Tax

Congress Extends R&D Tax Credit

Congress's last-minute renewal of the R&D tax credit has companies scrambling, but will help boost bottom lines in the final quarter of the year.
Helen ShawDecember 12, 2006

In the wee hours of the morning last Saturday, just before the 109th Congress ended, legislators extended the research and experimentation tax credit. They also changed the rules so the credit will apply to more companies. That’s the good news. The bad news: the last-minute passage means that companies will have to scramble in the next few weeks to calculate and record the credit before they close the books on 2006.

Corporate executives had been waiting anxiously for the tax credit, known as the R&D credit, which covers traditional corporate research and development and experimentation for new products or processes. Originally introduced 25 years ago to boost spending for technological research, the credit has always been temporary, with Congress renewing it each time it expired. Since it expired at the end of 2005, however, its renewal has been stalled on Capitol Hill, leaving companies to guess about its chances — and how to deal with related accounting and financial reporting.

The renewal, which is retroactive to January 1, 2006, doesn’t leave companies much time to figure out the numbers, though few are complaining. The tax credit is worth an estimated $16.5 billion over the next 10 years. “Overall, companies are very happy it was extended,” observes Tony Mondoro, a partner at Ernst & Young’s national federal tax practice. “It increases cash flows, earnings per share, and effectively helps cover some of the riskier expenditures they’ve incurred as they go into these research projects to develop new products or processes.”

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At the same time, a change in the way the credit is calculated will likely mean that more companies can take advantage of it. Previously, the credit was calculated by examining a company’s rate of research spending from 1984 through 1988, shutting out companies that didn’t spend enough. In essence, says Mondoro, that “penalized success.”

Now, firms can either calculate their R&D credit as they did in the past, or by using an alternative simplified credit. Under the latter method, a company can compare its current year research spending to 50 percent of its average research spending during the last three years: if the firm spends more than 50 percent of its trailing three-year average, it can claim a 12 percent R&D tax credit, explains Mondoro.

The new alternative calculation will let more companies claim the credit because they won’t need to consider the company’s research and development investments in the 1980s. While the tax credit will help a broad range of industries, Mondoro expects that mature high-tech companies, firms in the defense, retail, and financial services industries will benefit most.

With the tax credit stalled in Congress for most of the year, however, companies have been reporting financial results as if the credit didn’t exist. Indeed, some companies stated publicly that their lower earnings were partly due to their higher tax rate without the research credit. “Companies now, in a fairly short period of time, need to figure out what the retroactive impact is and record the benefit all in the last quarter,” said Mondoro.

That will involve some digging into records, and may even present companies with an opportunity to get advance sign-off from the Internal Revenue Service, says Mondoro. Under an IRS pre-filing program, companies can meet with the IRS to explain how they will calculate their taxes and agree on numbers with the IRS to eliminate future controversy. “We expect as companies look at the new research credit, they will revisit this pre-filing program,” he says.

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