Texas Final Regulations May Trigger Adjustments to Franchise Tax Returns From 2014 Onward
The Texas Comptroller of Public Accounts on October 15, 2021 issued final regulations to title 34 of the Texas Administrative Code (TAC) §3.340, applicable to sales and use taxes, and §3.599, applicable to the Texas franchise tax. The amended TAC §3.599 contains substantial modifications to the Texas research and development (R&D) activities credit, which apply retroactively to Texas franchise tax reports originally due on or after January 1, 2014. This alert examines the salient changes to the Texas R&D credit under TAC §3.599 and the potential impacts to taxpayers.
IRC and Treasury Regulations Conformity Date
For purposes of the Texas R&D credit, TAC §3.599 conforms to the IRC effective as of December 31, 2011, thus excluding any modifications to the federal statute effective after that date. The Texas R&D credit also generally conforms to the federal Treasury Regulations effective as of December 31, 2011; however, Treasury Regulations effective after that date are applicable to the Texas R&D credit to the extent the federal regulation was mandatory for the 2011 federal income tax year.
By limiting state conformity to the 2011 IRC and, generally, the 2011 Treasury Regulations issued thereunder, Texas taxpayers are effectively limited to outdated federal guidance without subsequent clarifications that were issued on important matters such as the treatment of internal use software, pilot models and prototype research activities.
The Federal Four-Part Test
The amended rules generally conform the Texas definition of “qualified research” to the definition provided under IRC Section 41(d), except that all qualified research activities must be conducted in Texas. IRC Section 41(d) enumerates the federal “four-part test” as applicable to each “business component,” which is defined as a “product, process, computer software, technique, formula, or invention.”
However, Texas diverges from federal law by providing two important exclusions from the definition of “business component” that may be authorized for inclusion in the federal R&D credit. Specifically, the Texas regulations now exclude from qualification:
- Designs - Expenses incurred in resolving uncertainty as to the appropriate design of a business component will not qualify for inclusion in the Texas R&D credit. The Comptroller emphasizes that the design of a structure or the associated blueprints used for contribution are not business components (therefore, the expenses undertaken to produce those designs do not meet the requirements of qualified expenses), however, the structure itself may be.
This amendment may have significant impact to architecture, engineering or construction companies seeking to claim the Texas R&D credit.
- Services - Expenses incurred in providing services to customers do not qualify for the Texas R&D credit. However, the regulations clarify that a business component “used by a taxable entity to provide services to its customers” may still qualify for inclusion in the Texas R&D credit.
Additionally, the final Texas regulations provide that expenses incurred in performing non-experimental methods, such as simple trial and error, brainstorming or reverse engineering, will not qualify for inclusion in the Texas R&D credit. The Comptroller outlines factors that may be considered in determining whether a trial-and-error methodology is experimental, systematic trial and error (expenses for which may qualify for inclusion in the state credit), or non-experimental simple trial and error. These factors include the following:
- Whether the person conducting the trial-and-error methodology stops testing when a result is identified or continues to find alternative acceptable results;
- Whether all results are recorded for evaluation; and
- Whether there are written procedures for conducting and evaluating the results of the trial-and-error methodology.
These amendments do not conform to the current federal regulations and may be interpreted to require a taxpayer to continue testing after an acceptable result has been obtained in order to claim the expenses for Texas R&D credit purposes. However, the Comptroller commits in the preamble to the regulations that it “was not the intent” of the regulations to mandate the evaluation of multiple alternatives “because such a requirement is not required by the IRC.” These conflicting provisions may create confusion as to which standard has to be met to be considered an eligible process of experimentation.
Non-Qualified Activities
The amended Texas regulations provide a list of research activities that are excluded from qualification, many of which mirror the federal Treasury regulations. However, Texas deviates significantly from federal guidance on funded research and internal use software development, as follows:
Funded Research
In general, “funded research” The adopted rules define non-qualified “funded research” as research funded by any grant, contract or otherwise by another person or governmental entity when: (1) the taxpayer does not retain substantial rights to the research or (2) when payments to the taxpayer are not contingent upon the success of the research. The Comptroller clarifies that if a taxpayer-researcher retains substantial rights to its funded research, but its payment for the research is not contingent upon the success of the research, the taxpayer-researcher may only include in its Texas R&D credit expenses incurred in excess of the payment it earns for performing the research. For example, if a taxpayer earns a non-contingent $100 payment for performing research on behalf of a third party, but incurs $110 in expenses for performing the contract research, the net $10 expenses in excess of the payment qualifies for inclusion in the taxpayer’s Texas R&D credit.
This “contingent-upon-success” standard does not conform to federal rules and is intended to prevent multiple taxpayers from claiming R&D expenses incurred under a research contract.
Additionally, the Comptroller clarified its position that combined groups with any qualified research expenses under higher education contracts are allowed to claim the credit at a 6.25% rate at the combined group level even if not all of the qualified research expenses relate to higher education contracts.
Software Development
The Texas R&D credit rules exclude any software that will not be commercially sold, leased, licensed or otherwise marketed to unrelated third parties. Based on this distinction within the amended regulations, the Comptroller has indicated that internal use software development research activities do not meet the requirements under Texas law.
The Comptroller provides several examples of software development activities that are “likely to qualify” which include (1) development of an initial release of a new application using new constructs; (2) system software such as operating systems and compilers; (3) specialized technologies such as image processing, artificial intelligence or speech recognition; and (4) software as part of a hardware product where the software interacts with the hardware to make the package function as a unit.
However, the adopted rules also include examples of what is deemed “unlikely” to qualify in Texas. The extensive list was adapted from an IRS Audit Guidelines document from 2005 but, rather than assessing the risk level on which the federal guidelines are based, the Comptroller simply provides the activities are “not likely” to qualify. One notable example from the adopted rules references software development activities aimed at developing a business component that is substantially similar in technology, functionality and features to the capabilities already in existence at other companies. This may be read as a troubling reincarnation of the “discovery test,” which has been eliminated from federal mandate.
Excluded Supply Costs for Manufacturing Product or Process Development
The final regulations exclude from qualification any expenses a taxpayer incurs in purchasing tangible personal property on which it has not paid sales or use tax due to an exemption. The rule effectively requires taxpayers to elect either a sales and use tax exemption or an R&D credit for any eligible supplies or materials.
Documentation Requirements
Pursuant to the amended regulations, a taxpayer reporting a Texas R&D credit must maintain contemporaneous business records that establish “clear and convincing” evidence that its research activities meet the state’s definition of qualified research. This may be read as a significantly higher standard as compared to the federal mandate, which encourages reporting taxpayers to retain contemporaneous business records that establish qualification by maintaining documents “in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.”
Combined Reporting Requirements and Carryforward Rules
The final regulations require a combined group to calculate its Texas R&D credit based on the total qualified research expenditures of each member of the combined group. However, if there is a change in membership of the combined group that results in a new taxable entity, the new taxable entity may not carryforward the Texas R&D credits of the former combined group.
The amended regulations permit the Comptroller to review credit carryforwards by verifying qualified research activities for all years that the resulting credit that created the carryforward was based. This change could pose significant administrative challenges to taxpayers to maintain records beyond the statute of limitations. The verification, however, will not result in adjustments to tax, penalty or interest for any years which the statute of limitations has expired.
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