What is R&D Tax Credit and How to Qualify & Claim It?
Research and development (R&D) are the cornerstones of growth and innovation for organizations worldwide as they compete against the backdrop of a fast-changing technology landscape. As businesses globally increase their R&D expenses, they can benefit from the federal R&D tax credits incentive to reduce their dollar-for-dollar tax liability on such expenditure if they meet specific conditions. Notably, this US federal tax incentive program helps organizations lower their tax liabilities only on certain expenses incurred domestically in the USA.
The spirit of the R&D tax credit incentive is to encourage innovation. That’s the reason why organizations are eligible for tax benefits even if they don’t succeed in their R&D efforts.
Did You Know?
US businesses have led the global rebound in R&D investments by building unique products and competing successfully. Chinese companies were the second-largest investors in R&D activities, followed by Germany in the third spot.
What is R&D Tax Credit?
R&D tax credit (26 U.S. Code §41) is a tax concession offered by the government of the United States of America to businesses for research and innovation activities undertaken domestically. It’s formally known as the Credit for Increasing Research Activities.
Granted under the Internal Revenue Code Section 41, the tax credit was introduced by the American Congress in the form of ‘The Economic Recovery Tax Act’ (ERTA) 1981 to offer tax stimulus to US businesses. This legislation intended to stimulate investments, innovation, and foreign direct and indirect investment into the country.
What constitutes qualified research has been debated fiercely and interpreted differently by companies and the federal tax body, the IRS. This has led to several revisions of the Act, starting with the Tax Reform Act of 1986.
Several countries besides the USA offer such incentives to attract businesses to set up shops and unleash their innovative spirits. Such initiatives empower nations to compete globally. Plus, they profoundly impact any country’s standing on the Global Competitive Index and its stature as an attractive corporate investment destination.
What Activities Qualify for R&D Tax Credits?
Organizations must meet the requirements laid down in section 41(d). It states that the term “qualified research” means research activities undertaken:
- To discover technological information
- To develop or improve a business component
- Around all activities of process experimentation for a qualified business purpose
- Where spending may be treated as expenses under section 174, such as operating expenses for research facilities, cost of supplies and wages for researchers, etc.
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Organizations must demonstrate clearly that the research activity meets the requirements laid out in all four tests separately to qualify for an R&D tax credit claim. For this, businesses can take a four-part test to understand whether their R&D activities qualify for tax credit.
The 4-Part Test
The 4-part qualification test helps assess whether a taxpayer can classify research and innovation expenses as qualified research expenses. Let’s understand these tests better.
1. The Section 174 Test
According to the IRS, expenses that organizations incur on their business “and represent a research and development cost in the experimental or laboratory sense” meet the section 174 test or the elimination of uncertainty test.
Reasonable limitations include expenses on land assets or exploration of gas, oil, mineral and ore. Plus, expenses on activities like customer surveys, acquisitions and promotions.
2. The Discovering Technological Information Test
This means that an organization must demonstrate that its research would discover information that can improve existing business components or help develop new business components. The IRS mandates that taxpayers should fundamentally base their research on existing hard scientific disciplines of engineering, computer, physical and biological sciences for its expenses to be considered QRE (qualified research expenses).
3. The Business Component Test
The research must aim to improve business components and processes or create more efficient processes. It could mean developing a new software, product, technique, process, invention, or formula that a taxpayer can use for business purposes.
4. The Process of Experimentation Test
Taxpayers must establish that they have experimented substantially. They can conduct the experiment if there’s no uncertainty that they are capable of achieving the results they desire or in the method that they use. They need to find out if such uncertainties exist, find suitable alternatives to end the uncertainties and even assess these alternatives.
What Activities Don’t Qualify for R&D Tax Credits?
According to the IRS, activities that do not qualify for R&D tax credit include:
- Research conducted outside the United States or funded by foreign governments.
- Routine data collection, reverse engineering minus any significant innovation, research conducted after a commercial rollout, and duplication of an existing business process or product/s.
- Developing software products for internal consumption or conducting market surveys, data sampling and collection and undertaking arts and humanities-related research.
- Travel, meals, and telephone expenses of researchers, relocation or rental/lease expenses, or professional dues or royalty/license expenses and substantials.
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What Expenses Qualify for R&D Tax Credit?
In-house research expenses and contract research expenses cumulatively account for qualified research expenses. To understand this in detail, let’s take a look at the eligible activities that can give rise to such expenses. Organizations can claim tax credits for activities prescribed under the qualified research expense (QRE) as per the R&D tax credit scheme. They can easily assess whether the expenses incurred for R&D activities can be classified as QRE. Businesses can claim expenses as QRE if they:
- Show a purpose to create a new technology or improve the functioning of an existing business.
- Eliminate ambiguity by clearly demonstrating how its research and innovation will lead to new information or insights. This should leave no room for misinterpretation.
- Establish the process of experimentation, showing how they are alleviating the lack of information and uncertainty around their product or technology.
- Showcase a technological bend and involve scientific research in areas like mathematics, chemistry, physics, biology, etc.
What Constitutes In-house Research Expenses?
According to Section 41(b)(2) of the IRS, in-house research includes:
- Employee wages paid for their services that support the research activities
- Sums spent on materials and supplies, with certain exceptions like land
- Expenses incurred in the use of computers for research
What Constitutes Contract Research Expenses?
Contract research expenses can constitute 65% of any outflow of wages or remuneration to an individual not on a taxpayer’s payroll. This is paid by any taxpayer who utilizes the services of such individuals for qualified research or services. These services must be deemed qualified under section 41(b)(2)(B), if performed by the employees of a taxpayer to qualify for contract research expenses.
How to Claim R&D Tax Credit
Businesses need to fill out IRS Form 6765 or ‘Credit for Increasing Research Activities’ to claim their R&D tax credit under code section 41 of the IRS. According to the IRS, businesses can use Form 6765 to “figure and claim the credit for increasing research activities, elect the reduced credit under section 280C, and elect and figure the payroll tax credit.”
Industries eligible for this R&D tax credit include software development, IT, engineering, pharmaceuticals and cloud computing. For the uninitiated, tax-paying organizations can use Form 6765 to claim R&D tax credit in two ways:
- Regular credit
- Alternative simplified credit (ASC)
Keep Your Documents in Order
Any R&D tax claim requires a fool-proof paper trail. Therefore, the importance of documentation cannot be understated. Organizations should ensure accurate documentation of all expenses on different heads, including wages, equipment and supplies. Documenting scope changes, minutes of meetings, contracts & invoices for any 3rd party partners, assets related to blueprints/patents and other such details can help lower rejections. Moreover, it can ensure that taxpayers claim their R&D spends rightfully.
Automating payroll, time and attendance, billing, and invoicing can significantly reduce errors and improve efficiency. Most importantly, it can ensure an accurate paper trail for IRS audits. That’s where time-tracking and project management software can help.
How Deltek | Replicon Can Help You With R&D Tax Credit Claims
Deltek | Replicon’s time-tracking solution and Polaris project portfolio management solution are designed to help businesses maximize their R&D tax credit. Here’s how:
- Automated capture of employee time spent on R&D activities
- Advanced validations to accurately capture timesheets and ensure error-free calculation of R&D hours
- The ability to set costs at the resource level and easily estimate their R&D claim limit
- Prioritize and capture all R&D-related projects in real time with a centralized view of ongoing R&D projects
- The ability to optimize resource utilization on R&D projects
Conclusion
R&D will likely remain central to organizational efforts in the coming years, especially as the technological landscape evolves to create new business models. Businesses that succeed in innovating their products and services will become more competitive. Plus, they would be better placed to meet intensifying client expectations and tide over market complexities.
However, innovation and research must not be at the cost of financial exuberance. The adage ‘a penny saved is a penny earned’ holds true for businesses as much as for individuals.
The R&D tax credit is a fantastic tool to encourage businesses to think of out-of-the-box solutions to challenges, boosting their innovative spirit. Reclaiming the hard-earned dollars would ensure that businesses continue to optimize their R&D spending and future-proof themselves.
Take a personalized demo now to learn more about how Deltek | Replicon can help your organization maximize its R&D tax savings.
