Iowa Enacts Substantial Changes To State’s Research Credit
Iowa Enacts Substantial Changes To State’s Research CreditIowa Governor Kim Reynolds on March 1, 2022, signed House File 2317 (HF 2317) into law. In addition to lowering individual and corporate tax rates, the new law contains revenue-raising measures that significantly modify existing tax credits, most notably the state’s research activities credit.
HF 2317 eliminates the option for certain taxpayers to elect to use the alternative simplified credit method, limits the amount of research activity credit that can be refunded, phases out certain qualified research expenditures and places additional limitations on claiming the credit on amended returns.
Background on Iowa Research Activities CreditCompanies with qualified research activity occurring in Iowa are eligible to receive the Iowa research activities credit in addition to the federal research tax credit. The definitions for eligible expenses, like wages, supplies and outside research are the same under Iowa law as under Section 41 of the Internal Revenue Code.
Iowa allows a refundable research activities credit equal to 6.5% of Iowa’s apportioned share of qualifying expenditures for increasing research activities that exceed the larger of a base amount or 50% of qualifying research expenditures. Taxpayers also can elect to calculate their research activities credit using the federal alternative simplified credit method, which is equal to 4.55% of expenditures occurring in Iowa that exceed 50% of the average of the prior three-year qualified research expenses.
The research activities credit cannot be carried forward and is available only to businesses conducting qualified research within the manufacturing, life sciences, agriscience, software engineering, aviation or aerospace industries.
Before the changes under HF 2317, Iowa taxpayers could elect to use this method regardless of the method they used for federal income tax purposes. Additionally, before the changes under HF 2317, the research activities credit was fully refundable after a company’s tax liabilities were met.
Changes to Take Effect in 2023HF 2317 enacts the following changes to the research activities credit, which, on balance, will have the effect of limiting the amount of credit available on 2024 state returns and onwards, as these changes generally take effect for tax years beginning on or after January 1, 2023.
Alternative Simplified Credit Computation Election UpdateFor tax years that begin in 2023 and onwards, Iowa taxpayers that elected or were required to use the alternative simplified credit for federal tax purposes must also use this method for their state tax calculation for the same tax year.
Reduced RefundHF 2317 places new limits on the amount of credit that can be refunded. Starting in 2023, the refundable portion of the credit exceeding a taxpayer’s liabilities will be reduced incrementally over five years by 10% each year. Specifically, the refundable amount will drop to 90% of excess credit in 2023, 80% in 2024, 70% in 2025, 60% in 2026 and 50% in 2027 and onwards. Alternatively, a taxpayer claiming a refund may elect to have the overpayment otherwise eligible for a refund credited to the following year’s tax liability. HF 2317 does not allow taxpayers to carry forward the unused portion of their refundable credits.
Limitations on Qualified Research ExpensesPayments for supplies will also be phased out from inclusion as qualified research expenses incrementally over five years, starting in 2023. The phaseout schedule is as follows: qualified supply expenses will be limited to 80% of the supply expenses actually incurred in 2023, 60% in 2024, 40% in 2025 and 20% in 2026. For tax years beginning on or after January 1, 2027, payments for supplies will no longer be eligible to be included in the qualified research expenses calculation.
HF 2317 further limits qualified research expenses by removing the “substantially all” rules described in IRC Sec. 41(b)(2)(B). Generally, substantially all of a taxpayer’s research activities with respect to a business component must constitute elements of a process of experimentation. For federal purposes, if 80% or more of the taxpayer’s research activities constitute a process of experimentation, the taxpayer has met the “substantially all” rule. However, Iowa’s research activities credit seemingly requires that 100% of a taxpayer’s research activities constitute a process of experimentation.
HF 2317 also disallows the inclusion of computer lease or rental costs as described in IRC Sec. 41(b)(2)(A)(iii), which are commonly claimed as part of federal research activities credits.