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R&D Capitalization is here! Are you wondering how this change impacts your business? Join our live Q&A to get answers.
R&D Capitalization is here! Are you wondering how this change impacts your business? Join our live Q&A to get answers.
The research and development (R&D) tax credit is tax legislation passed to incentivize American companies to invest in innovation.More than $12 billion worth of R&D tax credits were claimed in 2014, but a significant portion 0of that money went to Fortune 500 companies. Congress has taken specific action of the last half-decade to make sure the credit is available to early-stage startups. The goal is to give innovative startups the tax credit they need to create new, valuable ideas in the United States.
If you’re a startup in the tech space, you more than likely qualify for the R&D Tax Credit. The qualifications for the credit are:
Importantly, in order to use the R&D Credit towards your payroll rather than your income, you must also fit these 3 criteria:
The 2016 expansion of the R&D Tax Credit allows startups to claim the credit against their payroll tax for up to 5 years. Each year, they can receive a maximum credit of $250,000, so theoretically, a company could receive a maximum of $1.25 million over their first five years.
First, the tax code is purposely obscured. Second, the R&D Tax Credit didn’t apply to startups like yours until 2016. The newness of the law means many companies are leaving money on the table. But, we’re here to help. neo.tax’s automated filing system can complete the process for your company in less than 15 minutes. We take just 5% of your savings and only after they arrive in your bank account. The R&D Tax Credit was written for startups like yours; get the money that you’re owed.
When Ronald Reagan signed the Economic Recovery Tax Act of 1981 into law, businesses quickly jumped to take advantage of the new tax break that let them lease or rent computers. At the time, computers were prohibitively expensive, which made them impossible to own for all but the largest corporations and research institutions. Instead, most people leased time on mainframe computers. The 1981 bill made it so the money companies spent leasing mainframe computers were Qualified Expenses towards a tax credit. While the bill was built to democratize access to computers in the business world, it ended up becoming most valuable for the largest companies. In a section of The Protecting Americans From Tax Hikes Act of 2015 (PATH), congress set out to fix that issue. For years, the R&D tax credit could only be used to offset a company’s income tax. Obviously, most early-stage startups don’t have any income to offset. So, starting in 2016, in order to incentivize innovation at the early startup level, the PATH Act allowed early startups to use the R&D Tax Credit towards payroll tax as well. That law made thousands of startups newly eligible for the R&D Tax Credit; unfortunately, most still don’t realize or have the resources to file for the money they’re owed.
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This whole year, founders, CFOs, and accountants have been staring down a new tax paradigm. When former President Donald Trump passed his Tax Cuts and Jobs Act in 2017, it included a five-year ticking time bomb that would completely change the way R&D expenses could be deducted. In earlier posts, we’ve outlined how changing R&D from a deductible expense to a capitalized one would cost companies of all sizes dearly on Tax Day.
There was hope that legislators could overturn this costly tax law before the 2023 tax year (and even pass a law that would undo the effect on the 2022 tax year), but the lame-duck Congress was unable to strike a deal. So, for the foreseeable future, R&D Capitalization is here to stay.
As we explained in our post “R&D Capitalization Has Arrived (For Now)—Here's What You Need To Know,” the new law changes the way R&D spend can be deducted, which completely changes the calculus for pre-revenue startups. Up until 2023, R&D spend could be deducted all at once, which allowed companies in the red to stack NOLs. Now, R&D spend must be amortized fractionally over the course of 5 or 15 years, depending on whether the expenses are domestic or international. That means, tax bills will rise and NOLs will become harder to compile; it’s bad news for innovative companies.
At Neo.Tax, we’ve been preparing for this eventuality. We view it as our duty to make taxes work for innovative companies, so we’re proud to say that Neo.Tax has the only software solution that can cover all aspects of R&D tax strategy: from credits to amortization, and everything in between.
We’re the only company on the market that specifically addresses this new tax change. Fortune 500 companies are treating this as a Big Forkin’ Deal, so it’s essential to get ahead of this before it’s too late. Get in touch today, or come to our weekly webinar to learn more about how to weather this coming tax storm!
BECOME AN R&D CAPITALIZATION EXPERT:
the world’s most unpopular tax change just went into effect.
but how, if both parties hate this law, did it still go through?
and why is everyone surprised that it actually happened?
and why does it affect businesses that aren’t profitable?
and what in the heavens can you possibly do about it?
we answer all of these questions and more below =]
something had to pay for trump’s ‘17 tax cuts.
a tax time bomb, scheduled to go off in 5 years.
a terrible idea, but it balanced the budget perfectly.
and having it go into effect 5 years later bought time.
more than enough time for congress to repeal or delay it.
if both sides could get their act together and work together.
republicans + democrats agree this law had to be repealed.
but because both parties agreed on how terrible it is,
neither party could use it as a bargaining chip,
to get something else passed in return.
i wish i was joking — i am not =/
companies can no longer write off r&d expenses.
(costs related to building or improving products)
this hits technology companies particularly hard.
of all sizes! baby startups that aren’t profitable,
up to raytheon cutting cashflow by $2b. yikes!
when taxes made sense, the math used to be:
$2m revenue - $5m expenses = -$3m losses
the new math, starting tax year 2022, is now:
$2m rev - ($5m/5years → $1m) = $1m profit
worse, offshore r&d gets spread over 15 years:
$2m rev - ($5m/15y → $300k) = $1.7m profit
the government is being a little schizophrenic.
on the one hand, r&d is rewarded with r&d credits.
on the other hand, r&d is punished with capitalization.
and those rewards + punishments are to differing degrees,
depending on each company’s revenues, expenses, NOLs, etc.
sounds like an optimization problem to me! to balance all of that out.
fortunately, this is the perfect problem for software to solve.
neo.tax connects to your accounting, payroll and business data,
then scans the universe of all possible tax outcomes for your situation,
to apply the tax strategy with the most optimal outcome for your business.
can you imagine getting an estimated tax bill from the irs,
then going back in time to adjust your tax strategy,
way after the fact as if that isn’t suspicious?
During the rollout of his signature corporate tax cut, the Tax Cut and Jobs Act of 2017, President Donald Trump argued that his plan would stop U.S. companies from offshoring their work overseas. But according to Reuters, it failed to curtail the flow of American jobs abroad:
“During the four years of the Trump administration, [the Labor Department] program certified 2,095 petitions covering 202,151 workers who lost jobs that moved overseas. That’s only slightly less than the 2,170 petitions approved during the last four years of the Obama administration, which covered 209,735 workers.”
Additionally, the TCJA included a provision that changed how R&D deductions can be taken by American companies—rather than being deducted all at once, R&D costs must be amortized over 5 years for domestic spending and 15 years for foreign expenditures. The change threatens to disincentivize American companies to invest in innovation. “In a letter dated Nov. 4, 178 chief financial officers, primarily from large U.S. companies, including Ford Motor Co., Raytheon Technologies Corp., Lockheed Martin Corp. and Boeing Co., said the new rules create a competitive disadvantage for American companies and will lead to job losses and thwart innovation,” an article in the Wall Street Journal explained. “They are asking Congress to move back to immediate deductibility before the end of the year.”
The CFOs argue that the R&D capitalization change will threaten American business and foreign policy interests; they argue that a country that stops prioritizing innovation will fall behind on the global playing field. “On a level playing field, the U.S. can compete for R&D investment with any country in the world,” they wrote. “Unfortunately, the current playing field is tilted against the U.S., and every day this policy continues to be in place makes it harder for the U.S. to remain a global leader in innovation.”
So, how does American R&D policy compare to competitors abroad? And what could we learn from their policies? Ernst & Young’s (EY) 2022 Worldwide R&D Incentives Reference Guide offers a fascinating look.
Since World War II, the United States has functioned as the world’s economic superpower. Prior to that, Great Britain held that mantle, and many believe that China may soon surpass the U.S. and claim that title in the future. It turns out that both the UK and China have committed to a much more robust R&D investment than the current American plan—the two countries have “super deductions” for R&D expenditures, allowing companies there to deduct more than 100% of R&D costs from their taxes. According to EY’s Worldwide R&D Incentives Guide, mainland China-based companies can deduct 175% of qualified R&D expenses for purposes; manufacturing enterprises began deducting up to 200% of qualified R&D expenses starting in 2021!
Until a new R&D policy was announced this month, the UK had a more favorable (or, perhaps, favourable) R&D credit for all businesses, and was especially invested in domestic small-to-medium-sized enterprises (SMEs). SMEs could claim an enhanced deduction of 230% of qualifying R&D spend, as a deduction against taxpayers’ profits. If the deduction was more than the taxes, these SMEs could claim a cash credit at 14.5%, according to EY’s Worldwide R&D Incentives Guide.
The tax code in the UK and China is a demonstration of the way each country works to incentivize R&D, but taxes only tell part of the story. The UK also has a large number of public grants meant to spur innovation. For example, Innovate UK, which gets funding from the Department for Business, Energy & Industrial Strategy (BEIS), works to get academia and industry working towards UK-based patents and products and gives around £1 billion in direct grant funding every year for company-run R&D projects.
The United States has a similar SMB R&D grant called the Small Business Innovation Research program, but most of the R&D spend is done by private industry. As the Wall Street Journal explains: “U.S. companies spent an estimated $532 billion on R&D in 2020, representing the lion’s share of what the U.S. as a country allocates to it, according to the National Center for Science and Engineering Statistics, a statistical government agency. A 2019 report from Big Four accounting firm Ernst & Young forecasts that U.S. R&D spending would be cut by $4.1 billion a year for five years because of the change and then by $10.1 billion annually for the subsequent half-decade.”
The change in R&D capitalization threatens to accelerate that reduction in industrial R&D spending. Without the public grants to buoy American innovation, it could lead America to fall behind in the global race towards innovation.
India is a fascinating case study in R&D tax law and its impact. During its rapid push to liberalize and modernize the economy, the Indian government introduced an R&D tax credit to stimulate innovation. From 2001 to 2010, the R&D tax deductions were worth 150% of any capital and revenue R&D spend by firms in qualifying sectors. Starting in 2010, the R&D tax deduction was increased to 200% and became available to every Indian company. That new structure helped make India one of the most tax-friendly countries in the world in regards to R&D. (Note: in 2020-21, the deduction was reduced to 100% of R&D expenditure.) Researchers at three universities looked at the effects and found a substantial rise in R&D spending and patent applications in both India and in the US due to the changes: “We find that the R&D tax credit scheme and its 2010-11 reform spurred firm innovation,” they wrote in their 2021 journal article R&D tax credit and innovation: Evidence from private firms in India. “In response, such firms became more innovative and more productive.”
The finding is intuitive, but it doesn’t make it any less striking when compared to the US policy toward R&D spending: lowering the cost of R&D through tax credits increases research spending, which leads to more domestic patents.
Canada has an interesting R&D policy that could be a valuable model for making R&D reform more politically palatable in the United States. The country offers a 15% federal R&D credit on all qualifying expenses. However, in addition, they offer an enhanced credit rate of 35% for R&D spend by small Canadian-controlled private corporations (CCPC) on their first $3 million of R&D expenditures each year. That 35% credit is 100% refundable.
The policy is specifically crafted to incentivize domestic small-and-medium-sized businesses run by Canadians. For a company to qualify as a CCPC, it must be privately owned and operated in Canada, and must not be controlled directly or indirectly by a nonresident or a public corporation.
The PATH Act, passed in 2015, is an example of an American law with a similar aim. It amended the R&D Credit so that it could count against payroll taxes rather than just income tax for pre-revenue and early-revenue startups. It meant that the credit could be claimed by the companies that were actually sparking much of American innovation over the last decade: technological startups.
Clearly, as the letter-writing CFOs explained, the change to R&D Capitalization threatens to make America a country that disincentivizes domestic R&D. That could have stark consequences for the next generation of American business and American foreign policy. There seems to be bipartisan support for a change to the law, but it’s unclear if the political climate or economic moment will allow it to be prioritized. According to a recent piece in Marketwatch, the “bipartisan push on R&D tax break looks likely to flop.”
At Neo.Tax, we hope lawmakers will look abroad and realize there is a way to incentivize innovation. Perhaps a “super deduction” is not possible at this moment, but a model that allows SMBs to continue to innovate should be a no-brainer. Either way, we’ll do our part to make sure startups maximize their R&D credits and minimize their R&D tax burden; that’s why we built Neo.Tax, and our mission hasn’t changed.
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