Consider the Research Tax Credit in M
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From-SaveMoneyGuides.com-Congress is considering several proposals to extend the federal research and experimentation (”R&E”) tax credit or to make it permanent. The R&E tax credit has provided and, if extended or made permanent, will continue to provide taxpayers with a significant incentive to perform domestic research and development activities.
Like most government incentives, the R&E tax credit is subject to a complicated set of mechanical rules. These rules are notably different from those for many other tax incentives. These rules can catch taxpayers off guard. This is especially true for taxpayers that have acquired or are planning to acquire a business.
Learning the Lingo
The R&E tax credit rewards taxpayers who increase research spending. The Code provides a formula for determining whether research spending has increased.
Research spending can include wages, supplies, payments for contractors, and certain computer rental costs. These costs are referred to as qualified research expenses (”QREs”). The R&E tax credit formula compares the aggregate of the taxpayer’s QREs for the current year divided by the average gross receipts for the prior four years to similar information for a specific base period. The base period information is referred to as the taxpayer’s fixed-base percentage.
Here is an example. Assume that a taxpayer’s business includes a team that designs custom parts to sell to customers. Also, assume that the design team is comprised of twenty employees. The annual wages paid to these employees could exceed half a million dollars. These wages would likely constitute QREs. The taxpayer’s supply and contractor QREs could be even greater than the taxpayer’s wage QREs, raising the taxpayer’s total QREs to over a million dollars. Assuming a reasonable fixed-base percentage, the taxpayer’s R&E tax credit could amount to several hundred thousand dollars each year. A poorly conceived or structured acquisition could reduce this amount to a few thousand dollars, or it could eliminate the credit altogether.
Assessing the Attributes
An acquisition has the potential to increase the buyer’s current year and base period QREs and gross receipts. The acquisition could also decrease these amounts for the seller.
The Code makes it clear that a buyer must include QREs and gross receipts that are attributable to the target in computing its R&E tax credit for the year following an acquisition. [Code. Sec. 41(f)(3)(A).] The Code also provides that a seller that disposes of a business can make corresponding reductions in its QREs and gross receipts for its taxtrouble.com/written_tax_opinions.php”>R&E tax credit in the year following the disposition if certain requirements are met. [Code. Sec. 41(f)(3)(B).]
Given the formula for calculating the R&E tax credit, a taxpayer’s R&E tax credit is generally larger if it has a high amount of current year QREs and low gross receipts for the prior four years, coupled with a low fixed-base percentage. Thus, the buyer’s future R&E tax credits would be reduced if the target has low current year QREs and high gross receipts, coupled with a high fixed-base percentage. Similarly, the seller’s future R&E tax credits would be reduced if it only retained portions or separate units of its business that have these characteristics. This axiom alone can be of benefit when planning acquisitions.
In conducting their due diligence for an acquisition, buyers and sellers may not realize that they need to examine the R&E tax credit calculation for the buyer and seller to determine how the acquisition will impact their future R&E tax credits. Buyers and sellers may not even understand what transactions constitute acquisitions for purposes of the R&E tax credit.
Avoiding the Accidental Acquisitions
tax advisers are used to thinking of acquisitions using Subchapter C principles. This is where a little M&A knowledge can be dangerous, as the R&E tax credit takes a different approach.
For the R&E tax credit, “acquisition” refers to the purchase of a major portion of a trade or business or a major portion of a separate unit of a trade or business. The term “major portion of a trade or business” has not been defined. Instead, the implementing regulations direct readers to the regulations for the new jobs credit. [Treas. Reg. ? 1.41-7(b).]
The new jobs credit regulations provide that all of the facts and circumstances surrounding the transaction are to be considered in determining whether a major portion of a trade or business has been acquired. The new jobs credit regulations, the following factors are particularly relevant:
- The fair market value of the assets in the portion relative to the fair market value of the other assets of the trade or business,
- The proportion of goodwill attributable to the portion of the trade or business,
- The proportion of the number of employees attributable to the portion of the trade or business in the periods immediately preceding the transaction, and
- The proportion of the sales or gross receipts, net income, and budget of the trade or business attributable to the portion of the trade or business. [See Treas. Reg. ? 1.52-2(b)(3).]
For purposes of the new jobs credit, a “separate unit of a trade or business” is loosely defined as a segment of a trade or business that is capable of operating as a self-sustaining enterprise with minor adjustments. The regulations add that an allocation of a portion of the goodwill of a trade or business to one of its segments is a strong indication that the segment is a separate unit.
Given these rules, the purchase of a single asset - such as a lease or a patent - can constitute a major portion of a trade or business. That means it can be an acquisition for purposes of the R&E tax credit. Even assets that do not form a self-sustaining business can constitute a separate unit of major portion of a trade or business, which in turn can be considered an acquisition for purposes of the R&E tax credit.
Buyers and sellers may not view these types of transactions as acquisitions in the normal sense. That means they may well be unaware that these transactions can impact their R&E tax credits. They may also be unaware of how the acquisition will impact their R&E tax credit base period.
Breaking the Base Periods
The R&E tax credit compares the taxpayer’s current year research spending to a base period to determine the amount of the increase in the taxpayer’s research spending. The R&E tax credit provides for two types of base periods, namely historic and start-up base periods.
taxpayers that have a historic base period are those that (1) had at least one dollar of QREs and gross receipts prior to 1984 or (2) had at least one dollar of QREs and gross receipts for at least three years between 1984 through 1988. These taxpayers are required to use 1984 through 1988 as their base period. All other taxpayers must use the ten-year start-up base period, which begins in the year in which the taxpayer first had QREs and gross receipts.
A buyer that uses the start-up base period must use the historic base period if it acquires a business that is required to use the historic base period. Conversely, a seller that uses the historic base period must use the start-up base period if it disposes of the portion of its assets that qualified it to use the historic base period.
This type of base period change can reduce or even eliminate the buyer’s or seller’s R&E tax credits. In performing their due diligence, buyers and sellers may overlook this issue as well. Buyers and sellers that miss this issue will probably overlook the R&E tax credit aggregation rules.
Aggregating the Aggravations
A taxpayer which is a member of a controlled group of corporations is required to aggregate the QREs of the group in determining its R&E tax credits. The group’s R&E tax credit is then allocated to the group members based on the members’ QREs.
A “controlled group of corporations” is one that is identified in Subsection (a) of Code Sec. 1563. The R&E tax credit statute specifies that the normal eighty percent ownership rules in Code Sec. 1563 are reduced to fifty percent for purposes of determining the taxpayer’s R&E tax credit.
Here again is a potential trap. Many buyers and sellers may not know that a business that does not meet the normal eighty percent ownership rules - whether it is the buyer’s or seller’s group - could impact the buyer’s (and possibly the seller’s) R&E tax credits. This trap can be even more dangerous when businesses are treated as members of the corporate group for purposes of the R&E tax credit, but not members of the group for purposes of the consolidated tax return rules.
If the fifty percent ownership rules are satisfied, these rules can make it nearly impossible to determine the impact of an acquisition on the buyer’s (and possibly the seller’s) R&E tax credits. Even if the buyer and seller recognize the need to examine these issues, they may not be able to determine the full impact of the acquisition on their R&E tax credits. Even then, the buyer and seller may fail to obtain sufficient documentation to substantiate their R&E tax credits after the acquisition.
Digging Up the Documents
While there is no heightened recordkeeping requirement for R&E tax credits, the IRS takes the position that taxpayers who cannot fully substantiate their QREs and gross receipts for all of their trades and businesses are not entitled to any R&E tax credit. This draconian maxim bears repeating. No “full substantiation” can mean no credit.
This can be particularly troubling for buyers that acquire assets. Most asset purchase agreements do not provide that the buyer is acquiring the seller’s business records.
Moreover, even if the deal documents do specify that the buyer is acquiring the seller’s business records, the seller may not have developed or retained the records that are necessary to substantiate R&E tax credits. IRS standards for full substantiation are high. Meeting them can be especially tough for historic companies that would need to provide business records from the late 1980s.
Very few buyers or sellers go back and gather these records, even though acquiring a business that does not have sufficient business records - whether through an asset or stock purchase - will decrease the buyer’s (and possibly the seller’s) future R&E tax credits. Even if the taxpayer has the necessary records, the IRS has other avenues for reducing or denying R&E tax credits.
Avoiding the Avoidance Limitations
While the taxpayer’s post-acquisition R&E tax credits generally do not fall within the reach of Code Sec. 383 (because Code Section 383 only deals with the target’s pre-acquisition credits), they may fall within the reach of Code Sec. 269 if the acquisition involved the sale of stock.
Section 269 may not be regarded as having very sharp teeth, but its overhang of influence bears noting, particularly in this area. When any person acquires control of a corporation or when any corporation acquires property of another corporation, Code Sec. 269 gives the IRS the authority to disallow any credit that has a carryover tax basis if the principal purpose of the acquisition was the evasion or avoidance of federal income tax.
It is not clear whether the IRS would be able to successfully invoke Code Sec. 269 to disallow or limit a buyer’s R&E tax credit. After all, the R&E tax credit statute expressly requires the buyer to account for the target’s QREs and gross receipts. Maybe these specific rules trump Code Sec. 269. However, historically the IRS has trotted out Code Sec. 269 along with other rules (such as Code Sec. 382) that impose more quantifiable and express limitations. So it seems more than conceivable that the acquisition of a business that increase the buyer’s R&E tax credits will increase the chances that the IRS will try to impose this limitation.
Doing the Due Diligence
If the buyer and seller have claimed R&E tax credits in the past, some of the information that the parties need to consider should be available on the parties’ Forms 6765 that they filed with their federal income tax returns. However, in most cases the parties need to request and review additional information. For example, the buyer and seller may need additional information to determine how to allocate the target’s QREs and gross receipts between the buyer and seller if the acquisition involves the purchase of a portion or unit of the seller’s business.
If the buyer or the seller have not claimed R&E tax credits in the past, the parties may need to perform the calculations for either or both of the parties from scratch as part of the due diligence process for the acquisition. Buyers and sellers should not assume that the other party does not qualify for the R&E tax credit just because they did not claim an R&E tax credit in any one year. Many taxpayers do not claim R&E tax credits because they are not aware that they qualify for the credits, they do not expect to have a sufficiently large tax liability to use the credits to offset, or they feel the R&E tax credit is too complicated. Even if no previous R&E tax credit was claimed, these acquisitions can still impact the buyer’s and seller’s future R&E tax credits.
Conclusion
The buyer’s and seller’s post-transaction R&E tax credits are often overlooked in the acquisition process. A little pre-acquisition planning can go a long way in preserving the taxpayer’s R&E tax credits. This type of planning can also increase the taxpayer’s post-acquisition R&E tax credits.
