In late 2006, Congress revived a key research and development tax credit that will deliver an estimated $16 billion in savings to U.S. businesses over the next decade. The latest extension to the 25-year-old R&D credit, which had expired Dec. 31, 2005, was made retroactive to Jan. 1, 2006. It passed with help from a vigorous push by lobbyists in industries ranging from biotechnology to software development. While it will remain in force through 2007, advocates say the patchwork approach to tax policy puts U.S. companies at a competitive disadvantage.
“At least 10 nations around the world offer more generous R&D incentives that are permanently written into the tax codes of those countries,” says Monica McGuire, senior director for tax policy at the National Association of Manufacturers in Washington, D.C.
Qualifying for the Credit
In short, the R&D credit helps ease the financial burden on businesses investing in the development of new or improved products, processes, formulas, software or other technical operations. However, to qualify for the credit, a company’s research efforts must meet the following four requirements:
Permitted purpose. The activity must relate to a new or improved business component’s function, performance, reliability and quality. A new product or process counts as a business component.
Elimination of uncertainty. The intent of the activity must be to discover information to eliminate uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of product design.
Technological in nature. This step is pretty clear-cut: Qualifying research must be rooted in the physical sciences such as biology and chemistry or in defined technology areas such as engineering and computer science.
Process of experimentation. Substantially all of the activity must be part of a process of experimentation involving:
• Evaluation of alternatives
• Confirmation of hypotheses through trial and error, testing or modeling
• Refining or discarding of hypotheses.
Once an activity qualifies for the research credit, the research expenses are determined. Eligible expenditures include W-2 wages for employees, supplies and 65 percent of fees paid to outside consultants.
In recent years, about 75 percent of U.S. companies applying for the R&D credit were in the manufacturing sector. Experts say small to mid-sized players in that segment benefit most from the credit, largely because innovation investments in those firms can more visibly dampen profitability.
Broadening R&D Credit Appeal
The traditional method for calculating the R&D credit requires an established company to document its research spending from 1984 to 1988 to determine a base amount. A company may claim an R&D tax credit on 20 percent of expenses over the base amount or 50 percent of qualifying research expenses, whichever is higher. Taxpaying companies that didn’t exist during the 1984 to 1988 timeframe or which didn’t have three years of qualified research and gross receipts during that period use separate startup company rules. Companies must add the credit to taxable income or elect to claim a reduced credit of 13 percent.
Companies may elect to calculate the Alternative Incremental Credit (AIC), which provides businesses with a tax credit as long as qualified R&D expenses exceed 1 percent or more of the company’s gross annual receipts. Recent legislation increases the credits beginning in 2007 to:
• 3 percent (an increase from 2.65 percent) of qualified research expenses greater than 1 percent and less than 1.5 percent of average annual gross receipts
• 4 percent (an increase from 3.2 percent) of qualified research expenses greater than 1.5 percent and less than 2 percent of average annual gross receipts
• 5 percent (an increase from 3.75 percent) of qualified research expenses exceeding 2 percent of average annual gross receipts.
A second key change in 2007 is the introduction of an Alternative Simplified Credit. This method allows businesses to total qualifying R&D spending for the current year and compare it with R&D expenses over the preceding three years. If current qualified R&D spending is more than 50 percent of the average for the past three years, the company may claim a 12 percent tax credit. If there were no qualified expenses in that prior threeyear period, the company still can claim a 6 percent credit on qualifying R&D expenses.
“This was the biggest change in the R&D credit in over 10 years,” McGuire says. “While the alternative simplified credit will be beneficial to some large companies, it really helps small and mid-sized companies, because it eliminates that fixed base period in favor of a rolling base over a more recent period of time.”
Can your company benefit from the newly extended R&D tax credit? If so, experts suggest a few quick tips to help smooth the process:
Do your homework. Applying for the R&D credit involves more than crunching numbers. It also means working with your technical personnel to build documentation that your research projects meet the four-part test. If in doubt, consult with a trusted third party experienced in developing support for the R&D credit.
Review open tax years. Because R&D tax credit extension passed late in 2006, many C corporations on a calendar year will need to scramble to make an initial tax filing deadline of March 15, 2007. However, tax experts say business leaders who need more time to document their research work can file for a six-month extension on their corporate tax submission. Additionally, your company can take this opportunity to file for the most recent R&D credit as well as for any past credits to which your business may be entitled. IBI
“At least 10 nations around the world offer more generous R&D incentives that are permanently written into the tax codes of those countries,” says Monica McGuire, senior director for tax policy at the National Association of Manufacturers in Washington, D.C.
Qualifying for the Credit
In short, the R&D credit helps ease the financial burden on businesses investing in the development of new or improved products, processes, formulas, software or other technical operations. However, to qualify for the credit, a company’s research efforts must meet the following four requirements:
Permitted purpose. The activity must relate to a new or improved business component’s function, performance, reliability and quality. A new product or process counts as a business component.
Elimination of uncertainty. The intent of the activity must be to discover information to eliminate uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of product design.
Technological in nature. This step is pretty clear-cut: Qualifying research must be rooted in the physical sciences such as biology and chemistry or in defined technology areas such as engineering and computer science.
Process of experimentation. Substantially all of the activity must be part of a process of experimentation involving:
• Evaluation of alternatives
• Confirmation of hypotheses through trial and error, testing or modeling
• Refining or discarding of hypotheses.
Once an activity qualifies for the research credit, the research expenses are determined. Eligible expenditures include W-2 wages for employees, supplies and 65 percent of fees paid to outside consultants.
In recent years, about 75 percent of U.S. companies applying for the R&D credit were in the manufacturing sector. Experts say small to mid-sized players in that segment benefit most from the credit, largely because innovation investments in those firms can more visibly dampen profitability.
Broadening R&D Credit Appeal
The traditional method for calculating the R&D credit requires an established company to document its research spending from 1984 to 1988 to determine a base amount. A company may claim an R&D tax credit on 20 percent of expenses over the base amount or 50 percent of qualifying research expenses, whichever is higher. Taxpaying companies that didn’t exist during the 1984 to 1988 timeframe or which didn’t have three years of qualified research and gross receipts during that period use separate startup company rules. Companies must add the credit to taxable income or elect to claim a reduced credit of 13 percent.
Companies may elect to calculate the Alternative Incremental Credit (AIC), which provides businesses with a tax credit as long as qualified R&D expenses exceed 1 percent or more of the company’s gross annual receipts. Recent legislation increases the credits beginning in 2007 to:
• 3 percent (an increase from 2.65 percent) of qualified research expenses greater than 1 percent and less than 1.5 percent of average annual gross receipts
• 4 percent (an increase from 3.2 percent) of qualified research expenses greater than 1.5 percent and less than 2 percent of average annual gross receipts
• 5 percent (an increase from 3.75 percent) of qualified research expenses exceeding 2 percent of average annual gross receipts.
A second key change in 2007 is the introduction of an Alternative Simplified Credit. This method allows businesses to total qualifying R&D spending for the current year and compare it with R&D expenses over the preceding three years. If current qualified R&D spending is more than 50 percent of the average for the past three years, the company may claim a 12 percent tax credit. If there were no qualified expenses in that prior threeyear period, the company still can claim a 6 percent credit on qualifying R&D expenses.
“This was the biggest change in the R&D credit in over 10 years,” McGuire says. “While the alternative simplified credit will be beneficial to some large companies, it really helps small and mid-sized companies, because it eliminates that fixed base period in favor of a rolling base over a more recent period of time.”
Can your company benefit from the newly extended R&D tax credit? If so, experts suggest a few quick tips to help smooth the process:
Do your homework. Applying for the R&D credit involves more than crunching numbers. It also means working with your technical personnel to build documentation that your research projects meet the four-part test. If in doubt, consult with a trusted third party experienced in developing support for the R&D credit.
Review open tax years. Because R&D tax credit extension passed late in 2006, many C corporations on a calendar year will need to scramble to make an initial tax filing deadline of March 15, 2007. However, tax experts say business leaders who need more time to document their research work can file for a six-month extension on their corporate tax submission. Additionally, your company can take this opportunity to file for the most recent R&D credit as well as for any past credits to which your business may be entitled. IBI
