Tax reform results in favorable impact to R&D tax credit election

Lower tax rate causes increased reduced credit election percentage

The Tax Cuts and Jobs Act (H.R. 1) was signed into law by President Trump on Dec. 22, 2017. Of its many provisions, one of the key highlights of tax reform is the well-publicized reduction in corporate tax rates from 35 percent to 21 percent. On its face, lower corporate tax rates suggest that credits against tax, such as the R&D tax credit under section 41, would be somewhat less valuable as corporations presumably have lower taxes to offset. While this certainly could be the result for some taxpayers, R&D tax credits actually increase as a result of statutory provisions.

As background, R&D tax credits under section 41 may be computed under the ‘regular’ method (section 41(a)) with a gross tax credit of 20 percent or the alternative simplified credit (ASC) method (section 41(c)(5)) with a gross tax credit rate of 14 percent. The ASC method has become increasingly popular with taxpayers, given its relative simplicity.

Section 280C(c)(1) was enacted to prevent taxpayers from receiving a double-benefit from both a tax credit and a tax deduction for the same research expenditures. Section 280C(c)(3) provides taxpayers with a reduced credit election in lieu of reducing the deduction. Generally speaking, for corporations paying regular tax, there is no difference in net benefit by electing the reduced credit under section 280C(c)(3) versus claiming the gross credit and reducing the deduction for research expenditures by the amount of credit claimed.

The statutory mechanics for computing the reduced Federal R&D tax credit under the two available R&D tax credit methods is explained below.

Regular method

Section 280C(c)(3)((B) provides the language for determining the reduced credit and it references the corporate tax rates in section 11(b)(1). Mechanically, you take the R&D tax credit rate of 20 percent and subtract the product of the R&D rate (20 percent) less the maximum rate under section 11(b)(1) which had been 35 percent. 

Therefore, the reduced credit rate would be [20% - (20% x 35%)] = 13%.

After Dec. 31, 2017, the new maximum corporate tax rate under section 11(b)(1) is 21 percent and so the reduced credit rate under section 280C(c)(3) will automatically adjust.

As a result, the reduced credit rate for the 2018 calendar year is now [20% - (20% x 21%)] = 15.8%.

Alternative simplified credit (ASC) method

Interestingly, section 280C(c)(3) only references section 41(a) and does not directly reference section 41(c)(5); however, section 41(c)(5) is the authority for replacing 20 percent under the regular method with 14 percent under the ASC method such that if a taxpayer makes an ASC election, then the credit rate determined under section 41(a)(1) becomes 14 percent.

Therefore, the reduced credit rate would be [14% - (14% x 35%)] = 9.1%

As a result, the reduced credit rate for the 2018 calendar year is now [14% - (14% x 21%)] = 11.1%.

The result is that there is approximately a 21 percent increase in the value of R&D tax credits. 

How does this affect fiscal year taxpayers?

Section 15 provides guidance with respect to tax rate changes occurring during a taxpayer’s fiscal year.  Specifically, section 15(e) provides that if the tax rate change in effect involves the highest rate of tax imposed by section 11(b), that a weighted average of the highest rates before and after the change will apply (determined on the basis of the respective portions before and after the taxpayer’s taxable year). Based on the section 280C(c)(3) formula noted above, a blended corporate tax rate less than 35 percent will still result in an increase to the reduced R&D credit rate. For example, a taxpayer with a fiscal year end of March 31, would compute a blended maximum tax rate of 35% x (275 / 365) + 21% x (90 / 365) = 26.37% + 5.18% = 31.55%. Accordingly, 31.55 percent would be substituted in the reduced credit rate formula for the highest tax rate under section 11(b)(1).

Illustrations

The illustration below shows that tax reform results in increased R&D credits under either the Regular method or ASC. For simplicity, the illustrations reflect a calendar year corporate taxpayer.

Facts for illustration:

• Assumes $1,000,000 in qualified research expenditures (QREs) for 2018 and each of 3 prior years
• For illustration and simplicity, assumes base amount is limited to 50 percent of 2018 QREs

Regular method

ASC method

The example below illustrates this additional benefit for a corporate taxpayer using the regular R&D tax credit method.

Note:  Each taxpayer’s situation should be evaluated as different facts could impact the actual benefit received. 

Example: Increased credits applied to corporate tax