The Research and Development (R&D) tax credit has been extended retroactively for expenses paid or incurred during 2014, creating many new opportunities for manufacturers. The most recent IRS data shows that manufacturing companies claimed nearly $6 billion in federal R&D credits in 2011, accounting for over 64% of the $9.2 billion in total federal R&D credits claimed that year.
R&D Tax Credit Overview
Manufacturing companies attempting to develop new or improved products, processes, or software are eligible for federal and state R&D tax credits. These credits can equal up to 15 percent or more of qualified spending costs, i.e., taxable wages, supply expenses, and a percentage of contract research expenses related to research.
Dollar-for-dollar reductions in tax liability, these credits allow manufacturers of all sizes to reduce their effective tax rate as well as increase their cash flow, earnings per share, and return on investment. Eligible activities include attempting to develop or improve products, manufacturing equipment, prototypes, new materials, environmental impact, automation opportunities, lean manufacturing, and software.
New Regulations Make Software Investments Easier to Claim
On January 16, 2015, the IRS proposed taxpayer-friendly regulations concerning activities related to computer software developed primarily for a company’s internal use. Before the regulations, activities to develop or improve such software had to meet higher standards in order to qualify. Now, the regulations narrow the definition of internal use software (“IUS”), broadening the range of software development expenditures eligible for the credit.
Under the new regulation, IUS refers to software developed to perform back-office functions across almost every business performs, regardless of industry, such as financial management, human-resource management, and support services.
A breakthrough for manufacturers and other companies alike is that software won’t be treated as IUS if it is developed to either:
- be commercially sold, leased, licensed, or otherwise marketed to third parties;
- enable a taxpayer to interact with third parties; or
- allow third parties to initiate functions or review data on the taxpayer’s system.
Thus, if the software is consumer-facing and benefits third parties, it may not be treated as IUS as it would have been previously. Examples include software that allows third parties to track the progress of a delivery of goods, search a company’s inventory for goods, or receive services over the Internet.
As the National Association of Manufacturers recently observed, “manufacturers spend billions of dollars annually on computer expenses in the course of research and experimentation, in undertaking the creation of new software products and in developing software to facilitate innovative manufacturing processes.” The proposed IUS regulations now make it easier for manufacturers to claim higher research credits for these expenses.
Recent Court Decision Supports Expanded View of Qualified Activities
A recently-decided U.S. Tax Court case, Suder v. Commissioner, also provides many taxpayer-friendly points that can assist manufacturers in defending their R&D tax credit claims:
- Qualified Activities: activities tax examiners historically have disallowed as “routing engineering” or “routing software development,” including quality assurance and field testing, were upheld as qualified;
- Executives’ Activities: 75 percent of the manufacturer’s CEO’s time, and 100 percent of other senior management’s time, were upheld as qualified, including time spent attending strategy meetings, brainstorming ideas for new products and ways to improve existing products, following up throughout the product development process, and reviewing and signing off on specifications; and
- Patent-Related Activities: expenses for patent research and prosecution were also permitted.
Suder also helps taxpayers by giving considerable weight to employee oral testimony and representations in finding that qualified research activities were performed – in the past, extensive documentation often was required to prove how much time an employee spent performing qualified research. Although tax examiners will continue to request such documentation, Suder stands for the proposition that employee oral testimony has meaningful probative value as well.
Qualified Supplies Used During Research
Recent Treasury Regulations are also useful for manufacturers who use supplies during their research and development activities. Released last year, these regulations affirm that supply expenses can be creditable whether the supplies are ultimately sold or, under certain conditions, depreciated, provided the intent in using them was to try to discover whether or how a product or process could be developed or improved. Previously, tax examiners disallowed such expenses if the supply was sold or depreciated.
A Simpler Way of Claiming the Credit
More positive news for manufacturers? The chance to elect a simpler method, the Alternative Simplified Credit (ASC) on an amended tax return.
Until recently, taxpayers who didn’t elect the ASC on an original return couldn’t amend their returns to do so. They had to use the Regular Credit, whose calculation requires qualified expenses for many more tax years – sometimes dating back to 1984 – as well as gross receipts from many of these same years. Comparatively, the ASC is simpler to calculate and support on exam: it is calculated without gross receipts and uses only qualified expenses from the prior three tax years. Additionally, because the Regular Credit and ASC are calculated differently, the Regular Credit can sometimes be zero while the ASC may be quite significant.
Because of this new rule generally allowing the ASC to be claimed on amended returns, manufacturers may be able to take advantage of large benefits in prior years that they may have previously missed.
The R&D tax credit has long been, for most manufacturers, one of the best tax-planning opportunities to save and even generate cash and reduce effective tax rates. With the recent developments outlined above, this opportunity has become even greater.
Material discussed is meant to provide general information and should not be acted upon without first obtaining professional advice appropriately tailored to your individual circumstances.