Oddities of No §174 R&D Fix in 2022

I thought Congress would repeal or extend the Tax Cuts and Jobs Act of 2017 delayed change to §174 that changes from expensing R&D (the law since 1954) to capitalizing and amortizing over 5 years (domestic) or 15 years (foreign). After all, a key purpose of the TCJA was to make our tax system more internationally competitive. Providing a more unfavorable rule for R&D expenditures goes in the opposite direction. But it wasn't to be effective until tax years beginning after 12/31/21 (most TCJA changes were effective after 2017). So it was arguably more of a budget gimmick to reach the desired revenue loss target set for the TCJA. But, it was not delayed or repealed - although that might still happen.

Two observations:

1. Is expensing the right tax policy? I think so. Generally, a long-lived asset should be amortized over its useful life. But not all R&D has a life beyond one year and when it does, it is hard to estimate. So, I think economic growth and administrative convenience reach an appropriate result to just expense the R&D when incurred.

2. Capitalizing and expensing over 5 years is too long and sends the wrong message that R&D work in the U.S. is not valued. A recent report from the National Academies of Sciences, Engineering and Medicine entitled Protecting U.S. Technological Advantage notes in the first paragraph in the preface:

"U.S. leadership in technology innovation is central to our nation’s interests, including its security, economic prosperity, and quality of life. Our nation has created a science and technology ecosystem that fosters innovation, risk taking, and the discovery of new ideas that lead to new technologies through robust collaborations across and within academia, industry, and government, and our research and development enterprise has attracted the best and brightest scientists, engineers, and entrepreneurs from around the world. The quality and openness of our research enterprise have been the basis of our global leadership in technological innovation, which has brought enormous advantages to our national interests."

I think most people agree with that. Innovation, high-paying jobs, development of new technologies - are things we want to encourage in the U.S.

What do you think?

Innovation box tax reform proposal

Sample patent from Microsoft

On July 29. 2015, the House Ways and Means Committee announced that some members had drafted a bill calling for an innovation box (aka patent box), similar to what is used in a few others countries, such as the UK. Chairman Ryan praised the bill as relevant to international tax reform and helping US companies be more competitive.

The proposal has two parts:

1. 71% deduction of the lesser of (a) "innovation box profit for the year" or (b) taxable income (without the deduction).
2. Provision to allow US companies to bring back to the US foreign intellectual property tax free.

While that may sound simple, the challenge will be in defining "innovation box profits." That involves a few more definitions. It is not the definitions that will be most challenging, but identifying a company's costs relevant to each definition.

"Innovation box profits" = "Tentative innovation profit" x a ratio comparing 5 years of US R&D to 5 years of total costs. It appears that the rationale for this ratio is to be sure this primarily benefits companies that engage in a lot of R&D.  For example, if a company generated a lot of profit from a patent, but there was not significant R&D spent to create that, that company's deduction would be reduced.

There is a lot more. I won't go into to define "tentative innovation profit" but that will be the challenging area. It will be similar to calculating the Section 199 or DPAD deduction in that a company needs to identify its cost of sales and other expenses attributable to the innovation profits. That will be challenging and a key IRS examination area.

Observations:

• The proposal is a deduction rather than a lower rate on innovation profits. I note this because some of the explanatory information suggests the proposal is for a 10% rate rather than 35% rate on innovation profits, but the benefit instead is what I refer to as a "bonus" deduction in that it is not a cash outlay, but an extra deduction (similar to how the Section 199 deduction works).
• Given that R&D spending as a percentage of all spending factors in, why not just increase the research tax credit? That would be easier to calculate.  If the research tax credit remains along with the innovation box, it will be more difficult for some companies to use the credit because their overall tax will already have been reduced due to the extra deduction.
• Why not reform the research credit by increasing the percentage, keeping only the simplified version of the credit, and allowing start-up companies to also use the credit against payroll taxes (since they might not have taxable income)?  But still enact the part to encourage companies to bring their foreign IP to the US - and reform our system so that the tax rules don't encourage developing IP outside of the US to start with.
• Perhaps the innovation box is offered because the OECD BEPS project suggests this regime is permissible in that it better matches value generation with taxation (see Q&A 19 - 21 from OECD). Also, per the bill sponsors: "The OECD BEPS project will soon require every innovation box to include a nexus component. In other words, a company will have to locate its research and development—and the high-paying jobs that go with it—in the country offering the special tax rate."  However, it seems that the research credit should also be fine in that it is for R&D in the US and will reduce your US taxes.  If there are foreign profits from the R&D, they are taxed where generated (and in the US unless we also move to a territorial system).
• Why 71% and not 70%? Why not a different rate on the profits rather than a deduction? As a deduction, the issue arises as to the effect of the deduction creating a loss (negative taxable income). The proposal specifies that the innovation deduction is not considered in calculating an NOL (similar to the 199 deduction). And if a company has negative taxable income prior to measuring the deduction, there is no deduction because the lesser of (a) innovation box profit and (b) taxable income would be taxable income at zero.  In contrast, a credit carries over if not usable in the year generated.

So, it is an interesting idea to have on the table as part of tax reform discussions. Perhaps it will help highlight a need to have a system that encourage more innovation in the US and the best design for the research credit. Let's see what happens.

The sponsors are seeking comments on some specific questions including definitions and approaches for allocating expenses between the innovation profits and other sources.

Additional resources:

• Section-by-section analysis
• Technical explanation from the JCT (22 pages)
• Rationale (2 pages)
• Why needed (from House Ways and Means)

What do you think?

A Permanent R&D Credit - Will It Happen this Year?

4/29/14 House Ways & Means Committee Markup Meeting

The federal income tax credit for certain R&D expenditures (primarily wages and supplies) has been a temporary provision since first enacted in 1981 (it first expired in 1985 and has been extended about 14 times since). The temporary credit seems odd considering the following:

• Every President and probably most legislators since 1985 have called for a permanent credit.
• Unlike most other credits, there is economic justification for the credit beyond only incentivizing R&D in the U.S. There are spillover effects from a company's R&D activity and the credit helps compensate for them.
• Most countries not only have a lower corporate statutory income tax rate, but also research and innovation incentives on a permanent basis.
• Our global economy enables companies to take advantage of permanent incentives in other countries and then the US loses the R&D work. R&D work involves the need for a highly educated and compensated workforce, something good for our economy and society.
• A permanent credit would enable companies to better plan for its use likely resulting in more R&D work in the US. It is impossible to plan to fully utilize the credit when it continues to expire with renewal uncertainty (once in the late 1990s, it was left to expire for one year).
• A permanent credit means there is no need for renewal of it which often happens retroactively and diminishes the incentive value of the credit.

But, today, there is no research credit because it expired at the end of 2013.

On April 29, 2014, the House Ways and Means Committee held a markup meeting to look at just six of the 57 provisions that expired at the end of 2013. One of these proposals was H.R. 4438 to make the research tax credit permanent. It would also make significant changes including the following:

• Repeal the "regular" credit that uses the 1984-1988 base years and only keep the alternative simplified credit that looks at qualified research expenditures in the past three years for the base.
• Increases the simplified credit percentage from 14% to 20% (10% in the first year the business has QRE).

The proposal passed by the Ways and Means Committee did not include some items just recently proposed by Congressman Camp in his Tax Reform Act of 2014 discussion draft, released February 2014. The discussion draft (pages 73-74) proposed to exclude supplies from the credit as well as not have it apply to software development costs. He also proposed earlier to only increase the simplified credit to 15% (from 14%).

The Joint Committee on Taxation estimates the cost of the modified, permanent credit at about $15 billion per year (JCX-44-14).

For a list of the other five expired items the committee voted to make permanent, click here.

Next steps?  The House needs to vote and the Senate Finance Committee needs to review and the Senate vote.  Then if both the House and Senate have approved, it would go to President Obama for signature. I think if it all goes as separate bills, the research credit has a better chance of being made permanent because President Obama has also called for a permanent credit (see FY2015 Greenbook, page 12).

The issue of whether renewing expired provisions requires revenue offsets must be resolved.  The House Ways and Means Committee has posted a piece from the Heritage Foundation (4/28/14) that says renewing an expired provision is not a tax cut so it does not need a revenue offset for revenue neutrality. The issue relates to assumptions made (or not made) in the CBO baseline and estimates of discretionary spending. Congressman Camp seems to be following the assumption that revenue offsets are not needed as there are none for the permanent tax credit and the Heritage Foundation article is posted to the committee's website.  Others say that extending tax cuts (such as a credit) requires revenue offsets (tax increases or spending cuts) to be revenue neutral. See articles from the Center for Budget and Policy Priorities (CBPP) and the Committee for a Responsible Federal Budget (CRFB). I agree with the CBPP and CRFB. The CBO baseline assumes that expired provisions permanently expire. Also, one of several reasons why these provisions are temporary rather than permanent is that when a tax cut is in only one year of a ten-year budget, it costs less than if it were in for each of the ten years. Thus, bills with these items only in as temporary measures don't need as much revenue offset.

We'll see what happens with H.R. 4438. It certainly has support and I believe it can also be down outside of tax reform as there are reasons that justify having a research tax credit (see a few more in testimony on incentives for innovation I delivered to the Senate Finance Committee in 2011).

What do you think?

California and Incentives for Job Creation and Innovation

On 12/5/11, the California Assembly Revenue & Taxation Committee held a hearing on job creation and innovation (see prior post). I had the opportunity to testify. A few points I offered:

• California has one of the most generous research tax credits among the states and an underutilized jobs credit. Identify why these provisions are not promoting job creation and innovation to the desired level. For example, in 2009, $400 million was set aside for a $3,000 per new job tax credit for employers with employees with less than 20 employees. In November 2011, only $75 million has been used.
• Conform California law to more favorable depreciation rules of federal MACRS and Section 179 expensing. Encourage Congress to allow the IRS to update depreciable lives, such as for computers and semiconductor manufacturing equipment which generally is too long (5 years). In addition, encourage Congress to modernize Section 179 to apply to both tangible and intangible assets. While there should be discussion of whether any special rules, such as tax credits, should be in the law (they tend to add complexity and inequities and inefficiencies), there are considerations in designing the base that affect the economy. For example, to calculate taxable income of a business, depreciation needs to be calculated. If equipment can be depreciated using double-declining balance over 3 years, that has a different economic impact and affect on interstate and international business competitiveness than straight-line over 10 years.
• Encourage Congress and the IRS to improve the federal research tax credit including making it permanent.
• Develop a plan to phase out the sales tax on business purchases of manufacturing and R&D equipment. This might be funded by broadening the sales tax base for consumers to include consumption of personal services and digital goods, and to repeal the elective approach to apportionment (adopting the single sales factor approach due to its economic development foundation).
• Be ready with incentives for corporations to utilize cash in California should the federal government enact a repatriation tax break.

I had 18 recommendations which you can find here.

Four items in particular I found interesting about the hearing:

1. Three people testified via Skype - we could see and hear them well and they could hear us and participate. It did go down once for a few minutes, but technicians restored the connections.
   
2. The business rep panel for the most part suggested that California needs to get rid of the elective apportionment and go to just single sales factor apportionment. I agree and had the opportunity to note that, today, the corporate income tax has become an economic development tool. Thus, if we want to use it to encourage companies to locate employees and property in the state without having their tax bills go up, we offer single sales factor apportionment. But, at the same time to tell companies that do not locate payroll and property here, we want your CA taxes to be lower too, we are just fools (I didn't say fools, but that is what we are).
3. Professor Robert S. Chirinko, University of Illinois at Chicago, shared some of his research findings on the benefits of jobs credits. In a nutshell, that research found that there were no benefits. He also noted that such provisions can have some negative impact because when enacted, the incentives are not usually immediately effective so employers delay hiring until the effective date.
4. The Legislative Analyst's Office seems to have modified its view on the California research. James Nachbaur, an economist with the LAO presented a background paper on the credit. In a 2003 report, the LAO stressed that a key purpose of a research credit is to address spillover effects, but that the federal credit already handles that so why would a state also offer a credit? The 12/5/11 report notes that 2003 comment, but does not emphasize it. I think this may be because since 2003, corporate income taxes have become more of an economic development tool meaning that we should view a state research credit primarily in terms of whether it causes companies to engage in R&D in the state rather than elsewhere.

The hearing information should be posted to the committee's website soon.

What do you think?