The mechanics of California’s R&D tax credit – research and development
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 1.65 percent to 2.65 percent in tier one; from 2.2 percent to 3.2 percent in tier two; and from 2.75 percent to 3.75 percent in tier three.
The federal act also expanded the definition of qualified research to include research undertaken in Puerto Rico and possessions of the United States. Under the clarification, however, any employee compensation or other expense claimed for computation of the research credit may not also be claimed for the purpose of any credit allowable under section 30A (Puerto Rico economic activity credit) or under section 936 (Puerto Rico and possessions tax credits).
Finally, research tax credits that are attributable to the period beginning on July 1, 1999, and ending on September 30, 2000, may not be taken into account in determining any amount required to be paid for any purpose under the Internal Revenue Code prior to October 1, 2000.
For purposes of the credit, qualified research expenses must relate to a taxpayer’s trade or business. In addition, qualified research must generally meet the following four tests:
* The costs for the research must be deductible under section 174 of the Internal Revenue Code (CRTC 17201 and 24365). As a result, there must be uncertainty in the development effort (note that an activity can qualify for deductibility under section 174, but not be a qualified activity for purposes of claiming the R&D credit). * The research must be for the purpose of discovering information that is technological in nature and its intended application is to be useful in developing a new or improved business component (i.e., the process of experimentation of the physical or biological sciences, engineering, or computer science). * Experimentation must comprise substantially all of the taxpayer’s research, testing different alternatives as a means of eliminating the uncertainty factor; and * The research must relate to performance, reliability, quality, or a new or improved function of a business component.
Qualified research includes in-house research expenses and contract research expenses. In-house research expenses include:
* Employee wages for researchers, supervisors, and support services; * Supplies used in conducting the research; and * Amounts paid to another person for the right to use personal property for research.
Example: Qualified Research
Engineers who design an improved networking system for use in computers may be engaged in qualified research because the design of such a system is uncertain at the onset. The engineers can only determine whether they can develop a viable product by experimenting.
Similarly, engineers who design an improved toaster for retail sale may be engaged in qualified research because the new heating element represents a significant subset of elements of the original business component, the toaster, and is treated as a new and separate business component.
The following research activities generally do not qualify for the research credit:
* Research conducted after the beginning of commercial production; * Research adapting an existing product or process to a particular customer’s needs; * Duplication of an existing product or process; * Surveys and studies; * Research relating to certain internal-use computer software; * Research conducted outside of California (outside of the United States for federal purposes); * Research in the social sciences, arts, or humanities; * Research funded by another person or governmental agency; * Research whose purpose is ascertaining the existence, location, extent, or quality of any deposit of ore and other minerals (including oil and gas); and * Research whose purpose is to improve a commercial product if the improvements relate to style, taste, cosmetic, or seasonal design factors.
Example: Non-Qualified Research
Engineers who design a transparent casing for a toaster for retail sale may not be engaged in qualified research because the new casing that allows consumers to watch their toast burn represents a duplication of an existing product. Telephones and computers with transparent casings are already on the market.
Section 41 of the federal code requires an activity-based analysis, which means the results of the activity do not necessarily matter. In order to qualify for the credit, the engineers in the above example must add new or improved function, performance, reliability, or quality to the toaster.
Similarly, expenses for developing a generic drug may not be used to claim the research credit, although they are deductible under section 174 of the Internal Revenue Code. This is because, under the Food and Drug Administration’s approval procedures, a generic drug’s therapeutic effect must duplicate that of an already-approved drug. Generic drug development is normally non-qualified activity because it is excluded under section 41(d)(4) of the Internal Revenue Code. Under section 41(d)(4)(C), activities excluded from the definition of qualified research include any research related to the reproduction of an existing business component (in whole or in part) from a physical examination of the business component itself, or from plans, blueprints, detailed specifications, or publicly available information with respect to such business component (reverse engineering).
Businesses Under Common Control
For California purposes, according to the Franchise Tax Board, taxpayers may not allocate or otherwise transfer the R&D credit to another taxpayer, even if the other taxpayer is a member of a unitary or combined group or otherwise affiliated with the taxpayer that qualified for the credit. This is true for all of California’s credits, except for the Low-Income Housing Credit. For example, a subsidiary corporation that generates the R&D credit cannot allocate the credit to the parent corporation, or to another member of the same unitary group. Some practitioners believe that, because of California’s adoption of section 41(f) of the federal law without modification, an argument can be made that the unitary group should be treated as a single taxpayer.
For federal purposes, in contrast, the credit is computed as if all members of a controlled group and all members of a group of businesses under common control were a single taxpayer. The credit is then allocated to a member based upon the proportionate shares of the group’s qualified research expenses and basic research payments.
California’s research credit is permanent and has been since 1993. The federal credit is set to expire on June 30, 2004. If the credit exceeds the tax, then the excess may be carried over. California does not allow a one-year carry-back like the federal credit does. California’s credit, however, may be carried forward indefinitely, whereas the federal carryforward period is limited to 20 years.
For purposes of determining the base amount, taxpayers who conduct business both within and outside of California must include receipts from the sale of property that is held primarily for sale to customers and that is delivered or shipped to customers in California.
For California purposes, taxpayers may not include any amounts paid or incurred on or after January 1, 1999, for tangible personal property eligible for the sales and use tax exemption for teleproduction or other post-production services under CRTC 6378.
Calculating the Credit Percentages
Generally, the credit for a particular taxable or income year equals 12 percent (20 percent for federal purposes) of the amount by which a taxpayer’s qualified research expenses during the year exceed a base amount for that year. The research credit also covers 24 percent (20 percent for federal purposes) of certain basic research payments to qualified organizations (e.g., universities and non-profit scientific research organizations).
Under state and federal laws, contract research expenses are limited to 65 percent of the amount paid to another person (other than an employee) for qualified research. A taxpayer, however, may use 75 percent (instead of 65 percent) for the amount paid to a qualified research consortium. A qualified research consortium is a tax-exempt organization under section 501(c)(3) or 501(c)(6) of the Internal Revenue Code that is organized and operated primarily to conduct scientific research and is not a private foundation.
Calculating the Base Amount
Generally, the credit applies only to the extent that the qualified research expenses for the current year exceed the base amount, as defined. To compute the base amount for the current year, the taxpayer must multiply the fixed-base percentage by the taxpayer’s average amount of gross receipts for the four preceding years, but not less than 50 percent.
Calculating the Fixed-Base Percentage
The fixed-base percentage calculation depends upon whether the company is an existing business or a start-up company. A start-up company has both gross receipts and qualified research expenses either:
* For the first time in a year beginning after 1983; * For less than three years beginning after 1983 and before 1989.
To compute the fixed-base percentage for an existing company, the taxpayer must divide the aggregate qualified research expenses for years beginning after 1983 and before 1989 by the aggregate gross receipts for those years. The fixed-base percentage for a start-up company is assigned at three percent for each of the company’s first five years beginning after 1993, in which the company has qualified research expenses.
The assigned percentage for start-up companies results in a more lucrative research credit. There is a 10-year phase-in period leading up to a credit based upon five years of experience. The fixed-base percentage for both existing and start-up companies cannot exceed 16 percent.
Example: Calculating the Fixed-Based Percentage
Company A has been in business since 1957 and had $170,000 of qualified research expenses in 1999. For the years 1984 through 1988, Company A had $500,000 of aggregate qualified research expenses and $5.5 million of aggregate gross receipts. Its average annual gross receipts for the years 1995 through 1998 were $1,420,000. Company A must use a fixed-based percentage of 9 percent ($500,000 / $5.5 million).
Example: Calculating the Base Amount & Research Credit
Continuing with the foregoing example, Company A’s base amount for 1999 is $127,800 ($1,420,000 x 9%). The excess of Company As 1999 qualified research expenses over the base amount is $42,200 ($170,000 – $127,800). Therefore, Company A is allowed a California research credit of $5,064 ($42,200 x 12%).
Electing the AIC
Taxpayers may claim the regular research credit or may elect to claim the alternative incremental credit (AIC). Under the AIC, a smaller, three-tier fixed-based percentage applies. Under California law, a taxpayer may make the election to claim the AIC for years beginning on or after January 1, 1998. Under federal law, a taxpayer may make the election for years beginning on or after July 1, 1996.
A taxpayer may make separate California and federal elections and is not bound by its federal election. A taxpayer should figure the credit both ways to see which produces the larger credit. It requires some tax planning on the part of the taxpayer because, once a taxpayer elects the AIC, it applies to the current year and all later tax years, unless the taxpayer receives IRS and FTB written approval to revoke the election.
If the taxpayer elects to use the AIC, the credit equals the total of these three amounts:
* 1.32 percent (for federal purposes, it is 2.65 percent for years beginning after June 30, 1999) of qualified research expenses for the year in excess of an amount that is 1 percent of the taxpayer’s average gross receipts for the four preceding years, but not more than 1.5 percent of the average; plus * 1.76 percent (for federal purposes, it is 3.2 percent for years beginning after June 30, 1999) of qualified research expenses for the year in excess of an amount that is 1.5 percent of the taxpayer’s average gross receipts for the four preceding years, but not more than 2 percent of the average; plus * 2.2 percent (for federal purposes, it is 3.75 percent for years beginning after June 30, 1999) of qualified research expenses for the year in excess of an amount that is 2 percent of the taxpayer’s average gross receipts for the four preceding years.
This helps those taxpayers that had large research expenditures during the period 1984 through 1988 by allowing them to figure the credit using base figures from more recent years. For example, aerospace firms frequently had huge research expenditures during the late 1980s. For them, that base period sometimes meant no credit in current years, even though research expenditures were relatively high and growing in size.
Example: Regular Credit v. AIC
Tired Tires, Inc., a California, calendar-year tire manufacturer that has been in business since 1950, wants to build a tireless tire that will not deteriorate as rapidly as existing tires. The expenses of designing such a tire qualify for the research credit. Tired Tires started laboratory research in 1985, and substantially completed its research by December 31, 1999. Tired Tires rolled its first tireless tire off the assembly line on March 1, 2000. Tired had $1.7 million of qualified research expenses in 1999.
For years 1984 through 1988 (the base period), Tired had aggregate qualified research expenses of $1 million and aggregate gross receipts of $10 million. Tired’s fixed-base percentage is, therefore, 10 percent ($1 million / $10 million). Tired’s average annual gross receipts for the four income years preceding 1999 (1995 through 1998) are $16 million, so its base amount for 1999 is $1.6 million ($16 million x 10%).
Using the regular research credit, Tired may claim a credit equal to 12 percent of the excess of the qualified research expenses for 1999 ($1.7 million) over the base amount ($1.6 million). So, Tired’s regular research credit for 1999 would be $12,000 [($1.7 million – $1.6 million) x 12%]. If Tired elects to use the AIC, the credit is almost tripled to $32.824 ($1,056 + $1,408 + $30,360), which equals the total of these three credit tiers:
TIER 1 CREDIT
$1,056 ($80,000 x 1.32%). The $80,000 figure is the difference between the average gross receipts for the four preceding years ($16 million) multiplied by a fixed-base percentage of 1.5 percent and the $16 million multiplied by a fixed-base percentage of 1 percent, or [($16 million x 1.5%) – ($16 million x 1%)].
TIER 2 CREDIT
$1,408 ($80,000 x 1.76%). The $80,000 figure is the difference between the average gross receipts for the four preceding years ($16 million) multiplied by a fixed-base percentage of 2 percent and the $16 million multiplied by a fixed-base percentage of 1.5 percent, or [($16 million x 2%) – ($16 million x 1.5%,)].
TIER 3 CREDIT
$30,360 [($1.7 million – $320,000) x 2.2%). This is the fixed-base percentage of 2.2 percent multiplied by the amount of the qualified research expenses for the year ($1.7 million) in excess of: the average gross receipts for the four preceding years ($16 million) multiplied by a fixed-base percentage of 2 percent, or $320,000.
Extraordinary Documentation Required
The benefits of the R&D credit are often negated by a taxpayer’s costs of compliance. For example, assume that a company’s researchers spent four hours of their 40-hour workweek in order to document their qualified research activities for the purpose of claiming the credit. That would mean that the company has lost 10 percent of available research time.
Extraordinary documentation seems to be an absolute necessity when it comes to claiming the R&D credit. There is no other way to respond to an auditor’s Information Document Request (IDR) that requires an explanation of every hypothesis considered and every alternative tested for every experiment for which the research credit was claimed.
Aggressive FTB Auditing
The FTB is actively auditing taxpayers who claim large credits and those that appear to be overzealous in claiming California’s research credit. The issues surrounding the R&D credit are so comp]ex that the Internal Revenue Service has a Research Credit Issues Specialists Team dedicated to resolving these issues. Other issues include the section 41(g) federal limitation and rules for pass-through entities.
Check Forms and Regulations
The federal credit has substantial regulations that are currently undergoing revisions. Thus, it is imperative for taxpayers to carefully examine all of the statutes, regulations, and forms before claiming this credit. California’s research credit is claimed on FTB Form 3523, Research Credit.
CHRIS MICHELI is an attorney and registered lobbyist for the Sacramento governmental relations firm of Carpenter Snodgrass & Associates. GINA RODRIQUEZ is an enrolled agent and Sacramento Editor of Spidell Publishing. E. SCOTT EWING is a Senior Tax Manager with Deloitte & Touche in Los Angeles. VIRGINIA GATES is a partner with PricewaterhouseCoopers in San Jose. Portions of this article were extracted with permission from Spidell’s California Taxletter.
COPYRIGHT 2000 Tax Executives Institute, Inc.
COPYRIGHT 2002 Gale Group