R&D Tax Credits and M&A Transactions

by Jonathan Forman and Michael Wilshere, JD Dec 15, 2022, 07:00 AM

When considering a merger or acquisition, tax attributes are often not a due diligence priority. Incorrect assumptions are often made about the value and utility of these attributes. An acquiring company can be surprised to find out it cannot use any of the target’s R&D tax credits following the acquisition. Worse yet, they may discover that their own future R&D tax credits will be reduced because of a recalculation of base amounts. There are two main reasons for this: Section 383 limitations on credit usage and the incremental nature of R&D credits.

Section 383 Limitations

According to Section 383 of the Internal Revenue Code (IRC), after a change in corporate ownership any general business credits are limited by the same rules by which Section 382 limits net operating losses (NOLs), meaning only a portion (if any at all) may be used post acquisition.

The limitation is approximated based on the following formula:

Base Limitation = FMV of Loss Corporation x Federal Long-Term Tax-Exempt Rate

Assume the fair market value (FMV) of the loss corporation is $5 million, the federal long-term tax-exempt rate is 3.5%, and the target’s R&D tax credit carryforwards are $1.5 million. The annual base limitation for the use of credit carryforwards will be $5 million x 3.5%, or $175,000.¹This means that in any year following the change of control, the maximum amount of the acquired credits that can be used annually is $36,750 ($175,000 income limitation x 21% tax rate). Since credits can be carried forward 20 years, at the calculated rate the new corporation could only use $735,000 ($36,750 x 20) of the available credits, with the remainder expiring unused.

If the old corporation also had $10 million in NOLs, it would never get to the credits because ordering rules require using NOLs before credits, essentially rendering the acquired credits worthless.

There is an important exception to the limitation for start-ups. If a company elected to use credits to offset payroll tax and has a carryforward of such credits, the acquiring company can use these credits to offset future payroll tax as the Section 383 limitation does not apply to the payroll tax offset.

The Incremental R&D Credit

The R&D tax credit encourages companies to increase their research spending annually. The bigger the increase, the bigger the reward. There are two methods to measure this increase:

Regular calculation: comparing qualified research expenses (QREs) to gross receipts
Alternative simplified calculation (ASC): comparing credit-year QREs to QREs in the preceding three years

Arguably the most important aspect of the comparison in either method is that you compare apples to apples (QREs to QREs). The second most important part is ensuring that the entity, or group of entities, being compared is equivalent.

The R&D credit is claimed on a controlled group basis. All entities under common control are treated as a single claimant for calculation purposes, and the credit is allocated to contributing entities via specific rules. When a transaction has occurred, the new corporation acquires the history of the old corporation, including its QREs. This means that a transaction triggers a recalculation of the base amount to which the QREs in the credit year are compared.

Under the regular calculation method, a company is considered a start-up or non-start-up based on when it first had both QREs and gross receipts. If this was after 1983, then the company is a start-up for credit purposes; if it was before 1984, then the company is not a start-up. This determination is based on the facts of all entities within the controlled group. Therefore, a company founded in 2015 – with $2 billion in revenue and a start-up for credit purposes – that acquires a $50 million entity which had both QREs and gross receipts in 1982 would now be a non-start-up for credit purposes. The new combined company’s base amount would be determined by the ratio of QREs to gross receipts in the 1984-1988 period. Importantly, it may change the fixed-base percentage (the ratio that dictates the base amount) from a low fixed-base percentage enjoyed by the 2015 entity to a high fixed-base percentage of the 1982 entity, and greatly reduce the new company’s future credits.

If using the ASC method, the situation is less complex but can still be impactful. In this case, the only consideration is QREs. As with the regular method, the acquired company’s history becomes part of the new company’s history. In this case, the new company must adjust its base amount from the prior three years to include the acquired company’s QREs from the same period.

The bottom line is that if acquiring or merging with an R&D company, analysis of the utility of carryforward credits should be a focused aspect of the due diligence process.

¹ For illustration purposes, the example ignores the potential for increasing the limitation by recognized built-in gains.

Jonathan Forman and Michael Wilshere, JD, are with Global Tax Management in New York. Forman is a managing director and practice leader in the credits and incentives practice, and can be reached at jforman@gtmtax.com. Wilshere is an R&D tax credit senior analyst in the credits and incentives practice, and can be reached at mwilshere@gtmtax.com.