2013 - Issue 42—As we approach the year-end for most companies, we find that once again, the R&D tax credit is set to expire on December 31. As Congress grapples with the aftermath of the government shutdown, the latest round of federal extenders remains on hold. So once again, taxpayers are facing the expiration of a number of popular tax provisions — an expiration that may adversely affect their business. Although it again faces expiration on December 31, the R&D credit had been renewed by Congress more than a dozen times since its inception in 1981.
The R&D credit is a popular item in Congress, if not within the IRS. Thus, we expect the credit will be at least extended, although enriching the alternative simplified credit (ASC), as some had hoped, may not occur until Congress finally tackles true tax reform.
The R&D Basics — A Quick Review
As we have previously written, the regular credit R&D credit rewards taxpayers that increase their historical domestic spending on research. The specific historical increase that Congress targeted was the ratio of research spending to a company’s domestic revenues. To determine whether there is an increase, Congress picked a reference period that remains constant, namely the five-year period from 1984 through 1988. So, if a company was devoting, say, 2 percent of every domestic dollar of revenue to domestic research during this reference period, any increase in this ratio for the current credit determination year would result in a research credit. If this same company devoted, say, 3 percent to research in 2012, then the credit would be available for the research costs that make up this 1 percent increment. The "before tax" credit rate is 20 percent.
The alternative simplified credit eliminates the historical intricacies of the regular credit in favor of a moving three-year average of domestic spending on research. Taxpayers electing this calculation methodology are entitled to claim a credit for current-year expenses that exceed 50 percent of this three-year moving average. The "before tax" credit rate is 14 percent.
What Is the Credit Expiration Impact on the Tax Provision?
Although the status of the extenders package remains in question, it is still likely to be passed with a retroactive effective date. Unfortunately, the benefit cannot be recorded until the extenders bill is passed and signed into law by the president. This will not affect your 2013 provision, but could be a potential issue for 2014 (as it was for your 2012 provision, given that the extenders package for that year wasn’t signed into law until early 2013). That said, taxpayers should not ignore the R&D tax credit now or in 2014. Neglecting to follow a process of documenting and calculating the R&D credit may result in having insufficient information to claim the credit on your originally filed return. This will have negative implications at both the federal and state level.
For example, taxpayers must account for uncertain tax positions, including the R&D credit, according to the guidance provided in FASB ASC 740 (formerly FASB 109 and FIN 48). This analysis includes a two-pronged determination of whether the R&D credit meets the “more likely than not” threshold and a measurement of the largest amount of tax benefit that is more than 50 percent likely to be realized upon ultimate settlement. Omission or improper calculation of the credit could have a significant impact on required reserve amounts for the applicable tax year.
Once an extenders package is signed into law, tax departments should be prepared to substantiate large credit amounts that need to be recorded in a single quarter. Additionally, filing a refund claim on an amended return related to qualified research expenditures may subject a taxpayer to an audit.
Additionally, because the R&D credit is expiring on December 31, fiscal year taxpayers will be required to adjust their 2013 credit calculation. Taxpayers who have elected the regular credit must adjust their prior four years’ gross receipts based on the number of days in their tax year that fall in 2013. Similarly, taxpayers who have elected the ASC must adjust the prior three years’ QRE amounts based on the number of days in their tax year that fall in 2013. For example, a taxpayer with a March 31, 2014 year-end will have 275 days of its tax year fall in 2013. If this taxpayer has elected the ASC, it should use 275/365 of the prior year’s QREs when calculating its ASC credit amount.
What Effect Does the Expiration of the Federal Credit Have on State R&D Credits?
While federal extenders legislation continues to be a focal point of consideration, taxpayers must also examine how the absence of an extenders package influences R&D tax credits at the state level. Each state has its own set of rules and definitions for calculating the credit. Additionally, the credit’s expiration date at the state level is not the same as at the federal level. Therefore, maintaining the process and documentation, even while the credit is expired at the federal level, may still be just as important.
Furthermore, a number of states have imposed budgetary limits on the total amount of R&D credits available each year. As a result, taxpayers with research activities in these states may not know their true state tax expense until each state has determined its respective annual budgetary credit limitation. Therefore, it is critical that taxpayers make timely submissions of R&D credit claims in certain states to ensure that they get their fair share of a limited credit pool.
Alvarez & Marsal Taxand Says:
While an extenders bill seems to be the furthest thing on Congress’s mind at the moment, the fact that the R&D tax credit has been extended more than a dozen times underscores its importance as a tool to encourage domestic innovation in a highly competitive global economy. Similar to the federal credit, state R&D tax credits incentivize economic development at the state level. Each state follows its own set of rules incorporating a combination of federal and state-specific R&D principles. As states continue to face budgetary challenges, state R&D credit rules, requirements and expiration dates will remain fluid.
Although the R&D credit will probably be extended, it will continue to receive high scrutiny from the IRS. If you currently claim the regular credit, ignoring the fine points of that calculation methodology (e.g., the 1984-1988 fixed-base percentage) could result in claiming less of a credit than what Congress intended and for which you are entitled. The determinations are not necessarily simple. Extensive fact-finding is often required to substantiate the fixed base period. But unless and until Congress enriches the ASC, claiming the regular credit may be your best course.
And in the absence a federal extenders bill, taxpayers should still evaluate state R&D tax rules to maximize their 2014 benefit where possible. R&D tax credits should be filed on initial state returns to avoid miscalculating reserves, encountering additional administrative burdens and overlooking potential benefit because of state limitations. Also, even though we expect the credit to be extended, taxpayers should consider accelerating research activities and development work into 2013 if possible. This will allow you to maximize this year’s credit and minimize the possible financial statement distortion we observed with the 2012 credit that could reoccur if a 2014 credit extension isn’t signed into law until 2015.
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James Eberle, Managing Director, and Kathleen King, Managing Director, contributed to this article.
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