In 2007, companies will seek to increase their return on investment (ROI) on technology investments by claiming more than an estimated $1 billion in U.S. R&D Tax Credits (RTCs). In addition, they will claim similar benefits in more than 30 countries that offer similar incentives, factoring them into both their ROI calculations as well as their decisions about whether and where to offshore their future IT investments.
What are these benefits, and what’s involved in realizing them? Recent developments have changed the answers—for the better.
Federal and state RTCs can provide a benefit of as much as 15 percent of the qualified wages and contractor expenses involved in qualified activities. Activities often encompass efforts to develop or improve the functionality or performance of data storage, security, VoIP, visualization, ERP or other IT applications or capabilities.
In addition, certain IT-related costs not eligible for RTCs may be currently deductible, including costs for business process reengineering, IT support, employee training, data conversion and system rollouts or implementations.
Finally, as a way to improve their economies and future tax base, most states and larger cities offer generous jobs, training and other credits and incentives to companies that plan and make IT-type investments in their jurisdictions.
Other countries offer RTCs, deductions and “super-deductions” worth as much as twice the U.S. benefits. For example:
- Australia allows a 125 percent deduction for qualifying expenses, plus a 175 percent deduction for qualifying expenses exceeding a base amount of prior-year spending (incremental spending).
- Canada offers a 20 percent RTC to large companies—35 percent for Canadian-controlled private corporations. Canada also offers provincial incentives in most provinces, some of which are refundable.
- China provides a 150 percent deduction without its former requirement that spending increases by 10 percent.
- France offers a 50 percent RTC of which 10 percent is flat and 40 percent is incremental.
- India allows a 100 percent deduction.
- Ireland provides a 20 percent RTC, plus a 100 percent deduction.
- Japan offers a flat 10 percent RTC, with 15 percent for small companies.
Israel, Mexico, Netherlands, Portugal, Singapore, Spain and the United Kingdom also offer significant benefits for IT investments.
Sometimes the non-U.S. benefit is greater because more costs are eligible: gross instead of just taxable wages, 100 percent of contractor expenses instead of just 65 percent and overhead. Sometimes it is because the non-U.S. credit and deduction rates are higher, or because the non-U.S. benefits are flat or volume-based instead of incremental. Other times it is because companies can claim a benefit in more than one country for the same IT costs; some countries don’t require that the qualified work is performed in their jurisdiction, such as the U.K. and Japan.
Realizing (More) Benefits: Recent Developments
Many companies are not aware of the scope of activities that may qualify for RTCs. They may believe that the only qualifying research takes place in the traditional laboratory. This is not the case, either in the U.S. or in most other countries that offer RTCs. Such companies claim only costs associated with their core R&D departments, not realizing that qualified activities often take place in other departments as well. Other activities include marketing, sales, executive management, quality assurance and customer service. By understanding what qualifies, and how to make a claim, companies can realize more benefits more efficiently.
Each country has its own rules about the types of costs and activities that qualify for their incentives and how to claim them. Some require that certain information be filed with the claim, while others provide certain rules regarding how those claims are administered. It is important to understand not only what information is required but also the timing of when to file, as some countries have strict deadlines.
In the past, such requirements and administration have reduced the value of some of these benefits. Perhaps no country’s RTC has suffered more from such restrictions than the U.S. RTC. Recent developments, however, have made the U.S. RTC both more accessible and more beneficial.
New discoveries not necessary. Realizing that the benefit of the U.S. RTC formerly meant that companies had to venture into uncharted waters or exceed, expand or refine the principles of computer science. This is no longer the case as no such discoveries are necessary. To qualify, companies must only attempt to develop or improve the functionality, performance, reliability or quality of the software, product, process, invention, technique or formula.
Documentation requirements relaxed. It is also no longer the case that companies must—before or during the early stages of a project—prepare written documentation describing the principal questions to be answered and the information to be discovered. Before they allow an RTC claim, tax authorities will still generally require that certain information is provided. They will still prefer documentation created by IT personnel as part of the IT project to documentation created by tax department personnel years after the project for the explicit purpose of supporting an RTC claim. But the requirement that “principal questions” be documented at the outset of a project no longer exists.
Many companies endeavor to claim the credit years after the work is done. During the time between the claim and when the work was completed, documentation may have been destroyed or lost. In addition, many companies have data retention policies that require data to be purged within certain timelines. The lack of early project documentation should not necessarily deter a company from claiming credits if the activities qualify.
New simplified credit: 1984 to 1988 not relevant. For many companies, the regular RTC equals a percentage of the excess of their qualified spending over a base amount calculated with reference to sales and qualified spending from 1984 to 1988. Because many companies’ qualified spending does not exceed this amount, their regular RTC is $0. In addition, because many companies don’t have information from 1984 through 1988, they cannot even reliably calculate their optimal regular RTC.
For these reasons, a new Alternative Simplified Credit (ASC) was enacted for 2007 expenditures. Calculated with reference to the three prior years’ qualified spending instead of that from 1984 to1988, the ASC’s net value can equal as much as 7.8 percent of current-year qualified spending—20 percent more than the regular RTC’s 6.5 percent. In addition, there are proposals currently before Congress that call for an increase in the net value of the ASC to as much as 10 percent by 2010.
Increased alternative incremental credit (AIC) rates. Companies whose regular RTC and ASC are small may find the rates for the 2007 AIC more beneficial: They’ve been increased by 33 percent.
Common errors. In addition to these recent developments, there are common errors companies make that may limit their RTCs. Some examples of errors include:
Start-up rules. The rules for calculating the credit are different for companies determined to be start-up companies than for other companies. Many companies believe they are start-ups when in fact they are not, and vice versa. The difference lies in how the base amount is calculated. A high base amount may limit a company’s RTC to $0. Because of this, it is critical to use the correct calculation method.
The date a company was founded is only one factor of many that determines whether a company is a start-up. There are many companies that have existed for more than 25 years that are, according to the U.S. tax rules, start-up companies. It is also important to note that acquisitions and dispositions of businesses (and even of only business assets) can affect this determination. As a result, there are companies that have recently been founded who assume they are start-ups but, due to an acquisition, may not be. The start-up calculation determination alone may be the difference between a large RTC and none.
Calculating gross receipts and qualified costs. The calculation of gross receipts and qualified costs are two essential elements in calculating RTCs. Many companies fail to apply acquisition and disposition information properly to their calculations. Like the start-up calculation error, this can impact the base amount calculation greatly and thus be the difference between a large RTC and no RTC.
In addition, many companies incorrectly calculate gross receipts. The definition of gross receipts is not the same in all jurisdictions, and care must be taken to use the correct definition for calculations.
Finally, in determining qualified costs, many companies fail to include costs that should be included. Examples include:
These developments and the correction of common errors should improve the value of the U.S. RTC to most companies. And although it is set to expire on December 31, 2007, most commentators share Senator Orrin Hatch’s confidence that “the research credit will be extended once again”—it has expired and has been reenacted 12 times since 1981.
- Taxable wages for employees involved in direct support and supervision of qualified work
- Project costs that had previously been capitalized
- Costs associated with work funded by a foreign parent company
The Bottom Line
As we approach year-end, many technology businesses are eligible to claim tax credit benefits for expenditures to develop or improve their products, manufacturing processes or software. In evaluating whether and where to make your next significant IT investment, consider the relative advantages of U.S. and non-U.S. tax credits and incentives. Doing so will help maximize your return on investment.
Chris Bard and Jonathan Forman are principals in the Technology Practice of BDO Seidman, LLP, one of the nation’s leading accounting and consulting firms.
For more tax tips, visit IRS.gov.