In 2012, the energy sector spent $17.9 billion on global research and development, more than $6.6 billion of which was conducted in the U.S. Assuming small and midsize businesses perform 20 percent of the U.S. energy sector’s R&D, these companies could incur up to $1.3 billion in R&D expenditures, the benefits of which may not be fully realized because they underutilize the R&D tax credit, says Robert Henry, a partner in Tax and Strategic Business Services at Weaver.
In addition, the R&D tax credit represents a permanent tax benefit; it reduces the overall effective tax rate as presented in generally accepted accounting principles basis financial statements.
Smart Business spoke with Henry about new ways to utilize R&D tax credits.
What is the R&D credit?
The federal R&D tax credit is a mechanism to spur technological advances and hiring in R&D fields. It has expired and been extended multiple times, but has most recently been extended through 2013. With support in both political parties, it is likely to be continued.
In addition, many states offer R&D tax incentives in the form of state income, franchise, or sales and use tax credits and exemptions. Texas’s R&D credit will come back into law effective Jan. 1, 2014. Texas HB 800 provides a sales and use tax exemption or a franchise tax credit related to qualified R&D activities taking place within Texas. This will greatly increase the potential tax benefit available to taxpayers conducting their R&D within Texas.
How is qualifying R&D activity defined?
Internal Revenue Code section 174 describes research and experimental expenditures as activities intended to discover information that will eliminate uncertainty concerning the development or improvement of a product. The activity must:
- Be related to the development or improvement of a product, inclusive of a technique, invention, formula or process.
- Address uncertainty regarding the appropriate method or design for the product.
Activities deemed eligible by section 174 qualify for immediate tax deduction. They also may qualify under section 41, where they must:
- Be technological in nature, based in hard sciences, such as geology or engineering.
- Contain a sufficient degree of development uncertainty.
- Contain the process of experimentation.
- Have a permitted purpose that improves a business component, which includes a product, process, software, technique, formula or invention.
What oil and gas activities may qualify?
‘Wildcat’ exploration, the drilling of a well, the development of logistical infrastructure — really the entire exploration and production process — may qualify for the R&D credit. That also includes improved analytics and software that enables more accurate interpretation of reservoir studies. A pipeline company in the industry’s midstream sector may be more efficiently monitoring flows of oil and natural gas or overcoming adverse field conditions in placing a pipeline. Downstream companies may benefit from improved processes for purifying or refining natural gas or oil.
What costs are eligible for the credit?
Wages for employees engaging in qualified research, directly supervising qualified research or supporting it are eligible. A company may also deduct 65 percent of contract labor costs associated with qualifying R&D activities.
Tangible property costs used in the R&D process or in the construction of a prototype can be qualifying expenditures. Supply expenses, though, cannot include land or land improvements, or property subject to depreciation. Expenses for royalties, shipping or travel also cannot be included. In addition, special considerations apply for internal-use software.
In order to capture all eligible credit when R&D activities are identified, companies must track and record labor costs of internal employees, contractor and vendor expenses, and supplies or materials costs. A business that is aware of the manner in which these costs are tracked and accounted for will more accurately define what it can claim for an R&D tax credit. ●
Robert Henry, CPA, is a partner in Tax and Strategic Business Services at Weaver. Reach him at (800) 332-7952 or [email protected].
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