With a 28% global share, the United States is a world leader in research and development. As such, the federal government is taking measures to ensure that U.S.-based R&D efforts continue to thrive.
However, recent tax reform imposes penalties on companies conducting R&D activities outside the country, which means that a large tax bill is inevitable. The reform also has a negative impact on businesses based in the U.S. In fact, many are already seeing the financial impact of these new guidelines as well as the implications they will continue to have.
With penalties expected to further increase, it’s time for business leaders to reevaluate where they pursue their R&D efforts. While there is no one-size-fits-all approach that can accommodate every business, understanding the landscape of this tax reform is imperative to making the right decisions.
To understand what these businesses are facing, we must first understand the evolution of R&D tax credits.
Incentivizing R&D through tax credits has been a long-standing practice in the United States, as businesses have been encouraged to invest in research and development to spur innovation and economic growth. In fact, the National Bureau of Economic Research says that, “state-level credits increase average entrepreneurial activity by around 7 percent; counties in states with R&D credits experience a rise in new firm formation of more than 20 percent over 10 years.”
First introduced in 1981, the R&D tax credit program was initially a temporary measure to encourage businesses to increase their investments in U.S.-based R&D. In 2015, the credit was made permanent by the Protecting Americans from Tax Hikes (PATH) Act. But in 2017, the Tax Cuts and Jobs Act of 2017 (TCJA) brought significant changes to how companies can account for R&D expenses, causing some concerns among businesses that rely on R&D for their growth.
What the new guidelines mean for business
The TCJA requires that companies capitalize and amortize R&D expenses incurred after December 31, 2022 over five years if done domestically and over 15 years for foreign R&D. Therefore, the immediate benefit of the R&D tax credit has been reduced and severely penalizes companies with foreign R&D. This applies to companies that may not yet be profitable but that will be left with a hefty tax bill regardless.
Although these changes represent an effort to modernize and simplify U.S. tax law, while also promoting R&D reporting accuracy, they are creating unprecedented hurdles to achieving innovation.
Further, the change in the law has created a huge backlash for small and large corporations alike. In a recent WSJ article, Yelp’s Chief Financial Officer David Schwarzbach said, “Yelp expects its effective tax rate to rise to more than 38% from 18% in 2019, with the R&D change being a significant driver behind the increase. That’s a 20 percentage point increase in tax… so obviously very meaningful for us.”
A few weeks later, CNBC indicated that “…far greater pain is being felt by small businesses in the software development world, which have been blindsided by income tax bills that rose by as much as 400%, draining cash flow.”
These cries for help have slowly made their way to Capitol Hill. Senators Maggie Hassan and Todd Young recently proposed the The American Innovation and Jobs Act, which seeks to expand the R&D tax credit and make it permanent while also increasing the tax credit rate for certain small businesses. The bill also proposes to repeal the R&D capitalization requirements imposed by TCJA, making it easier for companies to immediately expense their R&D costs.
How can businesses mitigate the impact of this tax change?
From a tactical standpoint, companies should start early and be intentional when identifying, analyzing and quantifying research and development expenses. This is key to ensure a smooth process, especially for those who don’t claim tax credits.
Companies should also identify qualified research expenses as outlined in Section 41 and determine additional costs needed for purposes as outlined in Section 174. Businesses must then determine the appropriate method by which to monitor the amortization of the capitalized expenses.
Lastly, businesses need to document the effort they put into identifying and quantifying R&D expenses for future reference and adjust them based on the business’ needs.
The bottom line
The changes to R&D expense accounting under the TCJA have created significant challenges for businesses that rely on research and development to drive innovation and growth. While there is hope for relief through proposed legislation, companies must take steps to mitigate the financial impact of the change. It is critical for business leaders to stay up-to-date on any legislative changes and adjust their R&D strategy accordingly to maximize the benefit of the R&D tax credit.