Start-up Nation: Israel’s Path in Becoming Knowledge Economy

Night Scape Of Tel Aviv

Israel, popularly known as the “start-up nation” not only holds the record for highest number of start-ups per capita in the world but also the highest R& D intensity. The country’s R&D stands second in the world only to South Korea by a mere 0.01% among all Organization of Economic Cooperation and Development (OECD) countries. Holding second place after the silicon valley in the USA, Israel’s success in technology can be figured in three important factors. Firstly, the country’s “start-up culture” is widely attributed to the conscription- a mandatory military service for the citizens upto three years. Second, as Teubal (2013) describes, Israel’s vision involved “the overarching national goal” of developing a knowledge economy and society with a strong Science, Technology and Higher Education (STHE) focus which lays the foundations to advance with innovation as a tool. Located in the middle east, unlike its neighbours Israel has less significant natural resources but reroute to adopt a more competitive strategy and establish amongst the developed economies. Third, a lot of innovators and entrepreneurs benefit from the geography and government initiatives. Being a small country, all tech hubs and research institutions are located in close proximity, in addition to government schemes strongly encourage knowledge sharing through cluster formation and industry-academia cooperation therefore enabling faster progress. 

There are multiple targeted fiscal policies and grant schemes which drive innovation in Israel- governed by the Office of the Chief Scientist (OCS) established in 1969 to fund commercial R&D projects. The policies also aim to develop their science and technology sector under the ‘Encouragement of Research and Development in the Industry Law 1984’ (R&D Law). In 2016, OCS was replaced with National Authority for Technological Innovation (NATI) otherwise known as Israel Innovation Authority (IIA) which provides grants to Israeli companies and researchers. 

Evolution of R&D Law 

The R&D Law of 1984 had four key objectives – development of science intensive industry and improving the knowledge base in the industry, creating new employment opportunities, fostering added value for the Israeli economy from such R&D and improve balance of payments through manufacture and export of indigenously developed science intensive products. 

It has 4 basic requirements as well when it was introduced:

  1. Funding would be provided for up to 50% of an R&D program, geared towards a product, by an Israeli company with a manufacturing base.
  2. Funding would only be given where the recipient undertook to develop and manufacture the product in Israel and sell it abroad.
  3. The transfer of know-how resulting from the R&D program was prohibited.
  4. The recipient would repay the funding in the form of royalties from sales of the product.

The transfer of Know-how was even considered a criminal offence with a 3-year prison sentence in an effort to avoid knowledge-drain and safeguard their innovations close to home. This is similar ro an anti-avoidance provision but with extremely narrow scope for any get-out clauses. If the innovator wanted to shift their production base out of Israel (even partially) there was a penalty applied in the form of increase in royalties payable under point 4.  This caused concern for companies to avail funding under this plan as it would curtail their global movement in future. In response, the law has been amended in the years of 2005 and 2016 bringing  vital changes to the transferability of know-how  and shifting the authority to decide upon the transfer to IIA. 

Grant Programs

Israel offers a suite of R&D grant programs apart from tax incentives to companies at each stage along its growth. The support rate for R&D ranges between 20-50% or higher in certain schemes, based on the innovation level and requirements as well. There are different types of grants such as employment or for investment or for R&D, innovation, and technological collaboration. It also has bilateral research programs with the US, South Korea, China, and European Union. The multitude of these schemes as shown in Figure 1 are captured by Wonglimpiyarat (2016). The Ministry of Economy also provides detailed eligibility conditions and benefits for each scheme. MNC’s with Israelis subsidiaries can also avail of these benefits.

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Figure 1: The Innovation Authority’s Grant Programs (Source: Ministry of Economy, Israel)

Tax Incentives

The various taxation benefits of indulging in R&D activities are as shown in Figure 2 below. Amongst the four incentives in blue focussed to encourage capital investments, only ‘Technological Enterprise’ and ‘Preferred Technological Enterprise’ require the companies to mandatorily invest 7% of its total sales in R&D activities over the three years preceding the tax year or to have received approval from the Innovation Authority amongst other eligibility criteria. But the important ones to focus on are the incentives for R&D- Expenses Deduction for R&D and The Angel Law.

Expense deduction

Clause 20A of the Israeli Income Tax Ordinance enables companies to deduct their R&D expenses in the year they were paid from their current income (even if they are capital costs). The deduction is contingent on the Chief Scientist’s confirmation regarding the expenses towards research and development. 

There are two types of investors for these costs, one who is an owner and spends it to develop his own enterprise and the other who is not an owner but participates to enjoy a reasonable return. The former can deduct the costs in the tax year incurred or over the next three tax years if approval is not obtained. The latter has a cap of not more than 40% of his taxable income can be spent on R&D costs in a year and the costs can be deducted over two tax years. There is apparent encouragement by design to ensure entrepreneurs invest in R & D. 

The Angel Law

First enacted in 2010 and then amended in 2016, it provides tax benefits to single investors who invest in Israeli companies in their initial R&D stage (seed) i.e., venture capital stage. It aims to increase funding for Israeli companies in their infancy. The law enables single investors’ investments in eligible companies to be recognized as expenditures for tax purposes. Eligible companies are Israeli companies with R&D expenses of 70% or more of their total company expenditures for the relevant tax year. Companies must receive approval from the OCS for their R&D expenditure. There are three different tracks with unique rules under this scheme based on whether they are a Israeli tax resident company or single investors and the stages of the company (seed or early stage).

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Figure 2: Tax Incentives for R&D activities(Source: Ministry of Economy, Israel)

Conclusion

Despite such meticulous government support, the direct government support as a percentage of total Business Expenditure on R&D (BERD) in Israel has declined from 9.8% in 2000 to 2.7% in 2017 of which close to 84% comes from the private sector. There is no data available for Israel to analyse its indirect funding through R&D tax incentives. Israel’s expenditure on R&D is $15.95bn in 2017, though the majority is from the private sector while Ireland spent around €2.8bn ($3bn) in 2017. These figures show the intrinsic nature of Israeli economy which relies heavily on R&D. In its total R&D expenditure around 50% is received from foreign sources with over 250+ MNCs locating their R&D activities there to benefit from the specialised talent. 

Off late it’s not just Israel, but many other countries as well which are in the race to provide better and lucrative opportunities for increasing R&D activities to develop  into knowledge economies. This would also provide a better standard of living for their citizens and activities of higher importance to enhance their standing in the global marketplace. With schemes beneficial to corporates, profits are rerouted to more investments in technology thereby, increasing employment and growth rate. Israel is a successful example  as it is solely focussed on being a knowledge economy despite being in a location so close to a conflict area and lacking any natural resources. 

Divya Sindhu
Currently pursuing her Master’s in Taxation from University of Limerick, Ireland. Previously worked with EY on US Taxes with Enrolled Agent license. Completed Bachelor’s of Commerce (Honors) from Christ (Deemed to be University), Bengaluru, India (2014-17).