President Bush signed the Tax Relief and Health Care Act of 2006 into law on December 20, 2006. The 10-year, $45 billion tax relief package contains a two-year, retroactive renewal of the research tax credit and other individual and business tax incentives that had expired at the end of 2005. In addition to the extending the R&D credit, the bill also makes two important changes to the credit, most notably adding a third method of calculating the research tax credit -- the new alternative simplified credit ("ASC") and increasing the rates of the alternative incremental research credit ("AIRC"). A summary of the changes follows, and taxpayers claiming the R&D credit should evaluate these changes in light of their past calculations and anticipated expenditures going forward.
Changes to the Research Tax Credit Calculation
ASC - The new "third" method of credit calculation
Taxpayers can elect the ASC for qualified research expenditures ("QRE"). The ASC equals 12 percent of the QRE for taxable years that exceed 50 percent of the average QRE for the three taxable years preceding the credit determination year. If the taxpayer has no QRE in any one of the three preceding tax years, the rate of the ASC equals six percent of the QRE for the credit determination year. Unlike the regular research credit ("RRC"), the ASC does not have a minimum base amount equal to 50-percent of credit determination year QRE.
AIRC increased rates
The rates of the AIRC are increased for each of the three steps, i.e., first step increased to three percent from 2.65 percent; second step increased to four percent from 3.2 percent; and third step increased to five percent from 3.75 percent.
These two changes are effective for taxable years ending after December 31, 2006, subject to the general termination provision applicable to the credit. Special transitional rules apply to fiscal year 2006-2007 taxpayers.
Impact on Taxpayers
The reenactment of the credit has several direct and indirect benefits. For taxable years ending after December 31, 2006, taxpayers now have the option to choose between three credit calculation methods: (1) the RRC; (2) the AIRC; or (3) the new ASC.
The RRC calculation remains unchanged, and the rates for the AIRC have been increased.
However, with the introduction of the ASC, many taxpayers may benefit from the removal of the traditional "base period" (generally the tax years ended 1984-1988) and the research intensity approach (the relation of QREs to gross receipts). This will allow ASC taxpayers to measure the credit solely on the calculation of incremental QREs. This new calculation method will be particularly important for taxpayers with:
• Incomplete records from the 84-88 base period;
• Significant growth of gross receipts in recent years;
• A complex history of organizational activity (mergers, acquisitions, and dispositions); and
• Significant amounts of dividends repatriated into the United States (generally during 2005) pursuant to the temporary dividends received deduction of section 965. Note: Because the possible treatment of section 965 dividends as gross receipts for purposes of the research credit is uncertain, section 965 dividends may have significant impacts on the calculation of four-year average annual gross receipts for purposes of both the RRC and AIRC.
Calculating and substantiating the RRC can be a cumbersome task. Election of the ASC, although binding, will relieve much of this administrative burden by shifting the measurement of research incrementally over the three prior years. This is a key consideration for taxpayers unable to claim the reinstated research credit because their current R&D intensity is lower than during the credit's 1984-1988 fixed base period.
For some taxpayers, one key benefit in calculating the ASC is the removal of gross receipts from the equation if their facts reflect a rising revenue stream. In addition, many manufacturing and high technology companies especially will benefit from this change if their facts reflect a limitation in the amount of RRC available to them due to a shift in the relationship of QREs to gross receipts from the base period to current years. During 1984-1988, it was common for manufacturing companies, in particular taxpayers in the government contracting industry, to spend significant amounts of money on R&D in relation to sales in those same years. As these companies have increased research expenditures through the development of more efficient, cost-effective processes over the years, the relative sales may have increased faster than the increase in research spending. As a result, the ratio of QREs to gross receipts has been decreasing, effectively limiting the amount of credit available under the RRC.
Section 280C Considerations
Section 280C provides for the disallowance of expenses where a credit is allowable for these same expenses. Section 280C(c)(1) applies this rule to section 174 research and experimental expenditures that also qualify for the section 41 research tax credit. Under section 280C(c)(3), taxpayers can make an annual election to claim a reduced RRC (at a 13-percent rate rather than the normal 20-percent rate for the regular credit) and thereby avoid the necessity of reducing the deduction for section 174 research and experimental expenditures. Similarly, if a taxpayer calculates the credit under the AIRC or ASC method and makes a section 280C(c)(3) election, the credit will be 65-percent of the full amount of the credit.
Under section 280C(c)(3)(C), an election to claim the reduced section 41 credit for any taxable year shall be made on the tax return not later than the time for filing the return of tax for such year (including extensions), and shall be made in such manner as the IRS may prescribe. Retroactive sections 280C elections cannot be made on an amended tax return.
Section 123(a) of the Act provides that
"In the case of any taxable year ending after December 31, 2005, and before the date of the enactment of this Act, any election under section 41(c)(4) or section 280C(c)(3)(C) of the Internal Revenue Code of 1986 shall be treated as having been timely made for such taxable year if such election is made not later than the later of April 15, 2007, or such time as the Secretary of the Treasury, or his designee, may specify. Such election shall be made in the manner prescribed by such Secretary or designee."
ASC Revocations
Section 104(c) of the bill provides in part that "An election under this paragraph shall apply to the taxable year for which made and for all succeeding taxable years unless revoked with the consent of the Secretary." This is very similar to the language in the Code governing AIRC elections. Section 1.41-8(b)(3) of the regulations provides special rules for revoking the AIRC:
An [AIRC] election under this section may not be revoked except with the consent of the Commissioner. A taxpayer is deemed to have requested, and to have been granted, the consent of the Commissioner to revoke an election under section 41(c)(4) if the taxpayer completes the portion of Form 6765 relating to the regular credit and attaches the completed form to the taxpayer's timely filed (including extensions) original return for the year to which the revocation applies. An election under section 41(c)(4) may not be revoked on an amended return. [Emphasis added.]
However, it remains to be seen whether ASC revocations will be covered by additional regulatory guidance similar to Treas. Reg. Sec. 1.41-8(b)(3), or whether taxpayers wishing to revoke an ASC election will have to seek consent through a Private Letter Ruling.
Summary
Overall, the option to elect the ASC will provide long-awaited tax relief to research-intensive companies that have not, up until this point, had advantageous business models with respect to the mechanics of research credit calculation.
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