Special Report Research Tax Credit 2012 Mcladery Click

8/13/2019 Special Report Research Tax Credit 2012 Mcladery Click

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SPECIAL REPORT®

The failure to timely renew a tax provision

widely relied on by U.S. businesses is indicative ofCongress’s lack of significant activity.2 et! despitethe expiration of the research credit in 2"#2! therewas a great deal of credit$related activity at theadministrative and %udicial levels. This report re$views those recent developments and considers the

credit’s future in light of proposals for tax reform.

I. Administrative Action

& ma%or change in administrative practice last

year should have a positive effect on the '(S’sexamination of the research credit. The )arge *usi$ness and 'nternational +ivision eliminated its tiered

issues process and replaced it with issue practicegroups ,'-s/! effective in &ugust.

0stablished in 2""1! the industry issue focus program prioritied issues into tiers. Tiered issueswere identified as high risk for noncompliance andre3uired mandatory coordination with an '(S issue

owner . *ecause the outcome of tiered issuesoften rested in the hands of a few '(S issue experts!exam resolution was fre3uently taken away fromlocal examination teams! and decision$makers were

often inaccessible! which resulted in a bottleneckof un$resolved cases.

Caught up in that bottleneck were refund claims

based on the research credit. Taxpayers and their

advisers had begun inundating '(S service centers

with those claims after final research credit regula$tions were released at the end of 2""4. The '(S became concerned that some of the claims were55thrown together’’ with little supporting documen$

tation. 'n 2""6 the '(S issued 7otice 2""6$89!8

re3uiring special filing of all refund claims based on

the research credit. :hen the '(S rolled out itsindustry issue focus program! the research credit

debuted as a Tier ' issue.

the chaotic fiscal cliff negotiations. 'n addition to retroactively

extending the credit! section 8"# of the bill clarified rules

concerning ac3uisitions and dispositions! and the aggregation

2

last hours of the last day of the year to address an issue weshould have dealt with months ago. This marks another sad

chapter in what has been the least productive Congress since

#94;.’’ -ress release! 55Statement by Senator <ohn =cCain on

2013-169! 2013 TNT 3-20! rescued the research credit as part of

(Footnote continued in next column.)

TAX NOTES, February 4, 2013

. . . . . . . . . . . . . . . . . . . . . . .

This report represents the views of the author

only and does not necessarily represent the views

or professional advice of =cladrey.

Copyright 2"#8 +avid ). Click.

&ll rights reserved.

Table of Contents

I. Administrative Action . . . . . . . . . . . . . . . 1"#

II. Litigation . . . . . . . . . . . . . . . . . . . . . . . . . 1"2

&. +irect >ersus 'ndirect 0xpenses . . . . . . . 1"8

*. (esearch &ctivity and *usiness

Component . . . . . . . . . . . . . . . . . . . . . 1"8

C. >ariance +octrine . . . . . . . . . . . . . . . . . 1"8

+. ross (eceipts . . . . . . . . . . . . . . . . . . . 1"4

0. 0(- 'mplementation . . . . . . . . . . . . . . . 1"4

?. @air Care . . . . . . . . . . . . . . . . . . . . . . . 1"4

III. Congressional Inaction . . . . . . . . . . . . . . . 1"A

IV. Tax Reform and the Research Credit . . . . .

1"A V. Conclusion

1"6

The research credit died in 2"#2 B at least in the

short term. Congress allowed the credit to lapse at

the end of 2"##! leavin tax a ers in limbo for the2"#2 calendar ear . &fter needless drama! Con ressstepped in several minutes after the final hour and

restored the research credit for 2"#2 ,retroactively/

+avid ). Click is a tax

director at =cladrey in+enver . @e also teaches in

the graduate accounting program at the University of

Colorado at +enver.

'n this report! Click re$views developments regard$

ing the research credit in2"#2 and the possibility oftax reform affecting the

credit in 2"#8.

By David L. Clic

David L. Click

T!e "e#earc! Ta$ Credi% i& 2012

T!e "e#earc! Ta$ Credi% i& 2012

of research expenditures.

55't should be embarrassing to all of us that it took until the

tax notes



CO''ENTA"( ) S*EC+AL "E*O"T

0xaminations of the research credit grew burden$

some! contentious! and time$consuming.

Taxpayers became frustrated with tedious

information docu$ment re3uests! prepackaged

examination write$ups generally denying the

credit! and '(S 55issue owners’’ deciding cases

with little input from tax$ payers engaged in the

research. The overnment &ccountability fficeaddressed the clash over credit administration

in a 7ovember 2""9 report that instructed

taxpayers and the '(S to engage in a dialogue to try

to bridge the gap.4 To its credit! )*D' began

holding informal meetings with taxpayer

representatives for an open discussion of long$

standing issues. Those informal discussions! hosted

by the '(S in :ashington! helped to clear the air

and promote greater understanding.

Tiered issues outlived their usefulness. =any of

the original tiered issues were tax shelter strategies

that had been effectively dealt with through '(S

enforcement and increased penalties passed by

Congress. ther tiered issues lost their importance

either through litigation or inertia. The '(S also

seemed sensitive to practitioner criticism concern$

ing lack of transparency and delays in issue resolu$

tion.

)ast &ugust )*D' Commissioner @eather =al$

loy announced the end of the tiered issue process

and the debut of '-s and international practice

networks.A The new system will focus on internal

knowledge management groups that will work

collaboratively to advise field examiners on techni$

cal issues.1 The '-s! comprising experienced rev$enue agents! chief counsel attorneys! and industry

specialists! will serve the field as consultants or

advisers.

The goal of the '-s is to provide timely guid$

ance to examination teams while providing ac$

countability and transparency for taxpayers. '-s

will work as consultants to )*D' examiners! but

final determination of an issue will rest with the

local examination team. The veto power that the

former issue owners could exercise is no more!

preventing cases from getting backlogged in the '(S

system. =oreover! '-s will increase transparency

4

tion Can *e 'mproved!’’ &$#"$#81 ,7ov. 1! 2""9/! Doc 2009-

)*D'$"4$"6#2$"#"! Doc 2012-17527 ! 2012 TNT 161-51. practice network process! see (obert &dams! 557ew )*D'See <eremiah Coder! 55)*D' fficially 0nds 'ssue Tiering!’’ Enowledge =anagement StrategiesF '-s and '-7s!’’ 48 Tax

)*D'$"4$#2#2$"#4! Doc 2012-25308 ! 2012 TNT 238-13.

by allowing taxpayers to have access to '- ad$

visers to discuss pending issues.;

The &ugust )*D' memorandum provides that all

prior industry issue directives relevant to tiered

issues 55are withdrawn and should no longer be

consulted or followed’’ and that other internal

guidance addressing the program ,such as 'nternal

(evenue =anual references/ 55are no longer valid.’’&long those lines! )*D' on +ecember ; issued new

exam guidance on computing and substantiating

the research credit.6 't is unusual in that it allows

)*D' examiners to have a taxpayer sign a certifica$

tion statement regarding 3ualified research ex$

penses ,G(0s/ incurred in Stage ' and Stage '' drug

development . 'f the taxpayer provides the certifica$

tion! the )*D' examiner will not challenge the

certified amounts. This new procedure could go a

long way toward removing from examination an

area on which there should be little disagreement

between the '(S and the taxpayer.

?or taxpayers with research credit examinations!

the administrative move from the tiered issues

process to '-s is a positive change. )ocal )*D'examiners will be able to settle cases based on their

own %udgment! with input from an '-. The trans$

parency afforded by allowing taxpayers to discuss

issues with '(S advisers has already significantlyimproved research credit examinations. The re$ placement of tiered issues with '-s should alone

expedite the resolution of those examinations! withfairer and more understandable outcomes to tax$

payers.

II. Litigation

<ust as the administrative treatment of the re$search credit appeared to calm! the amount oflitigation increased. Court decisions on the researchcredit have typically been few and far between.0ven the most contentious tax cases often settle atthe &ppeals ffice level! but because of the coordi$nation between 0xamination and &ppeals on tieredissues! settlements have been more difficult. =ore$over! tax refund cases are generally litigated indistrict court and aggressively pursued by the <us$

tice +epartment. 'n the past #6 months! litigation

activity has been higher than normal! with mixedresults. Some of the issues addressed in litigationare summaried below.

b allowin b

b allowin tax a ers to have access to '-

by

allow

ing

b allowin tax a ers to have access to '- ad$visers to discuss




&! 55The (esearch Tax Credit’s +esign and &dministra$



A. irect Versus Indirect !x"enses

The Second Circuit clarified the definition of supplies.

9 Union Carbide Corp. claimed as a re$

search cost supplies used in developing its manu$

facturing process. Some of the supplies ended up in

finished products. Union Carbide was unable todistinguish between supplies that were used inresearch and supplies that wound up in inventory.The company argued that because it was experi$

menting with improvements to its manufacturing process! all supplies used in the research processshould 3ualify for the credit. The Second Circuitdistinguished direct expenses from indirect ex$

penses. 't held that the supplies at issue wereindirect expenses and thus ineligible for the re$search credit.

The supplies were deemed indirect expenses because they were the type of raw materials held ininventory for the production of products and were

not specified as research supplies. *ecause produc$tion supplies and research supplies were inter$changeable! the court treated the supplies claimedas a research expense as indirect expenses. 'f UnionCarbide had done a better %ob of segregating itsresearch supplies from its production supplies! or if

it had been able to demonstrate an increase inmaterials beyond the company’s normal inventory

re3uirements! it may have been able to show directresearch expenses.

#. Research Activit$ and #usiness Com"onent

*ayer Corp. engaged in research and develop$ment at more than #"" locations throughout theUnited States. 't calculated the research credit using

a 55cost center’’ approach rather than accounting forresearch expenses on a product$by$product basis.'n refund litigation in district court! thegovernment argued that *ayer was re3uired to

group its G(0s by business component and not by cost center. *ayer contended that because of

its extensive re$search activities! it wasimpractical to group ex$ penses by business

component. The company re3uested that thecourt approve a statistical sam$ pling of itsresearch expenses by cost center to validate itsresearch activities and expenses.

iven the volume of documents generated by the

litigation! the court appointed a special master tooversee discovery. *ayer ob%ected to an interroga$tory asking it to identify and describe each new orimproved business component. +efending againsta motion to compel! the company argued thatits proposed sampling method would reduce the

bur$den of document production. The specialmaster

#8

2"#2/! Doc 2012-18723! 2012 TNT 175-19. 2"#2/! Doc 2012-19746 ! 2012 TNT 185-22 , Bayer II /.


asked the court to step in to decide the issue. U.S.

+istrict <udge :illiam ). Standish abruptly denied*ayer’s re3uest.#" @e concluded that the govern$ment’s interest in determining *ayer’s businesscomponents outweighed any discovery burden im$

posed on the company. &llowing *ayer to limit its production of documents to a small sample would

relieve the company from its regulatory obligation

to maintain records 55to substantiate that the expen$ditures claimed are eligible for the credit.’’## &ccord$ingly! the court refused to allow the use of statisticalsampling to limit pretrial discovery.

C. Variance octrine

?lush with victory! the government moved for

partial summary %udgment against *ayer . @avingsuccessfully forced the company to reorganie its

research expenses by business component ratherthan cost center! the government argued that*ayer’s refund claim now substantially varied fromits original claim and should therefore be dismissed

for violating the variance doctrine articulated in Lockheed Mart!.#2

Seeing the apparent chutpah in the govern$ment’s argument! the court 3uickly ruled againstthe <ustice +epartment in Bayer II .#8 n the onehand! <ustice opposed *ayer’s attempts to substan$

tiate its research expenses on a cost center basis!appealing to the court to have *ayer classify each

research expenses based business component. &ftercomplying with the court’s order! <ustic then

argued that *ayer is somehow 55varying’’ itsoriginal claim and it should be dismissed. &sstated by <udge StandishF 55@owever! the

government will not be permitted to demand alist of business components for the first time in this

Court and then ob%ect based on the substantial

variance rule to *ayer’s need to gather

99



TAX NOTES, February 4, 2013 03

#" Bayer "or#$ %$ &!ted State'! 6A" ?. Supp.2d A22 ,2"#2/! Doc

2012-2400! 2012 TNT 26-10 , Bayer I /.##(eg. section #.4#$4,d/.

Lockheed Mart! "or#$ %$ &!ted State'! 2#" ?.8d #811 ,?ed.#2

Cir . 2"""/! Doc 2000-12106 ! 2000 TNT 83-10. 'n #992 )ockheed

=artin Corp. filed a protective claim pending the outcome of

(arch)d %$ &!ted State'! ;# ?.8d 616 ,?ed. Cir . #99A/! Doc 95-10743! 95 TNT 234-17 ! which presented the 3uestion

whether a government contractor could claim a researchcredit for research expenses incurred in a fixed price contract

under reg. section #.4#$1. &fter the ?ederal Circuit decided

the issue in favor of ?airchild! )ockheed unsuccessfully

attempted to amend its refund claim to include additional

research expenses. The ?ederal Circuit found that

)ockheed’s inclusion of the addi$tional expenses would

constitute a 55substantial variance’’ from the original claim

submitted to the '(S. )ockheed was one of many defense

contractors that filed protective claims and re$fund claims

Bayer "or#$ %$ &!ted State'! 7o. 2F"9$cv$""8A# ,:.+. -a.




with the demand when the G(0 credits underlying*ayer’s refund claim have not changed.’’#4

. %ross Recei"ts

@ewlett -ackard ,@-/ calculated a research

credit for #999 through 2""# using the alternativeincremental research credit ,&'(C/ method. Underthat method! the credit reflects the extent to which

G(0s exceed a base amount! which is a percentageof the taxpayer’s average annual gross receipts forthe prior four years.#A @- reported as its grossreceipts only the amounts shown on line # of ?orm##2" B gross receipts from sales less returns andallowances. 0xcluded from @-’s gross receipts cal$culation were dividends! interest! rents! royalties!and other income. @- later filed amended returnsfurther reducing gross receipts by the income attrib$

uted to its controlled foreign corporation.

The '(S examined @-’s research credit and is$sued notices of deficiency asserting that the com$ pany improperly calculated the credit. @- had

computed its average annual gross receipts basedonly on sales. (eg. section #.4#$8,c/ ,promulgatedafter the years at issue/ contains a broad definitionof gross receipts that includes sales! interest! divi$dends! and other income. 'n the Tax Court! bothsides moved for summary %udgment on the issue of

gross receipts. The '(S conceded that gross receiptsdid not include income from C?Cs! but it prevailed

on the 3uestion whether the term 55gross receipts’’was limited to sales receipts! as advocated by @-.The court adopted the broader definitionH it found

that the '(S’s interpretation of gross receipts was

consistent with other provisions of the code.#1

!. !R& Im"lementation0nterprise resource planning ,0(-/ systems are

integrated business systems that are usually de$

signed and sold by national software companies.&lthough most systems can be purchased as anoff$the$shelf product! customers often spend manyhours and thousands of dollars developing a sys$

tem to meet their business needs. 'n Da%e!#ort !#; theowners of a family business filed refund claims based on the expenses they incurred in customiingand implementing an 0(- system. They arguedthat 0(- implementation constituted 3ualifiedresearch for purposes of the research credit.

#4

?ailed &ttempt to >ary the >ariance +octrine!’’ Tax Note'! ct.

22! 2"#2! p. 844! Doc 2012-21474! or 2012 TNT 204-5.

years beginning after 2""6. See section 4#,h/,2/. 2012 TNT 56-9.

&!ted State' %$ Da%e!#ort ! 7o. 8F"9$cv$"24AA ,7.+. Tex. by the entertainer eorge =. Cohan. 'n the #942 movie! *a!kee

The '(S denied the claims! and the +avenports brought a refund suit in district court. The govern$

ment sought summary %udgment on grounds thatthe documents provided by the +avenports failed

to establish compliance with the 55process of experi$mentation’’ test. The court agreed. 't held that the

work was not done to refine a hypothesis but tovalidate and integrate the system according to

business re3uirements. There was no uncertainty atthe outset of the pro%ect and no process of experi$

mentation to test various hypotheses. The govern$

ment was invited to move for costs.

F. 'air Care

@air care is an issue that re3uires constant re$

search and attention. 'n Ba'+ Sha+!#6 an S corpo$

ration claimed a research tax credit based on itsdevelopment of hair care products including *io$Silk! +eep *rilliance! and Sunlit. The company

included as G(0s some of the wages it paid its C0and vice president. To support the refund claim! the

company estimated the percentage of the execu$tives’ time devoted to research efforts. 't then mul$

tiplied that percentage by the executives’ ?orm :$2

wages. The taxpayers argued that under the"oha! rule! the estimates should be permitted as

evidence to support the research credit. The well$established and well$worn "oha! rule providesthat the court may make reasonable estimates provided that the taxpayer comes forth withsome evidence that al$lows the court to make that

estimate.#9

The Tax Court held against the taxpayers and

refused to apply the "oha! rule. &ccording to thecourt! the executives failed to establish a reasonable

basis from which to make an estimate of time spenton research. 55:ithout such basis! any allowancewould amount to unguided largesse!’’ the TaxCourt said. The taxpayers failed to provide anysupporting documentation! and their witnesses’testimony was 55general! vague! conclusory andinsufficient.’’

*oth Da%e!#ort and Sha+ illustrate a reason why

refund claims based on the research credit becameTier ' issues. *oth cases involved speculative claimslacking solid! factual! supporting evidence. The '(S!

with some %ustification! has been concerned about

these types of refund claims inundating its service

centers. The opinions in Da%e!#ort and Sha+should provide some caution to taxpayers contem$

#A#A #A#A

#A#A #A

#A

#A

#A

#A

#A

?or further analysis of the Bayer II decision! see Coder! 55&



III. Congressional Inaction

&s noted earlier! Congress retroactively restored

the research credit for 2"#2! but only at the verylast minute and amid chaos.2" 0xtension of the

credit should not have been so uncertain orcontentious. 'n &ugust the Senate ?inanceCommittee reported out an extension of theresearch credit.2# Unfortu$nately! no action wastaken by the full Senate on the bill! and theextension of the credit languished along with

other expiring tax provisions such as alternativeminimum tax relief.

-ermanent research credit bills were introduced

in the Senate and the @ouse! but neither bill madeit out of committee.22 'n <une ?inance Committeemember Sherrod *rown! +$hio! introduced legis$lation to make the research tax credit permanent.28

@ouse :ays and =eans Committee member <imerlach! ($-a.! introduced legislation to allowstart$up business to use the research tax credit to

offset payroll taxes.24 The research credit garnered agreat deal of bipartisan support within Congress!

but because of the general election in 7ovember!there was little congressional action.

*efore the &merican Taxpayer (elief &ct of 2"#2rescued the credit! it had lapsed five times and been

extended by Congress #4 times. 'n 2"#" Congress passed the Tax (elief! Unemployment Compensa$tion (eauthoriation! and <ob Creation &ct of 2"#"!which retroactively extended the credit for 2"#" andinto 2"##. 0xtension of the credit is often contingenton budget concerns. 'n one of the more confusingextensions of the credit! in #999 Congress extendedit for five years but delayed the use of somecredits.2A (esearch credits attributable to the period

beginning on <uly #! #999! and ending on September8"! 2"""! were not to be taken into account in

2"

Sullivan! 55+ouble +isappointment :ith the ?iscal Cliff +eal!’’

Tax Note'! <an. ;! 2"#8! p. 41! Doc 2013-46 ! or 2013 TNT 2-2.

55nce again! simplicity was sacrificed on the altar of political

expedi$ency. :orking behind closed doors! leaders managed

to muck up even more the code they perennially vow to

simplify.’’

8A2#/! Doc 2012-18214! 2012 TNT 168-19. 49-9! the '(S outlined procedures that allowed some corporate

,(:T@/ &ct ,S. #A;;/! was introduced by ?inance Commit$ tax returns without paying the balance due if the outstanding

tee Chair =ax *aucus! +$=ont.! and ?inance member rrin . balance resulted from suspended tax credits.

&merican (esearch and Competitiveness &ct ,@.( . 942/ was and proposals. ?or a good introduction! see @arry ). utman!

introduced by :ays and =eans Committee members Eevin 55@ow to Think &bout (eal Tax (eform!’’ Tax Note'! &ug. 1!

2"#2! *rady! ($Texas! and <ohn *. )arson! +$Conn.! and referred to the p. 19A! Doc 2012-14466 ! or 2012 TNT 152-5. utman is a

former :ays and =eans Committee. 7either bill was introduced to the chief of staff for the <oint Committee on Taxation.

2#st Century 'nvestment &ct of 2"#2 ,S. 88";/! Doc 2012- Credit! 55Table #F Corporations Claiming a Credit! by 'ndustrial

29

Ticket to :ork 'ncentives 'mprovement &ct of #999 ,-.). ears 2"##$2"#A!’’ <CS$#$#2 ,<an. #;! 2"#2/! Doc 2012-894! 2012

2#2# 2#2#

2#2#

2# 2#2#

2# 2#

2#

2#2#

2#2# 2#

2#

2#2#



TAX NOTES, February 4, 2013 0-


determining any amount of tax re3uired to be paid

under the code before ctober #! 2""" ,that is!3uarterly tax payments/. That limitation createdunderstandable confusion! which was 3uelledsomewhat by timely and useful '(S guidance.21

@owever! the incident demonstrates Congress’sambivalence toward a permanent research credit

and how a tax credit to stimulate research is sacri$

ficed to budgetary gimmicks.

The research credit is often criticied for its lack of permanence. The fate of a permanent credit maynow rest with the larger debate over tax reform.

IV. Tax Reform and the Research Credit

Congress may grapple with tax reform in 2"#8.

The basic elements of tax reform include base broadening and rate reduction. To achieve ratereduction at the corporate tax level! deductions and

credits have to be curtailed! and that may includethe research credit.2;

&ccording to government statistics! corporate

research credit claims in 2""9 amounted to approxi$mately I;.;; billion! spread among #2!8A9 corpora$tions.26 *y far the largest sector claiming theresearch credit was manufacturing! with A!#9; cor$ porate manufacturers claiming more than IA.89 billion of tax credits. The <oint Committee on Taxa$tion estimates that the research credit will represent

8.; percent of all corporate tax expenditures for2"##$2"#A.29

-resident bama kicked off the tax reform de$ bate last ?ebruary with the release of a 28$pagereport! 55The -resident’s ?ramework for *usinessTax (eform!’’ outlining the following five elements

of business tax reformFJ broaden the tax base and cut the corporate tax

rate to spur growthH

J strengthen incentives in the manufacturingsectorH

J substantially revamp the international tax sys$

temH

?or a criticism of Congress’s handiwork! see =artin &.



are reducing the corporate tax rate to 2A percent and

broadening the tax base so that revenues compose between #6 to #9 percent of +-. The bill has nospecific comment regarding the research credit orany other tax expenditure. The bill in its findingsstatesF 55=any tax preferences! sometimes referredto as 5tax expenditures!’ are similar to government

spending B instead of markets directing economic

resources to their most efficient uses! the overn$ment directs resources to other uses! creating a dragon economic growth and %ob creation.’’ 't is notclear to which tax expenditures Camp isreferring.84

*ase broadening means eliminating tax deduc$tions and tax credits. The last$in! first$out inventorymethod! debt financing! carried interest! and the oildepletion allowance have drawn the attention of

the administration. &lso of concern is 55establishinggreater disparity between large corporations andlarge non$corporate counterparts!’’ effectively tax$ing passthrough entities. @owever! the administra$

tion’s proposal singles out manufacturing andsmall business for continued tax incentives!including the research credit.

The research credit has always been a key el$ement in the administration’s tax policy. 'n =arch

2"## Treasury’s ffice of Tax -olicy released areport! 55'nvesting in U.S. CompetitivenessF The*enefits of 0nhancing the (esearch and 0xperimen$tation ,(D0/ Tax Credit!’’ on the benefits of anenhanced research credit for U.S. business.8A 'n thatreport and in a ?ebruary 2"#2 %oint report issued byTreasury and the :hite @ouse!81 the administrationrecommended strengthening the credit by making it

permanent and increasing the alternative simplifiedcredit rate from #4 to #; percent. The report statesF

(D+ is especially important for manufactur$

ing! which is a technology$intensive sector . 'nthe #96"s! the United States was the leader in providing tax incentives for (D+ through the(esearch and 0xperimentation Tax

Credit ,(D0 Tax Credit/. Today! however!many na$tions provide far more generous tax

incentives for research than does the UnitedStates. Cur$rent tax policy also undermines

the effective$ness of the incentive forresearch! because it is extended periodically

on only a temporary basis. Eeeping thisincentive under constant

The <ob -rotection and (ecession -revention &ct of 2"#2

2"#2. (evenue bills originate in the @ouse! and @.( . 6 passed ,@.( . 6/! section 2"2,a/,8/. &mong the other findings in the billF

the @ouse by voice vote. The @ouse legislation then gathered 55Since 2""#! there have been nearly 4!A"" changes made to the

dust in the Senate. &s the fiscal cliff approached the final hours! tax code! averaging more than one each day over the past

8A

sent back to the @ouse for an up or down vote as the retitled of 0nhancing the (esearch and 0xperimentation ,(D0/ Tax

&merican Taxpayer (elief &ct of 2"#2. bama signed the bill Credit’’ ,=ar . 2A! 2"##/! Doc 2011-6342! 2011 TNT 59-41.

,@.( . 6/! morphed into the &merican Taxpayer (elief &ct of ,@.( . 6/! mor hed into the &merican Tax a er (elief

,@.( . 6/! morphed into the &merican Taxpayer (elief &ct of ,@.( . 6/! morphed into the &merican Taxpayer (elief

,@.( . 6/! morphed into the &merican Taxpayer (elief &ct of

,@.( . 6/! morphed into the &merican

Taxpayer (elief &ct of

,@.( . 6/! morphed into the &merican Taxpayer (elief

&ct of


J simplify taxes for small businessesH and

J restore fiscal responsibility.8"

The last point concerning fiscal responsibility

consists of one page in the report and warns thatcorporate tax reform will not be revenue neutral.

The framework provides broad direction for the

administration’s tax reform goals and leaves many

details to be worked out. The three most significantelements for companies engaged in research arerate reduction! base broadening! and incentives.*ase broadening generally means restricting oreliminat$ing tax expenditures B deductions and

credits B thereby exposing more income to tax!albeit at a lower rate. The research credit comes

in at number #2 in a list of the top #A business taxexpenditures in2"##. The top three are accelerateddepreciation ,section #1;/! the domestic

manufacturing deduc$tion ,section #99/! and tax$exempt interest on bonds ,section #"8/.8#

=ost policy observers and the administration

agree on reducing the top marginal corporate tax

rate. The administration proposes reducing it from

8A to 26 percent. The effective tax rate B what businesses actually pay B is a rate of 29.2 percent!according to the president’s report.82 The effectivetax rate may vary substantially depending on the

industry and available tax benefits. To reform the business tax rate! tax expenditures ,deductions and

credits/ will be reformed to broaden the base.

:ays and =eans Committee Chair +ave Camp!($=ich.! introduced @.( . 6 in <uly 2"#2! and it passed the @ouse by voice vote on &ugust 6.88 The

bill! which outlined a framework for tax reform in

2"#8! had two titles! the second being -athway to<ob Creation Through a Simpler! ?airer Tax Code

8"55The -resident’s ?ramework for *usiness Tax (eform’’

,?eb. 2"#2/! Doc 2012-3711! 2012 TNT 36-18.8#

ffice of =anagement and *udget! 55?iscal ear 2"##

*udget of the United States! &nalytical -erspectives! Tax 0xpen$ditures’’ ,ch. #1/.

82&mong industrialied countries! the U.S. federal corporate

tax rate is higher than the corporate tax rate in ermany or reat *ritain. @owever! the effective tax rate! the rate most

corporations pay after using deductions and credits! is about 29

percent and in line with most C0+ countries. See 55The

-resident’s ?ramework!’’ ',#ra note 8"! at 2" ,citing Treasury’sffice of Tax &nalysis/.

88



threat of expiration means that business plan$

ning and long$term research pro%ects have toaccount for the risk that the credit will not beavailable! blunting its effectiveness as an in$

centive.8;

'n the context of comprehensive corporate tax

reform! the policy support for specific tax expendi$

tures must be %ustified against the overall goal ofrate reduction. )ast September the Congressional(esearch Service issued a comprehensive report on

options for corporate tax reform.86 'n evaluating thecorporate tax system! the C(S examined the policy

goals of e3uity and progressivity in the tax system!economic efficiency! and simplicity and administra$

bility. The report notes that tax preferencesmay cause economic distortions that can reduceeco$nomic efficiencyF 55The potential for economicdis$tortions caused by higher marginal rates

should be weighed against the potential efficiencygains asso$ciated with various tax preferences.’’(egarding (D+! the C(S observedF

Some of the exemptions! credits! deductions!

and other tax preferences in the U.S. tax sys$tem represent attempts to address instanceswhere markets fail to maximie economic ef$ficiency. Take! for example! tax incentivesfor research and development ,(D+/ relatedac$tivities. (D+ that leads to technologicalinno$vation is associated with positiveexternalities. That is! there are benefits to(D+ that accrue to those not directlyinvolved in or paying for the research itself .0conomic theory suggests that activities thatgenerate positive externali$ties tend to be

underprovided by markets. Thus! providinga tax subsidy for (D+! thereby directingadditional economic re$sources to (D+related activities! could lead to additional (D+and improve overall eco$nomic efficiency.89

& detailed study by the Center for &merican-rogress ,55The Corporate (D+ Tax Credit and U.S.'nnovation and Competitiveness!’’ the Tyson study/

largely supports the administration’s position onthe research credit.4" The study surveys statistical

4#

?oundation! the United States ranks 2;th in the generosity of its

research tax credit! %ust behind Singapore but still ahead of

Id $ at ##. reece. See )uke &. Stewart et al.! 'nformation Technology and=ark -. Eeightley and =olly ?. Sherlock! C(S! 55The 'nnovation ?oundation! 55:e’re K2;LF The United States )ags ?ar

Tyson and )inden! ',#ra note 4"! at 2.

=ichael (ashkin! 55The (D0 Credit +oesn’t :ork!’’ 00 Id $ at #9$2". Times ,?eb. #! 2"#2/. (ashkin is a formidable criticH his treatise!

)aura Tyson and reg )inden! Center for &merican ractca) .,de to /D Tax I!ce!t%e' ,2""8/! is the standard

44

Tyson was a member of bama’s economic recovery advisory value of the research credit. See (obert &tkinson! 55Counter$

board and has a distinguished career in both government and pointF (D+ Tax Credit Spurs 'nnovation!’’ 00 Times ,7ov. ##!

academia. She is currently professor of global management at 2"#2/.

(Footnote continued in next column.)

TAX NOTES, February 4, 2013 0.

8;

86

8;

86

8;

8;

8;

86

8;

8;8;

8;


information on the credit as well as much of theacademic literature concerning its effectiveness. 7oting that other countries have enacted tax incen$

tives for (D+! the study ranks the United States24th in terms of generosity of tax subsidies for business (D+! coming in %ust ahead of reece.4#

&ccording to the studyF

Competition among nations to attract busi$ness (D+ and to develop technology$intensive industries is growing. Thischallenges U.S. policymakers to strengthen

policies that make the United States anattractive location for these activities. Themost important of these tax incentives is the

corporate research tax credit.42

The study makes several positive recommenda$

tions regarding (D+! the three most salient points being ,#/ extend the research credit for five to #"years to assess its effectiveness! ,2/ increase thecredit by 2" percent to keep it competitive with

incentives offered by other countries! and ,8/ pro$vide small companies with a larger B and in some

cases! refundable B version of the research credit.

7ot everyone is in agreement on the value of the

research credit. 'n a provocative online article!=ichael (ashkin argues that companies do notundertake research because of a 55small taxsubsidy’’ but to remain competitive in the globalmarket.48 The credit is often used by large

corporations with large cash positions that aretherefore unmotivated to increase research based

on a relatively small tax incentive. (ashkinobservesF 55The research credit has been in

existence for over 8" years. +uring that time! notone company has announced an invention or

product that was produced as a result of the (D+tax credit.’’44

That criticism is arguably misplaced. :hether

the research credit is viewed as an incentive or a

the @aas School of *usiness at the University of California!

*erkele . )inden is a research associate at the 'nstitute&ccording to the 'nformation Technology and 'nnovation




reward! it is similar to other countries’ tax incen$

tives for research and can be an important tax policytool. :hether the research credit is effective as a taxincentive has long been debated. There are severalapproaches to evaluating the effectiveness of thecredit! including whether there are social benefits to

increased technological development and whethera tax credit for research stimulates more investment

and economic activity.4A The Tyson study contains acomprehensive summary of ## ma%or studies of theeffectiveness of the research credit. 't concludes that55the credit is effective in that each tax dollar offorgone tax revenue or tax expenditure for thecredit causes businesses to invest at least an addi$

tional dollar in (D+. . . . The inclusion of socialreturns! if they could be measured! would make theresult even more favorable.’’41 @owever! the Tysonstudy concedes that that conclusion is not univer$sally accepted.4;

Congress and the administration may grapplewith corporate tax reform in 2"#8. The source of

ongoing tension will be the elimination of taxdeductions! credits! and expenditures in order to broaden the tax base as a trade$off to achievingsignificant rate reduction. The research credit’s lowincentive rate and lack of permanence bring into3uestion its effectiveness as a tax expenditure.@arder to 3uantify is the credit’s effectiveness inkeeping high$paying research %obs in the UnitedStates! %obs that would instead be outsourced tocountries with lower wages or more generous (D+incentives. 'n considering a tax preference for (D+!

4A

)aw! )egislation in the ##2th Congress and -olicy 'ssues!’’

()8##6# ,=ar . ;! 2"#2/! Doc 2012-4987 ! 2012 TNT 47-16 . The

report! which is updated regularly! provides a good summary of

tax policy issues and the research credit.

credit. 't notes that 44 percent of credits generated in 2""A ended

up being a carryforward or a carryback and that '(S audits of

the credit often result in a lower aggregate amount of credit . See

&! ',#ra note 4! at #4$#A.

0/

Congress and taxpayers will need to confront the

following tax policy concernsF

J Can a substantial tax expenditure B a taxcredit for (D+ B be sustained if the topcorporate tax rate is significantly reducedM

J 's the research credit effectiveM :hether thecredit is seen as an incentive or a reward! does

it produce enough economic and social ben$efits to make it worthwhile to keep as a taxexpenditureM

J 'f the research credit is dropped in exchange

for a lower corporate tax rate! will the UnitedStates be able to attract technological research

away from countries offering a generous tax benefit for conducting research within their bordersM

V. Conclusion

& research tax credit for 2"#2 was retroactivelyresurrected only at the last minute through theconfusing legislative process to avoid the fiscal cliff.+espite Congress’s tardy attention to the researchcredit! there were important developments in both

the administrative and the %udicial arenas withsignificant impact on the credit. The most important

development is the '(S’s switch from tiered exami$nation issues to its new '-s for dealing with the

research credit and other complex tax issues. Thechange is already improving '(S field examinations

of the research credit. &lso! several recent %udicialdecisions have resolved some important technical

3uestions and illustrated that refund claims withscant support continue to be a problem for the '(S

and the courts.

Significant corporate tax reform efforts in 2"#8

could bring changes to the tax base and the tax rate.The tax reform debate will renew focus on taxexpenditures! including the research credit. &l$

though the administration and business groupslargely support maintaining a research credit! it isonly one piece in the complex undertaking ofcorporate tax reform.


Con ress and tax a ers will need to confront

CCongress and taxpayers will need to confront

Special Report Research Tax Credit 2012 Mcladery Click

Documents