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Texas adopts significant changes to research and development tax credit rule
November 2021
In brief
On October 15, Texas promulgated significant amendments to Texas Admin Code Sec. 3.599 concerning the research and development activities franchise tax credit.
The amendments do not provide a general applicable date. Existing franchise tax rule Sec. 3.599 applies to “franchise tax reports originally due on or after January 1, 2014.” Accordingly, the Comptroller may seek to apply the changes retroactively. The amendments provide the Comptroller’s interpretation and implementation for state tax purposes of IRC Section 41 and applicable regulations adopted thereunder.
For consideration: The amendments offer a significant departure from IRC statute and regulations when addressing the definitions of qualified research and qualified research expenditures. The changes also provide significant administrative challenges to taxpayers by requiring the research credit to be computed for each legal entity and records to be maintained beyond the normal statute of limitations.
Taxpayers should review their facts and the rule amendments to analyze the impact. Taxpayers may experience significant credit reductions for any open tax period relating to internal-use software, prototype research activities, or supplies used in a product or process improvement. The Comptroller has clarified that the credit will be calculated at the combined group level, but has provided additional guidance, such as for a change to the combined group, where a taxpayer may lose access to the carryforward.
In detail
In April 2021, the Comptroller submitted significant proposed amendments to Texas Admin Code Sec. 3.599, concerning the research and development activities franchise tax credit.
On October 15, 2021, the amendments became final by virtue of their publication in the Texas Register. The final amendments generally are consistent with the proposed amendments, with certain differences noted below.
Background
Effective for reports originally due on or after January 1, 2014, Texas allows a franchise tax credit to entities performing qualified research. Pursuant to Texas Tax Code Ann. § 171.651(3), “qualified research” has the meaning assigned by IRC Section 41(d) and associated federal regulations, except that the research must be conducted in Texas. “Qualified research expenditures” (QREs) has the meaning assigned by IRC Section 41(b) and associated federal regulations.
Applicability
The amendments do not provide a general applicable date. Existing Texas Administrative Code § 3.599 applies to “franchise tax reports originally due on or after January 1, 2014.” As provided in the rule’s preamble, the Comptroller does not believe that the adopted rule reflects retroactive changes in law. The Comptroller states that the changes are expositions of existing Comptroller policy rather than changes. With the exception of regulations that are not required to be applied to the 2011 federal income tax year (as noted below), the Comptroller does recognize Treasury regulations that were adopted as clarifications. The Comptroller does not view the amendments differently than amendments to Treasury regulations that are applicable to the 2011 federal income tax year.
Conformity to federal regulations
For purposes of the credit, Texas law defines the “Internal Revenue Code” as the Code in effect on December 31, 2011, and includes Treasury regulations “applicable to the tax year to which provisions of the code in effect on that date applied.”
The amendments interpret conformity to federal regulations by providing that a federal regulation adopted after December 31, 2011, is included only “to the extent that the regulation requires a taxpayer to apply the regulation to the 2011 federal income tax year” (emphasis added).
In the rule’s preamble, the Comptroller provides an example of a federal regulation to which Texas would not conform. Treas. Reg. Sec. 1.41-4, adopted on November 3, 2016, provides that regulatory guidance for internal-use software applies for tax years beginning on or after October 4, 2016. Because such guidance was not mandatory for the 2011 tax year, the Comptroller has interpreted that it is not incorporated into the definition of “Internal Revenue Code” for Texas purposes.
Another example provided by the Comptroller addresses changes to the definition of research and experimental expenditures in Treas. Reg. Sec. 1.174-2 adopted on July 21, 2014. Certain changes were applicable for tax years ending on or after July 21, 2014. Because these changes were not applicable to the 2011 tax year, they are not included in the definition of “Internal Revenue Code” for Texas purposes.
Observation: The Comptroller’s interpretation of the Internal Revenue Code as of December 31, 2011, provides strict limitations on Treasury regulations that may have been proposed or outstanding as of the 2011 effective date. While the subsequent federal regulations have been interpreted to be clarifying in nature, the Comptroller has effectively opined that it will not allow internal-use software or prototype research activities described under subsequent federal regulations to meet the requirements under the Texas statute.
Supplies used in a manufacturing product or process improvement excluded
The amendments exclude from “qualified research” any item of tangible personal property where the taxpayer would not have paid Texas sales and use tax due to the manufacturing exemption or the sale for resale exemption.
Observation: This treatment requires taxpayers to choose either a sales and use tax exemption or a research and development supplies credit. As the sales tax exemption effectively reduces tax by approximately 8% and a claim for a credit under this section results in an approximate 2.5% credit, manufacturers likely would choose the sales and use tax exemption.
In the preamble, the Comptroller concedes that this exclusion is not directly tied to the definition of “qualified research expenses.” Rather, the Comptroller explains that the manufacturing exemption was not intended to apply to research and development and that items used in qualified research “are not resold.”
Observation: Taxpayers undertaking research in the development of a new product or process generally may intend to create a new or improved product for sale. Treas. Reg. Sec. 1.174-2(a)(1) addressed the distinction to be made between qualified and nonqualified research expenditures utilized in producing a product:
The ultimate success, failure, sale, or use of the product is not relevant to a determination of eligibility under section 174. Costs may be eligible under section 174 if paid or incurred after production begins but before uncertainty concerning the development or improvement of the product is eliminated.
Internal-use software excluded
The amendments exclude from “qualified research” any research activities with respect to internal-use software.
Internal-use software is computer software developed by, or for the benefit of, the taxpayer primarily for the taxpayer’s internal use. Software developed by a taxpayer primarily for internal use by an entity that is part of an affiliated group to which the taxpayer also belongs is considered internal-use software.
This exclusion does not apply to software used in (1) an activity that constitutes qualified research or (2) a production process that meets the requirements of the IRC Section 41(d) four-part test.
The Comptroller also provided examples of software development activities that likely would be deemed to satisfy the qualified research definition. These include “developing software as part of a hardware product where the software interacts directly with that hardware in order to make the hardware/software package function as a unit.”
Observation: The Comptroller’s rule does not specifically define what should be considered “internal-use” software. However, it does provide what is not internal-use — software that is “sold, leased, licensed, or otherwise marketed for separately stated consideration to unrelated third parties.” Accordingly, the Comptroller may decide based upon facts and circumstances as to whether their software is deemed internal-use software.
Exclusions of other software activities
The Comptroller provides several examples of how the four-part test applies to software development activities. The Comptroller also identifies a list of software development activities that likely would be considered qualified research and a list of 21 software development activities that are unlikely to be considered qualified research. The examples and lists are adapted from the IRS Audit Guidelines on the Application of Process of Experimentation for All Software.
Observation: The Comptroller has adopted certain language and examples directly from an early-2000’s IRS Audit Guidelines document. However, there are several differences. Within the referenced guide, there are 21 activities that are stated as “high-risk” and “moderate-risk” activities subject to further review and investigation. There are also four noted “low-risk” activities. The Comptroller has taken the position that “high-risk” and “moderate-risk” activities are “unlikely to qualify” within the proposed amendments and stated that “low-risk” activities are “likely to qualify.”
The IRS Audit Guidelines technological references (e.g., Y2K Program Changes) do not address today's cellular phone technology, blockchain, web-based services, or the proliferation of cloud computing technologies which drive current research expenditures. As a result, the IRS Audit Guide and thus the amendments may offer only limited guidance as to the types of qualifying research projects currently being reviewed and approved by the IRS for the IRC Section 41 credit.
Exclusion of funded research from qualified research expenditures
The amendments provide that qualified research does not include the activities of “funded research.” Research is considered funded if (1) the taxpayer retains no substantial rights to the research and (2) the payments to the researcher are not contingent upon the success of the research. If the taxable entity retains substantial rights, then research is only funded to the extent of the payments and fair market value of any property that the taxable entity becomes entitled to by performing the research. If the expenses related to the research exceed the amount the researcher is entitled to receive, the research is not considered funded only with respect to the excess expenses.
Observation: The amendments depart from the IRC statutory provision that attempts to prevent the double counting of research and development expenses by various parties who may not retain rights to the research. The regulation provides an example stating that regardless of whether rights are retained to the research, only those expenses in excess of the consideration received would qualify as qualified research expenditures. Taxpayers in the aerospace and defense industry and software contractors who retain rights should evaluate the example provided within the amendments.
Update: The Comptroller has stated in the preamble to the final rule that they will take into consideration federal case law for interpretation of the respective statutes on a case-by-case basis.
Combined reporting
The combined group is the taxable entity for purposes of the credit. The total qualified research expenses of each member of the combined group are added together to determine the total credit claimed on the combined report.
If there is a change in membership of the combined group, the resulting combined group is a new taxable entity; the resulting combined group is not entitled to the credit carryforward because it no longer is the same taxable entity as the taxable entity that established the credit carryforward. The rule provides only a limited number of examples of when no change in membership occurs.
Observation: In a departure from the April 2021 proposed changes, the Comptroller will compute QREs on an entity-by entity-basis, then combine those QREs to begin computing the base-period and current-period QREs. Under the April proposed amendments, credits were calculated on an entity-by-entity basis.
Observation: A significant departure from the April proposed amendments is the potential to lose credit carryforwards if a combined group “changes.” It remains uncertain how the Comptroller will define a
“change in combined group.” The Comptroller appears to be reverting to positions taken in 2008-2010 when the agency’s position was that acquiring or selling a single entity could result in the loss of the temporary credit carryforward amount for the entire combined group. It is uncertain whether such an approach should be considered consistent with the statutory treatment for credit transfers and carryforwards.
Requirements for claiming the credit
The amendments provide that:
- The taxable entity has the burden of proof to establish its entitlement to, and value of, the credit by clear and convincing evidence.
- All QREs must be connected to specific qualified research activities.
- All QREs must be supported by contemporaneous business records.
- Any determination by the IRS that a taxable entity is entitled to the federal research and development credit does not bind the Comptroller when determining a taxable entity's eligibility for the credit.
Observation: Even though Texas incorporates IRC Section 41 into its R&D credit rule, under the amendments, an IRS determination that certain expenditures qualify for the federal credit would not be deemed binding upon the Comptroller.
Calculation and audits for years closed under the normal statute of limitations
The amendments allow the Comptroller to verify the QREs used to compute the prior-year average even if the statute of limitations for the prior year has expired. This verification will not result in an adjustment to tax, penalty, or interest for any report year for which the statute of limitations is closed.
Similarly, the amendments allow the Comptroller to verify credit carryforwards by verifying the qualified research activities on which the credit that created the carryforward was based. This verification may occur even if the statute of limitations has expired for the report year on which the original credit was claimed. This verification will not result in an assessment of tax, penalty, or interest for any period for which the statute of limitations is closed, but may result in an adjustment to the credit carryforward for any periods for which the statute of limitations is open.
Changes from April proposed amendments
The adopted rule does not reflect any significant changes from the proposed rule other than the following:
- The final rule provides that while case law on various issues is persuasive, it is not binding on the Comptroller. However, the Comptroller intends to follow federal case law regarding the definition of funded research.
- The burden of proof does not align with the federal standard; rather, the rule includes a section on the agency’s “clear and convincing evidence” standard.
- The Comptroller no longer will calculate the credit individually for each legal entity but instead will compute QREs on an entity-by entity-basis and then combine those QREs to calculate the combined group’s credit.
- If a combined group “changes” then the ability to claim the carryforward amount may be lost.
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