Making the R&D Tax Credit Work

ongress and the Internal Revenue Service may soon assign more certainty to how the federal government treats tax credits for research and development cost, welcome news to corporate tax departments that have had to handle ambiguity on the issue for decades.

The United States lags behind more than two-dozen other industrialized countries in rewarding companies for their technological innovation with tax credits. Matt Miller, senior director of government affairs for Financial Executives International, says Congress and the IRS are under increasing pressure to cut the complexity and uncertainty around the R&D credit. “The uncertainty goes much deeper than how to file your tax returns or your financial statements,” he says. “It's about how to make business decisions and how to invest your money.” Congress, he continues, is starting to recognize that cultivating the development of technology drives economic growth and the creation of jobs.

Miller

Among the biggest sources of frustration to companies is the status of the Research & Experimentation tax credit. The credit was created in 1981 with an act of Congress as a temporary incentive to spur investment in technology research. It has persisted as a temporary measure ever since, renewed by Congress in more than a dozen legislative packages until it was allowed to lapse at the end of 2009.

Companies have watched Congress toy with an extension through much of 2010, and may have to wait through the November elections and a lame duck session of Congress to see it renewed, says Dean Zerbe, national managing director for tax consulting firm AlliantGroup and former tax counsel to the Senate Finance Committee.

Despite the uncertainty created both by Congress and the IRS, companies continue to capture information in hopes they can claim the credit and survive an IRS examination, says John Boseman, managing director for advisory firm True Partners Consulting. That can result in a costly and uncertain exercise, followed by potentially a last-minute scramble if companies must make year-end adjustments to financial statements, tax returns, or both.

Zerbe

Congress and the Obama Administration say they will renew the credit yet again and make it retroactive to 2010, and President Obama has proposed making it permanent. “Folks are pretty comfortable they're going to keep it going,” Zerbe says. “The real discussion is going to be what we can do to make the R&D credit more robust.”

“It's a huge problem for companies. They know these credits are well scrutinized by the IRS, and often times adding a research credit claim to a tax return will result in an audit .”

—John Boseman,Managing Director,True Partners Consulting

The Government Accountability Office published a report in November 2009 saying that the current design and administration of the credit fails to achieve its goal of creating an incentive for companies to develop new technologies. The GAO said the IRS often ends up fighting with taxpayers over what qualifies for the credit and how it must be documented. The report also called on the U.S. Treasury to provide more guidance.

Boseman

Some tax experts say the IRS really needs to change its perspective on the tax credit; they say the agency historically has been skeptical of how companies claim it. “There's been a mindset among tax authorities that taxpayers often overstate their research tax credit opportunity,” Boseman says. “That has generated a great deal of audit intensity from the IRS and state agencies.”

That hard line toed by the IRS has led to a lot of heartburn in the corporate tax department, as companies have coped with increasing disclosure requirements about where they may have uncertainty in their tax positions, both in financial statements and now in disclosures to the IRS directly, Boseman says.

First, companies complied with requirements under Accounting Standards Codification Topic 740, Income Taxes, to disclose in their financial statements where they have made reserves for tax positions that might not survive an audit or litigation. Now companies are facing a similar requirement from the IRS in Schedule UTP, which directs companies to inventory and rank their uncertain positions in order of risk magnitude.

“It's a huge problem for companies,” Boseman says. “They know these credits are well scrutinized by the IRS, and often times adding a research credit claim to a tax return will result in an audit.”

GAO REPORT FINDINGS

The following excerpt from the GAO report on the research tax credit details the GAO's findings and suggestions for improvement:

What GAO Found

Large corporations have dominated the use of the research credit, with 549 corporations with receipts of $1 billion or more claiming over half of the $6 billion of net credit in 2005 (the latest year available). In 2005, the credit reduced the after-tax price of additional qualified research by an estimated 6.4 to 7.3 percent. This percentage measures the incentive intended to stimulate additional research.

The incentive to do new research (the marginal incentive) provided by the credit could be improved. Based on analysis of historical data and simulations using the corporate panel, GAO identified significant disparities in the incentives provided to different taxpayers with some taxpayers receiving no credit and others eligible for credits up to 13 percent of their incremental spending. Further, a substantial portion of credit dollars is a windfall for taxpayers, earned for spending they would have done anyway, instead of being used to support potentially beneficial new research. An important cause of this problem is that the base for the regular version of the credit is determined by research spending dating back to the 1980s. Taxpayers now have an “alternative simplified credit” option, but it provides larger windfalls to some taxpayers and lower incentives for new research. Problems with the credit's design could be reduced by eliminating the regular credit and modifying the base of the alternative simplified credit to reduce windfalls.

Credit claims have been contentious, with disputes between IRS and taxpayers over what qualifies as research expenses and how to document expenses. Insufficient guidance has led to disputes over the definitions of internal use software, depreciable property, indirect supervision, and the start of commercial production. Also disputed is the documentation needed to support a claim, especially in cases affected by changes in the law years after expenses were recorded. Such disputes leave taxpayers uncertain about the amount of credit to be received, reducing the incentive.

What GAO Recommends

Congress should consider eliminating the regular credit option and adding a minimum base to the alternative simplified credit. GAO recommends that the Secretary of the Treasury clarify the definition of qualified research expenses and organize a working group to develop standards for documentation. Treasury agreed with our recommendation and plans to provide additional guidance in the next few months.

Source

GAO Report on the Research Tax Credit (November 2009)

Kendall Fox, a tax partner at PwC who specializes in the R&D credit, says the documentation is difficult for most taxpayers because the IRS seems to prefer “project accounting,” which tracks time and expenses to specific projects rather than functional areas within the company. That approach isn't specifically required anywhere in the tax code or related guidance, but the IRS likes it because it's easier to audit. “It makes it easy to accept or disallow the costs,” Fox says.

Fox

Plenty of companies have considered developing a project accounting system to accommodate the IRS preference and more confidently claim the credit, he says. “But companies are reluctant to make the investment if they don't have certainty that the credit will be available,” Fox says. It can also be a difficult cultural change for entrepreneurial, innovative companies.

Linda Stiff, a managing director with PwC, said during a recent Webcast that companies now have good reason to believe that the IRS will change its tack going forward. With the new Schedule UTP requirement in hand, the IRS now plans to study UTP filings to get a sense for the causes of uncertainty, she said. “Is it due to a lack of clarity and guidance?” she asks. That message will eventually reach the IRS as it sees companies listing their R&D credits in their UTP disclosures, she claimed.

Based on various initiatives and public comments, the IRS appears to be “putting a laser-like focus on their ability to close uncertainty,” Stiff said. “It's going to have to be some sort of cultural shift that is going to have to be mandated that says research credits aren't inherently bad.” She believes IRS leadership is committed to making such a shift.

Giardino

That means keeping up the vigilance on documentation that can support the research credit, says Carl Giardino, tax principal with regional audit firm Marcum. “Documentation continues to be the biggest challenge on the part of taxpayers,” he says. Especially through the current recession, as companies may be turning over staffing, careful documentation is critical to assure all the pieces are in place to eventually claim and defend the credit, whenever Congress finally reinstates it.