Embracing Industry 4.0 means investing time, energy and capital to implement advanced technologies and practices. Cost can be one of the biggest roadblocks to progress, particularly in the middle market. Pilot programs—even if you anticipate significant ROI in the long-term—may require reallocating budget or raising additional capital. For some manufacturers, it’s a make-or-buy decision between building new capabilities or buying through strategic acquisitions.
Tax reform has added another layer of complexity to these financing and budgeting considerations, as manufacturers scramble to parse through the 1,000+ pages of provisions and explanatory statements in the new bill. Its impact goes far beyond the finance and accounting departments. Companies on the verge of major strategic business decisions, including those concerning Industry 4.0, all need to seriously consider the implications of tax reform.
While many of the changes introduced will benefit middle market manufacturers—particularly the corporate tax rate cut—others create new challenges for funding innovation. For example, the new legislation introduces limitations on interest expensing as well as new restrictions on the carryback and use of Net Operating Losses, both of which could present a significant cash flow obstacle and hamstring emerging companies (in addition to the “start-up” and enacted research expenditure capitalization provisions). The tax bill also eliminates the section 199 domestic production activities deduction (“DPAD”), historically a key tax break for U.S. manufacturers, but its loss is offset by the corporate rate reduction.
Amidst the frenzy of tax reform, one no-brainer for manufacturers exploring Industry 4.0 financing options is maximizing federal and state tax incentives. Manufacturers that take advantage of available credits and deductions have more cash, increased earnings per share, lower effective tax rates, and the opportunity to increase their Industry 4.0 investments.
R&D TAX CREDITS
Last year, more than 6,000 manufacturers claimed an estimated $10 billion in R&D tax credits at an average benefit of $1.67 million per company. The number of eligible manufacturers is much higher, meaning many have yet to capitalize on this opportunity, potentially leaving money on the table. Some good news for manufacturers is that the federal R&D tax credit remains intact—and its net value was effectively increased by 22 percent, from 65 to 79 percent of incremental qualified spending because of the corporate rate’s reduction to 21 percent and the required Sec. 280C(c)(3) election or add back of the section 174 Research & Experimental Expenditures tax deduction. The elimination of the corporate Alternative Minimum Tax also means that more manufacturers can benefit from the R&D tax credit.
The objective of R&D credits is to encourage exactly the type of efforts that are at the core of Industry 4.0. Qualifying activities don’t need to be flashy or revolutionary, or even succeed. If companies are trying to make products, processes or software better, faster, cheaper or greener, they probably qualify—and many may not even know it. For the transition to Industry 4.0, manufacturers often qualify if they are attempting to design, develop or incorporate sensors, transmitters, smart devices or other types of machine intelligence into their products or plants.
FOREIGN-DERIVED INTANGIBLE INCOME (FDII)
In addition to preserving the R&D credit, the new tax law introduces a deduction on FDII. The FDII deduction functions similarly to a patent box in European tax systems and is intended to incentivize innovation by offering preferential treatment for income from the export of U.S.-held intangibles, including intellectual property revenues. It will initially be taxed at an effective rate of 13.125 percent and increase to 16.406 percent after 2025.
Manufacturers should identify ways to isolate and track this income, as well as the other components necessary to compute the FDII benefit. However, there is concern that, like other U.S. export incentives that preceded it, the provision may eventually be challenged in world trade courts.
*Note that recent tax reform efforts may put these incentives on the chopping block