Indiana taxpayer not entitled to research and expense tax credits
TAX ALERT |
On July 29, 2020, the Indiana Department of Revenue ruled that a company that designs and manufactures specialty buildings was not entitled to claim Indiana state research expense credits for income tax purposes. Like many states, Indiana provides a state level statutory research expense credit similar to the federal credit. Qualifying research expense is defined by section 41(b) of the Internal Revenue Code that is incurred for research conducted in Indiana.
The taxpayer designed and manufactured ‘pole’ buildings which are pre-engineered agricultural, livestock, suburban, commercial, and industrial structures. For the taxable years 2013 through 2015, research and expense credits were claimed for both federal and state purposes. The Internal Revenue Service denied the federal claim for research credits under section 41(b). The department subsequently audited the taxpayer and denied the state claim. The department determined that the taxpayer did not keep contemporaneous documentation of the expenses and there was no evidence that the taxpayer’s actions constituted experimentation which led to technological innovation otherwise outside the knowledge of other skilled professionals.
Citing federal law, the department maintained that to claim the state’s research and expense credits a taxpayer must prove that the activities were undertaken for the purpose of discovering information which is technological in nature and the application of which is intended to be useful in the development of a new or improved business component. In addition, substantially all of the activities must constitute elements of a process of experimentation. The taxpayer argued that each building constituted a component which was completed through a process of experimentation. The department however found that the taxpayer could point to nothing they had done to discover information useful in the development of a “new or improved business component” beyond the exercising the common knowledge of other building contractors which regularly face routine - or even difficult - choices between the alternatives faced in constructing any building. Accordingly, the department found that taxpayer's activities were better categorized as efforts to refine, understand, and apply upon long standing techniques of constructing buildings which overcome the difficulties in each particular construction site and which meets the demands and requirements of each of its customers. That is, the taxpayer had not established that it fundamentally expanded upon the common knowledge or existing level of information in its field of science or engineering.
The department also found that the taxpayer failed to adequately document its employees’ activities and wages attributable to the research projects that were the basis for the claimed credits. Indeed, the taxpayer admitted that it did not maintain a contemporary system of project accounting in order to quantify the research expenses.
Many states provide research credits similar to those in Indiana. Businesses should be aware that state revenue departments interpret the eligibility for research credits narrowly. This ruling illustrates the general concept that research expenses must involve some level of experimentation. A taxpayer cannot claim that building to a customer’s specifications alone constitutes experimentation. Additionally, state research and development tax credit requirements may vary from the federal credit, even if the state uses federal definitions for purposes of the state program. As importantly, it is critical that business seeking to claim research expense credits maintain contemporaneous records of all related expenditures. Businesses performing research and development activities should speak to their state tax advisers with questions about the opportunities and how to navigate the state programs.