U.S Tax Reforms:
Research and Development Tax Credit
On December 22, 2017, President Trump signed into law H.R. 1, more commonly referred to as the Tax Cuts and Jobs Act (the Act). While maintaining the permanency of the Research Tax Credit, the Act eliminated the Domestic Production Activities Deduction under Section 199 of the Internal Revenue Code (IRC). With the elimination of the Section 199 deduction, effective for tax years beginning January 1, 2018, the value of the Research Tax Credit could not be more beneficial to U.S. companies than it is now.
In 1981, Congress enacted the Research Tax Credit to incentive taxpayers to invest in research and innovation related to new or improved products, processes, computer software, techniques, formulae, or inventions within the United States. Since its inception, Congress has continuously extended the Research Tax Credit incentive to stimulate the U.S. economy, until making it permanent under the PATH Act in 2015. With the permanency of the Research Tax Credit, U.S. companies can utilize.
The Act's Enhanced Impact on the Research Tax Credit
| Reduced Corporate Tax Rate
The Act lowers the corporate tax rate from 35% to 21% which, in effect, provides an increased net benefit from 65% to 79%. This is true even when making the IRC Section 280C(c)(3) election (known as a “280C election”).
A taxpayer generally must add the Research Tax Credit back to its taxable income through an M-1 adjustment. However, a 280C election allows taxpayers to take a reduced credit election and forego any addback related to the credit. Prior to tax reform, the credit was reduced by 35% (the corporate tax rate). Now, with the reduction of the corporate tax rate, the 280C election will only reduce the Research Tax Credit by 21%. Additionally, by electing to reduce the Research Tax Credit under 280C, a taxpayer may reduce potential negative state income tax effects.
Ultimately, the decrease in tax rate serves to make the U.S. corporate tax rate more competitive from a global perspective, which in turn allows for the increased net benefit that taxpayers will see from the Research Tax Credit beginning in tax year 2018.
| Corporate Alternative Minimum Tax
The Act also eliminates the alternative minimum tax (AMT) for tax years beginning after December 31, 2017. Prior to the repeal of AMT for corporations, corporate taxpayers could not utilize the Research Tax Credit to offset AMT, unless the corporate taxpayer was an “eligible small business” under IRC Section 38(c) (5)3. With the elimination of AMT, corporations that have historically been paying AMT now have the opportunity to take advantage of the Research Tax Credit to offset any regular tax liability, subject to general business credit limitations under IRC Section 38(c)(1)4. Under this limitation, a taxpayer may reduce its liability to 25% of the amount of net regular tax liability that exceeds $25,000.
| Net Operating Losses under IRC Section 172
For tax years ending after December 31, 2017, the net operating loss (NOL) deduction is limited to 80% of taxable income. While the Act repeals the current carryback/carryforward provisions under IRC Section 1725, it also allows for an indefinite carryforward for NOLs. Because of this provision under the Act, taxpayers in a NOL position should consider whether or not to forego the 280C election. The Research Tax Credit itself may not be carried forward indefinitely, but if a company is operating under a NOL, foregoing the Section 280C election may be more advantageous. Doing so may increase the Research Tax Credit carryforward because a higher Research Tax Credit may have the ability to offset tax liability for a longer period, extending the taxpayer’s ability to utilize NOL carryforwards.
| Amortization of IRC Section 174 Expenses
Currently, under IRC Section 174, taxpayers may deduct research and experimental expenditures paid or incurred during a tax year, or choose to amortize such costs over no less than 60 months. Alternatively, under IRC Section 59(e), a taxpayer may elect to amortize research expenses over a 10-year period.
For tax years beginning after December 31, 2021, the Act requires taxpayers to capitalize and amortize IRC Section 174 research and experimental expenditures over a period of five years. Additionally, the Act requires that software development costs be treated as research and experimental costs. Therefore, software development costs will also receive the five-year amortization treatment. Further, the Act requires that a taxpayer must capitalize and amortize expenditures related to research conducted outside of the United States over a period of 15 years. The purpose of this provision in the Act is to incentivize taxpayers to move research activities to the United States.
The implications of this provision are far reaching. Taxpayers will lose the immediate ability to reduce tax liability through a current year deduction. In addition, the amortization provision under IRC Section 174, for state purposes, may be substantial if the deduction typically reduces a taxpayer’s state tax burden. However, to overcome the IRC Section 174 implications, taxpayers may be able to characterize a portion of research and experimental expenditures as ordinary and necessary business expenses under IRC Section 162, which would allow for a current year deduction.
One caveat that may prove to be beneficial to taxpayers under IRC Section 174 is that, presently, only “reasonable” research expenditures may be deducted. Under new tax law, the Act removes IRC Section 174 (e), which deems that research expenditures must be “reasonable under the circumstances.” Thus, this may provide taxpayers with the ability to include research and experimental expenditures that have been deemed “unreasonable” under current law.
The important takeaway is that, although capitalization under IRC Section 174 will create higher tax liabilities after December 31, 2021, those liabilities will be present for a short period because of the timing differences generated by amortization. Over time, these liabilities will flatten out as the capitalization of expenses catches up to the five-year amortization schedule.
Even with the negative impact by IRC Section 174 on current-year deductions beginning after December 31, 2021, the Research Tax Credit under IRC Section 41 remains virtually untouched and intact, and incredibly valuable for minimizing tax liability.
The reduction of the corporate tax rate and the elimination of AMT will not only increase the overall credit benefit to U.S. taxpayers, it will also provide taxpayers, that have historically been deprived of the Research Tax Credit, the ability to benefit from and take advantage of the Credit.
ABGi USA is here to help you navigate the complicated nature of the R&D Tax Credit and other tax incentives.