Research and Development Expenditures (Portfolio 556)
The Portfolio, Research and Development Expenditures, analyzes the tax treatment of research and development expenditures.
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 ability to claim a credit for increasing research expenditures. Bloomberg Tax Portfolio, Research and Development Expenditures, No. 556, analyzes each of these incentive provisions. In 1954, Congress enacted §174 allowing taxpayers, for expenditures incurred after December 31, 1953, to elect either to deduct research or experimental expenditures paid or incurred “in connection with” a present or future trade or business or to amortize these costs over a period of not less than 60 months. Eligible research costs include research conducted by the taxpayer as well as research conducted on the taxpayer’s behalf.
The purpose of this provision was to encourage taxpayers to carry on research and experimental expenditures by eliminating the uncertainty concerning the tax treatment of these expenditures. Prior to the enactment of §174, there was no specific treatment authorized for research and experimental expenditures. To the extent ordinary and necessary they were deductible; to the extent capital in nature they were to be capitalized and amortized over useful life. Losses were permitted where amounts had been capitalized in connection with abandoned projects. However, where projects were not abandoned or where a useful life could not be definitely determined, taxpayers had no means of amortizing research expenditures.
Research and experimentation are basic activities that must precede (1) the development and application to production of new techniques and equipment, and (2) 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 substantial tax credit for incremental research expenditures in order to overcome the reluctance of many ongoing 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, in order to encourage enlarged research efforts by companies which already may be engaged in some research activities. Because of perceived difficulties for taxpayers and the IRS in distinguishing research expenditures from non-research expenditures, and in order to limit the credit to the principal types of research expenditures which distinctly reflect the extent of increased research activities, Congress limited eligible expenditures to certain direct wage, supply, and equipment research expenditures (or a specified percentage of contract research expenditures). The credit is not allowed for indirect, administrative, or overhead expenditures.
The original legislation contained a sunset provision providing for the credit to expire in 1985 in order for Congress to be able study the effectiveness of the credit. The areas of focus were whether categories of qualifying research expenditures were too broad or narrow; whether taxpayers and the IRS had been able accurately to distinguish qualifying research expenditures from non-qualifying research-related expenditures, such as indirect, overhead, or administrative wage expenditures, and from non-research expenditures, such as costs of market research, quality control, or production; whether the base period computation rules were appropriate; and whether the restrictions and limitations on the availability and use of the credit (e.g., the “carrying on” requirement) were effective to accomplish the Congressional intent.
Satisfied that the credit was effective in incentivizing business to increase research expenditures, the credit has been extended by Congress numerous times. When extending the credit in 1988 Congress stated “Research is the life-blood of our economic progress and effective tax incentives for research and development must be a fundamental element of America’s competitive strategy.” Over the years, the credit has undergone substantive modifications in how the credit is calculated and clarification of the definition of qualified research.
Because of the interaction between the R&D expensing provisions and the tax credit, this Portfolio discusses these two issues in parallel. It first considers what types of activities give rise to expenditures which qualify as research and experimental expenditures for current expensing purposes and then, what types of activities can give rise to expenditures eligible for the R&D tax credit. It then analyzes the specific expenditures eligible for expensing and the credit relating to those activities. The Portfolio also discusses several practical and technical issues in claiming the credit, the basic research R&D tax credit and various miscellaneous matters.
Table of Contents
II. Nature of Eligible Research Expenditures
III. Types of Research Related Expenditures Qualifying for the § 174 R& D Deduction and § 41 R& D Credit
IV. Trade or Business Requirement Under § 174 R& D Deduction and the § 41 R& D Credit
V. Computation of Section 174 Deduction
VI. R& D Credit Computational Rules
VII. The Basic Research Credit