Research tax credit audit plan and audit plan for internal-use software

Tax Executive, The, May-June, 1996

On March 29, 1996, Tax Executives Institute submitted the following comments to the Internal Revenue Service on two audit plans developed by the IRS's Research Credit Issue Specialist. The two plans are entitled "Research Tax Credit: Audit Plan for Examination of the Research Tax Credit" and "Research Tax Credit: Internal Use Software Audit Plan." TEI's written comments, which elaborate on issues discussed during a March 15 meeting between representatives of TEI's IRS Administrative Affairs Committee and the Internal Revenue Service, were submitted to David G. Harris, Director, Coordinated Examination Programs, and Ray Presley, Director, Industry Specialization Branch.

TEI's submission on the research tax credit audit plans were prepared under the aegis of TEI's IRS Administrative Affairs Committee, whose chair is Robert L. Ashby of Northern Telecom Inc. In addition to Mr. Ashby, the following individuals contributed to the preparation of the Institute's comments: Marc C. Filut of MCI Communications Corporation, Sheldon A. Kimel of Brunswick Corp., Kelly A. Nall and Karyn Ward of Electronic Data Systems Corp., Thomas B. Rogers of Apple Computer, Inc., Richard C. Sammut of Whirlpool Corporation, Paul J. Schaffhausen of McDonald's Corporation, and John P. Shepherd of PacifiCorp.

Background

Tax Executives Institute is a volunteer, professional association of approximately 5,000 accountants, lawyers, and other professionals who are responsible for managing the tax affairs of their companies. TEI members must contend daily with the recordkeeping and other compliance challenges associated with the business tax laws. TEI represents a cross-section of the business community, including companies that engage in all levels of research activities. We are dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and the government alike.

The Institute is firmly committed to maintaining a tax system that works -- both for taxpayers and tax administrators. We believe the diversity and training of our members enable us to bring a unique, balanced, and practical perspective to your attention.

General Comments

1. Overview of the Research Tax Credit: The research tax credit was enacted by Congress in 1981 in order to provide an incentive to taxpayers for increasing their research activities. Now contained in section 41 of the Internal Revenue Code, the research tax credit is equal to the sum of (i) 20 percent of the excess of the taxpayer's qualified research expenses for the taxable year over a base amount and (ii) 20 percent of the taxpayer's basic research payments. "Qualified research expenses" include in-house expenses for wages paid and supplies used in the conduct of qualified research, and 65 percent of any contract expenses for qualified research.

The definition of "qualified research" was amended by Congress in 1986. Section 41 provides that, to be eligible for the research tax credit, an activity must do more than satisfy the definition of research and experimental expenditures for purposes of section 174; it must also be undertaken for the purpose of discovering information that is technological in nature, the application of which is intended to be useful in development of a new or improved business component of the taxpayer. In addition, an activity is eligible for the research tax credit only if substantially all of the activities of the research constitute elements of a process of experimentation for a new or improved function, performance, reliability, or quality.

Given the menagerie of complicated concepts and terms in the research tax credit, it is not surprising that many disputes arise between taxpayers and the Internal Revenue Service concerning the meaning and application of section 41. The number and extent of disputes has no doubt been exacerbated by the lack of formal guidance from the IRS. Hence, although the IRS issued final regulations under section 41 in 1989, those regulations do not address themselves to the 1986 changes in the definition of qualified research and basic research, nor to the amended rules for computing the credit in respect of basic research payments. (The regulations similarly do not reflect changes made to section 41 in 1989 and 1993.) Without formal guidance, IRS agents have adopted differing views of what constitute qualified research activities and expenditures. TEI sincerely believes that the promulgation of regulations on the definition of credit-eligible activities and expenses would bring salutary clarity to the area, enhance the ability of taxpayers to voluntarily comply with the Internal Revenue Code's complicated requirements in respect of the research tax credit, and materially reduce the number and magnitude of disputes between taxpayers and the IRS in respect of the credit.

2. Issuance of Research Tax Audit Plans: Into the void created by the lack of current regulations, the IRS's research credit issue specialist in 1995 propounded two audit plans for use by examining agents. One of the two plans released by the issue specialist is addressed to general research tax credit issues, and is captioned "Research Tax Credit: Audit Plan for Examination of the Research Tax Credit" (10/12/95). The second plan addresses itself to software developed for the taxpayer's internal use, and is captioned "Research Tax Credit: Internal Use Software Audit Plan" (10/23/95).