IRS limits acquiree qualified research expenses used for R&D credit
Acquiror may only include target’s post-acquisition QREs
TAX ALERT |
In a recent field service advice memorandum (FSA 20144701F),1 the IRS denied an acquiror the ability to include a target's pre-acquisition qualified research expenses (QREs) in the total QRE amount used to calculate the acquiror's research and development (R&D) tax credit for the year of acquisition. In lieu of including these QREs in the acquiror's R&D credit calculation, the IRS required that the target include the QREs in its R&D credit calculation for the pre-acquisition period in which the QREs were paid or incurred. This treatment is consistent with prior IRS guidance,2 as well as the legislative intent behind the most recent amendments to section 41(f)(3).3
FSA 20144701F: An overview
The FSA analyzed a situation in which the parent of a consolidated group (Acquiror) acquired 100 percent of a publicly-traded corporation (Target). Following the acquisition, Target filed a return for the short period from Jan. 1 (the beginning of its tax year) to the date of the acquisition. In preparing its return, Target calculated its R&D credit using the QREs it paid or incurred during that period.
Acquiror then filed its calendar year tax return, which included Target's income tax attributes for the post-acquisition portion of the year. However, in calculating its R&D credit for the year of acquisition, Acquiror included Target's QREs for the entire year. This resulted in both Target and Acquiror claiming research credits based on the QREs Target paid or incurred during the pre-acquisition short taxable year.
In deciding which party was entitled to include Target's pre-acquisition period QREs in its R&D credit calculation, the IRS applied Reg. section 1.1502-76(b)(1)(ii)(A). This regulation provides that a corporation (other than an S corporation) that becomes a member of a consolidated group during that group's return year do so at the end of the day on which its status as a member changes. Simultaneous with becoming a member of the consolidated group, a corporation's tax year as an entity separate from the group ceases. As a result, a consolidated group's return includes the common parent's items of income, gain, deduction, loss and credit for the entire consolidated return year, as well as each subsidiary's items of income, gain, deduction, loss and credit for that portion of the year for which it was a member of the group. Any subsidiary joining the group during the tax year must then complete a return for the period beginning on the first day of its separate entity tax year and ending on the day on which it become a member of the combined group.4
In applying this regulation to the fact pattern addressed in the FSA, the IRS concluded that any QREs paid or incurred by Target from Jan. 1 of the acquisition year to the date of acquisition must be used in calculating the R&D credit on Target's return covering the same period. Furthermore, these QREs cannot be included in the R&D credit calculation on Acquiror's return for the year of acquisition.
Analysis of the FSA in conjunction with existing guidance
The conclusion reached by the IRS in this FSA is consistent with prior non-precedential R&D credit guidance relating to acquisitions, most notably that of technical advice memorandum (TAM) 201034017. This TAM took the analysis of pre- and post-acquisition QREs one step further by providing a methodology for calculating the credit in situations where (1) the target's current tax year is a short period, or (2) one of the target's base years is a short period. The first of these situations arises when a target files its short period return for the portion of its tax year in which it was not a group member. The second arises when the parent of the consolidated group needs to include the target's average annual gross receipts (AAGRs) for the post-acquisition portion of the tax year in the group's base amount.
As noted in both the FSA and the TAM, a target must include any QREs it paid or incurred during the pre-acquisition period in its R&D credit calculation for that period. In order to do so, the target must apply the short period provisions of Reg. section 1.41-3(b)(1). This regulation states that, "if a credit year is a short taxable year, then the base amount determined under section 41(c)(1) shall be modified by multiplying that amount by the number of months in the short taxable year and dividing the result by 12."5
After the target becomes a member of the consolidated group, the group's parent is confronted with another issue: How should the R&D credit be calculated if at least one of the four tax years included in the target's base amount is a short year? Reg. section 1.41-3(b)(2) resolves this, stating that "if one or more of the four taxable years preceding the credit year is a short taxable year, then the gross receipts for such year are deemed to be equal to the gross receipts actually derived in that year multiplied by 12 and divided by the number of months in that year."6
Application of the short period rules to acquisitions
In order to demonstrate how these provisions function, consider their application to the fact pattern set forth in the FSA. In this fact pattern, Acquiror purchased 100 percent of the stock in Target at some point during its tax year (for purposes of simplicity, assume that Target became a member of the consolidated group on July 1 of the acquisition year). Since Target and Acquiror both have a calendar tax year, Target will need to file a short period return for the period from Jan. 1 through June 30, and Acquiror will need to include Target's tax attributes in its consolidated return for the period from July 1 to Dec. 31.
In computing its R&D credit for the period from Jan. 1 through June 30, Target will take the base amount (calculated using the prior four years' AAGRs), multiply it by six and divide it by 12. It will then calculate its R&D credit using the QREs incurred during the short period from Jan. 1 through June 30 and the pro-rated base amount.
At the end of its tax year, Acquiror will include Target's post-acquisition QREs in its total R&D credit calculation. Since Target has only been a member of the consolidated group for six months, at least one of the tax years in its base period is a short period (for purposes of simplicity, assume that preceding tax years two through four were all 12 months long and the only short period is the first preceding tax year). In order to standardize the annual gross receipts amount from the short period with the amounts from the preceding three periods, Acquiror needs to annualize the short-period amount by multiplying the gross receipts generated during the six-month post-acquisition period by 12 and then dividing them by six. The sum of this amount and the annual gross receipts for preceding years two through four will be the total base amount for Target (total base amount).
Acquiror must complete one additional step before aggregating Target's total base amount with that of the rest of the group. Since the total base amount covers a 12-month period, the Acquiror needs to prorate it for the six-month period Target was a member of the consolidated group. To do so, Acquiror will multiply the total base amount by six and divide by 12. This prorated total base amount, as well as Target's post-acquisition QREs, will then be aggregated with the base amounts and QREs of Acquiror and its other subsidiaries in calculating the R&D credit for the entire consolidated group.
Although the FSA and TAM discussed above are not precedential, the similarities in their analyses (despite being over four years apart) demonstrate that the IRS is taking a fairly consistent approach in evaluating these situations. Therefore, when confronted with an acquisition situation (whether it be as the target or the acquiror), it is crucial when determining the R&D tax credit allowable for each party to consult the regulations cited above in determining how to properly account for the target entity's QREs and AAGRs.
1 Released Nov. 21, 2014, and dated June 16, 2014.
2 See TAM 201034017 (May 24, 2010).
3 The legislative rationale for enacting section 41(f)(3) was to ensure that "[QREs] paid or incurred by the disposing taxpayer in a taxable year that includes or ends with a change in ownership are treated as current year [QREs] of the disposing taxpayer and such expenses are not treated as current year [QREs] of the acquiring taxpayer." Joint Comm. on Taxation, General Explanation of Tax Legislation Enacted in the 112th Congress, at 140-41 (Comm. Print 2013), cited in FSA 20144701F.
4 See Reg. section 1.1502-76(b)(1)(i).
5 TAM 201034017 (May 24, 2010).