Innovation – taking a quantum leap

This article shows how fragile our industralisation policy is which since Independence has not been based on attracting cutting edge technology and transfer of intellectual talent but took the easy option of giving tax perks, including 10-year tax holidays and various incentives so long as the investor guarantees creation of jobs.

This policy attracted various cycles of investors since the sixties and apart from building a tourist infrastructure, we welcomed investors in the ‘cut-make-and-trim’ textile operations lured to the island because of our comparatively low labour cost. Such a nascent textile industry was not properly capitalised and excluded any R&D or innovation/design units. Such unique intellectual capital was not transferred by the foreign investor.

The obvious consequence of this weak industrialisation policy was that once wages increased beyond a certain level there was a mass exodus and the industrial estates became a ghost city.  Replacement of the textile industry was followed by attracting other manufacturing units, which included (but was not limited to) pharmaceuticals, microchip, printing and Playmobil investors. All these have a common denominator – they do not carry out any R&D studies in Malta.

This is a policy which cries out for reform as competition from other Eastern European countries is intensifying and we risk being exposed to another exodus as wages are gradually revised upwards. Having attracted foreign manufacturing companies in our industrial estates, not conducting our own R&D is a risky scenario.

Readers may ask – what is the solution?  The answer is not simple as the reform involves not only a sea change in the direction of Malta Enterprise but also a cultural and educational revolution that ensures that our young entrepreneurs are nurtured to explore innovation while the country invests more in attracting overseas talent. The target set by the government to reach 2% of GDP in R&D by 2020 is far higher than our current level of around 0.7%, reaching a mere €60 million. Other European countries have been keen to attract innovation to their shores and even give tax incentives fully approved by the Commission.

This year saw the inaugural launch of new “Innovation Box” tax rules in Netherlands, which was fully approved by the Commission after the OECD put some pressure on the Netherlands to change the old scheme which has been successfully running since 2007. The old scheme has been providential to attract many R& D companies to set up base in the Netherlands and claim tax exemptions, reducing the rate of corporate tax to a preferential rate. This means that instead of taxing the full amount of such profits at the general corporate income tax rate of 25 per cent, only one-fifth of such profits may be taxed at that rate.

This means charging an effective tax rate of five per cent. Of course, this year there are new rules to prevent any misuse of the scheme but the lower rates are still available. The incentive applies to self-developed (meaning in-house) technology and creation of other intangible assets, such as the know-how for a new product or for a new production process. 

The new scheme which has been styled “the nexus approach” – this allocates development expenditures into qualifying expenditures and non-qualifying expenditures. It is opportune to explain what are qualifying expenditures. These are expenditures exclusively incurred for the development of the intangible fixed asset, with the exception of costs incurred for the outsourcing of R&D to group companies and indirect costs such as accommodation and financing costs.

Expenses for contract R&D activities performed by third parties are considered qualifying expenses since a company is expected to only outsource ‘non-fundamental’ R&D activities to third parties. Another bonus in this Innovation Box scheme (which was never introduced in our tax code) is the treatment of losses in the start-up period.  In my opinion, this is a clever way to attract multinational companies to set up R&D centres in our country to support a dynamic economy buttressed by cutting-edge technology.

Simply put, the Innovation Box allows losses to be generally tax deductible at the general tax rate of 25 per cent (ours at 35%), not at the reduced effective tax rate of five per cent.  The cherry on the cake is that initial losses incurred before business operations have been started are also deductible at a 25 per cent tax rate.

At this stage, readers may ask, what has this genius piece of tax legislation got to do with us, a small island on the periphery of Europe?  It is only a part of the complex structure which constitutes an effective ecosystem that supports a culture of successful entrepreneurship. The grass roots of a successful industrialisation policy start with nurturing of start-ups (both local and those attracted to migrate here).

For this purpose we need a paradigm shift in our mentality to attract FDI that is sustainable and is anchored on fundamental research conducted through business accelerators. But simply throwing money at the national start-up scene will not automatically create more members of that Billion Euro Club, whose members are known as “unicorns”.  These start-ups don’t exist in isolation.  It is true that many of them fail to create success. Sometimes the causes of such failure are the lack of careful nurturing in an ecosystem, which comprises a mosaic between venture capital, angel investors, mentors and the bricks and mortar where the start-ups create their magic.

Since many a year we run incubators – which are more about providing bricks and mortar and a place to work and not so successful as they still have the connotation of ‘life support’ rather than inculcating the ambition to innovate and do something bigger and better. The alternative which proved successful in the USA was the accelerator business model, whose origins are most often attributed to a vibrant start-up scene.

These form part of the much desired ecosystem that fostered Airbnb & Uber (so called Unicorns now worth billions).  Why is it so hard for Malta to start enjoying the success registered at other innovation centres run by universities such as MIT, Stanford, Oxford, Leiden and others?  Now that we are hosting two new educational institutions such as Barts medical school and AUM, we may take heart and try to attract more universities to create a nucleus of talent.

Naturally the future output of graduates from these institutions can either result in a brain drain or ideally, they stay to populate innovation/research centres of international repute. These are non-existent locally and as stated earlier there is no impetus to sustain cohorts of talented graduates who simultaneously receive seed money, office space and mentoring in exchange for a percentage of equity.

What do such centres do?  Broadly speaking, they help ventures define and build their initial products, identify promising customer segments, and secure resources, including capital and employees. More specifically, we need accelerator programmes – these are usually of limited-duration, lasting about three to eight months, that help cohorts of start-ups with the new venture process. They also offer a plethora of networking opportunities, with both peer ventures and mentors, who might be successful entrepreneurs, programme graduates, venture capitalists, angel investors, or even corporate executives.

To conclude, this essential innovation reform may sound like a dream. Those enjoying the status quo criticise visionaries saying they are armchair critics lamenting that reality is somewhat different given limitations of our own size and geographical location away from the mainland. Surely, we have come a long way since the time when our island was a colony and we are a cohort of talented and resourceful people. It is a pity that our dreams cannot become reality unless somebody decides to pierce the proverbial glass ceiling. 

George M. Mangion is a senior partner of PKF Malta audit and consultancy firm, which has established many companies in Malta and placed PKF in the forefront as professional financial service providers on the island.