The R&D Tax Credit and Dynamic Scoring

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        Dynamic scoring is a process whereby legislative policy makers attempt to predict and quantify the overall economic impact that a particular tax provision will have on the economy.  With the tax reform discussions commencing in the year 2015, it is clear that dynamic scoring is going to part of the dialogue with all major tax provisions.

        The Federal R&D tax credit is one of the largest tax expenditure items so it will inevitably be subject to a dynamic scoring evaluation. 

The Research & Development Tax Credit

        Enacted in 1981, the federal Research and Development (R&D) Tax Credit allows a credit of up to 13% of eligible spending for new and improved products and processes. Qualified research must meet the following four criteria:

  • New or improved products, processes, or software
  • Technological in nature
  • Elimination of Uncertainty
  • Process of Elimination

        Eligible costs include employee wages, cost of supplies, cost of testing, contract research expenses, and costs associated with developing a patent. On December 19, 2014, President Obama signed the bill extending the R&D Tax Credit for the 2014 tax year.

The Credit Has Always Been Temporary

        Although the credit was enacted in 1981 and has enjoyed Bipartisan support it has always been a short term temporary credit that has had to go through over 15 separate legislative extensions.   The challenge with a temporary credit is that chief financial officers, financial analysts, and entrepreneurs cannot utilize the credit for long term project capital expenditure approvals either internally or with lenders including banks.  Simply stated, a permanent R&D tax credit would enable more innovative projects to meet hurdle rates and get approved and financed. 

U.S. State and International Tax Credit Regimes

State R&D Tax Credits
        Over 30 states have accompanying state R&D tax credits that often utilize the federal R&D tax credit definitions. Some of the state tax credits are refundable, so essentially they serve as state provided venture capital funds.  The country’s three largest states by population namely California, Florida and Texas all have state R&D tax credits.

International Tax Credits
        Over 30 countries now have R&D tax credits.  The U.S. is a laggard with a 2008 OECD study of global R&D tax incentives ranking the U.S. 24th among major developed nations offering an R&D tax incentive.  Some non U.S. jurisdictions also provide refundable R&D tax credits.

Developed Body of Tax Case Law

Since 1981 a rich body of tax case law provides much more clarity regarding the process a taxpayer can take for securing an R&D credit. Recent cases have been favorable for:
  1. CEO innovators
  2. Software
  3. Large Assembled Innovative products

R&D Tax Credit Dynamic Scoring Empirical Studies

        There have been over ten academic empirical studies regarding the economic impact of R&D tax credits, with most recent tax return year studies concluding that the credit induces at least $1.00 and perhaps $2.00 to $3.00 in additional U.S. R&D spending per incremental dollar of credit.     

What the Critics Have to Say

        There are of course critics of the R&D tax credit.  The critics will often arbitrarily select a technology sector that they don't feel should be credit eligible.

        Food processors are examples of an industry of critics who complain about the credit, despite the fact that obesity and diabetes are recognized as one of the country’s great health challenges. Others have challenged retail food automation even though food retailers represent one of America's largest international businesses and largest employers. Some have even challenged packaging innovation despite that new products require new packaging; and much of today's packing innovation involves sustainable packaging that is often recyclable, safer, and uses less materials and water.

        The bottom line is that a broad based technology incentive can't itself be an arbitrator of winning and losing technology.

The United States as an Innovation Nation

        Since the great recession the United States economy has shifted from an overweight in financial services to more of a technology based economy. K-12 schools and universities are making large investments in STEM (Science, Technology, Engineering, and Math) based curriculum so that America is prepared for the future. The federal tax system should support a culture of innovation. American businesses, America’s education system as the tax system needs to be in lockstep with the common goals of an innovation nation.

The R&D Tax Credit Dynamic Scoring Results

        The R&D tax credit achieves high dynamic scoring results.  A 2011 Ernst and Young report found that the R&D credit provides significant contributions to the U.S. economy in terms of additional private research spending, employment, and wages at both national and state level.

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Charles R Goulding Attorney/CPA, is the President of R&D Tax Savers.

Jennifer Reardon is a Project Coordinator with R&D Tax Savers.