Substantiating research credit claims has long been a major burden for tax departments. In fact, the research credit is perennially the most common uncertain tax position reported by taxpayers. In addition, considerable US Internal Revenue Service (“IRS”) audit resources have been consumed by research credit issues. For some taxpayers, that burden may soon be substantially reduced thanks to a new IRS directive to examiners for the IRS Large Business and International Division (“LB&I”) that became public on September 22, 2017 (the “Directive”).
For tax returns filed after September 11, 2017, examiners for LB&I will now permit taxpayers to determine their qualified research expenses for purposes of IRC Section 41 by starting with and then adjusting research expenses shown as a line item in or a separately stated note to its Certified Audited Financial Statements. The computation of research expenses on the financial statements must be computed pursuant to ASC 730 for US GAAP purposes.
Using ASC 730 as the starting point for research credit calculations can significantly simplify claiming the credit. A major challenge for taxpayers in claiming the credit is that the definitions of qualified research expenditures under Section 41 do not precisely or even easily match the definitions for financial accounts. Hence, taxpayers have been required to undertake separate studies to determine the amount of qualified research expenses, usually using information about the activities of numerous individual employees in multiple cost centers. Under the Directive, taxpayers will be able to start with the research expenses shown on the financials and then adjust those amounts. Although the required adjustments are not simple, the necessary information should be available within the financial records, thereby eliminating the need to contact numerous individuals throughout the enterprise.
Basing qualified research expenditures on financial statements is a remarkable departure from prior practice. Meeting the four-factor test for qualified research has been a widely-shared struggle for taxpayers. Much effort was devoted to establish that projects had the requisite level of uncertainty and that the uncertainty was resolved through the use of a process of experimentation. For taxpayers willing and able to make the required adjustments to their financial research expenses, those struggles will be a thing of the past.
The resulting simplification is refreshing—although not necessarily completely consistent with the statute. While there is substantial overlap between the definitions of research under ASC 730 and under Section 41, the definitions are not identical. Internal use software is a notable example. The Directive permits taxpayers to claim such software research costs by following the accounting treatment for software rather than the 2016 regulations.
The Directive embodies the view that the adjustments set forth on Appendixes C and D bring the research expenses for financial accounting purposes sufficiently close to the statutory definition of qualified research that devoting audit resources to identify the remaining differences is not productive. Some of the adjustments, such as removing expenses explicitly excluded from Section 41 (Appendix C, line 5) or removing overhead expenses (Appendix C, line 6), should produce precisely the same result as obtained previously. However, other adjustments reflect the adoption of simplifying rules to approximate the amount of qualified research expenditures that would result under the statutory language.
An example of such rules is the treatment of contract research. Line 8 of Appendix C requires the taxpayer to subtract all research costs for persons other than employees of the taxpayer. This subtraction will avoid the need to examine research contracts to determine how much, if any, of such costs belongs in qualified research expenditures. Clearly, LB&I could not prevail in court on a blanket exclusion of such costs. But while excluding such costs is detrimental to taxpayers, the upside of greater certainty that other costs will be treated as qualified may make the trade attractive for many taxpayers.
The Directive’s treatment of wages is a more nuanced approach. Taxpayers are allowed to include 95 percent of the wages paid to “Qualified Individual Contributors” (employees whose wages are charged to ASC 730 cost centers who do not manage any other employees) and “1st Level Supervisors” (employees whose wages are charged to ASC 730 cost centers who directly manage only Qualified Individual Contributors). This rule primarily addresses the requirements of Section 41(b)(2)(B) that qualified wages are limited to wages paid to individuals engaged in qualified research and those engaged in the direct supervision of such individuals. The 95 percent limitation probably reflects the fact that a typical research credit study would exclude portions of the wages of some qualified employees to reflect activities such as training sessions or assisting with product transfers. The 5 percent haircut to wages of all employees estimates such non-qualified activities.
The Directive also provides that a taxpayer may claim wages for “Upper Level Managers” (employees whose wages are included for purposes of ASC 730 who directly supervise any employee other than a Qualified Individual Contributor) subject to an “Upper Level Managers’ Limit” of the lesser of (i) 10 percent of the total wages allowed for Qualified Individual Contributors and 1st Level Supervisors or (ii) the actual wages paid to such Upper Level Managers. Presumably, these provisions were included in the Directive because some taxpayers have been able to prove that senior research executives directly participate in the research, e.g., the VP of research who is named on numerous patents, or manage those that directly perform the research.
For taxpayers who conclude that their executives directly participate in research more intensely, the instructions to Appendix D suggest that a taxpayer could forgo the “Upper Level Managers’ Limit” and attempt to establish the amount of qualified wages paid to such individuals through the audit process while still otherwise relying on the use of financial research expenses to establish its qualified research expenses for Qualified Individual Contributors and 1st Level Supervisor Managers under the Directive. However, this removes the wages for Upper Level Managers from the safety of the Directive and opens up any amount claimed as qualified wages for these Upper Level Managers to examination. Such examination could include whether the projects that such managers worked on satisfied the four-factor test that was previously used to determine if the activity was qualified research.
While the Directive provides a roadmap for determining the wages that will be eligible for the credit, traveling the road to get the credit could still be a bit rocky. The taxpayer will need to show that the wages were paid to an employee who was in a cost center that remains in the ASC 730 definition of research after the other adjustments in Appendix C and that such wages were appropriately adjusted for the level of management as discussed above. The Directive contemplates that the taxpayer will provide the IRS with a list of employees whose wages are being included that would identify the employee’s job title, reporting level and the cost center where each of those employees worked. Also, the Directive expects taxpayers to produce organization charts showing the employees and their level of management. These are not trivial requirements.
Nevertheless, these tasks are still likely to be less burdensome than the customary research credit study. Those studies have required large taxpayers to create numerous binders allocating an amount of qualified activity for every employee in multiple cost centers. Following the Directive will free taxpayers from the expense of performing those allocations and the risk that the allocations will not be respected.
By its terms the Directive applies to returns filed after September 11, 2017. However, the Directive does not seem to be limited to returns where the certifications described in the Directive were attached to the original return. If the certificates are not attached to the return, the Directive explicitly directs the examination team to ask at the beginning of the examination if the taxpayer plans to follow the Directive. There does not seem to be any reason why exam teams dealing with audits for returns filed prior to September 11, 2017, would not be willing to resolve cases on a similar basis. In any event, taxpayers should certainly consider proposing such a settlement methodology if it seems advantageous. The Directive is voluntary, so if the taxpayer’s study produces a higher credit, one may still conclude that proving up one’s credit study in an audit is the better choice.
A substantial attraction of the Directive is the ability of taxpayers to forego the substantial expense—both in dollars and time of the tax and research functions—of conducting research credit studies. However, taxpayers should be aware of the possible downsides to such a course of action. By its terms the Directive is only a guide to how LB&I will audit taxpayers. The Directive explicitly states that it “is not an official pronouncement of law.” Moreover, the Directive applies only until “any future guidance modifying or superseding this Directive.” If a taxpayer disagrees with the IRS about how the Directive applies, the absence of a research credit study could hamper the taxpayer’s ability to litigate the issue.
Furthermore, conducting a study may result in a potentially higher credit than the approach of the Directive. Indeed, the original motivation behind the research credit studies was the recognition that cost centers outside of traditional research cost centers can contribute to the process of experimentation in important ways. Taxpayers who have previously conducted such studies can compare the results of those studies—including, if applicable, the results after an audit of such studies—to the amount of research expenses shown on their financial statements to ballpark the potential loss from foregoing a study in the future. In any case, taxpayers need to keep in mind that sustaining the amount shown in a study will require substantial expense to prepare and defend the study. Taxpayers will need to balance the costs of a potentially higher credit against following the Directive to obtain a smaller but more certain credit.
The Directive is unclear on whether a taxpayer willing to incur the necessary cost could claim qualified research expenses based on a study but also file the information required to determine Adjusted ASC 730 Financial Statement R&D. The certification is titled “Certification Statement Claiming Adjusted ASC 730 Financial Statement R&D as QREs,” which would indicate that the taxpayer is claiming these amounts. Further, Appendix C, lines 20-22, indicate specific lines on Form 6765 where the adjusted amounts are to be reported. Nonetheless, Appendix B reconciles Adjusted ASC 730 Financial Statement R&D to Form 6765 suggesting that the amounts on Form 6765 could be different. Wages for Upper Management are the only costs that the Directive indicates would be examined separately from the computation of Adjusted ASC 730 Financial Statement R&D. But perhaps LB&I would be willing to consider other add-ons such as the exclusion of contact research costs discussed above. However, if the IRS is willing to consider amounts in excess of Adjusted ASC 730 Financial Statement R&D, the IRS will need to audit both the adjustments to financial research expenses and whatever issues relate to the excess reducing the efficiency that this Directive provides IRS auditors.
In summary, the Directive is a creative response to the IRS’s need to do more with less. The Directive substantially simplifies the process of determining which company activities constitute research and what the costs related to those activities are by taking those decisions out of the tax department and leaving them largely to the financial accounting function of the taxpayer. Adjustments will still need to be made to the financial expenses, and those adjustments will need to be documented. Nonetheless, those adjustments appear to be much more mechanical than the process of preparing a research credit study. As a result, taxpayers who choose to follow the Directive will have much greater assurance that the amount of credit that they claim on their return is the amount of the credit that they will ultimately receive.