Funding innovation: Strategic, creative sourcing can drive new products and process improvements

Innovation is the lifeblood of manufacturers, whether they’re high-tech startups or companies in mature industries. Unfortunately, many firms struggle to invest in R&D, despite the fact that substantial amounts of innovation funding are available from federal, state, local, and international credits and incentives, as well as direct-funding channels.

Only about half of manufacturers currently make use of federal R&D incentives, and fewer pursue state and local credits or direct funding (see Figure 1). Often this is because executives aren’t aware of how much help is out there. Other times, CFOs who are aware that funds are available still don’t pursue them, citing rigorous processes associated with R&D incentives and direct funding, including occasional audits. Yet savvy executives know that strategic planning and good documentation can land external funds that cover up to 20% of all innovation costs.

VACFO campaign - Innovation article“The CFOs we work with are actively involved in understanding the credits and selecting the funding provider,” says Mark Andrus, a partner in Grant Thornton LLP’s Strategic and Federal Tax Services practice. “They also look at a range of options in how to pursue credits, such as joint ventures with larger companies, and opportunities to combine funding sources (for example, using multiple credits, and/or discretionary or direct funding for the same project). These CFOs identify which activities are eligible for funding, determine the types of funding arrangements to pursue and create a list of potential partners.”

Billions of innovation dollars are available

Federal credits
The United States has been funding innovation via the R&D tax credit since 1981, awarding as much as $7 billion annually. The federal credit has turned into an annual political cliffhanger. It has expired 16 times and been renewed 15 times, most recently in 2014 — and its future for 2015 remains undecided.

State and local incentives
Nearly all states and hundreds of regions and municipalities offer some form of R&D credit or other incentive programs, which can cover as much as 10% of qualified R&D expenditures. The periodic uncertainty of the federal incentive has made state incentives popular, and makes the corporate requirements for documenting activities worth the effort in the event the federal credit disappears.

Credits are unique to each state and come with their own array of filing processes, including deadlines that may not be consistent with tax filing dates, application processes rather than tax claims and specific documentation requirements. Also differing substantially among locations are the parameters for what is considered innovation and the level of scrutiny applied to manufacturers.

International credits
Billions of dollars for innovation are available around the world. Ten countries account for 80% of the world’s R&D investments; the United States, China, and Japan account for more than 50% of all R&D investments.1

Many international credits are intended to spur relocation of R&D activities to host countries, but some have no relocation requirements. As with state and local incentives, many international incentives resemble U.S. federal credits in scope and filing requirements.

Direct funding
R&D expenditures at federally funded research and development centers (FFRDCs) totaled more than $17 billion in 2012 (see Figure 2).2  Depending on the nature of the innovation and source of monies, direct funding can be more lucrative and easier to obtain than tax credits. Direct funding is often for a specific purpose (e.g., AIDS research, renewable energy), and there are many ways to access funds:
  • Government agencies and programs (e.g., Digital Manufacturing and Design Innovation Institute)
  • Public/private partnerships (e.g., World Health Organization)
  • Third-party sponsorships (e.g., Microsoft Ventures Accelerators)
  • Nonprofit foundations (e.g., Small Business Innovation Research program)
  • Private investors (e.g., venture capitalists, angel investors, crowdfunding)

VACFO campaign - Innovation article

The good news for manufacturers is that many of these funding options can be combined to support the same innovation project.

Says Steven Carter, managing director of the Credits and Incentives practice at Grant Thornton: “We identify potential project programs and locations that CFOs may not know about. It could be cash grants or rebates from a state or local community to get them to land an innovative technology. There are thousands of these negotiated incentives across the country. Some are dedicated specifically for innovation, while others are associated with innovation based on the number of jobs they might generate overall or within a sector, such as high-tech or biomedicine. CFOs should not think of this as just an emerging technology program. They need to look holistically at where they want to put that first investment, and where they want to grow in the future.”

CFOs should look for several locations and tap multiple sources simultaneously. For example, in addition to securing direct funds from an R&D program, a company may be able to reduce state or local property-tax assessments. “Incentives are often just the tip of the iceberg of where you’re looking to put that initial investment, but from there it’ll grow into other areas, such as jobs credits and property tax abatements,” notes Carter. “Over time, you should be claiming all of these.”

Embrace a broader view of innovation

Unfortunately, many manufacturing CFOs don’t recognize all the work and processes that can qualify as R&D. “They take too narrow a view of innovation, one that focuses solely on developing a new product,” says Andrus. “For example, a company that develops a new production process or develops software to improve its transportation activities would be conducting a qualified research activity.”

Many state and local incentives mimic federal R&D credits, which encompass a broad definition of innovation — initiatives that improve or create new functionality, performance, reliability, or quality of a business component. These include:
  • Processes
  • Techniques
  • Inventions
  • Formulas
  • Software

At the core of each of these qualified activities is the intent to discover information that eliminates uncertainty. This activity must include experimentation and be technological in nature. Expenses covered by the R&D credits can include wages, supplies, research done by contractors, and payments to nonprofits and institutions.

Smart manufacturing CFOs know that good engineering that results in a process improvement is more than just good engineering — it’s qualified R&D."Andrus says CFOs should communicate regularly with engineering departments regarding activities that may qualify as R&D. “They should be asking design engineers, ‘Do you have some uncertainty or is there some unknown about whether your product design is going to meet all of your requirements?’ They should be asking manufacturing engineers whether the design of a new process experiments with a new way of working. Smart manufacturing CFOs know that good engineering that results in a process improvement is more than just good engineering — it’s qualified R&D.”

Keep an eye on the fine print

It’s common for R&D credits to be challenged by the government. Experienced CFOs aren’t surprised or worried by audits, but accept them as part of the overall tax credit process.

“Tax courts have stated that the R&D credit is one of the most complicated areas of tax law because the rules are subjective,” says Andrus. “Some CFOs find maneuvering in this gray area uncomfortable, but it can be well worth the complexity and effort.”

Uncertainty about tax credit rules grew over decades, because even though federal credits were enacted in 1981, regulations defining qualified research weren’t implemented until 2004. The risk of audits — at the federal or state level — often discourages executives at small and midsized companies from even starting the tax credit process.

“We know it’s not easy to stay committed and push forward with credits, especially after an audit,” says Andrus. “But the onerous nature of credits may be on the mend. In recent years, the IRS has tried to work with accounting firms to make the process less painful. With these guidelines in place, Grant Thornton has been able to develop new tools that help companies analyze and identify required R&D documentation.”

Implement an innovation funding strategy now

Most manufacturers have innovation activities that already qualify for innovation funding. CFOs must take the lead in developing strategies to get these activities funded.strategies to get these activities funded.Most manufacturers have innovation activities that already qualify for innovation funding. CFOs must take the lead in developing strategies to get these activities funded. “We usually deal with tax people,” says Carter, “and they don’t always know where new innovation is coming from or where the capital is going. That’s where our capital-expansion review program aligns activities with R&D credits, other investment credits at the state level, sales tax exceptions, direct funding, etc.”

Depending on the activity and its location, CFOs may be able to reduce the cost of a project by as much as 20%. “We can provide this analysis on every project in a CFO’s company, or just on selected projects to show them where they should consider locating work,” adds Carter. “We also review the tax regimes in different locations. For example, you might pay more tax in one state, even with incentives, than you’d pay in another state without incentives.”

It is also important for CFOs to bargain with multiple entities. “It is imperative to have a variety of options for a project,” says Carter. “If a city or a state believes that they’re your only option, you’re not going to get it. You have to show them that you have other options.” Typically, there is a negotiation process. It’s important to go into that negotiation with a clear idea of the restrictions (e.g., wage requirements or clawbacks) that make a deal less attractive, explains Carter.

Innovation is essential to long-term success. With a good understanding of the available options, strong strategic planning, skillful negotiation and detailed documentation, CFOs can fund the innovation necessary for growth.

How will your company fund innovation in 2015?

1 Battelle and R&D Magazine. 2014 Global R&D Funding Forecast, December 2013.
Britt, Ronda. FFRDC Research and Development Survey: Fiscal Year 2012, National Science Foundation, January 2014.