On July 15, 2022, the Texas Comptroller of Public Accounts (TX Comptroller) filed with the Secretary of State the final 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 (hereafter, the 2022 amendments). The 2022 amendments, which were adopted without changes to the proposed text, were published in the Texas Register on July 29, 2022 (see the proposed text published in the June 10, 2022 Texas Register for a mark-up of the changes).

The 2022 amendments clarify and modify changes to Section 3.599 that were adopted in October 2021 (see Tax Alert 2021-1860).

The TX Comptroller has also adopted 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 changes to the R&D exemption under the Texas sales tax law.

Definition of Internal Revenue Code in Section 3.599(b)(5)

The 2021 amendments had stated that for Texas R&D credit purposes, taxable entities should apply the IRC in effect as of December 31, 2011, and specified 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." The 2022 amendments changed this provision to "could have applied the regulation to the 2011 federal income tax year." In the Preamble of the 2022 amendment, the Comptroller said that it had reconsidered comments received during the 2021 amendments and agreed that the adopted definition was too restrictive.

The 2022 amendment also explains, through the use of examples, which federal Treasury Regulations apply to the 2011 federal income tax year (which can be used as a source for applying the rules for Texas purposes). Specifically, Treas. Reg. Section 1.174-2 (definition of research and experimental expenditures) and Treas. Reg. Section 1.41-4 (qualified research for expenditures paid or incurred in tax years ending on or after December 31, 2003) can be applied by taxable entities in 2011 for their Texas returns. For Treas. Reg. Sec. 1.41-4(c)(6) (internal use software), however, a taxable entity can elect to follow either: (1) Treas. Reg. Section 1.41-4(c)(6) in 26 CFR part 1 and IRB 2001-5, or (2) proposed Treas. Reg. Section 1.41-4(c)(6) described in IRB 2002-4 (as provided under Treas. Reg. Section 1.41-4(e) (effective/applicability dates)).

Definition of computer software with respect to internal use software in Section 3.599(d)(5)

According to the Preamble of the 2022 amendment, the definition of computer software with respect to internal use software in Section 3.599(d)(5) is amended to "remove items that are inconsistent with the changes made to the definition of IRC." As modified, "internal use software" continues to be defined as "computer software developed by, or for the benefit of, the taxable entity primarily for internal use by the taxable entity." The 2022 amendments, however, remove some of the restrictive language that was included in the 2021 amendment by deleting language that had:

• Specified that a taxable entity used software internally if the software was developed for use in the operation of the business
• Excluded software developed to be commercially sold, leased, licensed or otherwise marketed for separately stated consideration to third parties from the definition of internal use software
• Deemed software to be internal use software when it was developed by a taxable entity primarily for internal use by an entity in an affiliate group that includes the taxable entity
• Required that the determination of whether software is internal use software be dependent on the facts and circumstances that existed at the start of the software's development

Combined reporting and removal of provisions restricting credit carryforwards in Section 3.599(i)

The 2022 amendments retain the provision clarifying that the combined group is the taxable entity for purposes of calculating and reporting the R&D credit but reorganizes Section 3.599(i)(1) and (2). Significantly, Section 3.599(i)(3) is amended to remove language that had restricted credit carryforwards. As revised, Section 3.599(i)(3) explains how to determine the credit carryforward when there is a change in the membership of the combined group.

Credit carryforwards are determined as follows:

1. The amount of carryforward attributable to a member of the combined group for each prior report year is (1) the total credit carryforward for that report year multiplied by (2) the qualified research expense paid or incurred by the member during the report year over (3) the amount of such expense paid or incurred by the combined group during the report year.
2. When a member leaves the combined group, the credit carryforward is attributed to those members of the group that were included in the report for the year to which the carryforward relates.
1. Each group member that has an attributed credit carryforward, including members that leave the group, can use the credit on its future franchise tax report.
3. Credit carryforwards created by a taxable entity before it joins a combined group may be claimed on the combined group's future franchise tax reports.
4. Credit carryforwards established by a non-surviving entity of a merger may be claimed on the surviving entity's future franchise tax reports.
5. Credit carryforwards attributable to a member of the combined group that is terminated, dissolved or otherwise loses its status as a legal entity may not be claimed on any future franchise tax reports (this does not apply if "D" applies).
6. When all the assets of a group member are conveyed, assigned or transferred in a qualified manner (under Section 3.599(m)), that member's credit carryforward also may be conveyed, assigned or transferred as part of the transaction.
7. Credit carryforwards attributed to a member under "B," "C" or "D" can be used by the combined group only if that member is part of the combined group on the last day of the report's accounting period.

Section 3.599(m) is amended to make clear that the conveyance, assignment or transfer of an ownership interest in the taxable entity does not convey, assign or transfer the taxable entity's credit.

Implications

The 2022 amendments to Section 3.599, which define the IRC to include regulations adopted after December 31, 2011, to the extent that a taxable entity could have applied the regulation to the 2011 federal income tax year, is a welcome change for taxpayers with Texas credit claims. As provided in TD 9786 (the final federal regulations for internal use software), for tax years ending before January 20, 2015, taxpayers could have applied either: (1) Treas. Reg. Section 1.41-4(c)(6) in 26 CFR part 1 and IRB 2001-5, or (2) proposed Treas. Reg. Section 1.41-4(c)(6) described in IRB 2002-4.

In addition, Section 3.599 does not provide explicit rules for determining whether software development relates to software that is "primarily for internal use by the taxable entity," for purposes of Section 3.599(c)(5).

The 2022 amendments to Section 3.599 retain some rules that are different from the analogous federal rules under IRC Section 41, including:

• The Business Component Test of Section 3.599(c)(1)(C)(i) and (ii), which specifically excludes services and design from being business components
• Section 3.599(c)(1)(D), which lists factors for consideration in determining whether a trial and error process qualifies as a process of experimentation
• Section 3.599(c)(4)(B) and (C), which contain non-exclusive lists of software development activities that are likely and unlikely to constitute qualified research
• Section 3.599(d)(7)(E), which requires a taxpayer that performs research on behalf of another person to identify any other person paying for the research activities and any other person with substantial rights to the research results
• Section 3.599(e), which provides eligibility rules that apply a "clear and convincing evidence" standard and require the claim be supported by contemporaneous business records

These differences could require separate federal and Texas R&D credit calculations, even when all research activities are performed in Texas. This disparity between the applicable federal and Texas R&D rules could increase the complexity and cost to taxpayers for compliance and recordkeeping. The absence of rules for determining whether a taxpayer's R&D expenditures in Texas are for "internal use software" leaves taxpayers in the position of having no applicable federal or state rules upon which to rely.

The effective date listed at the end of the 2022 amendments is August 4, 2022; however, Section 3.599 specifically states that it is effective for reports due on or after January 1, 2014, and as such can be considered retroactive.

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