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entitled 'Tax Policy: The Research Tax Credit's Design and
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Report to the Committee on Finance, U.S. Senate:
United States Government Accountability Office:
GAO:
November 2009:
Tax Policy:
The Research Tax Credit's Design and Administration Can Be Improved:
GAO-10-136:
GAO Highlights:
Highlights of GAO-10-136, a report to Committee on Finance, U.S.
Senate.
Why GAO Did This Study:
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.
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 IRS and taxpayer
representatives.
What GAO Found:
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.
Figure: An Illustration of How Base Design Affects Windfall Credits:
[Refer to PDF for image: illustration]
A 20% flat credit (with no base):
Marginal incentive (20% of $100): $20;
Marginal incentive (20% of $1000): $200;
Revenue cost: $220.
An incremental 20% credit with a $1,000 base:
Marginal incentive (20% of $100): $20;
Windfall credit: 0;
Revenue cost: $20.
Qualified research spending:
$100: Taxpayer’s marginal spending;
$1,000: Spending on research that taxpayer would have done anyway.
Source: GAO.
[End of figure]
What GAO Recommends:
Congress should consider eliminating the regular credit option and
adding a minimum base to the alternative simplified credit. GAO
recommends that the Secretary of the Treasury clarify the definition of
qualified research expenses and organize a working group to develop
standards for documentation. Treasury agreed with our recommendation
and plans to provide additional guidance in the next few months.
View [hyperlink, http://www.gao.gov/products/GAO-10-136] or key
components. For more information, contact James White at (202) 512-9110
or whitej@gao.gov.
[End of section]
Contents:
Letter:
Background:
Large Corporations Have Dominated the Use of the Research Credit, Which
Provided an Average Marginal Incentive of About 7 Percent in 2003
through 2005:
Important Trade-Offs Exist in the Choice of Research Credit Designs:
Issues of Contention between Taxpayers and IRS Relating to the Research
Credit Are Both Extensive and Acute:
Conclusions:
Matters for Congressional Consideration:
Recommendations for Executive Action:
Agency Comments:
Appendix I: Scope and Methodology:
Appendix II: Data Relating to the Use of the Research Tax Credit by
Corporations:
Appendix III: Examples of How the Base of the Credit Affects Marginal
Incentives and Windfall Credits:
Appendix IV: Issues Relating to the Definition of Qualified Research
Expenses:
Appendix V: Issues Relating to the Definition of Gross Receipts for a
Controlled Group of Corporations:
Appendix VI: Issues Relating to Recordkeeping and Substantiation:
Appendix VII: Issues Relating to the Computation Rules for the Group
Credit:
Appendix VIII: Comments from the U.S. Department of Treasury:
Appendix IX: GAO Contact and Staff Acknowledgements:
Tables:
Table 1: Maximum MERs and Average Effective Rates of Credit for
Different Categories of Credit Claimants, 2005:
Table 2: Summary Comparison of Leading Design Options:
Table 3: Total Claimants, Qualified Research Expenses, and Net Credits,
2003 to 2005:
Table 4: Marginal Effective Rates, Discounted Revenue Costs, and Bangs-
per-Buck of the Research Credit, 2003 to 2005:
Table 5: Comparison of Initial and Amended Claims of the Research
Credit by Panel Corporations:
Table 6: Comparison of Initial and Amended Claims of the Research
Credit by Those Corporations That Made a Change:
Table 7: Changes in the Basic Elements of the Research Credit
Computation between Initial and Amended Claims:
Table 8: Changes in the Basic Elements of the Research Credit
Computation between Initial and Amended Claims for Those Corporations
That Made a Change:
Table 9: Comparison of Final Taxpayer Pre-Exam Credit Claim to Latest
Available IRS Position:
Table 10: Comparison of Final Taxpayer Pre-Exam Credit Claim to Latest
Available IRS Position for Those Cases in Which IRS Made a Change:
Table 11: Changes in the Basic Elements of the Research Credit
Computation between Final Taxpayer Pre-Exam Credit Claim to Latest
Available IRS Position:
Table 12: Changes in the Basic Elements of the Research Credit
Computation between Final Taxpayer Pre-Exam Credit Claim to Latest
Available IRS Position for Those Cases in Which IRS Made a Change:
Table 13: Distribution of QREs and Revenues Cost by Type of Credit User
Prior to and After the Introduction of the ASC (Panel Corporations
Only):
Table 14: Weighted Average Marginal Incentives and Revenue Costs for
the Panel Population Before and after the Introduction of the ASC:
Table 15: Percentage Changes in Marginal Incentives and Revenue Costs
Relative to 2009 Rules If the ASC Is the Only Credit Allowed:
Table 16: Percentage Changes in Marginal Incentives and Revenue Costs
Relative to 2009 Rules If a Choice Is Allowed between the ASC and the
Regular Credit with an Updated Base:
Table 17: Percentage Revenue Savings from Adding a Minimum Base
Constraint to the ASC If the ASC Is the Only Credit Allowed:
Table 18: Percentage Reductions in Marginal Incentives and Revenue
Costs If Only the ASC Is Allowed, Rather than Both the ASC and the
Regular Credit, When Both Credits Have a 50% Minimum Base:
Table 19: Percentage Reductions in Marginal Incentives and Revenue
Costs If Only the ASC Is Allowed, Rather than Both the ASC and the
Regular Credit, When Both Credits Have a 75% Minimum Base:
Table 20: A Comparison of Two Methods for Allocating Group Credits in
Selected Situations:
Figures:
Figure 1: A Comparison of an Incremental Credit to Flat and Capped
Credits:
Figure 2: Information Needed to Estimate the Bang-per-Buck of the
Credit:
Figure 3: Illustration of How Current Spending Increases Reduce Future
Credits Under the ASC:
Figure 4: Distribution of Claimants, Qualified Research Expenses, and
Net Credits, by Size of Taxpayer, 2003 to 2005:
Figure 5: Shares of Claimants, QREs and Research Credits, by Taxpayer's
Credit Status, 2005:
Figure 6: Percentage of Credit Claimants Subject to Tax Liability
Constraints, 2003 to 2005:
Figure 7: Illustration of How Inaccuracies in the Base of the Credit
Result in Disparities in Incentives Across Taxpayers:
AER: Average Effective Rate:
AIRC: Alternative Incremental Research Credit:
ASC: Alternative Simplified Credit:
ATG: Audit Technique Guides:
EIN: Employer Identification Number:
FBP: Fixed Base Percentage:
IDR: Information Document Request:
IRC: Internal Revenue Code:
IRS: Internal Revenue Service:
IUS: Internal-Use Software:
LMSB: Large and Mid-Size Business:
MER: Marginal Effective Rate:
PFA: Prefiling Agreement:
QRE: Qualified Research Expense:
RCRA: Research Credit Recordkeeping Agreements:
SME: Subject Matter Experts:
SOI: Statistics of Income:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
November 6, 2009:
The Honorable Max Baucus:
Chairman:
The Honorable Charles E. Grassley:
Ranking Minority Member:
Committee on Finance:
United States Senate:
Since 1981, the tax credit for qualified research expenses has provided
significant subsidies (an estimated $5.6 billion for fiscal year 2009)
to encourage business investment in research and development. This type
of investment can have a profound effect on long-term growth if it
fosters innovation. Economists widely agree that some government
subsidy for research is justified because the social returns from
research exceed the private returns that investors receive. In the
absence of a subsidy, the amount invested in research would be less
than optimal from society's standpoint.
Despite the widespread support for the concept of a credit for
increasing research activities, concerns have been raised about the
cost-effectiveness of the design of the current credit and its
administrative and compliance costs. Very generally, the research
credit provides a subsidy for spending in excess of a base amount. One
design issue is how the base is determined and how well it achieves its
objective of targeting benefits only to research spending that would
not have been done without the credit.
To help inform congressional deliberations on the credit, you asked us
to (1) describe how taxpayers are currently using the credit; (2)
identify what, if any, changes to the credit's design may be able to
increase the incentive to do additional research with social benefits;
and (3) identify specific and significant problems, if any, that exist
in the administration of the credit and options to address them.
To provide information on the use of the research credit we analyzed
Internal Revenue Service (IRS) taxpayer data from the Statistics of
Income (SOI) Division's annual samples of corporate tax returns for the
most recent years available (2003 through 2006) supplemented by data
collected by IRS examiners. We determined that the data were
sufficiently reliable for our purpose of describing the general
characteristics of R&E Credit claimants; the amount and type of R&E
Credit claimed by taxpayers; the average rate of credit for claimants;
and the types of research spending for which taxpayers are claiming the
credit (i.e., basic vs. applied research, as defined by tax rules).
However, we do discuss certain limitations of the data and how those
may affect selected statistics.
To identify what, if any, problems exist with the design of the credit,
we examined its performance, relative to alternative designs, in terms
of three criteria. Our first criterion was the amount of revenue the
government must forgo under each of the alternative credit designs in
order to provide a given level of incentive.[Footnote 1] Our second
criterion was the extent to which each design minimizes unintended
variations in the rates of incentives across taxpayers. Our final
criterion was the extent to which each design of the credit helps to
minimize the administrative and compliance burdens on IRS and
taxpayers. We compared alternative designs of the credit by using a
panel of SOI taxpayer data to simulate the sizes of the incentives and
revenue costs of different credit designs under different scenarios, as
well as by interviewing research credit experts. We performed a
sensitivity analysis that allowed certain data and parameters of our
simulation model to vary. For example, one aspect of our sensitivity
analysis involved running the simulations using data collected at
different stages of the tax filing process, including data from the
original returns as well as from amended or audited returns, where
applicable.[Footnote 2] Our panel database included most of the largest
credit claimants in 2003 and 2004, which accounted for about half of
the total credits claimed and 54 percent to 55 percent of total
qualified research expenses in each of those years. These corporations
are not representative of all research credit claimants; however, the
data available to us do not suggest that the remainder of the credit
claimant population is so different from our panel population in key
respects that we would have reached different conclusions and
recommendations had we been able to run our simulations for the full
population.[Footnote 3]
To identify what, if any, specific problems exist with the IRS's
administration of the credit or with taxpayers' ability to comply with
credit rules, we interviewed IRS and Department of the Treasury
officials, tax practitioners, and industry representatives about their
principal concerns and how these concerns might best be addressed. In
addition, we reviewed public comments made to Treasury about research
credit regulations, as well as Treasury's responses to the comments.
Finally, we analyzed data collected by IRS examiners relating to
amended credit claims and audit adjustments to credit claims to
identify which key line items in the credit computation are most
subject to change after an initial claim has been filed.
We conducted this performance audit from January 2007 through August
2009 in accordance with generally accepted government auditing
standards. Those standards require that we plan and perform the audit
to obtain sufficient, appropriate evidence to provide a reasonable
basis for our findings and conclusions based on our audit objectives.
We believe that the evidence obtained provides a reasonable basis for
our findings and conclusions based on our audit objectives.
Background:
History and Overview of Credits for Different Types of Research:
Congress created the research tax credit in 1981 to encourage
businesses to do more research.[Footnote 4] The credit has never been a
permanent part of the Internal Revenue Code (IRC). Since its enactment
on a temporary basis in 1981, the credit had been extended 13 times,
often retroactively. There was only a 1-year period (between June 30,
1995, and July 1, 1996) during which the credit was allowed to lapse
with no retroactive provision upon reinstatement. Most recently, the
credit was extended through December 31, 2009.
The basic design of the credit has been modified or supplemented
several times since its inception. For tax years ending after December
31, 2006, through December 31, 2008, IRC Section 41 allowed for five
different credits. Three of the credits, the regular research credit,
the alternative incremental research credit (AIRC), and the alternative
simplified credit (ASC), rewarded the same types of qualified research
and are simply alternative computational options available to
taxpayers. Each taxpayer could claim no more than one of these credits.
(For purposes of this report we use the term research credit when
referring collectively to these options.) The AIRC option was repealed
beginning January 1, 2009, while the ASC and regular research credit
are available through the end of 2009. The other two separate credits,
the university basic research credit and the energy research credit are
targeted to more specific types of research and taxpayers that
qualified could claim them in addition to the research credit. This
report does not address those separate credits.
How the Research Credit Is Targeted:
Both the definition of research expenses that qualify for the credit
and the incremental nature of the credit's design are important in
targeting the subsidy to increase the social benefit per dollar of
revenue cost. In order to earn the research credit a taxpayer has to
have qualified research expenses (QREs) in a given year and those
expenses have to exceed a threshold or base amount of spending.
Qualified Research Expenses:
The IRC defines credit eligibility in terms of both qualifying research
activities and types of expenses. It specifies the following four
criteria that a research activity must meet in order to qualify for
purposes of the credit:
* The activity has to qualify as research under IRC section 174 (which
provides a separate expensing allowance for research), which requires
that an activity be research in the "experimental or laboratory sense
and aimed at the development of a new product."
* The research has to be undertaken for the purpose of discovering
information that is technological in nature.
* The objective of discovering the information has to be for use in the
development of a new or improved business component of the taxpayer.
* Substantially all of the research activities have to constitute
elements of a process of experimentation for a qualified purpose.
The IRC also specifies that only the following types of expenses for in-
house research or contract research would qualify:
* wages paid or incurred to employees for qualified services;
* amounts paid or incurred for supplies used in the conduct of
qualified research;
* amounts paid or incurred to another person for the right to use
computers in the conduct of qualified research; and:
* in the case of contract research, 65 percent of amounts paid or
incurred by the taxpayer to any person, other than an employee, for
qualified research.
Spending for structures, equipment, and overhead do not qualify. In
addition, the IRC identifies certain types of activities for which the
credit cannot be claimed, including research that is:
* conducted outside of the United States, Puerto Rico, or any other
U.S. possession;
* conducted after the beginning of commercial production of a business
component;
* related to the adaptation of an existing business component to a
particular customer's requirements;
* related to the duplication of an existing business component;
* related to certain efficiency surveys, management functions, or
market research;
* in the social sciences, arts, or humanities; or:
* funded by another entity.
As will be discussed in a section below, the practical application of
the various criteria and restrictions specified in the IRC has been the
source of considerable controversy between IRS and taxpayers.
The Rationale behind an Incremental Design for the Credit:
The research credit has always been an incremental subsidy, meaning
that taxpayers earn the credit only for qualified spending that exceeds
a defined base amount of spending. The purpose of this design is to
reduce the cost of providing a given amount of incentive. Figure 1
illustrates the difference between an incremental credit and two common
alternative designs for a subsidy--a flat credit and a capped flat
credit. In the case of the flat credit a taxpayer would earn a fixed
rate of credit, 20 percent in this example, for every dollar of
qualified spending. The taxpayer's total qualified spending consists of
the amount that it would have spent even if there were no subsidy, plus
the additional or "marginal" amount that it spends only because the
credit subsidy is available. The subsidy encourages additional spending
by reducing the after-tax cost of a qualified research project and,
thereby, increasing the project's expected profitability sufficiently
to change the taxpayer's investment decision from no to yes. The
subsidy provided for the marginal spending is the only portion of the
credit that affects the taxpayer's research spending behavior. The
remainder of the credit is a windfall to the taxpayer for doing
something that it was going to do anyway. In the case of a capped
credit, the taxpayer earns a fixed rate of credit on each dollar of
qualified spending up to a specified limit. If, as in the example shown
in figure 1, the credit's limit is less than the amount that the
taxpayer would have spent anyway, all of the credit paid is a windfall
and no additional spending is stimulated because no incentive is
provided at the margin. In contrast, the objective of an incremental
credit is to focus as much of the credit on marginal spending while
keeping the amount provided as a windfall to a minimum. The last
example in figure 1 shows the case of an ideal incremental credit--one
for which the base of the credit (the amount of spending that a
taxpayer must exceed before it can begin earning any credit) perfectly
measures the amount of spending that the taxpayer would have done
anyway. This credit maintains an incentive for marginal spending but
eliminates windfall credits, substantially reducing the credit's
revenue cost. Alternatively, the savings from the elimination of
windfalls could be used to increase the rate of credit on marginal
spending.
Figure 1: A Comparison of an Incremental Credit to Flat and Capped
Credits:
[Refer to PDF for image: illustration]
A 20% flat credit (with no base):
Marginal incentive (20% of $100): $20;
Marginal incentive (20% of $1000): $200;
Revenue cost: $220.
A 20% flat credit capped at $80:
Marginal incentive: (No marginal incentive so taxpayer decides not to
do the marginal spending);
Windfall credit (20% flat credit with $80 cap applied): $80;
Revenue cost: $80.
An incremental credit with an ideal base:
Marginal incentive (20% of $100): $20;
Windfall credit: 0;
Revenue cost: $20.
Qualified research spending:
$100: Taxpayer’s marginal spending;
$1,000: Spending on research that taxpayer would have done anyway.
Source: GAO.
[End of figure]
Computation of the Research Credit:
The primary differences across the research credit computation options
are in (1) how the base spending is defined and (2) the rate of credit
that is then applied to the difference between current-year QREs and
the base amounts. The box below shows the detailed computation rules
for each option. Alternative Computation Options for the Research Tax
Credit (Before Restrictions)
Regular Credit Option:
Credit = 20% × [current-year QREs - base QREs],
where base QREs equal the greater of:
[the sum of QREs for 1984 to 1988/the sum of gross receipts for 1984 to
1988] × average gross receipts for the 4 tax years immediately
preceding the current one, or:
50% × current-year QREs. [This is known as the minimum base amount.]
The ratio of QREs to gross receipts during the historical base period
is known as the fixed base percentage (FBP). A maximum value for the
FBP is set at 16 percent. Also, special "start-up" rules exist for
taxpayers whose first tax year with both gross receipts and QREs
occurred after 1983, or that had fewer than 3 tax years from 1984 to
1988 with both gross receipts and QREs. The FBP for a start-up firm is
set at 3% for a firm's first 5 tax years after 1993 in which it has
both gross receipts and QREs. This percentage is gradually adjusted so
that by the 11th tax year it reflects the firm's actual experience
during its 5th through 10th tax years.
ASC Option:
Credit = 14% × [current-year QREs - 50% × average QREs in the 3
preceding tax years]
If a taxpayer has no QREs in any of its 3 preceding tax years, then the
credit is equal to 6% of its QREs in the current tax year.
AIRC Option:
(discontinued as of January 1, 2009):
Credit = 3% of QREs that are above 1% but not greater than 1.5% of
average annual gross receipts in the 4 preceding tax years:
+ 4% of QREs that are above 1.5% but not greater than 2% of average
annual gross receipts in the 4 preceding tax years:
+ 5% of QREs that are above 2% of average annual gross receipts in the
4 preceding tax years:
Restrictions on the Credit's Use:
The IRC requires that taxpayers reduce the amount of their deductions
for research expenses under section 174 by the amount of research
credit that they claim. Alternatively, the taxpayer can elect to claim
a reduced credit, equal to 65 percent of the credit that it otherwise
would have been able to claim.
The research credit is a component of the general business credit and,
therefore, is subject to the limitations that apply to the latter
credit. Specifically, the general business credit is generally
nonrefundable, except for the provisions of section 168(k)(4), so if
the taxpayer does not have a sufficient precredit tax liability against
which to use the credit in the current tax year, the taxpayer must
either carry back some or all of the credit to the preceding tax year
(if had a tax liability that year), or carry the credit forward for use
in a future tax year. Unused general business credits may be carried
forward up to 20 years.
Group Aggregation Rules:
When Congress originally enacted the research credit in 1981, it
included rules "intended to prevent artificial increases in research
expenditures by shifting expenditures among commonly controlled or
otherwise related persons."[Footnote 5] Without such rules, a corporate
group might shift current research expenditures away from members that
would not be able to earn the credit due to their high base
expenditures to members with lower base expenditures. A group could,
thereby, increase the amount of credit it earned without actually
increasing its research spending in the aggregate. Under the IRC, for
purposes of determining the amount of the research credit, the
qualified expenses of the same controlled groups of corporations are
aggregated together. The language of the relevant subsection
specifically states that:
1. All members of the same controlled group of corporations shall be
treated as a single taxpayer,[Footnote 6] and:
2. The credit (if any) allowable under this section to each such member
shall be its proportionate share of the qualified research expenses and
basic research payments giving rise to the credit.
Congress directed that Treasury regulations drafted to implement these
aggregation rules be consistent with these stated principles. As
discussed in a later section, some tax practitioners say that
Treasury's regulations on this issue are unnecessarily burdensome.
The Marginal Incentive Provided by the Research Tax Credit:
One of the key measures that we will use to compare credit designs is
the marginal effective rate (MER) of the credit, which quantifies the
incentive that a credit provides to marginal spending and which can be
simply stated as:
MER = change in the credit benefit/marginal qualified research expenses
(QREs):
The MER is the same as the marginal rate of incentive that we presented
in figure 1. It measures the reduction in the after-tax price of
marginal research due to the credit. In the example of a flat credit
with a 20-percent statutory rate shown in that figure, the taxpayer
received $20 when it increased its spending by $100, giving it an MER
of 20 percent (the credit reduces the price of marginal research by 20
percent).[Footnote 7] However, factors other than just the statutory
rate of a tax credit can also be important in determining its marginal
incentive. Measures that take those other factors into account are
commonly known as "effective rates." In a later section we explain how
various features of the credit's design can affect the MER; however,
one factor that reduces the MER for all credit earners, regardless of
the design, is the offset of the credit against the section 174
deduction for research spending (or the alternative election of the
reduced credit amount) mentioned earlier. For corporations subject to
the top corporate income tax rate of 35 percent, this offset
effectively reduces the regular credit's MER from 20 percent to 13
percent and the ASC's MER from 14 percent to 9.1 percent.[Footnote 8]
Another factor that reduces the MER of many taxpayers is the fact that
they do not have sufficient tax liabilities to use all of the credits
they earn in the current year. When a taxpayer cannot use the credit
until sometime in the future, the present value of the credit decreases
according to the taxpayer's discount rate. For example, if the taxpayer
has a discount rate of 5 percent and must delay the use of $1 million
of credit for three years, the present value of that credit is reduced
to approximately $864,000.[Footnote 9] Such a delay, therefore, would
reduce the regular credit's MER from 13 percent to about 11.2 percent.
This delay in the use of the credit also reduces the present value of
the revenue cost to the government. In the remainder of this report we
make a distinction between the amount of net credit (after the section
174 offset) that taxpayers earn for a given tax year and the credit's
discounted revenue cost, which reflects delays in the use of credits.
Unless otherwise specified, we use the term revenue cost to refer to
the discounted revenue cost.
Estimating the Credit's Stimulative Effect:
Three pieces of information are needed to estimate the amount of
spending stimulated by the research credit. Then, to determine how much
spending is stimulated per dollar of revenue cost (colloquially known
as the "bang-per-buck" of the credit), the tax revenue cost of the
credit is also needed. The steps in this estimation process are
illustrated in figure 2. The shaded boxes identify the information
required. The first step is to multiply the weighted average MER
provided by the credit times a measure of the responsiveness of total
research spending to the price reduction.[Footnote 10] This
responsiveness measure is called the price elasticity of research
spending and is defined as the percentage change in total QREs divided
by the percentage change in the price of a unit of research. If the
average MER were 5 percent and the price elasticity were -1, then the
credit would increase total QREs by 5 percent. The next step in the
computation is to apply the percentage increase to the amount of
aggregate qualified spending that would have been done without the
credit in order to determine the total amount of spending stimulated by
the credit. Finally, the bang-per-buck can be estimated by dividing the
total amount stimulated by the credit's revenue cost.
Figure 2: Information Needed to Estimate the Bang-per-Buck of the
Credit:
[Refer to PDF for image: illustration]
Percentage increase in qualified research spending due to the credit:
Equals:
Percentage reduction in the after-tax price of a unit of qualified
research:
Marginal effective rate (MER) of the credit.
Times:
Percentage by which spending increases for each 1% reduction in the
price:
Price elasticity of research spending.
Dollar increase in qualified research spending due to the credit:
Equals:
Percentage increase in qualified research spending due to the credit:
Times:
Aggregate qualified research spending.
Dollar increase in qualified research spending due to the credit:
Divided by:
Revenue Cost;
Equals:
Bang-per-buck of the credit (Amount of spending stimulated for each
dollar of revenue forgone).
Source: GAO.
[End of figure]
In this study, we provide some estimates of the credit's weighted
average MER and revenue cost, as well as estimates of the aggregate
amount of qualified research spending. We have not estimated the price
elasticity of research spending and the available estimates from past
empirical research leave considerable uncertainty regarding the size of
that elasticity.[Footnote 11] Nevertheless, as can be seen in figure 2,
for any value of the price elasticity, a credit design that provides
the same weighted average MER as another design, but at a lower revenue
cost, should provide a higher bang-per-buck than that other credit.
Therefore, comparing different designs on the basis of their MER and
revenue cost should be equivalent to comparing them on the basis of
their bang-per-buck.
To fully assess the research credit's value to society, more than just
the amount of spending stimulated per dollar of revenue cost would have
to be examined. A comparison would have to be made between (1) the
total benefits gained by society from the research stimulated by the
credit and (2) the estimated costs to society resulting from the
collection of taxes required to fund the credit. The social benefits of
the research conducted by individual businesses include any new
products, productivity increases, or cost reductions that benefit other
businesses and consumers throughout the economy. Although most
economists agree that research spending can generate social benefits,
the effects of the research on other businesses and consumers are
difficult to measure. We are not aware of any studies that have
empirically estimated the credit's net benefit to society.
Large Corporations Have Dominated the Use of the Research Credit, Which
Provided an Average Marginal Incentive of About 7 Percent in 2003
through 2005:
Although more than 15,000 corporate taxpayers claimed research credits
each year from 2003 through 2005, a significantly smaller population of
large corporations (those with business receipts of $1 billion or more)
claimed most of the credit during this period. In 2005, 549 such
corporations accounted for about 65 percent of the $6 billion of net
credit claimed that year (see figure 4 and table 3 in appendix II).
[Footnote 12] Even within the population of large corporations credit
use is concentrated among the largest users. The 101 corporations in
our panel database in 2004 accounted for about 50 percent of the net
credit claimed that year. Corporations with business receipts of $1
billion or more accounted for an even larger share--about 70 percent--
of the $131 billion of total QREs reported by credit claimants for
2005.[Footnote 13] In 2005 approximately 69 percent of QREs were for
wages paid to employees engaged in qualified research activities.
Almost all of the remaining QREs were for supplies used in research
processes (about 16 percent) and for contract research (about 15
percent).[Footnote 14]
Prior to the introduction of the ASC in 2006, taxpayers that used the
regular credit accounted for the majority of QREs and an even larger
majority of the research credit claimed.[Footnote 15] In 2005, regular
credit users reported about 75 percent of all QREs and claimed about 90
percent of total research credits.[Footnote 16] (See figure 5 in
appendix II.) Their share of total credits was larger than their share
of total QREs because the regular credit rules were more generous than
those of the AIRC for taxpayers who could qualify for the former. Most
of the regular credit users were subject to the 50-percent minimum
base, which, as we will explain in a later section, had a significant
effect on the MER they received from the credit. The lack of current
tax liabilities was another factor that affected the MERs of many
credit claimants. In 2005, 44 percent of total net credits earned could
not be used immediately. (See figure 6 in appendix II.)
By taking into account factors, such as which credit a taxpayer
selected, whether it was subject to a minimum base, and whether it
could use its credit immediately, we were able to estimate MERs for all
of the credit claimants represented in SOI's corporate database (see
appendix I for details). These individual estimates allowed us to
compute a weighted average MER for all taxpayers. We also estimated the
discounted cost to the government of the credits that all taxpayers
earned. These estimates, along with data on total QREs, permitted us to
estimate the bang-per-buck of the credit for 2003 through 2005 for
alternative assumptions about the price elasticity of research
spending. (See table 4 in appendix II.) Our estimate of the overall MER
in 2005 ranged between 6.4 percent and 7.3 percent, depending on
assumptions about discount rates and the length of time before
taxpayers could use their credits. Our estimates of the discounted
revenue cost were also sensitive to these assumptions and ranged
between $4.8 billion and $5.8 billion. The bang-per-buck estimates were
not sensitive to these particular assumptions;[Footnote 17] however,
they were quite sensitive to the price elasticity assumptions. If the
elasticity was -0.5, the bang-per-buck for 2005 would have been about
$0.80. If the elasticity was -2, the bang-per-buck would have been
about $3.00.
Data on amended claims filed by our panel of large corporations
indicate that, in the aggregate, these amendments increased the amount
of credit claimed by between 1.5 percent and 5.4 percent (relative to
the amounts claimed on initial returns) for each tax year from 2000
through 2003. (See tables 5 through 8 in appendix II.) The credit
increase through amendments for tax year 2004 was only 0.5 percent.
Data from IRS examinations of these large corporations indicate that
examiners recommended changes that, in the aggregate, would have
decreased credits claimed by between 16.5 and 27.1 percent each tax
year from 2000 through 2003.[Footnote 18] (See tables 9 through 12 in
appendix II.) The lower percentage change of 9 percent for 2004
reflects, in part, the fact that audits for that tax year had not
progressed as far as those for the earlier years.
Changes of these magnitudes raise the question of how much credit
taxpayers actually expected to receive when they filed their claims
and, more important, when they were making their research spending
decisions for the years in question.[Footnote 19] These expectations
are critical because they are what affect the taxpayer's decisions, not
the amounts of credit actually received well after the decisions have
been made. For those taxpayers that do not expect to file amendments
and do not expect IRS to change their credits, the amounts claimed on
their original returns should be the best estimate of their
expectations. For taxpayers that know they may be stretching the rules
with some of the expenses they are trying to claim as QREs, their post-
exam credit amounts may be better estimates of their expectations. In
other cases, given the lack of clarity in certain aspects of the
definitions of both QREs and gross receipts, taxpayers may be uncertain
whether they will receive any credit for particular research projects.
Such uncertainty reduces the credit's effective incentive.
Important Trade-Offs Exist in the Choice of Research Credit Designs:
The regular credit provides a higher average MER for a given revenue
cost than does the current ASC; however, over time, the historically
fixed base of the regular credit becomes a very poor measure of the
research spending that taxpayers would have done anyway. As a result,
the benefits and incentives provided by the credit become allocated
arbitrarily and inequitably across taxpayers, likely causing
inefficiencies in resource allocation.
As we noted earlier, an ideal incremental credit would reward marginal
research spending but not any spending that a taxpayer would have done
anyway. In reality, it is impossible for policymakers to know how much
research spending taxpayers would have done without the credit. Any
practical base that can be designed for the credit will only
approximate the ideal base with some degree of inaccuracy. The primary
base for the regular credit (except for start-up companies) is
determined by a taxpayer's spending behavior that occurred up to 25
years ago (see the computation rules on page 7).[Footnote 20] There is
little reason to believe that, in most cases, the ratio of research
spending to gross receipts from that long ago, when multiplied by the
taxpayer's most recent 4-year average of gross receipts, would
accurately approximate the ideal base for that taxpayer.
Most credit claimants received substantial windfalls. Regular credit
claimants subject to the 50 percent minimum base represented about 71
percent of all claimants in 2005 (see figure 5 in appendix II). More
than half of the credit such claimants earned was a windfall. Even the
highest elasticity estimates and the largest possible MER (which
together should produce the largest increase in research spending)
indicate that spending increases due to the credit represent less than
15 percent of the total research spending of these claimants. Since
regular credit users subject to the 50 percent minimum base receive a
credit for half of their research spending, the credit for marginal
spending is less than half of the credit they receive.
Inaccuracies in the base also cause disparities across taxpayers in
both the marginal incentives and windfall benefits that they receive
from the credit. Table 1 shows the extent of the disparities across
taxpayers that use different credit options and are subject to
different constraints. Taxpayers for which bases exceeded their actual
spending received no incentive from the credit. Regular credit users
whose primary bases were not so inaccurately low that the minimum base
took effect received had MERs of 13 percent (if they could use their
credits immediately), while those with primary bases so inaccurate that
they were subject to the minimum base had their MERs cut to 6.5 percent
(again, if they could use their credits immediately).[Footnote 21]
Using the IRS tax data, we estimated that the regular credit users
subject to the minimum base received an average effective rate of
credit (total credit divided by total spending) more than one and one-
half times as large as those who were not subject to the minimum base.
The average effective rate includes windfall credits, which the MER
does not. This result indicates that, even though the minimum base
reduced the credits that taxpayers earned on both their marginal
spending and on the spending they would have done anyway, taxpayers
subject to the minimum base still received larger windfall credits than
those who were not.
Meanwhile, AIRC users received significantly lower MERs and average
effective credit rates than did either group of regular credit users.
Table 1: Maximum MERs and Average Effective Rates of Credit for
Different Categories of Credit Claimants, 2005:
Maximum MER;
Had QREs below base amounts: 0%;
Claimed regular credit: Not subject to minimum base: 13.0%;
Claimed regular credit: Subject to minimum base: 6.5%;
Claimed AIRC: 2.4%.
Average Effective Rate;
Had QREs below base amounts: 0%;
Claimed regular credit: Not subject to minimum base: 4.1%;
Claimed regular credit: Subject to minimum base: 6.5%;
Claimed AIRC: 1.9%.
Source: GAO analysis based on IRS data and the IRC.
[End of table]
Although data are not yet available on credit use after the ASC was
introduced, we applied current credit rules to the historical data from
our panel of large credit claimants to estimate how many of them would
have chosen ASC if it had been available in 2003 and 2004. We found
that, if taxpayers had selected the option that provided them with the
largest credit amount, most of the panel members would have switched to
the ASC, but a significant number would still have claimed the regular
credit. ASC users would have accounted for about 62 percent of the
panel population's total QREs and between 56 percent to 60 percent of
the revenue cost of all panel members in those years. (See table 13.)
Some taxpayers still had MERs over 10 percent while others had negative
MERs.
The disparate distribution of incentives and windfalls is not only
inequitable, it can also result in a misallocation of research spending
and economic activity in general across competing sectors.[Footnote 22]
These misallocations may reduce economic efficiency and, thereby,
diminish any economic benefits of the credit.
An additional significant problem with the regular credit's base is the
difficulty that taxpayers have in substantiating their base
computations to the IRS. Many businesses lack the types of records
dating to the mid 1980s that are needed to complete these computations
with a high degree of accuracy and the substantiation of base QREs has
become a leading issue of contention between regular credit users and
the IRS. (This problem will be discussed in more detail in a later
section.)
Under the ASC's Moving-Average Base, Marginal Incentives Are Reduced
Because Current Spending Reduces the Amount of Credit Earned in Future
Years:
The base of the ASC continually updates itself; however, an important
disadvantage of this updating is that a taxpayer's current year
research spending will increase its base in future years, thereby
reducing the amount of credit it earns in those years. Figure 3
illustrates this problem in the case that a taxpayer earns a credit
each year but is not subject to the minimum base. For every $1 million
of spending increase this year, the taxpayer's base in each of the next
3 years would increase by $166,667. These base increases reduce the
amount of credit that the taxpayer can earn in each of the next 3 years
by $15,167, for a combined total of $45,500.[Footnote 23] As a result,
the actual benefit that the taxpayer receives for increasing this
year's spending is cut in half, and the MER is reduced to 4.6
percent.[Footnote 24] If the taxpayer anticipated that its future
spending would decline so much that it would not be able to earn any
credit in the next 3 years, then there would be no negative future
consequences from increasing this year's spending and the MER would be
9.1 percent. However, if a taxpayer does not expect to exceed its base
in the current year, even after increasing its spending by a marginal
amount, but plans to increase its future spending enough to earn
credits in the future years, then it would receive no current benefit
for that marginal spending. The taxpayers would still suffer the
negative effects in the future years, meaning that, in this case, the
MER would actually be negative.
Figure 3: Illustration of How Current Spending Increases Reduce Future
Credits Under the ASC:
[Refer to PDF for image: illustration]
This illustration depicts taxpayer marginal spending:
Spending on research that taxpayer would have done anyway: range is $1
million to $10 million.
Marginal spending in year 1:
Base amounts without the marginal spending in Year 1:
Increase in future base amounts due to the marginal spending: Causes an
increase in the base for the three following years that, in turn,
reduces the credit the taxpayer earns in those years.
Source: GAO.
[End of figure]
Given that the ASC base is only one-half of the taxpayer's past 3
years' average spending, most research-performing companies should be
able to earn some credit every year, which was an important reason why
this option was introduced. However, the low base is likely to be below
most taxpayer's ideal base and some are likely to earn credit on
substantial amounts of research spending that they would have done
anyway. There currently is no minimum base for the ASC to limit the
amount of windfall credit that taxpayers can earn. Only the lower
credit rate (14 percent vs. 20 percent for the regular credit) contains
the cost of these windfalls.
The Introduction of the ASC Option Is Likely to Have Lowered the Bang-
per-Buck of the Research Credit but Increased the Number of Taxpayers
Receiving Positive Incentives:
By applying the credit rules that existed immediately prior to the
introduction of the ASC to the historical data for our panel of
corporations and, then, applying the rules that existed in 2009, we
were able to compare how these taxpayers would have fared under the
different sets of options available. If we assumed a relatively low
discount rate and short length of carryforward (for those who could not
use their credits immediately), then the estimated weighted average MER
for our panel prior to the introduction of the ASC ranged between 7.4
percent and 8.3 percent, depending on which years of data we used and
whether the data related to before or after amendments and IRS exams.
[Footnote 25] If the ASC option had been available to these
corporations and they chose the credit option that provided them the
largest amount of credit, we estimate that their weighted average MER
would have been between 5.6 percent and 6.3 percent. (See table 14 in
appendix II.) This decline in the MER would have been accompanied by an
increase in the revenue cost of the credit of between about 17 percent
and 29 percent.[Footnote 26] These results indicate that the
introduction of the ASC lowered the bang-per-buck of the credit. The
availability of the new option would not have reduced any taxpayer's
windfall credit, but it would likely have increased the windfalls of
some. Those taxpayers that would have switched from the regular credit
to the ASC are likely to have seen their MERs decline, while those who
switched from the AIRC may have seen their MERs increase or decrease.
[Footnote 27]
Our estimates are based on an analysis of a fixed population of
corporations; it does not reflect the effects of the likely increase in
the number of taxpayers claiming the credit thanks to the lower base of
the ASC. The addition of these new claimants likely would have reduced
the credit's bang-per-buck further because they would all have the
lower MERs provided by the ASC. The MERs of these taxpayers would be
higher than the zero MERs they faced before the ASC was available;
however, the revenue cost of providing them with the credit, which also
was zero previously, would have increased as well.
Changing the Regular Credit to Reduce Distortions Caused by Base
Inaccuracies Would Come at the Cost of Reducing the Credit's Bang-per-
Buck:
The problems we identified with the base of the regular credit can be
addressed by either (1) eliminating the regular credit option or (2)
retaining the regular credit but updating its base so that the
distribution of credit benefits and incentives across taxpayers would
be less uneven and arbitrary. Under either of these approaches the
primary bases for all taxpayers would be linked to their recent
spending behavior, rather than decades-old behavior. The recent
behavior is likely to be more closely correlated with their ideal bases
than the older behavior would be.
The results of our simulations (summarized in the top portion of table
2) indicate that both of these changes would have approximately the
same effect because, in each case, all of the corporations in our panel
would use the ASC.[Footnote 28] (Details of our results are presented
in tables 15 and 16 in appendix II.) Under the first change, the ASC
would be the only option available; under the second change, all of the
taxpayers would receive larger amounts of credits under the ASC than
under the regular credit (except for those that could not earn either
credit), so they would voluntarily choose the ASC.[Footnote 29] In both
cases, if the rate of the ASC is kept at 14 percent, both the average
MER and the revenue cost would decrease, but the percentage decrease in
the average MER in most cases would be at least twice as large, meaning
that the credit's bang-per-buck would decrease. If the rate of the ASC
were raised to 20 percent, the average MER would increase relative to
existing rules under most combinations of assumptions, but the revenue
cost would increase to a much larger extent, again, meaning that the
bang-per-buck would decrease.
No clear purpose would be served by retaining both the ASC and a
regular credit whose base would be updated almost as frequently as that
of the ASC. If the bases for both of the options were linked to recent
spending behavior, there would be no rationale for providing taxpayers
with different rates of credit under two options. Moreover, once
taxpayers began to expect regular updates of the base, the expected
negative effects on future credits would lower the MER of the regular
credit in the same way that they do for the ASC. One potential
compromise between a frequently updated base that significantly reduces
the credit's bang-per-buck and a fixed base that causes distorting
disparities is to have a base that is updated only in those cases where
it has become evidently far out of line for individual taxpayers. For
example, taxpayers that spend less than 75 percent of their base amount
for the regular credit could be given the option of using a more recent
period of years for computing their fixed base percentage. Taxpayers at
the other extreme--those subject to the current minimum base--could be
required to use a more recent base period. Taxpayers between these two
extremes would not have their bases updated, which means that, if they
are not close to the minimum base, they would not face negative future
effects. However, one significant problem with this approach is that it
would give taxpayers who are close to being subject to the minimum base
an extremely large disincentive to increase their spending. In
addition, the taxpayers without updated bases would still face the
substantial recordkeeping difficulties that are discussed in a later
section.
Table 2: Summary Comparison of Leading Design Options:
Options for the ASC: No minimum base and credit rate = 14 percent;
Options for the regular credit: Eliminate the regular credit option:
Relative to 2009 law, this combination is likely to reduce both the
average MER and the revenue cost;
however, it is likely to reduce the average MER to a greater degree,
resulting in a decline in the credit's bang-per-buck; The benefit of
this combination is that it would significantly reduce unintended
disparities in MERs across taxpayers;
Options for the regular credit: Retain the option but update the
base[A]: If no minimum base were added to the ASC the short-term
results of updating the base of the regular credit would differ only
minimally from those of eliminating the regular credit because all
taxpayers in our panel would choose the ASC over the regular credit;
Over the longer term, until the base is updated again, the situation is
likely to gradually approach that which existed under 2009 law.
Options for the ASC: No minimum base and credit rate = 20 percent;
Options for the regular credit: Eliminate the regular credit option:
Raising the rate of the ASC to 20 percent would increase the revenue
cost significantly and also increase the average MER under most of the
combinations of assumptions we examined. The increases in the average
MER would be smaller than the increases in the revenue cost, again
resulting in a decline in the credit's bang-per-buck; This combination
would also significantly reduce unintended disparities in MERs across
taxpayers;
Options for the regular credit: Retain the option but update the
base[A]: Same as above in the short term. Over the longer term, there
should be a slower and smaller shift back to use of the regular credit
if the ASC rate is raised to 20 percent.
Options for the ASC: 50-percent minimum base and credit rate = 14
percent;
Options for the regular credit: Eliminate the regular credit option:
Relative to having only an ASC with no minimum base, this design is
likely to provide the same incentive at a lower revenue cost, thereby
providing a higher bang-per-buck;
Options for the regular credit: Retain the option but update the
base[A]: If the rate of the ASC were kept at 14 percent, some taxpayers
would choose the regular credit option over the ASC. Those taxpayers
receive a higher MER than they would with the ASC, raising the average
MER for the whole population; In the short run, before the inaccuracy
of the regular credit's base grows, unintended disparities in MERs
should be no worse than with the ASC only.
Options for the ASC: 50-percent minimum base and credit rate = 20
percent;
Options for the regular credit: Eliminate the regular credit option:
Same as immediately above;
Options for the regular credit: Retain the option but update the
base[A]: The results of this design would differ only minimally from
those of allowing only an ASC with a 20-percent rate and a 50-percent
minimum base because almost all taxpayers in our panel would choose the
ASC over the regular credit.
Options for the ASC: 75-percent minimum base and credit rate = 14
percent;
Options for the regular credit: Eliminate the regular credit option:
Under almost all assumptions we found the revenue savings to be less
than or equal to those gained by adding a 50-percent minimum base;
Options for the regular credit: Retain the option but update the
base[A]: If the rate of the ASC were kept at 14 percent, some taxpayers
would choose the regular credit option over the ASC. Those taxpayers
receive a higher MER than they would with the ASC, raising the average
MER for the whole population; In the short run, before the inaccuracy
of the regular credit's base grows, unintended disparities in MERs
should be no worse than with the ASC only.
Options for the ASC: 75-percent minimum base and credit rate = 20
percent;
Options for the regular credit: Eliminate the regular credit option:
Under almost all assumptions we found the revenue savings to be less
than or equal to those gained by adding a 50-percent minimum base;
Options for the regular credit: Retain the option but update the
base[A]: The results of this design would differ only minimally from
those of allowing only an ASC with a 20-percent rate and a 50-percent
minimum base because ASC users would still account for between and 90
percent of the total revenue cost of the credit.
Source: GAO.
[A] The minimum base for the regular credit would be 50 percent, except
in the last two cases where it would be 75 percent.
[End of table]
The Credit's Bang-per-Buck Can Be Improved by Adding a Minimum Base
Constraint to the ASC:
Results from simulations based on our panel database suggest that
adding a minimum base to the ASC is likely to improve its bang-per-
buck.[Footnote 30] The effects of adding a minimum base vary, depending
on whether both the ASC and regular option are retained, or only the
former. These variations are summarized in the lower portion of table 2
and further details are provided in tables 17, 18 and 19 in appendix
II.
Under most combinations of assumptions that we examined, when an ASC is
the only option available, an ASC with a 50-percent minimum base could
provide the same average MER as an ASC without a minimum base, but at a
lower revenue cost. In all but one unlikely case, the reductions in
discounted revenue cost ranged between 1.5 percent and 18 percent with
most exceeding 3 percent.[Footnote 31] Revenue savings would be
achieved regardless of whether the rate of the ASC is 14 percent or 20
percent. We also examined the effects of adding a 75-percent minimum
base; however, under almost all assumptions we found the revenue
savings to be less than or equal to those gained by adding a 50-percent
minimum base.
If both the ASC with a 14-percent rate and the regular credit with a 20-
percent rate and an updated base are available, the addition of a
minimum base to the ASC would cause some taxpayers to prefer the
regular credit over the ASC.[Footnote 32] Those regular credit users
would have higher MERs than they would have had under the ASC, so the
average MER would be higher if both options were available. Those
users' credit amounts would also be higher; however, the percentage
differences in their credits would be smaller than the percentage
differences in their MERs (see tables 18 and 19), meaning that the
credit's bang-per-buck would be slightly higher. However, this
advantage in terms of bang-per-buck would come at the cost of providing
unequal incentives across taxpayers without a rationale.
In addition to examining the effects of adding a minimum base to the
ASC we also simulated the effects of increasing the credit's base rate
(i.e., having the base equal to 75 percent or 100 percent of a
taxpayer's 3-year moving average of spending, rather than 50 percent as
under current rules). We found that these changes would significantly
increase the percentage of our panel corporations that have negative
MERs.
Issues of Contention between Taxpayers and IRS Relating to the Research
Credit Are Both Extensive and Acute:
Several Aspects of the Definition of Qualified Research Expenses Have
Been Significant Sources of Contention between Taxpayers and IRS:
A well-targeted definition of QREs (and IRS's ability to enforce the
definition) can improve the efficiency of the credit to the extent that
it directs the subsidy toward research with high external benefits and
away from research with low external benefits. By focusing the subsidy
in this manner, the definition can increase the amount of social
benefit generated per dollar of tax subsidy provided through the
credit. Specifying a definition that serves this purpose and that is
also readily applied by both IRS and taxpayers has proven to be a
challenge for both Congress and the Department of the Treasury. There
are numerous areas of disagreement between IRS and taxpayers concerning
what types of spending qualify for the research credit. These disputes
raise the cost of the credit to both taxpayers and IRS and diminish the
credit's incentive effect by making the ultimate benefit to taxpayers
less certain.
Many of the tax practitioners we interviewed had a common general
complaint that IRS examiners often demanded that the research
activities result in a higher standard of innovation than required by
either the IRC or Treasury regulations. The IRS officials we
interviewed disagreed with these assertions and referred to language
from their Research Credit Audit Technique Guide that instructs
examiners on the relevant language from current regulations. Both
practitioners and IRS officials acknowledged that some controversies
arise because language in the IRC and regulations does not always
provide a bright line for identifying qualified activities. For
example, one qualification requirement is that the research must be
intended to eliminate uncertainty concerning the development or
improvement of a business component. The regulations say that
uncertainty exists "if the information available to the taxpayer does
not establish the capability or method for developing or improving the
business component, or the appropriate design of the business
component.[Footnote 33]" An IRS official said that examiners could use
clarification of the meaning of "information available to the
taxpayer," while a practitioner noted that the regulations do not say
what degree of improvement in a product is required for the underlying
research to be considered qualified. The practitioner said that
research for improvements is more difficult to get qualified than
research for new products.
Several particularly contentious issues relate to specific types of
research activities or expenses, including the following:[Footnote 34]
The definition and qualification standards for internal-use software
(IUS). Research relating to the development of software for the
taxpayer's own internal use is generally excluded from qualified
research, unless it meets an additional set of standards that are not
applied to other research activities.[Footnote 35] The IRC provides
Treasury the authority to specify exceptions to this exclusion but
Treasury did not address this issue when it published final research
credit regulations in 2004. Treasury pointed to the significant changes
in computer software and its role in business activity since the mid-
1980s (when the IUS exclusion was added to the IRC) as making it
difficult to determine how Congress intended the new technology to be
treated. Meanwhile, tax practitioners complain that IRS continues to
consider most software development expenditures in the services
industry to be IUS.[Footnote 36] Some commentators have questioned
whether there is still an economic rationale for distinguishing between
IUS and software used for other purposes, given that innovations in
software can produce spillover benefits regardless of whether the
software is sold to third parties. IRS officials say that eliminating
the distinction would significantly increase the revenue cost of the
credit but they doubt that it would simplify administration. They
believe that a bright-line definition of IUS, such as that contained in
2001 proposed regulations, is the only practical approach for dealing
with this issue.[Footnote 37] The development of IUS regulations has
been included in all of Treasury's priority guidance plans since the
issue was left out of the final research credit regulations; however,
Treasury officials have not indicated when they are likely to be issued
or what stand they are likely to take.
Late-stage testing of products and production processes. Treasury
regulations provide that "the term research or experimental
expenditures does not include expenditures for the ordinary testing or
inspection of materials or products for quality control (quality
control testing)." However, the regulations clarify that "quality
control testing does not include testing to determine if the design of
the product is appropriate."[Footnote 38] Some tax consultants told us
that IRS fairly consistently disqualifies research designed to address
uncertainty relating to the appropriate design of a product. One of
them said that IRS rejected testing activities simply on the basis of
whether the testing techniques, themselves, were routine. IRS officials
said that they typically reject testing that is done after the taxpayer
has proven the acceptability of its production process internally. They
noted that there is no bright line between nonqualifying ordinary
quality control testing and qualified validation testing. These
determinations are made on a case-by-case basis for each activity. The
official also said that they have disagreements with taxpayers over
when commercial production begins and suggested that this is one area
where some further clarification in regulations might help. Product
testing is a particularly important issue for software development,
which in general (not just IUS) is another area of significant
contention between IRS and taxpayers.
Direct supervisory and support activities. Qualified research expenses
include the wages of employees who provide direct supervision or direct
support of qualified research activities. The practitioners we
interviewed said that it is extremely difficult to get IRS to accept
that higher level managers are often involved in research and the
direct supervision of research. Many of their clients have flat
organizational structures and the best researchers are often given
higher titles so that they can be paid more. They say that IRS often
rejects wage claims simply on the basis of job titles. IRS officials
told us that wages of higher level managers could be eligible for the
credit; however, the burden of proof is on the taxpayer to substantiate
the amount of time that those managers actually spent directly
supervising a qualified activity. Regarding the issue of direct
support, some commentators would like IRS's guidance to more clearly
state that activities such as bid and proposal preparation (at the
front end of the research process) and development testing and
certification testing (at the final stages of the process) are
qualified support activities that do not have to meet specific
qualification tests themselves, as long as the activities that they
support already qualify as eligible research. IRS officials told us
that they would like better guidance on this issue and were concerned
that some taxpayers want to include the wages of anyone with any
connection at all to the research, such as marketing employees who
attend meetings to talk about what customers want.
Supplies. The IRC specifically excludes expenditures to acquire
depreciable property from eligibility for either the deduction of
research expenditures under section 174 or for the research credit.
[Footnote 39] Taxpayers have attempted to claim the deduction or the
credit for expenditures that they have made for labor and supplies to
construct tangible property, such as molds or prototypes, that they
used in qualified research activities. IRS has taken the position that
such claims are not allowed (even though the taxpayers do not,
themselves, take depreciation allowances for these properties) because
the constructed property is of the type that would be subject to
depreciation if a taxpayer had purchased it as a final product.
[Footnote 40] IRS also says that it is also improper for taxpayers to
include indirect costs in their claims for "self-constructed supplies,"
even when the latter are not depreciable property.[Footnote 41]
Taxpayers are challenging IRS's position in at least one pending court
case.[Footnote 42] Both taxpayers and IRS examiners would like to see
clearer guidance in this area. Treasury has had a project to provide
further guidance under section 174 in its priority guidance plans since
at least 2005 but the guidance has not yet been issued. IRS has also
been concerned with the extent to which taxpayers have attempted to
recharacterize ineligible foreign research services contracts as supply
purchases.
The Lack of Official Guidance Regarding the Definition of Gross
Receipts for Controlled Groups of Corporations Leaves Those Taxpayers
Very Uncertain about Their Credit Benefits:
For taxpayers claiming the regular research credit the definition of
gross receipts is important in calculating the "base amount" to which
their current-year QREs are compared. The definition also was critical
for determining the amount of credit that taxpayers could earn with the
AIRC. (Even though this credit option is no longer available, a
decision regarding the definition of gross receipts will affect
substantial amounts of AIRC claims that remain in contention between
taxpayers and IRS for taxable years before 2009.) Gross receipts do not
enter into the computation of the ASC or the basic research credit. If
the regular credit is eliminated, this becomes a nonissue for future
tax years, but the consequences for taxpayers and the revenue cost to
the government from past claims will be substantial (particularly as a
result of the extraordinary repatriation of dividends in response to
the temporary incentives under IRC section 965).[Footnote 43]
The principal issue of contention between taxpayers and IRS is the
extent to which sales and other types of payments among members of a
controlled group of corporations should be included in that group's
gross receipts for purposes of computing the credit.[Footnote 44]
Neither the IRC nor regulations are clear on this point and IRS has
issued differing legal analyses in specific cases over the years.
IRS's current interpretation of the credit regulations that generally
exclude transfers between members of controlled groups is that it
applies only to QREs and not to gross receipts; consequently, all
intragroup sales should be included when computing a group's total
gross receipts. This option would eliminate any double-counting of QREs
but could overstate the resources available to the group by double-
counting sales and income payments between group members. However,
going to the other extreme and excluding all intragroup transactions
from the group's total gross receipts could exclude a large share of
the export sales of U.S. multinational corporations (those made to
foreign affiliates for subsequent resale abroad) from gross receipts.
This result would favor regular credit users whose export sales have
increased as a share of their total sales and disfavor users whose
export shares have declined. These disparities in the credit benefits
across taxpayers serve no useful purpose.
An intermediate alternative would be to exclude all transactions
between controlled group members except for intermediate sales by U.S.
members to foreign members. This approach would not discriminate among
taxpayers on the basis of whether they export their products or sell
them domestically because it would include all sales that are
effectively connected with the conduct of a trade or business within
the United States in a group's gross receipts. This option would also
eliminate any double-counting of intragroup transfers in gross
receipts, which is important if Congress wishes to continue using gross
receipts as a measure of the resources available to corporations.
Substantiating the Validity of a Research Credit Claim Is a Demanding
Task for Both Taxpayers and IRS:
Neither the IRC nor Treasury regulations contain specific recordkeeping
requirements for claimants of the research credit. However, claimants
are subject to the general recordkeeping rules of IRC section 6001 and
Treasury regulations section 1.6001, applicable to all taxpayers, that
require them to keep books of account or records that are sufficient to
establish the amount of credit they are claiming. In the case of the
research credit, a taxpayer must provide evidence that all of the
expenses for which the credit is claimed were devoted to qualified
research activities, as defined under IRC section 41. Section 41
requires that the qualification of research activities be determined
separately with respect to each business component (e.g., a product,
process, or formula), which means that the taxpayer must be able to
allocate all of its qualified expenses to specific business components.
Moreover, the taxpayer must be able to establish these qualifications
and connections to specific components not only for the year in which
the credit is being claimed, but also for all of the years in its base
period.
There were wide difference in opinions between the IRS examiners and
the tax practitioners we interviewed regarding what methods are
acceptable for allocating wages between qualifying and nonqualifying
activities. Practitioners noted that IRS prefers project accounting
but, in its absence, used to accept cost center or hybrid accounting;
however, in recent years, IRS has been much less willing to accept
claims based on the latter two approaches.[Footnote 45] They also said
that IRS examiners now regularly require contemporaneous documentation
of QREs, even though this requirement was dropped from the credit
regulations in 2001. Some practitioners suggested that the changes in
IRS's practices came about because examiners were having difficulty
determining how much QREs to disallow in audits when they found that a
particular activity did not qualify. Others said that IRS does not want
to devote the considerable amounts of labor required to review the
hybrid documentation. The IRS officials we interviewed said that more
taxpayers have or had project accounting than was suggested by the tax
practitioners. The officials said that the consultants ignored these
accounts because they boxed them in (in terms of identifying qualified
research expenses). In their view the high-level surveys and interviews
of managers or technical experts from the business, which many
taxpayers try to use as evidence, are not a sufficient basis for
identifying QREs. The officials noted that sometimes consultants
conduct interviews for one tax year and then extrapolate their results
to support credit claims for multiple earlier tax years.
IRS officials have been particularly concerned with the quality of late
or amended filings of credit claims. In April 2007, IRS designated
"research credit claims" as a Tier I compliance issue because of the
volume and difficulty of auditing these claims.[Footnote 46] In
announcing the designation IRS noted that a growing number of credit
claims were based on marketed tax products supported by studies
prepared by the major accounting and boutique tax advisory firms. IRS
officials expressed concern that when taxpayers submit amendments to
their IRS Forms 6765, they often do so late in an audit after IRS has
already spent significant time reviewing the initial claims. In many
cases the taxpayers settle for 50 cents on the dollar as soon as IRS
challenges a claim.
Although most of the tax practitioners we interviewed acknowledged that
there was a proliferation of aggressive and sometimes sloppy research
credit claims, they pointed to many legitimate reasons for companies to
file claims on amended returns, including long-standing uncertainties
and changes in the research tax credit regulations. The practitioners
say that IRS's standards are stricter than Congress intended and what
has been allowed in recent court cases. IRS disagrees and says its
administrative practices are consistent with the court rulings.
[Footnote 47]
The burden of substantiating research credit claims represents a
significant discouragement to potential credit users; however, the
flexibility in substantiation methods that many practitioners seek
could help some taxpayers claim larger credits than those to which they
are entitled. Although some taxpayers, particularly those for which
research activities constitute a large proportion of their total
operations, are able to meet the recordkeeping standards that IRS is
currently enforcing, many taxpayers would find it extremely burdensome
to meet these requirements. One consulting firm told us that they
recently tried to shift all of their clients to project accounting.
This effort was successful; however, it was extremely difficult for the
businesses. Other practitioners said that many taxpayers simply would
not take on such an effort just to claim the credit. Allowing taxpayers
to allocate their expenses between qualified and nonqualified
activities after the fact and, in part, on the basis of oral testimony
of the taxpayers' experts would be less burdensome for businesses than
requiring contemporaneous time accounting by type of activity and by
specific project. However, the experts would have an incentive to
overstate the proportion of labor costs identified as QREs and IRS
would have no way to verify these oral estimates. Treasury and IRS face
a difficult trade-off between, on the one hand, increasing taxpayer
compliance burdens and deterring some taxpayers from using the credit
and, on the other hand, accepting overstated credit claims.
Substantiating Base Period QREs Is Extremely Challenging:
All of the difficulties that taxpayers face in substantiating their
QREs are magnified when it comes to substantiating QREs for the
historical base period (1984 through 1988) of the regular credit.
Taxpayers are required to use the same definitions of qualified
research and gross receipts for both their base period and their
current-year spending and receipts. However, many firms do not have
good (if any) expenditure records dating back to the early 1980s base
period and are unable to precisely adjust their base period records for
the changes in definitions promulgated in subsequent regulations and
rulings. Taxpayers also have great difficulty adjusting base period
amounts to reflect the disposition or acquisition of research-
performing entities within their tax consolidated groups. Some
practitioners would like to see some flexibility on IRS's part in terms
of base period documentation. They noted that in cases where a
taxpayer's records are missing or otherwise lacking, courts have
permitted taxpayers to prove the existence and amount of expenditure
through reasonable estimation techniques. The IRS officials we
interviewed said that estimates are allowable only if the taxpayer
clearly establishes that it has engaged in qualified research and that
its estimates have a sufficiently credible evidentiary basis to ensure
accuracy. One official noted that IRS not likely to question a
taxpayer's base amount if the latter uses the maximum fixed base
percentage; however, he did not think that IRS would have the authority
to say that taxpayers could take that approach without showing any
records at all for the base period. Neither IRS nor Treasury officials
we interviewed saw any administrative problems arising if the IRC were
changed to relieve taxpayers of the requirement to maintain base period
records if they used the maximum fixed base percentage.[Footnote 48]
Taxpayers Would Benefit from Greater Flexibility in Electing the ASC
Option:
Treasury regulations provide that elections to use the ASC or the AIRC
must be made on an original timely filed return for the taxable year
and may not be made on a late filed return or an amended return.
[Footnote 49] Some commentators on the regulations have questioned the
need for such limitations on taxpayers' ability to make the elections,
which they note the IRC does not specify. These commentators see no
reason why taxpayers who do not claim a credit until they file an
amended return are permitted to claim the regular credit but not the
ASC. They also believe that taxpayers should be allowed to change their
election if, as a result of an audit, IRS adjusts the amount of QREs or
base QREs in a manner which would make an alternative election more
advantageous to the taxpayer.
Treasury officials whom we interviewed said the legal "doctrine of
election" indicates that taxpayers must remain committed to their
choice once they have made their credit election.[Footnote 50] If
taxpayers are unhappy with the form of credit, they can choose another
form for the following tax year. Allowing taxpayers to elect different
forms of the credit on amended returns in response to an audit in order
to maximize their credit would create administrative burdens for IRS.
IRS officials agreed that permitting changes in credit elections could
require examiners to audit some taxpayers' credits twice; however, they
saw no problem with allowing taxpayers to claim either alternative
credit on an amended return if the taxpayer had not previously filed a
regular credit claim for the same tax year.
Taxpayers that fail to claim the research credit on timely filed tax
returns are materially disadvantaged by the election limitations that
apply to any subsequent claims they file on amended returns. There
appears to be no reason to prohibit taxpayers from electing either the
ASC or AIRC method of credit computation on an amended return for a
given tax year, as long as they have not filed a credit claim using a
different method on an earlier return for that same tax year.
Existing Rules for Allocating Group Credits Are Unnecessarily
Burdensome:
Under current Treasury regulations, the controlled group of
corporations must, first, compute a "group credit" by applying all of
the credit computational rules on an aggregate basis. The group must
then allocate the group credit amount among members of the controlled
group in proportion to each member's "stand-alone entity credit." The
stand-alone entity credit means the research credit (if any) that would
be allowed to each group member if the group credit rules did not
apply. Each member must compute its stand-alone credit according to
whichever method provides it the largest credit for that year without
regard to the method used to compute the group credit. The consultants
with whom we discussed this issue agreed that the rules were very
burdensome for those groups that are affected because it forces all of
their members to maintain base period records for the regular credit,
even if they would like to use just the ASC.[Footnote 51] Some very
large corporate groups must do these computations for all of their
subsidiaries, which could number in the hundreds, and they have no
affect on the total credit that a group earns.
Treasury maintains that a single, prescribed method is necessary to
ensure the group's members collectively do not claim more than 100
percent of the group credit. Treasury also maintains that the stand-
alone credit approach is more consistent with Congress's intent to have
an incremental credit than is the gross QRE allocation method that
others have recommended.[Footnote 52] In specifying that controlled
groups be treated as single taxpayers for purposes of the credit
Congress clearly wanted to ensure that a group, as a whole, exceeded
its base spending amount before it could earn the credit. It is not
clear that Congress was concerned that each member has an incentive to
exceed its own base. The reason for having a base amount is to contain
the revenue cost of the credit by focusing the incentive on marginal
spending. In the case of controlled groups the cost is controlled at
the group level; whether individual members exceed their own bases has
no bearing on the cost of the credit. If the choice between two
allocations methods does not affect the revenue cost, then the
remaining questions follow:
1. Does one of the methods provide a greater incentive to increase
research spending?
2. Is one significantly less burdensome to taxpayers and IRS?
For groups in which individual members determine their own research
budgets, neither the stand-alone credit allocation method nor the gross
QRE allocation method is unequivocally superior in terms of the
marginal incentives that they provide to individual members. Each of
the two methods performs better than the other in certain situations
that are likely to be common among actual taxpayers.[Footnote 53] Data
are not available that would allow us to say whether one of the methods
would result in higher overall research spending than the other. For
those groups in which the aggregate research spending of all members is
determined by group-level management, the only way that the allocation
rules can affect the credit's incentive is if they allow the shifting
of credits from members without current tax liabilities to those with
tax liabilities. If the group credit is computed according to the
method that yields the largest credit, then an additional dollar of
spending by any group member will increase the group credit by the same
amount, regardless of how the group credit total is allocated among
members.
The gross QRE allocation method is much less burdensome for controlled
groups and for IRS than the stand-alone method because it does not
require anyone to maintain base-period records for the regular credit,
unless they choose to use that credit themselves. If the regular credit
were eliminated, the burden associated with the stand-alone method
would be reduced considerably; however, it would still require more
work on the part of taxpayers and IRS than would the gross QRE method.
Conclusions:
Two significant concerns arise from the lack of any update of the
regular credit's base since it was introduced in 1989. First, the
misallocation of resources that can result from the uneven distribution
of both marginal incentives and windfall benefits across taxpayers
could lead to missed opportunities for the country to benefit from
research projects with higher social rates of return. Second, the
requirement to maintain detailed records from the 1980s, updated for
subsequent changes in law and regulations, represents a considerable
compliance burden for regular credit users (including some that are
required to use that option). Regular updates of the base would
substantially reduce these problems; however, no clear purpose would be
served by retaining both the ASC and a regular credit, the base of
which would be updated almost as frequently as that of the ASC.
Unfortunately, neither of the problems can be avoided without a
reduction in the credit's bang-per-buck. The addition of a minimum base
to the ASC would likely improve the bang-per-buck of that credit (the
extent would depend on certain estimating assumptions) and also reduce
inequities in the distribution of windfall credits.
The research credit presents many challenges to both taxpayers and IRS.
In a number of areas, current guidance for identifying QREs does not
enable claimants or IRS to make bright-line determinations. In some of
these areas further clarification is possible; in others ambiguity may
be difficult to reduce. In some cases, drawing lines that make the
definition of QREs more liberal would likely result in the credit being
less well-targeted to research with large spillover benefits to
society. Instead, the credit would be shifted toward a broader subsidy
for high-tech jobs or manufacturing in general. Documenting and
verifying that particular expenses are qualified for the credit involve
considerable resource costs on the part of taxpayers and IRS. Moreover,
widespread disagreements between IRS and taxpayers over the adequacy of
documentation leave many taxpayers uncertain about the amounts of
credit they will ultimately receive. Recordkeeping burdens may
discourage some taxpayers from using the credit and the uncertainty
reduces the credit's effective incentive. Relaxing recordkeeping
requirements would alleviate these problems; however, there remains a
risk that such a relaxation could significantly increase the amount of
credit provided for spending of questionable merit. Despite the current
wide gap between the views of taxpayers and IRS, there may be
opportunities to reduce certain burdens without opening the door to
abuse. At a minimum, an organized dialogue among Treasury, IRS, and
taxpayers should be able to reduce some uncertainty over what types of
documentation are acceptable.
Matters for Congressional Consideration:
In order to reduce economic inefficiencies and excessive revenue costs
resulting from inaccuracies in the base of the research tax credit,
Congress should consider the following two actions:
* Eliminating the regular credit option for computing the research
credit.
* Adding a minimum base to the ASC that equals 50 percent of the
taxpayer's current-year qualified research expenses.
If Congress nevertheless wishes to continue offering the regular
research credit to taxpayers, it may wish to consider the following
three actions to reduce inaccuracies in the credit's base and to reduce
taxpayers' uncertainty and compliance costs and IRS's administrative
costs:
* Updating the historical base period that regular credit claimants use
to compute their fixed base percentages.
* Eliminating base period recordkeeping requirements for taxpayers that
elect to use a fixed base percentage of 16 percent in their computation
of the credit.
* 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.
Recommendations for Executive Action:
In order to allow more taxpayers to benefit from the reduced
recordkeeping requirements offered by the ASC option, the Secretary of
the Treasury should take the following two actions:
* Modify credit regulations to permit taxpayers to elect any of the
computational methods prescribed in the 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.
* Modify credit regulations to allow controlled groups to allocate
their group credits in proportion to each member's share of total group
QREs, provided that all group members agree to this allocation method.
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 take the following six actions:
* Issue regulations clarifying the definition of internal-use software.
* Issue regulations clarifying the definition of gross receipts for
purposes of computing the research credit for controlled groups of
corporations.
* 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).
* Provide additional guidance to more clearly identify what types of
activities are considered to be qualified support activities.
* Provide additional guidance to more clearly identify when commercial
production of a qualified product is deemed to begin.
* Organize a working group that includes IRS and taxpayer
representatives to develop standards for the substantiation of QREs
that:
- can be built upon taxpayers' normal accounting approaches,
- 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.
Agency Comments:
We provided a draft of this report to the Secretary of Treasury and the
Commissioner of IRS in September 2009. In written comments the Acting
Assistant Secretary (Tax Policy) agreed that the credit's structure
could be simplified or updated in certain respects to improve its
effectiveness. He also agreed that the issuance of guidance relating to
the definition of gross receipts, the treatment of inventory property
under section 174, and the definition of internal use software will
enhance the administration of the credit and Treasury plans to provide
additional guidance in the next few months. The Acting Assistant
Secretary said that the Administration's priority is to make the credit
permanent. His letter is reprinted in appendix VIII. Treasury and IRS
officials also provided technical comments that we have addressed as
appropriate.
As we agreed with your offices, unless you publicly announce the
contents of this report, we plan no further distribution of it until 30
days from the date of this letter. This report is available at no
charge on GAO's web site at [hyperlink, http://www.gao.gov]. If you or
your staff have any questions on this report, please call me at (202)
512-9110 or whitej@gao.gov. Contact points for our Office of
Congressional Relations and Public Affairs may be found on the last
page of this report. Key contributors to this report are listed in
appendix VIII.
Signed by:
James R. White:
Director Tax Issues:
Strategic Issues:
[End of section]
Appendix I: Scope and Methodology:
Computation of the Marginal Effective Rate of Credit:
The Regular Credit Case:
If a taxpayer's marginal spending in the current tax year leaves its
total qualified spending above its base spending (but not equal to two
or more times the base amount determined by its fixed base percentage),
the marginal benefit the taxpayer receives from the regular credit
equals:
0.2 × 0.65 × marginal spending,
The factor of 0.65 reflects the fact that the taxpayer must either
elect to reduce its credit by 35 percent or reduce the size of its
section 174 deduction for research spending by the amount of the
credit. In either case, for taxpayers subject to the typical 35 percent
corporate income tax rate, the benefit of the credit is reduced by 35
percent. In addition, if the taxpayer cannot use all of its credit in
the current tax year or carry it back to use against last year's taxes,
then the net present value of the benefit is reduced according to the
following formula:
Discounted benefit = (0.2 × 0.65 × marginal spending) × (1 + r)-Y0 ,
where r is the taxpayer's discount rate and y0 is the number of years
before the taxpayer is able to use the credit.
If a taxpayer's marginal spending in the current tax year leaves its
total qualified spending equal to two or more times the base amount
determined by its fixed base percentage, the discounted marginal
benefit the taxpayer receives from the regular credit equals:
(0.1 × 0.65 × marginal spending) × (1 + r)-Y0,
because each additional dollar of spending raises the taxpayer's base
by 50 cents. Consequently, the taxpayer's benefit is effectively cut in
half.
If the taxpayer's total current-year spending is less than its base
spending (even after the marginal spending), then:
Current benefit = 0.
The Alternative Simplified Credit Case - Current year Effects:
Under the alternative simplified credit (ASC) a taxpayer may receive a
benefit in the current tax year by spending additional (also known as
marginal) amounts on qualified research in that year. However, this
additional spending also reduces the potential tax benefits that the
taxpayer can earn in the 3 succeeding years. The marginal effective
rate (MER) measures the net present value of the current tax benefit
and the reductions in future tax benefits resulting from the firm's
additional spending on research, all as a percentage of the additional
spending.
Current-Year Benefit:
If the taxpayer's total current-year spending is greater than its base
spending, then:
Current benefit = 0.14 × 0.65 × marginal spending × (1 + r)-Y0.
If the taxpayer's total current-year spending is less than its base
spending (even after the marginal spending), then:
Current benefit = 0.
The Alternative Simplified Credit Case - Future-Year Effects:
Given that the base spending amount for the next tax year equals half
of the taxpayer's average research spending in the current year and the
2 immediately preceding years, the marginal spending in the current
year can reduce the value of the credit benefit the taxpayer can earn
next year as follows:
Benefit reduction next year = -(1/3) × 0.5 × 0.65 × 0.14 × current-year
marginal spending × (1 + r)-Y1.
The value of y1 equals 1 if the credit that the taxpayer loses in the
next year could have been used that year. If that lost credit could not
have been used until a later year anyway, then y1 equals the number of
years between the current tax year and the year in which the lost
credit could have been used.
If the taxpayer's total qualified spending next year is less than its
base spending (even after the marginal spending), then:
Benefit reduction next year = 0.
Benefit reductions in the second and third years into the future are
computed in a similar manner.
The Complete MER:
Combining all of the effects described above yields the following
formula for a taxpayer that exceeds its base spending every year:
MER = {0.091 × marginal spending × [(1 + r)-Y0 - (1/6) × (1 + r)-Y1 -
(1/6) × (1 + r)-Y2 - (1/6) × (1 + r)-Y3]} / marginal spending.
If a taxpayer's total qualified spending is less than its base spending
in any of the four years covered by this formula, then the "(1 + r)"
term associated with that year would be set equal to zero.
Computation of the Discounted Revenue Cost:
To compute the discounted revenue cost we first compute the net credit
(after the offset against the section 174 deduction or the election of
a reduced credit) that each taxpayer would earn under existing or
hypothetical credit rules, based on their current qualified research
expenses (QREs), base QREs, and if relevant, gross receipts. We then
use data from each taxpayer's Form 3800 to estimate the amount, if any,
of research credit that the taxpayer could use immediately and the
amount, if any, that it had to carry forward to future years. In cases
where the credit had to be carried forward, we used ranges of
assumptions for both discount rates and number of years carried forward
(see sensitivity discussion below) to discount the value of credit
amounts used in future years.
Data Used for the Computations:
Full Population Data:
We based our estimates of credit use by the full population of
corporate taxpayers on the Statistics of Income (SOI) Division's sample
of corporate tax returns for 2003, 2004, and 2005. For 2003 and 2004 we
were able to fill in some data that were missing for a few large credit
claimants by using data we obtained from Internal Revenue Service (IRS)
examiners for our panel database. For all 3 years we adjusted the data
for members of controlled groups to avoid the double counting of QREs
and gross receipts (see discussion below for further detail).
The Panel Database of the Largest Credit Users:
We began the construction of our panels by selecting all corporations
that met either of the following criteria:
The corporation's total QREs had to account for at least 0.2 percent of
aggregate QREs for all firms in SOI's annual samples for either 2003 or
2004; or:
The corporation's total grossed-up credit (meaning prior to any
reduction under section 280(c)) had to account for at least 0.2 percent
of aggregate grossed-up credits for all firms in SOI's annual samples
for either 2003 or 2004.
We attempted to obtain a complete set of tax returns from 2000 through
2004 for each corporate taxpayer that met our panel criteria for either
2003 or 2004. In addition, we tried to keep the scope of each corporate
taxpayer over the 5 years to be as consistent as possible with that
taxpayer's scope as of 2003 and 2004. (This consistency is important
because we wanted the 5-year history of QREs for each taxpayer to
closely represent the spending histories that they would actually have
used for computing their moving-average base expenditures if the ASC
had been in place for 2003 and 2004.)
We constructed time series records for each taxpayer by linking the
data from the taxpayer's returns from 2000 through 2004 by the Employer
Identification Number (EIN) that SOI included in each year's tax return
record. In some cases a taxpayer's time series was reported under more
than one EIN over the period. This discontinuity usually occurred in
cases of a corporate reorganization, such as a merger or spin-off. In
cases where we did not find a complete 5-year set of tax returns for
one of the EINs selected into our panel, we searched to see if we could
find the missing returns under a different EIN. We focused our search
on cases where taxpayers had reported substantial amounts of research
credits or QREs for tax years early in our period and then they stopped
appearing in SOI's corporate sample (because they stopped filing a
return under their initial EIN). For example, we examined the cases of
taxpayers that filed returns in 2000 and 2001 and then stopped filing
returns to see if they were related to cases in our panel for which we
were missing tax returns for those 2 years. If the companies that
stopped filing returns were not related to any companies for which we
were missing returns, we then checked to see if they were related to
any other members of our panel (because they might have been merged
into an ongoing corporation that kept the same EIN before and after the
merger). Conversely, if the panel member for which we were missing
early-year tax returns did not match up with any cases that had stopped
filing after those years, we checked to see if that panel member had
been spun off of any other panel member (meaning that it was once
included in the consolidated tax return of the other panel member and
than was either sold off or became deconsolidated and filed its own
return). We did a similar examination for companies that showed
dramatic changes in the level of their QREs from one year to the next.
We extended our search for potential merger and spin-off candidates to
any companies in the annual SOI samples that accounted for at least 0.1
percent of either QREs or grossed up credit in any year from 2000
through 2004. In this manner we identified a number of pairs of
taxpayers that combined with or split off from one another during our
panel period. We could usually confirm these corporate changes from
publicly available information on the Internet, but we also had the IRS
examiners review our linkages. In order to ensure that we did not miss
any significant mergers or splits among our panel members, we asked the
Large and Mid-Sized Business (LMSB) Division examiners that reviewed
each case to identify any that we may have missed.
We made the following adjustments to ensure the consistency of spending
histories in cases where we had identified significant corporate
reorganizations within our panel members:
* In cases in which one of our panel members in 2003 or 2004
encompassed an entity that had filed its own tax return in an earlier
year during the panel period, we added the QREs that the former return
filer had reported for that year to the QREs that our panel member had
reported in the same year (because those QREs of the formerly separate
entity would be included in the panel member's moving average base
amount under the ASC).
* In cases in which one of our panel members in 2003 or 2004 had sold a
subsidiary or spun off some other entity that had been included in its
consolidated tax return in an earlier year of our panel period. We
subtracted the estimated QREs of that spun-off entity from the panel
member's QREs for that earlier year. (We assumed that the spun-off
entity's share of total QREs in the earlier year was the same
proportion as the following ratio: The spun-off entity's QREs in the
first year that it filed its own return, divided by the sum of the spun-
off companies QREs plus the QREs of the corporation from which it had
been spun off.)
By making these adjustments, we were able to create reasonably
consistent spending histories for those cases where we had identified
(on our own or with the assistance of IRS examiners) significant
corporate reorganizations in our panel population. In a number of cases
we concluded that we did not have sufficient information to construct
reliably consistent time series and we, therefore, dropped those cases
from our panel.
Although we believe that we have accounted for all major mergers and
splits within our panel members, we cannot be sure that we have
accounted for all smaller acquisitions or dispositions that may have
affected the consistency of the individual spending histories within
the panel. For this reason, we ran a sensitivity analysis in which we
examined the effects on our results of altering the relationship
between current and base QREs for each taxpayer (see below).
Adjusting for Group Credits:
Taxpayers that are subject to the group credit rules are required to
file their own Form 6765 on which they report their group's aggregate
values for QREs, base QREs, and gross receipts; however, the credit
amount reported on each member's form is that member's share of the
total group's credit. (See appendix VII for an explanation of how these
shares are computed.) Whether or not a member can actually use a group
credit depends on its own tax position for the year, not on an
aggregated group tax position.
We used several indicators to identify potential group credit
claimants, based on the reporting requirements described above. First,
for claimants of the regular credit we computed the ratio of the amount
of credit they claimed, divided by the difference between their current
QREs and their base QREs. If this ratio was a value other than 0.13 or
0.2, we flagged the case as a potential group member. Second, for
claimants of the alternative incremental research credit (AIRC), we
computed the ratio of the credit they actually claimed over the amount
of credit that they could have claimed if all of the QREs and gross
receipts reported on their 6765 were their own. If this ratio was other
than 1 or 0.65, we flagged the case as a potential group claimant.
Third, we also searched the SOI databases for groups of cases that
reported the same exact amounts of QREs in a given year.
For the purpose of calculating the ASC for group members we gave each
member of a group the group's aggregate spending history and gross
receipts history; however, each member had its own amount of research
credit claimed and its own values for the variables taken from the
general business credit form. In order to avoid double-counting (or
more) the QREs of the groups or giving them too much weight when
computing our weighted average effective rates of credit, we created a
variable named CREDSHR, which we then used to assign each group member
only a fraction of the group's total QREs or weighting in the effective
rate calculation.
The value of CREDSHR for each group member is equal to the ratio of the
amount of research credit that the member claimed over the aggregated
amount of credit that the group would be able to claim, based on the
group's aggregated QREs and base QREs or gross receipts. In other
words, we gave each member a share of the group's QREs that was
proportionate to its share of the group's total credit. Although this
allocation method is not precisely derived from the group credit
allocation regulations, it should yield a close approximation of the
true distribution of QREs across group members. We do not have the
detailed attachments to Form 6765 that show exactly what each group
member's QREs and gross receipts were. In most cases the sum of CREDSHR
for all members of a group in our panel population was approximately
equal to 100 percent. When the sum did not reach 100 percent we assumed
that there are other members who were not represented in the SOI sample
for a given year. The absence of these missing members does not affect
the validity of the computations for the group members we had; it
simply means that the missing members were treated as any other company
that did not meet the criteria for inclusion in our panel.
Because some taxpayers in the panel belonged to controlled groups that
together determined the amount of qualified spending in 2003 or 2004,
we adjusted for the composition of these groups when we assembled the
panel. In particular, spending and other variables were adjusted to
hold constant the group's composition in 2003 or 2004, the 2 years for
which credit was computed. This was accomplished in several ways.
First, the SOI data allowed us to identify certain controlled groups
from duplications in the amount of reported spending. Second, we
researched mergers, acquisitions and dispositions for these firms from
2000 through 2004, or the years for which we constructed the panel.
Third, we requested confirmation of our knowledge about these
controlled groups from LMSB, in addition to any other information about
the groups' composition that LMSB might have had. Clearly, constructing
the panel involved balancing trade-offs between the number of users and
the availability of data.
Key Assumptions and Sensitivity Analyses:
We tested the sensitivity of our results to variations in assumptions
or observations concerning the following factors:
Future credit status--The MER for the ASC depends, in part, on whether
the taxpayer anticipates being able to earn the credit in each of the
next 3 years and, if so, whether that taxpayer would be subject to a
minimum base constraint. In order to predict the status for a given
taxpayer in a given future year, we needed to predict, within a certain
range,[Footnote 54] the ratio of spending in that year to the average
of spending for the 3 years preceding that year. Our baseline
prediction was that the probability of a taxpayer moving from one
particular ratio range into another specific ratio range was equal the
probability of such a move that we observed in our historical data. We
used Markov chains of probabilities to predict changes in status two
and three years into the future. In our sensitivity analysis, we
examined 12 alternative sets of probabilities. For example, in one
alternative all taxpayers were less likely to move into a higher range
of ratios than they would have been with the observed probabilities.
Switching probabilities--In choice scenarios, we were required to
estimate the probability of switching from one credit to another in
future years, which has the potential to influence the effect of
research spending in 2003 or 2004 on the amount of credit earned in
subsequent years for which data are not available. In our sensitivity
analysis, we allowed the probability of switching from the ASC to the
Regular Credit from one year to the next to be higher or lower than our
baseline estimate (which was based on simulated behavior from 2003 to
2004). We did the same for the probability of switching from the
Regular Credit to the ASC from one year to the next, and we
incorporated all four possible combinations of deviations from the
baseline.
Discount rate--At higher rates of discount, credit that is carried
forward to be claimed in subsequent years is worth less in present
value terms in 2003 or 2004. Additionally, at higher discount rates,
the effect of spending in 2003 or 2004 on the amount of credit earned
in subsequent years is mitigated, since credit earned in subsequent
years is worth less in present value terms in 2003 and 2004 at higher
rates of discount. In our sensitivity analysis, we allowed the discount
rate to vary between 4 percent and 8 percent.
Carryforward length--The model required an assumption about the number
of years that credit would be carried forward. (The Research Tax Credit
stipulates that credit that cannot be claimed in the year in which it
is earned may be carried forward for up to 20 years.) Lacking data on
carryforward patterns, we based our assumption about the length of the
carryforward period on behavior that was "observed" as part of the
simulation. For example, in some cases we could simulate the taxpayer's
carryforward status in both 2003 and 2004. If this taxpayer were
observed to carry forward credit in both years as part of this
simulation, it would have a longer carryforward period than if it were
observed to carry forward credit in one year or the other, or if it
were observed not to carry credit forward at all. In our sensitivity
analysis, we allowed the longest carryforward period to vary between 2
and 10 years in length.
The relationship between current and base QREs--We tested how our
estimates for the ASC would differ if the spending histories for our
panel corporations were significantly different from what we observed.
To do this, we estimated what the MERs and discounted revenue costs
would be if the ratio of each taxpayer's current QREs to base QREs were
10 percent higher and 10 percent lower than the observed amounts.
Another aspect of our sensitivity analysis involved using of data from
different stages in the taxpaying process. We used data from original
returns, and from amended and audited returns, where applicable.
[End of section]
Appendix II: Data Relating to the Use of the Research Tax Credit by
Corporations:
Figure 4: Distribution of Claimants, Qualified Research Expenses, and
Net Credits, by Size of Taxpayer, 2003 to 2005:
[Refer to PDF for image: stacked vertical bar graph]
Share of claimants:
Year: 2003;
Business receipts < $5 million: 3.1%;
$5 million <= business receipts < $250 million: 3.3%;
$250 million <= business receipts < $1 billion: 38.1%;
$1 billion <= business receipts: 55.5%.
Year: 2004;
Business receipts < $5 million: 3.1%;
$5 million <= business receipts < $250 million: 3.5%;
$250 million <= business receipts < $1 billion: 40.3%;
$1 billion <= business receipts: 53.1%.
Year: 2005;
Business receipts < $5 million: 3.2%;
$5 million <= business receipts < $250 million: 3.8%;
$250 million <= business receipts < $1 billion: 45%;
$1 billion <= business receipts: 48%.
Share of qualified research expenses:
Year: 2003;
Business receipts < $5 million: 70.2%;
$5 million <= business receipts < $250 million: 10.2%;
$250 million <= business receipts < $1 billion: 13.8%;
$1 billion <= business receipts: 5.8%.
Year: 2004;
Business receipts < $5 million: 69.8%;
$5 million <= business receipts < $250 million: 11%;
$250 million <= business receipts < $1 billion: 13.6%;
$1 billion <= business receipts: 5.6%.
Year: 2005;
Business receipts < $5 million: 70.2%;
$5 million <= business receipts < $250 million: 10.5%;
$250 million <= business receipts < $1 billion: 14%;
$1 billion <= business receipts: 5.2%.
Share of net credit:
Year: 2003;
Business receipts < $5 million: 63.7%;
$5 million <= business receipts < $250 million: 11.2%;
$250 million <= business receipts < $1 billion: 16.5%;
$1 billion <= business receipts: 8.5%.
Year: 2004;
Business receipts < $5 million: 63.6%;
$5 million <= business receipts < $250 million: 12%;
$250 million <= business receipts < $1 billion: 16.4%;
$1 billion <= business receipts: 7.9%.
Year: 2005;
Business receipts < $5 million: 64.5%;
$5 million <= business receipts < $250 million: 11.8%;
$250 million <= business receipts < $1 billion: 16.7%;
$1 billion <= business receipts: 7%.
Source: GAO analysis of IRS data.
[End of figure]
Figure 5: Shares of Claimants, QREs and Research Credits, by Taxpayer's
Credit Status, 2005:
[Refer to PDF for image: vertical bar graph]
Share of claimants:
Had QREs below base amounts: 4.1%;
Claimed regular credit, not subject to 50% base: 19.3%;
Claimed regular credit, subject to 50% base: 70.9%;
Claimed AIRC: 5.7%.
Share of QREs:
Had QREs below base amounts: 0.6%;
Claimed regular credit, not subject to 50% base: 31.5%;
Claimed regular credit, subject to 50% base: 43.2%;
Claimed AIRC: 24.6%.
Share of net credit:
Had QREs below base amounts: 0%;
Claimed regular credit, not subject to 50% base: 28.2%;
Claimed regular credit, subject to 50% base: 61.8%;
Claimed AIRC: 10%.
Source: GAO analysis of IRS data.
[End of figure]
Figure 6: Percentage of Credit Claimants Subject to Tax Liability
Constraints, 2003 to 2005:
[Refer to PDF for image: stacked vertical bar graph]
Percentage of claimants:
Year: 2003;
S corporations: 27.2%;
C corporations that cannot use their credits immediately: 40.6%;
C corporations that can use their credits immediately: 32.2%.
Year: 2004;
S corporations: 24.6%;
C corporations that cannot use their credits immediately: 37.7%;
C corporations that can use their credits immediately: 37.6%.
Year: 2005;
S corporations: 24.6%;
C corporations that cannot use their credits immediately: 34.7%;
C corporations that can use their credits immediately: 37.6%.
Percentage of net credit:
Year: 2003;
Credits earned by C corporations that can be used immediately: 38.7%;
Credits earned by C corporations that cannot be used immediately:
58.3%;
Credits earned by S corporations: 3%.
Year: 2004;
Credits earned by C corporations that can be used immediately: 41.2%;
Credits earned by C corporations that cannot be used immediately:
55.2%;
Credits earned by S corporations: 3.6%.
Year: 2005;
Credits earned by C corporations that can be used immediately: 51.7%;
Credits earned by C corporations that cannot be used immediately: 44%;
Credits earned by S corporations: 4.2%.
Source: GAO analysis of IRS data.
[End of figure]
Table 3: Total Claimants, Qualified Research Expenses, and Net Credits,
2003 to 2005:
Number of claimants;
2003: 15,678;
2004: 16,731;
2005: 17,105.
Qualified research expenses;
2003: 119.1;
2004: 122.3;
2005: 130.9.
Net credit;
2003: 5.1;
2004: 5.4;
2005: 6.0.
Source: GAO analysis of IRS data.
Note: Qualified research expenses and net credit in billions of
dollars.
[End of table]
Table 4: Marginal Effective Rates, Discounted Revenue Costs, and Bangs-
per-Buck of the Research Credit, 2003 to 2005:
All claimants: Average MER;
Under low discount rate and short carryforward assumptions: 2003:
7.59%;
Under low discount rate and short carryforward assumptions: 2004:
7.38%;
Under low discount rate and short carryforward assumptions: 2005:
7.31%;
Under high discount rate and long carryforward assumptions: 2003:
5.93%;
Under high discount rate and long carryforward assumptions: 2004:
5.46%;
Under high discount rate and long carryforward assumptions: 2005:
6.36%.
All claimants: Discounted revenue cost;
Under low discount rate and short carryforward assumptions: 2003: 4.7;
Under low discount rate and short carryforward assumptions: 2004: 5.0;
Under low discount rate and short carryforward assumptions: 2005: 5.8;
Under high discount rate and long carryforward assumptions: 2003: 3.6;
Under high discount rate and long carryforward assumptions: 2004: 3.9;
Under high discount rate and long carryforward assumptions: 2005: 4.8.
Regular credit: Average MER;
Under low discount rate and short carryforward assumptions: 2003:
9.26%;
Under low discount rate and short carryforward assumptions: 2004:
9.11%;
Under low discount rate and short carryforward assumptions: 2005:
8.98%;
Under high discount rate and long carryforward assumptions: 2003:
7.22%;
Under high discount rate and long carryforward assumptions: 2004:
6.70%;
Under high discount rate and long carryforward assumptions: 2005:
7.77%.
Regular credit: Discounted revenue cost;
Under low discount rate and short carryforward assumptions: 2003: 4.2;
Under low discount rate and short carryforward assumptions: 2004: 4.4;
Under low discount rate and short carryforward assumptions: 2005: 5.0;
Under high discount rate and long carryforward assumptions: 2003: 3.3;
Under high discount rate and long carryforward assumptions: 2004: 3.3;
Under high discount rate and long carryforward assumptions: 2005: 4.3.
AIRC: Average MER;
Under low discount rate and short carryforward assumptions: 2003:
2.31%;
Under low discount rate and short carryforward assumptions: 2004:
2.34%;
Under low discount rate and short carryforward assumptions: 2005:
2.37%;
Under high discount rate and long carryforward assumptions: 2003:
1.85%;
Under high discount rate and long carryforward assumptions: 2004:
1.86%;
Under high discount rate and long carryforward assumptions: 2005:
2.20%.
AIRC: Discounted revenue cost;
Under low discount rate and short carryforward assumptions: 2003: .5;
Under low discount rate and short carryforward assumptions: 2004: .5;
Under low discount rate and short carryforward assumptions: 2005: .6;
Under high discount rate and long carryforward assumptions: 2003: .4;
Under high discount rate and long carryforward assumptions: 2004: .4;
Under high discount rate and long carryforward assumptions: 2005: .5.
Bang-per-buck if the price elasticity equaled: -0.5;
Under low discount rate and short carryforward assumptions: 2003: .90;
Under low discount rate and short carryforward assumptions: 2004: .85;
Under low discount rate and short carryforward assumptions: 2005: 0.80;
Under high discount rate and long carryforward assumptions: 2003: .92;
Under high discount rate and long carryforward assumptions: 2004: .84;
Under high discount rate and long carryforward assumptions: 2005: 0.81.
Bang-per-buck if the price elasticity equaled: -1;
Under low discount rate and short carryforward assumptions: 2003: 1.74;
Under low discount rate and short carryforward assumptions: 2004: 1.64;
Under low discount rate and short carryforward assumptions: 2005: 1.55;
Under high discount rate and long carryforward assumptions: 2003: 1.78;
Under high discount rate and long carryforward assumptions: 2004: 1.64;
Under high discount rate and long carryforward assumptions: 2005: 1.57.
Bang-per-buck if the price elasticity equaled: -1.5;
Under low discount rate and short carryforward assumptions: 2003: 2.52;
Under low discount rate and short carryforward assumptions: 2004: 2.38;
Under low discount rate and short carryforward assumptions: 2005: 2.25;
Under high discount rate and long carryforward assumptions: 2003: 2.60;
Under high discount rate and long carryforward assumptions: 2004: 2.40;
Under high discount rate and long carryforward assumptions: 2005: 2.29.
Bang-per-buck if the price elasticity equaled: -2;
Under low discount rate and short carryforward assumptions: 2003: 3.25;
Under low discount rate and short carryforward assumptions: 2004: 3.07;
Under low discount rate and short carryforward assumptions: 2005: 2.90;
Under high discount rate and long carryforward assumptions: 2003: 3.38;
Under high discount rate and long carryforward assumptions: 2004: 3.12;
Under high discount rate and long carryforward assumptions: 2005: 2.97.
Source: GAO analysis of IRS data.
Note: Revenue cost is in billions of dollars; bang-per-buck is in
dollars. MER is the marginal effective rate of the credit.
[End of table]
Table 5: Comparison of Initial and Amended Claims of the Research
Credit by Panel Corporations (Dollars in millions):
Number of cases;
2000: 107;
2001: 109;
2002: 109;
2003: 104;
2004: 105.
Initial net research credit claimed: Regular credit;
2000: 3,146;
2001: 2,940;
2002: 2,550;
2003: 2,248;
2004: 2,290.
Initial net research credit claimed: AIRC;
2000: 274;
2001: 328;
2002: 338;
2003: 421;
2004: 466.
Initial net research credit claimed: Total;
2000: 3,420;
2001: 3,268;
2002: 2,888;
2003: 2,669;
2004: 2,756.
Net difference between final amendment and initial claim--dollar
amounts: Regular credit;
2000: 65;
2001: 81;
2002: 4;
2003: 205;
2004: 12.
Net difference between final amendment and initial claim--dollar
amounts: AIRC;
2000: $54;
2001: $60;
2002: $39;
2003: -$62;
2004: $2.
Net difference between final amendment and initial claim--dollar
amounts: Total;
2000: $119;
2001: $141;
2002: $43;
2003: $143;
2004: $13.
Net difference between final amendment and initial claim--percentage
change: Regular credit;
2000: 2.1%;
2001: 2.7%;
2002: 0.2%;
2003: 9.1%;
2004: 0.5%.
Net difference between final amendment and initial claim--percentage
change: AIRC;
2000: 19.6%;
2001: 18.4%;
2002: 11.6%;
2003: -14.6%;
2004: 0.4%.
Net difference between final amendment and initial claim--percentage
change: Total;
2000: 3.5%;
2001: 4.3%;
2002: 1.5%;
2003: 5.4%;
2004: 0.5%.
Source: GAO analysis of IRS data.
Note: The number of cases in this table represents the number of
corporations or corporate groups for which we were able to determine
whether or not the amount of credit claimed was amended as of December
2007 and, if so, what the amount of the amended credit was. It includes
cases that made changes as well as those that did not.
[End of table]
Table 6: Comparison of Initial and Amended Claims of the Research
Credit by Those Corporations That Made a Change:
Number of cases;
2000: 28;
2001: 32;
2002: 25;
2003: 19;
2004: 9.
Net difference between final amendment and initial claim--percentage
change: Regular credit;
2000: 18.5%;
2001: 10.5%;
2002: 1.0%;
2003: 64.6%;
2004: 7.1%.
Net difference between final amendment and initial claim--percentage
change: AIRC;
2000: 37.8%;
2001: 33.6%;
2002: 61.3%;
2003: -48.8%;
2004: 7.9%.
Net difference between final amendment and initial claim--percentage
change: Total;
2000: 24.1%;
2001: 14.9%;
2002: 9.2%;
2003: 32.4%;
2004: 7.2%.
Source: GAO analysis of IRS data.
Note: The number of cases in this table represents the subset of cases
from the first table that actually amended the amount of research
credit claimed.
[End of table]
Table 7: Changes in the Basic Elements of the Research Credit
Computation between Initial and Amended Claims (Dollars in millions):
Number of cases;
2000: 89;
2001: 90;
2002: 94;
2003: 90;
2004: 94.
Elements from the initial claims: Net credit claimed;
2000: 3,109;
2001: 2,906;
2002: 2,668;
2003: 2,390;
2004: 2,635.
Elements from the initial claims: Current year QREs;
2000: 62,404;
2001: 63,226;
2002: 62,114;
2003: 60,295;
2004: 66,131.
Elements from the initial claims: Base QREs (for regular credit
claimants not subject to the 50% base limit);
2000: 13,087;
2001: 15,280;
2002: 18,136;
2003: 20,550;
2004: 17,911.
Elements from the initial claims: Average gross receipts (for those
claiming the AIRC);
2000: $319,551;
2001: $342,545;
2002: $376,261;
2003: $382,097;
2004: $423,817.
Net difference between final amendments and initial claims - dollar
amounts: Net credit claimed;
2000: $88;
2001: $141;
2002: $45;
2003: $24;
2004: $7.
Net difference between final amendments and initial claims - dollar
amounts: Current year QREs;
2000: $2,313;
2001: $2,422;
2002: $1,172;
2003: $237;
2004: $90.
Net difference between final amendments and initial claims - dollar
amounts: Base QREs (for regular credit claimants not subject to the 50%
limit);
2000: -$3;
2001: $26;
2002: $31;
2003: -$56;
2004: -$37.
Net difference between final amendments and initial claims - dollar
amounts: Average gross receipts (for those claiming the AIRC);
2000: -$29,437;
2001: -$32,649;
2002: -$9,235;
2003: -$5,059;
2004: $0.
Net difference between final amendments and initial claims--percentage
change: Net credit claimed;
2000: 2.8%;
2001: 4.8%;
2002: 1.7%;
2003: 1.0%;
2004: 0.3%.
Net difference between final amendments and initial claims--percentage
change: Current year QREs;
2000: 3.7%;
2001: 3.8%;
2002: 1.9%;
2003: 0.4%;
2004: 0.1%.
Net difference between final amendments and initial claims--percentage
change: Base QREs (for regular credit claimants not subject to the 50%
limit);
2000: 0.0%;
2001: 0.2%;
2002: 0.2%;
2003: -0.3%;
2004: -0.2%.
Net difference between final amendments and initial claims--percentage
change: Average gross receipts (for those claiming the AIRC);
2000: -9.2%;
2001: -9.5%;
2002: -2.5%;
2003: -1.3%;
2004: 0.0%.
Source: GAO analysis of IRS data.
Note: The number of cases in this table represents those corporations
for which data relating to the detailed elements of their computations
were available. It includes cases that made changes as well as those
that did not.
[End of table]
Table 8: Changes in the Basic Elements of the Research Credit
Computation between Initial and Amended Claims for Those Corporations
That Made a Change:
Number of cases;
2000: 17;
2001: 25;
2002: 16;
2003: 14;
2004: 8.
Net difference between final amendments and initial claims--percentage
change: Net credit claimed;
2000: 39.7%;
2001: 19.4%;
2002: 15.3%;
2003: 10.8%;
2004: 5.5%.
Net difference between final amendments and initial claims--percentage
change: Current year QREs;
2000: 24.8%;
2001: 12.6%;
2002: 13.8%;
2003: 3.5%;
2004: 2.6%.
Net difference between final amendments and initial claims--percentage
change: Base QREs (for regular credit claimants not subject to the 50%
limit);
2000: -0.8%;
2001: 1.1%;
2002: 1.2%;
2003: -3.0%;
2004: -3.6%.
Net difference between final amendments and initial claims--percentage
change: Average gross receipts (for those claiming the AIRC);
2000: -16.0%;
2001: -16.1%;
2002: -8.4%;
2003: -7.1%;
2004: 0.0%.
Source: GAO analysis of IRS data.
Note: The number of cases in this table represents those corporations
that actually amended the amount of research credit claimed and for
which data relating to the detailed elements of their computations were
available.
[End of table]
Table 9: Comparison of Final Taxpayer Pre-Exam Credit Claim to Latest
Available IRS Position (Dollars in millions):
Number of cases;
2000: 107;
2001: 109;
2002: 109;
2003: 104;
2004: 105.
Final taxpayer pre-exam net research credit claim: Regular credit;
2000: 3,211;
2001: 3,021;
2002: 2,554;
2003: 2,453;
2004: 2,302.
Final taxpayer pre-exam net research credit claim: AIRC;
2000: 328;
2001: 388;
2002: 377;
2003: 360;
2004: 468.
Final taxpayer pre-exam net research credit claim: Total;
2000: 3,539;
2001: 3,409;
2002: 2,931;
2003: 2,81;
2004: 2,770.
Net difference between final taxpayer claim and latest IRS position--
dollar amounts: Regular credit;
2000: -$540;
2001: -$599;
2002: -$748;
2003: -$654;
2004: -$236.
Net difference between final taxpayer claim and latest IRS position--
dollar amounts: AIRC;
2000: -$44;
2001: -$58;
2002: -$45;
2003: -$34;
2004: -$14.
Net difference between final taxpayer claim and latest IRS position--
dollar amounts: Total;
2000: -$584;
2001: -$657;
2002: -$794;
2003: -$689;
2004: -$250.
Net difference between final taxpayer claim and latest IRS position--
percentage changes: Regular credit;
2000: -16.8%;
2001: -19.8%;
2002: -29.3%;
2003: -26.7%;
2004: -10.2%.
Net difference between final taxpayer claim and latest IRS position--
percentage changes: AIRC;
2000: -13.4%;
2001: -14.9%;
2002: -12.0%;
2003: -9.6%;
2004: -3.0%.
Net difference between final taxpayer claim and latest IRS position--
percentage changes: Total;
2000: -16.5%;
2001: -19.3%;
2002: -27.1%;
2003: -24.5%;
2004: -9.0%.
Source: GAO analysis of IRS data.
Note: The number of cases in this table represents the number of
corporations or corporate groups for which we were able to determine
whether or not IRS examiners had recommended an adjustment in the
amount of credit claimed as of December 2007 and, if so, what the
amount of the adjusted credit was. It includes cases where IRS made an
adjustment as well as those where IRS did not.
[End of table]
Table 10: Comparison of Final Taxpayer Pre-Exam Credit Claim to Latest
Available IRS Position for Those Cases in Which IRS Made a Change:
Number of cases;
2000: 69;
2001: 66;
2002: 62;
2003: 49;
2004: 28.
Net Difference between final taxpayer claim and latest IRS position - %
changes: Regular credit;
2000: -19.5%;
2001: -25.2%;
2002: -37.6%;
2003: -38.6%;
2004: -28.8%.
Net Difference between final taxpayer claim and latest IRS position - %
changes: AIRC;
2000: -20.7%;
2001: -20.0%;
2002: -20.1%;
2003: -18.6%;
2004: -15.5%.
Net Difference between final taxpayer claim and latest IRS position - %
changes: Total;
2000: -19.6%;
2001: -24.7%;
2002: -35.8%;
2003: -36.6%;
2004: -27.5%.
Source: GAO analysis of IRS data.
Note: The number of cases in this table represents the subset of cases
from table 9 for which IRS actually changed the credit amount upon
examination.
[End of table]
Table 11: Changes in the Basic Elements of the Research Credit
Computation between Final Taxpayer Pre-Exam Credit Claim to Latest
Available IRS Position (Dollars in millions):
Number of Cases;
2000: 78;
2001: 79;
2002: 85;
2003: 79;
2004: 86.
Elements from final taxpayer claims: Net credit claimed;
2000: 2,237;
2001: 2,353;
2002: 2,257;
2003: 1,967;
2004: 2,283.
Elements from final taxpayer claims: Current year QREs;
2000: 48,904;
2001: 53,459;
2002: 54,941;
2003: 52283;
2004: 59,611.
Elements from final taxpayer claims: Base QREs (for regular credit
claimants not subject to the 50% limit);
2000: 9,046;
2001: 11,779;
2002: 15,991;
2003: 18,230;
2004: 16,456.
Elements from final taxpayer claims: Average gross receipts (for those
claiming the AIRC);
2000: $290,004;
2001: $309,896;
2002: $367,026;
2003: $377,037;
2004: v423,817.
Net difference between final taxpayer pre-exam claim and latest IRS
position--dollar amounts: Net credit claimed;
2000: -$297;
2001: -$282;
2002: -$362;
2003: -$335;
2004: -$74.
Net difference between final taxpayer pre-exam claim and latest IRS
position--dollar amounts: Current year QREs;
2000: -$4,994;
2001: -$4,557;
2002: -$3,868;
2003: -$2,848;
2004: -$1,375.
Net difference between final taxpayer pre-exam claim and latest IRS
position--dollar amounts: Base QREs (for regular credit claimants not
subject to the 50% limit);
2000: -$243;
2001: -$385;
2002: -$162;
2003: $401;
2004: -$366.
Net difference between final taxpayer pre-exam claim and latest IRS
position--dollar amounts: Average gross receipts (for those claiming
the AIRC);
2000: $24,381;
2001: $49,468;
2002: $64,806;
2003: v45,998;
2004: v9,517.
Net difference between final taxpayer pre-exam claim and latest IRS
position--percentage changes: Net credit claimed;
2000: -13.3%;
2001: -12.0%;
2002: -16.0%;
2003: -16.9%;
2004: -3.3%.
Net difference between final taxpayer pre-exam claim and latest IRS
position--percentage changes: Current year QREs;
2000: -10.2%;
2001: -8.5%;
2002: -7.0%;
2003: -5.4%;
2004: -2.3%.
Net difference between final taxpayer pre-exam claim and latest IRS
position--percentage changes: Base QREs (for regular credit claimants
not subject to the 50% limit);
2000: -2.7%;
2001: -3.3%;
2002: -1.0%;
2003: 2.2%;
2004: -2.2%.
Net difference between final taxpayer pre-exam claim and latest IRS
position--percentage changes: Average gross receipts (for those
claiming the AIRC);
2000: 8.4%;
2001: 16.0%;
2002: 17.7%;
2003: 12.9%;
2004: 2.2%.
Source: GAO analysis of IRS data.
Note: The number of cases in this table represents those corporations
for which data relating to the detailed elements of their computations
were available. It includes cases where IRS made changes as well as
those where it did not.
[End of table]
Table 12: Changes in the Basic Elements of the Research Credit
Computation between Final Taxpayer Pre-Exam Credit Claim to Latest
Available IRS Position for Those Cases in Which IRS Made a Change:
Number of cases;
2000: 45;
2001: 43;
2002: 45;
2003: 32;
2004: 18.
Net difference between final taxpayer pre-exam claim and latest IRS
position--percentage changes: Net credit claimed;
2000: -16.6%;
2001: -16.4%;
2002: -22.0%;
2003: -30.9%;
2004: -15.8%.
Net difference between final taxpayer pre-exam claim and latest IRS
position--percentage changes: Current year QREs;
2000: -13.4%;
2001: -11.4%;
2002: -10.0%;
2003: -10.5%;
2004: -10.4%.
Net difference between final taxpayer pre-exam claim and latest IRS
position--percentage changes: Base QREs (for regular credit claimants
not subject to the 50% limit);
2000: -3.5%;
2001: -4.1%;
2002: -1.3%;
2003: 4.0%;
2004: -6.5%.
Net difference between final taxpayer pre-exam claim and latest IRS
position--percentage changes: Average gross receipts (for those
claiming the AIRC);
2000: 13.2%;
2001: 23.4%;
2002: 31.1%;
2003: 26.6%;
2004: 14.9%.
Source: GAO analysis of IRS data.
Note: The number of cases in this table represents the subset of cases
from table 11 for which IRS actually changed the credit amount upon
examination.
Note: The number of cases in this table represents those cases where
IRS actually changed the credit amount upon exam and for which data
relating to the detailed elements of their computations were available.
[End of table]
Table 13: Distribution of QREs and Revenues Cost by Type of Credit User
Prior to and After the Introduction of the ASC (Panel Corporations
Only):
2003 Data:
Prior to ASC: Regular credit users;
Share of QREs: 65.9%;
Share of Revenue Cost: (Low Discount Rate and Carryforward
Assumptions): 79.9%;
Share of Revenue Cost: (High Discount Rate and Carryforward
Assumptions): 78.3%.
Prior to ASC: AIRC users;
Share of QREs: 34.1%;
Share of Revenue Cost: (Low Discount Rate and Carryforward
Assumptions): 20.1%;
Share of Revenue Cost: (High Discount Rate and Carryforward
Assumptions): 21.7%.
2009 credit rules: Regular credit users;
Share of QREs: 37.4%;
Share of Revenue Cost: (Low Discount Rate and Carryforward
Assumptions): 42.6%;
Share of Revenue Cost: (High Discount Rate and Carryforward
Assumptions): 36.7%.
2009 credit rules: ASC users;
Share of QREs: 62.6%;
Share of Revenue Cost: (Low Discount Rate and Carryforward
Assumptions): 57.4%;
Share of Revenue Cost: (High Discount Rate and Carryforward
Assumptions): 63.3%.
2004 Data:
Prior to ASC: Regular credit users;
Share of QREs: 64.2%;
Share of Revenue Cost: (Low Discount Rate and Carryforward
Assumptions): 78.5%;
Share of Revenue Cost: (High Discount Rate and Carryforward
Assumptions): 77.1%.
Prior to ASC: AIRC users;
Share of QREs: 35.8%;
Share of Revenue Cost: (Low Discount Rate and Carryforward
Assumptions): 21.5%;
Share of Revenue Cost: (High Discount Rate and Carryforward
Assumptions): 22.9%.
2009 credit rules: Regular credit users;
Share of QREs: 38.7%;
Share of Revenue Cost: (Low Discount Rate and Carryforward
Assumptions): 45.4%;
Share of Revenue Cost: (High Discount Rate and Carryforward
Assumptions): 43.2%.
2009 credit rules: ASC users;
Share of QREs: 61.3%;
Share of Revenue Cost: (Low Discount Rate and Carryforward
Assumptions): 54.6%;
Share of Revenue Cost: (High Discount Rate and Carryforward
Assumptions): 56.8%.
Source: GAO analysis of IRS data.
[End of table]
Table 14: Weighted Average Marginal Incentives and Revenue Costs for
the Panel Population Before and after the Introduction of the ASC:
4% Discount Rate and Short Carryforward Assumed:
2003 Filing Year for Panel: Initial return;
Prior to Introduction of ASC: Weighted Average MER: 7.8%;
Prior to Introduction of ASC: Revenue Cost: $2.5 billion;
Rules Effective for 2009: Weighted Average MER: 6.2%;
Rules Effective for 2009: Revenue Cost: $3.0 billion;
Percentage Change: Weighted Average MER: -21.4%;
Percentage Change: Revenue Cost: 20.4%.
2003 Filing Year for Panel: After amendments;
Prior to Introduction of ASC: Weighted Average MER: 8.3%;
Prior to Introduction of ASC: Revenue Cos: $2.6 billion;
Rules Effective for 2009: Weighted Average MER: 6.3%;
Rules Effective for 2009: Revenue Cost: $3.0 billion;
Percentage Change: Weighted Average MER: -24.7%;
Percentage Change: Revenue Cost: 16.8%.
2003 Filing Year for Panel: After exam recommendations;
Prior to Introduction of ASC: Weighted Average MER: 7.4%;
Prior to Introduction of ASC: Revenue Cost: $1.8 billion;
Rules Effective for 2009: Weighted Average MER: 5.9%;
Rules Effective for 2009: Revenue Cost: $2.3 billion;
Percentage Change: Weighted Average MER: -20.7%;
Percentage Change: Revenue Cost: 28.8%.
2004 Filing Year for Panel: Initial return;
Prior to Introduction of ASC: Weighted Average MER: 7.4%;
Prior to Introduction of ASC: Revenue Cost: $2.7 billion;
Rules Effective for 2009: Weighted Average MER: 6.0%;
Rules Effective for 2009: Revenue Cost: $3.3 billion;
Percentage Change: Weighted Average MER: -18.7%;
Percentage Change: Revenue Cost: 22.5%.
2004 Filing Year for Panel: After amendments;
Prior to Introduction of ASC: Weighted Average MER: 7.4%;
Prior to Introduction of ASC: Revenue Cost: $2.7 billion;
Rules Effective for 2009: Weighted Average MER: 5.7%;
Rules Effective for 2009: Revenue Cost: $3.2 billion;
Percentage Change: Weighted Average MER: -23.2%;
Percentage Change: Revenue Cost: 21.1%.
2004 Filing Year for Panel: After exam recommendations;
Prior to Introduction of ASC: Weighted Average MER: 8.1%;
Prior to Introduction of ASC: Revenue Cost: $1.9 billion;
Rules Effective for 2009: Weighted Average MER: 5.6%;
Rules Effective for 2009: Revenue Cost: $2.4 billion;
Percentage Change: Weighted Average MER: -30.6%;
Percentage Change: Revenue Cost: 28.8%.
8% Discount Rate and Long Carryforward Assumed:
2003 Filing Year for Panel: Initial return;
Prior to Introduction of ASC: Weighted Average MER: 5.9%;
Prior to Introduction of ASC: Revenue Cost: $1.8 billion;
Rules Effective for 2009: Weighted Average MER: 4.8%;
Rules Effective for 2009: Revenue Cost: $2.3 billion;
Percentage Change: Weighted Average MER: -19.2%;
Percentage Change: Revenue Cost: 24.2%.
2003 Filing Year for Panel: After amendments;
Prior to Introduction of ASC: Weighted Average MER: 6.4%;
Prior to Introduction of ASC: Revenue Cost: $1.9 billion;
Rules Effective for 2009: Weighted Average MER: 4.9%;
Rules Effective for 2009: Revenue Cost: $2.3 billion;
Percentage Change: Weighted Average MER: -23.4%;
Percentage Change: Revenue Cost: 19.5%.
2003 Filing Year for Panel: After exam recommendations;
Prior to Introduction of ASC: Weighted Average MER: 5.3%;
Prior to Introduction of ASC: Revenue Cost: $1.3 billion;
Rules Effective for 2009: Weighted Average MER: 4.4%;
Rules Effective for 2009: Revenue Cost: $1.8 billion;
Percentage Change: Weighted Average MER: -17.0%;
Percentage Change: Revenue Cost: 32.8%.
2004 Filing Year for Panel: Initial return;
Prior to Introduction of ASC: Weighted Average MER: 5.2%;
Prior to Introduction of ASC: Revenue Cost: $2.0 billion;
Rules Effective for 2009: Weighted Average MER: 4.3%;
Rules Effective for 2009: Revenue Cost: $2.4 billion;
Percentage Change: Weighted Average MER: -16.9%;
Percentage Change: Revenue Cost: 24.4%.
2004 Filing Year for Panel: After amendments;
Prior to Introduction of ASC: Weighted Average MER: 5.2%;
Prior to Introduction of ASC: Revenue Cost: $2.0 billion;
Rules Effective for 2009: Weighted Average MER: 4.1%;
Rules Effective for 2009: Revenue Cost: $2.4 billion;
Percentage Change: Weighted Average MER: -21.6%;
Percentage Change: Revenue Cost: 22.8%.
2004 Filing Year for Panel: After exam recommendations;
Prior to Introduction of ASC: Weighted Average MER: 5.7%;
Prior to Introduction of ASC: Revenue Cost: $1.4 billion;
Rules Effective for 2009: Weighted Average MER: 4.1%;
Rules Effective for 2009: Revenue Cost: $1.8 billion;
Percentage Change: Weighted Average MER: -29.3%;
Percentage Change: Revenue Cost: 31.5%.
Source: GAO analysis of IRS data.
[End of table]
Table 15: Percentage Changes in Marginal Incentives and Revenue Costs
Relative to 2009 Rules If the ASC Is the Only Credit Allowed:
4% Discount Rate and Short Carryforward Assumed:
Panel Data with 2003 as the Filing Year: Initial return;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -30.1%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -11.2%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: -1.9%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 25.5%.
Panel Data with 2003 as the Filing Year: After amendments;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -31.6%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -12.4%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: -3.9%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 24.7%.
Panel Data with 2003 as the Filing Year: After recommended exam
changes;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -29.4%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -9.6%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: 0.3%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 29.0%.
Panel Data with 2004 as the Filing Year: Initial return;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -26.3%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -10.9%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: 4.7%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 27.2%.
Panel Data with 2004 as the Filing Year: After amendments;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -22.4%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -11.3%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: 10.0%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 26.7%.
Panel Data with 2004 as the Filing Year: After recommended exam
changes;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -22.8%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -7.0%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: 10.0%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 32.8%.
8% Discount Rate and Long Carryforward Assumed:
Panel Data with 2003 as the Filing Year: Initial return;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -25.4%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -8.6%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: -6.9%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 27.8%.
Panel Data with 2003 as the Filing Year: After amendments;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -27.4%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -10.1%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: -8.8%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 25.4%.
Panel Data with 2003 as the Filing Year: After recommended exam
changes;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -21.2%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -7.7%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: 9.7%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 30.4%.
Panel Data with 2004 as the Filing Year: Initial return;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -21.7%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -9.2%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: 7.4%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 29.0%.
Panel Data with 2004 as the Filing Year: After amendments;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -17.4%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -9.6%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: 12.3%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 28.3%.
Panel Data with 2004 as the Filing Year: After recommended exam
changes;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -19.7%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -6.2%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: 12.9%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 33.1%.
Source: GAO analysis of IRS data.
[A] This is the rate for the revised set of credit options. In the
comparison the rate of the ASC for 2009 is kept at 14%.
[End of table]
Table 16: Percentage Changes in Marginal Incentives and Revenue Costs
Relative to 2009 Rules If a Choice Is Allowed between the ASC and the
Regular Credit with an Updated Base:
4% Discount Rate and Short Carryforward Assumed:
2003 Filing Year for Panel: Initial return;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -28.0%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -11.2%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: 1.6%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 26.5%.
2003 Filing Year for Panel: After amendments;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -31.6%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -12.4%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: -3.1%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 24.7%.
2003 Filing Year for Panel: After exam recommendations;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -29.4%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -9.6%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: 0.8%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 29.0%.
2004 Filing Year for Panel: Initial return;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -26.3%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -10.9%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: 4.7%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 27.2%.
2004 Filing Year for Panel: After amendments;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -22.4%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -11.3%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: 10.8%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 26.7%.
2004 Filing Year for Panel: After exam recommendations;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -22.8%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -7.0%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: 10.1%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 32.8%.
8% Discount Rate and Long Carryforward Assumed:
2003 Filing Year for Panel: Initial return;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -25.4%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -8.6%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: -6.8%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 27.8%.
2003 Filing Year for Panel: After amendments;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -27.4%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -10.1%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: -8.3%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 25.4%.
2003 Filing Year for Panel: After exam recommendations;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -21.2%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -7.7%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: 10.3%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 30.4%.
2004 Filing Year for Panel: Initial return;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -21.7%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -9.2%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: 7.4%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 29.0%.
2004 Filing Year for Panel: After amendments;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -17.4%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -9.6%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: 12.9%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 28.3%.
2004 Filing Year for Panel: After exam recommendations;
When the ASC's Rate = 14%: % Change in Weighted Average MER: -18.0%;
When the ASC's Rate = 14%: % Change in Revenue Cost: -6.2%;
When the ASC's Rate = 20%[A]: % Change in Weighted Average MER: 13.0%;
When the ASC's Rate = 20%[A]: % Change in Revenue Cost: 33.1%.
Source: GAO analysis of IRS data.
[A] This is the rate for the revised set of credit options. In the
comparison the rate of the ASC for 2009 is kept at 14%.
[End of table]
Table 17: Percentage Revenue Savings from Adding a Minimum Base
Constraint to the ASC If the ASC Is the Only Credit Allowed:
4% Discount Rate and Short Carryforward Assumed:
2003 Filing Year for Panel: Initial return;
When the ASC's Rate = 14%: Minimum Base = 50% of Current Research
Spending: 4.1%;
When the ASC's Rate = 14%: Minimum Base = 75% of Current Research
Spending: 2.7%;
When the ASC's Rate = 20%: Minimum Base = 50% of Current Research
Spending: 5.1%;
When the ASC's Rate = 20%: Minimum Base = 75% of Current Research
Spending: 6.6%.
2003 Filing Year for Panel: After amendments;
When the ASC's Rate = 14%: Minimum Base = 50% of Current Research
Spending: 3.3%;
When the ASC's Rate = 14%: Minimum Base = 75% of Current Research
Spending: 5.6%;
When the ASC's Rate = 20%: Minimum Base = 50% of Current Research
Spending: 2.0%;
When the ASC's Rate = 20%: Minimum Base = 75% of Current Research
Spending: 6.0%.
2003 Filing Year for Panel: After exam recommendations;
When the ASC's Rate = 14%: Minimum Base = 50% of Current Research
Spending: 16.5%;
When the ASC's Rate = 14%: Minimum Base = 75% of Current Research
Spending: 4.4%;
When the ASC's Rate = 20%: Minimum Base = 50% of Current Research
Spending: 18.1%;
When the ASC's Rate = 20%: Minimum Base = 75% of Current Research
Spending: 4.8%.
2004 Filing Year for Panel: Initial return;
When the ASC's Rate = 14%: Minimum Base = 50% of Current Research
Spending: 2.3%;
When the ASC's Rate = 14%: Minimum Base = 75% of Current Research
Spending: -2.0%;
When the ASC's Rate = 20%: Minimum Base = 50% of Current Research
Spending: 1.9%;
When the ASC's Rate = 20%: Minimum Base = 75% of Current Research
Spending: -3.4%.
2004 Filing Year for Panel: After amendments;
When the ASC's Rate = 14%: Minimum Base = 50% of Current Research
Spending: 1.5%;
When the ASC's Rate = 14%: Minimum Base = 75% of Current Research
Spending: -3.4%;
When the ASC's Rate = 20%: Minimum Base = 50% of Current Research
Spending: 1.2%;
When the ASC's Rate = 20%: Minimum Base = 75% of Current Research
Spending: -2.3%.
2004 Filing Year for Panel: After exam recommendations;
When the ASC's Rate = 14%: Minimum Base = 50% of Current Research
Spending: 5.6%;
When the ASC's Rate = 14%: Minimum Base = 75% of Current Research
Spending: 0.1%;
When the ASC's Rate = 20%: Minimum Base = 50% of Current Research
Spending: 4.3%;
When the ASC's Rate = 20%: Minimum Base = 75% of Current Research
Spending: 1.1%.
8% Discount Rate and Long Carryforward Assumed:
2003 Filing Year for Panel: Initial return;
When the ASC's Rate = 14%: Minimum Base = 50% of Current Research
Spending: 1.9%;
When the ASC's Rate = 14%: Minimum Base = 75% of Current Research
Spending: 0.5%;
When the ASC's Rate = 20%: Minimum Base = 50% of Current Research
Spending: 6.3%;
When the ASC's Rate = 20%: Minimum Base = 75% of Current Research
Spending: 7.9%.
2003 Filing Year for Panel: After amendments;
When the ASC's Rate = 14%: Minimum Base = 50% of Current Research
Spending: -2.3%;
When the ASC's Rate = 14%: Minimum Base = 75% of Current Research
Spending: 0.1%;
When the ASC's Rate = 20%: Minimum Base = 50% of Current Research
Spending: 3.2%;
When the ASC's Rate = 20%: Minimum Base = 75% of Current Research
Spending: 7.2%.
2003 Filing Year for Panel: After exam recommendations;
When the ASC's Rate = 14%: Minimum Base = 50% of Current Research
Spending: 10.5%;
When the ASC's Rate = 14%: Minimum Base = 75% of Current Research
Spending: 1.8%;
When the ASC's Rate = 20%: Minimum Base = 50% of Current Research
Spending: 11.5%;
When the ASC's Rate = 20%: Minimum Base = 75% of Current Research
Spending: -5.2%.
2004 Filing Year for Panel: Initial return;
When the ASC's Rate = 14%: Minimum Base = 50% of Current Research
Spending: -4.3%;
When the ASC's Rate = 14%: Minimum Base = 75% of Current Research
Spending: -3.7%;
When the ASC's Rate = 20%: Minimum Base = 50% of Current Research
Spending: -3.4%;
When the ASC's Rate = 20%: Minimum Base = 75% of Current Research
Spending: -4.0%.
2004 Filing Year for Panel: After amendments;
When the ASC's Rate = 14%: Minimum Base = 50% of Current Research
Spending: -4.3%;
When the ASC's Rate = 14%: Minimum Base = 75% of Current Research
Spending: -5.3%;
When the ASC's Rate = 20%: Minimum Base = 50% of Current Research
Spending: -2.1%;
When the ASC's Rate = 20%: Minimum Base = 75% of Current Research
Spending: -3.1%.
2004 Filing Year for Panel: After exam recommendations;
When the ASC's Rate = 14%: Minimum Base = 50% of Current Research
Spending: -0.2%;
When the ASC's Rate = 14%: Minimum Base = 75% of Current Research
Spending: -1.8%;
When the ASC's Rate = 20%: Minimum Base = 50% of Current Research
Spending: 0.3%;
When the ASC's Rate = 20%: Minimum Base = 75% of Current Research
Spending: 0.0%.
Source: GAO analysis of IRS data.
Note: The ASC rates for the credits with minimum bases are adjusted to
provide the same average incentive as the ASC without a minimum base.
[End of table]
Table 18: Percentage Reductions in Marginal Incentives and Revenue
Costs If Only the ASC Is Allowed, Rather than Both the ASC and the
Regular Credit, When Both Credits Have a 50% Minimum Base:
4% Discount Rate and Short Carryforward Assumed:
2003 Filing Year for Panel: Initial return;
When the ASC Rate = 14%: % Change in Weighted Average MER: -7.5%;
When the ASC Rate = 14%: % Change in Revenue Cost: -1.4%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -0.9%;
When the ASC Rate = 20%: % Change in Revenue Cost: 0.0%.
2003 Filing Year for Panel: After amendments;
When the ASC Rate = 14%: % Change in Weighted Average MER: -6.3%;
When the ASC Rate = 14%: % Change in Revenue Cost: -0.9%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -0.7%;
When the ASC Rate = 20%: % Change in Revenue Cost: 0.0%.
2003 Filing Year for Panel: After exam recommendations;
When the ASC Rate = 14%: % Change in Weighted Average MER: -5.6%;
When the ASC Rate = 14%: % Change in Revenue Cost: -1.1%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -0.7%;
When the ASC Rate = 20%: % Change in Revenue Cost: 0.0%.
2004 Filing Year for Panel: Initial return;
When the ASC Rate = 14%: % Change in Weighted Average MER: -10.3%;
When the ASC Rate = 14%: % Change in Revenue Cost: -0.8%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -0.6%;
When the ASC Rate = 20%: % Change in Revenue Cost: 0.0%.
2004 Filing Year for Panel: After amendments;
When the ASC Rate = 14%: % Change in Weighted Average MER: -5.9%;
When the ASC Rate = 14%: % Change in Revenue Cost: -0.6%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -0.6%;
When the ASC Rate = 20%: % Change in Revenue Cost: 0.0%.
2004 Filing Year for Panel: After exam recommendations;
When the ASC Rate = 14%: % Change in Weighted Average MER: -7.8%;
When the ASC Rate = 14%: % Change in Revenue Cost: -0.8%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -0.4%;
When the ASC Rate = 20%: % Change in Revenue Cost: 0.0%.
8% Discount Rate and Long Carryforward Assumed:
2003 Filing Year for Panel: Initial return;
When the ASC Rate = 14%: % Change in Weighted Average MER: -7.9%;
When the ASC Rate = 14%: % Change in Revenue Cost: -1.6%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -0.8%;
When the ASC Rate = 20%: % Change in Revenue Cost: 0.0%.
2003 Filing Year for Panel: After amendments;
When the ASC Rate = 14%: % Change in Weighted Average MER: -6.7%;
When the ASC Rate = 14%: % Change in Revenue Cost: -1.0%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -0.5%;
When the ASC Rate = 20%: % Change in Revenue Cost: 0.0%.
2003 Filing Year for Panel: After exam recommendations;
When the ASC Rate = 14%: % Change in Weighted Average MER: -6.2%;
When the ASC Rate = 14%: % Change in Revenue Cost: -1.2%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -0.8%;
When the ASC Rate = 20%: % Change in Revenue Cost: 0.0%.
2004 Filing Year for Panel: Initial return;
When the ASC Rate = 14%: % Change in Weighted Average MER: -11.3%;
When the ASC Rate = 14%: % Change in Revenue Cost: -0.7%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -0.6%;
When the ASC Rate = 20%: % Change in Revenue Cost: 0.0%.
2004 Filing Year for Panel: After amendments;
When the ASC Rate = 14%: % Change in Weighted Average MER: -5.5%;
When the ASC Rate = 14%: % Change in Revenue Cost: -0.5%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -0.5%;
When the ASC Rate = 20%: % Change in Revenue Cost: 0.0%.
2004 Filing Year for Panel: After exam recommendations;
When the ASC Rate = 14%: % Change in Weighted Average MER: -7.6%;
When the ASC Rate = 14%: % Change in Revenue Cost: -0.7%;
When the ASC Rate = 20%: % Change in Weighted Average MER: 0.3%;
When the ASC Rate = 20%: % Change in Revenue Cost: 0.0%.
Source: GAO analysis of IRS data.
[End of table]
Table 19: Percentage Reductions in Marginal Incentives and Revenue
Costs If Only the ASC Is Allowed, Rather than Both the ASC and the
Regular Credit, When Both Credits Have a 75% Minimum Base:
4% Discount Rate and Short Carryforward Assumed:
2003 Filing Year for Panel: Initial return;
When the ASC Rate = 14%: % Change in Weighted Average MER: -27.6%;
When the ASC Rate = 14%: % Change in Revenue Cost: -4.8%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -0.9%;
When the ASC Rate = 20%: % Change in Revenue Cost: -0.1%.
2003 Filing Year for Panel: After amendments;
When the ASC Rate = 14%: % Change in Weighted Average MER: -29.9%;
When the ASC Rate = 14%: % Change in Revenue Cost: -4.3%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -0.6%;
When the ASC Rate = 20%: % Change in Revenue Cost: -0.1%.
2003 Filing Year for Panel: After exam recommendations;
When the ASC Rate = 14%: % Change in Weighted Average MER: -11.1%;
When the ASC Rate = 14%: % Change in Revenue Cost: -3.9%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -0.9%;
When the ASC Rate = 20%: % Change in Revenue Cost: -0.1%.
2004 Filing Year for Panel: Initial return;
When the ASC Rate = 14%: % Change in Weighted Average MER: -19.2%;
When the ASC Rate = 14%: % Change in Revenue Cost: -5.8%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -1.4%;
When the ASC Rate = 20%: % Change in Revenue Cost: -0.1%.
2004 Filing Year for Panel: After amendments;
When the ASC Rate = 14%: % Change in Weighted Average MER: -25.5%;
When the ASC Rate = 14%: % Change in Revenue Cost: -5.7%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -2.4%;
When the ASC Rate = 20%: % Change in Revenue Cost: 0.0%.
2004 Filing Year for Panel: After exam recommendations;
When the ASC Rate = 14%: % Change in Weighted Average MER: -25.0%;
When the ASC Rate = 14%: % Change in Revenue Cost: -5.8%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -1.6%;
When the ASC Rate = 20%: % Change in Revenue Cost: -0.1%.
8% Discount Rate and Long Carryforward Assumed:
2003 Filing Year for Panel: Initial return;
When the ASC Rate = 14%: % Change in Weighted Average MER: -32.3%;
When the ASC Rate = 14%: % Change in Revenue Cost: -5.9%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -0.8%;
When the ASC Rate = 20%: % Change in Revenue Cost: -0.1%.
2003 Filing Year for Panel: After amendments;
When the ASC Rate = 14%: % Change in Weighted Average MER: -34.8%;
When the ASC Rate = 14%: % Change in Revenue Cost: -5.1%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -0.4%;
When the ASC Rate = 20%: % Change in Revenue Cost: 0.0%.
2003 Filing Year for Panel: After exam recommendations;
When the ASC Rate = 14%: % Change in Weighted Average MER: -10.5%;
When the ASC Rate = 14%: % Change in Revenue Cost: -4.3%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -1.0%;
When the ASC Rate = 20%: % Change in Revenue Cost: -0.1%.
2004 Filing Year for Panel: Initial return;
When the ASC Rate = 14%: % Change in Weighted Average MER: -20.8%;
When the ASC Rate = 14%: % Change in Revenue Cost: -6.6%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -1.1%;
When the ASC Rate = 20%: % Change in Revenue Cost: -0.1%.
2004 Filing Year for Panel: After amendments;
When the ASC Rate = 14%: % Change in Weighted Average MER: -27.7%;
When the ASC Rate = 14%: % Change in Revenue Cost: -6.6%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -2.4%;
When the ASC Rate = 20%: % Change in Revenue Cost: -0.1%.
2004 Filing Year for Panel: After exam recommendations;
When the ASC Rate = 14%: % Change in Weighted Average MER: -27.3%;
When the ASC Rate = 14%: % Change in Revenue Cost: -5.9%;
When the ASC Rate = 20%: % Change in Weighted Average MER: -1.2%;
When the ASC Rate = 20%: % Change in Revenue Cost: -.01%.
Source: GAO analysis of IRS data.
[End of table]
[End of section]
Appendix III: Examples of How the Base of the Credit Affects Marginal
Incentives and Windfall Credits:
Figure 7 presents five examples that illustrate how inaccuracies in the
credit's base cause disparities across taxpayers in both the marginal
incentives and windfall benefits that they receive from the credit. In
each example the taxpayer would have spent $10 million on qualified
research in the current year, even without the credit. Also in each
example, the taxpayer is contemplating doing an additional $1 million
in spending, but wants to estimate how much of a credit benefit it will
receive for that marginal spending before deciding whether to undertake
it. What differs across each example is the size of the taxpayer's base
for the regular credit. In the first example the taxpayer's spending
and gross receipts history result in a primary base that is relatively
close to its ideal base, being only $1 million below the latter. The
taxpayer receives a windfall credit of $130,000 for the $1 million
worth of spending that it would have done anyway in excess of its base.
The taxpayer would receive an additional $130,000 worth of credit if it
increased its spending by $1 million, which represents a marginal
effective rate (MER) of 13 percent---the maximum MER available under
the regular credit.[Footnote 55] The taxpayer's total credit ($260,000)
divided by its total spending ($11 million) equals its average
effective rate of credit (about 2.4 percent). In the second example the
taxpayer's primary base exceeds the ideal base by $600,000, which
prevents the taxpayer from receiving any windfall credit; however, it
also reduces the incentive that the taxpayer has to spend another $1
million on research by cutting the credit on that marginal spending
from $130,000 to $52,000, for an MER of 5.2 percent. In the third
example the taxpayer's primary base is well above all of the spending
that the taxpayer was contemplating for the year, so the credit
provides no incentive for the taxpayer to increase its spending beyond
what it would have done anyway. The MER is zero. The fourth example
shows what could happen when a taxpayer's primary base was much too low
and if there were no minimum base for the credit. The credit would
provide the taxpayer with the same marginal incentive as in the first
example; however, the taxpayer's windfall credit would be nine times
larger than in that first case. Finally, the last example shows how the
minimum base can reduce the cost of the credit by significantly
reducing windfalls in some cases. Unfortunately, this windfall cannot
be reduced without also cutting the marginal incentive. Given that the
minimum base is 50-percent of current spending, every $1 million of
marginal spending increases the base by $500,000, so the taxpayer can
earn only $650,000 of credit on that spending, representing an MER of
6.5 percent.
Figure 7: Illustration of How Inaccuracies in the Base of the Credit
Result in Disparities in Incentives Across Taxpayers:
[Refer to PDF for image: illustration]
Example: Base of $9 million is slightly too low:
Taxpayer’s marginal spending: $1 million.
Spending taxpayer would have done anyway: $10 million.
Windfall credit:
If the base spending amount is $9 million, then the taxpayer earns
$130,000 of windfall credit on the $1 million of spending that it would
have done anyway that exceeds the base.
Marginal incentive: It also earns $130,000 on $1 million of marginal
spending, which represents an MER of 13 percent.
Example: Base of $10.6 million is slightly too high:
Taxpayer’s marginal spending: $1 million.
Spending taxpayer would have done anyway: $10 million.
Windfall credit:
If the base spending amount is $10.6 million, then it exceeds the
amount of spending the taxpayer would have done anyway and there is no
windfall credit. In fact, the taxpayer would have to increase its
spending by over $.6 million before it would start earning any credit.
Marginal incentive:
The taxpayer earns only $52,000 of credit on the $.4 million of
marginal spending that exceeds the base. The MER in this case is 5.2
percent ($52,000 divided by $1 million).
Example: Base of $12 million is much too high:
Taxpayer’s marginal spending: $1 million.
Spending taxpayer would have done anyway: $10 million.
Windfall credit:
If the base spending amount is $12 million, then it exceeds all of the
spending that the taxpayer had considered.
Marginal incentive:
The taxpayer would earn no credit on any of its marginal spending. The
MER is zero.
Example: Base of $1 million is much too low:
Taxpayer’s marginal spending: $1 million.
Spending taxpayer would have done anyway: $10 million.
Windfall credit:
This example shows what would happen if base spending was only $1
million and there was no minimum base for the credit. The taxpayer
would earn a windfall credit of $1,170,000 (.13 times the $9 million of
the spending it would have done anyway in excess of its base).
Marginal incentive:
Despite the much larger total credit, the taxpayer would receive the
same MER of 13 percent, as in the first example.
Example: Base of $5 million: Taxpayer is subject to the 50% minimum
base; (Increase in base due to marginal spending);
Taxpayer’s marginal spending: $1 million.
Spending taxpayer would have done anyway: $10 million.
Windfall credit:
This example shows how the 50-percent minimum base reduced the windfall
credit that the previous taxpayer would have earned from $1,170,000 to
$650,000 (.13 times one-half of $10 million).
Marginal incentive:
The minimum base also reduces the credit that the taxpayer earns on its
marginal spending because, when the taxpayer increases its spending by
$1 it also increases its base amount by $.50. The MER in this case is
6.5 percent (one-half of 13 percent).
Source: GAO.
[End of figure]
ASC users currently are not subject to a minimum base. If they were to
be, then the final example in figure 7 shows how that minimum base
could affect their current year credits. The minimum base could also
affect the negative future-year effects arising from current-year
marginal spending (which were illustrated in figure 3). If a taxpayer's
primary base for the ASC would be less than the minimum base in future
years, even after accounting for the increase due to current-year
marginal spending, then current spending would not cause any reduction
in future credits. If the primary base exceeded the minimum base in
future years, then the negative future effects would occur, just as
they did in the case without a minimum base.
Appendix IV: Issues Relating to the Definition of Qualified Research
Expenses:
Background and Significance:
In 1986, Congress narrowed the definition of qualified research out of
a concern that many taxpayers claiming the credit did not engage in
high technology activities and some claimed the credit for virtually
any expenditures relating to product development.[Footnote 56]
Currently, research activities must satisfy four tests in order to
qualify for the credit:
1. Expenditures connected with the research must be eligible for
treatment as expenses under section 174.[Footnote 57]
2. The research must be undertaken for the purpose of discovering
information that is technological in nature.
3. The taxpayer must intend that information to be discovered will be
useful in the development of a new or improved business component of
the taxpayer.
4. Substantially all of the research activities must constitute
elements of a process of experimentation for a purpose relating to a
new or improved function, performance, reliability, or quality.
These four eligibility criteria are known as the section 174 test,
discovering technological information test, business component test,
and process of experimentation test.
Treasury regulations[Footnote 58] elaborate on these requirements as
follows:
* Research is undertaken for the purpose of discovering information if
it is intended to eliminate uncertainty concerning the development or
improvement of a business component.
* Uncertainty exists if the information available to the taxpayer does
not establish the capability or method for developing or improving the
business component, or the appropriate design of the business
component.
* A determination that research is undertaken for the purpose of
discovering information that is technological in nature does not
require the taxpayer be seeking to obtain information that exceeds,
expands or refines the common knowledge of skilled professionals in the
particular field of science or engineering in which the taxpayer is
performing the research; nor does it require that the taxpayer succeed
in developing a new or improved business component. (The underlined
language, which TD 9104 explicitly rejected, is commonly referred to as
"the discovery test" from TD 8930, which many commenters contended was
an overly stringent interpretation of the discovering technological
information test.)
* Generally, the issuance of a U.S. patent is conclusive evidence that
the research meets the "discovering information" test. However, the
issuance of a patent is not a precondition for credit availability.
* A process of experimentation is designed to evaluate one or more
alternatives to achieve a result where the capability or method of
achieving that result, or the appropriate design of that result, is
uncertain as of the beginning of the taxpayer's research activities.
The process must fundamentally rely on the principles of the physical
or biological sciences, engineering or computer science.
* A process of experimentation is undertaken for a qualified purpose if
it relates to a new or improved function, performance, reliability or
quality of the business component. Research relating to style, taste,
cosmetic, or seasonal design factors does not qualify.
The Internal Revenue Code (IRC) identifies the following types of
activities that do not qualify as research for purposes of the credit:
[Footnote 59]
* Any research conducted after the beginning of commercial production
of the business component.
* Any research related to the adaptation of an existing business
component to a particular customer's requirement or related to the
reproduction of an existing business component.
* Efficiency surveys; activity relating to management function; market
research, testing or development; routine data collection; routine or
ordinary testing or inspection for quality control; or any research in
the social sciences, arts or humanities.
* Except to the extent provided in regulations, any research with
respect to computer software which is developed by (or for the benefit
of) the taxpayer primarily for internal use by the taxpayer, other than
for use in:[Footnote 60]
- an activity which constitutes qualified research, or:
- a production process that meets the requirements of the credit.
* Research conducted outside the United States, the Commonwealth of
Puerto Rico, or any possession of the United States.
* Any research to the extent funded by any grant, contract, or
otherwise by another person (or government entity).
There are numerous areas of disagreement between IRS and taxpayers
concerning what types of spending qualify for the research credit.
These disputes raise the cost of the credit to both taxpayers and IRS
and diminish the credit's incentive effect by making the ultimate
benefit to taxpayers less certain.
General Qualification Tests:
The tax practitioners we interviewed almost universally told us that
Internal Revenue Service (IRS) auditors are still applying the
discovery test from Department of the Treasury regulations[Footnote 61]
that were explicitly rejected in subsequent regulations.[Footnote 62]
Some of the tax consultants pointed to language in the regulations
saying that the section 174 and process of experimentation tests are
met as long as the experimentation addresses uncertainty relating to
either the capability or method for developing or improving the
product, or the appropriate design of the product. One consultant said
IRS examiners have disqualified design and development activities that
address these uncertainties because they considered the activities to
be "routine development" or "routine engineering."
Officials from IRS's Large and Mid-Size Business (LMSB) Division whom
we interviewed denied that examiners are inappropriately applying the
old discovery test and referred to language from their Research Credit
Audit Technique Guide that instructs examiners on the relevant language
from current regulations. One of the practitioners that complained
about the standards used by examiners acknowledged that, if they call
in IRS's Research Credit Technical Advisors, they can get the correct
rules applied.
Both practitioners and IRS officials acknowledged that some
controversies arise because language in the IRC and regulations does
not always provide a bright line for identifying qualified activities.
For example, one qualification requirement is that the research must be
intended to eliminate uncertainty concerning the development or
improvement of a business component. The regulations say that
uncertainty exists "if the information available to the taxpayer does
not establish the capability or method for developing or improving the
business component, or the appropriate design of the business
component."[Footnote 63] An IRS official said that examiners could use
clarification of the meaning of "information available to the
taxpayer," while a practitioner noted that the regulations do not say
what degree of improvement in a product is required for the underlying
research to be considered qualified. The practitioner said that
research for improvements is more difficult to get approved as QREs
than research for new products.
Product testing around the end of the development process is a
particularly contentious issue under the section 174 and process of
experimentation tests. Treasury regulations provide that "the term
research or experimental expenditures does not include expenditures for
the ordinary testing or inspection of materials or products for quality
control (quality control testing)." However, the regulations clarify
that "quality control testing does not include testing to determine if
the design of the product is appropriate."[Footnote 64] Some tax
consultants told us that IRS fairly consistently disqualifies research
designed to address uncertainty relating to the appropriate design of a
product. One of them said that IRS rejected testing activities simply
on the basis of whether the testing techniques, themselves, were
routine.[Footnote 65] IRS officials said that they typically reject
testing that is done after the taxpayer has proven the acceptability of
its production process internally. They have disagreements with
taxpayers over when commercial production begins and suggested that
this is one area where some further clarification in regulations might
help. Officials from IRS Appeals told us that they could benefit from
additional guidance (including industry-specific guidance) in the
regulations relating to the process of experimentation test.
Product testing is a particularly important issue for software
development, which is another area of significant contention between
IRS and taxpayers. Many tax consultants and industry groups that we
spoke with believe that IRS has a general bias against software
development activities qualifying for the credit. For their part, IRS
officials believe that the true cause of controversy is taxpayers'
belief in the so-called "per se rule," which considers all software
development to inherently entail a qualifying process of
experimentation. The officials note that IRS and the courts have
uniformly rejected this notion. IRS's Audit Guidelines on the
Application of the Process of Experimentation for All Software state
that, in order for a software development activity to meet the
experimentation test, as specified in Treasury regulations, it must do
all of the following: address one of the qualified uncertainties;
evaluate alternatives; and rely on the principles of computer science.
The guidelines identify numerous activities, including the detection of
flaws and bugs in software, as "high risk categories of software
development," which usually fail to constitute qualified research. A
special subset of controversies relate to software that is considered
to have been developed for a taxpayer's own use.
Internal-Use Software:
When Congress narrowed the definition of the term "qualified research"
in the Tax Reform Act of 1986,[Footnote 66] it specifically excluded
several activities, one of them being the development of computer
software for the taxpayer's own internal use (other than for use in an
activity which constitutes qualified research, or a production process
that meets the requirements of the credit). The act provided Treasury
the authority to specify exceptions to this exclusion; however, the
legislative history to the Act states that Congress intended that
regulations would make the costs of new or improved internal-use
software (IUS) eligible for the credit only if the research satisfies,
in addition to the general requirements for credit eligibility, the
following three-part test that:
1. the software was innovative;
2. the software development involved significant economic risk; and:
3. the software was not commercially available for use by the taxpayer.
The statutory exclusion for internal-use software and the regulatory
exceptions to this exclusion have been the subject of a series of
proposed and final regulations (and also considerable controversy). On
January 3, 2001, Treasury published final regulations[Footnote 67]
ruling that "software is developed primarily for the taxpayer's
internal use if the software is to be used internally, for example, in
general administrative functions of the taxpayer (such as payroll,
bookkeeping, or personnel management) or in providing noncomputer
services (such as accounting, consulting, or banking services)."
[Footnote 68] If the software was developed primarily for those
purposes, it was deemed to be IUS, even if it is subsequently sold,
leased or licensed to third parties. This regulation did not provide a
specific definition but instead identified two general categories of
software as examples of IUS. In response to further taxpayer concerns
Treasury reconsidered the positions it took in TD 8930 and issued
proposed regulations on December 26, 2001, which stated, among other
things, that, unless computer software is developed to be commercially
sold, leased, licensed or otherwise marketed, for separately stated
consideration to unrelated third parties, it is presumed to be IUS.
[Footnote 69]
In publishing both TD 8930 and the proposed regulations Treasury
declined to adopt the recommendation of commentators that the
definition of IUS should not include software used to deliver a service
to customers or software that includes an interface with customers or
the public. Financial services and telecommunications companies are
among those particularly concerned with this issue. They note that
their software systems are integrally related to the provision of
services to their customers, yet expenditures to develop those systems
would not qualify for the credit (unless they met the additional set of
standards) under the "separately stated consideration" standard because
they do not charge customers specifically for the use of the software.
Several commentators noted that the original treatment of IUS
introduced by the 1986 act predated the occurrence of a dramatic shift
in computer usage that transformed the US economy from one based on
production of tangible goods to one based on services and information.
They question whether there is still an economic rationale for making a
distinction between IUS and software used for other purposes, given
that innovations in software can produce spillover benefits regardless
of whether the software is sold to third parties. Some commentators
supported their recommendations for a narrower definition of IUS by
referring to the legislative history included in the Conference Report
accompanying the Tax Relief Extension Act of 1999,[Footnote 70] which
included the following language:
The conferees further note the rapid pace of technological advance,
especially in service-related industries, and urge the Secretary to
consider carefully the comments he has and may receive in promulgating
regulations in connection with what constitutes "internal use" with
respect to software expenditures. The conferees also wish to observe
that software research that otherwise satisfies the requirements of
section 41, which is undertaken to support the provision of service,
should not be deemed to be "internal use" solely because the business
component involves the provision of a service.[Footnote 71]
Tax consultants complain that IRS continues to consider software
development expenditures in the services industry to be IUS, despite
the guidance Congress provided in the 1999 conference report. Some also
say that the lack of clarity in current guidance regarding the
characteristics of innovative software has permitted IRS examiners to
apply an overly restrictive interpretation of this eligibility
requirement. IRS officials told us that some exceptions were added to
both TD 8930 and the proposed regulations in response to the conference
report. They also note that the report did not suggest that all
software providing a service should be excepted from IUS treatment;
rather, it suggested that such software not be automatically classified
as IUS.
Treasury itself acknowledged the changes in computer software and its
role in business activity since the mid-1980s in an Advanced Notice of
Proposed Rulemaking,[Footnote 72] which explained why the department
was not ready to address the issue of IUS in the final regulations on
the research credit that it published in 2004. Treasury said it was
concerned about the difficulty of effecting congressional intent behind
the exclusion for internal-use software with respect to software being
developed today. As an example, it was concerned that the tendency
toward the integration of software across many functions of a
taxpayer's business activities may make it difficult for both taxpayers
and the IRS to separate internal-use software from non-internal-use
software under any particular definition of internal-use software. Even
with Congress's broad grant of regulatory authority to Treasury on this
issue, Treasury believed that this authority may not be broad enough to
resolve those difficulties.
Treasury has not yet been able to publish final regulations relating to
IUS; the issue remains on the department's latest priority guidance
plan. In the meantime, for tax years beginning after December 31, 1985,
Treasury has allowed taxpayers to rely upon all of the provisions
relating to IUS in the proposed regulations or, alternatively, on all
of the provisions relating to IUS in TD 8930. However, if taxpayers
choose to rely on TD 8930, Treasury required that they also apply the
"discovery test" contained in that document. Nonetheless, a recent
court decision allowed a taxpayer to rely on TD 8930 for IUS guidance
and TD 9104 regarding the discovering technological information test.
[Footnote 73] The Department of Justice has filed a motion for
reconsideration on the grounds that the court's holding is based on a
mistake in law.
Direct Supervision and Direct Support of Qualified Research Activities:
Qualified research expenses include the wages of employees who provide
direct supervision or direct support of qualified research activities.
Treasury regulations define direct supervision as "the immediate
supervision (first-line management) of qualified research.[Footnote
74]" Direct supervision does not include supervision by a higher level
manager. The same section of the regulations provides the following
examples of activities that qualify as direct support: the typing of a
report describing laboratory results derived from qualified research,
the machining of a part of an experimental model, and the cleaning of
equipment used in qualified research. The section also provides the
following examples of activities that do not qualify: payroll,
accounting and general janitorial services.
Some practitioners told us that IRS is very stringent with respect to
allowing the wages of supervisors higher in the chain of command to be
included in QREs. Many of their clients have flat organizational
structures and the best researchers are often given higher titles so
that they can be paid more. They say that IRS often rejects wage claims
simply on the basis of job titles. IRS officials told us that wages
higher level managers could be eligible for the credit; however, the
burden of proof is on the taxpayer to substantiate the amount of time
that those managers actually spent directly supervising a qualified
activity. They note that some taxpayers try to include unallowable
costs relating to production labor, sales and marketing, information
technology personnel, and legal personnel.
Some commentators would like IRS's guidance to more clearly state that
activities such as bid and proposal preparation (at the front end of
the research process) and development testing and certification testing
(at the final stages of the process) are qualified support activities
that do not have to meet specific qualification tests themselves, as
long as the activities that they support already qualify as eligible
research. IRS officials told us that they would like better guidance on
this issue and were concerned that some taxpayers want to include the
wages of anyone with any connection at all to the research, such as
marketing employees who attend meetings to talk about what customers
want.
Exclusion of Activities Occurring after the Commencement of Commercial
Production:
According to existing Treasury regulations, activities are conducted
after the beginning of commercial production of a business component if
such activities are conducted after the component is developed to the
point where it is ready for commercial sale or use, or meets the basic
functional and economic requirements of the taxpayer for the
component's sale or use.[Footnote 75] The regulations specifically
identify the following activities as being deemed to occur after the
beginning of commercial production of a business component:
A. Preproduction planning for a finished business component;
B. Tooling-up for production;
C. Trial production runs;
D. Trouble shooting involving detecting faults in production equipment
or processes;
E. Accumulating data relating to production processes; and:
F. Debugging flaws in a business component.
The exclusions relating to postcommencement activities apply separately
for the activities relating to the development of the product and the
activities relating to the development of the process for commercially
manufacturing that product. For example, even after a product meets the
taxpayer's basic functional and economic requirements, activities
relating to the development of the manufacturing process still may
constitute qualified research, provided that the development of the
process itself separately satisfies the standard eligibility
requirements and the activities are conducted before the process meets
the taxpayer's basic functional and economic requirements or is ready
for commercial use.
Some commentators requested clarification of these regulations,
suggesting a need for greater flexibility in defining the commencement
of commercial production. In particular, they objected to Treasury
deeming certain activities, such as preproduction planning, tooling,
trial production runs, and debugging flaws, to occur after commencement
of production when they often actually occur before the manufacturing
process is ready for commercial use. Treasury, as stated in the
preamble to the final regulations, believes that "the multitude of
factual situations to which these exclusions might apply make it
impractical to provide additional clarification that is both meaningful
and of broad application."[Footnote 76] It also stated that the
specific exclusions do not apply to research activities that otherwise
satisfy the requirements for qualified research. Some tax consultants
claim that IRS disallows research relating to the development of
manufacturing processes that should qualify (according to the
consultants' interpretation of those regulations). IRS officials
acknowledged that they do have disputes with taxpayers regarding when
commercial production of a particular product has begun and that their
determinations must be based on the facts and circumstances of the
particular cases. There is no "bright line" test for when a product is
ready for commercial production or when a manufacturing process is no
longer being improved.
Supplies and Depreciable Assets:
The Internal Revenue Code specifically excludes expenditures to acquire
"property of a character subject to the allowance for depreciation"
from eligibility for either the deduction of research expenditures
under section 174 or for the research credit.[Footnote 77] Taxpayers
have attempted to claim the deduction or the credit for expenditures
that they have made for labor and supplies to construct tangible
property, such as molds or prototypes, that they used in qualified
research activities. IRS has taken the position that such claims are
not allowed (even though the taxpayers do not, themselves, take
depreciation allowances for these properties) because the constructed
property is of the type that would be subject to depreciation if a
taxpayer had purchased it as a final product.[Footnote 78] IRS also
says that it is also improper for taxpayers to include indirect costs
in their claims for "self-constructed supplies," even when the latter
are not depreciable property.[Footnote 79] Taxpayers are challenging
IRS's position in at least one pending court case[Footnote 80] because,
among other reasons, they believe the agency's position is inconsistent
with both Treasury regulations under section 174, which allow the
deductibility of expenditures for pilot models and the legislative
history of section 41, which, they say, implies that such expenditures
could qualify for the credit. IRS says that some taxpayers have labeled
custom-designed property intended to be held for sale in their ordinary
course of business as prototypes, solely for the purpose of claiming
the research credit. Consequently, IRS considers the costs associated
with the manufacture of such products to be "inventory costs" and not
QREs. Both taxpayers and IRS examiners would like to see clearer
guidance in this area and Treasury has a project to provide further
guidance under section 174 in its most recent priority guidance plan.
IRS has also been concerned with the extent to which taxpayers have
attempted to recharacterize ineligible foreign research services
contracts as supply purchases.
[End of section]
Appendix V: Issues Relating to the Definition of Gross Receipts for a
Controlled Group of Corporations:
Background and Significance:
For taxpayers claiming the regular research credit the definition of
gross receipts is important in calculating the base amount to which
their current-year qualified research expenses (QRE) are compared. The
definition also was critical for determining the amount of credit that
taxpayers could earn with the alternative incremental research credit
(AIRC). (Even though this credit option is no longer available, a
decision regarding the definition of gross receipts will affect
substantial amounts of AIRC claims that remain in contention between
taxpayers and the Internal Revenue Service (IRS) for taxable years
before 2009.) Gross receipts do not enter into the computation of the
alternative simplified credit (ASC) or the basic research credit.
The House Budget Report[Footnote 81] accompanying the Omnibus Budget
Reconciliation Act of 1989[Footnote 82] that introduced the current
form of the regular credit provided two rationales for indexing a
taxpayer's base spending amount to the growth in its gross receipts:
1. Businesses often determine their research budgets as a fixed
percentage of their gross receipts; therefore, the revised computation
of the base amount would better achieve the intended objective of
approximating the amount of research the taxpayer would have done in
any case.
2. Indexing the base to gross receipts would effectively index the
credit for inflation.
3. Neither the House, Senate, nor Conference reports accompanying the
Small Business Job Protection Act of 1996 provided any rationale for
the design of the AIRC.
Neither the statute nor the legislative histories for either of these
Acts defined the term gross receipts in detail. Section 41(c)(7) of the
IRC simply provides that, for purposes of the credit, gross receipts
for any taxable year are reduced by returns and allowances made during
the tax year, and, in the case of a foreign corporation, that only
gross receipts effectively connected with the conduct of a trade or
business within the United States, Puerto Rico, or any U.S. possession
are taken into account.
Department of the Treasury regulations for the credit generally define
gross receipts as the total amount, as determined under the taxpayer's
method of accounting, derived by a taxpayer from all its activities and
all sources. However, "in recognition of the fact that certain
extraordinary gross receipts might not be taken into account when a
business determines its research budget," the regulations provide,
among other things, that certain extraordinary items (such as receipts
from the sale or exchange of capital assets) are excluded from the
computation of gross receipts.[Footnote 83]
The principal issue of contention between taxpayers and IRS is the
extent to which sales and other types of payments among members of a
controlled group of corporations should be included in that group's
gross receipts for purposes of computing the credit. Neither the IRC
nor Treasury regulations are clear on this point and IRS has issued
differing legal analyses in specific cases over the years. Several of
the tax practitioners that we interviewed emphasized the importance of
this issue, particularly as a consequence of the extraordinary
repatriation of dividends in response to the temporary incentives under
section 965. One noted that it is the most significant Fin 48 issue for
them.[Footnote 84] Others noted that it is a $100 million issue for
some taxpayers and will determine whether other taxpayers will earn any
credit or not in given years. Uncertainty surrounding the definition of
gross receipts makes it difficult for some regular credit users to know
how much credit they would receive for spending more on research and,
thereby, reduces the effectiveness of the credit.
Differing Legal Positions Taken by IRS and Taxpayers:
Several private sector commentators and tax professionals we
interviewed have taken the position that all transfers within a
controlled group of corporations, including those between foreign
subsidiaries and U.S. parent corporations should be excluded from gross
receipts. In 2002 IRS issued a Chief Counsel Advice memorandum that
supported this interpretation on behalf of a particular taxpayer,
noting that the decision was based on the particular facts and
circumstances of the case and should not be cited as precedent for
other cases.[Footnote 85] A subsequent, 2006, IRS Chief Counsel
Memorandum came to the opposite conclusion, again based on the specific
facts and circumstances of the case. The uncertainty for taxpayers
results from the fact that neither memorandum identified which
particular circumstances in each case were decisive and the
descriptions provided of each case were very similar.[Footnote 86]
Moreover, the two IRS memorandums applied differing interpretations of
congressional intent.
The critical disagreement between IRS and the taxpayer representatives
is whether the disregarding of intragroup transfers under the group
credit rules applies to gross receipts as well as to qualified research
expenses. The current position taken by IRS is that the credit
regulations section stating that transfers between members of a
controlled group are generally disregarded is that it applies only to
QREs and not to gross receipts because those rules were in place prior
to 1989, when gross receipts first became a factor in the computation
of the credit, and neither Congress (with respect to the Internal
Revenue Code (IRC)) nor Treasury (with respect to its regulations)
modified the rules to specifically indicate that they apply to gross
receipts. Some tax professionals counter this reasoning by saying that
the specific language in the IRC states that the rules apply for
purposes of "determining the amount of the credit"; consequently, there
was no need for Congress to explicitly link the rules to gross receipts
because the latter obviously play a critical role in determining the
amount of the credit. Treasury has yet to address the treatment of
gross receipts under the group credit rules, even though the issue has
been in Treasury's priority guidance plans since 2004.
A Treasury official told us that one issue the department would need to
decide, even if they accept that Congress intended for the rules to
apply to gross receipts, is whether Congress intended such a broad
exclusion or, instead, wanted to generally exclude intragroup
transactions, except for sales by a domestic member to a foreign
affiliate that are subsequently passed through as sales to foreign
third parties.
Consequences of Alternative Decisions:
In General:
Changing the scope of gross receipts would not affect the amount of
regular credit earned by a regular credit user (and, therefore, the
revenue cost) if the relative sizes of the various components of that
taxpayer's gross receipts remained the same as they were during the
base period. For example, if dividends from foreign members accounted
for 10 percent of the group's gross receipts during the base period and
10 percent of the gross receipts over the past four years, then the
taxpayer's regular credit would be the same regardless of whether such
dividends were counted in gross receipts. However, if the share of such
dividends in gross receipts had grown over time, the taxpayer's credit
would be smaller if those dividends were included in the definition of
gross receipts than if they were excluded. Conversely, if the dividend
share declined over time the inclusion of the dividends in gross
receipts would give the taxpayer a larger credit.
The effect that changes in the scope of gross receipts would have on
the marginal incentive that the regular credit provides to a particular
taxpayer would depend on whether the changes affect the credit
constraints that the taxpayer faces. Specifically,
* the inclusion of a component that has increased its relative share
since the base period would eliminate the marginal incentive for a
taxpayer who had been able to earn the credit if the inclusion caused
that taxpayer's base amount to exceed current-year QREs;
* the inclusion of a component that has increased its relative share
would increase the marginal incentive if it increased the taxpayer's
base amount from being less than half of its current-year QREs to more
than half (because this would remove the taxpayer from being subject to
the 50-percent base constraint);[Footnote 87]
* The inclusion of a component that has decreased its relative share
since the base period would have effects opposite to those described in
the first two bullets; and:
* if any potential component of gross receipts accounts for the same
proportion of the taxpayer's total gross receipts in the base period
and over the last 4 years, then the marginal incentive would not be
affected by the inclusion or exclusion of that component.
The broader the definition of gross receipts, the less credit taxpayers
would earn under the AIRC (for a given set of credit rates). This would
reduce the revenue cost of the AIRC and it may reduce the marginal
incentive provided to some taxpayers, depending on where their
resultant ratio of QREs to gross receipts leaves them in the credit's
graduated rate structure. Unless Congress reverses its decision and
reinstitutes the AIRC for tax years after 2008, the amount of research
spending will not be affected by any reduction in that credit's
marginal incentive resulting from a broader interpretation of gross
receipts.
Option 1--Exclude All Transactions Between Controlled Group Members
From the Group's Total Gross Receipts:
Under this option, gross receipts would consist of all payments
received from parties outside of the group by any member of the group
that are derived from the member's trade or business within the United
States, except for those extraordinary items currently excluded by
Treasury regulations. Sales of products by a U.S. member to a foreign
member that are subsequently sold to a foreign third party would be
excluded, as would be any dividend or royalty payments that are derived
from such sales. Any amounts that a foreign member receives from third
parties that are derived from that member's trade or business within
the United States would be included in the group's total gross receipts
on a current basis (not just when such amounts are repatriated to the
United States). Also, any sales that a domestic member makes to third
parties within the United States of products imported from a foreign
member (even when the latter has no trade or business within the United
States) would be included in the group's gross receipts.
If Section 41(c)(7) of the IRC reflects an expectation by Congress that
taxpayers would not fund research within the United States out of sales
made by foreign members, this option would meet that expectation. It
would be consistent with the view that foreign members should be
allowed to use their resources for the research they perform abroad
and, given that the foreign research does not qualify for the credit,
the foreign resources should not enter into the credit computation
either. In addition, this option would provide symmetry between the
treatment of sales by U.S. members of products imported from foreign
affiliates and sales by foreign members of products that they purchase
from U.S. members. However, this option would provide disparate
treatment between foreign sales that a U.S. member makes directly to a
foreign third party (which would be included in the group's gross
receipts) and foreign sales that a U.S. member passes through a foreign
member (which would be excluded). This disparate treatment would give
regular credit users some incentive to pass their sales through foreign
members rather than to sell directly to foreign third parties. It also
would provide some advantage for regular credit users to manufacture
and sell products overseas, rather than to manufacture them in the
United States and sell them directly to third parties overseas;
however, it would not give those users any advantage to manufacture
overseas, rather than to manufacture in the United States and pass
their sales through foreign members.[Footnote 88] It is not clear that
any of these incentive effects that would result from this option would
be significant relative to the many other tax and nontax factors that
businesses consider when deciding where to locate their activities and
how to route products and transfers through their affiliates. Perhaps
most importantly, this option could exclude a substantial amount of
export sales of U.S. multinational corporations from gross receipts.
This result would favor regular credit users whose export sales have
increased as a share of their total sales and disfavor users whose
export shares have declined. It would also provide more generous AIRC
benefits to users that export relatively large shares of their products
than to users whose export shares are smaller. These disparities in the
credit benefits across taxpayers serve no useful purpose.
Option 2--Include All Transactions Covered by Treasury's Current
Definition, Except Payments for Research Services, Even If They Are
Made Between Two Members of Controlled Group.
This option, which would be consistent with IRS's current
interpretation that the aggregation rules for computing the group
credit apply only to QREs and not to gross receipts, appears to be
inconsistent with Congress's intent of using the ratio of QREs to gross
receipts as a measure of a taxpayer's research effort in the base
period and in the current year. This option would eliminate any double-
counting of QREs but would overstate the resources available to the
group by double-counting sales and income payments between group
members. One consequence of this approach would be to encourage regular
credit users to reduce the volume of intragroup transfers as a share of
total gross receipts relative to what that share was during the base
period. Distorting business practices in this manner would serve no
purpose and could reduce efficiency. For AIRC users this option would
reduce the amount of credit they could earn and would put taxpayers
with relatively high volumes of intragroup transactions at an
unjustified disadvantage.
Option 3--Exclude Everything That Would Be Excluded Under Option 1,
Except for Intermediate Sales by U.S. Members to Foreign Members.
This option is preferable to option 1 because it would not discriminate
among taxpayers on the basis of whether they export their products or
sell them domestically because it would include all sales that are
effectively connected with the conduct of a trade or business within
the United States in a group's gross receipts. This option is
preferable to option 2 because it would eliminate any double-counting
of intragroup transfers in gross receipts, which is important if
Congress wishes to continue using gross receipts as a measure of the
resources available to corporations. Relative to option 1, this option
would give corporate groups that use the regular credit some incentive
to produce goods abroad that they intend to sell abroad, rather than
produce them in the United States; however, it is not clear that this
incentive is significant relative to other factors that influence the
location of production.
Option 3 would be less costly than option 1 and more costly than option
2 in terms of historic claims by users of the AIRC. In terms of future
claims by users of the regular credit, the relative costs of the three
options are difficult to determine because they depend on how the
proportionate shares of certain types of intragroup transfers in the
future will compare to what they were during taxpayer's base periods.
[End of section]
Appendix VI: Issues Relating to Recordkeeping and Substantiation:
[End of section]
Substantiating the validity of a research credit claim is a demanding
task for both taxpayers and the Internal Revenue Service (IRS),
particularly in cases where research is not a primary function of the
business in question. Two factors have led to a considerable degree of
controversy between IRS and taxpayers over the types of evidence that
are sufficient to support a claim for the credit:
* Most taxpayers do not maintain project-based accounts for normal
business purposes (and even those that do must collect additional
details solely for purposes of claiming the credit),
* There has been an increase in the number of taxpayers filing claims
on amended returns, based on studies prepared by consultants, and:
* There is no specific guidance in law, regulations, or from IRS
examiners as to what constitutes sufficient substantiation.
Neither the Internal Revenue Coder (IRC) nor Department of the Treasury
regulations contain specific recordkeeping requirements for claimants
of the research credit. However, claimants are subject to the general
recordkeeping rules of the IRC[Footnote 89] and Treasury regulations,
[Footnote 90] applicable to all taxpayers, that require them to keep
books of account or records that are sufficient to establish the amount
of credit they are claiming. In the case of the research credit, a
taxpayer must provide evidence that all of the expenses for which the
credit is claimed were devoted to qualified research activities, as
defined under IRC section 41. Under that section the qualification of
research activities are determined separately with respect to each
business component (e.g., a product, process, or formula), which means
that the taxpayer must be able to allocate all of its qualified
expenses to specific business components. Moreover, the taxpayer must
be able to establish these qualifications and connections to specific
components not only for the year in which the credit is being claimed,
but also for all of the years in its base period.
Establishing the Nexus between Expenses and Qualified Activities:
The tax practitioners we interviewed recognize that a nexus needs to be
shown between expenses and business components or projects; however,
they noted that documenting this connection requires considerable
effort for businesses that use cost center accounting, rather than
project accounting to track their expenses. Standard business
accounting typically focuses on the financial status of organizational
units, such as geographical or functional departments. Large businesses
often have cost centers, which are separately identified units (such as
research, engineering, manufacturing and marketing departments) in
which costs can be segregated and the manager of the center is
responsible for all of its expenses. Project accounting is the practice
of creating reports that track the financial status of specific
projects, the cost of which are often incurred across multiple
organizational units.
Practitioners that work with both large multinational corporations and
small family-owned businesses told us that most of their clients
claiming the research credit do not use project accounting. Project
accounting is typically used by government contractors, which are
usually required to account for their costs on a contract-by-contract
basis, and in certain industries, such as pharmaceuticals and software
development. However, even those firms that use project accounting need
to collect additional details that are required only for purposes of
claiming the credit. Consequently, many firms rely on third-party
consultants (with expertise in the complexities of research credit
rules) to conduct studies that bridge their cost-center accounting of
research expenditures to project-based accounting that is acceptable to
IRS. IRS and practitioners often refer to this attempt to bridge the
two accounting approaches as the "hybrid" approach.
A key component of the documentation needed to support a credit claim,
regardless of which accounting approach a taxpayer uses, is the
allocation of wage expenses between qualifying and nonqualifying
activities. In the case of a taxpayer using project accounting, those
accounts make it easier to demonstrate that an employee worked on a
project to develop a new or improved business component; however, even
then, additional support is needed to show how much of the employee's
time was spent on activities that qualify as a process of
experimentation intended to eliminate uncertainty (or on a qualifying
support activity). In the case of a taxpayer using cost-center
accounting, documentation also needs to be generated to show the amount
of wages devoted to each qualifying project. Wage allocations made by
consultants are typically based on after-the-fact surveys or interviews
of managers who are asked to estimate the percent time that their
employees spent on different projects and activities. In addition,
subject matter experts (SME), such as a firm's managers, scientists and
engineers, are often interviewed to gain explanations of how particular
activities meet the standards of qualifying research. Some of the
consultants also told us they also try to gather whatever relevant
technical documentation may exist to support this testimonial evidence.
In the case of large corporations with numerous research projects
detailed allocation estimates may be made for only a representative
sample of projects and then extrapolated across the population of all
projects.
There were wide difference in opinions between the IRS examiners and
the tax practitioners we interviewed regarding what methods are
acceptable for allocating wages between qualifying and nonqualifying
activities. Practitioners noted that IRS used to accept cost center or
hybrid accounting in the absence of project accounting; however, in
recent years IRS has been much less willing to accept claims based on
the first two approaches. They also said that IRS examiners now
regularly require contemporaneous documentation of qualified research
expenses (QRE), even though this requirement was dropped from the
credit regulations in 2001. Some practitioners suggested that the
changes in IRS's practices came about because examiners were having
difficulty determining how much QREs to disallow in audits when they
found that a particular activity did not qualify. Others said that IRS
does not want to devote the considerable amounts of labor required to
review the hybrid documentation. The IRS officials we interviewed said
that many more taxpayers have or had project accounting than was
suggested by the tax practitioners. The officials said that the
consultants ignored these accounts because they boxed them in (in terms
of identifying qualified research expenses). They noted that, before
the surge in new claims by firms that had never claimed the credit
previously, taxpayers used to supply more documentary evidence, such as
budgets and e-mails. In their view the use of high level surveys and
uncorroborated testimony of SMEs are not a sufficient basis for
identifying QREs. The officials noted that sometimes consultants
conduct interviews for one tax year and then extrapolate their results
to support credit claims for multiple earlier tax years In their view,
these are the types of claims that the new penalty on erroneous claims
will combat.[Footnote 91] These officials would also like to see a new
line item added to tax returns on which taxpayers would be required to
show the amount of the research deduction they were claiming under IRC
section 174. They would like to make taxpayers go on record as having
considered the expenses to be research when they first incurred them,
rather than after the fact on an amended return.
A common complaint among the practitioners we interviewed is that IRS
examiners routinely reject their credit studies but will not also say
what would be acceptable, short of contemporaneous project-based
accounts. They also say that IRS mixes up a taxpayer's requirement to
keep records and what is required to substantiate credit claims. The
taxpayers do have records of all their expenses, but not of which ones
are tied to qualified activities. Supplemental records and narratives
are needed to explain how the expenses qualify. The practitioners said
that it is unreasonable to expect that many businesses will maintain
contemporaneous records of how much time each of their employees spends
on qualified activities simply for purposes of claiming the credit;
therefore, after-the-fact estimated allocations should be allowed. Some
observed that when Congress renewed the credit in 1999 it expressed
concern about unnecessary and costly taxpayer recordkeeping burdens and
reaffirmed that "eligibility for the credit is not intended to be
contingent on meeting unreasonable recordkeeping requirements." They
also note that recent court decisions have allowed the research tax
credit in the absence of contemporaneous allocations when the evidence
provided by the taxpayer has been convincing, which courts have cited
in two recently decided research tax credit cases. IRS officials told
us that their current practices are consistent with these recent
decisions, which, they emphasize, require estimates to have a credible
evidentiary basis.[Footnote 92] The key issue is not the
contemporaneity of the evidence, but its quality (e.g., time survey
estimates made by employees who actually performed or supervised the
research, rather than estimates made by someone in the firm's tax
department who had no first-hand knowledge of the research). Some
practitioners doubted the usefulness of specific recordkeeping
guidelines, given the wide range of practice across industries. Others
would greatly welcome additional guidance and thought that the separate
audit technique guides that IRS developed for the pharmaceuticals and
aerospace industries, which several practitioners commended, could
serve as models.
IRS officials say that they do not require project-based accounting
records and they disagree with taxpayer assertions that they routinely
deny credit claims for lack of such accounting or lack of
contemporaneous records. Examiners consider these types of records to
be the most reliable and relevant form of substantiation; however, in
the absence of project-based accounts, the examiners are instructed to
consider and verify all credible evidence.
The officials note that two audit technique guides (ATG) they have
published--one (issued in June 2005) covering research credit issues in
general and the other (issued in May 2008) covering issues relating to
amended claims--provide general descriptions of necessary documentation
and lists specific types of documentation that would be acceptable for
addressing particular issues.[Footnote 93] The latter states that IRS
does not have to accept either estimates or extrapolations because IRC
section 6001 requires taxpayers to keep records to support their
claims. It instructs examiners to consider the extent to which
taxpayers rely on oral testimony and/or estimations, rather than
documentation, when deciding whether to reject a claim and that
information to support the claim should be contemporaneous. Examiners
are also directed to consider whether oral testimony was from employees
who actually performed the qualified research and how much time elapsed
between the research and the testimony. To enable examiners to make
such determinations without having to go through often voluminous
amounts of documentation, IRS is now requiring examiners to issue a
standardized information document request (IDR) questionnaire to all
taxpayers with amended claims for the research tax credit that are in
the early stages of examination. This IDR asks taxpayers for complete
answers (not just references to other documentation) to questions
concerning key aspects of the support for their credit claims. For
example, the IDR asks what percentage of QREs are base on oral
testimony or employee surveys, who was interviewed or surveyed, and how
much time elapsed between the claim year and the time of the interview
or survey. If some of the support for the answers is contained in other
records, the taxpayer must supply specific location references. The ATG
advises examiners that, in some cases they can use the responses to the
IDR alone to determine that the amount claimed is not adequately
supported and should be disallowed without further examination.
The IRS officials we interviewed pointed to the research credit
recordkeeping agreements (RCRA) as examples of the recordkeeping that
they would accept and some practitioners said that IRS could use the
knowledge it gained through RCRAs about industry-specific record
keeping practices to develop more industry-specific recordkeeping
guidance. The officials said a contemporaneous allocation was not an
absolute requirement, but timeliness is a major factor in improving the
credibility of any evidence.
Amended Filings Abuses and Penalties:
In designating research credit claims (i.e., claims made after the
initial filing of a tax return) as a Tier I compliance issue, IRS noted
that a growing number of the credit claims were based on marketed tax
products supported by studies prepared by the major accounting and
boutique firms. It further noted that these studies were typically
marketed on a contingency fee basis and exhibited one or more of the
following characteristics:
* high-level estimates;
* biased judgment samples;
* lack of nexus between the business component and QREs; and:
* inadequate contemporaneous documentation.[Footnote 94]
IRS's concern is focused on credit claims that were not taken into
account on a taxpayer's original return and the Tier I coverage is
limited to that type of claim. Most of these claims are made on amended
returns, which generally must be filed within 3 years after the date
the corporation filed its original return or within 2 years after the
date the corporation paid the tax (if filing a claim for a refund),
whichever is later. The period may be longer for taxpayers that file
for extensions.
IRS officials have noted a particular concern with new or expanded
credit claims that can be made for tax years up to 20 years earlier
than the current tax year, provided that the taxpayer still has unused
tax credits or net operating loss carryforwards from that earlier
year.[Footnote 95] These long-delayed credit changes are especially
troublesome for IRS examiners because many taxpayers do not file an
amended Form 6765 or specifically indicate anywhere on their current
year returns that they have changed the amounts of credit claimed for
earlier years.[Footnote 96] Consequently, the adjusted claims are not
likely to be detected unless IRS is already auditing the taxpayer's
current return. IRS officials said that this practice has gone from
seldom to quite often in recent years and is being used by both large
and mid-size firms.
IRS officials expressed concern that when taxpayers do submit
amendments to their Forms 6765, they often do so late in an audit after
IRS has already spent significant time reviewing the initial claims. In
many cases the taxpayers settle for 50 cents on the dollar as soon as
IRS challenges a claim. In other cases, taxpayers make claims based on
studies that consultants have sold to them on a contingency-fee basis.
Treasury Circular No. 230 now prohibits those who practice before IRS
from collecting contingency fees for these types of studies; however,
some studies may be prepared by consultants who do not practice before
IRS.[Footnote 97]
IRS officials said one reason that led the agency to designate the
credit as a Tier 1 issue was to push taxpayers to make better initial
credit claims before IRS spends substantial time on audits. As a result
of the Tier I designation, the research credit has been assigned an
issue management team to ensure that the issue is fully developed with
appropriate direction and a compliance resolution strategy. Three
requirements that currently form part of this strategy are that:
* all claims for the credit that are not made on or before the due date
of the taxpayer's Form 1120 for a given tax year must be filed at IRS's
Ogden Service Center;
* examiners must issue a standardized information document request
(IDR) to taxpayers at the outset of all new examinations of the credit;
and:
* in all cases where any amount of a research credit claim is
disallowed by IRS, the examiners must determine whether the recently
enacted penalty for filing erroneous claims for refund or credit should
be applied. The examiners must obtain and document the concurrence of a
technical advisor in all such cases where they decide not to impose the
penalty.
Although most of the tax practitioners we interviewed acknowledged that
there was a proliferation of aggressive and sometimes sloppy research
credit claims, they pointed to many legitimate reasons for companies to
file claims on amended returns, including the following:
* Substantiating and documenting research expenses in a manner that is
acceptable to IRS is time consuming and labor intensive, making it
difficult to file for the credit on a timely basis on an original
return. The firms' tax preparers need the assistance of the firms'
scientists, engineers, and technicians, who cannot be made available in
time for a current-year filing. Pulling these technical experts away
from their research represents a significant financial burden for
taxpayers. Consequently, when taxpayers go through this effort it makes
sense for them to cover multiple tax years at a time on amended
returns.
* The prevalence of amended returns in recent years also can be
attributed to long-standing uncertainties in credit regulations. The
definition of qualified research expenses was only resolved in final
regulations in 2003[Footnote 98], and the "discovery test" was also
abandoned in the final regulations by Treasury and IRS.[Footnote 99]
This clarification of the rules prompted taxpayers to file claims for
the credit for past tax years on amended returns. Similarly, changes in
regulations relating to the definition of gross receipts also prompted
many taxpayers to file amended claims.
* Start-up companies often don't consider it worthwhile to file credit
claims until they turn profitable. Once they decide to make the effort,
they also submit their claims for earlier years through amended
returns.
* The long-term nature of research projects is another reason why
taxpayers submit claims on amended returns. Taxpayers must often know
the end result of a process/project to establish the eligibility of
research expenses as part of a "process of experimentation," which is
part of the statutory definition of qualified expenses.
* Many firms, large and small, don't realize that they actually do
things that qualify for the credit. Once outside consultants make them
aware of this fact, it makes sense for them to want to go back and
claim the credit for earlier years as well.
Many large practitioners we interviewed said that aggressive and poorly
documented research credit claims are largely generated by "boutique"
research credit consultants who aggressively market their services. The
larger practitioners feel that IRS has taken things too far by
presuming that all amended claims are abusive. They said the larger
accounting firms are governed by strict professional standards and the
new penalties will not have much effect on their behavior, but the
penalties should help to reduce abuses by the boutique firms.
Practitioners did express concern that the new penalties would make the
audit and appeals processes even more contentious and they questioned
the appropriateness of imposing penalties in areas where Treasury
guidance is limited and problematic. The only practitioner we
interviewed that had actual experience with the new penalties said that
the penalties were typically applied in all cases where claims were
reduced; however, after taxpayers had spent the time and money to make
legal cases against them, all of the penalties were rescinded.
The IRS officials we interviewed expressed strong disagreement with the
view of the large accounting firms that the abusive amended returns
problem is primarily a "boutique" practitioner problem. They said that
you can see any problematic practice at any level of practitioner.
However, the officials did note that the use of the credit has expanded
downward in terms of the size of the claimants and that the expansion
has been driven by the growth of boutique research credit consultant
shops.
Base Period Documentation:
All of the difficulties that taxpayers face in substantiating their
QREs are magnified when it comes to substantiating QREs for the
historical base period (1984 through 1988) of the regular credit.
Taxpayers are required to use the same definitions of qualified
research and gross receipts for both their base period and their
current-year spending and receipts. However, given the fact that few
firms have good (if any) expenditure records dating back to the early
1980s base period, most firms are unable to precisely adjust their base
period records for the changes in definitions promulgated in subsequent
regulations and rulings. Taxpayers also have great difficulty adjusting
base period amounts to reflect the disposition or acquisition of
research-performing entities within their tax consolidated groups. Some
practitioners would like to see some flexibility on IRS's part in terms
of the use of estimates and employee testimony to substantiate QREs in
accordance with the Cohan rule; other practitioners simply suggested
doing away with the regular credit. They believe that some taxpayers
will choose to use the new ASC simply to avoid the burden of base
period documentation.[Footnote 100] One IRS official noted that IRS is
not likely to challenge a taxpayer's base amount if the latter uses the
maximum fixed base percentage;[Footnote 101] however, he did not think
that IRS would have the authority to say that taxpayers could take that
approach without showing any records at all for the base period.
Neither the IRS nor Treasury officials we interviewed saw any
administrative problems arising if the IRC were changed to relieve
taxpayers of the requirement to maintain base period records if they
used the maximum fixed base percentage. Our analysis of taxpayer data
from SOI for 2005 suggests that about 25 percent of all regular credit
users had fixed base percentages of 16 percent or were subject to the
minimum base constraint and would remain subject to that constraint
even if they elected to use a fixed base percentage of 16 percent.
Specific Issues Relating to Sampling:
Many taxpayers use statistical sampling to estimate their QREs and IRS
frequently uses sampling when auditing taxpayer's records supporting
research credit claims. Several practitioners we interviewed had
specific concerns with IRS's guidance and audit practices relating to
sampling; however, some noted that they have seen improvements in
recent months. The practitioners' biggest concern is that, unless
taxpayers can achieve a 10 percent relative precision in their
estimates, IRS makes them use the lower limit of the confidence
interval for their estimates of QREs, which is the least advantageous
to the taxpayer. Practitioners say this standard is too difficult to
meet, even in cases where taxpayers use large samples, and that IRS
should have a less demanding threshold for allowing taxpayers to use
point estimates. Moreover, they objected to IRS's requirement that they
exclude the "certainty stratum" when calculating relative precision,
which they considered to be just bad statistics.[Footnote 102] IRS
officials responded that having a precision threshold encourages
taxpayers to do a quality sample and that 10 percent precision is a
good indicator of a high quality sample. They said that without some
control standards taxpayers could try to make do with very small
samples. The officials also noted that there are methods other than
increasing sample sizes, such as improving sample design, population
definition and stratification techniques, by which taxpayers can reduce
their sampling errors. With respect to the exclusion of the certainty
stratum, IRS acknowledged that this requirement was not justified on
statistical grounds; however, they believe it is needed to prevent
potential abuses. They are concerned that taxpayers would include
extraneous accounts in their 100 percent stratum for the sole purpose
of reducing their relative precision. IRS officials said that they are
in the final stages of releasing guidance on sampling that addresses
practitioners' concerns regarding the certainty stratum and the 10-
percent precision test.
Practitioners also expressed concerns that IRS was hardening its
position against accepting multi-year samples. They said it is more
cost-effective to take one sample that covers multiple years and has a
reasonable overall accuracy for the entire time period than to take
several single-year samples that have narrow confidence intervals each
year. IRS acknowledged that the practitioners' point was correct from a
statistical point of view; however, they noted that, given the
incremental nature of the credit, that it is important for estimates of
QREs to be accurate for each specific year, not just over the multi-
year period as a whole. In addition, IRS does not want to encourage
taxpayers to hold off filing their claims for several years and then do
a multi-year sample.
Recordkeeping and Prefiling Agreements:
Practitioners and taxpayer representatives differed on the usefulness
of IRS's RCRA and prefiling agreement (PFA) programs. The RCRA program
was a pilot effort intended to let IRS develop and evaluate procedures
that would reduce costs for both taxpayers and IRS by resolving issues
concerning the type and amount of documents that a taxpayer must
maintain and produce to support research credit claims. Taxpayers that
complied with the terms of the agreements worked out with IRS are
deemed to have satisfied their recordkeeping requirements for the tax
years covered by the agreement. Five taxpayers participated in the
pilot program. The PFA program is an ongoing effort by IRS designed to
permit taxpayers, before filing their returns, to resolve the treatment
of an issue that would likely be disputed in an examination.
Some of the practitioners had had good experiences with PFAs for
particular clients, but they noted that the $50 thousand fee was too
expensive and that IRS has been less willing to enter into PFAs because
it did not have sufficient staff resources. Other practitioners said
that RCRAs and PFAs are not likely to be much help, given the animosity
and distrust between taxpayers and IRS. They think that IRS is asking
for too much in these agreements. One noted that it had five recent
experiences with PFAs and all of them were bad, so it no longer
recommends them to clients. In the current environment taxpayers are
unwilling to invite IRS in for a look at their records and taxpayers do
not believe that an RCRA ensures that IRS will not ask for additional
documents during an exam. In addition, the practitioners said that
RCRAs are unlikely to be helpful in the long-term, given the variable
nature of research projects. Agreements made in an RCRA may not be
applicable to other research projects in future tax years, or even the
same project in future tax years as the project evolves.
[End of section]
Appendix VII: Issues Relating to the Computation Rules for the Group
Credit:
Background and Significance:
When Congress originally enacted the research credit in 1981 it
included rules "intended to prevent artificial increases in research
expenditures by shifting expenditures among commonly controlled or
otherwise related persons."[Footnote 103] Without such rules a
corporate group might shift current research expenditures away from
members that would not be able to earn the credit due to their high
base expenditures to members with lower base expenditures. A group
could, thereby, increase the amount of credit it earned without
actually increasing its research spending in the aggregate. Department
of the Treasury and Internal Revenue Service (IRS) officials told us
that the rules also guard against manipulation within a group that
would shift credits from members with tax losses to those with tax
liabilities. Under the Internal Revenue Code (IRC), for purposes of
determining the amount of the research credit, the qualified expenses
of the same controlled groups of corporations are aggregated together.
The language of the relevant subsection specifically states that:
A. all members of the same controlled group of corporations[Footnote
104] shall be treated as a single taxpayer, and:
B. the credit (if any) allowable under this section to each such member
shall be its proportionate share of the qualified research expenses and
basic research payments giving rise to the credit.
Congress directed that Treasury regulations drafted to implement these
aggregation rules be consistent with these stated principles.
Under current Treasury regulations[Footnote 105] the controlled group
of corporations must, first, compute a "group credit" by applying all
of the credit computational rules on an aggregate basis. The group must
then allocate the group credit amount among members of the controlled
group in proportion to each member's "stand-alone entity credit" (as
long as the group credit amount does not exceed the sum of the stand-
alone entity credits of all members). If the group credit does exceed
the sum of the stand-alone credits, then the excess amount is allocated
among the members in proportion to their share of the group's aggregate
qualified research expenses (QRE). The stand-alone entity credit means
the research credit (if any) that would be allowed to each group member
if the group credit rules did not apply. Each member must compute its
stand-alone credit according to whichever method provides it the
largest credit for that year without regard to the method used to
compute the group credit. The group credit may be computed using either
the rules for the regular credit or the rules for the alternative
simplified credit (ASC) (or, until the end of tax year 2008, the rules
for the alternative incremental research credit (AIRC)). The group
credit computation is the same for all members of the group.
For purposes of the initial allocation of the group credit among
members that file their own federal income tax returns, consolidated
groups of corporations are treated as single members.[Footnote 106]
However, once a consolidated member receives its allocation of the
group credit, that allocation must be further allocated among the
individual members of the consolidated group in a manner similar to the
one used for the initial allocation.
Although some private sector research credit consultants told us that
the group credit rules do not affect large numbers of taxpayers,
several others said that the opposite was true with one pointing out
that the rules affect all groups that have any of the following:
* members that are between 50 percent and 80 percent owned;
* noncorporate members;
* members departing in a given year; or:
* U.S. subsidiaries that are owned by foreign parents and are members
of different U.S. consolidated groups.
One consultant that works primarily with mid-sized businesses,
including many S corporations, noted that such corporations are heavily
affected by these rules. A second consultant that also works primarily
with S corporations said that between 10 and 15 percent of their
clients are affected by these rules. The consultants with whom we
discussed this issue agreed that the rules were very burdensome for
those groups that are affected. Some very large corporate groups must
do these computations for all of their subsidiaries, which could number
in the hundreds, and they have no affect on the total credit that a
group earns. None of these affected groups can benefit from the
simplified recordkeeping that the ASC offers to other taxpayers because
they must be able to show which stand-alone credit method provides the
highest credit for each member, which can only be done by computing the
credit under both the ASC and regular credit rules (and AIRC rules in
the years for which it was available) for each member. Some consultants
expressed concern that IRS could reject credit claims completely even
if the only deficiency is in the allocation computation.
Differing Legal Positions Taken by IRS and Taxpayers:
The primary objection that taxpayer representatives have raised with
respect to the group credit regulations is that all affected groups are
required to use the same burdensome allocation procedures even though
there is no clear basis for them in the IRC, which they say only
requires that the allocation be in proportion to the QREs "giving rise
to the credit." Some commentators contend that the stand-alone credit
method does not satisfy the principle set out in the IRC any better
than would a simpler allocation based on each member's share of current
QREs. If a group, as a whole, is above its base spending amount, then
an additional dollar of spending by any group member will increase the
group credit by the same amount, regardless of how the group credit
total is allocated among members. Some would say, in this sense, all
QREs give rise to the credit to the same extent. Several public
commentators and consultants we interviewed recommend that groups be
allowed to allocate their group credits by any reasonable means, as
long as the sum of the credits that each member receives does not
exceed the group credit amount.
Treasury maintains that a single, prescribed method is necessary to
ensure the group's members collectively do not claim more than 100
percent of the group credit. An official explained that if two members
of a group each used a different method that maximized their share of
the group credit, this would result in the members claiming in
aggregate more than the group credit amount. If taxpayers could use any
reasonable method of allocation and group members used different
methods, then IRS would have no basis for saying whose individual
credit had to be reduced in order that the aggregate claims by members
did not exceed the group credit amount. While acknowledging that
disagreements within groups are likely to be rare, the official noted a
case where representatives of two members of the same group separately
argued in favor of differing allocation rules.
Treasury also maintains that the stand-alone credit approach is more
consistent with Congress's intent to have an incremental credit than is
the gross QRE approach. According to Treasury, the former approach
appears to be the only one that would provide each member some
incentive to exceed their base spending amount, given that each member
may not know the tax positions of other group members (i.e., current-
year and base QREs) until the end of the tax year. The individual
member may not know the extent to which one more dollar of its own
spending will increase the group credit amount, but it does know that
by maximizing its stand-alone credit amount, it will maximize its share
of whatever amount the group earns as a credit in the aggregate. An IRS
official added that requiring everyone to use the stand-alone method
would ensure a fairer distribution of the credit within groups.
Otherwise, a parent corporation may discriminate in favor of 100-
percent owned members and against 50-percent members in the allocation
of credits because some of the benefit given to the latter would go to
unrelated parties.
Consequences of Alternative Decisions:
Effects on Compliance and Enforcement Burden:
Allowing controlled groups to use an alternative allocation method
could significantly reduce both the compliance burden on the affected
groups and IRS's cost of verifying their compliance. If a controlled
group agrees to use the ASC computation for its group credit and
allocates that credit among its members on the basis of either each
member's current QREs or each member's stand-alone ASC, then no member
would have to maintain and update records from the base period for the
regular credit, nor would IRS have to review those records. Under the
current regulations every member's credit claim would be open to
revision if IRS found that any of their base period spending records
are deficient. This alternative approach should not impose any other
types of costs on IRS beyond what it faces under the current
regulations. Under either of these approaches the only way that IRS can
confirm that the group credit has not been exceeded is to add up all of
the credits claimed by individual members and compare that to the group
credit amount.
Effects on Marginal Incentives:
In specifying that controlled groups be treated as single taxpayers for
purposes of the credit Congress clearly wanted to ensure that a group,
as a whole, exceeded its base spending amount before it could earn the
credit. It is not clear that Congress was concerned that each member
has an incentive to exceed its own base.
For groups in which individual members determine their own research
budgets, the allocation rules can affect aggregate group research
spending because they affect the incentives that each member faces.
Therefore, if one of the allocation methods on average provides higher
marginal incentives to individual group members, then applying that
method could result in higher overall research spending. However,
neither the stand-alone credit allocation method nor the gross QRE
allocation method is unequivocally superior in terms of the marginal
incentives that they provide to individual members. Each of the two
methods performs better than the other in certain situations that are
likely to be common among actual taxpayers.[Footnote 107] Data are not
available that would allow us to say whether one of the methods would
result in higher overall research spending than the other.[Footnote
108]
For those groups in which the aggregate research spending of all
members is determined by group-level management, the only way that the
allocation rules can affect the credit's incentive is if they allow the
shifting of credits from members without current tax liabilities to
those with tax liabilities. If the group credit is computed according
to the method that yields the largest credit, then an additional dollar
of spending by any group member will increase the group credit by the
same amount, regardless of how the group credit total is allocated
among members. However, if group management were able to shift credits
from tax loss members to those with positive liabilities, the group
would be able to use more of its aggregate credit immediately, rather
than carrying it forward to future years. The effect of this type of
shifting on the efficiency of the credit should be relatively minor
because, when a credit is carried forward, the benefit to the taxpayer
and the cost to the government are both discounted to the same degree.
In any case, a controlled group's ability to target credit shares to
members with positive tax liabilities should not be greater under the
gross QRE allocation method than under the stand-alone credit
allocation method.
The Computation of Marginal Incentives for Individual Members of a
Controlled Group:
The marginal incentive that a particular member of a controlled group
would face under alternative group credit allocation methods depends on
multiple factors, including:
1. Which credit method (regular or alternative simplified credit (ASC))
is used to compute the group credit;
2. Which credit method yields the highest stand-alone credit for the
member;
3. What, if any, base constraints apply to whichever credit is used;
4. Whether or not the member is allowed to use its highest stand-alone
credit method;
5. How the size of the member's stand-alone credit compares to its
current-year qualified research expenses (QRE); and:
6. How the member's share of the group's total QREs compares to its
share of the sum of all members' stand-alone credits.
When Both the Group and the Member Use the Regular Credit Computation
Method:
In the case where a controlled group uses the regular credit method to
compute its group credit and an individual member earns its highest
stand-alone credit under the regular credit method and the group credit
is less than or equal to the sum of the members' stand-alone credit,
the marginal incentive for that member to spend an additional dollar on
research under the current rules (MERSA) can be computed as:
MERSA = [(ISAC + mrm) / (ISUMSAC + mrm)] × (IGC + mrg) - (ISAC /
ISUMSAC ) × IGC:
where ISAC is the member's initial stand-alone credit before making
it's additional expenditure; ISUMSAC is the initial sum of the stand-
alone credits of all group members before the one member spends its
additional dollar; IGC is the initial group credit before the member
spends the additional dollar; mrm is the applicable marginal rate of
credit for the member's stand-alone credit; and mrg is the applicable
marginal rate of credit for the group credit.[Footnote 109] The
italicized part of this formula shows the member's share of the group
credit after spending an additional dollar on research;[Footnote 110]
the unitalicized part of the formula shows the member's share before
the additional expenditure. The difference between the two parts equals
the marginal benefit that the member receives for spending the
additional dollar.
If the group credit exceeds the sum of the stand-alone credits, then
the formula for MERSA becomes:
MERSA = mrm + [(IQRE + 1) / (ISUMQRE + 1)] × (IGC + mrg - (ISUMSAC +
mrm)):
- (IQRE / ISUMQRE) × (IGC - ISUMSAC):
The first term on the right-hand side of the formula, "mrm," represents
the member's share of that portion of the group credit that equals the
sum of the stand-alone credits.[Footnote 111] The remainder of the
formula shows the member's share of the excess of the group credit over
the sum of the stand-alone credits.[Footnote 112] The italicized
portion of the formula shows the member's share of the excess portion
of the credit after spending an additional dollar on research;[Footnote
113] the underlined portion shows the member's share before the
additional expenditure.
The marginal incentive that this same member would face if the entire
group credit were allocated according to each member's share of the
group's gross QREs (MERQ) can be computed as follows:
MERQ = [(IQRE+ 1) / (ISUMQRE + 1)] × (IGC + mrg) - (IQRE / ISUMQRE) ×
IGC:
where IQRE is the member's initial QREs before making its additional
expenditure; ISUMQRE is the initial sum of the QREs of all group
members before the one member spends its additional dollar; and IGC is,
again, the initial group credit before the member spends the additional
dollar. This formula is the same, regardless of whether IGC is less
than, equal to, or greater than ISUMSAC.
When Both the Group and the Member Use the ASC Computation Method:
The computation of MERs for group members when either the group or the
member uses the ASC is more complex than in the case of the regular
credit because each dollar a firm spends in the current year will
affect its current-year credit as well as its credits in the next three
years. The MER is the present value sum of these four separate effects.
In the case where a controlled group uses the ASC method to compute its
group credit and an individual member earns its highest stand-alone
credit under the ASC method and the group credit is less than or equal
to the sum of the members' stand-alone credit, the current-year effect
when that member spends an additional dollar on research under the
current rules can be computed as:
CY Effect = [(ISAC + mrm) / (ISUMSAC + mrm)] × (IGC + mrg) - (ISAC /
ISUMSAC ) × IGC,
which is similar to the first MERSA formula introduced above, except in
this case both mrm and mrg will equal 0.14. The marginal incentive
effect in the following year can be computed as:
Next Year Effect = [(ISAC1 - (1/6) × mrm) / (ISUMSAC1 - (1/6) × mrm)] ×
(IGC1 - (1/6) × mrg) - (ISAC1 / ISUMSAC1) × IGC1:
The "1" at the end of the variable names indicate that they represent
the values for that variable in the first year into the future. The
italicized portion of the formula shows how the member's share of the
sum of all group members' stand-alone credits for the next year would
change if the member increased its spending by $1 this year.[Footnote
114] The underlined portion shows that the member's spending also
reduces next year's group credit that is allocated among the members.
The final unitalicized, nonunderlined portion is the amount of the
group credit that the member would have received next year without the
additional spending this year. Similar effects would occur in the 2
subsequent years. The net incentive provided to the member is obtained
by discounting the three future effects and adding them to the current-
year effect.
The current-year incentive effect that this same member would face if
the entire group credit were allocated according to each member's share
of the group's gross QREs can be computed as follows:
CY Effect = [(IQRE + 1) / (ISUMQRE + 1)] × (IGC + mrg) - (IQRE /
ISUMQRE ) × IGC,
which is the same as for the regular credit, except for the value of
mrg. The effect in the following year would be:
Next Year Effect = (IQRE1 / ISUMQRE1) × (IGC1 - (1/6) × mrg) - (IQRE1 /
ISUMQRE1) × IGC1.
The member's additional spending this year does not affect its share of
the groups total spending next year, but it does increase the base for
next year's group credit and, thereby reduces the amount of credit that
gets allocated to members. Again, this latter effect would be repeated
in the subsequent 2 years. The formulas for the marginal incentives
when the ASC is used and the group credit exceeds the sum of the stand-
alones are more complicated than those above and are not needed to make
the basic point that there are common situations in which each credit
allocation method provides a higher incentive than the other.
Results Based on Numerical Simulations:
One can run numerical simulations with the various formulas for MERSA
and MERQ to identify common situations in which each allocation method
provides a higher marginal incentive to a member than the other method.
The cases identified in table 20 are simply broad examples and do not
cover all situations in which one or the other allocation methods is
superior; however, they are sufficient to demonstrate that each of the
allocation methods performs better than the other in different
situations that are likely to be common to actual taxpayers.[Footnote
115] For example, when a member of a group is subject to the 50-percent
base constraint, the stand-alone credit method provides that member a
larger incentive when the member's share of the sum of all members'
stand-alone credits is greater than the member's share of the group's
gross QREs; the gross QREs method provides a greater incentive when the
converse is true. In 2004 approximately 75 percent of all regular
credit users were subject to the 50 percent minimum base constraint.
Table 20: A Comparison of Two Methods for Allocating Group Credits in
Selected Situations:
Both the member and group use the regular credit:
When the member is subject to the 50 percent minimum base constraint
(regardless of whether the group is subject to that constraint):
When the group credit is less than or equal to the sum of the members'
standalone credits: The standalone credit method provides a larger
incentive when the member's share of the sum of all members' stand-
alone credits is greater than the member's share of the group's gross
QREs. The gross QREs method provides a larger incentive when the
member's share of the group's gross QREs is greater than the member's
share of the sum of all members' stand-alone credits;
When the two shares are equal, the two allocation methods provide the
same incentive;
When the group credit is greater than the sum of the members'
standalone credits: The standalone credit method provides a larger
incentive when the member's share of the sum of all members' stand-
alone credits is greater than the member's share of the group's gross
QREs. The gross QREs method provides a larger incentive when the
member's share of the group's gross QREs is greater than the member's
share of the sum of all members' stand-alone credits. When the two
shares are equal, the two allocation methods provide the same
incentive.
When the member is not subject to the 50 percent minimum base
constraint:
When the group credit is less than or equal to the sum of the members'
standalone credits: The relationship between the two methods is more
difficult to summarize under these conditions;
however the stand-alone method performs considerably better relative to
the gross QREs method under these conditions than when the member is
subject to the 50 percent constraint;
When the group credit is greater than the sum of the members'
standalone credits: The two allocation methods provide the same
incentive when the member's share of the sum of stand-alone credits
equals the member's share of group QREs times the ratio of the member's
stand-alone credit over 0.2 times the member's QREs. The stand-alone
credit method provides a larger incentive when the member's share of
the sum of all member's stand-alone credits is greater than the
member's share of group QREs times the ratio of the member's stand-
alone credit over 0.2 times the member's QREs. The gross QREs method
provides a larger incentive when the member's share of the sum of all
member's stand-alone credits is less than the member's share of group
QREs times the ratio of the member's stand-alone credit over 0.2 times
the member's QREs. Given that the ratio of the member's stand-alone
credit over 0.2 times the member's QREs must always be less than 0.5,
the stand-alone method performs considerably better relative to the
gross QREs method under these conditions than when the member is
subject to the 50 percent constraint.
Both the member and the group use the ASC:
When the member's QREs grow at a 5 percent rate per year:
When the group credit is less than or equal to the sum of the members'
standalone credits: The stand-alone credit method provides a larger
incentive when the member's share of the sum of all members' stand-
alone credits is greater than the member's share of the group's gross
QREs. The gross QREs method provides a larger incentive when the
member's share of the group's gross QREs is greater than the member's
share of the sum of all members' stand-alone credits. When the two
shares are equal, the two allocation methods provide the same
incentive;
When the group credit is greater than the sum of the members'
standalone credits: We did not do simulations for such cases because
the computations are particularly burdensome.
When the member's QREs grow at a rate of more than 5 percent per year:
When the group credit is less than or equal to the sum of the members'
standalone credits: The higher the rate of growth, the higher the ratio
of the member's share of the group's stand-alone credits to the
member's share of the group's gross QREs must be in order for the stand-
alone credit method to provide a higher incentive than the gross QREs
method;
When the group credit is greater than the sum of the members'
standalone credits: We did not do simulations for such cases.
When the member's QREs grow at a rate of less than 5 percent per year:
When the group credit is less than or equal to the sum of the members'
standalone credits: The lower the rate of growth, the lower the ratio
of the member's share of the group's stand-alone credits to the
member's share of the group's gross QREs can be in order for the stand-
alone credit method to provide a higher incentive than the gross QREs
method;
When the group credit is greater than the sum of the members'
standalone credits: We did not do simulations for such cases.
Source: GAO.
[End of table]
[End of section]
Appendix VIII: Comments from the U.S. Department of Treasury:
Department of Treasury:
Washington, DC 20220:
October 22, 2009:
Mr. James R. White:
Director, Tax Issues:
Strategic Issues Team:
United States Government Accountability Office:
441 G Street, NW:
Washington, DC 20548:
Dear Mr. White:
Thank you for the opportunity to comment on GAO's draft report entitled
"The Research Tax Credit's Design and Administration Can Be Improved"
(GAO-10-136). The draft report recommends that "Congress should
consider eliminating the regular credit option and adding a minimum
base to the alternative simplified credit. GAO recommends that the
Secretary of the Treasury clarify the definition of qualified research
expenses and organize a working group to develop standards for
documentation."
The research tax credit encourages technological developments that are
an important component of economic growth. However, we believe that
credit's temporary nature undermines its effectiveness. Uncertainty
about the future availability of the research tax credit diminishes the
incentive effect of the credit because it is difficult for taxpayers to
factor the credit into decisions to invest in research projects that
will not be initiated and completed prior to the credit's expiration.
Therefore, the Administration's priority is to make the credit
permanent and we included a proposal to make it permanent in the
Administration's FY 2010 Budget. We also agree that the credit's
structure could he simplified or updated in certain respects to improve
its effectiveness, and we would he happy to work with Congress on
possible improvements.
As noted in the draft report, Treasury and the Internal Revenue Service
are currently working on guidance involving several of the interpretive
issues surrounding the research credit. For example, we are developing
guidance to clarify the definition of gross receipts, the treatment of
inventory property under section 174, and the definition of internal
use software. We agree with the report that the issuance of such
guidance will enhance the administration of the research credit and are
working diligently to provide additional guidance in the next few
months.
We also have technical comments on the draft report, which we will
discuss with your staff.
Thank you again.
Sincerely,
Signed by:
Michael F. Mundaca:
Acting Assistant Secretary (Tax Policy):
[End of section]
Appendix IX: GAO Contact and Staff Acknowledgements:
GAO Contact:
James R. White, (202) 512-9110 or whitej@gao.gov:
Acknowledgments:
In addition to the contact named above, James Wozny, Assistant
Director, Ardith Spence, Susan Baker, Sara Daleski, Kevin Daly, Mitch
Karpman, Donna Miller, Cheryl Peterson, and Steven Ray, made key
contributions to this report.
[End of section]
Footnotes:
[1] Comparing alternative designs on the basis of this criterion is
equivalent to comparing the designs on the basis of the level of
incentive that each would provide at a given revenue cost to the
government.
[2] Appendix I details how we estimate the incentive provided by
various designs of the credit and the revenue cost associated with each
design. The appendix also describes our sensitivity analyses and
discusses limitations of our methodology.
[3] Appendix II provides selected comparative data for the panel and
full populations; it also summarizes the results of sensitivity
analyses in which we allow the spending histories of our panel
population to vary significantly from those used for our baseline
results.
[4] Economic Recovery Tax Act of 1981, Pub. L. No. 97-34 (1981).
[5] Joint Committee on Taxation, General Explanation of the Economic
Recovery Tax Act of 1981 (JCS-71-81), December 29, 1981.
[6] The definition of a "controlled group of corporations" for purposes
of the credit has the same meaning as used in determining a parent -
subsidiary controlled group of corporations for the consolidated return
rules except the aggregate rule is broader, substituting corporations
that are greater than 50 percent owned for 80 percent owned
corporations. The aggregation rules also apply to trades or businesses
under common control. A trade or business is defined as a sole
proprietorship, a partnership, a trust or estate or a corporation that
is carrying on a trade or business.
[7] The average effective rate (AER) of the credit equals the total
credit benefit that the taxpayer earns divided by its total qualified
spending. In the case of the uncapped flat credit, the AER equals the
MER because the taxpayer earns the same rate on every dollar that it
spends. In contrast, the AER of an incremental credit will differ from
that credit's MER. In the third example shown in figure 1, the MER is
20 percent ($20/$100); however, the AER is slightly less than 2 percent
($20/$1,100).
[8] At the 35 percent tax rate the value of being able to deduct $1
from taxable income is $0.35. Therefore, when a taxpayer must reduce
its deduction for each dollar of research credit, the value of the
credit is reduced by 35 percent. Expressed in terms of the rate of
credit, the 35 percent reduction drops the MER from 20 percent to (1
-0.35) × 20 percent, or 13 percent.
[9] The present value = $1 million / (1 + 0.05)3.
[10] This weighted average MER is computed by estimating each
taxpayer's MER and giving each one a weight that equals the taxpayer's
share of aggregate QREs.
[11] In 1996, at the request of Congressman Robert T. Matsui, we
reviewed then-recent studies of the effectiveness of the credit to
determine whether adequate evidence existed to support claims that each
dollar of the tax credit stimulated at least one dollar of research
spending in the short run and about two dollars of spending in the long
run. We concluded that all of the available studies had data and
methodological limitations that were significant enough to leave
considerable uncertainty about the true responsiveness of research
spending to tax incentives. None of the studies we reviewed estimated
the long-run price elasticity of spending to be greater (in absolute
terms) than -2; other estimates were considerably lower. We are not
aware of any studies since 1996 that provide new estimates of the price
elasticity of research spending by U.S. firms. In a later section we
report our own estimates of the average MER and the revenue cost of the
research credit and note what the bang-per-buck of the credit would be,
if one assumed particular values for the price elasticity.
[12] The aggregate data on research credit claimants that we present
differ in several respects from the data that IRS publicly reports.
First, IRS excludes credit data reported by S corporations, which are
"pass-through" entities, meaning that they are not subject to the
corporate income tax. Instead, these entities' income, deductions, and
credits are allocated to their shareholders. We include S corporations
in our tables and figures that show the amounts of qualified spending
done and the amounts of credits earned because those entities do the
spending that generate the credits. However, we exclude S corporations
from our computations of MERs because the latter depend on the tax
attributes of the shareholders, not the S corporations themselves.
Second, IRS reports the amounts of credit claimed as they are reported
on the taxpayers' returns, which means in some cases these amounts will
be for reduced credits, while in other cases they will be for full
credits (with the taxpayers reducing their research expense deductions
elsewhere on their returns). For the sake of consistency when comparing
amounts of credits across different taxpayers, we report all credits on
a net basis (subtracting the offset against the deduction where
relevant). Third, the aggregated data IRS reports contains some double
counting of QREs, which occurs because members of controlled groups are
each required to report the total QREs of all group members. (They each
report only their own share of the group's total credit.) We have
eliminated clear cases of double counting for all taxpayers with at
least $10 million of QREs (see appendix I for details).
[13] IRS's aggregate data shows QREs and credits growing by about 13
percent and 15 percent, respectively, from 2005 to 2006. We would
expect approximately the same rate of growth in our totals between
those two years. The taxpayer-level data for 2006 were not available in
time for us to make them consistent with the series reported in out
tables and figures.
[14] These shares are based on data for those corporations that
reported their spending by category.
[15] The data available from IRS, which covers corporate returns with
tax years ending on or before June 30, 2007, do not yet reflect the
full impact of the ASC option (first available for tax years ending
after December 31, 2006). In a later section we estimate how many of
our panel members would have chosen the ASC if it had been available in
2003 and 2004.
[16] The data in the figure do not include the negligible amounts of
basic research credits earned or the qualified spending giving rise to
those credits. In 2005 basic credits amounted to less than 1 percent of
all credits earned and basic research spending was only about 0.2
percent of all qualified research spending. In 2005 corporations also
reported receiving about $150 million of credits from pass-through
entities. Some of these credits may be from S corporations included in
our population and, therefore, would have been double-counted if we
included them in the figure.
[17] The discounting in the MER is counteracted by the discounting in
the revenue cost when computing the bang-per-buck because one is a
factor in the numerator and the other is a factor in the denominator.
[18] The data on amendments and examinations that we obtained from
IRS's Large and Mid-Size Business (LMSB) Division reflect the status of
claims as of late 2007. Some of the audit changes that examiners had
recommended at that point in time had already been agreed to by
taxpayers; others were still open and ultimately could be appealed by
taxpayers.
[19] The percentages reported above represent averages across all of
the panel corporations--both those that had their credits changed and
those that did not. The percentage reductions for those corporations
that actually had credits changed by examiners were actually higher--
between 19.6 percent and 36.6 percent from 2000 through 2003.
[20] We use the term primary base in reference to the base that is
computed prior to determining whether that base is greater or less than
the minimum base (50 percent of current-year QREs). The taxpayer's
ultimate base is the greater of the primary base or the minimum base.
[21] Appendix III provides a detailed explanation of how these results
arise.
[22] The inequitable distribution of the marginal incentives distorts
the allocation of research spending, while the inequitable distribution
of the total credits earned distorts the allocation of resources in
general.
[23] The current spending is weighted by one-third in the computation
of next year's base, which is the average of 3 years of spending. The
base equals half of that average. Therefore, each $1 million of current
spending increases next year's base by $1 million / 6 and it has the
same effect on the bases in the following 2 years. The credit amount
equals 0.091 × 166,667, reflecting the fact that the 14 percent rate is
effectively reduced to 9.1 percent due to the offset against the
deduction.
[24] The future effects would be discounted for the time value of money
so the benefit would be slightly higher.
[25] We do not know whether taxpayers' expectations relating to the
amount of credit they will receive on their marginal spending are best
reflected in the amounts of credit they report on their original tax
returns, on their amended tax returns, or the amounts after adjustments
resulting from IRS examinations. We provide separate estimates based on
each of these three alternatives. The estimates values for MERs and
revenue costs that we present in table 14 and elsewhere in this report
vary depending on which of these three types of data we use; however,
the variations do not affect any of our conclusions or recommendations.
[26] If we had assumed a higher discount rate and longer carryforward
length, then the MERs and revenue costs would have been lower in all
cases, but the effect of the introduction the ASC on the credit's bang-
per-buck would have been similar.
[27] The regular credit users that had the lowest average rates of
credit (and, thereby, were more likely to switch to the ASC) were those
that were not subject to the minimum base. Their MER under the regular
credit would have been 13 percent (before taking tax liability
constraints into account); the maximum MER that we estimated for our
panel corporations that could use all of their credits immediately was
between 10.9 percent and 12.5 percent, depending on the discount rate
assumption. The maximum MER under the AIRC was 3.25 percent.
[28] We used our panel data to simulate the effects of these two
approaches for correcting base distortions. To simulate an update of
the regular credit base for our panel corporations we set the base
equal to the average QREs over the three years preceding the year in
which the credit is earned. We were constrained to use a 3-year
average, given the limits of our panel database; however, past evidence
suggests that updates of the base should not be much less frequent than
every 3 years. In 1995, we testified that the inaccuracy of the base
began to be a problem as early as 3 years after the introduction of the
regular credit's design. As of tax year 1992, 60 percent of all credit
claimants were already subject to the minimum base constraint. See GAO,
Tax Policy: Additional Information on the Research Tax Credit,
[hyperlink, http://www.gao.gov/products/GAO/T-GGD-95-161] (Washington,
D.C.: May 10, 1995).
[29] The revenue costs of these two changes would be the same but the
average MER would be very slightly higher if the regular credit option
were retained simply because taxpayers would have the option of
switching to that credit in future years if it suited them better. That
small probability of switching in the future can reduce the negative
future effects that the taxpayer expects to encounter under the ASC.
See appendix I for further explanation.
[30] The effects on taxpayers' MERs of adding a minimum base to the ASC
are more complicated than the effects of the regular credit's minimum
base. See appendix III for details.
[31] The only cases that we found where the minimum base would have a
slightly negative effect on the bang-per-buck were when we assumed a
discount rate of 7 percent or higher. We believe that taxpayer's
discount rates are likely to be lower than that (see appendix I for
further discussion).
[32] If the rates of both credits were 20-percent, then all of the
members of our panel would choose the ASC over the regular credit. In
that case the differences between having only an ASC with a minimum
base and having both credits with minimum bases would be negligible. As
explained earlier, those differences are due to the possibility that
taxpayers could choose the regular credit in future years.
[33] Treas. Reg. Section 1.41-4(a)(3)
[34] See appendix IV for summaries of these and other issues relating
to the definition of QREs.
[35] If the software is used in another activity that constitutes
qualified research, or in a production process that meets the
requirements of the credit, then it is not considered IUS.
[36] The practitioners say that this practice runs counter to
congressional guidance provided in the conference report to accompany
the Tax Relief Extension Act of 1999 Pub. L. No. 106-170 (H.R. Conf.
Rep. No. 106-478, 106th Cong. at 132 (1999)). IRS officials respond by
noting that the report said only that software research should not be
deemed IUS solely because the business component involves the provision
of a service. The development activity still must satisfy the other
qualification criteria of Section 41.
[37] The notice of proposed rulemaking 66 FR 66362 (proposed December
26, 2001) stated that: "Unless computer software is developed to be
commercially sold, leased, licensed or otherwise marketed for
separately stated consideration to unrelated third parties, it is
presumed to be developed by (or for the benefit of) the taxpayer
primarily for the taxpayer's internal use." Financial services and
telecommunications companies are concerned with such a test. They note
that their software systems are integrally related to the provision of
services to their customers, yet expenditures to develop those systems
would not qualify for the credit (unless they met the additional set of
standards) under the "separately stated consideration" standard because
they do not charge customers specifically for the use of the software.
[38] Treas. Reg. Section 1.174-2(a).
[39] 26 U.S.C. Section 174(c) and 26 U.S.C. Section 41(b)(1)(C)(ii).
[40] In fact, some prototypes that are used in qualified research are
subsequently sold to customers who then claim depreciation allowances
for them.
[41] One example of a self-constructed supply is a chemical that a
business produces itself and then uses in a research project. The
taxpayer is not permitted to include overhead or administrative costs
attributable to the production of that chemical as QREs. However, if
the taxpayer had purchased the chemical from a third party, such costs
would have been included in the purchase price and could, thereby, be
included in QREs.
[42] TG Missouri Corporation v. Commissioner, Docket Number 8333-06 Tax
Court.
[43] The American Jobs Creation Act of 2004, Pub. L. No 108-357 (2004),
provided a temporary incentive under IRC section 965 for U.S.
corporations to repatriate certain income from foreign affiliates
during either the recipient's last tax year beginning before October
22, 2004, or its first tax year beginning after that date, provided
that the repatriated income was used for qualified purposes.
[44] See appendix V for a summary of the differing legal
interpretations made by IRS and taxpayers, as well as for a more
detailed discussion of the consequences of adopting alternative
definitions of gross receipts.
[45] Large businesses often have cost centers, which are separately
identified units (such as research, engineering, manufacturing and
marketing departments) in which costs can be segregated and the manager
of the center is responsible for all of its expenses. Project
accounting is the practice of creating reports that track the financial
status of specific projects, the cost of which are often incurred
across multiple organizational units. Many firms rely on third-party
consultants to conduct studies that bridge their cost-center accounting
of research expenses to project-based accounting that is acceptable to
IRS. IRS and practitioners often refer to this attempt to bridge the
two accounting approaches as the "hybrid" approach.
[46] IRS uses the term credit claims specifically in reference to
claims made after initial returns are filed.
[47] See appendix VI for further discussion.
[48] Our analysis of 2005 tax data from SOI suggests that about 25
percent of all regular credit users had fixed base percentages of 16
percent or were subject to the minimum base constraint and would remain
subject to that constraint even if they elected to use a fixed base
percentage of 16 percent. Those taxpayers would benefit from this
recordkeeping relief.
[49] Treas. Reg. Section 1.41-8(b) (2) and Temp. Treas. Reg. Section
1.41-8T(b) (2).
[50] In the case Pacific National Co. v. Welch, 304 U.S. 191 (1938) the
Supreme Court held that the taxpayer had made a binding election and
reasoned that a change from one method of accounting for payments to
another would require recomputation and readjustment of tax liability
for subsequent years and impose burdensome uncertainties upon the
administration of the revenue laws.
[51] One practitioner who works primarily with mid-sized businesses,
including many S-corporations, noted that the latter are heavily
affected by these rules. A second practitioner who also works primarily
with S-corporations said that between 10 and 15 percent of their
clients are affected by these rules. A practitioner that works
primarily with very large corporations said that about 20 percent of
their clients are affected by the rules.
[52] Under the gross QRE approach, the group's research credit amount
is allocated among the members in proportion to their share of the
group's aggregate QREs.
[53] See appendix VII for a comparison of the marginal incentives
provided by the stand-alone credit and gross QRE allocation methods, as
well as for a discussion of other issues pertaining to the group credit
rules.
[54] Each credit status can be associated with a specific range of
values for the ratio. For example, the taxpayer would be able to earn a
credit but would be subject to a 50-percent minimum base if its ratio
of current to base spending was any value greater than or equal to two.
[55] The 13 percent rate of credit reflects the 20-percent statutory
rate and the offset against the section 174 deduction.
[56] See S. Rep. No. 99-313 (1986), pp. 694-95
[57] In order to meet the section 174 test, the expenditure must (1) be
incurred in connection with the taxpayer's trade or business, and (2)
represent a research and development cost in the experimental or
laboratory sense. Expenditures represent research and development costs
in the experimental or laboratory sense if they are for activities
intended to discover information that would eliminate uncertainty
concerning the development or improvement of a product. Uncertainty
exists if the information available to the taxpayer does not establish
the capability or method for developing or improving the product or the
appropriate design of the product. Whether expenditures qualify as
research or experimental expenditures depends on the nature of the
activity to which the expenditures relate, not the nature of the
product or improvement being developed or the level of technological
advancement the product or improvement represents. See Treas. Reg.
Section 1.174-2(a)(1). Expenditures for land and depreciable property
are not allowed under section 174, although in certain cases,
depreciation may be treated as a section 174 expense. (Depreciation is
not a qualified research expenditure (QRE) under section 41).
[58] Treas. Reg. Section 1.41-4.
[59] 26 U.S.C. Section 41(d)(4).
[60] Treasury has yet to issue final regulations regarding internal-use
software. See further discussion below.
[61] T.D. 8930, 66 Fed. Reg. 280 (2001) (TD 8930).
[62] T.D. 9104, 66 Fed. Reg. 22-01 (T.D.9104). In United States v.
McFerrin, 570 F. 3d. 672 (5TH Cir. 2009), the Court of Appeals held
that the IRS inappropriately applied the discovery test. In Union
Carbide Corp. et. al. v. Commissioner, T.C. Memo 2009-50, the Tax Court
applied the eliminate uncertainty test instead of the discovery
standard.
[63] Treas. Reg. Section 1.41-4(a)(3).
[64] Treas. Reg. Section 1.174-2(a).
[65] The consultant shared a redacted excerpt from IRS's audit summary
for a client in which the examiner referred to the taxpayer's software
testing, including regression testing, functional testing, security
testing, and stress testing as "routine" and "run-of-the-mill" and
concluded that such testing is generally not a qualifying process of
experimentation activity.
[66] Pub. L. No. 99-514 (1986).
[67] TD 8930, 66 Fed. Reg. 280 (2001) (TD 8930).
[68] Software used to provide noncomputer services was excepted from
the additional three-part test if that software, among other things,
contained features or improvements not yet offered by a taxpayer's
competitors.
[69] 66 Fed. Reg. 66362 (Proposed Regulations).
[70] Pub. L. No. 106-170 (1999).
[71] H.R. Conf. Rep. No. 106-478, at 132 (1999).
[72] 69 Fed. Reg. 43.
[73] See FEDEX Corp. et. al. v. United States, No 08-2423 (W.D. Tenn.
June 9, 2009) where a federal district court ruled there was an
inconsistency in the government's guidance.
[74] Treas. Reg. Section 1-41-2(c).
[75] Treas. Reg. Section 1.41-4(c)(2).
[76] T.D. 9104.
[77] 26 U.S.C. Section 174(c) and 26 U.S.C. Section 41(b)(1)(C)(ii).
[78] In fact, some prototypes that are used in qualified research are
subsequently sold to customers who then claim depreciation allowances
for them.
[79] One example of a self-constructed supply is a chemical that a
business produces itself and then uses in a research project. IRS's
position is that the taxpayer is not permitted to include overhead or
administrative costs attributable to the production of that chemical as
QREs. However, if the taxpayer had purchased the chemical from a third
party, such costs would have been included in the purchase price and
could, thereby, be included in QREs.
[80] TG Missouri Corporation v. Commissioner, Docket Number 8333-06 Tax
Court.
[81] H. Conf. Rep. No. 101-247 (1989).
[82] Pub. L. No. 101-508 (1989).
[83] TD 8930, 66 Fed. Reg. 280 (2001) (TD 8930).
[84] FIN 48, Accounting for Uncertainty in Income Taxes, is guidance
provided by the Financial Accounting Standards Board that standardizes
accounting for uncertain tax benefits and requires companies to
disclose their tax reserve amounts.
[85] CCA 200233011 (5/1/2002).
[86] CCA 200620023 (2/14/2006).
[87] When a taxpayer that is subject to the 50-percent base constraint
increases its current-year spending by $1, its base QREs increase by 50
cents and its credit increases by 10 cents (which equals 0.2 × ($1
minus 50 cents)). When a taxpayer that is not subject to that
constraint increases its current-year spending by $1, its credit
increases by 20 cents.
[88] Many U.S. manufacturers that export their products do so through
foreign affiliates, rather than directly to foreign third parties.
[89] 26 U.S.C. Section 6001.
[90] Treas. Reg. Section 1.6001.
[91] The Small Business and Work Opportunity Tax Act of 2007, Pub.L.
No. 110-28 (2007) provided IRS with the authority to impose a penalty
on any taxpayer that claimed an excessive amount of refund or credit,
unless the taxpayer can show that the claim has a reasonable basis. The
penalty equals 20 percent of the excessive portion of the claim
(defined as the amount not allowable under law). The penalty does not
apply to earned income credit claims. See 26 U.S.C. Section 6676(a).
[92] In two decisions earlier this year (a Tax Court opinion in Union
Carbide Corp. v. Commissioner, T.C. Memo 2009-50, and a Fifth Circuit
appellate decision in United States v. McFerrin, 570 F. 3d. 672(5TH
Cir. 2009)) courts referred to an earlier ruling in Cohan v.
Commissioner, 39 F. 3d. 540 (1930) in supporting taxpayers' use of
testimony and other evidence in estimating their credits. IRS
recognizes that under the Cohan rule the courts may estimate the
allowable amount of credit, but only if two conditions are met: (1) the
taxpayer has demonstrated that it has engaged in qualified research but
does not have sufficient records to document the amount of QREs and (2)
there is sufficient credible evidence to provide a basis for making an
estimate.
[93] Credit for Increasing Research Activities (i.e. Research Tax
Credit) Audit Technique Guide (ATG) (June 2005) and Research Credit
Claims Audit Techniques Guide (RCCATG): for Increasing Research
Activities Section 41 (LMSB-04-0508-030) (May 2008).
[94] Issues relating to the sufficiency of taxpayers' support for their
claims are discussed in a separate section covering recordkeeping and
substantiation.
[95] 26 U.S.C. Section 39(a). Any unused credits after the last year of
the 20-year carryforward period may be taken as a deduction in the tax
year following the last tax year of the 20-year carryforward period.
[96] These taxpayers simply include the new amount of research credit
from the earlier year in the amount on line on IRS Form 3800 (General
Business Credit), which shows the total amount of all types of credits
carried forward from any earlier years. This practice is applicable to
all credits included under the general business credit, not just the
research credit.
[97] Practicing before IRS essentially means communicating with the IRS
on behalf of a taxpayer or otherwise representing a taxpayer's
interests to IRS.
[98] Treas. Reg. Section 1.41-4, TD 9104, 69 Fed. Reg. 22
[99] IRS Notice 2001-19, 2001-10, 66 Fed. Reg. 66362.
[100] However, as explained in the section on the allocation of credits
among members of controlled groups, current regulations require all
members to compute (and substantiate) amounts they would earn under the
regular credit, even if the group elects to use the ASC.
[101] No changes that IRS may make to base period spending amounts
could ever raise a taxpayer's fixed base percentage above the maximum
of 16 percent.
[102] The certainty stratum actually consists of the stratum of a
stratified sample in which cases are sampled at a 100 percent rate,
plus the stratum in which cases are sampled at an 80 percent rate.
[103] Joint Committee on Taxation, General Explanation of the Economic
Recovery Tax Act of 1981 (JCS-71-81), December 29, 1981.
[104] The definition of a "controlled group of corporations" for
purposes of the credit has the same meaning as used in determining a
parent-subsidiary controlled group of corporations for the consolidated
return rules except the aggregate rule is broader substituting
corporations that are greater than 50 percent owned for 80 percent
owned corporations. The aggregation rules also apply to trades or
businesses under common control. A trade or business is defined as a
sole proprietorship, a partnership, a trust or estate or a corporation
that is carrying on a trade or business.
[105] Treas. Reg. Section 1-46-6.
[106] A consolidated group of corporations is one in which all members
(each of which must be at least 80 percent owned (vote and value) by
the group) file a federal income tax return as one taxpayer.
[107] See the technical addendum for a description of selected
situations in which each method is superior.
[108] Taxpayers are not required to show the computations of their
members' stand-alone credits on their tax returns. Each group member
reports the group's total QREs and base QREs on its tax return;
therefore, data on the spending of individual members are not
available.
[109] The mrm equals 0.2 if the member can earn the regular credit
without being subject to the 50-percent base limitation; it equals .1
if the member is subject to that limitation. The mrg is also either 0.2
or 0.1, depending on whether the group is subject to the 50-percent
limit. The formulas in this appendix ignore the 35 percent reduction in
the credit benefit due to the offset against the section 174 deduction.
(This offset would simply reduce all of the marginal effective rates we
compute by the same proportion with no effect on the comparison we make
across allocation methods.) The formulas also ignore delays in credit
benefits due to the insufficiency of tax liabilities. (We assume that
each taxpayer's tax liability status would be the same under either
allocation method, so taking credit carryforwards into account would
not change the ranking of the two methods' marginal incentives.)
[110] When the member increases its QREs by $1 its stand-alone credit
increases by mrm, the sum of the group members' stand-alone credit
increases by mrm, and the group's credit increases by mrg.
[111] This share is determined as [(ISAC + mrm)/(ISUMSAC + mrm)] ×
(ISUMSAC + mrm) - (ISAC/ISUMSAC) × ISUMSAC. All of the terms in this
expression cancel out, except for mrm.
[112] The share of the stand-alone sum is used to allocate that portion
of the group credit that is less than or equal to the sum of the stand-
alone credits; the share of QREs is used to allocate the portion (if
any) of the group credit that exceeds the sum of the stand-alone
credits.
[113] When the member increases its QREs by $1 the sum of the group
members' QREs also increases by $1, and the group's credit increases by
mrg.
[114] The $1 increase this year increases next year's base for the
member's stand-alone credit by 1/6 of a dollar. (This year is only one
of the 3 years that factor into next year's base and only half of each
year's spending goes into that base.) That base increase reduces next
year's credit by 1/6 × 0.14 and that reduction also gets reflected in
the sum of the members' credits.
[115] There is also the more obvious case where the gross QRE method
provides a higher incentive when the group earns a credit but the
individual member cannot exceed its own base under either credit
computation method. The statements regarding the ASC in table 20 assume
that the credit is extended in its current form for future years.
[End of section]
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