RESEARCH AND DEVELOPMENT TAX INCENTIVES Federal, State, and Foreign

Michael D. Rashkin, J.D., LL.M. Table of Contents

CCH INCORPOR ATED Chicago

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Chapter 1: Introduction to R&D Tax Incentives and Their Role in the World Economy Overview—Introduction to R&D Tax Incentives and Their Role in the World Economy . . . . . . . . . . . . . . . . . . . . . . The Importance of Research and Development in Today’s Information Economy . . . . . . . . . . . . . . . . . . . . . . . . . . The Role of Government . . . . . . . . . . . . . . . . . . . . . . . . . . . . Worldwide Research and Development Expenditures . . . . . Research Spending in the United States . . . . . . . . . . . . . . . . Nature of Research and Development Expenditures . . . . . . Costs That May Be Eligible . . . . . . . . . . . . . . . . . . . . . . Characteristics of Tax Incentives for Research and Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Definition of Research and Development . . . . . . . . . . . . . . . R&D as Defined in the World of Science . . . . . . . . . . . R&D as Defined in the Tax World . . . . . . . . . . . . . . . . Conflict Within Tax Legislation . . . . . . . . . . . . . . . . . . Effectiveness of R&D Credits in Increasing R&D Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

101 115 120 125 130 135 135.01 140 145 145.01 145.02 145.03 150

Chapter 2: The Deduction for R&D Expenditures Overview—The Deduction for R&D Expenditures . Electing to Expense Research and Development Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . Treatment as Deferred Expenses . . . . . . . . . . . . . . . Changing to a Different Method . . . . . . . . . . . . . . . Trade or Business Requirement . . . . . . . . . . . . . . . . Definition of Research and Experimental Expenses Research Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Definition of Product . . . . . . . . . . . . . . . . . . . . . . . . Excluded Activities . . . . . . . . . . . . . . . . . . . . . . . . . Software Expenditures . . . . . . . . . . . . . . . . . . . . . . . Copyright ©2003, CCH INCORPORATED. All rights reserved.

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201

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215 220 225 230 235 240 245 250 255

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Web Site Development Costs . . . . . . . . . . . . Unreasonable Expenses . . . . . . . . . . . . . . . . . . . . . Contract Research . . . . . . . . . . . . . . . . . . . . . . . . . Expenditures for Land and Depreciable Property . The Alternative Minimum Tax . . . . . . . . . . . . . . .

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255.01 260 265 270 275

Chapter 3: The Research Credit: Foundations and Eligible Expenditures Overview—The Research Credit: Foundations and Eligible Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Legislative Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Qualified Research Expenses—Generally . . . . . . . . . . . . . . . In-house Research Expenses—Wages . . . . . . . . . . . . . . . . . . In-house Research Expenses—Qualified Services . . . . . . . . . In-house Research Expenses—Determining the Ratio of Qualified Wages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The “Substantially All” Rule . . . . . . . . . . . . . . . . . . . . In-house Research Expenses—Supplies . . . . . . . . . . . . . . . . In-house Research Expenses—Use of Computers . . . . . . . . . Contract Research Expenses . . . . . . . . . . . . . . . . . . . . . . . . . Research Consortia . . . . . . . . . . . . . . . . . . . . . . . . . . . . Summary of Qualified Research Expense Components . . . . Trade or Business Requirement . . . . . . . . . . . . . . . . . . . . . . .

301 315 320 330 335 340 340.01 345 350 360 360.01 365 370

Chapter 4: The Research Credit: Elements of Qualified Research Overview—The Research Credit: Elements of Qualified Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interaction of T.D. 8930 and the 2001 Proposed Regulations Qualified Research Defined . . . . . . . . . . . . . . . . . . . . . . . . . . Test Number 1: Code Sec. 174 Expense Treatment . . . . . . . . Test Number 2: Discovering Information That Is Technological in Nature . . . . . . . . . . . . . . . . . . . . . . . . . Patent Safe Harbor . . . . . . . . . . . . . . . . . . . . . . . . . . . . Information That Is Technological in Nature . . . . . . . . New or Improved Business Component of the Taxpayer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . History of the Discovery of Information Test . . . . . . . . . . . . Test Number 3: The Process of Experimentation . . . . . . . . . . Evaluation of Alternatives . . . . . . . . . . . . . . . . . . . . . . Facts and Circumstances Test . . . . . . . . . . . . . . . . . . . . “Elements” of a Process of Experimentation . . . . . . . .

401 415 420 430 440 440.01 440.02 440.03 445 450 450.01 450.02 450.03

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Substantially All Requirement . . . . . . . . . . . . . . . . . . . Readily Discernible and Applicable Method, Capability, or Design . . . . . . . . . . . . . . . . . . . . . . . History of the Process of Experimentation Test . . . . . . . . . . . Test Number 4: The Purpose of the Research . . . . . . . . . . . . Production Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Shrinking Back Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . Summary of Four-Part Test for Qualified Research . . . . . . . .

450.04 450.05 455 460 470 480 490

Chapter 5: The Research Credit: Excluded Activities Overview—The Research Credit: Excluded Activities . . . . . Research After Commercial Production . . . . . . . . . . . . . . . . Improvements to Existing Products . . . . . . . . . . . . . . . Pharmaceutical Products . . . . . . . . . . . . . . . . . . . . . . . Adaptation of Existing Business Components . . . . . . . . . . . Duplication of Existing Business Components . . . . . . . . . . . Surveys and Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Internal-use Software—Generally . . . . . . . . . . . . . . . . . . . . . Software Primarily for Internal Use . . . . . . . . . . . . . . . Software Used in the Provision of Services . . . . . . . . . Internal-use Software—High Threshold of Innovation Test . High Threshold of Innovation Test—Examples . . . . . . Foreign Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Social Sciences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Funded Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Chapter 6: The Research Credit: Computational Rules Overview—The Research Credit: Computational Rules . . . . Calculating the Amount of the Credit . . . . . . . . . . . . . . . . . . Alternative Incremental Credit . . . . . . . . . . . . . . . . . . . . . . . The Base Amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fixed-base Percentage for Start-up Companies . . . . . . . . . . . Gross Receipts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Re Double Benefit—R&D Deduction Reduced . . . . . . . . . . . Re Double Benefit—Election to Reduce the Credit . . . . . . . . Research Credits During Suspension Periods . . . . . . . . . . . . Consistency Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounting Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Controlled Groups and Groups Under Common Control . . Definition of Trade or Business Under Common Control and Controlled Group of Corporations . . Copyright ©2003, CCH INCORPORATED. All rights reserved.

501 515 515.01 515.02 520 525 535 540 540.01 540.02 545 545.01 550 555 560

601 615 620 625 630 635 640 645 650 655 660 665 665.01

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Different Tax Years Among Members of Controlled Group . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Acquisitions and Dispositions . . . . . . . . . . . . . . . . . . . . . . Definition of Acquisition, Separate Unit, and Major Portion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Passthrough Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Short Tax Years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Limits on Use of Research Credits . . . . . . . . . . . . . . . . . . . Credit Limitation for Individuals . . . . . . . . . . . . . . . . . . . Effective Date . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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665.02 670

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670.01 675 680 685 690 695

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Chapter 7: The Research Credit: Payments for Basic Research Overview—The Research Credit: Payments for Basic Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Credit Calculation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

701 715 725

Chapter 8: The Research Credit: Documenting the Credit and Defending Against IRS Challenges Overview—The Research Credit: Documenting the Credit and Defending Against IRS Challenges . . . . . . . . . . . . . Recordkeeping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Five-step Plan for Maximizing the Credit and Handling Audit Challenges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Step 1: Gain a Complete Understanding of the Company’s Technology and Research . . . . . . . . . Step 2: Assess Whether Each of the Company’s Research Activities Satisfies the Tests of Code Sec. 41 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Step 3: Communicate Your Conclusions to Company Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Step 4: Develop and Implement a Plan for Documenting the Credit . . . . . . . . . . . . . . . . . . . . Step 5: Plan for an Audit . . . . . . . . . . . . . . . . . . . . . . . . Alternative Approaches . . . . . . . . . . . . . . . . . . . . . . . .

801 815 825 825.01

825.02 825.03 825.04 825.05 825.06

Chapter 9: The Research Credit: Evaluation of the Credit Overview—The Research Credit: Evaluation of the Credit . . Fundamental Questions Regarding the Credit . . . . . . . . . . . What Kind of Research Did Congress Actually What to Encourage? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

901 915 915.01

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Is the R&D Credit Effective? . . . . . . . . . . . . . . . . . . . . . Is the IRS Capable of Administering the Research Credit? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Congress Needs to Reassess . . . . . . . . . . . . . . . . . . . . .

915.02 915.03 915.04

Chapter 10: State Tax Incentives for Research and Development Overview—State Tax Incentives for Research and Development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Features of State Research Incentives . . . . . . . . . . . . . . . . . . Deductibility of R&D Expenses . . . . . . . . . . . . . . . . . . Refundability and Exchangeability . . . . . . . . . . . . . . . Limitations on Use of the Research Credit . . . . . . . . . . Carryover and Carryback . . . . . . . . . . . . . . . . . . . . . . . Definition of Qualified Research Expenses . . . . . . . . . Basic Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Incremental Feature . . . . . . . . . . . . . . . . . . . . . . . . . . . Base Amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alternative Incremental Credit . . . . . . . . . . . . . . . . . . . Code Sec. 280C(c) Reduction of R&D Expense Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expiration of Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . Other Research Incentives . . . . . . . . . . . . . . . . . . . . . . Survey of State Research Incentives . . . . . . . . . . . . . . . . . . . Alabama . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Alaska . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Arizona . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Arkansas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . California . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Colorado . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Connecticut . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Delaware . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . District of Columbia . . . . . . . . . . . . . . . . . . . . . . . . . . . Florida . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Georgia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Hawaii . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Idaho . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Illinois . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Indiana . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Iowa . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Kansas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Kentucky . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Copyright ©2003, CCH INCORPORATED. All rights reserved.

1001 1015 1015.01 1015.02 1015.03 1015.04 1015.05 1015.06 1015.07 1015.08 1015.09 1015.10 1015.11 1015.12 1030 1030.01 1030.02 1030.03 1030.04 1030.05 1030.06 1030.07 1030.08 1030.09 1030.10 1030.11 1030.12 1030.13 1030.14 1030.15 1030.16 1030.17 1030.18

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Louisiana . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Maine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Maryland . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Massachusetts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Michigan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Minnesota . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mississippi . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Missouri . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Montana . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Nebraska . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Nevada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . New Hampshire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . New Jersey . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . New Mexico . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . New York . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . North Carolina . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . North Dakota . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ohio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Oklahoma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Oregon . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Pennsylvania . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Rhode Island . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . South Carolina . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . South Dakota . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tennessee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Texas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Utah . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Vermont . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Virginia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Washington . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . West Virginia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Wisconsin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Wyoming . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Chapter 11: International Research Tax Incentives Overview—International Research Tax Incentives . . . . . . . . Tax Incentives vs. Direct Funding . . . . . . . . . . . . . . . . . . . . . Type and Nature of Tax Incentives . . . . . . . . . . . . . . . . . . . . Measuring the Size of Tax Incentives . . . . . . . . . . . . . . . . . . Qualifying R&D Activities . . . . . . . . . . . . . . . . . . . . . . . . . . Survey of Foreign Tax Incentives . . . . . . . . . . . . . . . . . . . . . .

1030.19 1030.20 1030.21 1030.22 1030.23 1030.24 1030.25 1030.26 1030.27 1030.28 1030.29 1030.30 1030.31 1030.32 1030.33 1030.34 1030.35 1030.36 1030.37 1030.38 1030.39 1030.40 1030.41 1030.42 1030.43 1030.44 1030.45 1030.46 1030.47 1030.48 1030.49 1030.50 1030.51

1101 1115 1125 1135 1145 1160

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Australia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Austria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Belgium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . China . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Denmark . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . France . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Germany . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Hong Kong . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . India . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ireland . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Israel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Italy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Japan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Korea . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Malaysia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mexico . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Netherlands . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . New Zealand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Norway . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Portugal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Singapore . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Spain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sweden . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Taiwan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Thailand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . United Kingdom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Appendix—Practice Tools Legislative Activity Concerning the Federal Research Credit . ......................................... Audit Techniques Guide . . . . . . . . . . . . . . . . . . . . . . . . . . . . Regulatory Activity Under Code Sec. 41 . . . . . . . . . . . . . . . . Summary of Internal-use Software Examples . . . . . . . . . . . . Survey Form for Research Managers . . . . . . . . . . . . . . . . . . . Summary of State Research Incentives . . . . . . . . . . . . . . . . . Summary Chart of International R&D Tax Incentives . . . . . . Form 6765 and Instructions . . . . . . . . . . . . . . . . . . . . . . . . . .

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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1160.01 1160.02 1160.03 1160.04 1160.05 1160.06 1160.07 1160.08 1160.09 1160.10 1160.11 1160.12 1160.13 1160.14 1160.15 1160.16 1160.17 1160.18 1160.19 1160.20 1160.21 1160.22 1160.23 1160.24 1160.25 1160.26 1160.27

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