2014 - Issue 39—As we approach the year-end for most companies, taxpayers are once again faced with how to handle a number of tax provisions that expired on December 31, 2013. The research tax credit is one of the more popular extenders. Given its broad support in Congress, it is widely expected that the research tax credit and other extenders will be retroactively extended at the end of 2014, or shortly thereafter. The research tax credit has been retroactively reinstated the last 10 times it expired, so many businesses have continued to collect and maintain the documentation required to sustain their research credit for 2014.
The focus of this edition of Tax Advisor Weekly is a review of the major 2014 research tax credit developments as well as a primer for taxpayers on dealing with tax incentives during the expiration period.
The Research Tax Credit — Recent Developments
Consistency Rule clarified by Fifth Circuit: Section 41 and the regulations (Internal Revenue Code Section 41(c)(6)(A) and Treasury Regulation Section 1.41-3(d)(1)) provide that qualified research expenses (QREs) taken into account in computing the fixed-base percentage must be determined on a basis consistent with the determination of QREs for the credit year. This rule should eliminate over- or understated credits by ensuring that taxpayers compare consistently calculated QREs in the base-period years and the credit year.
In Trinity Industries, Inc. v. United States, No. 12-11015 (July 2, 2014), the Fifth Circuit Court of Appeals held that base-period expenses similar to projects for which the taxpayer was determined not to have incurred QREs should be excluded from the credit calculation. InTrinity, the district court disallowed expenses for four claimed projects during the credit years, but did not adjust the base period QREs by excluding expenses for similar base-period projects. Thus, Trinity appealed to the Fifth Circuit for a determination of whether the consistency rule required that base-period QREs similar to the four projects for which credit-year QREs were disallowed should be excluded from its research tax credit calculation. The Fifth Circuit agreed that QREs for similar projects should be excluded and remanded the case to the district court for a determination of whether any base-period QREs were similar to the excluded credit-year QREs and, thus, should be excluded from the credit calculation.
Regulations now permit election of simplified credit on amended returns: On June 2, 2014, the IRS issued temporary regulations permitting taxpayers to elect the alternative simplified credit on an amended return, as long as the taxpayer (or a member of its controlled group) did not make an election to use any other method of calculating the research credit on an original or amended return for that year (T.D. 9666). Final regulations issued in 2011 (T.D. 9528) did not permit making this election on an amended return. However, given comments received by the IRS that “the burden of substantiating expenditures and costs for the base period under the regular credit can be costly, time-consuming, and difficult,” the IRS amended the earlier regulations (Temporary Treasury Regs. Section 1.41-9T(b)(2)). This will provide taxpayers with additional time to determine whether they should use the regular method or alternative simplified method to calculate their research tax credit. The new regulations apply for tax years that end on or after June 3, 2014. Additionally, taxpayers may make the election permitted by the new regulations for any prior tax years for which the statute of limitations has not expired.
It should be noted that once a taxpayer makes an election to use a method to calculate the research credit on an original return, it cannot later be changed. Also, taxpayers must continue to make the 280C(c) election on an original return if they choose to apply it.
Geosyntec appeal could further limit definition of funded research: As we discussed in Tax Advisor Weekly Issue 14 this year, R&D Tax Credit and Fixed-Price Contracts — When Risk Is Worth It (April 8, 2014), the court for the Southern District of Florida held that activities conducted pursuant to fixed-price contracts were not funded research (and therefore were eligible for the research tax credit), but that activities pursuant to capped cost-plus (CCP) contracts were funded research (and ineligible for the credit). Geosyntec is now appealing that decision to the Eleventh Circuit Court of Appeals, arguing that the terms of some of its CCPs include similar default provisions as their fixed-price contracts. These terms give Geosyntec’s customers the right to withhold payment if they find that Geosyntec has not delivered what was promised under the terms of the contract. Geosyntec argues that these terms place the risk of non-performance squarely on its shoulders, not on its customers, meaning these contracts are not funded and eligible for the credit. If the Eleventh Circuit agrees with Geosyntec, this would be a major win for taxpayers and again place the focus on what constitutes funded research on the economic risk created by the contract terms, not on contract labels or anticipated contract results.
Suder decision disallows “unreasonable” compensation: In a case of first impression, the Tax Court in Suder v. Commissioner, T.C. Memo 2014-210 (October 1, 2014) denied a portion of the taxpayer’s research credits because it found that most of the claimed wage expenses were not reasonable expenditures under Section 174(e).
For the years at issue, the taxpayer’s CEO (Eric Suder) was very involved in product development, which included 76 projects for which the credit was claimed. Most of the claimed wage QREs were Mr. Suder’s wages, which averaged approximately $9 million per year. The IRS denied all research credits claimed for the years in question. At trial, the Tax Court first determined that 11 of 12 sample projects did meet the four-part test of Section 41. The Tax Court also ruled that the taxpayer had adequately substantiated project expenses, including the fact that Mr. Suder spent 75 percent of his working time involved in qualified research and development activities.
However, the Tax Court held that Mr. Suder’s wages were not reasonable expenses. Section 174(e) allows a taxpayer to deduct research and development expenses only to the extent that “the amount thereof is reasonable under the circumstances.” After hearing both parties’ expert witnesses testify, the Tax Court relied on the government’s expert, who identified what he expected CEOs of similarly situated businesses (based on annual revenues and SIC code) would reasonably be expected to earn. Based on his testimony, the Tax Court found Mr. Suder’s wages to be unreasonable and ruled that approximately $2.5 million per year was a reasonable amount of compensation for Mr. Suder. The Tax Court held that 75 percent of this reasonable compensation was the amount of Mr. Suder’s wage QREs that could be claimed for the credit. It should be noted that the Tax Court did allow testimonial evidence from a number of witnesses that helped the taxpayer establish estimated percentages of time that its employees spent working on qualified activities.
Internal-use software final regulations on the horizon: IRS guidance on internal-use software (IUS) "is well down [the] path" and should be published by the end of the year, Alexa Claybon, attorney-adviser, Treasury Office of Tax Legislative Counsel, said September 19, at the Tax Accounting session of the American Bar Association Section of Taxation meeting. Ms. Claybon also said she doesn't expect a long waiting period before regulations are also released on the allocation of the research credit to corporations and trades or businesses under common control. You may recall that in March 2013, the IRS released interim guidance in Notice 2013-20, 2013-15 IRB 902 (Doc 2013-5577), which states that controlled groups must allocate the group credit to each member of the controlled group in proportion to each member's contribution of qualified research expenses to the controlled group's total qualified research expenses for the tax year.
As we discussed in Tax Advisor Weekly Issue 30 this year, Internal-Use Software Finally Gets Some Love (July 30, 2014), the IUS regulations have been in proposed form since 2001. This has caused a high level of uncertainty and numerous taxpayer-IRS conflicts when determining what IUS activities and expenses qualify for the credit. Hopefully, the final IUS regulations will be issued in 2015, allowing for more certainty in this area.
What Is the Credit Expiration Impact on the Tax Provision?
A number of proposals to extend the research tax credit have been introduced or discussed in Congress during 2014. These proposals have ranged from a simple two-year extension of the existing credit regimes to the enactment of a permanent, enhanced simplified credit and the elimination of the regular credit. It appears that none of these will be made law until after the mid-term elections in November at the earliest. Some commentators predict that any action during the lame duck session of Congress will not be finalized until early in 2015.
Although the status of a research tax credit extension remains uncertain at this date, we think it is highly likely that one will be passed with a retroactive effective date. Unfortunately, the financial statement benefit cannot be recorded until the extension bill is both passed and signed into law by the president. This will affect your 2014 tax provision if the renewed credit is not made law until early in 2015 (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 research tax credit now. Neglecting to follow a process of documenting and calculating the research 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 research 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 research 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 the research tax credit extension is signed into law, tax departments should be prepared to substantiate large credit amounts that need to be recorded in a single quarter. It should also be noted that filing a refund claim on an amended return related to qualified research expenditures may subject a taxpayer to an audit.
What Effect Does the Expiration of the Federal Credit Have on State Research 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 research 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 research 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 research credit claims in certain states to ensure that they get their fair share of a limited credit pool.
Alvarez & Marsal Taxand Says:
Many recent research tax credit developments have been taxpayer-favorable — clarification of the consistency rule, the ability to elect the alternative simplified credit on amended returns, and the possible limiting of what constitutes funded research are all wins for taxpayers who claim the research tax credit. Of course, taxpayers need an extension of the credit for these wins to have continuing value. While an extenders bill still seems to be months away, the fact that the research tax credit has been extended more than a dozen times underscores its importance as a tool to encourage domestic innovation and job creation in a highly competitive global economy. Similar to the federal credit, state research 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 research tax credit principles. As states continue to face budgetary challenges, state research tax credit rules, requirements and expiration dates will remain fluid.
After the research tax credit is extended, it will continue to receive close 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 research tax credit rules to maximize their 2014 benefit where possible. Research 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.
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Kathleen King, Managing Director, contributed to this article.
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