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 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 R&D for the Credit Year."

The Directive applies to 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 amount of a taxpayer's QREs that will not be challenged for the credit year is the adjusted "ASC 730 Financial Statement R&D." The adjustments to the taxpayer's research and development costs currently expensed under ASC 730 include amounts related to foreign entities, Schedule M-3 amounts, amounts specifically excluded from Section 174, certain general ledger accounts, prototype overhead amounts, certain upper-level management wages and stock-based compensation. The adjustments to the ASC 730 Financial Statement R&D amount are both exclusions and inclusions, and such adjustments have defined terms in the Directive.

The Directive contains a certification statement to be executed by the taxpayer under penalties of perjury. Additionally, the taxpayer must agree to maintain and make available documentation that will support the amounts claimed as adjusted ASC 730 Financial Statement R&D. The certification statement and related appendices may be attached to the taxpayer's return to demonstrate eligibility under the Directive. If the taxpayer does not attach the certification statement and appendices, the IRS will request the documents upon examination.

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 apply, however, to amounts not expensed for financial statement purposes, or expensed under other provisions.

EY will publish a Tax Alert with more detailed analysis and 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.

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