Business & Money
Utilities will gain from new regs for research tax credits.
The 1990s ushered in the era of deregulation, bringing the disposition of generation assets by utilities, the decline or end of rate cases, and the reluctance of state commissions to approve large capital expenditures for transmission and distribution (T&D). Unfortunately, time has shown that this reduced level of spending was not enough to maintain existing T&D assets, let alone add new capacity.
To make up for this, capital spending has increased dramatically in the last few years: between 2002 and 2004, investor-owned utilities averaged $5.4 billion a year on new distribution, and another $3.5 billion annually on new transmission construction expenditures, according to Edison Electric Institute (EEI) estimates.1
Now the federal government is stepping in to help utilities prime the pump: To partially mitigate these cash outlays and or to help utilities make additional funds available for this construction, the government created several opportunities for tax relief. EEI President Tom Kuhn acknowledged the importance of these tax savings presentation to Wall Street analysts in January.
The final regulations, issued in early 2004 by the U.S. Department of the Treasury should make it a little easier for utilities, as well as other taxpayers, to use research and development (R&D) expenditures to help lower their effective tax rates.
Significantly, the regulation both expands the definition of what can be considered R&D activities for tax credit purposes and eases certain record keeping requirements for companies seeking to recoup a portion of their R&D outlays. These rule changes had been under consideration since December 2001.
As the regulations are now written (under U.S. Internal Revenue Code Sections 174 and 41), utility companies can earn tax credits for "processes of experimentation" without having to prove that "new-to-the-world" technological information has been discovered.
In the past, the IRS took a more narrow view of R&D. For utilities, that meant R&D tax credits could be earned only for projects or activities that resulted in the discovery of information that was new to the industry, such as those relating to alternative energy sources like wind- or solar-power generation. Under the newly written regulations, it is the inherently competitive nature of the now-deregulated industry sector that will spark wider eligibility for the credits:
Specifically, the wording of the new regulations allows utilities to seek tax credits for conducting "a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer's research activities." (The IRS cautions, however, that the mere "existence" of uncertainty will not satisfy this requirement.)
When these requirements or tests are met and fully documented, utility 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 (, product, process, formula, technique);
2. Undertaken for the purpose of discovering information that is technological in nature (, 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 more test they must meet before they are granted tax credits for their R&D efforts: This is the "substantially all" requirement. We believe that the "substantially all" rule in the final regulations may create additional opportunities to enhance credit-eligible expenditures through the inclusion of costs that are deductible under Section 174 but that don't meet all three of the additional tests under Section 41: design costs, patent costs, and other nonqualified, Section 174-eligible costs. As an example: An engineer's time to reverse engineer a competitor's product. Unfortunately, this provision may also require more work on a taxpayer's part. As is common in the area of tax legislation, there is a bit of uncertainty surrounding the "substantially all" requirement.
Clearly, a company's response to the rule changes will depend on its current tax position but in every case, timely response is critical:
Companies that currently are taxable should take immediate steps to ensure that they are claiming the right amount of expenses possible for this credit. Alternatively, businesses whose credits are currently being examined by the IRS should make sure that any disallowances proposed by the IRS reflect these recent developments. Finally, in situations where losses preclude a company from paying taxes currently, management should still take immediate action to document the right amount of qualified expenses. In sum, as with the administration's new American Jobs Creation Act-as well as for most other recent tax legislation, for that matter-the current rule changes to the tax treatment of R&D expenses present a mix of challenges and opportunities.
Endnotes
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