The tax credit for increasing research activities, commonly known as the R&D credit, is back in effect as of January 2013. The research credit begun in 1981 has expired and been reinstated 15 times. It currently is available through the end of this year.
If history is any indication, the credit will be extended into 2014. But to be safe, now is the time for manufacturers to review their eligibility for the tax credit.
The tax law provides two specific tax incentives to taxpayers who undertake research activities – current expensing of research-related costs and a tax credit for research activity.
Since the fruits of research and development efforts often are difficult to predict or are unsuccessful, the tax rules allow a current deduction rather than requiring capitalization and depreciation of those costs. In this case, the tax and accounting rules follow the same approach.
Taxpayers have the choice of two different R&D credit computations: the regular credit or the alternative simplified credit. For the regular credit, an incremental amount of qualified research expenditures is determined with reference to a baseline of prior research expenditures incurred over a fixed period of time. This may be administratively difficult or impossible to document. So, an alternative simplified credit for an incremental amount of qualified research expenditures for a given year may be determined for qualified research expenditures generally incurred on a rolling average in the three prior years.
Amounts defined as R&D costs for tax credit purposes generally include certain costs incurred in the experimental or laboratory sense related to development or improvement of a product. A product includes, for instance, any pilot model, process, formula, invention, technique or software to be used by the taxpayer.
Qualifying costs are those incurred for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists when information available to the taxpayer is not sufficient to ascertain the capability or method for developing, improving or appropriately designing the product.
Examples of qualifying costs for the credit include salaries and wages for those engaged in research or experimentation efforts, outside services (contractors) and expenditures or materials and supplies used and consumed in the course of the research or experimentation.
Research does not qualify if substantially all of the activities relate to style, taste, cosmetic or seasonal design factors, sometimes referred to as “taste and texture.” Research does not qualify for the credit if conducted after the beginning of commercial production or if related to the adaptation of an existing business component to a particular customer’s requirements. A taxpayer may claim a research credit equal to 20 percent of the amount that qualified research expenses for a taxable year exceed its base amount for that year. An alternative simplified research credit with a 14 percent rate may be claimed instead.
A 20 percent credit also is available for corporate cash expenses for basic research conducted by universities on behalf of the taxpayer. Because the credit applies to incremental research above a baseline that generally is not less than half of current-year costs, a rough estimate of a current-year credit would be 10 percent of current-year qualified costs. To avoid double dipping, deductions taken for research costs are reduced by the research credit determined for the taxable year. Research does not qualify if conducted outside of the United States, Puerto Rico or any U.S. possession.
Availability of a credit should be considered for research undertaken to discover information that is technological in nature and intended to be useful in the development of a new or improved business component. Substantially all activities should constitute elements of a process of experimentation for functional aspects, performance, reliability or quality of a business component.