Research and implementation as an investment alternative: the effect of the incremental tax credit. (Federal Taxation)by Schroeder, Jack D.
The R&E incremental tax credit provisions may provide meaningful levels of incentives to most R&E intensive firms. Under the new formula fixed base percentage), the credit generally will apply to firms experiencing rapid growth in R&E outlays, or a growth rate in R&E in excess of the growth rate in gross receipts.
The incremental R&E credit is 20% of incremental R&E spending in the computation year. For this purpose, incremental spending is the excess of qualified R&E expenditures over the calculated base.
Definition of Qualified R&E
Qualified R&E expenditures are defined under IRC Sec. 41(b) and associated regulations as the sum of the taxpayer's in-house expenses and contract research expenses paid or incurred in the taxable year in carrying on a trade or business. ORRA 89 also imposed a reasonableness standard to foreclose characterizations of disguised dividends, gifts, loans, and similar payments from qualifying for Sec. 174 deductibility. To be creditable, R&E expenses must satisfy the statutory definition for deductibility under Sec. 174 and must be for discovering information that 1) is technological in nature and 2) applies to the development of a new or an improved business component of the taxpayer.
To be considered as technological in nature, the process of experimentation must rely on principles of the physical sciences, biological sciences, engineering, computer sciences, or economics. The use of a computer as part of the research process does not by itself qualify such research as being technological in nature.
The process of experimentation engenders the evaluation of several alternatives designed to achieve a result from several possibilities. In this regard, the achievement of such a result must be uncertain at the outset. Significantly, research related to style, taste, cosmetic, or seasonal design factors is expressly ineligible for the credit.
Sec. 174 defines a business component as a product, a process, computer software, a technique, a formula, or an invention that will ultimately be held for sale, lease, rental, or licenses. For this purpose, the business component test also can be satisfied by considering the significant elements of the respective product, process, etc.
Under the Conference Agreement of the TRA 86, computer software developed for internal use is eligible for the credit only if the software is used in 1) qualified research other than the development of the software in question and 2) a qualified process. The cost of developing software for functions related to payroll, bookkeeping, personnel management, consulting, or banking services are presumed to be for internal use. As such, these costs are ineligible for the credit. The Conference Agreement provides that the software must result in a reduction of cost or an improvement in speed on an economically significant basis to qualify for the credit. In addition, the software development must pose significant risks with respect to obtaining the desired result and the software must not otherwise be commercially available.
Excluded Activities The incurring of R&E outlays after commercial production begins is made ineligible for the credit even though all other requirements are met. As such, R&E related costs incident to product adaptation, market surveys, studies, and duplications are statutorily ineligible. Significantly, research conducted outside the U.S., conducted in the social sciences, or funded by any person other than the taxpayer is ineligible for the credit.
Chances in Business Ownership. Sec. 7110(b)(2)(D)(i) of the ORRA 89 and IRC Sec. 41(f)(3) provide that the buyer of a business inherits the R&E attributes of the purchased business. As such, the existing R&E and sales data for the purchased business must be added to the buyer's data in the R&E tax credit computations. In this regard, the purchaser must actually increase R&E activities to obtain the incremental credit. To the extent a short period return is filed, the data used in the fixed base percentage calculations must be annualized.
Methods of Determining the R&E Base
As the name implies, the incremental credit is allowed on annual growth in R&E spending over historical levels of funding. There are two methods of determining incremental R&E spending. The first relates to prior law and the second, current law.
Moving Average Base Formula Prior to january 1, 1990, Sec. 41 allowed a tax credit of 20% of a firm's qualified research expenses" for the taxable year in excess of a calculated base amount. The base period research expenses were defined as the average research expenses of the three years immediately preceding the computation year. The average of the base period research expenses, however, could never be less than 50% of the current period's qualified research expenditures. The effect of this 50% minimum was to limit the R&E credit to a maximum of 10% of qualifying expenditures.
Problems with the Moving Average Base. The primary criticism of prior law was that the moving average formula did not provide for increases in R&E outlays due to inflation in the determination of incremental spending. Because the base figure was a moving average of annual R&E expenditures, growth in spending in the current year was included in the base period for the purpose of computing the subsequent year's incremental spending. Such an approach increased the base figure and reduced the incremental spending in the computation year. Indeed, assuming a four year planning horizon for R&E expenditures (three year base period plus the computation year), the spending pattern that would maximize the credit would be one that had no outlays in the first three years and the total outlay in year four. Under this scenario, the credit would be 10% of the fourth year's expenditure. A credit formula that promotes the above spending pattern would be counterproductive to most research programs.
Fixed Base Percentage Formula Unlike the moving average formula of prior law, the fixed base percentage formula under current law bases the credit on the historical relationship between R&E and sales and on the average of the gross receipts (sales) of the four most recent years. The base amount is the product of the fixed base percentage and the average gross receipts for the four years immediately preceding the computation year. The fixed base percentage is the ratio of R&E expenses to gross receipts for the taxable years 1984-1988.
Therefore, the computation of the base period amount is as follows:
Several limits may be applicable to the fixed base percentage or to the base amount depending upon varying circumstances. First, the fixed base percentage cannot exceed 16%. This limit favors the taxpayer, because a computed fixed base percentage in excess of 16% would result in a larger base in the computation year which, in turn, would lower the incremental spending that would otherwise be eligible for the credit.
A second limit is applied to those firms without the requisite number of taxable years in the 1984-1988 period. In these situations, the fixed base percentage is given at 3%. Third, the base period amount as computed above cannot be less than 50% of the current year's qualifying R&E expenses. The effect of this provision is to limit incremental spending qualifying for the 20% R&E expenses for the computation year. Therefore, even in a best case scenario, the 20% R&E credit is limited to 10% of a firm's R&E expenditures for a year.
Additional limits are imposed on the tax deductibility of R&E expenditures. The Sec. 174 deduction is decreased by 100% of the credit taken. Taxpayers can elect to reduce the credit by the tax detriment suffered as a result of the loss of the Sec. 174 tax deduction. The tax detriment is computed by assuming the highest marginal income tax rate in effect. Reg. Sec. 1-280C-4 prescribes the manner in which the election is to be made. Once the election is made it becomes irrevocable for that year. To the extent the credit cannot be fully used in the computation year, Sec. 196(d) requires the credit induced reduction in the Sec. 174 deduction to be carried out notwithstanding.
The loss of part of the Sec. 174 deduction further erodes the tax benefit of the credit. In fact, for a firm in the 34% tax bracket, the maximum tax saving associated with the 20% R&E credit is only 6.6% of qualifying R&E expenditures.
Example 1. Corporation A spent $10 million on qualified R&E expenses in 1990. Regardless of the calculated base, the base amount for purposes of the incremental credit cannot exceed $5 million (50% of $10 million). As a result, the credit is $1 million (20% of $5 million).
In addition, the Sec. 174 deduction for R&E expenses is reduced by $1 million (100% of the credit). Other things being equal, the federal income tax liability will likely increase by $340,000 (34% of $1 million) as a result of the credit induced reduction of the Sec. 174 deduction. Therefore, Corporation A should receive a net benefit from the credit of $660,000 ($1 million - $340,000). This transforms into an effective credit rate of 6.6% $660,000/ $10 million).
Indeed, the 6.6% effective rate of credit is the best case scenario; most firms will likely receive a much lower rate depending on the calculated base figure (see Table 1 omitted for a sample of effective rates).
Projected Effect on R&E Intensive Firms
To determine the relative impact calculations were made of the effective rate of R&E credit for 80 firms for 1990 using information available from published sources. Table 1 omitted presents the effective rate of R&E credit under both the moving average and the fixed base percentage formulas for a sample of firms included in the calculations. The rates are intended to demonstrate the results under the two methods and because of the source of the data are not intended to reflect the actual credits available. Effective rates were defined as the net R&E tax credit divided by the total R&E outlay. For this purpose, the net R&E tax credit is the credit obtained under the incremental formula reduced by the product of 34% (federal marginal tax rate) and 100% of the credit taken.
For those firms that received a credit under either formula, the average effective rate under the fixed base approach is 2.5% and 1.9% under the moving average approach. These rates are significantly less than the 20% rate provided in the IRC.
Of the 80 firms included in Table 1 omitted, 72% received more generous benefits under the fixed base percentage formula when compared to the moving average formula. A number of firms in the electronics, foods, metals, and telecommunications industries received higher credits under the moving average formula than under the fixed base formula, however. Interestingly, all the sampled firms in the telecommunications industry received a smaller amount of credits under the fixed base percentage formula.
Generally, firms that reduced R&E as a percentage of sales in the computation year relative to the base period (19841988) are penalized under the fixed base percentage formula. Ten percent of the firms are eligible for a credit under the moving average formula but not under the fixed base percentage formula. A preponderance of these firms belong to the machine tools and metals industries. Indeed, if the purpose of the R&E credit is to encourage R&E spending, it is questionable whether the modest benefit provided under the current formulation would be effective in attaining that goal.
The R&E incremental tax credit may provide meaningful levels of incentives to most R&E intensive firms. Firms with the following financial characteristics appear to be the most likely candidates for the credit: 1) a growth rate in R&E in excess of the growth rate in sales; or 2) a growth rate in the R&E budget as a percentage of sales significantly in excess of the base period relationship between R&E and sales.
Although the statutory rate of credit is 20%, applicable limitations reduce the maximum rate to 6.6% under the best case scenario.
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