R&E Prop. Regs. ease eligibility.

• Author: Grace, Debra M.
• Position: Tax credit for research and experimentation activities

Almost 20 years ago, Congress created a research and experimentation (R&E) credit to induce businesses to increase their research efforts. The Sec. 41 credit was supposed to be temporary, but has been extended again and again.

While a dollar of credit generates a dollar of research spending, many businesses (particularly smaller ones) fail to use it. This may be due to the credit's inherent complexity or the lack of IRS guidance as to "qualified research." Regulations were issued 16 years after the credit's creation, and were extremely restrictive in defining qualified research. Final regulations (1) issued in January 2001 eased the definition somewhat. However, in March 2001, Notice 2001-19 (2) provided that the Sec. 41 regulations would be reviewed and any changes issued as proposed regulations.

Proposed regulations (3) issued in December 2001 represent a substantially pro-business approach to the definition of qualified research, making it easier for businesses to qualify for the credit. (4) Further, the preamble states that the IRS generally will not challenge return positions consistent with the proposed regulations; taxpayers may rely on them until final regulations are issued.

However, businesses seeking to claim the R&E credit must exercise due diligence from the outset of a research project. Any relief the proposed regulations provide depends on a thorough understanding of the critical requirements for qualified research.

This article explains the credit's workings, thoroughly reviews critical and controversial areas of the proposed regulations and provides guidance to businesses seeking to qualify research efforts for the R&E credit.

Who Benefits?

In the U.S., research and development (R&D) expenditures were projected to be $264.2 billion in 2000; they have increased six percent annually since 1994. Industry accounts for 75.4% of total R&D expenses and pays for 88.2% with its own funds.

Manufacturers (5) and firms with over $250 million in assets claim most R&E credits (6); firms with $10 million or less in assets claim about 11% of the credit. (7) The largest expense category is salaries. (8)

Computing the Credit

R&E Credit

Under Sec. 41, businesses can claim an R&E credit for qualified research expenditures (QREs) exceeding a base amount. The base amount is the product of a fixed percentage (now generally supplied by the IRS) and the company's average annual gross receipts (AAGR) measured over the last four years. The credit calculation uses the smaller of (1) excess R&E expenses multiplied by either 20% or 13% (under Sec. 280C(c)) or (2) 50% of current-year R&E expenses (see Exhibit 1 on p. 182).

AIRC

Instead, a business can elect an alternative incremental research credit (AIRC) under Sec. 41(c)(4)(B), which applies three progressive rates to three layers of research expenditures exceeding AAGR. (9) The AIRC adds flexibility to the credit to address changes in business models and spending patterns that are a normal part of a company's life cycle. (10) However, a business cannot change back to the R&E credit from the AIRC without IRS consent (see Example 2).

The R&E credit or the AIRC is claimed using Form 6765, Credit for Increasing Research Activities.

Problems

Temporary Nature

The credit has always been temporary in nature--its continued existence depends on Congress's tax-writing committees. As a result, the credit has expired, then been legislatively extended nine times since first enacted (11) and its focus constrained through limits on qualifying activities and eligible expenses. (12) Under Sec. 41(h), it is currently scheduled to expire on June 30, 2004. Congress is under increasing pressure to make the credit permanent.

The IRS's Restrictive Approach

Over the years, the most frustrating issue for taxpayers has been the lack of Treasury and IRS guidance in defining qualified research for R&E credit purposes. Although the credit was created in 1981, regulations were not issued until 1989, but offered guidance only for pre-1986 credit claims. (13)

Proposed regulations (14) for post-1985 credit claims were issued in 1998, and took a harsh and limiting approach in defining qualifications. Tax professionals criticized those rules, arguing they thwarted Congressional intent; the House Ways and Means Committee echoed these concerns to the IRS. (15) In a 1999 Conference Report, (16) Congress criticized the proposed regulations and instructed the IRS to ease the requirements. Taxpayers thought the proposed rules attempted to reduce the kind of research qualifying for the R&E credit by applying a "discovery test" built on a proposed "common knowledge" standard. (17) In addition, the proposed regulations' definition of the process of experimentation relied on a purely academic "scientific method" approach to conducting research and mandated contemporaneous recording of the results of the scientifically based experiments. (18)

Finally, in Tax and Accounting Software Corp., (19) a district court invalidated portions of the proposed regulations, rejecting the IRS's discovery test and other court opinions relying on it. Importantly, the court stated that the proposed regulations' highly structured definition of research made it virtually impossible for commercial research to qualify for the Sec. 41 credit, contrary to Congressional intent.

The IRS responded by revising the proposed regulations and issuing final regulations in January 2001. While the final regulations lessened somewhat the IRS's harsh approach in...