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Overview of 2005 developments on the research credit.

The scope and interpretation of the research credit (Sec. 41) were shaped by several significant developments during 2005. The credit was expanded by the Energy Policy Act of 2005 (EPA) (P.L. 109-58). Important guidance on computing the credit and allocating it among control group members appeared in temporary regulations (TD 9205). Also, these regulations simplified electing in and out of the alternative incremental research credit (AIRC) regime.

At the start of 2006, Congress was poised to enact another one-year extension of the research credit (which otherwise expired on Dec. 31, 2005) as part of the budget reconciliation process, and to expand further the options for computing it.


Among a variety of tax provisions enacted to promote energy production and conservation, the EPA expanded the Sec. 41 research credit in two respects. First, it added new Sec. 41(b) (3) (D), which allows taxpayers to claim 100% (rather than only 65% as under old law) as a "contract research expense" when they pay a small business, university or Federal laboratory for energy research conducted on the payor's behalf. Second, the EPA also added new Sec. 41(a)(3), which allows taxpayers to claim a separate 20% credit for payments they make to an "energy research consortium," regardless of whether the base amount computed for regular credit (i.e., for Sec. 41(a)(1)) purposes is exceeded. Both provisions are effective for expenses paid or incurred after Aug. 8, 2005.

Although the term "energy research" is not defined by statute, the EPA's legislative history indicates that the research must relate to production, supply or conservation of energy, such as efforts to develop hydrogen fuel cell vehicles or efforts to improve the energy-efficiency of lighting. Thus, the new research credit provisions apply to a wide variety of businesses (e.g., consumer product manufacturers), not merely to those commonly thought of as comprising the "energy industry."

Of the two research credit provisions contained in the EPA, new Sec. 41(a)(3) offers taxpayers the most potential benefit, while also raising more interpretive questions. Initially, it appeared that a taxpayer could claim the same payment made to a research consortium as eligible for both the regular, incremental credit computed under Sec. 41(a)(1) and the new, nonincremental credit computed under Sec. 41 (a)(3). More recently, however, this opportunity to "double dip" was eliminated retroactively by tax technical corrections provisions in the Gulf Opportunity Zone Act of 2005 (P.L. 109-135), signed into law on Dec. 21,2005. The technical corrections also clarified that, for new Sec. 41(a)(3) purposes, energy research conducted by a consortium must be conducted in the U.S., Puerto Rico or a U.S. possession.

Despite the recent technical corrections, the new Sec. 41 (a)(3) credit still has several ambiguities. Examining the statutory language, it appears that any payment made to an energy research consortium qualifies for the new credit, regardless of whether that payment is used by the consortium to fund research satisfying the existing Sec. 41(d) "qualified research" requirements. Although the legislative history suggests otherwise, the statute does not require that the payment to the consortium be used to fund energy-related research, as long as the payment is made by the taxpayer in carrying on its trade or business and the consortium itself satisfies certain organizational and funding standards (i.e., it is organized and operated primarily to conduct energy research and receives funding from at least five unrelated persons). Perhaps this means that the primary activities of an energy research consortium may include collaborative economics or other social science research projects ineligible for the regular credit under Sec. 41(d) (4) (G), or even research not involving a "process of experimentation" within the meaning of Sec. 41(d)(1)(C). And perhaps this means that, as long as an entity qualifies as an energy research consortium, any payment (e.g., dues) made to that entity automatically generates a 20% credit. New Sec. 41(b)(3)(D) specifically requires the payment to be "for qualified research which is energy research" but no similar statutory rule applies for purposes of the separate energy research consortium credit under new Sec. 41(a)(3).

Other ambiguities regarding the application of the new energy research consortium credit include the extent to which for-profit entities may qualify as an energy research consortium on grounds that they conduct energy research "in the public interest," and whether the consortium must itself directly conduct research activities or may (instead) subcontract the actual performance of research activities to others (compare Sec. 41 (e)(2)(g)(ii)).

These issues may be addressed by additional technical corrections legislation or by IRS guidance. Alternatively, some of these questions may become moot if Sec. 41(a) (3) is expanded so that the separate, nonincremental credit is available for payments made to a research consortium, regardless of whether that consortium conducts energy research or nonenergy research; see the Tax Relief Act of 2005 (S. 2020) Section 214, passed by the Senate on Nov. 18, 2005. Even so, the Senate-passed language does not address the fundamental question of whether a payment to a qualifying research consortium would automatically generate a credit, regardless of whether the payment is "for qualified research" within the meaning of Sec. 41(d).

Temp. Regs.: Research Credit for Controlled Groups

Temporary regulations published on May 24, 2005 primarily addressed how the research credit must be computed and allocated among members of a controlled group (generally determined by using a more-than-50% ownership test). When all the group members file a single consolidated return, the practical effect of the required allocation rules generally will be minimal. But when a controlled group includes members that are not part of the same consolidated group, the temporary regulations could produce very different results compared to the outcomes under two sets of proposed regulations previously issued in 2000 and 2003. Also, TD 9205 contains new simplified rules for electing or revoking the AIRC, both for controlled group members as well as for companies that are not part of a controlled group.

As originally published, TD 9205 was internally inconsistent as to whether the new controlled group rules generally were effective for all tax years ending after May 23, 2005, or only those years that began after that date. However, a technical correction was subsequently issued, clarifying that the new temporary regulations are effective for all tax years ending after May 23, 2005. As a result, for tax years that include May 24, 2005 (e.g., calendar-year 2005),Treasury and the Service did not adhere to their earlier commitment (from the 2003 proposed regulations) that the regulations would ultimately be applied only to tax years beginning after find publication.

With respect to the computation of the group credit--which is computed as if the controlled group were a single taxpayer and then allocated among group members--TD 9205 generally follows the approach of the two earlier proposed regulations. The one exception is that, under TD 9205, even though each member of the controlled group could be a "start-up" firm (subject to Sec. 41(c)(3)(B)) when considered on a stand-alone basis, yet, the controlled group (viewed collectively) nonetheless could be denied start-up firm status. In contrast, the proposed regulations issued in 2003 specified that, if all members of the group individually qualified as start-up firms, the controlled group likewise would be treated as a start-up firm. This change in the application of the start-up firm rules could have a significant adverse effect on some taxpayers, not only prospectively but also retroactively, due to the special effective-date provision that prevents members from collectively claiming (in any year ending after Dec. 28, 1999) more than 100% of the group credit amount allowable under the new computation rules; see Regs. Sec. 1.41-6T(j).

For the allocation of the group credit, Regs. Sec. 1.41-6T(c) mandates that it generally must be allocated based on the relative amounts of each member's "stand-alone entity credit," determined by using the computation method (i.e., regular credit or AIRC) that maximizes the stand-alone credit for each particular member. This is similar to the allocation rules in the 2003 proposed regulations, except that the new temporary regulations also provide as a "back-up" rule that, if the group credit exceeds the sum of the member's stand-alone credits, the excess must be allocated by reference to each member's proportionate share of qualified research expenses (QREs) incurred during the credit year (i.e., the so-called "gross QRE method").

As a further clarification, TD 9205 provides a two-step allocation process for a consolidated group that is part of a larger controlled group.

Under this two-step approach, a portion of the group credit is allocated by first treating the consolidated group as a single member. The consolidated group's credit amount is then sub-allocated among the consolidated group members using the same stand-alone-entity allocation approach. Because a consolidated group files a single Form 6765, Credit for Increasing Research Activities, with its consolidated return, it appears that, as a practical matter, this second step generally needs to be carried out only when a consolidated group has a carryforward credit and one of its members subsequently departs from the group. In such a case, it will be necessary to determine the carryover credit allocable to that member.

The new temporary regulations have a limited retroactive effect to prevent abuse. Specifically, the new computation and allocation rules will be applied retroactively to tax years ending after Dec. 28, 1999, if controlled group members (as a whole) claimed more than 100% of the group credit allowed under the temporary regulations. The new rules will also be applied retroactively if different controlled group members have different tax years and allocation methods. Otherwise, a taxpayer may use "any reasonable method" of computing and allocating the credit for tax years ending before May 24, 2005, although language contained in the preamble suggests that the gross QRE method might not be reasonable under some circumstances.

AIRC Elections and Revocations

The remainder of TD 9205 involves new rules for revoking AIRC elections under Sec. 41(c)(4), which otherwise apply to the tax year made and all succeeding years. Under the old rules, taxpayers could not revoke a previously made AIRC election unless consent was granted by the IRS through a letter ruling. Regs. Sec. 1.41-8T(b) (3) eliminates this burdensome process and allows an automatic revocation by simply claiming the regular 20% credit on Form 6765, attached to a timely filed (including extensions) original return for the revocation year. Further, taxpayers can (as under old rules) make an AIRC election under the new temporary regulations by simply computing their credit using the AIRC method in Part I, Section B, of Form 6765, attached to their original return. In effect, they can now elect in and out of the AIRC regime on a year-by-year basis, provided they decide either to make or revoke an AIRC election on their original return. This is an improvement over the old rules, although taxpayers may still encounter the problem of having to estimate (before all information is collected) which computation method maximizes their research credit at the time they irrevocably elect either the regular credit or AIRC on their original return for a given year.

Finally, TD 9205 also clarifies when an AIRC election made by one member of a group is treated as binding another group member that otherwise does not make the same election on its return for the year.

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Author:Arkin, Steven D.
Publication:The Tax Adviser
Date:Mar 1, 2006
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