On June 17, 2008, the IRS issued final and temporary regulations (T.D. 9401, Temp. Regs. Secs. 1.41-6T(j), 1.41-8T(b)(5), and 1.41-9T(d)) relating to the alternative simplified credit (ASC) method of computing the research and experimentation credit under Sec. 41(c)(5). The ASC was enacted in December 2006 as a part of the Tax Relief and Health Care Act of 2006, P.L. 109-432. Before the addition of the ASC, Sec. 41 allowed the taxpayer to choose between two other calculation methodologies: the regular credit calculation and the alternative incremental credit calculation (AIRC). (Note: Sec. 41 is not permanent and is currently expired. Congress must act or the credit provisions will not apply to expenses incurred after December 31, 2007.)
The regular credit calculation methodology is complicated and involves a computation of a “base amount,” which requires historical qualified research expenses (QREs) and gross receipts (many times going back as far as 24 years) as well as an average of the gross receipts for the last four years. The AIRC calculation methodology is somewhat simpler in that no historical QREs are necessary to compute the base amount, but there is still a gross receipts component to the calculation. The ASC simplified the calculation of the credit by limiting the base period computation solely to the use of average QREs incurred over the prior three-year period with no inclusion of gross receipts in any portion of the calculation. In addition, the ASC includes a special provision that allows taxpayers to take the credit even if they do not have QREs in all three of the preceding tax years.
CalculationThe ASC is calculated by multiplying the total amount of current-year QREs that exceed 50% of the average of the three prior tax years by 12% (see Exhibit 1). For taxpayers that did not have QREs in any of the three prior tax years, the credit is calculated using 6% of current-year QREs. Also, if any of the three prior tax years are short years, the total QREs for the short tax year must be annualized before being included in the calculation.
For a controlled group of corporations, the credit is computed for each single entity using the method that provides the greatest credit at the single-entity level. The credit is then computed at the group level to determine the method that produces the greatest group credit. Each single entity is allocated a portion of the total group credit based on a percentage of the individual credit to the total of all individual credits computed at the single entity level regardless of what method was used to compute each credit. For example, group ABC has the greatest combined credit using the ASC (see Exhibit 2). At the single-entity level, the greatest credit for A is created using the regular method, the greatest credit for B is created using the AIRC, and the greatest credit for C is created using the ASC. The total group credit is then allocated to each entity based on the regular credit for A, the AIRC credit for B, and the ASC credit for C. Temp. Regs. Sec. 1.41-6T(e), Example (3), demonstrates the computation of the group credit and the allocation of the credit among the companies included in the controlled group (see Exhibit 3).
Election and ReportingTo make a valid election of either the ASC or AIRC calculation methodology, a Form 6765, Credit for Increasing Research Activities, must be filed with the taxpayer’s timely filed return (including extensions). However, the regular credit calculation methodology may be claimed on Form 6765 on either a timely filed return (including extensions) or an amended return for which the statute of limitation has not run. The election to use the regular, AIRC, or ASC method is made by filing the form using the method chosen. For the AIRC or the ASC, once chosen, the taxpayer must use the calculation methodology each year until the taxpayer revokes this election. The taxpayer may revoke a prior election for the ASC or the AIRC by filing the subsequent year’s form using a different method. However, once either the ASC or the AIRC is elected for the current tax year, the taxpayer cannot change the election on an amended return.
For controlled groups, the election is made on the return of the designated member. Under Regs. Sec. 1.41-8(b)(4)(ii), the designated member is defined as the “member of the group that is allocated the greatest amount of the group credit” under Regs. Sec. 1.41-6(c). All members of the controlled group must follow this election and file Form 6765 using the same method.
Practical Application of the ASCThe addition of the ASC methodology has allowed many taxpayers to begin claiming the research credit for the first time or to increase the amount of credit claimed. There are several types of taxpayers who find the ASC methodology beneficial. Many taxpayers, especially small to midsize companies in manufacturing industries, were limited in their ability to claim the credit due to a lack of the historical records necessary to document their base amount or a lack of research activity in the time periods that define their base period (for many from 1984 to 1988). For other taxpayers with an established base amount and in high-growth industries such as pharmaceuticals and software, the inclusion of gross receipts as a part of the base amount calculation severely limited the amount of credit received because their QREs did not increase as fast as their gross receipts.
Another example of taxpayers that benefit from the ASC methodology are those in industries such as banking and insurance, with historically very low levels of QREs relative to gross receipts. Many of these types of taxpayers never before considered the research credit because the available calculation methodologies all included a base amount with a gross receipts component. For all these taxpayers, the ASC methodology provides a simplified way to calculate the research credit using recent QREs without any gross receipts component in the base amount calculation.
Future Changes?On September 25, 2008, the IRS is scheduled to hold a public hearing on these temporary regulations. As indicated in its hearing notice, the following issues will be discussed:
- Should the regulations allow a controlled group to elect to use the ASC for both computation of the group credit and computation of every member’s stand-alone entity credit, even if the ASC does not provide the greatest stand-alone entity credit?
- What relief should be made available to taxpayers that have used methodologies inconsistent with the short tax year rules provided in these regulations on tax returns filed after the effective date of Sec. 41(c)(5) and before the publication of these regulations?
Stephen E. Aponte is senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.
Unless otherwise noted, contributors are members of or associated with DFK International/USA.
For additional information about these items, contact Mr. Aponte at (212) 792-4813 or firstname.lastname@example.org.