Accounting and Tax Treatment of R&D: An Update
By Joseph R. Oliver
Research and development (R&D) is crucial to the U.S. economy. Few people, however, appreciate how pervasively R&D affects American industry. A study of all publicly held U.S. corporations, other than utilities, transportation, and financial enterprises, reveals that more than 50% reported at least some R&D in the last five years. According to the Federal Reserve Bank of Philadelphia, R&D grew from 1.8% of U.S. nonfinancial corporate gross domestic product in the 1970s to 2.9% in the 1990s.
U.S. GAAP for R&D
SFAS 2, Accounting for Research and Development Costs, requires that R&D generally be expensed as incurred and that each year’s total R&D be disclosed in the financial statements. SFAS 2 views the research component of R&D as a “planned search or critical investigation aimed at discovery of new knowledge” that could result in a new or improved product, service, process, or technique. The development component of R&D is translating “research findings or other knowledge into a plan or design” for a new or improved product, service, process, or technique. Development includes conceptual formulation, design, and testing of product alternatives; construction of prototypes and operation of pilot plants; but not routine alterations to existing products, processes, or operations. See the Exhibit for examples of R&D activities under SFAS 2.
Materials, equipment, and facilities used in R&D activities are expensed as consumed, including depreciation over useful lives if they have alternative future uses. If they have no alternative future uses, these items are expensed as acquired or constructed, never depreciated. Similarly, purchased intangibles are amortized into R&D costs over their useful lives if they have alternative future uses but are expensed as incurred if they do not. Additional R&D costs may include salaries, wages, and other personnel costs; contract services; and a reasonable allocation of indirect corporate costs unless they are not clearly related to R&D activities.
The “alternative future uses” concept sometimes results in different treatment options within the same family of companies. For example, Parent Corp. might capitalize and depreciate equipment acquired for research purposes if the enterprise has an alternative future use for the asset. Parent’s smaller subsidiary, XYZ, would expense the same machinery if XYZ has no alternative future use for it. This might occur even if XYZ is still establishing its business, according to SFAS 7, Accounting and Reporting by Development Stage Enterprises.
Although numerous studies indicate that part or all of R&D expenditures may provide some future benefit, FASB has permitted R&D to be capitalized only for certain kinds of software. SFAS 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed, divides the life of a software product into three segments:
SFAS 2 could lead to exaggerated results in reporting the acquisition of
a company with in-process R&D. If a portion of a purchased company’s
represented by R&D assets that have no alternative future use, SFAS 141 and FASB Interpretation 4 generally require that this part of the acquisition price be currently charged off. In some instances, this might amount to most of the price paid. Because the SEC wants to minimize earnings management opportunities, proper valuation of in-process R&D for acquired enterprises is critical.
SFAS 68, Research and Development Arrangements, is a catchall that attempts to include a variety of complex affiliations between companies for R&D activities. One enterprise may perform R&D for another as part of a contract, as a means of expanding and transferring technology, or as a way to share financial risk.
Depending upon the arrangement, R&D can result in charge-offs, and the means of financing could produce liabilities. Additional disclosures may include the terms of significant agreements and certain information required by SFAS 57, Related Party Disclosures, based upon how the research and funding enterprises align themselves for the project.
In addition to ensuring that treatment and disclosure satisfies relevant accounting standards, R&D may be encountered in connection with SAS 59, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern. An auditor who has substantial doubt about an entity’s ability to continue as a going concern should consider management’s plans, including postponement of R&D projects. Such an action might have mixed results; cash flow and earnings could benefit in the short run, but studies suggest that investors are drawn to R&D and that such cuts might drive down the stock price of a publicly held corporation.
International Accounting Standard 38, Intangible Assets, provides a view contrary to U.S. treatment of R&D. IAS 38 divides R&D into a research phase and a development phase. It requires that research costs be expensed, but allows development costs to be capitalized and amortized if they produce probable future economic benefits under certain criteria.
Deducting R&D for Federal Tax Purposes
IRC section 174 is more flexible than GAAP, allowing a taxpayer to currently deduct R&D (called “research and experimental costs” in tax law) or to capitalize and amortize such outlays over 60 months or more. Amortization begins with the month in which benefits are first realized—that is, put to income-producing use—and separate projects may be amortized over different periods. Once a corporation chooses either method, it may use the other method only with IRS permission. A taxpayer that neglects to make the choice is required to capitalize R&D without amortization.
Outlays are R&D for federal tax purposes if they are intended to discover information that would eliminate uncertainty regarding the development or improvement of a product. For this purpose, a product includes a pilot model, process, formula, invention, technique, patent, or similar property that the taxpayer will use in a trade or business or will hold for sale, lease, or license, according to Treasury Regulations section 1.174-2(a). To eliminate uncertainty, R&D must be intended to establish the capability or method for developing, improving, or designing the property.
While SFAS 2 excludes legal fees in making and perfecting patent applications, Treasury Regulations section 1.174-2 includes them in R&D. Nevertheless, tax law excludes quality-control testing (except for testing to determine if a design is appropriate), efficiency and consumer surveys, management studies, advertising, promotions, and the cost of purchasing a patent, model, production, or process. Also excluded is research regarding literary, historical, and similar projects; the latter, including costs of producing films, sound recordings, videotapes, books, and similar properties, may be subject to the uniform capitalization rules of IRC section 263A. The cost of land does not qualify as an R&D expense. Neither do expenditures for determining the existence, location, extent, or quality of oil and gas deposits, minerals, or ores.
U.S. tax law also differs from GAAP in the treatment of depreciable property acquired for purposes of R&D. While SFAS 2 insists that the cost of such property be currently expensed if it has no alternative future use, Treasury Regulations section 1.174-2(b) requires that property be depreciated for R&D purposes. If R&D results in the construction of depreciable property, however, the taxpayer generally must capitalize and depreciate only the costs of materials, labor, and other elements used in constructing and installing the property. Remaining costs are deductible or amortizable as R&D under IRC section 174.
Generally, none of the costs of a machine or plant purchased from another taxpayer qualify as R&D, except for depreciation allocable to R&D. Nevertheless, if the seller provides limited or no guarantees regarding a special-order asset’s performance, such as production quality or quantity or the asset’s consumption of fuel and raw materials, part of the cost may be deductible or amortizable as R&D.
Choosing whether to currently deduct or to amortize R&D typically depends on an entity’s projections of taxable income, on whether net operating loss carryovers might expire unused, and on other tax circumstances. In some cases, the at-risk rules of IRC section 465 or passive loss limits of IRC section 469 may be applicable.
Federal Tax Credit for Research
IRC section 41 provides a tax credit of 20% of certain increases in qualified research expenses (see IRS Form 6765). The IRC section 174 R&D deduction is reduced by the R&D credit taken under IRC section 280C(c). Alternatively, the taxpayer may elect to take the full R&D deduction but reduce the credit by 35% (the maximum corporate tax rate).
To qualify for the credit, eligible research must first meet four requirements provided by IRC section 41(d):
Qualifying research relates to new or improved functions, performance, reliability, or quality. It must not relate to style, taste, cosmetic, or seasonal factors. IRC section 41(d)(4) also specifically excludes research conducted after commercial production begins, an adaptation of an existing business product or process to a customer’s needs, duplication of an existing business product or process, surveys, market research, social science research, foreign research, and funded research. Also excluded are the costs of developing computer software for internal uses that do not qualify as R&D.
Eligible expenses include employee compensation for personnel directly engaged in the research or supervising or supporting qualified research activities, the cost of tangible property other than land or depreciable assets, and amounts paid or incurred for the right to use computers in conducting research. For contract research expenses, only 65% of amounts paid or incurred to nonemployees are eligible. This rises to 75% for research performed for the taxpayer by certain nonprofit scientific research organizations.
A troublesome technicality of IRC section 41 is that research costs qualify if they are paid or incurred “in carrying on” a trade or business rather than “in connection with” a trade or business, as under IRC section 174. This could deny the credit where, for example, a taxpayer funds contract research if the result is to be used by others in exchange for licensing or royalty payments and not in the taxpayer’s own trade or business, according to Treasury Regulations section 1.41-2(a). Similarly, no credit is available to a taxpayer that performs the research for another entity and retains no substantial rights to it.
The trade or business issue creates a special need for planning in start-up ventures. The IRC provides an exception for start-ups in section 41(b)(4) under which in-house research expenses meet the trade or business requirement if the taxpayer’s principal purpose is to use the results in actively conducting a future trade or business. However, Treasury Regulations section 1.41-2(a)(2) denies the credit for research expenses paid or incurred before business begins if the objective is to develop a product for sale by a new trade or business.
Evolving Treatment for R&D
As spending on R&D continues to increase and the scope of R&D activities widens, familiarity with its accounting and tax treatment becomes more important. At present, U.S. GAAP for R&D is governed almost entirely by SFAS 2 and SFAS 86, but R&D performed outside the U.S. may be subject to IAS 38 or other rules. Federal tax savings are also available for R&D that meets certain criteria. Today’s accounting and tax treatment of R&D reflects the increasing value of R&D in the world economy.
Robert H. Colson, PhD, CPA
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