2003 R&E tax credit regulations: opportunities and pitfalls.

• Author: Andreoli, Brian E.
• Position: Research and experimentation

During 2003, the U.S. Department of the Treasury and Internal Revenue Service issued proposed and final regulations affecting the manner in which taxpayers will calculate and document their research and experimentation (R&E) tax credit claims. These regulations create opportunities and pitfalls for taxpayers. Following a general explanation of section 41 of the Internal Revenue Code, (1) this article addresses the major changes made or proposed by the regulations, together with a description of the opportunities and pitfalls.

On July 28, 2003, new proposed regulations (the "2003 Proposed Regulations") were released addressing the allocation method to be utilized by members of a controlled group (2) in determining each member's R&E tax credit. (3) The proposed regulations primarily address Treas. Reg. [section] 1.41-6 and replace proposed regulations that were released in 2000. (4)

On December 23, 2003, the IRS released final regulations ("T.D. 9104" or the "2003 Final Regulations") (5) on the definition of qualified research under section 41(d). At that same time, the Treasury and IRS published an advance notice of proposed rulemaking (6) seeking comments on the definition of internal-use software under section 41(d)(4)(E). T.D. 9104 did not contain final rules relating to such software.

General Explanation of Section 41

Section 41 of the Code provides a non-refundable tax credit for incremental research expenses paid or incurred in a trade or business. The research credit is the sum of (1) 20 percent of the amount by which the taxpayer's qualified research expenses ("QREs") for the current year exceed the base amount (7) for that year, and (2) 20 percent of university basic research payments. (8) The base amount is computed under section 41(c) by multiplying the taxpayer's fixed-base percentage by the taxpayer's average annual gross receipts for the four proceeding tax years, provided that in no event shall the base amount be less than 50 percent of the QREs for the research credit tax year. (9) A taxpayer's fixed-based percentage is the percentage that the aggregate QREs for the taxable years beginning after December 31, 1983, and before January 1, 1989, is of the aggregate annual gross receipts for such taxable years. (10) A start-up company, (12) however, is assigned an initial fixed-based percentage of 3 percent for its first five taxable years (with adjustments thereafter). The fixed-base percentage is subject to a maximum ratio of 16 percent. (11) Once a taxpayer determines its total QREs and its base amount, it multiples the incremental QREs times 20 percent to determine its credit. Section 280(C)(c) reduces the actual benefit the taxpayer receives by requiring the taxpayer to reduce its expenses by the amount of the credit or by electing a reduced credit of 13 percent (as opposed to 20 percent). Assuming a 35-percent tax rate, the net effect of the calculations in section 280(C) provides a taxpayer with a reduced benefit that should not exceed 6 1/2 percent of the QREs incurred during the tax year. (See Exhibit 1.)

Avoid the Pitfall ... and Seek Out the Possible Opportunity. Taxpayers should determine whether the alternative incremental research credit (AIRC) provided for in section 41(c)(4) will provide a larger benefit than the general method. Often, the AIRC provides a greater benefit, especially in situations where the taxpayer has a high fixed base amount, decreasing research spending, or where sales growth significantly outpaces research spending. The election to use the AIRC method, however, applies to succeeding years and may not be revoked without the consent of the IRS. (13) New Regulations on Allocation Method for Controlled Groups

Section 41(f) addresses special calculation and allocation issues when taxpayers are members of a controlled group of corporations or part of trades or businesses under common control. Section 41(f)(1) provides that, in determining the amount of R&E tax credit, "(i) all members of the same controlled group of corporations shall be treated as a single taxpayer, and (ii) the credit (if any) allowable by this section to each such member shall be its proportionate shares of the qualified research expenses and basic research payments giving rise to the credit." (14) A similar rule is provided for a group of trades or businesses under common control. (15) Depending upon the ownership percentages and the types of entities involved, a controlled group may include entities that are not members of the same consolidated tax return group and there may be multiple consolidated tax return groups.

The 2003 Proposed Regulations follow the computational rules in the 2000 Proposed Regulations in that the rules are applied on an aggregate basis to determine the group credit. In other words, the group credit is computed by first combining all the controlled group members' QREs and base amount information and applying the computational rules on an aggregate basis as if a single taxpayer. (16) The 2003 regulations, however, differ from their 2000 counterpart in the manner in which the group credit is allocated. Under the 2000 Proposed Regulations, in allocating the group credit, an individual member's base amount was determined by applying the controlled group's fixed base percentage to the member's average annual gross receipts for the four taxable years preceding the credit year. The group credit was allocated to those members having an excess amount of QREs on the basis of the ratio that its increase in QREs over its base amount bore to the aggregate increases in QREs over the base amount of all members of the controlled group. (17)

In contrast, the 2003 Proposed Regulations allocate the group credit by first computing each member's stand-alone entity credit and then multiplying the group credit by the ratio that the member's stand-alone entity credit bears to the sum of the stand-alone entity credits of all the member's of the group. (18) (See Exhibit 2.) The stand-alone entity credit is defined as the R&E tax credit (if any) that would be allowable to a member of a group if the credit were computed without regard to section 41(f) (i.e., calculating and using the base amount for the member based on its sole base period and average annual gross receipts), using the computation method used to compute the group credit. Therefore, a member generating QREs but that is not entitled to claim the credit on a stand-alone entity basis will not have any of the group credit allocated to it. Conversely, the group credit is only allocated to those members that would have been able to claim the credit on a stand-alone entity basis. While the 2003 Proposed Regulations set forth examples that neatly allocate the R&E tax credit on a basis similar to the amount of QREs incurred by each entity, such a pretty result will not always occur (such as in the situation...