U.S. R&D Tax Relief Regime R&D Relief factsheet

Eligibility Criteria

To qualify for the R&D tax credit, a company must engage in qualified research activities (QRAs) as defined by the IRS. These activities must meet the following requirements:

• Technological in Nature: The activity must involve hard sciences such as engineering, computer science, biological sciences, or physical sciences.
• Elimination of Uncertainty: The company must be trying to resolve technological uncertainties through experimentation or scientific methods.
• Process of Experimentation: The company must engage in a systematic process of evaluating alternatives to achieve a technological advancement.
• Qualifying Purpose: The research must be intended to develop new or improved products, processes, software, techniques, formulas, or inventions.

Activities that qualify include basic and applied research, experimental development, and the design or improvement of prototypes, products, or processes.

Qualified Research Expenses (QREs)

The R&D tax credit is based on the company’s qualifying research expenses. The IRS defines QREs as the costs directly related to R&D activities. These can include:

• Wages: Salaries and wages paid to employees engaged in qualified research activities.
• Supplies: The cost of materials used or consumed in the R&D process, including materials for prototypes or testing.
• Contract Research: Payments to third-party contractors performing qualified research services on behalf of the business.
• Cloud Computing: Costs associated with developing software or applications using cloud computing resources may also qualify, provided they meet specific criteria.

Calculation of the R&D Tax Credit

There are two methods for calculating the R&D tax credit, the Regular Credit and the Alternative Simplified Credit (ASC):

• Regular Credit: The Regular Credit uses a fixed-base percentage (a percentage of the company’s historical research spending) to calculate the credit. The credit is typically 20% of the difference between the current year’s QREs and a base amount, which is derived from historical R&D spending.
• Alternative Simplified Credit (ASC): The ASC is a more straightforward method that calculates the credit as 14% of the QREs that exceed 50% of the average QREs over the previous three years.

The ASC generally offers a more predictable and less complex method for calculating the credit, while the Regular Credit can result in a larger benefit for companies with significant historical R&D spending.

Small Business R&D Tax Credit

Under the PATH Act of 2015, small businesses (with gross receipts of less than $5 million) can claim the R&D tax credit against their payroll taxes. This allows qualifying startups or companies in their early stages of development to offset payroll taxes up to $500,000 instead of income taxes, which is beneficial for companies that may not yet be profitable.

State-Level R&D Incentives

Many U.S. states offer additional R&D incentives to supplement the federal tax credit. These vary widely in terms of eligibility, benefits, and application processes. Some states offer direct tax credits, while others provide deductions or rebates for qualified research activities.

Examples of state-level R&D tax credits include:

• California R&D Tax Credit: Offers a credit for California expenditures based on a percentage of qualified research expenses, including wages, supplies and contractors, like the federal regular credit calculation but a15% rate is applied to the excess.
• New York State R&D Credit: Provides a percentage of qualified research expenditures and a credit for incremental research activities.
• Texas R&D Credit: Offers a credit for certain types of R&D activities, including some related to software and biotechnology.

These state credits can be in addition to the federal credit and provide substantial benefits for businesses in certain states.

Claiming the R&D Tax Credit

• Filing: Companies can claim the R&D tax credit by filing IRS Form 6765, “Credit for Increasing Research Activities,” alongside their business income tax return (Form 1120 or Form 1065).  The Form 6765 has changed for 2024, and the reporting requirements more closely mirror job costing of R&D costs based on business component.  Companies are required to meet this new reporting requirement if they meet the threshold of $1,500,000 of qualified research expenses or exceed $50,000,000 in gross receipts.
• Documentation: To substantiate a claim, businesses must keep detailed records of R&D activities and expenses. Documentation includes time tracking, project details, and costs associated with research activities, such as wages, materials, and contract expenses.
• Audit and Compliance: The IRS may audit claims to verify eligibility. It’s important for companies to maintain thorough and accurate records, as insufficient documentation can lead to denied claims.

Economic Impact and Effectiveness

The U.S. R&D tax credit has been instrumental in incentivizing businesses to invest in innovation. Over the years, the program has spurred significant private-sector spending on research and development, driving technological advancements, economic growth, and job creation.

The credit has been particularly beneficial to technology, manufacturing, life sciences, and other innovation-driven industries. However, challenges remain for companies in terms of understanding eligibility, proper documentation, and navigating complex calculation methods. Efforts are continually being made to streamline the process, and more companies are leveraging tax advisors or specialized R&D tax firms to maximize their claims.

Example Calculation

Consider a company that incurs $500,000 in qualified R&D expenses in a given year:

• Wages: $300,000
• Supplies: $100,000
• Contract Research: $100,000

If the company opts for the Alternative Simplified Credit (ASC), and its average R&D expenses over the past three years were $400,000, the credit would be:

• QREs exceeding 50% of the average: $500,000 – 50% of $400,000 = $300,000
• ASC credit = 14% of $300,000 = $42,000

The company would be eligible for a tax credit of $42,000.

Conclusion

In summary, the U.S. R&D tax relief system is a robust mechanism designed to incentivise businesses to innovate and invest in research. By offsetting a portion of qualifying research expenses, the credit supports technological advancement and economic growth. While the process can be complex, it offers significant financial benefits, particularly for businesses in technology, manufacturing, and scientific fields.