Research Tax Credit: Current Law, Legislation
in the 113th Congress, and Policy Issues and Policy
Issues for the 113th Congress
Gary Guenther
Analyst in Public Finance
February 1April 23, 2013
Congressional Research Service
7-5700
www.crs.gov
RL31181
CRS Report for Congress
Prepared for Members and Committees of Congress
Research Tax Credit: Current Law, Legislation in the 113th Congress, and Policy Issues and Policy Issues for the 113th Congress
Summary
Technological innovation is a primary engine of long-term economic growth, and research and
development (R&D) serves as the lifeblood of innovation. The federal government encourages
businesses to invest more in R&D in several ways, including a tax credit for increases in spending
on qualified research above a base amount.
This report describes the current status of the credit, summarizes its legislative history, discusses
policy issues it raises, and describes legislation in the 113th Congress to modify or extend it. The
report will be updated as warranted by legislative activity and other developments affecting the
credit.
The research credit (also known as the research and experimentation (R&E) tax credit) has never
been a permanent provision of the federal tax code. It expired at the end of 2011 and was
retroactively extended in earlyJanuary 2013 through the end of that year. Since its enactment in mid1981, the credit has been extended 15 times and significantly modified five times. While the
credit is usually assumed to be a single credit, it actually consists of four discrete credits: (1) a
regular credit, (2) an alternative simplified credit (ASC), (3) a basic research credit, and (4) an
energy research credit. A taxpayer may claim one of the first two and each of the other two,
provided it meets the requirements for each.
In essence, the research credit attempts to boost business investment in basic and applied research
by reducing the tax price (or after-tax cost) of undertaking qualified research above a base
amount. As a result, the credit’s effectiveness hinges on the sensitivity of the demand for this
research to decreases in its cost. It is unclear from available studies how sensitive that demand is.
While most analysts and lawmakers endorse the use of tax incentives to generate increases in
business R&D investment, some have some reservations about the current credit. Critics contend the
the credit is not as effective as it could be because of certain flaws in its design, such as a lack of
permanence, uneven and inadequate incentive effects, non-refundability, and an unsettled
definition of qualified research.
The 112th Congress made few changes to the credit. Under the American Taxpayer Relief Act of
2012 (ATRA, P.L. 112-240), the credit was extended from January 1, 2012, through the end of
2013. ATRA also clarified the rules governing the use of the credit by companies involved in
acquisitions to ensure that taxpayers who sell or otherwise dispose of a business unit receive the
credit for qualified research expenses incurred before the change in ownership. Finally, the act
altered the rules used to determine the allocation of the credit among members of a controlled
group of businesses to make that allocation proportionate to each member’s share of total
qualified research expenses for the group.
TwoSeveral bills to further modify the credit have been introduced in the 113th Congress, though none
has been considered at the committee level. H.R. 119 would
permanently extend the current
credit. H.R. 120 would extend the credit through the end of 2014,
increase the rates of the regular
and ASC credits for 2013 and 2014 only, and allow qualified
small businesses to transfer any
credit they can claim to other businesses for cash and exclude
that cash from their gross income.
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Research Tax Credit: Current Law, Legislation in the 113th Congress, and Policy Issues
H.R. 905 would permanently extend the current credits and raise the rate for the ASC to 17%.
And three bills (H.R. 714, S. 193, and S. 310) would allow eligible small firms to apply up to
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Research Tax Credit: Current Law and Policy Issues for the 113th Congress
$250,000 of any research credit they claim but cannot use in the current tax year because of
insufficient income tax liability against their federal payroll taxes.
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Contents
Introduction...................................................................................................................................... 61
Design of the R&E Tax Credit ......................................................................................................... 83
Qualified Research Expenditures .............................................................................................. 83
Nature of Qualified Research .............................................................................................. 83
Expenses Eligible for the Credit.......................................................................................... 94
Regular Research Credit ............................................................................................................ 94
Calculation: Regular Research Tax Credit ........................................................................ 11.. 6
Calculation: Alternative Simplified Research Credit ........................................................ 11.. 6
Calculation: Regular Research Tax Credit .......................................................................... 7 12
Calculation: Alternative Simplified Research Credit .......................................................... 8 13
Alternative Simplified Credit .................................................................................................... 8 13
Alternative Incremental Research Credit .................................................................................. 8 13
University Basic Research Credit .............................................................................................. 9 14
Energy Research Credit ........................................................................................................... 1510
Option to Claim a Refundable Research Tax Credit in Lieu of Bonus Depreciation in
2008 and 2009 ...................................................................................................................... 1510
Legislative History of the Research Tax Credit ............................................................................. 1611
Effectiveness of the Research Tax Credit ...................................................................................... 1914
Stimulative Effect of the Credit ..................................................................................................... 2015
Policy Issues Raised by the Current Research Tax Credit ............................................................. 2318
Lack of Permanence ................................................................................................................ 2318
Uneven and Inadequate Incentive Effects ............................................................................... 2419
Uneven Incentive Effect .................................................................................................... 2419
Inadequate Incentive Effect ............................................................................................... 2621
Non-refundable Status ............................................................................................................. 2924
Incomplete and Ambiguous Definition of Qualified Research and Difficulties in
Using the Credit.................................................................................................................... 3025
Original Definition ............................................................................................................ 3025
Changes Under the Tax Reform Act of 1986 .................................................................... 3025
Subsequent IRS Guidance ................................................................................................. 3126
Remaining Concerns ......................................................................................................... 3328
Insufficient Focus on Innovative Research Projects ................................................................ 3530
Legislation in the 112th and 113th Congress to Modify and Extend the Research Tax Credit ........ 36
112th Congress ......................................................................................................................... 37
House................................................................................................................................. 37
Senate ................................................................................................................................ 38............... 31
113th Congress ......................................................................................................................... 3832
House................................................................................................................................. 3832
Other Noteworthy Perspectives on the Future of the Credit.................................................... 3932
Figures
Figure 1. Share of U.S. Spending (current dollars) on Research and Development Held by
the Federal Government and Businesses, 1955 to 2008 ............................................................. 3631
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Tables
Table 1. Sample Calculations of the Regular and Alternative Simplified Research Tax
Credits in 2013 for an Established Firm ..................................................................................... 10.. 5
Table 2. Sample Calculations of the Regular and Alternative Simplified Research Tax
Credits in 2013 for a Start-up Firm............................................................................................... 7 12
Table 3. Business and Federal Spending on Domestic Research and Development, and
Claims for the Federal Research Tax Credit, 1999 to 2009 ........................................................ 2217
Contacts
Author Contact Information........................................................................................................... 3933
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Introduction
Economists have gained notoriety for their differences of opinion on a variety of policy issues.
Notable examples include the long-term economic effects of large, permanent tax cuts; the impact
of illegal immigration on domestic wages; and the best way to achieve price stability, full
employment, and greater income equality. But on the issues of the impact of technological
innovation on economic growth in the long run and the proper role of government in the
development of new technologies, there is relatively little dissent among practitioners of what
some have called the dismal science.
In general, economists agree that technological innovation has accounted for a major share of
long-term growth in real per-capita income in the United States.1 It is useful to clarify what
economists mean by technological innovation, since such a complex concept can mean different
things to different professions. Economists who study the forces driving economic growth tend to
see innovation as a convoluted and uncertain process that embraces the acquisition of new
scientific and technical knowledge and its application to the development of new goods and
services or methods of production through research and experimentation. Learning-by-doing and
learning-by-using often play crucial roles in this process.
In economies dominated by competitive markets, technological innovation is driven mainly by
the efforts of competing firms to gain, sustain, or reinforce competitive advantages by being the
first to introduce or use new or improved products or services; more efficient production
processes; or more effective strategies for management, marketing and promotion, and customer
service and support.
Most economists would also agree that private R&D investment is likely to be less than the
amounts that would be warranted by its economic benefits. The reason for this is thought to lie in
the nature of these benefits. Firms generally cannot capture all the returns to their R&D
investments, even in the presence of patents, trademarks, and other instruments of intellectual
property protection, and their strict enforcement. Numerous studies have found that the average
social returns to private R&D investments greatly exceeded the average private returns.2 This
finding held true whether a firm invested in research projects narrowly focused on its existing
lines of business, or in research projects aimed at extending the boundaries of knowledge in
particular scientific disciplines in ways that had no obvious or immediate commercial
applications.
Economists refer to an excess of social returns over private returns as the spillover effects or
external benefits of R&D. There are several channels through which the returns from innovation
may escape full capture by the innovating firms and spill over to society at large. The most
common ones are reverse engineering by competing firms, migration of research scientists and
1
Linda R. Cohen and Roger G. Noll, “Privatizing Public Research,” Scientific American, September 1994, p. 72.
See, for example, Edwin Mansfield, “Microeconomics of Technological Innovation,” in The Positive Sum Strategy,
Ralph Landau and Nathan Rosenberg, eds. (Washington: National Academy Press, 1986), pp. 307-325; and John C.
Williams and Charles I. Jones, “Measuring the Social Return to R&D,” Quarterly Journal of Economics, vol. 113, no.
4, November 1998, pp. 1119-1135.
2
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engineers from one firm to another, and the availability of new or improved goods and services at
prices below what most consumers would be willing to pay.3
When seen through the lens of standard economic theory, the external benefits of technological
innovation take on the appearance of a market failure. They signal that too few resources are
being allocated to the activities leading to the discovery and commercial development of new
technical knowledge and know-how. To remedy this failure, most economists recommend the
adoption of public policies aimed at boosting or supplementing private investment in R&D.
The federal government supports R&D in a variety of ways. Direct support comes mainly in the
form of research performed by federal agencies and federal grants for basic and applied research
and development intended to support concrete policy goals, such as protecting the natural
environment, exploring outer space, advancing the treatment of deadly diseases, and
strengthening the national defense. Indirect support is more diffuse. The chief sources are federal
funding of higher education in engineering and the natural sciences, legal protection of
intellectual property rights, special allowances under antitrust law for joint research ventures, and
tax incentives for business R&D investment.
Federal tax law offers two such incentives: (1) an unlimited expensing allowance for qualified
research spending under Section 174 of the Internal Revenue Code (IRC), and (2) a nonrefundable tax credit for qualified research spending above a base amount under IRC Section
41—known as the research and experimentation (R&E) tax credit, the research tax credit, the
R&D tax credit, or the credit for increasing research activities. The deduction has been a
permanent provision of the IRC since it was first enacted in 1954. Its main advantages are that the
deduction simplifies tax accounting for R&D expenditures and encourages business R&D
investment by taxing the returns to such investment at a marginal effective rate of zero. A similar
policy objective lies behind the research tax credit, which has been a temporary provision of the
IRC since it went into effect in July 198.11981. The credit is intended to stimulate more business R&D
investment than otherwise would occur by lowering the after-tax cost of qualified research.4 But
unlike the deduction, it complicates tax compliance for firms claiming the credit. In FY2010, the
combined budgetary cost of these incentives totaled an estimated $9.5 billion, or 6.5% of the
estimated $147.1 billion authorized for federal defense and non-defense R&D that year.5
This report examines the current status of the R&E tax credit, describes its legislative history,
discusses some important policy issues raised by it, and identifies legislative proposals in the
113th Congress to extend or otherwise modify the credit. It will be updated to reflect significant
legislative activity and other developments affecting the credit’s status.
3
For a brief discussion of these channels, see Bronwyn H. Hall, “The Private and Social Returns to Research and
Development,” in Technology, R&D, and the Economy, Bruce L. R. Smith and Claude E. Barfield, eds. (Washington:
Brookings Institution and American Enterprise Institute, 1996), pp. 140-141.
4
For more information on the Section 174 expensing allowance, see U.S. Congress, Senate Committee on the Budget,
Tax Expenditures, committee print, 107th Cong., 2nd sess. (Washington: GPO, 2002), pp. 55-58.
5
Office of Management and Budget, Analytical Perspectives, Fiscal Year 2012 (Washington: GPO, 2011), pp. 66 and
367.
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Design of the R&E Tax Credit
Although many think of the research tax credit as a single unified credit, it has four discrete
components: a regular research credit, an alternative simplified credit (ASC), a basic research
credit, and a credit for energy research.6 Each is non-refundable. In any tax year, taxpayers may
claim no more than the basic and energy research credits, plus either the regular credit or the
ASC. To prevent taxpayers from benefiting twice from the same expenditures, any research tax
credit claimed must be subtracted from deductible research expenses. The four components of the
research tax credit are due to expire at the end of 2013.
Qualified Research Expenditures
Ultimately, claims for the regular credit and the ASC rest on the definition of qualified research
expenditures (QREs). There are two aspects to this definition.
Nature of Qualified Research
One aspect deals with the nature of qualified research itself. Under Section 41(d) of the federal
tax code, research must satisfy four criteria in order to qualify for the regular credit and the ASC.
First, the research must involve activities that qualify for the deduction under Section 174:
namely, the activities must be “experimental” in the laboratory sense and aimed at the
development of a new or improved product or process. Second, the research must seek to
discover information that is “technological in nature.” Third, it should strive to gain new technical
knowledge that is useful in the development of a new or improved “business component,” which
is defined as a product, process, computer software technique, formula, or invention to be sold,
leased, licensed, or used by the firm performing the research. And fourth, the research must entail
a process of experimentation aimed at the development of a product or process with “a new or
improved function, performance or reliability or quality.”
According to Section 41(d)(3), research satisfies the four criteria if it is intended to develop a new
or improved function for a business component, or to improve the performance, reliability, or
quality of a business component. By contrast, research fails to meet these criteria if its main
purpose is to modify a business component according to “style, taste, (and) cosmetic, or seasonal
design factors.”
Businesses, the courts, and the IRS have clashed repeatedly over the interpretation of the four
criteria. Although the IRS issued final regulations clarifying the definition of qualified research in
December 2003 (T.D. 9104), disputes between businesses and the IRS over what activities qualify
for the credit have continued.7
6
Firms investing in qualified research that could not claim the regular credit had the option of taking what was known
as an alternative incremental R&E tax credit (or AIRC), under IRC Section 41(c)(4), for tax years from 1996 to 2008.
The Emergency Economic Stabilization Act of 2008 (P.L. 110-343) repealed the AIRC for the 2009 tax year, and
Congress has not reinstated it. See page 14 for more details on the AIRC.
7
See the discussion of concerns raised by the current definition of qualified research in the “Incomplete and
Ambiguous Definition of Qualified Research” section of this report.
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Section 41(d)(4) identifies the activities for which the credit may not be claimed. Specifically, the
credit does not apply to:
•
research conducted after the start of commercial production of a “business
component”;
•
research done to adapt an existing business component to a specific customer’s
needs or requirements;
•
research related to the duplication of an existing business component;
•
surveys and studies related to data collection, market research, production
efficiency, quality control, and managerial techniques;
•
research to develop computer software for a firm’s internal use (except as
allowed in any regulations issued by the IRS);
•
research conducted outside the United States, Puerto Rico, or any other U.S.
possession;
•
research in the social sciences, arts, or humanities; and
•
research funded by another entity.
Expenses Eligible for the Credit
The second aspect of the definition of QREs concerns the expenses to which the credit applies.
Under Section 41(b)(1), qualified expenses relate to both in-house research and contract research.
In the case of in-house research, the regular credit and ASC apply to the wages and salaries of
employees and supervisors engaged in qualified research, as well as the cost of materials,
supplies, and leased computer time used in this research. In the case of contract research, the
credits apply to the full amount paid for qualified research conducted by certain small firms,
colleges and universities, and federal laboratories; 75% of payments for qualified research
performed by certain research consortia; and 65% of payments for qualified research performed
by certain other non-profit entities dedicated to scientific research.
As a result, the credits do not cover all the expenses a company incurs in conducting qualified
research. Specifically, outlays for depreciable durable assets used in qualified research (such as
buildings and equipment), overhead expenses (e.g., heating, electricity, rents, leasing fees,
insurance, and property taxes), and the fringe benefits of research personnel are excluded. The
exclusion of these expenses has implications for the incentive effect of the credit (more on this
later). According to some estimates, the excluded expenses account for 27% to 50% of business
R&D spending.8
Regular Research Credit
The regular research tax credit has been extended 15 times and significantly modified five times.
Under IRC Section 41(a)(1), it is equal to 20% of a firm’s QREs beyond a base amount. Such an
incremental design is intended to encourage firms to spend more on R&D than they otherwise
8
U.S. Office of Technology Assessment, The Effectiveness of Research and Experimentation Tax Credits
(Washington: 1995), p. 29.
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would by lowering the after-tax cost to business taxpayers of investing in qualified research
above some normal amount by as much as 20%.9 Given that business R&D investment appears
sensitive to its cost, a decline in the after-tax cost of R&D can be expected to spur a rise in
business R&D investment, all other things being equal.10
The base amount for the regular credit is designed to approximate the amount a firm would spend
on qualified research in the absence of the credit. As such, the base amount can be viewed as a
firm’s normal or preferred level of R&D investment. Two rules govern the calculation of the base
amount under IRC Section 41(c). First, it must be equal to 50% or more of a firm’s QREs in the
current tax year—a rule that some refer to as the 50-percent rule.11 Second, the base amount
depends on whether the business taxpayer is considered an established firm or a start-up firm.
Established firms are defined as firms with gross receipts and QREs in at least three of the tax
years from 1984 through 1988. Start-up firms, by contrast, are defined as firms whose first tax
year with both gross receipts and QREs occurred after 1983, or firms that had fewer than three tax
years from 1984 to 1988 with both gross receipts and QREs.12 The base amount for all firms,
established or start-up, is the product of a fixed-base percentage and average annual gross receipts
in the previous four tax years. An established firm’s fixed-base percentage is the ratio of its total
QREs to total gross receipts in 1984 to 1988, capped at 16%. By contrast, a start-up firm’s fixedbase percentage is set at 3% during the firm’s first five tax years with spending on qualified
research and gross receipts. Thereafter, the percentage gradually adjusts to reflect a firm’s actual
experience, so that by its 11th tax year, the percentage equals the firm’s total QREs relative to its
total receipts in the 5th through 10th tax years.
In general, the lower a firm’s fixed-base percentage, the better its chances of claiming the regular
credit. Furthermore, a firm can expect to benefit from the regular credit if its ratio of QREs in the
current tax year to average annual gross receipts in the previous four tax years is greater than its
fixed-base percentage. (See Table 1 for a calculation of the regular credit for a hypothetical
established firm and Table 2 for a calculation of the regular credit for a hypothetical start-up
firm.)
Table 1. Sample Calculations of the Regular and Alternative Simplified Research Tax
Credits in 2013 for an Established Firm
($ millions)
Year
Gross Receipts
Qualified Research Expenses
1984
100
5
1985
150
8
1986
250
12
1987
400
15
9
For a variety of reasons, which will be discussed in a later section of the report, the actual or effective rate of the
credit is much lower than 20%.
10
Available studies indicate that the price elasticity of demand for R&D ranges from 0.2 to 2.0, which means that a 1%
reduction in the cost of R&D would raise R&D spending between 0.2% and 2%.
11
In other words, the expenses against which the regular research credit may be claimed can equal no more than 50%
of total QREs in a given tax year.
12
The definition of a start-up firm has changed a few times since the research credit was enacted. Presently, it denotes a
firm that recorded gross receipts and QREs in a tax year for the first time after 1993.
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Year
Gross Receipts
Qualified Research Expenses
1988
450
16
1989
400
18
1990
450
18
2006
835
45
2007
915
50
2008
1,005
53
2009
1,215
60
2010
1,465
70
2011
1,650
85
2012
1,825
95
2013
1,900
100
Source: Congressional Research Service.
Calculation: Regular Research Tax Credit
Compute the fixed-base percentage:
1. Sum the qualified research expenses for 1984 to 1988: $56 million.
2. Sum the gross receipts for 1984 to 1988: $1,350 million.
3. Divide the total qualified research expenses by the total gross receipts to determine the
fixed-base percentage: 4.0%.
Compute the base amount for 2013:
1. Calculate the average annual gross receipts for the four previous years (2009-2012): $1,539
million.
2. Multiply this average by the fixed-base percentage to determine the base amount: $62
million.
Compute the regular tax credit for 2013:
1. Reduce the $100 million in qualified research expenses for 2013 by the greater of the base
amount ($62 million) or 50% of the qualified research expenses for 2013 ($50 million): $38
million.
2. Multiply this amount by 20% to determine the regular R&E tax credit for 2013: $7.60
million.
Calculation: Alternative Simplified Research Credit
1. Calculate the average qualified research expenditures in the three previous years (20102012): $83 million.
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2. Divide this amount by 2: $41.5 million.
3. Subtract this amount from qualified research expenditures in 2013: $58.5 million.
4. Multiply this amount by 0.14 to determine the alternative simplified research credit for
2013: $8.2 million.
Table 2. Sample Calculations of the Regular and Alternative Simplified Research Tax
Credits in 2013 for a Start-up Firm
($ millions)
Year
Gross Receipts
Qualified Research Expenses
2005
30
35
2006
42
40
2007
55
45
2008
60
55
2009
210
65
2010
305
73
2011
400
82
2012
475
90
2013
600
105
Source: Congressional Research Service.
Calculation: Regular Research Tax Credit
Compute the fixed-base percentage:
1. According to current law, a start-up firm’s fixed-base percentage is fixed at 3% for each of
the first five years after 1993 when it has both gross receipts and qualified research expenses;
it then adjusts according to a formula over the next six years to reflect the firm’s actual
research intensity. Thus, the fixed-base percentages are 3% for 2005 through 2009, 7.4% in
2010, 8.9% in 2011, and 12.0% in 2012, and 14.9% in 3013.
Compute the base amount for 2013:
1. Calculate the average annual receipts for the four previous years (2009-2012): $347.5
million.
2. Multiply this amount by the fixed-base percentage (14.9%) to determine the base amount:
$52 million.
Compute the regular tax credit:
1. Reduce qualified research expenses for 2013 ($105 million) by the greater of the base
amount ($52 million) or 50% of the qualified research expenses for 2013 ($52.5 million):
$52.5 million.
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2. Multiply this amount by 20% to determine the regular R&E tax credit for 2013: $10.5
million.
Calculation: Alternative Simplified Research Credit
1. Calculate the average qualified research expenditures for the three previous years (20102012): $82 million.
2. Divide that amount by 2: $41 million.
3. Subtract that amount from qualified research expenditures in 2013: $64 million.
4. Multiply this amount by 0.14 to determine the alternative simplified research credit for
2013: $9.0 million.
Alternative Simplified Credit
The most recent addition to the array of research tax credits provided by Section 41 is the
alternative simplified credit (ASC). It was established by the Health Care and Tax Relief Act of
2006 (P.L. 109-432). Under Section 41(c)(5), a business taxpayer may claim the ASC in lieu of
the regular credit. The ASC is equal to 14% of a taxpayer’s QREs in the current tax year above
50% of its average QREs during the three previous tax years. If a taxpayer has no QREs in any of
those years, then the credit is equal to 6% of its QREs in the current tax year. A decision to elect
the ASC remains in effect until a taxpayer gains the consent of the IRS to claim the regular
research credit. (See Table 1 for a hypothetical calculation of the ASC for an established firm and
Table 2 for a similar calculation of the ASC for a startup firm.)
Taxpayers with one or more of the following conditions may benefit more from the ASC than the
regular credit:
•
a relatively large base amount under the regular credit;
•
incomplete records for determining the base period as a start-up firm;
•
substantial growth in gross receipts in recent years; and
•
a complicated history of mergers, re-organizations, acquisitions, and dispositions.
Alternative Incremental Research Credit
Firms investing in qualified research that could not claim the regular credit had the option of
claiming the alternative incremental R&E tax credit (or AIRC), under IRC Section 41(c)(4), for
tax years from 1996 to 2008. The Emergency Economic Stabilization Act of 2008 (P.L. 110-343)
repealed the AIRC for the 2009 tax year, and Congress has not reinstated it. When a firm elected
the AIRC for a particular tax year, it had to continue to do so, unless the firm received permission
from the IRS to switch to the regular research credit. There was some concern that such a rule
deterred firms from claiming the AIRC, even though they might have been better off doing so.
The definition of QREs for the AIRC was the same as the definition of QREs for the regular
credit. But that was where the similarity between the two credits ended. While the regular credit
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is equal to 20% of QREs in excess of a base amount, the AIRC, in the final year it could be taken,
was equal to 3% of a firm’s QREs above 1% but less than 1.5% of its average annual gross
receipts in the previous four tax years, plus 4% of its QREs above 1.5% but less than 2.0% of its
average annual gross receipts in the previous four tax years, plus 5% of its QREs greater than
2.0% of its average annual gross receipts in the previous four tax years.
In general, firms benefited from the AIRC if their QREs in the current tax year exceeded 1% of
their average annual gross receipts during the past four tax years. Moreover, the AIRC was
probably of greater benefit than the regular credit was to business taxpayers with relatively high
fixed-base percentages, or whose research spending was declining, or whose sales were growing
much faster than their research spending. (See Table 1 for a calculation of the AIRC for a
hypothetical established firm, and Table 2 for a calculation of the AIRC for a hypothetical startup firm.)
University Basic Research Credit
Firms that enter into contracts with certain non-profit organizations to perform basic research
may be able to claim a separate research credit for some of their expenditures for this purpose
under IRC Section 41(e). A primary aim of the credit is to foster collaborative research involving
U.S. firms and colleges and universities. The credit is equal to 20% of total payments for
qualified basic research above a base amount, which is known as the “qualified organization base
period amount.” This amount has little in common with the base amount for the regular R&E tax
credit, except that both amounts seem intended to approximate what firms would spend on
qualified research in the absence of the credits.13
For the purpose of the credit, basic research is defined as “any original investigation for the
advancement of scientific knowledge not having a specific commercial objective.”
The credit does not apply to qualified basic research done outside the United States, or to basic
research in the social sciences, arts, or the humanities.
In addition, the basic research credit applies only to payments for qualified basic research
performed under a written contract by the following organizations: educational institutions,
nonprofit scientific research organizations (excluding private foundations), and certain grantgiving organizations.
Firms conducting their own basic research may not claim the credit for their expenditures for this
purpose, but the spending may be included in their QREs for the regular credit or ASC. In
13
Calculating a firm’s base amount for the basic research credit is more complicated than calculating its base amount
for the regular credit. For the basic research credit, a firm’s base period is the three tax years preceding the first year in
which it had gross receipts after 1983. The base amount is equal to the sum of a firm’s minimum basic research amount
and its maintenance-of-effort amount in the base period. The former is the greater of 1% of the firm’s average annual
in-house and contract research expenses during the base period, or 1% of its total contract research expenses during the
base period. For a firm claiming the basic research credit, its minimum basic research amount cannot be less than 50%
of the firm’s basic research payments in the current tax year. The latter is the difference between a firm’s donations to
qualified organizations in the current tax year for purposes other than basic research and its average annual donations to
the same organizations for the same purposes during the base period, multiplied by a cost-of-living adjustment for the
current tax year.
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addition, basic research payments eligible for the credit that fall below the base amount are
treated as contract research expenses and may be included in the QREs for those credits as well.
Energy Research Credit
Under IRC Section 41(a)(3), taxpayers may claim a tax credit equal to 20% of payments to
certain entities for energy research. To qualify for the credit, the payments must be made to a nonprofit organization exempt from taxation under IRC Section 501(a) and “organized and operated
primarily to conduct energy research in the public interest.” In addition, at least five different
entities must contribute funds to the organization for energy research in a calendar year; none of
these entities may account for more than half of total payments to the organization for qualified
research.
The credit also applies to the full amount (i.e., 100%) of payments to colleges and universities,
federal laboratories, and certain small firms for energy research performed under contract. In the
case of small firms performing this research, a business taxpayer may claim a credit for the full
amount of payments with two limitations. First, the taxpayer cannot own 50% or more of the
stock of the small firm performing the research (if the firm is a corporation), or hold 50% or more
of the small firm’s capital and profits (if the firm is a non-corporate entity such as a partnership).
Second, the firm performing the research must have an average of 500 or fewer employees in one
of the two previous calendar years.
Because the credit is flat rather than incremental, it is more generous than the other four
components of the research tax credit.
Option to Claim a Refundable Research Tax Credit in Lieu of
Bonus Depreciation in 2008 and 2009
As a result of the Economic Stimulus Act of 2008 (P.L. 110-185), corporate and non-corporate
firms could claim an additional first-year depreciation deduction equal to 50% of the cost of
qualified property placed in service between March 31, 2008, and December 31, 2008. The
deduction was known as the 50% bonus depreciation allowance. A provision of the Housing and
Economic Recovery Act of 2008 (P.L. 110-289) gave corporations only the option of claiming a
limited refundable tax credit for unused research and alternative minimum tax (AMT) credits
stemming from tax years before 2006, in lieu of any bonus depreciation allowance they could
claim for qualified property acquired after March 31, 2008. The credit was capped at $30 million
for a single corporation and was set to expire at the end of 2008.
The American Recovery and Reinvestment Act of 2009 (ARRA, P.L. 111-5) extended both the
first-year 50-percent bonus depreciation allowance and the option to claim a refundable research
and AMT credit through 2009.
Under the Tax Relief, Unemployment Compensation Reauthorization, and Job Creation Act of
2010 (P.L. 111-312), the option to monetize unused AMT credits from tax years before 2006 in
lieu of claiming a bonus depreciation allowance was extended so that it applied to qualified
property acquired after March 31, 2008, and before January 1, 2013. The extension did not apply
to unused research credits from the same tax years.
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Legislative History of the Research Tax Credit
The research tax credit entered the tax code as a temporary provision through the Economic
Recovery Tax Act of 1981 (P.L. 97-34). In adopting the credit, the 97th Congress was hoping to
stem a decline in spending on R&D by the private sector as a share of U.S. gross domestic
product that commenced in the late 1960s. Around the time the credit was enacted, more than a
few analysts thought the decline was a primary cause of both a slowdown in U.S. productivity
growth and an unexpected loss of competitiveness by a variety of U.S. industries in the 1970s. A
majority in Congress concluded that a “substantial tax credit for incremental research and
experimental expenditures was needed to overcome the reluctance of many ongoing companies to
bear the significant costs of staffing and supplies, and certain equipment expenses such as
computer charges, which must be incurred to initiate or expand research programs in a trade or
business.”14
The initial credit was equal to 25% of qualified research spending above a base amount, which
was equal to average spending on such research in the three previous tax years, or 50% of
current-year spending, whichever was greater. It is not clear from the historical record why
Congress chose a statutory rate of 25%. But there is no evidence that the rate was chosen on the
basis of a rigorous assessment of the gap between the private and social returns to R&D
investment, or the sensitivity of R&D expenditures to declines in their after-tax cost. Any
taxpayer that claimed the credit and could not apply the entire amount against its current-year
federal income tax liability was allowed to carry the unused portion back as many as three tax
years, or forward as many as 15 tax years. The credit was to remain in effect from July 1, 1981, to
December 31, 1985.
Congress made the first significant changes in the original research tax credit with the passage of
the Tax Reform Act of 1986 (TRA86, P.L. 99-514). Among the many significant changes it made
in the federal tax code, the act extended the credit through December 31, 1988, and folded it into
the general business credit under IRC Section 38, thereby subjecting it to a yearly cap. In
addition, the act lowered the credit’s statutory rate to 20%, modified the definition of QREs so
that the credit applied to research intended to produce new technical knowledge deemed useful in
the commercial development of new products and processes, and created a separate 20%
incremental tax credit for payments to universities and certain other nonprofit organizations for
the conduct of basic research according to a written contract. The reduction in the credit’s rate
seemingly was not based on an analysis of the credit’s effectiveness in the first five years. Rather,
it seemed to stem from the overriding goals of TRA86, which were to lower income tax rates
across the board, broaden the income tax base, and shrink the differences in tax burdens among
major categories of business investments. Since 1954, firms investing in R&D had already been
benefiting from the option to expense qualified R&D spending under the IRC Section 174
expensing allowance.15
The regular and basic research credits were further altered by the Technical and Miscellaneous
Revenue Act of 1988 (P.L. 100-647). Specifically, the act extended the credits through December
14
U.S. Congress, Joint Committee on Taxation, General Explanation of the Economic Recovery Tax Act of 1981, joint
committee print, 97th Cong., 1st sess. (Washington: GPO, 1981), p. 120.
15
U.S. Congress, General Explanation of the Tax Reform Act of 1986, joint committee print, 100th Cong., 1st sess.
(Washington: GPO, 1987), p.130.
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31, 1989. It also curtailed the overall tax preference for private-sector R&D investment by
requiring business taxpayers to reduce any deduction they claim for research spending under IRC
Section 174 by half of the sum of any regular and basic research credits they claim. This new rule
decreased the maximum effective rate of the regular research tax credit by a factor equal to 0.5
times a taxpayer’s marginal income tax rate.16
Continuing disappointment with the design of the original credit among interested parties led to
the enactment of several additional changes in the regular credit through the Omnibus Budget
Reconciliation Act of 1989 (OBRA89, P.L. 101-239). Much of the disappointment was focused
on the formula for determining the base amount of the credit. Critics rightly pointed out that
under the formula, which was based on a three-year moving average of a firm’s annual spending
on qualified research, an increase in a firm’s research spending in one year would raise its base
amount in each of the following three years by an amount equal to one-third of that increase,
possibly making it more difficult to claim the credit in those three years. Some argued that such a
design would be less cost-effective in boosting business R&D investment than one in which a
firm’s base amount was completely independent of its current spending on qualified research.17
To address this concern, OBRA89 changed the formula for the base amount so that it was equal to
the greater of 50% of a firm’s current-year QREs, or the product of the firm’s average annual
gross receipts in the previous four tax years and a “fixed-base percentage.” The act set this
percentage equal to the ratio of a firm’s total QREs to total gross receipts in the four tax years
from 1984 to 1988, capped at 16%. OBRA89 also made the credit available on more favorable
terms to start-up firms, which it defined as firms without gross receipts and QREs in three of the
four years from 1984 to 1988; these firms were assigned a fixed-base percentage of 3%. In
addition, the act effectively extended the credits to December 31, 1990 (by requiring that QREs
incurred before January 1, 1991, be prorated), made it clear that firms could apply the regular
credit to QREs related to current lines of business and possible future lines of business, and
required firms claiming the regular and basic research credits to reduce any deduction they claim
under IRC Section 174 by the entire amount of the credits.
In 1990 and 1991, Congress passed two bills that, among other things, temporarily extended the
credits. The Omnibus Budget Reconciliation Act of 1990 (P.L. 101-508) extended the credits
through December 31, 1991, and repealed the requirement that QREs made before January 1,
1991, be prorated. And the Tax Extension Act of 1991 (P.L. 102-227) pushed the expiration date
for the credits forward to June 30, 1992. A major obstacle to longer extensions of the credits at the
time lay in congressional budget rules requiring that the revenue cost of lengthy or permanent
extensions be scored over 10 fiscal years and offset with tax increases or cuts in non-defense
discretionary spending.
Although Congress passed two bills in 1992 that would have extended the credits beyond June 30
of that year, President George H. W. Bush vetoed both for reasons that had nothing to do with the
credit provisions. As a result, the credits expired and remained unavailable from July 1, 1992,
until the enactment of the Omnibus Budget Reconciliation Act of 1993 (OBRA93, P.L. 103-66) in
August 1993. That act extended the credits retroactively from July 1, 1992, through June 30,
16
For a business taxpayer in the 30% tax bracket, the rule reduced the maximum effective rate of the regular research
credit from 20% to 17.5%: .20 x [1-(.5 x .30)].
17
See U.S. Congress, Joint Economic Committee, The R&D Tax Credit: An Evaluation of Evidence on Its
Effectiveness, joint committee print, 99th Cong., 1st sess. (Washington: GPO, 1985), pp. 17-22.
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1995. It also modified the fixed-base percentage for start-up firms. Specifically, a firm lacking
gross receipts in three of the years from 1984 to 1988 was assigned a percentage of 3% for the
first five tax years after 1993 in which it reported QREs. Starting in the sixth year, the percentage
was to adjust gradually so that by the 11th year the percentage would reflect its actual ratio of total
QREs to total gross receipts in five of the previous six tax years.
Congressional inaction allowed the credits to expire again on June 30, 1995. They remained in
abeyance until the enactment of the Small Business Job Protection Act of 1996 (P.L. 104-188) in
August 1996. That act retroactively reinstated the credits from July 1, 1996, to May 31, 1997,
leaving a one-year gap in the credit’s coverage since its inception in mid-1981. The act also
expanded the definition of a start-up firm to include any firm whose first tax year with both gross
receipts and QREs was 1984 or later, added a three-tiered alternative incremental research credit
(AIRC) with initial rates of 1.65%, 2.2%, and 2.75%, and made 75% of payments for qualified
research performed under contract by nonprofit organizations “operated primarily to conduct
scientific research” eligible for the regular credit and the AIRC.
The credits expired again in 1997, but they were extended retroactively from June 1, 1997, to
June 30, 1998, by the Taxpayer Relief Act of 1997 (P.L. 105-34). A further extension of the
credits to June 30, 1999, was included in the revenue portion of the Omnibus Consolidated and
Emergency Supplemental Appropriations Act, 1998 (P.L. 105-277).
Under circumstances reminiscent of 1997, the credits expired in 1999. But the revenue portion of
the Ticket to Work and Work Incentives Improvement Act of 1999 (P.L. 106-170) extended them
from July 1, 1999, to June 30, 2004. It also increased the three rates of the AIRC to 2.65%, 3.2%,
and 3.75% and expanded the definition of qualified research to include qualified research
performed in Puerto Rico and the other territorial possessions of the United States.
On October 4, 2004, President George W. Bush signed into law the Working Families Tax Relief
Act of 2004 (P.L. 108-311), which included a provision extending the research tax credit through
December 31, 2005.
The Energy Policy Act of 2005 (P.L. 109-58) added a fourth component to the research tax credit
by establishing a credit equal to 20% of payments for energy research performed under contract
by qualified research consortia, colleges and universities, federal laboratories, and eligible small
firms.
Under the Tax Relief and Health Care Act of 2006 (P.L. 109-432), the research tax credit was
extended retroactively through the end of 2007. The act also raised the three rates for the AIRC to
3%, 4%, and 5%, and established yet another research tax credit, known as the alternative
simplified credit (ASC). This fifth component of the credit was equal to 12% of QREs in excess
of 50% of average QREs in the past three tax years; for business taxpayers with no QREs in any
of the three preceding tax years, the credit was equal to 6% of QREs in the current tax year.
The Emergency Economic Stabilization Act of 2008 (P.L. 110-343) retroactively extended the
research credit through 2009. It also raised the rate of the ASIC from 12% to 14% and repealed
the AIRC for the 2009 tax year only.
Under the Housing and Economic Recovery Act of 2008 (P.L. 110-289), corporations gained the
option for the 2008 tax year only of claiming a limited refundable credit for unused research and
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AMT credits from tax years before 2006, in lieu of any bonus depreciation allowance they could
claim for qualified assets placed in service between March 31, 2008, and December 31, 2008.
The American Recovery and Reinvestment Act of 2009 (P.L. 111-5) extended that option through
2009, along with the bonus depreciation allowance that applied in 2008.
As a result of the Tax Relief, Unemployment Compensation Reauthorization, and Job Creation
Act of 2010, (P.L. 111-312), the research credit was extended through 2011.
After a one-year lapse, Congress retroactively extended the credit through 2013 and made some
minor changes in the rules governing the allocation of research credits among members of
controlled groups of companies and the use of the credit by parties to business acquisitions by
passing the American Taxpayer Relief Act of 2012 (P.L. 112-240).
Going back to the mid-1990s, a cycle seems to emerge every time the credit is about to expire.
The cycle commences when congressional and business supporters of the credit issue public
statements calling for a permanent extension of the credit and denouncing what they see as the
folly of repeated temporary extensions.18 Then the President expresses his support for such an
extension. In the next stage of the cycle, leaders in both houses of Congress enter into
negotiations on tax legislation that may include a permanent extension of the credit. But in the
end, Congress and the President can agree only on a limited extension of the credit, stymied by
the difficulty of reconciling the revenue cost of a permanent extension with other budget
priorities. The main elements of the cycle seemed to reappear in the recent round of negotiations
between Congress and President Obama over agreeing on a bill to avoid across-the-board rises in
individual tax rates at the end of 2012.
Effectiveness of the Research Tax Credit
For analysts and lawmakers alike, probably the most important policy issue raised by the research
tax credit is its effectiveness. Basically, there are two approaches to assessing this critical aspect
of the credit.
Among economists, the preferred approach is to compare the social benefits from any added
qualified research induced by the credit with the social costs of that research. Such an undertaking
involves comparing the returns to society of the additional qualified research spending associated
with the credit to the opportunity costs to society of those outlays. The social cost of the credit
can be thought of as the net loss of tax revenue because of the credit, together with the public and
private costs of administering the credit. Unfortunately, this approach has little application in
policymaking, largely because it is difficult to measure accurately the social returns to R&D.19
18
Martin A. Sullivan, “Research Credit Hits New Heights, No End in Sight,” Tax Notes, vol. 94, no. 7, February 18,
2002, p. 801.
19
The principal barriers to measuring the social returns to R&D are developing adequate price indices for the cost
elements of R&D for specific industries, specifying the time period in which to assess the productivity gains from
R&D, and determining the depreciation rate for a society’s stock of R&D assets. For a detailed discussion of these
issues, see Bronwyn H. Hall, “The Private and Social Returns to Research and Development,” in Technology, R&D,
and the Economy, Bruce L. Smith and Claude E. Barfield, eds. (Washington: Brookings Institution, 1996), pp. 141-145.
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As a result, economists have relied on the next best approach: estimating the additional qualified
research (if any) stimulated by the regular credit, and comparing the dollar value of that gain with
the tax revenue lost because of the credit. Such an approach compares the direct benefits (i.e.,
added research investment) with the direct costs (revenue loss) of the regular credit. It
presupposes that the social returns to the research far exceed the private returns, and that the
optimal size of any tax subsidy for R&D can be estimated. If the ratio of benefits to cost is greater
than one, then the credit can be seen as a more cost-effective way to boost research than direct
research subsidies; if it is less than one, then funding the research directly would be more costeffective.20
What do available studies say about the effectiveness of the regular research credit? Going back
to the early days of the credit, economists who have evaluated its impact on business investment
in qualified research have used a variety of methods to estimate the amount of additional research
that can be attributed to the credit. These methods were reviewed in a 1995 study by economist
Bronwyn Hall.21 She found that the studies using data on the credit from 1981 to 1983 came up
with lower estimates of the added research associated with one dollar of the credit than did the
studies based on data from 1984 and after. Taking into consideration the strengths and weaknesses
of the studies, Hall concluded that the credit led to a “dollar-for-dollar increase in reported R&D
spending on the margin.”22 In other words, over the period (mid-to-late 1980s) covered by the
later studies, she found that one dollar of the credit resulted in a company spending an additional
dollar on qualified research, suggesting that the credit was as cost-effective as federal research
grants.
Stimulative Effect of the Credit
What does available evidence say about the stimulative effect of the credit? This effect refers to
the percentage increase in research spending over a period that can be attributed to the credit.
Answering the question entails applying what is known about the responsiveness of business
spending on research to declines in its tax price to the reduction in the aggregate cost of research
that could be due to the credit.
In theory, the credit stimulates increased investment in qualified research by lowering the aftertax cost of undertaking another dollar of research. In other words, the credit lowers the tax price
of research, and firms respond to the reduced prices by spending more on it, all other things being
equal. Early studies of the responsiveness of research spending to price decreases estimated that
the tax price elasticity of demand for research was less than one, perhaps somewhere between 0.2 to -0.5. This meant that a 10% reduction in the after-tax (or net) cost of research would lead to
an increase in research spending of 2% to 5%. More recent studies, however, indicated that
research spending was more sensitive to price changes. On the whole, they suggested that the tax
price elasticity was closer to -1.0 in the short run, which meant that a 10% reduction in the cost of
research would trigger a 10% rise in research spending. Several of the studies also concluded that
20
This argument assumes that government research grants to the private sector do not lead firms receiving the grants to
reduce their own R&D spending by similar amounts.
21
See Bronwyn H. Hall, Effectiveness of Research and Experimentation Tax Credits: Critical Literature Review and
Research Design, report for Office of Technology Assessment, June 15, 1995, pp. 11-13, available at
http://emlab.berkeley.edu/~bhhall/papers/BHH95%20OTArtax.pdf.
22
Ibid., p. 18.
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research tax credits may have an even larger impact on research spending in the longer run, on the
order of -2.0.
Still, the question of how responsive the demand for research is to tax price decreases remains
open to further debate and analysis, since available studies have data and methodological
limitations that cast serious doubt on the validity of their estimates. In an assessment of the
revenue effects of President Bush’s FY2004 budget request, the Joint Committee on Taxation
(JCT) noted that “the general consensus when assumptions are made with respect to research
expenditures is that the price elasticity of research is less than -1.0 and may be less than -0.5.”23
Therefore, considering the findings of the studies that have been done, it seems reasonable to
assume that the short-run price elasticity for qualified research lies between -0.4 and -0.8.
A measure of the reduction in the cost of qualified research that can be attributed to the credit is
its average effective rate. The rate captures the percentage reduction in that cost that is due to the
credit. It is derived by dividing the total amount of claims for the research credit in a tax year by
some measure of total business spending on qualified research in the same year. For the research
tax credit, there are two such measures: QREs, as reported by the IRS, and business spending on
domestic basic and applied research and development, as reported by the National Science
Foundation (NSF). As a result, the average effective rate can be computed for both QREs and
business investment in domestic R&D.
As Table 3 shows, the average effective rate of the credit from 1999 to 2009 was 3.3% for
business investment in domestic R&D and 5.3% for QREs. This implies that the credit lowered
the average after-tax cost of R&D investment by 3.3% and qualified research by 5.3% during that
decade. By contrast, the statutory rate is 20% for the regular credit and 14% for the ASC. While
claims for the regular credit accounted for nearly all QREs in 1999, QREs associated with claims
for the ASC amounted to two-thirds of total QREs in 2009.
The gap between the rates largely reflects the difference in the scope of QREs and business R&D
spending, as estimated by the NSF. Aggregate QREs amounted to 62.2% of aggregate business
R&D spending from 199 to 2009. The NSF estimate covers domestic R&D funded by firms. It is
based on annual surveys of business R&D and takes into account the wages, salaries, and fringe
benefits of research personnel; the cost of materials and supplies, overhead expenses; and
depreciation related to research activities. Excluded from the estimate are expenditures on the
buildings and equipment used in research, quality control, routine product testing, and prototype
production.24 By contrast, QREs represent total spending on research that is eligible for the credit,
as reported to the IRS on Form 6765; they cover the wages and salaries of research personnel,
materials, supplies, leased computer time used in qualified research, and 65% to 75% of contract
research funded by the taxpayers claiming the credit. Since the NSF figures include more of the
total cost of business investment in R&D, they should be larger than the QREs for the same years.
The figures in Table 3 suggest that the credit delivered, at most, a modest stimulus to domestic
business R&D investment from 1999 to 2009. Specifically, assuming the price elasticity of
demand for qualified research lies between -0.4 and -0.8, and the credit lowers the net cost of
23
U.S. Congress, Joint Committee on Taxation, Description of Revenue Provisions in the President’s Fiscal Year 2004
Budget Proposal, JCS-7-03, 108th Cong., 1st sess. (Washington: March 2003), p. 250.
24
National Science Foundation, Division of Science Resource Statistics, The Methodology Underlying the
Measurement of R&D Expenditures: 2000 (data update) (Arlington, VA: December 10, 2001), p. 2.
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business spending on qualified research by 5.3%, one can argue the credit may have boosted that
spending somewhere between 2.1% (0.4 x 5.3%) and 4.2% (0.8 x 5.3%), compared with the
investment that might have taken place in the absence of the credit.25
Table 3. Business and Federal Spending on Domestic Research and Development,
and Claims for the Federal Research Tax Credit, 1999 to 2009
($ billions)
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Business
Spending
on
Domestic
R&D
(BSDRD)a
$162
$183
$185
$177.5
$183
$188
$204
$223
$243
$254
243
Qualified
Research
Spending
(QRS)b
$103
$110
$100
$116
$124.5
$116
$130
$145
$158
$151
$143
Federal
R&D
Spendingc
$75
$76
$84.5
$94
$103.5
$112
$119
$122
$127
$127
$133
CurrentYear
Research
Tax
Creditd
$5.3
$7.2
$6.4
$5.7
$5.5
$5.6
$6.4
$7.3
$8.3
$8.3
$7.9
Ratio of
Credit to
BSDRD
(%)
3.3%
3.9%
3.5%
3.2%
3.0%
3.0%
3.1%
3.3%
3.4%
3.3%
3.2%
Ratio of
Credit to
QRS (%)
5.2%
6.5%
6.4%
4.9%
4.4%
4.8%
4.9%
5.0%
5.2%
5.5%
5.5%
25
This estimate assumes that all the credits claimed in each year of that decade were used immediately and were not
subject to reduction because of IRS audits. Delays in the use of any credit shrink its present value, and thus its marginal
effective rate. For instance, if a taxpayer claims a research credit of $1 million, has a discount rate of 5%, and cannot
use the credit for three years, then the present value of the credit drops to about $864,000. Because the top marginal
effective rate for the credit is 13%, owing to the rule that any deduction of research expenditures under Section 174
must be reduced by the amount of the credit, the delay in using the credit lowers the marginal effective rate to 11.2%
(13% x 0.864). Delays can occur for two reasons: time-consuming IRS audits or insufficient or no tax liability against
which to apply credit in the current tax year.
A 2009 report on the design of the research tax credit by the Government Accountability Office (GAO) casts doubt on
the plausibility of the assumptions underlying the estimated stimulative effect of the credit from 1998 to 2008. The
report found that 44% of the “total net credits earned” in 2005 could not be used immediately and thus could be carried
back one tax year or forward up to 20 tax years. It also noted that IRS data on examinations of claims for the credit by
corporations with annual business receipts of $1 billion or more from 2000 to 2003 indicated that the examiners
recommended changes that would have lowered the aggregate amount of credits claimed by 16.5% in 2000, 19.3% in
2001, 27.1% in 2002, and 24.5% in 2003. See U.S. Congress, Government Accountability Office, Tax Policy: The
Research Tax Credit’s Design and Administration Can Be Improved, GAO-10-136 (Washington: November 2009), pp.
14-15.
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Source: National Science Foundation, Division of Science Resources Statistics, Science and Engineering Indicators
2012, appendix table 4-3; National Science Foundation, Division of Science Resources Statistics, Federal Funds for
Research and Development: Fiscal Years 2009-11, table 1; Internal Revenue Service, available at http://www.irs.gov/
uac/SOI-Tax-Stats-Corporation-Research-Credit.
a.
Total spending on domestic basic and applied research and development by companies only.
b.
Spending on research that qualifies for the regular, alternative incremental, and university basic research tax
credits, as reported by corporations claiming the credit on their federal income tax returns.
c.
Federal obligations for defense and non-defense R&D spending by fiscal year.
d.
Total value of claims for the regular, incremental and basic research tax credits reported in federal
corporate income tax returns. Because of limitations on the use of the general business credit, of which the
research credit is a component, and audits of corporate claims for the credit by the Internal Revenue
Service, the total amount of the research credit actually used in a particular year may differ from the total
amount claimed.
Policy Issues Raised by the Current Research
Tax Credit
Many policy analysts and lawmakers endorse the use of tax incentives to spur increased business
R&D investment. Yet the current research tax credit sometimes seems to attract more words of
criticism than praise. The main concern of critics is that the credit has not been as effective as it
should have because of what they say are certain problems with its design. In their view, the
credit can yield its intended benefits only if it is altered to remedy five problems in particular: (1)
the credit is not a permanent provision of the IRC; (2) it still has weak and uneven incentive
effects; (3) it is not refundable; (4) the definition of qualified research remains incomplete and
ambiguous, and thus a major source of disputes between the IRS and taxpayers; and (5) the credit
is not targeted at investments that are likely to generate relatively large economic benefits. Each
potential difficulty is discussed in some depth below.
Lack of Permanence
The research tax credit is due to expire on December 31, 2013. At least one bill to extend it
permanently has been introduced in the 113th Congress—a step that the Obama Administration
has supported in its last three budget requests. The credit has never been a permanent provision of
the IRC, despite repeated attempts in Congress to extend it permanently in the past decade.26 In
fact, the credit has now been extended 15 times, most recently by the American Taxpayer Relief
Act of 2012.
This lack of permanence is a cause for concern to many because it is thought to weaken the
credit’s incentive effect. Many R&D projects have planning horizons that extend beyond a year or
two. If business managers cannot count on receiving the credit over the expected life of an R&D
project, they may not take it into account when setting the size of annual R&D budgets. If this
were to happen, the credit would be likely to exert little or no influence over R&D investment
decisions. Instead of boosting R&D investment, a temporary research tax credit could end up
26
The R&E tax credit has been in effect for each year between July 1, 1981, and the present except for period from
July 1, 1995, to June 30, 1996, when it expired. Since July 1, 1996, the credit has not been renewed to include this
period.
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restraining it by compounding the uncertainty that typically characterizes projected after-tax
returns on planned R&D investments, and by keeping the cost of capital for such investments
higher than it otherwise would be. A combination of added uncertainty and larger capital costs
may deter managers from pursuing some of the R&D projects they would undertake if the credit
were permanent.
Still, it seems unlikely that all firms investing in R&D would be affected in the same manner by a
temporary research tax credit. Firms with relatively long R&D planning horizons and relatively
high fixed costs for R&D investment might show more sensitivity to uncertainty in the
availability of a credit than firms with shorter horizons and relatively low fixed investment costs.
For example, it is conceivable (though hard to prove) that a string of temporary credits may lead
pharmaceutical firms to expand their research budgets slower than software firms, simply because
pharmaceutical R&D projects, on average, have longer planning horizons and require greater
investments in plant and equipment than software R&D projects do.
Uneven and Inadequate Incentive Effects
Critics maintain that another significant problem with the research tax credit is its incentive
effect. A credit’s incentive effect refers to the size of the benefit it offers eligible taxpayers. In the
view of critics, the research credit’s incentive effect varies among firms conducting qualified
research in ways that are not supported by economic theory and can even defeat the credit’s
purpose. In addition, they contend that this incentive effect is too meager to offset the inclination
of firms to invest less in research than its potential spillover benefits warrant. To what extent can
it be said that the credit’s incentive effect is too uneven and small?
Uneven Incentive Effect
The regular credit’s incentive effect appears to vary widely among firms investing in qualified
research, including those that gradually increase their research investment over an extended
period. Evidence for such variation can be found in a number of sources, including a 1996 study
by economist William Cox that estimated which of a large group of domestic corporations with
sizable research budgets in 1994 should have be able to claim the regular credit.
The study was based on a sample of 900 publicly traded U.S.-based firms with the largest R&D
budgets, culled from a database maintained by Compustat, Inc. Under the reasonable assumption
that QREs for these firms were equal to 70% of their reported R&D spending for 1994, Cox
determined that 62.5% of the firms could be considered established firms for the purpose of
claiming the regular credit, as they had both business revenue and QREs in three of the years
from 1984 to 1988; the remainder were treated as start-up firms. Cox found that 78% of the 900
firms in the sample (44.4% of the established firms and 33.5% of the start-up firms) could have
claimed the credit in 1994, while 22% could have claimed no credit (18% of established firms
and 4% of start-up firms).27 He also found that 34% of all firms (32.3% of established firms and
1.7% of start-up firms) had QREs greater than their base amounts but less than twice those
amounts, allowing them to claim credits with a marginal effective rate of 13%, and that 43.8% of
27
CRS Report 96-505, Research and Experimentation Tax Credits: Who Got How Much? Evaluating Possible
Changes, by William A. Cox, pp. 5-10. (The report is out of print. Copies may be obtained from Gary Guenther (202)
707-7742, upon request.) (Hereinafter cited as Cox, Research and Experimentation Tax Credits.)
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all firms had QREs greater than double their base amounts, allowing them to claim credits with a
marginal effective rate of 6.5%.28 These rates measure the reduction in the after-tax cost of
qualified research as a result of taking the regular credit. In addition, Cox found that some of the
most research-intensive firms could claim either no credit or credits with a marginal effective rate
half as large as the rate for the credits that could be claimed by firms with much lower propensity
to invest in research.
The results seemed to confirm that the regular credit was most beneficial to firms whose research
intensities had grown since their base periods and least beneficial to firms whose research
intensities had changed little or not at all or had shrunk since their base periods. Most of the firms
whose research intensities had declined found themselves in that position for two reasons: (1)
their R&D spending was lower in 1994 than it was in their base period, or (2) their sales revenue
had grown faster than their R&D expenditures over the same period.
Critics of the design of the regular credit argue that the pattern of R&D subsidization found in the
Cox study is unfair and arbitrary, has no justification in standard economic theory, and undercuts
the intended purpose of the credit, which is to encourage all firms to spend more on R&D than
they otherwise would. Cox said as much when he concluded that the wide variation in the
marginal effective rates of the credit among the firms in his analysis suggested “that society
places a higher value on adding R&D at certain firms than at others and on adding R&D of
certain types than others, when little or no basis for such different valuations exists.”29
Two rules governing the use of the regular credit are responsible for most of the variation in its
incentive effect. One is the requirement that the base amount for the regular credit cannot be less
than 50% of QREs. The other rule is the requirement that established firms use gross receipts and
QREs from 1984 to 1988 to calculate their fixed-base percentages.
In combination, the rules can produce remarkably dissimilar outcomes in the use of the regular
credit among firms that spend substantial amounts on qualified research. Of particular concern to
critics are firms whose research-intensity (as measured by spending on R&D as a share of
revenue) has shrunk over time. The structure of the U.S. economy can and does change markedly
in a period of 20 or so years. So it is likely that economic and competitive conditions in researchintensive industries today bear little resemblance to the conditions that prevailed in the 1980s.
Most of the firms that have remained in business as independent entities and invested
considerable amounts in R&D relative to revenues since then face much different climates for
R&D investment. In some cases, the change in circumstances has led established firms to invest
less in R&D as a share of revenues. Firms in this position may not be able to claim the regular
credit, even if they spend relatively large sums on R&D.30
28
Their effective credit rate was lower because each firm was subject to the 50-percent rule, which reduced the
marginal effective rate of the credit on R&D spending above the base amount by 50%.
29
Cox, Research and Experimentation Tax Credits, p. 10.
30
Two examples are aerospace and semiconductor chip manufacturers. See McGee Grisby and John Westmoreland,
“The Research Tax Credit: A Temporary and Incremental Dinosaur,” Tax Notes, vol. 93, no. 12, December 17, 2001, p.
1633.
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Inadequate Incentive Effect
In claiming that the regular credit’s incentive effect is inadequate, critics actually have in mind
two different measures of the effect. One deals with the credit rate deemed essential to coaxing
companies to increase their R&D investments to socially optimal levels; the other concerns
differences between the regular credit’s statutory rate and its average marginal effective rate. Both
measures are examined here.
Research Credit Rate and Socially Optimal Levels of Investment in Research
Critics maintain that the average effective rate of the regular credit is too low to support levels of
business investment in research commensurate with its economic benefits. To substantiate this
contention, they point to another study by Cox, one that focused on the efficacy of the research
tax credit.31 Cox built the analysis around the premise that tax incentives can overcome the
private sector’s inclination to invest too little in the creation of new technical knowledge and
know-how. For tax incentives to have this effect, they must be designed so they subsidize R&D
spending above and beyond what firms would undertake on their own, and they must be large
enough to “raise private after-tax returns on R&D investments to the levels that would result from
applying the same rate of taxation to the social rate of return from R&D.”32 A variety of studies
from the past 50 years or so have concluded that the median private rate of return on R&D
investment is roughly 50% of the median social rate of return.33 Thus, assuming that the average
social pre-tax rate of return is two times the average private pre-tax rate of return, the optimal
R&D tax subsidy would double the private after-tax rate of return to R&D investment. For
example, given a corporate tax rate of 35%, after-tax returns would equal 65% of pre-tax returns
for corporations, assuming no tax subsidies or preferences. In this case, the optimal R&D tax
subsidy would double the private after-tax returns to R&D investment by increasing them to
130% of pre-tax returns [2 x (1-0.35)].
Cox’s analysis implied that the optimal average effective rate for an R&D tax subsidy, or a
combination of such subsidies (e.g., a research tax credit combined with the treatment of research
expenditures as a current business expense), was 30%. In discussing the policy implications of
this finding, Cox noted that such a rate was an average and thus would not address the
considerable variation among R&D investments in the difference between private and social
returns. So using tax incentives to boost pre-tax returns on R&D investment by 30% across all
industries would provide excessive subsidies for projects with below-average spillover benefits
and insufficient subsidies for projects with above-average spillover benefits. According to Cox,
lawmakers should be aware that “this imprecision is unavoidable, and its consequences are hard
to assess.”34
How do existing federal tax subsidies for R&D investment compare with Cox’s assessment of the
optimal R&D tax subsidy? To determine the incentive effect of then-current federal subsidies, he
estimated the pre-tax and after-tax rates of return under 1995 federal tax law for a variety of
31
See CRS Report 95-871, Tax Preferences for Research and Experimentation: Are Changes Needed? by William A.
Cox. (This report is out of print. Copies may be obtained from Gary Guenther at (202) 707-7742, upon request.)
(Hereinafter cited as Cox, Tax Preferences for Research and Experimentation.)
32
Ibid., p. 8.
33
See, for example, Edwin Mansfield, The Positive Sum Strategy, pp. 309-311.
34
Ibid., p. 9.
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hypothetical R&D projects. The projects differed in the share of R&D expenditures devoted to
depreciable assets like structures and equipment, the share of R&D expenditures eligible for both
expensing under IRC Section 174 and the regular research credit, and the economic lives of the
intangible assets created by the investments. Cox compared the combined effect of expensing and
the credit on after-tax returns to investment in capital-intensive, intermediate, and labor-intensive
R&D projects producing intangible assets with economic lives of 3, 5, 10, and 20 years.35
Expensing has the effect of equalizing the pre-tax and after-tax rates of return on an investment,
since it taxes the income earned by affected assets at a marginal effective rate of zero.36 For the
typical business R&D investment, it is likely that only part of the total cost may be expensed
under IRC Section 174, as tangible depreciable assets like structures and equipment do not
qualify for such treatment. Therefore, how expensing affects an R&D investment’s after-tax rate
of return depends on two factors: (1) the percentage of the total cost that may be expensed, and
(2) the marginal effective tax rate on income earned by the assets (including labor) eligible for
expensing.
The regular research credit raises the after-tax rate of return only on a portion of current-year
QREs: those above a base amount. So its effect on the after-tax returns to an R&D investment
depends on both the percentage of the investment’s total cost that qualifies for the credit and the
effective tax rate on income earned by assets eligible for the credit.
Allowing for these limitations on the benefits of expensing and the regular credit, Cox estimated
that expensing and the credit together produced median after-tax rates of return ranging from
101.0% of pre-tax returns for a hypothetical capital-intensive project yielding intangible assets
with an economic life of 20 years to 124.7% for a hypothetical labor-intensive project yielding
intangible assets with an economic life of three years.37 As these percentages are less than 130%,
he inferred that the research tax subsidies in existence in 1995 did not increase private after-tax
returns to R&D investments to the “levels warranted by the spillover benefits that are thought to
be typical” for these investments.38
Gap Between the Credit’s Average Effective Rate and Its Statutory Rate
Some critics of the regular credit see its incentive effect in a somewhat different, though related,
light. For them, a more important concern than the credit’s potential to boost business investment
in research to socially optimal levels is any differences between the regular credit’s average
effective rate and its statutory rate of 20%. As noted earlier, whatever differences exist from firm
to firm can be ascribed largely to three of the rules governing the use of the credit.
35
In the case of capital-intensive projects, 50% of outlays go to structures and equipment, 35% qualify for expensing
and the credit, and 15% qualify for expensing alone. In the case of intermediate projects, 30% of outlays go to
structures and equipment, 50% qualify for expensing and the credit, and 20% qualify for expending alone. And in the
case of labor-intensive projects, 15% of outlays go to structures and equipment, 65% qualify for expensing and the
credit, and 20% qualify for expensing only.
36
See Jane G. Gravelle, “Effects of the 1981 Depreciation Revisions on the Taxation of Income from Business
Capital,” National Tax Journal, vol. 35, no. 1, March 1982, pp. 2-3.
37
Cox, Tax Preferences for Research and Experimentation, p. 15.
38
Ibid., p. 17.
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One of the rules is the basis adjustment under IRC Section 280C(c)(1), which requires taxpayers
investing in qualified research to reduce any deduction for research expenditures they take under
IRC Section 174 by the amount of any research credit they claim. This adjustment effectively
adds the credit to a firm’s taxable income and taxes it at the firm’s income tax rate. Consequently,
for business taxpayers taking the credit that are subject to the maximum corporate or individual
tax rate of 35%, the basis adjustment decreases the marginal effective rate of the credit from 20%
to 13%. Firms have the option of computing the regular research credit at a statutory rate of 13%
in exchange for leaving intact any Section 174 deduction.
A second rule is the requirement that the base amount for the regular credit cannot be less than
50% of a firm’s current-year QREs. Perhaps unintentionally, the rule curtails the credit’s potential
benefit to established firms whose ratio of current-year QREs to gross income is more than
double their fixed-base percentages, or more than double the 16% cap on the fixed-base
percentage—which is to say established firms that historically have invested heavily in qualified
research. Start-up firms, whose current-year ratio of QREs to gross income exceeds 6% during
their first five tax years, or whose current-year ratio is more than double their fixed-base
percentages in the next six tax years, also are affected by the rule. For both sets of firms, it further
reduces the marginal effective rate of the credit to 6.5%.
The third rule is the exclusion of expenditures for equipment and structures and overhead costs
from expenses eligible for the regular credit—even though many business research investments
involve the acquisition of elaborate buildings and sophisticated equipment, and all research
projects have overhead costs. In this case, the rule’s effect on the marginal effective rate of the
credit depends on the share of the cost of an R&D investment to which the credit does not apply.
As this share rises, the credit’s marginal effective rate drops, all other things being equal. For
example, if expenditures for physical capital account for half of the cost of an R&D investment,
then the marginal effective rate of the credit for the entire investment is half of what it would be if
the entire cost were eligible for the credit. For firms subject to the 50% rule that invest in research
projects where physical capital represents 50% of the total cost, the marginal effective rate could
fall to 3.25%.
In addition, in a 2009 report on problems with the credit’s design, the GAO brought into the
analysis of the credit’s marginal effective rate the impact of delays in the use of the credit. In
essence, they reduce the present value of the credit, and such a reduction lowers the rate. The
longer the delay and the larger a taxpayer’s discount rate, the larger the rate decline. GAO
estimated the marginal effective rate for all the corporations in the IRS database that claimed the
credit in 2003 to 2005 and used them to compute a weighted average rate for all taxpayers. It
found that the rate ranged from 6.4% to 7.3%, depending on the assumptions about the length of
any delay in using the credit and the discount rate.39
As these considerations suggest, one of the keys to bolstering the regular credit’s incentive effect
is to increase its marginal effective rate. There are two ways to do so: (1) keep the current
statutory rate and relax or repeal one or more of the three rules, and (2) retain the rules but raise
the credit’s statutory rate to offset their effects.
Cox analyzed the effects of both options on after-tax rates of return for the same hypothetical
R&D investments discussed above. In the case of labor-intensive R&D projects, he estimated that
39
GAO, The Research Tax Credit’s Design and Administration Can Be Improved, p. 14.
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1995 research tax preferences produced median after-tax returns that were 124.7% of pre-tax
returns for projects yielding intangible assets with an economic life of three years, and 115.5% for
projects yielding intangible assets with an economic life of 20 years. Repealing the basis
adjustment for the credit caused median after-tax returns to increase to 146.0% of pre-tax returns
for assets with a three-year economic life, and 130.1% for assets with a 20-year economic life.40
Increasing the statutory rate of the credit to 25% but retaining existing rules (including the basis
adjustment) led to similar results: median after-tax returns for assets with a three-year economic
life were an estimated 133.9% of pre-tax returns, and an estimated 121.9% for assets with a 20year economic life.41 As one might expect, increasing the rate to 25% and removing the basis
adjustment led to the biggest boost in the ratio of after-tax returns to pre-tax returns: 165.8% for
assets with a three-year economic life, and 143.4% for assets with a 20-year economic life.
If it is true that the optimal R&D tax subsidy should raise after-tax returns to 130% of pre-tax
returns, Cox’s analysis suggested that keeping the regular credit’s statutory rate at the current
level of 20% but eliminating or relaxing the three rules governing the credit’s use might be the
better policy option for strengthening the credit’s incentive effect.
Non-refundable Status
The research tax credit is non-refundable. This means that only firms with sufficient income tax
liabilities may benefit from the full amount of the credit claimed in a tax year. In addition, the
credit is a component of the general business credit (GBC) under IRC Section 38, and therefore
subject to its limitations. For firms undertaking qualified research, a key limitation is that the
GBC cannot exceed a taxpayer’s net income tax liability, less the greater of its tentative minimum
tax under the alternative minimum tax or 25% of its regular income tax liability above $25,000.
Unused GBCs may be carried forward 20 years or back one year. Although there are some
advantages to having an inventory of tax credits to apply against future or past tax liabilities, the
advantages do not necessarily outweigh the disadvantages for firms investing in R&D. One
disadvantage is that a business taxpayer is better off using the full amount of a credit today, rather
than 5 or 10 years from now, owing to the time value of money.
Critics contend that the credit’s lack of refundability can pose a special problem for small,
fledgling, research-intensive firms. In recent decades, numerous commercially successful
technological innovations have originated with such firms. Many of them spend substantial sums
on R&D during their first few years, while recording a stream of net operating losses. In the view
of critics, a non-refundable research credit is likely to reduce the typical small, research-intensive
start-up firm’s prospects of survival and growth, as the firm cannot count on having access to the
credit when the need for it is greatest. To remedy this problem, some advocate making the credit
wholly or partially refundable for firms under a certain asset or employment size or age.42 Other
options include allowing small start-up firms that cannot use the current-year credit to sell it to
other firms or use it to offset their employment taxes.43
40
Ibid., p. 27.
Ibid., p. 27.
42
For further discussion of the possible benefits to small firms of making the credit wholly or partially refundable, see
Scott J. Wallsten, “Rethinking the Small Business Innovation Research Program,” in Investing in Innovation, Lewis M.
Branscomb and James H. Keller, eds. (Cambridge, MA: MIT Press, 1998), pp. 212-214.
43
Michael D. Rashkin, “The Dysfunctional Research Credit Hampers Innovation,” Tax Notes, June 6, 2011, p. 1066.
41
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Incomplete and Ambiguous Definition of Qualified Research and
Difficulties in Using the Credit
Critics claim that another problem raised by the current research tax credit is the activities that
qualify for it. At its core, the issue concerns the definition of qualified research and how the IRS
and taxpayers interpret it in the real world of business investment in basic and applied research.
Critics argue that the statutory definition in IRC Section 41(d) and IRS regulations implementing
it are vague and incomplete. In their view, this lack of clarity and finality, coupled with the
complexity of the credit, the difficulty of documenting claims for the credit in a manner that
passes muster with the IRS, and a lack of useful guidance from the IRS and courts, paves the way
for protracted and costly disputes between taxpayers and the IRS over the validity of claims for
the credit.44 These disputes can dampen the stimulative effect of the credit in two ways. IRS
audits of claims for the credit can lead to firms receiving smaller credits than they thought they
were entitled to. In addition, the prospect of having a claim audited and engaging in a lengthy
dispute with the IRS over its legitimacy can deter some firms that invest in qualified research
from claiming the credit.
Original Definition
Under the original credit, which was in effect from 1981 through 1985, research expenditures
generally qualified for the credit if they were eligible for expensing under IRC Section 174. There
were three exceptions to this general rule, however: no credit could be claimed for research
conducted outside the United States, research in the social sciences or humanities, and any
portion of research funded by another entity. Section 174 allows business taxpayers to deduct all
“research or experimental expenditures” incurred in connection with their trade or business,
without defining those outlays.
The IRS filled the gap by issuing regulation 1.174-2(a), which defined research or experimental
expenditures as “research and development costs in the laboratory sense,” especially “all such
costs incident to the development or improvement of a product.” Expenditures can be considered
R&D costs in the “experimental or laboratory sense” if they relate to activities intended to
discover information that would eliminate uncertainty concerning the development or
improvement of a product.” Uncertainty exists in the R&D process when the information
available to researchers does not clearly show how they should proceed in developing a new
product or improving an existing one. According to the regulation, the proper standard in
determining whether research expenditures qualify for expensing under Section 174 is the “nature
of the activity to which the expenditures relate, not the nature of the product or improvement
being developed.”
Changes Under the Tax Reform Act of 1986
Responding to a concern that business taxpayers were claiming the credit for activities that had
more to do with product development than technological innovation, Congress tightened the
44
Disputes over the credit are a recurring issue in IRS audits of large corporations in manufacturing, energy, chemicals,
and information technology. See Alex E. Sadler and Jennifer A. Ray, “Navigating the Research Credit,” Tax Notes,
September 19, 2011, p. 1254.
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definition by adding three tests through the Tax Reform Act of 1986 (TRA86).45 Under the act,
qualified research still had to involve the activities eligible for expensing under Section 174. But
such activities also had to satisfy the following criteria:
•
they were directed at discovering information that is “technological in nature”
and useful in the development of a new or improved business component for the
taxpayer;
•
they constituted “elements of a process of experimentation”; and”
•
they were intended to improve the function, performance, quality or reliability of
a business component.46
TRA86 defined a business component as “a product, process, computer software, technique,
formula, or invention” held for sale or lease or used by a taxpayer in its trade or business. It also
specified that research aimed at developing new or improved internal-use software could qualify
for the credit only if it met the general requirements for the credit, was intended to develop
software that was innovative and not commercially available, and involved “significant economic
risk.”
Subsequent IRS Guidance
In light of the significant changes made by the act, there was renewed pressure on the IRS to
issue final regulations clarifying the meaning and limits of the three new tests for qualified
research. But for reasons that still are not entirely clear, the IRS did not issue proposed
regulations (REG-105170-97) on the tests until December 1998.
Among other things, the regulations set forth guidelines for determining whether or not a business
taxpayer has discovered information that is “technological in nature” and “useful in developing a
new or improved business component of the taxpayer” through a “process of experimentation that
relates to a new or improved function, performance, reliability, or quality.” The IRS proposed that
research would meet the so-called discovery test if it were intended to obtain “knowledge that
exceeds, expands, or refines the common knowledge of skilled professionals in the particular
field of technology or science.” At the same time, according to the proposed regulations, such a
standard did not necessarily mean the credit would be denied to taxpayers who made
technological advances in an “evolutionary” manner, or taxpayers who failed to achieve the
desired result, or taxpayers who were not the first to achieve a certain technological advance. In
addition, the IRS proposed that research would meet the experimentation test if it were to draw
upon the “principles of physical or biological sciences, engineering, or computer science (as
appropriate)” to evaluate “more than one alternative designed to achieve a result where the means
of achieving the result are uncertain at the outset.” Such an evaluation should involve developing,
testing, and refining or discarding hypotheses related to the design of new or improved business
components.
The release of the proposed regulations drew more criticism than praise from the business
community. Much of the dissent focused on the proposed guidelines for the discovery test. A
45
See P.L. 99-514, Section 231.
U.S. Congress, Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, JCS-10-87
(Washington: GPO, 1987), pp. 132-134.
46
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widely shared complaint was that the “common knowledge” test violated the intent of Congress
and would prove burdensome and unworkable for tax practitioners because it was too subjective.
Most tax practitioners and businesses that commented on the proposal urged the IRS to jettison
the test.47
After reviewing the many comments it received and examining recent case law and the legislative
history of the research tax credit, the IRS issued what was intended to be a final set of regulations
(T.D. 8930) on the definition of qualified research in late December 2000. While differing
somewhat from the proposed regulations, the final regulations retained the common knowledge
test for determining if the information gained through research was technological in nature and
useful in the development of a new or improved business component. But they clarified the
application of the test by noting that the “common knowledge of skilled professionals in a
particular field of science or engineering” referred to information that would be known by those
professionals if they were to investigate the state of knowledge in a field of science or
engineering before undertaking a research project. The final regulations also carved out a safe
harbor for patents by affirming that a taxpayer would be presumed to have passed the common
knowledge test if the taxpayer could prove it had been awarded a patent for a new or improved
business component. They also established new standards for determining when the development
of computer software for internal use qualified for the credit. Specifically, research on internaluse software was eligible for the regular credit only if it satisfied the general requirements for the
credit, entailed “significant economic risk,” and resulted in the development of innovative
software that was not commercially available.
To the surprise of some, the final regulations aroused as much opposition within the business
community as the proposed regulations. A principal concern was the IRS’s insistence on retaining
the discovery test. Many tax practitioners also complained that a number of the provisions in the
final regulations were not included in the proposed regulations, precluding public comment on
them.48
This second round of criticism spurred the IRS to take an unusual procedural step. About one
month after the release of the regulations, the Treasury Department published a notice (Notice
2001-19) retracting them. The notice also requested further comment “on all aspects” of the
suspended regulations, promised that the IRS would carefully review all questions and concerns,
and committed the IRS to issue any changes to the final regulations in proposed form for
additional comment.49
In December 2001, the IRS delivered on this promise by releasing more proposed regulations
(REG-112991-01). They departed in some important ways from previous guidance. Among other
things, the regulations did not include the requirement set forth in T.D. 8930 that qualified
research seek to discover “knowledge that exceeds, expands, or refines the common knowledge
of skilled professionals in a particular field of science or engineering.” The regulations also
modified the definition of the experimentation test so that it became a “process designed to
47
Sheryl Stratton and Barton Massey, “Major Changes to Research Credit Rules Sought at IRS Reg Hearing,” Tax
Notes, May 3, 1999, pp. 623-624.
48
David L. Click, “Treasury Discovers Problems With New Research Tax Credit Regulations,” Tax Notes, March 12,
2001, p. 1531.
49
Sheryl Stratton, “Treasury Puts Brakes on Research Credit Regs; Practitioners Applaud,” Tax Notes, vol. 90, no. 6,
February 5, 2001, pp. 713-715.
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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 determination of whether a taxpayer engaged in such a
process would be made on the basis of relevant facts and circumstances. In addition, the proposed
regulations stipulated that internal-use software could not to be sold, leased, or licensed to third
parties and was eligible for the credit only if it is intended to be novel in its design or
applications. Tax practitioners and businesses generally approved the proposed changes.50
About two years later, the IRS published another set of final regulations (T.D. 9104) that was
intended to clarify the definition of qualified research and certain other matters related to the
credit.51 Some analysts saw them as an attempt by the IRS to adhere to congressional intent in
altering the definition of qualified research, as specified in TRA86.
The regulations noted that information is technological in nature if the process of experimentation
used to discover it relies on the principles of the physical or biological sciences, engineering, or
computer science. Though they discarded the discovery test included in T.D. 8930, the regulations
made it clear that taxpayers would be deemed to have discovered information that is
technological in nature by applying “existing technologies.... and principles of the physical or
biological sciences, engineering, or computer science” in the process of experimentation. Such a
discovery would not depend on whether a taxpayer succeeded in developing a new or improved
business component. At the same time, having a patent for a business component would be
considered “conclusive evidence that a taxpayer has discovered information that is technological
in nature that is intended to eliminate uncertainty concerning the development or improvement of
(such a) component.”
In addition, T.D. 9104 shed additional light on what constituted a “process of experimentation.”
Basically, the regulations specified that such a process had three critical aspects. First, the actual
outcome must be uncertain at the outset. Second, the process must allow researchers to identify
more than one approach to achieving a desired outcome. And third, researchers must use certain
scientific methods to evaluate the efficacy of these alternatives (e.g., modeling, simulation, and a
systematic trial-and-error investigation). The regulations stressed that a process of
experimentation is evaluative in nature and therefore “often involves refining throughout much of
the process the taxpayer’s understanding of the uncertainty the taxpayer is trying to address.” A
taxpayer’s relevant facts and circumstances should be considered in determining whether it has
engaged in such a process.
Remaining Concerns
Although the regulations seemed to settle several contentious issues regarding the definition of
qualified research, they did not address several other issues regarding claims for the credit that are
viewed as consequential by many firms.
50
For more details on the latest set of proposed regulations and reactions to them in the business community, see David
Lupi-Sher and Sheryl Stratton, “Practitioners Welcome New Proposed Research Credit Regulations,” Tax Notes,
December 24, 2001, vol. 93, no. 13, pp. 1662-1665.
51
Alison Bennett, “IRS Issues Final Research Credit Rules With Safe Harbor For Qualified Activities,” Daily Report
for Executives, Bureau of National Affairs, December 23, 2003, p. GG-2.
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One issue is the circumstances under which spending on the development of internal-use software
can be deemed eligible for the credit. In proposed regulations issued in 2001, the IRS stated that
any costs incurred to develop such software were eligible for the credit only if the software was
intended to be unique or novel and to differ in a “significant and inventive” way from previous
software. But in the absence of further guidance on the meaning of “significant and inventive,”
disputes between IRS examiners and taxpayers over the validity of claims for the credit tied to
internal-use software are more likely than not. One analyst has noted that since the release of the
final regulations, the IRS has interpreted the definition of significant and inventive in a way that
imposes the same requirements on the development of internal-use software that the discarded
discovery test did.52
Another issue is the eligibility of research aimed at achieving significant cost reductions. Cost
reduction is not identified in the statute as a purpose of qualified research, but the research
required to lower costs can be as challenging as research done to improve a business component’s
reliability or performance. Some have pointed out that research that allows a product or process to
deliver the same performance at a reduced cost represents an improvement in performance.53
In addition, tax practitioners have complained that in the wake of the strong opposition within the
business community to T.D. 8930, the IRS has stopped using revenue rulings and regulations in
favor of internal administrative announcements to communicate its interpretations of the IRC
Section 41. These announcements, according to these critics, are sent to IRS employees in an
effort to build a uniform approach to auditing claims for the credit that avoid public comment.
Critics charge that these internal communications force some business taxpayers to “resort to
costly litigation to determine the application of Section 41 to their facts and circumstances,”
undermining the credit’s incentive effect.54
Finally, substantiation of claims for the credit remains a significant source of disputes with the
IRS, curtailing its incentive effect. Concerned about the legitimacy of late or amended claims for
the credit, the IRS decided to designate “research credit claims” as a tier 1 compliance issue in
April 2007. Supporting claims for the credit typically requires subjective judgments that are
subject to differing interpretations. These differences often surface in IRS examinations of claims
for the credit. Examiners allegedly “routinely” deny claims because they do not strictly follow
IRS’s documentation standards, even though the standards never have been clarified in IRS
regulations.55 Taxpayers are upset because the IRS expects them to provide supportive evidence
without useful guidance on the required documentation standards. In its defense, the IRS
maintains that it cannot audit claims for the credit unless it has detailed records linking specific
expenses to specific qualified research activities. According to a 2009 GAO report, in many
cases, “taxpayers settle for 50 cents on the dollar when the IRS challenges a claim.”56
52
Christopher J. Ohmes, David S. Hudson, and Monique J. Migneault, “Final Research Credit Regulations Expected to
Immediately Affect IRS Examinations,” Tax Notes, February 23, 2004, p. 1024.
53
Michael D. Rashkin, Research and Development Tax Incentives: Federal, State, and Foreign (Chicago: CCH Inc.,
2003), p. 87.
54
David L. Click, “Zeal and Activity in the Arena of the Research Tax Credit,” Tax Notes, December 15, 2008, p.
1307.
55
David Click, “Substantiating the Research Credit,” The Tax Adviser, vol. 41, no. 4, April 2010, p. 227.
56
GAO, The Research Tax Credit’s Design and Administration Can Be Improved, p. 33.
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Insufficient Focus on Innovative Research Projects
Another problem with the current research credit, according to critics, is that it is not targeted at
research projects with a significant potential for producing substantial economic benefits. In their
view, the design of the credit makes it likely that it generates less bang for the buck in the long
run than federal grants for basic and applied research in fields with broad commercial
applications.
Assessing the validity of this claim is a challenge, largely because it is unclear at the outset of a
research project how innovative it will prove to be. There are no known studies that undertake
such an assessment. Nonetheless, the contention seems plausible in a way that might be difficult
to disprove.
In general, businesses seek the highest possible return on their investments. So in selecting
research projects to fund, they can be expected to assign a higher priority to projects that are
likely to earn substantial profits in the short run than to projects directed at expanding the
frontiers of knowledge in a scientific field that have relatively low prospects of yielding profits in
the short run. This assumes, of course, that a firm has the option of investing in either kind of
project or both at the same time.
Such an expectation not only seems reasonable by the logic of business investment and growth,
but it is consistent with several significant trends in U.S. research spending that stretch back to
the 1950s. As Figure 1 illustrates, the federal government has long served as the major source of
funding for basic research performed in the United States; from 1955 to 2008, its share of total
spending (in current dollars) for this purpose was about three times the share for businesses,
though the gap has narrowed somewhat since the early 1980s. At the same time, U.S.- and
foreign-based companies steadily expanded their share of total funding for applied research and
development performed in the United States in that period; by 2008, the business share was 88%
greater than the federal share for applied research and more than five times greater for
development.
These trends arguably confirm that the average firm prefers to invest much more in applied
research and development than in basic research. This is hardly surprising, as the returns on
investment in basic research tend to be more difficult to appropriate and more uncertain at the
outset, than the returns to investment in applied research and development. The trends also lend
support to the view that the credit mainly subsidizes research projects with relatively small
spillover benefits, as it applies to qualified projects involving basic and applied research, as well
as development.
To address this concern, critics recommend that Congress modify the credit so that it expressly
targets investment in research aimed at developing “breakthrough products that create new
product categories or innovative enhancements to existing products.”57 Among the options are (1)
replacing the current credit with one that has a larger credit rate (say 30%) for such expenditures
and(2) transferring the authority to administer the credit to the NSF. A presumed advantage of
using the NSF rather than the IRS to identify investments that would qualify for the revised credit
57
Rashkin, “The Dysfunctional Research Credit Hampers Innovation,” pp. 1066-1067.
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is that the NSF has a greater supply of the expertise required to evaluate research projects for the
purpose of determining which could be regarded as innovative.58
Figure 1. Share of U.S. Spending (current dollars) on Research and Development
Held by the Federal Government and Businesses, 1955 to 2008
Percent of Total Spending (current dollars)
90
80
70
60
50
40
30
20
10
0
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2008
Year
Federal Share of Basic Research (%)
Federal Share of Development (%)
Business Share of Applied Research (%)
Federal Share of Applied Research (%)
Business Share of Basic Research (%)
Business Share of Development (%)
Source: National Science Foundation, Division of Science Resources Statistics, National Patterns of R&D
Resources: 2008 Data Update, NSF 10-314, tables 6-8.
Legislation in the 112th and 113th Congress to Modify
and and
Extend the Research Tax Credit
The research tax credit has enjoyed strong bipartisan support since its inception, and there is no
evidence that the current Congress is an exception.
For over two decades, a major obstacle to extending the credit longer than a year or two, or to
improving its efficacy, has been the revenue cost of doing so. If anything, this issue is even more
of an obstacle in the current Congress, which has been grappling with finding politically feasible
ways to reduce or eliminate current and projected future budget deficits and federal debt.
58
Rashkin, “The Dysfunctional Research Credit Hampers Innovation,” p. 1069.
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112th Congress
A number of bills to revise the research credit were introduced in the 112th Congress. The changes
they would have made are summarized below.
House
H.R. 871 would have permanently extended the current credit and increased the credit rate for
taxpayers with more than 50% of gross receipts from domestic production activities.
H.R. 942 would have permanently extended the ASC and increased its rate to 20%; it would also
have extended the regular credit through 2012 and then repealed it.
H.R. 1329 would have made the same changes as H.R. 871.
H.R. 1693 would have permanently extended the current credit and raised the rate for the ASC to
17%.
H.R. 1773 would have permanently extended the current credit, increased the ASC rate to 20%,
and repealed the AIRC.
H.R. 2632 would have modified Section 41 of the federal tax code to create a new credit for
“initial life sciences research.” The regular credit would have been equal to 40% of qualified
expenses, while the ASC would have been equal to 28% of those expenses, capped at $150
million per taxpayer. The entire amount of payments for qualified contract research conducted by
certain research consortia, federal laboratories, and eligible small firms would have qualified for
the credit. Life sciences research would have qualified for the credit if it involved “the branch of
knowledge or study of biology, biochemistry, biophysics, bioengineering, biotechnology,
microbiology, genetics, or physiology,” as it related to human beings.
H.R. 5727 would have extended the research tax credit through 2016 and modified the ASC so
that its rate, which is 14%, would have risen by one percentage point for each 2% gain in a
company’s full-time equivalent (FTE) manufacturing employment over the five previous tax
years. The rise in the credit rate would have been capped at 20% for companies with a 12% or
greater increase in qualified employment. In addition, the increase in the ASC beyond the amount
calculated with a 14% rate would have been limited to $5,000 multiplied by the number of
qualified employees taken into account in determining the increased credit.
H.R. 5893/S. 3217 would have revised the current research credit to include a refundable credit
for firms that had less than $5 million in the current tax year and had no gross receipts in any tax
year before the previous five years. The credit would have been limited to the lesser of $250,000
or 20% of W-2 wages paid for each qualified business.
H.R. 6109 would have extended the current research credit through the end of 2012.
H.R. 6240 would have extended the credit for five years, through the end of 2016, and raised the
statutory rate for the ASC to 25% for tax years beginning after December 31, 2011.
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Senate
S. 155 would have raised the rates for the four research credits by “bonus amounts” that varied
with the share of a taxpayer’s gross receipts derived from domestic production activities.
S. 239 would have altered the university basic research credit so that it applied to research with
specific commercial objectives or applications.
S. 361 would have extended the current credit though 2016 and increased the ASC rate from 14%
to 20% for tax years after 2012 (or from 6% to 10% for taxpayers with at least one tax year out of
the previous three with no QREs).
S. 825 would have permanently extended the ASC, raised its rate to 20% (and 10% for companies
not eligible for the higher rate) for tax years after 2011, and made the credit refundable for
companies with 500 or fewer employees in the current tax year. It would also have created an
enhanced credit for domestic manufacturers that received more than 50% of their gross receipts
from domestic production activities.
S. 1410 would have changed the research credit in the same manner as H.R. 2632.
S. 1577 would have permanently extended the ASC, increased its rate to 20% (and 10%), and
repealed the current regular, university basic research, and energy research credits.
S. 1866 would have permanently extended the ASC and increased its rate to 20%, extended the
regular credit through 2012 (and then allowed it to expire), and allowed domestic manufacturers
to claim a bonus credit if their domestic production receipts accounted for 50% or more of their
total production gross receipts. The bonus amount would have risen for each 10-percentage point
gain in the share of the former to the latter, up to a share of 100%.
S. 3217 would have established the same credit for small young companies as H.R. 5893.
S. 3460/H.R. 6319 would have permitted any C corporation, partnership, or S corporation with
less than $5 million in gross receipts in the current tax year and no gross receipts in any tax year
before the previous five tax years to use any research tax credit it is due to offset up to $250,000
in payroll taxes for employees.
S. 3521, as reported by the Senate Finance Committee on August 2, 2012, would have
retroactively extended the credit through 2013. It also would have modified the rules governing
claims for the credit by companies under common control and the computation of the credit when
a business or major portion thereof changes hands.
113th Congress
House
H.R. 119 would permanently extend the research tax credits.
H.R. 120 would extend the credits through 2014, raise the rate of the regular credit to 30% and
the rates for the maximum and minimum ASC to 20% and 12% in 2013 and 2014 only, and
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permit qualified small firms to transfer credits they can claim but not use to other businesses for
cash and to exclude those payments from their gross incomes.
Other Noteworthy Perspectives on the Future of the Credit
In its budget request for FY2013, the Obama Administration asks Congress to permanently
extend the existing research credit and increase the rate for the ASC from 14% to 17%. The
projected revenue cost for these changes is $108.5 billion from FY2013 to FY2022.59
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113th Congress
House
H.R. 119 would permanently extend the research tax credits.
H.R. 120 would extend the credits through 2014, raise the rate of the regular credit to 30% and
the rates for the maximum and minimum ASC to 20% and 12% in 2013 and 2014 only, and
permit qualified small firms to transfer credits they can claim but not use to other businesses for
cash and to exclude those payments from their gross incomes.
H.R. 714 would modify the Section 41 to allow qualified small firms to apply a portion of any
research tax credit they claim but cannot use because of insufficient income tax liability against
their federal payroll taxes; the portion that can be used for this purpose would be limited to
$250,000 in a tax year.
H.R. 905 would permanently extend the research tax credits and raise the rate for the ASC to
17%.
Senate
S. 193 and S. 310 would make the same change in the research tax credit as H.R. 714 would.
Other Noteworthy Perspectives on the Future of the Credit
In its budget request for FY2014, the Obama Administration asks Congress to pass a number of
proposals as part of a plan for revenue-neutral business tax reform it outlined in early 2012. One
proposal would permanently extend the existing research credits and increase the rate for the ASC
from 14% to 17%. The projected revenue cost for these changes is $99.4 billion from FY2014 to
FY2023.59
And in a report issued in November 2009, the Government Accountability Office (GAO)
recommended that Congress consider simplifying the credit by eliminating the regular credit and
establishing a minimum base amount for the ASC equal to 50% of a taxpayer’s current-year
QREs.60 The reportGAO also noted that if Congress preferspreferred to retain the structure of the existing credit,
it it
might consider updating the base period that many companies are required to use to calculate
their fixed-base percentages for the regular credit. Finally, GAOthe report recommended that Congress
consider making certain changes in the administration of the credit to reduce the compliance
burden on firms and the cost to the IRS of ensuringverifying that claims for the credit comply with existing
regulations.
Author Contact Information
Gary Guenther
Analyst in Public Finance
gguenther@crs.loc.gov, 7-7742
existing regulations.
59
Department of the Treasury, General Explanations of the Administration’s Fiscal Year 20132014 Revenue Proposals
(Washington: Feb. 2012April 2013), pp. 3113 and 202242.
60
U.S. Government Accountability Office, The Research Tax Credit’s Design and Administration Can Be Improved,
GA0-10-136 (Washington: November 2009), p. 39.
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Author Contact Information
Gary Guenther
Analyst in Public Finance
gguenther@crs.loc.gov, 7-7742
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