By Natalie Grumhaus
As tax and legal advisors to corporations with multinational businesses, it’s important to provide your clients with advice to help them minimize their tax liabilities in all markets. While the U.S. Section 41 credit (the “R&D credit”) may be complicated, with practice, it can be understood.
The eligibility of expenses and activities in qualified R&D work is generally determined through a four-part test laid out in the Internal Revenue Code and clarified through the courts. The steps of the test are as follows:
- Permitted Purpose: Development activities must be to develop a new or improved business component, which is further defined as a product, process, invention, technique, formula, or software. This component must relate to a new (or improved) functionality, performance, quality, or reliability of the component, and it must be held for sale or used in the taxpayer’s own business.
- Technological Nature: In the U.S., only development in the “hard” sciences, such as engineering, metallurgy, material science, chemistry, biology, or computer science, can be considered qualified research. Humanities, social sciences, and any subject in the arts are excluded.
- Technical Uncertainty: The research must address the technical uncertainty involved in creating the component. This uncertainty can lie in determining the optimal design or in the best method of successfully creating the component. In short, this test simply requires that there be uncertainty in either the ‘what’ or the ‘how’ (it does not require both) of the component’s design.
- Process of Experimentation: Research must follow the standard process of experimentation, that is, testing one or more alternatives to resolve the uncertainty encountered in the third test. This process must also be followed in the development of the component. For software developers, this may look like the Scrum or Agile method; in other industries, it may include modeling, simulations, prototypes, or lab testing.
When claiming the credit, there are four categories of expenses that can be considered: the salaries and wages of those doing research and those directly supporting or supervising; contract research expenses, which is 65% of the amount paid to outside firms for qualifying activities; supply costs, exclusive of depreciable equipment or tooling; and finally, computer rental time, e.g., costs for services such as Amazon Web Services or Google Cloud. Claiming contract research expenses also entails two requirements that are often brought up under audit. For a contract to be qualified, the taxpayer must bear the ‘economic risk’ of doing the research, and it must ‘retain rights’ to its research. This analysis is very important and has been at the forefront of some recent court opinions (see, e.g., MBJ v. Comm’r, Betz v. Comm’r, and Grigsby v. Comm’r). Another recent change has affected how the credit can be claimed. Under Section 174 (TCJA, 2022), most of a company’s R&D expenses must now be capitalized and amortized over five years. For foreign companies, this amortization requirement goes up to fifteen years.
In addition to the arts and ‘soft’ sciences, among other exclusions such as funded research, testing for quality control, duplication of existing components, and others, there is one particularly relevant exclusion to qualified research: no research performed outside of the United States or various U.S. territories may be included in the claim. However, this is not to say that advisors to non-U.S. companies should advise their clients not to bother with the R&D credit. Corporations that do business in the U.S. are subject to U.S. taxes on taxable income that is ‘effectively connected’ (using either the “business activities” or the “asset use” test) to a U.S. trade or business. However, when a foreign corporation earns tax liability, it also has the opportunity to take advantage of any credits or policies available to U.S. corporations. While that same foreign corporation may not count all their R&D expenses towards the credit, under Section 41(c)(6), “there shall be taken into account only gross receipts which are effectively connected with the conduct of a trade or business within the United States, the Commonwealth of Puerto Rico, or any possession of the United States.”
This provision in Section 41 allows non-U.S. companies to take advantage of the U.S. R&D credit, which can be claimed on any open tax return with a benefit of 6-10% of the qualified research expenses. Companies in almost any industry can qualify, as long as they meet the 4-part test discussed above, and understanding the impact of claiming the U.S. R&D credit is crucial for advising clients who may conduct business in the U.S. effectively. However, because the R&D credit is interpreted through the courts and requirements often change or shift, it remains best practice to work with a firm that specializes in U.S. specialty tax credits so your client can get the most benefit with the least risk.
