By Margaret Krajcer, JD
There is significant momentum building in Congress to address various provisions within the Tax Cuts and Jobs Act of 2017 (TCJA). A number of these provisions, it seems, were constructed to disincentivize U.S. businesses from investing in research and development (R&D). One example is the requirement to capitalize and amortize R&D expenditures over a five-year period, preventing businesses from being able to fully deduct R&D expenses in the year in which they were incurred. If this provision of the TCJA goes into effect, it is likely businesses will spend less on R&D-related activities, and thus earn less R&D credit.
On March 16, the Senate Finance Committee held a hearing to discuss U.S. manufacturing tax issues. In an opening statement, Sen. Ron Wyden (D-Ore.) and other ranking members of the Senate Finance Committee highlighted the importance of building up domestic manufacturing and investment in R&D to generate jobs as we emerge from the COVID-19 crisis. Wyden specifically called out the TCJA and the work needed to fix the tax law so it no longer presents a disincentive for R&D, but rather creates “strong and liable long-term incentives.”
Additionally, there have been two bipartisan bills presented in the Senate and the House of Representatives, both of which call on reversing provisions within the TCJA that require businesses to amortize R&D expenses.
The 2021 American Innovation and Jobs Act, presented by the Senate, and the American Innovation and R&D Competitiveness Act, presented by the House, both recognize the importance of investing in the development of new products. Although these bills have only just begun their journey to become legislation, their bipartisan support in Congress shows that R&D incentives will likely be a high priority in future tax laws.
Impact of Corporate Tax Rates
While on the campaign trail, now President Biden proposed several tax changes, which he has reiterated since taking office. One of these, as proposed in the administration’s infrastructure proposal, involves raising the corporate income tax rate to 28%, a seven percentage point increase over what was set by the TCJA. This increase in the corporate tax rate, however, would also have a negative impact on the value of the R&D credit because of a required IRC Section 280C(c) adjustment. For example, a business investing $2 million in 2022, which earned a $110,000 R&D credit at the 21% corporate tax rate, would only earn a $100,000 credit if the rate increased to 28%.
It seems evident that some increase to the corporate tax rate will happen, so it’s critical that future tax planning take into consideration that there may be less R&D credit available to offset tax liability, regardless of whether R&D spending has remained consistent or even increased.
Several ongoing court cases have taxpayers, IRS officials, and legislators paying close attention.
One case is Little Sandy Coal Company Inc. v. Commissioner. The IRS disallowed claimed R&D credits of a shipbuilder for failure to substantiate the development of 11 vessels. In computing its credit, the taxpayer included engineering employee wages for researching, designing, and developing the vessels; production employee wages for the fabrication of prototypes; and material costs of the prototypes. The taxpayer claimed that substantially all of its activities related to new elements of the vessels, thus these expenses would qualify for the credit.
The court concluded that Little Sandy Coal did not document that substantially all of its research activities were elements of a process of experimentation. In coming to this conclusion, the court held that only direct research activities are considered in determining the “substantially all” computation, not the supporting or supervision activities, which it felt were not services engaged in research. In addition, the court held the costs to build the prototypes are not considered, since they do not constitute “activities” at all. While it is possible that this case will proceed forward to appeals, there is now a precedent set requiring taxpayers to establish documentation that will show how specific research activities that are considered a part of a process of experimentation are tied to R&D projects.
The recent case of Populous Holdings Inc. v. Commissioner involves the ongoing controversy over funded research.
Populous Holdings provided architectural design services and claimed the R&D credit relating to specific projects. The parties filed cross-motion for summary judgment to determine whether the research expenses were considered “funded.” The court examined a sample of the Populous contracts and found that, due to the nature of these “fixed price” contracts as well as provisions that allowed the client to approve design documents and dispute invoices, the provisions supported the holding that payment was contingent upon successful research, therefore the financial risk was on Populous. Further, the court found that even though the clients retained project-related research documents, there were no provisions that restrained Populous from using their research in other business ventures. Therefore, Populous was found to retain substantial rights. The court held that the research was unfunded, and Populous was entitled to the Section 41 credit.
Given the changing legislative and compliance landscapes, taxpayers should begin planning now for what may be significant changes to the R&D credit in the future.
Margaret Krajcer, JD, is vice president and general counsel of Tax Credits Group, a Cleveland-based firm specializing in federal and state R&D tax credits. She can be reached at email@example.com.
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