Tax Policy: The Research Tax Credit's Design and Administration Can Be Improved
Published: 2009-11-06T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: 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. Government Accountability Office (GAO) was asked to describe the credit's use, determine whether it could be redesigned to improve the incentive to do new research, and assess whether recordkeeping and other compliance costs could be reduced. GAO analyzed alternative credit designs using a panel of corporate tax returns and assessed administrability by interviewing Internal Revenue Service (IRS) and taxpayer representatives.
section_title: What GAO Found
paragraphs: 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.

section_title: Letter
paragraphs: Since 1981, the tax credit for qualified research expenses has provided  significant subsidies (an estimated $5.6 billion for fiscal year 2009) to  encourage business investment in research and development.  This type of  investment can have a profound effect on long-term growth if it fosters  innovation.  Economists widely agree that some government subsidy for  research is justified because the social returns from research exceed the  private returns that investors receive.  In the absence of a subsidy, the  amount invested in research would be less than optimal from society’s  standpoint.
Despite the widespread support for the concept of a credit for increasing  research activities, concerns have been raised about the cost-effectiveness  of the design of the current credit and its administrative and compliance  costs.  Very generally, the research credit provides a subsidy for spending  in excess of a base amount.  One design issue is how the base is  determined and how well it achieves its objective of targeting benefits only  to research spending that would not have been done without the credit.
To help inform congressional deliberations on the credit, you asked us to  (1) describe how taxpayers are currently using the credit; (2) identify  what, if any, changes to the credit’s design may be able to increase the  incentive to do additional research with social benefits; and (3) identify  specific and significant problems, if any, that exist in the administration of  the credit and options to address them.
To provide information on the use of the research credit we analyzed  Internal Revenue Service (IRS) taxpayer data from the Statistics of Income  (SOI) Division’s annual samples of corporate tax returns for the most  recent years available (2003 through 2006) supplemented by data collected  by IRS examiners.  We determined that the data were sufficiently reliable  for our purpose of describing the general characteristics of R&E Credit  claimants; the amount and type of R&E Credit claimed by taxpayers; the  average rate of credit for claimants; and the types of research spending for  which taxpayers are claiming the credit (i.e., basic vs. applied research, as  defined by tax rules).  However, we do discuss certain limitations of the  data and how those may affect selected statistics.
To identify what, if any, problems exist with the design of the credit, we  examined its performance, relative to alternative designs, in terms of three  criteria.  Our first criterion was the amount of revenue the government  must forgo under each of the alternative credit designs in order to provide  a given level of incentive.  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.  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.
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.
subsections: section_title: Background
subsections: section_title: History and Overview of Credits for Different Types of Research
paragraphs: Congress created the research tax credit in 1981 to encourage businesses  to do more research.  The credit has never been a permanent part of the  Internal Revenue Code (IRC).  Since its enactment on a temporary basis in  1981, the credit had been extended 13 times, often retroactively.  There  was only a 1-year period (between June 30, 1995, and July 1, 1996) during  which the credit was allowed to lapse with no retroactive provision upon  reinstatement.  Most recently, the credit was extended through December  31, 2009.
The basic design of the credit has been modified or supplemented several  times since its inception.  For tax years ending after December 31, 2006,  through December 31, 2008, IRC Section 41 allowed for five different  credits.  Three of the credits, the regular research credit, the alternative  incremental research credit (AIRC), and the alternative simplified credit  (ASC), rewarded the same types of qualified research and are simply  alternative computational options available to taxpayers.  Each taxpayer  could claim no more than one of these credits.  (For purposes of this  report we use the term research credit when referring collectively to these  options.)  The AIRC option was repealed beginning January 1, 2009, while  the ASC and regular research credit are available through the end of 2009.   The other two separate credits, the university basic research credit and the  energy research credit are targeted to more specific types of research and  taxpayers that qualified could claim them in addition to the research  credit.  This report does not address those separate credits.
section_title: How the Research Credit Is Targeted
paragraphs: 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.
subsections: section_title: Qualified Research Expenses
paragraphs: The IRC defines credit eligibility in terms of both qualifying research  activities and types of expenses.  It specifies the following four criteria  that a research activity must meet in order to qualify for purposes of the  credit:    The activity has to qualify as research under IRC section 174 (which  provides a separate expensing allowance for research), which requires  that an activity be research in the “experimental or laboratory sense  and aimed at the development of a new product.”
The research has to be undertaken for the purpose of discovering  information that is technological in nature.
The objective of discovering the information has to be for use in the  development of a new or improved business component of the  taxpayer.
Substantially all of the research activities have to constitute elements  of a process of experimentation for a qualified purpose.
The IRC also specifies that only the following types of expenses for in- house research or contract research would qualify:    wages paid or incurred to employees for qualified services;    amounts paid or incurred for supplies used in the conduct of qualified    amounts paid or incurred to another person for the right to use  computers in the conduct of qualified research; and  in the case of contract research, 65 percent of amounts paid or  incurred by the taxpayer to any person, other than an employee, for  qualified research.
Spending for structures, equipment, and overhead do not qualify.  In  addition, the IRC identifies certain types of activities for which the credit  cannot be claimed, including research that is    conducted outside of the United States, Puerto Rico, or any other U.S.    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.
section_title: The Rationale behind an Incremental Design for the Credit
paragraphs: The research credit has always been an incremental subsidy, meaning that  taxpayers earn the credit only for qualified spending that exceeds a  defined base amount of spending.  The purpose of this design is to reduce  the cost of providing a given amount of incentive.  Figure 1 illustrates the  difference between an incremental credit and two common alternative  designs for a subsidy—a flat credit and a capped flat credit.  In the case of  the flat credit a taxpayer would earn a fixed rate of credit, 20 percent in  this example, for every dollar of qualified spending.  The taxpayer’s total  qualified spending consists of the amount that it would have spent even if  there were no subsidy, plus the additional or “marginal” amount that it  spends only because the credit subsidy is available.  The subsidy  encourages additional spending by reducing the after-tax cost of a  qualified research project and, thereby, increasing the project’s expected  profitability sufficiently to change the taxpayer’s investment decision from  no to yes.  The subsidy provided for the marginal spending is the only  portion of the credit that affects the taxpayer’s research spending  behavior.  The remainder of the credit is a windfall to the taxpayer for  doing something that it was going to do anyway.  In the case of a capped  credit, the taxpayer earns a fixed rate of credit on each dollar of qualified  spending up to a specified limit.  If, as in the example shown in figure 1,  the credit’s limit is less than the amount that the taxpayer would have  spent anyway, all of the credit paid is a windfall and no additional  spending is stimulated because no incentive is provided at the margin.  In  contrast, the objective of an incremental credit is to focus as much of the  credit on marginal spending while keeping the amount provided as a  windfall to a minimum.  The last example in figure 1 shows the case of an  ideal incremental credit—one for which the base of the credit (the amount  of spending that a taxpayer must exceed before it can begin earning any  credit) perfectly measures the amount of spending that the taxpayer would  have done anyway.  This credit maintains an incentive for marginal  spending but eliminates windfall credits, substantially reducing the credit’s  revenue cost.  Alternatively, the savings from the elimination of windfalls  could be used to increase the rate of credit on marginal spending.
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)
Credit  =  20%  ×  ,  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.
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.  (discontinued as of January 1, 2009)
section_title: Restrictions on the Credit’s Use
paragraphs: 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.
section_title: Group Aggregation Rules
paragraphs: 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.”  Without such rules, a corporate group might shift current  research expenditures away from members that would not be able to earn  the credit due to their high base expenditures to members with lower base  expenditures.  A group could, thereby, increase the amount of credit it  earned without actually increasing its research spending in the aggregate.   Under the IRC, for purposes of determining the amount of the research  credit, the qualified expenses of the same controlled groups of  corporations are aggregated together.  The language of the relevant  subsection specifically states that:  1.  All members of the same controlled group of corporations shall be  treated as a single taxpayer,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.
section_title: The Marginal Incentive Provided by the Research Tax Credit
paragraphs: 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 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. 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.  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.  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.
section_title: Estimating the Credit’s Stimulative Effect
paragraphs: . 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.
In this study, we provide some estimates of the credit’s weighted average  MER and revenue cost, as well as estimates of the aggregate amount of  qualified research spending.  We have not estimated the price elasticity of  research spending and the available estimates from past empirical  research leave considerable uncertainty regarding the size of that  elasticity.  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.
section_title: Large Corporations Have Dominated the Use of the Research Credit, Which Provided an Average Marginal Incentive of About 7 Percent in 2003 through 2005
paragraphs: 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).  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.  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).
Prior to the introduction of the ASC in 2006, taxpayers that used the  regular credit accounted for the majority of QREs and an even larger  majority of the research credit claimed.  In 2005, regular credit users  reported about 75 percent of all QREs and claimed about 90 percent of  total research credits.  (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; however, they were  quite sensitive to the price elasticity assumptions.  If the elasticity was -0.5,  the bang-per-buck for 2005 would have been about $0.80.  If the elasticity  was -2, the bang-per-buck would have been about $3.00.
Data on amended claims filed by our panel of large corporations indicate  that, in the aggregate, these amendments increased the amount of credit  claimed by between 1.5 percent and 5.4 percent (relative to the amounts  claimed on initial returns) for each tax year from 2000 through 2003.  (See  tables 5 through 8 in appendix II.)  The credit increase through  amendments for tax year 2004 was only 0.5 percent.  Data from IRS  examinations of these large corporations indicate that examiners  recommended changes that, in the aggregate, would have decreased  credits claimed by between 16.5 and 27.1 percent each tax year from 2000  through 2003.  (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.  These expectations are critical because they  are what affect the taxpayer’s decisions, not the amounts of credit actually  received well after the decisions have been made.  For those taxpayers  that do not expect to file amendments and do not expect IRS to change  their credits, the amounts claimed on their original returns should be the  best estimate of their expectations.  For taxpayers that know they may be  stretching the rules with some of the expenses they are trying to claim as  QREs, their post-exam credit amounts may be better estimates of their  expectations.  In other cases, given the lack of clarity in certain aspects of  the definitions of both QREs and gross receipts, taxpayers may be  uncertain whether they will receive any credit for particular research  projects.  Such uncertainty reduces the credit’s effective incentive.
section_title: Important Trade-Offs Exist in the Choice of Research Credit Designs
paragraphs: The regular credit provides a higher average MER for a given revenue cost  than does the current ASC; however, over time, the historically fixed base  of the regular credit becomes a very poor measure of the research  spending that taxpayers would have done anyway.  As a result, the  benefits and incentives provided by the credit become allocated arbitrarily  and inequitably across taxpayers, likely causing inefficiencies in resource  allocation.
As we noted earlier, an ideal incremental credit would reward marginal  research spending but not any spending that a taxpayer would have done  anyway.  In reality, it is impossible for policymakers to know how much  research spending taxpayers would have done without the credit.  Any  practical base that can be designed for the credit will only approximate  the ideal base with some degree of inaccuracy.  The primary base for the  regular credit (except for start-up companies) is determined by a  taxpayer’s spending behavior that occurred up to 25 years ago (see the  computation rules on page 7).  There is little reason to believe that, in  most cases, the ratio of research spending to gross receipts from that long  ago, when multiplied by the taxpayer’s most recent 4-year average of gross  receipts, would accurately approximate the ideal base for that taxpayer.
Most credit claimants received substantial windfalls.  Regular credit  claimants subject to the 50 percent minimum base represented about 71  percent of all claimants in 2005 (see figure 5 in appendix II).  More than  half of the credit such claimants earned was a windfall.  Even the highest  elasticity estimates and the largest possible MER (which together should  produce the largest increase in research spending) indicate that spending  increases due to the credit represent less than 15 percent of the total  research spending of these claimants.  Since regular credit users subject to  the 50 percent minimum base receive a credit for half of their research  spending, the credit for marginal spending is less than half of the credit  they receive.
Inaccuracies in the base also cause disparities across taxpayers in both the  marginal incentives and windfall benefits that they receive from the credit.   Table 1 shows the extent of the disparities across taxpayers that use  different credit options and are subject to different constraints.  Taxpayers  for which bases exceeded their actual spending received no incentive from  the credit.  Regular credit users whose primary bases were not so  inaccurately low that the minimum base took effect received had MERs of  13 percent (if they could use their credits immediately), while those with  primary bases so inaccurate that they were subject to the minimum base  had their MERs cut to 6.5 percent (again, if they could use their credits  immediately).  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.
Although data are not yet available on credit use after the ASC was  introduced, we applied current credit rules to the historical data from our  panel of large credit claimants to estimate how many of them would have  chosen ASC if it had been available in 2003 and 2004.  We found that, if  taxpayers had selected the option that provided them with the largest  credit amount, most of the panel members would have switched to the  ASC, but a significant number would still have claimed the regular credit.   ASC users would have accounted for about 62 percent of the panel  population’s total QREs and between 56 percent to 60 percent of the  revenue cost of all panel members in those years.  (See table 13.)  Some  taxpayers still had MERs over 10 percent while others had negative MERs.
The disparate distribution of incentives and windfalls is not only  inequitable, it can also result in a misallocation of research spending and  economic activity in general across competing sectors.  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.)
subsections: section_title: Under the ASC’s Moving- Average Base, Marginal Incentives Are Reduced Because Current Spending Reduces the Amount of Credit Earned in Future Years
paragraphs: 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.  As a result, the actual benefit that the taxpayer receives for  increasing this year’s spending is cut in half, and the MER is reduced to 4.6  percent.  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.
Given that the ASC base is only one-half of the taxpayer’s past 3 years’  average spending, most research-performing companies should be able to  earn some credit every year, which was an important reason why this  option was introduced.  However, the low base is likely to be below most  taxpayer’s ideal base and some are likely to earn credit on substantial  amounts of research spending that they would have done anyway.  There  currently is no minimum base for the ASC to limit the amount of windfall  credit that taxpayers can earn.  Only the lower credit rate (14 percent vs.  20 percent for the regular credit) contains the cost of these windfalls.
section_title: The Introduction of the ASC Option Is Likely to Have Lowered the Bang- per-Buck of the Research Credit but Increased the Number of Taxpayers Receiving Positive Incentives
paragraphs: 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.  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.  These results indicate that the  introduction of the ASC lowered the bang-per-buck of the credit.  The  availability of the new option would not have reduced any taxpayer’s  windfall credit, but it would likely have increased the windfalls of some.   Those taxpayers that would have switched from the regular credit to the  ASC are likely to have seen their MERs decline, while those who switched  from the AIRC may have seen their MERs increase or decrease.
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.
section_title: Changing the Regular Credit to Reduce Distortions Caused by Base Inaccuracies Would Come at the Cost of Reducing the Credit’s Bang-per-Buck
paragraphs: The problems we identified with the base of the regular credit can be  addressed by either (1) eliminating the regular credit option or (2)  retaining the regular credit but updating its base so that the distribution of  credit benefits and incentives across taxpayers would be less uneven and  arbitrary.  Under either of these approaches the primary bases for all  taxpayers would be linked to their recent spending behavior, rather than  decades-old behavior.  The recent behavior is likely to be more closely  correlated with their ideal bases than the older behavior would be.
The results of our simulations (summarized in the top portion of table 2)  indicate that both of these changes would have approximately the same  effect because, in each case, all of the corporations in our panel would use  the ASC. (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.  In both cases, if the rate of the ASC is kept  at 14 percent, both the average MER and the revenue cost would decrease,  but the percentage decrease in the average MER in most cases would be at  least twice as large, meaning that the credit’s bang-per-buck would  decrease.  If the rate of the ASC were raised to 20 percent, the average  MER would increase relative to existing rules under most combinations of  assumptions, but the revenue cost would increase to a much larger extent,  again, meaning that the bang-per-buck would decrease.
No clear purpose would be served by retaining both the ASC and a regular  credit whose base would be updated almost as frequently as that of the  ASC.  If the bases for both of the options were linked to recent spending  behavior, there would be no rationale for providing taxpayers with  different rates of credit under two options.  Moreover, once taxpayers  began to expect regular updates of the base, the expected negative effects  on future credits would lower the MER of the regular credit in the same  way that they do for the ASC.  One potential compromise between a  frequently updated base that significantly reduces the credit’s bang-per- buck and a fixed base that causes distorting disparities is to have a base  that is updated only in those cases where it has become evidently far out  of line for individual taxpayers.  For example, taxpayers that spend less  than 75 percent of their base amount for the regular credit could be given  the option of using a more recent period of years for computing their fixed  base percentage.  Taxpayers at the other extreme—those subject to the  current minimum base—could be required to use a more recent base  period.  Taxpayers between these two extremes would not have their  bases updated, which means that, if they are not close to the minimum  base, they would not face negative future effects.  However, one  significant problem with this approach is that it would give taxpayers who  are close to being subject to the minimum base an extremely large  disincentive to increase their spending.  In addition, the taxpayers without  updated bases would still face the substantial recordkeeping difficulties  that are discussed in a later section.
section_title: The Credit’s Bang-per- Buck Can Be Improved by Adding a Minimum Base Constraint to the ASC
paragraphs: 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.  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.  Revenue savings would be achieved  regardless of whether the rate of the ASC is 14 percent or 20 percent.  We  also examined the effects of adding a 75-percent minimum base; however,  under almost all assumptions we found the revenue savings to be less than  or equal to those gained by adding a 50-percent minimum base.
If both the ASC with a 14-percent rate and the regular credit with a 20- percent rate and an updated base are available, the addition of a minimum  base to the ASC would cause some taxpayers to prefer the regular credit  over the ASC.  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.
section_title: Issues of Contention between Taxpayers and IRS Relating to the Research Credit Are Both Extensive and Acute
subsections: section_title: Several Aspects of the Definition of Qualified Research Expenses Have Been Significant Sources of Contention between Taxpayers and IRS
paragraphs: A well-targeted definition of QREs (and IRS’s ability to enforce the  definition) can improve the efficiency of the credit to the extent that it  directs the subsidy toward research with high external benefits and away  from research with low external benefits.  By focusing the subsidy in this  manner, the definition can increase the amount of social benefit generated  per dollar of tax subsidy provided through the credit.  Specifying a  definition that serves this purpose and that is also readily applied by both  IRS and taxpayers has proven to be a challenge for both Congress and the  Department of the Treasury.  There are numerous areas of disagreement  between IRS and taxpayers concerning what types of spending qualify for  the research credit.  These disputes raise the cost of the credit to both  taxpayers and IRS and diminish the credit’s incentive effect by making the  ultimate benefit to taxpayers less certain.
Many of the tax practitioners we interviewed had a common general  complaint that IRS examiners often demanded that the research activities  result in a higher standard of innovation than required by either the IRC or  Treasury regulations.  The IRS officials we interviewed disagreed with  these assertions and referred to language from their Research Credit Audit  Technique Guide that instructs examiners on the relevant language from  current regulations.  Both practitioners and IRS officials acknowledged  that some controversies arise because language in the IRC and regulations  does not always provide a bright line for identifying qualified activities.   For example, one qualification requirement is that the research must be  intended to eliminate uncertainty concerning the development or  improvement of a business component.  The regulations say that  uncertainty exists “if the information available to the taxpayer does not  establish the capability or method for developing or improving the  business component, or the appropriate design of the business  component.”  An IRS official said that examiners could use clarification  of the meaning of “information available to the taxpayer,” while a  practitioner noted that the regulations do not say what degree of  improvement in a product is required for the underlying research to be  considered qualified.  The practitioner said that research for  improvements is more difficult to get qualified than research for new  products.
Several particularly contentious issues relate to specific types of research  activities or expenses, including the following:  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.  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.  Some commentators have questioned  whether there is still an economic rationale for distinguishing between IUS  and software used for other purposes, given that innovations in software  can produce spillover benefits regardless of whether the software is sold  to third parties.  IRS officials say that eliminating the distinction would  significantly increase the revenue cost of the credit but they doubt that it  would simplify administration.  They believe that a bright-line definition of  IUS, such as that contained in 2001 proposed regulations, is the only  practical approach for dealing with this issue.  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.”   Some tax consultants told us that IRS fairly consistently disqualifies  research designed to address uncertainty relating to the appropriate  design of a product.  One of them said that IRS rejected testing activities  simply on the basis of whether the testing techniques, themselves, were  routine.  IRS officials said that they typically reject testing that is done  after the taxpayer has proven the acceptability of its production process  internally.  They noted that there is no bright line between nonqualifying  ordinary quality control testing and qualified validation testing.  These  determinations are made on a case-by-case basis for each activity.  The  official also said that they have disagreements with taxpayers over when  commercial production begins and suggested that this is one area where  some further clarification in regulations might help.  Product testing is a  particularly important issue for software development, which in general  (not just IUS) is another area of significant contention between IRS and  taxpayers.
Direct supervisory and support activities.  Qualified research  expenses include the wages of employees who provide direct supervision  or direct support of qualified research activities.  The practitioners we  interviewed said that it is extremely difficult to get IRS to accept that  higher level managers are often involved in research and the direct  supervision of research.  Many of their clients have flat organizational  structures and the best researchers are often given higher titles so that  they can be paid more.  They say that IRS often rejects wage claims simply  on the basis of job titles.  IRS officials told us that wages of higher level  managers could be eligible for the credit; however, the burden of proof is  on the taxpayer to substantiate the amount of time that those managers  actually spent directly supervising a qualified activity.  Regarding the issue  of direct support, some commentators would like IRS’s guidance to more  clearly state that activities such as bid and proposal preparation (at the  front end of the research process) and development testing and  certification testing (at the final stages of the process) are qualified  support activities that do not have to meet specific qualification tests  themselves, as long as the activities that they support already qualify as  eligible research.  IRS officials told us that they would like better guidance  on this issue and were concerned that some taxpayers want to include the  wages of anyone with any connection at all to the research, such as  marketing employees who attend meetings to talk about what customers  want.
Supplies.  The IRC specifically excludes expenditures to acquire  depreciable property from eligibility for either the deduction of research  expenditures under section 174 or for the research credit.  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.   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.  Taxpayers are challenging IRS’s position in at least  one pending court case. 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.
section_title: 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
paragraphs: 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).
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  regulations are clear on this point and IRS has issued differing legal  analyses in specific cases over the years.
IRS’s current interpretation of the credit regulations that generally exclude  transfers between members of controlled groups is that it applies only to  QREs and not to gross receipts; consequently, all intragroup sales should  be included when computing a group’s total gross receipts.  This option  would eliminate any double-counting of QREs but could overstate the  resources available to the group by double-counting sales and income  payments between group members.  However, going to the other extreme  and excluding all intragroup transactions from the group’s total gross  receipts could exclude a large share of the export sales of U.S.  multinational corporations (those made to foreign affiliates for subsequent  resale abroad) from gross receipts.  This result would favor regular credit  users whose export sales have increased as a share of their total sales and  disfavor users whose export shares have declined.  These disparities in the  credit benefits across taxpayers serve no useful purpose.
An intermediate alternative would be to exclude all transactions between  controlled group members except for intermediate sales by U.S. members  to foreign members.  This approach would not discriminate among  taxpayers on the basis of whether they export their products or sell them  domestically because it would include all sales that are effectively  connected with the conduct of a trade or business within the United States  in a group’s gross receipts.  This option would also eliminate any double- counting of intragroup transfers in gross receipts, which is important if  Congress wishes to continue using gross receipts as a measure of the  resources available to corporations.
section_title: Substantiating the Validity of a Research Credit Claim Is a Demanding Task for Both Taxpayers and IRS
paragraphs: Neither the IRC nor Treasury regulations contain specific recordkeeping  requirements for claimants of the research credit.  However, claimants are  subject to the general recordkeeping rules of IRC section 6001 and  Treasury regulations section 1.6001, applicable to all taxpayers, that  require them to keep books of account or records that are sufficient to  establish the amount of credit they are claiming.  In the case of the  research credit, a taxpayer must provide evidence that all of the expenses  for which the credit is claimed were devoted to qualified research  activities, as defined under IRC section 41.  Section 41 requires that the  qualification of research activities be determined separately with respect  to each business component (e.g., a product, process, or formula), which  means that the taxpayer must be able to allocate all of its qualified  expenses to specific business components.  Moreover, the taxpayer must  be able to establish these qualifications and connections to specific  components not only for the year in which the credit is being claimed, but  also for all of the years in its base period.
There were wide difference in opinions between the IRS examiners and  the tax practitioners we interviewed regarding what methods are  acceptable for allocating wages between qualifying and nonqualifying  activities.  Practitioners noted that IRS prefers project accounting but, in  its absence, used to accept cost center or hybrid accounting; however, in  recent years, IRS has been much less willing to accept claims based on the  latter two approaches.  They also said that IRS examiners now regularly  require contemporaneous documentation of QREs, even though this  requirement was dropped from the credit regulations in 2001.  Some  practitioners suggested that the changes in IRS’s practices came about  because examiners were having difficulty determining how much QREs to  disallow in audits when they found that a particular activity did not  qualify.  Others said that IRS does not want to devote the considerable  amounts of labor required to review the hybrid documentation.  The IRS  officials we interviewed said that more taxpayers have or had project  accounting than was suggested by the tax practitioners.  The officials said  that the consultants ignored these accounts because they boxed them in  (in terms of identifying qualified research expenses).  In their view the  high-level surveys and interviews of managers or technical experts from  the business, which many taxpayers try to use as evidence, are not a  sufficient basis for identifying QREs.  The officials noted that sometimes  consultants conduct interviews for one tax year and then extrapolate their  results to support credit claims for multiple earlier tax years.
IRS officials have been particularly concerned with the quality of late or  amended filings of credit claims.  In April 2007, IRS designated “research  credit claims” as a Tier I compliance issue because of the volume and  difficulty of auditing these claims.  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.
The burden of substantiating research credit claims represents a  significant discouragement to potential credit users; however, the  flexibility in substantiation methods that many practitioners seek could  help some taxpayers claim larger credits than those to which they are  entitled.  Although some taxpayers, particularly those for which research  activities constitute a large proportion of their total operations, are able to  meet the recordkeeping standards that IRS is currently enforcing, many  taxpayers would find it extremely burdensome to meet these  requirements.  One consulting firm told us that they recently tried to shift  all of their clients to project accounting.  This effort was successful;  however, it was extremely difficult for the businesses.  Other practitioners  said that many taxpayers simply would not take on such an effort just to  claim the credit.  Allowing taxpayers to allocate their expenses between  qualified and nonqualified activities after the fact and, in part, on the basis  of oral testimony of the taxpayers’ experts would be less burdensome for  businesses than requiring contemporaneous time accounting by type of  activity and by specific project.  However, the experts would have an  incentive to overstate the proportion of labor costs identified as QREs and  IRS would have no way to verify these oral estimates. Treasury and IRS  face a difficult trade-off between, on the one hand, increasing taxpayer  compliance burdens and deterring some taxpayers from using the credit  and, on the other hand, accepting overstated credit claims.
section_title: Substantiating Base Period QREs Is Extremely Challenging
paragraphs: All of the difficulties that taxpayers face in substantiating their QREs are  magnified when it comes to substantiating QREs for the historical base  period (1984 through 1988) of the regular credit.  Taxpayers are required  to use the same definitions of qualified research and gross receipts for  both their base period and their current-year spending and receipts.   However, many firms do not have good (if any) expenditure records dating  back to the early 1980s base period and are unable to precisely adjust their  base period records for the changes in definitions promulgated in  subsequent regulations and rulings.  Taxpayers also have great difficulty  adjusting base period amounts to reflect the disposition or acquisition of  research-performing entities within their tax consolidated groups.  Some  practitioners would like to see some flexibility on IRS’s part in terms of  base period documentation.  They noted that in cases where a taxpayer’s  records are missing or otherwise lacking, courts have permitted taxpayers  to prove the existence and amount of expenditure through reasonable  estimation techniques.  The IRS officials we interviewed said that  estimates are allowable only if the taxpayer clearly establishes that it has  engaged in qualified research and that its estimates have a sufficiently  credible evidentiary basis to ensure accuracy.  One official noted that IRS  not likely to question a taxpayer’s base amount if the latter uses the  maximum fixed base percentage; however, he did not think that IRS would  have the authority to say that taxpayers could take that approach without  showing any records at all for the base period.  Neither IRS nor Treasury  officials we interviewed saw any administrative problems arising if the IRC  were changed to relieve taxpayers of the requirement to maintain base  period records if they used the maximum fixed base percentage.
section_title: Taxpayers Would Benefit from Greater Flexibility in Electing the ASC Option
paragraphs: 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.  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.  If taxpayers are unhappy with  the form of credit, they can choose another form for the following tax  year.  Allowing taxpayers to elect different forms of the credit on amended  returns in response to an audit in order to maximize their credit would  create administrative burdens for IRS.  IRS officials agreed that permitting  changes in credit elections could require examiners to audit some  taxpayers’ credits twice; however, they saw no problem with allowing  taxpayers to claim either alternative credit on an amended return if the  taxpayer had not previously filed a regular credit claim for the same tax  year.
Taxpayers that fail to claim the research credit on timely filed tax returns  are materially disadvantaged by the election limitations that apply to any  subsequent claims they file on amended returns.  There appears to be no  reason to prohibit taxpayers from electing either the ASC or AIRC method  of credit computation on an amended return for a given tax year, as long  as they have not filed a credit claim using a different method on an earlier  return for that same tax year.
section_title: Existing Rules for Allocating Group Credits Are Unnecessarily Burdensome
paragraphs: 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.  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.  In specifying that controlled groups be treated as single  taxpayers for purposes of the credit Congress clearly wanted to ensure  that a group, as a whole, exceeded its base spending amount before it  could earn the credit.  It is not clear that Congress was concerned that  each member has an incentive to exceed its own base.  The reason for  having a base amount is to contain the revenue cost of the credit by  focusing the incentive on marginal spending.  In the case of controlled  groups the cost is controlled at the group level; whether individual  members exceed their own bases has no bearing on the cost of the credit.   If the choice between two allocations methods does not affect the revenue  cost, then the remaining questions follow:   1.  Does one of the methods provide a greater incentive to increase  research spending?  2.  Is one significantly less burdensome to taxpayers and IRS?
For groups in which individual members determine their own research  budgets, neither the stand-alone credit allocation method nor the gross  QRE allocation method is unequivocally superior in terms of the marginal  incentives that they provide to individual members.  Each of the two  methods performs better than the other in certain situations that are likely  to be common among actual taxpayers.  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.
section_title: Conclusions
paragraphs: Two significant concerns arise from the lack of any update of the regular  credit’s base since it was introduced in 1989.  First, the misallocation of  resources that can result from the uneven distribution of both marginal  incentives and windfall benefits across taxpayers could lead to missed  opportunities for the country to benefit from research projects with higher  social rates of return.  Second, the requirement to maintain detailed  records from the 1980s, updated for subsequent changes in law and  regulations, represents a considerable compliance burden for regular  credit users (including some that are required to use that option).  Regular  updates of the base would substantially reduce these problems; however,  no clear purpose would be served by retaining both the ASC and a regular  credit, the base of which would be updated almost as frequently as that of  the ASC.  Unfortunately, neither of the problems can be avoided without a  reduction in the credit’s bang-per-buck.  The addition of a minimum base  to the ASC would likely improve the bang-per-buck of that credit (the  extent would depend on certain estimating assumptions) and also reduce  inequities in the distribution of windfall credits.
The research credit presents many challenges to both taxpayers and IRS.   In a number of areas, current guidance for identifying QREs does not  enable claimants or IRS to make bright-line determinations.  In some of  these areas further clarification is possible; in others ambiguity may be  difficult to reduce.  In some cases, drawing lines that make the definition  of QREs more liberal would likely result in the credit being less well- targeted to research with large spillover benefits to society.  Instead, the  credit would be shifted toward a broader subsidy for high-tech jobs or  manufacturing in general.  Documenting and verifying that particular  expenses are qualified for the credit involve considerable resource costs  on the part of taxpayers and IRS.  Moreover, widespread disagreements  between IRS and taxpayers over the adequacy of documentation leave  many taxpayers uncertain about the amounts of credit they will ultimately  receive.  Recordkeeping burdens may discourage some taxpayers from  using the credit and the uncertainty reduces the credit’s effective  incentive.  Relaxing recordkeeping requirements would alleviate these  problems; however, there remains a risk that such a relaxation could  significantly increase the amount of credit provided for spending of  questionable merit.  Despite the current wide gap between the views of  taxpayers and IRS, there may be opportunities to reduce certain burdens  without opening the door to abuse.  At a minimum, an organized dialogue  among Treasury, IRS, and taxpayers should be able to reduce some  uncertainty over what types of documentation are acceptable.
section_title: Matters for Congressional Consideration
paragraphs: 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.
section_title: Recommendations for Executive Action
paragraphs: In order to allow more taxpayers to benefit from the reduced  recordkeeping requirements offered by the ASC option, the Secretary of  the Treasury should take the following two actions:    Modify credit regulations to permit taxpayers to elect any of the  computational methods prescribed in the IRC in the first credit claim  that they make for a given tax year, regardless of whether that claim is  made on an original or amended tax return.
Modify credit regulations to allow controlled groups to allocate their  group credits in proportion to each member’s share of total group  QREs, provided that all group members agree to this allocation  method.
In order to significantly reduce the uncertainty that some taxpayers have  about their ability to earn credits for their research activities, the Secretary  of the Treasury should take the following six actions:  Issue regulations clarifying the definition of internal-use software.  Issue regulations clarifying the definition of gross receipts for purposes  of computing the research credit for controlled groups of corporations.  Issue regulations regarding the treatment of inventory property under  section 174 (specifically relating to the exclusion of depreciable  property and indirect costs of self-produced supplies).
Provide additional guidance to more clearly identify what types of  activities are considered to be qualified support activities.
Provide additional guidance to more clearly identify when commercial  production of a qualified product is deemed to begin.
Organize a working group that includes IRS and taxpayer  representatives to develop standards for the substantiation of QREs  that     can be built upon taxpayers’ normal accounting approaches,     but also exclude practices IRS finds of greatest threat to  compliance, such as high-level surveys and claims filed long after  the end of the tax year in which the research was performed.
section_title: Agency Comments
paragraphs: We provided a draft of this report to the Secretary of Treasury and the  Commissioner of IRS in September 2009.  In written comments the Acting  Assistant Secretary (Tax Policy) agreed that the credit’s structure could be  simplified or updated in certain respects to improve its effectiveness.  He  also agreed that the issuance of guidance relating to the definition of gross  receipts, the treatment of inventory property under section 174, and the  definition of internal use software will enhance the administration of the  credit and  Treasury plans to provide additional guidance in the next few  months.  The Acting Assistant Secretary said that the Administration’s  priority is to make the credit permanent.  His letter is reprinted in  appendix VIII.  Treasury and IRS officials also provided technical  comments that we have addressed as appropriate.
As we agreed with your offices, unless you publicly announce the contents  of this report, we plan no further distribution of it until 30 days from the  date of this letter.  This report is available at no charge on GAO’s web site  at http://www.gao.gov.  If you or your staff have any questions on this  report, please call me at (202) 512-9110 or whitej@gao.gov.  Contact points  for our Office of Congressional Relations and Public Affairs may be found   on the last page of this report.  Key contributors to this report are listed in  appendix VIII.
section_title: Appendix I: Scope and Methodology
subsections: section_title: Computation of the Marginal Effective Rate of Credit
subsections: section_title: The Regular Credit Case
paragraphs: 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.
section_title: The Alternative Simplified Credit Case – Current year Effects
paragraphs: 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.
section_title: Current-Year Benefit
paragraphs: 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.
section_title: The Alternative Simplified Credit Case - Future-Year Effects
paragraphs: Given that the base spending amount for the next tax year equals half of  the taxpayer’s average research spending in the current year and the 2  immediately preceding years, the marginal spending in the current year  can reduce the value of the credit benefit the taxpayer can earn next year  as follows:  Benefit reduction next year = -(1/3) × 0.5 × 0.65 × 0.14 × current- year marginal spending × (1 + r)-y1.
The value of y1 equals 1 if the credit that the taxpayer loses in the next  year could have been used that year.  If that lost credit could not have  been used until a later year anyway, then y1 equals the number of years  between the current tax year and the year in which the lost credit could  have been used.
If the taxpayer’s total qualified spending next year is less than its base  spending (even after the marginal spending), then  Benefit reduction next year = 0.
Benefit reductions in the second and third years into the future are  computed in a similar manner.
section_title: The Complete MER
paragraphs: 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.
section_title: Computation of the Discounted Revenue Cost
paragraphs: 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.
section_title: Data Used for the Computations
subsections: section_title: Full Population Data
paragraphs: 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).
subsections: section_title: The Panel Database of the Largest Credit Users
paragraphs: We began the construction of our panels by selecting all corporations that  met either of the following criteria:    The corporation’s total QREs had to account for at least 0.2 percent of  aggregate QREs for all firms in SOI’s annual samples for either 2003 or  2004; or      The corporation’s total grossed-up credit (meaning prior to any  reduction under section 280(c)) had to account for at least 0.2 percent  of aggregate grossed-up credits for all firms in SOI’s annual samples for  either 2003 or 2004.
We attempted to obtain a complete set of tax returns from 2000 through  2004 for each corporate taxpayer that met our panel criteria for either 2003  or 2004.  In addition, we tried to keep the scope of each corporate  taxpayer over the 5 years to be as consistent as possible with that  taxpayer’s scope as of 2003 and 2004.  (This consistency is important  because we wanted the 5-year history of QREs for each taxpayer to closely  represent the spending histories that they would actually have used for  computing their moving-average base expenditures if the ASC had been in  place for 2003 and 2004.)
We constructed time series records for each taxpayer by linking the data  from the taxpayer’s returns from 2000 through 2004 by the Employer  Identification Number (EIN) that SOI included in each year’s tax return  record.  In some cases a taxpayer’s time series was reported under more  than one EIN over the period.  This discontinuity usually occurred in cases  of a corporate reorganization, such as a merger or spin-off.  In cases where  we did not find a complete 5-year set of tax returns for one of the EINs  selected into our panel, we searched to see if we could find the missing  returns under a different EIN.  We focused our search on cases where  taxpayers had reported substantial amounts of research credits or QREs  for tax years early in our period and then they stopped appearing in SOI’s  corporate sample (because they stopped filing a return under their initial  EIN).  For example, we examined the cases of taxpayers that filed returns  in 2000 and 2001 and then stopped filing returns to see if they were related  to cases in our panel for which we were missing tax returns for those 2  years.  If the companies that stopped filing returns were not related to any  companies for which we were missing returns, we then checked to see if  they were related to any other members of our panel (because they might  have been merged into an ongoing corporation that kept the same EIN  before and after the merger).  Conversely, if the panel member for which  we were missing early-year tax returns did not match up with any cases  that had stopped filing after those years, we checked to see if that panel  member had been spun off of any other panel member (meaning that it  was once included in the consolidated tax return of the other panel  member and than was either sold off or became deconsolidated and filed  its own return).  We did a similar examination for companies that showed  dramatic changes in the level of their QREs from one year to the next.  We  extended our search for potential merger and spin-off candidates to any  companies in the annual SOI samples that accounted for at least 0.1  percent of either QREs or grossed up credit in any year from 2000 through  2004.  In this manner we identified a number of pairs of taxpayers that  combined with or split off from one another during our panel period.  We  could usually confirm these corporate changes from publicly available  information on the Internet, but we also had the IRS examiners review our  linkages.  In order to ensure that we did not miss any significant mergers  or splits among our panel members, we asked the Large and Mid-Sized  Business (LMSB) Division examiners that reviewed each case to identify  any that we may have missed.
We made the following adjustments to ensure the consistency of spending  histories in cases where we had identified significant corporate  reorganizations within our panel members:  In cases in which one of our panel members in 2003 or 2004  encompassed an entity that had filed its own tax return in an earlier  year during the panel period, we added the QREs that the former return  filer had reported for that year to the QREs that our panel member had  reported in the same year (because those QREs of the formerly  separate entity would be included in the panel member’s moving  average base amount under the ASC).  In cases in which one of our panel members in 2003 or 2004 had sold a  subsidiary or spun off some other entity that had been included in its  consolidated tax return in an earlier year of our panel period.  We  subtracted the estimated QREs of that spun-off entity from the panel  member’s QREs for that earlier year.  (We assumed that the spun-off  entity’s share of total QREs in the earlier year was the same proportion  as the following ratio:  The spun-off entity’s QREs in the first year that  it filed its own return, divided by the sum of the spun-off companies  QREs plus the QREs of the corporation from which it had been spun  off.)
By making these adjustments, we were able to create reasonably  consistent spending histories for those cases where we had identified (on  our own or with the assistance of IRS examiners) significant corporate  reorganizations in our panel population.  In a number of cases we  concluded that we did not have sufficient information to construct reliably  consistent time series and we, therefore, dropped those cases from our  panel.
Although we believe that we have accounted for all major mergers and  splits within our panel members, we cannot be sure that we have  accounted for all smaller acquisitions or dispositions that may have  affected the consistency of the individual spending histories within the  panel.  For this reason, we ran a sensitivity analysis in which we examined  the effects on our results of altering the relationship between current and  base QREs for each taxpayer (see below).
section_title: Adjusting for Group Credits
paragraphs: Taxpayers that are subject to the group credit rules are required to file  their own Form 6765 on which they report their group’s aggregate values  for QREs, base QREs, and gross receipts; however, the credit amount  reported on each member’s form is that member’s share of the total  group’s credit.  (See appendix VII for an explanation of how these shares  are computed.)  Whether or not a member can actually use a group credit  depends on its own tax position for the year, not on an aggregated group  tax position.
We used several indicators to identify potential group credit claimants,  based on the reporting requirements described above.  First, for claimants  of the regular credit we computed the ratio of the amount of credit they  claimed, divided by the difference between their current QREs and their  base QREs.  If this ratio was a value other than 0.13 or 0.2, we flagged the  case as a potential group member.  Second, for claimants of the alternative  incremental research credit (AIRC), we computed the ratio of the credit  they actually claimed over the amount of credit that they could have  claimed if all of the QREs and gross receipts reported on their 6765 were  their own.  If this ratio was other than 1 or 0.65, we flagged the case as a  potential group claimant.  Third, we also searched the SOI databases for  groups of cases that reported the same exact amounts of QREs in a given  year.
For the purpose of calculating the ASC for group members we gave each  member of a group the group’s aggregate spending history and gross  receipts history; however, each member had its own amount of research  credit claimed and its own values for the variables taken from the general  business credit form.  In order to avoid double-counting (or more) the  QREs of the groups or giving them too much weight when computing our  weighted average effective rates of credit, we created a variable named  CREDSHR, which we then used to assign each group member only a  fraction of the group’s total QREs or weighting in the effective rate  calculation.
The value of CREDSHR for each group member is equal to the ratio of the  amount of research credit that the member claimed over the aggregated  amount of credit that the group would be able to claim, based on the  group’s aggregated QREs and base QREs or gross receipts.  In other  words, we gave each member a share of the group’s QREs that was  proportionate to its share of the group’s total credit.  Although this  allocation method is not precisely derived from the group credit allocation  regulations, it should yield a close approximation of the true distribution  of QREs across group members.  We do not have the detailed attachments  to Form 6765 that show exactly what each group member’s QREs and  gross receipts were.  In most cases the sum of CREDSHR for all members  of a group in our panel population was approximately equal to 100  percent.  When the sum did not reach 100 percent we assumed that there  are other members who were not represented in the SOI sample for a  given year.  The absence of these missing members does not affect the  validity of the computations for the group members we had; it simply  means that the missing members were treated as any other company that  did not meet the criteria for inclusion in our panel.
Because some taxpayers in the panel belonged to controlled groups that  together determined the amount of qualified spending in 2003 or 2004, we  adjusted for the composition of these groups when we assembled the  panel.  In particular, spending and other variables were adjusted to hold  constant the group’s composition in 2003 or 2004, the 2 years for which  credit was computed.  This was accomplished in several ways.  First, the  SOI data allowed us to identify certain controlled groups from  duplications in the amount of reported spending.  Second, we researched  mergers, acquisitions and dispositions for these firms from 2000 through  2004, or the years for which we constructed the panel.  Third, we  requested confirmation of our knowledge about these controlled groups  from LMSB, in addition to any other information about the groups’  composition that LMSB might have had.  Clearly, constructing the panel  involved balancing trade-offs between the number of users and the  availability of data.
section_title: Key Assumptions and Sensitivity Analyses
paragraphs: We tested the sensitivity of our results to variations in assumptions or  observations concerning the following factors:    Future credit status—The MER for the ASC depends, in part, on whether  the taxpayer anticipates being able to earn the credit in each of the next 3  years and, if so, whether that taxpayer would be subject to a minimum  base constraint.  In order to predict the status for a given taxpayer in a  given future year, we needed to predict, within a certain range, the ratio of  spending in that year to the average of spending for the 3 years preceding  that year.  Our baseline prediction was that the probability of a taxpayer  moving from one particular ratio range into another specific ratio range  was equal the probability of such a move that we observed in our  historical data.  We used Markov chains of probabilities to predict changes  in status two and three years into the future.  In our sensitivity analysis, we  examined 12 alternative sets of probabilities.  For example, in one  alternative all taxpayers were less likely to move into a higher range of  ratios than they would have been with the observed probabilities.
Switching probabilities—In choice scenarios, we were required to  estimate the probability of switching from one credit to another in future  years, which has the potential to influence the effect of research spending  in 2003 or 2004 on the amount of credit earned in subsequent years for  which data are not available.  In our sensitivity analysis, we allowed the  probability of switching from the ASC to the Regular Credit from one year  to the next to be higher or lower than our baseline estimate (which was  based on simulated behavior from 2003 to 2004).  We did the same for the  probability of switching from the Regular Credit to the ASC from one year  to the next, and we incorporated all four possible combinations of  deviations from the baseline.
Discount rate—At higher rates of discount, credit that is carried forward  to be claimed in subsequent years is worth less in present value terms in  2003 or 2004.  Additionally, at higher discount rates, the effect of spending  in 2003 or 2004 on the amount of credit earned in subsequent years is  mitigated, since credit earned in subsequent years is worth less in present  value terms in 2003 and 2004 at higher rates of discount.  In our sensitivity  analysis, we allowed the discount rate to vary between 4 percent and 8  percent.
Carryforward length—The model required an assumption about the  number of years that credit would be carried forward.  (The Research Tax  Credit stipulates that credit that cannot be claimed in the year in which it  is earned may be carried forward for up to 20 years.) Lacking data on  carryforward patterns, we based our assumption about the length of the  carryforward period on behavior that was “observed” as part of the  simulation.  For example, in some cases we could simulate the taxpayer’s  carryforward status in both 2003 and 2004.  If this taxpayer were observed  to carry forward credit in both years as part of this simulation, it would  have a longer carryforward period than if it were observed to carry  forward credit in one year or the other, or if it were observed not to carry  credit forward at all.  In our sensitivity analysis, we allowed the longest  carryforward period to vary between 2 and 10 years in length.
The relationship between current and base QREs—We tested how our  estimates for the ASC would differ if the spending histories for our panel  corporations were significantly different from what we observed.  To do  this, we estimated what the MERs and discounted revenue costs would be  if the ratio of each taxpayer’s current QREs to base QREs were 10 percent  higher and 10 percent lower than the observed amounts. Another aspect of  our sensitivity analysis involved using of data from different stages in the  taxpaying process.  We used data from original returns, and from amended  and audited returns, where applicable.
section_title: Appendix II: Data Relating to the Use of the Research Tax Credit by Corporations
subsections: section_title: Net difference between final amendment and initial claim—dollar amounts
paragraphs: Net difference between final amendment and initial claim— percentage change  Net difference between final amendment and initial claim—percentage change  Base QREs (for regular credit claimants not subject to the 50% base  limit)
Average gross receipts (for those claiming the AIRC)
Base QREs (for regular credit claimants not subject to the 50% limit)
Average gross receipts (for those claiming the AIRC)
Net difference between final amendments and  initial claims— percentage change  Base QREs (for regular credit claimants not subject to the 50% limit)
Average gross receipts (for those claiming the AIRC)
Net difference between final amendments and  initial claims— percentage change  Base QREs (for regular credit claimants not subject to the 50% limit)
Average gross receipts (for those claiming the AIRC)
Base QREs (for regular credit claimants not subject to the 50% limit)
Average gross receipts (for those claiming the AIRC)
Net difference between final taxpayer pre-exam claim and latest  IRS position—dollar amounts  Base QREs (for regular credit claimants not subject to the 50% limit)
Average gross receipts (for those claiming the AIRC)
Net difference between final taxpayer pre-exam claim and latest  IRS position—percentage changes  Base QREs (for regular credit claimants not subject to the 50% limit)
Average gross receipts (for those claiming the AIRC)
Net difference between final taxpayer pre-exam claim and latest  IRS position—percentage changes  Base QREs (for regular credit claimants not subject to the 50% limit)
Average gross receipts (for those claiming the AIRC)
section_title: Appendix III: Examples of How the Base of the Credit Affects Marginal Incentives and Windfall Credits
paragraphs: 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.  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  taxpayer can earn only $650,000 of credit on that spending, representing  an MER of 6.5 percent.
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.
section_title: Appendix IV: Issues Relating to the Definition of Qualified Research Expenses
subsections: section_title: Background and Significance
paragraphs: 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.  Currently, research  activities must satisfy four tests in order to qualify for the credit:  1.  Expenditures connected with the research must be eligible for  treatment as expenses under section 174.   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 regulations 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.
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:    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.
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:    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 regulations that were explicitly  rejected in subsequent regulations.  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  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.”  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.”  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 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.
subsections: section_title: Internal-Use Software
paragraphs: When Congress narrowed the definition of the term “qualified research” in  the Tax Reform Act of 1986, 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  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 regulations 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).”  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.
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.
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, 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.
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  Proposed Rulemaking, 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.  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.
section_title: Direct Supervision and Direct Support of Qualified Research Activities
paragraphs: 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.” 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  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.
section_title: Exclusion of Activities Occurring after the Commencement of Commercial Production
paragraphs: 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.  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;  B.  Tooling-up for production;  C.  Trial production runs;  D.  Trouble shooting involving detecting faults in production  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.”  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.
section_title: Supplies and Depreciable Assets
paragraphs: 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.  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.  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.  Taxpayers are challenging IRS’s position in at  least one pending court case 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.
section_title: Appendix V: Issues Relating to the Definition of Gross Receipts for a Controlled Group of Corporations
subsections: section_title: Background and Significance
paragraphs: 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.
The House Budget Report accompanying the Omnibus Budget  Reconciliation Act of 1989 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  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.
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.  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.
subsections: section_title: Differing Legal Positions Taken by IRS and Taxpayers
paragraphs: 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.  A subsequent, 2006, IRS Chief Counsel  Memorandum came to the opposite conclusion, again based on the  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.  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.
section_title: Consequences of Alternative Decisions
subsections: section_title: In General
paragraphs: 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  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);      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  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.
section_title: Option 1—Exclude All Transactions Between Controlled Group Members From the Group’s Total Gross Receipts
paragraphs: 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.
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  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.  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.
section_title: 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.
paragraphs: 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.
section_title: Option 3—Exclude Everything That Would Be Excluded Under Option 1, Except for Intermediate Sales by U.S. Members to Foreign Members.
paragraphs: 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  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.
section_title: Appendix VI: Issues Relating to Recordkeeping and Substantiation
paragraphs: 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 IRC and Treasury regulations, 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.
subsections: section_title: Establishing the Nexus between Expenses and Qualified Activities
paragraphs: 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  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  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.  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  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.  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  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.  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  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.
section_title: Amended Filings Abuses and Penalties
paragraphs: 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.
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  net operating loss carryforwards from that earlier year.  These long- delayed 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.  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.
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;    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 2003, and the “discovery test” was also abandoned in  the final regulations by Treasury and IRS.  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  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.
section_title: Base Period Documentation
paragraphs: 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  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. 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; 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.
section_title: Specific Issues Relating to Sampling
paragraphs: 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,  which they considered to be just bad statistics.  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.
section_title: Recordkeeping and Prefiling Agreements
paragraphs: 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  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.
section_title: Appendix VII: Issues Relating to the Computation Rules for the Group Credit
subsections: section_title: Background and Significance
paragraphs: 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.”  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:  A.  all members of the same controlled group of corporations 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 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” (as long as the  group credit amount does not exceed the sum of the stand-alone entity  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 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 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.  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  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.
section_title: Differing Legal Positions Taken by IRS and Taxpayers
paragraphs: 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  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.
section_title: Consequences of Alternative Decisions
subsections: section_title: Effects on Compliance and Enforcement Burden
paragraphs: 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.
section_title: Effects on Marginal Incentives
paragraphs: In specifying that controlled groups be treated as single taxpayers for  purposes of the credit Congress clearly wanted to ensure that a group, as a  whole, exceeded its base spending amount before it could earn the credit.   It is not clear that Congress was concerned that each member has an  incentive to exceed its own base.
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 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.  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.  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  greater under the gross QRE allocation method than under the stand-alone  credit allocation method.
section_title: The Computation of Marginal Incentives for Individual Members of a Controlled Group
paragraphs: 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  3.  What, if any, base constraints apply to whichever credit is used;  4.  Whether or not the member is allowed to use its highest stand- 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.
section_title: When Both the Group and the Member Use the Regular Credit Computation Method
paragraphs: In the case where a controlled group uses the regular credit method to  compute its group credit and an individual member earns its highest stand- alone 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 =   × (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  credit for the group credit.  The italicized part of this formula shows the  member’s share of the group credit after spending an additional dollar on  research; 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 +  × (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.  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.  The italicized portion of the formula shows the  member’s share of the excess portion of the credit after spending an  additional dollar on research; 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 =  × (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.
section_title: When Both the Group and the Member Use the ASC Computation Method
paragraphs: 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 =  × (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:  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.  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 =  × (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  point that there are common situations in which each credit allocation  method provides a higher incentive than the other.
section_title: Results Based on Numerical Simulations
paragraphs: 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. For example, when a  member of a group is subject to the 50-percent base constraint, the stand- alone 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.
section_title: Appendix VIII: Comments from the U.S. Department of Treasury
section_title: Appendix IX: GAO Contact and Staff Acknowledgements
subsections: section_title: GAO Contact
section_title: Acknowledgments
paragraphs: 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.