	Background

		History and Overview of Credits for Different Types of Research

Congress created the research tax credit in 1981 to encourage businesses  to do more research. Three of the credits, the regular research credit, the alternative  incremental research credit (AIRC), and the alternative simplified credit  (ASC), rewarded the same types of qualified research and are simply  alternative computational options available to taxpayers. The purpose of this design is to reduce  the cost of providing a given amount of incentive. The Marginal Incentive Provided by the Research Tax Credit

One of the key measures that we will use to compare credit designs is the  marginal effective rate (MER) of the credit, which quantifies the incentive  that a credit provides to marginal spending and which can be simply stated  as  MER = change in the credit benefit / marginal qualified research  expenses (QREs)
The definition of a “controlled group of corporations” for purposes of the credit  has the  same meaning as used in determining a parent -subsidiary controlled group of corporations  for the consolidated return rules except  the aggregate rule is broader, substituting  corporations that are greater than 50 percent owned for 80 percent owned corporations. Large Corporations Have Dominated the Use of the Research Credit, Which Provided an Average Marginal Incentive of About 7 Percent in 2003 through 2005

Although more than 15,000 corporate taxpayers claimed research credits  each year from 2003 through 2005, a significantly smaller population of  large corporations (those with business receipts of $1 billion or more)  claimed most of the credit during this period. In 2005, 44 percent of total net credits earned could not  be used immediately. This result indicates that, even though the minimum base  reduced the credits that taxpayers earned on both their marginal spending  and on the spending they would have done anyway, taxpayers subject to  the minimum base still received larger windfall credits than those who  were not. An additional significant problem with the regular credit’s base is the  difficulty that taxpayers have in substantiating their base computations to  the IRS. Does one of the methods provide a greater incentive to increase  research spending? Moreover, widespread disagreements  between IRS and taxpayers over the adequacy of documentation leave  many taxpayers uncertain about the amounts of credit they will ultimately  receive. Recordkeeping burdens may discourage some taxpayers from  using the credit and the uncertainty reduces the credit’s effective  incentive. 3. Specifically,  the inclusion of a component that has increased its relative share since  the base period would eliminate the marginal incentive for a taxpayer  who had been able to earn the credit if the inclusion caused that  taxpayer’s base amount to exceed current-year QREs;    the inclusion of a component that has increased its relative share  would increase the marginal incentive if it increased the taxpayer’s  base amount from being less than half of its current-year QREs to more  than half (because this would remove the taxpayer from being subject  to the 50-percent base constraint);      The inclusion of a component that has decreased its relative share  since the base period would have effects opposite to those described in  the first two bullets; and    if any potential component of gross receipts accounts for the same  proportion of the taxpayer’s total gross receipts in the base period and  over the last 4 years, then the marginal incentive would not be affected  by the inclusion or exclusion of that component. Two factors have led to a considerable degree of controversy between IRS  and taxpayers over the types of evidence that are sufficient to support a  claim for the credit:    Most taxpayers do not maintain project-based accounts for normal  business purposes (and even those that do must collect additional  details solely for purposes of claiming the credit),    There has been an increase in the number of taxpayers filing claims on  amended returns, based on studies prepared by consultants, and    There is no specific guidance in law, regulations, or from IRS  examiners as to what constitutes sufficient substantiation. Supplemental records and narratives are needed to explain how  the expenses qualify.
Why GAO Did This Study

The tax credit for qualified research expenses provides significant subsidies to encourage business investment in research intended to foster innovation and promote long-term economic growth. Generally the credit provides a subsidy for research spending in excess of a base amount but concerns have been raised about its design and administrability. Government Accountability Office (GAO) was asked to describe the credit's use, determine whether it could be redesigned to improve the incentive to do new research, and assess whether recordkeeping and other compliance costs could be reduced. GAO analyzed alternative credit designs using a panel of corporate tax returns and assessed administrability by interviewing Internal Revenue Service (IRS) and taxpayer representatives.

What GAO Found

Large corporations have dominated the use of the research credit, with 549 corporations with receipts of $1 billion or more claiming over half of the $6 billion of net credit in 2005 (the latest year available). In 2005, the credit reduced the after-tax price of additional qualified research by an estimated 6.4 to 7.3 percent. This percentage measures the incentive intended to stimulate additional research. The incentive to do new research (the marginal incentive) provided by the credit could be improved. Based on analysis of historical data and simulations using the corporate panel, GAO identified significant disparities in the incentives provided to different taxpayers with some taxpayers receiving no credit and others eligible for credits up to 13 percent of their incremental spending. Further, a substantial portion of credit dollars is a windfall for taxpayers, earned for spending they would have done anyway, instead of being used to support potentially beneficial new research. An important cause of this problem is that the base for the regular version of the credit is determined by research spending dating back to the 1980s. Taxpayers now have an "alternative simplified credit" option, but it provides larger windfalls to some taxpayers and lower incentives for new research. Problems with the credit's design could be reduced by eliminating the regular credit and modifying the base of the alternative simplified credit to reduce windfalls. Credit claims have been contentious, with disputes between IRS and taxpayers over what qualifies as research expenses and how to document expenses. Insufficient guidance has led to disputes over the definitions of internal use software, depreciable property, indirect supervision, and the start of commercial production. Also disputed is the documentation needed to support a claim, especially in cases affected by changes in the law years after expenses were recorded. Such disputes leave taxpayers uncertain about the amount of credit to be received, reducing the incentive.