State Tax Credits for Research and Experimentation
By B. Anthony Billings and Melvin Houston
Simulation Shows State-by-State Benefits
Companies seeking to locate or relocate their research and experimentation (R&E) facilities can frequently benefit from state business incentives such as state R&E credits. In addition to summarizing the R&E credits offered by the states, the authors compare the effective rates of these credits based on the differences in the statutory rates, the definition of creditable research, and the limitations imposed in the credit formulae used to compute the credit. Using sales and research and development expenditures from the Ford Motor Companys published financial statements, they simulate the effective rate of R&E credit for the 32 states that have some form of R&E tax credit.
To keep pace with technology, U.S. companies must make significant investments in research and experimentation (R&E). Both the federal and state governments support a broad range of R&E initiatives, both directly and indirectly.
The most direct support, which involves government funding of basic and applied R&E, is often tied to objectives such as national defense or future economic growth. Indirect support is offered through a variety of policies, including a federal R&E tax credit, which encourages firms to spend more on research.
Most state governments have also enacted tax credits to encourage firms to conduct research within their state. Although the statutory rate to compute the credit varies from state to state, most states structure their credits after the federal tax credit for R&E expenses. The Exhibit identifies the 32 states with some form of tax credit for qualified R&E expenditures. The majority of these states base the amount of the credit on the increase in qualified R&E expenditures over a three- or five-year base period. The states statutory rates range between 5% and 6.5% of qualified R&E costs for a majority of states. Generally, those states with lower credit rates are more liberal in the items that are eligible for the credit. Most of the states offering R&E credits allow unused credits to carry over to future years.
Between 1998 and 2000, 32 states offered R&E credits at rates ranging from 3% to 20 %. However, the effective rates of credit for the 32 states presented in the Exhibit range from a low of zero to a high of 100% of its statutory rate. Moreover, a number of states reduce the credits attractiveness through restrictions, such as the requirement to locate in designated enterprise zones and the inability to carry unused R&E credit back or forward to other taxable years.
Federal Definition of Eligible Expenditures
The United States first offered an R&E tax credit in 1981: a 20% percent credit for expenditures made in an experimental or laboratory sense (Public Law 97-34). Qualified expenses included in-house, contract, or basic research; for example, wages for research employees, research supplies, lease payments for property used in research, and 65% of contract research costs. Such expenditures are eligible for either a basic research credit or an incremental credit. To obtain the credit, R&E costs must be technological in nature, potentially useful in the development of a new or improved business component, or elements of experimentation for a functional process.
The development or improvement of an experimental model, plant process, or formula qualifies for the credit, but expenditures for the refinement or production of a product do not quality for the credit. Expenses for testing, efficiency surveys, and consumer surveys on existing products are also disqualified. Furthermore, R&E conducted outside of the United States does not qualify for the federal R&E tax credit.
States definitions of eligible expenditures. Nearly all of the 32 states included in the Exhibit adopted the federal definition of qualified expenses under IRC section 41, which distinguishes between in-house and contract-related R&E expenditures but does not restrict the credit to expenditures incurred in designated enterprise zones. Some states, however, define qualified expenses differently or otherwise allow for special exceptions. Colorado, for example, requires that R&E expenditures be made in approved enterprise zones within the state. Arkansas defines qualified research expenses as scientific research and development in the field of biotechnology.
Federal Credit Formula
The federal credit is based on the historical relation between R&E and sales to current R&E costs, and is determined using a fixed-base percentage formula (IRC section 41). The credit is computed by applying the statutory rate of 20% to the excess of the current years R&E over a base period amount, computed by taking the ratio of R&E to sales during the statutory base period (19841988) and multiplying the result by the average sales for the four most recent taxable years preceding the taxable year of the credit. A company can also elect an alternative computation for the incremental credit that focuses more on the four most recent taxable years.
The IRC section 174 deduction for R&E expenditures is reduced by 100% of the credit taken. The loss of the IRC section 174 deduction decreases the tax benefit of the credit well below its statutory rate of 20%. For a company in the 35% tax bracket, the maximum tax savings generated by the 20% R&E credit is equal to only 6.5% of qualifying R&E expenditures. Indeed, the 6.5% effective rate of credit is the best-case scenario.
State credit formulas. The credits offered by most states range between 5% and 6.5% of qualified costs. Delaware, Georgia, Massachusetts, New Jersey, Pennsylvania, Vermont, and West Virginia allow a statutory rate of 10%. Arizona, Arkansas, and Hawaii offer the highest statutory rate (20%), while Colorado offers the lowest statutory rate (3%). All but one state either refunds the credit or allows unused credits to be carried over to other years; West Virginia considers all such unused credits forfeited. Montana and North Dakota are the only states that allow companies to carry unused credits back (two and three years, respectively), or forward (15 years). Hawaii and Iowa are the only states that refund any unused credits. To compute the credit, most states require the use of a three- or five-year base period. States can be divided into three groups based on the benefits they provide.
Group 1, federal definition states. This largest of the three groups (Arizona, California, Hawaii, Idaho, Indiana, Iowa, Massachusetts, Minnesota, Montana, New Jersey, North Carolina, North Dakota, Oregon, Rhode Island, Texas, Utah, and Wisconsin) adheres to the federal definition of qualified R&E costs as defined in IRC section 41. Most of these states allow a credit of between 5% and 10% on the excess of qualified costs over the five-year base amount. California, which has the most liberal definition of qualified research expenditures, allows a number of research-type credits.
In Hawaii, the provisions for the R&E tax credit mirror those offered by the federal government. The credit is equal to 20% of increased research activities in the state, but without the restrictions and limitations imposed by Arizona and California. Moreover, if the claimed tax credit exceeds the amount of income tax due for a given year, the excess will be refunded. All claims for a tax credit must be filed on or before the end of the twelfth month following the close of the taxable year for which the credit may be claimed.
Idaho allows a credit of 5% of the excess of qualified research payments for research conducted in Idaho over the base amount. The term base amount is defined the same as in IRC sections 41(c) and 41(h), except that average annual gross receipts must be calculated using sales or receipts attributable to sources within Idaho.
A company that incurs qualified research expense in Indiana, and that has income apportioned to the state, is entitled to a research expense tax credit equal to the lesser of the following:
Iowa allows a credit of 6.5% of the excess of qualified research expenses during the tax year over the base amount for the year, using the states apportioned share of the qualified expenditures for incremental research activities, plus 6.5% of the basic research payments under the basic research credit for federal income tax purposes [IRC section 41 (e)(1)(A)].
In Minnesota, a company is allowed a credit against the states franchise tax equal to 5% of the first $2 million of the excess (if any) of qualified research expenses for the year over the base amount, and 2.5% on all such expenses over $2 million. Qualified research is defined as in IRC section 41(d), except that the term does not include research conducted outside of Minnesota. Base amount is also defined as under IRC section 41(c), except that the average annual gross receipts must be calculated using Minnesota sales or receipts.
Montana allows a credit of 5% of the excess of qualified research expenses during the year over the base amount, determined using amounts related to research conducted in Montana. The amount of the credit must be determined in accordance with the procedures outlined in IRC section 41. For a company that has income from a business activity that is taxable both within and outside the state, however, only the gross sales less returns apportioned to Montana can be used to determine the tax credit. The credit cannot exceed the tax liability due for any year. Unused credits may be carried back two years or forward 15 years, but this entire amount must first be carried to the earliest tax year in which it may be applied and then to each succeeding tax year.
New Jersey allows a tax credit equal to 10% of the excess of qualified research expenses for the year over the base amount and 10% of the basic research payments made by a firm in accordance with the federal definition under IRC section 41. The amount of credit applied during a given taxable year may not, however, exceed 50% of the tax liability otherwise due and may not reduce the firms liability to an amount less than the statutory minimum tax required from by the state. Unused credits may be carried forward, but only for seven years.
In North Carolina, a company that claims a federal income tax credit under IRC section 41 is allowed a credit equal to 5% of the states apportioned share of the companys expenditures for increasing research activities. The states apportioned share of the firms expenditures equals the excess of qualified expenses over the base amount, multiplied by the ratio of qualified expenses incurred in the state over the total of qualified expenses.
In North Dakota, the allowable credit for R&E is 8% of the first $1.5 million of qualified research expenses in excess of the base period expenses and 4% of all qualified research expenses over $1.5 million in excess of the base period expenses. The credit allowed cannot exceed the liability for taxes otherwise due; any unused credits may be carried back to the preceding three years or forward to the 15 succeeding taxable years.
The statutory rate of credit in Oregon is 5%. Qualified and basic research includes amounts only to the extent research is conducted in Oregon. The maximum credit that can be claimed by a firm in any tax year is $500,000.
Texas allows a tax credit equal to 5% of the excess of qualified research expenses for the year over the base amount, which should be determined using amounts for research conducted in Texas. The amount of the credit must be determined in accordance with the procedures outlined in IRC section 41, while using gross receipts attributable to Texas. The credit allowed for any year is limited to 50% of the firms total franchise tax liability before any other credits. In addition, expenditures and payments made by firms in designated strategic areas may be doubled for purposes of calculating the credit.
Group 2, unique base period states. These states (Colorado, Delaware, Illinois, Kansas, Maine, Missouri, Ohio, and Pennsylvania) use a different base to compute creditable expenditures than that used in IRC section 41. Colorado applies a rate of 3% to the excess of qualified expenditures over the average of expenditures for the prior two years. Illinois, Kansas, and Missouri all determine the credit by applying a rate of 6.5% to the excess of the current years qualified costs over a computed base amount. All three states determine the base period by averaging the amount of qualifying expenditures for the three years immediately preceding the year in which the credit is being computed.
Delaware allows a credit equal to 10% of the excess of the companys total Delaware qualified R&E expenses for the year over the companys Delaware base amount. The base amount is determined by averaging the amount of total Delaware qualified R&E expenses incurred for the four preceding years. The credit allowed for any year cannot exceed 50% percent of the qualified tax liability. Delaware limits the total amount of this credit to $5 million per year for all taxpayers.
In Missouri, however, no tax credit is allowed on that portion of the firms qualified research expenses incurred within the state that exceeds 200% of the firms three-year average research expenses.
Maine, which has a credit rate of 5%, and Ohio, which has a credit rate of 7%, both determine the base period by averaging the amount of qualifying expenditures made in the preceding three years. In Ohio, the credit is nonrefundable and must be claimed in the order stipulated under Ohio Revised Code Annotated Section 5733.98. All unused credits may be carried forward, but only for seven years.
Pennsylvania allows a credit of 10% on the excess of the current years qualified R&E costs, the highest rate for the states in this group. The base period in Pennsylvania is determined by averaging the amount of qualifying expenditures made for the four preceding years. To receive the credit a company must submit an application to the states Department for Qualified Research and Development Expenses that shows the amount of expense incurred.
Group 3, unique credit formula states. The states included in this group (Arkansas, Connecticut, Georgia, Maryland, South Carolina, Vermont, and West Virginia) use a significantly different approach from the federal credit formula. Arkansas, which offers one of the highest statutory rates available, limits the credit to firms engaged in biotechnology. Three credits of this type are defined: 1) a tax credit equal to 5% of the costs for biotechnology facilities; 2) a tax credit for biotechnology business activities equal to 30% of the costs of training employees or 30% of the cost of providing higher education partnerships; and 3) a tax credit for biotechnology research equal to 20% of the excess of such expenses for the year over 1996 expenditures (the states base year).
The credit rate allowed by Connecticut increases as R&E expenses increase. The credit rate ranges from 1%, for expenses equal to or less than $50 million, to $5.5 million plus 6% of the excess over $200 million, for companies incurring more than $200 million in R&E expenses.
Georgia allows a credit for qualified research expenses equal to 10% of the excess of R&E expenses over a computed base amount, determined by taking the product of a companys Georgia taxable net income in the current taxable year and the average of the ratios of the firms aggregate qualified research expenses to Georgia taxable net income for the preceding three taxable years or 0.3, whichever is less. The credit taken in any one taxable year cannot exceed 50% of the companys remaining Georgia net income tax liability after all other credits have been applied.
Maryland uses two rates to determine the amount of R&E credit each year. The credit allowed is equal to 3% of the amount by which qualified R&E expenses paid during the year are below the base amount for the state, plus 10% of the amount of such expenses in excess of the base amount. By using this approach, companies incurring R&E expenditures are expected to claim the credit during the period in which the R&E expenditures are incurred.
South Carolina allows a credit equal to 5% of qualified R&E expenditures made within the state for all taxpayers claiming a federal credit under IRC section 41. Because use of a base amount is not required, the effective rate of credit in South Carolina may be higher than that of other states having the same statutory rate. However, the amount of credit taken in any one taxable year may not exceed 50% of the taxpayers remaining tax liability after all other tax credits have been applied.
Vermont allows a credit equal to 10% of qualified research and development expenditures within the state of Vermont in the tax year for which the credit is claimed. Qualified research and development expenditures is defined as the term qualified research expenses in IRC section 41(b). Any unused credits may be carried forward, but only for five years.
West Virginia, which was the first state to enact an R&E tax credit, allows a credit equal to 10% of expenditures on property and services purchased for eligible research and experimentation projects. This credit, however, must be applied over a 10-year period at the rate of one-tenth of the total amount allowable during the year in which the investment was first placed in service or used in the state. The aggregate amount of credit allowable is limited to no more than 50% of taxes due.
Effective Rates of Credit
Using data from Ford Motor Companys published annual reports, we computed the tax credit Ford could have claimed for 2000 to estimate the average effective rates of credit in each of the 32 states. For computing the credit, sales and R&E expenditures were extracted for 1998 to 2000 and the years needed to compute the base period spending. The GAAP definition of research expenses is much broader than that for federal income tax purposes. Therefore, the credit amounts in the Exhibit are probably higher than the amounts Ford would actually receive.
The calculation assumes that Ford earned all its revenues and conducted all its R&E activities in each of the states in the Exhibit. The estimated effective rates and the average effective rates as a proportion of the statutory rates for each of the 32 states for the year 2000 are presented. It was further assumed, for the sake of simplicity, that the companys first year of operation in each state was 1998. For those states recently enacting the credit, the credit was assumed available for all of the years associated with this simulation.
Although statutory rates ranged from a high of 20% to a low of 3%, for most states the range related to the effective rate the credit was narrow and much lower. Vermont had the highest effective credit, rate 10%, while Arizona and Oregon had the lowest effective rate, 0.01%. Even though 11 states offered statutory rates equal to or greater than Vermonts effective credit rate, the limitations and other restrictions reduced the actual benefits. Indeed, Vermont and South Carolina were the only states in which the statutory rates and the effective rates for the credit were equal.
Although the effective rates varied among the three groups, there were some commonalties. The first group of states, which included Arizona and Oregon, had the second widest range of effective credit rates. The effective credit rates for this group ranged from 6.88% for Hawaii to 0.01% for Arizona and Oregon. The range of effective credit rates for Group 2 was the narrowest; the percentages here ranged from a high of 0.40% for Kansas to 0.07% for Delaware. The Group 3 states, which included the highest and lowest effective credit rate states, Vermont and Arkansas, had the widest range of effective credit rates. Clearly, the statutory rate of the R&E credit is not a good indicator of the actual or effective rate a company can expect.
From 1998 to 2000, about two-thirds of states offered some form of tax credit
for R&E expenditures. The statutory rates of credit range from 3% to 20%.
The statutory credit rate is not, however, a good indicator of actual benefits.
Most of the states with high statutory rates of credit sharply restrict the
types of costs that qualify for the credit and impose other restrictions that
lower the effective credit rate. A number of states restrict the credit to
specific activities or to certain designated enterprise zones. These restrictions
may make the credit unattractive to some.
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