Credits Against Tax
The IRS has generally audited claims for the Sec. 41 research and experimentation (R&E) tax credit with a highly coordinated review. This is evident by its Tier I review status, to which the IRS elevated it in 2007, identifying it as a “high risk transaction.” The underlying expenditures often deducted as R&E expenditures as defined by Sec. 174 have generally not received the same level of review upon audit. However, many taxpayers may have noticed a recent increased IRS focus on R&E expenditures. As a result of this increased focus, it is time for taxpayers to increase their focus as well.
R&E expenditures can have a potential impact on other tax attributes as well. For example, Sec. 174 R&E expenditures can generally affect the Sec. 41 R&E tax credit; cross-border cost-sharing arrangements governed by Sec. 482 and Temp. Regs. Sec. 1.482-7T; the Sec. 901 foreign tax credit (FTC); and the Sec. 199 domestic production activities deduction (DPAD), among others.
Observation: Schedule M-3, line 35, uses the term “R&D costs”; however, this item uses the term “R&E expenditures” throughout for consistency and discussion purposes.
What Constitute R&E Expenditures?
R&E expenditures are defined in Regs. Sec. 1.174-2 as
expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense . . . Expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.
R&E expenditures may be either currently deducted under Sec. 174(a) or treated as deferred expenses and deducted ratably over a period of not less than 60 months under Sec. 174(b). Current deduction treatment is assumed for purposes of this item. Sec. 174 is the first threshold requirement the expenditures must meet to be eligible for the R&E tax credit. As such, there are many expenditures that may qualify for deductibility but may not qualify for the R&E tax credit. For example, “the costs of obtaining a patent, such as attorneys’ fees expended for perfecting a patent application” will typically qualify for deductibility under Sec. 174 (Regs. Sec. 1.174-2), but generally not for the credit under Sec. 41.
Recent Examples of Heightened IRS Scrutiny
Schedule M-3: The IRS introduced two new line items to Part III of the 2010 Form 1120 Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More, one of which is for R&E expenditures. The new instructions for the R&E expenditure line (line 35 in Part III of Schedule M-3) requires a supporting schedule to be attached reconciling the R&E expenditures computed for financial statement purposes to the R&E expenditures deducted on the tax return. Different reporting requirements apply in 2012 for Sec. 174(a), current deduction method, and Sec. 174(b), deferral and amortization method.
The IRS recently announced that it removed the requirement for a supporting schedule to be attached for both the 2010 and 2011 tax returns. However, taxpayers must still complete line 35. There is typically a significant difference between R&E expenditures reported for financial statement purposes and those reported for the R&E tax credit. As a result, taxpayers may require substantial time to group the R&E expenditures from multiple general-ledger accounts to comply with the new Schedule M-3 reporting requirements. Further IRS scrutiny may result if the amount of R&E expenditures included on Schedule M-3 does not appear consistent with the amount of expenditures qualified for the R&E tax credit.
When the new line item on Schedule M-3 pertaining to the R&E expenditures was first introduced, many taxpayers were (and continue to be) uncertain as to how to properly complete the form. Taxpayers also likely remain uncertain as to what consequences result if they simply leave that line item blank, especially if they have not recorded a book-to-tax difference for this line item. Failure to properly disclose the R&E expenditures on Schedule M-3 could create a significant red flag for a taxpayer engaged in R&E activities, especially if that taxpayer is also claiming the R&E tax credit, FTC, or DPAD. For example, a company that has R&E expenditures and fails to include them on line 35 may fail to meet the accuracy-reporting requirements under Sec. 6662. The IRS posted on its Frequently Asked Questions (FAQs) for Form 1120 Schedule M-3 page that, while no specific penalties currently exist for not filing a complete and accurate Schedule M-3, “all penalties applicable to Form 1120 are applicable to Schedule M-3 which is filed as part of Form 1120” (Q-024).
Heritage: The Tax Court, in a decision issued on October 19, 2011, Heritage Organization, LLC, T.C. Memo. 2011-246, disallowed certain costs claimed as R&E expenses under Sec. 174 for researching tax planning strategies. While this case involved a “son-of-boss” transaction, the primary focus of both the IRS and the court surrounded the claim for deduction of R&E expenditures. This case is another example of the IRS’s increased focus on R&E expenditures in general.
In this case, Heritage, a life insurance company, became involved with tax and estate planning for high-net-worth individuals in the 1990s. Heritage’s research entity was charged with using publicly available information to identify possible high-net-worth clients who might be interested in Heritage’s planning techniques and insurance products. The research entity also conducted legal and tax research regarding corporate and trust structures that would allow individuals to minimize income and estate tax. Heritage spent hundreds of thousands of dollars for legal advice from estate and tax planning attorneys from around the United States.
As a result of its research, Heritage assisted its clients in implementing son-of-boss tax planning strategies designed to allow clients to derive tax benefits from built-in losses. Heritage made 11 payments of $550,000 to the corporations it created to implement the son-of-boss transaction. Heritage then deducted the $6,050,000 on its 2001 tax return as Sec. 174 R&E expenditures.
The court held that the payments for tax planning research did not qualify either as R&E expenditures under Sec. 174 or as ordinary and necessary business expenses under Sec. 162. As part of its decision, the court limited the nature of qualified expenditures by specifically stating that “[t]he payoff amounts fail to meet the [Sec. 174] requirement that the expenditures be for research in the experimental or laboratory sense. The payments were not made for scientific activities.” The court further held that the payments did not result in constructive dividends to a partner, and that Heritage was liable for accuracy-related penalties under Sec. 6662.
Both taxpayers and tax preparers should be aware that the R&E tax credit and associated R&E expenditures can affect other areas of the tax return. For example, the most common areas include, but are not limited to:
- Cross-border cost-sharing arrangements (potential for deemed income)
- Foreign tax credit
- Domestic production activities deduction
Other areas that may be affected by R&E expenditures but are outside the scope of this item include start-up expenditures, capitalization elections, inventory and self-constructed assets, and transfer pricing.
Tax preparers should be sensitive to the potential overall tax implications of the R&E tax credit and its impact on cross-border cost-sharing arrangements. As described in the example below, increased qualified research expenditures (QREs) may result in an increased cost-sharing reimbursement obligation from the controlled foreign corporation (CFC) (as defined in Sec. 957), which would then be taxed at 35%, a rate much higher than the effective R&E tax credit rate of 6.5% under the regular credit, or approximately 4.5% under the alternative simplified credit. (See Sec. 41 for further definition of the regular and alternative simplified credits.) This situation can arise when a tax preparer is not cognizant of the impact that an R&E tax credit position can have on the cost-sharing arrangement.
For example, suppose a U.S. company had a 50%-50% cost-sharing arrangement in place for R&E expenditures with its CFC. In this example, book R&E expenditures were determined to be $1 million, for which the U.S. company was reimbursed $500,000 by its CFC. This reimbursement would not affect the computation of the R&E tax credit as the credit is computed under the controlled group rules. Regs. Sec. 1.41-6(i)(1) states that “[b]ecause all members of a group under common control are treated as a single taxpayer for purposes of determining the research credit, transfers between members of the group are generally disregarded.” However, if the tax preparer is not aware of this cost-sharing arrangement and concludes that the QREs are actually $2 million, the IRS could deem an additional $500,000 as income (50% of the additional $1 million). The result is an additional 6.5% of R&E tax credit under the regular credit ($65,000) on the additional $1 million of QREs, along with an additional $500,000 of income taxed at 35% ($175,000), resulting in a net detriment of $110,000 of additional tax liability to the U.S. company. This is obviously not a favorable result.
Foreign Tax Credit
Generally, Sec. 901(b) provides for a foreign tax credit, subject to the limitation defined under Sec. 904 (FTC limitation), in “the amount of any income, war profits, and excess profits taxes paid or accrued during the taxable year to any foreign country or to any possession of the United States.” Although the computation of the FTC limitation and the various expense apportionment and allocation methods are beyond the scope of this item, it is important to understand the basic interplay between the FTC and R&E expenditures.
The FTC limitation determines the amount of FTC a taxpayer can apply against its U.S. tax liability. Generally, as the FTC limitation is increased, a taxpayer can utilize a greater amount of FTC on its U.S. tax return. A taxpayer’s foreign-source income is a key component in computing the FTC limitation where expenses are allocated and apportioned against foreign-source income. Special rules exist under Regs. Sec. 1.861-17 for allocating and apportioning R&E expenditures against foreign-source income. Since these special R&E expenditure allocation methods differ from the general expense allocation methodologies used for other expense categories, a taxpayer must consider the impact of additional R&E expenditures’ being allocated against foreign-source income when computing the FTC limitation. For example, depending upon the allocation methodology implemented, if a taxpayer reclassifies certain costs from a selling, general, and administrative expense category to the R&E expense category, then the amount of expenses allocated against foreign-source income could be affected. Thus, this reclassification could affect the FTC limitation and, ultimately, the amount of FTC available to offset the U.S. tax liability of the U.S. company.
Domestic Production Activities Deduction
Sec. 199 provides for a deduction “equal to 9 percent of the lesser of (A) the qualified production activities income of the taxpayer for the taxable year, or (B) taxable income . . . for the taxable year.” The qualified production activities income (QPAI) is derived by computing the domestic production gross receipts (DPGR) and reducing it by the allocable expenses and costs of goods sold (COGS). Under Regs. Sec. 1.199-4(d)(3), R&E expenditures are a component of expenses that must be allocated against DPGR by applying the special rules discussed above under Regs. Sec. 1.861-17. To the extent that the R&E expenditures relate to the production or manufacturing activities of an organization, those costs will further reduce QPAI. For example, the reclassification of costs as R&E expenditures by the unwary could potentially dilute QPAI, along with the resulting DPAD deduction, if the majority of the R&E expenditures are allocable to DPGR. (This example assumes QPAI is less than taxable income.)
What This Means to the Taxpayer
Many companies engage outside advisers to assist in the preparation and documentation of their R&E tax credit. These companies should not simply assume that those services will provide the information necessary to complete the Schedule M-3 or to consider the impact of R&E expenditures on other IRC provisions. The Schedule M-3, as it pertains to R&E expenditures, is generally not going to be within the current scope of services included in a general R&E tax credit study and likely will not provide the amounts necessary to complete that portion of the return accurately.
An R&E tax credit study examines and identifies the expenses that qualify for the R&E tax credit under Sec. 41, not necessarily the expenses that would qualify for the R&E deduction under the more liberal definition included within Sec. 174. Additionally, there can be a significant interplay between line 35 (i.e., R&D costs) and lines 28 and 31 (i.e., amortization and depreciation) that should be considered as well. Although the supporting schedule for line 35 was not required for 2010 and is not required for 2011, taxpayers should begin to become familiar with the intent of Schedule M-3. The IRS has essentially provided taxpayers with a two-year grace period before it will begin requiring the attached schedule reconciling on an entity-by-entity basis the R&E expenditures claimed for financial statement purposes to the tax return. Taxpayers should take advantage of this interim period by implementing a process to build upon and leverage in future tax years. The following suggested actions may assist taxpayers in preparing for the IRS’s increased focus on R&E expenditures, while also ensuring that they are maximizing their U.S. tax benefit:
- Review the method of accounting on an entity-by-entity basis;
- Identify all expenses that qualify for Sec. 174 (a more liberal definition when compared to Sec. 41 criteria);
- Perform a detailed capitalization and expense review to identify and reconcile those Sec. 174 R&E expenditures that have been capitalized and those that have been expensed for financial statement and tax purposes;
- Identify existing cost-sharing arrangements and any potential impact from a global tax perspective;
- Model the potential impact on the FTC, if applicable;
- Model the potential impact on the DPAD, if applicable; and
- Create a supporting schedule on an entity-by-entity basis, taking into account the taxpayer’s treatment of the R&E expenditures under either Sec. 174(a) or (b) for tax years 2012 and beyond.
This additional effort should provide the amounts necessary to complete the Schedule M-3, as it pertains to line 35 and the R&E expenditure-related portions of lines 28 and/or 31. This review may provide the additional benefit of uncovering costs that otherwise may have been capitalized for tax, and it should help ensure that the R&E expenditures claimed do not adversely affect other areas of the company’s tax return.
Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, DC.
For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.