White House releases research tax credit proposal

The White House today released the following (original pdf at http://bit.ly/9Dy8XU).  While it *is* just a proposal at this point (and would still need to get through Congress), it would arguably make it easier for businesses to make use of the research tax credit.

Also, as I suspected, the proposal expressly seems to eliminate the traditional 1984 - 1988 "base period" that in my experience has caused some serious headaches for businesses that hadn't kept records going back that far.  Next step, Congress!

EXPANDED, SIMPLIFIED AND PERMANENT RESEARCH AND EXPERIMENTATION TAX CREDIT

The President proposes to expand, simplify, and permanently extend the Research and Experimentation Tax Credit in order to help companies create good jobs in America now while increasing future productivity and growth. This is a win-win—encouraging job growth and investment now that will pay off with stronger economic growth in the future.

Specifically, the President proposes to:

• Expand the R&E credit by about 20 percent. This would be the largest increase in the credit in its history. In total, the expanded credit would devote about $100 billion over the next 10 years to leverage additional R&D investment. Like the current credit, eligible research and experimentation needs to be performed in the United States, keeping high-skilled jobs in America.
• Simplify the credit. Currently, businesses must choose between using a complex formula for calculating their R&E credit that provides a 20 percent credit rate for investments over a certain base and a much simpler one that provides a 14 percent credit in excess of a base amount. The complex formula is, in fact, so outdated that it takes into account the amount of a business’s R&D expenses from 1984 to 1988. The Administration proposes to increase the rate of the simpler credit to 17 percent, which would make it more attractive and simplify tax filing for businesses. Simplifying the credit in this manner will increase its salience and impact on encouraging investment in research in the United States.
• Permanent credit. The President would make the credit permanent so that businesses could make investments and create jobs today confident that they will continue to benefit from the credit in the future. The President supports fully paying for this permanent tax policy, for example with the over $300 billion in loophole closers and other measures proposed in the FY 2011 Budget.

An expanded, simplified, and permanent R&E credit will help keep the U.S. economy at the cutting-edge of 21st century technologies, while expanding high-tech jobs, encouraging innovation, and increasing future productivity and growth:

• Increasing business certainty. The credit has been extended 13 times since its creation in 1981, with some extensions lasting just 6 months, and has also been allowed to lapse since the end of last year. However, although Republicans have supported extension in the past, they have voted against it multiple times this year, and are now blocking legislation that would renew this credit, creating uncertainty with two-thirds of the year already complete. Making this provision permanent would avoid this type of outcome and give businesses the certainty they need to accelerate R&E investments to create jobs today and in the future.
• 80 percent of the benefit directly supports jobs in the United States, and every dollar spent encourages U.S.-based investment. Four-fifths of tax credits are attributable to salaries of U.S. workers performing U.S.-based research—meaning that the credit helps create high-skilled jobs, as well as encouraging new innovations and future productivity. The entire credit goes to research and experimentation in the United States, with additional spillover benefits for jobs.
• Increase competitiveness to prevent the United States from falling further behind other countries in tax incentives for R&E. Increasing the R&E tax credit will strengthen innovation at home and make the United States more competitive abroad—helping us to reach our goal of bringing total R&D to 3 percent of GDP. In the 1980s, the United States was the leader in generous tax treatment of R&D; however, today many nations now provide far more generous tax incentives for research than does the United States. By 2008, we had fallen to 17th in generosity for general R&D amongst OECD nations. (Information Technology and Innovation Foundation) Among nations with tax incentives for R&D, the United States now provides one of the weakest incentives, below our neighbors Canada and Mexico, and behind many Asian and European nations. Leverage—each $1 spent on the tax credit creates $2 of benefits for the economy. Studies have shown that every dollar of tax benefit stimulates as much as an additional dollar of private R&D spending in the short run and two dollars in the long run. Every $1 of R & D adds about $2 of benefit to our economy and society as a whole.

What Outside Voices Say about the R&E Credit

• Chamber of Commerce: “The R&D tax credit creates high-wage, American jobs….Extension and expansion of the R&D tax credit will encourage investment in R&D in the United States that will enhance high-wage job growth and contribute to the revitalization of the American economy.” (Chamber website)
• Rob Atkinson, President of the Information Technology and Innovation Foundation: “If the United States is to remain the world’s preeminent location for technological innovation (and the high paying jobs that result), Congress will need to significantly expand and reform the Research and Experimentation Tax Credit.” (Foundation papers)
• Kevin Hassett, American Enterprise Institute: The R&E credit is “one of the most successful government tax provisions on the books….If the credit were to become permanent, then the benefits could well be higher, since the uncertainty surrounding its renewal would be removed.” (testimony)
• Douglas Holtz-Eakin (when John McCain’s top economic adviser): “Give companies a permanent R&D credit because we know if the R&D is done here, the manufacturing is more likely to be done here, according to the research literature.” (US News and World Report)

President Obama to reportedly outline a proposal to make Research Tax Credit permanent

According to numerous sources, President Obama will ask Congress on Wednesday to both expand, and make permanent, the research tax credit under section 41.  Under current law, the federal research credit expired for qualified expenses (as defined under section 41(b)) paid or incurred after December 31, 2009.

While details are still scarce, here is what I've seen so far.  Please note that until something official comes out, these are just unconfirmed rumors.

• Would expand the credit percentage under the Alternative Simplified Method (under section 41(c)(5)) from the generally-applicable pre-2010 amount of 14% to 17%.
• The $100 billion proposal will be announced at a speech in Cleveland on September 8, as part of a discussion on the economy.
• Of the $100 billion, $85 billion represents the 10-year cost of making the credit permanent.  The other $15 billion is the reported cost of expanding it.
• I have seen no mention of whether these proposals would apply retroactively (i.e., starting January 1, 2010).  My personal expectation is that it would, especially in light of the upcoming midterm elections, but we're likely to find out on Wednesday.
• No information is available regarding the standard computation method, but if House Bill 422 and Senate Bill 1203 are any indication (and which seem to have substantial bipartisan support), I suspect that the standard computation method will not be brought back.  Observation:  The standard method is a thorn in many sides due to taxpayers generally being required to base their research credit computations in part on their activities during the 1984 - 1988 time frame.  Not surprisingly, many taxpayers don't have information (much less documentation) going back that far.

Sources:

• New York Times:  http://nyti.ms/alAYBQ
• Washington Post (via Associated Press):  http://bit.ly/c7oEKq

More to come...

"Qualified research activities" in plain English

From talking with other CPAs and business owners, it seems pretty clear that even after all the years that the research credit has been around, the types of activities that qualify for the credit are still not widely recognized.

For the record, it does not necessarily require teams of scientists in lab coats, rows of Bunsen burners, and electron microscopes. In fact, it can involve something as seemingly simple as trying to create a nontoxic coating for the inside of a pizza box that minimizes leakage during delivery! Hardly what many people would consider high tech research, but often research nonetheless for purposes of IRC section 41.

Given that common misunderstanding, and in the interest of providing a relatively simple explanation to clients (and prospects) when discussing the research credit, I wrote a memorandum for that very purpose, which I'd like to share here as well.

So, without further ado, I've reproduced it below. (Caveat: I ask that you read it as a general guide and not as a definitive treatise on the subject. It is meant strictly as a starting point for discussion, and by design does not address every possible issue...not even close.)  If you're interested in seeing whether your business might qualify, drop me a note at my email address under "About Me."

(p.s. - While the federal credit did expire for expenditures after 12/31/09, it appears likely to be reinstated.  In addition, California's research credit is permanent, as may be other states.)

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For purposes of the credit, qualified research activities means those which satisfy the following criteria:

• The activity is experimental or laboratory in nature,
• For the purpose of discovering information,
• Which is technological in nature,
• The application of which is intended to be useful in the development of a new or improved business component, 
• Substantially all of the activities of which constitute elements of a process of experimentation, relating to
• A new or improved function;
• Performance; or
• Reliability or quality of a business component.

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• An activity that qualifies as research and development (R&D) is one that is experimental or laboratory in nature. This term generally includes all activities incident to the development or improvement of a product.
• Activities represent R&D in the experimental or laboratory sense if they are intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.
• Uncertainty exists if the information available to the company at the outset does not establish either the capability or the particular method for developing or improving the product or the appropriate design of the product.
• note: It is unnecessary that there be uncertainty as to whether the component or improvement can be designed at all; rather, there need only be uncertainty with respect to the best method of design necessary to achieve the desired result.
• Whether activities qualify as R&D depends on the nature of the activity to which the efforts relate, not the nature of the product or improvement being developed or the level of technological advancement the product or improvement represents.
• An activity which is for the purpose of discovering information,
• Which is technological in nature,
• This test depends on whether the process of experimentation (see below for definition) utilized in the research fundamentally relies on principles of the physical or biological sciences, engineering, or computer science.
• Research does not rely on the principles of computer science merely because a computer is involved. However, research is considered to be undertaken to discover information which is technological in nature if such information expands or refines existing principles of computer science. The development or improvement of computer software can, in some cases, be considered an activity which is technological in nature.
• The application of which is intended to be useful in the development of a new or improved business component. A business component is any product, process, computer software, technique, formula, or invention which is:
• To be held for sale, lease or license, or
• Used by the taxpayer in the trade or business of the company.
• Also included in the definition of a business component are certain production processes such as any plant process, machinery, or technique for commercial production of a business component.
• Each business component must be evaluated separately to see if its R&D qualifies under the applicable rules. Thus, any plant process, machinery, or technique for commercial production of a business component is treated as a separate business component (and not as part of the business component being produced).
• If all aspects of the requirement of new or improved function, performance, or reliability or quality (mentioned below) are not met with respect to a business component, but are met with respect to one or more elements thereof, the term “business component” means the most significant set of elements of such product, etc. with respect to which all aspects of the requirement are met.
• The requirement of “new or improved function,” etc. is applied first at the level of the entire business component to be offered for sale, etc. by the taxpayer. If all aspects of that requirement are not met at that level, the test applies at the most significant subset of elements of the business component. This "shrinking back" of the product is to continue until either a subset of elements of the product that satisfies the requirement is reached, or the most basic element of the product is reached and such element fails to satisfy the test.
• Substantially all of the activities constitute elements of a process of experimentation, relating to:
• A new or improved function;
• Performance; or
• Reliability or quality of a business component.
• “Process of experimentation” means a process involving the evaluation of more than one alternative designed to achieve a result where the means of achieving that result is uncertain at the outset. This may involve developing one or more hypotheses, testing and analyzing those hypotheses (through, for example, modeling or simulation), and refining or discarding the hypotheses as part of a sequential design process to develop the overall component.
• Qualified research does not include the following:
• Any research conducted after the beginning of commercial production of the business component.
• Any research related to the adaptation of an existing business component to a particular customer's requirement or need.
• Work which is related to the reproduction of an existing business component (in whole or in part) from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information with respect to such business component.
• Surveys and studies of the following nature: efficiency surveys, management studies, market research, testing, or development (including advertising or promotions), routine data collection, or routine or ordinary testing or inspection for quality control.
• Testing or inspection to determine whether particular units of materials or products conform to specified parameters is quality control testing. However, quality control testing does not include testing to determine if the design of the product is appropriate.
• Any research conducted outside the United States.
• Research in the social sciences, arts, or humanities.
• Funded research.
• Activities relating to style, taste, cosmetic, or seasonal design factors.
• If an employee has performed both qualified services and nonqualified services, only the amount of time allocated to the performance of qualified services is treated as research.
• If substantially all of the services performed by an individual consist of R&D services, then all of that individual's time can be considered as R&D. The term “substantially all” is defined as 80% or more of the time spent by an individual on R&D activities.
• Direct supervision and direct support of qualified activities may also constitute qualified R&D under the following circumstances:
• Direct supervision means the immediate supervision (first-line management) of qualified research (as in the case of a scientist who directly supervises research, but who may not actually perform research). Direct supervision does not include supervision by a higher-level manager to whom first-line managers report, even if that manager is a qualified research scientist.
• Direct support includes the services which directly assist either those engaging in actual qualified R&D or those who are directly supervising those engaged in qualified R&D. Examples include the services of a secretary typing reports describing research results and a clerk for compiling research data. Direct support of research activities does not include general administrative services or other services only indirectly of benefit to research activities. For example, services of payroll personnel in preparing salary checks of scientists, of an accountant for accounting for research expenses, of a janitor for general cleaning of a research laboratory, or of officers engaged in supervising financial or personnel matters do not qualify as direct support of research. This is true whether general administrative personnel are part of the research department or in a separate department.
• Activities related to the development of computer software for the taxpayer's own internal use (e.g., for payroll, bookkeeping, or personnel management functions) are generally not considered qualified R&D. However, under forthcoming regulations, the development of internal-use computer software may be treated as qualified R&D only if it can established that, in addition to satisfying the general requirements for R&D treatment:
• That the software is innovative (as where the software results in a reduction in cost, or improvement in speed, that is substantial and economically significant);
• Note that the proposed regulations provide a slightly modified standard than the legislative history in that the software “is innovative in that the software is intended to be unique or novel and is intended to differ in a significant and inventive way from prior software implementations or methods”.
• That the software development involves significant economic risk (as where the taxpayer commits substantial resources to the development and also there is substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period); and
• That the software is not commercially available for use by the taxpayer (as where the software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the first two requirements just stated).