Ascing for Credit: a Proposal for California to Adopt the Federal Alternative Simplified Credit

• Publication year: 2021
• Author: Saba S. Shatara and Campbell D. McLaren, II

ASCING FOR CREDIT: A PROPOSAL FOR CALIFORNIA TO ADOPT THE FEDERAL ALTERNATIVE SIMPLIFIED CREDIT1, 2

AUTHORS

Saba S. Shatara

Campbell D. McLaren, II

EXECUTIVE SUMMARY

The primary problem this Article seeks to address is the compliance and substantiation burden imposed by California's current Research and Development credit ("R&D Credit") calculation regime—namely, the requirement that taxpayers employ a base amount computation including either historical qualified research expenditure ("QRE") data and/or gross receipts. The federal R&D Credit was designed to incentivize research and the development of new technologies above what companies would otherwise perform.³ As a matter of policy, many states use the R&D Credit to encourage innovation of new technologies, improvement to existing methods, and the advancement of certain industries within the state. However, as a practical matter, it can be somewhat difficult to quantify the "base level" of research and development taxpayers are encouraged to exceed via the R&D Credit.

The "standard" or "regular" R&D Credit calculation method, to which California still conforms with certain modifications,⁴ requires a taxpayer to determine the "base level" of research activity by reference to the ratio of its QREs to gross receipts over a stipulated base period from its history ("Fixed Base Percentage"). The "base level" (or "base amount" as it is more formally known) is calculated as the product of the Fixed Base Percentage multiplied by the taxpayer's average prior four years gross receipts. Calculating the base amount in this manner essentially requires taxpayers to spend a greater portion of their "current" gross receipts on QREs than they did during the historic base period. However, given that the historic base period may begin, for many taxpayers, more than three decades in the past, collecting records and substantiating QREs and gross receipts can be difficult or impossible. Given the difficulties of obtaining these historic records and substantiating levels of QREs, alternative calculation methods have been provided in the federal and

[Page 9]

California tax codes. The federal alternative, which is generally very popular among taxpayers, is the Alternative Simplified Credit (the "ASC").⁵ The ASC made it easier for taxpayers to meet the evidentiary burden and, accordingly, simplified the audit process by relying only on QRE data from a taxpayer's prior three years. Taxpayers who tend to benefit from the ASC method include those with a relatively large base amount under the regular credit; substantial growth in gross receipts relative to QREs in recent years; and/or a complicated history of mergers, reorganizations, acquisitions, and dispositions.⁶

Despite the success of the ASC method, California has not adopted this method for determining the R&D Credit and California taxpayers cannot elect to use this methodology. Rather, California still conforms to the previous rendition of the federal alternative to the standard calculation—Alternative Incremental Research Credit ("AIRC")—a method which was eliminated under federal law. The calculation method for the AIRC can prove difficult for taxpayers, as it relies on less recent information than the ASC. As such, this proposal recommends that the Legislature consider adoption of the ASC to provide taxpayers a significantly simplified R&D Credit calculation methodology and to ease the burden on taxpayers to obtain, store, and substantiate records pertaining to qualified research activities and applicable gross receipts.

Further, given California's temporary Net Operating Loss ("NOL") suspension and cap on the utilization of credits through December 31, 2022,⁷ adopting the ASC may permit California to both increase tax revenue (by limiting NOLs and credits, at it has done), and continue to provide an incentive for companies to conduct research. This proposal has the benefit of harmonizing the seemingly disparate goals of encouraging innovation, while not greatly impacting revenue during the Covid-19 pandemic. Adoption of the ASC would likely be seen as a positive step in California supporting research, while any potential taxpayer benefit (in terms of actual reduction in a taxpayer's total tax liability) will likely be limited until the $5 million cap expires in 2023.

INTRODUCTION

This proposal recommends the California legislature adopt the federal ASC method. For reasons discussed below, and consistent with the federal regime, this change will reduce the burden of substantiating the elements of California's R&D Credit for both taxpayers and auditors, incentivize research and development activities and provide an overall benefit to the state and taxpayers alike.

BACKGROUND OF VARIOUS R&D CREDIT CALCULATION METHODOLOGIES

The R&D Credit is designed to encourage companies to invest and perform research in the state. As with the Internal Revenue Code ("IRC") section 41 federal R&D Credit, California provides a permanent tax credit as an incentive for taxpayers to conduct certain qualified research and development activities and serves to reduce income or franchise tax. California's original R&D Credit was enacted in 1987 as part of two general federal tax conformity bills.⁸ Qualified research must occur in California to generate the California credit.⁹ QREs generally include wages, supplies, and contract research costs. As with the federal credit, the calculation in California is based upon the excess of California QREs over a base amount. The regular credit base amount is the product of the fixed base percentage and the average annual gross receipts for the four preceding tax years. The base amount can never be less than 50 percent of the QREs for the credit year.

A simplified explanation of California's standard method of R&D Credit calculation, to which California conforms, can be found below:

15% of current year QREs less the "Base Amount"


PLUS


24% of the basic research expenses paid to a qualified organization

[Page 10]

PLUS


20% of the amounts paid in carrying on any trade or business to an energy research consortium for qualified energy research.

These rates have been subject to change over the years through various amendments.¹⁰ The California R&D Credit rate has not changed substantially since the rate was increased from 12% to 15% in 2000.¹¹ The base amount of QREs is the "fixed base percentage" multiplied by the taxpayer's average gross receipts for the past four years. Notably, California does not conform to the federal definition of gross receipts for purpose of the R&D Credit; rather, California accounts for gross receipts from the sale of property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business delivered to a purchaser within this state (rather than taxpayer's aggregate gross receipts reduced only by returns and allowances).¹² Generally, California's gross receipts calculation results in a much lower base amount for many taxpayers than its federal counterpart, particularly for taxpayers that do not sell tangible goods or that sell mostly out of state. Further, the fixed base percentage is derived by the following calculation:

Aggregate QREs from 1984-1988

Aggregate Gross Receipts from 1984-1988

If the taxpayer does not have QREs in three or more years in the 1984 to 1988 period, the fixed base percentage is determined based on a complex schedule provided by the Internal Revenue Service.¹³ As will be discussed in greater detail below, this fixed based percentage can pose a challenge for taxpayers and taxing agencies due to issues related to the passage of time—employees responsible for maintaining the information may come and go, when companies are acquired their records can be misplaced—and substantiating this information to the satisfaction of the FTB during an audit, where the taxpayer has the burden of proof, can prove difficult.

In 1996, the United States adopted the AIRC method, as part of an effort to help companies with significant research and development expenditures that did not qualify for the credit due to economic circumstances during the base period.¹⁴ The amount of usable credits generated by the AIRC is typically less than the regular R&D Credit.¹⁵ California similarly adopted the AIRC in 1997,¹⁶ and implemented subsequent amendments to reflect the changes to the California research credit percentage.¹⁷ Notably, the AIRC election is made for a particular year on a return filed with the California Franchise Tax Board ("FTB") and can only be revoked with consent from the FTB.¹⁸ The California AIRC calculation methodology is outlined below:

• 1.49% of Current Year QREs if:
• Current Year QREs are greater than a base amount using a 1% fixed based percentage AND
• Current Year QREs are less than a base amount using a 1.5% fixed based percentage.
• 1.98% of Current Year QREs if:
• Current Year QREs are greater than a base amount using a 1.5% fixed based percentage AND
• Current Year QREs are less than a base amount using a 2% fixed based percentage.
• 2.48% of Current Year QREs if:
• Current Year QREs are greater than a base amount using a 2% fixed based percentage

The Emergency Economic Stabilization Act of 2008 (P.L. 110-343) repealed the AIRC for federal purposes for the 2009 tax year, and Congress has not reinstated it.¹⁹ California has continued to use the AIRC method, even though that method is no longer available for federal purposes.

Prior to the federal elimination of the AIRC, the U.S. enacted the ASC method in 2006.²⁰ The ASC eased

[Page 11]

the burden created by the fixed base percentage reliance on historical information and sought to address concerns about using a moving average base. California has not yet conformed to the ASC method.

One of the basic benefits to the ASC is that it relies on QRE information from the current year and the immediately preceding three years, which is information that generally should be readily available. Under the ASC, the R&D Credit is calculated as...