The R&D tax credit system is a measure that allows corporations engaged in research and development (R&D) activities to deduct a certain percentage of experimental research expenses, or investment in R&D, from their corporation tax liability. The system, which is applicable to blue form corporation tax filers, sets different tax rates for each research project with deductible experimental research expenses within each fiscal year. It aims to maintain and increase R&D spending within the private sector, promote innovative research and development, as well as enhance Japan's growth potential and international competitiveness.

The system can be broadly divided into three categories or "types": the general type (formerly the "total amount type", officially known as the "Ippan Shiken Kenkyūhi no Gaku ni Kakawaru Zeigaku Kōjo Seido"), the SME technology enhancement type, in addition to the open innovation type (a tax credit system for special experimental research expenses).

The open innovation type in particular – which allows for partial corporation tax deductions on expenses incurred through activities such as collaborative research with universities, startups and other entities – has garnered attention in recent years. It incentivises collaborative R&D activity with external organisations, leading to the creation of new value and a level of competitiveness that businesses may not be able to achieve on their own. This is why the Ministry of Economy, Trade and Industry's 2023 tax reforms broadened the eligibility criteria for startups and established a mechanism that allows for higher tax deduction rates for the open innovation type, compared to the general type.

This article hones in on the open innovation type and explains the requirements for applying the R&D tax credit, including the limits on tax deductions.

What's in this article?

• What kind of research is eligible under the R&D tax credit system?
  
• What kind of experimental research and R&D expenses are eligible for deductions?
  
• Deduction rates and limits for experimental research expenses
  
• Potential for future reductions in R&D tax credit system benefits　
  

What kind of research is eligible under the R&D tax credit system?

In short, the tax deductions apply to experimental research expenses – but these are finely categorised by the type of research involved. Below are some examples of research categories that meet the open innovation type requirements.

Research meeting the requirements of the open innovation type:

• Collaborative and commissioned research with special research institutions, universities, etc. (30%)
  
• Collaborative and commissioned research with startups (25%)
  
• Collaborative and commissioned research with other private businesses (20%)
  
• Experimental research involving the use of intellectual property from small and medium-sized enterprises (SMEs) (20%)
  
• Experimental research conducted cooperatively by members of a technical research association (20%)
  
• Experimental research using highly skilled research personnel (20%)
  
• Experimental research of pharmaceuticals for rare diseases and specific applications, etc. (20%)
  

The deduction rates are indicated in parentheses. Details on collaborative and commissioned research with entities such as special research institutions, universities and startups (as mentioned above) are discussed in the latter part of this article under the heading "[Collaborative and commissioned experimental research (open innovation)](https://stripe.com/resources/more/r-and-d-tax-in-japan?#collaborative-and-commissioned-experimental-research-open-innovation-type "Stripe | Collaborative and commissioned experimental research (open innovation type))".

What kind of experimental research and R&D expenses are eligible for deductions?

The scope of tax-deductible experimental research expenses can be broadly categorised into products and technology. (Note: Experimental research and R&D are generally equivalent in definition.)

According to the Ministry of Economy, Trade and Industry's "Overview of the R&D tax credit system", experimental research expenses are defined as "costs incurred through R&D activities in the natural sciences".

Accordingly, to qualify for a tax credit, experimental research expenses must meet the following criteria:

• The expenses must be included as costs in the calculation of the income for each fiscal year.
  
• The expenses must be accounted for as R&D costs in the calculation of the income for each fiscal year and included in the acquisition costs for software, etc.
  

Eligibility criteria for experimental research expenses:

• Manufacture of products
  
• Improvement, invention or creation of technology
  
• Development of new services provided for a fee
  

Tax-deductible experimental research expenses include the following R&D costs:

• Materials, personnel and overheads
  
• Commissioned research expenses (payments to external parties for the purpose of experimental research)
  
• Dues paid to technical research associations
  

Collaborative and commissioned experimental research (open innovation type)

To use the tax credit for collaborative or commissioned research with startups (specified new business development enterprises) or special research institutions, universities, etc., the startups or highly skilled research personnel (doctorate holders or those with a certain amount of outside research career experience) in question must meet the open innovation type criteria.

Criteria where the research partner is a startup (deduction rate: 25% of experimental research expenses)

The partner startup must meet all of the following criteria for the tax credit to be applicable:

• Must have been established for less than 15 years and meet specific requirements
  
• Must be an unlisted company
  
• Must not be a subsidiary of your company, such as a member of a specific corporate group
  
• Must be a recipient of a venture fund or R&D corporation that meets the requirements
  
• Must have an R&D expenses to net sales ratio of 10% or higher
  

The corporation applying for the tax credit must verify that the startup meets all of the above criteria during tax filing. The partner startup in question must therefore obtain a certificate from the Ministry of Economy, Trade and Industry and send a copy to the said corporation.

Criteria where the research partner is highly skilled research personnel (deduction rate: 20% of the experimental research expenses attributable to personnel costs)

To improve R&D quality, encouraging investment in the "people" who undertake the R&D is imperative. The following two requirements must be met when using highly skilled research personnel:

• When it comes to R&D expenses, the proportion of staff costs attributable to highly skilled research personnel must have increased compared to the previous year.
  
• The R&D activity must be widely publicised to potential talent both internally and externally.
  

For more details on the criteria for partner startups and highly skilled research personnel, refer to the Ministry of Economy, Trade and Industry's "Overview of the R&D tax credit system".

Deduction rates and limits for experimental research expenses

The amount that corporations can deduct from their corporation tax liability through the R&D tax credit system is capped, and the deduction rate (the percentage of experimental research expenses that can be deducted) varies between the general type, the SME technology enhancement type, as well as the open innovation type.

The tax credit cap and how it's calculated

The tax credit cap is calculated as:

The Amount of Experimental Research Expenses × The Deduction Rate

For example, the deduction rate for the general type is between 1% and 14%, and so the tax credit cap would be the amount of experimental research expenses multiplied by the applicable percentage.

Additionally, the deduction limit is calculated as:

The Corporate Tax Amount × The Deduction Limit Percentage Set for Each Type

So, if the deduction limit is 25% (as is the case for the general type), it would be:

The Corporate Tax Amount × 25%

The deductible amount will be the lesser of the tax credit cap or the deduction limit as calculated per the above methods.

General type

As shown above, the deduction rate for the general type is between 1% and 14%, and the deduction limit is 25% of the corporation tax amount. Even if the calculated amount exceeds this 25%, the maximum tax credit remains capped at 25%.

SME technology enhancement type

This system, specifically designed for SMEs with capital of up to ¥100 million, offers preferential deduction rates higher than the general type – at 12% to 17%. The deductible amount is capped at the same amount as for the general type: 25% of the corporate tax liability.

Moreover, as a temporary measure for the general type and the SME technology enhancement type until the end of fiscal year 2025, an additional percentage (up to 10%) may be added to the usual 25% deduction limit when the proportion of experimental research expenses* exceeds 10% of average sales. The tax credit cap varies along with increases and decreases in experimental research expenses. Refer to the Ministry of Economy, Trade and Industry's "Overview of the R&D tax credit system" for details regarding the temporary measure.

*The ratio of experimental research expenses to average sales (average sales for the year in question as well as the past three fiscal years).

Open innovation type

The deduction rates for the open innovation type are 20%, 25% or 30% – depending on the nature of the research – and the deduction limit is up to 10% of the corporation tax liability.

The above three deduction rates and deduction limits can be explored further in the Ministry of Economy, Trade and Industry's "Overview of the R&D tax credit system", which provides detailed information, including examples of deduction calculations.

Potential for future reductions in R&D tax credit system benefits

As of now, there has been no official announcement from the Japanese government in respect of any reductions in the benefits offered by the R&D tax credit system. However, if we assume that experimental research expenses decrease with the establishment of new systems similar to the R&D tax credit system in the future, it is possible that the Japanese government may gradually adjust or phase out the R&D tax system.

Nonetheless, as mentioned at the outset, given its aim of maintaining and expanding R&D investment, the existing R&D tax credit system is expected to continue to hold great importance for the Japanese government. In particular, the open innovation type – which provides significant incentives for collaborations in joint and commissioned research with startups, universities and national research institutions, etc. – is a highly regarded system that has expanded the potential and supported the growth of many firms.

The Ministry of Economy, Trade and Industry's website provides more detailed information about the open innovation type, including an overview of the system, report formats, and procedures for collaborative research with startups.

The R&D tax credit system has undergone frequent revisions to make it more accessible to a broader range of firms. These have included reviews of deduction rates and limits, as well as other preferential measures including expansions in eligibility criteria and scope. It's important to keep a close eye on government trends and the latest information about the system to stay current with any amendments going forward.

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