Due to the negative effect of COVID-19 on the state’s budget, on June 29th, 2020, California Governor Gavin Newsom signed into law a revenue enhancement measure and revised budget plan.  The new law suspends the ability to offset California taxable income with Net Operating Losses (“NOLs”) for three years (2020 – 2022) and limits the maximum tax credit that can be used in a year to $5 million for the next three years.

Because California taxpayers will be unable to utilize NOLs to offset taxable income through 2022, the California Research & Development tax credit immediately becomes very valuable.  Your company may also need to account for this in your financial statement tax provision.  The NOL suspension corresponds with California Franchise Tax Board (“FTB”) audits of research credits becoming routine.  

Recently, California’s Administrative Tax Appeal Panel upheld the FTB’s denial of a clothing company’s $2.4 million of R&D tax credits (In re Swat-Fame, Inc., 2020-0TA-046P; 2020-OTA-045P, 6/1/20).  The three-judge panel ruled that Swat-Fame did not engage in a process of experimentation for a qualified purpose.  The panel stated that many of the Swat-Fame’s activities appeared to be simple trial and error as opposed to engaging in a scientific method of research.  This decision establishes an important precedent for the California R&D tax credit.  It emphasizes that your California R&D credit must be properly documented AND the “process of experimentation” must be specifically identified and systematically conducted.  

If your company plans on claiming the California R&D tax credit during the next three years, you should ensure that your qualitative and quantitative documentation is sufficient to sustain the credit during an FTB audit.  Simply using quantitative estimates without identifying and documenting a systematic process of experimentation could cause some taxpayers to involuntarily help California satisfy its budget shortfall via an FTB credit disallowance determination. 

Contact an A&M Taxand R&D specialist to learn more about these developments.  It’s more important than ever to ensure you are meeting the criteria.