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Annette Nellen

Our Neglected Federal Research Credit

Despite desires to increase economic growth and improve the competitiveness of U.S. businesses, our federal research tax credit is a temporary provision with structural flaws that lessen its effectiveness.

September 25, 2008
by Annette Nellen, CPA/Esq.

The federal research credit (IRC §41) was enacted as part of the Economic Recovery Tax Act of 1981 (P.L. 97-34, August 1981) to encourage and support greater research activity in the U.S. Congress was concerned with a decline in research and development (R&D) spending and the fact that non-government research spending in the U.S. was below that of Japan and Germany. (Joint Committee on Taxation (JCT), General Explanation of the Economic Recovery Tax Act of 1981, (JCS-71-81), December 1981).

Jump ahead 27 years and we continue to have concerns over insufficient R&D spending plus increased concern about global competition. The credit has expired an additional 12 times since its first scheduled expiration date in1985. Many proposals have been made over the years to improve the research credit, but few have been enacted.

This article explains the credit’s rationale, summarizes usage data and notes some problem areas in need of reform. (For background on the credit, see Nellen, Tax Treatment of Research Expenditures (PDF), 2008; and IRS, Audit Techniques Guide: Credit for Increasing Research Activities, 2005.)

Rationale

The economic rationale for the research credit is that companies do not always reap the entire reward for what they spend on research. For example, a new technology may lead to a new industry and rewards for companies that did not have to make the initial R&D investment. Or the limited life of a patent means that others will be able to exploit it later. These spillover benefits justify some government subsidy for research.

Both government and private studies indicate that the credit has led to increased research spending. In 1989, the GAO released a report, The Research Tax Credit Has Stimulated Some Additional Research Spending (PDF) (GGD-89-114, September 1989). This study indicated that the credit led to increased R&D spending of $1 billion to $2.5 billion in its first five years.

Private studies of the credit have also found that it increased research spending (for example, Bronwyn Hall, Fiscal Policy Towards R&D in the United States: Recent Experience (PDF), 1995). See also, Congressional Budget Office, Federal Support for Research and Development (PDF), June 2007.

Another rationale for the credit is that several other countries offer research incentives (OECD, Tax Incentives for Research and Development (PDF), 2003; and R&D Credit Coalition, International R&D Tax Incentives Survey (PDF), 2008). OECD data indicate that U.S. firms increased their percentage of research conducted outside of the U.S. from 1995 to 2005 (OECD, "Research and Development: Going Global," Policy Brief (PDF), July 2008).

The R&D Credit Coalition notes that other countries compete for R&D to improve economic growth and quality of jobs. They also note that tax incentives for R&D are becoming increasingly important in other countries (see March 2006 statement (PDF) for a Senate Commerce Committee hearing).

Data

For 2005, C corporations claimed $6.4 billion of research credit, which was almost 15 percent more than for 2004. In addition, there was a 10 percent increase in the number of corporations claiming the credit in 2005 compared to 2004. While corporations of all sizes claim the credit, in 2005, about 80 percent of the dollar amount of the credit was claimed by corporations with $250 million or more of receipts. For 2005, manufacturers claimed about 71 percent of the aggregate C corporation credit amount. (The Credit for Increasing Research Activities: Statistics from Tax Years 2004–2005, IRS Statistics of Income Bulletin, 2008.)

It is estimated to cost $8.7 billion over 10 years for a one-year extension of the research credit in its current form (JCT, Estimated Revenue Effects of H.R. 6049 (PDF), May 2008).

Problem Areas

Following is a summary of some of the problems limiting the effectiveness of the credit.

Temporary: Planning for research activities typically involves a long-term perspective. Thus, research incentives that focus on the short-term are unlikely to be fully beneficial and effective.

Small benefit: While the standard research tax credit formula uses a 20 percent rate, the effective rate is smaller due to the incremental nature of the credit and the reduction required by §280C(c). The maximum credit possible under this formula is 6.5 percent of the current year’s qualified research expenditures (QRE). The benefit might be slightly higher under the alternative simplified formula (§41(c)(5)). Also, because not all research expenditures deductible under §174 qualify as QRE, the ratio of the credit to total §174 expenditures is typically less than 6.5 percent.

Inequities: The standard research credit formula uses a base period of 1984 to 1988. If a firm had high R&D spending relative to receipts in those years, it may be disadvantaged today in calculating a credit unless one of the alternative formulas provide a better benefit (§41(c)(4) and (5)). Other inequities can exist due to the types of research expenditures included in the credit calculation. For example, a labor-intensive firm might generate a higher credit than a capital-intensive research firm.

Formula disincentives: Under the standard formula, if the base amount is less than 50 percent of the current year QRE, then 50 percent of current year QRE must be used as the base. Since a lower base amount generates a higher credit, the 50 percent base limitation can prevent some firms from generating a 20 percent credit despite increasing QRE over their base amount.

Example: X Corporation uses the standard formula to calculate the credit. Its base amount is $10 and current year QRE is $20. Thus, its credit is $2 (20 percent x $10). If instead, X’s current year QRE were $30, its base would be $15 (rather than $10 due to the 50 percent limit). Its credit would be $3 (20 percent x $15). Thus, the additional $10 of current year QRE only generated $1 (10 percent) of credit for X, rather than $2.

A 1995 study found that for 1992 almost 60 percent of corporations were subject to the 50 percent base limitation (GAO, Additional Information on the Research Tax Credit (PDF), May 1995).

Use limitations: Because the research credit is not refundable, it does not benefit all companies, particularly start-up firms in a loss position. In addition, because the credit is generally not usable against AMT, not all firms can currently use their credit. A temporary provision of the Housing Assistance Tax Act of 2008 allows limited refundable treatment of the research credit (see Bernard, Bonus Depreciation vs. Refundable Credits,  September 2008).

Complexity: With three possible formulas to select from to calculate the credit, taxpayers must spend time determining which yields the greatest benefit. In addition, research credit guidance is incomplete and clarification is needed for several terms used in §41.

Looking Forward

More than 20 bills affecting the research credit were introduced in the 110th Congress. Yet, as this session nears its end, the credit remains expired and once again, a one-year extension is likely to be the only reform we’ll see despite the need for changes to improve the credit.

To help promote innovation and economic growth, Congress and the President must review the data and proposals and make the reforms that will improve the effectiveness of the research credit. Annual, delayed actions that only renew the credit for a year are not enough.

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Annette Nellen, CPA, Esq., is a tax professor and Director of the MST Program at San José State University. Nellen is an active member of the tax sections of the ABA and AICPA. She serves on the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.