On September 22, 2017, the IRS publicly released guidance for large business and international (LB&I) examiners regarding the examination of certain R&D expenses under Financial Accounting Standards Board Accounting Standards Codification® Topic 730, Research and Development.
What the Directive Does
The directive—LB&I-04-0917-005—indicates the IRS won’t challenge certain qualified research expenses (QRE) that are a taxpayer’s adjusted ASC 730 financial statement R&D costs. It applies to corporations, S corporations, and partnerships with greater than $10 million in assets that identify, either by account or footnote disclosure, R&D expenses on their audited financial statements under US generally accepted accounting principles (GAAP).
With this guidance, taxpayers now have the option to reconcile ASC 730 with the QRE claimed on their tax return by adjusting ASC 730 financial statement R&D costs to arrive at the amount the IRS considers as qualifying for safe harbor. Safe harbor, in this instance, means the IRS won’t challenge the amount.
Amounts that aren’t eligible for safe harbor can then be added back to arrive at the amount of QRE claimed on the tax return. However, these addbacks won’t be eligible for safe harbor.
Safe Harbor R&D Expenses
The following self-funded R&D expenses, which must relate to activities occurring in the United States, will qualify for safe harbor under this guidance:
- Wages. A total of 95% of taxable wages for qualified individual contributors and first-level supervisor managers. 10% of this amount can be used for upper-level managers.
- Supplies. All supplies used in the R&D process other than prototype overhead expenses.
- Computer rentals and leases. Amounts paid by a taxpayer for the right to use computers during the conduct of qualified research. This may include qualified cloud-computing costs associated with R&D.
Any R&D activities required to be performed to meet the terms of a contract are ineligible for safe harbor.
Excluded R&D Expenses
Taxpayers that decide to apply for safe harbor aren’t excluded from including additional expenses as part of their R&D tax credit calculation. However, these expenses won’t receive safe harbor treatment.
Additionally, expenses related to contract research, research performed to fulfill contract terms, and additional upper-level employee wages may still be considered qualified R&D expenses and treated accordingly.
Items related to other aspects of the R&D tax credit, such as the base amount and controlled group considerations, aren’t addressed in this guidance.
To apply for safe harbor treatment under this directive, a taxpayer must complete and sign a certification statement claiming its adjusted ASC 730 financial statement R&D as QRE on its federal income tax return. Two appendices detailing the reconciliation between ASC 730 and R&D expenses must also be included in the application to provide the IRS with further details on what’s being included in a taxpayer’s overall R&D expense calculation, not just its safe harbor calculation.
Alternatively, the taxpayer may submit the certification and related appendices to an IRS examiner at the onset of an audit. A separate certification must be completed for each tax year in which a taxpayer wishes to apply for the safe harbor.
The directive is an optional certification process that applies to tax returns filed on time—including extensions—on or after September 11, 2017. Corporations, S corporations, and partnerships should consider the following when deciding whether to apply:
- R&D expenses
- Financial statement audit process, including ASC 730
Looking at historical guidance, the IRS often signals examination trends through directives. Accordingly, although this guidance applies to a specific group of taxpayers, it’s possible it represents a potentially greater shift in the IRS examination process for all taxpayers claiming the R&D credit.
This means now may be a good time for companies to revisit their R&D accounting method and compare how R&D expenses are being captured for both book and tax purposes as well as how they align. This is also a good opportunity for businesses to review their FASB Interpretation No. 48—known as FIN 48—reserves and how the new guidance may impact this calculation with respect to the R&D tax credit.
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