Companies are Benefiting from the IRS’s Guidance on Section 41 Research Credit Expenses

December 2018

Summary

September 2017, the IRS released a Directive (LB&I-04-0917-005) providing Large Business & International (LB&I) Division taxpayers the option of applying a “safe harbor” to determine certain expenses that are included under the Internal Revenue Code Section 41 research credit (Research Credit). The guidance set forth that qualified research expenses (QREs) will not be challenged by the IRS if certain requirements are followed. Recognizing that determining the amount of Research Credits claimed by LB&I taxpayers and later examined by auditors imposes a significant burden on both parties, the IRS released this Directive with the intent to provide an efficient way to determine QREs.

Eligible companies in any industry can choose to follow this Directive. Now that taxpayers have had some time to review the Directive and evaluate its approach, most have found it to be beneficial.
 

Details

The Directive’s stated purpose is being realized by companies that have benefited from a more efficient approach to determining the amount of their QREs. Some taxpayers have found that although the implementation and integration of the processes to capture these expenses have taken time and resources up front, by following the Directive, their processes and workflow will be simplified going forward. By doing so, some taxpayers have found that not only will they lessen the time committed by technical and other employees to quantify and identify qualified activities by streamlining their methodology of capturing QREs, but it has also resulted in an increase in the amount of QREs themselves.

Companies following the U.S. generally accepted accounting principles (GAAP) that are required to evaluate and disclose income tax risks for financial statement recognition under ASC 740-10 are also benefiting. When claiming the Research Credit, a company assesses the amount of the benefit that is more likely than not to be sustained and books a reserve for the amount that does not meet that threshold. By applying the safe harbor, companies can lower their reserves considering that the IRS will not challenge certain QREs, and thus have a higher likelihood of being sustained than in the past.

Companies have historically identified the burden of documentation to support Research Credits as one of the reasons why they choose not to claim them. Treasury Regulations Section 1.41-4(d) states that a taxpayer “must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.” While there is no specific documentation required to claim Research Credits, this requirement has generally included technical documentation such as design requirements, design drawings, test plans, and the like that support the claimed expenses and activities of a company. For some companies that do not create contemporaneous documentation, be it that they are a fast-paced technology startup without formal documentation or a mature company with processes in place that don’t require employees to document their activities, the fear of having to produce these technical documents has deterred them from claiming credits in the past.

The Directive can ease this burden, by providing examples of documentation to be retained and by shifting a focus from technical to financial documentation. The Directive requires taxpayers to make available upon request the “underlying books and records” that support the amounts claimed as part of the safe harbor. These include certified audited financial statements, chart of accounts, GL detail, etc. that were used in determining QREs. Although not an exhaustive list, taxpayers at the very least can maintain these forms of documentation with confidence to substantiate their Research Credits.
 

BDO Insight

Companies that have yet to determine whether following the Directive is advantageous for them should engage in a meaningful exercise of evaluating its potential impact to their credit claims. Companies can perform a strategic review of their approach to classifying ASC 730 R&D costs on their financial statements and identifying QREs for their Research Credits to determine whether they too can conduct these activities more efficiently.

For further background and details on the Directive, please see BDO’s tax alert.
 

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