The purpose of this article is to review the Franchise Tax Board’s manuals on California’s research and development (R&D) tax credit. It is based upon the FTB’s Multistate Audit Technique Manual Section 9140, as well as FTB Publication 1082.
California allows a credit against tax for the amounts paid or incurred for research conducted in California. Generally, the credit is allowed in accordance with Internal Revenue Code (IRC) § 41, modified for California by California Revenue & Taxation Code (CRTC) § 23609.
California conforms to the federal rules for assigning this credit among members of a controlled group. To determine the amount of the credit, all members of the same controlled group of corporations are treated as a single taxpayer. The credit amount is assigned to the members of the controlled group based upon their proportionate share of the qualified research expenses and basic research payments.
The research credit may reduce tax below the tentative minimum tax. If the credit is not used in the current year, it may be carried over to subsequent years until it is exhausted.
Audit Tip: If a material credit is being claimed, the auditor should, at the very minimum, determine if the research is conducted in California and verify the mathematical computation. A review of the costs included in the qualified research expense should also be considered. Qualified research expense includes compensation, supplies, and contract research costs.
Compensation: Compensation must be directly related to the research activities and paid by the taxpayer. This may include direct supervision, direct support or direct performance of qualified research. An allocation of the purchasing or receiving departments' wages does not qualify because they are indirect costs. Items that are considered compensation for purposes of determining the credit include, but are not limited to, salaries, wages and taxable income from non-qualifying stock plans or disqualifying dispositions of incentive stock options.
Deferred compensation and fringe benefits (such as health benefits) are not qualifying expenditures. Audit Tip: Information to make the above determinations may be found in employees' W-2 records, job descriptions, duty statements, employee evaluations, etc.
Supplies: Supplies include all tangible property that is consumed directly by the research activity or that goes into the prototype. The supplies must be used in the conduct of qualified research. Supplies mean any tangible property other than land, improvements to land and property subject to the allowance for depreciation. Generally, utilities (phone and electricity), small tools, and allocations of the total shipping cost are not qualifying supply expenses.
Contract Research: Contract research expense means amounts paid to non-employees (outside consultants) to perform qualified research. The outside consultant must perform the research in California. 65% of this expense qualifies as a research expense. Audit Tip: The auditor may review the taxpayer's vendor files and vendor contracts to determine if the expense qualifies.
While California law generally conforms to the federal research credit, California does make some modifications, including:
· The definition of “qualified organization” includes hospitals run by public universities and certain cancer centers.
· “Basic research” and “qualified research” must be conducted in California to qualify for the California credit.
· For taxable years beginning on or after 1/1/2000, the credit is 15 percent for qualified research for all taxpayers and 24 percent for basic research conducted by corporations.
· For taxable years beginning on or after 1/1/2000, the percentages for the 3-tier alternative incremental credit (AIC) are 1.49 percent, 1.98 percent, and 2.48 percent, respectively.
· The credit cannot be carried back.
· The definition of “gross receipts” differs.
· The termination dates provided under federal law do not apply (i.e., the California credit is permanent).
Research must meet four tests to be eligible for the R&D credit under state and federal laws. IRC Section 41 states that the research activity must:
If the research activity does not meet any one of these requirements, it is not considered a qualified research activity.
IRC Section 41 (and, therefore, California) also specifically excludes research activities relating to the following:
Chris Micheli is an attorney and registered lobbyist for the Sacramento governmental relations firm of Carpenter Snodgrass & Associates (916/447-2251), where he specializes in tax legislative matters.