Legislation enacted in 2013 and recent guidance issued by the Texas Comptroller of Public Accounts allow taxpayers engaged in qualified research in Texas to claim either: (i) a sales and use tax exemption on certain property directly used in qualified research; or (ii) a Revised Texas Franchise Tax (RTFT) credit based on qualified research expenses.1 The taxpayer cannot claim both the sales tax exemption and the franchise tax credit for the same year.2 Taxpayers may utilize the optimal benefit for each period and are allowed to switch from the credit to the exemption, and the exemption to the credit, from year to year.

Overview

The sales tax exemption is effective for sales tax liabilities incurred on or after January 1, 2014. The franchise tax credit can be claimed on reports due on or after January 1, 2014 (federal income tax years ending during 2013).3 This difference in legislative language allows taxpayers to claim the franchise tax credit on research activities conducted prior to January 1, 2014 on the report originally due on May 15, 2014. Both incentives are currently scheduled to expire December 31, 2026.4

The Texas Comptroller's office recently released guidance and forms concerning the reporting requirements and administration of the exemption and credit. This information, which is available on the Comptroller's website,5 provides details regarding qualification for the exemption as well as registration and reporting requirements.

Taxpayers with qualified research activities in Texas can choose between a sales tax exemption and franchise tax credit on an annual basis. "Qualified research" is defined in Internal Revenue Code (IRC) Section 41(d) as:

  • research with respect to which expenditures may be treated as expenses under Section 174;
  • which is undertaken for the purpose of discovering information which is technological in nature; and
  • the application of which is intended to be useful in the development of a new or improved business component of the taxpayer; and
  • substantially all of the activities of which constitute elements of a process of experimentation relating to a new or improved function, performance, reliability or quality.6

Sales and Use Tax Exemption

The sale, storage or use of depreciable tangible personal property directly used in qualified research is exempt from sales and use tax if the taxpayer registers with the Comptroller's office and will not, as a taxable entity or as a member of a combined group, claim a research credit on a RTFT report for the period which the eligible property would first be subject to sales or use tax.7 "Depreciable tangible personal property" is tangible personal property that has a useful life of more than one year and is subject to depreciation under either GAAP or IRC Section 167 or 168.8 "Directly" means having an immediate effect on an item or in an activity, without an intervening, ancillary or prior effect.9 For example, if a company were to purchase equipment that was used to test the performance of a new product that had been developed, this would fall within the "directly" definition. However, if a company were to purchase computers used by the payroll department to process paychecks for the company's research and development (R&D) scientists, then this would be considered indirectly related to the research.

Registration

Taxpayers must register with the Comptroller's office before claiming the exemption on qualifying purchases. This registration form (AP-234: Texas Registration for Qualified Research and Development Sales Tax Exemption) is available on the Comptroller's website.10 Registrants must identify the date that the registration will become effective which can be no earlier than January 1, 2014 and no more than four years prior to when the registration is received. The registrant must also confirm that it will not take the franchise tax credit for the same period that the exemption will be claimed.11

A registration can be filed late and an exemption can be granted retroactively. A refund can be requested directly from the retailer or from the Comptroller's office with an Assignment of Right to Refund (Form 00-985) provided by the retailer. If the taxpayer's registration is not effective as of the purchase date of the item, then no exemption or refund of taxes will be allowed.

The Comptroller's office will issue a Registration Number after the registration has been completed. This Registration Number should be provided on a signed and properly completed Texas Qualified Research Sales and Use Tax Exemption Certificate (Form 01-931) to retailers when claiming an exemption on eligible property used directly in qualified research. The generic Texas Sales and Use Tax Exemption Certificate (Form 01-339) should not be used to claim the qualified research exemption.

Annual Compliance Requirements

An Annual Information Report (AIR) must be filed with the Comptroller's office by March 31st of the year following the calendar year in which the sales tax exemption was claimed. The taxpayer provides details regarding the amount of qualified research performed in Texas, the number of employees engaged in research and development in Texas, and sales tax revenue data. This information is required for the Comptroller's internal reporting to the Texas Legislature only. There are no minimum or maximum requirements for the taxpayer to meet to be able to claim the exemption. A registrant can also renew its Registration Number on the AIR. Failure to timely file the AIR will result in cancellation of the Registration Number.

Whether the Comptroller or the registrant cancels or terminates the Registration Number, the registrant will be required to pay the tax, penalty and interest due from the date of purchase on all ineligible tax-free purchases. A former registrant with a cancelled Registration Number may request reinstatement of that number.

Revised Texas Franchise Tax Credit

As an alternative to the sales tax exemption, taxpayers may claim a franchise tax credit on qualified research expenses in Texas. Qualified research expenses (QRE) are defined under IRC Section 41 as wages, supplies and contract research and must be related to research conducted in Texas.12

The credit is equal to 5 percent of the difference between the current report period's QRE and 50 percent of the average amount of the three preceding report periods' QRE.13 If the taxpayer does not have QRE during any of the three preceding periods, the credit will equal 2.5 percent of the QRE for the current reporting period.14 If the taxpayer incurs any qualified research expenditures under contract with one or more public or private institutions of higher education in Texas, the credit rate is increased to 6.25 percent if the taxpayer has three years of QRE15 and 3.125 percent if it does not.16 This higher credit rate is applied to all QRE incurred during the current reporting period, not just the amount related to the higher education contracts.

Annual Compliance Requirements

The Comptroller's office has not currently released any specific guidance on its website related specifically to the franchise tax credit. However, the Texas Franchise Tax Research and Development Activities Credits Schedule (Form 05-178) has been released and is available on the website with the RTFT forms.17 This form details the calculation described above and requests other required information such as the average number of R&D positions and the average salary of those positions. The R&D position and salary information does not impact the taxpayer's ability to claim the credit and, similar to the sales tax revenue data (above), the information is required for the Comptroller's internal reporting to the Texas Legislature.

Unlike the sales tax exemption, registration is not required to claim the franchise tax credit.18 If a taxpayer registers for the sales tax exemption and decides to claim the franchise tax credit for a future report year, the registrant should ensure that it cancels its sales tax exemption registration with the Comptroller as of a date that would not fall within the accounting period that would be included in the report year in which the franchise tax credit would be claimed. For example, if a calendar year taxpayer was currently claiming the sales tax exemption and wanted to claim the franchise tax credit on the 2016 report year, it would need to ensure that the exemption registration was cancelled as of December 31, 2014, so that none of the 2015 calendar year would be subject to the exemption.

Commentary

The flexibility of Texas' R&D tax incentives provides taxpayers an opportunity to evaluate their research activities and expenditures on an annual basis to determine the most beneficial tax strategy. One example of a favorable fact pattern which may maximize the taxpayer's benefit from these incentives would be the purchase of R&D equipment in year one resulting in a sales tax exemption, with operation of the equipment and conduct of R&D activities in year two resulting in a franchise tax credit. Determining the optimal answer does require additional time and analysis for taxpayers incurring qualifying expenditures that would result in an exemption and a credit (and may require multiple sales tax exemption registrations).

A taxpayer should annually review its projected expenditures (over the next several years if possible) related to research and development. The review would ideally occur prior to the beginning of a new accounting period (whether a calendar year or fiscal year company) in order to either obtain the exemption Registration Number prior to making eligible purchases or to cancel the exemption registration before tax-free purchases are made during a year in which a franchise tax credit is to be claimed. If the analysis is done after the beginning of an accounting period or the taxpayer's situation changes during an accounting period, the election can be changed, though such change adds more complexity.

While an exemption can be retroactively cancelled, any unpaid taxes related to the purchases previously exempted will become due in addition to penalties and interest as of the property purchase date. As discussed earlier, an exemption can also be retroactively granted, in which case the purchaser then must seek refunds from either the retailer or the Comptroller for the previous purchases.

One important benefit to note is that although a taxpayer cannot claim both the exemption and the credit for research expenditures incurred during the same report year, this does not impact the taxpayer's ability to utilize credit carryforwards.19 For example, if a taxpayer decided to claim the exemption for a particular report year's research expenditures, the taxpayer would still be able to utilize research credit carryforwards from prior years on the current RTFT report. However, the taxpayer would not be allowed to calculate a current year franchise tax credit on current research expenditures. The credit utilization would still be limited to 50 percent of the current RTFT liability and credits are able to be carried forward for 20 report years.20

Observations

  • Taxpayers may claim the enhanced franchise tax credit on all QREs by generating any QREs through public or private institutions of higher education in Texas.
  • The franchise tax credit and sales/use tax exemption may be claimed irrespective of whether or not the taxpayer claims the federal credit.
  • The franchise tax credit operates in a manner similar to the federal Alternative Simplified R&D Credit,21 except that the Texas credit includes only R&D performed in Texas, so federal records may be a good source of data.
  • The franchise tax credit and sales/use tax exemption remain in effect through December 31, 2026 regardless of the renewal or expiration of the federal R&D credit.
  • Note that taxpayers may include in their RTFT cost of goods sold deduction "all research or experimental expenditures described by Section 174, Internal Revenue Code."22
  • The sales/use tax exemption should be carefully planned and timely registered for and claimed to avoid penalties, complexity and audits.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.