Tax Policy
The Research Tax Credit's Design and Administration Can Be Improved Gao ID: GAO-10-136 November 6, 2009The tax credit for qualified research expenses provides significant subsidies to encourage business investment in research intended to foster innovation and promote long-term economic growth. Generally the credit provides a subsidy for research spending in excess of a base amount but concerns have been raised about its design and administrability. Government Accountability Office (GAO) was asked to describe the credit's use, determine whether it could be redesigned to improve the incentive to do new research, and assess whether recordkeeping and other compliance costs could be reduced. GAO analyzed alternative credit designs using a panel of corporate tax returns and assessed administrability by interviewing Internal Revenue Service (IRS) and taxpayer representatives.
Large corporations have dominated the use of the research credit, with 549 corporations with receipts of $1 billion or more claiming over half of the $6 billion of net credit in 2005 (the latest year available). In 2005, the credit reduced the after-tax price of additional qualified research by an estimated 6.4 to 7.3 percent. This percentage measures the incentive intended to stimulate additional research. The incentive to do new research (the marginal incentive) provided by the credit could be improved. Based on analysis of historical data and simulations using the corporate panel, GAO identified significant disparities in the incentives provided to different taxpayers with some taxpayers receiving no credit and others eligible for credits up to 13 percent of their incremental spending. Further, a substantial portion of credit dollars is a windfall for taxpayers, earned for spending they would have done anyway, instead of being used to support potentially beneficial new research. An important cause of this problem is that the base for the regular version of the credit is determined by research spending dating back to the 1980s. Taxpayers now have an "alternative simplified credit" option, but it provides larger windfalls to some taxpayers and lower incentives for new research. Problems with the credit's design could be reduced by eliminating the regular credit and modifying the base of the alternative simplified credit to reduce windfalls. Credit claims have been contentious, with disputes between IRS and taxpayers over what qualifies as research expenses and how to document expenses. Insufficient guidance has led to disputes over the definitions of internal use software, depreciable property, indirect supervision, and the start of commercial production. Also disputed is the documentation needed to support a claim, especially in cases affected by changes in the law years after expenses were recorded. Such disputes leave taxpayers uncertain about the amount of credit to be received, reducing the incentive.
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Report to the Committee on Finance, U.S. Senate:
United States Government Accountability Office:
GAO:
November 2009:
Tax Policy:
The Research Tax Credit's Design and Administration Can Be Improved:
GAO-10-136:
GAO Highlights:
Highlights of GAO-10-136, a report to Committee on Finance, U.S.
Senate.
Why GAO Did This Study:
The tax credit for qualified research expenses provides significant
subsidies to encourage business investment in research intended to
foster innovation and promote long-term economic growth. Generally the
credit provides a subsidy for research spending in excess of a base
amount but concerns have been raised about its design and
administrability.
GAO was asked to describe the credit‘s use, determine whether it could
be redesigned to improve the incentive to do new research, and assess
whether recordkeeping and other compliance costs could be reduced. GAO
analyzed alternative credit designs using a panel of corporate tax
returns and assessed administrability by interviewing IRS and taxpayer
representatives.
What GAO Found:
Large corporations have dominated the use of the research credit, with
549 corporations with receipts of $1 billion or more claiming over half
of the $6 billion of net credit in 2005 (the latest year available). In
2005, the credit reduced the after-tax price of additional qualified
research by an estimated 6.4 to 7.3 percent. This percentage measures
the incentive intended to stimulate additional research. The incentive
to do new research (the marginal incentive) provided by the credit
could be improved. Based on analysis of historical data and simulations
using the corporate panel, GAO identified significant disparities in
the incentives provided to different taxpayers with some taxpayers
receiving no credit and others eligible for credits up to 13 percent of
their incremental spending. Further, a substantial portion of credit
dollars is a windfall for taxpayers, earned for spending they would
have done anyway, instead of being used to support potentially
beneficial new research. An important cause of this problem is that the
base for the regular version of the credit is determined by research
spending dating back to the 1980s. Taxpayers now have an ’alternative
simplified credit“ option, but it provides larger windfalls to some
taxpayers and lower incentives for new research. Problems with the
credit‘s design could be reduced by eliminating the regular credit and
modifying the base of the alternative simplified credit to reduce
windfalls.
Credit claims have been contentious, with disputes between IRS and
taxpayers over what qualifies as research expenses and how to document
expenses. Insufficient guidance has led to disputes over the
definitions of internal use software, depreciable property, indirect
supervision, and the start of commercial production. Also disputed is
the documentation needed to support a claim, especially in cases
affected by changes in the law years after expenses were recorded. Such
disputes leave taxpayers uncertain about the amount of credit to be
received, reducing the incentive.
Figure: An Illustration of How Base Design Affects Windfall Credits:
[Refer to PDF for image: illustration]
A 20% flat credit (with no base):
Marginal incentive (20% of $100): $20;
Marginal incentive (20% of $1000): $200;
Revenue cost: $220.
An incremental 20% credit with a $1,000 base:
Marginal incentive (20% of $100): $20;
Windfall credit: 0;
Revenue cost: $20.
Qualified research spending:
$100: Taxpayer‘s marginal spending;
$1,000: Spending on research that taxpayer would have done anyway.
Source: GAO.
[End of figure]
What GAO Recommends:
Congress should consider eliminating the regular credit option and
adding a minimum base to the alternative simplified credit. GAO
recommends that the Secretary of the Treasury clarify the definition of
qualified research expenses and organize a working group to develop
standards for documentation. Treasury agreed with our recommendation
and plans to provide additional guidance in the next few months.
View [hyperlink, http://www.gao.gov/products/GAO-10-136] or key
components. For more information, contact James White at (202) 512-9110
or whitej@gao.gov.
[End of section]
Contents:
Letter:
Background:
Large Corporations Have Dominated the Use of the Research Credit, Which
Provided an Average Marginal Incentive of About 7 Percent in 2003
through 2005:
Important Trade-Offs Exist in the Choice of Research Credit Designs:
Issues of Contention between Taxpayers and IRS Relating to the Research
Credit Are Both Extensive and Acute:
Conclusions:
Matters for Congressional Consideration:
Recommendations for Executive Action:
Agency Comments:
Appendix I: Scope and Methodology:
Appendix II: Data Relating to the Use of the Research Tax Credit by
Corporations:
Appendix III: Examples of How the Base of the Credit Affects Marginal
Incentives and Windfall Credits:
Appendix IV: Issues Relating to the Definition of Qualified Research
Expenses:
Appendix V: Issues Relating to the Definition of Gross Receipts for a
Controlled Group of Corporations:
Appendix VI: Issues Relating to Recordkeeping and Substantiation:
Appendix VII: Issues Relating to the Computation Rules for the Group
Credit:
Appendix VIII: Comments from the U.S. Department of Treasury:
Appendix IX: GAO Contact and Staff Acknowledgements:
Tables:
Table 1: Maximum MERs and Average Effective Rates of Credit for
Different Categories of Credit Claimants, 2005:
Table 2: Summary Comparison of Leading Design Options:
Table 3: Total Claimants, Qualified Research Expenses, and Net Credits,
2003 to 2005:
Table 4: Marginal Effective Rates, Discounted Revenue Costs, and Bangs-
per-Buck of the Research Credit, 2003 to 2005:
Table 5: Comparison of Initial and Amended Claims of the Research
Credit by Panel Corporations:
Table 6: Comparison of Initial and Amended Claims of the Research
Credit by Those Corporations That Made a Change:
Table 7: Changes in the Basic Elements of the Research Credit
Computation between Initial and Amended Claims:
Table 8: Changes in the Basic Elements of the Research Credit
Computation between Initial and Amended Claims for Those Corporations
That Made a Change:
Table 9: Comparison of Final Taxpayer Pre-Exam Credit Claim to Latest
Available IRS Position:
Table 10: Comparison of Final Taxpayer Pre-Exam Credit Claim to Latest
Available IRS Position for Those Cases in Which IRS Made a Change:
Table 11: Changes in the Basic Elements of the Research Credit
Computation between Final Taxpayer Pre-Exam Credit Claim to Latest
Available IRS Position:
Table 12: Changes in the Basic Elements of the Research Credit
Computation between Final Taxpayer Pre-Exam Credit Claim to Latest
Available IRS Position for Those Cases in Which IRS Made a Change:
Table 13: Distribution of QREs and Revenues Cost by Type of Credit User
Prior to and After the Introduction of the ASC (Panel Corporations
Only):
Table 14: Weighted Average Marginal Incentives and Revenue Costs for
the Panel Population Before and after the Introduction of the ASC:
Table 15: Percentage Changes in Marginal Incentives and Revenue Costs
Relative to 2009 Rules If the ASC Is the Only Credit Allowed:
Table 16: Percentage Changes in Marginal Incentives and Revenue Costs
Relative to 2009 Rules If a Choice Is Allowed between the ASC and the
Regular Credit with an Updated Base:
Table 17: Percentage Revenue Savings from Adding a Minimum Base
Constraint to the ASC If the ASC Is the Only Credit Allowed:
Table 18: Percentage Reductions in Marginal Incentives and Revenue
Costs If Only the ASC Is Allowed, Rather than Both the ASC and the
Regular Credit, When Both Credits Have a 50% Minimum Base:
Table 19: Percentage Reductions in Marginal Incentives and Revenue
Costs If Only the ASC Is Allowed, Rather than Both the ASC and the
Regular Credit, When Both Credits Have a 75% Minimum Base:
Table 20: A Comparison of Two Methods for Allocating Group Credits in
Selected Situations:
Figures:
Figure 1: A Comparison of an Incremental Credit to Flat and Capped
Credits:
Figure 2: Information Needed to Estimate the Bang-per-Buck of the
Credit:
Figure 3: Illustration of How Current Spending Increases Reduce Future
Credits Under the ASC:
Figure 4: Distribution of Claimants, Qualified Research Expenses, and
Net Credits, by Size of Taxpayer, 2003 to 2005:
Figure 5: Shares of Claimants, QREs and Research Credits, by Taxpayer's
Credit Status, 2005:
Figure 6: Percentage of Credit Claimants Subject to Tax Liability
Constraints, 2003 to 2005:
Figure 7: Illustration of How Inaccuracies in the Base of the Credit
Result in Disparities in Incentives Across Taxpayers:
AER: Average Effective Rate:
AIRC: Alternative Incremental Research Credit:
ASC: Alternative Simplified Credit:
ATG: Audit Technique Guides:
EIN: Employer Identification Number:
FBP: Fixed Base Percentage:
IDR: Information Document Request:
IRC: Internal Revenue Code:
IRS: Internal Revenue Service:
IUS: Internal-Use Software:
LMSB: Large and Mid-Size Business:
MER: Marginal Effective Rate:
PFA: Prefiling Agreement:
QRE: Qualified Research Expense:
RCRA: Research Credit Recordkeeping Agreements:
SME: Subject Matter Experts:
SOI: Statistics of Income:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
November 6, 2009:
The Honorable Max Baucus:
Chairman:
The Honorable Charles E. Grassley:
Ranking Minority Member:
Committee on Finance:
United States Senate:
Since 1981, the tax credit for qualified research expenses has provided
significant subsidies (an estimated $5.6 billion for fiscal year 2009)
to encourage business investment in research and development. This type
of investment can have a profound effect on long-term growth if it
fosters innovation. Economists widely agree that some government
subsidy for research is justified because the social returns from
research exceed the private returns that investors receive. In the
absence of a subsidy, the amount invested in research would be less
than optimal from society's standpoint.
Despite the widespread support for the concept of a credit for
increasing research activities, concerns have been raised about the
cost-effectiveness of the design of the current credit and its
administrative and compliance costs. Very generally, the research
credit provides a subsidy for spending in excess of a base amount. One
design issue is how the base is determined and how well it achieves its
objective of targeting benefits only to research spending that would
not have been done without the credit.
To help inform congressional deliberations on the credit, you asked us
to (1) describe how taxpayers are currently using the credit; (2)
identify what, if any, changes to the credit's design may be able to
increase the incentive to do additional research with social benefits;
and (3) identify specific and significant problems, if any, that exist
in the administration of the credit and options to address them.
To provide information on the use of the research credit we analyzed
Internal Revenue Service (IRS) taxpayer data from the Statistics of
Income (SOI) Division's annual samples of corporate tax returns for the
most recent years available (2003 through 2006) supplemented by data
collected by IRS examiners. We determined that the data were
sufficiently reliable for our purpose of describing the general
characteristics of R&E Credit claimants; the amount and type of R&E
Credit claimed by taxpayers; the average rate of credit for claimants;
and the types of research spending for which taxpayers are claiming the
credit (i.e., basic vs. applied research, as defined by tax rules).
However, we do discuss certain limitations of the data and how those
may affect selected statistics.
To identify what, if any, problems exist with the design of the credit,
we examined its performance, relative to alternative designs, in terms
of three criteria. Our first criterion was the amount of revenue the
government must forgo under each of the alternative credit designs in
order to provide a given level of incentive.[Footnote 1] Our second
criterion was the extent to which each design minimizes unintended
variations in the rates of incentives across taxpayers. Our final
criterion was the extent to which each design of the credit helps to
minimize the administrative and compliance burdens on IRS and
taxpayers. We compared alternative designs of the credit by using a
panel of SOI taxpayer data to simulate the sizes of the incentives and
revenue costs of different credit designs under different scenarios, as
well as by interviewing research credit experts. We performed a
sensitivity analysis that allowed certain data and parameters of our
simulation model to vary. For example, one aspect of our sensitivity
analysis involved running the simulations using data collected at
different stages of the tax filing process, including data from the
original returns as well as from amended or audited returns, where
applicable.[Footnote 2] Our panel database included most of the largest
credit claimants in 2003 and 2004, which accounted for about half of
the total credits claimed and 54 percent to 55 percent of total
qualified research expenses in each of those years. These corporations
are not representative of all research credit claimants; however, the
data available to us do not suggest that the remainder of the credit
claimant population is so different from our panel population in key
respects that we would have reached different conclusions and
recommendations had we been able to run our simulations for the full
population.[Footnote 3]
To identify what, if any, specific problems exist with the IRS's
administration of the credit or with taxpayers' ability to comply with
credit rules, we interviewed IRS and Department of the Treasury
officials, tax practitioners, and industry representatives about their
principal concerns and how these concerns might best be addressed. In
addition, we reviewed public comments made to Treasury about research
credit regulations, as well as Treasury's responses to the comments.
Finally, we analyzed data collected by IRS examiners relating to
amended credit claims and audit adjustments to credit claims to
identify which key line items in the credit computation are most
subject to change after an initial claim has been filed.
We conducted this performance audit from January 2007 through August
2009 in accordance with generally accepted government auditing
standards. Those standards require that we plan and perform the audit
to obtain sufficient, appropriate evidence to provide a reasonable
basis for our findings and conclusions based on our audit objectives.
We believe that the evidence obtained provides a reasonable basis for
our findings and conclusions based on our audit objectives.
Background:
History and Overview of Credits for Different Types of Research:
Congress created the research tax credit in 1981 to encourage
businesses to do more research.[Footnote 4] The credit has never been a
permanent part of the Internal Revenue Code (IRC). Since its enactment
on a temporary basis in 1981, the credit had been extended 13 times,
often retroactively. There was only a 1-year period (between June 30,
1995, and July 1, 1996) during which the credit was allowed to lapse
with no retroactive provision upon reinstatement. Most recently, the
credit was extended through December 31, 2009.
The basic design of the credit has been modified or supplemented
several times since its inception. For tax years ending after December
31, 2006, through December 31, 2008, IRC Section 41 allowed for five
different credits. Three of the credits, the regular research credit,
the alternative incremental research credit (AIRC), and the alternative
simplified credit (ASC), rewarded the same types of qualified research
and are simply alternative computational options available to
taxpayers. Each taxpayer could claim no more than one of these credits.
(For purposes of this report we use the term research credit when
referring collectively to these options.) The AIRC option was repealed
beginning January 1, 2009, while the ASC and regular research credit
are available through the end of 2009. The other two separate credits,
the university basic research credit and the energy research credit are
targeted to more specific types of research and taxpayers that
qualified could claim them in addition to the research credit. This
report does not address those separate credits.
How the Research Credit Is Targeted:
Both the definition of research expenses that qualify for the credit
and the incremental nature of the credit's design are important in
targeting the subsidy to increase the social benefit per dollar of
revenue cost. In order to earn the research credit a taxpayer has to
have qualified research expenses (QREs) in a given year and those
expenses have to exceed a threshold or base amount of spending.
Qualified Research Expenses:
The IRC defines credit eligibility in terms of both qualifying research
activities and types of expenses. It specifies the following four
criteria that a research activity must meet in order to qualify for
purposes of the credit:
* The activity has to qualify as research under IRC section 174 (which
provides a separate expensing allowance for research), which requires
that an activity be research in the "experimental or laboratory sense
and aimed at the development of a new product."
* The research has to be undertaken for the purpose of discovering
information that is technological in nature.
* The objective of discovering the information has to be for use in the
development of a new or improved business component of the taxpayer.
* Substantially all of the research activities have to constitute
elements of a process of experimentation for a qualified purpose.
The IRC also specifies that only the following types of expenses for in-
house research or contract research would qualify:
* wages paid or incurred to employees for qualified services;
* amounts paid or incurred for supplies used in the conduct of
qualified research;
* amounts paid or incurred to another person for the right to use
computers in the conduct of qualified research; and:
* in the case of contract research, 65 percent of amounts paid or
incurred by the taxpayer to any person, other than an employee, for
qualified research.
Spending for structures, equipment, and overhead do not qualify. In
addition, the IRC identifies certain types of activities for which the
credit cannot be claimed, including research that is:
* conducted outside of the United States, Puerto Rico, or any other
U.S. possession;
* conducted after the beginning of commercial production of a business
component;
* related to the adaptation of an existing business component to a
particular customer's requirements;
* related to the duplication of an existing business component;
* related to certain efficiency surveys, management functions, or
market research;
* in the social sciences, arts, or humanities; or:
* funded by another entity.
As will be discussed in a section below, the practical application of
the various criteria and restrictions specified in the IRC has been the
source of considerable controversy between IRS and taxpayers.
The Rationale behind an Incremental Design for the Credit:
The research credit has always been an incremental subsidy, meaning
that taxpayers earn the credit only for qualified spending that exceeds
a defined base amount of spending. The purpose of this design is to
reduce the cost of providing a given amount of incentive. Figure 1
illustrates the difference between an incremental credit and two common
alternative designs for a subsidy--a flat credit and a capped flat
credit. In the case of the flat credit a taxpayer would earn a fixed
rate of credit, 20 percent in this example, for every dollar of
qualified spending. The taxpayer's total qualified spending consists of
the amount that it would have spent even if there were no subsidy, plus
the additional or "marginal" amount that it spends only because the
credit subsidy is available. The subsidy encourages additional spending
by reducing the after-tax cost of a qualified research project and,
thereby, increasing the project's expected profitability sufficiently
to change the taxpayer's investment decision from no to yes. The
subsidy provided for the marginal spending is the only portion of the
credit that affects the taxpayer's research spending behavior. The
remainder of the credit is a windfall to the taxpayer for doing
something that it was going to do anyway. In the case of a capped
credit, the taxpayer earns a fixed rate of credit on each dollar of
qualified spending up to a specified limit. If, as in the example shown
in figure 1, the credit's limit is less than the amount that the
taxpayer would have spent anyway, all of the credit paid is a windfall
and no additional spending is stimulated because no incentive is
provided at the margin. In contrast, the objective of an incremental
credit is to focus as much of the credit on marginal spending while
keeping the amount provided as a windfall to a minimum. The last
example in figure 1 shows the case of an ideal incremental credit--one
for which the base of the credit (the amount of spending that a
taxpayer must exceed before it can begin earning any credit) perfectly
measures the amount of spending that the taxpayer would have done
anyway. This credit maintains an incentive for marginal spending but
eliminates windfall credits, substantially reducing the credit's
revenue cost. Alternatively, the savings from the elimination of
windfalls could be used to increase the rate of credit on marginal
spending.
Figure 1: A Comparison of an Incremental Credit to Flat and Capped
Credits:
[Refer to PDF for image: illustration]
A 20% flat credit (with no base):
Marginal incentive (20% of $100): $20;
Marginal incentive (20% of $1000): $200;
Revenue cost: $220.
A 20% flat credit capped at $80:
Marginal incentive: (No marginal incentive so taxpayer decides not to
do the marginal spending);
Windfall credit (20% flat credit with $80 cap applied): $80;
Revenue cost: $80.
An incremental credit with an ideal base:
Marginal incentive (20% of $100): $20;
Windfall credit: 0;
Revenue cost: $20.
Qualified research spending:
$100: Taxpayer‘s marginal spending;
$1,000: Spending on research that taxpayer would have done anyway.
Source: GAO.
[End of figure]
Computation of the Research Credit:
The primary differences across the research credit computation options
are in (1) how the base spending is defined and (2) the rate of credit
that is then applied to the difference between current-year QREs and
the base amounts. The box below shows the detailed computation rules
for each option. Alternative Computation Options for the Research Tax
Credit (Before Restrictions)
Regular Credit Option:
Credit = 20% × [current-year QREs - base QREs],
where base QREs equal the greater of:
[the sum of QREs for 1984 to 1988/the sum of gross receipts for 1984 to
1988] × average gross receipts for the 4 tax years immediately
preceding the current one, or:
50% × current-year QREs. [This is known as the minimum base amount.]
The ratio of QREs to gross receipts during the historical base period
is known as the fixed base percentage (FBP). A maximum value for the
FBP is set at 16 percent. Also, special "start-up" rules exist for
taxpayers whose first tax year with both gross receipts and QREs
occurred after 1983, or that had fewer than 3 tax years from 1984 to
1988 with both gross receipts and QREs. The FBP for a start-up firm is
set at 3% for a firm's first 5 tax years after 1993 in which it has
both gross receipts and QREs. This percentage is gradually adjusted so
that by the 11th tax year it reflects the firm's actual experience
during its 5th through 10th tax years.
ASC Option:
Credit = 14% × [current-year QREs - 50% × average QREs in the 3
preceding tax years]
If a taxpayer has no QREs in any of its 3 preceding tax years, then the
credit is equal to 6% of its QREs in the current tax year.
AIRC Option:
(discontinued as of January 1, 2009):
Credit = 3% of QREs that are above 1% but not greater than 1.5% of
average annual gross receipts in the 4 preceding tax years:
+ 4% of QREs that are above 1.5% but not greater than 2% of average
annual gross receipts in the 4 preceding tax years:
+ 5% of QREs that are above 2% of average annual gross receipts in the
4 preceding tax years:
Restrictions on the Credit's Use:
The IRC requires that taxpayers reduce the amount of their deductions
for research expenses under section 174 by the amount of research
credit that they claim. Alternatively, the taxpayer can elect to claim
a reduced credit, equal to 65 percent of the credit that it otherwise
would have been able to claim.
The research credit is a component of the general business credit and,
therefore, is subject to the limitations that apply to the latter
credit. Specifically, the general business credit is generally
nonrefundable, except for the provisions of section 168(k)(4), so if
the taxpayer does not have a sufficient precredit tax liability against
which to use the credit in the current tax year, the taxpayer must
either carry back some or all of the credit to the preceding tax year
(if had a tax liability that year), or carry the credit forward for use
in a future tax year. Unused general business credits may be carried
forward up to 20 years.
Group Aggregation Rules:
When Congress originally enacted the research credit in 1981, it
included rules "intended to prevent artificial increases in research
expenditures by shifting expenditures among commonly controlled or
otherwise related persons."[Footnote 5] Without such rules, a corporate
group might shift current research expenditures away from members that
would not be able to earn the credit due to their high base
expenditures to members with lower base expenditures. A group could,
thereby, increase the amount of credit it earned without actually
increasing its research spending in the aggregate. Under the IRC, for
purposes of determining the amount of the research credit, the
qualified expenses of the same controlled groups of corporations are
aggregated together. The language of the relevant subsection
specifically states that:
1. All members of the same controlled group of corporations shall be
treated as a single taxpayer,[Footnote 6] and:
2. The credit (if any) allowable under this section to each such member
shall be its proportionate share of the qualified research expenses and
basic research payments giving rise to the credit.
Congress directed that Treasury regulations drafted to implement these
aggregation rules be consistent with these stated principles. As
discussed in a later section, some tax practitioners say that
Treasury's regulations on this issue are unnecessarily burdensome.
The Marginal Incentive Provided by the Research Tax Credit:
One of the key measures that we will use to compare credit designs is
the marginal effective rate (MER) of the credit, which quantifies the
incentive that a credit provides to marginal spending and which can be
simply stated as:
MER = change in the credit benefit/marginal qualified research expenses
(QREs):
The MER is the same as the marginal rate of incentive that we presented
in figure 1. It measures the reduction in the after-tax price of
marginal research due to the credit. In the example of a flat credit
with a 20-percent statutory rate shown in that figure, the taxpayer
received $20 when it increased its spending by $100, giving it an MER
of 20 percent (the credit reduces the price of marginal research by 20
percent).[Footnote 7] However, factors other than just the statutory
rate of a tax credit can also be important in determining its marginal
incentive. Measures that take those other factors into account are
commonly known as "effective rates." In a later section we explain how
various features of the credit's design can affect the MER; however,
one factor that reduces the MER for all credit earners, regardless of
the design, is the offset of the credit against the section 174
deduction for research spending (or the alternative election of the
reduced credit amount) mentioned earlier. For corporations subject to
the top corporate income tax rate of 35 percent, this offset
effectively reduces the regular credit's MER from 20 percent to 13
percent and the ASC's MER from 14 percent to 9.1 percent.[Footnote 8]
Another factor that reduces the MER of many taxpayers is the fact that
they do not have sufficient tax liabilities to use all of the credits
they earn in the current year. When a taxpayer cannot use the credit
until sometime in the future, the present value of the credit decreases
according to the taxpayer's discount rate. For example, if the taxpayer
has a discount rate of 5 percent and must delay the use of $1 million
of credit for three years, the present value of that credit is reduced
to approximately $864,000.[Footnote 9] Such a delay, therefore, would
reduce the regular credit's MER from 13 percent to about 11.2 percent.
This delay in the use of the credit also reduces the present value of
the revenue cost to the government. In the remainder of this report we
make a distinction between the amount of net credit (after the section
174 offset) that taxpayers earn for a given tax year and the credit's
discounted revenue cost, which reflects delays in the use of credits.
Unless otherwise specified, we use the term revenue cost to refer to
the discounted revenue cost.
Estimating the Credit's Stimulative Effect:
Three pieces of information are needed to estimate the amount of
spending stimulated by the research credit. Then, to determine how much
spending is stimulated per dollar of revenue cost (colloquially known
as the "bang-per-buck" of the credit), the tax revenue cost of the
credit is also needed. The steps in this estimation process are
illustrated in figure 2. The shaded boxes identify the information
required. The first step is to multiply the weighted average MER
provided by the credit times a measure of the responsiveness of total
research spending to the price reduction.[Footnote 10] This
responsiveness measure is called the price elasticity of research
spending and is defined as the percentage change in total QREs divided
by the percentage change in the price of a unit of research. If the
average MER were 5 percent and the price elasticity were -1, then the
credit would increase total QREs by 5 percent. The next step in the
computation is to apply the percentage increase to the amount of
aggregate qualified spending that would have been done without the
credit in order to determine the total amount of spending stimulated by
the credit. Finally, the bang-per-buck can be estimated by dividing the
total amount stimulated by the credit's revenue cost.
Figure 2: Information Needed to Estimate the Bang-per-Buck of the
Credit:
[Refer to PDF for image: illustration]
Percentage increase in qualified research spending due to the credit:
Equals:
Percentage reduction in the after-tax price of a unit of qualified
research:
Marginal effective rate (MER) of the credit.
Times:
Percentage by which spending increases for each 1% reduction in the
price:
Price elasticity of research spending.
Dollar increase in qualified research spending due to the credit:
Equals:
Percentage increase in qualified research spending due to the credit:
Times:
Aggregate qualified research spending.
Dollar increase in qualified research spending due to the credit:
Divided by:
Revenue Cost;
Equals:
Bang-per-buck of the credit (Amount of spending stimulated for each
dollar of revenue forgone).
Source: GAO.
[End of figure]
In this study, we provide some estimates of the credit's weighted
average MER and revenue cost, as well as estimates of the aggregate
amount of qualified research spending. We have not estimated the price
elasticity of research spending and the available estimates from past
empirical research leave considerable uncertainty regarding the size of
that elasticity.[Footnote 11] Nevertheless, as can be seen in figure 2,
for any value of the price elasticity, a credit design that provides
the same weighted average MER as another design, but at a lower revenue
cost, should provide a higher bang-per-buck than that other credit.
Therefore, comparing different designs on the basis of their MER and
revenue cost should be equivalent to comparing them on the basis of
their bang-per-buck.
To fully assess the research credit's value to society, more than just
the amount of spending stimulated per dollar of revenue cost would have
to be examined. A comparison would have to be made between (1) the
total benefits gained by society from the research stimulated by the
credit and (2) the estimated costs to society resulting from the
collection of taxes required to fund the credit. The social benefits of
the research conducted by individual businesses include any new
products, productivity increases, or cost reductions that benefit other
businesses and consumers throughout the economy. Although most
economists agree that research spending can generate social benefits,
the effects of the research on other businesses and consumers are
difficult to measure. We are not aware of any studies that have
empirically estimated the credit's net benefit to society.
Large Corporations Have Dominated the Use of the Research Credit, Which
Provided an Average Marginal Incentive of About 7 Percent in 2003
through 2005:
Although more than 15,000 corporate taxpayers claimed research credits
each year from 2003 through 2005, a significantly smaller population of
large corporations (those with business receipts of $1 billion or more)
claimed most of the credit during this period. In 2005, 549 such
corporations accounted for about 65 percent of the $6 billion of net
credit claimed that year (see figure 4 and table 3 in appendix II).
[Footnote 12] Even within the population of large corporations credit
use is concentrated among the largest users. The 101 corporations in
our panel database in 2004 accounted for about 50 percent of the net
credit claimed that year. Corporations with business receipts of $1
billion or more accounted for an even larger share--about 70 percent--
of the $131 billion of total QREs reported by credit claimants for
2005.[Footnote 13] In 2005 approximately 69 percent of QREs were for
wages paid to employees engaged in qualified research activities.
Almost all of the remaining QREs were for supplies used in research
processes (about 16 percent) and for contract research (about 15
percent).[Footnote 14]
Prior to the introduction of the ASC in 2006, taxpayers that used the
regular credit accounted for the majority of QREs and an even larger
majority of the research credit claimed.[Footnote 15] In 2005, regular
credit users reported about 75 percent of all QREs and claimed about 90
percent of total research credits.[Footnote 16] (See figure 5 in
appendix II.) Their share of total credits was larger than their share
of total QREs because the regular credit rules were more generous than
those of the AIRC for taxpayers who could qualify for the former. Most
of the regular credit users were subject to the 50-percent minimum
base, which, as we will explain in a later section, had a significant
effect on the MER they received from the credit. The lack of current
tax liabilities was another factor that affected the MERs of many
credit claimants. In 2005, 44 percent of total net credits earned could
not be used immediately. (See figure 6 in appendix II.)
By taking into account factors, such as which credit a taxpayer
selected, whether it was subject to a minimum base, and whether it
could use its credit immediately, we were able to estimate MERs for all
of the credit claimants represented in SOI's corporate database (see
appendix I for details). These individual estimates allowed us to
compute a weighted average MER for all taxpayers. We also estimated the
discounted cost to the government of the credits that all taxpayers
earned. These estimates, along with data on total QREs, permitted us to
estimate the bang-per-buck of the credit for 2003 through 2005 for
alternative assumptions about the price elasticity of research
spending. (See table 4 in appendix II.) Our estimate of the overall MER
in 2005 ranged between 6.4 percent and 7.3 percent, depending on
assumptions about discount rates and the length of time before
taxpayers could use their credits. Our estimates of the discounted
revenue cost were also sensitive to these assumptions and ranged
between $4.8 billion and $5.8 billion. The bang-per-buck estimates were
not sensitive to these particular assumptions;[Footnote 17] however,
they were quite sensitive to the price elasticity assumptions. If the
elasticity was -0.5, the bang-per-buck for 2005 would have been about
$0.80. If the elasticity was -2, the bang-per-buck would have been
about $3.00.
Data on amended claims filed by our panel of large corporations
indicate that, in the aggregate, these amendments increased the amount
of credit claimed by between 1.5 percent and 5.4 percent (relative to
the amounts claimed on initial returns) for each tax year from 2000
through 2003. (See tables 5 through 8 in appendix II.) The credit
increase through amendments for tax year 2004 was only 0.5 percent.
Data from IRS examinations of these large corporations indicate that
examiners recommended changes that, in the aggregate, would have
decreased credits claimed by between 16.5 and 27.1 percent each tax
year from 2000 through 2003.[Footnote 18] (See tables 9 through 12 in
appendix II.) The lower percentage change of 9 percent for 2004
reflects, in part, the fact that audits for that tax year had not
progressed as far as those for the earlier years.
Changes of these magnitudes raise the question of how much credit
taxpayers actually expected to receive when they filed their claims
and, more important, when they were making their research spending
decisions for the years in question.[Footnote 19] These expectations
are critical because they are what affect the taxpayer's decisions, not
the amounts of credit actually received well after the decisions have
been made. For those taxpayers that do not expect to file amendments
and do not expect IRS to change their credits, the amounts claimed on
their original returns should be the best estimate of their
expectations. For taxpayers that know they may be stretching the rules
with some of the expenses they are trying to claim as QREs, their post-
exam credit amounts may be better estimates of their expectations. In
other cases, given the lack of clarity in certain aspects of the
definitions of both QREs and gross receipts, taxpayers may be uncertain
whether they will receive any credit for particular research projects.
Such uncertainty reduces the credit's effective incentive.
Important Trade-Offs Exist in the Choice of Research Credit Designs:
The regular credit provides a higher average MER for a given revenue
cost than does the current ASC; however, over time, the historically
fixed base of the regular credit becomes a very poor measure of the
research spending that taxpayers would have done anyway. As a result,
the benefits and incentives provided by the credit become allocated
arbitrarily and inequitably across taxpayers, likely causing
inefficiencies in resource allocation.
As we noted earlier, an ideal incremental credit would reward marginal
research spending but not any spending that a taxpayer would have done
anyway. In reality, it is impossible for policymakers to know how much
research spending taxpayers would have done without the credit. Any
practical base that can be designed for the credit will only
approximate the ideal base with some degree of inaccuracy. The primary
base for the regular credit (except for start-up companies) is
determined by a taxpayer's spending behavior that occurred up to 25
years ago (see the computation rules on page 7).[Footnote 20] There is
little reason to believe that, in most cases, the ratio of research
spending to gross receipts from that long ago, when multiplied by the
taxpayer's most recent 4-year average of gross receipts, would
accurately approximate the ideal base for that taxpayer.
Most credit claimants received substantial windfalls. Regular credit
claimants subject to the 50 percent minimum base represented about 71
percent of all claimants in 2005 (see figure 5 in appendix II). More
than half of the credit such claimants earned was a windfall. Even the
highest elasticity estimates and the largest possible MER (which
together should produce the largest increase in research spending)
indicate that spending increases due to the credit represent less than
15 percent of the total research spending of these claimants. Since
regular credit users subject to the 50 percent minimum base receive a
credit for half of their research spending, the credit for marginal
spending is less than half of the credit they receive.
Inaccuracies in the base also cause disparities across taxpayers in
both the marginal incentives and windfall benefits that they receive
from the credit. Table 1 shows the extent of the disparities across
taxpayers that use different credit options and are subject to
different constraints. Taxpayers for which bases exceeded their actual
spending received no incentive from the credit. Regular credit users
whose primary bases were not so inaccurately low that the minimum base
took effect received had MERs of 13 percent (if they could use their
credits immediately), while those with primary bases so inaccurate that
they were subject to the minimum base had their MERs cut to 6.5 percent
(again, if they could use their credits immediately).[Footnote 21]
Using the IRS tax data, we estimated that the regular credit users
subject to the minimum base received an average effective rate of
credit (total credit divided by total spending) more than one and one-
half times as large as those who were not subject to the minimum base.
The average effective rate includes windfall credits, which the MER
does not. This result indicates that, even though the minimum base
reduced the credits that taxpayers earned on both their marginal
spending and on the spending they would have done anyway, taxpayers
subject to the minimum base still received larger windfall credits than
those who were not.
Meanwhile, AIRC users received significantly lower MERs and average
effective credit rates than did either group of regular credit users.
Table 1: Maximum MERs and Average Effective Rates of Credit for
Different Categories of Credit Claimants, 2005:
Maximum MER;
Had QREs below base amounts: 0%;
Claimed regular credit: Not subject to minimum base: 13.0%;
Claimed regular credit: Subject to minimum base: 6.5%;
Claimed AIRC: 2.4%.
Average Effective Rate;
Had QREs below base amounts: 0%;
Claimed regular credit: Not subject to minimum base: 4.1%;
Claimed regular credit: Subject to minimum base: 6.5%;
Claimed AIRC: 1.9%.
Source: GAO analysis based on IRS data and the IRC.
[End of table]
Although data are not yet available on credit use after the ASC was
introduced, we applied current credit rules to the historical data from
our panel of large credit claimants to estimate how many of them would
have chosen ASC if it had been available in 2003 and 2004. We found
that, if taxpayers had selected the option that provided them with the
largest credit amount, most of the panel members would have switched to
the ASC, but a significant number would still have claimed the regular
credit. ASC users would have accounted for about 62 percent of the
panel population's total QREs and between 56 percent to 60 percent of
the revenue cost of all panel members in those years. (See table 13.)
Some taxpayers still had MERs over 10 percent while others had negative
MERs.
The disparate distribution of incentives and windfalls is not only
inequitable, it can also result in a misallocation of research spending
and economic activity in general across competing sectors.[Footnote 22]
These misallocations may reduce economic efficiency and, thereby,
diminish any economic benefits of the credit.
An additional significant problem with the regular credit's base is the
difficulty that taxpayers have in substantiating their base
computations to the IRS. Many businesses lack the types of records
dating to the mid 1980s that are needed to complete these computations
with a high degree of accuracy and the substantiation of base QREs has
become a leading issue of contention between regular credit users and
the IRS. (This problem will be discussed in more detail in a later
section.)
Under the ASC's Moving-Average Base, Marginal Incentives Are Reduced
Because Current Spending Reduces the Amount of Credit Earned in Future
Years:
The base of the ASC continually updates itself; however, an important
disadvantage of this updating is that a taxpayer's current year
research spending will increase its base in future years, thereby
reducing the amount of credit it earns in those years. Figure 3
illustrates this problem in the case that a taxpayer earns a credit
each year but is not subject to the minimum base. For every $1 million
of spending increase this year, the taxpayer's base in each of the next
3 years would increase by $166,667. These base increases reduce the
amount of credit that the taxpayer can earn in each of the next 3 years
by $15,167, for a combined total of $45,500.[Footnote 23] As a result,
the actual benefit that the taxpayer receives for increasing this
year's spending is cut in half, and the MER is reduced to 4.6
percent.[Footnote 24] If the taxpayer anticipated that its future
spending would decline so much that it would not be able to earn any
credit in the next 3 years, then there would be no negative future
consequences from increasing this year's spending and the MER would be
9.1 percent. However, if a taxpayer does not expect to exceed its base
in the current year, even after increasing its spending by a marginal
amount, but plans to increase its future spending enough to earn
credits in the future years, then it would receive no current benefit
for that marginal spending. The taxpayers would still suffer the
negative effects in the future years, meaning that, in this case, the
MER would actually be negative.
Figure 3: Illustration of How Current Spending Increases Reduce Future
Credits Under the ASC:
[Refer to PDF for image: illustration]
This illustration depicts taxpayer marginal spending:
Spending on research that taxpayer would have done anyway: range is $1
million to $10 million.
Marginal spending in year 1:
Base amounts without the marginal spending in Year 1:
Increase in future base amounts due to the marginal spending: Causes an
increase in the base for the three following years that, in turn,
reduces the credit the taxpayer earns in those years.
Source: GAO.
[End of figure]
Given that the ASC base is only one-half of the taxpayer's past 3
years' average spending, most research-performing companies should be
able to earn some credit every year, which was an important reason why
this option was introduced. However, the low base is likely to be below
most taxpayer's ideal base and some are likely to earn credit on
substantial amounts of research spending that they would have done
anyway. There currently is no minimum base for the ASC to limit the
amount of windfall credit that taxpayers can earn. Only the lower
credit rate (14 percent vs. 20 percent for the regular credit) contains
the cost of these windfalls.
The Introduction of the ASC Option Is Likely to Have Lowered the Bang-
per-Buck of the Research Credit but Increased the Number of Taxpayers
Receiving Positive Incentives:
By applying the credit rules that existed immediately prior to the
introduction of the ASC to the historical data for our panel of
corporations and, then, applying the rules that existed in 2009, we
were able to compare how these taxpayers would have fared under the
different sets of options available. If we assumed a relatively low
discount rate and short length of carryforward (for those who could not
use their credits immediately), then the estimated weighted average MER
for our panel prior to the introduction of the ASC ranged between 7.4
percent and 8.3 percent, depending on which years of data we used and
whether the data related to before or after amendments and IRS exams.
[Footnote 25] If the ASC option had been available to these
corporations and they chose the credit option that provided them the
largest amount of credit, we estimate that their weighted average MER
would have been between 5.6 percent and 6.3 percent. (See table 14 in
appendix II.) This decline in the MER would have been accompanied by an
increase in the revenue cost of the credit of between about 17 percent
and 29 percent.[Footnote 26] These results indicate that the
introduction of the ASC lowered the bang-per-buck of the credit. The
availability of the new option would not have reduced any taxpayer's
windfall credit, but it would likely have increased the windfalls of
some. Those taxpayers that would have switched from the regular credit
to the ASC are likely to have seen their MERs decline, while those who
switched from the AIRC may have seen their MERs increase or decrease.
[Footnote 27]
Our estimates are based on an analysis of a fixed population of
corporations; it does not reflect the effects of the likely increase in
the number of taxpayers claiming the credit thanks to the lower base of
the ASC. The addition of these new claimants likely would have reduced
the credit's bang-per-buck further because they would all have the
lower MERs provided by the ASC. The MERs of these taxpayers would be
higher than the zero MERs they faced before the ASC was available;
however, the revenue cost of providing them with the credit, which also
was zero previously, would have increased as well.
Changing the Regular Credit to Reduce Distortions Caused by Base
Inaccuracies Would Come at the Cost of Reducing the Credit's Bang-per-
Buck:
The problems we identified with the base of the regular credit can be
addressed by either (1) eliminating the regular credit option or (2)
retaining the regular credit but updating its base so that the
distribution of credit benefits and incentives across taxpayers would
be less uneven and arbitrary. Under either of these approaches the
primary bases for all taxpayers would be linked to their recent
spending behavior, rather than decades-old behavior. The recent
behavior is likely to be more closely correlated with their ideal bases
than the older behavior would be.
The results of our simulations (summarized in the top portion of table
2) indicate that both of these changes would have approximately the
same effect because, in each case, all of the corporations in our panel
would use the ASC.[Footnote 28] (Details of our results are presented
in tables 15 and 16 in appendix II.) Under the first change, the ASC
would be the only option available; under the second change, all of the
taxpayers would receive larger amounts of credits under the ASC than
under the regular credit (except for those that could not earn either
credit), so they would voluntarily choose the ASC.[Footnote 29] In both
cases, if the rate of the ASC is kept at 14 percent, both the average
MER and the revenue cost would decrease, but the percentage decrease in
the average MER in most cases would be at least twice as large, meaning
that the credit's bang-per-buck would decrease. If the rate of the ASC
were raised to 20 percent, the average MER would increase relative to
existing rules under most combinations of assumptions, but the revenue
cost would increase to a much larger extent, again, meaning that the
bang-per-buck would decrease.
No clear purpose would be served by retaining both the ASC and a
regular credit whose base would be updated almost as frequently as that
of the ASC. If the bases for both of the options were linked to recent
spending behavior, there would be no rationale for providing taxpayers
with different rates of credit under two options. Moreover, once
taxpayers began to expect regular updates of the base, the expected
negative effects on future credits would lower the MER of the regular
credit in the same way that they do for the ASC. One potential
compromise between a frequently updated base that significantly reduces
the credit's bang-per-buck and a fixed base that causes distorting
disparities is to have a base that is updated only in those cases where
it has become evidently far out of line for individual taxpayers. For
example, taxpayers that spend less than 75 percent of their base amount
for the regular credit could be given the option of using a more recent
period of years for computing their fixed base percentage. Taxpayers at
the other extreme--those subject to the current minimum base--could be
required to use a more recent base period. Taxpayers between these two
extremes would not have their bases updated, which means that, if they
are not close to the minimum base, they would not face negative future
effects. However, one significant problem with this approach is that it
would give taxpayers who are close to being subject to the minimum base
an extremely large disincentive to increase their spending. In
addition, the taxpayers without updated bases would still face the
substantial recordkeeping difficulties that are discussed in a later
section.
Table 2: Summary Comparison of Leading Design Options:
Options for the ASC: No minimum base and credit rate = 14 percent;
Options for the regular credit: Eliminate the regular credit option:
Relative to 2009 law, this combination is likely to reduce both the
average MER and the revenue cost;
however, it is likely to reduce the average MER to a greater degree,
resulting in a decline in the credit's bang-per-buck; The benefit of
this combination is that it would significantly reduce unintended
disparities in MERs across taxpayers;
Options for the regular credit: Retain the option but update the
base[A]: If no minimum base were added to the ASC the short-term
results of updating the base of the regular credit would differ only
minimally from those of eliminating the regular credit because all
taxpayers in our panel would choose the ASC over the regular credit;
Over the longer term, until the base is updated again, the situation is
likely to gradually approach that which existed under 2009 law.
Options for the ASC: No minimum base and credit rate = 20 percent;
Options for the regular credit: Eliminate the regular credit option:
Raising the rate of the ASC to 20 percent would increase the revenue
cost significantly and also increase the average MER under most of the
combinations of assumptions we examined. The increases in the average
MER would be smaller than the increases in the revenue cost, again
resulting in a decline in the credit's bang-per-buck; This combination
would also significantly reduce unintended disparities in MERs across
taxpayers;
Options for the regular credit: Retain the option but update the
base[A]: Same as above in the short term. Over the longer term, there
should be a slower and smaller shift back to use of the regular credit
if the ASC rate is raised to 20 percent.
Options for the ASC: 50-percent minimum base and credit rate = 14
percent;
Options for the regular credit: Eliminate the regular credit option:
Relative to having only an ASC with no minimum base, this design is
likely to provide the same incentive at a lower revenue cost, thereby
providing a higher bang-per-buck;
Options for the regular credit: Retain the option but update the
base[A]: If the rate of the ASC were kept at 14 percent, some taxpayers
would choose the regular credit option over the ASC. Those taxpayers
receive a higher MER than they would with the ASC, raising the average
MER for the whole population; In the short run, before the inaccuracy
of the regular credit's base grows, unintended disparities in MERs
should be no worse than with the ASC only.
Options for the ASC: 50-percent minimum base and credit rate = 20
percent;
Options for the regular credit: Eliminate the regular credit option:
Same as immediately above;
Options for the regular credit: Retain the option but update the
base[A]: The results of this design would differ only minimally from
those of allowing only an ASC with a 20-percent rate and a 50-percent
minimum base because almost all taxpayers in our panel would choose the
ASC over the regular credit.
Options for the ASC: 75-percent minimum base and credit rate = 14
percent;
Options for the regular credit: Eliminate the regular credit option:
Under almost all assumptions we found the revenue savings to be less
than or equal to those gained by adding a 50-percent minimum base;
Options for the regular credit: Retain the option but update the
base[A]: If the rate of the ASC were kept at 14 percent, some taxpayers
would choose the regular credit option over the ASC. Those taxpayers
receive a higher MER than they would with the ASC, raising the average
MER for the whole population; In the short run, before the inaccuracy
of the regular credit's base grows, unintended disparities in MERs
should be no worse than with the ASC only.
Options for the ASC: 75-percent minimum base and credit rate = 20
percent;
Options for the regular credit: Eliminate the regular credit option:
Under almost all assumptions we found the revenue savings to be less
than or equal to those gained by adding a 50-percent minimum base;
Options for the regular credit: Retain the option but update the
base[A]: The results of this design would differ only minimally from
those of allowing only an ASC with a 20-percent rate and a 50-percent
minimum base because ASC users would still account for between and 90
percent of the total revenue cost of the credit.
Source: GAO.
[A] The minimum base for the regular credit would be 50 percent, except
in the last two cases where it would be 75 percent.
[End of table]
The Credit's Bang-per-Buck Can Be Improved by Adding a Minimum Base
Constraint to the ASC:
Results from simulations based on our panel database suggest that
adding a minimum base to the ASC is likely to improve its bang-per-
buck.[Footnote 30] The effects of adding a minimum base vary, depending
on whether both the ASC and regular option are retained, or only the
former. These variations are summarized in the lower portion of table 2
and further details are provided in tables 17, 18 and 19 in appendix
II.
Under most combinations of assumptions that we examined, when an ASC is
the only option available, an ASC with a 50-percent minimum base could
provide the same average MER as an ASC without a minimum base, but at a
lower revenue cost. In all but one unlikely case, the reductions in
discounted revenue cost ranged between 1.5 percent and 18 percent with
most exceeding 3 percent.[Footnote 31] Revenue savings would be
achieved regardless of whether the rate of the ASC is 14 percent or 20
percent. We also examined the effects of adding a 75-percent minimum
base; however, under almost all assumptions we found the revenue
savings to be less than or equal to those gained by adding a 50-percent
minimum base.
If both the ASC with a 14-percent rate and the regular credit with a 20-
percent rate and an updated base are available, the addition of a
minimum base to the ASC would cause some taxpayers to prefer the
regular credit over the ASC.[Footnote 32] Those regular credit users
would have higher MERs than they would have had under the ASC, so the
average MER would be higher if both options were available. Those
users' credit amounts would also be higher; however, the percentage
differences in their credits would be smaller than the percentage
differences in their MERs (see tables 18 and 19), meaning that the
credit's bang-per-buck would be slightly higher. However, this
advantage in terms of bang-per-buck would come at the cost of providing
unequal incentives across taxpayers without a rationale.
In addition to examining the effects of adding a minimum base to the
ASC we also simulated the effects of increasing the credit's base rate
(i.e., having the base equal to 75 percent or 100 percent of a
taxpayer's 3-year moving average of spending, rather than 50 percent as
under current rules). We found that these changes would significantly
increase the percentage of our panel corporations that have negative
MERs.
Issues of Contention between Taxpayers and IRS Relating to the Research
Credit Are Both Extensive and Acute:
Several Aspects of the Definition of Qualified Research Expenses Have
Been Significant Sources of Contention between Taxpayers and IRS:
A well-targeted definition of QREs (and IRS's ability to enforce the
definition) can improve the efficiency of the credit to the extent that
it directs the subsidy toward research with high external benefits and
away from research with low external benefits. By focusing the subsidy
in this manner, the definition can increase the amount of social
benefit generated per dollar of tax subsidy provided through the
credit. Specifying a definition that serves this purpose and that is
also readily applied by both IRS and taxpayers has proven to be a
challenge for both Congress and the Department of the Treasury. There
are numerous areas of disagreement between IRS and taxpayers concerning
what types of spending qualify for the research credit. These disputes
raise the cost of the credit to both taxpayers and IRS and diminish the
credit's incentive effect by making the ultimate benefit to taxpayers
less certain.
Many of the tax practitioners we interviewed had a common general
complaint that IRS examiners often demanded that the research
activities result in a higher standard of innovation than required by
either the IRC or Treasury regulations. The IRS officials we
interviewed disagreed with these assertions and referred to language
from their Research Credit Audit Technique Guide that instructs
examiners on the relevant language from current regulations. Both
practitioners and IRS officials acknowledged that some controversies
arise because language in the IRC and regulations does not always
provide a bright line for identifying qualified activities. For
example, one qualification requirement is that the research must be
intended to eliminate uncertainty concerning the development or
improvement of a business component. The regulations say that
uncertainty exists "if the information available to the taxpayer does
not establish the capability or method for developing or improving the
business component, or the appropriate design of the business
component.[Footnote 33]" An IRS official said that examiners could use
clarification of the meaning of "information available to the
taxpayer," while a practitioner noted that the regulations do not say
what degree of improvement in a product is required for the underlying
research to be considered qualified. The practitioner said that
research for improvements is more difficult to get qualified than
research for new products.
Several particularly contentious issues relate to specific types of
research activities or expenses, including the following:[Footnote 34]
The definition and qualification standards for internal-use software
(IUS). Research relating to the development of software for the
taxpayer's own internal use is generally excluded from qualified
research, unless it meets an additional set of standards that are not
applied to other research activities.[Footnote 35] The IRC provides
Treasury the authority to specify exceptions to this exclusion but
Treasury did not address this issue when it published final research
credit regulations in 2004. Treasury pointed to the significant changes
in computer software and its role in business activity since the mid-
1980s (when the IUS exclusion was added to the IRC) as making it
difficult to determine how Congress intended the new technology to be
treated. Meanwhile, tax practitioners complain that IRS continues to
consider most software development expenditures in the services
industry to be IUS.[Footnote 36] Some commentators have questioned
whether there is still an economic rationale for distinguishing between
IUS and software used for other purposes, given that innovations in
software can produce spillover benefits regardless of whether the
software is sold to third parties. IRS officials say that eliminating
the distinction would significantly increase the revenue cost of the
credit but they doubt that it would simplify administration. They
believe that a bright-line definition of IUS, such as that contained in
2001 proposed regulations, is the only practical approach for dealing
with this issue.[Footnote 37] The development of IUS regulations has
been included in all of Treasury's priority guidance plans since the
issue was left out of the final research credit regulations; however,
Treasury officials have not indicated when they are likely to be issued
or what stand they are likely to take.
Late-stage testing of products and production processes. Treasury
regulations provide that "the term research or experimental
expenditures does not include expenditures for the ordinary testing or
inspection of materials or products for quality control (quality
control testing)." However, the regulations clarify that "quality
control testing does not include testing to determine if the design of
the product is appropriate."[Footnote 38] Some tax consultants told us
that IRS fairly consistently disqualifies research designed to address
uncertainty relating to the appropriate design of a product. One of
them said that IRS rejected testing activities simply on the basis of
whether the testing techniques, themselves, were routine. IRS officials
said that they typically reject testing that is done after the taxpayer
has proven the acceptability of its production process internally. They
noted that there is no bright line between nonqualifying ordinary
quality control testing and qualified validation testing. These
determinations are made on a case-by-case basis for each activity. The
official also said that they have disagreements with taxpayers over
when commercial production begins and suggested that this is one area
where some further clarification in regulations might help. Product
testing is a particularly important issue for software development,
which in general (not just IUS) is another area of significant
contention between IRS and taxpayers.
Direct supervisory and support activities. Qualified research expenses
include the wages of employees who provide direct supervision or direct
support of qualified research activities. The practitioners we
interviewed said that it is extremely difficult to get IRS to accept
that higher level managers are often involved in research and the
direct supervision of research. Many of their clients have flat
organizational structures and the best researchers are often given
higher titles so that they can be paid more. They say that IRS often
rejects wage claims simply on the basis of job titles. IRS officials
told us that wages of higher level managers could be eligible for the
credit; however, the burden of proof is on the taxpayer to substantiate
the amount of time that those managers actually spent directly
supervising a qualified activity. Regarding the issue of direct
support, some commentators would like IRS's guidance to more clearly
state that activities such as bid and proposal preparation (at the
front end of the research process) and development testing and
certification testing (at the final stages of the process) are
qualified support activities that do not have to meet specific
qualification tests themselves, as long as the activities that they
support already qualify as eligible research. IRS officials told us
that they would like better guidance on this issue and were concerned
that some taxpayers want to include the wages of anyone with any
connection at all to the research, such as marketing employees who
attend meetings to talk about what customers want.
Supplies. The IRC specifically excludes expenditures to acquire
depreciable property from eligibility for either the deduction of
research expenditures under section 174 or for the research credit.
[Footnote 39] Taxpayers have attempted to claim the deduction or the
credit for expenditures that they have made for labor and supplies to
construct tangible property, such as molds or prototypes, that they
used in qualified research activities. IRS has taken the position that
such claims are not allowed (even though the taxpayers do not,
themselves, take depreciation allowances for these properties) because
the constructed property is of the type that would be subject to
depreciation if a taxpayer had purchased it as a final product.
[Footnote 40] IRS also says that it is also improper for taxpayers to
include indirect costs in their claims for "self-constructed supplies,"
even when the latter are not depreciable property.[Footnote 41]
Taxpayers are challenging IRS's position in at least one pending court
case.[Footnote 42] Both taxpayers and IRS examiners would like to see
clearer guidance in this area. Treasury has had a project to provide
further guidance under section 174 in its priority guidance plans since
at least 2005 but the guidance has not yet been issued. IRS has also
been concerned with the extent to which taxpayers have attempted to
recharacterize ineligible foreign research services contracts as supply
purchases.
The Lack of Official Guidance Regarding the Definition of Gross
Receipts for Controlled Groups of Corporations Leaves Those Taxpayers
Very Uncertain about Their Credit Benefits:
For taxpayers claiming the regular research credit the definition of
gross receipts is important in calculating the "base amount" to which
their current-year QREs are compared. The definition also was critical
for determining the amount of credit that taxpayers could earn with the
AIRC. (Even though this credit option is no longer available, a
decision regarding the definition of gross receipts will affect
substantial amounts of AIRC claims that remain in contention between
taxpayers and IRS for taxable years before 2009.) Gross receipts do not
enter into the computation of the ASC or the basic research credit. If
the regular credit is eliminated, this becomes a nonissue for future
tax years, but the consequences for taxpayers and the revenue cost to
the government from past claims will be substantial (particularly as a
result of the extraordinary repatriation of dividends in response to
the temporary incentives under IRC section 965).[Footnote 43]
The principal issue of contention between taxpayers and IRS is the
extent to which sales and other types of payments among members of a
controlled group of corporations should be included in that group's
gross receipts for purposes of computing the credit.[Footnote 44]
Neither the IRC nor regulations are clear on this point and IRS has
issued differing legal analyses in specific cases over the years.
IRS's current interpretation of the credit regulations that generally
exclude transfers between members of controlled groups is that it
applies only to QREs and not to gross receipts; consequently, all
intragroup sales should be included when computing a group's total
gross receipts. This option would eliminate any double-counting of QREs
but could overstate the resources available to the group by double-
counting sales and income payments between group members. However,
going to the other extreme and excluding all intragroup transactions
from the group's total gross receipts could exclude a large share of
the export sales of U.S. multinational corporations (those made to
foreign affiliates for subsequent resale abroad) from gross receipts.
This result would favor regular credit users whose export sales have
increased as a share of their total sales and disfavor users whose
export shares have declined. These disparities in the credit benefits
across taxpayers serve no useful purpose.
An intermediate alternative would be to exclude all transactions
between controlled group members except for intermediate sales by U.S.
members to foreign members. This approach would not discriminate among
taxpayers on the basis of whether they export their products or sell
them domestically because it would include all sales that are
effectively connected with the conduct of a trade or business within
the United States in a group's gross receipts. This option would also
eliminate any double-counting of intragroup transfers in gross
receipts, which is important if Congress wishes to continue using gross
receipts as a measure of the resources available to corporations.
Substantiating the Validity of a Research Credit Claim Is a Demanding
Task for Both Taxpayers and IRS:
Neither the IRC nor Treasury regulations contain specific recordkeeping
requirements for claimants of the research credit. However, claimants
are subject to the general recordkeeping rules of IRC section 6001 and
Treasury regulations section 1.6001, applicable to all taxpayers, that
require them to keep books of account or records that are sufficient to
establish the amount of credit they are claiming. In the case of the
research credit, a taxpayer must provide evidence that all of the
expenses for which the credit is claimed were devoted to qualified
research activities, as defined under IRC section 41. Section 41
requires that the qualification of research activities be determined
separately with respect to each business component (e.g., a product,
process, or formula), which means that the taxpayer must be able to
allocate all of its qualified expenses to specific business components.
Moreover, the taxpayer must be able to establish these qualifications
and connections to specific components not only for the year in which
the credit is being claimed, but also for all of the years in its base
period.
There were wide difference in opinions between the IRS examiners and
the tax practitioners we interviewed regarding what methods are
acceptable for allocating wages between qualifying and nonqualifying
activities. Practitioners noted that IRS prefers project accounting
but, in its absence, used to accept cost center or hybrid accounting;
however, in recent years, IRS has been much less willing to accept
claims based on the latter two approaches.[Footnote 45] They also said
that IRS examiners now regularly require contemporaneous documentation
of QREs, even though this requirement was dropped from the credit
regulations in 2001. Some practitioners suggested that the changes in
IRS's practices came about because examiners were having difficulty
determining how much QREs to disallow in audits when they found that a
particular activity did not qualify. Others said that IRS does not want
to devote the considerable amounts of labor required to review the
hybrid documentation. The IRS officials we interviewed said that more
taxpayers have or had project accounting than was suggested by the tax
practitioners. The officials said that the consultants ignored these
accounts because they boxed them in (in terms of identifying qualified
research expenses). In their view the high-level surveys and interviews
of managers or technical experts from the business, which many
taxpayers try to use as evidence, are not a sufficient basis for
identifying QREs. The officials noted that sometimes consultants
conduct interviews for one tax year and then extrapolate their results
to support credit claims for multiple earlier tax years.
IRS officials have been particularly concerned with the quality of late
or amended filings of credit claims. In April 2007, IRS designated
"research credit claims" as a Tier I compliance issue because of the
volume and difficulty of auditing these claims.[Footnote 46] In
announcing the designation IRS noted that a growing number of credit
claims were based on marketed tax products supported by studies
prepared by the major accounting and boutique tax advisory firms. IRS
officials expressed concern that when taxpayers submit amendments to
their IRS Forms 6765, they often do so late in an audit after IRS has
already spent significant time reviewing the initial claims. In many
cases the taxpayers settle for 50 cents on the dollar as soon as IRS
challenges a claim.
Although most of the tax practitioners we interviewed acknowledged that
there was a proliferation of aggressive and sometimes sloppy research
credit claims, they pointed to many legitimate reasons for companies to
file claims on amended returns, including long-standing uncertainties
and changes in the research tax credit regulations. The practitioners
say that IRS's standards are stricter than Congress intended and what
has been allowed in recent court cases. IRS disagrees and says its
administrative practices are consistent with the court rulings.
[Footnote 47]
The burden of substantiating research credit claims represents a
significant discouragement to potential credit users; however, the
flexibility in substantiation methods that many practitioners seek
could help some taxpayers claim larger credits than those to which they
are entitled. Although some taxpayers, particularly those for which
research activities constitute a large proportion of their total
operations, are able to meet the recordkeeping standards that IRS is
currently enforcing, many taxpayers would find it extremely burdensome
to meet these requirements. One consulting firm told us that they
recently tried to shift all of their clients to project accounting.
This effort was successful; however, it was extremely difficult for the
businesses. Other practitioners said that many taxpayers simply would
not take on such an effort just to claim the credit. Allowing taxpayers
to allocate their expenses between qualified and nonqualified
activities after the fact and, in part, on the basis of oral testimony
of the taxpayers' experts would be less burdensome for businesses than
requiring contemporaneous time accounting by type of activity and by
specific project. However, the experts would have an incentive to
overstate the proportion of labor costs identified as QREs and IRS
would have no way to verify these oral estimates. Treasury and IRS face
a difficult trade-off between, on the one hand, increasing taxpayer
compliance burdens and deterring some taxpayers from using the credit
and, on the other hand, accepting overstated credit claims.
Substantiating Base Period QREs Is Extremely Challenging:
All of the difficulties that taxpayers face in substantiating their
QREs are magnified when it comes to substantiating QREs for the
historical base period (1984 through 1988) of the regular credit.
Taxpayers are required to use the same definitions of qualified
research and gross receipts for both their base period and their
current-year spending and receipts. However, many firms do not have
good (if any) expenditure records dating back to the early 1980s base
period and are unable to precisely adjust their base period records for
the changes in definitions promulgated in subsequent regulations and
rulings. Taxpayers also have great difficulty adjusting base period
amounts to reflect the disposition or acquisition of research-
performing entities within their tax consolidated groups. Some
practitioners would like to see some flexibility on IRS's part in terms
of base period documentation. They noted that in cases where a
taxpayer's records are missing or otherwise lacking, courts have
permitted taxpayers to prove the existence and amount of expenditure
through reasonable estimation techniques. The IRS officials we
interviewed said that estimates are allowable only if the taxpayer
clearly establishes that it has engaged in qualified research and that
its estimates have a sufficiently credible evidentiary basis to ensure
accuracy. One official noted that IRS not likely to question a
taxpayer's base amount if the latter uses the maximum fixed base
percentage; however, he did not think that IRS would have the authority
to say that taxpayers could take that approach without showing any
records at all for the base period. Neither IRS nor Treasury officials
we interviewed saw any administrative problems arising if the IRC were
changed to relieve taxpayers of the requirement to maintain base period
records if they used the maximum fixed base percentage.[Footnote 48]
Taxpayers Would Benefit from Greater Flexibility in Electing the ASC
Option:
Treasury regulations provide that elections to use the ASC or the AIRC
must be made on an original timely filed return for the taxable year
and may not be made on a late filed return or an amended return.
[Footnote 49] Some commentators on the regulations have questioned the
need for such limitations on taxpayers' ability to make the elections,
which they note the IRC does not specify. These commentators see no
reason why taxpayers who do not claim a credit until they file an
amended return are permitted to claim the regular credit but not the
ASC. They also believe that taxpayers should be allowed to change their
election if, as a result of an audit, IRS adjusts the amount of QREs or
base QREs in a manner which would make an alternative election more
advantageous to the taxpayer.
Treasury officials whom we interviewed said the legal "doctrine of
election" indicates that taxpayers must remain committed to their
choice once they have made their credit election.[Footnote 50] If
taxpayers are unhappy with the form of credit, they can choose another
form for the following tax year. Allowing taxpayers to elect different
forms of the credit on amended returns in response to an audit in order
to maximize their credit would create administrative burdens for IRS.
IRS officials agreed that permitting changes in credit elections could
require examiners to audit some taxpayers' credits twice; however, they
saw no problem with allowing taxpayers to claim either alternative
credit on an amended return if the taxpayer had not previously filed a
regular credit claim for the same tax year.
Taxpayers that fail to claim the research credit on timely filed tax
returns are materially disadvantaged by the election limitations that
apply to any subsequent claims they file on amended returns. There
appears to be no reason to prohibit taxpayers from electing either the
ASC or AIRC method of credit computation on an amended return for a
given tax year, as long as they have not filed a credit claim using a
different method on an earlier return for that same tax year.
Existing Rules for Allocating Group Credits Are Unnecessarily
Burdensome:
Under current Treasury regulations, the controlled group of
corporations must, first, compute a "group credit" by applying all of
the credit computational rules on an aggregate basis. The group must
then allocate the group credit amount among members of the controlled
group in proportion to each member's "stand-alone entity credit." The
stand-alone entity credit means the research credit (if any) that would
be allowed to each group member if the group credit rules did not
apply. Each member must compute its stand-alone credit according to
whichever method provides it the largest credit for that year without
regard to the method used to compute the group credit. The consultants
with whom we discussed this issue agreed that the rules were very
burdensome for those groups that are affected because it forces all of
their members to maintain base period records for the regular credit,
even if they would like to use just the ASC.[Footnote 51] Some very
large corporate groups must do these computations for all of their
subsidiaries, which could number in the hundreds, and they have no
affect on the total credit that a group earns.
Treasury maintains that a single, prescribed method is necessary to
ensure the group's members collectively do not claim more than 100
percent of the group credit. Treasury also maintains that the stand-
alone credit approach is more consistent with Congress's intent to have
an incremental credit than is the gross QRE allocation method that
others have recommended.[Footnote 52] In specifying that controlled
groups be treated as single taxpayers for purposes of the credit
Congress clearly wanted to ensure that a group, as a whole, exceeded
its base spending amount before it could earn the credit. It is not
clear that Congress was concerned that each member has an incentive to
exceed its own base. The reason for having a base amount is to contain
the revenue cost of the credit by focusing the incentive on marginal
spending. In the case of controlled groups the cost is controlled at
the group level; whether individual members exceed their own bases has
no bearing on the cost of the credit. If the choice between two
allocations methods does not affect the revenue cost, then the
remaining questions follow:
1. Does one of the methods provide a greater incentive to increase
research spending?
2. Is one significantly less burdensome to taxpayers and IRS?
For groups in which individual members determine their own research
budgets, neither the stand-alone credit allocation method nor the gross
QRE allocation method is unequivocally superior in terms of the
marginal incentives that they provide to individual members. Each of
the two methods performs better than the other in certain situations
that are likely to be common among actual taxpayers.[Footnote 53] Data
are not available that would allow us to say whether one of the methods
would result in higher overall research spending than the other. For
those groups in which the aggregate research spending of all members is
determined by group-level management, the only way that the allocation
rules can affect the credit's incentive is if they allow the shifting
of credits from members without current tax liabilities to those with
tax liabilities. If the group credit is computed according to the
method that yields the largest credit, then an additional dollar of
spending by any group member will increase the group credit by the same
amount, regardless of how the group credit total is allocated among
members.
The gross QRE allocation method is much less burdensome for controlled
groups and for IRS than the stand-alone method because it does not
require anyone to maintain base-period records for the regular credit,
unless they choose to use that credit themselves. If the regular credit
were eliminated, the burden associated with the stand-alone method
would be reduced considerably; however, it would still require more
work on the part of taxpayers and IRS than would the gross QRE method.
Conclusions:
Two significant concerns arise from the lack of any update of the
regular credit's base since it was introduced in 1989. First, the
misallocation of resources that can result from the uneven distribution
of both marginal incentives and windfall benefits across taxpayers
could lead to missed opportunities for the country to benefit from
research projects with higher social rates of return. Second, the
requirement to maintain detailed records from the 1980s, updated for
subsequent changes in law and regulations, represents a considerable
compliance burden for regular credit users (including some that are
required to use that option). Regular updates of the base would
substantially reduce these problems; however, no clear purpose would be
served by retaining both the ASC and a regular credit, the base of
which would be updated almost as frequently as that of the ASC.
Unfortunately, neither of the problems can be avoided without a
reduction in the credit's bang-per-buck. The addition of a minimum base
to the ASC would likely improve the bang-per-buck of that credit (the
extent would depend on certain estimating assumptions) and also reduce
inequities in the distribution of windfall credits.
The research credit presents many challenges to both taxpayers and IRS.
In a number of areas, current guidance for identifying QREs does not
enable claimants or IRS to make bright-line determinations. In some of
these areas further clarification is possible; in others ambiguity may
be difficult to reduce. In some cases, drawing lines that make the
definition of QREs more liberal would likely result in the credit being
less well-targeted to research with large spillover benefits to
society. Instead, the credit would be shifted toward a broader subsidy
for high-tech jobs or manufacturing in general. Documenting and
verifying that particular expenses are qualified for the credit involve
considerable resource costs on the part of taxpayers and IRS. Moreover,
widespread disagreements between IRS and taxpayers over the adequacy of
documentation leave many taxpayers uncertain about the amounts of
credit they will ultimately receive. Recordkeeping burdens may
discourage some taxpayers from using the credit and the uncertainty
reduces the credit's effective incentive. Relaxing recordkeeping
requirements would alleviate these problems; however, there remains a
risk that such a relaxation could significantly increase the amount of
credit provided for spending of questionable merit. Despite the current
wide gap between the views of taxpayers and IRS, there may be
opportunities to reduce certain burdens without opening the door to
abuse. At a minimum, an organized dialogue among Treasury, IRS, and
taxpayers should be able to reduce some uncertainty over what types of
documentation are acceptable.
Matters for Congressional Consideration:
In order to reduce economic inefficiencies and excessive revenue costs
resulting from inaccuracies in the base of the research tax credit,
Congress should consider the following two actions:
* Eliminating the regular credit option for computing the research
credit.
* Adding a minimum base to the ASC that equals 50 percent of the
taxpayer's current-year qualified research expenses.
If Congress nevertheless wishes to continue offering the regular
research credit to taxpayers, it may wish to consider the following
three actions to reduce inaccuracies in the credit's base and to reduce
taxpayers' uncertainty and compliance costs and IRS's administrative
costs:
* Updating the historical base period that regular credit claimants use
to compute their fixed base percentages.
* Eliminating base period recordkeeping requirements for taxpayers that
elect to use a fixed base percentage of 16 percent in their computation
of the credit.
* Clarifying for Treasury its intent regarding the definition of gross
receipts for purposes of computing the research credit for controlled
groups of corporations. In particular it may want to consider
clarifying that the regulations generally excluding transfers between
members of controlled groups apply to both gross receipts and QREs and
specifically clarifying how it intended sales by domestic members to
foreign members to be treated. Such clarification would help to resolve
open controversies relating to past claims, even if the regular credit
were discontinued for future years.
Recommendations for Executive Action:
In order to allow more taxpayers to benefit from the reduced
recordkeeping requirements offered by the ASC option, the Secretary of
the Treasury should take the following two actions:
* Modify credit regulations to permit taxpayers to elect any of the
computational methods prescribed in the IRC in the first credit claim
that they make for a given tax year, regardless of whether that claim
is made on an original or amended tax return.
* Modify credit regulations to allow controlled groups to allocate
their group credits in proportion to each member's share of total group
QREs, provided that all group members agree to this allocation method.
In order to significantly reduce the uncertainty that some taxpayers
have about their ability to earn credits for their research activities,
the Secretary of the Treasury should take the following six actions:
* Issue regulations clarifying the definition of internal-use software.
* Issue regulations clarifying the definition of gross receipts for
purposes of computing the research credit for controlled groups of
corporations.
* Issue regulations regarding the treatment of inventory property under
section 174 (specifically relating to the exclusion of depreciable
property and indirect costs of self-produced supplies).
* Provide additional guidance to more clearly identify what types of
activities are considered to be qualified support activities.
* Provide additional guidance to more clearly identify when commercial
production of a qualified product is deemed to begin.
* Organize a working group that includes IRS and taxpayer
representatives to develop standards for the substantiation of QREs
that:
- can be built upon taxpayers' normal accounting approaches,
- but also exclude practices IRS finds of greatest threat to
compliance, such as high-level surveys and claims filed long after the
end of the tax year in which the research was performed.
Agency Comments:
We provided a draft of this report to the Secretary of Treasury and the
Commissioner of IRS in September 2009. In written comments the Acting
Assistant Secretary (Tax Policy) agreed that the credit's structure
could be simplified or updated in certain respects to improve its
effectiveness. He also agreed that the issuance of guidance relating to
the definition of gross receipts, the treatment of inventory property
under section 174, and the definition of internal use software will
enhance the administration of the credit and Treasury plans to provide
additional guidance in the next few months. The Acting Assistant
Secretary said that the Administration's priority is to make the credit
permanent. His letter is reprinted in appendix VIII. Treasury and IRS
officials also provided technical comments that we have addressed as
appropriate.
As we agreed with your offices, unless you publicly announce the
contents of this report, we plan no further distribution of it until 30
days from the date of this letter. This report is available at no
charge on GAO's web site at [hyperlink, http://www.gao.gov]. If you or
your staff have any questions on this report, please call me at (202)
512-9110 or whitej@gao.gov. Contact points for our Office of
Congressional Relations and Public Affairs may be found on the last
page of this report. Key contributors to this report are listed in
appendix VIII.
Signed by:
James R. White:
Director Tax Issues:
Strategic Issues:
[End of section]
Appendix I: Scope and Methodology:
Computation of the Marginal Effective Rate of Credit:
The Regular Credit Case:
If a taxpayer's marginal spending in the current tax year leaves its
total qualified spending above its base spending (but not equal to two
or more times the base amount determined by its fixed base percentage),
the marginal benefit the taxpayer receives from the regular credit
equals:
0.2 × 0.65 × marginal spending,
The factor of 0.65 reflects the fact that the taxpayer must either
elect to reduce its credit by 35 percent or reduce the size of its
section 174 deduction for research spending by the amount of the
credit. In either case, for taxpayers subject to the typical 35 percent
corporate income tax rate, the benefit of the credit is reduced by 35
percent. In addition, if the taxpayer cannot use all of its credit in
the current tax year or carry it back to use against last year's taxes,
then the net present value of the benefit is reduced according to the
following formula:
Discounted benefit = (0.2 × 0.65 × marginal spending) × (1 + r)-Y0 ,
where r is the taxpayer's discount rate and y0 is the number of years
before the taxpayer is able to use the credit.
If a taxpayer's marginal spending in the current tax year leaves its
total qualified spending equal to two or more times the base amount
determined by its fixed base percentage, the discounted marginal
benefit the taxpayer receives from the regular credit equals:
(0.1 × 0.65 × marginal spending) × (1 + r)-Y0,
because each additional dollar of spending raises the taxpayer's base
by 50 cents. Consequently, the taxpayer's benefit is effectively cut in
half.
If the taxpayer's total current-year spending is less than its base
spending (even after the marginal spending), then:
Current benefit = 0.
The Alternative Simplified Credit Case - Current year Effects:
Under the alternative simplified credit (ASC) a taxpayer may receive a
benefit in the current tax year by spending additional (also known as
marginal) amounts on qualified research in that year. However, this
additional spending also reduces the potential tax benefits that the
taxpayer can earn in the 3 succeeding years. The marginal effective
rate (MER) measures the net present value of the current tax benefit
and the reductions in future tax benefits resulting from the firm's
additional spending on research, all as a percentage of the additional
spending.
Current-Year Benefit:
If the taxpayer's total current-year spending is greater than its base
spending, then:
Current benefit = 0.14 × 0.65 × marginal spending × (1 + r)-Y0.
If the taxpayer's total current-year spending is less than its base
spending (even after the marginal spending), then:
Current benefit = 0.
The Alternative Simplified Credit Case - Future-Year Effects:
Given that the base spending amount for the next tax year equals half
of the taxpayer's average research spending in the current year and the
2 immediately preceding years, the marginal spending in the current
year can reduce the value of the credit benefit the taxpayer can earn
next year as follows:
Benefit reduction next year = -(1/3) × 0.5 × 0.65 × 0.14 × current-year
marginal spending × (1 + r)-Y1.
The value of y1 equals 1 if the credit that the taxpayer loses in the
next year could have been used that year. If that lost credit could not
have been used until a later year anyway, then y1 equals the number of
years between the current tax year and the year in which the lost
credit could have been used.
If the taxpayer's total qualified spending next year is less than its
base spending (even after the marginal spending), then:
Benefit reduction next year = 0.
Benefit reductions in the second and third years into the future are
computed in a similar manner.
The Complete MER:
Combining all of the effects described above yields the following
formula for a taxpayer that exceeds its base spending every year:
MER = {0.091 × marginal spending × [(1 + r)-Y0 - (1/6) × (1 + r)-Y1 -
(1/6) × (1 + r)-Y2 - (1/6) × (1 + r)-Y3]} / marginal spending.
If a taxpayer's total qualified spending is less than its base spending
in any of the four years covered by this formula, then the "(1 + r)"
term associated with that year would be set equal to zero.
Computation of the Discounted Revenue Cost:
To compute the discounted revenue cost we first compute the net credit
(after the offset against the section 174 deduction or the election of
a reduced credit) that each taxpayer would earn under existing or
hypothetical credit rules, based on their current qualified research
expenses (QREs), base QREs, and if relevant, gross receipts. We then
use data from each taxpayer's Form 3800 to estimate the amount, if any,
of research credit that the taxpayer could use immediately and the
amount, if any, that it had to carry forward to future years. In cases
where the credit had to be carried forward, we used ranges of
assumptions for both discount rates and number of years carried forward
(see sensitivity discussion below) to discount the value of credit
amounts used in future years.
Data Used for the Computations:
Full Population Data:
We based our estimates of credit use by the full population of
corporate taxpayers on the Statistics of Income (SOI) Division's sample
of corporate tax returns for 2003, 2004, and 2005. For 2003 and 2004 we
were able to fill in some data that were missing for a few large credit
claimants by using data we obtained from Internal Revenue Service (IRS)
examiners for our panel database. For all 3 years we adjusted the data
for members of controlled groups to avoid the double counting of QREs
and gross receipts (see discussion below for further detail).
The Panel Database of the Largest Credit Users:
We began the construction of our panels by selecting all corporations
that met either of the following criteria:
The corporation's total QREs had to account for at least 0.2 percent of
aggregate QREs for all firms in SOI's annual samples for either 2003 or
2004; or:
The corporation's total grossed-up credit (meaning prior to any
reduction under section 280(c)) had to account for at least 0.2 percent
of aggregate grossed-up credits for all firms in SOI's annual samples
for either 2003 or 2004.
We attempted to obtain a complete set of tax returns from 2000 through
2004 for each corporate taxpayer that met our panel criteria for either
2003 or 2004. In addition, we tried to keep the scope of each corporate
taxpayer over the 5 years to be as consistent as possible with that
taxpayer's scope as of 2003 and 2004. (This consistency is important
because we wanted the 5-year history of QREs for each taxpayer to
closely represent the spending histories that they would actually have
used for computing their moving-average base expenditures if the ASC
had been in place for 2003 and 2004.)
We constructed time series records for each taxpayer by linking the
data from the taxpayer's returns from 2000 through 2004 by the Employer
Identification Number (EIN) that SOI included in each year's tax return
record. In some cases a taxpayer's time series was reported under more
than one EIN over the period. This discontinuity usually occurred in
cases of a corporate reorganization, such as a merger or spin-off. In
cases where we did not find a complete 5-year set of tax returns for
one of the EINs selected into our panel, we searched to see if we could
find the missing returns under a different EIN. We focused our search
on cases where taxpayers had reported substantial amounts of research
credits or QREs for tax years early in our period and then they stopped
appearing in SOI's corporate sample (because they stopped filing a
return under their initial EIN). For example, we examined the cases of
taxpayers that filed returns in 2000 and 2001 and then stopped filing
returns to see if they were related to cases in our panel for which we
were missing tax returns for those 2 years. If the companies that
stopped filing returns were not related to any companies for which we
were missing returns, we then checked to see if they were related to
any other members of our panel (because they might have been merged
into an ongoing corporation that kept the same EIN before and after the
merger). Conversely, if the panel member for which we were missing
early-year tax returns did not match up with any cases that had stopped
filing after those years, we checked to see if that panel member had
been spun off of any other panel member (meaning that it was once
included in the consolidated tax return of the other panel member and
than was either sold off or became deconsolidated and filed its own
return). We did a similar examination for companies that showed
dramatic changes in the level of their QREs from one year to the next.
We extended our search for potential merger and spin-off candidates to
any companies in the annual SOI samples that accounted for at least 0.1
percent of either QREs or grossed up credit in any year from 2000
through 2004. In this manner we identified a number of pairs of
taxpayers that combined with or split off from one another during our
panel period. We could usually confirm these corporate changes from
publicly available information on the Internet, but we also had the IRS
examiners review our linkages. In order to ensure that we did not miss
any significant mergers or splits among our panel members, we asked the
Large and Mid-Sized Business (LMSB) Division examiners that reviewed
each case to identify any that we may have missed.
We made the following adjustments to ensure the consistency of spending
histories in cases where we had identified significant corporate
reorganizations within our panel members:
* In cases in which one of our panel members in 2003 or 2004
encompassed an entity that had filed its own tax return in an earlier
year during the panel period, we added the QREs that the former return
filer had reported for that year to the QREs that our panel member had
reported in the same year (because those QREs of the formerly separate
entity would be included in the panel member's moving average base
amount under the ASC).
* In cases in which one of our panel members in 2003 or 2004 had sold a
subsidiary or spun off some other entity that had been included in its
consolidated tax return in an earlier year of our panel period. We
subtracted the estimated QREs of that spun-off entity from the panel
member's QREs for that earlier year. (We assumed that the spun-off
entity's share of total QREs in the earlier year was the same
proportion as the following ratio: The spun-off entity's QREs in the
first year that it filed its own return, divided by the sum of the spun-
off companies QREs plus the QREs of the corporation from which it had
been spun off.)
By making these adjustments, we were able to create reasonably
consistent spending histories for those cases where we had identified
(on our own or with the assistance of IRS examiners) significant
corporate reorganizations in our panel population. In a number of cases
we concluded that we did not have sufficient information to construct
reliably consistent time series and we, therefore, dropped those cases
from our panel.
Although we believe that we have accounted for all major mergers and
splits within our panel members, we cannot be sure that we have
accounted for all smaller acquisitions or dispositions that may have
affected the consistency of the individual spending histories within
the panel. For this reason, we ran a sensitivity analysis in which we
examined the effects on our results of altering the relationship
between current and base QREs for each taxpayer (see below).
Adjusting for Group Credits:
Taxpayers that are subject to the group credit rules are required to
file their own Form 6765 on which they report their group's aggregate
values for QREs, base QREs, and gross receipts; however, the credit
amount reported on each member's form is that member's share of the
total group's credit. (See appendix VII for an explanation of how these
shares are computed.) Whether or not a member can actually use a group
credit depends on its own tax position for the year, not on an
aggregated group tax position.
We used several indicators to identify potential group credit
claimants, based on the reporting requirements described above. First,
for claimants of the regular credit we computed the ratio of the amount
of credit they claimed, divided by the difference between their current
QREs and their base QREs. If this ratio was a value other than 0.13 or
0.2, we flagged the case as a potential group member. Second, for
claimants of the alternative incremental research credit (AIRC), we
computed the ratio of the credit they actually claimed over the amount
of credit that they could have claimed if all of the QREs and gross
receipts reported on their 6765 were their own. If this ratio was other
than 1 or 0.65, we flagged the case as a potential group claimant.
Third, we also searched the SOI databases for groups of cases that
reported the same exact amounts of QREs in a given year.
For the purpose of calculating the ASC for group members we gave each
member of a group the group's aggregate spending history and gross
receipts history; however, each member had its own amount of research
credit claimed and its own values for the variables taken from the
general business credit form. In order to avoid double-counting (or
more) the QREs of the groups or giving them too much weight when
computing our weighted average effective rates of credit, we created a
variable named CREDSHR, which we then used to assign each group member
only a fraction of the group's total QREs or weighting in the effective
rate calculation.
The value of CREDSHR for each group member is equal to the ratio of the
amount of research credit that the member claimed over the aggregated
amount of credit that the group would be able to claim, based on the
group's aggregated QREs and base QREs or gross receipts. In other
words, we gave each member a share of the group's QREs that was
proportionate to its share of the group's total credit. Although this
allocation method is not precisely derived from the group credit
allocation regulations, it should yield a close approximation of the
true distribution of QREs across group members. We do not have the
detailed attachments to Form 6765 that show exactly what each group
member's QREs and gross receipts were. In most cases the sum of CREDSHR
for all members of a group in our panel population was approximately
equal to 100 percent. When the sum did not reach 100 percent we assumed
that there are other members who were not represented in the SOI sample
for a given year. The absence of these missing members does not affect
the validity of the computations for the group members we had; it
simply means that the missing members were treated as any other company
that did not meet the criteria for inclusion in our panel.
Because some taxpayers in the panel belonged to controlled groups that
together determined the amount of qualified spending in 2003 or 2004,
we adjusted for the composition of these groups when we assembled the
panel. In particular, spending and other variables were adjusted to
hold constant the group's composition in 2003 or 2004, the 2 years for
which credit was computed. This was accomplished in several ways.
First, the SOI data allowed us to identify certain controlled groups
from duplications in the amount of reported spending. Second, we
researched mergers, acquisitions and dispositions for these firms from
2000 through 2004, or the years for which we constructed the panel.
Third, we requested confirmation of our knowledge about these
controlled groups from LMSB, in addition to any other information about
the groups' composition that LMSB might have had. Clearly, constructing
the panel involved balancing trade-offs between the number of users and
the availability of data.
Key Assumptions and Sensitivity Analyses:
We tested the sensitivity of our results to variations in assumptions
or observations concerning the following factors:
Future credit status--The MER for the ASC depends, in part, on whether
the taxpayer anticipates being able to earn the credit in each of the
next 3 years and, if so, whether that taxpayer would be subject to a
minimum base constraint. In order to predict the status for a given
taxpayer in a given future year, we needed to predict, within a certain
range,[Footnote 54] the ratio of spending in that year to the average
of spending for the 3 years preceding that year. Our baseline
prediction was that the probability of a taxpayer moving from one
particular ratio range into another specific ratio range was equal the
probability of such a move that we observed in our historical data. We
used Markov chains of probabilities to predict changes in status two
and three years into the future. In our sensitivity analysis, we
examined 12 alternative sets of probabilities. For example, in one
alternative all taxpayers were less likely to move into a higher range
of ratios than they would have been with the observed probabilities.
Switching probabilities--In choice scenarios, we were required to
estimate the probability of switching from one credit to another in
future years, which has the potential to influence the effect of
research spending in 2003 or 2004 on the amount of credit earned in
subsequent years for which data are not available. In our sensitivity
analysis, we allowed the probability of switching from the ASC to the
Regular Credit from one year to the next to be higher or lower than our
baseline estimate (which was based on simulated behavior from 2003 to
2004). We did the same for the probability of switching from the
Regular Credit to the ASC from one year to the next, and we
incorporated all four possible combinations of deviations from the
baseline.
Discount rate--At higher rates of discount, credit that is carried
forward to be claimed in subsequent years is worth less in present
value terms in 2003 or 2004. Additionally, at higher discount rates,
the effect of spending in 2003 or 2004 on the amount of credit earned
in subsequent years is mitigated, since credit earned in subsequent
years is worth less in present value terms in 2003 and 2004 at higher
rates of discount. In our sensitivity analysis, we allowed the discount
rate to vary between 4 percent and 8 percent.
Carryforward length--The model required an assumption about the number
of years that credit would be carried forward. (The Research Tax Credit
stipulates that credit that cannot be claimed in the year in which it
is earned may be carried forward for up to 20 years.) Lacking data on
carryforward patterns, we based our assumption about the length of the
carryforward period on behavior that was "observed" as part of the
simulation. For example, in some cases we could simulate the taxpayer's
carryforward status in both 2003 and 2004. If this taxpayer were
observed to carry forward credit in both years as part of this
simulation, it would have a longer carryforward period than if it were
observed to carry forward credit in one year or the other, or if it
were observed not to carry credit forward at all. In our sensitivity
analysis, we allowed the longest carryforward period to vary between 2
and 10 years in length.
The relationship between current and base QREs--We tested how our
estimates for the ASC would differ if the spending histories for our
panel corporations were significantly different from what we observed.
To do this, we estimated what the MERs and discounted revenue costs
would be if the ratio of each taxpayer's current QREs to base QREs were
10 percent higher and 10 percent lower than the observed amounts.
Another aspect of our sensitivity analysis involved using of data from
different stages in the taxpaying process. We used data from original
returns, and from amended and audited returns, where applicable.
[End of section]
Appendix II: Data Relating to the Use of the Research Tax Credit by
Corporations:
Figure 4: Distribution of Claimants, Qualified Research Expenses, and
Net Credits, by Size of Taxpayer, 2003 to 2005:
[Refer to PDF for image: stacked vertical bar graph]
Share of claimants:
Year: 2003;
Business receipts < $5 million: 3.1%;
$5 million
