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May 11, 2021

Texas proposes amending franchise tax credit for research and development activities

On April 16, 2021, the Texas Comptroller of Public Accounts (TX Comptroller) released proposed amendments to its franchise tax rule, 34 Tex. Admin. Code Section 3.599 (Section 3.599), regarding the tax credit for research and development (R&D) activities. The proposed amendments, if adopted, would be retroactively effective for Texas franchise tax reports originally due on or after January 1, 2014.

The TX Comptroller has also proposed amendments to the R&D exemption under its sales and use tax rule, 34 Tex. Admin. Code Section 3.340. This Alert does not address the proposed changes to the R&D exemption under the TX sales tax.

Comments on the proposed amendments to both the TX franchise and sales and use tax rules are due May 16, 2021.

The proposed franchise tax amendments would make significant changes to Section 3.599, including:

  • Incorporating, in general, the four-part test for the federal research credit articulated in IRC Section 41(d)
  • Amending the definition of qualified research expense to mean the sum of all in-house research and contract research expenses
  • Clarifying that the applicable reference to the IRC for R&D credit purposes would be the IRC in effect as of December 31, 2011, and specifying that any federal regulation adopted after this date is only included in this term to the extent a taxpayer must apply that regulation in the 2011 tax year
  • Listing activities that would not constitute qualified research activities (such as "internal use software")
  • Clarifying that tangible personal property would not qualify as a research expense for purposes of the TX R&D credit if the taxpayer claimed a manufacturing or resale sales tax exemption when purchasing that property
  • Modifying credit eligibility requirements
  • Providing guidance to TX franchise tax combined groups claiming the TX R&D credit

Four-part test

According to the Preamble to the proposed amendments, new Prop. Section 3.599(c) "discusses the application of the Four-Part Test to explain the basic requirement for research activities to be qualified research" and is based primarily on IRC Section 41(d) and Treas. Reg. Section 1.41-4. The proposed amendments, however, differ from these federal rules when applying two parts of the test: (1) the Business Component Test and (2) the Process of Experimentation Test.

The amended Business Component Test explicitly states that a business component would not include a service provided to a customer or a design.1

The amended Process of Experimentation Test specifically identifies "non-experimental methods" (including simple trial and error) and describes factors considered in determining whether a trial-and-error method is experimental or non-experimental.2

Rules of applicability

In describing the application of the Four-Part Test, the proposed amendments would add non-exclusive lists of software development activities that are both likely and unlikely to constitute qualified research.3

Excluded research activities

Prop. Section 3.599(d) lists activities that do not constitute qualified research activities. According to the Preamble, this list is based on IRC Section 41(d)(4) and Treas. Reg. Sections 1.41-4(c) and 1.41-4A(d) (specifically related to the funded research exclusion).

Excluded activities would include:

  • Research after commercial production of the business component
  • Adaptation of existing business components
  • Duplication of existing business components
  • Surveys, studies, market research, etc.
  • Internal use computer software
  • Social sciences, arts or humanities
  • Research funded by a grant, contract or by another person or governmental entity

These excluded activities are similar to exclusions under the federal rules except for that of internal use computer software. The proposed TX amendments would define internal use software as computer software developed for use in the operation of the business, rather than basing the definition on the federal regulations. Under the proposed definition, internal use software would not include software that is developed to be commercially sold, leased, licensed or otherwise marketed for separately stated consideration to third parties.4

The proposed amendment relating to the exclusion from qualified research for funded research states that "a taxable entity performing research for another person must identify any other person paying for the research activities and any person with substantial rights to the results of the research."5

The proposed amendment includes examples.

Credit eligibility requirements

Prop. Section 3.599(e) discusses the eligibility requirements for the credit. The proposed amendment would add a provision explaining that the taxable entity has the burden of establishing its entitlement to, and the value of, the credit by clear and convincing evidence. The proposed amendment would further require (1) all qualified research expenses to be paid or incurred in connection with qualified research activities; and (2) all qualified research expenses to be supported by contemporaneous business records. The proposed amendment describes contemporaneous business records for wages, supplies and contract research expenses.

The proposed amendment also specifies that an IRS audit determination of eligibility for the federal research credit is not binding on the TX Comptroller's determination of eligibility for the credit.6

Other changes

The proposed amendments would also expand the provisions on combined reporting under renumbered Prop. Section 3.599(i) by clarifying that:

  • Each member of a combined group determines its credit as if it were an individual taxable entity with the total credits for each entity added together to determine the credit claimed on the combined report
  • Each member of the combined group may claim a portion of the credit carryforward corresponding to the credit amount that member generated (the member could still claim the portion of the credit even if it became a member of a different combined group)
  • The rate for qualified research expenses under a higher education contract would apply to each member of the combined group separately and not the group as a whole
  • Eligibility for the credit would be determined by each member of the group as if it were an individual taxable entity

If a credit were carried forward, the TX Comptroller could verify that the credit creating the carryforward was based on qualified research activities, even if the statute of limitations has expired for the year of the credit's creation. This verification would not result in an adjustment to tax, penalty or interest for any report year for which the statute of limitations has expired but could result in the adjustment to the carryforward for all open and future periods.7


Process of Experimentation Test

The factors in the proposed amendments that would be used to distinguish between experimental and non-experimental trial-and-error methods, for purposes of the Process of Experimentation test, are similar to criteria listed in the proposed and withdrawn final regulations under IRC Section 41. These factors were ultimately rejected in the current final federal regulations because they failed to reflect the manner in which a taxpayer conducts commercial research. One of the factors identified in the proposed amendments (i.e., "whether the person conducting the [trial-and-error] methodology stops testing alternatives once a single acceptable result is found or continues to find multiple acceptable results for comparison") is an good example of a factor that does not reflect commercial research. The factor indicates that a taxpayer should continue to incur costs even if a solution is found, through trial and error, that resolves the taxpayer's uncertainty. None of the examples illustrating the Process of Experimentation Test apply the trial-and-error factors, and it is unclear how the factors help distinguish between "systematic" and "simple" trial-and-error methods.

Internal use software

The definition of internal use software in the proposed amendments essentially excludes any software that is not intended to directly generate revenue, regardless of whether the software is developed for use by a taxpayer's customers or the general public or for use in the taxpayer's core business activities (e.g., manufacturing, providing services, transaction processing). Under the proposed amendments, a hospital that develops artificial intelligence software to avoid administration of contra-indicated medicines, a manufacturer that develops software to run its robotic machinery or a financial services company that develops software to enable clients to execute transactions online could not treat their software development activities as qualified research. The proposed amendments do not provide any exceptions from the exclusion of internal use software. Under the IRC Section 41 regulations, software development activities for internal use software are not excluded activities if the taxpayer can meet additional requirements. The proposed amendments are significantly more restrictive than the analogous federal rules.

The Four-Part Test, as applied to software development, lists only four activities that are likely to be considered qualified research and includes an extensive list of activities that are unlikely to be considered as such. Even if the listed activities (such as developing image processing, artificial intelligence, speech recognition or developing an operating system) were considered qualified research, they would ultimately be excluded if they were developed for use in the taxpayer's business, and not marketed for separately stated consideration.


The Preamble does not explain why the proposed amendments would require a taxable entity performing research on behalf of another person to identify any other person paying for the research activities and any person with substantial rights to the research. This disclosure is not required for federal income tax purposes under IRC Section 41. The proposed amendment does not indicate whether it applies only if the amounts are determined to be funded (i.e., not contingent on success or the taxpayer performing research does not retain substantial rights) or unfunded (i.e., contingent on success and the taxpayer performing research retains substantial rights), or both. This requirement may be included to facilitate the TX Comptroller's examination of the research credit claims of the party for whom the research is being performed.

Contemporaneous business records

The proposed amendments would also require "contemporaneous business records" to support all qualified research expenses and define "contemporaneous business records" for wages, supplies and contract research. For records destroyed by flood, hurricane, fire or other disaster, or when business units, divisions, subsidiaries or related parties are disposed of between the credit year and the year of examination, the rules requiring "contemporaneous business records" do not seem to allow any relief, even if information about the qualified research expenses could be reliably recreated or estimated by other means.

Burden of proof

The proposed amendments would require "clear and convincing evidence" to meet the burden of proof (the highest standard applicable to civil cases), which is not required for purposes of claiming a research credit under the analogous federal rules.


There are several important differences between the IRC Section 41 rules and the proposed TX R&D rules that could require separate federal and TX R&D credit calculations even when all research activities are performed in Texas. This disparity in the applicable rules could increase the complexity and cost of taxpayers' recordkeeping and compliance. Because the TX Comptroller's proposed amendments would exclude a large category of software development activities from credit eligibility, taxpayers may wish to consider other states' R&D, location and/or employment credits and incentives regimes when deciding where software development activities are performed.

Affected taxpayers should review the proposed amendments and may submit comments to the TX Comptroller through May 16, 2021.

The earliest possible date the proposed amendments could be adopted is May 16, 2021. EY will continue to monitor this situation as it develops and issue additional Alerts as needed.


Contact Information
For additional information concerning this Alert, please contact:
State and Local Taxation Group
   • Jamie Bowden (
   • Karen Currie (
   • Donna Rutter (
National Tax – Accounting Periods, Methods, and Credits
   • Alexa Claybon (


1 Prop. Section 3.599(c)(1)(C).

2 Prop. Section 3.599(c)(1)(D).

3 Prop. Section 3.599(c)(4)(B) and (C).

4 Prop. Section 3.599(d)(5).

5 Prop. Section 3.599(d)(7).

6 Prop. Section 3.599(e)(3).

7 Prop. Section 3.599(l)(3).