Practical documentation of QRAs for the R&D tax credit.

• Author: Jones, Cherie L.
• Position: Qualified research activities, research & development tax credit

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The federal research tax credit--also known as the research credit or R&D tax credit--was made permanent by the Protecting Americans From Tax Hikes Act of 2015 (PATH Act) in December 2015. (1) Despite its prolonged status as a temporary provision, being enacted and extended, often retroactively over the past 35 years, (2) the mechanics of the tax credit largely remained the same, which facilitated a smooth transition to permanent status. The PATH Act makes the Sec. 41 research tax credit a permanent provision of the Internal Revenue Code, retroactive to Jan. 1, 2015 (it had expired), and retains a regular credit and alternative simplified credit (ASC) option. (3)

The research tax credit rewards taxpayers for engaging in qualified research activities (QRAs) by providing a tax credit equal to a percentage of certain eligible expenses.

QRAs are defined by a four-part test. The test requires that:

* The activities involve the elimination of uncertainty concerning the development or improvement of a product, so that the expenses of the activities would be deductible under Sec. 174 (Sec. 174 test); (4)

* The activities are useful in the development of a new or improved business component (business component test); (5)

* The activities discover information that is technological in nature (discovery test); (6) and

* Substantially, the activities are experimental in nature and conducted for a permitted purpose (process-of-experimentation test). (7)

Each activity must pass all four tests to be considered a QRA. Additionally, these tests must be applied separately to each of the taxpayer's business components.

Qualified research expenses (QREs) are expenditures that have a nexus to a QRA and are eligible to be included in the research tax credit computation. QREs can include wages paid to employees or amounts paid to self-employed individuals and owner-employees (wage QREs), (8) supplies used (supply QREs), (9) amounts paid to another person for the right to use computers (computer rental QREs), (10) and amounts paid to third parties to perform research (contract QREs). (11) Wage QREs can include amounts for engaging in qualified research, direct supervision, or support of QRAs. (12)

Accordingly, after identifying eligible QRAs, most taxpayers will compute wage QREs. Supply QREs, computer rental QREs, and contract QREs associated with these projects are then identified and added to the taxpayer's research tax credit computation. (13)

There is a noticeable absence of guidance from Congress, Treasury, and the IRS as to what documentation is sufficient to substantiate research tax credits. The current regulations simply state that a taxpayer claiming research tax credits must retain records in a sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit. (14) They also refer to the general record retention requirements found in Regs. Sec. 1.6001-1. (15)

While traditional accounting and financial systems may capture QRE amounts, they typically do not capture the information needed to substantiate that the QRA four-part test and other rules have been satisfied. In the absence of records specifically created to document the research tax credit, taxpayers often have to rely on estimates and an assortment of documents, interviews, and other evidence to substantiate their expenditures that qualify for the research tax credits. This has resulted in controversy between taxpayers and the IRS as to what documentation is sufficient to substantiate expenditures.

Overview of the QRA Rules

To appreciate the difficulty in documenting and ultimately successfully substantiating research tax credits, one must consider the type of information that the taxpayer must capture. This information is outlined in the four-part test and other limiting rules that define what qualifies as a QRA for the research tax credit.

Sec. 174 Test

The Sec. 174 test is sometimes referred to as the elimination of uncertainty requirement and provides a tax deduction for expenses that are incurred or paid while a business is attempting to solve an uncertainty related to a development or improvement of a product.

This test looks to the nature of the activity. (16) To meet the Sec. 174 test, the research and experimental expenditure must:

* Be incurred in connection with the taxpayer's trade or business; and

* Represent a research-and development cost in the experimental or laboratory sense. (17)

In practice, Sec. 174 allows a deduction for development expenses that have a direct nexus to activities that involve eliminating uncertainty through a methodology that could be replicated in a laboratory or testing environment. (18) Although the activities are not required to be conducted in a laboratory, the taxpayer must document the methods used to discover the new information and eliminate the uncertainty. This test is also met if the information that eliminates the uncertainty has already been discovered but is not available to the taxpayer, i.e., was not in the public domain and reasonably accessible at the time the activity was conducted. (19)

It is important to note that this test is not applied to the final research outcome but instead focuses on the methods used in the development process itself. (20) Consequently, this test can be satisfied where the underlying product or improvement is not itself technologically advanced.

Business Component Test

The business component test requires that the activities be useful in the development of a new or improved business component. (21) The term "business component" means any product, process, computer software, technique, formula, or invention that is to be held for sale, lease, or license or used by the taxpayer in a trade or business. (22) A production process or manufacturing technique may also be an example of a business component. (23)

Discovery Test

The discovery test is sometimes referred to as the technological in nature requirement and differs from the Sec. 174 test, as it focuses on the technical nature of the activity rather than the methodologies used. It requires that the purpose of the activity be to discover information that is technological in nature. (24) Information is technological if the process of experimentation used to discover the information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science. (25)

This test requires that the activity be undertaken to discover technological information to be used in developing a business component. (26) Research is undertaken for the purpose of discovering information if it is intended to eliminate uncertainty about the development or improvement of the business component. (27) It is generally agreed that technological uncertainty exists in situations where the information available in the public domain does not establish the capability or method for developing or improving the business component. (28)

Importantly, this test does not require the taxpayer to seek or obtain information that exceeds, expands, or refines the common knowledge of skilled professionals in the particular field of science or engineering in which the taxpayer is performing the research. (29) It also does not require the activity to be successful. (30)

Process-of-Experimentation Test

The process-of-experimentation test expands on the Sec. 174 test as it applies to the entire research process, not just the elimination of uncertainty. However, unlike the Sec. 174 test, the process-of-experimentation test includes thepermittedpurpose requirement, meaning that the experiment must relate to a new or improved function, performance, reliability, or quality of the business component. (31)

The activity is not treated as conducted for a permitted purpose if it relates to style, taste, cosmetic, or seasonal design factors. (32)

Generally, to meet the requirements of this test, the taxpayer should (through its activities) establish a systematic progression of work that is based on the principles of established science and proceeds from hypothesis, observation, and evaluation and leads to logical conclusions. (33) More specifically, the process must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science and involve:

* Identifying uncertainty concerning the development or improvement of a business component;

* Identifying one or more alternatives intended to eliminate that uncertainty; and

* Identifying and conducting a process of evaluating the alternatives (e.g., through modeling, simulation, or a systematic trial-and-error methodology). (34)

The taxpayer does not need to actually consider more than one alternative (or solution to a problem). However, the process must be evaluative, in that it generally should be capable of evaluating more than one solution or alternative. (35)

A taxpayer may undertake a process of experimentation even if there is no uncertainty concerning the taxpayer's capability or method of achieving the desired result, so long as the method of achieving that result and the appropriate design of that result are uncertain at the outset of the activity. (36)

The process of experimentation is evaluated on an activity-by-activity basis and generally is met if substantially all, i.e., at least 80% (measured by cost or other reasonably consistent basis), of the activities relate to a new or improved function, performance, reliability, or quality. (37)

Other Limiting Rules

The four-part test is supplemented by various rules that disqualify certain activities that would otherwise be qualified. These rules exclude research (1) that begins after commercial production (38) (2) to adapt existing business components, (39) (3) duplicating existing business components (40) (4) involving surveys, studies, including activities related...