Last week we looked at the first four categories of projects specifically excluded from qualified R&D under IRC Section 41(d)(4). Today we will look at the remaining four categories and discuss the application of each in practice.
Development efforts funded by grants, contracts or otherwise are specifically excluded from qualified research (IRC Regulation Section 1.41-4(c)(9)). Any contracts entered into between a taxpayer performing the research, and other persons are considered in determining whether the research being conducted is funded. In the event payments under the contract are contingent upon success of the research are not considered funded (however, would most likely not be considered qualified research because rights to the results would transfer to the other party).
It should be noted that partial payments to pay for separately stated engineering efforts can also be considered partial funding for research activities and revenue received and would need to offset internal R&D costs.
However, manufacturing contracts for the development and production of final deliverable products would be considered a manufacturing contract and may not be considered a contract to conduct qualified research. As a result, payments made would be for a manufactured product and not qualified research.
Research conducted outside the US is considered foreign research and is specifically excluded from qualified research. Some US companies and specifically, software development companies have begun using programmers located in foreign countries to save money on development costs. These expenses would need to be eliminated from the R&D tax credit calculation.
Reverse engineering of a product is specifically excluded under (Duplication of an existing business component). While the term “reverse engineering” is not detailed, the section defines efforts related to a “physical examination of the business component...”
However, efforts that begin with new research to improve with new functionalities a business component may qualify even if initial concept development must be excluded due to reverse engineering.
Research based in the social sciences, arts or humanities do not qualify for Research & Development tax credits and would fail due to the lack of physical sciences missing from the process of experimentation. However, the Internal Revenue Code still specifically excludes this type of research.
Next week we will review the four non-statutory exclusions from qualified research and development.
What say you my friends?
When was the last time you reviewed your contracts to assess whether any of your revenue should be offsetting your qualified R&D expenses?
Do you currently use offshore resources for R&D and are you removing them from your calculations for the R&D Credit?
Randy Eickhoff, CPA is President of Acena Consulting. With more than 20 years of tax and consulting experience, Randy focused on helping companies successfully document and secure tax incentives throughout the US. He has been a long-time speaker nationally as well as conducted numerous training sessions on R&D tax credits and other US tax incentives.