September 25, 2017
LB&I provides a qualified research expense safe harbor for research credits claimed on or after September 11, 2017
Long-anticipated examination guidance on the credit for increasing research activities under Section 41 (research credit) was released in a directive dated September 11, 2017 (LB&I-04-0917-005) (the Directive). The stated purpose of the guidance is "to provide an efficient manner of determining qualified research expenses (QREs) for LB&I taxpayers that meet the requirements of this Directive and to more efficiently manage LB&I's audit resources." The Directive essentially describes a safe harbor methodology for determining a category of QREs that will not be challenged by the IRS. The Directive states that it provides an administrative solution to accept as sufficient evidence of QREs the Adjusted ASC 730 Financial Statement Research & Development (R&D) for the credit year.
The Directive applies to Large Business and International (LB&I) taxpayers that follow US GAAP for their certified audited financial statements. The certified audited financial statements must show "the amount of the currently expensed ASC 730 Financial Statement R&D" as a "separate line item on the income statement" or a "separately stated … note." The Directive only applies to original tax returns that are timely filed (including extensions) on or after September 11, 2017. The Directive is not, however, an official pronouncement of law, and cannot be used, cited, or relied on as such. In addition, nothing in the Directive should be construed as affecting the operation of any other provision of the Internal Revenue Code, Treasury Regulations or guidance thereunder.
Expenses that qualify for the Directive
The amount of a taxpayer's QREs that IRS examiners will not challenge for the credit year is the "Adjusted ASC 730 Financial Statement R&D." The Directive requires multiple adjustments to the taxpayer's research and development costs currently expensed under ASC 730 to eliminate costs that would not be eligible research expenses under Section 41 (such as amounts specifically excluded from Section 174, certain general ledger accounts (i.e., depreciation, shipping, rent, overhead, general and administrative), and costs for R&D performed outside of the US). The Directive also requires reduction of the expensed ASC 730 Financial Statement R&D amount by costs for contract research performed by, and on behalf of, the taxpayer; all amounts related to foreign entities; prototype overhead amounts; patent costs; severance pay and wages; and stock-based compensation not already subtracted.
The ASC 730 Financial Statement R&D amount is further adjusted to include 95% of Form W-2 wages for qualified individual contributors and 1st level supervisor managers. Qualified individual contributors are defined in the Directive as "[e]mployees of Taxpayer who do not manage any Taxpayer employees and whose wages are charged to [US] ASC 730 Financial Statement Cost Centers." Similarly, 1st level supervisor managers are "[m]anagers that directly manage only [q]ualified [i]ndividual [c]ontributors and whose wages are charged to [US] ASC 730 Financial Statement Cost Centers."
The ASC 730 Financial Statement R&D amount is also adjusted to include certain Form W-2 wages for upper level managers, which are limited by the upper level managers' limit. Upper level managers are "[m]anagers that directly supervise any employee other than [q]ualified [i]ndividual [c]ontributors and whose wages are charged to [US] ASC 730 Financial Statement Cost Centers." the directive provides examples of upper level managers, including a manager that directly supervises a 1st level supervisor manager and/or another upper level manager, as well as a manager that supervises both another manager and directly supervises qualified individual contributors.
The upper level managers' limit is the lesser of: (1) 10% of the Form W-2 base wage and stock option amount computed for qualified individual contributors and 1st level supervisor managers or (2) 100% of the Form W-2 wage and stock option costs for upper level managers that is charged to ASC 730 cost centers. If the taxpayer wants to include more than the upper level managers' limit, the Directive states that, for purposes of the upper level manager's limit computation, the Form W-2 wage and stock option costs for upper level managers that is charged to ASC 730 cost centers is considered to be $0.
Requirements to adopt the Directive
Taxpayers that choose to follow the Directive must execute the certification statement provided in Appendix A of the Directive, as well as complete Appendices B, C and D reconciling Form 6765 QREs with Adjusted ASC 730 Financial Statement R&D, detailing the computation of the Adjusted ASC 730 Financial Statement R&D, and calculating the upper level managers' limit, respectively. Additionally, taxpayers must maintain the following books and records to be made available upon request:
a. Certified Audited Financial Statement for the Credit Year, including auditor's certifying opinion
b. Taxpayer's Chart of Accounts
c. List of US ASC 730 Financial Statement Cost Centers that make up the ASC 730 Financial Statement R&D amount
d. All ASC 730 R&D GL Accounts with account balance details that make up the ASC 730 Financial Statement R&D amount
e. List of ASC 730 R&D GL Accounts with account balances that make up the adjustments in Steps 2 through 4 of Appendix C
f. Taxpayer's organization chart showing employees and levels of management for the Credit Year;
g. Executed contracts under which Taxpayer is performing ASC 730 research to comply with the terms of the contract
h. Executed contracts under which persons other than employees of Taxpayer are performing ASC 730 research on behalf of Taxpayer (this would include sufficient information to show what research was performed outside the US)
i. List of employees, with their respective W-2 Wage amounts, claimed as additions to US ASC 730 Financial Statement R&D in Step 4 of Appendix C, which list would also identify for the applicable taxable year each employee's job title and reporting level and the cost center where each of those employees worked.
Notably, the certification statement and appendices may be, but are not required to be, attached to the taxpayer's timely filed (with extensions) tax return. If the taxpayer does not attach these items to its return, an IRS examiner will request the items upon examination. If the taxpayer does not provide this documentation upon request, the Directive states that "the applicable Director of Field Operations or his/her delegate may determine that this Directive does not apply to Taxpayer."
For taxpayers with comprehensive and detailed books and records that apply ASC 730 for US GAAP purposes, the Directive may be an effective method of limiting the burden and examination risk related to a portion of their QREs. The Directive does not, however, apply to amounts not expensed for financial statement purposes, or expensed under other provisions. These amounts may be subject to examination, even if the taxpayer follows the Directive for Adjusted ASC 730 Financial Statement R&D amounts. Amounts related to contract research performed by the taxpayer and performed by a third party on behalf of the taxpayer are excluded from the Adjusted ASC 730 Financial Statement R&D amount, in addition to amounts related to foreign entities (even if the R&D activities are performed in the US). Taxpayers with significant Section 41 QREs related to research conducted under an agreement or incurred by foreign entities may not benefit more from following the Directive than they currently do under a traditional tax analysis.
The Directive's computational steps may be onerous, depending on the level of detail in the taxpayer's financial recordkeeping systems. Taxpayers unable or unwilling to identify the detailed account and cost center information to satisfy the computational requirements may not be able to apply the Directive. Taxpayers with traditionally low financial statement R&D (under ASC 730) may also find little value in changing their research credit analysis method. Because the Directive does not require a taxpayer to identify, qualify, or document the activities being performed that generate expenses included in Adjusted ASC 730 Financial Statement R&D, however, taxpayers should weigh which requirements are easier to comply with (extensive recordkeeping and analysis for individual employees or R&D project qualification).
Taxpayers may also need to assess their human resource models in order to determine whether their internal hierarchy structure and relative QRE expensing is consistent with the IRS's employee-level assumptions. Form W-2 wages that would otherwise qualify under a traditional QRE examination model may not qualify under the Directive's safe harbor due to the upper level managers' limit and other exclusions required by the Directive. Under the broad definition of Upper Level Manager, many employees could be subject to this limit. Taxpayers may continue to claim Form W-2 wages for Upper Level Managers above the limit, but will not receive the favorable audit treatment provided by the Directive and instead will be subject to regular IRS audit procedures.
Taxpayers should also consider how they will respond to IRS examination inquiries for tax years in which the Directive is used. Currently, the tax department, operations/engineering department, R&D department and human resources department provide much of the information required for a R&D credit analysis under Section 41. Under the Directive, the taxpayer's finance and accounting personnel will likely be responsible for providing IRS examination support for the portion of the credit attributable to the Adjusted ASC 730 Financial Statement R&D amount. This shift in responsibilities for the finance and accounting personnel may be disruptive to the taxpayer's operations.
The Directive does not address how the consistency requirement of Section 41(c)(6) applies for taxpayers that choose to apply the Directive for a return filed on or after September 11, 2017. It is unclear whether, to satisfy the consistency requirement, a taxpayer would be required to re-compute the base period QREs in a manner consistent with the current credit year (i.e., using the computational schedules in the Directive to arrive at Adjusted ASC 730 Financial Statement R&D amounts for each base year) or if a taxpayer is to assume that the IRS will treat the current year and prior years' QREs as having been determined on a consistent basis under Treas. Reg. Section 1.41-3(d) and 1.41-9(c)(2). Taxpayers that are acquisitive may have difficulty identifying the necessary information to make base-year adjustments. It is unclear whether a taxpayer that acquires an entity that did not have a certified financial statement, use U.S. GAAP, or expense R&D costs under ASC 730 prior to the acquisition would be able to apply the Directive because of the inconsistency in determining base period QREs.
Finally, because a taxpayer's R&D expenditures might be included as ASC 730 expenses in a year other than the year in which paid or incurred, it is unclear how the Section 41 requirement to include only amounts paid or incurred in the credit year and the QREs allowed under the Directive may be reconciled.
Taxpayers that are considering following the Directive for their October 15, 2017 tax return filings should begin a detailed examination of their various cost centers, account balances and Form W-2 wages in order to properly assess whether the Directive will provide any meaningful benefit. In addition, taxpayers should model the differences between QREs as calculated under the Directive and without following the Directive to determine which would yield the greatest benefit.
Taxpayers that have already filed their 2016 tax returns, but have an October 15, 2017 extended filing deadline, are still eligible to use this Directive. If a credit was claimed on the originally filed return, the taxpayer would have to re-compute its QREs under the Directive and file a superseding return reflecting the re-computed QREs before the extended filing deadline to be considered a timely filed return and thus eligible for the Directive. If the taxpayer did not claim a credit on its 2016 tax return that was timely filed before September 11, 2017, it could similarly file a superseding return before the extended filing deadline with the QREs computed under the Directive.
EY will hold a webcast on Tuesday, November 7 from 1:00 - 2:30 p.m., about the Directive and other recent research credit guidance. Information on how to join that webcast will be provided soon.