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Are you taking advantage of productivity incentives in the Tax Reform Act of 1986?

There is little evidence that some important provisions of the Tax Reform Act of 1986 are used by business in setting competitive strategy. Proper use of certain tax credit provisions of the Act may make some projects feasible, which would be discarded without this consideration otherwise. Additionally, some firms may already qualify for carry back and carry forward provisions of the Act if relevant business activities are properly documented.

Taxation has been a major concern to businesses of all sizes for many years. According to a 1984 survey conducted by the National Federation of Independent Businesses, taxes were the most important problem areas for small businesses. Several of the over fifty recommendations introduced at the 1986 White House Conference on Small Business dealt with taxation. Examples of these concerns are found in the following two tax-related recommendations made at the conference:

* Implement new capital formation and retention vehicles for small business, including tax incentives for investment in this sector; and

* Either retain the Investment Tax Credit or restore it for the purchase of new and used equipment by small businesses.

Fortune magazine reports general concern about the impact on the after-tax cost of capital investment. Other Fortune articles also report on concerns of business over the Tax Act.

In recent years considerable attention has been given to many factors of competition that a firm might employ when attempting to achieve competitive advantage. Models are developed that include consideration of the external environment in which government agencies are generally lumped together under the term "regulatory agencies." The case studies used as learning vehicles in executive development courses often contain financial statements, which students analyze in preparing case analyses. However, the productivity incentive portions of the Tax Act are generally ignore. Quite likely this has occurred because tax law is an area that is considered to fall into one of the functional areas of the firm that is taken care of routinely in the conduct of business. Yet, tax law is an important consideration in setting competitive strategy. It is important to note that the provisions of the act described herein have been continued on a year-to-year basis. The Bush administration introduced legislation to enact the provisions over a longer term, but Congress sees fit to continue the provisions on a yearly basis. In any event, the carry back and carry forward provisions still make the act useful as a competitive weapon.

As competition in both the industrial and service sectors becomes more severe, each firm must seek every legitimate means to increase its competitive advantage. This applies to setting competitive strategies as well as to improving day-to-day operations. Appropriate employment of provisions of the 1986 Tax Reform Act can enable an organization to find or increase competitive advantage in product development, engineering, operations, personnel, finance and marketing, which may in turn enhance competitive position. Some basic areas of the Tax Reform Act that may enable a firm to be more competitive are discussed.

The Act

The Tax Reform Act of 1986 became law on October 22, 1986. It was the most drastic overhaul of the Federal tax system in 40 years. Most provisions of the 1986 Tax Act directly amend the Internal Revenue Code. Consequently, the Internal Revenue Code is now known to many as the Internal Revenue Code of 1986. An immediate concern to business was the news that the regular investment tax credit was repealed for property placed in service after December 31, 1985. However, certain investment tax credits do remain for specified properties and activities of the firm.

Of great significance in the Tax Act are those rules and definitions concerning the investment tax credit, which enables those who are taking specific action toward improving their competitive position through quality and productivity improvements. Rules affecting such actions have a three year carry back and a 15 year carry forward provision. The apparent opportunities for small business lie in the definitions and descriptions found in the Research and Experimental (R&E) tax credit areas of the new Act. The Act extended the research credit with some important modifications. The Act reduces the R&E credit to 20 percent and keeps the base period rule only for qualified research expenses. The base period is the three-tax-year period ending with the tax year immediately preceding the tax years beginning after 1986.

The Act introduces a new 20 percent credit and a special set of operating rules for "basic research expenses," a new category that replaces prior law's contract research expenses. While the new definitions seem more restrictive than the old, it is important to explore the opportunities which lie in the new definitions. The definitions and provisions should be investigated for application to activities and programs already in place as well as for future activities.

The Tax Act defines "qualified research" and "qualified research expenses" as follows:

Qualified Research -- The 1986 Tax Act provides that the term "qualified research" means research with respect to which expenditures may be treated as expenses under Code Section 174 if undertaken for the purpose of discovering information that is technological in nature, and the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, and substantially all of the activities of which constitute elements of a process of experimentation as defined. The term does not include any activity specifically excluded.

Qualified Research Expenses -- Qualified research expenses includes all internal and external expenses in the appropriate activity categories. Sixty-five per cent of qualified outside research expenses are allowable. This includes:

* Wages for qualified expenses;

* Supplier used in conducting qualified research; and

* Rentals for the use of computer and software in qualified research.--Code Section 41(d)(1) as added by '86 Act 231(b)

Other considerations

Despite the seemingly restrictive definitions and the exclusions found in the Code, there are many opportunities available to the organization to take advantage of investment tax credits. There are several key words to consider:

* Quality;

* Reliability;

* Performance; and

* New or improved function.

These are words that relate to day-to-day production processes in many firms, including service as well as manufacturing. The chief watchwords here lie in the code definition of the term "business component." Business component is defined as: any product, process, computer software, technique, formula or invention that is to be held for sale, lease or license, or used by the taxpayer in a trade or business of the taxpayer--Code Section 41(d)(2)(B).

If the requirements of a business component described above are not met with respect to a product but are met with respect to one or more elements thereof, the term business component means the most significant set of elements of such products with respect to which all requirements are met. In other words, there is a shrinking back process which allows the business to move from applying the definition to the end item offered for sale back to the components of the product or service until the definition is satisfied.

The information above sets the stage for managers to identify activities in the organization which can qualify as business components or subsets thereof. Note that qualified research expenses include in-house research expenses and contracted research expenses. However, not included is research conducted outside the United States, research in the social sciences, arts, or humanities or research funded by government agencies. Additionally, there are special rules for production processes (see Code Section 41 (d)(2)(C)). Some examples of where the Act applies are as follows:

Product-Design and Development -- Applies to new and improved products, but not to debugging or correcting functions of products already on the market. However, this can include developing a "new and improved" version of an existing component in, for example, an automotive engine for example.

Process Analysis -- process quality assurance activities designed to produce a better product. This goes beyond the normal quality activities.

Process Design -- research aimed at improving the manufacturing processes thereby producing higher quality products.

Inventory Policy -- extraordinary efforts taken to purchase better parts, not just more expensive parts. Also, above normal efforts to increase quality of incoming parts.

Quality Assurance -- extraordinary efforts in packaging, shipping and handling, preservation, etc., which will help ensure product quality. This area also includes efforts in getting and using feedback from customers if this feedback results in improved quality of the products.

Automation and Advanced Technology -- Leased CAD/CAM work stations, software and certain other equipment. Also, qualified research in this area includes the development of robotics and software for the robotics for use in operating a manufacturing process, and the taxpayer's research costs of developing the robotics. Costs of new or improved internal-use software must also meet the requirement that the software is innovative (as where the software results in a reduction in cost, or improvement in speed, that is substantial or economically significant), that substantial risk is involved in committing the funds to the software development, and that the software is not commercially available without significant modification so that it will meet user requirements.

"Direct supervision" is the key in the management area. For example, a firm embarking on a JIT inventory project might find significant tax savings in the wages of those researching and implementing the process, as well as the salary of a manager who is providing direct supervision of the project. The tax credit for qualified outside research might enable the firm to employ services not normally considered affordable. Significant dollar savings may be available in the "wages for qualified services" area. While it is not advisable to put the wages of everyone in the inventory management area into the investment tax credit scheme, investigation may well reveal that a number of employees, including senior management, are active enough in certain improvement areas to warrant their inclusion.

An example

Goodshirt Screenprinters has annual sales of around $50 million. The president of the firm initiated a project for quality improvement which was called "Top Quality." In 1987, the firm allocated $400,000 to the project. The same amount was allocated in 1988 with an increase to $1 million planned for 1989 to qualified R & E expenses. The base amount is the running three year average, but not less that 50 percent of the current year qualified R & E expenses. A comparison of these base amounts shows the following:

* Three year average = (400,000 + 400,000 + 1,000,000)/3 = 600,000

* 50 percent of 1,000,000 (current year R & E) = 500,000

So, Goodshirt would choose a tax credit based on the larger qualified amount of $600,000. This would provide a tax credit of (.20)$600,000 = $120,000. In a project of this nature, Goodshirt should consider the following potentially allowable expenses under Section 41 of the tax code:

* Research into what the customer perceives as quality in the product, especially customer satisfaction. (Must have documented feedback and action taken.);

* Extraordinary efforts to buy better, not necessarily more expensive, raw materials such as shirts, inks, etc.;

* Designer (artist) extra efforts to produce better screens;

* Improved equipment leased (not purchased) to achieve a higher quality end product;

* Process quality assurance efforts to achieve higher quality end product. This is over and above ordinary quality control efforts. This could include improved filtering systems to remove lint, cleanliness of handling systems, etc.;

* Extraordinary effort to prevent incoming defectives from entering the production process. (Must document feedback to supplier.);

* Quality efforts by engineers to preserve the cleanliness of the product. For example visits to the contract packagers to provide instructions and inspection. Special packaging, wrapping, and sealing products;

* Quality efforts to ensure on-time delivery. Value engineering efforts to improve process productivity without reducing customer quality perceptions. For example, the research that led to having adjacent machines rotate in opposite directions and assignment of left-handed and right-handed workers to facilitate productivity;

* Extra efforts in inventory/storage/shipping of raw materials and finished products. Cleanliness is a quality factor.

* Efforts of field service staff to feedback design changes in shirts, caps, etc. that could help improve productivity and quality; and

* The salaries of management directly involved in the supervision of the "Top Quality" project. (Indirect management or supervision is specifically excluded.)

The above example is related to a specific project. However, some specific individual activities or operations of the firm may qualify for tax credit. Some of these areas are:

Inventory management --

* JIT Projects (incoming). Fresh shirts, caps, etc. make for higher quality end products because there is less chance of soil, dust, moisture damage and loss. Reducing work-in-process stock is a part of the high quality fresh product concept. This requires extraordinary efforts such as working with suppliers, etc. Routine activities do not qualify. Think back, was what is now routine started less than three years ago as an extra effort? It could qualify. There is a three year carry back and a 15 year carry forward.

* JIT Projects (outgoing). Extra efforts to ensure that the product is shipped immediately after packaging. Efforts which result in identifiable improvements in customer satisfaction, not the routine efforts. Quality of service counts also. (Get documented feedback.)

Manufacturing -- Have quality circles or some ongoing team activity specifically aimed at consistent quality improvement and increased customer satisfaction by feedback to suppliers, designers, and management on processes and the technology involved been established. This is a wide open area for qualifying R & E expenses.

Training -- The participation of eligible people, including the President of the firm. The President's efforts are a key in getting the message across about quality. REMEMBER: Document, document, and document.


The Tax Reform Act of 1986 is a complicated document, but those rules that provide incentives will be rather straightforward to those businesses that are willing to put forth the extra effort to identify the investment tax credit opportunities available. Incentives to improve quality and productivity should be considered in light of developing competitive strategy, for aiding in the strategic decision processes concerning the employment of new technologies and venturing into new areas. There are other provisions of the Tax Act that impact the firm which were not covered here since the intent was to focus on the Research and Experimental tax credit provisions. Businesses should take advantage of the expertise of their own staff or, if necessary, contact a major accounting firm for guidance in this important area. The potential cost savings are significant and may well allow a given firm to compete in situations where the margin of the investment tax credit makes the difference between profit and loss.

The example provided above was for a relatively small operation in terms of dollars involved. Consider those large corporations whose senior officers have salaries of over a million dollars a year. If the CEO were to directly supervise the implementation of activities qualifying for investment tax credit under the code, the salary of the CEO might qualify for the R&E investment tax credit.

It is recommended that business aggressively pursue this matter, because not only will it affect future earnings, but some activities of the past three years may also be eligible for inclusion. For firms involved in significant expenditures for expansion, proper employment of the new tax code provisions could provide significant advantage and shorten the break-even time. Further, academicians should investigate the tax law area to determine the appropriateness of including it in the strategic management courses. Consultants should ensure that their clients are aware of the benefits available to those firms which are making definite efforts to increase productivity and quality. Seek advice from knowledgeable tax experts before you embark on such projects.

For further reading

"A Concise Explanation of the Tax Reform Act of 1986," Prentice-Hall Information Systems, 1986.

Blackman, Ralph and J.H. Thompson, "The 1986 White House Conference on Small Business," Journal of Small Business Management, January 1987.

"Coming: The Great Tax Reform of -Yes- 1987," Fortune, October 27, 1986.

"Fortune Forecast -Business Won't Untie Its Pursestrings," Fortune, December 8, 1986.

"How to Cope with Tax Reform," Fortune, September 15, 1986.

Quarterly Report for Small Business, National Federation of Independent Business, April 1984.

The RIA Complete Analysis of the '86 Tax Reform Act, The Research Institute of America, Inc., New York, 1986.

Smith, James E., West's Internal Revenue Code of 1986 and Treasury Regulations: Annotated and Selected 1990 Edition, West Publishing Co., New York.

J. Michael Alford is associate professor of business administration at The Citadel. He earned his Ph.D. at the University of Georgia and his M.S. at the University of Oklahoma. Mark F. Hartley is currently an assistant professor of business administration at The College of Charleston. He received his D.B.A. at Louisiana Tech University. B. Perry Woodside is associate professor of finance at The College of Charleston. He received his Ph.D. from the University of South Carolina.
COPYRIGHT 1993 Institute of Industrial Engineers, Inc. (IIE)
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Author:Alford, J. Michael; Hartley, Mark F.; Woodside, B. Perry
Publication:Industrial Management
Date:Mar 1, 1993
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