By Tom Donovan and Kelly Logan
Foster growth through research & development and get a tax break? The R&D tax break is back in Texas.
The State of Texas adopted Texas House Bill 800 (House Bill 800) providing state tax benefits for engaging in qualified research expenditures in the State of Texas beginning January 1, 2014. The Texas legislature noted that Texas accounts for more than eight percent of the U.S. economic activity, but only five percent of research and development spending in the U.S. The new law gives taxpayers an option to choose between a sales tax exemption or a franchise tax credit.
Texas Has Joined the Rest of the U.S.
Before passing this law, Texas was one of only a handful of states that did not offer some sort of research and development tax incentive. It is estimated the lack of this tax incentive cost the state over $3 billion in lost economic activity and over 20,000 jobs. The incentive is aimed at creating jobs, providing new technologies and bridging the gap between private-sector research and institutions of higher education. This tax benefit should make Texas economically competitive in R&D, reduce the tax burden on R&D conducted in Texas, promote the creation of new, highly skilled high paying jobs, and complement Texas manufacturing industries by encouraging innovation and efficiencies in applying new technologies and products. It is an excellent opportunity for Texas businesses to foster growth and take advantage of some tax breaks along the way.
The Difference Between the Options
The exemption of sales taxes is available on depreciable tangible personal property used in qualified research. For example, a $1 million purchase of lab equipment used in qualified research could result in an immediate reduction of $82,500 in related sales tax (based on an 8.25 percent sales tax rate). This option does not require the Company to be paying the Texas Franchise tax to benefit. Alternatively, the other option is a five percent credit on qualified research expenses (6.25 percent if the qualified research expenses are conducted with institutions of higher education located in Texas). This credit will be used against the taxable entities Texas franchise tax obligation. This is not the first time Texas has provided a research and development tax break. However, all previous credits were frozen when the state adopted the margin calculation in 2008.
Who is Eligible?
Patterned after federal law, the incentive will be available to a wide range of businesses across a variety of industries. The bill references Section 41 of the Internal Revenue Code (IRC Section 41) in defining qualified research expenses. Research expenses are qualified if they:
a) Help discover new information that is technological in nature
b) Are useful in the development of a new or improved business component
c) Relate to a new or improved function, performance, reliability or quality
IRC Section 41 provides some latitude in determining qualified research expenditures and will benefit companies in a diverse range of industries. For example companies developing new fracking techniques, mobile applications, new processes for manufacturing, and other items that would be more process versus pure research would also qualify under IRC Section 41.
Timing and a Key Feature of the Act
The sales tax exemption is effective on January 1, 2014. The credit applies to reports originally due on or after January 1, 2014. Both the exemption and the credit expire on December 31, 2026. House Bill 800’s intent is that taxpayers utilize either the exemption or the credit for a given period, but not both options. It is important that all members of a combined franchise tax report take advantage of the same incentive, either the credit or the exemption. A member of a combined group who utilizes the sales tax exemption will prevent the combined group from filing for the franchise tax credit.
How Do You Qualify?
The basis for the credit is the difference between current period qualified expenses and 50 percent of average qualified expenses from the three previous periods. The qualified expenses must have been incurred in Texas. If there are no qualified expenses from one or more of the three previous periods, the credit is lowered to 2.5 percent. For any qualified research expenses contracted with an institute of higher education, the credit increases to 6.25 percent (3.125 percent if there are no previous period qualified expenses). The credit is limited to 50 percent of the total franchise tax due, including any carry forward credit amounts. Credits can be carried forward for up to 20 consecutive reports and are utilized on a first in-first out basis.
A Tough Decision May Be Needed
The need to choose between the sales tax exemption and the franchise tax credit creates an interesting decision for businesses. The sales tax exemption provides an immediate benefit of up to 8.25 percent on the purchase price of depreciable property. It is money that never leaves the business. The franchise tax credit, however, is a lesson in delayed gratification. The benefit is not recognized until the year following the period in which the expenses were incurred (when the report is filed). Ideally, businesses would have the opportunity to evaluate both alternatives and elect the method providing the greatest tax benefit. There is also the challenge of coordinating and evaluating all the members of a combined report.
Texas Will Need to Get Creative with Their Reporting
House Bill 800 places requirements on the Texas Comptroller to track and report the amount of credits and exemptions taxpayers utilize for research and development. There are existing forms in place to report franchise tax credits, but the Texas Comptroller will have to establish reporting guidelines for taxpayers taking advantage of the sales tax exemption. It is expected the Texas Comptroller will issue guidelines in the near future to clear up some of the questions surrounding the new research and development tax incentives.
Tom Donovan is a founding partners for PMB Helin Donovan and has over 20 years of experience working with corporations, not-for-profits and investment companies. firstname.lastname@example.org, 512-583-2908
Kelly Logan has over 25 years of experience serving privately held and public companies and their owners/executives in tax planning and compliance matters. email@example.com, 512-600-8446