FIN 48 and R&D Tax Credits

By Chris Bard, J.D.

Editor: Terence E. Kelly, CPA

Under Financial Accounting Standards Board Interpretation No. (FIN) 48, Accounting for Uncertainty in Income Taxes, claims for research and development (R&D) credits are tax positions that companies following GAAP must evaluate to determine whether (and the extent to which) they may be recorded as a tax benefit in financial statements for fiscal years beginning after Dec. 15, 2006.

FIN 48 Evaluations

In general, FIN 48 calls for companies to:

  1. Inventory their tax positions (i.e., identify all positions taken or expected to be taken);
  2. Determine which positions meet the “recognition threshold” (i.e., are more likely than not (MLTN) to be sustained on examination, including resolution of any appeals or litigation processes) and derecognize positions that do not, or cease to, meet that threshold; and
  3. Measure the benefit of recognized positions (i.e., identify the largest amount of benefit for each position that meets the MLTN threshold that is more-than-50% likely to be realized on ultimate settlement with tax authorities). This is the amount of benefit to record in financial statements.

Identifying the R&D Credit Tax Position

First, a tax adviser should consider the scope of the position. This means considering all the company’s activities and costs and all the jurisdictions in which benefits for R&D exist (i.e., most U.S. states and more than 30 countries). It also means considering all the tax years that can be included in the tax position.

2006 and 2007: On Dec. 20, 2006, the Sec. 41 R&D credit, which had expired at the end of 2005, was extended to include costs incurred through the end of 2007.

Certain closed years: Under certain circumstances, R&D credit positions may also include credits generated in tax years for which the statute of limitations has run. Provided they could not have been used in an earlier, closed year, under Rev. Rul. 82-49, such credits may be carried forward to and used in an open tax year.

Determining Which Positions Meet the Recognition Threshold

There are three steps in making this determination:

Step one—identify appropriate unit(s) of account: The appropriate unit(s) of account for an R&D credit position must be determined based on all available evidence. This includes how the company prepares and supports its tax returns, and the approach it anticipates the taxing authority will take during an examination.

FIN 48 uses R&D credit projects as an example of a unit of account, and the IRS and state authorities often examine R&D credit costs by project. Thus, projects can be appropriate units of account. Many companies, however, do not have project accounting systems; even those that do may find using other units of account more appropriate.

Using projects alone may not take into account some qualified costs: (1) project codes are often not set up until after some related costs are incurred or some level of technological feasibility is reached; (2) technical personnel sometimes do not reliably charge their time to appropriate project codes; (3) it may be difficult or time-consuming to apply comprehensively the “80% rule” (i.e., if an employee spends at least 80% of his or her time performing qualified services, 100% of his or her taxable wages qualify), in which case, up to 20% of qualified wages may not be claimed; and (4) if another unit of account is used (instead of, or in addition to, projects), even if a particular project fails to meet the MLTN test, some subunit of the project (e.g., certain job titles or activities) may meet it.

In addition to projects, tax authorities have examined R&D credit claims using types of projects (e.g., in-house vs. vendor, enhancement vs. maintenance, commercial vs. internal-use software projects); employees; types of employees (e.g., highly compensated, above-first-line supervisory, noncore R&D, direct support, marketing, technical writers); contractors; contracts; cost centers; departments; business units; job titles; types of accounts (e.g., supplies, prototypes, patent costs); and types of activities or tasks (e.g., those describing the stages of the company’s development process).

Once costs included in the R&D credit position have been organized into appropriate units of account, the next step is to determine which of those units of account may be recognized.

Step two—determine which units of account meet the MLTN test: In making this determination, the technical merits of each unit of account must be determined presuming that the credits claimed will all be examined by an appropriate tax authority with full knowledge of all relevant information.

The technical merits of a set of costs are strong for eligible costs related to activities that (1) are not excluded from qualification by statute, legislative intent, regulations, rulings or case law and (2) were intended to develop or improve the functionality, performance, reliability or quality of a business component through a process of experimentation designed to discover technological information to eliminate uncertainty as to the company’s capability or method to do so, or the component’s appropriate design.

To improve the technical merits of the costs included in an R&D credit position, the company should identify them in a way that reliably and demonstrably excludes all costs associated with nonqualified activities and includes only those costs for activities that comprise or directly supervise or support elements of such a process of experimentation (i.e., for qualified activities).

If a project accounting system is in place, one way to do so is to (1) segregate qualified time (using task or activity codes) and qualified contractors or contracts from nonqualified ones; (2) include only the cost of eligible supplies used in those activities; and (3) document that and how all nonqualified activities are thereby specifically and reliably excluded.

If such a system is not in place, surveys can be used to identify the time or percentage that employees, contractors and supply accounts were involved in qualified and nonqualified activities. Such surveys are more effective when (1) they present at least the statutory exclusions as options, if not also other nonqualified activities (e.g., training or
administration); (2) the options describing the activities that qualify are not labeled “qualified,” so user bias is neither created nor reasonably presumable; and (3) those (qualified) options are described in such a way that the requirements of Sec. 41(d) are expressly stated, so that their technical merits are obvious. Using the stages of the company’s development process as these options will often work well, especially if they are described both in the terms (1) the company uses (so that company personnel can readily understand them) and (2) of elements of a qualified process of experimentation (so that examiners can see that they are prima facie qualified). This approach typically has the added benefit that the options described in the survey are directly supported by (often substantial) documentation (e.g., regarding design requirements, design specifications, prototypes or models, test plans and test results).

Because these kinds of surveys can help companies segregate qualified from nonqualified costs and improve the technical merits of an R&D credit position, even companies with project accounting systems may want to use them to identify their credits and supplement their documentation.

Step three—recalculate using only costs meeting the MLTN test: First, the base amount must be recalculated using only costs that meet the MLTN test. This may increase or decrease the base amount and, thus, the company’s regular R&D credit. If it decreases it, the company should calculate its alternative incremental credit (AIC) and alternative simplified credit (ASC), both of which are computed without regard to the regular credit’s base amount, to see whether either provides a greater benefit. The AIC must be elected on a timely filed (including extensions) original return for the tax year to which the election applies; the ASC may currently be elected only for 2007. (Treasury’s consent is required to revoke an ASC election.) (For a discussion of the AIC and ASC, see Arkin and Goldbas, Tax Clinic, “Enhanced Research Credit for 2007,” TTA, March 2007.)

Second, the credit must be calculated correctly, avoiding some common—and potentially significant—mistakes. For example, companies often fail to include all relevant entities, not realizing that all companies more-than-50%-owned or -controlled must be included, not just those 80%-or-more-owned or -controlled.

Another common error is calculating the base amount incorrectly—for example, failing to use the expanded definition of “gross receipts”; not including or excluding, respectively, the R&D credit history of its acquisitions and dispositions; or not properly identifying itself or its group as a “start-up company” (i.e., as a company meeting either of two conditions: (1) the first tax year in which it had both gross receipts and qualified research expenses (QREs) began after 1983; or (2) there are fewer than three tax years beginning after 1983 and before 1989 in which it had both gross receipts and QREs). Again, if an error is found that decreases the regular credit, the company should consider electing the AIC or ASC.

Measuring the Benefit

To measure the R&D credit position’s benefit, the company must assess the largest amount of credit that is more-than-50% likely to be realized on ultimate settlement, taking into account both the technical merits of its position and how it typically settles issues with tax authorities.

In deciding whether a benefit can be recognized, a company should assume resolution in the court of last resort. In measuring the benefit, on the other hand, the company should consider what it would ultimately accept on settlement with the tax authorities. If the company’s R&D claims have been examined previously, that experience should be used in making this determination. For companies without such previous experience, Federal and state examiners have historically subjected R&D claims to high scrutiny, typically requesting information companies do not have readily available. (For more information on IRS reviews of R&D credit claims, see Audit Techniques Guide: Credit for Increasing Research Activities (June 2005), at,,id=153347,00.html.)

Generally, information about the credit calculation and qualified costs is readily available. It is documentation describing why the activities qualify (i.e., how they meet the legal tests) that is lacking. Without such documentation, examiners may propose to disallow some (or all) of the claim, and company accountants may not allow the benefit to be stated for financial reporting purposes.

The needed documentation describes the company’s process of experimentation; the developments and improvements it attempted to realize; the technological information it attempted to discover; and the uncertainties it encountered in at-tempting to do so.

The company should inventory its existing documentation to see whether it contains this information and whether gaps exist. For qualified activities, these types of documents typically contain credit-relevant information: design-requirements documents (technological objectives); design-specifications documents and drawings (hypotheses or alternatives to be evaluated); and test plans and test results (experimentation). These documents, however, are drafted for the purpose of developing new or improved technologies, not to support R&D credits. Thus, their credit relevance is not always immediately apparent to a reviewer.

To highlight this relevance, the company should consider drafting an outline that explains how sections in a particular type of document contain information relevant to specific legal tests. If this outline and the company’s existing documentation do not create a more-than-50% likelihood that the R&D credit would be realized on ultimate settlement, the company should consider interviewing technical personnel about their qualified activities to document them further.


Because FIN 48 is effective for fiscal years beginning after Dec. 15, 2006, companies should begin immediately to inventory their tax positions, including their R&D credit positions.

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