Credits Against Tax

For tax years ending after 2006 (i.e., either calendar-year 2007 or fiscal years that include a portion of 2007), taxpayers have three options: they can claim a regular 20% credit, use the AIRC with a top rate of 5% or claim the new ASC (12% rate). Calendar-year taxpayers can simply use whichever of the three computation methods generates the largest expected benefit for calendar-year 2007. For fiscal-year taxpayers, however, the computation will be more complex; a special transition rule effectively allows such taxpayers to claim the enhanced AIRC with a top rate of 5% or the new ASC, but only for the portion of the fiscal year that falls within 2007.

New ASC

A taxpayer that elects the ASC option for a tax year ending after 2006 can claim a credit of 12% of its current-year qualified research expenses (QREs) that exceed 50% of its average QREs for the three preceding tax years. In effect, a taxpayer with relatively constant qualified research spending in recent years will be able to claim an ASC credit of approximately 6% of total QREs. As with the other credit options, the ASC is subject to the Sec. 280C(c) “cutback” rule, which generally reduces the value of the credit by 35%.

State tax implications: While many states “piggyback” on the Federal research credit provisions, no state has yet adopted the additional ASC option. However, California and other states may consider adding a similar ASC option to their tax credit regimes. Because California and other states do not bind taxpayers to the method used for computing a research credit on their Federal returns, it may be possible to adopt the ASC for state purposes, while claiming the “regular” credit on the Federal return (or vice versa).

Who will benefit?: Many companies have been unable to claim the regular credit because of changes in their business models and economic circumstances. In many industries, R&D spending relative to gross receipts has not kept pace with the ratio in the so-called “base period” (generally, 1984 to 1988). For example, a company may enter into a new line of business (e.g., retail operations) that generates significant gross receipts, but does not require additional research spending. As some industries or particular companies mature, they may naturally become less research-intensive or more efficient in their R&D processes. These changes are prevalent in many industries (including aerospace, automotive, chemical, consumer products, defense, information technology and telecommunications).

Moreover, many companies received significant dividends from their controlled foreign corporations (CFCs) in 2005. These companies responded to Sec. 965 (enacted in 2004), which provided an incentive to repatriate foreign earnings by temporarily reducing the tax otherwise applicable to dividends paid by a CFC. If such extraordinary dividends are treated as “gross receipts” for research credit purposes—an issue that remains unsettled—this could affect the calculation of the research credit from 2006–2009, by potentially increasing the U.S. parent’s base amount for regular credit or AIRC purposes.

The enactment of the ASC will greatly benefit many companies whose regular credit claims have been shrinking because their QREs have not kept pace with their growth in gross receipts, or that previously had no choice but to claim the AIRC. Indeed, taxpayers that drastically increase their current-year QREs may be able to claim an ASC that exceeds the maximum “regular” 20% credit, because the regular credit cannot be claimed on more than 50% of current-year QREs. This 50% base limit does not apply to the ASC.

In sum, the ASC is likely to benefit (1) companies currently reporting AIRCs or no research credits at all, due to base-amount considerations; (2) those that currently have limited credit opportunities, due to increasing gross receipts; (3) companies planning  large research efforts in 2007 (relative to research spending in prior years); (4) those having difficulty determining their “regular” base amount due to lack of substantiation from 1984–1988 (e.g., due to adjustments required for certain acquisitions/dispositions); and (5) smaller companies that cannot justify the compliance cost of reconstructing historic data from 1984–1988.

Start-up companies: For start-up firms and other taxpayers that have not incurred QREs during each of three years preceding the current year, the current-year ASC will simply be computed by applying a flat 6% credit rate to the taxpayer’s total current-year QREs. Thus, in some circumstances, a start-up company will benefit by claiming the regular credit (which can result in a maximum 10% flat credit), rather than making an ASC election.

Control group rules: All corporations and other businesses that are members of a controlled group must consistently elect and compute their credit by using the regular credit, AIRC or ASC, with each group member then allocated a portion of the group credit consistent with Regs. Sec. 1.41-6. Regardless of whether all controlled group members file a single consolidated return or separate returns, they must use the same computation method (regular credit, AIRC or ASC) when claiming a research credit.

Transition relief for fiscal-year taxpayers: A special rule provides that, in the case of a fiscal year that ends after Dec. 31, 2006 and includes that date, the taxpayer’s research credit will have two components—(1) a credit amount computed under “old law” (i.e., either the regular 20% credit or AIRC with a top rate of 3.75%), prorated by the ratio that the number of pre-2007 days in such fiscal year bears to the total days in such year; plus (2) a credit amount computed under the “new law” (i.e., the regular 20% credit, AIRC with a top rate of 5%, or new ASC) prorated by the ratio that the number of post-2006 days in such fiscal year bears to the total days in such year.

Example: X Co.’s fiscal year began on Oct. 1, 2006 and ends on Sept. 30, 2007. X would first compute its credit for the year by electing either a regular 20% credit or AIRC with a top rate of 3.75%, and multiply the credit amount by approximately 25% (because three months of its fiscal year were in 2006). X would then compute its credit for the year by electing the regular 20% credit, AIRC with a top rate of 5% or new ASC (whichever method generates the largest expected benefit) and would multiply the credit amount by approximately 75% (because nine months of its fiscal year were in 2007). Adding these two prorated credit amounts together would equal X’s total research credit for the fiscal year, effectively allowing X to receive the benefit of either the “enhanced” AIRC or new ASC for the portion of its fiscal year that falls within 2007.

ASC elections and revocations: The new statutory language provides that an ASC election “shall apply to the taxable year for which made and all succeeding taxable years unless revoked with the consent of the Secretary.” Neither the statute nor the legislative history specifies the time or manner for making an ASC election, nor do the statutory provisions governing the AIRC (first enacted in 1996). Regulations, however, ultimately required that an AIRC election be made by completing the appropriate portion of Form 6765, Credit for Increasing Research Activities, and attaching it to the taxpayer’s timely filed (including extensions) original return for the year to which the election applies. An AIRC election cannot be made on an amended return; see Regs. Sec. 1.41-8(b)(2).

It can be expected that—prior to the filing date for original returns for fiscal years that include a portion of 2007 or for calendar-year 2007—Treasury will clarify whether the time-and-manner regulatory rules governing an AIRC election likewise apply to the new ASC. In the meantime, however, the safest course is for taxpayers to assume that they will need to gather sufficient data by the time they file their 2007 original returns, to determine whether it is advantageous to make the ASC election; if so, they will simply compute the ASC on a Form 6765 attached to the original return.

Until further IRS or Treasury guidance is issued, it is also safe to assume that, once an ASC election is made, there will be no opportunity for a taxpayer to seek the Service’s consent to revoke the ASC for that same election year. This is the case with the AIRC; the IRS will not consent to retroactive revocations of a previously made election. Nonetheless, the Service has simplified the procedure for taxpayers to revert to the regular credit regime for a subsequent tax year. Specifically, Regs. Sec. 1.41-8(b)(3) provides automatic consent for taxpayers to revoke prospectively an AIRC election, simply by completing the portion of Form 6765 relating to the regular credit and attaching it to the original return for the year that succeeds the year the AIRC election was first made.

Similarly, the new legislation contains a special transition rule granting taxpayers automatic consent to revoke a previously made AIRC election for a year that includes Jan. 1, 2007, if the taxpayer simply elects the ASC for such year. This automatic-consent procedure eventually may be extended by regulation or other published guidance to allow revocation of an ASC election. If not, assuming that the research credit is extended beyond its scheduled expiration date of Dec. 31, 2007, taxpayers that elect the ASC for 2007 may be required to file a letter ruling request for consent to return to the regular credit or AIRC for a subsequent year.

Election-related implications: Some taxpayers may face difficulties in determining whether to make an ASC election, because the answer ultimately could depend on whether the IRS or courts will accept certain positions with respect to unsettled areas of the law. For example, many taxpayers have taken the position that—consistent with the “single taxpayer” principle of Sec. 41(f)(1) and the general rule of Regs. Sec. 1.41-6(i)—transactions with CFCs should be disregarded when calculating “gross receipts” for research credit purposes. The Service initially accepted this position (in Chief Counsel Advice (CCA) 200233011, 8/16/02), but later reached the opposite conclusion (in CCA 200620023, 2/14/06). Because the question of how to treat intragroup transactions when calculating “gross receipts” remains on the Treasury and IRS “2006-2007 Priority Guidance Plan” (8/15/06), the government has not yet adopted a “final” position on this issue. Consequently, this uncertainty alone could complicate a taxpayer’s decision whether to make an ASC election. If transactions between a taxpayer and its foreign affiliate must be taken into account when calculating gross receipts, the taxpayer’s base amount for the regular 20% credit may be so high that the ASC (with the lower 12% credit rate, but ignoring all gross receipts) may result in a greater benefit. On the other hand, if the taxpayer excludes intragroup transactions and the “gross receipts” position ultimately is sustained by the Service or a court, the regular 20% credit may yield the larger benefit.

In this regard, if Treasury ultimately issues regulations requiring an ASC election to be made only on an original (not an amended) return, taxpayers will not initially be able to claim a regular credit, and then “settle” on an ASC if one or more of their legal or factual positions are challenged on audit. Accordingly, the hazards of taking certain positions will need to be weighed when companies decide whether, on balance, electing the ASC is beneficial.

Financial Reporting Issues 

Although a discussion of the financial-statement implications of the new research credit provisions is beyond this item’s scope, calendar-year companies may be able to factor the retroactive extension of the credit into the final effective tax rate to determine their 2006 tax expense. Fiscal-year companies that previously reported limited credits for their 2006 year may need to adjust their current-quarter financial statements to account for research credits that will be claimed (under the new law) for fiscal-year 2006 and subsequent quarters.  

Conclusion

Enactment of the new ASC, as well as the increased AIRC rates, will encourage companies to conduct additional research in the U.S. (as opposed to other countries with substantial research incentives). For many taxpayers, the base-amount computation rules governing the regular 20% credit have become increasingly arbitrary limits on their ability to receive a meaningful incentive. The option of computing an ASC solely by reference to the taxpayer’s recent QREs will appropriately “modernize” the research credit regime and (in contrast to the provisions enacted in 1989) will be self-correcting should the research credit be further extended beyond 2007. In fact, because the new ASC does not include a minimum-base limit rule, taxpayers that drastically increase their research spending potentially can claim an ASC that exceeds the maximum regular credit available for such spending. Thus, companies should immediately begin to consider the effect of the new research credit options so they can calculate effective tax rates on financial statements for their first quarter ending in 2007, make estimated tax payments, and be prepared to elect the most beneficial credit computation method when filing their 2007 original returns.

From Steven D. Arkin, J.D., Washington, DC, and Michael Goldbas, J.D., Hartford, CT