Author: Antonia Kwan, CPA, MST
The tax rules allow a business to expense its research and development (R&D) costs or capitalize and amortize of such costs over a period of not less than 60 months (§174). To ensure economic growth of U.S. and global competitive, Congress enacted the research and development tax credit (§41) to encourage the increase of research spending. This tax reduction package really benefits the businesses in the United States. However, a company in software industry needs to be careful when taking the R&D deduction or credit because its claims on R&D might be audited by IRS. The software company should draw attention on the following three technical issues associated with R&D.
1. Qualified Research Activities
Software industry develops and produces external or commercial software. This external or commercial software includes software developed for sale, lease, or license to other companies and individuals, software used in R&D, software used in a production process that qualifies as R&D, and software used in providing a computer service to customers. For a software company that develops this kind of products, it must meet the following four-part tests:
1) Technical Uncertainty Test
The activities must be planned to discover new information that would remove technical uncertainty about the development or improvement of the product or process. The uncertainty exists when the available information does not enable a company to develop or improve the product or the appropriate design that would attain the desired result (Reg. §1.174-2(a)(1)).
2) Process of Experimentation Test
A process of experimentation must be designed to evaluate one or more alternatives to attain a new development or a significant improvement over existing software (Reg. §1.174-2(a)(1)).
3) Technological in Nature
The research must satisfy technological in nature requirement. The test is met when the process of experimentation utilized in the research basically relies on principals of the physical or biological sciences, engineering, or computer science (§41(d)(1)(B)(i)).
4) New or Improved Business Component
The activities must be useful in the development of a new or significant improvement in business components. These business components include a new or improved product, process, formula, technique, invention, or software component (§41(d)(1)(B)(ii)).
In addition to the external or commercial software, a software company may develop and produce software for its internal use. To qualify for the R&D credit, it must meet an additional test – high threshold of innovation test (Reg. §1.41-4(c)(6), 2001 proposed regulation):
1) The software must be innovative, so it is intended to be unique, new, or different in significant way from prior software accomplishment or methods.
2) The software development must involve significant economic risk and substantial uncertainty, so the software company is uncertain whether it will recover the project money within a reasonable period of time.
3) The software is not commercially available to the company.
2. Contract Research Expenses
In addition to producing commercial and internal software, a software company may contract with third-party to perform qualified research on behalf of it. The tax rule allows the software company to deduct 65% of contract research payments as qualified research costs if the payments made are under the agreement that (1) is entered before the qualified research begins, (2) provides that the research is performed on behalf of the software company, and (3) requires the software company bears the expenses although the research is unsuccessful. However, if the payments are contingent on the success of the research, it is not a contract research expense (Reg. §1.41-2(e)).
If the software company performs research on behalf of others and retain substantial rights in the software created, it may claim the research credit. However, if it does not retain the substantial rights in the software created, the research expenses must be excluded from the calculation of research credit (Reg. §1.41-2(a)(3)). For example, under an agreement, a software company is prohibited from marketing its created software, so the company does not have substantial rights. As a result, this company cannot claim the research expenses that incurred for the created software.
It is difficult for both parties of the contract to determine whether they conduct in the qualified activities on their behalf, so both parties may claim the research expenses. The IRS has recently noticed this situation, and it increases the examination in contract research expenses. To determine whether a party qualifies to claim the research expenses and credit, the IRS examines and evaluates the terms in research contractual agreements. The IRS evaluates the contingent and guarantee provisions in consideration of a software company that claims for the risk bearing (IRS Research Credit Claims Audit Techniques Guide: Credit for Increasing Research Activities §41). Therefore, a software company has to evaluate its contractual agreement to determine whether it qualifies for the claims of research costs.
After a software company identifies its qualified activities and decides to take R&D deductions or research credit, it must have adequate documentation for the qualified research costs because the burden of proof is on the taxpayer. The software company may choose project-based accounting system, cost center accounting system, or hybrid approach to substantiate R&D costs or credit. Project based accounting provides the ability to track financial performance at the project-level. Cost center accounting is a department methodology. A cost center is a department, division, or unit of an organization whose managers and employees are responsible for its costs. Hybrid approach is a combination of project and cost center methods. Among these three approaches, the IRS prefers the project-based accounting because it records research costs at the “business component” level that is the qualified activity level. It also generates the required nexus between qualified research expenses and qualified research activities. On the other hand, cost center accounting does not always provide such nexus. The hybrid approach does not support the relationship between the accounting records and qualified research activities or qualified research expenses, so it does not establish the nexus. For example, to calculate the qualified wages, managers may estimate “qualified” percentage based on their recall of the amount of time that particular employees are assigned to the qualified activity. Next, they multiply this “qualified” percentage by W-2 wages based on cost center. Because this calculation may not be supported by adequate substantiation, this cost is not acceptable by the IRS (IRS Research Credit Claims Audit Techniques Guide: Credit for Increasing Research Activities §41).
In conclusion, before a software company begins a research project, it must perform a study to show the details of the research includes how to identify qualified research activities, how to properly write a contractual agreement, and how to document its research costs. For documentation, a software company may consider the project-based accounting system that preferred by the IRS.