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Submission No. 234 Back to full list of submissions
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Australian Pharmaceutical Manufacturers Association

 

Submission to the

Review of Business Taxation

 

16 April 1999

 

Executive Summary

1.0 Introduction

2.0 Vision of the Business Income Taxation System

3.0 Review of Business Taxation: A Platform for Consultation

3.1 Tax Incentive Benchmark

3.1.1 Harmful Tax Competition

4.0 Incentives for Innovation in Knowledge-intensive Industries

4.1 The Importance of Innovation and Knowledge intensive Industries

4.2 Tax Induced Market Failure is Constraining Innovation in the Economy

4.3 Australia’s business income tax system is internationally uncompetitive

4.4 Benchmarking Business Income Tax Incentive Mechanisms

4.4.1 Ireland

4.4.2 Singapore

4.5 History of Government Incentive Mechanisms Available to Knowledge-Intensive Industries in Australia

4.5.1 Research & Development (R&D) Tax Concession

4.5.2 Factor (f) Scheme

4.5.3 Pharmaceutical Industry Investment Program (PIIP)

5.0 Suggested Business Income Tax Reforms

5.1 Tax incentives v non-tax incentives

5.2 The importance of tax considerations

5.3 Suggested reforms

5.3.1 Specific measures

5.3.2 General measures

6.0 Policy Issues with the Adoption of the Suggested Business Income Tax Reforms

6.1 Defining the boundaries of the incentive mechanism

6.2 Ensuring the integrity of the incentive mechanism

6.3 Revenue Implications/Other

6.4 Practical implementation issues

7.0 Other Related Non Tax Issues

7.1 Coordinated whole of government approach to industry development.

7.2 The effects of the Pharamaceutical Benefits Scheme ("PBS") pricing policies

7.3 Protection of Intellectual Property

Appendix 1 Examples of Successful Collaboration between Multinational Pharmaceutical Firms and Australian Pharmaceutical Firms

Appendix 2 Australia’s Inefficient Capital Gains Tax System

Appendix 3 Benchmarking Business Income Tax Incentive Mechanisms

Appendix 4 History of Government Incentive Mechanisms Available to Knowledge-Intensive Firms in the Pharmaceutical Industry in Australia

 

Executive Summary

Multinational pharmaceutical firms are committed to investment programs worth billions of dollars. These knowledge-based industry investments include new synthesis plants, formulation and packaging plants and research and development ("R&D") centres.

By its very nature, this type of high technology investment is extremely mobile and predominantly based on tax considerations. Further, due to the ongoing global rationalisation in the pharmaceutical industry, companies are critically reviewing these investment activities to determine the best environment where they might be located. This investment is currently by-passing Australia due to its unfavourable tax policy settings.

The Australian Pharmaceutical Manufacturers Association ("the APMA") outlines herein a tax plan which it believes can be implemented to attract some of this investment to Australia. If implemented, this plan will significantly add to the country’s economic activity and GDP growth and generate substantial additional tax revenue.

Missed Opportunities…

A large share of the pharmaceutical industry’s investment in primary manufacturing is currently being made in Singapore and Ireland, as a result of the tax incentives offered by these countries to attract high-technology investments. As a result, these economies have enjoyed large increases in manufactured exports, production and employment in their pharmaceutical industries.

For example, in Ireland, the pharmaceutical industry employs over 11,000 people and exported 6,220 million pounds worth of pharmaceuticals in 1997, resulting in a positive balance of trade for pharmaceuticals of 4,870 million. Further, the Irish pharmaceutical industry has an annual wage bill of 280 million, paid 200 million in Corporations Tax and purchased 400 million worth of services from Irish businesses. In the last 8 years, 65 pharmaceutical projects, involving a total investment of over 2,200 million, have been undertaken in Ireland.

Singapore has enjoyed similar success in attracting foreign investments in its pharmaceutical industry. For example:

Schering-Plough recently invested US$300 million in a state-of-the-art manufacturing facility in Singapore. The new plant, which employs 180 people, will manufacture active ingredients for the treatment of allergies and asthma. The company has also entered into a collaboration agreement with the BioInformatics Centre of the National University of Singapore to test proprietary analytical software products developed by the centre. The regional headquarters is also based in Singapore.

In 1998, Glaxo Wellcome invested S$80 million in a new state-of-the-art pharmaceutical manufacturing and development facility in Singapore. The facility will produce active ingredients to meet the worldwide demand for better treatment of conditions such as asthma and viral disease. Glaxo Wellcome’s total investment in Singapore amounts to more than S$600 million, with three manufacturing facilities, regional headquarters and scientific research activities. This investment has provided a substantial boost to R&D expenditure in Singapore and contributed to the improvement of the skills of the local workforce. The R&D centre has also resulted in other spin-offs for the local pharmaceutical industry, including R&D collaborations with local Singaporean pharmaceutical firms, research organisations and universities.

In 1998, Merck & Co announced an investment of over US$300 million to construct a new facility in Singapore. The facility will manufacture bulk chemicals of human prescription pharmaceutical products to meet the increasing global demand for such products. Over 800 workers will be employed by Merck during the construction of the plant and 150 workers will be employed when the plant is fully operational. Merck has also agreed to fund a scholarship program for students entering the manufacturing sector in Singapore.

Opportunities are being lost or missed…

A major American based pharmaceutical multinational enterprise, as part of a worldwide consolidation of its manufacturing operations, recently took the difficult decision to move its Australian manufacturing operations to Ireland and Singapore. This has resulted in the closure of two existing manufacturing operations and the loss of 300 jobs and all the associated benefits for local industry

Rhone Poulenc Rorer recently lost the opportunity to invest $30 million in Australia over a period of 2 to 3 years because of an unattractive tax regime. That investment would have resulted in an increase in exports of $400 million over a period of three years and would have directly created 20 new jobs.

Similarly, SmithKline Beecham recently chose to invest Aus$80 million over a period of 2 years in Singapore, rather than Australia, because Singapore has a more attractive tax regime than Australia.

Eli Lilly recently decided not to invest in R&D in Australia because of the relatively low level of investment in biomedical research in Australia. Australia has competent centres working in basic research, but less "cutting edge" research of the quality to attract significant investment.

Tax costs are key drivers in global corporates’ locational decisions, and Australia is losing out because it does not have an internationally competitive business tax system. As demonstrated by the experience of Singapore and Ireland, there are clearly enormous opportunities for large investments by multinational pharmaceutical firms to be enticed to Australia if a suitably attractive tax regime is in place. For example,

as a consequence of its large pipeline of new products, another major American-based pharmaceutical multinational enterprise needs to significantly increase its organic synthesis production capacity and is currently considering the location of possibly two, but definitely, one organic synthesis plants ("OSP") in a number of countries, including Australia. The OSP in question is a massive investment involving an initial capital outlay of approximately $US400 million to establish. Importantly, such a facility will be world class in equipment, technology and practices – and will be built to allow substantial capacity increases over time. The development of a large scale organic synthesis expertise in Australia of the type and size being considered by this company would be a first for the Australian pharmaceutical industry and provide a substantial and long term economic contribution to this country. Long term employment (post-construction) would be 260 in this high technology plant. The annual production capacity is expected to represent some $2 billion - in today's terms - in active pharmaceutical ingredients, the majority of which would be exported to other locations of.that company around the globe, generating vast export income for Australia.

A Workable Tax Solution…

The APMA considers that the following package of tax initiatives would deliver the required incentives to pharmaceutical and other high-technology multinational enterprises to capture some of the long-term investment opportunities illustrated above.

An immediate reduction in the general company tax rate to 30 per cent, and reducing to 25 per cent over a 5-year period. This would be financed by the elimination of accelerated depreciation and the substantial growth dividends arising from the measures outlined below.

A special category of company tax rate of 10 per cent for firms making new incremental investments in knowledge-intensive industries, as a reward for innovation. This would bring the taxation of these firms into line with firms operating in key competitor countries, such as Ireland and Singapore. The lower corporate tax rate would be clearly defined and would last for 10 years from the date of agreement between the Government and the relevant investor. The special company tax rate would then be phased-up to the general company tax rate over a subsequent 5 year period.

A reduction in the CGT rate for firms investing in knowledge intensive industries to 10 per cent. A lower CGT rate would be consistent with international practice and would reduce the disincentive that firms face when considering new investments in knowledge-intensive industries. A lower CGT rate would also encourage the commercialisation of local technology.

The introduction of a CGT rollover for knowledge-intensive firms exempting them from CGT while their investments are rolled over within knowledge-intensive industries. This is particularly important for firms in knowledge-intensive industries due to the high incidence of enterprise restructuring, mergers and acquisitions.

Knowledge-intensive firms should be permitted to amortise acquired goodwill at the rate of 5 per cent per annum. This would remove the existing non-neutrality between the treatment of physical assets and intellectual property. This is a major issue in the pharmaceutical industry due to ongoing consolidation and mergers. The United States allows amortisation of acquired goodwill at the rate of 6.67 per cent per annum.

The existing R&D tax concession should be retained. This would acknowledge the significance of this measure in encouraging innovation in Australia. The cost to revenue of the R&D tax concession will be minimal if the suggested changes to the company tax rate outlined above are implemented. Moreover, consideration should be given to removing the requirement for exploitation rights to be owned locally, as this effectively prevents MNEs from using the concession. The APMA considers that the spillover associated with R&D that is undertaken in Australia, but owned offshore, are substantial.

The six measures outlined above are an integrated package and need to be viewed in that context together, not separately. In addition, to provide some certainty for investors, these measures must be long-term in nature.

If this package of tax incentives succeeds in attracting only a small proportion of the investment opportunities mentioned, the resulting incremental investments in the Australian pharmaceutical and other high-technology industries would benefit Australia enormously.

The Rewards for Australia

This package of tax incentives will nurture the development of knowledge-intensive industries in Australia. Knowledge-intensive industries are major contributors to economic growth and living standards. Such industries improve rates of productivity growth, support rising real wages, drive export expansion and create and extend competitive advantage.

In this regard, the pharmaceutical industry is among the most knowledge-intensive of all industries, with very high levels of R&D, strong linkages to other knowledge-intensive industries, and is characterised by higher rates of innovation than almost any other manufacturing industry. This high level of R&D expenditure improves the skills of the local workforce and provides spin-offs for the local pharmaceutical and other industries. The global pharmaceutical industry is also characterised by rapid export growth, high wage rates and has experienced strong sales growth of over 10 per cent a year for an extended period (refer to the Factor (f) scheme - section 4.5.2).

The availability of strategic tax incentives targeted at such industries is guaranteed to attract incremental investment to Australia, with resulting positive effects on GDP growth, employment and exports.

The tax incentives will encourage capital inflows into the Australian economy, particularly knowledge-intensive industries. This will help to broaden the industrial base of Australia and promote Australia as a regional high-technology centre.

Importantly, these tax incentives will increase private sector investment in R&D, make the private sector more inventive and internationally competitive, and improve the conditions for the commercialisation of new process and product technologies.

As the suggested tax incentives target incremental investment only, they would not harm Australian revenue. In fact, there would be an opportunity to take a share in a significant increase in revenue resulting from higher growth in the medium to long term. This is because the incremental investment would result in additional employment, resulting in higher direct and indirect revenues (e.g. PAYE, Payroll, GST, etc) and reduced unemployment benefit payments.

As new investment is attracted to Australia, so too will the associated functions, assets and risks. This will substantially increase the value of export sales made from Australia and, in turn, the proportion of profits earned in Australia.

Moreover, in the absence of these incentives, innovative Australian firms may shift their operations offshore. While other firms may take their place, these firms would be likely to have lower growth rates due to the relatively high growth rates of innovative firms in knowledge-intensive industries. Accordingly, in the absence of the incentives, it could be expected that the revenue derived from firms in knowledge-intensive industries would be eroded over time.

1.0 Introduction

This submission has been prepared by the Australian Pharmaceutical Manufacturers Association (the "APMA") and its members with assistance from Arthur Andersen, in response to the release of A Platform for Consultation ("APC"), the second Discussion Paper in respect of Australian tax reform, by the Federal Government’s Review of Business Taxation ("RBT") on 22 February 1999.

The APMA is the Australian prescription pharmaceutical industry’s peak association, representing pharmaceutical business interests in Australia.

The primary purpose of this submission is to outline the taxation, economic and practical implications of the proposed business taxation changes for APMA member companies and to provide input on options discussed in APC. This submission will also provide alternative, more viable options, where appropriate.

In order to achieve this primary objective, the submission will highlight the issues facing APMA member companies and the importance of business tax reform in their ongoing businesses.

This submission is divided into a number of Sections. Section 2 outlines the APMA’s vision for the business income tax system. Section 3 of the submission outlines the APMA’s stance on the APC. Section 4 discusses the importance of innovation and knowledge-intensive industries and identifies some tax-induced market failures that are constraining innovation in these industries. Section 5 details our options for business income tax reforms to address these distortions. Finally, section 6 deals with various related non-tax issues of concern to member firms relevant in the context of the review.

2.0 Vision of the Business Income Taxation System

The APMA’s vision for business income taxation in Australia corresponds closely with the RBT design principles and the benchmarks for reform outlined in APC. Most importantly, the APMA supports reforms of business income taxation resulting in:

  • an internationally competitive business income taxation system;
  • a lower company tax rate; and
  • focused and carefully targeted tax incentives to attract new investment.

It is believed that these issues are critical in designing a tax system, which will not impede Australia’s long term growth prospects in a global business environment.

Moreover, the APMA considers that the Government’s business tax reform strategy should be directed towards assisting knowledge-intensive industries and increasing incentives for innovation generally.

Knowledge-intensive industries are major contributors to economic growth and living standards. Such industries improve rates of productivity growth, support rising real wages, drive export expansion and create and extend competitive advantage.

Knowledge-intensive industries, including computing hardware and software, telecommunications, pharmaceuticals, biotechnology and aerospace, are generally characterised by two types of firms:

First, the small innovative local business, with limited product sales, primarily focussed on research and development ("R&D"); and

Secondly, the large multinational enterprise ("MNE") with significant resources of capital and intellectual property. MNEs, like small innovative firms, have high R&D spends, but they also have the infrastructure to commercialise newly developed products and technologies.

For example, the pharmaceutical industry includes both small innovative local firms and large MNEs that maintain global operations and make strategic decisions in a worldwide context. The existence and interaction of these two types of businesses has important domestic policy implications.

In particular, it means that knowledge-intensive firms in Australia must be internationally competitive to attract new investments and ensure continued viability. Relevantly, any excessive Australian tax burden would tend to result in the shift of such businesses and/or new investments offshore. Moreover, the tax system must encourage and support an "environment of innovation" for local investment in R&D.

Accordingly, the APMA supports the use of tax incentives to cultivate the development and growth of knowledge-intensive industries. These tax incentives should:

  • be provided only following a formal assessment of their net impact on the national taxation objectives, and only where assessed to be an essential and superior form of government intervention;
  • maximise the national return on the tax investment;
  • be focussed and carefully targeted to those investors for whom a lower effective tax rate will "tip the scales" in favour of a new incremental investment;
  • be equitable, so that all qualifying taxpayers receive the same treatment;
  • involve minimal administrative and compliance costs;
  • be transparent, both domestically and internationally;
  • be the best method of delivering the assistance;
  • be long-term in nature; and
  • be part of a whole of government approach.

3.0 Review of Business Taxation: A Platform for Consultation

The APMA supports the RBT and many of the business income tax reforms outlined in the APC.

In particular, the APMA strongly supports the following proposed reform options:

  • the move to a company tax rate of 30 per cent or lower;
  • the proposed changes to the capital gains tax ("CGT"), including the reduction in the rate of CGT and the introduction of a scrip-for-scrip CGT rollover exemption;
  • the proposed Resident Dividend Withholding Tax ("RDWT"), provided that foreign companies are taxed at the current non-resident dividend withholding tax (‘DWT") rate. A higher rate would be inappropriate given the mobility of capital in knowledge-intensive industries; and
  • the introduction of an optional system of consolidated group taxation.

In recognition of the objective of revenue neutrality, the APMA would be willing to endorse the withdrawal or modification of the accelerated depreciation provisions and certain other capital allowances, provided the company tax rate is reduced to 30 per cent, and consideration is given to designing an incentive structure for new investment in knowledge-intensive industries, as outlined in sections 5 and 6, and the Executive Summary.

The APMA supports the proposals in APC for CGT concessions for venture capital, as it believes there are clear market failure and international competitiveness issues constraining innovation in Australia, both in terms of R&D spending and the commercialisation of successful research. These concessions will go some way to providing a boost to innovation in the Australian economy.

However, it should be recognised that such incentives should also be available to established firms, not only small start-up companies. In the pharmaceutical industry, large MNEs are responsible for the vast majority of expenditure on further research and development and initial commercialisation of R&D. This is because of the economies of scale and scope available in developing knowledge-intensive products and the high level of risk involved in R&D.

Large MNEs spend approximately 15 per cent of sales revenue on R&D to maintain a flow of new products onto the market. Accordingly, consideration should be given to extending these tax incentives to established companies.

Furthermore, the provision of CGT concessions alone may not be sufficient to assist innovative firms. Some additional mechanisms for assisting these firms need to be identified.

3.1 Tax Incentive Benchmark

The collection of taxes is an important role for government, as it allows it to fulfill its social responsibilities. Much of the effort of the RBT is being put into designing a tax system to allow the Federal Government to achieve its revenue objective in the most efficient, equitable and administratively simple manner.

Taxation, however, is also a very important tool which government can use to intervene in the market to deal with market failures or achieve social objectives. The tax incentive benchmark outlined in the overview of APC recognises this.

3.1.1 Harmful Tax Competition

The discussion of the tax incentive benchmark in APC also implies that Australia should refrain from engaging in so called harmful tax competition with other countries.

The APMA recognises that tax competition may be "harmful" from a global perspective. However, the APMA considers that tax competition is justified, and in Australia’s best interests, in certain circumstances, for the following reasons:

Tax considerations are often critically important in deciding the location of activities and associated investments that are internationally very mobile. Knowledge-intensive industries, in particular, are characterised by functions that are very mobile, such as R&D activities, which can be undertaken in any number of countries. The availability of strategic tax incentives targeted at such industries is likely to attract incremental investment to Australia, with resulting positive effects on growth, employment and exports;

Tax incentives that target incremental investment only would not harm Australian revenue. In fact, there would be an opportunity to take a share in a significant increase in revenue resulting from higher growth in the medium to long term;

Australia has sovereign taxing powers, which should not be constrained by international agreements, unless such constraints provide identifiable tangible benefits for Australia; and

The spillovers from increased foreign investment in knowledge-intensive industries are potentially substantial.

4.0 Incentives for Innovation in Knowledge-intensive Industries

4.1 The Importance of Innovation and Knowledge intensive Industries

Productivity growth is at the heart of strong and sustainable economic growth. Increases in productive resources such as the employment of labour and capital, at any one time, can increase economic activity, but these resources are limited. Thus in order to achieve productivity growth, these resources need to be used more efficiently to maximise returns to their owners. The returns to these inputs and their capacity to produce economic output depend on productivity and growth in productivity.

If production inputs can be brought together in a more efficient, more productive way, more output (and hence higher income) will be achieved. Further, higher productivity provides greater economic output that in turn can allow greater resources to be devoted to finding new ways to produce more efficiently.

Growth in productivity depends on the successful, practical implementation of innovation. Innovation is the ability to manage technology to gain market advantage through the introduction of new products, production processes and management systems. The introduction and exploitation of new ideas drives growth and is the prime source of improvement and competitive challenge in the economy.

International studies and Australian experience suggest that growth tends to come primarily from innovative businesses. These firms are a major source of employment and income growth. High rates of innovation are a key attribute of knowledge-intensive industries. In those industries, R&D plays an important role in allowing companies to develop and refine products.

Innovation is not an exogenous factor to growth in a modern industrial economy. Investments by governments to encourage R&D, education and training by firms pay dividends in the long term in the form of higher labour and capital productivity. Only by creating a business environment conducive to innovation can governments endogenise long term growth.

Knowledge-intensive industries are major contributors to economic growth and living standards. Such industries improve rates of productivity growth, support rising real wages, drive export expansion and create and extend competitive advantage.

The pharmaceutical industry is among the most knowledge-intensive of all industries, with very high levels of R&D, strong linkages to other knowledge-intensive industries, and is characterised by higher rates of innovation than almost any other manufacturing industry. This high level of R&D expenditure improves the skills of the local workforce and provides spin-offs for the local pharmaceutical industry and other sectors.

In this regard, a number of multinational pharmaceutical firms are engaged in R&D collaborations with local Australian pharmaceutical firms, research organisations and universities. Some examples of successful collaboration between multinational pharmaceutical firms and local firms are outlined in Appendix 1.

Additionally, multinational pharmaceutical firms are regularly commercialising the outcomes of their research programmes and establishing new synthesis and formulation manufacturing facilities to service global requirements. Significant process development occurs throughout this manufacturing chain, adding to the knowledge and skills base in those countries in which such facilities are located.

The global pharmaceutical industry is characterised by rapid export growth, a highly skilled workforce, high wage rates and has experienced strong sales growth of over 10 per cent a year for an extended period. This is, of course, in addition to the industry’s role in promoting health among the workforce and the population generally, and in reducing hospital and related health costs.

Australian pharmaceutical sales make up about 1 per cent of the world market. The industry in Australia has shown very strong economic performance over recent years, as measured by indicators such as:

employment (3.7 per cent growth pa between 1991 and 1996);

R&D (15 per cent growth pa between 1985-1990, compared to an average growth rate of 7.5 per cent for the G7 for the same period. (AEA vol. 2, p71)

  • exports (19.7 per cent growth pa between 1990 and 1995); and
  • output (real average annual growth rates in pharmaceutical and veterinary product manufacturing of 10.8 per cent pa between 1990 and 1995, compared to 1.9 per cent for general manufacturing for the same period).

While these growth rates are impressive, the Australian pharmaceutical industry’s high rates of growth are still lagging global and Asian growth rates in the pharmaceutical industry. Furthermore, it should be recognised that these high rates of growth were a direct result of the Factor (f) scheme, which has now been replaced by the Pharmaceutical Industry Investment Program ("PIIP"), and other industry incentive schemes.

These short-term industry incentive schemes have, only to a limited extent, counteracted the price suppressing effects of the Federal Government’s pharmaceutical pricing policies. Further, these schemes have benefited only a limited number of industry participants, due to their limited scope.

The Pharmaceutical Benefits Scheme ("PBS") continues to have a negative impact on the industry returns and substantially reduces incentives for further investment in the Australian pharmaceutical industry because of the negative image created. Accordingly, the APMA considers that additional incentives are required to compensate for these effects.

There are a number of examples of businesses that have shifted offshore due to the lack of an internationally competitive tax regime in Australia. For example, a subsidiary of a major multinational pharmaceutical enterprise recently decided to close all of its Australian manufacturing operations and source, in future, its products from Ireland and Singapore.

4.2 Tax Induced Market Failure is Constraining Innovation in the Economy

Given the importance of knowledge-intensive industries, it is essential that the tax system not unduly hinder innovative enterprises in these industries reaching their full potential.

This submission contends that various tax and non-tax induced market failures are constraining innovation by knowledge-intensive firms. This submission argues that the significant disadvantages imposed by the current tax system are impeding the growth of these firms and should be removed. In this regard, the APMA considers that the proposals in APC for CGT concessions for venture capital are a move in the right direction, but they do not go far enough.

One example of tax-induced market failure constraining innovation by knowledge-intensive firms is Australia’s inefficient CGT system, which imposes substantial deadweight costs on the economy. It encourages short-term consumption at the expense of saving and investment (and, therefore, future economic growth), and introduces non-neutralities. These distortions are outlined in Appendix 2.

4.3 Australia’s business income tax system is internationally uncompetitive

Australia’s general corporate tax rate is uncompetitive with key trading partners. For example:

  • in the United Kingdom, the general corporate tax rate will be reduced to 30 per cent from 1 April 1999;
  • in the United States, the maximum general corporate tax rate is 35 per cent;
  • in Ireland, the current standard 32 per cent general company tax rate is to be reduced by 4 percentage points a year to reach 12.5 per cent from 2003. The company tax rate for manufacturing will remain at 10 per cent until 2010; and
  • in Singapore, the general corporate tax rate is 26 per cent, with special tax incentives for high-technology businesses.

Australia’s CGT system is also uncompetitive with key trading partners. For example:

  • in the United Kingdom, the CGT system includes tapers that reduce the proportion of capital gains subject to CGT over time, and scrip-for-scrip rollover exemptions;
  • in the United States, the CGT rate is capped at 28 per cent for corporations. Further, the CGT system includes tapers that reduce the rate of CGT over time, and scrip-for-scrip rollover exemptions;
  • in Ireland, the CGT system includes scrip-for-scrip rollover relief and various other exemptions; and
  • in Singapore, there is no CGT system. However, normal income tax treatment applies to capital gains realised within three years of acquisition.

Furthermore, in Australia, the purchase cost of intellectual property bound up in business goodwill cannot be written off or amortised. By comparison, the United States allows amortisation of acquired goodwill at the rate of 6.67 per cent per annum.

The Australian tax system allows depreciation deductions for "plant" (physical assets) but is selective in allowing depreciation or amortisation of intellectual and intangible property. For example, standard patents can be amortised at 5 per cent per annum, whereas the purchase cost of goodwill can not be amortised. This means that the Australian tax system is non-neutral in its treatment of intellectual or intangible property vis--vis its treatment of physical assets.

This can disadvantage innovative enterprises, in particular, because they tend to be rich in intellectual or intangible property. For example, local innovative firms without the resources to commercialise their technologies often seek to dispose of their valuable intangible assets to a MNE. In the absence of amortisation of the purchase cost of goodwill, MNEs could be expected to pay a lower price for the intangible asset than would be the case if such amortisation were permitted.

4.4 Benchmarking Business Income Tax Incentive Mechanisms

An analysis of the specific business income tax incentive mechanisms available to knowledge-intensive industries in selected counties is summarised below, and is presented in further detail in Appendix 3. In particular we have focussed on Ireland and Singapore. These countries offer a range of tax incentives to attract knowledge-intensive industries, particularly the pharmaceutical industry.

Ireland’s low corporate tax rate and Singapore’s array of tax incentives have been very important in attracting a large number of foreign enterprises since their introduction. As a result, there has been a large increase in manufactured exports, production and employment in knowledge-intensive industries in those countries.

These concessions have been very successful. This analysis will assist in gaining a perspective of what a "world’s best practice" tax incentive mechanism for knowledge-intensive industries may look like.

4.4.1 Ireland

Ireland uses a range of tax incentives to attract and maintain overseas investment in the industrial and financial service sectors. A 10 per cent corporate tax rate applies to certain manufacturing companies - based on a wide definition of "manufacturing". The 10 per cent rate also applies to certain trading activities within the Shannon Airport Free Trade Zone, and to companies providing certain financial activities in the Custom House area of Dublin. Branches and subsidiaries of foreign companies can apply to be taxed at a higher rate if this would be beneficial - such companies are not subject to withholding tax on interest paid overseas.

Companies that have established operations, and made substantial investments, in Ireland include:

  • SmithKline Beecham;
  • American Home Products;
  • Rhone Poulenc Rorer;
  • Schering-Plough;
  • Novartis;
  • Warner Lambert; and
  • Bristol Myers Squibb.

4.4.2 Singapore

Singapore, like many other developing countries, is heavily dependent on foreign capital inflows for economic expansion and development. To encourage these inflows it provides a comprehensive program of incentives and grants to encourage investment in selected sectors and firms. The industries selected for special assistance have changed over time as its activist industry policy has shifted focus.

Many of these incentives are targeted at knowledge intensive industries and towards the development of Singapore as a finance, treasury, trade and regional centre. Some of the more notable targeted tax incentives include investment allowances, company tax holidays (up to 15 years for selected industries and/or companies) and accelerated depreciation. There are also concessions for certain banking, leasing, insurance and approved company headquarters.

Singapore includes administrative flexibility as a deliberate part of its tax system. In some cases, this has been put to good effect to target concessions to particular industries or activities while at the same time avoiding corruption. The APMA recognises that these arrangements need to be transparent and would like to work with the RBT to identify ways to implement such schemes in Australia.

Companies that have established operations, and made substantial investments, in Singapore include:

  • Schering-Plough;
  • Pfizer;
  • American Home Products;
  • Merck & Co; and
  • Glaxo Wellcome.

4.5 History of Government Incentive Mechanisms Available to Knowledge-Intensive Industries in Australia

An analysis of the positive effects of selected government incentive mechanisms available to knowledge-intensive firms and/or industries in Australia, now and in the past, is presented below and in further detail in Appendix 4.

4.5.1 Research & Development (R&D) Tax Concession

Various R&D tax and non-tax incentives are available in Australia. In particular, the R&D Tax Concession offers eligible companies an income tax deduction of up to 125 per cent of their R&D expenditure. The aim of this program is to increase private sector investment in R&D, to improve the conditions for commercialisation of new process and product technologies, and to develop a greater capacity for the adoption of foreign technology.

ABS statistics show that business expenditure on R&D reached a record of $4.24 billion in 1995/96. However, this level of R&D expenditure is expected to fall as the rate of R&D deductions was recently reduced from 150 per cent to 125 per cent of eligible R&D expenditure.

The APMA considers that the spillovers associated with R&D are substantial and warrant the retention of the R&D tax concession. The original intention of the concession was simply to recognise that R&D activities carried out in Australia provide major benefits in the form of improved skills for workers and spin-offs for local industries, that cannot be captured fully by the entity undertaking the R&D. The concession was aimed at correcting this market failure. This market failure has not diminished.

"While the returns to the nation from R&D are high, this does not always translate into high returns to individual firms investing in R&D. Often the benefits of improved knowledge and technology from R&D spillover to the international community and other firms and cannot be captured by the firm undertaking the R&D investment. This can lead to inadequate levels of R&D investment." (Investing for Growth – The Government’s Industry Statement)

Further, eligible R&D activities excludes R&D carried out by foreign entities in Australia, where the effective exploitation rights are not owned locally and the rights will not be exploited for the benefit of the Australian economy.

The APMA considers that the requirement for exploitation rights to be owned locally should be removed, as this effectively prevents MNEs from using the concession. The APMA considers that the spillovers associated with R&D that is carried out in Australia, but owned offshore, are substantial. Further, to be even more effective, the expenditure eligible for the R&D tax concession should include several of the additional features, such as patent costs, that are deemed eligible R&D expenditure under the PIIP. This would make the definition of eligible R&D consistent with the definition used in the context of the PIIP.

By facilitating investment in scientific infrastructure, the R&D tax concession is providing career options for Australian scientists and reversing the trend of our scientists furthering their careers overseas.

4.5.2 Factor (f) Scheme

The scheme was introduced to partially compensate pharmaceutical manufacturers for the relatively low prices negotiated by the Government through the PBS scheme, compared to the prices realised in other jurisdictions (refer to section 7.2).

The Factor (f) scheme offered eligible pharmaceutical companies partial compensation in return for R&D and value added production or "any other significant contribution to internationally competitive production in Australia". Companies receive up to 25 per cent of the value of additional activity beyond the level that existed in the base year. Payments are made via notional price increases for products under the Pharmaceutical Benefits Scheme (PBS) up to a maximum of the average European price of the product.

The Factor (f) scheme has been enormously successful, with just over $1 billion allocated by the Federal Government to Factor (f), resulting in nearly $8 billion worth of new activity, and around 1000 new jobs. However, the PIIP will soon replace the scheme.

Merck, Sharp and Dohme ("MSD"), provides an excellent example of the benefits of the Factor (f) scheme, as it was a participant in both Phase One and Phase Two of the scheme. In its submission to the Industry Commission’s Pharmaceutical Industry Inquiry in 1996, MSD claimed that as a result of the Factor (f) scheme, the parent company’s attitude towards Australia had changed, allowing the company to:

  • secure agreement from the parent company for capital expenditure of $75 million to upgrade operations in Sydney;
  • inject more than $18 million into Australian based R&D through its involvement with AMRAD and CSL;
  • become the supply source for MSD products for the South East Asian and New Zealand markets;
  • become Australia’s largest pharmaceutical exporter with cumulative exports forecast to reach $1.47 billion by 1999, from a base of $2 million in 1986;
  • secure agreement from the parent company that Australia would become one of only three MSD sites around the world to manufacture Proscar, as well as MSD’s global manufacturer and supplier of Clinoril from 1996.

(Source: Industry Commission Report No 51, p125)

Glaxo Wellcome Australia Ltd ("Glaxo") also participated in both Phase I and II of the Factor (f) scheme. Since the commencement of its participation in the Factor (f) scheme in 1986, Glaxo has been able to increase:

  • sales from $86 million to $432 million;
  • exports from $2 million to $70 million;
  • employees by from 431 to 788;
  • R&D expenditure from $1 million to $20 million; and
  • R&D employees from 14 to 80.

Glaxo’s participation in the Factor (f) scheme has encouraged additional investment in capital equipment of $125 million over the 10 years to 1998. The scheme has also encouraged significant investment in R&D infrastructure, most notably the construction of a pharmaceutical product development facility at Boronia and the James Lance Clinical Phase I Unit at the Prince of Wales Hospital. The collaboration between Glaxo and Biota Holdings to develop Relenza, the first Australian discovered pharmaceutical compound to complete development, was also supported by Glaxo’s participation in the Factor (f) scheme (refer to Appendix 1).

Similarly, as a result of funding received under the Factor (f) scheme, AMRAD will this year commission a new $10 million facility, including state-of-the-art laboratories, in Melbourne.

It is important to note that this scheme only partially offsets the price suppressing effects of the PBS discussed earlier. It is also important to note that many firms are excluded from the Factor (f) incentives. Only 10 out of over 30 APMA member firms benefited from the Factor (f) incentives.

4.5.3 Pharmaceutical Industry Investment Program (PIIP)

The PIIP has been designed to replace the Factor (f) scheme outlined above. The PIIP is expected to be introduced in July 1999, and runs until June 2004. Admission is on a competitive basis, based on an assessment of the relative merits of broad programs proposed by companies. Total funding available is only $300 million over five years.

The scheme covers the same activities as its predecessor, the Factor (f), scheme, (i.e. production value added activity ("PVA"), and R&D), however; the payment rate has been reduced to 20 per cent of the difference between actual and base level activity. Payment will take the form of notional price increases where there is a clear case of prices being suppressed below the European Union average as a result of the PBS scheme.

A recent survey of our members indicates that 20 companies applied for PIIP funding. The aggregate PIIP funding sought by the companies was $513 million and the total activity target was $10,606 million, giving a ratio of PIIP funding sought to total activity target of 4.8 per cent. The additional employment associated with the PIIP commitments is 1,766 over the five years of the PIIP. The additional capital investment associated with the PIIP commitments is forecast to be $567 million over the five years of the PIIP.

Details of the final offers to the ten successful companies are not available as yet but the remaining companies had sought PIIP entitlements of $185 million and the total activity target was $3,663 million, giving a ratio of PIIP funding sought to total activity target of 5 per cent. The additional (lost) employment and (lost) capital investment associated with these PIIP commitments is 578 and $155 million respectively over the five years of the PIIP.

This limited and short-term incentive, which has been oversubscribed by $213 million, demonstrates the capacity of the pharmaceutical industry to produce extremely high returns from relatively low levels of incentives.

5.0 Suggested Business Income Tax Reforms

This submission contends that taxation concessions should be provided to firms willing to invest in knowledge-intensive industries for the long-term. The justifications for such concessions are outlined above. In summary:

  • tax-induced and non-tax induced market failure is constraining innovation in knowledge intensive industries;
  • comparatively attractive long-term taxation concessions are being offered to attract knowledge-intensive industries in some other countries; and
  • these incentives, and previous short-term incentives in Australia, have been successful in attracting and maintaining investment in knowledge-intensive industries.

5.1 Tax incentives v non-tax incentives

Changes in the corporate tax rate and investment allowances and grants, can significantly change the cost and availability of funds for, and the expected returns from, particular investments. Incentives and tax changes may affect not only the level of investment, but also the type of investment.

It is considered that the best form of government intervention is the one that most directly addresses the market failure. This has been recognised by the government in the past when it has sought, to partially compensate some pharmaceutical companies for the price suppressing effects of the PBS, through the Factor (f) scheme. Similarly, the government has recognised the direct spillover effects of R&D by offering a concessionary income tax deduction.

The market failures, which result from inefficiencies in Australia’s CGT regime and its internationally uncompetitive corporate tax rate also need to be addressed. The manner in which it is addressed needs to recognise the market failures and the key objectives of government, including encouraging:

  • innovation and R&D;
  • export growth;
  • consistent GDP growth; and
  • Australia as a regional centre for economic activity.

5.2 The importance of tax considerations

The importance of tax considerations in deciding the international location of activities varies between industries. However, the greater the similarity of "competing" host countries in relation to relevant non-tax factors, such as the availability and cost of infrastructure and appropriately skilled labour, the more influential tax factors are likely to become.

Knowledge-intensive industries are very sensitive to differences in tax or other fiscal incentives. This is because knowledge-intensive industries are characterised by certain functions which can be easily "decoupled" from the other operations of a multinational enterprise - such as financing and distribution centres, some manufacturing assembly operations, and R&D activities.

For example, in the pharmaceutical industry, tax considerations overwhelm non-tax factors due to the high value added nature of pharmaceutical products. Furthermore, the emphasis on intellectual property means that such enterprises are internationally very mobile, as R&D expenditure can be undertaken in any number of countries. This is particularly relevant given the surplus capacity in manufacturing in the pharmaceutical industry, which will continue to lead to a consolidation of this function in fewer regional production centres.

Accordingly, a lack of tax incentives for investments in knowledge-intensive industries may deter investors, even if the overall investment climate in Australia is favourable.

Further, any incentives for firms investing in knowledge-intensive industries should be available to firms of all sizes, not just small start-up companies. In the pharmaceutical industry, large MNEs are responsible for the vast majority of expenditure on the further research and development and commercialisation of initial R&D.

5.3 Suggested reforms

The APMA proposes the following package of tax initiatives to deliver the required incentives to innovative firms. These initiatives, outlined below, comprise measures specifically for knowledge-intensive firms, as well as general measures.

5.3.1 Specific measures

The APMA proposes:

A special category of company tax rate of 10 per cent for firms making new investments in export-oriented knowledge-intensive industries. The lower corporate tax rate would be clearly defined and would last for 10 years from the date of agreement between the Government and the relevant investor. The special company tax rate would then be phased-up to the general company tax rate over a subsequent 5 year period.

In addition, for the reasons outlined earlier, the APMA is of the view that the CGT rate for innovative firms investing in knowledge-intensive industries should be reduced to 10 per cent. This would also allow integration of the company tax and CGT systems. Australia’s rate of CGT tends to be higher than that in other comparable countries. A lower CGT rate will reduce the disincentive that innovative firms face when considering new investments in knowledge-intensive industries.

5.3.2 General measures

The APMA supports:

An immediate reduction in the general company tax rate to 30 per cent, reducing to 25 per cent over a 5-year period.

In addition, the APMA supports the adoption of a tapered system of CGT, based on the length of time an asset is held, for innovative firms investing in knowledge-intensive industries. It is submitted that this tapered system should incorporate steps based on the proportion of the capital gains that are taxable, rather than on the rate of CGT. This approach, which has been adopted in the UK, would encourage a higher proportion of "patient" capital for knowledge-intensive industries. Further, this approach would avoid the need to change the CGT rate every time personal marginal tax rates are changed. In order to provide the maximum encouragement for long-term, patient investment, the steps should reflect a long holding period and a lower rate, rather than a shorter holding period with a higher rate. In particular, we suggest that 50 per cent of the capital gain be taxable after 2 years, declining to 20 per cent after 5 years. This approach represents an effective compromise as it would penalise speculators and encourage patient capital to assist investment in knowledge-intensive industries.

Furthermore, a CGT rollover should be provided to knowledge-intensive firms exempting them from CGT while their investments are rolled over within knowledge-intensive industries. As discussed earlier, this is particularly important for firms in knowledge-intensive industries due to the high incidence of enterprise restructuring, mergers and acquisitions during the dynamic development phases of these investments.

The APMA also considers that knowledge-intensive firms should be permitted to amortise purchased goodwill at the rate of 5 per cent per annum. This is a major issue in the pharmaceuticals industry due to ongoing consolidation and mergers.

In addition, the APMA considers that the existing R&D tax concession should be retained. This would acknowledge the significance of this measure in encouraging innovation in Australia. Moreover, consideration should be given to removing the requirement for exploitation rights to be owned locally, as this effectively prevents MNEs from using the concession. As outlined earlier, the APMA considers that the spillovers associated with R&D that is undertaken in Australia, but owned offshore, are substantial.

In return for these incentives, the APMA would support the removal or modification of certain existing tax concessions, including accelerated depreciation and various other capital allowances.

The APMA considers that the proposed incentives would not have a negative revenue impact in the long term. This is because the proposed incentives are intended to encourage incremental investment that would not have occurred in the absence of the incentives.

6.0 Policy Issues with the Adoption of the Suggested Business Income Tax Reforms

To ensure that the tax incentives proposed above are well targeted, and effective in achieving their objectives, a number of issues will need to be resolved, including:

6.1 Defining the boundaries of the incentive mechanism

To maximise the effectiveness of the incentives, it is important that the "boundaries" of the proposed 10 per cent company tax rate and the 10-15 per cent CGT rate for investments by firms in knowledge-intensive industries be carefully defined.

We suggest that these boundaries be defined by reference to particular activities. That is, the investments would need to be made in a defined set of knowledge-intensive industries to qualify for the incentives. Furthermore, additional eligibility criteria could be defined, along the lines of the Factor (f)/PIIP scheme guidelines, prescribing minimum levels of:

  • investment expenditure on production plant, facilities or equipment;
  • economic returns to Australia;
  • R&D expenditure as a proportion of turnover; and
  • project duration.

There should also be requirements that the defined activities be carried out in a new entity and involve incremental investment. This would require consideration of the potential behavioural responses to the introduction of the tax incentives. For example, the extent of incremental investment that would not have taken place in the absence of the tax incentives.

The defined activities could be outlined in an agreement with the Federal Government. The incentives would then begin from the date of the agreement and would last for 15 years. However, the concessions would not commence until the relevant firm has demonstrated a substantial commitment to make the promised investments.

6.2 Ensuring the integrity of the incentive mechanism

To minimise tax avoidance opportunities, the distribution of the benefits of the tax incentives could be confined to the relevant beneficiary entities. That is, the benefit of the tax incentives would not be transferable to other entities.

We note that the pharmaceutical industry has previously entered into similar agreements in the context of the Factor (f) scheme. These agreements were very successful, with minimal tax loopholes and unintended consequences.

To prevent excessive monitoring costs for government and minimise compliance costs for the firms, we suggest that a Factor (f) type compliance and performance monitoring method is implemented.

6.3 Revenue Implications/Other

While it is impossible to accurately estimate the revenue implications of the proposed tax incentives, the APMA considers that they would not have a negative revenue impact due to the compensating gains identified above.

As the proposed incentives are intended to encourage incremental investment, that would not have occurred in the absence of the incentives, it can be expected that they will result in substantial growth dividends in the medium to long-term.

Moreover, in the absence of these incentives, innovative firms may continue to move their operations offshore. While other firms may take their place, these firms would be likely to have lower growth rates, as innovative firms in knowledge-intensive industries have very high growth rates. Accordingly, in the absence of the incentives, it could be expected that the revenue derived from firms in knowledge-intensive industries would be eroded over time.

The proposed tax incentives will not be risk neutral, as they will favour relatively risky, high growth investments. However, knowledge-intensive industries, such as the pharmaceutical industry, are proven globally over a long period of time as high risk, but importantly, also high return industries.

6.4 Practical implementation issues

We suggest that the incentives outlined above be administered by a separate agency of the Department of Industry, Science and Resources. This agency should be focused on the development of knowledge-intensive industries and should ideally be responsible for both the proposed tax incentives and any other fiscal and non-fiscal programs directed at these industries.

The ATO would have a general role in ensuring that the tax incentives are not subject to avoidance.

The proposed tax incentives should be reviewed after 5 years to assess their effectiveness and efficiency.

7.0 Other Related Non Tax Issues

The strong economic performance of the pharmaceutical industry has recently been assisted by short-term industry development programs, such as the Factor (f) scheme mentioned above, which to a limited extent counteract the effects of the Government’s pharmaceutical pricing policies.

Recent changes to pharmaceutical pricing, however, present substantially reduced incentives for further investment in the Australian pharmaceutical industry.

7.1 Coordinated whole of government approach to industry development.

Investment in the pharmaceutical industry is lower than it otherwise would be due to the current tensions between tax, health and industry policy. Uncoordinated administration of pricing, tax and intellectual property rules and drug evaluation and scheduling policies is impeding growth.

A comprehensive integration of the health, fiscal and industry development components of pharmaceutical policy is required to remove this impediment to growth and produce optimal outcomes for both the industry and the Australian community.

Further, inconsistent government policy towards the industry increases complexity and makes planning long-term investments difficult. Frequent policy changes undermine investor confidence and increase the risks for investors of committing to long-term projects.

Australian involvement within the regional tariff associations (e.g. ASEAN) is also essential for equal access for Australian exports in other countries.

7.2 The effects of the Pharmaceutical Benefits Scheme ("PBS") pricing policies

The Federal Government’s role of providing drugs for the Australian community, under the PBS, means that it is the major purchaser of pharmaceutical products in Australia and is able to exercise great influence over the price of drugs in Australia. The Government is effectively a monopsonist, accounting for 80 per cent of prescription drug sales and 60 per cent of the total market (Source: Australian Economic Analysis Pty Ltd., 1998, p. 4-4).

According to the Industry Commission Report (Number 51 1996, p 199), the weighted average of PBS prices for the leading 38 products in Australia was 54 per cent of weighted world prices. Some progress has been made recently, the weighted average of PBS prices of 19 new products is 70 per cent of weighted world prices. This may, however, be a result of fewer generic equivalents being available for these drugs.

The introduction of Therapeutic Group Premiums ("TGP") for four therapeutic categories on 1 February 1998 has further exacerbated the pricing problems under PBS. Prices paid for drugs are now limited to the lowest price for a drug with similar clinical activity, rather than identical clinical activity. This has resulted in even lower prices to manufacturers, and resultant lower incentive to bring new drugs into Australia.

Further PBS listing is a long and complex process, and according to the Industry Commission Inquiry, is in need of thorough review as a matter of urgency.

The PBS also limits the indications for which drugs are listed, meaning that drugs are subsidised to the consumer for only a limited range of their actual indications. The requirement for prescribing authorisation of some drugs further restricts the market use of these drugs.

This position is not sustainable and is already having a significant impact on sales volumes of some drugs, increasing the risk of non-supply and a reduction in the Australian community’s access to important drugs.

These problems will also certainly play a part in decisions about whether MNEs locate their activities in Australia. Irrespective of what business tax reforms are undertaken, or the tax incentives are offered, if the PBS system is not reformed, there will be insufficient incentive to support further investment in the pharmaceutical industry in Australia.

7.3 Protection of Intellectual Property

The introduction of TGP has undermined the benefits of patent protection by pooling out of patent products with unpatented products (i.e. generic products). This pooling, based on arguable therapeutic equivalence, makes product differentiation difficult, and further discourages investment in new products. This is because prices are limited by generic product prices, where less R&D expenditure is required.

 

Appendix 1

Examples of Successful Collaboration between Multinational Pharmaceutical Firms and Australian Pharmaceutical Firms

There are presently a significant number of multinational pharmaceutical firms investing large amounts of money in research & development ("R&D") in Australia. This investment provides benefits to Australia, as the new medicines created help us to overcome all types of illness including real Australian problems like Asthma and Hepatitis C virus. These multinational pharmaceutical firms conduct a significant proportion of their R&D activities through collaborations with local pharmaceutical firms and research organisations. Two of the more prominent local companies collaborating with multinational pharmaceutical firms in Australia are Biota and AMRAD.

Biota/ Glaxo Wellcome

Biota is a small Australian pharmaceutical company based in Melbourne that is collaborating with Glaxo Wellcome on the development of an anti-flu drug. Biota and Glaxo Wellcome have developed, and are now marketing, a drug called "Relenza" for the treatment of the influenza A and B virus. With the backing of Glaxo Wellcome, Biota is able to carry on with its commitment to fighting disease through the creation of new and innovative medicines.

AMRAD/ various partners

There are a number of MNEs which partner local firms in the marketing of medicines. One such partnership is that between Merck Sharp & Dohme (MSD) and AMRAD. This partnership began in 1988. AMRAD Pharmaceuticals is the result of this successful trading organisation.

AMRAD is currently undertaking various contracts with large multinational pharmaceutical firms.

AMRAD has an agreement with the US-based Chiron Corporation ("Chiron"), for collaboration in the discovery of new medicines for the treatment of Hepatitis C Virus.

AMRAD also has agreements with Rhone-Poulenc Rorer Inc ("RPR"), a French firm and Chugai Pharmaceutical Co ("Chiron"), a Japanese firm. AMRAD is collaborating with these companies in the discovery of novel pharmaceutical compounds through natural product screening.

AMRAD has also granted an option to SmithKline Beecham to acquire a licence to AMRAD’s potential rotavirus vaccine.

AMRAD, together with the Ludwig Institute for Cancer Research, have an agreement with RPR in relation to cardiovascular gene therapy research and Baxter Healthcare in relation to cardiovascular therapy.

MSD’s vaccines are marketing exclusively in Australia by CSL Ltd

 

Appendix 2

Australia’s Inefficient Capital Gains Tax System

The current system of CGT in Australia is inefficient and imposes substantial deadweight costs on the economy. It encourages short-term consumption at the expense of saving and investment (and, therefore, future economic growth), and introduces distortions (non-neutralities).

In this regard, the CGT system can disadvantage risky projects, particularly those undertaken by innovative enterprises. This disadvantage is above and beyond the inherent disadvantage that risky projects face, and arises because of the inadequate treatment of losses. In particular, in some circumstances, capital losses can not be utilised for tax purposes. A misallocation of resources and lower economic growth is likely to result from this non-neutrality. If the CGT system was risk neutral (a key policy design principle proposed by the RBT), with consistent and symmetrical treatment of gains and losses, it would no longer discourage risk taking.

Another aspect of the adverse efficiency effects of the CGT is the well-known "lock-in effect", which causes inefficiencies by penalising capital mobility. This distortion is attributable to the fact that investors with accumulated capital gains may not realise those gains in order to avoid the CGT. To the extent that this is the case, investors may hold onto assets that yield a lower rate of return than could be available if the portfolio were reallocated. In such cases, the investment portfolio would be inefficient.

There is also a low level of domestic investment in knowledge-intensive industries in Australia. There are many features of the Australian tax system that are likely to be contributing to this problem, relating to both international competitiveness and domestic economic efficiency.

An internationally high rate of CGT means Australian investors demand more equity for a given cash outlay in an Australian enterprise, and a higher pre-tax rate of return, than do foreign investors. A lower rate of CGT would encourage investment by established firms in small knowledge-intensive enterprises and encourage the commercialisation of local technology.

It is not just the ‘headline’ rate of CGT that is important, but also whether or not a transaction triggers a CGT liability. If a liability is deferred – for example, if rollover relief is available – the effective rate of CGT (in present value terms) is reduced. The current CGT rollover relief provisions are not sufficient and lock-in inefficient forms of business organisation. This is because the life cycle of a typical high growth innovative enterprise is characterised by frequent changes in the structure of the entity for commercial or legislative reasons, as it moves from one stage to another. That is, the business may need to be transferred to another company or entity, to meet the requirements of the expanded investor base. These transitions are generally treated for tax purposes as capital gain realisations, giving rise to tax-driven distortions.

Rollover relief can improve economic efficiency by reducing the ‘lock-in’ effect of CGT and encouraging the re-organisation and continued development of innovative enterprises. There are also strong practical reasons for rollover relief, for example when there is no cash from a transaction (such as a scrip-for-scrip swap) to pay a tax liability. Furthermore, in the context of knowledge-intensive industries, a scrip-for-scrip rollover would facilitate the commercialisation of processes and products developed by local innovative firms, through the acquisition of these firms or their technologies by MNEs.

Many countries provide broader rollover relief than is available in Australia. In particular, some countries allow rollover relief when a business disposes of one asset and purchases another of a similar kind.

Reducing the burden of CGT on innovative enterprises would benefit the Australian economy. By reducing the above distortions, innovative enterprises could grow faster, invest more and employ more people. Additionally, new enterprises would be created that are currently not viable. R&D expenditure would be brought forward, leading to additional investment and employment. In addition to these benefits to the economy, reducing the burden of CGT on innovative companies would lead to increased innovation that would improve the productivity of the nation’s existing capital stock.

 

Appendix 3

Benchmarking Business Income Tax Incentive Mechanisms

An analysis of the specific business income tax incentive mechanisms available to knowledge-intensive industries available in Ireland and Singapore is presented below.

IRELAND

Ireland uses a range of tax incentives to attract and maintain overseas investment in the industrial and financial service sectors. Capital grants (of at least 25 per cent of capital expenditure on plant, machinery and buildings) are also available to overseas companies setting up in Ireland.

The key incentive available in Ireland is the low company tax rate of 10 per cent. This concession is available to companies involved in "Manufacturing activities", "International Financial Services" and the Shannon Airport.

A 10 per cent corporate tax rate applies to certain manufacturing companies - based on a wide definition of "manufacturing". The 10 per cent rate also applies to certain trading activities within the Shannon Airport Free Trade Zone, and to companies providing certain financial activities in the Custom House area of Dublin (branches and subsidiaries of foreign companies can apply to be taxed at a higher rate if this would be beneficial - such companies are not subject to withholding tax on interest paid overseas).

Manufacturing activities

A wide range of manufacturing activities qualify for the 10 per cent rate of company tax. "Manufacturing activities" is widely defined to include manufacturing operations in the ordinary sense of manufacturing, as well as high technology, export-oriented manufacturing activities, such as engineering services, grant aided software development and data processing. In addition, the 1990 Finance Act deems certain specified activities to be manufacturing activities, including:

  • certain computer services receiving grants;
  • repair and maintenance of aircraft, aircraft engines and components; and
  • manufacture and repair of computer equipment or of subassembly.

In order to qualify for this concession, a company must be engaged in manufacturing or processing, and production of goods for export. This concession is guaranteed and EU approved until 2010.

International Financial Services

A tax concession of 10 per cent will apply for financial services, including treasury management, fund management and insurance and reinsurance activities. In order to qualify for this concession, the financial activities must be carried out in the International Financial Service Centre in Dublin.

Shannon Airport

The Minister for Finance is empowered to grant the 10 per cent company tax rate to any trading operations which, in the opinion of the Minister for Finance, contributes to the use or the development of the airport. Other relevant considerations include whether the activities employ a certain minimum number of people, and are principally export oriented. The 10 per cent company tax rate applies until the year 2005 for qualifying Shannon activities. In addition to the 10 per cent company tax rate, companies operating in Shannon may claim accelerated capital allowances.

These concessions provide a number of benefits, including the following:

  • the concessions encourage foreign investment in Ireland. Ireland’s low corporate tax rate has been important in attracting a large number of foreign enterprises since the early 1990s; and
  • there has been a large increase in manufactured exports, production and employment in these assisted industries.

SINGAPORE

Singapore has a wide range of tax incentives and grants to encourage investment in selected sectors and firms. These tax incentives are mainly targeted at knowledge intensive industries. In particular, a number of tax incentives are provided under the Economic Expansion Incentives Act to the engineering and technical industries, computer-based and computer-related industries, and medical industries. These tax incentives are discuss below:

Pioneer Company Status

Pioneer company status is extended to companies that provide specific qualifying services to the engineering and technical industries, computer-based and computer-related industries, and medical industries. The tax concessions available to companies with pioneer status include:

  • an exemption from income tax for a period of up to 10 years;
  • losses incurred by a pioneer company can be set off against its future pioneer income;
  • any unabsorbed losses of a pioneer company at the end of the tax holiday can be set off against the company’s post pioneer profit; and
  • dividends paid by the company out of its exempt income from the qualifying activity are exempt in the hand of the recipient shareholders.

The following considerations are relevant to whether Pioneer status is granted to a company:

  • whether the firm is specialised and manufactures new and high technology products; and
  • longer tax holidays are given for projects with higher investment, advanced technology, greater skills and long gestation periods.

Various non-tax incentives are also available to Pioneer companies, including land grants and training grants.

The Minister for Finance is empowered to grant pioneer company status to an industry, and any product or service of such industry. Without the Minister’s written approval, an enterprise with pioneer status may not carry on non-pioneer trade or business, as non-pioneer income is taxed at the normal corporate rate.

Development and Expansion Incentive

The Development & Expansion Incentive ("DEI") applies to companies that have previously enjoyed pioneer company status, as well as any qualifying companies that may not have qualified for pioneer status. A company that qualifies for this incentive is taxed at a concessionary rate of not less than 10 per cent on expansion income (amount of income derived from qualifying activities that exceed the taxpayer’s average corresponding income)

The initial tax relief period of a qualifying company is determined by the Minister, subject to a maximum of ten years. The Minister may extend the tax relief period under the post pioneer incentive and DEI of the qualifying company for up to 5 years at a time, subject to a maximum total tax relief period of ten years.

Benefits

The DEI:

  • encourages capital inflows into the Singapore economy, which in turn helps to broaden the industrial and financial base of Singapore
  • creates job opportunities, through the setting up of new companies in Singapore;
  • encourages industries which have a high technology content; and
  • helps to advance Singapore as a regional centre for advanced technology.

Investment Allowances

An Investment Allowance is available to existing enterprises to expand and diversify into manufacturing operations. The investment allowance is based on an approved percentage, which does not exceed 100 per cent of a company’s qualifying expenditure incurred on plant, machinery and factory building for an approved project.

In order to qualify for this incentive, the company must engaged in approved qualifying activities, which include:

  • technical and engineering services;
  • R&D projects;
  • computer based information and other computer related services; and
  • projects for the operation of any space satellite.

The Ministry of Trade is responsible for the approval of investment allowances.

Investment in New Technology Company

This incentive provide tax incentives to encourage local companies to invest in new technology projects, as follows:

  • A holding company which holds share in an approved technology company may be eligible for a deduction for the unabsorbed losses or capital allowances of that company
  • An approved technology company which has incurred an overall loss at the end of its 3 years qualifying period may, within 5 years of hat date, elect for its losses and unabsorbed capital allowances to be made available for relief to the eligible holding company.

In order to qualify for this scheme, the investment must be made by an eligible holding company in a new technology company. An "Eligible Holding Company" is one incorporated and resident in Singapore for tax purposes and at least 50 per cent owned by Singapore citizens or permanent residents. Further, the company must be is incorporated in Singapore and the new technology must promote or enhance the economic or technological development of Singapore. The tax incentive is granted upon approval by the Minister of Finance.

Benefits

The benefits of the incentive include:

  • promotion of the economic or technological development in Singapore, through the setting up of companies which invest in the use of new technology; and
  • improvement of worker productivity, through the use of high tech machinery.

Research and Development Tax Incentives

Tax incentives are also provided for R&D activities under the Income Tax Act. The following incentives are provided for manufacturing enterprises conducting R&D and for R&D institutions servicing them:

  • a double income tax deduction is allowed for operating expenses, including manpower, materials and utilities of qualifying R&D activities;
  • accelerated capital allowances over 3 years for all plant and machinery used for R&D;
  • investment allowances for companies that plan to incur heavy capital expenditure. Investment allowances of up to 50 per cent of the capital investment in R&D are allowed on a case by case basis;
  • industrial building allowances;
  • expenditure on R&D which is incurred under an approved cost sharing agreement may be written off over 5 years at 20 per cent p.a.; and
  • lump sum payments of manufacturing licenses may be capitalised and will be deductible for income tax purposes over a period of 5 years.

 

Appendix 4

History of Government Incentive Mechanisms Available to Knowledge-Intensive Firms in the Pharmaceutical Industry in Australia

An analysis of the positive effects of selected government incentive mechanisms available to knowledge-intensive firms and/or industries in Australia, now and in the past, is presented below.

R&D Tax Concession

The R&D tax concession allows eligible companies to claim a tax deduction of up to 125 per cent of their eligible R&D expenditure. The concession is jointly administered by the Industry Research and Development Board ("IRDB"), through the office of AusIndustry, and the Australian Taxation Office ("ATO").

Criteria for Involvement

Companies incorporated in Australia, public trading trusts and eligible companies in partnership, qualify for the program. Eligible R&D activities must:

  • be carried out by, or on behalf of, the company claiming the concession;
  • have adequate Australian content;
  • be exploited on normal commercial terms for the benefit of the Australian economy.

Concessional treatment is also available for R&D plants, pilot plants; interest incurred in financing R&D, and core R&D technology. Some R&D undertaken outside Australia is eligible for the program, where a certificate is sought from the IRDB. However, the eligible overseas expenditure is limited to 10 per cent of the total project cost.

Benefits of the Program

The aim of the program is to:

  • increase private sector investment in R&D, to make the private sector more inventive and internationally competitive;
  • encourage the more efficient use of Australia’s existing research infrastructure;
  • improve the conditions for commercialisation of new process and product technologies; and
  • develop a greater capacity for the adoption of foreign technology.

ABS statistics show that business expenditure on R&D reached $4.24 billion in 1995/96, but was expected to drop by 12 per cent in 1996/1997, after the concession rate was reduced from 150 per cent to 125 per cent.

Factor (f) Scheme

The Factor (f) Scheme allows for payments to be made to subsidise R&D and value added production or "any other significant contribution to internationally competitive production in Australia". Companies qualify to enter the scheme based on the contributions mentioned above.

Companies receive up to 25 per cent of the value of additional activity beyond the level that existed in the base year. Payments are made via notional price increases for products under the Pharmaceutical Benefits Scheme (PBS) up to a maximum of the average European price of the product.

What is the aim of the scheme?

To partially compensate pharmaceutical manufacturers for the relatively low prices negotiated by the Federal Government through the PBS scheme.

What were the Results of the Scheme?

Just over $1 billion was allocated to Factor (f), as a result of nearly $8 billion worth of new activity, and around 1000 new jobs. According to the Department of Industry, Science and Tourism Annual Report 1996/97: Industry Liaison, phase II of the scheme in that year reported $225.6 million of export value added, $228 million of domestic value added, and $75 million of R&D expenditure. In return, the Government has paid participants a total of $146 million. There were also secondary benefits of the scheme such as development of strategic alliances (e.g. Glaxo Wellcome and Biota who together developed an anti flu drug, see Appendix 2).

Pharmaceutical Industry Investment Program (PIIP)

This scheme has been designed to replace the Factor (f) scheme outlined above. PIIP will be introduced in July 1999, and runs until June 2004. Admission is on a competitive basis, based on an assessment of the relative merits of broad programs proposed by companies. Total funding available is $300 million over five years.

The scheme covers the same activities as its predecessor (i.e. production value added activity, and R&D), however; the payment rate has been reduced to 20 per cent of the difference between actual and base level activity. Production value added activity is measured against a moving average base, and R&D against a fixed average base.

Payment will take the form of price increases where there is a clear case of prices being suppressed below the European Union average as a result of the PBS scheme. Firms will now also have the option of taking price increases as notional or actual adjustments.