Manufacturing is the largest industry claiming the Research and Development (R&D) tax credit — in fact, in 2013, over 6,000 manufacturers claimed more than $6.8 billion in federal R&D tax credits, with the average credit exceeding $1 million. As the industry continues to invest in the development and improvement of software to manage or automate in-house processes and business intelligence, companies may be able to take advantage of new regulations that broaden the range of software development activities eligible for the credit. These dollar-for-dollar offsets against certain tax liabilities can enable businesses to invest in new technologies, expand their labor force and finance other business objectives.
R&D Tax Credit Explained
The R&D tax credit is an activities-based credit. To qualify for the credit, these activities must:
- Be performed in an attempt to develop or improve the functionality, performance, reliability or quality of a product, process, software, invention, technique or formula (known as a “business component”)
- Attempt to eliminate uncertainty regarding the capability or method of developing or improving the business component or the component’s appropriate design
- Fundamentally rely on the hard sciences, such as engineering, physics or computer sciences
- Be designed to evaluate alternatives to achieve the desired result through modeling, simulation, systematic trial and error or other methods.
Many manufacturers are already performing qualifying activities, including developing software to automate or refine production processes, improving software to manage and monitor machinery and developing e-commerce software. What’s more, there’s no requirement that attempts at development succeed in order to qualify for the credit, so businesses that have failed at developing certain software could still stand to benefit.
Software Development Related Activities
Historically, activities related to software development that were found to be developed by or for the taxpayer primarily for internal use had to meet a higher standard to qualify. Now, per final regulations issued in October, the definition of internal-use software (IUS) has been narrowed and, thus, the scope of software development activities eligible for the credit is broader.
The final regulations define IUS as software developed for use in general and administrative (G&A) back-office functions that facilitate or support the conduct of the company’s trade or business. G&A functions are defined as financial management functions, human resource management functions and support services functions. Whether software is considered IUS depends upon the taxpayer’s intent, as well as the facts and circumstances when development begins.
Development of IUS can still qualify for the R&D tax credit, but it must meet an additional three-part “high threshold of innovation” (HTI) test in addition to the four requirements listed above. The HTI test requires that the software:
- Be innovative, resulting in a reduction in cost, improvement in speed or other measurable, substantial and economically significant improvement
- Involve significant economic risk during development, where the taxpayer commits substantial resources—and there is considerable uncertainty due to technical risk that those resources would be recovered within a reasonable period. The focus should be on the level of uncertainty rather than the type of uncertainty
- Not be commercially available for use by the taxpayer, where the software cannot be purchased, leased or licensed and used for the intended purpose without modifications that would satisfy the first two requirements
Manufacturers and the R&D Tax Credit
These new regulations apply to a vast array of manufacturers’ activities, and businesses should consider whether they’re taking advantage of opportunities to benefit from the R&D tax credit. In efforts to digitalize global operations, supply chains and markets, many manufacturers are increasingly engaged in the development and improvement of business intelligence software systems and enterprise resource management tools. Efforts to enhance manufacturing and operations processes to take advantage of data-driven technology, the Industrial Internet of Things and other technological advancements may qualify for credits.
Additionally, sales and operations planning requires data from all aspects of a business, from production throughput to financial metrics. The development and implementation of software to monitor and manage back-office functions could qualify for the R&D credit under the HTI test. Software systems with the following functionalities should be considered:
- Advanced supply chain functionality
- Forecasting based on historical baselines, promotions and sales
- Pricing optimization, for both sales to consumers and procurement of supplies
- Inventory management
- Order management
- Revenue management
- Routing engineering/software development
- Security against cyberattacks
The final regulations also clarify that software is not IUS — and thus not subject to the HTI Test — if the software is developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer’s system. Manufacturers should take note that software developed to manage supply orders, sales or production data with third parties, or software that enables customers or third parties to track delivery of goods, search inventory or receive services over the Internet, may qualify under the new regulations without having to meet the higher standards.
Manufacturers of all sizes are already investing in software development activities, many of which qualify for the R&D tax credit. The adoption of new technologies, including the Internet of Things, automation, robotics and more, will likely be an iterative process, and R&D tax credits are just one incentive to help fund those efforts. The new regulations regarding IUS could mean manufacturers that attempt to develop or improve software for all aspects of their business can recoup a larger portion of those expenses, thus reducing their taxes, freeing up capital and retaining a competitive advantage.
Chai Hoang is a Manager and Chris Bard is the Practice Leader at BDO’s Research and Development (R&D) Tax Services Practice. Rick Schreiber is an Assurance & Advisory Managing Partner and the National Leader of BDO’s Manufacturing & Distribution practice.