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Texas proposes significant changes to research and development tax treatment

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April 2021

In brief

The Comptroller has submitted significant proposed amendments to Texas Admin Code Sec. 3.599, concerning the research and development activities franchise tax credit. 

The proposed amendments do not provide a general applicable date. Existing franchise tax rule Sec. 3.599 applies to “franchise tax reports originally due on or after January 1, 2014.” Accordingly, the Comptroller may be intending to apply the changes retroactively. The proposed amendments provide the Comptroller’s interpretation and implementation of IRC Section 41 and applicable regulations adopted thereunder. 

The publication triggers a 30-day period of public commentary. The earliest date of adoption is May 16, 2021.

For consideration. Taxpayers should review their facts and the proposed amendments to determine the impact of the proposal. Taxpayers may experience significant credit reductions for any open tax period relating to internal-use software, prototype research activities, or supplies used in a product or process improvement. Additionally, a taxpayer’s credit may significantly change due to the proposed separate-entity calculation.

In detail
Background

Effective for reports originally due on or after January 1, 2014, Texas allows a franchise tax credit to entities performing qualified research. Pursuant to Texas Tax Code Ann. § 171.651(3), “qualified research” has the meaning assigned by IRC Section 41(d) and associated federal regulations, except that the research must be conducted in Texas. “Qualified research expenditures” has the meaning assigned by IRC Section 41(b) and associated federal regulations.

Conformity to federal regulations

Texas law defines the “Internal Revenue Code” as the Code in effect on December 31, 2011, and includes Treasury regulations “applicable to the tax year to which provisions of the code in effect on that date applied.”

The proposed amendments interpret conformity to federal regulations by providing that a federal regulation adopted after December 31, 2011, is included only “to the extent that the regulation requires a taxpayer to apply the regulation to the 2011 federal income tax year” (emphasis added).

The Comptroller provides an example of a federal regulation to which Texas would not conform. Treasury Regulation Sec. 1.41-4 was adopted on November 3, 2016. It provides that regulatory guidance for internal-use software applies for tax years beginning on or after October 4, 2016. Because such guidance was not mandatory for the 2011 tax year, the Comptroller has interpreted that it is not incorporated into the definition of “Internal Revenue Code” for Texas purposes. 

Another example advanced by the Comptroller regards changes to the definition of research and experimental expenditures in Treasury Regulation 1.174-2 adopted on July 21, 2014. Certain changes were applicable for tax years ending on or after July 21, 2014. Because these changes were not applicable to the 2011 tax year, they are not included in the definition of ‘Internal Revenue Code’ for Texas purposes.

Observation: The Comptroller’s interpretation of the Internal Revenue Code as of December 31, 2011, provides strict limitations on Treasury regulations that may have been proposed or outstanding as of the 2011 effective date. While the subsequent federal regulations have been interpreted to be clarifying in nature, the Comptroller has effectively opined that it will not allow internal-use software or prototype research activities described under subsequent federal regulations to meet the requirements under the Texas statute.

Supplies used in a manufacturing product or process improvement excluded

The proposed amendments would exclude from “qualified research” any item of tangible personal property where the taxpayer would not have paid Texas sales and use tax due to the manufacturing exemption or the sale for resale exemption. 

Observation: This proposed treatment requires taxpayers to choose either a sales and use tax exemption or a research and development supplies credit. As the sales tax exemption effectively reduces tax by approximately 8% and a claim for a credit under this section results in an approximate 2.5% credit, manufacturers likely would choose the sales and use tax exemption if the rule is applied as proposed. 

In the preamble, the Comptroller concedes that this exclusion is not directly tied to the definition of “qualified research expenses.” Rather, the Comptroller explains that the manufacturing exemption was not intended to apply to R&D and that items used in qualified research “are not resold.” 

Observation: Taxpayers undertaking research in the development of a new product or process generally may intend to create a new or improved product for sale. Treasury Regulation 1.174-2(a)(1) addressed the distinction to be made between qualified and non-qualified research expenditures utilized in producing a product:

The ultimate success, failure, sale, or use of the product is not relevant to a determination of eligibility under section 174. Costs may be eligible under section 174 if paid or incurred after production begins but before uncertainty concerning the development or improvement of the product is eliminated.

Internal-use software excluded

The proposed amendments would exclude from “qualified research” any research activities with respect to internal-use software. 

Internal-use software is computer software developed by, or for the benefit of, the taxpayer primarily for the taxpayer’s internal use. Software developed by a taxpayer primarily for internal use by an entity that is part of an affiliated group to which the taxpayer also belongs is considered internal-use software. 

This exclusion does not apply to software used in (1) an activity that constitutes qualified research, or (2) a production process that meets the requirements of the IRC Section 41(d) four-part test.

The Comptroller also provided examples of software development activities that likely would be deemed to satisfy the qualified research definition. These include “developing software as part of a hardware product where the software interacts directly with that hardware in order to make the hardware/software package function as a unit.”

Observation: The Comptroller’s rule does not specifically define what should be considered “internal-use” software. However, it does provide what is not internal-use — software that is “sold, leased, licensed, or otherwise marketed for separately stated consideration to unrelated third parties.” Accordingly, companies are left to the discretion of the Comptroller based upon facts and circumstances as to whether their software is deemed internal-use software.

Exclusions of other software activities

The Comptroller provides several examples of how the four-part test applies to software development activities. The Comptroller also identifies a list of software development activities that likely would be considered qualified research and a list of 21 software development activities that are unlikely to be qualified research. The examples and lists are adapted from the IRS Audit Guidelines on the Application of Process of Experimentation for All Software. 

Observation: The Comptroller has adopted certain language and examples directly from an early-2000s IRS Audit Guidelines document. However, there are several differences. Within the referenced guide, there are 21 activities that are stated as “high-risk” and “moderate-risk” activities subject to further review and investigation. There are also four noted “low-risk” activities. The Comptroller has taken the position that “high-risk” and “moderate-risk” activities are “unlikely to qualify” within the proposed amendments and stated that “low-risk” activities are “likely to qualify.”

The IRS Audit Guidelines technological references (e.g., Y2K Program Changes) do not address today's cellular phone technology, blockchain, web-based services or the proliferation of cloud computing technologies which drive current year research expenditures. As a result, the IRS Audit Guide and thus the proposed amendments may offer only limited guidance as to the types of qualifying research projects currently being reviewed and approved by the IRS under IRC Section 41.

Exclusion of funded research from qualified research expenditures

The proposed amendments provide that qualified research does not include the activities of “funded research.” Research is considered funded if (1) the taxpayer retains no substantial rights to the research and (2) the payments to the researcher are not contingent upon the success of the research. If the taxable entity does retain substantial rights, then research is only funded to the extent of the payments and fair market value of any property that the taxable entity becomes entitled to by performing the research. If the expenses related to the research exceed the amount the researcher is entitled to receive, the research is not considered funded only with respect to the excess expenses. 

Observation: The proposed amendments depart from the IRS statute that attempts to prevent the double counting of research and development expenses by various parties who may not retain rights to the research. The regulation provides an example stating that regardless of whether rights are retained to the research, only those expenses in excess of the consideration received would qualify as qualified research expenditures. Taxpayers in the aerospace and defense industry and software contractors who retain rights should evaluate the example provided within the proposed amendments.

Combined reporting 

The proposed amendments provide the following guidance for combined groups:

  • Each member of a combined group determines the amount of the R&D credit separately and then the combined group includes the credits of each member on the combined report.
  • A combined group must prorate any carryforward of the credit among the members of the combined group. This prorated carryforward credit remains with the member of the combined group for future tax periods, regardless of whether the member remains in the same combined group. 
  • A combined group is the ‘taxable entity’ for the purposes of claiming the credit.

Observation: The credit would be calculated on an entity-by-entity level and individually combined in calculating the credit. This is a significant change in the method under which entities currently calculate credits on a combined basis and is not outlined in the current forms prescribed by the Comptroller. It is expected that taxpayers will have materially different calculations in calculating their credits on an entity-by-entity basis when utilizing the average of the prior three years qualified research expenditures (QREs) as their base period. 

Requirements for claiming the credit

The proposed amendments provide that: 

  • The taxable entity has the burden of proof to establish its entitlement to, and value of, the credit by clear and convincing evidence.
  • All QREs must be connected to specific qualified research activities.
  • All QREs must be supported by contemporaneous business records.
  • Any determination by the IRS that a taxable entity is entitled to the federal research and development credit does not bind the Comptroller when determining a taxable entity's eligibility for the credit.

Observation: Even though Texas incorporates IRC Section 41 into its R&D credit, under the proposed amendments, an IRS determination that certain expenditures qualify for the federal credit would not be binding upon the Comptroller. 

Calculation and audits for years closed under the normal statute of limitations

The proposed amendments allow the Comptroller to verify the qualified research expenses used to compute the prior year average even if the statute of limitations for the prior-year has expired. This verification will not result in an adjustment to tax, penalty, or interest for any report year for which the statute of limitations is closed.

Similarly, the proposed amendments allow the Comptroller to verify credit carryforwards by verifying the qualified research activities on which the credit that created the carryforward was based. This verification may occur even if the statute of limitations has expired for the report year on which the original credit was claimed. This verification will not result in an assessment of tax, penalty, or interest for any period for which the statute of limitation is closed, but may result in an adjustment to the credit carryforward for any periods for which the statute of limitations is open.

The takeaway

The Comptroller’s proposed amendments offer a significant departure from IRS statute and regulations when addressing the definitions of qualified research and qualified research expenditures. The changes would also provide significant administrative challenges to taxpayers by requiring the research credit to be computed by legal entity and records to be maintained beyond the normal statute of limitations. 

Comments on the proposal may be submitted to Teresa G. Bostick, Director, Tax Policy Division, P.O. Box 13528, Austin, Texas 78711-3528. Comments must be received no later than 30 days from the date of publication of the proposal in the Texas Register. Taxpayers also may request a public hearing pursuant to Government Code, Chapter 2001 (Administrative Procedure Act). The Comptroller will grant an opportunity for a public hearing before it adopts a substantive rule if a public hearing is requested by (1) at least 25 persons, (2) a governmental subdivision or agency, or (3) an association having at least 25 members.

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