Recession And The Research Tax Credit

As Congress responds to the economic recession, job creation will be high on its list of priorities, and one option for encouraging innovation and job growth is to dust off the research credit and better align it with the policies it’s meant to promote.

Congress has a spotty history in strengthening tax incentives for research and development. The United States led the world in providing tax benefits for research when it enacted the research credit as part of the Economic Recovery Tax Act of 1981. The bill’s objective was to cut taxes to stimulate economic growth. The credit is now among the largest business tax expenditures, and the Joint Committee on Taxation estimates that it will cost just under $70 billion between 2019 and 2023 (JCX-55-19). Despite its price tag, the research credit isn’t living up to its potential. And it’s not nearly as generous as the tax incentives offered by other countries.

The rapidly unfolding economic crisis might be a good opportunity to make the research credit more generous, because it would support the twin goals of encouraging innovation in key industries and helping drive job creation.

Under section 41, a taxpayer can claim a research credit equal to 20 percent of the amount by which its qualified research expenses for the year exceed the credit’s base amount for that year. The alternative simplified credit (ASC) provides a 14 percent rate based on a different base amount. That ASC rate has been surprisingly intractable, having resisted at least a decade of proposals for raising it. The research credit remained temporary until the Protecting Americans From Tax Hikes Act of 2015 made it permanent and allowed small businesses to apply it to their alternative minimum tax liabilities and new companies that had less than $5 million in gross receipts to use part of it to offset payroll liabilities.

The Tax Cuts and Jobs Act did little to change the section 41 research credit. It kept the ASC rate of 14 percent. However, it significantly altered the deduction for research and experimentation expenditures in section 174. For tax years that begin after December 31, 2021, taxpayers must capitalize and amortize R&E expenditures over five years.

The rapidly unfolding economic crisis might be a good opportunity to make the credit more generous, because it would support the twin goals of encouraging innovation in key industries and helping drive job creation. “One thing that this crisis has shown is how vital it is to have increased technological research, especially in areas like the biomedical field, and to have that research performed by American companies in America. A more robust research credit would go a long way towards supporting that goal,” said Robert J. Kovacev of Norton Rose Fulbright US LLP.

Options

The most obvious changes for Congress to make are to repeal the section 174 switch to amortization after December 31, 2021, and leave the deduction for R&E expenditures, and to increase the ASC rate. The hitch is that both will come with a revenue cost and neither is easily characterized as virus-related relief as opposed to general economic stimulus. But there’s bipartisan support for expanding the research credit, and economic stimulus measures that support American jobs are likely to be the focus of future phases of the legislative coronavirus response.

Congress’s collective memory has recently been refreshed regarding the need to clean up the federal incentives for research. On February 11 Jason Furman of Harvard University testified before Congress on the corporate income tax, and one of his proposals was an expansion of the credit for R&D spending by almost 50 percent.

The other elements of Furman’s proposal to reform domestic corporate taxation by changing the tax base were to provide full expensing of investments in equipment, structures, and intangibles while eliminating the interest deduction; raise the corporate rate to 28 percent; require large businesses to file as C corporations; and eliminate extenders. He argued that by changing the tax base and expanding incentives for new investments and R&D, statutory rates could be increased so that more revenue could be raised on the “supernormal” returns on past investment decisions and their future profit windfalls, but the rate on “normal” returns could be cut.

Furman argued that the business tax provisions don’t “fully reflect the positive externality associated with R&D,” and he said research suggests that the optimal subsidy for research should be larger than that under current law. He proposed that one way to simplify the research credit is to increase the ASC from 14 percent to 20 percent.

TCJA Repeal

Removing the switch to amortization of R&E expenditures under section 174 is popular among taxpayers, although that change isn’t specific to the coronavirus crisis and the subsequent economic upheaval. If Congress repeals that TCJA provision now, the reasons will most likely be that the deadline to make the change is looming, but that it should be done anyway and legislative action on the economy is imperative.

Switching from a deduction under section 174 to amortization would have substantial ramifications for corporate taxpayers and the incentives to invest in research activities, said Alex E. Sadler of Morgan, Lewis & Bockius LLP. He explained that there are unintended consequences to the change to amortization for both section 174 and the research credit for costs that until 2022 are treated as equal expenses under the credit. In an article in Tax Notes, Sadler and Douglas Norton, also of Morgan Lewis, explained that although the conforming change that the TCJA made to section 41(d)(1) appears to have been intended as non-substantive, “in practice this change could have a significant and unintentional dilutive impact on the research credit when the new section 174 rules take effect in 2022.” (Prior analysis: Tax Notes, Apr. 16, 2018, p. 319.)

The most recent legislative attempt to roll back the TCJA’s amendment of section 174 was in September 2019, when House Ways and Means Committee members John B. Larson, D-Conn., and Ron Estes, R-Kan., introduced the American Innovation and Competitiveness Act (H.R. 4549). Larson and Estes both pointed to supporting job growth as a principal reason for the bill.

Increasing the ASC Rate

Expansion of the ASC rate is another piece of the research credit that Congress could look to in order to promote growth, but other refinements to the ASC might be targeted to help both smaller and newer businesses. “Right now, taxpayers face a choice: Either they go dig out all the research credit information from 1984-1988, or they take a significant haircut in the amount of the credit they can claim. That’s just not right,” Kovacev said. The movement to clean up the ASC isn’t new and has bipartisan support at least in principle, but it hasn’t managed to make it over the legislative finish line yet.

The research credit’s incremental nature adds complexity and compliance costs that effectively limit the amount of tax benefits that flow to smaller companies. Kovacev noted that one major hurdle for small and medium-size businesses in claiming the research credit is compliance costs. “Those companies are performing qualified research activities, but they feel that it is not worth it to jump through the hoops to claim it,” he said. In contrast, a credit based on current R&D spending rather than the incremental spending would reduce complexity and probably be more attractive to companies.

A credit based on current R&D spending rather than the incremental spending would reduce complexity and probably be more attractive to companies.

There are a range of options for expanding the ASC rate. The Obama administration proposed raising it from 14 percent to 17 percent. In a 2019 report, Robert D. Atkinson of the Information Technology and Innovation Foundation suggested raising it to at least 25 percent. His report said the foundation calculated that “expanding the R&D tax credit would pay for itself from the additional revenue growth in 15 years.”

Making the ASC more generous for start-up businesses without income tax liabilities would be a useful change, Atkinson said. In July 2019 Senate Finance Committee member Maggie Hassan, D-N.H., and Sen. Thom Tillis, R-N.C., proposed increasing the ASC rate to 20 percent for qualified small businesses in the Research and Development Tax Credit Expansion Act of 2019 (S. 2207). The bill would also have doubled the cap on the refundable portion of the credit for new and small businesses from $250,000 to $500,000 and expanded the number of firms that would qualify for a refund of their payroll taxes by raising the maximum amount of gross receipts from $5 million to $10 million.

Atkinson said the proposals in that bill would help young firms that are doing R&D, because it would give them cash in the form of a refund of payroll taxes — including Medicare and unemployment insurance taxes — immediately instead of forcing them to carry credits forward. “If Congress is going to do an overhaul of the credit, which is long overdue, that would be a very useful provision,” he said.

Making the ASC more generous for start-up businesses without income tax liabilities would be a useful change, Atkinson said.

Atkinson said another option for the ASC is to expand the base and rate. Under section 41(c)(4)(A), the ASC applies to the amount of qualified research expenses for the tax year that exceed 50 percent of the average qualified research expenses for the three preceding tax years. Increasing the 50 percent base to 75 percent and simultaneously increasing the ASC rate to 28 percent would give taxpayers more of an incentive to expand their research activities, he said.

Coronavirus-Specific Responses

Norton said one option for a coronavirus-related response would be to prorate the current-year qualified research expenses or base period under the ASC. Given the number of furloughs and stay-at-home orders that restrict what research activities can be done, companies may find when they calculate their current-year expenses that they reflect only nine to 10 months, rather than 12. Allowing taxpayers to prorate expenses over the time they were actually able to conduct research activities would provide an apples-to-apples comparison with prior years, Norton said.

Another issue companies may encounter in calculating their credit is the impact of programs that encourage companies to continue paying workers even if they don’t have enough to do or cannot do their jobs because of stay-at-home restrictions. If a company pays wages to employees who would otherwise be performing R&D activities, Congress could make those wage payments qualifying expenses, Norton suggested.

Allowing taxpayers to prorate expenses over the time they were actually able to conduct research activities would provide an apples-to-apples comparison with prior years, Norton said.

Section 41(g) limits the amount of the research credit that can be passed through to owners of interests in unincorporated trades or businesses, partners, estate or trust beneficiaries, or shareholders in S corporations. The credit shouldn’t exceed the amount of tax attributable to the portion of a person’s taxable income allocable or apportionable to the person’s interest in the trade or business or entity. Suspending that limitation would make more of the credit available to help offset debt and free up income, Sadler said.

Advance Payments

In other jurisdictions, tax authorities have expedited payment of their research credits. New Zealand decided to allow taxpayers to receive refunds for R&D credits a year early. Ireland is also willing to expedite the 2020 installments of payments of excess R&D credits for small and medium-size businesses with turnover of less than €3 million. Taxpayers must request expedited payments, and the Irish Revenue will review them before disbursing them. Spain also has a plan for small and medium-size entities that conduct R&D activities.

Congress restored carrybacks for net operating losses in the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136), which can be claimed as tentative refunds, so it might be open to an advance payment regime using the research credit similarly to deliver cash to companies that need it. But legislators would need to act quickly if they want to use advance payments of the credit as a stimulus measure. Kovacev noted that although Congress and the IRS would have compliance issues to sort out because accelerating payments hasn’t been done before, it should be possible to set up the necessary mechanisms for their speedy delivery.

External Applied Research

Congress should fix section 41 so that it doesn’t differentiate between R&D done internally by a company and done externally at a university, Atkinson said. Currently, taxpayers that fund external research activities take only 70 percent of those expenses as a credit on the grounds that some of them represent overhead at the university or outside lab rather than pure research. “There is evidence that there should be an extra incentive to do research ‘extramurally,’ because of the spillover effects such as publishing that research,” Atkinson said, noting that other countries such as France, South Korea, and Canada all provide a larger incentive for research conducted at a university or government laboratory.

The research credit may not be the first place Congress looks to remedy economic damage, but it has been shown to encourage R&D, which in turn could help create jobs. It also enjoys the sort of bipartisan support that makes it a prime candidate for a stimulus measure.