Why Industry 4.0 Matters to a Tax Department
Industry 4.0. Smart Manufacturing. Robots. Machine Learning. Data Science. Industrial Internet of Things. The list could go on. The buzz is that Industry 4.0 will forever change the manufacturing world. Data science and technology will become the core of all businesses. You will be able to see the technology oozing through the facility at every turn.
History has witnessed many changes in industrial processes. At the turn of the 18th Century, the introduction of water and steam power brought about the First Industrial Revolution. As the 20th Century dawned, the Second Industrial Revolution was pushed by electrical power and the telephone. The Third Industrial Revolution, often referred to as the Digital Revolution, began in the 1950s with the implementation of technology and electronic systems.
And now as the 21st Century unfolds, we see manufacturers leveraging digital, biological, and physical systems to introduce Artificial Intelligence (AI), cloud computing, robotics, 3-D printing, Internet of Things (IoT), and advanced wireless technologies. This is smart manufacturing, otherwise known as the Fourth Industrial Revolution, 4IR or I4.0, where data is king.
Data allows teams to progress with manufacturing advancements seen around the world by shifting from an outdated and inefficient approach to an approach leveraged by data. Smart manufacturing equips manufacturing leaders with real-time information to make smarter, quicker choices. For instance, manufacturers can implement robotic and vision system technologies to reduce the errors associated with human visual inspections. This could eliminate manufacturing downtime, reduce or eliminate product defects, and enhance product quality and performance.
Manufacturers are investing in significant upgrades to their existing footprint through capital project spending. This may consist of a completely re-vamped manufacturing layout, including evaluating brand-new equipment, brand new line set-ups, new robotics, and incorporating software and cloud capabilities into the day-to-day production efforts. This all entails money going out of the business, but the benefits that these expenditures and research will bring back to the company are proving well worth the investments, especially in the current economy.
During the investigatory and implementation years, large capital expenditures are to be expected, and at times, excessive. There may also be an uptick in hiring surges, including third-party consultants and temporary labor with specific areas of expertise. These costs will pay off in the long-run with significantly reduced operating costs and enhanced product quality, ultimately contributing to a manufacturer’s bottom line.
Once implemented, employee focus will transition from the traditional day-to-day operations to maintaining these technologies and continually exploring and iterating newer methods to produce the highest quality products. Companies will be placing higher value in both mechanical and software backgrounds for employees rather than just the traditional focus on mechanical and manufacturing engineering. These changes are bringing about much excitement in the workforce, for all stakeholders.
I4.0 has already impacted the largest manufacturers in terms of spending and short-term financial performance. Tax departments should proactively understand what is going on at their company in order to identify how this spending might result in tax planning opportunities. This may include the research and development tax credit, accelerated depreciation deductions, and many others.
What does this exactly look like? It might even seem irrelevant during the Covid-19 environment full of financial and workplace uncertainties. Certain business models have paused all investment type spending. Taxpayers are in survival mode operating under lean budgets and a reduction in the active work force. Changes to a business model consistent with this approach also eliminates the opportunity to pursue tax credits and deductions that that would traditionally reward investment spending, ultimately impacting tax liability and cash flow.
Some of the largest and most sophisticated taxpayers are looking at this differently. Rather than cutting back on spending, they are doubling down. They see this as an opportunity with the workforce operating from their homes to “reset” and “think differently” about available data and technologies, and how making an investmentnowcould be viewed as chasing a prime opportunity. This is where the concepts and practices of I4.0 are crucial to the future of manufacturing.
Consider Company ABC in the following example:
Company ABC develops and manufactures widgets. In the past two years, Company ABC’s management has tasked the R&D, manufacturing, and operations teams to identify how to improve the margins within Line 5. Line 5 generates $40 million in net income each year. However, it operates with older machinery, too many human touchpoints (i.e. high labor and overhead costs), and increasing scrap and quality defect rates each quarter. Margins were slipping. Downtime and product failures resulted in lost revenue of $8 million per year. The R&D, manufacturing, and operations team worked together to identify the root cause analysis of the issues and collaborated with the manufacturing line workforce (i.e. non-traditional engineers) to hypothesize how to implement and execute upon an automation strategy and real-time failure analysis. These discussions resulted in purchasing a new vision system, architecting software code, and developing a new process to x-ray each widget coming through Line 5 with a precision rate of 98.99%, 12% higher than human review.
Large outlays of investment dollars, such as the above example, breeds tax planning opportunities. Congress designed incentives, such as the research and development tax credit, to incentivize companies to invest in high paying, highly technical jobs here in the U.S. Taxable compensation paid to individuals may be considered qualifying research expenditures (QREs) eligible for the R&D tax credit. In order to qualify, the individual must perform activities that (1) fundamentally rely upon the hard sciences such as engineering, physical science, or computer science, (2) develop a new or improved product, process, software, technique, formula, or invention, (3) eliminate a technical uncertainty, as the information available does not establish the capability, method, or most appropriate design, and, (4) constitute a process of experimentation to overcome the technical challenge which may include evaluating, discarding, and/or confirming alternatives.
Consider the aforementioned example. In order for ABC to achieve their goals, they would need to re-purpose their workforce into more strategic and technical roles, hire outside specialists, and invest in capital expenditures. This included the following:
Pulling 25 full-time equivalent manufacturing engineers from their day to day activities ($1.7 million in payroll) and 45 R&D engineers from various disciplines around the company ($5.6 million in payroll). Prior to this endeavor, the manufacturing engineers did not meet the criteria to qualify as a QRE and the R&D engineers only qualified at half or less of their time during any given year. Given the manufacturing engineers’ involvement with identifying the root cause analysis and potential alternatives to improve Line 5, their activities now are deemed as QREs. Similarly, the R&D engineers were able to include more of their time as qualifying time given their role in the project.
Hiring 15 various technical specialists including data scientists, software engineers, and transformation specialists ($2.6 million in payroll). The specialists were 100% dedicated to activities that met the outlined criteria for the R&D credit.
Increasing spend with various third-party specialists ($6 million) to assist with testing, prototyping, and analysis.
Investing in $5 million of new Capital Equipment and related expenditures. The equipment was purchased through the R&D budget as prototypes at first. The project teams needed to experiment with the prototypes, perform systematic trial and error, and conduct pilot experiments to validate the original hypothesis of implementing a new vision system.
In summary, ABC spent nearly $21 million, where $14 million was new investment spending and $7 million was spend they had already been incurring but was re-purposed to focus on this project. These investments in new jobs, repurposing existing jobs, third-party spending, and prototype spending resulted in nearly $1 million in after-tax benefits to ABC above and beyond their average annual R&D tax benefit of $5 million. ABC also reduced the Line 5 lost revenue from $8 million to $3.5 million in year one, with anticipated further reductions to $750,000 in year two and beyond.
The benefits to the R&D tax credit may seem obvious to any sophisticated taxpayer that already has some level of spend that is considered qualifying spend. The key takeaway is to proactively segregate the investments made, the intent of that spend, and to implement a record-keeping strategy that will allow the taxpayer to capitalize on the additional bottom-line opportunities. In ABC’s case, they must:
determine how all individuals involved in the project may or may not meet the qualifying criteria, which was drastically different from their “day jobs” prior to this project rollout,
analyze the contracts with the third-parties they engaged to determine whether they have maintained the appropriate risk and rights associated with qualification for the R&D tax credit, and
determine the portions of prototype spending that was used during the project work in an experimental sense.
ABC must maintain contemporaneous documentation to support all the analysis and inclusion of QREs. This may include capturing meeting notes, iterations of technical drawings, meeting notes including the key stakeholders, time-tracking and expense-tracking records demonstrating nexus to the project, and various other technical documentation.
The bottom-line is pursuing updates to engage in I4.0 improvements in this context will include significant investments to most taxpayers over a five-year period. However, awareness of tax benefits such as the R&D tax credit in advance, including the record-keeping requirements, will help partially offset (i.e. fund) the investments made.