Catalyst - Summer 2009 - Is Your Company Benefiting From The Research Credit?
Catalyst Summer 2009
Although billions of dollars in research tax credits are generated each year, the credit retains elements of complexity and misunderstanding. Corporations often view efforts to develop new products, improve legacy products, or to enhance outdated and costly processes merely as a cost of doing business. As a result, these businesses may be overlooking a potential tax benefit. The credit is in addition to the tax deduction for research expenses and the benefit results in a dollar-for-dollar reduction of the business' income tax liability.
What is the research tax credit?
The research tax credit was enacted as a provision of the Economic Recovery Tax Act of 1981 as a key component of a multi-faceted tax reduction package to ensure future economic growth. The credit offered a financial incentive to profitable U.S. companies of all sizes that were engaged in certain types of product development and process engineering activities. Unfortunately, many small and medium size companies have distanced themselves from the credit either because of confusion on what qualified research is, or how the credit is computed.
What is qualified research?
Claims for the research credit rely on two factors – the definition of qualified research and the expenses eligible for the credit. With respect to the definition of qualified research it must: 1) involve activities aimed at the development of a new or improved product or process. This includes all technical activities such as analysis, design technical requirements, developing, coding, testing, etc. undertaken from initial design, proof of concept, planning and definition, architecture and detailed design, and development testing. 2) be intended to discover information that is "technical in nature" and useful in the development of a new or improved business product, process, computer software, technique, formula or invention. 3) rely upon a process of experimentation whose ultimate aim is the development of a business component with a "new or improved function, performance or reliability or quality." These activities generally involve the evaluation of alternatives, trial and error, failures, or other testing methodologies. Examples of qualifying activities include developing new and improved legacy products, designing and testing preproduction prototypes and models, and developing software applications. By contrast, research conducted outside the United States, research related to the social sciences, or research funded by the Federal government or a corporate entity is ineligible for the credit.
What expenses are eligible for the credit?
In regard to qualified research expenses ("QREs"), only in-house salaries and wages of employees and supervisors engaged in qualified research, as well as cost of materials, supplies and certain time-sharing costs for computer use in qualified research are included in the credit computation. In addition, 65% of amounts paid to third-party contractors for conducting qualified research are eligible for the credit.
It is important to understand that certain related research and development ("R&D") expenses are ineligible for the credit. For example, amounts expended on depreciable property (i.e., depreciation) used in qualified research, such as buildings and equipment are ineligible for the credit. Also, overhead expenses, such as utility expenses, rent, and employee benefits are ineligible for the credit.
How is the research credit computed?
For tax year 2008, companies have the opportunity to elect one of the three formulas to compute the research credit: 1) the traditional credit; 2) the alternative incremental research credit ("AIRC"); and 3) the alternative simplified credit ("ASC").
Under the traditional method, businesses receive a 20 percent tax credit for qualified research expenses in excess of a computed base amount. The base amount for any given tax year is determined using the business' history of qualified research expenses and gross receipts. This methodology is beneficial for companies that have maintained its historical records and whose R&D spending has grown consistently with, or faster than, its revenues.
For companies that are making significant R&D investments but are unable to use the traditional method, the AIRC may be beneficial. The AIRC utilizes a reduced three-tiered fixed base percentage with a reduced three-tiered credit percentage applied to the increment to compute the credit. This method can only be used for tax year 2008; it was repealed beginning with tax year January 2009.
The ASC is a simplified computation that provides a 12 percent credit (14 percent beginning in tax year 2009) on current year QREs in excess of 50 percent of a company's prior three- year average of QREs. The ASC is computed without reference to gross receipts, and utilizes a more current view of a company's R&D expenses.
Do the states offer a research credit?
In addition to the federal research credit, approximately 35 states have enacted some form of research credit. R&D activities may also enable a company to qualify for other incentives, such as investment credits, jobs credits, and sales and use tax exemptions.
New Jersey has a comprehensive package of tax incentives for research, including a research credit, an investment credit, a jobs credit, and a sales and use tax exemption. Additionally, certain technology and biotechnology companies may be able to transfer their unused research tax credits and net operating loss carryovers to other New Jersey taxpayers.
Pennsylvania offers a non refundable incremental research credit of 10% for research activities conducted within the state. The credit is based on the rules set forth in IRS Code section 41. Companies must apply for the credit by September 15 and are notified by December 15 of the amount approved.
New York does not provide a research credit, but it offers other incentives including an investment credit for R&D property.
How should the credit be documented?
Documentation is essential for receiving and supporting the research credit. It is vital to be able to clearly and completely demonstrate to the Internal Revenue Service ("IRS"), as well as state jurisdictions that the project work was indeed qualified research. It is also required that QREs be identified by qualified activity. Accordingly, if upon examination an examiner is unable to connect specific research projects and the underlying activities to the qualified expenses, the credit claim will not be sustained.
Contemporaneous books and records are the basis for research credit examinations. In addition, computational workpapers, along with the following types of qualitative support would be helpful:
- Materials explaining the research activities, including the difficulties encountered during the course of the project;
- Project summaries and/or progress reports indicating the issues encountered during the course of the research;
- Minutes of meetings that discuss research activities, including the resolution of uncertainties;
- Complete copies of contracts for research performed by outside contractors.
The IRS issued an Industry Directive in 2007 advising the designation of the research credit as a Tier I issue. As such, the IRS considers research credit claims of "high strategic importance" to the agency. Thus, it is important to retain all the information necessary to support the credit if an examination arises.
Is your company a candidate for the research credit?
Any firm with leading edge technology is likely to have qualified research and eligible costs. Companies in the chemical, electronics, manufacturing, medical technology, pharmaceutical, and software industry sectors are candidates for the credit.
Foreign R&D credits
Most of the industrialized nations offer some type of tax incentive and/or other nontax programs for R&D initiatives. The offering of tax incentives is intended to encourage technological innovation in a particular country. Some countries have enacted subsidies to attract R&D facilities such as Singapore and India. While the type of tax incentive or subsidy varies among nations, private industries are the direct beneficiary of this governmental support.
Currently, Congress is seeking to simplify the credit calculation while still maintaining its legislative purpose. As such, it is conceivable that with grass roots support, along with support from the Obama Administration, Congress will enact legislation to incent U.S. companies to continue to engage in R&D efforts.
Fred Lesser, Partner, Integral Consulting Services, LLP. He can be reached at 732.290.1943.
Lori McMahon, Tax Senior Manager, EisnerAmper. She can be reached at 732.287.1000 x 1351.
EisnerAmper's Catalyst: Summer 2009
- Welcome to Catalyst
- Moving Science Forward: Rescinded Stem Cell Funding Ban a Huge Step
- The Pharmaceutilization of Stem Cells Celgene Cellular Therapeutics: On the Brink of a Breakthrough
- Store Adult Stem Cells Today – For Use Tomorrow
- Coriell Restructures Stem Cell Activities, Incorporates Latest Technology
- Beyond Transplantation: Progenitor Cell Therapy Sees 'Endless Opportunities' Ahead
- Flex Work: A Competitive Advantage for a Start-up Biotech?
- Is Your Company Benefiting From The Research Credit?