Editor: Anthony S. Bakale, CPA, M. Tax.
Credits Against Tax
As of the writing of this item, Congress had not extended to 2012 the Sec. 41 credit for increasing research activities, more commonly referred to as the research and development (R&D) credit. Thus, the credit is not available for expenditures after Dec. 31, 2011. With the credit in limbo, it is an opportune time to reevaluate the entire system by looking at other countries’ R&D tax incentives.
Many of these countries far exceed the United States in generosity of the subsidy. In fact, an Organisation for Economic Co-operation and Development (OECD) study that uses a single summary measure of the net tax subsidy in 38 OECD and industrialized countries found the United States ranked 24th in terms of the generosity of the subsidy in 2008 (see OECD, OECD Science, Technology and Industry Scoreboard, 2009, §2.14 (OECD Publishing 2010)). It is important to note, however, there is not always a direct correlation between a government subsidy and business-level R&D spending. Often, a subsidy is introduced or amplified to stimulate growth to compensate for a weak business environment.
Because of the lost tax revenue, Congress has never made the R&D credit permanent but has extended it periodically or annually. Originally enacted in 1981, it was last extended (retroactively) on Dec. 17, 2010, for a two-year period for expenditures incurred prior to Jan. 1, 2012. The longest extension period was five years, enacted Dec. 17, 1999, effective July 1, 1999.
Usually, the credit has expired but been reenacted retroactively to the prior expiration date to prevent lapses in eligibility. There was only one “blackout” period when the credit lapsed for one year (July 1, 1995, through June 30, 1996). Retroactive renewal causes problems with financial statement accounting for income taxes (FASB Accounting Standards Codification Topic 740, Income Taxes , formerly FASB Statement No. 109, Accounting for Income Taxes ) because the credit cannot be considered a tax asset until Sec. 41 has been renewed. For example, the R&D credit should not have been recognized as a tax asset for financial statement purposes for the first and second quarters of 2012 for calendar-year financial statements since the statute had not been extended past Dec. 31, 2011.
With the exception of the introduction of the alternative simplified credit (ASC) in 2006 and availability of the alternative incremental research credit (AIRC) from July 1, 1996, through Dec. 31, 2008, the calculation method or the definition of qualified research has changed little in more than 20 years. Instead of again “rubber stamping” an extension, Congress should look to other countries’ programs for best practices on defining and implementing the R&D credit.
Administrative Complexity of the R&D Credit
The administrative and compliance burdens of the R&D credit in the United States have always been a problem. Since its inception, the R&D credit amount has been based on increasing research expenditures above a “base amount.” This base amount calculation has evolved over the years and has been the source of many contentious tax audits. (Discussion of the mechanical rules for determining the base amount is beyond the scope of this item.) Although the AIRC and ASC simplified the administrative burden of calculating the credit amount, many definitional issues still require taxpayers and the IRS to make judgment calls on the qualifying nature of the activities as well as adjustments to the base amount.
Further, although the IRS often employs engineers to assist an IRS examination agent with assessing the qualifying nature of a claimed research activity, the IRS engineer often has much less technical expertise than the taxpayer’s personnel in the particular science and the intended application of the research. The qualifying nature of the activity often is based on implementing technology within a unique customer environment where the IRS engineer may have limited or no experience. Although the engineer may have a separate supervisor from the agent, the engineer is often engaged and directed by the agent, and this may reduce the engineer’s independence. Similarly, the IRS often engages a separate software specialist group to handle internal-use software cases. Since these specialists are compensated by the IRS, they may not be entirely independent.
These compliance risks and burdens, in addition to the vagaries of the definition of qualified research, have spooked otherwise deserving taxpayers from pushing forward with claiming the credit. As a result, R&D tax incentives elsewhere around the world have made companies rethink where to locate or establish an R&D site. The balance of this item highlights aspects of R&D tax incentives in some key countries where many multinational companies have operations.
Benefits, incentives, and calculation: Canada offers a permanent tax credit of 20% for all expenditures related to scientific research and experimental development (SR&ED) (Canada Income Tax Act, R.S.C., ch. 1, §127.3 (1985, 5th supp. 2012)). (Note that Canadian provinces also offer SR&ED incentives.) This credit is also increased for certain qualifying companies. The standard SR&ED credit is increased to 35% on expenditures of up to $3 million (all amounts are in Canadian dollars) for small private Canadian-controlled corporations. The credit is refundable (incorporating the $3 million cap) for Canadian-controlled corporations that claim a 35% credit. To be considered a small corporation eligible for the higher credit rate, the company must have less than $800,000 of taxable income and less than $50 million in taxable capital in the prior year.
Definitions, qualifications, and limitations: Canadian law defines SR&ED as the discovery of knowledge that advances the understanding of scientific relations or technologies. Qualifying work includes experimental development conducted to achieve technological advancement by creating new materials, devices, products, or processes, or to improve existing ones.
Additional comments: A company claiming the credit must file an application (Form T661, Scientific Research and Experimental Development (SR&ED) Expenditures Claim) with the Canada Revenue Agency and also submit Schedule T2 SCH 31, Investment Tax Credit—Corporations, with its corporate income tax return or within 12 months of the return’s due date. Once the agency receives the form and schedule, the company’s claim is subject to audit.
Any missing or inadequate information is addressed prior to the allowance of the credit, which helps Canadian companies to take full advantage of the credit. The IRS may want to consider the Canadian application process. Two years ago, the IRS administered the qualifying therapeutic discovery project tax credit under Sec. 48D with an application process.
Benefits, incentives, and calculation: The United Kingdom offers a permanent superdeduction (a deduction greater than the amount of qualifying expenses) for qualified R&D activities (see Her Majesty’s Revenue and Customs, “Research and Development (R&D) Relief for Corporation Tax”). Deduction rates differ depending on the size of the taxpayer. Large companies are defined as having 500 or more employees and either gross revenue over €100 million or gross assets of more than € 86 million. Qualifying large companies are able to take a 130% superdeduction. Small to medium-size enterprises (SMEs) are those with fewer than 500 employees and either gross revenue of up to €100 million or gross assets of up to € 86 million. Before April 1, 2011, SMEs were able to claim a 175% superdeduction. This deduction increased to 200% on April 1, 2011 (Finance Act, 2011, §43), and to 225% on April 1, 2012 (Her Majesty’s Treasury, Budget 2011, ¶¶1.92, 2.79). Further, SMEs can receive cash credits of up to 25% of qualified expenditures if they are in a taxable loss position.
Definitions, qualifications, and limitations: Within the United Kingdom, an R&D project is defined as an activity that seeks to achieve an advance in science or technology through the resolution of scientific or technological uncertainties. Eligibility is based exclusively on the nature of the company’s activities. Qualifying expenditures for the superdeduction include employing staff who are directly and actively engaged in carrying out R&D; consumable or transformable materials used directly in carrying out R&D; and power, water, fuel, and computer software used directly in carrying out R&D.
Additional comments: The United Kingdom does not restrict where the R&D work is performed. This does not motivate innovation and adaptation of products and methods in the United Kingdom. However, the United Kingdom offers different deductions for different sizes of businesses, which the United States might want to emulate.
Benefits, incentives, and calculation: China is now the second largest nation (after the United States) in gross R&D spending (OECD, OECD Science, Technology and Industry Scoreboard, 2011, Figure 1.23). The country has had a program for more than 10 years that currently offers a permanent deduction and tax exemption for R&D activity. A 150% superdeduction is given for qualifying R&D expenditures (China Corporate Income Tax Implementation Rules, Article 95). There is also a business tax exemption for expenses associated with the transfer of qualified technology. China also offers a corporate tax rate of 15% (normally 25%) for companies granted high and new technology enterprise (HNTE) status.
Definitions, qualifications, and limitations: Companies granted HNTE status must apply for and renew this status every three years to be eligible for the reduced tax rate. HNTE industries include electronic and information technology, biological and new medical technology, aviation and space technology, new materials technology, new energy and energy conservation technology, high-technology service industries, resource and environmental protection technology, and transformation of traditional industries through high and new technology.
Incentives for HNTEs include:
- The first 5 million yuan in income from qualified technology transfers is exempt from China’s enterprise income tax (EIT).
- Income from technology transfers in excess of 5 million yuan is taxed at a 50% reduced EIT rate.
- New software companies may have a tax holiday; taxable software companies may be granted a business tax exemption on qualified income.
- Qualified newly established HNTEs in special zones are granted a two-year tax holiday.
- HNTE companies are eligible for the 150% superdeduction in addition to the reduced corporate tax rate.
Companies that are not considered HNTEs are still eligible for the superdeduction. Companies can carry forward tax losses attributable to R&D superdeduction claims up to five years.
China defines qualified R&D activities as the development of new technology, new products, and/or new techniques. Qualified costs for such activities include personnel costs for employees directly engaged in R&D activities, direct expenses, supplies, depreciation for equipment and amortization of intangibles used exclusively for R&D activities, design costs, equipment installation costs, and contracted R&D costs (see State Administration of Taxation, Guoshuifa  No. 116 (Circular 116)).
There are several limitations for claiming the superdeduction or rate reduction. For an HNTE to receive the 15% rate, it must conduct less than 40% of its activities outside China, and it must create and retain all intellectual property in China.
Additional comments: China is expected to spend $198.9 billion on R&D this year (Grueber and Studt, “2012 Global R&D Forecast,” R&D Magazine (Dec. 16, 2011)). R&D equipment in China can be expensed immediately or depreciated more rapidly than under U.S. law. Further, it appears that the qualifications for incentives in China are less restrictive than in the United States.
Benefits, incentives, and calculation: In recent years, India has been aggressive with its R&D tax incentive programs, offering a 200% superdeduction for in-house R&D expenditures and a 125% to 200% superdeduction for payments made to certain entities carrying out R&D in India (India Income Tax Act, 1961, §35(2AB)). (The 200% superdeduction for certain industries expired March 31, 2012, but India is already working on legislation to extend this provision to March 31, 2017.) For other expenses that do not qualify for the superdeduction, there is a 100% deduction. In addition there is a 15-year phased income tax holiday for taxpayers exporting research services from special economic zones.
Definitions, qualifications, and limitations: All R&D activities must be carried out within India to qualify. There is no cap for the R&D expenses that a company may claim. Qualifying expenditures for the superdeduction include wages, supplies, utilities, and other expenses directly related to R&D. However, general and administrative costs as well as depreciation and overhead are not qualifying expenditures.
The 200% superdeduction is limited to taxpayers in the business of biotechnology or manufacturing products (and there is a list of excluded products, such as alcohol, tobacco, and cosmetics). Qualified R&D expenses for the superdeduction cannot be deducted under any other provision of the Indian tax code. Standards for what are considered in-house R&D expenditures include:
- The R&D unit should be located in a separate earmarked area;
- The R&D unit should have an exclusive workforce;
- The facility must not be used exclusively for market research, sales promotion, quality control, testing, commercial production, style changes, routine data collection, or similar activities;
- The taxpayer must maintain a separate account for each approved facility that is audited by the secretary of the Indian Department of Scientific and Industrial Research by Oct. 31 of each succeeding year; and
- Assets acquired with respect to development of scientific R&D facilities cannot be disposed of without the approval of the secretary of the Department of Scientific and Industrial Research.
Additional comments: Those taking advantage of the 200% or 125% deduction and holiday can easily navigate and define what expenses meet the R&D standards in India. The limited scope of the 200% superdeduction prevents abuse, but it may also restrict the number of companies that benefit.
Encouraging R&D remains a priority of the United States and governments of other industrialized nations. Many countries have harnessed the relationship between increased R&D spending and rising GDP by offering businesses enhanced tax deductions or credits for their R&D costs. Although Congress may consider the R&D credit too expensive to make it permanent, it should consider evaluating other countries’ programs such as those of Canada, the United Kingdom, China, and India for best practices as it deliberates an extension of the U.S. credit for 2012 and beyond.
Anthony Bakale is with Cohen & Co., Ltd., Baker Tilly International, Cleveland.
For additional information about these items, contact Mr. Bakale at 216-579-1040 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly International.