General overview of the innovation incentives
The U.S. offers a federal tax credit for incurring qualified research expenditures (QREs). In addition, most states offer a similar tax credit for investing in research and development.
Types of tax incentives offered
- Are there specific industries that qualify or are there reliefs that require a particular industry focus?
- No. All industries are eligible if qualified activities are performed.
- Do you have to apply for incentives prior to conducting the research or claiming the benefit?
- Not at the federal level. Some states require an application to be filed before being awarded a credit.
- Are there specific documentation or reporting requirements for claiming incentives?
- Claims for R&D tax credits should be submitted with the annual tax return. There is additional documentation that needs to be maintained for supporting the claim in the event of a taxing authority examination but doesn’t need to be filed with the application.
Benefit available in terms of R&D spend
On average, the federal benefit is between 7% and 10% of qualified research expenditures. State credits vary from state to state but usually result in 2% to 5% of qualified research expenditures incurred at the relevant state.
Claim deadline
Applications for federal tax credits are made with the annual income tax return. Most state credits are obtained with the state income tax return filing, although some states require applications. Federal and most state R&D credits also can be claimed through amending previously filed returns.
Qualification criteria for claiming R&D tax incentives
The federal R&D credit is based on wages, materials/supplies, contractor costs, and computer hosting costs incurred in connection with a qualifying activity. Qualifying activities must meet a four-part test:
- They must relate to a new and improved product or process.
- They must be technological in nature.
- At the onset of the project there must be a technical uncertainty.
- A process of experimentation must be used to eliminate the technical uncertainty.
Any taxpayer can claim an R&D credit if they are performing an eligible activity. There are no size requirements or limits to the amount of credit that can be claimed.
Types of activities that qualify as R&D
- What are the criteria that define activities that qualify as R&D, and who determines the criteria?
Qualifying activities are:
- Product development
- Product improvements
- Process development
- Process improvements
- Software development
- Prototype development/testing
Qualifying activities must meet the four-part test outlined above. The burden of proof falls on taxpayers to support how their activities meet the eligibility criteria.
- Do the R&D activities have to be performed within the country to qualify? If not, is there a distinction made between the country where the claimant company is resident?
- Yes, qualified research expenditures must be incurred on U.S. soil to be eligible for the U.S. credit. There is no distinction made based on the residency of the claimant company.
- Does the intellectual property need to reside in the country granting the incentives or in the company claiming the incentives?
- IP can be held in any country, but the taxpayer or taxpayer-controlled group must maintain substantial rights to the intellectual property being developed.
- Does the tax authority have to review the resultant developments to allow a deduction or credit?
- There is no mandatory review, but tax authorities retain the right to review a claimed credit if selected for examination.
Types of expenditures that qualify for R&D
The federal R&D credit is based on wages, materials/supplies, contractor costs, and computer hosting costs incurred in connection with a qualifying activity.
The cash/tax benefit of making an R&D claim
- Are the incentives temporary or permanent?
Federal R&D tax credits are permanent and not subject to congressional extension. Some state R&D credit programs are temporary in nature and subject to periodic extension.
- How is the benefit obtained?
The benefit is claimed on the company’s annual income tax return (or amended return) and the benefit is obtained by directly reducing the company’s tax liability by the amount of the credit.
Qualified Small Businesses (QSBs) can elect to use their R&D credit to offset payroll taxes as a means of monetizing the credit prior to incurring income tax.
State R&D credits usually offset state income tax, but some are refundable or can be used to offset payroll withholdings.
- Are the incentives incremental in nature or volume-based?
- R&D tax credits are based on the incremental spend over a base amount determined by qualified research expenditures incurred in prior years.
- Are there general rules for estimating the value of the incentives?
- The federal R&D credit is typically 7% to 10% of qualified research expenditures. State programs vary but often state credits range between 2% and 5% of the state qualified research expenditures incurred.
Process for making an R&D claim
Federal and state R&D credits:
- Determine qualifying projects
- Quantify associated expenditure
- Prepare a detailed R&D report
- Complete relevant regulatory requirements
- Claim R&D credits via federal or state income tax returns. Some states require applications to claim credits.
Limitations on the amount of R&D tax incentives that can be used each year
- Is there a cap on the maximum level of benefit that can be received per year, per company, or for all the qualifying taxpayers together?
- The amount of benefit is only limited by the level of qualifying research expenditures incurred. There is no maximum. Most state credits also are unlimited.
- Are tax credits refundable?
- Federal credits are not refundable, but Qualified Small Businesses can elect to use their R&D credits to offset payroll taxes. Some state credits are refundable.
- Can surplus incentives be carried back or forward and used in years other than the origination years?
- Yes, the federal R&D credit can be carried back one year and then forward 20 years. State R&D credits often can be carried forward to offset tax in future years.
- Are there any other types of limitations?
- The credit can only be utilized against income tax (or payroll tax for QSBs) generated from the taxpayer performing the R&D activities.
- Are the R&D costs deductible when deriving taxable income?
- At federal level, costs are currently required to be capitalized. State treatment varies by state.
