On September 10, 2020 the Commissioner, Large Business and International Division (LB&I) of the IRS issued a Directive which revises and clarifies the Directive dated September 11, 2017. Both Directives provide LB&I examiners with guidance regarding the examination of the research credit under section 41 of the Internal Revenue Code.
Let us begin with some background on the topic of IRS examinations of the research credit. After spending several years at the Service as Director Field Operations for Engineering with responsibility over research credit examinations, I know firsthand how time consuming and difficult examinations can be for both the taxpayer and the IRS. The difficulty stems from a long history of revisions to the law, regulations, and court decisions, particularly around the area of substantiation. Generally speaking, there is not a “one size fits all” methodology when it comes to claiming the research credit.
After decades of examining the issue and the Service finding themselves with dwindling resources, they were very motivated to find a way to take some of the issues off the table. Then in 2014, an Industry Issue Resolution proposal was submitted and after much debate was approved by the IRS. This proposal was intended to use R&D to arrive at qualified research expenses (QREs) for tax purposes. The idea was not a new one. However, the timing was right. After nearly three years, on September 11, 2017 a Directive was issued allowing LB&I taxpayers to use the amount disclosed on their certified audited financial statements as Accounting Standards Codification (ASC 730) as a starting point for their QREs. Taxpayers who complied with the adjustments to the disclosed ASC 730 R&D expense set forth in the Directive, were afforded audit protection for any “safe harbor” amounts.
Surprised by the results, the Service learned two major things:
- First, a “certified audited financial statement” certifies the entire statement and does not address a specific line item. The ASC amount disclosed may be immaterial and got little to no attention by the independent auditor. Since the thought was the Service could rely on an independent third party for the accuracy of the amount, this was a major problem!
- Second, while ASC 730 does not apply to IUS expenses and therefore should not be included in the financial statement disclosure, the Service became convinced the amount disclosed contained internal use software. If true, that would be a problem, because additional standards apply to IUS to qualify for the research credit that differ from Generally Accepted Accounting Principles (GAAP).
The way the original Directive was written, if a taxpayer disclosed their research and development costs through a line item or foot note in their certified audited financials and made the proper adjustments required by the Directive, there was really no legitimate reason to not allow the taxpayer to apply the Directive.
Now we come to the revised Directive and the changes to address IRS concerns.
- GAAP financials are required: While the U.S. uses GAAP, many international entities use International Financial Reporting Standards (IFRS). There seemed to be a loophole if a taxpayer had U.S. GAAP audited financials even though they used IFRS for worldwide income. In a clarifying move, the Service stated that a taxpayer must use U.S. GAAP financial statements to reconcile book income to federal income on Schedule M-3 to qualify for the Directive.
- IRS can request more proof: To address the issue of the exam team having doubts about data in the financials, the revised Directive gives the IRS the authority–with permission from the territory manager–to request documentation besides what is required in Part V.
- Changes were made to documentation requirements
- Part V, Item d. removes the reference to “the ASC 730 Financial Statement R&D amount” and simple states Financial Statement R&D amount. I believe this is addressing the issue of items other than ASC 730 being contained in this number.
- Part V, Item g. is changed to state supporting documentation showing all employees and levels of management included in the total QREs for the Credit Year. The prior requirement was an organization chart. This is actually taxpayer friendly since many companies claim not to have a detailed organization chart and will allow them to provide other documentation.
- Part V, Item k. is a significant change, requiring a written narrative of the methodology and calculations for determining the amounts on Appendix C Lines 3a and 3b of the Directive. If no amount is listed, then the taxpayer must explain the methodology utilized to make this determination. The gist of this requirement is for the taxpayer to prove they have properly excluded any software expenses not for sale, lease or otherwise marketed and all other non-ASC 730 costs.
- Part V, Item l. requires substantiation of Internal Control Over Financial Reporting (ICFR) to mitigate material misstatement of expenses reported on the financial statements. FAQ Q-6 under Substantiation clarifies this means internal control for R&D expenses, not just in general. A presentation to the exam team is expected, including an explanation of how transactions are initiated, authorized, processed, and recorded. The taxpayer needs to be prepared to walk through examples of R&D expenses from initiation of purchase to financial statements.
- Internal Use Software is Classified Differently: The final and perhaps the most significant change to the Directive is in the area of software. The revised FAQs, under Software Development Activities, Q-1 to Q-11 go into great detail on what is included in and excluded from the ASC 730 amounts under the Directive.
- The final paragraph of Q-8 which states, “For purposes of this Directive, LB&I considers any software that is not for sale, lease or otherwise marketed by the taxpayer per the criteria in ASC 985-20-15 (see Qs 1 and 5) as internal-use software under ASC 350-40.
- Unless the software is for sale, lease or otherwise marketed, the expenses are considered IUS and not included in the Directive. In the case of a hosting arrangement, the expenses to develop the software are considered IUS, unless both (1) the customer has a contractual right to take possession of the software at any time during the hosting period without significant penalty or (2) it is feasible for the customer to either run the software on its own hardware or contract with another party unrelated to the vendor to host the software.
- Businesses Have a Unique Opportunity to Benefit
To summarize, there are some significant changes to the IRS’ latest Research & Development Tax Credit Directive. However, the majority relate to software. Research on software that is not for sale, lease or otherwise marketed, (including most hosting arrangements), do not qualify for the Directive because the expenses should not be treated as ASC 730 costs for book purposes, and therefore should not be included in any ASC 730 R&D expense disclosure.
Although some service providers have not been keen on the Directive in the past and probably less so now, I suspect because there are less fees to be made.
Even though the Directive clearly excludes any research for software not falling under ASC 730, I think there is real opportunity for many taxpayers to benefit from the Directive. To do so, it is imperative that a taxpayer make the required disclosure on their certified audited financial statements for the year in which they apply the Directive. In addition to making the disclosure, the key to success is having verifiable internal controls in place and ensuring the required documentation is kept.
A key step is to have internal measures in place to ensure all costs not qualifying for the Directive are tracked and excluded (e.g. internal use software costs.) Often time tracking is an excellent way to achieve this and can be demonstrated to the IRS upon request.
Keep in mind that any qualified research expenses falling outside of the Directive can still be claimed to compute to the research credit.
We at TCC are available to discuss your specific questions and navigate you through applying the Directive correctly. Learn more about R&D Tax Credits.