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Giving Credit Where It’s Due

Utilities will gain from new regs for research tax credits.

Fortnightly Magazine - April 2005

companies are likely to find that more commonplace activities—for example, searching for the optimal design for a new substation or the best materials to protect underground cables—are now eligible for a tax credit.

Taxpayers Must Pass A Four-Part Test

Under the final regulations, utilities seeking tax credits must demonstrate that their R&D activities are:

1. Being undertaken to eliminate uncertainty regarding the capability, methodology, or appropriate design of a business component ( e.g., product, process, formula, technique);

    2. Undertaken for the purpose of discovering information that is technological in nature ( i.e., fundamentally relies upon the principles of engineering, computer physical or biological sciences);

      3. Part of an experimentation process that involves evaluating one or more alternative via modeling, simulation or systematic trial and error; and

        4. Related to the development of a new or improved product, process, formula, technique, invention or computer software.

          In addition to a deduction for these costs, meeting these criteria can save a company up to 65 cents on every dollar of qualified costs. For example, if an engineer with taxable wages of $60,000 spends more than 80 percent of his or her time during a given year on activities that meet the IRS's four-part test, the employer will be entitled to a tax deduction and a credit. The company would receive a tax deduction under Section 174 of $60,000, worth $21,000 at a 35 percent tax rate, and a maximum credit of $3,900 ($60,000 * 50 percent limitation * 13 percent reduced credit rate).

          First, the Good News

          The language change first proposed for these regulations in 2001 would have mandated that taxpayers meet a "discovery" test separate from the uncertainty requirement. It also introduced a new, more onerous record-keeping requirement.

          In the revised and final regulations, Treasury has done away with the discovery test and further decided that the record-keeping requirement for the R&D credit is now the same as for the rest of the income tax return.

          Less happily, the new regulations retain the more expansive definition of gross receipts first proposed in the 2001 regulations. The IRS does not view this as a change but rather as an affirmation of what it believes has always been the correct method of calculating the credit, which is based on an increase in R&D spending as a percentage of sales. Thus, taxpayers first must calculate the following "base" amount:

          The R&D credit is based on the extent to which current R&D costs exceed this "base" amount. Previously, most taxpayers included only gross sales (less returns and allowances) in this computation. Now, the IRS is mandating that all sources of income be figured into the calculations, including: interest, dividends, rents, royalties, and other income items. Although this is a requirement for federal credits, not all states conform to it. California for example, requires those seeking the tax credit to include only income derived from the sale of tangible property. The IRS is also placing new emphasis on the process of experimentation.

          Specifically, companies that have met all other requirements will find that there is one