When claiming the R&D Tax Credit, it's important to understand the Consistency Rule. In essence, the rule requires that qualified research expenditures used to determine the base amount of the R&D Tax Credit should be defined consistently year over year. When filing for the R&D tax credit, you must comply with the consistency rule to avoid overstatement or understatement of research expenses.
Understanding the Consistency Rule
The consistency rule states that in order to “accurately calculate a credit, the taxpayer is required to define qualified research expenditures the same from year to year.” The taxpayer also must show consistency between the credit year and the base year. Not only that, but the gross receipts in the base years also have to agree with the prior four years’ average.
According to the IRS, companies should consider the following questions with respect to the consistency requirement:
- Is the fixed-base percentage (the ratio of 84-88 QREs to gross receipts) in the base years substantially lower than current research ratios? If so, why?
- Do past annual reports or 10Ks support the reported base years’ QREs?
- If the research credit was claimed in prior years (under the Regular Research Credit or Alternative Simplified Credit), were the same base years’ attributes used? If not, why not?
- Was there a prior research credit examination? Did it cover one or more of the base years?
Valuing Your R&D Tax Credit
The consistency rule is an important rule for valuing your R&D Tax Credit. Valuing takes place after you’ve identified your qualified activities and before you file for the tax credit. Understanding the base level of R&D activities will help to identify a true increase in R&D activities that qualify for the tax credit.
Be sure to save any relevant documentation for at least four years as it may need to be used to prove out the consistency rule.
For example, in one case example shared by the IRS, a taxpayer was denied the research credit because the base period research expenses attributable to its "special system projects" could not be quantified. The expenses associated with these special projects were included in the credit year and the taxpayer said that the same type of expenses were incurred in the base period. Unfortunately, the taxpayer did not save the documentation and could not determine the amount incurred in the base period. This means the relative increase in qualified research expenses could not be measured and the credit could not be claimed.
The Four-Part Test
Remember that all research activities must also pass the four-part test. Once you’ve identified potential qualifying activities, run them through the four-part test to verify. All parts of the test must be met in order to qualify. The four parts of the test are:
- Permitted Purpose. This is the activity intended to make or improve either a product or process that results in improved function, performance, reliability, quality or cost efficiency.
- Technical Uncertainty. This is the activity intended to eliminate technical uncertainty when developing or improving a product or process related to methodology, design, techniques, formulas or inventions.
- Process of Experimentation. This is the activity that includes a process of experimentation to eliminate or resolve technical uncertainty. During the process, various alternatives and approaches are evaluated by modeling, simulation, trial and error, prototyping and other methods.
- Technological in Nature. The process of experimentation must rely on the hard sciences (engineering, physics, biology, chemistry, computer science).
Applying for the R&D Tax Credit can be a complex process. Be sure to consult with a reputable R&D Tax Credit expert to ensure the process is completed in a thorough and accurate manner.