Tax Uncertainty Sparks R&D Jitters

To the surprise of companies across the country, the research and experimentation tax credit wasn't extended by Congress. The clock is ticking for ...
Helen ShawSeptember 8, 2006

Executives at corporations with sizable research budgets are on tenterhooks about whether Congress will bring the research and experimentation tax credit back to life in September before members head home to campaign for the November elections.

A provision for such a credit is part of a larger estate tax bill that was passed by the House but has been mired in the Senate since early August. Corporate jitters abound because the credit’s uncertain status has led to accounting and reporting challenges — not to mention actual earnings shortfalls — for U.S. companies at a time when other countries are using tax incentives to attract research companies. Between 14,000 and 16,000 firms a year claim the R&D credit on their tax returns, according to a 2004 report by Washington Council Ernst & Young.

In the past 25 years, a temporary tax credit has been extended almost every time it expired. Despite its inclusion in two different House and Senate versions of budget reconciliation legislation that passed the respective houses in 2005, however, the credit has not been extended.

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To the surprise of companies across the country this year, a compromise budget reconciliation bill that did not include the extension was signed into law, notes Tony Mondoro, a partner at Ernst & Young’s national federal tax practice. There is broad support for the credit, he says, and President Bush called for its permanent extension in this year’s State of the Union address. The proposed credit would provide annual benefits to companies of about $5 billion by 2010, according to the Congressional Joint Committee on Taxation.

Also known as the research credit, the research and experimentation tax credit (which covers traditional corporate research and development, as well as experimentation that might not result in a product) offers an incentive for companies to boost spending for technological research. A company can get a tax credit of up to 6.5 percent of the amount it spends on qualifying research. Congress first passed the credit as a temporary measure in 1981, when the U.S. steel and automotive industries were losing competitive ground and the then-fledgling computer and biotechnology industries needed a boost.

The impact of the credit on a company’s research budget, tax bill, and financials can be significant. When companies take advantage of the credit, their cash flow and earnings increase, explains Mondoro.

The uncertainty has resulted in some challenges for companies. “Will this translate into a decrease in spending and hiring in research and development — not only for 2006, but also on a go-forward basis?” asked Mondoro. “This uncertainty comes at a time when other [foreign] jurisdictions are courting…these types of research jobs.”

Indeed, other countries are providing tax incentives to lure technological and scientific research companies to them. For example, Australia provides a 125 percent deduction on research expenses, which equates to a flat 7.5 percent research tax credit, according to the R&D Credit Coalition. Singapore offers a five-year tax holiday for foreign income earned that is related to Singapore-based research.

Other worries loom for U.S. companies. Since, under current accounting rules, companies aren’t allowed to report in their financials the effect of legislation that has not yet been enacted, they have been recording their financial statements as if the credit doesn’t exist. The result: lower reported earnings and higher corporate tax bills for 2006. “Some companies are coming in with lower earnings now, and they’re saying part of the reason is because they have a higher tax rate because the research tax credit is gone,” says Mondoro.

There is also a logistical reporting challenge: companies are wondering whether or not to gather the necessary information to calculate their research tax credit for 2006. Further, if it is passed into law in September, companies that report on a calendar-year basis must record three quarters’ worth of the credit in the third quarter. That would be an unusual move, since they had been recording the benefit every quarter, notes Mondoro.

While he can’t predict what will happen during Congress’s final flurry of activity this fall, the tax expert notes that there’s a clear desire for an extension of the credit. “Because it runs across all industries and it’s got such broad-based support, companies are looking for some decision,” he observes.