Tax Policy: The Research Tax Credit's Design and Administration Can Be Improved
GAO-10-136
Published: Nov 06, 2009. Publicly Released: Dec 08, 2009.
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Highlights
The tax credit for qualified research expenses provides significant subsidies to encourage business investment in research intended to foster innovation and promote long-term economic growth. Generally the credit provides a subsidy for research spending in excess of a base amount but concerns have been raised about its design and administrability. Government Accountability Office (GAO) was asked to describe the credit's use, determine whether it could be redesigned to improve the incentive to do new research, and assess whether recordkeeping and other compliance costs could be reduced. GAO analyzed alternative credit designs using a panel of corporate tax returns and assessed administrability by interviewing Internal Revenue Service (IRS) and taxpayer representatives.
Large corporations have dominated the use of the research credit, with 549 corporations with receipts of $1 billion or more claiming over half of the $6 billion of net credit in 2005 (the latest year available). In 2005, the credit reduced the after-tax price of additional qualified research by an estimated 6.4 to 7.3 percent. This percentage measures the incentive intended to stimulate additional research. The incentive to do new research (the marginal incentive) provided by the credit could be improved. Based on analysis of historical data and simulations using the corporate panel, GAO identified significant disparities in the incentives provided to different taxpayers with some taxpayers receiving no credit and others eligible for credits up to 13 percent of their incremental spending. Further, a substantial portion of credit dollars is a windfall for taxpayers, earned for spending they would have done anyway, instead of being used to support potentially beneficial new research. An important cause of this problem is that the base for the regular version of the credit is determined by research spending dating back to the 1980s. Taxpayers now have an "alternative simplified credit" option, but it provides larger windfalls to some taxpayers and lower incentives for new research. Problems with the credit's design could be reduced by eliminating the regular credit and modifying the base of the alternative simplified credit to reduce windfalls. Credit claims have been contentious, with disputes between IRS and taxpayers over what qualifies as research expenses and how to document expenses. Insufficient guidance has led to disputes over the definitions of internal use software, depreciable property, indirect supervision, and the start of commercial production. Also disputed is the documentation needed to support a claim, especially in cases affected by changes in the law years after expenses were recorded. Such disputes leave taxpayers uncertain about the amount of credit to be received, reducing the incentive.
Recommendations
Matter for Congressional Consideration
| Matter | Status | Comments |
|---|---|---|
| In order to reduce economic inefficiencies and excessive revenue costs resulting from inaccuracies in the base of the research tax credit, Congress should consider eliminating the regular credit option for computing the research credit. | As of January 2024, Congress had not enacted legislation to eliminate the regular computation option for the research tax credit or to add a minimum base to the ASC option, as GAO suggested in November 2009. The credit is designed to encourage business innovation by providing a subsidy for new research. Continued use of the regular computation credit option, which arbitrarily distributes subsidies across taxpayers, can distort investment decisions so that research spending and economic activity are not allocated to sectors that offer the highest returns to society. These misallocations may reduce economic efficiency and, thereby, diminish any economic benefits of the credit. | |
| In order to reduce economic inefficiencies and excessive revenue costs resulting from inaccuracies in the base of the research tax credit, Congress should consider adding a minimum base to the ASC that equals 50 percent of the taxpayer's current-year qualified research expenses. | As of January 2024, Congress had not enacted legislation to eliminate the regular computation option for the research tax credit or to add a minimum base to the ASC option, as GAO suggested in November 2009. The credit is designed to encourage business innovation by providing a subsidy to new research. Continued use of the regular computation credit option, which arbitrarily distributes subsidies across taxpayers, can distort investment decisions so that research spending and economic activity are not allocated to sectors that offer the highest returns to society. These misallocations may reduce economic efficiency and, thereby, diminish any economic benefits of the credit. Adding a minimum base for the ASC would reduce the revenue cost of the credit without affecting the average incentive it provides for research. | |
| If Congress nevertheless wishes to continue offering the regular research credit to taxpayers, it may wish to consider reducing inaccuracies in the credit's base and to reduce taxpayers' uncertainty and compliance costs and IRS's administrative costs by updating the historical base period that regular credit claimants use to compute their fixed base percentages. | As of January 2024, no action has been taken by Congress to update the historical base period that regular credit claimants use to compute their fixed base percentages. | |
| If Congress nevertheless wishes to continue offering the regular research credit to taxpayers, it may wish to consider reducing inaccuracies in the credit's base and to reduce taxpayers' uncertainty and compliance costs and IRS's administrative costs by eliminating base period recordkeeping requirements for taxpayers that elect to use a fixed base percentage of 16 percent in their computation of the credit. | As of January 2024, no action has been taken to eliminate base period recordkeeping requirements for taxpayers that elect to use a fixed base percentage of 16 percent in their computation of the credit. | |
| If Congress nevertheless wishes to continue offering the regular research credit to taxpayers, it may wish to consider reducing inaccuracies in the credit's base and to reduce taxpayers' uncertainty and compliance costs and IRS's administrative costs by clarifying for Treasury its intent regarding the definition of gross receipts for purposes of computing the research credit for controlled groups of corporations. In particular it may want to consider clarifying that the regulations generally excluding transfers between members of controlled groups apply to both gross receipts and QREs and specifically clarifying how it intended sales by domestic members to foreign members to be treated. Such clarification would help to resolve open controversies relating to past claims, even if the regular credit were discontinued for future years. | As of January 2024, no action has been taken by Congress to clarify for Treasury its intent regarding the definition of gross receipts for purposes of computing the research credit for controlled groups of corporations. In particular, it may want to consider clarifying that the regulations generally excluding transfers between members of controlled groups apply to both gross receipts and QREs and specifically clarifying how it intended sales by domestic members to foreign members to be treated. Such clarification would help to resolve open controversies relating to past claims, even if the regular credit was discontinued for future years. |
Recommendations for Executive Action
| Agency Affected | Recommendation | Status |
|---|---|---|
| Department of the Treasury | In order to allow more taxpayers to benefit from the reduced recordkeeping requirements offered by the alternative simplified credit (ASC) option, the Secretary of the Treasury should modify credit regulations to permit taxpayers to elect any of the computational methods prescribed in the Internal Revenue Code (IRC) in the first credit claim that they make for a given tax year, regardless of whether that claim is made on an original or amended tax return. |
Treasury issued regulations (TD 9666, effective June 3, 2014) that removed the prohibition of taxpayers electing to use the alternative simplified credit (ASC) option on an amended tax return. Taxpayers will now be permitted to make such an election on an amended return as long as they have not used a different credit option on their original return or on a prior amended return for the same tax year.
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| Department of the Treasury | In order to allow more taxpayers to benefit from the reduced recordkeeping requirements offered by the alternative simplified credit (ASC) option, the Secretary of the Treasury should modify credit regulations to allow controlled groups to allocate their group credits in proportion to each member's share of total group qualified research expenses (QREs), provided that all group members agree to this allocation method. |
Treasury never issued regulations to allow this simplified approach to allocating group credits; however,the American Taxpayer Relief Act of 2012 (P.L. 112-240) modified the Internal Revenue Code to make this simplified approach the only one that taxpayers can now use.
|
| Department of the Treasury | In order to significantly reduce the uncertainty that some taxpayers have about their ability to earn credits for their research activities, the Secretary of the Treasury should issue regulations clarifying the definition of internal-use software. |
On January 16, 2015 the Department of the Treasury issued regulations setting forth rules for when expenditures relating to the development of computer software by a taxpayer for its own internal use qualify for the research tax credit.
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| Department of the Treasury | In order to significantly reduce the uncertainty that some taxpayers have about their ability to earn credits for their research activities, the Secretary of the Treasury should issue regulations clarifying the definition of gross receipts for purposes of computing the research credit for controlled groups of corporations. |
Treasury issued proposed regulations clarifying the definition of gross receipts on December 13, 2013 and solicited public comments. During the course of 2014, tax practitioners and business executives submitted comments criticizing the regulations and asking for them to be withdrawn. As of October 2024, Treasury has yet to issue final regulations that would include responses to these criticisms. The regulations would not become effective until the tax year beginning after the date on which the regulations are published in final form. We have contacted Treasury to confirm the status of these regulations and will update accordingly once we have more details.
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| Department of the Treasury | In order to significantly reduce the uncertainty that some taxpayers have about their ability to earn credits for their research activities, the Secretary of the Treasury should issue regulations regarding the treatment of inventory property under section 174 (specifically relating to the exclusion of depreciable property and indirect costs of self-produced supplies) of Treasury Regulation Section 1.174-2(a)(1). |
Treasury issued new regulations in July 2014 relating to depreciable property under section 174. Those regulations also noted in regard to concerns about the eligibility of indirect costs, that while ineligible under section 41, are eligible under the current 174 regulations, which include all costs incident to development.
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| Department of the Treasury | In order to significantly reduce the uncertainty that some taxpayers have about their ability to earn credits for their research activities, the Secretary of the Treasury should provide additional guidance to more clearly identify what types of activities are considered to be qualified support activities. |
As of October 2024, Treasury has not issued regulations to clarify what types of activities are considered to be qualified support activities. We have contacted Treasury to confirm the status of these regulations and will update accordingly once we have more details.
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| Department of the Treasury | In order to significantly reduce the uncertainty that some taxpayers have about their ability to earn credits for their research activities, the Secretary of the Treasury should provide additional guidance to more clearly identify when commercial production of a qualified product is deemed to begin. |
As of October 2024, Treasury has not issued regulations to more clearly identify when commercial production of a qualified product is deemed to begin. We have contacted Treasury to confirm the status of these regulations and will update accordingly once we have more details.
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| Department of the Treasury | In order to significantly reduce the uncertainty that some taxpayers have about their ability to earn credits for their research activities, the Secretary of the Treasury should organize a working group that includes IRS and taxpayer representatives to develop standards for the substantiation of QREs that (1) can be built upon taxpayers' normal accounting approaches; (2) but also exclude practices IRS finds of greatest threat to compliance, such as high-level surveys and claims filed long after the end of the tax year in which the research was performed. |
The Department of the Treasury held several meetings of a Research Credit working group that included representatives from IRS and several large accounting firms and preparers, to discuss issues relative to research credit studies performed in support of research credits claimed on original and amended tax returns. In some instances, IRS has met with the firms/preparers as a group and in certain instances individually with a firm to discuss the firm's due diligence standards. IRS also issued additional guidance in 2012 relating specifically to substantiation of activities involved in developing new pharmaceutical drugs and therapeutic biologics. According to Treasury officials, Treasury and IRS continue to have regular meetings on substantiation issues.
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Cost analysisInvestmentsResearch and developmentResearch and development costsSubsidiesTax administrationTax creditTaxpayersComplianceTax incentives