Tax benefits for IT and games developers

This article was written by Futura Digital co-founder Alexandra Kurdyumova and associate Roman Motorin.

One of the most common manners in which governments try to attract digital or other R&D-intensive businesses to their countries is through tax benefits.

Obviously, the most common and one of the most burdensome taxes is the corporate income tax (CIT), so it is only natural that the tax benefits are usually related to this tax specifically.

In this article we will provide a brief review of the types of CIT benefits which are most commonly used by our clients and which, therefore, appear to be most relevant for IT and games development businesses. 

1. R&D deductions

What is the tax benefit: Software development costs can be deducted immediately at a 100%+ rate rather than capitalised.

Examples of jurisdictions: Czech Republic, Denmark

Relevant for: Companies with high development costs; startups with high cash-burn rate.

Details: Usually, a company that bears R&D costs can do either of the following things: 

1. Deduct these costs immediately
2. Capitalise these costs as the value of intangible assets

However, certain jurisdictions allow the companies to deduct the R&D costs at a rate higher than 100%. This means that the company can effectively increase its development costs for tax purposes.

Consider a company that makes $1,000,000 of revenue (i.e. income not adjusted for costs) and spends $300,000 on development in a given year (say, 2024). For simplicity’s sake, let us imagine that the company has no other costs whatsoever.

Normally, the company would deduct $300,000 of its costs from the $1,000,000 of its revenue, and would pay CIT on the remaining $700,000. 

Due to the beneficial R&D deduction rules, however, the company could deduct the R&D costs at a rate higher than 100%. For instance, a Czech company could deduct it at a 200% rate. So in our example ($1,000,000 of revenue; $300,000 of R&D costs), the Czech company will be able to deduct not $300,000, but $600,000. This would mean that the company would be taxed not on $700,000 of profit, but on $400,000.

The effect of this tax benefit is that the more R&D costs the company bears, the less CIT it pays, and the greater share of the income is not taxed.

Businesses with high R&D (large and expensive staff; high outsourcing costs, etc.) are naturally the ones that benefit the most from these deduction rules. If the costs of development of your project are going to be quite high, you could consider the countries that offer this tax incentive for incorporation. 

NB! If your company does not generate any profit yet, but already has a high cash-burn rate, pay close attention to the carry-forward rules for these deductions. The Czech Republic allows taxpayers to carry these R&D deductions forward for three years, so plan your release date accordingly.

If you have a high cash-burn rate because of R&D costs, but are planning to have a release date within the next three years, this type of tax benefit might be just right for you.

2. Tax deferral 

What is the tax benefit: CIT is not paid until the profits are distributed

Examples of jurisdictions: Estonia, Georgia

Relevant for: Holding companies; venture capital funds investing in IT and game development; cost centers, especially focused on non-R&D costs (e.g. ad traffic costs for the whole group).

Details: Usually, the CIT is paid on a yearly basis: e.g. after the end of 2024 the company will pay its CIT for on the profits made during 2024; after the end of 2025 - on the profits made in 2025; and so on.

However, certain jurisdictions allow the companies not to pay any CIT until they distribute dividends. For example, let us imagine that a company makes a profit (adjusted for deductible costs) of $500,000 during the year 2024 (before taxes). In Estonia or Georgia, this company does not have to pay any CIT on this profit until it distributes dividends. 

The effect of this tax benefit is temporal: The company is not taxed on its profits until it distributes dividends. This means that the company can reinvest its profits into its business and assets without paying CIT. The companies are incentivised to acquire new assets.

This effectively allows one to establish a holding company in Estonia or Georgia and buy new assets: shares in other companies; stock options; other financial instruments; new intellectual property and other assets which can be used to expand the business. 

3. Reduction of tax under IP-box regime

What is the tax benefit: The CIT is reduced through applying a reduced rate or through reducing the tax base.

Examples of jurisdictions: Cyprus, UAE, Kazakhstan

Relevant for: Entities that carry out simultaneously the development and the publishing / licensing of the games / software.

Details: This is a mechanism for reducing the CIT paid by a company developing software in the jurisdiction. Each jurisdiction provides for specific ways to reduce the tax: 

• In Kazakhstan the tax base is reduced by 100%
  
• In Cyprus the tax base is reduced by 80%
  
• In UAE the 0% CIT rate applies 

However, these tax benefits are applied only to a part of the profits made through the use of intellectual property. This part is defined based on the nexus ratio - a ratio of qualified development costs to all development costs. 

The formula for this nexus ratio is as follows:

NR = (CQ*130%) / CT, where:

• NR stands for the Nexus Ratio
• CQ stands for Qualified R&D costs (e.g. salary paid to the development staff; costs of outsourcing to independent contractors; etc.)
• CT stands for Total R&D costs borne by the company.

In other words, developing software through the efforts of salaried or waged staff, through contracts with independent developers increases the ratio. Purchasing rights to ready-made software or outsourcing development to an affiliate decreases the ratio. In any case, the ratio cannot exceed one. 

Once this ratio is calculated, the profits derived from the intellectual property are multiplied by the nexus ratio, and the result is the portion of the profit which benefits from the tax incentive.

For instance, if the ratio for a UAE company is 80%, and the UAE company makes $1,000,000 of profit adjusted for costs, the 0% CIT rate will apply to 80% of that $1,000,000. This means that the sum of $800,000 is taxed at a 0%-rate, and the sum of $200,000 is taxed at a rate of 9%. 

We have devised a simple tool that will help to get the gist of the IP-box principle. Please find it here and try it out with specific numbers. You can download it through the link - https://goo.su/4Nulan 

The effect of this tax benefit is the reduction of actual CIT payable. However, it has its drawbacks as well: 

• This type of tax benefit requires additional accounting, it is quite bureaucratic.
• This type of tax is only available to the companies which actually bear development costs for employees’ salary and for independent developers.
• The company has to generate income from intellectual property: royalties, licensing fees and other similar types of incoming payments; any other types of income (e.g. payments for development services) will not necessarily benefit from this type of benefit automatically. 

It would be fitting to conclude this brief overview of some of the types of tax benefits with a recommendation to contact a professional tax advisor and discuss which specific type of tax benefit would be best suited for your business.