Alongside the flow of knowledge into the Israeli economy and the high productivity of multinational corporations' R&D centers, incentives must be created for expanding their scope of operation and employment. Adoption of the BEPS Regulations by the developed countries presents Israel with an excellent opportunity for doing so.

The Israeli innovation system constitutes a focus of attraction for the most advanced technology companies in the world. Over recent decades, more than 300 multinational corporations, active at the forefront of technology, chose to establish a research and development center in Israel, and some even operate a number of centers in different fields of development. During the previous ten years, multinational corporations have been thronging to Israel in increasing numbers: between 2007-2016, an average of twenty new R&D centers were established every year.[1]

The establishment of a center, or its expansion, frequently takes place following the purchase of Israeli companies. Over time, multinational corporations operating R&D centers in Israel have acquired more than 100 Israeli companies. A number of multinational corporations – Intel, Microsoft, Broadcom, Cisco, IBM, and EMC – have even acquired more than 10 local companies each during their operations in Israel.[2] This phenomenon reached its peak earlier this year with the purchase of Mobileye by Intel for the sum of USD 15.3 billion, a huge transaction expected to lead to the expansion of both companies' operations in Israel.

This lively activity is sustained by the many assets of the Israeli innovation scene: leading research, skilled personnel, a culture of innovation, pioneering technologies, and flourishing innovation, especially in the fields of computing, communications, and software (ICT). The question naturally arises regarding the degree to which these centers contribute to the local innovation system and the Israeli economy.

 

R&D Centers Create Significant Technological Value

The multinational corporations' R&D centers (hereinafter: R&D centers) claim a place of respect in the development of Israeli high-tech. The pioneers - IBM, National Semiconductors and Intel – began operating in Israel already in the 1970's and paved the way for the hundreds of companies that followed in their footsteps. Today, R&D centers comprise an essential element in the Israeli innovation system and create significant technological value. One illustration of this is the fact that the increase in their activity constituted the primary source of growth of corporate R&D in Israel over the last decade. Since 2005, the R&D centers' share of the business sector's total expenditure on R&D increased from 29 percent to 47 percent.[3] The number of those working in these centers (mainly R&D employees, as will be seen below) increased during this period at an average annual rate of 14 percent, this compared with 5 percent a year in other companies engaging in R&D.

Furthermore, the R&D centers positively influence salary and productivity related aspects of the economy. A study conducted by the Chief Economist's Division of the Finance Ministry reveals that the salaries of workers employed in multinational corporations are expected to be significantly higher later in their careers than that of workers employed only in local companies.[4] An empiric estimate calculated as part of the study reveals a positive and clear salary differential of 8.4 percent paid by the multinational corporation to any given employee.[5] Another study conducted by the Applied Economics Corporation found that start-up companies established by former employees of multinational corporations grow at a faster rate in human resources and salaries than start-up companies founded by entrepreneurs employed solely in local companies.[6] The R&D center graduates who move throughout their careers between the different players in the high-tech industry, thereby distribute their accumulated technological and management skills – a phenomenon the professional literature terms spillover.

 

Increasing the R&D Center' Economic Influence      

Despite the figures cited above, and as stated in the Innovation Authority's Strategy chapter, the economic impact described here does not adequately summarize the underlying potential in the technological value created by the R&D centers. Specifically, the overwhelming majority of the centers engage exclusively in R&D activity, while other links in the corporate value chain are active in other countries. This phenomenon is even more marked when examining the employment aspect of their activity. Although the R&D centers create approximately 40 percent of all R&D jobs in the business sector, the total of all the jobs they provide, including peripheral jobs, constitutes only 18 percent of all positions in companies engaging in R&D. The reason for this is that approximately 68 per cent of jobs in R&D centers are those at the core of the R&D process itself, and most are intended for engineers and programmers.[7] In other words: these centers create high-quality employment, however only within limited spheres of employment.

This focus on R&D and the resultant engineer-biased employment mix restrict the potential influence of the R&D centers. This is especially so since the players in the innovation arena – multinational corporations, start-up ventures, small and medium sized businesses, growth companies and senior and established corporations – are all competing for the same limited pool of skilled engineers. The shortage in supply of high-tech engineers and programmers coupled with the ever-growing demand for these professionals leads primarily to an increase in their salary and an indirect impingement of the competitiveness of Israeli high-tech. Furthermore, in this competition, the R&D centers possess significant advantages that their competitors are having difficulty overcoming. They can offer employees an attractive remuneration package, the building of a reputation, knowledge, experience, and access to other international centers of the multinational corporation. Therefore, as long as there is no significant increase in the supply of engineers, the R&D centers' demand for skilled workers is expressed mainly by their ability to recruit the best engineers available. Their influence on the scope of high-quality employment in Israel is therefore limited, and more specifically, they contribute only modestly to increasing the economy's quota of high added-value jobs.

The Israeli economy will also yield great benefit from the expansion of the R&D centers' existing activity to other spheres of the corporate value chain: manufacturing, marketing, support, design, and others. For example, expanded manufacturing activity of high-tech multinational corporations will have a far-reaching influence on the cultivation of skilled technological personnel for the manufacturing industries, for strengthening a culture of technological innovation and toward the accumulation of relevant knowledge. Further activities in the chain of value will widen the circle of high-salaried employment that the R&D centers create around them, thus enabling workers in non-technological professions to be able to also benefit from the many advantages of multinational corporations. Expansion of the Israeli R&D centers' scope of operation to becoming more complete companies is, therefore, a strategic objective of innovation policy in Israel.

It should be mentioned in this context that already today, approximately 20 percent of the R&D centers also engage, to varying extents, in manufacturing of high technological intensity, usually in locations in the geographical periphery.[8] Among the multinational corporations conducting manufacturing operations in Israel in addition to their R&D activity are KLA-Tenkor, HP Indigo, Applied Materials and of course, Intel.

 

Encouraging R&D Centers' Activity in Additional Technological Fields

Although the multinational corporations' activity in the ICT field is already widespread, in other spheres, the scope of their R&D activity in Israel is relatively low. For example, while the ICT fields are responsible for 90 percent of R&D expenditure in the multinational corporations' R&D centers, medical equipment is responsible for 4 percent, and pharmaceuticals for merely 2 percent (see Diagram 3). Non-ICT manufacturing sectors such as chemicals, plastic, and others – occupy only a tiny proportion of these corporations' R&D expenditure.


Technological sectors suffering from under-representation in the multinational corporations' R&D activity do not currently benefit from the technological advantages that they bring to the fields of ICT. These sectors will, therefore, profit greatly from the attraction of multinational corporations' R&D centers in Israel. The cultivation of additional thriving innovation systems in areas in which the Israeli economy possesses a leverageable advantage is a central component in the Innovation Authority's strategy. Accordingly, the granting of appropriate incentives to multinational corporations choosing to conduct R&D and other activity in the value chain, in fields other than ICT, is a clear strategic objective both for the Innovation Authority and for the government in general.

Indeed, the government has already begun acting in this direction: this year, the Innovation Authority launched a program to encourage the establishment or expansion of R&D centers' activity in the fields of biotechnology and medicine. Also, the Ministry of Economy and Industry's Foreign Investment and Industrial Cooperation Authority is active in attracting investments to Israel in the field of advanced manufacturing (for more details on these two programs, see the table below).

 

Steps to Expand the R&D Centers' Activity in Israel

> The Innovation Authority is launching a trial program to encourage the establishment or expansion of the R&D centers' activity in the fields of medicine and biotechnology.

The Innovation Authority is currently launching a pilot program with the objective of enabling multinational corporations, active in the fields of medicine and biotechnology, to establish or expand their Israeli R&D activity, technological innovation or production. The program leverages the changes in the tax regime of high-tech companies to expand their economic activity in Israel. The program has two central elements:

  1. Selection of R&D Centers Operating in the Fields of Biotechnology and Medicine: The selection entitles the centers to submit requests for grants from the Innovation Authority. The criteria for selection emphasize technological innovation alongside the expected contribution to the economy. Particular emphasis will be placed on the possibilities for the expansion of employment circles beyond the R&D employees and the contribution to the Israeli eco-system through activity in new technological fields or in areas in which the R&D activity in Israel is relatively low but possesses high potential.
  2. Awarding of R&D Grants to Companies Selected as R&D Centers in the following fields: The centers selected as eligible in this track will be able to submit a request for grants for R&D programs, including perennial programs, for a total of up to NIS 50 million for a six-year period. Centers receiving a grant will be exempt from paying royalties to the Innovation Authority. In addition to the degree of technological innovation and risk, the criteria for authorization of support for an R&D project in this track also include the expected contribution to the economy, from taxation and employment aspects, to innovation activities in which the Israeli economy lacks experience, and R&D supporting activities.            

> The Foreign Investment and Industrial Cooperation Authority strives to encourage investments by multinational corporations in advanced production in Israel.

The Foreign Investment and Industrial Cooperation Authority, under the auspice of the Ministry of Economy and Industry, was established in its present format approximately two years ago out of a desire to increase quality foreign investment in Israel. Investment in advanced manufacturing by innovative multinational corporations is central in this regard, the objective being the expansion of Israel's share in the innovative multinational corporations' value chain from R&D alone to the manufacturing of higher technological intensity.

Within this framework, the Authority is operating on three central axes: Firstly, the Authority is focusing its marketing and development efforts towards promoting this model by means of designated conferences, global campaigns via different forms of media, delegations, and activity with target companies while utilizing the Department's global array of attaches, and while relying on business intelligence capabilities developed by the Authority. Secondly, the Authority offers investors a One-Stop-Shop model including accompaniment throughout all stages of the investment with designated sector managers. Because investment in manufacturing occasionally results in increased "friction" between the company and government regulators, the Authority has also established an Investors Service Center with the goal of reducing this friction.

Thirdly, the establishment of the Authority in its current format merged the encouragement of foreign investments and activity associated with the foreign companies' offset obligation in Israel. Because the majority of the obligated companies are also the world's largest industrial corporations, the consolidation of these two spheres enables the leverage of the local activity from one of the foreign company's obligation to that of opportunity for investment and growth in Israel, including manufacturing.

Further information can be seen on The Foreign Investment and Industrial Cooperation Authority

 

The BEPS Regulations: An Opportunity to Maximize Economic Value

As mentioned above, the consistent growth in the R&D centers' activity is powered by Israel's comparative advantages. Efficient tax planning constitutes another incentive for dispersing operations in the multinational corporations' value chain between different countries. In this way, while their activity in Israel yields large-scale R&D output, the intellectual property developed within the framework of this activity has, until now, been listed in other countries in which taxation of income from intellectual property is considered more convenient.

Accordingly, the R&D centers' operations in Israel is, in most cases, taxed by the 'cost-plus' method[9] that fails to gross up the actual business profit from the company’s R&D activity. This means that tax revenue from the R&D centers in Israel does not reflect the added value of their research and development activity, i.e., the high income from the sale of products worldwide. 

This status quo of dispersal of global activity based on tax planning was interrupted during 2016 with the publication by the OECD of the BEPS Regulations.[10] The objective of the regulations is to prevent the relocation of high-tech companies' profits to countries with favorable tax regulations and to tax havens worldwide. The regulations mean, among other things, that intellectual property must be registered in its country of development. The full adoption of the BEPS Regulations by the developed countries, therefore, presents multinational corporations with two alternatives: the first, to transfer their R&D operations to a country in which both the tax and business conditions are optimal for them. The second option is to leave the R&D activity in those countries possessing the comparative technological and systemic advantages for innovation, despite the change in tax payments expected with the ascription of sales income to these countries.      

At the same time, countries of the second category, including Israel, will be required to conform their tax system to prevent corporations from transferring their R&D activity to countries enjoying a comparative tax advantage. The regulations determine that only the country in which intellectual property has been developed may bestow tax benefits on income derived from it, and they therefore provide an opportunity for countries that have hitherto hosted multinational corporations' R&D activity, to create an attractive tax regime.

If so, the BEPS Regulations constitute a challenge for preserving the attractiveness of the Israeli innovation system in the eyes of multinational corporations. Primarily, the State of Israel must maintain those comparative advantages due to which multinational corporations have come here in such large numbers – skilled personnel mainly in ICT, groundbreaking high-tech companies, world-leading technology, and others. Also, the restriction on granting tax benefits on income from intellectual property creates an opportunity to incentivize multinational corporations to register here the intellectual property developed in Israel. Experience proves that the establishment of intellectual property in a particular country frequently leads to the expansion of that company's management activity there. Such a dynamic is also expected to bring about an increase in high-salaried employment of workers in supportive functions, including management. The registration of intellectual property in Israel may therefore lead in the long-term, to an expansion of the multinational high-tech corporations' economic activity in Israel.

And indeed, the government is currently engaged in adapting the tax system that applies to high-tech companies to the international tax environment in accordance with the recent changes. Following preparatory work led by the Ministry of Finance, the Knesset authorized in late 2016, Amendment No. 73 to the Encouragement of Capital Investments Law and the Finances Committee recently authorized the ordinances for its implementation. The Amendment creates a special track for high-tech companies and grants them significant tax benefits on income from technological developments. The benefits include the lowering of corporate tax from 25 percent to 6-12 percent[11] and significant benefits in the tax rates on dividends and capital gains.

Within the framework of the Amendment, the Innovation Authority received several consulting and arbitral powers the objective of which is to make the Amendment's implementation easier for technology companies, this based on its proximity to the industry and its in-depth familiarity with research and development processes. Firstly, it was determined that companies failing to conform to the special track's conditions as determined by the law, may submit a request to the Innovation Authority asking to be included in the definition of an "innovation advancing plant." This definition will allow them to receive the benefit granted in the Amendment. Secondly, the Innovation Authority has the power to adjudge whether technological knowledge developed in Israel or transferred to Israel conforms to the application of tax benefits.[12]

The described changes will allow multinational corporations to continue expanding their R&D activity while registering the resultant intellectual property in Israel, and will even make the transfer of intellectual property from other countries to Israel worthwhile. These changes are not, of course, only relevant to Israel: with the publication of the BEPS Regulations, a kind of 'arms race' of tax regime adaptation developed in the international arena. Will the changes that Israel is implementing be effective in preserving and expanding the R&D activity of multinational corporations? How will their tax revenues change? In light of the central role played by the multinational corporations in the local economy, these are indeed critical questions for the future of Israeli innovation.

 

The Innovation Authority – In Practice: Supporting Strategic Cooperation between Israeli Companies and Multinational Corporations

Multinational high-tech corporations can benefit the Israeli high-tech system not only by means of the activity of the R&D centers located here but also, via strategic collaborations with Israeli start-up companies. These collaborations pave Israeli companies' way to markets and avenues of operation both in Israel and around the world, and infuse Israeli industry with knowledge, experience and skills at all stages of the technological development's value chain.

A successful example of such cooperation is the connection between the Israeli company Qlight and the global chemical and pharmaceutical corporation Merck. Qlight was founded in 2009 and develops applications for LED lighting and television screens, based on a nano-technology originally developed at the Hebrew University, that enables precision color control. Merck expressed interest in Qlight's technology already at its inception, joined forces with it in joint development and invested in the start-up company at an increasing rate. The Innovation Authority's support of Qlight, within the framework of the Global Enterprise Collaboration Program, assisted in strengthening the strategic collaboration between the two companies. Merck's vast knowledge aided Qlight in understanding market needs and focusing on new directions.     

In 2015, following years of joint endeavor, Merck completed acquisition of Qlight. Following the acquisition, Qlight's R&D infrastructures were significantly expanded. The company is continuing its operation in Jerusalem as a R&D center of the global Merck Corporation in the field of advanced materials.    

 

We wish to thank The Foreign Investment and Industrial Cooperation Authority in the Ministry of Economy and Industry for its contribution to this chapter.  

 

[1] According to Dun and Bradstreet (Israel) Ltd.

[2] According to Start UP Nation Central

[3] National Bureau of Statistics, Corporate Sector R&D Survey, 2014 and annual statistical journal 2016.  

[4] In a sample of workers employed by multinational companies between 2005-2010, the average salary of workers also employed at the end of the period was higher by 43 percent than the salary of those working in local companies during the same period. The gap grows to 64 percent when examined versus a general sample of workers in local companies (without the requirement of previous employment in multinational corporations). 

[5] Slobodnitsky, Drucker and Geva; The Contribution of Multinational Companies to Productivity in Israel, September 2016, Chief Economist's Division in the Ministry of Finance.

[6] The study was conducted for the National Council for Civilian Research and Development by the Applied Economics Corporation Ltd. together with a steering committee headed by Prof. Zvi Ekstein.

[7] National Bureau of Statistics 2015. It should be mentioned that the NBS definition for multinational corporations' centers is slightly more limited than that of other information sources.

[8] According to figures of the Authority for Industrial Cooperation and the Advancement of Foreign Investments

[9] Pricing of the added value according to the operation's cost price plus a profit constant accepted in the sector, and determined by the tax authorities. The accepted rate in multinational corporations' R&D centers is 5-12 percent.

[10] Base Erosion and Profit Shifting

[11] Twelve per cent for preferred technological factories, 7.5 per cent for preferred technological factories in Development Areas 'A', and 6 per cent for special preferred technological factories (giant corporations).

[12] The full details are updated on the innovation Authority's website.