Changes to how US taxes handle research expenses

Understanding the Tax Cuts and Jobs Act’s impact

The US Tax Cuts and Jobs Act (TCJA) of 2017 brought about changes in how research and experimental (R&E) expenses are treated for tax purposes. These changes particularly impact businesses that invest in innovation. They come into play starting with the 2022 tax year, affecting corporations whose income tax returns’ extended deadline is in October 2023.

Shifting deduction rules for research expenses

Under the previous tax regime, businesses could easily deduct R&E expenses as part of their ordinary and necessary operational costs. However, with the new rules set in motion after December 31, 2021, this landscape is altered. Now, companies are required to spread out these expenses over a period of time, making deductions more structured. For research conducted within the US, these costs need to be capitalised and amortised over five years, while foreign research expenses have a 15-year amortisation period. Interestingly, the US TCJA’s also affects costs related to software development, which must now be treated as R&E expenses

Industries feeling the impact the most

Industries at the forefront of innovation, such as technology, software development, and life sciences, will feel the brunt of these modifications. These are the sectors that often allocate significant resources to research and experimentation. This shift in tax treatment might lead to increased taxable income for these companies, even if they’ve historically had no federal taxable income.

Pending legislation: Bill 3938 – Built-It-In-America Act

While these tax changes are in motion, there’s a potential lifeline for businesses in the form of legislation. Bill 3938, known as the Built-It-In-America Act, is making its way through Congress. This bill would delay the implementation of the new deductions over five or 15 years until tax years that begins after December 31, 2025, providing some breathing room for affected companies. However, as of August 2023, the bill hasn’t been put to a vote in the House of Representatives. It only got approval from the House Ways and Means Committee in June 2023. Still, many tax advisers are skeptical about its passage before the extended 2022 corporate income tax return deadline of October 15, 2023.

In light of these changes, businesses are advised to plan accordingly. Consulting with a tax professional becomes crucial to comprehend the exact impact on a business’s financials.

Leveraging the Research Tax Credit

With the recent shift in the tax treatment of R&E expenses, the existing Research Tax Credit emerges as a potential antidote for affected companies. This research credit is a tax incentive designed to encourage businesses to invest in research and development activities within the US. As such, it is more valuable than ever.

Understanding the Research Tax Credit

The Research Tax Credit can provide relief to companies investing in research. It is non-refundable and calculated as a percentage of “qualified research expenses” (QREs). These expenses can include wages of employees involved in research and development, supplies, equipment, and even contract research expenses beyond a baseline. One of the advantages is its flexibility – if a company can’t utilise the credit in the current tax year, it can carry it forward for up to 20 years and apply it against future tax obligations.

Tailoring the Research Tax Credit for small businesses

Certain small businesses have an extra benefit – they can use the Research Tax Credit as a payroll tax credit to offset their Social Security payments. To qualify for this perk, the business must be a corporation or a partnership with gross revenues under $5 million for the tax year and no revenue in the five tax years leading up to it.

Determining eligibility for the Research Tax Credit

For research expenses to qualify for the Research Tax Credit, businesses must demonstrate that their research activities meet specific criteria outlined by the Internal Revenue Code. These research criteria include:

1. Technological in Nature: The research must rely on principles of physical or biological sciences, engineering, or computer science.
2. Permitted Purpose: The research must aim to create new or improve functionality, performance, reliability, or quality of a business component.
3. Uncertainty Elimination: The research must involve a process of experimentation to resolve technical uncertainties related to the business component’s development or improvement.
4. Experimentation Process: The research must follow a systematic process of experimentation, which can involve modeling, simulation or other analytical techniques.

Expenses that fall under the umbrella of qualified research expenses (QREs) include employee wages directly linked to research activities, costs for supplies and materials used in research, and expenditures associated with renting or leasing equipment for research and development. However, it’s important to note that not all research expenses qualify for Tax Research Credit. For example, costs related to market research, advertising, or routine product testing are excluded.

How ZEDRA can help

In essence, the recent alterations in tax treatment of research and experimental expenses hold significant implications for businesses that drive innovation. While the Research Tax Credit could provide some relief, not all research-related expenses qualify. The tax professionals at ZEDRA Global Expansion US can help your business navigate this complex terrain to ensure compliance and help businesses capitalise on available tax incentives. For more information, contact Kathryn Loranger, Tax Director or Luoxi Li, Tax Manager in Boston.