Few would debate that among the most sweeping corporate tax reforms in history is the research and development (R&D) tax incentives. The complexities of these incentives are multilayered and therefore much clarification and guidance is needed on many aspects of the rules.
While the Internal Revenue Service has provided some clarifications around R&D tax incentives, companies are looking to the government for their recommendations in order to set clarity and streamline the calculation and application processes for R&D credits, particularly under Section 41 (Credit for Increasing Research Activities) and Section 174 (R&E Expenditures).
R&D tax areas most in need of clarification
Based on comments from a recent leading tax conference, below are five key areas in which additional clarifications is most needed:
1. Software development costs
The evolving nature of technology and software development presents challenges in defining what is considered software development costs that are eligible for R&D tax credits. Authorities are addressing this, not only now but in the future, as they consider comprehensive regulations to address the breadth of activities that qualify, from preliminary research and design to testing and deployment. Given the warp-speed of innovation and of software development, the guidance has to be flexible yet precise enough to include a wide range of activities. At the same time, it also needs to be able to exclude routine or maintenance tasks that do not contribute to technological advancement.
2. Timing of labor costs
One of the most pressing issues is the definition and timing of labor costs eligible for inclusion in the Specified Research or Experimental Expenditures (SRE) calculation. This includes determining which employee’s activities are qualified as direct research activities rather than supporting or ancillary work. Additionally, guidance is needed on how to allocate labor costs when employees are engaged in both qualifying and non-qualifying activities.
3. Incidental costs on “safe harbor” rules
Businesses need to fully understand the “safe harbor” rules for incidental costs associated with R&D activities. These rules could specify a fixed percentage of direct R&D costs that can be automatically treated as qualifying incidental expenses, thereby simplifying the calculation process and reducing administrative burdens. Establishing clear criteria for what constitutes incidental costs — such as materials, supplies, and overhead — would help companies more accurately estimate their eligible R&D expenditure.
4. Treatment of contract research
Contract research plays an important role in the R&D ecosystem, allowing companies to leverage external expertise and resources. However, there is some ambiguity regarding the eligibility of contract research expenses, especially in determining the ownership of the resulting intellectual property and the allocation of risks and rewards between the contracting parties. Future guidance should clarify the conditions under which contract research expenses qualify for R&D tax credits and provide a framework for contractual arrangements that facilitate collaboration while ensuring it meets with tax incentive criteria.
5. “Unit of account” for Sect. 41 business components
A critical and complex issue is the determination of the unit of account for the purpose of distinguishing between Section 41 business components and Section 174 products. This distinction between the two categories impacts whether expenditures are eligible for R&D tax credits, because it defines the scope of what constitutes a separate and distinct component of research or a new or improved product. Better guidelines are needed to assist companies in identifying the appropriate unit of account, considering the details of technological advancements and the integration of components into comprehensive systems or solutions.
While the United States government strives to be the most innovative country in the world and provides ways to encourage innovation, for example, by creating tax incentives to help businesses offset the cost of innovation. Over the years, however, some of these regulations — including newer or updated rules — have left businesses at times trying to figure out how best to take advantage of these tax credits.
Now, companies are eagerly anticipating the additional clarification and guidance from the IRS on R&D tax incentives over the coming months. As policymakers work to refine these regulations, it is imperative that they engage with business and tax advisory communities to develop practical, forward-looking guidance that accommodates the complexities of modern R&D practices.
