(TL:DR à The research and experimentation tax credit is a cost-efficient way of stimulating research and development by the private sector for the public good, and Congress let it expire. Again).
Congress is toying with renewing the Research and Experimentation Tax Credit. Again. It’s not even really news. The credit expired at midnight, January 1, 2015 because Congress couldn’t agree to renew a temporary tax credit that’s been renewed so often before that it’s practically permanent. It’s so permanent a temporary tax credit that they teach it in a basic business tax class in law school. Once you reach syllabus status, after all, you’re kind of a legend.
The temporary tax credit is so permanent that it’s expired eight times and been renewed back into uncertain, immortal life 16 times. It’s like that guy from Game of Thrones that…nevermind. For intents and purposes, it’s basically here to stay. If precedent is any indicator, it will be breathed back into life before the end of this year with its provisions to apply retroactively, so as not to shut out any businesses that had planned to take advantage of it this year.
Well, if it’s so great, why do they keep letting it expire? I think you mispronounced “why do they keep renewing it?” Some would argue that the credit expires only to be renewed based on principled arguments. Seasoned watchers of Washington would argue something a trifle more cynical – think found cottage industry.
Could the credit be dead again?
(Sorry. Couldn’t resist).
Regardless, the credit was born in 1981 as part of an economic stimulus package designed to aid flagging American manufacturing, specifically, the auto industry. Apparently, at the time, no one paused to consider that American cars kind of sucked.
Anyway, over the last 34 years, the tax credit has expired, been revived, and seen changes, but fundamentally, the credit has always aimed to stimulate American innovation by incentivizing the private sector to make investments that it might otherwise eschew for reasons of cost or lost profits. The credit purports to mitigate or eliminate the gap between research dollars invested by private businesses (presumably larger) and actual dollars returned through selling the fruits of that R&D (presumably smaller, at first) in the hopes that some otherwise impossible or unavailable good will inure to that business or to the public at large – whether directly or indirectly. Cited results are increased innovation and first-mover advantages, job growth, and higher productivity levels in addition to the less easily quantified multiplier effects that redound to area economies.
How does the credit work?
To qualify for the credit, research must be “qualified research,” and to be that, it must pass a four-part test. The four parts of the test are (1) permitted purpose; (2) elimination of uncertainty; (3) process of experimentation; and (4) technological in nature. Moreover, the research at issue must not fall under one of the exclusions designed to prevent ordinary business expenses (that are otherwise deductible) from being characterized as qualified research and qualifying for the potentially more lucrative R&D credit.
This does not mean that the costs of research cannot be deducted. In fact, they can. However, a business that wishes to claim the credit and the deduction must make an election and offset one with the other – essentially, no double counting. Eligible expenses of qualified research can include wages, supplies, and contract research expenses.
In fact, according to the Tax Policy Center, in 2012, contract research accounted for 16% of the claimed credit, the cost of supplies 15%, and wages amounted to fully 69% of the claimed credit.
How is it calculated?
A taxpayer who meets the requirements of the four-part test can calculate the credit under one of three methods, each of which is designed to reward the taxpayer for increases in R&D spending over previous periods. Under the first method, the firm will receive a credit of 20% of its qualified research expenses over a base amount with the base amount defined as a ratio of its research expenses to gross receipts for the years 1984 to 1988 (with the ratio capped at 16%); for firms begun after 1988, the ratio was set at 3%.
Under the second method, a taxpayer can receive a credit equal to 14% of qualified research expenses over 50% of the average of qualified research expenses for the three immediately preceding taxable years. Under the third method, a firm with no prior qualified research expenses can receive a credit of 6% of the qualified research expenses for that taxable year. After that calculation, the credit (combined with other credits taken by the business) is limited to 25% o the taxpayer’s tax liability that exceeds $25,000. Any unused credit can be carried back one year or carried forward as long as 20 years.
In all cases, the credit targets increases in research; maximizing the credit’s effect on tax liability requires reducing the base amount or increasing the qualified research expenses.
Does It Work?
Evidence going back to at least 1990s suggests that it does – that the credit has a positive correlation with increased research dollars.
The National Science Foundation published a paper in 2005 stating that during the period from 1990 to 2001, dollars claimed under the credit grew twice as fast as private sector R&D dollars, even as direct federal R&D spending dropped. The report went on to cite growth in annual credit claims from $1.5 billion in the period ending in 1996 to annual claims topping $4 billion every year from 1997 to 2001. The coincidence with the late 90s tech boom may not be such a coincidence; the NSF paper goes on to note that, in that period ending in 2001, computer and electronic products and software and information accounted for no less than 42% of the claimed credits.
That trend has not abated.
An April 2015 paper by Nirupama Rao, PhD, at the Wharton School’s Public Policy Initiative stated:
“In fiscal year 2012, U.S. firms received R&D tax credits totaling $11.1 billion, or about 8 percent of the estimated $140.9 billion spent by federal agencies on defense and non-defense R&D that year.” (The U.S. Treasury cites $8.3 billion in credits claimed in 2008, consistent with the sharply upward trend since the late 1990s). The continued associate with tech sectors is also apparent with computer and electronic manufacturing part of a group accounting for nearly 80% of credits claimed in 2008.
In the paper, Rao argues that private sector spending on research and development is “highly sensitive” to the credit.
“Short-run elasticity estimates exceed one, meaning that a 10 percent reduction in the cost of R&D leads the average firm to increase its research intensity by more than 10 percent. In other words, when it gets cheaper to spend on qualified R&D, firms actually do spend more, as policymakers hope.”
Rao notes the significant portion of the credit allocable to wages. Indeed, the Tax Policy Center confirms this data, placing wages at 69% of claimed research credits.
And yet.
There are currently arguments that the credit does not work as well as it did, or as well as it could. Frequently cited causes are that other countries better implement such a credit or other similar incentives; the failure to make the credit permanent credits too much uncertainty to stimulate companies to gamble on that investment; and the calculations are simply too difficult and unwieldy.
Rao also notes this problem, arguing that “firms do not time their research spending to maximize their R&D tax credits. This perhaps reflects uncertainty about the continued existence of the credit.”
This is a real problem as companies that would use the credit to make long-term investments or capital outlays on research and development must pause and consider risk. The risk to them is that they could make the investments based on the availability of the credit, but should the credit be discontinued, they would blow their budgets out of the water.
The complexity of the credit calculation carries the risk of underreporting and underpaying should the IRS disallow any or all of a firm’s claim (not to mention leaving money on the table by electing an unfavorable base amount). Combined with the interest and penalties that would accompany the additional assessed liability, and the disincentives grow in magnitude.
As to the first issue, Rao believes that smaller and younger firms are more responsive to a temporary credit, yet this should be cold comfort for the credit’s advocates as more than 80% of the credits claimed go to firms with receipts greater than $250 million.
In advocating for making the credit permanent, a 2012 paper by the Brookings Institution argued that a permanent credit would produce “$66 billion increase in annual GDP, at least 162,000 new jobs, and an additional 3,850 patents issued to American inventors.”
Whither Credit?
Much of the conversation around the credit views it as a net positive, albeit not a perfect remedy. It is a creature of federal government, yet it leaves the decisions about which research to attempt and how much of it to attempt to the private sector. Its renewal seems likely given its fairly long history and its seeming contribution to tech research and the dividends that spending yields. Yet, given the current political climate, its renewal is not certain, and any revision – no matter how necessary it may be deemed by wise counselors – seems unlikely for the foreseeable future, particularly when its very existence is the only issue up for debate.
Estate Law in Texas 