The Credit For Increasing Research Activities (R&D Tax Credit) is a general business tax credit under Internal Revenue Code Section 41 for companies that incur research and development (R&D) costs in the United States. The R&D Tax Credit was originally introduced in the Economic Recovery Tax Act of 1981 sponsored by U.S. Representative Jack Kemp and U.S. Senator William Roth.Encyclopedia of Taxation and Tax Policy, By Joseph J. Cordes, Robert D. Ebel, Jane Gravelle, Urban Institute, pages 330-332 Since the credit's original expiration date of December 31, 1985, the credit has expired eight times and has been extended fifteen times. The last extension expired on December 31, 2014. In 2015, Congress made permanent the research and development tax credit in a measure of the government spending bill.8 Things Congress Actually Did This Year, NPR
Qualified research, history and definitions With widespread concern that U.S. economic performance had fallen well below its potential, Congress passed 'The Economic Recovery Tax Act' (ERTA) of 1981. The ERTA was intended to act as an economic stimulus that would encourage investment within the United States. Congress perceived that research spending declines had adversely affected the Country's economic growth, productivity gains, and competitiveness within the global marketplace (defined by the fall of the U.S. automaker). Included within the ERTA was a provision called the 'Credit for Increasing Research Activities' (the Credit). The Credit was tailored to reverse the decline in U.S. research spending by providing an incentive that was premised on benefiting increases in (as opposed to total) year over year research spending.
Originally embodied within House Report No. 97-201 (H.R. 4242) and then later codified by The Tax Reform Act of 1986, 'Qualified Research' generally constitutes private sector or commercially driven development effort intended to yield innovation within a scientific or technological field. However, administrative difficulties coupled with divergent interpretations by the IRS and Taxpayers have led to a series of revisions to the Code Section and related Treasury Regulations.
In practice, 'Qualified Research' is often reduced to a "Four Part Test" to provide a frame of reference. However, this can be misleading due to the number of requirements or elements within each "Test" and the extensive Regulations that were provided to supplement some parts of Section 41 with examples. This convention belies the need for fact intensive evaluations and documentation of taxpayer research efforts over a period of time on the business component level (see below). This evaluation can be further complicated by a large body of case law and the need to reconcile research activities with allowable expenditures.
Four-part test Generally, qualified research is an activity or project undertaken by a taxpayer (directly or through direct funding of a third party on the taxpayers behalf) that comprises each of the four distinct elements:
Permitted Purpose: The purpose of the activity or project must be to create new (or improve existing) functionality, performance, reliability, or quality of a business component. A business component is defined as any product, process, technique, invention, formula, or computer software (see exclusion for internal use software below) that the taxpayer intends to hold for sale, lease, license, or actual use in the taxpayer's trade or business.
Elimination of Uncertainty: The taxpayer must intend to discover information that would eliminate uncertainty concerning the development or improvement of the business component. Uncertainty exists if the information available to the taxpayer does not establish the capability of development or improvement, method of development or improvement, or the appropriateness of the business component's design.
Process of Experimentation: The taxpayer must undergo a systematic process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer's research activities. Treasury Regulations define this as broadly as conventional implementation of the scientific method to something as informal as systematic trial and error process.
Technological in Nature: The process of experimentation used to discover information must fundamentally rely on principles of the physical or biological sciences, engineering, or computer science. A taxpayer may employ existing technologies and may rely on existing principles of the physical or biological sciences, engineering, or computer science to satisfy this requirement.
Exclusions Notwithstanding the general application and evaluation of the requirements stated above, the following do not constitute qualified research. Research conducted after the beginning of commercial production of the business component; Adaptation of existing business components; Duplication of existing business components; Reverse Engineering; Surveys, studies, activity relating to management function/technique, market research, routine data collection, or routine testing/quality control; Software developed for internal use except software developed by (or for the benefit of) the taxpayer primarily for the taxpayer's use in selling, general, and administrative expenses and limited to financial management functions, human resources management functions, and support service functions. Foreign research conducted outside the United States, the Commonwealth of Puerto Rico, or any possession of the United States; Research related to social sciences, arts, or humanities; Research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).
Research & Experimentation Tax Credit Calculation The Research and Experimentation Tax Credit hinges on the quantification of eligible expenses during one of three possible base periods. The three base period calculation methods are referred to as the Traditional Credit Calculation, Start-Up Credit Calculation, and Alternative Simplified Credit.
Eligible expenses The eligible expenses or qualified research expenditures include four types of expenses. The quantification of each of these varies based on each company's accounting methodologies.
Wages 41(b)(2)(D)Wages for in-house research and development activities usually constitute the majority of expenses eligible for the credit.Final Regulations §1.41-4: Qualified Research Expenditures Incurred After January 3, 2001For purposes of the I.R.C. §41, the term "wages" is defined by wages in I.R.C. §3401(a).Final Regulations §1.41-2: Qualified Research Expenses The research expenditure is only eligible if the wage is paid to the employee for the performance of a qualified service. Qualified Services consist of:
engaging in qualified research directly supervising qualified research supporting qualified research
"Engaging in qualified research" means the direct conduct of research and development. "Directly supervising qualified research" is the first-line supervision of qualified research. This does not include the higher-level managers to whom the first-line supervisors report. "Supporting qualified research" includes an employee's time spent aiding the direct conduct of research and development. This includes data recording, prototype building, and performing test/trials.IRS Research Credit Audit Techniques Guide June 2005
Companies must provide contemporaneous documentation that links an employee's time directly to a project or activity. This documentation takes the form of two methods; Project Approach and Departmental Approach. The project approach relies on a taxpayer's time tracking documentation to directly link an employee's hours to a specific qualified R&D project. The departmental approach relies on oral testimony, contemporaneous engineering documentation, job descriptions, educational background, and other information to develop a time estimate.
Supplies I.R.C. §41(b)(2)(C) defines the term supply to mean any tangible property other than land or land improvements, and property subject to depreciation. Supply expense must be directly linked to qualified research activities using the taxpayer's accounting system. This can include using general ledgers or job summary reports. Qualified supplies include prototypes and testing materials. The taxpayer cannot include travel, shipping, or royalty expenses as supply expenses.
Contract research I.R.C. §41(b)(2)(B) and Treasury Regulation §1.41-2(e) requires a third party to perform a qualified research service on behalf of the taxpayer; and requires the taxpayer to make payment to the third party regardless of success. The "on behalf of" is refined by I.R.C. §1.41-2(e)(3), which requires the taxpayer to have rights into the research results. The contract research payments are included at 65% of the actual expense.
Basic research payments I.R.C. §41(e)(2) qualifies basic research payments made to qualified non-profit organizations and institutions. Basic research refers to fundamental research that focuses on evaluating theories and hypotheses regardless of an application. Basic research payments are included at 75% of the actual expense.Final Regulations §1.41-5: Basic Research for Taxable Years Beginning After December 31, 1986
Credit calculation The R&D Tax Credit allows for three calculation methods based on the taxpayer's date of incorporation, initiation of qualified research, and ability to collect required contemporaneous documentation.A fourth calculation method called the Alternative Incremental Research Credit may be elected but this method has largely become obsolete due to the inclusion of the Alternative Simplified Credit in the code. The Traditional Credit Calculation and Start-Up Credit Calculation provide a credit of 20% of the taxpayers qualified research expenditures that exceed a calculated base amount. The Alternative Simplified Credit Calculation provides a credit of 14% of the taxpayer's qualified research expenditures that exceed a calculated base amount. Regardless of calculation method the base amount cannot be less than 50% of the taxpayer's current year qualified expenditures. The following sections describe the three calculation methods; Traditional Credit Calculation, Start-Up Credit Calculation, and Alternative Simplified Credit.Final Regulations §1.41-3: Base Amount Calculation
Traditional credit calculation I.R.C. §41(c)(3)(A) establishes a fixed-base percentage calculation for companies that incorporated prior to January 1, 1984, and had 3 or more tax years with qualified research expenditures and revenue between January 1, 1984, and December 31, 1988. The fixed-base percentage is calculated by dividing the taxpayer's aggregate qualified research expenses by the aggregate gross receipts for taxable years beginning after December 31, 1983, and before January 1, 1989.
For purposes of the calculation, the resulting fixed-base percentage is multiplied by the average of the taxpayer's gross revenue for the 4 years prior to the calculation year. The fixed-base percentage should only change for purposes of meeting the consistency rule or adjusting for an acquisition or disposition.
Start-up credit calculation I.R.C. §41(c)(3)(B) establishes a fixed-base percentage calculation for companies that incorporated after December 31, 1983, or had fewer than 3 years with qualified research expenditures and revenue between January 1, 1984, and December 31, 1988. The fixed-base percentage is calculated according to the code as follows.
§41(c)(3)(B)(ii)(I) 3 percent for each of the taxpayer's 1st 5 taxable years beginning after December 31, 1993, for which the taxpayer has qualified research expenses,