GAO 

United States Government Accountability Office

Report to the Committee on Finance, 

U.S. Senate 

TAX POLICY

The Research Tax 

Credit’s Design and 

Administration Can Be 

Improved 

November 2009 

GAO-10-136 
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

November 2009

TAX POLICY

The Research Tax Credit's Design and Administration 

Can be Improved 

Highlights of GAO-10-136, a report to 

Committee on Finance, U.S. Senate 

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 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. 

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. 

An Illustration of How Base Design Affects Windfall Credits

Source: GAO.

Qualified research spending

A 20% flat credit (with no base)

Taxpayer’s marginal 

spending

Spending on research 

that taxpayer would 

have done anyway Revenue cost: $220 Revenue cost: $20

$100

$1,000

$100

$1,000

$20$20

Marginal

incentive

(20% of $100)

Marginal

incentive

(20% of $100)

Windfall

credit

(20% of $1,000)

$200

Windfall

credit

An incremental 20% credit 

with a $1,000 base

$100

$1,000

View GAO-10-136 or key components.

For more information, contact James White at 

(202) 512-9110 or whitej@gao.gov. 
Page i GAO-10-136 

Contents 

Letter 1

Background 3 

Large Corporations Have Dominated the Use of the Research 

Credit, Which Provided an Average Marginal Incentive of About 

7 Percent in 2003 through 2005 13 

Important Trade-Offs Exist in the Choice of Research Credit 

Designs 16 

Issues of Contention between Taxpayers and IRS Relating to the 

Research Credit Are Both Extensive and Acute 25 

Conclusions 38 

Matters for Congressional Consideration 39 

Recommendations for Executive Action 39 

Agency Comments 40 

Appendix I Scope and Methodology 42 

Appendix II Data Relating to the Use of the Research Tax Credit 

by Corporations 51 

Appendix III Examples of How the Base of the Credit Affects 

Marginal Incentives and Windfall Credits 66 

Appendix IV Issues Relating to the Definition of Qualified 

Research Expenses 69 

Appendix V Issues Relating to the Definition of Gross Receipts 

for a Controlled Group of Corporations 80 

Appendix VI Issues Relating to Recordkeeping and Substantiation 87 

Tax Policy 
Appendix VII Issues Relating to the Computation Rules for the 

Group Credit 99 

Appendix VIII Comments from the U.S. Department of Treasury 111 

Appendix IX GAO Contact and Staff Acknowledgements 112 

Tables 

Table 1: Maximum MERs and Average Effective Rates of Credit for 

Different Categories of Credit Claimants, 2005 17 

Table 2: Summary Comparison of Leading Design Options 23 

Table 3: Total Claimants, Qualified Research Expenses, and Net 

Credits, 2003 to 2005 53 

Table 4: Marginal Effective Rates, Discounted Revenue Costs, and 

Bangs-per-Buck of the Research Credit, 2003 to 2005 54 

Table 5: Comparison of Initial and Amended Claims of the 

Research Credit by Panel Corporations 54 

Table 6: Comparison of Initial and Amended Claims of the 

Research Credit by Those Corporations That Made a 

Change 55 

Table 7: Changes in the Basic Elements of the Research Credit 

Computation between Initial and Amended Claims 55 

Table 8: Changes in the Basic Elements of the Research Credit 

Computation between Initial and Amended Claims for 

Those Corporations That Made a Change 56 

Table 9: Comparison of Final Taxpayer Pre-Exam Credit Claim to 

Latest Available IRS Position 57 

Table 10: Comparison of Final Taxpayer Pre-Exam Credit Claim to 

Latest Available IRS Position for Those Cases in Which 

IRS Made a Change 57 

Table 11: Changes in the Basic Elements of the Research Credit 

Computation between Final Taxpayer Pre-Exam Credit 

Claim to Latest Available IRS Position 58 

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 58 

Page ii GAO-10-136 Tax Policy
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) 59 

Table 14: Weighted Average Marginal Incentives and Revenue 

Costs for the Panel Population Before and after the 

Introduction of the ASC 60 

Table 15: Percentage Changes in Marginal Incentives and Revenue 

Costs Relative to 2009 Rules If the ASC Is the Only Credit 

Allowed 61 

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 62 

Table 17: Percentage Revenue Savings from Adding a Minimum 

Base Constraint to the ASC If the ASC Is the Only Credit 

Allowed 63 

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 64 

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 65 

Table 20: A Comparison of Two Methods for Allocating Group 

Credits in Selected Situations 109 

Figures 

Figure 1: A Comparison of an Incremental Credit to Flat and 

Capped Credits 6 

Figure 2: Information Needed to Estimate the Bang-per-Buck of the 

Credit 11 

Figure 3: Illustration of How Current Spending Increases Reduce 

Future Credits Under the ASC 19 

Figure 4: Distribution of Claimants, Qualified Research Expenses, 

and Net Credits, by Size of Taxpayer, 2003 to 2005 51 

Figure 5: Shares of Claimants, QREs and Research Credits, by 

Taxpayer’s Credit Status, 2005 52 

Figure 6: Percentage of Credit Claimants Subject to Tax Liability 

Constraints, 2003 to 2005 53 

Page iii GAO-10-136 Tax Policy
Figure 7: Illustration of How Inaccuracies in the Base of the Credit 

Result in Disparities in Incentives Across Taxpayers 67 

Abbreviations 

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 

This is a work of the U.S. government and is not subject to copyright protection in the 

United States. The published product may be reproduced and distributed in its entirety 

without further permission from GAO. However, because this work may contain 

copyrighted images or other material, permission from the copyright holder may be 

necessary if you wish to reproduce this material separately. 

Page iv GAO-10-136 Tax Policy
Page 1 GAO-10-136 

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 

Tax Policy 
 

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.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.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.3

 

 

1

Comparing alternative designs on the basis of this criterion is equivalent to comparing the 

designs on the basis of the level of incentive that each would provide at a given revenue 

cost to the government. 

2

Appendix I details how we estimate the incentive provided by various designs of the credit 

and the revenue cost associated with each design. The appendix also describes our 

sensitivity analyses and discusses limitations of our methodology. 

3

Appendix II provides selected comparative data for the panel and full populations; it also 

summarizes the results of sensitivity analyses in which we allow the spending histories of 

our panel population to vary significantly from those used for our baseline results. 

Page 2 GAO-10-136 Tax Policy
 

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.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 

 

4

Economic Recovery Tax Act of 1981, Pub. L. No. 97-34 (1981). 

Page 3 GAO-10-136 Tax Policy
 

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. 

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: 

Qualified Research Expenses 

• 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 inhouse 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 

Page 4 GAO-10-136 Tax Policy
 

• 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 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 Rationale behind an 

Incremental Design for the 

Credit 

Page 5 GAO-10-136 Tax Policy
 

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 

Source: GAO.

Qualified research spending

Taxpayer’s marginal spending

Spending on research that taxpayer would have done anyway

Revenue cost: $220 Revenue cost: $20

$100

$1,000

$100

$1,000

$20

Marginal

incentive

(20% of $100)

Marginal

incentive

(20% of $100)

Marginal

incentive

(No marginal

incentive so

taxpayer

decides not to

do the marginal

spending)

Windfall

credit

(20% flat credit

with $80 cap

applied)

Windfall

credit

(20% of $1,000)

$200

Windfall

credit

$100

$1,000

A 20% flat credit

A 20% flat credit 

capped at $80 An incremental credit with 

an ideal base

$100

$1,000

$20

$80

Revenue cost: $80

Page 6 GAO-10-136 Tax Policy
 

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) 

Computation of the Research 

Credit 

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 

Page 7 GAO-10-136 Tax Policy
 

+ 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.”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: 

 

5

Joint Committee on Taxation, General Explanation of the Economic Recovery Tax Act of 

1981 (JCS-71-81), December 29, 1981. 

Page 8 GAO-10-136 Tax Policy
 

1. All members of the same controlled group of corporations shall be 

treated as a single taxpayer,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).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; 

 

6

The definition of a “controlled group of corporations” for purposes of the credit has the 

same meaning as used in determining a parent -subsidiary controlled group of corporations 

for the consolidated return rules except the aggregate rule is broader, substituting 

corporations that are greater than 50 percent owned for 80 percent owned corporations. 

The aggregation rules also apply to trades or businesses under common control. A trade or 

business is defined as a sole proprietorship, a partnership, a trust or estate or a corporation 

that is carrying on a trade or business. 

7

The average effective rate (AER) of the credit equals the total credit benefit that the 

taxpayer earns divided by its total qualified spending. In the case of the uncapped flat 

credit, the AER equals the MER because the taxpayer earns the same rate on every dollar 

that it spends. In contrast, the AER of an incremental credit will differ from that credit’s 

MER. In the third example shown in figure 1, the MER is 20 percent ($20 / $100); however, 

the AER is slightly less than 2 percent ($20 / $1,100). 

Page 9 GAO-10-136 Tax Policy
 

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.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 $864,000.9

 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. 10 This responsiveness measure is called the price elasticity of 

 

8

At the 35 percent tax rate the value of being able to deduct $1 from taxable income is 

$0.35. Therefore, when a taxpayer must reduce its deduction for each dollar of research 

credit, the value of the credit is reduced by 35 percent. Expressed in terms of the rate of 

credit, the 35 percent reduction drops the MER from 20 percent to (1 - 0.35) × 20 percent, 

or 13 percent. 

9

The present value = $1 million / (1 + 0.05)3. 

10This weighted average MER is computed by estimating each taxpayer’s MER and giving 

each one a weight that equals the taxpayer’s share of aggregate QREs. 

Page 10 GAO-10-136 Tax Policy
 

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 

Source: GAO.

x x

Percentage by which 

spending increases

for each 1% 

reduction in the price

Amount of spending 

stimulated for each 

dollar of revenue 

forgone

÷ =

Percentage reduction 

in the after-tax price 

of a unit of qualified 

research.

Price 

elasticity of 

research 

spending

Percentage increase in qualified research 

spending due to the credit

Dollar increase in qualified research spending due to the credit

Aggregate 

qualified 

research 

spending

Revenue 

cost

Bang-per-buck 

of the credit

Marginal 

effective 

rate (MER) 

of the credit

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 

Page 11 GAO-10-136 Tax Policy
 

elasticity.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. 

 

11In 1996, at the request of Congressman Robert T. Matsui, we reviewed then-recent studies 

of the effectiveness of the credit to determine whether adequate evidence existed to 

support claims that each dollar of the tax credit stimulated at least one dollar of research 

spending in the short run and about two dollars of spending in the long run. We concluded 

that all of the available studies had data and methodological limitations that were 

significant enough to leave considerable uncertainty about the true responsiveness of 

research spending to tax incentives. None of the studies we reviewed estimated the longrun price elasticity of spending to be greater (in absolute terms) than -2; other estimates 

were considerably lower. We are not aware of any studies since 1996 that provide new 

estimates of the price elasticity of research spending by U.S. firms. In a later section we 

report our own estimates of the average MER and the revenue cost of the research credit 

and note what the bang-per-buck of the credit would be, if one assumed particular values 

for the price elasticity. 

Page 12 GAO-10-136 Tax Policy
 

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).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 2005.13 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).14

Large Corporations 

Have Dominated the 

Use of the Research 

Credit, Which 

Provided an Average 

Marginal Incentive of 

About 7 Percent in 

2003 through 2005 

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 

 

12The aggregate data on research credit claimants that we present differ in several respects 

from the data that IRS publicly reports. First, IRS excludes credit data reported by S 

corporations, which are “pass-through” entities, meaning that they are not subject to the 

corporate income tax. Instead, these entities’ income, deductions, and credits are allocated 

to their shareholders. We include S corporations in our tables and figures that show the 

amounts of qualified spending done and the amounts of credits earned because those 

entities do the spending that generate the credits. However, we exclude S corporations 

from our computations of MERs because the latter depend on the tax attributes of the 

shareholders, not the S corporations themselves. Second, IRS reports the amounts of 

credit claimed as they are reported on the taxpayers’ returns, which means in some cases 

these amounts will be for reduced credits, while in other cases they will be for full credits 

(with the taxpayers reducing their research expense deductions elsewhere on their 

returns). For the sake of consistency when comparing amounts of credits across different 

taxpayers, we report all credits on a net basis (subtracting the offset against the deduction 

where relevant). Third, the aggregated data IRS reports contains some double counting of 

QREs, which occurs because members of controlled groups are each required to report the 

total QREs of all group members. (They each report only their own share of the group’s 

total credit.) We have eliminated clear cases of double counting for all taxpayers with at 

least $10 million of QREs (see appendix I for details). 

13IRS’s aggregate data shows QREs and credits growing by about 13 percent and 15 percent, 

respectively, from 2005 to 2006. We would expect approximately the same rate of growth 

in our totals between those two years. The taxpayer-level data for 2006 were not available 

in time for us to make them consistent with the series reported in out tables and figures. 

14 These shares are based on data for those corporations that reported their spending by 

category. 

Page 13 GAO-10-136 Tax Policy
 

majority of the research credit claimed.15 In 2005, regular credit users 

reported about 75 percent of all QREs and claimed about 90 percent of 

total research credits.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;17 however, they were 

 

15The data available from IRS, which covers corporate returns with tax years ending on or 

before June 30, 2007, do not yet reflect the full impact of the ASC option (first available for 

tax years ending after December 31, 2006). In a later section we estimate how many of our 

panel members would have chosen the ASC if it had been available in 2003 and 2004. 

16The data in the figure do not include the negligible amounts of basic research credits 

earned or the qualified spending giving rise to those credits. In 2005 basic credits 

amounted to less than 1 percent of all credits earned and basic research spending was only 

about 0.2 percent of all qualified research spending. In 2005 corporations also reported 

receiving about $150 million of credits from pass-through entities. Some of these credits 

may be from S corporations included in our population and, therefore, would have been 

double-counted if we included them in the figure. 

17The discounting in the MER is counteracted by the discounting in the revenue cost when 

computing the bang-per-buck because one is a factor in the numerator and the other is a 

factor in the denominator. 

Page 14 GAO-10-136 Tax Policy
 

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 2003.18 (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.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 

 

18The data on amendments and examinations that we obtained from IRS’s Large and MidSize Business (LMSB) Division reflect the status of claims as of late 2007. Some of the 

audit changes that examiners had recommended at that point in time had already been 

agreed to by taxpayers; others were still open and ultimately could be appealed by 

taxpayers. 

19The percentages reported above represent averages across all of the panel corporations—

both those that had their credits changed and those that did not. The percentage 

reductions for those corporations that actually had credits changed by examiners were 

actually higher—between 19.6 percent and 36.6 percent from 2000 through 2003. 

Page 15 GAO-10-136 Tax Policy
 

uncertain whether they will receive any credit for particular research 

projects. Such uncertainty reduces the credit’s effective incentive. 

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. 

Important Trade-Offs 

Exist in the Choice of 

Research Credit 

Designs 

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).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. 

 

20We use the term primary base in reference to the base that is computed prior to 

determining whether that base is greater or less than the minimum base (50 percent of 

current-year QREs). The taxpayer’s ultimate base is the greater of the primary base or the 

minimum base. 

Page 16 GAO-10-136 Tax Policy
 

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).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 

Claimed regular credit 

Had QREs below base 

amounts

Not subject to minimum 

base

Subject to minimum 

base Claimed AIRC

Maximum MER 0% 13.0% 6.5% 2.4%

Average Effective Rate 0% 4.1% 6.5% 1.9%

Source: GAO analysis based on IRS data and the IRC. 

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 

 

21Appendix III provides a detailed explanation of how these results arise. 

Page 17 GAO-10-136 Tax Policy
 

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.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 MovingAverage 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 

$45,500.23 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 

 

22The inequitable distribution of the marginal incentives distorts the allocation of research 

spending, while the inequitable distribution of the total credits earned distorts the 

allocation of resources in general. 

23The current spending is weighted by one-third in the computation of next year’s base, 

which is the average of 3 years of spending. The base equals half of that average. 

Therefore, each $1 million of current spending increases next year’s base by $1 million / 6 

and it has the same effect on the bases in the following 2 years. The credit amount equals 

0.091 × 166,667, reflecting the fact that the 14 percent rate is effectively reduced to 9.1 

percent due to the offset against the deduction. 

Page 18 GAO-10-136 Tax Policy
 

percent.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 

Marginal 

spending in 

Year 1

Taxpayer’s

marginal spending

Base amounts without the marginal spending in Year 1

Spending on 

research that 

taxpayer would 

have done 

anyway

Source: GAO.

Causes an increase in 

the base for the three 

following years that, 

in turn, reduces the 

credit the taxpayer 

earns in those years

$1M

$10M

Year 1 Year 2 Year 3 Year 4

Increase in future base amounts due to the marginal spending

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 

 

24The future effects would be discounted for the time value of money so the benefit would 

be slightly higher. 

Page 19 GAO-10-136 Tax Policy
 

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 Bangper-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.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.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 

 

25We do not know whether taxpayers’ expectations relating to the amount of credit they 

will receive on their marginal spending are best reflected in the amounts of credit they 

report on their original tax returns, on their amended tax returns, or the amounts after 

adjustments resulting from IRS examinations. We provide separate estimates based on 

each of these three alternatives. The estimates values for MERs and revenue costs that we 

present in table 14 and elsewhere in this report vary depending on which of these three 

types of data we use; however, the variations do not affect any of our conclusions or 

recommendations. 

26If we had assumed a higher discount rate and longer carryforward length, then the MERs 

and revenue costs would have been lower in all cases, but the effect of the introduction the 

ASC on the credit’s bang-per-buck would have been similar. 

Page 20 GAO-10-136 Tax Policy
 

ASC are likely to have seen their MERs decline, while those who switched 

from the AIRC may have seen their MERs increase or decrease.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 

 

27The regular credit users that had the lowest average rates of credit (and, thereby, were 

more likely to switch to the ASC) were those that were not subject to the minimum base. 

Their MER under the regular credit would have been 13 percent (before taking tax liability 

constraints into account); the maximum MER that we estimated for our panel corporations 

that could use all of their credits immediately was between 10.9 percent and 12.5 percent, 

depending on the discount rate assumption. The maximum MER under the AIRC was 3.25 

percent. 

Page 21 GAO-10-136 Tax Policy
 

the ASC. 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.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-perbuck 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 

 

28We used our panel data to simulate the effects of these two approaches for correcting 

base distortions. To simulate an update of the regular credit base for our panel 

corporations we set the base equal to the average QREs over the three years preceding the 

year in which the credit is earned. We were constrained to use a 3-year average, given the 

limits of our panel database; however, past evidence suggests that updates of the base 

should not be much less frequent than every 3 years. In 1995, we testified that the 

inaccuracy of the base began to be a problem as early as 3 years after the introduction of 

the regular credit’s design. As of tax year 1992, 60 percent of all credit claimants were 

already subject to the minimum base constraint. See GAO, Tax Policy: Additional 

Information on the Research Tax Credit, GAO/T-GGD-95-161 (Washington, D.C.: May 10, 

1995). 

29The revenue costs of these two changes would be the same but the average MER would 

be very slightly higher if the regular credit option were retained simply because taxpayers 

would have the option of switching to that credit in future years if it suited them better. 

That small probability of switching in the future can reduce the negative future effects that 

the taxpayer expects to encounter under the ASC. See appendix I for further explanation. 

Page 22 GAO-10-136 Tax Policy
 

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 regular credit 

Options for the ASC Eliminate the regular credit option Retain the option but update the basea

No minimum base and 

credit rate = 14 percent 

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-perbuck. 

The benefit of this combination is that it would 

significantly reduce unintended disparities in 

MERs across taxpayers. 

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. 

No minimum base and 

credit rate = 20 percent 

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. 

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. 

50-percent minimum 

base and credit rate = 

14 percent 

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. 

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. 

Page 23 GAO-10-136 Tax Policy
 

Options for the regular credit 

Options for the ASC Eliminate the regular credit option Retain the option but update the basea

50-percent minimum 

base and credit rate = 

20 percent 

Same as immediately above. 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. 

75-percent minimum 

base and credit rate = 

14 percent 

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 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. 

75-percent minimum 

base and credit rate = 

20 percent 

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. 

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. 

The Credit’s Bang-perBuck 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.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.31 Revenue savings would be achieved 

 

30The effects on taxpayers’ MERs of adding a minimum base to the ASC are more 

complicated than the effects of the regular credit’s minimum base. See appendix III for 

details. 

31The only cases that we found where the minimum base would have a slightly negative 

effect on the bang-per-buck were when we assumed a discount rate of 7 percent or higher. 

We believe that taxpayer’s discount rates are likely to be lower than that (see appendix I 

for further discussion). 

Page 24 GAO-10-136 Tax Policy
 

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.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 

 

32If the rates of both credits were 20-percent, then all of the members of our panel would 

choose the ASC over the regular credit. In that case the differences between having only 

an ASC with a minimum base and having both credits with minimum bases would be 

negligible. As explained earlier, those differences are due to the possibility that taxpayers 

could choose the regular credit in future years. 

Page 25 GAO-10-136 Tax Policy
 

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. 

Several Aspects of the 

Definition of Qualified 

Research Expenses Have 

Been Significant Sources 

of Contention between 

Taxpayers and IRS 

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.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. 

 

33Treas. Reg. Section 1.41-4(a)(3) 

Page 26 GAO-10-136 Tax Policy
 

Several particularly contentious issues relate to specific types of research 

activities or expenses, including the following: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.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.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 

 

34See appendix IV for summaries of these and other issues relating to the definition of 

QREs. 

35If the software is used in another activity that constitutes qualified research, or in a 

production process that meets the requirements of the credit, then it is not considered IUS. 

36The practitioners say that this practice runs counter to congressional guidance provided 

in the conference report to accompany the Tax Relief Extension Act of 1999 Pub. L. No. 

106-170 (H.R. Conf. Rep. No. 106-478, 106th Cong. at 132 (1999)). IRS officials respond by 

noting that the report said only that software research should not be deemed IUS solely

because the business component involves the provision of a service. The development 

activity still must satisfy the other qualification criteria of Section 41. 

Page 27 GAO-10-136 Tax Policy
 

practical approach for dealing with this issue.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.”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 

 

37The notice of proposed rulemaking 66 FR 66362 (proposed December 26, 2001) stated 

that: “Unless computer software is developed to be commercially sold, leased, licensed or 

otherwise marketed for separately stated consideration to unrelated third parties, it is 

presumed to be developed by (or for the benefit of) the taxpayer primarily for the 

taxpayer’s internal use.” Financial services and telecommunications companies are 

concerned with such a test. They note that their software systems are integrally related to 

the provision of services to their customers, yet expenditures to develop those systems 

would not qualify for the credit (unless they met the additional set of standards) under the 

“separately stated consideration” standard because they do not charge customers 

specifically for the use of the software. 

38Treas. Reg. Section 1.174-2(a). 

Page 28 GAO-10-136 Tax Policy
 

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.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. 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 

 

3926 U.S.C. Section 174(c) and 26 U.S.C. Section 41(b)(1)(C)(ii). 

40In fact, some prototypes that are used in qualified research are subsequently sold to 

customers who then claim depreciation allowances for them. 

Page 29 GAO-10-136 Tax Policy
 

depreciable property.41 Taxpayers are challenging IRS’s position in at least 

one pending court case.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).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 

 

41One example of a self-constructed supply is a chemical that a business produces itself and 

then uses in a research project. The taxpayer is not permitted to include overhead or 

administrative costs attributable to the production of that chemical as QREs. However, if 

the taxpayer had purchased the chemical from a third party, such costs would have been 

included in the purchase price and could, thereby, be included in QREs. 

42TG Missouri Corporation v. Commissioner, Docket Number 8333-06 Tax Court. 

43The American Jobs Creation Act of 2004, Pub. L. No 108-357 (2004), provided a temporary 

incentive under IRC section 965 for U.S. corporations to repatriate certain income from 

foreign affiliates during either the recipient’s last tax year beginning before October 22, 

2004, or its first tax year beginning after that date, provided that the repatriated income 

was used for qualified purposes. 

Page 30 GAO-10-136 Tax Policy
 

receipts for purposes of computing the credit.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 doublecounting 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 

 

44See appendix V for a summary of the differing legal interpretations made by IRS and 

taxpayers, as well as for a more detailed discussion of the consequences of adopting 

alternative definitions of gross receipts. 

Page 31 GAO-10-136 Tax Policy
 

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.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 

 

45Large businesses often have cost centers, which are separately identified units (such as 

research, engineering, manufacturing and marketing departments) in which costs can be 

segregated and the manager of the center is responsible for all of its expenses. Project 

accounting is the practice of creating reports that track the financial status of specific 

projects, the cost of which are often incurred across multiple organizational units. Many 

firms rely on third-party consultants to conduct studies that bridge their cost-center 

accounting of research expenses to project-based accounting that is acceptable to IRS. IRS 

and practitioners often refer to this attempt to bridge the two accounting approaches as the 

“hybrid” approach. 

Page 32 GAO-10-136 Tax Policy
 

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. 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.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 

 

46IRS uses the term credit claims specifically in reference to claims made after initial 

returns are filed. 

47 See appendix VI for further discussion. 

Page 33 GAO-10-136 Tax Policy
 

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 

Page 34 GAO-10-136 Tax Policy
 

were changed to relieve taxpayers of the requirement to maintain base 

period records if they used the maximum fixed base percentage.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. 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.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. 

 

48Our analysis of 2005 tax data from SOI suggests that about 25 percent of all regular credit 

users had fixed base percentages of 16 percent or were subject to the minimum base 

constraint and would remain subject to that constraint even if they elected to use a fixed 

base percentage of 16 percent. Those taxpayers would benefit from this recordkeeping 

relief. 

49Treas. Reg. Section 1.41-8(b) (2) and Temp. Treas. Reg. Section 1.41-8T(b) (2). 

50 In the case Pacific National Co. v. Welch, 304 U.S. 191 (1938) the Supreme Court held 

that the taxpayer had made a binding election and reasoned that a change from one method 

of accounting for payments to another would require recomputation and readjustment of 

tax liability for subsequent years and impose burdensome uncertainties upon the 

administration of the revenue laws. 

Page 35 GAO-10-136 Tax Policy
 

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.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.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 

 

51One practitioner who works primarily with mid-sized businesses, including many Scorporations, noted that the latter are heavily affected by these rules. A second 

practitioner who also works primarily with S-corporations said that between 10 and 15 

percent of their clients are affected by these rules. A practitioner that works primarily with 

very large corporations said that about 20 percent of their clients are affected by the rules. 

52Under the gross QRE approach, the group’s research credit amount is allocated among 

the members in proportion to their share of the group’s aggregate QREs. 

Page 36 GAO-10-136 Tax Policy
 

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.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. 

 

53See appendix VII for a comparison of the marginal incentives provided by the stand-alone 

credit and gross QRE allocation methods, as well as for a discussion of other issues 

pertaining to the group credit rules. 

Page 37 GAO-10-136 Tax Policy
 

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. 

Conclusions 

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 welltargeted 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. 

Page 38 GAO-10-136 Tax Policy
 

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. 

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: 

Matters for 

Congressional 

Consideration 

Recommendations for 

Executive Action 

• 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: 

Page 39 GAO-10-136 Tax Policy
 

• 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. 

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. 

Agency Comments 

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 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 

Page 40 GAO-10-136 Tax Policy
 

on the last page of this report. Key contributors to this report are listed in 

James R. White

appendix VIII. 

Director Tax Issues 

Strategic Issues 

Page 41 GAO-10-136 Tax Policy
Appendix I: Scope and Methodology 

Page 42 GAO-10-136 

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. 

Tax Policy 
Appendix I: Scope and Methodology 

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 × currentyear 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. 

Page 43 GAO-10-136 Tax Policy
Appendix I: Scope and Methodology 

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. 

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. 

Computation of the 

Discounted Revenue 

Cost 

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). 

Page 44 GAO-10-136 Tax Policy
Appendix I: Scope and Methodology 

We began the construction of our panels by selecting all corporations that 

met either of the following criteria: 

The Panel Database of the 

Largest Credit Users 

• 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 

Page 45 GAO-10-136 Tax Policy
Appendix I: Scope and Methodology 

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 

Page 46 GAO-10-136 Tax Policy
Appendix I: Scope and Methodology 

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 

Page 47 GAO-10-136 Tax Policy
Appendix I: Scope and Methodology 

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: 

Page 48 GAO-10-136 Tax Policy
Appendix I: Scope and Methodology 

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,1

 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. 

 

1

Each credit status can be associated with a specific range of values for the ratio. For 

example, the taxpayer would be able to earn a credit but would be subject to a 50-percent 

minimum base if its ratio of current to base spending was any value greater than or equal to 

two. 

Page 49 GAO-10-136 Tax Policy
Appendix I: Scope and Methodology 

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. 

Page 50 GAO-10-136 Tax Policy
Appendix II: Da

Research T

ta Relating to the Use of the

ax Credit by Corporations 

Page 51 GAO-10-136 

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 

Percent

Year

Business receipts < $5 million

$5 million <= business receipts < $250 million

$250 million <= business receipts < $1 billion

$1 billion <= business receipts

Source: GAO analysis of IRS data.

0

10

20

30

40

50

60

70

80

90

100

2003 2004 2005 2003 2004 2005 2003 2004 2005

Share of claimants

Share of qualified 

research expenses Share of net credit

55.5 53.1

38.1 40.3

45.0

48.0

13.8 13.6 14.0

16.5 16.4 16.7

5.8 5.6 5.2 8.5 7.9 7.0

3.1 3.1

3.5 3.2

70.2 69.8 70.2 63.7 63.6 64.5

11.2 12.0 11.8

10.2 11.0 10.5

3.3 3.8

Tax Policy 
Appendix II: Data Relating to the Use of the 

Research Tax Credit by Corporations 

Figure 5: Shares of Claimants, QREs and Research Credits, by Taxpayer’s Credit Status, 2005 

Percent

Source: GAO analysis of IRS data.

0

10

20

30

40

50

60

70

80

Claimed AIRC

Claimed regular credit,

Claimed regular credit, not

Had QREs below

Percent

0

10

20

30

40

50

60

70

80

Claimed AIRC

Claimed regular credit,

Claimed regular credit, not

Had QREs below

Percent

0

10

20

30

40

50

60

70

80

Claimed AIRC

Claimed regular credit, 

Claimed regular credit, not

Had QREs below

subject to 50% base

subject to 50% base

subject to 50% base

subject to 50% base

base amounts

base amounts

subject to 50% base

subject to 50% base

ase amounts

Share of claimants Share of QREs Share of net credit

4.1

19.3

70.9

5.7

0.6

31.5

24.6

43.2

0.0

61.8

10.0

28.2

Page 52 GAO-10-136 Tax Policy
Appendix II: Data Relating to the Use of the 

Research Tax Credit by Corporations 

Figure 6: Percentage of Credit Claimants Subject to Tax Liability Constraints, 2003 

to 2005 

0

10

20

30

40

50

60

70

80

90

100

2003 2004 2005 2003 2004 2005

Percentage of claimants Percentage of net credit

Year

S corporations

C corporations that cannot

use their credits immediately

C corporations that can use

their credits immediately

Credits earned by S corporations

Credits earned by C corporations that 

cannot be used immediately

Credits earned by C corporations that can 

be used immediately

Source: GAO analysis of IRS data.

27.2

40.6

32.2

24.6

37.7

37.6

24.6

34.7

37.6

3.6 4.2

38.7

58.3

3.00

41.2

55.2

51.7

44.0

Table 3: Total Claimants, Qualified Research Expenses, and Net Credits, 2003 to 

2005 

2003 2004 2005

Number of claimants 15,678 16,731 17,105

Qualified research expenses 119.1 122.3 130.9

Net credit 5.1 5.4 6.0

Source: GAO analysis of IRS data. 

Note: Qualified research expenses and net credit in billions of dollars. 

Page 53 GAO-10-136 Tax Policy
Appendix II: Data Relating to the Use of the 

Research Tax Credit by Corporations 

Table 4: Marginal Effective Rates, Discounted Revenue Costs, and Bangs-per-Buck of the Research Credit, 2003 to 2005 

Under low discount rate and short 

carryforward assumptions 

Under high discount rate and long 

carryforward assumptions 

2003 2004 2005 2003 2004 2005

All claimants 

Average MER 7.59% 7.38% 7.31% 5.93% 5.46% 6.36%

Discounted revenue cost 4.7 5.0 5.8 3.6 3.9 4.8

Regular credit 

Average MER 9.26% 9.11% 8.98% 7.22% 6.70% 7.77%

Discounted revenue cost 4.2 4.4 5.0 3.3 3.3 4.3

AIRC 

Average MER 2.31% 2.34% 2.37% 1.85% 1.86% 2.20%

Discounted revenue cost .5 .5 .6 .4 .4 .5

Bang-per-buck if the price 

elasticity equaled: 

-0.5 .90 .85 0.80 .92 .84 0.81

-1 1.74 1.64 1.55 1.78 1.64 1.57

-1.5 2.52 2.38 2.25 2.60 2.40 2.29

-2 3.25 3.07 2.90 3.38 3.12 2.97

Source: GAO analysis of IRS data. 

Note: Revenue cost is in billions of dollars; bang-per-buck is in dollars. MER is the marginal effective 

rate of the credit. 

Table 5: Comparison of Initial and Amended Claims of the Research Credit by Panel Corporations 

Dollars in millions 

2000 2001 2002 2003 2004

Number of cases 107 109 109 104 105

Initial net research credit claimed 

Regular credit 3,146 2,940 2,550 2,248 2,290

AIRC 274 328 338 421 466

Total 3,420 3,268 2,888 2,669 2,756

Net difference between final amendment and initial claim—dollar 

amounts 

Regular credit 65 81 4 205 12

AIRC 54 60 39 -62 2

Total 119 141 43 143 13

Page 54 GAO-10-136 Tax Policy
Appendix II: Data Relating to the Use of the 

Research Tax Credit by Corporations 

Dollars in millions 

2000 2001 2002 2003 2004

Net difference between final amendment and initial claim—

percentage change 

Regular credit 2.1% 2.7% 0.2% 9.1% 0.5%

AIRC 19.6% 18.4% 11.6% -14.6% 0.4%

Total 3.5% 4.3% 1.5% 5.4% 0.5%

Source: GAO analysis of IRS data. 

Note: The number of cases in this table represents the number of corporations or corporate groups 

for which we were able to determine whether or not the amount of credit claimed was amended as of 

December 2007 and, if so, what the amount of the amended credit was. It includes cases that made 

changes as well as those that did not. 

Table 6: Comparison of Initial and Amended Claims of the Research Credit by Those Corporations That Made a Change 

2000 2001 2002 2003 2004

Number of cases 28 32 25 19 9

Net difference between final amendment and initial claim—percentage change 

Regular credit 18.5% 10.5% 1.0% 64.6% 7.1%

AIRC 37.8% 33.6% 61.3% -48.8% 7.9%

Total 24.1% 14.9% 9.2% 32.4% 7.2%

Source: GAO analysis of IRS data. 

Note: The number of cases in this table represents the subset of cases from the first table that 

actually amended the amount of research credit claimed. 

Table 7: Changes in the Basic Elements of the Research Credit Computation between Initial and Amended Claims 

Dollars in millions 

2000 2001 2002 2003 2004

Number of cases 89 90 94 90 94

Elements from the initial claims 

Net credit claimed 3,109 2,906 2,668 2,390 2,635

Current year QREs 62,404 63,226 62,114 60,295 66,131

Base QREs (for regular credit claimants not subject to the 50% base 

limit) 13,087 15,280 18,136 20,550 17,911

Average gross receipts (for those claiming the AIRC) 319,551 342,545 376,261 382,097 423,817

Net difference between final amendments and initial claims – 

dollar amounts 

Net credit claimed 88 141 45 24 7

Page 55 GAO-10-136 Tax Policy
Appendix II: Data Relating to the Use of the 

Research Tax Credit by Corporations 

Dollars in millions 

2000 2001 2002 2003 2004

Current year QREs 2,313 2,422 1,172 237 90

Base QREs (for regular credit claimants not subject to the 50% limit) -3 26 31 -56 -37

Average gross receipts (for those claiming the AIRC) -29,437 -32,649 -9,235 -5,059 0

Net difference between final amendments and initial claims—

percentage change 

Net credit claimed 2.8% 4.8% 1.7% 1.0% 0.3%

Current year QREs 3.7% 3.8% 1.9% 0.4% 0.1%

Base QREs (for regular credit claimants not subject to the 50% limit) 0.0% 0.2% 0.2% -0.3% -0.2%

Average gross receipts (for those claiming the AIRC) -9.2% -9.5% -2.5% -1.3% 0.0%

Source: GAO analysis of IRS data. 

Note: The number of cases in this table represents those corporations for which data relating to the 

detailed elements of their computations were available. It includes cases that made changes as well 

as those that did not. 

Table 8: Changes in the Basic Elements of the Research Credit Computation between Initial and Amended Claims for Those 

Corporations That Made a Change 

2000 2001 2002 2003 2004

Number of cases 17 25 16 14 8

Net difference between final amendments and initial claims—

percentage change 

Net credit claimed 39.7% 19.4% 15.3% 10.8% 5.5%

Current year QREs 24.8% 12.6% 13.8% 3.5% 2.6%

Base QREs (for regular credit claimants not subject to the 50% limit) -0.8% 1.1% 1.2% -3.0% -3.6%

Average gross receipts (for those claiming the AIRC) -16.0% -16.1% -8.4% -7.1% 0.0%

Source: GAO analysis of IRS data. 

Note: The number of cases in this table represents those corporations that actually amended the 

amount of research credit claimed and for which data relating to the detailed elements of their 

computations were available. 

Page 56 GAO-10-136 Tax Policy
Appendix II: Data Relating to the Use of the 

Research Tax Credit by Corporations 

Table 9: Comparison of Final Taxpayer Pre-Exam Credit Claim to Latest Available IRS Position 

Dollars in millions 

2000 2001 2002 2003 2004

Number of cases 107 109 109 104 105

Final taxpayer pre-exam net research credit claim 

Regular credit 3,211 3,021 2,554 2,453 2,302

AIRC 328 388 377 360 468

Total 3,539 3,409 2,931 2,81 2,770

Net difference between final taxpayer claim and latest IRS 

position—dollar amounts 

Regular credit -540 -599 -748 -654 -236

AIRC -44 -58 -45 -34 -14

Total -584 -657 -794 -689 -250

Net difference between final taxpayer claim and latest IRS 

position—percentage changes 

Regular credit -16.8% -19.8% -29.3% -26.7% -10.2%

AIRC -13.4% -14.9% -12.0% -9.6% -3.0%

Total -16.5% -19.3% -27.1% -24.5% -9.0%

Source: GAO analysis of IRS data. 

Note: The number of cases in this table represents the number of corporations or corporate groups 

for which we were able to determine whether or not IRS examiners had recommended an adjustment 

in the amount of credit claimed as of December 2007 and, if so, what the amount of the adjusted 

credit was. It includes cases where IRS made an adjustment as well as those where IRS did not. 

Table 10: Comparison of Final Taxpayer Pre-Exam Credit Claim to Latest Available IRS Position for Those Cases in Which 

IRS Made a Change 

2000 2001 2002 2003 2004

Number of cases 69 66 62 49 28

Net Difference between final taxpayer claim and latest IRS position 

– % changes 

Regular credit -19.5% -25.2% -37.6% -38.6% -28.8%

AIRC -20.7% -20.0% -20.1% -18.6% -15.5%

Total -19.6% -24.7% -35.8% -36.6% -27.5%

Source: GAO analysis of IRS data. 

Note: The number of cases in this table represents the subset of cases from table 9 for which IRS 

actually changed the credit amount upon examination. 

Page 57 GAO-10-136 Tax Policy
Appendix II: Data Relating to the Use of the 

Research Tax Credit by Corporations 

Table 11: Changes in the Basic Elements of the Research Credit Computation between Final Taxpayer Pre-Exam Credit Claim 

to Latest Available IRS Position 

Dollars in millions 

2000 2001 2002 2003 2004

Number of Cases 78 79 85 79 86

Elements from final taxpayer claims 

Net credit claimed 2,237 2,353 2,257 1,967 2,283

Current year QREs 48,904 53,459 54,941 52283 59,611

Base QREs (for regular credit claimants not subject to the 50% limit) 9,046 11,779 15,991 18,230 16,456

Average gross receipts (for those claiming the AIRC) 290,004 309,896 367,026 377,037 423,817

Net difference between final taxpayer pre-exam claim and latest 

IRS position—dollar amounts 

Net credit claimed -297 -282 -362 -335 -74

Current year QREs -4,994 -4,557 -3,868 -2,848 -1,375

Base QREs (for regular credit claimants not subject to the 50% limit) -243 -385 -162 401 -366

Average gross receipts (for those claiming the AIRC) 24,381 49,468 64,806 45,998 9,517

Net difference between final taxpayer pre-exam claim and latest 

IRS position—percentage changes 

Net credit claimed -13.3% -12.0% -16.0% -16.9% -3.3%

Current year QREs -10.2% -8.5% -7.0% -5.4% -2.3%

Base QREs (for regular credit claimants not subject to the 50% limit) -2.7% -3.3% -1.0% 2.2% -2.2%

Average gross receipts (for those claiming the AIRC) 8.4% 16.0% 17.7% 12.9% 2.2%

Source: GAO analysis of IRS data. 

Note: The number of cases in this table represents those corporations for which data relating to the 

detailed elements of their computations were available. It includes cases where IRS made changes 

as well as those where it did not. 

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 

2000 2001 2002 2003 2004

Number of cases 45 43 45 32 18

Net difference between final taxpayer pre-exam claim and latest 

IRS position—percentage changes 

Net credit claimed -16.6% -16.4% -22.0% -30.9% -15.8%

Current year QREs -13.4% -11.4% -10.0% -10.5% -10.4%

Base QREs (for regular credit claimants not subject to the 50% limit) -3.5% -4.1% -1.3% 4.0% -6.5%

Average gross receipts (for those claiming the AIRC) 13.2% 23.4% 31.1% 26.6% 14.9%

Source: GAO analysis of IRS data. 

Note: The number of cases in this table represents the subset of cases from table 11 for which IRS 

actually changed the credit amount upon examination. 

Page 58 GAO-10-136 Tax Policy
Appendix II: Data Relating to the Use of the 

Research Tax Credit by Corporations 

Note: The number of cases in this table represents those cases where IRS actually changed the 

credit amount upon exam and for which data relating to the detailed elements of their computations 

were available. 

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) 

Share of Revenue Cost 

Share of QREs

(Low Discount 

Rate and 

Carryforward 

Assumptions) 

(High Discount 

Rate and 

Carryforward 

Assumptions)

2003 Data 

Prior to ASC 

Regular credit users 65.9% 79.9% 78.3%

AIRC users 34.1% 20.1% 21.7%

2009 credit rules 

Regular credit users 37.4% 42.6% 36.7%

ASC users 62.6% 57.4% 63.3%

2004 Data 

Prior to ASC 

Regular credit users 64.2% 78.5% 77.1%

AIRC users 35.8% 21.5% 22.9%

2009 credit rules 

Regular credit users 38.7% 45.4% 43.2%

ASC users 61.3% 54.6% 56.8%

Source: GAO analysis of IRS data. 

Page 59 GAO-10-136 Tax Policy
Appendix II: Data Relating to the Use of the 

Research Tax Credit by Corporations 

Table 14: Weighted Average Marginal Incentives and Revenue Costs for the Panel Population Before and after the 

Introduction of the ASC 

Prior to Introduction of ASC Rules Effective for 2009 Percentage Change 

Weighted 

Average 

MER 

Revenue 

Cost ($

billions) 

Weighted 

Average 

MER 

Revenue 

Cost ($

billions) 

Weighted 

Average 

MER 

Revenue 

Cost 

4% Discount Rate and Short 

Carryforward Assumed 

2003 Filing Year for Panel 

 Initial return 7.8% 2.5 6.2% 3.0 -21.4% 20.4%

 After amendments 8.3% 2.6 6.3% 3.0 -24.7% 16.8%

 After exam recommendations 7.4% 1.8 5.9% 2.3 -20.7% 28.8%

2004 Filing Year for Panel 

 Initial return 7.4% 2.7 6.0% 3.3 -18.7% 22.5%

 After amendments 7.4% 2.7 5.7% 3.2 -23.2% 21.1%

 After exam recommendations 8.1% 1.9 5.6% 2.4 -30.6% 28.8%

8% Discount Rate and Long 

Carryforward Assumed 

2003 Filing Year for Panel 

 Initial return 5.9% 1.8 4.8% 2.3 -19.2% 24.2%

 After amendments 6.4% 1.9 4.9% 2.3 -23.4% 19.5%

 After exam recommendations 5.3% 1.3 4.4% 1.8 -17.0% 32.8%

2004 Filing Year for Panel 

 Initial return 5.2% 2.0 4.3% 2.4 -16.9% 24.4%

 After amendments 5.2% 2.0 4.1% 2.4 -21.6% 22.8%

 After exam recommendations 5.7% 1.4 4.1% 1.8 -29.3% 31.5%

Source: GAO analysis of IRS data. 

Page 60 GAO-10-136 Tax Policy
Appendix II: Data Relating to the Use of the 

Research Tax Credit by Corporations 

Table 15: Percentage Changes in Marginal Incentives and Revenue Costs Relative to 2009 Rules If the ASC Is the Only Credit 

Allowed 

When the ASC’s Rate = 14% When the ASC’s Rate = 20%a

% Change in 

Weighted 

Average MER 

% Change in

Revenue Cost 

% Change in 

Weighted 

Average MER 

% Change in

Revenue Cost 

4% Discount Rate and Short Carryforward 

Assumed 

Panel Data with 2003 as the Filing Year 

 Initial return -30.1% -11.2% -1.9% 25.5%

 After amendments -31.6% -12.4% -3.9% 24.7%

 After recommended exam changes -29.4% -9.6% 0.3% 29.0%

Panel Data with 2004 as the Filing Year 

 Initial return -26.3% -10.9% 4.7% 27.2%

 After amendments -22.4% -11.3% 10.0% 26.7%

 After recommended exam changes -22.8% -7.0% 10.0% 32.8%

8% Discount Rate and Long Carryforward 

Assumed 

Panel Data with 2003 as the Filing Year 

 Initial return -25.4% -8.6% -6.9% 27.8%

 After amendments -27.4% -10.1% -8.8% 25.4%

 After recommended exam changes -21.2% -7.7% 9.7% 30.4%

Panel Data with 2004 as the Filing Year 

 Initial return -21.7% -9.2% 7.4% 29.0%

 After amendments -17.4% -9.6% 12.3% 28.3%

 After recommended exam changes -19.7% -6.2% 12.9% 33.1%

Source: GAO analysis of IRS data. 

a

This is the rate for the revised set of credit options. In the comparison the rate of the ASC for 2009 is 

kept at 14%. 

Page 61 GAO-10-136 Tax Policy
Appendix II: Data Relating to the Use of the 

Research Tax Credit by Corporations 

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 

When the ASC's Rate = 14% When the ASC's Rate = 20%a 

% Change in 

Weighted 

Average MER 

% Change in 

Revenue Cost 

% Change in 

Weighted 

Average MER 

% Change in 

Revenue Cost 

4% Discount Rate and Short Carryforward 

Assumed 

2003 Filing Year for Panel 

 Initial return -28.0% -11.2% 1.6% 26.5%

 After amendments -31.6% -12.4% -3.1% 24.7%

 After exam recommendations -29.4% -9.6% 0.8% 29.0%

2004 Filing Year for Panel 

 Initial return -26.3% -10.9% 4.7% 27.2%

 After amendments -22.4% -11.3% 10.8% 26.7%

 After exam recommendations -22.8% -7.0% 10.1% 32.8%

8% Discount Rate and Long Carryforward 

Assumed 

2003 Filing Year for Panel 

 Initial return -25.4% -8.6% -6.8% 27.8%

 After amendments -27.4% -10.1% -8.3% 25.4%

 After exam recommendations -21.2% -7.7% 10.3% 30.4%

2004 Filing Year for Panel 

 Initial return -21.7% -9.2% 7.4% 29.0%

 After amendments -17.4% -9.6% 12.9% 28.3%

 After exam recommendations -18.0% -6.2% 13.0% 33.1%

Source: GAO analysis of IRS data. 

a

This is the rate for the revised set of credit options. In the comparison the rate of the ASC for 2009 is 

kept at 14%. 

Page 62 GAO-10-136 Tax Policy
Appendix II: Data Relating to the Use of the 

Research Tax Credit by Corporations 

Table 17: Percentage Revenue Savings from Adding a Minimum Base Constraint to the ASC If the ASC Is the Only Credit 

Allowed 

When the ASC's Rate = 14% When the ASC's Rate = 20% 

Minimum Base =

50% of Current

Research Spending

Minimum Base =

75% of Current

Research Spending

Minimum Base = 

50% of Current 

Research Spending 

Minimum Base =

75% of Current

Research Spending

4% Discount Rate and Short 

Carryforward Assumed 

2003 Filing Year for Panel 

 Initial return 4.1% 2.7% 5.1% 6.6%

 After amendments 3.3% 5.6% 2.0% 6.0%

 After exam recommendations 16.5% 4.4% 18.1% 4.8%

2004 Filing Year for Panel 

 Initial return 2.3% -2.0% 1.9% -3.4%

 After amendments 1.5% -3.4% 1.2% -2.3%

 After exam recommendations 5.6% 0.1% 4.3% 1.1%

8% Discount Rate and Long 

Carryforward Assumed 

2003 Filing Year for Panel 

 Initial return 1.9% 0.5% 6.3% 7.9%

 After amendments -2.3% 0.1% 3.2% 7.2%

 After exam recommendations 10.5% 1.8% 11.5% -5.2%

2004 Filing Year for Panel 

 Initial return -4.3% -3.7% -3.4% -4.0%

 After amendments -4.3% -5.3% -2.1% -3.1%

 After exam recommendations -0.2% -1.8% 0.3% 0.0%

Source: GAO analysis of IRS data. 

Note: The ASC rates for the credits with minimum bases are adjusted to provide the same average 

incentive as the ASC without a minimum base. 

Page 63 GAO-10-136 Tax Policy
Appendix II: Data Relating to the Use of the 

Research Tax Credit by Corporations 

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 

When the ASC Rate = 14% When the ASC Rate = 20% 

% Change in

Weighted Average

MER

% Change in

Revenue Cost

% Change in

Weighted Average

MER

% Change in

Revenue Cost

4% Discount Rate and Short Carryforward 

Assumed 

2003 Filing Year for Panel 

 Initial return -7.5% -1.4% -0.9% 0.0%

 After amendments -6.3% -0.9% -0.7% 0.0%

 After exam recommendations -5.6% -1.1% -0.7% 0.0%

2004 Filing Year for Panel 

 Initial return -10.3% -0.8% -0.6% 0.0%

 After amendments -5.9% -0.6% -0.6% 0.0%

 After exam recommendations -7.8% -0.8% -0.4% 0.0%

8% Discount Rate and Long Carryforward 

Assumed 

2003 Filing Year for Panel 

 Initial return -7.9% -1.6% -0.8% 0.0%

 After amendments -6.7% -1.0% -0.5% 0.0%

 After exam recommendations -6.2% -1.2% -0.8% 0.0%

2004 Filing Year for Panel 

 Initial return -11.3% -0.7% -0.6% 0.0%

 After amendments -5.5% -0.5% -0.5% 0.0%

 After exam recommendations -7.6% -0.7% 0.3% 0.0%

Source: GAO analysis of IRS data. 

Page 64 GAO-10-136 Tax Policy
Appendix II: Data Relating to the Use of the 

Research Tax Credit by Corporations 

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 

When the ASC Rate = 14% When the ASC Rate = 20% 

% Change in

Weighted Average

MER

% Change in

Revenue Cost

% Change in

Weighted Average

MER

% Change in

Revenue Cost

4% Discount Rate and Short Carryforward 

Assumed 

2003 Filing Year for Panel 

 Initial return -27.6% -4.8% -0.9% -0.1%

 After amendments -29.9% -4.3% -0.6% -0.1%

 After exam recommendations -11.1% -3.9% -0.9% -0.1%

2004 Filing Year for Panel 

 Initial return -19.2% -5.8% -1.4% -0.1%

 After amendments -25.5% -5.7% -2.4% 0.0%

 After exam recommendations -25.0% -5.8% -1.6% -0.1%

8% Discount Rate and Long Carryforward 

Assumed 

2003 Filing Year for Panel 

 Initial return -32.3% -5.9% -0.8% -0.1%

 After amendments -34.8% -5.1% -0.4% 0.0%

 After exam recommendations -10.5% -4.3% -1.0% -0.1%

2004 Filing Year for Panel 

 Initial return -20.8% -6.6% -1.1% -0.1%

 After amendments -27.7% -6.6% -2.4% -0.1%

 After exam recommendations -27.3% -5.9% -1.2% -.01%

Source: GAO analysis of IRS data. 

Page 65 GAO-10-136 Tax Policy
Appendix III: Examples of How the Base of 

the Credit Affects Marginal Incentives and Appendix III: Examples of How the Base of Windfall Credits 

the Credit Affects Marginal Incentives and 

Windfall Credits 

Figure 7 presents five examples that illustrate how inaccuracies in the 

credit’s base cause disparities across taxpayers in both the marginal 

incentives and windfall benefits that they receive from the credit. In each 

example the taxpayer would have spent $10 million on qualified research 

in the current year, even without the credit. Also in each example, the 

taxpayer is contemplating doing an additional $1 million in spending, but 

wants to estimate how much of a credit benefit it will receive for that 

marginal spending before deciding whether to undertake it. What differs 

across each example is the size of the taxpayer’s base for the regular 

credit. In the first example the taxpayer’s spending and gross receipts 

history result in a primary base that is relatively close to its ideal base, 

being only $1 million below the latter. The taxpayer receives a windfall 

credit of $130,000 for the $1 million worth of spending that it would have 

done anyway in excess of its base. The taxpayer would receive an 

additional $130,000 worth of credit if it increased its spending by $1 

million, which represents a marginal effective rate (MER) of 13 percent—-

the maximum MER available under the regular credit.1

 The taxpayer’s 

total credit ($260,000) divided by its total spending ($11 million) equals its 

average effective rate of credit (about 2.4 percent). In the second example 

the taxpayer’s primary base exceeds the ideal base by $600,000, which 

prevents the taxpayer from receiving any windfall credit; however, it also 

reduces the incentive that the taxpayer has to spend another $1 million on 

research by cutting the credit on that marginal spending from $130,000 to 

$52,000, for an MER of 5.2 percent. In the third example the taxpayer’s 

primary base is well above all of the spending that the taxpayer was 

contemplating for the year, so the credit provides no incentive for the 

taxpayer to increase its spending beyond what it would have done anyway. 

The MER is zero. The fourth example shows what could happen when a 

taxpayer’s primary base was much too low and if there were no minimum 

base for the credit. The credit would provide the taxpayer with the same 

marginal incentive as in the first example; however, the taxpayer’s windfall 

credit would be nine times larger than in that first case. Finally, the last 

example shows how the minimum base can reduce the cost of the credit 

by significantly reducing windfalls in some cases. Unfortunately, this 

windfall cannot be reduced without also cutting the marginal incentive. 

Given that the minimum base is 50-percent of current spending, every $1 

million of marginal spending increases the base by $500,000, so the 

 

1

The 13 percent rate of credit reflects the 20-percent statutory rate and the offset against 

the section 174 deduction. 

Page 66 GAO-10-136 Tax Policy 
Appendix III: Examples of How the Base of 

the Credit Affects Marginal Incentives and 

Windfall Credits 

taxpayer can earn only $650,000 of credit on that spending, representing 

an MER of 6.5 percent. 

Figure 7: Illustration of How Inaccuracies in the Base of the Credit Result in Disparities in Incentives Across Taxpayers 

Source: GAO.

Windfall credit

If the base spending 

amount is $9 million, then 

the taxpayer earns

$130,000 of windfall credit 

on the $1 million of 

spending that it would 

have done anyway that 

exceeds the base. 

Marginal incentive

It also earns $130,000 on 

$1 million of marginal 

spending, which 

represents an MER of 13

percent.

1M

10M

1M

10M

1M

10M 10M

Base is

slightly 

too low

Base is

slightly 

too high

Base is

much too 

high

Taxpayer 

is subject 

to the 

50% 

minimum 

base

A

B

Windfall credit

If the base spending amount 

is $10.6 million, then it 

exceeds the amount of 

spending the taxpayer would 

have done anyway and there 

is no windfall credit. In fact, 

the taxpayer would have to 

increase its spending by over 

$.6 million before it would 

start earning any credit. 

Marginal incentive

The taxpayer earns only 

$52,000 of credit on the $.4 

million of marginal spending 

that exceeds the base. The 

MER in this case is 5.2 

percent ($52,000 divided by 

$1 million).

A

B

Windfall credit

If the base spending 

amount is $12 million, then 

it exceeds all of the 

spending that the taxpayer 

had considered.

Marginal incentive

The taxpayer would earn no 

credit on any of its marginal 

spending. The MER is zero.

A

B

Windfall credit

This example shows what 

would happen if base 

spending was only $1 

million and there was no 

minimum base for the 

credit. The taxpayer would 

earn a windfall credit of 

$1,170,000 (.13 times the 

$9 million of the spending 

it would have done anyway 

in excess of its base).

Marginal incentive

Despite the much larger 

total credit, the taxpayer 

would receive the same 

MER of 13 percent, as in 

the first example. 

A

B

Windfall credit

This example shows how the 

50-percent minimum base 

reduced the windfall credit that 

the previous taxpayer would 

have earned from $1,170,000 

to $650,000 (.13 times

one-half of $10 million).

Marginal incentive

The minimum base also 

reduces the credit that the 

taxpayer earns on its marginal 

spending because, when the 

taxpayer increases its

spending by $1 it also 

increases its base amount by 

$.50. The MER in this case is

6.5 percent (one-half of 13

percent).

A

B

A=0 A=0

B=0

Spending taxpayer would have done anyway

1M Taxpayer’s marginal spending

10M

9M

10.6M

12M

5M

B

A

B

1M

10M

Base 

is much 

too low

1M

B

A

B

1M

A Increase in 

base due 

to marginal 

spending

Page 67 GAO-10-136 Tax Policy
Appendix III: Examples of How the Base of 

the Credit Affects Marginal Incentives and 

Windfall Credits 

ASC users currently are not subject to a minimum base. If they were to be, 

then the final example in figure 7 shows how that minimum base could 

affect their current year credits. The minimum base could also affect the 

negative future-year effects arising from current-year marginal spending 

(which were illustrated in figure 3). If a taxpayer’s primary base for the 

ASC would be less than the minimum base in future years, even after 

accounting for the increase due to current-year marginal spending, then 

current spending would not cause any reduction in future credits. If the 

primary base exceeded the minimum base in future years, then the 

negative future effects would occur, just as they did in the case without a 

minimum base. 

Page 68 GAO-10-136 Tax Policy
Appendix IV: Is

of Qualif

sues Relating to the Definition 

ied Research Expenses 

Page 69 GAO-10-136 

Appendix IV: Issues Relating to the Definition 

of Qualified Research Expenses 

In 1986, Congress narrowed the definition of qualified research out of a 

concern that many taxpayers claiming the credit did not engage in high 

technology activities and some claimed the credit for virtually any 

expenditures relating to product development.1

 Currently, research 

activities must satisfy four tests in order to qualify for the credit: 

Background and 

Significance 

1. Expenditures connected with the research must be eligible for 

treatment as expenses under section 174.2

 

2. The research must be undertaken for the purpose of discovering 

information that is technological in nature. 

3. The taxpayer must intend that information to be discovered will be 

useful in the development of a new or improved business 

component of the taxpayer. 

4. Substantially all of the research activities must constitute elements 

of a process of experimentation for a purpose relating to a new or 

improved function, performance, reliability, or quality. 

These four eligibility criteria are known as the section 174 test, discovering 

technological information test, business component test, and process of 

experimentation test. 

Treasury regulations3

 elaborate on these requirements as follows: 

• Research is undertaken for the purpose of discovering information if it 

is intended to eliminate uncertainty concerning the development or 

improvement of a business component. 

 

1

See S. Rep. No. 99-313 (1986), pp. 694-95 

2

In order to meet the section 174 test, the expenditure must (1) be incurred in connection 

with the taxpayer’s trade or business, and (2) represent a research and development cost in 

the experimental or laboratory sense. Expenditures represent research and development 

costs in the experimental or laboratory sense if they are for activities intended to discover 

information that would eliminate uncertainty concerning the development or improvement 

of a product. Uncertainty exists if the information available to the taxpayer does not 

establish the capability or method for developing or improving the product or the 

appropriate design of the product. Whether expenditures qualify as research or 

experimental expenditures depends on the nature of the activity to which the expenditures 

relate, not the nature of the product or improvement being developed or the level of 

technological advancement the product or improvement represents. See Treas. Reg. 

Section 1.174-2(a)(1). Expenditures for land and depreciable property are not allowed 

under section 174, although in certain cases, depreciation may be treated as a section 174 

expense. (Depreciation is not a qualified research expenditure (QRE) under section 41). 

3

Treas. Reg. Section 1.41-4. 

Tax Policy 
Appendix IV: Issues Relating to the Definition 

of Qualified Research Expenses 

• 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. 

• A determination that research is undertaken for the purpose of 

discovering information that is technological in nature does not require 

the taxpayer be seeking to obtain information that exceeds, expands 

or refines the common knowledge of skilled professionals in the 

particular field of science or engineering in which the taxpayer is 

performing the research; nor does it require that the taxpayer succeed 

in developing a new or improved business component. (The 

underlined language, which TD 9104 explicitly rejected, is commonly 

referred to as “the discovery test” from TD 8930, which many 

commenters contended was an overly stringent interpretation of the 

discovering technological information test.) 

• Generally, the issuance of a U.S. patent is conclusive evidence that the 

research meets the “discovering information” test. However, the 

issuance of a patent is not a precondition for credit availability. 

• A process of experimentation is designed to evaluate one or more 

alternatives to achieve a result where the capability or method of 

achieving that result, or the appropriate design of that result, is 

uncertain as of the beginning of the taxpayer’s research activities. The 

process must fundamentally rely on the principles of the physical or 

biological sciences, engineering or computer science. 

• A process of experimentation is undertaken for a qualified purpose if it 

relates to a new or improved function, performance, reliability or 

quality of the business component. Research relating to style, taste, 

cosmetic, or seasonal design factors does not qualify. 

The Internal Revenue Code (IRC) identifies the following types of 

activities that do not qualify as research for purposes of the credit: 4

• Any research conducted after the beginning of commercial production 

of the business component. 

• Any research related to the adaptation of an existing business 

component to a particular customer’s requirement or related to the 

reproduction of an existing business component. 

• Efficiency surveys; activity relating to management function; market 

research, testing or development; routine data collection; routine or 

ordinary testing or inspection for quality control; or any research in the 

social sciences, arts or humanities. 

 

4

26 U.S.C. Section 41(d)(4). 

Page 70 GAO-10-136 Tax Policy
Appendix IV: Issues Relating to the Definition 

of Qualified Research Expenses 

• Except to the extent provided in regulations, any research with respect 

to computer software which is developed by (or for the benefit of) the 

taxpayer primarily for internal use by the taxpayer, other than for use 

in:5

• an activity which constitutes qualified research, or 

• a production process that meets the requirements of the credit. 

• Research conducted outside the United States, the Commonwealth of 

Puerto Rico, or any possession of the United States. 

• Any research to the extent funded by any grant, contract, or otherwise 

by another person (or government entity). 

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. 

General Qualification Tests The tax practitioners we interviewed almost universally told us that 

Internal Revenue Service (IRS) auditors are still applying the discovery 

test from Department of the Treasury regulations6

 that were explicitly 

rejected in subsequent regulations.7

 Some of the tax consultants pointed 

to language in the regulations saying that the section 174 and process of 

experimentation tests are met as long as the experimentation addresses 

uncertainty relating to either the capability or method for developing or 

improving the product, or the appropriate design of the product. One 

consultant said IRS examiners have disqualified design and development 

activities that address these uncertainties because they considered the 

activities to be “routine development” or “routine engineering.” 

Officials from IRS’s Large and Mid-Size Business (LMSB) Division whom 

we interviewed denied that examiners are inappropriately applying the old 

discovery test and referred to language from their Research Credit Audit 

Technique Guide that instructs examiners on the relevant language from 

 

5

Treasury has yet to issue final regulations regarding internal-use software. See further 

discussion below. 

6

T.D. 8930, 66 Fed. Reg. 280 (2001) (TD 8930). 

7

T.D. 9104, 66 Fed. Reg. 22-01 (T.D.9104). In United States v. McFerrin, 570 F. 3d. 672 (5th

Cir. 2009), the Court of Appeals held that the IRS inappropriately applied the discovery test. 

In Union Carbide Corp. et. al. v. Commissioner, T.C. Memo 2009-50, the Tax Court 

applied the eliminate uncertainty test instead of the discovery standard. 

Page 71 GAO-10-136 Tax Policy
Appendix IV: Issues Relating to the Definition 

of Qualified Research Expenses 

current regulations. One of the practitioners that complained about the 

standards used by examiners acknowledged that, if they call in IRS’s 

Research Credit Technical Advisors, they can get the correct rules applied. 

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.”8

 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 approved as QREs than research for 

new products. 

Product testing around the end of the development process is a 

particularly contentious issue under the section 174 and process of 

experimentation tests. 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.”9

 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.10 IRS officials said that they 

 

8

Treas. Reg. Section 1.41-4(a)(3). 

9

Treas. Reg. Section 1.174-2(a). 

10The consultant shared a redacted excerpt from IRS’s audit summary for a client in which 

the examiner referred to the taxpayer’s software testing, including regression testing, 

functional testing, security testing, and stress testing as “routine” and “run-of-the-mill” and 

concluded that such testing is generally not a qualifying process of experimentation 

activity. 

Page 72 GAO-10-136 Tax Policy
Appendix IV: Issues Relating to the Definition 

of Qualified Research Expenses 

typically reject testing that is done after the taxpayer has proven the 

acceptability of its production process internally. 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. Officials from IRS Appeals told us that they could 

benefit from additional guidance (including industry-specific guidance) in 

the regulations relating to the process of experimentation test. 

Product testing is a particularly important issue for software development, 

which is another area of significant contention between IRS and 

taxpayers. Many tax consultants and industry groups that we spoke with 

believe that IRS has a general bias against software development activities 

qualifying for the credit. For their part, IRS officials believe that the true 

cause of controversy is taxpayers’ belief in the so-called “per se rule,” 

which considers all software development to inherently entail a qualifying 

process of experimentation. The officials note that IRS and the courts 

have uniformly rejected this notion. IRS’s Audit Guidelines on the 

Application of the Process of Experimentation for All Software state that, 

in order for a software development activity to meet the experimentation 

test, as specified in Treasury regulations, it must do all of the following: 

address one of the qualified uncertainties; evaluate alternatives; and rely 

on the principles of computer science. The guidelines identify numerous 

activities, including the detection of flaws and bugs in software, as “high 

risk categories of software development,” which usually fail to constitute 

qualified research. A special subset of controversies relate to software 

that is considered to have been developed for a taxpayer’s own use. 

Internal-Use Software When Congress narrowed the definition of the term “qualified research” in 

the Tax Reform Act of 1986,11 it specifically excluded several activities, one 

of them being the development of computer software for the taxpayer’s 

own internal use (other than for use in an activity which constitutes 

qualified research, or a production process that meets the requirements of 

the credit). The act provided Treasury the authority to specify exceptions 

to this exclusion; however, the legislative history to the Act states that 

Congress intended that regulations would make the costs of new or 

improved internal-use software (IUS) eligible for the credit only if the 

research satisfies, in addition to the general requirements for credit 

eligibility, the following three-part test that 

 

11Pub. L. No. 99-514 (1986). 

Page 73 GAO-10-136 Tax Policy
Appendix IV: Issues Relating to the Definition 

of Qualified Research Expenses 

1. the software was innovative; 

2. the software development involved significant economic risk; and 

3. the software was not commercially available for use by the 

taxpayer. 

The statutory exclusion for internal-use software and the regulatory 

exceptions to this exclusion have been the subject of a series of proposed 

and final regulations (and also considerable controversy). On January 3, 

2001, Treasury published final regulations12 ruling that “software is 

developed primarily for the taxpayer’s internal use if the software is to be 

used internally, for example, in general administrative functions of the 

taxpayer (such as payroll, bookkeeping, or personnel management) or in 

providing noncomputer services (such as accounting, consulting, or 

banking services).”13 If the software was developed primarily for those 

purposes, it was deemed to be IUS, even if it is subsequently sold, leased 

or licensed to third parties. This regulation did not provide a specific 

definition but instead identified two general categories of software as 

examples of IUS. In response to further taxpayer concerns Treasury 

reconsidered the positions it took in TD 8930 and issued proposed 

regulations on December 26, 2001, which stated, among other things, that, 

unless computer software is developed to be commercially sold, leased, 

licensed or otherwise marketed, for separately stated consideration to 

unrelated third parties, it is presumed to be IUS.14

In publishing both TD 8930 and the proposed regulations Treasury 

declined to adopt the recommendation of commentators that the 

definition of IUS should not include software used to deliver a service to 

customers or software that includes an interface with customers or the 

public. Financial services and telecommunications companies are among 

those particularly concerned with this issue. They note that their software 

systems are integrally related to the provision of services to their 

customers, yet expenditures to develop those systems would not qualify 

for the credit (unless they met the additional set of standards) under the 

“separately stated consideration” standard because they do not charge 

customers specifically for the use of the software. 

 

12TD 8930, 66 Fed. Reg. 280 (2001) (TD 8930). 

13Software used to provide noncomputer services was excepted from the 

additional three-part test if that software, among other things, contained features 

or improvements not yet offered by a taxpayer’s competitors. 

1466 Fed. Reg. 66362 (Proposed Regulations). 

Page 74 GAO-10-136 Tax Policy
Appendix IV: Issues Relating to the Definition 

of Qualified Research Expenses 

Several commentators noted that the original treatment of IUS introduced 

by the 1986 act predated the occurrence of a dramatic shift in computer 

usage that transformed the US economy from one based on production of 

tangible goods to one based on services and information. They question 

whether there is still an economic rationale for making a distinction 

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. Some commentators supported their 

recommendations for a narrower definition of IUS by referring to the 

legislative history included in the Conference Report accompanying the 

Tax Relief Extension Act of 1999,15 which included the following language: 

The conferees further note the rapid pace of technological 

advance, especially in service-related industries, and urge the 

Secretary to consider carefully the comments he has and may 

receive in promulgating regulations in connection with what 

constitutes “internal use” with respect to software expenditures. 

The conferees also wish to observe that software research that 

otherwise satisfies the requirements of section 41, which is 

undertaken to support the provision of service, should not be 

deemed to be “internal use” solely because the business 

component involves the provision of a service.16

Tax consultants complain that IRS continues to consider software 

development expenditures in the services industry to be IUS, despite the 

guidance Congress provided in the 1999 conference report. Some also say 

that the lack of clarity in current guidance regarding the characteristics of 

innovative software has permitted IRS examiners to apply an overly 

restrictive interpretation of this eligibility requirement. IRS officials told 

us that some exceptions were added to both TD 8930 and the proposed 

regulations in response to the conference report. They also note that the 

report did not suggest that all software providing a service should be 

excepted from IUS treatment; rather, it suggested that such software not 

be automatically classified as IUS. 

Treasury itself acknowledged the changes in computer software and its 

role in business activity since the mid-1980s in an Advanced Notice of 

 

15Pub. L. No. 106-170 (1999). 

16H.R. Conf. Rep. No. 106-478, at 132 (1999). 

Page 75 GAO-10-136 Tax Policy
Appendix IV: Issues Relating to the Definition 

of Qualified Research Expenses 

Proposed Rulemaking,17 which explained why the department was not 

ready to address the issue of IUS in the final regulations on the research 

credit that it published in 2004. Treasury said it was concerned about the 

difficulty of effecting congressional intent behind the exclusion for 

internal-use software with respect to software being developed today. As 

an example, it was concerned that the tendency toward the integration of 

software across many functions of a taxpayer’s business activities may 

make it difficult for both taxpayers and the IRS to separate internal-use 

software from non-internal-use software under any particular definition of 

internal-use software. Even with Congress’s broad grant of regulatory 

authority to Treasury on this issue, Treasury believed that this authority 

may not be broad enough to resolve those difficulties. 

Treasury has not yet been able to publish final regulations relating to IUS; 

the issue remains on the department’s latest priority guidance plan. In the 

meantime, for tax years beginning after December 31, 1985, Treasury has 

allowed taxpayers to rely upon all of the provisions relating to IUS in the 

proposed regulations or, alternatively, on all of the provisions relating to 

IUS in TD 8930. However, if taxpayers choose to rely on TD 8930, 

Treasury required that they also apply the “discovery test” contained in 

that document. Nonetheless, a recent court decision allowed a taxpayer to 

rely on TD 8930 for IUS guidance and TD 9104 regarding the discovering 

technological information test.18 The Department of Justice has filed a 

motion for reconsideration on the grounds that the court’s holding is 

based on a mistake in law. 

Direct Supervision and 

Direct Support of Qualified 

Research Activities 

Qualified research expenses include the wages of employees who provide 

direct supervision or direct support of qualified research activities. 

Treasury regulations define direct supervision as “the immediate 

supervision (first-line management) of qualified research. 19” Direct 

supervision does not include supervision by a higher level manager. The 

same section of the regulations provides the following examples of 

activities that qualify as direct support: the typing of a report describing 

laboratory results derived from qualified research, the machining of a part 

 

1769 Fed. Reg. 43. 

18See FEDEX Corp. et. al. v. United States, No 08-2423 (W.D. Tenn. June 9, 2009) where a 

federal district court ruled there was an inconsistency in the government’s guidance. 

19Treas. Reg. Section 1-41-2(c). 

Page 76 GAO-10-136 Tax Policy
Appendix IV: Issues Relating to the Definition 

of Qualified Research Expenses 

of an experimental model, and the cleaning of equipment used in qualified 

research. The section also provides the following examples of activities 

that do not qualify: payroll, accounting and general janitorial services. 

Some practitioners told us that IRS is very stringent with respect to 

allowing the wages of supervisors higher in the chain of command to be 

included in QREs. 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 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. They note that some 

taxpayers try to include unallowable costs relating to production labor, 

sales and marketing, information technology personnel, and legal 

personnel. 

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. 

Exclusion of Activities 

Occurring after the 

Commencement of 

Commercial Production 

According to existing Treasury regulations, activities are conducted after 

the beginning of commercial production of a business component if such 

activities are conducted after the component is developed to the point 

where it is ready for commercial sale or use, or meets the basic functional 

and economic requirements of the taxpayer for the component's sale or 

use. 20 The regulations specifically identify the following activities as being 

deemed to occur after the beginning of commercial production of a 

business component: 

A. Preproduction planning for a finished business component; 

 

20Treas. Reg. Section 1.41-4(c)(2). 

Page 77 GAO-10-136 Tax Policy
Appendix IV: Issues Relating to the Definition 

of Qualified Research Expenses 

B. Tooling-up for production; 

C. Trial production runs; 

D. Trouble shooting involving detecting faults in production 

equipment or processes; 

E. Accumulating data relating to production processes; and 

F. Debugging flaws in a business component. 

The exclusions relating to postcommencement activities apply separately 

for the activities relating to the development of the product and the 

activities relating to the development of the process for commercially 

manufacturing that product. For example, even after a product meets the 

taxpayer's basic functional and economic requirements, activities relating 

to the development of the manufacturing process still may constitute 

qualified research, provided that the development of the process itself 

separately satisfies the standard eligibility requirements and the activities 

are conducted before the process meets the taxpayer's basic functional 

and economic requirements or is ready for commercial use. 

Some commentators requested clarification of these regulations, 

suggesting a need for greater flexibility in defining the commencement of 

commercial production. In particular, they objected to Treasury deeming 

certain activities, such as preproduction planning, tooling, trial production 

runs, and debugging flaws, to occur after commencement of production 

when they often actually occur before the manufacturing process is ready 

for commercial use. Treasury, as stated in the preamble to the final 

regulations, believes that “the multitude of factual situations to which 

these exclusions might apply make it impractical to provide additional 

clarification that is both meaningful and of broad application.” 21 It also 

stated that the specific exclusions do not apply to research activities that 

otherwise satisfy the requirements for qualified research. Some tax 

consultants claim that IRS disallows research relating to the development 

of manufacturing processes that should qualify (according to the 

consultants' interpretation of those regulations). IRS officials 

acknowledged that they do have disputes with taxpayers regarding when 

commercial production of a particular product has begun and that their 

determinations must be based on the facts and circumstances of the 

particular cases. There is no “bright line” test for when a product is ready 

for commercial production or when a manufacturing process is no longer 

being improved. 

 

21 T.D. 9104. 

Page 78 GAO-10-136 Tax Policy
Appendix IV: Issues Relating to the Definition 

of Qualified Research Expenses 

The Internal Revenue Code specifically excludes expenditures to acquire 

“property of a character subject to the allowance for depreciation” from 

eligibility for either the deduction of research expenditures under section 

174 or for the research credit.22 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.23 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. 24 Taxpayers are challenging IRS’s position in at 

least one pending court case25 because, among other reasons, they believe 

the agency’s position is inconsistent with both Treasury regulations under 

section 174, which allow the deductibility of expenditures for pilot models 

and the legislative history of section 41, which, they say, implies that such 

expenditures could qualify for the credit. IRS says that some taxpayers 

have labeled custom-designed property intended to be held for sale in their 

ordinary course of business as prototypes, solely for the purpose of 

claiming the research credit. Consequently, IRS considers the costs 

associated with the manufacture of such products to be “inventory costs” 

and not QREs. Both taxpayers and IRS examiners would like to see 

clearer guidance in this area and Treasury has a project to provide further 

guidance under section 174 in its most recent priority guidance plan. IRS 

has also been concerned with the extent to which taxpayers have 

attempted to recharacterize ineligible foreign research services contracts 

as supply purchases. 

Supplies and Depreciable 

Assets 

 

22 26 U.S.C. Section 174(c) and 26 U.S.C. Section 41(b)(1)(C)(ii). 

23 In fact, some prototypes that are used in qualified research are subsequently sold to 

customers who then claim depreciation allowances for them. 

24 One example of a self-constructed supply is a chemical that a business produces itself 

and then uses in a research project. IRS’s position is that the taxpayer is not permitted to 

include overhead or administrative costs attributable to the production of that chemical as 

QREs. However, if the taxpayer had purchased the chemical from a third party, such costs 

would have been included in the purchase price and could, thereby, be included in QREs. 

25 TG Missouri Corporation v. Commissioner, Docket Number 8333-06 Tax Court. 

Page 79 GAO-10-136 Tax Policy
Appendix V: Iss

of Gross Re

Corporations 

ues Relating to the Definition 

ceipts for a Controlled Group of 

Page 80 GAO-10-136 

Appendix V: Issues Relating to the Definition 

of Gross Receipts for a Controlled Group of 

Corporations 

For taxpayers claiming the regular research credit the definition of gross 

receipts is important in calculating the base amount to which their 

current-year qualified research expenses (QRE) are compared. The 

definition also was critical for determining the amount of credit that 

taxpayers could earn with the alternative incremental research credit 

(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 the Internal 

Revenue Service (IRS) for taxable years before 2009.) Gross receipts do 

not enter into the computation of the alternative simplified credit (ASC) or 

the basic research credit. 

Background and 

Significance 

The House Budget Report1

 accompanying the Omnibus Budget 

Reconciliation Act of 19892

 that introduced the current form of the regular 

credit provided two rationales for indexing a taxpayer’s base spending 

amount to the growth in its gross receipts: 

1. Businesses often determine their research budgets as a fixed 

percentage of their gross receipts; therefore, the revised 

computation of the base amount would better achieve the intended 

objective of approximating the amount of research the taxpayer 

would have done in any case. 

2. Indexing the base to gross receipts would effectively index the 

credit for inflation. 

3. Neither the House, Senate, nor Conference reports accompanying 

the Small Business Job Protection Act of 1996 provided any 

rationale for the design of the AIRC. 

Neither the statute nor the legislative histories for either of these Acts 

defined the term gross receipts in detail. Section 41(c)(7) of the IRC 

simply provides that, for purposes of the credit, gross receipts for any 

taxable year are reduced by returns and allowances made during the tax 

year, and, in the case of a foreign corporation, that only gross receipts 

effectively connected with the conduct of a trade or business within the 

United States, Puerto Rico, or any U.S. possession are taken into account. 

Department of the Treasury regulations for the credit generally define 

gross receipts as the total amount, as determined under the taxpayer’s 

 

1

H. Conf. Rep. No. 101-247 (1989). 

2

Pub. L. No. 101-508 (1989). 

Tax Policy 
Appendix V: Issues Relating to the Definition 

of Gross Receipts for a Controlled Group of 

Corporations 

method of accounting, derived by a taxpayer from all its activities and all 

sources. However, “in recognition of the fact that certain extraordinary 

gross receipts might not be taken into account when a business 

determines its research budget,” the regulations provide, among other 

things, that certain extraordinary items (such as receipts from the sale or 

exchange of capital assets) are excluded from the computation of gross 

receipts.3

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. Neither the IRC nor 

Treasury regulations are clear on this point and IRS has issued differing 

legal analyses in specific cases over the years. Several of the tax 

practitioners that we interviewed emphasized the importance of this issue, 

particularly as a consequence of the extraordinary repatriation of 

dividends in response to the temporary incentives under section 965. One 

noted that it is the most significant Fin 48 issue for them.4

 Others noted 

that it is a $100 million issue for some taxpayers and will determine 

whether other taxpayers will earn any credit or not in given years. 

Uncertainty surrounding the definition of gross receipts makes it difficult 

for some regular credit users to know how much credit they would receive 

for spending more on research and, thereby, reduces the effectiveness of 

the credit. 

Differing Legal Positions 

Taken by IRS and 

Taxpayers 

Several private sector commentators and tax professionals we interviewed 

have taken the position that all transfers within a controlled group of 

corporations, including those between foreign subsidiaries and U.S. parent 

corporations should be excluded from gross receipts. In 2002 IRS issued a 

Chief Counsel Advice memorandum that supported this interpretation on 

behalf of a particular taxpayer, noting that the decision was based on the 

particular facts and circumstances of the case and should not be cited as 

precedent for other cases.5

 A subsequent, 2006, IRS Chief Counsel 

Memorandum came to the opposite conclusion, again based on the 

 

3

TD 8930, 66 Fed. Reg. 280 (2001) (TD 8930). 

4

FIN 48, Accounting for Uncertainty in Income Taxes, is guidance provided by the Financial 

Accounting Standards Board that standardizes accounting for uncertain tax benefits and 

requires companies to disclose their tax reserve amounts. 

5

CCA 200233011 (5/1/2002). 

Page 81 GAO-10-136 Tax Policy
Appendix V: Issues Relating to the Definition 

of Gross Receipts for a Controlled Group of 

Corporations 

specific facts and circumstances of the case. The uncertainty for 

taxpayers results from the fact that neither memorandum identified which 

particular circumstances in each case were decisive and the descriptions 

provided of each case were very similar.6

 Moreover, the two IRS 

memorandums applied differing interpretations of congressional intent. 

The critical disagreement between IRS and the taxpayer representatives is 

whether the disregarding of intragroup transfers under the group credit 

rules applies to gross receipts as well as to qualified research expenses. 

The current position taken by IRS is that the credit regulations section 

stating that transfers between members of a controlled group are generally 

disregarded is that it applies only to QREs and not to gross receipts 

because those rules were in place prior to 1989, when gross receipts first 

became a factor in the computation of the credit, and neither Congress 

(with respect to the Internal Revenue Code (IRC)) nor Treasury (with 

respect to its regulations) modified the rules to specifically indicate that 

they apply to gross receipts. Some tax professionals counter this 

reasoning by saying that the specific language in the IRC states that the 

rules apply for purposes of “determining the amount of the credit”; 

consequently, there was no need for Congress to explicitly link the rules to 

gross receipts because the latter obviously play a critical role in 

determining the amount of the credit. Treasury has yet to address the 

treatment of gross receipts under the group credit rules, even though the 

issue has been in Treasury’s priority guidance plans since 2004. 

A Treasury official told us that one issue the department would need to 

decide, even if they accept that Congress intended for the rules to apply to 

gross receipts, is whether Congress intended such a broad exclusion or, 

instead, wanted to generally exclude intragroup transactions, except for 

sales by a domestic member to a foreign affiliate that are subsequently 

passed through as sales to foreign third parties. 

Consequences of 

Alternative Decisions 

Changing the scope of gross receipts would not affect the amount of 

regular credit earned by a regular credit user (and, therefore, the revenue 

cost) if the relative sizes of the various components of that taxpayer’s 

gross receipts remained the same as they were during the base period. For 

In General 

 

6

CCA 200620023 (2/14/2006). 

Page 82 GAO-10-136 Tax Policy
Appendix V: Issues Relating to the Definition 

of Gross Receipts for a Controlled Group of 

Corporations 

example, if dividends from foreign members accounted for 10 percent of 

the group’s gross receipts during the base period and 10 percent of the 

gross receipts over the past four years, then the taxpayer’s regular credit 

would be the same regardless of whether such dividends were counted in 

gross receipts. However, if the share of such dividends in gross receipts 

had grown over time, the taxpayer’s credit would be smaller if those 

dividends were included in the definition of gross receipts than if they 

were excluded. Conversely, if the dividend share declined over time the 

inclusion of the dividends in gross receipts would give the taxpayer a 

larger credit. 

The effect that changes in the scope of gross receipts would have on the 

marginal incentive that the regular credit provides to a particular taxpayer 

would depend on whether the changes affect the credit constraints that 

the taxpayer faces. Specifically, 

• the inclusion of a component that has increased its relative share since 

the base period would eliminate the marginal incentive for a taxpayer 

who had been able to earn the credit if the inclusion caused that 

taxpayer’s base amount to exceed current-year QREs; 

• the inclusion of a component that has increased its relative share 

would increase the marginal incentive if it increased the taxpayer’s 

base amount from being less than half of its current-year QREs to more 

than half (because this would remove the taxpayer from being subject 

to the 50-percent base constraint);7

 

• The inclusion of a component that has decreased its relative share 

since the base period would have effects opposite to those described in 

the first two bullets; and 

• if any potential component of gross receipts accounts for the same 

proportion of the taxpayer’s total gross receipts in the base period and 

over the last 4 years, then the marginal incentive would not be affected 

by the inclusion or exclusion of that component. 

The broader the definition of gross receipts, the less credit taxpayers 

would earn under the AIRC (for a given set of credit rates). This would 

reduce the revenue cost of the AIRC and it may reduce the marginal 

incentive provided to some taxpayers, depending on where their resultant 

ratio of QREs to gross receipts leaves them in the credit’s graduated rate 

 

7

When a taxpayer that is subject to the 50-percent base constraint increases its current-year 

spending by $1, its base QREs increase by 50 cents and its credit increases by 10 cents 

(which equals 0.2 × ($1 minus 50 cents)). When a taxpayer that is not subject to that 

constraint increases its current-year spending by $1, its credit increases by 20 cents. 

Page 83 GAO-10-136 Tax Policy
Appendix V: Issues Relating to the Definition 

of Gross Receipts for a Controlled Group of 

Corporations 

structure. Unless Congress reverses its decision and reinstitutes the AIRC 

for tax years after 2008, the amount of research spending will not be 

affected by any reduction in that credit’s marginal incentive resulting from 

a broader interpretation of gross receipts. 

Under this option, gross receipts would consist of all payments received 

from parties outside of the group by any member of the group that are 

derived from the member’s trade or business within the United States, 

except for those extraordinary items currently excluded by Treasury 

regulations. Sales of products by a U.S. member to a foreign member that 

are subsequently sold to a foreign third party would be excluded, as would 

be any dividend or royalty payments that are derived from such sales. Any 

amounts that a foreign member receives from third parties that are derived 

from that member’s trade or business within the United States would be 

included in the group’s total gross receipts on a current basis (not just 

when such amounts are repatriated to the United States). Also, any sales 

that a domestic member makes to third parties within the United States of 

products imported from a foreign member (even when the latter has no 

trade or business within the United States) would be included in the 

group’s gross receipts. 

Option 1—Exclude All 

Transactions Between 

Controlled Group Members 

From the Group’s Total Gross 

Receipts 

If Section 41(c)(7) of the IRC reflects an expectation by Congress that 

taxpayers would not fund research within the United States out of sales 

made by foreign members, this option would meet that expectation. It 

would be consistent with the view that foreign members should be 

allowed to use their resources for the research they perform abroad and, 

given that the foreign research does not qualify for the credit, the foreign 

resources should not enter into the credit computation either. In addition, 

this option would provide symmetry between the treatment of sales by 

U.S. members of products imported from foreign affiliates and sales by 

foreign members of products that they purchase from U.S. members. 

However, this option would provide disparate treatment between foreign 

sales that a U.S. member makes directly to a foreign third party (which 

would be included in the group’s gross receipts) and foreign sales that a 

U.S. member passes through a foreign member (which would be 

excluded). This disparate treatment would give regular credit users some 

incentive to pass their sales through foreign members rather than to sell 

directly to foreign third parties. It also would provide some advantage for 

regular credit users to manufacture and sell products overseas, rather than 

to manufacture them in the United States and sell them directly to third 

Page 84 GAO-10-136 Tax Policy
Appendix V: Issues Relating to the Definition 

of Gross Receipts for a Controlled Group of 

Corporations 

parties overseas; however, it would not give those users any advantage to 

manufacture overseas, rather than to manufacture in the United States and 

pass their sales through foreign members.8

 It is not clear that any of these 

incentive effects that would result from this option would be significant 

relative to the many other tax and nontax factors that businesses consider 

when deciding where to locate their activities and how to route products 

and transfers through their affiliates. Perhaps most importantly, this 

option could exclude a substantial amount of export sales of U.S. 

multinational corporations 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. It would 

also provide more generous AIRC benefits to users that export relatively 

large shares of their products than to users whose export shares are 

smaller. These disparities in the credit benefits across taxpayers serve no 

useful purpose. 

This option, which would be consistent with IRS’s current interpretation 

that the aggregation rules for computing the group credit apply only to 

QREs and not to gross receipts, appears to be inconsistent with Congress’s 

intent of using the ratio of QREs to gross receipts as a measure of a 

taxpayer’s research effort in the base period and in the current year. This 

option would eliminate any double-counting of QREs but would overstate 

the resources available to the group by double-counting sales and income 

payments between group members. One consequence of this approach 

would be to encourage regular credit users to reduce the volume of 

intragroup transfers as a share of total gross receipts relative to what that 

share was during the base period. Distorting business practices in this 

manner would serve no purpose and could reduce efficiency. For AIRC 

users this option would reduce the amount of credit they could earn and 

would put taxpayers with relatively high volumes of intragroup 

transactions at an unjustified disadvantage. 

Option 2—Include All 

Transactions Covered by 

Treasury’s Current Definition, 

Except Payments for Research 

Services, Even If They Are 

Made Between Two Members 

of Controlled Group. 

This option is preferable to option 1 because it 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 is preferable to option 2 because it 

would eliminate any double-counting of intragroup transfers in gross 

Option 3—Exclude Everything 

That Would Be Excluded Under 

Option 1, Except for 

Intermediate Sales by U.S. 

Members to Foreign Members. 

 

8

 Many U.S. manufacturers that export their products do so through foreign affiliates, 

rather than directly to foreign third parties. 

Page 85 GAO-10-136 Tax Policy
Appendix V: Issues Relating to the Definition 

of Gross Receipts for a Controlled Group of 

Corporations 

receipts, which is important if Congress wishes to continue using gross 

receipts as a measure of the resources available to corporations. Relative 

to option 1, this option would give corporate groups that use the regular 

credit some incentive to produce goods abroad that they intend to sell 

abroad, rather than produce them in the United States; however, it is not 

clear that this incentive is significant relative to other factors that 

influence the location of production. 

Option 3 would be less costly than option 1 and more costly than option 2 

in terms of historic claims by users of the AIRC. In terms of future claims 

by users of the regular credit, the relative costs of the three options are 

difficult to determine because they depend on how the proportionate 

shares of certain types of intragroup transfers in the future will compare to 

what they were during taxpayer’s base periods. 

Page 86 GAO-10-136 Tax Policy
Appendix

Recordkeep

 VI: Issues Relating to 

ing and Substantiation 

Page 87 GAO-10-136 

Appendix VI: Issues Relating to 

Recordkeeping and Substantiation 

Substantiating the validity of a research credit claim is a demanding task 

for both taxpayers and the Internal Revenue Service (IRS), particularly in 

cases where research is not a primary function of the business in question. 

Two factors have led to a considerable degree of controversy between IRS 

and taxpayers over the types of evidence that are sufficient to support a 

claim for the credit: 

• Most taxpayers do not maintain project-based accounts for normal 

business purposes (and even those that do must collect additional 

details solely for purposes of claiming the credit), 

• There has been an increase in the number of taxpayers filing claims on 

amended returns, based on studies prepared by consultants, and 

• There is no specific guidance in law, regulations, or from IRS 

examiners as to what constitutes sufficient substantiation. 

Neither the Internal Revenue Coder (IRC) nor Department of the Treasury 

regulations contain specific recordkeeping requirements for claimants of 

the research credit. However, claimants are subject to the general 

recordkeeping rules of the IRC1

 and Treasury regulations,2 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. Under that section 

the qualification of research activities are 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. 

Establishing the Nexus 

between Expenses and 

Qualified Activities 

The tax practitioners we interviewed recognize that a nexus needs to be 

shown between expenses and business components or projects; however, 

they noted that documenting this connection requires considerable effort 

for businesses that use cost center accounting, rather than project 

 

1

26 U.S.C. Section 6001. 

2

Treas. Reg. Section 1.6001. 

Tax Policy 
Appendix VI: Issues Relating to 

Recordkeeping and Substantiation 

accounting to track their expenses. Standard business accounting 

typically focuses on the financial status of organizational units, such as 

geographical or functional departments. Large businesses often have cost 

centers, which are separately identified units (such as research, 

engineering, manufacturing and marketing departments) in which costs 

can be segregated and the manager of the center is responsible for all of its 

expenses. Project accounting is the practice of creating reports that track 

the financial status of specific projects, the cost of which are often 

incurred across multiple organizational units. 

Practitioners that work with both large multinational corporations and 

small family-owned businesses told us that most of their clients claiming 

the research credit do not use project accounting. Project accounting is 

typically used by government contractors, which are usually required to 

account for their costs on a contract-by-contract basis, and in certain 

industries, such as pharmaceuticals and software development. However, 

even those firms that use project accounting need to collect additional 

details that are required only for purposes of claiming the credit. 

Consequently, many firms rely on third-party consultants (with expertise 

in the complexities of research credit rules) to conduct studies that bridge 

their cost-center accounting of research expenditures to project-based 

accounting that is acceptable to IRS. IRS and practitioners often refer to 

this attempt to bridge the two accounting approaches as the “hybrid” 

approach. 

A key component of the documentation needed to support a credit claim, 

regardless of which accounting approach a taxpayer uses, is the allocation 

of wage expenses between qualifying and nonqualifying activities. In the 

case of a taxpayer using project accounting, those accounts make it easier 

to demonstrate that an employee worked on a project to develop a new or 

improved business component; however, even then, additional support is 

needed to show how much of the employee’s time was spent on activities 

that qualify as a process of experimentation intended to eliminate 

uncertainty (or on a qualifying support activity). In the case of a taxpayer 

using cost-center accounting, documentation also needs to be generated to 

show the amount of wages devoted to each qualifying project. Wage 

allocations made by consultants are typically based on after-the-fact 

surveys or interviews of managers who are asked to estimate the percent 

time that their employees spent on different projects and activities. In 

addition, subject matter experts (SME), such as a firm’s managers, 

scientists and engineers, are often interviewed to gain explanations of how 

particular activities meet the standards of qualifying research. Some of the 

consultants also told us they also try to gather whatever relevant technical 

Page 88 GAO-10-136 Tax Policy
Appendix VI: Issues Relating to 

Recordkeeping and Substantiation 

documentation may exist to support this testimonial evidence. In the case 

of large corporations with numerous research projects detailed allocation 

estimates may be made for only a representative sample of projects and 

then extrapolated across the population of all projects. 

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 used to accept cost center or 

hybrid accounting in the absence of project accounting; however, in recent 

years IRS has been much less willing to accept claims based on the first 

two approaches. They also said that IRS examiners now regularly require 

contemporaneous documentation of qualified research expenses (QRE), 

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 many 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). They noted that, before the surge in new claims by 

firms that had never claimed the credit previously, taxpayers used to 

supply more documentary evidence, such as budgets and e-mails. In their 

view the use of high level surveys and uncorroborated testimony of SMEs 

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 In their view, these are the types of claims that the new penalty on 

erroneous claims will combat. 3 These officials would also like to see a 

new line item added to tax returns on which taxpayers would be required 

to show the amount of the research deduction they were claiming under 

IRC section 174. They would like to make taxpayers go on record as 

 

3

The Small Business and Work Opportunity Tax Act of 2007, Pub.L. No. 110-28 (2007) 

provided IRS with the authority to impose a penalty on any taxpayer that claimed an 

excessive amount of refund or credit, unless the taxpayer can show that the claim has a 

reasonable basis. The penalty equals 20 percent of the excessive portion of the claim 

(defined as the amount not allowable under law). The penalty does not apply to earned 

income credit claims. See 26 U.S.C. Section 6676(a). 

Page 89 GAO-10-136 Tax Policy
Appendix VI: Issues Relating to 

Recordkeeping and Substantiation 

having considered the expenses to be research when they first incurred 

them, rather than after the fact on an amended return. 

A common complaint among the practitioners we interviewed is that IRS 

examiners routinely reject their credit studies but will not also say what 

would be acceptable, short of contemporaneous project-based accounts. 

They also say that IRS mixes up a taxpayer’s requirement to keep records 

and what is required to substantiate credit claims. The taxpayers do have 

records of all their expenses, but not of which ones are tied to qualified 

activities. Supplemental records and narratives are needed to explain how 

the expenses qualify. The practitioners said that it is unreasonable to 

expect that many businesses will maintain contemporaneous records of 

how much time each of their employees spends on qualified activities 

simply for purposes of claiming the credit; therefore, after-the-fact 

estimated allocations should be allowed. Some observed that when 

Congress renewed the credit in 1999 it expressed concern about 

unnecessary and costly taxpayer recordkeeping burdens and reaffirmed 

that “eligibility for the credit is not intended to be contingent on meeting 

unreasonable recordkeeping requirements.” They also note that recent 

court decisions have allowed the research tax credit in the absence of 

contemporaneous allocations when the evidence provided by the taxpayer 

has been convincing, which courts have cited in two recently decided 

research tax credit cases. IRS officials told us that their current practices 

are consistent with these recent decisions, which, they emphasize, require 

estimates to have a credible evidentiary basis. 4 The key issue is not the 

contemporaneity of the evidence, but its quality (e.g., time survey 

estimates made by employees who actually performed or supervised the 

research, rather than estimates made by someone in the firm’s tax 

department who had no first-hand knowledge of the research). Some 

practitioners doubted the usefulness of specific recordkeeping guidelines, 

given the wide range of practice across industries. Others would greatly 

welcome additional guidance and thought that the separate audit 

technique guides that IRS developed for the pharmaceuticals and 

 

4

In two decisions earlier this year (a Tax Court opinion in Union Carbide Corp. v. 

Commissioner, T.C. Memo 2009-50, and a Fifth Circuit appellate decision in United States 

v. McFerrin, 570 F. 3d. 672(5th Cir. 2009)) courts referred to an earlier ruling in Cohan v. 

Commissioner, 39 F. 3d. 540 (1930) in supporting taxpayers’ use of testimony and other 

evidence in estimating their credits. IRS recognizes that under the Cohan rule the courts 

may estimate the allowable amount of credit, but only if two conditions are met: (1) the 

taxpayer has demonstrated that it has engaged in qualified research but does not have 

sufficient records to document the amount of QREs and (2) there is sufficient credible 

evidence to provide a basis for making an estimate. 

Page 90 GAO-10-136 Tax Policy
Appendix VI: Issues Relating to 

Recordkeeping and Substantiation 

aerospace industries, which several practitioners commended, could serve 

as models. 

IRS officials say that they do not require project-based accounting records 

and they disagree with taxpayer assertions that they routinely deny credit 

claims for lack of such accounting or lack of contemporaneous records. 

Examiners consider these types of records to be the most reliable and 

relevant form of substantiation; however, in the absence of project-based 

accounts, the examiners are instructed to consider and verify all credible 

evidence. 

The officials note that two audit technique guides (ATG) they have 

published—one (issued in June 2005) covering research credit issues in 

general and the other (issued in May 2008) covering issues relating to 

amended claims—provide general descriptions of necessary 

documentation and lists specific types of documentation that would be 

acceptable for addressing particular issues.5

 The latter states that IRS 

does not have to accept either estimates or extrapolations because IRC 

section 6001 requires taxpayers to keep records to support their claims. It 

instructs examiners to consider the extent to which taxpayers rely on oral 

testimony and/or estimations, rather than documentation, when deciding 

whether to reject a claim and that information to support the claim should 

be contemporaneous. Examiners are also directed to consider whether 

oral testimony was from employees who actually performed the qualified 

research and how much time elapsed between the research and the 

testimony. To enable examiners to make such determinations without 

having to go through often voluminous amounts of documentation, IRS is 

now requiring examiners to issue a standardized information document 

request (IDR) questionnaire to all taxpayers with amended claims for the 

research tax credit that are in the early stages of examination. This IDR 

asks taxpayers for complete answers (not just references to other 

documentation) to questions concerning key aspects of the support for 

their credit claims. For example, the IDR asks what percentage of QREs 

are base on oral testimony or employee surveys, who was interviewed or 

surveyed, and how much time elapsed between the claim year and the 

time of the interview or survey. If some of the support for the answers is 

contained in other records, the taxpayer must supply specific location 

 

5

Credit for Increasing Research Activities (i.e. Research Tax Credit) Audit Technique 

Guide (ATG) (June 2005) and Research Credit Claims Audit Techniques Guide 

(RCCATG): for Increasing Research Activities Section 41 (LMSB-04-0508-030) (May 2008). 

Page 91 GAO-10-136 Tax Policy
Appendix VI: Issues Relating to 

Recordkeeping and Substantiation 

references. The ATG advises examiners that, in some cases they can use 

the responses to the IDR alone to determine that the amount claimed is 

not adequately supported and should be disallowed without further 

examination. 

The IRS officials we interviewed pointed to the research credit 

recordkeeping agreements (RCRA) as examples of the recordkeeping that 

they would accept and some practitioners said that IRS could use the 

knowledge it gained through RCRAs about industry-specific record 

keeping practices to develop more industry-specific recordkeeping 

guidance. The officials said a contemporaneous allocation was not an 

absolute requirement, but timeliness is a major factor in improving the 

credibility of any evidence. 

Amended Filings Abuses 

and Penalties 

In designating research credit claims (i.e., claims made after the initial 

filing of a tax return) as a Tier I compliance issue, IRS noted that a 

growing number of the credit claims were based on marketed tax products 

supported by studies prepared by the major accounting and boutique 

firms. It further noted that these studies were typically marketed on a 

contingency fee basis and exhibited one or more of the following 

characteristics: 

• high-level estimates; 

• biased judgment samples; 

• lack of nexus between the business component and QREs; and 

• inadequate contemporaneous documentation.6

IRS’s concern is focused on credit claims that were not taken into account 

on a taxpayer’s original return and the Tier I coverage is limited to that 

type of claim. Most of these claims are made on amended returns, which 

generally must be filed within 3 years after the date the corporation filed 

its original return or within 2 years after the date the corporation paid the 

tax (if filing a claim for a refund), whichever is later. The period may be 

longer for taxpayers that file for extensions. 

IRS officials have noted a particular concern with new or expanded credit 

claims that can be made for tax years up to 20 years earlier than the 

current tax year, provided that the taxpayer still has unused tax credits or 

 

6

Issues relating to the sufficiency of taxpayers’ support for their claims are discussed in a 

separate section covering recordkeeping and substantiation. 

Page 92 GAO-10-136 Tax Policy
Appendix VI: Issues Relating to 

Recordkeeping and Substantiation 

net operating loss carryforwards from that earlier year.7 These longdelayed credit changes are especially troublesome for IRS examiners 

because many taxpayers do not file an amended Form 6765 or specifically 

indicate anywhere on their current year returns that they have changed the 

amounts of credit claimed for earlier years.8

 Consequently, the adjusted 

claims are not likely to be detected unless IRS is already auditing the 

taxpayer’s current return. IRS officials said that this practice has gone 

from seldom to quite often in recent years and is being used by both large 

and mid-size firms. 

IRS officials expressed concern that when taxpayers do submit 

amendments to their 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. In other cases, taxpayers make claims based on 

studies that consultants have sold to them on a contingency-fee basis. 

Treasury Circular No. 230 now prohibits those who practice before IRS 

from collecting contingency fees for these types of studies; however, some 

studies may be prepared by consultants who do not practice before IRS.9

IRS officials said one reason that led the agency to designate the credit as 

a Tier 1 issue was to push taxpayers to make better initial credit claims 

before IRS spends substantial time on audits. As a result of the Tier I 

designation, the research credit has been assigned an issue management 

team to ensure that the issue is fully developed with appropriate direction 

and a compliance resolution strategy. Three requirements that currently 

form part of this strategy are that: 

• all claims for the credit that are not made on or before the due date of 

the taxpayer’s Form 1120 for a given tax year must be filed at IRS’s 

Ogden Service Center; 

 

7

26 U.S.C. Section 39(a). Any unused credits after the last year of the 20-year carryforward 

period may be taken as a deduction in the tax year following the last tax year of the 20-year 

carryforward period. 

8

These taxpayers simply include the new amount of research credit from the earlier year in 

the amount on line on IRS Form 3800 (General Business Credit), which shows the total 

amount of all types of credits carried forward from any earlier years. This practice is 

applicable to all credits included under the general business credit, not just the research 

credit. 

9

Practicing before IRS essentially means communicating with the IRS on behalf of a 

taxpayer or otherwise representing a taxpayer's interests to IRS. 

Page 93 GAO-10-136 Tax Policy
Appendix VI: Issues Relating to 

Recordkeeping and Substantiation 

• examiners must issue a standardized information document request 

(IDR) to taxpayers at the outset of all new examinations of the credit; 

and 

• in all cases where any amount of a research credit claim is disallowed 

by IRS, the examiners must determine whether the recently enacted 

penalty for filing erroneous claims for refund or credit should be 

applied. The examiners must obtain and document the concurrence of 

a technical advisor in all such cases where they decide not to impose 

the penalty. 

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 the following: 

• Substantiating and documenting research expenses in a manner that is 

acceptable to IRS is time consuming and labor intensive, making it 

difficult to file for the credit on a timely basis on an original return. 

The firms’ tax preparers need the assistance of the firms’ scientists, 

engineers, and technicians, who cannot be made available in time for a 

current-year filing. Pulling these technical experts away from their 

research represents a significant financial burden for taxpayers. 

Consequently, when taxpayers go through this effort it makes sense for 

them to cover multiple tax years at a time on amended returns. 

• The prevalence of amended returns in recent years also can be 

attributed to long-standing uncertainties in credit regulations. The 

definition of qualified research expenses was only resolved in final 

regulations in 200310, and the “discovery test” was also abandoned in 

the final regulations by Treasury and IRS.11 This clarification of the 

rules prompted taxpayers to file claims for the credit for past tax years 

on amended returns. Similarly, changes in regulations relating to the 

definition of gross receipts also prompted many taxpayers to file 

amended claims. 

• Start-up companies often don’t consider it worthwhile to file credit 

claims until they turn profitable. Once they decide to make the effort, 

they also submit their claims for earlier years through amended 

returns. 

• The long-term nature of research projects is another reason why 

taxpayers submit claims on amended returns. Taxpayers must often 

 

10 Treas. Reg. Section 1.41-4, TD 9104, 69 Fed. Reg. 22 

11 IRS Notice 2001-19, 2001-10, 66 Fed. Reg. 66362. 

Page 94 GAO-10-136 Tax Policy
Appendix VI: Issues Relating to 

Recordkeeping and Substantiation 

know the end result of a process/project to establish the eligibility of 

research expenses as part of a “process of experimentation,” which is 

part of the statutory definition of qualified expenses. 

• Many firms, large and small, don’t realize that they actually do things 

that qualify for the credit. Once outside consultants make them aware 

of this fact, it makes sense for them to want to go back and claim the 

credit for earlier years as well. 

Many large practitioners we interviewed said that aggressive and poorly 

documented research credit claims are largely generated by “boutique” 

research credit consultants who aggressively market their services. The 

larger practitioners feel that IRS has taken things too far by presuming that 

all amended claims are abusive. They said the larger accounting firms are 

governed by strict professional standards and the new penalties will not 

have much effect on their behavior, but the penalties should help to 

reduce abuses by the boutique firms. Practitioners did express concern 

that the new penalties would make the audit and appeals processes even 

more contentious and they questioned the appropriateness of imposing 

penalties in areas where Treasury guidance is limited and problematic. 

The only practitioner we interviewed that had actual experience with the 

new penalties said that the penalties were typically applied in all cases 

where claims were reduced; however, after taxpayers had spent the time 

and money to make legal cases against them, all of the penalties were 

rescinded. 

The IRS officials we interviewed expressed strong disagreement with the 

view of the large accounting firms that the abusive amended returns 

problem is primarily a “boutique” practitioner problem. They said that you 

can see any problematic practice at any level of practitioner. However, the 

officials did note that the use of the credit has expanded downward in 

terms of the size of the claimants and that the expansion has been driven 

by the growth of boutique research credit consultant shops. 

Base Period 

Documentation 

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, given the fact that few firms have good (if any) expenditure 

records dating back to the early 1980s base period, most firms are unable 

to precisely adjust their base period records for the changes in definitions 

promulgated in subsequent regulations and rulings. Taxpayers also have 

Page 95 GAO-10-136 Tax Policy
Appendix VI: Issues Relating to 

Recordkeeping and Substantiation 

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 the use of estimates and employee testimony to substantiate 

QREs in accordance with the Cohan rule; other practitioners simply 

suggested doing away with the regular credit. They believe that some 

taxpayers will choose to use the new ASC simply to avoid the burden of 

base period documentation.12 One IRS official noted that IRS is not likely 

to challenge a taxpayer’s base amount if the latter uses the maximum fixed 

base percentage;13 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 the 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. Our 

analysis of taxpayer data from SOI for 2005 suggests that about 25 percent 

of all regular credit users had fixed base percentages of 16 percent or were 

subject to the minimum base constraint and would remain subject to that 

constraint even if they elected to use a fixed base percentage of 16 

percent. 

Specific Issues Relating to 

Sampling 

Many taxpayers use statistical sampling to estimate their QREs and IRS 

frequently uses sampling when auditing taxpayer’s records supporting 

research credit claims. Several practitioners we interviewed had specific 

concerns with IRS’s guidance and audit practices relating to sampling; 

however, some noted that they have seen improvements in recent months. 

The practitioners’ biggest concern is that, unless taxpayers can achieve a 

10 percent relative precision in their estimates, IRS makes them use the 

lower limit of the confidence interval for their estimates of QREs, which is 

the least advantageous to the taxpayer. Practitioners say this standard is 

too difficult to meet, even in cases where taxpayers use large samples, and 

that IRS should have a less demanding threshold for allowing taxpayers to 

use point estimates. Moreover, they objected to IRS’s requirement that 

they exclude the “certainty stratum” when calculating relative precision, 

 

12 However, as explained in the section on the allocation of credits among members of 

controlled groups, current regulations require all members to compute (and substantiate) 

amounts they would earn under the regular credit, even if the group elects to use the ASC. 

13 No changes that IRS may make to base period spending amounts could ever raise a 

taxpayer’s fixed base percentage above the maximum of 16 percent. 

Page 96 GAO-10-136 Tax Policy
Appendix VI: Issues Relating to 

Recordkeeping and Substantiation 

which they considered to be just bad statistics.14 IRS officials responded 

that having a precision threshold encourages taxpayers to do a quality 

sample and that 10 percent precision is a good indicator of a high quality 

sample. They said that without some control standards taxpayers could 

try to make do with very small samples. The officials also noted that there 

are methods other than increasing sample sizes, such as improving sample 

design, population definition and stratification techniques, by which 

taxpayers can reduce their sampling errors. With respect to the exclusion 

of the certainty stratum, IRS acknowledged that this requirement was not 

justified on statistical grounds; however, they believe it is needed to 

prevent potential abuses. They are concerned that taxpayers would 

include extraneous accounts in their 100 percent stratum for the sole 

purpose of reducing their relative precision. IRS officials said that they 

are in the final stages of releasing guidance on sampling that addresses 

practitioners’ concerns regarding the certainty stratum and the 10-percent 

precision test. 

Practitioners also expressed concerns that IRS was hardening its position 

against accepting multi-year samples. They said it is more cost-effective to 

take one sample that covers multiple years and has a reasonable overall 

accuracy for the entire time period than to take several single-year 

samples that have narrow confidence intervals each year. IRS 

acknowledged that the practitioners’ point was correct from a statistical 

point of view; however, they noted that, given the incremental nature of 

the credit, that it is important for estimates of QREs to be accurate for 

each specific year, not just over the multi-year period as a whole. In 

addition, IRS does not want to encourage taxpayers to hold off filing their 

claims for several years and then do a multi-year sample. 

Recordkeeping and 

Prefiling Agreements 

Practitioners and taxpayer representatives differed on the usefulness of 

IRS’s RCRA and prefiling agreement (PFA) programs. The RCRA program 

was a pilot effort intended to let IRS develop and evaluate procedures that 

would reduce costs for both taxpayers and IRS by resolving issues 

concerning the type and amount of documents that a taxpayer must 

maintain and produce to support research credit claims. Taxpayers that 

complied with the terms of the agreements worked out with IRS are 

 

14 The certainty stratum actually consists of the stratum of a stratified sample in which 

cases are sampled at a 100 percent rate, plus the stratum in which cases are sampled at an 

80 percent rate. 

Page 97 GAO-10-136 Tax Policy
Appendix VI: Issues Relating to 

Recordkeeping and Substantiation 

deemed to have satisfied their recordkeeping requirements for the tax 

years covered by the agreement. Five taxpayers participated in the pilot 

program. The PFA program is an ongoing effort by IRS designed to permit 

taxpayers, before filing their returns, to resolve the treatment of an issue 

that would likely be disputed in an examination. 

Some of the practitioners had had good experiences with PFAs for 

particular clients, but they noted that the $50 thousand fee was too 

expensive and that IRS has been less willing to enter into PFAs because it 

did not have sufficient staff resources. Other practitioners said that 

RCRAs and PFAs are not likely to be much help, given the animosity and 

distrust between taxpayers and IRS. They think that IRS is asking for too 

much in these agreements. One noted that it had five recent experiences 

with PFAs and all of them were bad, so it no longer recommends them to 

clients. In the current environment taxpayers are unwilling to invite IRS in 

for a look at their records and taxpayers do not believe that an RCRA 

ensures that IRS will not ask for additional documents during an exam. In 

addition, the practitioners said that RCRAs are unlikely to be helpful in the 

long-term, given the variable nature of research projects. Agreements 

made in an RCRA may not be applicable to other research projects in 

future tax years, or even the same project in future tax years as the project 

evolves. 

Page 98 GAO-10-136 Tax Policy
Appendix VII: I

C

ssues Relating to the 

omputation Rules for the Group Credit 

Page 99 GAO-10-136 

Appendix VII: Issues Relating to the 

Computation Rules for the Group Credit 

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.”1

 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. 

Department of the Treasury and Internal Revenue Service (IRS) officials 

told us that the rules also guard against manipulation within a group that 

would shift credits from members with tax losses to those with tax 

liabilities. Under the Internal Revenue Code (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: 

Background and 

Significance

A. all members of the same controlled group of corporations2

 shall be 

treated as a single taxpayer, and 

B. 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. 

Under current Treasury regulations3

 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” (as long as the 

group credit amount does not exceed the sum of the stand-alone entity 

 

1

Joint Committee on Taxation, General Explanation of the Economic Recovery Tax Act of 

1981 (JCS-71-81), December 29, 1981. 

2

The definition of a “controlled group of corporations” for purposes of the credit has the 

same meaning as used in determining a parent –subsidiary controlled group of 

corporations for the consolidated return rules except the aggregate rule is broader 

substituting corporations that are greater than 50 percent owned for 80 percent owned 

corporations. The aggregation rules also apply to trades or businesses under common 

control. A trade or business is defined as a sole proprietorship, a partnership, a trust or 

estate or a corporation that is carrying on a trade or business. 

3

Treas. Reg. Section 1-46-6. 

Tax Policy 
Appendix VII: Issues Relating to the 

Computation Rules for the Group Credit 

credits of all members). If the group credit does exceed the sum of the 

stand-alone credits, then the excess amount is allocated among the 

members in proportion to their share of the group’s aggregate qualified 

research expenses (QRE). 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 standalone 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 group credit may be computed using either the rules for the 

regular credit or the rules for the alternative simplified credit (ASC) (or, 

until the end of tax year 2008, the rules for the alternative incremental 

research credit (AIRC)). The group credit computation is the same for all 

members of the group. 

For purposes of the initial allocation of the group credit among members 

that file their own federal income tax returns, consolidated groups of 

corporations are treated as single members.4

 However, once a 

consolidated member receives its allocation of the group credit, that 

allocation must be further allocated among the individual members of the 

consolidated group in a manner similar to the one used for the initial 

allocation. 

Although some private sector research credit consultants told us that the 

group credit rules do not affect large numbers of taxpayers, several others 

said that the opposite was true with one pointing out that the rules affect 

all groups that have any of the following: 

• members that are between 50 percent and 80 percent owned; 

• noncorporate members; 

• members departing in a given year; or 

• U.S. subsidiaries that are owned by foreign parents and are members of 

different U.S. consolidated groups. 

One consultant that works primarily with mid-sized businesses, including 

many S corporations, noted that such corporations are heavily affected by 

these rules. A second consultant that also works primarily with S 

corporations said that between 10 and 15 percent of their clients are 

affected by these rules. The consultants with whom we discussed this 

 

4

A consolidated group of corporations is one in which all members (each of which must be 

at least 80 percent owned (vote and value) by the group) file a federal income tax return as 

one taxpayer. 

Page 100 GAO-10-136 Tax Policy
Appendix VII: Issues Relating to the 

Computation Rules for the Group Credit 

issue agreed that the rules were very burdensome for those groups that are 

affected. 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. None of these 

affected groups can benefit from the simplified recordkeeping that the 

ASC offers to other taxpayers because they must be able to show which 

stand-alone credit method provides the highest credit for each member, 

which can only be done by computing the credit under both the ASC and 

regular credit rules (and AIRC rules in the years for which it was available) 

for each member. Some consultants expressed concern that IRS could 

reject credit claims completely even if the only deficiency is in the 

allocation computation. 

Differing Legal Positions 

Taken by IRS and 

Taxpayers 

The primary objection that taxpayer representatives have raised with 

respect to the group credit regulations is that all affected groups are 

required to use the same burdensome allocation procedures even though 

there is no clear basis for them in the IRC, which they say only requires 

that the allocation be in proportion to the QREs “giving rise to the credit.” 

Some commentators contend that the stand-alone credit method does not 

satisfy the principle set out in the IRC any better than would a simpler 

allocation based on each member’s share of current QREs. If a group, as a 

whole, is above its base spending amount, 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. Some would say, in this sense, all QREs give rise to the credit to 

the same extent. Several public commentators and consultants we 

interviewed recommend that groups be allowed to allocate their group 

credits by any reasonable means, as long as the sum of the credits that 

each member receives does not exceed the group credit amount. 

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. An official explained that if two members of a group 

each used a different method that maximized their share of the group 

credit, this would result in the members claiming in aggregate more than 

the group credit amount. If taxpayers could use any reasonable method of 

allocation and group members used different methods, then IRS would 

have no basis for saying whose individual credit had to be reduced in 

order that the aggregate claims by members did not exceed the group 

credit amount. While acknowledging that disagreements within groups 

are likely to be rare, the official noted a case where representatives of two 

Page 101 GAO-10-136 Tax Policy
Appendix VII: Issues Relating to the 

Computation Rules for the Group Credit 

members of the same group separately argued in favor of differing 

allocation rules. 

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 approach. According to Treasury, the former approach 

appears to be the only one that would provide each member some 

incentive to exceed their base spending amount, given that each member 

may not know the tax positions of other group members (i.e., current-year 

and base QREs) until the end of the tax year. The individual member may 

not know the extent to which one more dollar of its own spending will 

increase the group credit amount, but it does know that by maximizing its 

stand-alone credit amount, it will maximize its share of whatever amount 

the group earns as a credit in the aggregate. An IRS official added that 

requiring everyone to use the stand-alone method would ensure a fairer 

distribution of the credit within groups. Otherwise, a parent corporation 

may discriminate in favor of 100-percent owned members and against 50-

percent members in the allocation of credits because some of the benefit 

given to the latter would go to unrelated parties. 

Consequences of 

Alternative Decisions 

Allowing controlled groups to use an alternative allocation method could 

significantly reduce both the compliance burden on the affected groups 

and IRS’s cost of verifying their compliance. If a controlled group agrees 

to use the ASC computation for its group credit and allocates that credit 

among its members on the basis of either each member’s current QREs or 

each member’s stand-alone ASC, then no member would have to maintain 

and update records from the base period for the regular credit, nor would 

IRS have to review those records. Under the current regulations every 

member’s credit claim would be open to revision if IRS found that any of 

their base period spending records are deficient. This alternative 

approach should not impose any other types of costs on IRS beyond what 

it faces under the current regulations. Under either of these approaches 

the only way that IRS can confirm that the group credit has not been 

exceeded is to add up all of the credits claimed by individual members and 

compare that to the group credit amount. 

Effects on Compliance and 

Enforcement Burden 

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 

Effects on Marginal Incentives 

Page 102 GAO-10-136 Tax Policy
Appendix VII: Issues Relating to the 

Computation Rules for the Group Credit 

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. 

For groups in which individual members determine their own research 

budgets, the allocation rules can affect aggregate group research spending 

because they affect the incentives that each member faces. Therefore, if 

one of the allocation methods on average provides higher marginal 

incentives to individual group members, then applying that method could 

result in higher overall research spending. However, neither the standalone 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.5

 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.6

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. However, if group 

management were able to shift credits from tax loss members to those 

with positive liabilities, the group would be able to use more of its 

aggregate credit immediately, rather than carrying it forward to future 

years. The effect of this type of shifting on the efficiency of the credit 

should be relatively minor because, when a credit is carried forward, the 

benefit to the taxpayer and the cost to the government are both 

discounted to the same degree. In any case, a controlled group’s ability to 

target credit shares to members with positive tax liabilities should not be 

 

5

See the technical addendum for a description of selected situations in which each method 

is superior. 

6

Taxpayers are not required to show the computations of their members’ stand-alone 

credits on their tax returns. Each group member reports the group’s total QREs and base 

QREs on its tax return; therefore, data on the spending of individual members are not 

available. 

Page 103 GAO-10-136 Tax Policy
Appendix VII: Issues Relating to the 

Computation Rules for the Group Credit 

Tax Policy

greater under the gross QRE allocation method than under the stand-alone 

credit allocation method. 

The Computation of 

Marginal Incentives for 

Individual Members of a 

Controlled Group 

The marginal incentive that a particular member of a controlled group 

would face under alternative group credit allocation methods depends on 

multiple factors, including: 

1. Which credit method (regular or alternative simplified credit 

(ASC)) is used to compute the group credit; 

2. Which credit method yields the highest stand-alone credit for the 

member; 

3. What, if any, base constraints apply to whichever credit is used; 

4. Whether or not the member is allowed to use its highest standalone credit method; 

5. How the size of the member’s stand-alone credit compares to its 

current-year qualified research expenses (QRE); and 

6. How the member’s share of the group’s total QREs compares to its 

share of the sum of all members’ stand-alone credits. 

When Both the Group and 

the Member Use the 

Regular Credit 

Computation Method 

In the case where a controlled group uses the regular credit method to 

compute its group credit and an individual member earns its highest standalone credit under the regular credit method and the group credit is less 

than or equal to the sum of the members’ stand-alone credit, the marginal 

incentive for that member to spend an additional dollar on research under 

the current rules (MERSA) can be computed as: 

MERSA = [(ISAC + mrm) / (ISUMSAC + mrm)] × (IGC + mrg) - 

(ISAC / ISUMSAC ) × IGC 

where ISAC is the member’s initial stand-alone credit before making it’s 

additional expenditure; ISUMSAC is the initial sum of the stand-alone 

credits of all group members before the one member spends its additional 

dollar; IGC is the initial group credit before the member spends the 

additional dollar; mrm is the applicable marginal rate of credit for the 

member’s stand-alone credit; and mrg is the applicable marginal rate of 

Page 104 GAO-10-136 
Appendix VII: Issues Relating to the 

Computation Rules for the Group Credit 

credit for the group credit.7 The italicized part of this formula shows the 

member’s share of the group credit after spending an additional dollar on 

research;8

 the unitalicized part of the formula shows the member’s share 

before the additional expenditure. The difference between the two parts 

equals the marginal benefit that the member receives for spending the 

additional dollar. 

If the group credit exceeds the sum of the stand-alone credits, then the 

formula for MERSA becomes: 

MERSA = mrm + [(IQRE + 1) / (ISUMQRE + 1)] × (IGC + mrg – 

(ISUMSAC + mrm)) 

– (IQRE / ISUMQRE) × (IGC - ISUMSAC) 

The first term on the right-hand side of the formula, “mrm,” represents the 

member’s share of that portion of the group credit that equals the sum of 

the stand-alone credits.9

 The remainder of the formula shows the 

member’s share of the excess of the group credit over the sum of the 

stand-alone credits.10 The italicized portion of the formula shows the 

member’s share of the excess portion of the credit after spending an 

 

7

The mrm equals 0.2 if the member can earn the regular credit without being subject to the 

50-percent base limitation; it equals .1 if the member is subject to that limitation. The mrg 

is also either 0.2 or 0.1, depending on whether the group is subject to the 50-percent limit. 

The formulas in this appendix ignore the 35 percent reduction in the credit benefit due to 

the offset against the section 174 deduction. (This offset would simply reduce all of the 

marginal effective rates we compute by the same proportion with no effect on the 

comparison we make across allocation methods.) The formulas also ignore delays in credit 

benefits due to the insufficiency of tax liabilities. (We assume that each taxpayer’s tax 

liability status would be the same under either allocation method, so taking credit 

carryforwards into account would not change the ranking of the two methods’ marginal 

incentives.) 

8

When the member increases its QREs by $1 its stand-alone credit increases by mrm, the 

sum of the group members’ stand-alone credit increases by mrm, and the group’s credit 

increases by mrg. 

9

This share is determined as [(ISAC + mrm)/(ISUMSAC + mrm)] × (ISUMSAC + mrm) – 

(ISAC/ISUMSAC) × ISUMSAC. All of the terms in this expression cancel out, except for 

mrm. 

10The share of the stand-alone sum is used to allocate that portion of the group credit that is 

less than or equal to the sum of the stand-alone credits; the share of QREs is used to 

allocate the portion (if any) of the group credit that exceeds the sum of the stand-alone 

credits. 

Page 105 GAO-10-136 Tax Policy
Appendix VII: Issues Relating to the 

Computation Rules for the Group Credit 

additional dollar on research;11 the underlined portion shows the member’s 

share before the additional expenditure. 

The marginal incentive that this same member would face if the entire 

group credit were allocated according to each member’s share of the 

group’s gross QREs (MERQ) can be computed as follows: 

MERQ = [(IQRE+ 1) / (ISUMQRE + 1)] × (IGC + mrg) – (IQRE / 

ISUMQRE) × IGC 

where IQRE is the member’s initial QREs before making its additional 

expenditure; ISUMQRE is the initial sum of the QREs of all group 

members before the one member spends its additional dollar; and IGC is, 

again, the initial group credit before the member spends the additional 

dollar. This formula is the same, regardless of whether IGC is less than, 

equal to, or greater than ISUMSAC. 

When Both the Group and 

the Member Use the ASC 

Computation Method 

The computation of MERs for group members when either the group or 

the member uses the ASC is more complex than in the case of the regular 

credit because each dollar a firm spends in the current year will affect its 

current-year credit as well as its credits in the next three years. The MER 

is the present value sum of these four separate effects. In the case where a 

controlled group uses the ASC method to compute its group credit and an 

individual member earns its highest stand-alone credit under the ASC 

method and the group credit is less than or equal to the sum of the 

members’ stand-alone credit, the current-year effect when that member 

spends an additional dollar on research under the current rules can be 

computed as: 

CY Effect = [(ISAC + mrm) / (ISUMSAC + mrm)] × (IGC + mrg) - (ISAC / 

ISUMSAC ) × IGC, 

which is similar to the first MERSA formula introduced above, except in 

this case both mrm and mrg will equal 0.14. The marginal incentive effect 

in the following year can be computed as: 

 

11When the member increases its QREs by $1 the sum of the group members’ QREs also 

increases by $1, and the group’s credit increases by mrg. 

Page 106 GAO-10-136 Tax Policy
Appendix VII: Issues Relating to the 

Computation Rules for the Group Credit 

Next Year Effect = [(ISAC1 – (1/6) × mrm) / (ISUMSAC1 – (1/6) × 

mrm)] × (IGC1 – (1/6) × mrg) – (ISAC1 / ISUMSAC1) × IGC1 

The “1” at the end of the variable names indicate that they represent the 

values for that variable in the first year into the future. The italicized 

portion of the formula shows how the member’s share of the sum of all 

group members’ stand-alone credits for the next year would change if the 

member increased its spending by $1 this year.12 The underlined portion 

shows that the member’s spending also reduces next year’s group credit 

that is allocated among the members. The final unitalicized, 

nonunderlined portion is the amount of the group credit that the member 

would have received next year without the additional spending this year. 

Similar effects would occur in the 2 subsequent years. The net incentive 

provided to the member is obtained by discounting the three future effects 

and adding them to the current-year effect. 

The current-year incentive effect that this same member would face if the 

entire group credit were allocated according to each member’s share of 

the group’s gross QREs can be computed as follows: 

CY Effect = [(IQRE + 1) / (ISUMQRE + 1)] × (IGC + mrg) - (IQRE / 

ISUMQRE ) × IGC, 

which is the same as for the regular credit, except for the value of mrg. 

The effect in the following year would be: 

Next Year Effect = (IQRE1 / ISUMQRE1) × (IGC1 – (1/6) × mrg) – (IQRE1 / 

ISUMQRE1) × IGC1. 

The member’s additional spending this year does not affect its share of the 

groups total spending next year, but it does increase the base for next 

year’s group credit and, thereby reduces the amount of credit that gets 

allocated to members. Again, this latter effect would be repeated in the 

subsequent 2 years. The formulas for the marginal incentives when the 

ASC is used and the group credit exceeds the sum of the stand-alones are 

more complicated than those above and are not needed to make the basic 

 

12The $1 increase this year increases next year’s base for the member’s stand-alone credit 

by 1/6 of a dollar. (This year is only one of the 3 years that factor into next year’s base and 

only half of each year’s spending goes into that base.) That base increase reduces next 

year’s credit by 1/6 × 0.14 and that reduction also gets reflected in the sum of the members’ 

credits. 

Page 107 GAO-10-136 Tax Policy
Appendix VII: Issues Relating to the 

Computation Rules for the Group Credit 

point that there are common situations in which each credit allocation 

method provides a higher incentive than the other. 

Results Based on 

Numerical Simulations 

One can run numerical simulations with the various formulas for MERSA 

and MERQ to identify common situations in which each allocation method 

provides a higher marginal incentive to a member than the other method. 

The cases identified in table 20 are simply broad examples and do not 

cover all situations in which one or the other allocation methods is 

superior; however, they are sufficient to demonstrate that each of the 

allocation methods performs better than the other in different situations 

that are likely to be common to actual taxpayers.13 For example, when a 

member of a group is subject to the 50-percent base constraint, the standalone credit method provides that member a larger incentive when the 

member’s share of the sum of all members’ stand-alone credits is greater 

than the member’s share of the group’s gross QREs; the gross QREs 

method provides a greater incentive when the converse is true. In 2004 

approximately 75 percent of all regular credit users were subject to the 50 

percent minimum base constraint. 

 

13There is also the more obvious case where the gross QRE method provides a higher 

incentive when the group earns a credit but the individual member cannot exceed its own 

base under either credit computation method. The statements regarding the ASC in table 

20 assume that the credit is extended in its current form for future years. 

Page 108 GAO-10-136 Tax Policy
Appendix VII: Issues Relating to the 

Computation Rules for the Group Credit 

Table 20: A Comparison of Two Methods for Allocating Group Credits in Selected Situations 

When the group credit is less than or equal to 

the sum of the members’ standalone credits 

When the group credit is greater than the sum of 

the members’ standalone credits 

Both the member and 

group use the regular 

credit 

When the member is 

subject to the 50 percent 

minimum base constraint 

(regardless of whether 

the group is subject to 

that constraint) 

The standalone credit method provides a larger 

incentive when the member’s share of the sum of 

all members’ stand-alone credits is greater than 

the member’s share of the group’s gross QREs. 

The gross QREs method provides a larger 

incentive when the member’s share of the 

group’s gross QREs is greater than the 

member’s share of the sum of all members’

stand-alone credits. 

When the two shares are equal, the two 

allocation methods provide the same incentive. 

The standalone credit method provides a larger 

incentive when the member’s share of the sum of all 

members’ stand-alone credits is greater than the 

member’s share of the group’s gross QREs. 

The gross QREs method provides a larger incentive 

when the member’s share of the group’s gross QREs is 

greater than the member’s share of the sum of all 

members’ stand-alone credits. 

When the two shares are equal, the two allocation 

methods provide the same incentive. 

When the member is not 

subject to the 50 percent 

minimum base constraint 

The relationship between the two methods is 

more difficult to summarize under these 

conditions; however the stand-alone method 

performs considerably better relative to the gross 

QREs method under these conditions than when 

the member is subject to the 50 percent 

constraint. 

The two allocation methods provide the same incentive 

when the member’s share of the sum of stand-alone 

credits equals the member’s share of group QREs 

times the ratio of the member’s stand-alone credit over 

0.2 times the member’s QREs. 

The stand-alone credit method provides a larger 

incentive when the member’s share of the sum of all 

member’s stand-alone credits is greater than the 

member’s share of group QREs times the ratio of the 

member’s stand-alone credit over 0.2 times the 

member’s QREs. 

The gross QREs method provides a larger incentive 

when the member’s share of the sum of all member’s 

stand-alone credits is less than the member’s share of 

group QREs times the ratio of the member’s standalone credit over 0.2 times the member’s QREs. 

Given that the ratio of the member’s stand-alone credit 

over 0.2 times the member’s QREs must always be 

less than 0.5, the stand-alone method performs 

considerably better relative to the gross QREs method 

under these conditions than when the member is 

subject to the 50 percent constraint. 

Both the member and the 

group use the ASC 

Page 109 GAO-10-136 Tax Policy
Appendix VII: Issues Relating to the 

Computation Rules for the Group Credit 

When the group credit is less than or equal to 

the sum of the members’ standalone credits 

When the group credit is greater than the sum of 

the members’ standalone credits 

When the member’s 

QREs grow at a 5 

percent rate per year 

The stand-alone credit method provides a larger 

incentive when the member’s share of the sum of 

all members’ stand-alone credits is greater than 

the member’s share of the group’s gross QREs. 

The gross QREs method provides a larger 

incentive when the member’s share of the 

group’s gross QREs is greater than the 

member’s share of the sum of all members’

stand-alone credits. 

When the two shares are equal, the two 

allocation methods provide the same incentive. 

We did not do simulations for such cases because the 

computations are particularly burdensome. 

When the member’s 

QREs grow at a rate of 

more than 5 percent per 

year 

The higher the rate of growth, the higher the ratio 

of the member’s share of the group’s stand-alone 

credits to the member’s share of the group’s 

gross QREs must be in order for the stand-alone 

credit method to provide a higher incentive than 

the gross QREs method. 

We did not do simulations for such cases. 

When the member’s 

QREs grow at a rate of 

less than 5 percent per 

year 

The lower the rate of growth, the lower the ratio 

of the member’s share of the group’s stand-alone 

credits to the member’s share of the group’s 

gross QREs can be in order for the stand-alone 

credit method to provide a higher incentive than 

the gross QREs method. 

We did not do simulations for such cases. 

Source: GAO. 

Page 110 GAO-10-136 Tax Policy
Appendix VIII: Comments from the U.S. Appendix VIII: Comments from the U.S. Department of Treasury 

Department of Treasury 

Page 111 GAO-10-136 Tax Policy 
Appendix IX: GAO Contact and Staff Appendix IX: GAO Contact and Staff Acknowledgements 

Acknowledgements 

James R. White, (202) 512-9110 or whitej@gao.gov

In addition to the contact named above, James Wozny, Assistant Director, 

Ardith Spence, Susan Baker, Sara Daleski, Kevin Daly, Mitch Karpman, 

Donna Miller, Cheryl Peterson, and Steven Ray, made key contributions to 

this report. 

Page 112 GAO-10-136 Tax Policy

GAO Contact 

Acknowledgments 

(194736) 
GAO’s Mission The Government Accountability Office, the audit, evaluation, and 

investigative arm of Congress, exists to support Congress in meeting its 

constitutional responsibilities and to help improve the performance and 

accountability of the federal government for the American people. GAO 

examines the use of public funds; evaluates federal programs and policies; 

and provides analyses, recommendations, and other assistance to help 

Congress make informed oversight, policy, and funding decisions. GAO’s 

commitment to good government is reflected in its core values of 

accountability, integrity, and reliability. 

The fastest and easiest way to obtain copies of GAO documents at no cost 

is through GAO’s Web site (www.gao.gov). Each weekday afternoon, GAO 

posts on its Web site newly released reports, testimony, and 

correspondence. To have GAO e-mail you a list of newly posted products, 

go to www.gao.gov and select “E-mail Updates.” 

Obtaining Copies of 

GAO Reports and 

Testimony 

Order by Phone The price of each GAO publication reflects GAO’s actual cost of 

production and distribution and depends on the number of pages in the 

publication and whether the publication is printed in color or black and 

white. Pricing and ordering information is posted on GAO’s Web site, 

http://www.gao.gov/ordering.htm. 

Place orders by calling (202) 512-6000, toll free (866) 801-7077, or 

TDD (202) 512-2537. 

Orders may be paid for using American Express, Discover Card, 

MasterCard, Visa, check, or money order. Call for additional information. 

Contact: 

Web site: www.gao.gov/fraudnet/fraudnet.htm

E-mail: fraudnet@gao.gov

Automated answering system: (800) 424-5454 or (202) 512-7470 

Ralph Dawn, Managing Director, dawnr@gao.gov, (202) 512-4400 

U.S. Government Accountability Office, 441 G Street NW, Room 7125 

Washington, DC 20548 

To Report Fraud, 

Waste, and Abuse in 

Federal Programs 

Congressional 

Relations 

Chuck Young, Managing Director, youngc1@gao.gov, (202) 512-4800 

U.S. Government Accountability Office, 441 G Street NW, Room 7149 

Washington, DC 20548 

Public Affairs 

Please Print on Recycled Paper