While the United States has always been at the forefront of innovation, barriers continue to grow for it to continue its dominance. One of these barriers is the affordability of such projects, especially given the complicated nature of the R&D tax credit. According to a recent research study forthcoming in the Journal of Accounting & Economics, complex tax compliance requirements contribute to corporations passing on good R&D projects, suggesting that simplifying the requirements for the tax credit can be a path toward enhancing corporation innovation.
Overview Of The R&D Tax Credit
§ 41 of the Internal Revenue Code provides a 20% tax credit for qualified research expenditures. This credit has the potential to alter the manager’s calculations for choosing an innovation project by changing it from being negative net present value (the expected costs being greater than the expected benefits) to positive net present value (the expected benefits being greater than the expected costs). Research has shown that this tax credit has been successful in encouraging corporations to spend more on innovation.
However, the tax credit is complex. For instance, the technological innovation must meet a four-part test:
- Permitted Purpose: the project must develop or improve a product, process, software, formula, or technique
- Elimination Of Uncertainty: the project must be grounded in hard science and methods to achieve the intended purpose
- Process Of Experimentation: the project must be achieved through phases of trial and error
- Technological In Nature: the project must push the boundaries of knowledge
Beyond these technical requirements, companies must also maintain clear documentation as well as follow a complex formula for determining whether and how much of the tax credit they might be entitled to. These factors make complying with § 41 problematic, leading companies to potentially passing on this benefit, nullifying the intended purpose of the tax credit.
Tax Enforcement And R&D Tax Credits
In a study titled, “Tax enforcement and R&D credits” a researcher examined a sample of 8,146 observations across 1,592 unique corporations from 2008 to 2015. The research is primarily concerned with whether the Internal Revenue Service’s enforcement efforts have unintended consequences for corporations’ innovative activities. The article is authored by Dr. Mary Cowx of Arizona State University, and it is based on her dissertation completed at The Ohio State University.
Cowx says that she first became interested in this research project based on her own experiences working in practice. “I was asked to assist a new client in defending their R&D tax credits during an IRS audit. The legal landscape was murky, and the sheer volume of documentation was astounding. Around that time, the IRS had designated the R&D tax credit as a Tier 1 audit issue, signaling an elevated risk of adjustments if a firm’s R&D tax credit claim was audited. This experience sparked my curiosity: To what extent does the risk of IRS scrutiny influence the R&D tax credits that firms claim—and, more broadly, the R&D investments they make?” stated Cowx.
The researcher focuses on tax enforcement as a measure of corporations’ tax compliance costs. Using an archival research method, Cowx first shows that IRS enforcement spending is associated with lower R&D tax credits. She specifically documents that a 1% increase in enforcement spending is associated with $2.64 lower R&D tax credits. Cowx then switched to a survey-based research method with 116 corporate executives. In her survey, Cowx finds that the majority of them cite that the documentation surrounding the R&D tax credit is a big concern that affects the amount of R&D tax credits they claim.
“The risk of IRS scrutiny not only discourages firms from claiming R&D tax credits but also suppresses R&D investment more broadly—highlighting a potential social cost of tax enforcement. This is not to suggest that the IRS should scale back its oversight of the R&D credit, as doing so could lead to greater misuse of the credit. Instead, both survey responses and archival data point to the critical role of internal information quality in successfully claiming R&D tax credits,” says Cowx.
When asked about some of the key takeaways the study has for the business community, Cowx stated, “In interpreting the findings of this paper, it’s important to recognize the inherent complexity of the R&D tax credit. The credit is not only challenging for firms to claim, but also difficult for the IRS to enforce effectively. My internal information quality analyses show that IRS scrutiny’s negative impact on R&D investment is most pronounced among firms with lower-quality information environments. This suggests a potential avenue for policy improvement: simplifying the credit documentation requirements. Doing so could reduce compliance burdens and mitigate enforcement-related disincentives to investing in R&D.”
Implications For Corporations
These findings help shed light on the ongoing issues facing corporations in the space of innovation. As corporations continue to grapple with the costs of the R&D tax credit, they are also facing increased costs associated with complying with § 174, which requires them to amortize most of their R&D expenses over five years rather than immediately expensing them. Carefully understanding the costs that corporations face when engaging with and choosing innovation projects is paramount to the success of the R&D tax credit as well as ensuring the United States remains a destination for innovative activities.
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