R&E Prop. Regs. ease eligibility.
While a dollar of credit generates a dollar of research spending, many businesses (particularly smaller ones) fail to use it. This may be due to the credit's inherent complexity or the lack of IRS guidance as to "qualified research." Regulations were issued 16 years after the credit's creation, and were extremely restrictive in defining qualified research. Final regulations (1) issued in January 2001 eased the definition somewhat. However, in March 2001, Notice 2001-19 (2) provided that the Sec. 41 regulations would be reviewed and any changes issued as proposed regulations.
Proposed regulations (3) issued in December 2001 represent a substantially pro-business approach to the definition of qualified research, making it easier for businesses to qualify for the credit. (4) Further, the preamble states that the IRS generally will not challenge return positions consistent with the proposed regulations; taxpayers may rely on them until final regulations are issued.
However, businesses seeking to claim the R&E credit must exercise due diligence from the outset of a research project. Any relief the proposed regulations provide depends on a thorough understanding of the critical requirements for qualified research.
This article explains the credit's workings, thoroughly reviews critical and controversial areas of the proposed regulations and provides guidance to businesses seeking to qualify research efforts for the R&E credit.
In the U.S., research and development (R&D) expenditures were projected to be $264.2 billion in 2000; they have increased six percent annually since 1994. Industry accounts for 75.4% of total R&D expenses and pays for 88.2% with its own funds.
Manufacturers (5) and firms with over $250 million in assets claim most R&E credits (6); firms with $10 million or less in assets claim about 11% of the credit. (7) The largest expense category is salaries. (8)
Computing the Credit
Under Sec. 41, businesses can claim an R&E credit for qualified research expenditures (QREs) exceeding a base amount. The base amount is the product of a fixed percentage (now generally supplied by the IRS) and the company's average annual gross receipts (AAGR) measured over the last four years. The credit calculation uses the smaller of (1) excess R&E expenses multiplied by either 20% or 13% (under Sec. 280C(c)) or (2) 50% of current-year R&E expenses (see Exhibit 1 on p. 182).
Instead, a business can elect an alternative incremental research credit (AIRC) under Sec. 41(c)(4)(B), which applies three progressive rates to three layers of research expenditures exceeding AAGR. (9) The AIRC adds flexibility to the credit to address changes in business models and spending patterns that are a normal part of a company's life cycle. (10) However, a business cannot change back to the R&E credit from the AIRC without IRS consent (see Example 2).
The R&E credit or the AIRC is claimed using Form 6765, Credit for Increasing Research Activities.
The credit has always been temporary in nature--its continued existence depends on Congress's tax-writing committees. As a result, the credit has expired, then been legislatively extended nine times since first enacted (11) and its focus constrained through limits on qualifying activities and eligible expenses. (12) Under Sec. 41(h), it is currently scheduled to expire on June 30, 2004. Congress is under increasing pressure to make the credit permanent.
The IRS's Restrictive Approach
Over the years, the most frustrating issue for taxpayers has been the lack of Treasury and IRS guidance in defining qualified research for R&E credit purposes. Although the credit was created in 1981, regulations were not issued until 1989, but offered guidance only for pre-1986 credit claims. (13)
Proposed regulations (14) for post-1985 credit claims were issued in 1998, and took a harsh and limiting approach in defining qualifications. Tax professionals criticized those rules, arguing they thwarted Congressional intent; the House Ways and Means Committee echoed these concerns to the IRS. (15) In a 1999 Conference Report, (16) Congress criticized the proposed regulations and instructed the IRS to ease the requirements. Taxpayers thought the proposed rules attempted to reduce the kind of research qualifying for the R&E credit by applying a "discovery test" built on a proposed "common knowledge" standard. (17) In addition, the proposed regulations' definition of the process of experimentation relied on a purely academic "scientific method" approach to conducting research and mandated contemporaneous recording of the results of the scientifically based experiments. (18)
Finally, in Tax and Accounting Software Corp., (19) a district court invalidated portions of the proposed regulations, rejecting the IRS's discovery test and other court opinions relying on it. Importantly, the court stated that the proposed regulations' highly structured definition of research made it virtually impossible for commercial research to qualify for the Sec. 41 credit, contrary to Congressional intent.
The IRS responded by revising the proposed regulations and issuing final regulations in January 2001. While the final regulations lessened somewhat the IRS's harsh approach in determining R&E credit qualifications, their foundation was the proposed regulations' discovery test. After review, proposed regulations were issued December 2001, representing a more pro-taxpayer approach to qualifying for the credit.
Treasury and the IRS believe that the proposed regulations prescribe the proper treatment for the R&E credit. Taxpayers seeking to claim the R&E credit need to understand the new rules.
Expenses qualifying for the R&E credit are restricted by source and purpose. Only certain cost categories or sources may be considered; further, they must be incurred for preproduction research in one of four specific scientific areas.
Under Sec. 41( b)(2)(A) and (3), three cost sources can be considered for the credit: (1) in-house expenses for wages, salaries and supplies, (2) leasing or time-sharing costs for computers and (3) 75% of contract research, if performed by a tax-exempt research consortium. For many businesses, only the first category of expenses may be relevant. "Supplies" (as defined by Sec. 41(b)(2(C)(ii)) do not include depreciable assets; thus, a purchase of computer hardware does not qualify for the credit.
The costs must be incurred to conduct preproduction research for a new or substantially improved business component in physical science, biological science, engineering or computer science. Thus, under Prop. Regs. Sec. 1.41-4(c)(2)(ii)(B) and (C), costs incurred after commercial production of a product has begun (e.g., tooling up for production or conducting trial production runs) do not qualify.
Commercial production is the point at which a product is ready for commercial sale or use. Under Prop. Regs. Sec. 1.41-4(c)(2)(ii)(A)-(F), the following activities are disqualified as deemed to occur after the research phase has ended and commercial production begun:
* Preproduction planning for a finished product.
* Tooling-up for production.
* Trial production runs.
* Troubleshooting involving detecting faults in production equipment or processes.
* Accumulating data on production processes.
* Debugging flaws in a business component.
Costs incurred merely to duplicate or adapt an existing product or those related to style, taste, cosmetic or seasonal design factors, do not qualify; such costs are not deemed to result in a new or substantially improved business component. (20) Finally, according to Prop. Regs. Sec. 1.41-4(c)(5), the costs of research conducted in the social sciences (e.g., efficiency surveys or marketing research) do not qualify, because they are not incurred in one of the four specified scientific areas. According to Prop. Regs. Sec. 1.41-4(c)(2)-(9), qualified research does not include:
* Research after commercial production has begun (listed above).
* Adaptation of existing business components.
* Duplication of existing business components.
* Surveys, studies and research as to management functions.
* Internal-use software, unless additional tests are met.
* Research activities outside the U.S., Puerto Rico or other U.S. possessions. (21)
* Research in the social sciences.
* Research funded by a grant or contract.
Under Sec. 41(d)(1)(A)-(C), research expenses must meet the Sec. 174 requirements for R&E expenses and be undertaken to discover technological information whose application will be useful in developing a new or improved business component. Further, substantially all of the research activities must comprise elements of a process of experimentation.
Thus, there are four tests to qualify for the credit: (1) Sec. 174 test, (2) discovery test, (3) business-component test and (4) process-of-experimentation test. All four tests must be met to claim the credit.
Sec. 174 test: This test is met if research costs are expensable under Sec. 174. Regs. Sec. 1.174-2(a)(1) defines these as trade or business expenses representing R&D costs in the experimental or laboratory sense. These expenses generally include all costs incident to a product's development or improvement or the costs of obtaining a patent.
Discovery test: Sec. 41(d) requires that a taxpayer undertake research to discover information technological in nature. According to Prop. Regs. Sec. 1.41-4(a)(4), information is technological in nature only if the process of experimentation used relies on principles of physical, biological, engineering or computer sciences. Further, the means employed to discover knowledge need not be innovative; a taxpayer can employ existing technologies and rely on existing principles of science and engineering in the research.
The final regulations (and the 1998 proposed regulations) defined "discovering information" as obtaining knowledge that exceeds, expands or refines the "common knowledge" of skilled professionals in a particular field of science or engineering. (22) Prop. Regs. Sec. 1.41-4(a)(3)(ii) explicitly rejects this definition and the common-knowledge test, and indicates that discovery does not require a taxpayer to seek information exceeding, expanding or refining common knowledge.
The new rules use the Regs. Sec. 1.174-2(a)(1) uncertainty test and will be much easier for taxpayers to meet. The preamble states that there should be no discovery requirement in the research-credit regulations separate and apart from that already required under Regs. Sec. 1.174-2(a)(1).
Uncertainty test: Prop. Regs. Sec. 1.41-4(a)(3)(i) and (ii) state that the discovery test is met if a taxpayer's research efforts are intended to eliminate uncertainly as to the development or improvement of a business component. Uncertainty exists when the information available to a taxpayer at the outset of research does not establish either the (1) capability or method for developing or improving the business component or (2) component's appropriate design. In other words, there is no readily available solution to the project at the outset and the taxpayer must seek one by engaging in a process of experimentation (defined below). A taxpayer need not be successful at developing a new or improved business component; even unsuccessful efforts that comply with the new proposed rules qualify.
Patent safe harbor: Prop. Regs. Sec. 1.41-4(a)(3)(iii) retains the final regulations' patent-safe-harbor test. A taxpayer conclusively meets the discovery test and the underlying uncertainty test by obtaining a patent on research. However, the patent safe harbor does not apply to design patents.
The preamble to Regs. Sec. 1.41-4(a)(3)(iv), which contained the patent-safe-harbor provision, threatened to reexamine whether the discovery test was met if the patent application were denied: "factors underlying the denial of a patent application ... may be relevant to the determination of whether the discovery requirement is satisfied." There is no such statement in the new proposed regulations (another indication that they are designed to be pro-business).
Business-component test: The discovered information's application must be intended to be useful in developing new or improved business components. Under Prop. Regs. Sec. 1.41-4(b)(1), the qualified research requirements must be applied separately to each business component.
Process-of-experimentation test: Substantially all of the research must be conducted through a process of experimentation. According to Prop. Regs. Sec. 1.41-4(a)(5) and (6), this test has "substantially all" and "process of experimentation" requirements.
The Prop. Regs. Sec. 1.41-4(a)(6)(i) "substantially all" requirement is met only if 80% or more of a taxpayer's research activities comprise elements of a process of experimentation. Under Prop. Regs. Sec. 1.41-4(a)(5)(i), a taxpayer meets the process-of-experimentation requirement if it (1) evaluates one or more alternatives to a final result and (2) is initially uncertain at the outset as to the capability, method or appropriate design of achieving it.
The proposed regulations define process of experimentation by requiring a taxpayer to evaluate one or more alternatives; Regs. Sec. 1.41-4(a)(5) had called for evaluating more than one alternative.
Process of Experimentation
Qualifying factors: In defining a process of experimentation, Prop. Regs. Sec. 1.41-4(a)(5)(i), like the final regulations, suggests a process may exist when the scientific method is followed by (1) developing one or more hypotheses, (2) designing and conducting an experiment to test them and (3) refining or discarding them as part of a design process to develop or improve the business component.
However, Prop. Regs. Sec. 1.41-4(a)(5)(iv) also provides a list of illustrative factors (not requirements) indicating when a taxpayer has engaged in a process of experimentation. No inference should be drawn from a taxpayer's failure to meet any or all of the factors; they are not intended to be the only ones taken into account. Rather, a facts-and-circumstances approach will discern whether a taxpayer has followed a process of experimentation. Under Prop. Regs. Sec. 1.41-4(a)(5)(iv)(A)-(C), the factors that tend to indicate that the taxpayer has engaged in a process of experimentation are:
* The taxpayer tests and analyzes numerous alternative hypotheses to develop a new or improved business component.
* The taxpayer engages in extensive, comprehensive, intricate or complex scientific or laboratory testing.
* The taxpayer evaluates numerous or complex specifications as to the function, performance, reliability or quality of a new or improved business component.
Disqualifying factors: According to Prop. Regs. Sec. 1.41-4(a)(5)(i), a taxpayer will not be deemed to have engaged in a process of experimentation if the solution to the research is readily known at the outset and there is no uncertainty as to the capability or method of achieving the new or improved business component or its appropriate design. In such a case, according to Prop. Regs. Sec. 1.41-4(a)(5)(ii), a taxpayer does not have to engage in experimentation to test, analyze and choose among viable alternatives and, thus, the research does not qualify.
Further, the process of experimentation does not include merely selecting among several alternatives, if such alternatives are readily discernible and applicable at the beginning of the research efforts. The uncertainty element is not present--the taxpayer knows or can easily obtain the solution from existing information.
The recordkeeping requirements are brief and straightforward. Under Prop. Regs. Sec. 1.41-4(d), a taxpayer must retain records in sufficiently usable form and detail to substantiate the expenditures claimed eligible for the credit. The new rules emphasize providing reasonable flexibility for businesses in substantiating eligibility; the preamble indicates that failure to keep records in a particular manner cannot serve as a basis for denying the credit.
Prop. Regs. Sec. 1.41-4(d) also indicates that the IRS and the taxpayer may agree to guidelines of specific records for substantiating the credit. To address any ongoing recordkeeping concerns, the preamble proposes using pre-filing processes (e.g., industry issue resolutions, pre-filing agreements, determination letters and record retention agreements) to facilitate credit compliance and administration. Treasury and the IRS are soliciting comments on this, as well as on procedures for determining which expenses qualify and whether guidelines should be developed on an industry-by-industry basis.
While the proposed regulations take a more taxpayer-friendly approach to claiming the R&E credit than did the final regulations and the 1998 proposed regulations, a business seeking to claim it must nevertheless pay attention to steps taken prior to beginning research efforts, to meet the discovery test and its uncertainty component. As research proceeds, the business must then employ procedures to meet the process-of-experimentation test. Throughout, the business should maintain supporting documentation of the research efforts and the expenses claimed.
Before Research Begins
At the start of a research project, a business should:
* Write a statement of the research problem, the desired goal and the preliminary alternative(s) to be employed in reaching it. Indicate how uncertainty exists as to which (if any) alternative will be successful in reaching the goal.
* Create job-costing codes for the research project to be used by employees in tracking time and supply costs.
As Research Proceeds
The following activities should occur as research proceeds:
* Describe each alternative approach actually employed in the research process: document revision, testing or rejection of the approaches. As new alternatives are developed, document that initial uncertainty exists as to whether the approach will succeed.
* Determine the information obtained from the project and identify any new product or improved functionality resulting from the research. Research efforts can fail and still qualify for the credit.
* Determine the point at which the project is completed; costs incurred thereafter do not qualify.
* Retain documentation of costs, research alternatives explored and their outcomes in sufficiently usable form and detail to substantiate claiming the related expenses.
Businesses currently may rely on the proposed regulations in claiming the credit, as the IRS generally will not challenge return positions consistent with them. The new rules represent the most taxpayer-friendly approach to the R&E credit yet; there should be few disruptive changes when finalized. However, taxpayers should not delay in claiming the credit. Time may be running out: the provision to make the credit permanent was one of many business-related areas omitted from the Economic Growth and Tax Relief Reconciliation Act of 2001 .Without extension, the credit will expire in June 2004.
* Under the proposed regulations, four tests must be met to claim the R&E credit.
* A business should maintain supporting documentation of research efforts and the expenses claimed.
* The new rules emphasize for businesses in substantiating credit eligibility.
For more information about this article, contact Dr. Grace at email@example.com.
Exhibit 1: Computing the R&E credit Determining the Sec. 41 R&E credit requires calculating: 1.`Excess' R&E. 2. The credit base. 3. The credit. Excess R&E: Excess R&E expenditures are those exceeding a "base level," as shown below: Excess R&E = current-year R&E - base-level R&E "Base level R&E" is the product of a fixed-base percentage and the company's AAGR--a simple average of the firm's gross receipts for the previous four years. The fixed-base percentage is three percent for startup firms (i.e., those not in existence from 1984-1988 or having no R&E expenses in those years). The percentage approximates a base ratio of R&E expenses to gross revenues; it is adjusted gradually upward during a firm's sixth through tenth years to reflect actual research intensity. Thus, for a startup firm, the equation is: Excess R&E = current-year R&E - (0.03 x AAGR) Credit base: The credit base is the smaller of excess R&E or 50% of current-year R&E Credit computation: The credit base is multiplied by either 20% or 13% to compute the credit. The 20% rate requires the taxpayer to reduce R&E expense deductions by the amount of the credit; using the 13% reduced credit avoids this. Full credit = 20% x credit base Reduced credit = 13% x credit base Example 1: X Corp. has $90,000 of QREs for the credit in 2002. X's AAGR for the past four years were $500,000. X qualifies as a startup firm under Sec. 41(c)(3)(B); this is its first year of claiming the R&E credit. Excess R&E: = Current-year R&E - (0.03 x AAGR) = $90,000 - (0.03 x $500,000) = $90,000 - $15,000 = $75,000 Credit base: Credit base = smaller of excess R&E or 50% current-year R&E = smaller of $75,000 or (0.5 x $90,000) = $45,000 Credit computation: = (0.2 x $45,000) = $9,000 (R&E deductions must be reduced by this amount) Reduced credit = 13% x credit base = (0.13 x $45,000) = $5,850 Example 2: Y Corp. has $90,000 of QREs for the credit in 2002. Y's AAGR for the past four years were $500,000. Y qualifies as a start-up firm under Sec. 41(c)(3)(B); this is its first year claiming the AIRC. Excess R&E: Layer 1 = 0.0265 x R&E between 1% and 1.5% AAGR = 0.0265 [($90,000 - (0.01 x $500,000)) - ($90,000 - (0.015 x $500,000))] = 0.0265 [($90,000 - $5,000) - ($90,000 - $7,500)] = 0.0265 ($85,000 - $82,500) = 0.0265 ($2,500) = $66.25 Layer 2 = 0.032 x R&E between 1.5% and 2% AAGR = 0.032 [($90,000 - (0.015 x $500,000)) - ($90,000 - (0.02 x $500,000))] = 0.032 [($90,000 - $7,500)- ($90,000 - $10,000)] = 0.032 ($82,500 - $80,000) = 0.032 ($2,500) = $80 Layer 3 = 0.0375 x R&E in excess of 2% AAGR = 0.0375 ($90,000 - (0.02 x $500,000)) = 0.0375 ($90,000 - $10,000) = 0.0375 ($80,000) = $3,000 Credit base: Layer 1: $ 66.25 Layer 2: 80.00 Layer 3: 3,000.00 Credit base: $ 3,146.25 Computing the AIRC: Full credit = $3,146.25 (R&E deductions must be reduced by this amount) Reduced credit = 65% x credit base = 65% ($3,146.25) = $2,045
(1) TD 8930 (1/29/01).
(2) Notice 2001-19, IRB 2001-10, 784.
(3) REG-112991-01 (12/26/01).
(4) Treasury News Release PO-871 (12/14/01).
(5) As of 1992, 75%; see U.S. Congress, Office of Technology Assessment, The Effectiveness of Research and Experimentation Tax Credits (1995)(hereinafter, "Technology Report"), p. 18, at http://www.wws.princeton.edu/~ota/ns20/year_f.html. See also Joint Committee on Taxation, Description of Revenue Provisions Contained in the President's Fiscal Year 2000 Budget Proposal (J CS-1-99, 2/2/99)(hereinafter, "JCT Report"), p. 119.
(6) As of 1992, 70% of the credit; see Technology Report, note 6 supra, at p. 19. See also JCT Report, note 5 supra, at p. 120.
(7) Technology Report, note 5 supra, at p. 19.
(8) Salaries were 62% of qualified research expenses (QREs) claimed for the credit; see id.
(9) The AIRC has three fixed rates: 2.65%, 3.2% and 3.75%. The AIRC is the sum of 2.65% of QREs between one and 1.5% of AAGR, plus 3.2% of QREs between 1.5 and two percent of AAGR, plus 3.75% of such expenses above two percent of AAGR.
(10) U.S. Congress, Testimony of William Sample, Chairman, R&D Credit Coalition, before the House Ways and Means Committee's Oversight Subcommittee's Hearing on the Tax Code and the New Economy (9/28/00)(hereinafter cited as "Sample Testimony").
(11) See Guenther, The Research and Experimentation Tax Credit, Congressional Research Service Issue Brief No. 92039 (8/10/99), p. 1.
(12) For a comprehensive table of the R&E credit structure from 1981-1995, see Technology Report, note 5 supra, p. 10, Table 1.
(13) TD 8251 (5/16/89).
(14) REG-105170-97 (12/2/98).
(15) Sample Testimony, note 10 supra, at Part III.
(16) H. Rep't No. 106-478, 106th Cong., 1st Sess. (1999), p. 132.
(17) Sample Testimony, note 10 supra, at Part III.
(18) See Prop. Regs. Sec. 1.41-4(a)(5) (12/2/98).
(19) Tax and Accounting Software Corp., 111 FSupp2d 1153 (DC OK 2000).
(20) See Prop. Regs. Sec. 1.41-4(c)(3) and (4), Sec. 41(d)(3)(B) and Prop. Regs. Sec. 1.41-4(a)(5)(iii).
(21) This an expansion from the 1998 proposed regulations, which had excluded Puerto Rico and U.S. possessions.
(22) 8ee Regs. Sec. 1.41-4(a)(3)(i); and Prop. Regs. Sec. 1.41-4(a)(3) (12/2/98).
Debra M. Grace, Ph.D., CPA Professor of Accountancy California State University Long Beach, CA
Dr. Grace is Chief Financial Officer of Earth Science Associates, Long Beach, CA.
|Printer friendly Cite/link Email Feedback|
|Title Annotation:||tax credit for research and experimentation activities|
|Author:||Grace, Debra M.|
|Publication:||The Tax Adviser|
|Date:||Mar 1, 2002|
|Previous Article:||Sec. 338(h)(10) checklist.|
|Next Article:||Current corporate income tax developments.|