Paul McVoy, principal with KBKG, discusses research and development tax credits in Pennsylvania and at the federal level. He delves into which expenses qualify, what types of activities are excluded, and the process for claiming the credits.
By: Bill Hayes, Pennsylvania CPA Journal Managing Editor
With a great deal having changed in the area of the federal research & development tax credit in recent years, and more possibly down the road, it's a great time to dive into activities that are excluded from the federal R&D tax credit, how you calculate the credit, and more. We'll also talk specifically about the Pennsylvania R&D tax credit. To do this, today we are with Paul McVoy, principal with KBKG.
For Pennsylvania specifically, what types of expenses qualify for the R&D tax credit?
[McVoy] To understand what qualifies for R&D, we want to take a step back and make sure everybody understands what a tax credit is. So, a tax credit is an amount of money taxpayers can subtract directly from taxes owed to the government, unlike deductions, which reduce the amount of taxable income in which a tax liability is generated.
Pennsylvania offers an R&D tax credit to reduce the Pennsylvania tax liability. The types of expenses allowable in generating that tax credit will be wages – W2 box one wages for activities that are performed in Pennsylvania. Supplies used or consumed during the R&D process. Think about if we are making widgets, or a product, and we have to build a prototype, any materials, or ingredients, if we're coming up with a formula that are used in that R&D process can be claimed. As well as contract research payments, which are any payments made to third parties to do R&D on our behalf.
Just note that that will be subject to a 35% statutory limitation on the amount claimed. So, if we paid an outside party $100 to do R&D on our behalf, we can only claim $65 toward the Pennsylvania R&D credit. Then, there are some computer rental, lease, and time-sharing expenses for software development companies that may be claimed as well.
On the topic of the federal research & development tax credit, what must the activities show to qualify for the credit?
[McVoy] For federal purposes, the credit was enacted in 1981, and made permanent with the signing of the PATH back in 2015. At the highest level, the R&D program incentivizes taxpayers to participate in innovation. Systematic and continuous innovation has been a key driver of economic growth within the United States historically. The federal R&D credit incentivizes companies to participate in that process.
The federal R&D credit is defined by Section 41 of the Internal Revenue Code, back to the question, and the four-part test, which is outlined within section 41. I'll briefly walk through the four-part test at a high level. Any activities which meet this four-part test, we can then claim the expenses associated with them toward the federal R&D credit. I think we'll touch on it later, any state credits, and more specifically Pennsylvania's credit for activities performed within the state jurisdictions.
With that, the first test of the four-part test, which defines qualified research and development is the technological and nature test. Meaning any activity performed that fundamentally relies on the principles of one of the hard sciences, computer science, or engineering will meet the first part of the four-part test.
The second test is the permitted purpose test. Meaning the activity must relate to a new or improved business component's performance, functionality, reliability, or quality. Many times people ask, "Well, what is a business component?" What I like to tell them is it's just a fancy tax term for saying, what are we holding for sale? What are we leasing to third party? Whether that's a product, a process, a formula, an algorithm, a platform, that will be the business component in which we're trying to make that improvement we just talked about.
The third and fourth test work in concert. The third test is the elimination of uncertainty test, which means the activity must be intended to discover information to eliminate uncertainty related to the capability or methodology for improving or creating said business component, or the appropriate design for that business component.
Then, lastly, the process of experimentation means the taxpayer must engage in an evaluative process designed to identify, or evaluate, more than one alternative to eliminate the uncertainty we just talked about. Provided the activities which we're performing meet that four-part test we can take those expenses I addressed earlier – wages, supplies, contract, research – toward claiming an R&D credit for federal purposes. Furthermore, any state R&D incentives that are available like the Pennsylvania R&D tax credit.
What types of activities are excluded from the federal R&D tax credit?
[McVoy] Non-qualified activities include any activities that take place outside of the United States. The R&D credit is a domestic incentive. What we want to do is encourage innovation within our borders to create jobs and stimulate economies related to the creation of those jobs. Certain activities are specifically defined as non-qualifying within the Internal Revenue Code Section 41. In order, that would be any adaptation of an existing business component, any duplication or reverse-engineering of an existing business component. Think about a company who takes someone else's product and just reverse engineers it, so they can create one of their own that would not be qualifying.
Any activities around the social sciences or the humanities. Studies related to efficiencies or management operations or profitability. Let's say we bring in consultants to understand what processes internally we could perform better to maximize profits, but are not experimental in the laboratory sense. Those wouldn't be qualified either.
Routine data collection: Let's say we're mining the internet for data, that's not going to qualify. Any routine or ordinary quality control testing. If we create a product, and we have line operators inspecting that product to ensure it meets the specifications and requirements that we intended for them to meet prior to creating those, that would also not be qualifying.
Then, lastly, any research that's funded by grant or contract or any other person or governmental entity would not qualify. This is a more nuanced item. The exclusion for funded research will rely heavily on the terms and conditions within any contract. This has been litigated in many court cases over the years. Dependent on the contract terms and conditions will determine whether or not we can qualify a specific activity under those terms and conditions.
What's the process for claiming the Pennsylvania R&D credit?
[McVoy] Similar to the federal tax credit regime, the Commonwealth now offers an R&D credit to qualified taxpayers in order to create new jobs, grow or attract new businesses, help stimulate the economy, and increase the underlying tax base.
The Pennsylvania R&D credit program is based off of that federal program. As long as the activities are occurring within Pennsylvania, we can generate and claim the Pennsylvania R&D credit. The next question is, well, what is that? Just like you asked. Well, the R&D credit for Pennsylvania purposes is equal to 10% of qualified research expenditures above the taxpayer's base amount. This percentage does increase to 20% for qualified small businesses. Qualified small businesses are defined as businesses with less than $5 million in assets. This R&D tax credit program was adopted in 1997 and has been around since then.
One of the items that I think is key to the Pennsylvania program is that any R&D credit degenerated that cannot be utilized by a company who generated it may sell, or transfer, to other companies who could use the credits, but otherwise did not qualify for the credit. The process for claiming said credit is to apply by September 15th. We have to submit our annual approval application by September 15th of each year. The Department of Revenue must approve that application by December 15th. A lot of taxpayers within the state have taken advantage of this.
Just some numbers for context: In 2013, there were 747, I believe, applicants, of which 96% received R&D credits. In 2017, that percentage remained static at 96%, but there were 1,344 applicants who received the R&D credit. One of the items that I think is important to understand is, well, if everybody's generating these R&D credits, does everybody get to take advantage and utilize the entire amount of credit that they generated? The answer to that is no.
The reason for that is Pennsylvania sets aside a certain amount of money each year for their R&D credit program. Since 2011, that amount has been $55 million, of which $11 million is set aside for small-business research credits. Anybody who applies for the credits is entitled to them, but they do have to allocate that $55 million and that $11 million to all the applicants who apply and are approved.
Are there any other important items that are out there that people should know about the Pennsylvania rules connected to R&D?
[McVoy] I think that's an interesting question, and it might take us down a path that we might not have been thinking about before this discussion. In 2018, there were application changes for individuals who want to claim the R&D credit. Historically, to claim the credit, we submitted a form REV-545, made a few statements that we were subject to income tax. We incurred qualified research expenditures within Pennsylvania. We were in compliance with Pennsylvania laws and rules. We had historical qualified research expenditures within Pennsylvania.
In 2018, that application changed and went online. One of the interesting things about that change is it coincided with Pennsylvania finding out about some tax fraud that occurred with their R&D credit program. Just as a brief aside, a couple from Bucks County, who was originally from Hong Kong, created 20 companies using multiple false identities to file for Pennsylvania R&D credits as small businesses during the 2012 through 2017 tax periods. The credits that were claimed were in excess of $8 million.
If you remember, some portion of credits that are claimed, but can't be utilized can be sold. This couple was able to sell more than $6.3 million of credits fraudulently which – this is conjecture – I believe led to some of the application changes, and moving from a paper filing system to an electronic filing system during the 2018 timeframe.