U.S. Research and Development Tax CreditAnchin in the NewsOctober 30, 2017
Leader of Anchin's Research and Development Tax Credits Group, explains how the credit works and shares his findings on the impact of the PATH Act.
Governments typically incentivize private industry to produce research and development (R&D) as a strategic tool to advance their economies. Initially temporary, the federal R&D tax credit became the United States’ primary means for rewarding business for investment in research. The PATH Act of 2015 permanently extended the R&D tax credit and expanded its provisions. The author lays out the basics of R&D tax credit and investigates the initial impact of the PATH Act by surveying its effect on 40 companies.
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Rapid changes in technology over the past decades have forced most companies to constantly innovate. At every stage, companies encounter technical challenges related to developing new or improved products and trade processes and integrating them with existing assets. Being able to overcome these technical hurdles is critical to maintaining a successful, healthy business. As most business owners know, however, attempting to create and execute viable and worthwhile innovations can be extremely expensive and time consuming for management and employees. Innovative undertakings often fail with no return on investment.
Fortunately, the federal government, as well as many states, currently provides valuable economic incentives to alleviate some of the burden and reward companies for undertaking these inherently risky initiatives. These financial incentives are intended to foster innovation and technological advancement of U.S. companies, thereby creating jobs and increasing global competitiveness.
The federal R&D tax credit, also known as the Research and Experimentation (R&E) tax credit, was first introduced in 1981 as a two-year incentive and has remained part of the tax code ever since. Its purpose is to reward U.S. companies for increasing their investment in R&D in the current tax year. It is available to any business that attempts to develop new, improved, or technologically advanced products or trade processes. In addition to activities such as creating new products or trade processes, the credit may also be available to taxpayers that have improved upon the performance, functionality, reliability, or quality of existing products or trade processes.
Although many taxpayers have viewed this tax credit favorably, there were limitations on the applicability and utilization of the tax credit for certain taxpayers. On December 18, 2015, President Obama signed into law the Protecting Americans from Tax Hikes (PATH) Act. This legislation retroactively renewed and made permanent a collection of expired tax provisions for both businesses and individuals and addressed some of the credit’s limitations with regard to certain small businesses and startup companies.
How Does the R&D Tax Credit Work?
The rules of the R&D tax credit can be found under Internal Revenue Code (IRC) section 41 and the related regulations. The R&D tax credit may apply to any taxpayer that incurs expenses for performing Qualified Research Activities (QRA) on U.S. soil.
The R&D credit comprises the following types of Qualified Research Expenses (QRE):
- Wages paid to employees for qualified services (including amounts considered to be wages for federal income tax withholding purposes)
- Supplies (defined as any tangible property other than land or improvements to land, and property subject to depreciation) used and consumed in the R&D process
- Contract research expenses paid to a third party for performing QRAs on behalf of the taxpayer, regardless of the success of the research, allowed at 65% of the actual cost incurred
- Basic research payments made to qualified educational institutions and various scientific research organizations, allowed at 75% of the actual cost incurred.
To qualify as research according to IRC section 41, the taxpayer must show that the activities—
- are intended to resolve technological uncertainty that exists at the outset of the project or initiative, related to the capability or methodology for developing or improving the business component or the appropriate design of the business component;
- rely on a hard science, such as engineering, computer science, biological science, or physical science;
- relate to the development of a new or improved business component, defined as new or improved products, processes, internal use computer software, techniques, formulas, or inventions to be sold or used in the taxpayer’s trade or business; and
- substantially all constitute a process of experimentation involving testing and evaluation of alternatives to eliminate technological uncertainty.
If the development is related to internal use software (IUS), there are an additional three tests that must be satisfied:
- The software must be innovative. It should result in a reduction of cost or an improvement in speed that is substantial and economically significant.
- Developing the software involves significant economic risk, requiring the commitment of substantial resources and subject to substantial uncertainty of recovery in a reasonable time period.
- The software is not commercially available. The taxpayer cannot purchase, lease, or license and use the software for the intended purpose without having to make significant modifications that satisfy the first two requirements.
There are numerous activities that are not within the definition of qualified R&D activities. The following are 10 primary types of activities that are specifically excluded from the definition of qualified research:
- Research conducted after the beginning of commercial production or implementation of the business component (with some exceptions)
- Adaptation or duplication of existing business components
- Surveys, studies, or activities related to management functions or techniques
- Market research, testing, or development (including advertising or promotions)
- Routine data collection
- Routine or ordinary testing or inspection for quality control
- Computer software, except where developed for internal use
- Any research conducted outside of the United States
- Any research in social sciences
- Funded research.
The cost of acquiring fixed assets used in a taxpayer’s trade or business is also excluded.
Read the complete article in the October 2017 issue of The CPA Journal.