R&D Tax Credit and Deductions
August 23, 2022
The research and development tax credit is one of the most significant domestic tax credits remaining under current tax law. Savvy corporate tax teams use this important tool to help maximize their company’s value.
However, the tax issues around R&D investment and acquisitions are not trivial. They are complex, and like many other aspects of tax planning and compliance, require forethought and analysis to guide the business in making the right, tax-optimized decisions.
Learn about how Bloomberg Tax helps tax professionals in the technology industry plan today for the realities of tomorrow.d
What are R&D tax credits and deductions?
Congress has enacted two important incentives for a business to invest in research activities in the United States: the ability to elect to deduct such expenditures currently and the permanent ability to claim a credit for increasing research expenditures.
In 1954, Congress enacted I.R.C. §174 allowing taxpayers, for expenditures incurred after December 31, 1953, to either currently deduct research or experimental expenditures paid or incurred “in connection with” a present or future trade or business, or elect to amortize these costs over a period of not less than five years. Eligible research costs include those paid or incurred for research conducted by the taxpayer as well as research conducted on the taxpayer’s behalf.
The purpose of I.R.C. §174 was to encourage taxpayers to carry on research and experimental expenditures by eliminating the uncertainty concerning the tax treatment of these expenditures. Research and experimentation are basic activities that must precede the development and application to production of new techniques and equipment, as well as the development and manufacture of new products.
In 1981, concerned that spending for these activities was not adequate and was in fact declining, Congress enacted a nonrefundable income tax credit for incremental research and experimental expenditures to overcome the reluctance of companies to bear the significant costs of staffing and supplies that must be incurred to conduct research programs in a trade or business. The credit is incremental in nature to encourage enlarged research efforts by companies that already may be engaged in some research activities. I.R.C. §41 was made a permanent provision of the Internal Revenue Code as part of the Protecting Americans from Tax Hikes Act of 2015 (PATH Act).
The research credit is calculated, in part, by reference to a taxpayer’s qualified research. To be “qualified research,” the research must meet the following criteria: (1) the expenses must qualify as research or experimental expenditures under I.R.C. §174; (2) the research must be undertaken to discover information that is technological in nature, and the application of which is meant to be useful in developing a new or improved business component of the taxpayer; and (3) substantially all of the research activities must constitute elements of a process of experimentation relating to a new or improved function, performance, reliability, or quality. As such, the rules under I.R.C. §174 are relevant for purposes of I.R.C. §41.
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How did the TCJA impact the R&D tax credit and deductions, and lead to amortization of R&D expenses?
The Tax Cuts and Jobs Act of 2017 (TCJA) did not make significant changes to I.R.C. §41. However, the benefit of the research credit increased due to the reduction in the corporate tax rate (i.e., a smaller I.R.C. §280C “haircut” of 21% as opposed to 35%, historically).
A scheduled tax change that is part of the TCJA will further complicate planning for R&D acquisition and investment, and potentially discourage investment in R&D in the future. I.R.C. §174 was amended such that, beginning in 2022, firms that invest in R&D will no longer be able to currently deduct their R&D expenses. Rather, they must amortize their costs over five years, starting with the midpoint of the taxable year in which the expense is paid or incurred. For costs attributable to research conducted outside the United States, such costs must be amortized over 15 years. This will be the first time since 1954 that companies will have to amortize their R&D costs, rather than immediately deduct those expenses.
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For which types of research and experimental expenditures are current deductions allowed?
Under I.R.C. §174, a current deduction is allowed for research and experimental expenditures paid or incurred in tax years beginning before 2022. The deduction is allowed for expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense. These are expenditures for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. The term “product” includes, but is not limited to, any:
- pilot model
- patent or similar property
The current deduction (current expense method) and the deferred expense method are replaced with special capitalization and amortization treatment for expenditures made in tax years beginning after December 31, 2021, as discussed above.
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How does a taxpayer establish that research expenditures were made in connection with a trade or business?
Whether or not a taxpayer is engaged in a trade or business for purposes of qualifying for the deduction under I.R.C. §174 is a factual determination. Case law suggests that a taxpayer may establish that research expenditures were made in connection with a trade or business by showing a nontax profit motive and active involvement demonstrated by substantial and regular involvement in the activity. A good faith intention to make a profit is required, but the expectation of profit need not be reasonable. Courts have held that expenditures of startup enterprises are deductible where the taxpayer demonstrates a realistic prospect of entering a trade or business involving the technology. To this end, an objective intent to enter into a trade or business and the capability to do so must be shown.
[To understand some of the factors considered in determining whether an activity is engaged in for profit, read the full text of Reg. §1.183-2(b).]
May a taxpayer both deduct research expenditures and claim the research credit?
No, not for the same expenditures. (No double tax benefit.) Under I.R.C. §280C, a taxpayer must reduce the research expenditure deduction otherwise allowable by the amount of the research credit claimed.
If a taxpayer capitalizes rather than deducts research expenditures, and the research credit for the year exceeds the amount allowable as a deduction for qualified or basic research expenses, then the amount chargeable to the capital account for such expenses must be reduced by the amount of the excess.
However, taxpayers may elect to reduce their research credit instead of reducing their research expenditure deduction or capitalized amount.
As discussed above, no current deduction will be allowed for research or experimental expenditures paid or incurred in tax years beginning after December 31, 2021.
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