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Congress Adjourns Without Extending the Research Credit
KPMG’s Research Credit group will be providing future updates of the status of the research credit as well as other related information in TaxNewsFlash-Research Credit. If you would like to receive future email alerts concerning the research credit, reply to US-KPMGWNT@kpmg.com.
Congress adjourned for the year on December 19 without extending the research credit. Unless and until extenders legislation is enacted, research expenditures paid or incurred after December 31, 2007, will not be eligible for the credit. The second session of the 110th Congress will convene on January 15, 2008, but just how soon Congress might once again consider extending the credit is uncertain, as the controversy over offsetting revenue provisions is likely to continue.
The research credit last expired at the end of 2005, and an extension was not enacted until December 20, 2006. While that extension was fully retroactive to the beginning of 2006, it did present some complications, which should be kept in mind anticipating this next lapse.
Legislative Background
Congress was unable to reach agreement this year on legislation that would extend the research credit for amounts paid or incurred after December 31, 2007. In November, the House approved a bill, H.R. 3996, that would have provided a one-year extension of the research credit (with no substantive change) and other expiring provisions, including the AMT patch. There was no significant opposition in principle to extending the credit, which enjoys wide support in Congress, or to the other extenders. Congress was sharply divided, however, over whether and how to offset the revenue cost of the extenders.
Congress’s most urgent priority was the AMT. Without extension of the AMT patch, an estimated additional 19 million taxpayers would have been subject to the individual AMT. Congress did finally pass a one-year “patch” for 2007 on December 19 without offsetting the revenue cost, but only after a prolonged and rancorous debate. The “AMT patch” will prevent the AMT from applying to a greatly expanded group of individuals in 2007. The legislation did not address the research credit or any of the other provisions that are about to expire.
Congress will certainly return to the extension of expiring provisions, including the research credit, an extension that would be effective seamlessly as of January 1, 2008. It is quite uncertain, however, just when the extension might pass, as the debate over revenue offsets resumes. It could be several months (or more) into 2008 before Congress might act.
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The Effect of a Lapse in the Credit
The termination of the credit is not likely to have any cash-flow-related income tax effects for most calendar year companies until March 15, 2008, assuming there is no extension by the time first quarter corporate estimated payments are made. The termination applies to expenses paid
after December 31, 2007, regardless of the company’s tax year. Thus, calendar year taxpayers will not have any lapse that would affect their tax computations or liability for 2007. However, 2008 estimated tax payments may be affected.
Fiscal year taxpayers will need to make some adjustments for the first tax year ending in 2008, depending on how long the termination of the credit persists. For fiscal year taxpayers, estimated tax payments, extension payments, and the tax reported on the return may all be affected by the credit being in effect for less than 12 months of the tax year.
Only amounts paid or incurred by the end of 2007 can be reported as qualified research expenses. For taxpayers claiming the traditional incremental credit, or the Alternative Incremental Credit (AIRC), the base amount used to compute the fiscal year credit will need to be scaled back. A taxpayer with a 12-month March 31, 2008, tax year, for example, would need to compute its base amount using full tax year amounts and then multiply the base amount by 275/366 to compute the credit.
| QREs through 12/31/2007 for tax year ended 3/31/2008: | $10,000 |
| Average annual gross receipts for the four 12-month
tax years ending 3/31/2004 through 2007: | $200,000 |
| Fixed base percentage: | 4.65% |
| Base amount: ($200,000 x 275/366) x 4.65% = | $6,988 |
| QREs eligible for traditional incremental credit:
$10,000 - $6,988 = | $3,012 |
IRS guidance on issues dealing with the new Alternative Simplified Credit (ASC) has not yet been issued, but we expect that a similar scale-back adjustment will be required for the ASC. That is, we expect that if the taxpayer in the example above used the ASC, it would need to multiply its average QREs for the three preceding tax years by 275/366, before multiplying those “base QREs” by 50% to determine the amount of current year QRE paid or incurred through December 31, 2007, that is eligible for the 12% credit.
| QREs through 12/31/2007 for tax year ended 3/31/2008: | $10,000 |
| Average annual QREs for the three 12-month
tax years ending 3/31/2005 through 2007:
| $12,000 |
| Base QRE amount: ($12,000 x 275/366) x 50% = | $4,508 |
| QREs eligible for 12% ASC: $10,000 – $4,508 = | $5,492 |
Fiscal year taxpayers may face a dilemma in selecting the optimal method of computing the research credit if their 2008 tax returns need to be filed before the research credit is reinstated. For example, the company in our example might determine that the optimal credit based on nine months’ of QREs is computed under the traditional incremental credit, but that the ASC may provide a bigger credit if 12 months of QREs could be used. Following the December 2006 reinstitution of the credit, fiscal year taxpayers were given an opportunity to make a late AIRC election for the tax year in which the credit had lapsed. One would hope that Congress provides similar relief if the credit lapses at the end of 2007, as legislation is required to provide this option.
Continue to Document QREs
While a credit for expenses incurred in 2008 will not be available until extenders legislation is enacted, we encourage companies to continue to document their qualified research activities and the expenses incurred. As a practical matter, any lapse in contemporaneous documentation will need later to be remedied, which can result in a delay in computing the research credit amount. Also, the IRS has recently greatly increased its diligence in reviewing research credit claims, and any suggestion that qualified expenses had to be determined retrospectively—after the credit is reinstated—could give IRS examiners an opportunity to question the validity of the records.
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What Are the Legislative Possibilities?
If and when the credit is reinstated, it is unclear whether Congress would approve a one-year extension (as the House would have provided in H.R. 3996) or a longer-term measure. It is not out of the question that Congress might even make substantive changes. Senator Baucus, the chairman of the Senate Finance Committee, has endorsed a phased-in increase in the new Alternative Simplified Credit from 12% to 20%, and some part of that could be included in an extension. The big issue, however, will continue to be whether and how to offset the revenue cost of an extension. A one-year extension was estimated to cost about $9 billion (over 10 years) and making the credit permanent (with no modifications) has been estimated to cost more than $90 billion (over 10 years). Proposals to phase in an enhanced Alternative Simplified Credit would add substantially to that cost. It will very likely be difficult, once again, for Congress and the President to reach agreement on offsets.
We will continue to provide updates on the developments affecting the research credit in the new year.
For more information, contact a KPMG tax professional with the Research Credit group:
Christine Kachinsky, (212) 872-2187, ckachins@kpmg.com
Adam Uttley, (213) 593-6732, auttley@kpmg.com
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