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R&D credits: Tax savings value for 2014 and beyond

Robert W. Henry, CPA
Weaver

Recent news further illustrates the value oil and gas companies may realize from claiming research and development (R&D) tax credits at the federal and state levels.

Extension of the federal R&D tax credit for the 2014 and 2015 tax years was approved by the Democrat-led U.S. Senate Finance Committee in April 2014. Additionally, the Republican-led House of Representatives approved a bill in May 2014 that would make the R&D credit permanent.  The House measure passed with a vote of 274 – 131. The House bill still requires full Senate approval and President Obama’s signature, but it remains clear that the R&D tax credit enjoys widespread political support.  This bipartisan support for the R&D credit in general makes it more likely than ever (since the credit’s most recent expiration at 12/31/13) that its proposed extension will become law in either temporary or permanent form at some point in the foreseeable future. The R&D tax credit was originally enacted as part of the Economic Recovery Tax Act of 1981, and has been extended for virtually every year since.

Effective January 1, 2014, oil and gas companies may also claim an R&D tax credit in Texas. With that move, Texas joins other significant energy-producing states in offering an R&D tax credit.

Oil and gas companies operating in the industry’s upstream sector may undertake activities that qualify for the R&D tax credit when experimentation is used to overcome the uncertainty regarding recoverability of resource reserves. Activities to identify a petroleum or gas reservoir’s existence typically do not qualify for the credit. Many costs incurred in maximizing return on capital for recovery of known reserves, though, may qualify for the credit.

Various midstream and downstream activities, such as determining methods of more efficiently transporting or refining oil and gas, may likewise qualify for the credit.

U.S. Internal Revenue Code (IRC) sections 174 and 41 provide primary guidance for defining qualifying R&D activities.

Federal direction for defining R&D activity
US Treasury regulations section 1.174.2 (Regs. §1.174.2) defines qualifying research and experimental expenditures. A qualifying activity must:

  • Relate to the development or improvement of a “product,” inclusive of a technique, invention, formula or process; and;
  • Address uncertainty regarding the appropriate method or design for the product.
  • An eligible §174 activity may also qualify for the R&D credit under Internal Revenue Code section 41 (§41), if the activity:
  • Is technological in nature (i.e. based in engineering, geology or other hard science).
  • Contains a sufficient degree of development uncertainty.
  • Consists primarily of a process of experimentation.
  • Has a permitted purpose that improves a business component, which may be a product, process, software, technique, formula or invention.

Internal Use Software (IUS) may also meet the §41(d) qualified research definition if:

  • The software is innovative.
  • The software development involves significant economic risk (i.e. possible changes to anticipated return on investment is at risk due to developmental uncertainty), and;
  • The software is not available for commercial use.

Individual companies and industry vendors rely upon analytics and other software tools. An oil and gas company may develop its own software, which may qualify for the R&D credit. A vendor may likewise develop software that is not marketed as a separate product. Once a company has determined an activity meets R&D qualifications, it needs to determine that credit’s worth.

Calculation methods for the R&D tax credit
The Traditional Credit Method or the Alternative Simplified Credit (ASC) Method may be used to calculate the R&D tax credit’s value.

The Traditional Credit Method provides a credit equal to 20% of the excess of qualified research expenses (QRE) for the current tax year over a statutorily prescribed base period amount. 

The ASC Method uses a base amount equal to 50% of the average annual qualified research expenditures claimed by a company for the three immediately preceding tax years. The excess of current year QREs over that base is then multiplied by 14% to determine the credit.  Special rules also apply for first-time credit claims and start-ups.

Available state R&D credits
Various energy-producing states offer R&D tax credits. Texas is now offering a sales and use tax exemption or a franchise tax credit related to qualified R&D activities. With the volume of industry activity taking place within the state’s Barnett Shale, Eagle Ford and Permian Basin areas as well as other locales, companies have considerable incentive to investigate the Texas R&D tax credit.

Colorado also hosts a thriving energy industry and offers a 3% R&D tax credit. Qualifying activities must take place within designated enterprise zones. Louisiana offers up to a 40% R&D tax credit for qualifying activities. North Dakota bases eligibility for its R&D tax credit on §41 criteria. The percentages for the credit vary, based on the particular tax year(s) for which the credit is being claimed.

State tax codes vary immensely and not all states with a substantial oil and gas industry presence offer an R&D tax credit. An oil and gas company needs to determine where it has state tax nexus and identify whether an R&D tax credit is available for that state.

After determining that activities may qualify for R&D tax credits at the federal or state levels, a company needs to ensure that internal processes exist for capturing those tax credits.

Steps for capturing R&D tax benefits
Capitalizing upon potential R&D tax credit benefits begins with examining what company projects or functions have qualifying activities.

An upstream oil and gas company needs to examine how it maximizes return on investment regarding known reservoirs and how it extracts oil or natural gas, based on criteria defined by §1.174.2 and §41. Such examination needs to consider analytics and intellectual property as well as equipment and physical processes.

A midstream sector pipeline company may have devised means to more efficiently monitor oil and natural gas flows or may have overcome adverse field conditions in placing a pipeline. Various processes for purifying or refining oil or natural gas may have been improved upon, thereby giving a downstream sector company a substantial business benefit.

Industry vendors likewise need to evaluate what internal projects and functions might include qualifying R&D activity.

When R&D activities are identified, a company needs to determine how such costs are tracked. How are labor expenses tracked for internal employees? What about contractor and vendor expenses? What supplies or materials are used, and how are those costs recorded?

Such awareness enables a company to define what it can claim for an R&D tax credit. Applying the tax credit formula then takes into account a company’s historical QRE and gross receipts.

Individuals responsible for R&D activities should be interviewed. Those individuals can describe exactly what activities are taking place, what steps and processes are involved, and what costs are being incurred. Those interviews also help individuals gain awareness of how R&D activities may be defined and what activities need to be documented.

Conducting such internal analysis can be an expansive task. If necessary, company managers should consult with a tax advisor for assistance in both identifying and tracking R&D activity.

Potential tax return examination concerns
If a company’s R&D tax credit claims are examined and audited, several factors will be considered. The first is the nexus between costs and activities. A company needs to demonstrate that costs factored into the R&D credit claim are indeed relevant and incurred in direct relation to the attributed R&D activity.

The process of experimentation, which defines R&D activity, must be documented. That documentation must demonstrate the activities undertaken in the development initiative must consist of a process of experimentation.  A process of experimentation is any process that has the capability of measuring the effectiveness of more than one proposed design alternative related to the uncertainty being investigated.

The company must also be able to identify the business component being developed or improved, which can be a product, process, software, technique, formula or invention held for sale in use of the taxpayer’s trade or business.

While many state tax codes are based upon federal tax code, differences arise among tax jurisdictions. State tax credit criteria must also be evaluated to identify potential examination concerns.

The R&D tax credit supports long-term business aims
Oil and gas companies face considerable risks. Capitalizing upon potential business opportunities requires considerable capital investment, too. R&D activities are necessary to mitigate risks and to make capital investments as worthwhile as possible.

The R&D credit enables companies to realize substantial tax benefits from those activities. Companies must be aware of where such opportunities may exist, and what conditions must be met to meet requirements defined in §1.174.2 and §41. Supporting documRobert Henry, Weaverentation must be compiled, too. While that requires ongoing attention, the immediate and long-term tax savings make that effort worthwhile.

About the author
Robert W. Henry, CPA, is a partner in tax and strategic business services at Weaver, the largest independent accounting firm in the Southwest with offices throughout Texas. He can be reached at Robert.Henry@Weaver.com or 210.572.3750.

 

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