and the science sector. This came about because most of the researchers who worked in India in those early days had done their PhDs from the very same science institutes.

Perhaps that answers where the support and encouragement of the government belong. It needs to support and actively encourage Indian science to set up businesses. It needs to actively encourage a two-way street between science and business for PhDs working in India.

Here we go. The paternalistic encourage word again. Perhaps a reminder that even parental love and care includes something called tough love is in order here? The government needs to support and encourage the activity, by creating or inducing the creation of an ecosystem, but the product and businesses created need to stand on their own. Lots of businesses or business divisions doing some activities will also need to offer themselves up to fulfil the destruction part of the phrase creative destruction. Both support and encouragement for the scientist or entrepreneur and a strict market-oriented test for the businesses need to coexist.

Let me give you an example of just how powerful a force a change in competitive intensity can be, from the consumer banking and payments space that is unfolding right now. There is clearly a latent demand for payments using a modern electronic wallet-type payment system. It can be a massive facilitator of easier and low-cost (unlike say credit cards) micro payments.

Every bank in the country has the software tools and the access to a modern national electronic transfer network at the back-end and can easily offer such a product. Not one bank actually did. Even after the Reserve Bank of India (RBI) announced plans to issue payments bank licences, nothing much happened. As the process of selecting candidates for the licences gathered steam, the existing banks began to stir. Almost in parallel to the announcement of the licences, major private banks have begun to hard-sell their electronic wallet and payment solutions.

In the old days, you would get an RBI diktat saying that all banks must offer such a product from 1 April 2016, or else. RBI governor Raghuram Rajan has shown us a more elegant way. Maybe what this country needs is for him to don his professorial hat once more and conduct courses for the Indian science and technology, and industrial policy planning leadership to teach them how to save capitalism from the capitalists on a day-to-day basis.

Read an unabridged version on www.foundingfuel.com.

Sachin Joneja is an independent consultant in the venture capital, and private and corporate investment areas.

Courtesy – Livemint



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