Texas Clarifies 3 Major Changes to the R&D Tax Credit

Texas clarified its rules concerning application of the Texas R&D tax credit and the sales and use tax exemption for materials used in R&D, through guidance issued on October 15, 2021.

While the rules are generally more restrictive, they do provide helpful clarification and useful examples of the types of activities that may still be eligible for the credit.

These changes will impact Texas taxpayers claiming the state R&D credit or sales and use tax exemption for R&D activities in Texas.

Each company’s goals, values, and resources are unique, which makes it important to develop a customized project plan to identify, calculate, and support your company’s R&D tax credits and activities.

Services Don’t Qualify as Business Components

To qualify, the taxpayer must develop a new or improved business component. A business component is a product, process, formula, technique, invention, or piece of software.

Because a service isn’t a product or any other of the enumerated business components, expenses incurred for providing services to customers don’t qualify. However, a service may qualify if it results in delivery of one of the enumerated business components.

For example, expenses incurred preparing a product design for sale, lease, or license may not qualify. However, the expenses may qualify if the design culminates in the development or fabrication of a tangible product.

Many Software Development Activities No Longer Qualify

Some potentially qualified software activities are:

  • Development of an initial release of a software application that incorporates new algorithms, architectures, or database management techniques
  • Development of specialized technologies, such as artificial intelligence, image processing, or speech recognition

These activities related to software development are unlikely to qualify for exemptions:

  • Functionality enhancements to an existing product
  • Porting existing software application to a new framework or programming language
  • Development of graphical user interfaces (GUIs) and user experience (UX) design
  • Development of application programming interfaces (APIs) and interfaces for data exchange with third-party software
  • Development of software that’s substantially similar to software already in use by other companies
  • Development of embedded applications for deployment in vehicles

Internal Use Software

Under the new rules, internal use software for the operation of the taxpayer’s business doesn’t qualify. This differs from software used by clients that pay for its use.

While the state has limited the types of activities that qualify, the normal shrink-back rules still apply and may be used to carve out a portion of a development effort until 80% of the development effort satisfies the four-part test. When credit qualification criteria are not satisfied at the level of a discrete business component, the shrink-back rule permits taxpayers to determine whether credit qualification criteria are satisfied at the subset level.

In light of these regulations, which are more restrictive than the federal credit requirements, Texas taxpayers unsure if they meet the qualification criteria are encouraged to reach out to a tax professional to discuss the requirements.

We’re Here to Help

To learn more about R&D tax credits, see Five Misconceptions about R&D Tax Credits—and if You Qualify, request a complimentary credit benefit estimate to see how much your company could save, or contact your Moss Adams professional.

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