United States

IRS provides safe harbor for large businesses research credit costs

IRS allows ASC 730 Financial Statement research costs to compute QREs

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The IRS recently released a directive (the directive) to all IRS Large Business and International (LB&I) employees (LB&I-04-0917-005) providing guidance on the examination of the section 41 credit for increasing research activities (the research credit) claimed by certain taxpayers that expense research and development (R&D) costs on their financial statements pursuant to ASC 730. The directive, in the form of a memorandum, is intended to more efficiently manage LB&I’s audit resources by providing an efficient manner for determining qualified research expenses (QRE’s) for those LB&I taxpayers that meet the conditions of the directive.

In order to claim the research credit, a taxpayer is required to retain records that substantiate its expenditures as qualifying for the credit. This process of substantiation requires that a taxpayer have sufficient evidence to prove that an expense is a QRE, however, there is no one required method of substantiation provided in the code or regulations. Thus, determining the amount of QREs can be difficult for taxpayers to prove and for LB&I examiners to evaluate. The directive allows for LB&I examiners to accept a taxpayer’s adjusted ASC 730 Financial Statement R&D as sufficient evidence of QREs when the taxpayer complies with the outlined certification requirements.

The FASB Accounting Standards Codification (ASC) is the source of authoritative Generally Accepted Accounting Principles (GAAP) recognized to be applied to nongovernmental entities. ASC 730 establishes standards of financial accounting and reporting for research and development costs and specifies the following:

  • Those activities that shall be identified as research and development for financial accounting and reporting purposes;
  • The elements of costs that shall be identified with research and development activities;
  • The accounting for research and development costs; and
  • The financial statement disclosures related to research and development costs.

As stated above, the IRS will not challenge QREs that are calculated in accordance with the directive’s adjustments to the ASC 730 Financial Statement R&D. The calculation begins with the ASC 730 Financial Statement R&D and then adjusts for (in the form of both additions and subtractions) a number of specified items. These items include, but are not limited to, amounts relating to foreign entities, Schedule M-3 amounts, section 174 excluded expenses, stock-based compensation, and upper management wages. Any additional QREs claimed by the taxpayer on its Form 6765 that exceeds the adjusted ASC 730 Financial Statement R&D amount may be subject to risk assessment to determine the scope of an examination.

Taxpayers eligible for the treatment outlined in the directive are limited to those who have assets of $10,000,000 or greater and who follow GAAP to prepare their Certified Audited Financial Statements. Further, the taxpayer’s Certified Audited Financial Statements must show the amount of currently expensed ASC 730 financial statement R&D as a separate line item on the income statement or separately stated in a note to said financial statements. For purposes of the directive, other statements or reports (e.g. a review statement or a compilation report that is not subject to a full audit) are not considered certified audited statements. Further, for those taxpayers who choose to follow the terms of the directive, it applies only to original, timely filed returns (including extensions) which are filed on or after September 11, 2017.

Certification requirements

In order to receive the treatment outlined in the directive, a taxpayer must comply with the certification requirements enumerated in the directive. First, the taxpayer must complete and sign the 'Certification Statement Claiming Adjusted ASC 730 Financial Statement R&D as QREs' which states, under penalties of perjury, that the computation of the adjusted ASC 730 Financial Statement R&D is in accordance with the methodology set forth in the directive and is true, correct, and complete. The certification statement must be signed by an individual who is authorized to sign the taxpayer’s Federal income tax return, or in the case of consolidated return filers, the common parent must sign the statement on behalf of the group. Next, the taxpayer must complete the 'Reconciliation of Form 6765 QREs to Adjusted ASC 730 Financial Statement R&D'; the 'Computation of Adjusted ASC 730 Financial Statement R&D'; and the 'Adjusted ASC 730 Financial Statement R&D Wage Detail.'  Templates of all the certification materials are provided in the directive appendices.

Additionally, the taxpayer must retain and make available upon request the documentation (underlying books and records) that supports the amounts claimed under the directive. If the taxpayer fails to retain and timely submit the documentation, the IRS may determine that the directive does not apply to the taxpayer. Documentation required to be retained is similar to the documentation that has historically been compiled in support of claims for the research credit.

Prospective 'safe harbor' vs. retrospective audit response

A taxpayer who is eligible to take advantage of the QRE determination process provided in the directive can voluntarily attach the certification documents to its federal income tax return. In the alternative, if the certification documents were not voluntarily attached to the taxpayer’s federal income tax return, the audit team at the beginning of an examination of the taxpayer’s research credit will verify whether the taxpayer followed or plans to follow the directive. If the taxpayer then choses to follow the directive, the exam team will require that the taxpayer provide the certification documentation.

Conclusion and analysis

Although the directive is intended to provide a more efficient manner for verifying a taxpayer’s QREs, computing the directive’s adjusted ASC 730 Financial Statement R&D is a complex process. Furthermore, many hurdles can exist in the reconciliation of a taxpayer’s financial statement reporting of R&D expenses to the research credit determination of R&D expenses. Taxpayers should consult their tax advisors to determine if using the method outlined in the directive is the most beneficial process for calculating the QREs for their research credit.

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