The IRS Large Business & International Division (LB&I) released a directive to its examiners (LB&I-04-0917-005) that effectively provides large taxpayers with a new safe-harbor method for calculating certain qualifying research expenditures (QREs). In summary, the directive allows taxpayers to use research and development (R&D) costs reported on financial statements under FASB Accounting Standards Codification (ASC) Topic 730, Research and Development, as the starting point for computing QREs. This method could eliminate duplicate efforts and reduce the work required to document and substantiate qualified research costs.
The guidance outlines a method for taxpayers to start with the R&D costs as calculated on their certified audited financial statements under Topic 730, make certain adjustments, and end with QREs for claiming the R&D credit under Sec. 41.
The directive is a result of the efforts of the Silicon Valley Tax Directors Group working with the IRS through the Industry Issue Resolution Program. The directive acknowledges that certain activities and costs clearly qualify for the R&D credit, and efforts to substantiate clearly qualified activities and costs should be simplified when possible. This directive is akin to the Pharmaceutical Industry Research Credit Audit Guidelines issued in the past. It is not authoritative, and taxpayers cannot use, cite, or rely upon it as an official pronouncement, but LB&I examiners are instructed not to challenge QREs computed in accordance with this guidance. In addition, the directive applies only to LB&I taxpayers, i.e., those with assets equal to or greater than $10 million. The directive requires that taxpayers following the directive present Topic 730 R&D expenses in their certified audited financial statements as a separate line item on their income statement or a separately stated note.
Applying the directive
While the directive is a positive step forward and will be beneficial for some taxpayers, the safe harbor is limited to certain specific costs:
- Qualified individual contributors: 95% of the taxable wages of qualified individual contributors whose wages are charged to Topic 730 cost centers;
- First-level supervisor managers: 95% of the taxable wages of first-level supervisor managers whose wages are charged to Topic 730 cost centers; and
- Upper-level managers: Up to 10% of the amount computed above for qualified individual contributors and first-level supervisor managers is eligible as a safe harbor for upper-level managers.
Several types of costs will not fall within the safe harbor. The directive allows for these costs to be included in the computation as "additional costs," and they are subject to traditional exam procedures. These types of costs may include:
- Research conducted for others under contract;
- Prototype overhead costs;
- Costs to improve existing products, production processes, and manufacturing processes;
- Full-scale pilot model costs; and
- Development of internal-use software.
FIN 48 impact
A common consideration raised by this directive is the impact of FASB Interpretation No. (FIN) 48, Accounting for Uncertainty in Income Taxes, under ASC Topic 740, Income Taxes, which comprises two components: recognition and measurement.
Taxpayers following U.S. GAAP will recognize a tax position if the position meets the "more likely than not" (or over 50%) level of authority. A determination of more likely than not relies solely on the technical merits of the position, which are determined based on sources of authority (legislation, regulations, case law, etc.). Since the directive is not authoritative, taxpayers should not use it as a factor in the recognition analysis.
Once a tax position is recognized, the next step in the FIN 48 analysis is the measurement component, which determines how much of the position should be recognized on the financial statements. The amount recognized is the amount determined to be greater than 50% likely to be realized upon settlement with a taxing authority. The taxpayer makes this determination by weighing several factors, including expectations regarding the taxing authority's willingness to settle the issue. The directive may be one of several relevant data points for some taxpayers when making this determination.
The directive applies to original returns filed on or after Sept. 11, 2017. Taxpayers currently claiming R&D credits should evaluate the approach outlined in this directive against their existing methodology before filing their next return. Taxpayers who may benefit but do not currently disclose Topic 730 R&D costs in their financial statements may wish to consider doing so in the future to implement this simplified approach.
The IRS issued this guidance with large technology companies in mind, and it may have minimal impact on taxpayers in other industries. However, each taxpayer should compare the guidance of the directive to its particular fact pattern.
Note that the approach described in this guidance is not as simple as using book R&D costs to compute a credit. Applying the directive may require taxpayers to modify accounting systems to generate necessary data. Taxpayers may also need to modify organizational structures to align qualified activities with Topic 730 accounts. The additional costs will require additional analysis and substantiation documentation.
This directive provides a welcome safe harbor for some taxpayers. However, for others, it may have little or no applicability.
Greg Fairbanks is a tax managing director with Grant Thornton LLP in Washington.
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.