The mechanics of California's R&D tax credit.

• Author: Micheli, Chris
• Position: Research and development

Overview

Among the cache of tax credits offered by the Golden State, its R&D credit is one of the most interesting. California has legislated incremental changes during the past decade to make its R&D credit more attractive to R&D-dependent businesses, including those in the high-tech, biotech, and aerospace industries. This article discusses the nuts and bolts of claiming California's research and development tax credit. California, like federal law, provides three R&D credits: (1) one for qualified research expenditures, (2) another for basic research payments, and (3) the third for expenses under an alternative calculation. All three credits are addressed in this article.

Current California Law

Sections 17052.12 (personal income tax law) and 23609 (bank and corporation tax law) of the California Revenue & Taxation Code provide a franchise and income tax credit for certain increased research and experimentation expenditures. California has generally conformed to section 41 of the Internal Revenue Code as of January 1, 1998, with specific modifications.

Among these modifications are:

* the research must be conducted in California; * the percentage for the qualified research credit is 12, rather than 20; * the percentage for the basic (university- or hospital-based) research credit is 24, rather than 20; * the percentages for the three-tier alternative in cremental credit are 1.32, 1.76, and 2.2, rather than 2.65, 3.2, and 3.75. * the credit may not be combined with other credits (according to the Franchise Tax Board); * the definitions of gross receipts and basic research differ from federal law; * the credits are permanent, rather than being subject to a sunset date as are their federal counterparts; * taxpayers may make separate California and federal three-tier credit elections, rather than being bound by their federal election; * taxpayers may make the three-tier credit election for any year, rather than during a window period as with the federal credit; * research that has a specific commercial objective may qualify as basic research; * there is no one-year carryback period like the federal credit; * credits may be carried forward indefinitely, in contrast to the federal credit's 20-year limitation; and * for corporate taxpayers engaged in specified biopharmaceutical research and biotech R&D, the definition of qualified organization for purposes of the basic research credit includes hospitals run by public universities and certain cancer centers.

Development of California's Credit

California's R&D credit was enacted in 1986. The credit was originally effective for tax years beginning after January 1, 1987, for qualified expenses incurred on or after January 1, 1988 (AB 53, Ch. 1138). If the tax year began in 1987, then a proration of the base period was required. It was originally made contingent upon extensions of the federal credit for a number of years. Then, in 1993, the legislature made the state credit permanent (SB 671, Alquist, Ch. 881).

In 1996, the State's qualified research credit was increased from 8 percent to 11 percent, and the basic research credit was increased from 12 percent to 24 percent (SB 38, Lockyer, Ch. 954). In addition, in 1996 Congress created the alternative incremental credit (AIC) formula, which was designed to nullify some of the anomalous effects of the qualified credit.

In 1997, California conformed to the three-tier credit, but substituted lower percentages (an equivalent of 55 percent) (AB 1042, Wayne, Ch. 613). Owing to a chaptering error, California's three-tier credit percentages were equal to the federal percentages for taxable or income years beginning in 1998 only. In 1998, California increased the three percentages of the alternative incremental credit to an 80-percent equivalent of the federal credit percentages (AB 2798, Machado, Ch. 323). In 1999, the qualified credit was increased from 11 percent to 12 percent (SB 705, Sher, Ch. 77).

Purpose of the Credit

Both the federal and state credits are intended to encourage businesses to perform the technological research necessary to increase the innovative qualities and efficiency of the economy. The federal regulations, to which California conforms, urge taxpayers not to apply the credits too broadly or to treat virtually any expense relating to the development of a product as a qualifying expenditure. Of course, the defining characteristics of qualified research remain unclear.

Recent Changes to Federal Law

In December 1999, Congress extended the federal R&D credit for five years (i.e., for the period July 1, 1999, through June 30, 2004). In addition, credit rate applicable under the AIC was increased one percentage point per tier, from...