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Wall Street Journal reported that the House is likely to vote to extend a package of tax breaks the week of December 6. The bill would renew for one-year a number of provisions scheduled to expire on December 31, including the research tax credit for businesses. While there is no indication that changes to the tax credit are likely to occur in the bill, there are a number of major initiatives being considered:

  • President Obama has proposed making the credit permanent, which would cost about $68 billion in lost tax revenue over a decade.
  • Industry is also lobbying for expansion of the 20 percent R&D credit.
  • Legislation backed by Republican Orrin Hatch in the Senate and by Democrat Kendrick Meek and Republican Kevin Brady in the House, would make the credit permanent and also boost the rate on an increasingly popular simplified form of the credit from 14 percent to 20 percent.

Potential Modifications to the R&D Tax Credit

The U.S. Government Accountability Office (GAO) published a new report in November 2009 regarding a study performed to help inform congressional deliberations on the credit, by determining (1) how taxpayers are currently using the credit; (2) identify what, if any, changes to the credit’s design may be able to increase the incentive to do additional research with social benefits; and (3) identify specific and significant problems, if any, that exist in the administration of the credit and options to address them.

The GAO findings presented the following for Congressional consideration:

In order to reduce economic inefficiencies and excessive revenue costs resulting from inaccuracies in the base of the research tax credit:

  • Eliminate the regular credit option (reference to the 1984-1988 base-periods) for computing the research credit.
  • dd a minimum base to the ASC (Alternative Simplified Credit) that equals 50 percent of the taxpayer’s current-year qualified research expenses.

If Congress wishes to continue offering the regular research credit to taxpayers, it should:

  • Update the historical base period that regular credit claimants use to compute their fixed base percentages.
  • Eliminate base period recordkeeping requirements for taxpayers that elect to use a fixed base percentage of 16 percent in their computation of the credit.
  • Clarify for Treasury its intent regarding the definition of gross receipts for purposes of computing the research credit for controlled groups of corporations.

The GAO findings presented the following Recommendations for Executive Action:

In order to allow more taxpayers to benefit from the reduced recordkeeping requirements offered by the ASC option, the Secretary of the Treasury should take the following two actions:

  • Permit taxpayers to elect any of the computational methods prescribed in the IRC in the first credit claim that they make for a given tax year, regardless of whether that claim is made on an original or amended tax return.
  • Allow controlled groups to allocate their group credits in proportion to each member’s share of total group QREs, provided that all group members agree to this allocation method.

In order to significantly reduce the uncertainty that some taxpayers have about their ability to earn credits for their research activities, the Secretary of the Treasury should take the following six actions:

  • Issue regulations clarifying the definition of internal-use software.
  • Issue regulations clarifying the definition of gross receipts for purposes of computing the research credit for controlled groups of corporations.
  • Issue regulations regarding the treatment of inventory property under section 174 (specifically relating to the exclusion of depreciable property and indirect costs of self-produced supplies).
  • Provide additional guidance to more clearly identify what types of activities are considered to be qualified support activities.
  • Provide additional guidance to more clearly identify when commercial production of a qualified product is deemed to begin.
  • Organize a working group that includes IRS and taxpayer representatives to develop standards for the substantiation of QREs that can be built upon taxpayers’ normal accounting approaches, but also exclude practices IRS finds of greatest threat to compliance, such as high-level surveys and claims filed long after the end of the tax year in which the research was performed.

Potential Impacts and Implications

It is likely that the R&D Tax Credit will be extended for at least one-year through 2010. However, it does not appear that any significant changes will occur in the credit rate as part of that extension. The recommendations by the GAO are encouraging as the report findings and conclusions encourage addressing several major definitional areas, but more importantly encourage working to clarify and standardize substantiation requirements for tax credit claims. While these efforts are commendable, efforts and modifications from these recommendations may be years from being finalized. As with other R&D related issues, I expect that if these areas of concern are defined and clarified they will also serve as the standards for Section 174 deduction claims.

About the Author:

Greg Lormand is Director, Tax Services for BCP Engineers & Consultants where he concentrates on supporting clients on niche’ tax areas such as Research & Experimentation (R&E). Mr. Lormand has a BS degree in Mechanical Engineering and Masters Business Administration from Louisiana State University.

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