The Credit for Increasing Research Activities, also known as the Research and Development (R&D) tax credit or the Research and Experimentation (R&E) tax credit, is a rewarding program of which US subsidiaries may be able to take advantage to reduce their Federal and State income tax liabilities.
About the United States Research Tax Credit
Historically, the R&E tax credit has been claimed by large manufacturing companies, research facilities, software development companies, biotechnology companies, and companies in the pharmaceutical industry. However, changes to the governing Treasury Regulations have allowed additional industries such as custom manufacturers, engineering firms, and design-build contractors to take advantage of this growing US tax incentive.
While many countries reward research and development in many different ways, the US has adopted a broad definition of the type of activities that may qualify for the credit.
The US R&E tax credit is a wage-based tax credit that rewards companies for investing in qualified research activities. In addition to qualified wages, companies may capture supply costs for prototypes or models, as well as 65% of contracted labor performing research during the development process. Companies may benefit by both deducting the research expenditures and claiming the tax credit.
While the research expenditures are a reduction of taxable income, the credit is a dollar-for-dollar reduction of income tax. Companies claiming the credit must first use the credit to offset tax for the year in which the credit is generated. However, if additional credit remains, the company may carry the research tax credit back one previous tax year and forward the next 20 tax years. However, the recently enacted Small Business Jobs Act of 2010 allows research credits earned in 2010 by eligible small businesses to be carried back up to five previous tax years and forward the next 20 tax years.
There are four basic requirements for an activity to qualify for a research tax credit:
- Qualified research activities are defined as the development or improvement to a business component, which is defined as a product, process, technique, formula, invention, or software
- The research must be technological in nature. That is, the process of experimentation used to discover the information fundamentally relies upon the physical or biological sciences, engineering, or computer science. Furthermore, companies may use existing technologies and may rely upon existing principles to satisfy this requirement
- The research must be intended to eliminate uncertainty concerning the development or improvement of a business component. Uncertainty exists if the capability of method for developing the business component is unknown or if the appropriate design of the business component is unknown
- Elimination of the technical uncertainty must be accomplished through a process of experimentation, including systematic trial and error, modeling, or simulation
Examples of qualifying activities may include:
- Designing New Products
- Developing new, improved, or more reliable products, processes, or formulas
- Developing prototypes
- Designing tools, jigs, molds, or dies
- Developing patentable products or processes
- Performing certification testing
- Conducting testing of new concepts and technology
- Developing or improving production or manufacturing processes
- Improving manufacturing facilities
- Expending resources on outside consultants or contractors to do any of the above-stated activities
The R&E tax credit is an excellent instrument to reduce US Federal and State income tax liabilities, and, thereby, retain cash in an otherwise tight economy. As companies budget for expenditures allocated to research, taxpayers and their advisors should take into account the ability to subsidize research efforts with the US R&E tax credit.
The R&D tax credit has never been a permanent provision of the federal tax code, it has been extended 14 times since its original enactment, currently, the credit has expired as of December 31, 2011. However, there is still an opportunity to amend open tax periods to take advantage of these credits while we wait to see if the credit will be extended again.