Tax Executives Institute Houston Chapter TS1806. March 1, 2018

Transcription

1 Tax Executives Institute Houston Chapter TS1806 March 1, 2018

2 Federal research deduction ( 174), credit ( 41) and state research credits before and after reform Page 1

3 Speakers David Hudson, National Tax Principal, Ernst & Young LLP Susan Bennett, Americas Tax Director Engineering and Construction, Ernst & Young LLP Page 2

4 Agenda Overview of research credit rules Examples of qualifying research Research credit timeline Importance of determining whether research is funded by customers Research credit for computer software development Section 174 Tax reform Q&A Page 3

5 Overview of research credit rules Page 4

6 Definition of qualified research In late December 2003, final regulations were issued that made it clear that there was no requirement to discover information that would exceed or refine the principles of science in order to have qualified research. A taxpayer may employ existing technologies and may rely on existing principles of the physical or biological sciences, engineering, or computer science. Since then, IRS challenges in court to argue otherwise have been unsuccessful. Page 5

7 Definition of qualified research Wages, supplies and 65% of contract research in qualified research activities: Permitted purpose New or improved business component in terms of: Function Performance Reliability Quality Significant cost reduction Eliminating uncertainty Activity must be intended to discover information that would eliminate technical uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of the business component design. Technological in nature discovery test Discover information that fundamentally relies on principles of: Physical science Biological science Computer science Engineering Process of experimentation Evaluate alternatives Develop hypothesis Test hypothesis Refine or discard the hypothesis Success or failure Page 6

8 Excluded activities The credit rules provide that the following activities are excluded from qualified research: Funded research (time and materials reimbursement from third parties and/or contracts where all intellectual property (IP) rights go to the third party) Ordinary testing, efficiency surveys, management studies, consumer surveys, advertising, acquisition of another s patent or research in connection with a literary or historical project Research outside the US (and its territories) Page 7

9 Amount of research credit Three-year average 50% QREs QREs Year 1 Year 2 Year 3 Year 4 Research credit at 14% No research credit 14% of the amount by which post- 12/31/06 qualified research expense (QRE) exceeds 50% of average QRE from the prior three tax years Increases from 12% to14% for 2009 and subsequent years Separate R&D credit is available in certain states. Page 8

10 Eligible research expenditures Research performed in the United States: Wages: Direct research Direct support: Machinist making prototype part Secretary typing research notes Lab worker cleaning lab equipment used for testing Technical marketing, manufacturing, operational personnel performing field testing, gathering customer requirements, participation in project teams, etc. Direct supervision Eligible expenditures: Wages Supplies Contract research Page 9

11 Eligible research expenditures Research performed in the United States (continued): Supplies: Items used or consumed in the qualified activity Costs to fabricate prototypes sold to customers (including mfg costs) Prototypes may be sold to customers and still be included (TG Missouri, Trinity court cases) Prototypes prepared in US and tested outside of the US may still be qualified 65% of contract research: Where the taxpayer pays someone other than an employee to perform qualified research (consultants and testing) Taxpayer bears the economic risk (funding) and retain rights in the results of the research Includes time and material arrangements with subcontractors Per part charges (counts as supplies) Per test charge Eligible expenditures: Wages Supplies Contract research Page 10

12 Examples of qualifying research Page 11

13 Example of qualified research Example of qualified research (i) X is engaged in the business of manufacturing food products and currently manufactures a largeshred version of a product. X seeks to modify its current production line to permit it to manufacture both a large-shred version and a fine-shred version of one of its food products. A smaller, thinner shredding blade capable of producing a fine-shred version of the food product, however, is not commercially available. Thus, X must develop a new shredding blade that can be fitted onto its current production line. X is uncertain concerning the design of the new shredding blade, because the material used in its existing blade breaks when machined into smaller, thinner blades. X engages in a systematic trial and error process of analyzing various blade designs and materials to determine whether the new shredding blade must be constructed of a different material from that of its existing shredding blade and, if so, what material will best meet X s functional requirements. (ii) Conclusion X s activities to modify its current production line by developing the new shredding blade meet the requirements of qualified research as set forth in paragraph (a)(2) of this section. Substantially all of X s activities constitute elements of a process of experimentation because X evaluated alternatives to achieve a result where the method of achieving that result, and the appropriate design of that result, were uncertain as of the beginning of the taxpayer s research activities. X identified uncertainties related to the development of a business component, and identified alternatives intended to eliminate these uncertainties. Furthermore, X s process of evaluating identified alternatives was technological in nature, and was undertaken to eliminate the uncertainties. Income tax regulations (a)(8) Example 3 process of experimentation Page 12

14 TG Missouri (2009) Taxpayer developed and used production molds to manufacture automotive parts for its customers. Taxpayer contracted with thirdparty toolmakers to build production molds. After the third-party toolmaker finishes constructing a production mold, the taxpayer incurs additional design and engineering costs to modify the mold so that it can be used to produce the desired component part. Held that the taxpayer may include such costs and activities in its research credit computations. TG Missouri process of experimentation and qualified supplies Page 13

15 Trinity Industries (2010) Taxpayer claimed the engineering and fabrication costs of certain first-in-class ships on an all or nothing basis. Such activities and amounts were considered qualified research by the court as follows: Much of the design work at issue involved integrating extant subassemblies into a ship design. The government suggests that this is nothing more than ordering off a menu The Court finds this greatly oversimplifies the process. First, many of the systems at issue are not monolithic entities, but rather families of products with considerable flexibility in their configuration. Determining which configuration out of the universe available can, in particular cases, itself involve a significant research effort. Second, the systems do not exist in a vacuum. They interact with each other, sometimes in complex and nonintuitive ways. A change in electronics may require a change in power generation and distribution, which may require a change in the engine plant, any one of which may affect the weight distribution and performance of the vessel as a whole. Thus, the simple fact that a new vessel incorporates existing systems does not resolve the QRE issue against Trinity. Determining the degree of QRE involved requires an examination of the overall scope of the effort required to specify the components and integrate them into the overall design of the ship. Trinity Industries process of experimentation Page 14

16 Research credit timeline Page 15

17 Timeline of product development process Qualified Patented project Feasibility study, conceptual design Preliminary design Final design Mfg or construction (or prototype fabrication) Commissioning Regular production Not qualified More likely to have QRE Commissioning/construction means and methods or prototype fabrication may have QRE Page 16

18 What is a qualified prototype supply cost? The business component must be built or partially built in order to ensure that it will work, i.e., there is still technical uncertainty about the appropriate design during fabrication. Uncertainty cannot relate to small or insignificant portions of the sales order. Taxpayer must have the risk of fabrication. Page 17

19 Importance of determining whether research is funded by customers Page 18

20 Funded research Research funded by any agreement with an unrelated person is not qualified research: Taxpayer must have the financial/economics risk if the research fails. Taxpayer must have substantial rights to the research results. Taxpayer must reduce research expenditures by the amount of the funding received. Important for both contracted and sub-contracted research. Page 19

21 Economic risk Fairchild Indus., Inc. v. US, 71 F.3d 868 (Fed. Cir. 1995) Federal Circuit found research was not funded when payment was contingent on performance where the researcher bears the risk of failure. Geosyntec Consultants, Inc. v. US, 776 F.3d 1330 (11th Cir. 2015) payment was not contingent upon performance and therefore Geosyntec did not bear financial risk of failure. Key provisions were warranty, acceptance, dispute resolution terms. Dynetics, Inc. v. US, 121 Fed. CI. 492 (2015) Court reviewed contract terms and found that Dynetics had no risk that it would not be paid for unsuccessful research. Page 20

22 Ownership/substantial rights Research is treated as fully funded (i.e., not qualified) if, pursuant to the agreement, the taxpayer does not retain substantial rights in the research (Treas. Reg (d)(2)). Substantial rights include rights with economic value Right to make, use, or sell Right to exclude others from making, using or selling It is possible for both parties of a contract to retain substantial rights to the research Lockheed Martin, 210 F.3d 1366 (2000) Page 21

23 Research credit for computer software development Page 22

24 Research credit for computer software development Historically, Congress identified two types of internal-use software (IUS) that were the target of the original statutory exclusion from the definition of qualified research: Software used to provide non-computer services Accounting, consulting, banking, etc. Software used to support general and administrative functions Payroll, bookkeeping, personnel management, etc. Congress later advised Treasury to take note of the rapid pace of technological advancement and use of software by businesses to deliver services when developing regulations for IUS. Page 23

25 Research credit IUS regulations October 4, 2016 Treasury released final regulations clarifying rules related to IUS. High threshold of innovation Significant economic risk test Substantial uncertainty because of technical risk Types of uncertainty eligible to meet this include technical uncertainty related to appropriate design, as well as uncertainty of method or capability Effective date Tax years ending on or after October 4, 2016 At taxpayers election for tax years ending between January 20, 2015 and October 3, 2016 Page 24

26 Definition of internal-use software Definition of internal-use software: Software developed for use in general and administrative functions Financial management functions Human resources management functions Support services functions Definition of non-internal-use: Software not developed for use in general and administrative functions Example: Software developed to be commercially sold, leased, licensed or otherwise marketed to third parties Example: Software developed to software and platform to assist in optimizing operation by collecting, transmitting and analyzing data. It could include software to track field performance of tools and systems in each geological formation, field or plot. Time and manner of IUS or non-ius determination: The determination of whether software was developed for use in a G&A function is made based on the intent of the taxpayer and the facts and circumstances at the beginning of the development. Page 25

27 Dual function exception Dual function exception and safe harbor To the extent a taxpayer can identify a third-party subset, such portion is not IUS. If the intended use by third parties is at least 10% of all anticipated use, the dual function software or subset is not IUS and the taxpayer may include 25% of the development costs. Intended use by third parties may be shown by any reasonable method appropriate to the taxpayer s industry. A taxpayer may choose not to apply either of these rules, and show that software satisfies the high threshold of innovation standard. Page 26

28 Impact of new IUS regulations Significant investments within multiple industries relating to software and technology to improve operational efficiency and to allow greater connectivity with customers Regulatory compliance resulting in digital investments Industry focus shifting to automating, digitizing and providing services/data to customers via online/cloud/on-demand software Page 27

29 Section 174 Page 28

30 Section 174 A taxpayer may generally deduct research or experimental expenditures in connection with their trade or business. Under Section 174(a), taxpayer is permitted to deduct research or experimental expenses immediately. Section 174(b) permits taxpayer to elect to amortize the costs of research or experimental expenses over a period of not less than 60 months. Final Section 174 regulations were published July 21, Prototype definition Depreciable property rule clarification Meeting the Section 174 standard for uncertainty is the first step in meeting credit-qualified research eligibility. Page 29

31 Section 174 Revenue Ruling Taxpayer drilled holes for three distinct purposes: Core holes widely scattered for maximum coverage of geologic information Some holes used (at an additional cost) to test new hydraulic mining method developed by the taxpayer Some holes without cores drilled in closely spaced clusters to optimize production of the new mining method Expenditures paid or incurred involving the drilling of core and noncore holes in connection with the production of minerals are mining exploration expenditures subject to the provisions of Sections 615 or 617. Additional expenditures to use the drill holes for designing and testing a new mining method are research and experimental expenditures subject to the provisions of Section 174. Page 30

32 Section 174 Revenue Ruling A domestic mining corporation s expenditures incurred directly in developing prototype mining equipment and perfecting a new metallurgical process, including costs of shipping mineral samples to the laboratory, are considered research and experimental expenditures deductible under Section 174 (a). The expenses for driving shafts, drifts, cross-cuts and for other production facilities that are not limited to the research activities are considered mine development expenses within the meaning of Section 616. The expenses incurred in determining the location and quality of the mineral deposit are exploration expenditures within the meaning of Section 617. Page 31

33 Section 174 Method of accounting considerations Changing to a Section 174(a) method of accounting requires the filing of a Form Compare change in method vs. error in Rev. Rul Automatic provisions Rev. Proc , Section 7.01 Due before filing of timely filed tax return (including extension) Cut-off method of accounting Pro easier to implement because no need to calculate Section 481(a) adjustment Con cut-off reduces benefit of change in method of accounting Consider if expenses should be treated as errors that require amended tax return Page 32

34 Tax reform Page 33

35 Tax reform implications No substantive changes were made to Section 41 by the Tax Cuts and Jobs Act (the Act). However, a number of changes to other areas of corporate tax law were made that affect taxpayers taking advantage of the research credit, Section 174 and the orphan drug credit (Section 45C). Page 34

36 Section 174 Amortization of research or experimental expenditures Taxpayers elect to either deduct research or experimental expenditures paid in connection with a present or future trade or business, or amortize those costs over no less than 60 months. Taxpayers may elect to amortize their research expenditures over 10 years under Section 59(e). Software development costs may be expensed currently, amortized over: 60 months from the date development is completed in accordance with Revenue Procedure , Or 36 months from the date the software is placed in service in accordance with Section 167(f)(1) Page 35

37 Post-2021 treatment For amounts paid or incurred in tax years beginning after December 31, 2021, taxpayers are required to capitalize research or experimental expenditures as chargeable to a capital account and to amortize these expenses over 5 years (15 years for foreign research). Software development costs are required to be treated as research or experimental expenditures under Section 174. Under the Act, capitalized research or experimental expenditures that relate to property that is disposed of, retired or abandoned during the amortization period will continue to be amortized for the duration of the amortization period. Page 36

38 Section 174 modifications The Act Removed Section 174(e), which currently makes Section 174 applicable to research or experimental expenditures only to the extent that the amount thereof is reasonable under the circumstances. The Act does retain current exclusions from Section 174 for: (1) expenditures for the acquisition or improvement of land or depreciable property used in connection with the research or experimentation or (2) exploration expenditures. The Act modified Section 41(d)(1)(A) to remove the reference to expenses under [S]ection 174 to conform Section 41 to the amendments made to Section 174 applicable to amounts paid or incurred in tax years beginning after December 31, Page 37

39 Post-2021 treatment Section 162 The requirement to capitalize and recover Section 174 expenditures over 5 (or 15) years was a significant unfavorable change for taxpayers currently deducting their research and experimental expenditures under Section 174. The effect of the Section 174 amortization provision for state tax purposes may be substantial if the deduction of such expenditures typically reduces the taxpayer s state tax burden. Taxpayer will need to undertake a more careful identification of costs properly characterized as ordinary and necessary business expenses deductible under Section 162. Page 38

40 Section 59(e) Section 59(e) was left in place even with the repeal of the corporate income tax. Although not free from doubt, it appears that 10-year amortization under Section 59(e) will still not be available after 2021 because the Section 59(e) reference to Section 174 will no longer be allowable as a deduction. Section 174 also will refer to specified research or experimental expenditures, while Section 59(e) continues to refer to research or experimental expenditures. When the new Section 174 provisions take effect, the reference to Section 59(e) in the current Section 174(f)(2) will be removed. Page 39

41 Software development costs Presently, these costs may be deducted or amortized under Revenue Procedure Once the new Section 174 provisions take effect after 2021, Revenue Procedure will no longer apply to any software development costs, and they will be subject to the required amortization under Section 174. As a general rule, purchased software may be amortized over 36 months under Section 167(f)(1). This means that, under the Act, taxpayers developing software will be in a less favorable tax position than those acquiring it. Page 40

42 Removal of reasonable Regarding the removal of the requirement for expenditures to be reasonable for Section 174 to apply, the Act should provide taxpayers with the opportunity to include in their research or experimental expenditures amounts paid or incurred in tax years beginning after 2021 that have been challenged by the IRS as unreasonable under current law. Page 41

43 Section 45C Orphan drug credit Under prior law, Section 45C allowed a taxpayer to claim a credit equal to 50% of qualified clinical testing expenses incurred in connection with the testing of a drug for a rare disease or condition (the orphan drug credit). Under the Act, the orphan drug credit is limited to 25% of qualified clinical testing expenses for tax years beginning after December 31, Under a new Section 280C(b)(3), for tax years beginning after December 31, 2017, taxpayers may elect a reduced orphan drug credit in lieu of reducing allowable deductions in a manner similar to the Section 280C(c)(3) election for the research credit. Page 42

44 Section 280C Reduced credit election Under Section 280C(c)(3) and (b)(3), taxpayers must choose between reducing the Section 174 expense deduction (or reducing the basis created by costs that a taxpayer has elected to treat as deferred expenses under Section 174(b)) or electing to reduce their credits available under Section 41 and, for tax years beginning after December 31, 2017, under Section 45C. If a taxpayer does not make the election under Section 280C, it may claim 100% of the credit it has computed, but cannot deduct all of the qualified research expenses (QREs) or qualified clinical testing expenses (QCTEs) for which it is claiming the respective credit. Under the Section 280C election, the taxpayer will reduce the amount of the credit claimed rather than adjusting the Section 174 deduction. Page 43

45 Section 280C Reduced credit election Before the enactment of the Act, the amount of this reduction was the amount of the credit multiplied by the maximum rate of tax under Section 11(b)(1), i.e., 35%. The Act replaced Section 11(b)(1) with Section 11(b) and a 21% corporate rate. A conforming amendment was made to Section 280C(c)(3) and (b)(3) to replace the reference to Section 11(b)(1) with a reference to Section 11(b). Note that fiscal-year taxpayers should apply Section 15(e) to determine a blended rate for their tax year that includes January 1, Note that this prevents a mismatch of tax rates. The Section 280C election must be made on a timely filed (including extensions) original return and cannot be made on an amended return filed after the extended due date of the return. The reduced credit election is a year-by-year election which, once made, is irrevocable for that year. Page 44

46 Section 280C Reduced credit election opportunities The Section 280C election (including protective ) is commonly made for administrative convenience, especially due to state income tax impacts. Care should be taken to ensure the appropriateness of the Section 280C election, especially for the 2017 tax year given the substantial reduction of the corporate income tax rate. Instead, taxpayers should consider the impact of making, or not making, a Section 280C(c)(3) election for purposes of evaluating the highest value of tax attributes that could be carried forward (net operating loss carryforward versus research credit carryforward) and the immediate impact of a higher or lower research credit for purposes of Section 965 (the transition tax on deferred foreign income). Page 45

47 Section 172 Net operating losses For losses arising in tax years beginning after December 31, 2017, the net operating loss (NOL) deduction is limited to 80% of taxable income. The carryback provisions are repealed for losses arising in tax years ending after December 31, 2017, except for losses incurred in a farming trade or business (which is allowed a two-year carryback) or in a property and casualty company (which is allowed a 2-year carryback and 20-year carryforward). For losses arising in tax years ending after December 31, 2017, companies are allowed an indefinite carryforward. Fiscal-year taxpayer with a tax year ending after December 31, 2017, cannot carry back NOLs arising in its tax year that includes December 31, Page 46

48 Impact of Section 280C for NOL taxpayer Taxpayers with tax years ending on or before December 31, 2017, with current-year NOLs that exceed taxable income will want to consider whether it is better to make the Section 280C(c)(3) election and increase their Section 174 deduction to get a larger carryback, or to forgo the Section 280C election to increase their research credit carryforward. It will likely be more advantageous for a taxpayer to increase its research credit carryforward because the research credit does not depend on tax rate, and a higher research credit may offset a taxpayer s tax liability for a longer period. For taxpayers operating in states that do not have a research credit, it may make sense to maximize their Section 174 deductions to reduce state tax liability. Taxpayers looking to maximize their cash on-hand now and taxpayers with expiring credits may also prefer to increase their NOL carryback. Taxpayers should model both options to determine what works best for their particular situation. Page 47

49 Section 965 Tax on deferred foreign income Under the Act, Section 965 requires certain US shareholders of certain foreign corporations to include in income an amount of previously untaxed deferred foreign income (mandatory income inclusion). Existing attributes can be used to offset the tax resulting from the mandatory income inclusion, including the research credit. The mandatory income inclusion is an inclusion in the US shareholder s gross income under Section 951(a) (i.e., a Subpart F inclusion) and occurs in the foreign corporation s last tax year beginning before January 1, For a calendar year-end US shareholder that owns a calendar year-end foreign corporation, the income inclusion will be reported for the US shareholder s tax year ended December 31, If the foreign corporation has a fiscal year ended November 30, 2017, the income inclusion will be reported for the US shareholder s tax year ending December 31, Page 48

50 Impact of Section 280C on Section 965 For the tax year that the tax is imposed on the mandatory income inclusion, a taxpayer may want to forgo the election of the reduced credit under Section 280C to maximize the research credit available to offset the tax imposed for the transition year. Additionally, taxpayers that have qualifying research activities but have not taken a research credit should evaluate the benefit of the research credit with respect to the additional tax burden imposed under Section 965. Page 49

51 Alternative minimum tax repeal The corporate alternative minimum tax (AMT) is repealed for tax years beginning after Taxpayers with an AMT credit may use the credit to offset regular tax liability. Taxpayers may claim a refund of 50% (100% for years beginning in 2021) of the remaining credits (to the extent the credits exceed regular tax for the year) in tax years beginning before Taxpayers formerly paying AMT should reconsider claiming the research credit. Section 38(c) continues to limit the general business credit to 25% of so much of the taxpayer s net regular tax liability as exceeds $25,000. Page 50

52 Section 59A Base erosion and anti-abuse tax The Act created a new minimum tax, the base erosion and anti-abuse tax (BEAT). The BEAT applies to a corporation (other than RICs, REITs or S corporations) with average annual gross receipts of at least $500m for the three-year period ending with the preceding tax year that has a base erosion percentage for the current tax year of at least 3% (2% for certain banks and security dealers) (an applicable taxpayer). The base erosion percentage is generally the aggregate amount of base erosion tax benefits divided by the aggregate amount of all allowable deductions. Page 51

53 Section 59A Base erosion and anti-abuse tax The base erosion minimum tax amount owed by an applicable taxpayer under the BEAT for tax years beginning before January 1, 2026, is the excess of 10% (5% for tax years beginning in calendar year 2018, 11% and 6%, respectively, for certain banks and security dealers) of the taxpayer s modified taxable income over its regular tax liability for the year, reduced by all Chapter 1 income tax credits (except the research credit and applicable Section 38 credits (i.e., the low-income housing credit, renewable electricity production credit and investment credit allocable to the energy credit)). Modified taxable income for these purposes is the taxable income for the year of the taxpayer, determined without regard to any base erosion tax benefit or the base erosion percentage of any NOL for the year. Page 52

54 Section 59A Base erosion and anti-abuse tax For tax years beginning after December 31, 2025, the base erosion minimum tax amount is computed as 12.5% (13.5% for certain banks and security dealers) of an applicable taxpayer s modified taxable income in excess of its regular tax liability for the year reduced by all Chapter 1 income tax credits, including the research credit and applicable Section 38 credits. Page 53

55 Section 280C impact on BEAT An applicable taxpayer subject to the BEAT may consider forgoing the election of the reduced credit under Section 280C. Because a higher regular tax liability favorably affects the computation of the BEAT amount for tax years beginning before January 1, 2026, forgoing a Section 280C election is an indirect means to reducing the taxpayer s liability under the BEAT for those tax years. Partnerships may want to continue maximizing their Section 174 deductions and electing the reduced credit under Section 280C because they will not be subject to the BEAT and AMT considerations do not apply. Page 54

56 Looking forward Section 174 amortization Companies with a large amount of foreign research expenditures should pay particular attention to how such costs are characterized. Taxpayers should consider how characterizing costs as Section 162 costs could affect their BEAT liability from two perspectives: the benefit of a higher research credit and the benefit of a greater amount capitalized as cost of goods sold. Taxpayers should keep in mind that engineering or design costs related to the production of tangible personal property that are not allowable Section 174 costs must be capitalized under Section 263A. Capitalizing such amounts paid or accrued to a foreign related person to inventory under Section 263A may favorably affect a taxpayer s BEAT liability to the extent such capitalized amounts are recovered as cost of goods sold. Not all amounts paid or accrued to a foreign related person with respect to self-constructed assets that are capitalized under Section 263A may permanently avoid the BEAT. Taxpayers should take into account the manner in which amounts capitalized under Section 263A are recovered (e.g., as cost of goods sold or as a deduction for depreciation (or amortization)) in determining the timing and extent to which such capitalized amounts are subject to the BEAT. Page 55

57 Other reform considerations Taxpayers with significant Section 174 expenses but small research credits: For future tax years, consider reviewing the costs to see if any of them can be characterized as expenses under Section 162. Taxpayers with significant Section 174 foreign expenses: For future tax years, consider how the location of the research activity impacts tax liabilities (15-year amortization of foreign research). Taxpayers with significant state research expenses: In states that do not have a research credit, increasing Section 174 expenses and electing Section 280C may be the better answer. Taxpayers should re-evaluate their research credit posture under LB&I Page 56

58 Q&A Page 57

59 Thank you Page 58

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