First, the “what”: what are tax breaks or tax credits for research and development (R&D)? Glad you asked. At the highest level, it is a list of tax incentives designed to attract companies with high R&D spending in one country or another.
Since 1954, Section 174 and his report regulations allowed companies to expense qualified research expenses in the first year, rather than having to capitalize and amortize these expenses in a manner similar to more general business expenses. Qualified research expenses include expenses incurred in the course of a trade or business and representing the costs of research and development, such as the development, improvement, production and patenting of a product.
In addition, there are R&D tax credits. First established in the United States in 1981 through the Economic Recovery Tax Act, or ERTA, these were temporary credits that were extended for the most part without exception through 2015. In 2015, the credits were made permanent and breaks were extended in the Protecting Americans From Tax Hikes Act. . The objective, in both the deduction and the credit, was and remains to make American companies more competitive in areas where research costs are high.
Some changes were made to the R&D deduction in the Tax Cuts and Jobs Act 2017, which contained a provision that, from 2022, would require companies claiming deductions for investment in research and the development to do it over five years instead of spending them the first year. This change was seen by some as a reduction in US competitiveness in R&D.
At the outset, a distinction should be made between the two R&D tax benefits: the R&D tax credit and the R&D expenditure charge. The first is a more targeted R&D pause which is linked to direct research expenditure and in situations where R&D expenditure exceeds a threshold; it is the latter which is in question here.
In short, starting with this tax year (2022), section 174 expenses will have to be amortized over five years rather than deducted in the first year if no changes are made to the current law.
How is the United States positioned in terms of R&D competitiveness?
Not good – or at least not as good as it once was. In 1981, when credit was first established through ERTA, it was among the first of its kind, putting the United States ahead of the pack in R&D. In 2018, the United States spent approximately $607 billion on research and development, with China coming second with about $465 billion. In 2019, the gap narrowed to $657 billion and $525 billion, respectively. As a percentage of gross domestic product, R&D spending in the United States is good for 10th place overall. Now, according to a 2020 Information Technology and Innovation Foundation reportthe United States ranks 24th out of 30 in terms of combined federal and state grants for research, well below Russia and China.
It is in part this bridged, or closed, gap that gives rise to the bipartisan support for repealing the five-year amortization requirement on R&D investments.
What would the repeal of the depreciation requirement do?
In terms of financial effect, according to a EY Study 2019 ordered by the R&D coalitionit would reduce R&D spending in the United States by $4.1 billion per year for the first five years and $10.1 billion per year for the next five years and would significantly reduce jobs in the affected sectors.
Administratively, this would remove the burden of tracking and capitalizing research costs for many companies – a significant cost in itself, considered around 8 billion dollars already this tax year.
What does this bipartisan support look like?
It looks like a letter-writing campaign, led by Reps. John B. Larson (D-Conn.) and Ron Estes (R-Kan.) along with 67 other lawmakers, sent to House Speaker Nancy Pelosi (D- Calif.) and Minority Leader Kevin McCarthy (R-California). The letters are meant to target the so-called “China Competition Bill” or “America COMPETES Act,” which is being reconciled between the House and Senate.
The bill aims to subsidize domestic semiconductor manufacturing, above all else, and benefit other nascent domestic technology sectors. The Biden administration has explicitly stated that it is essential to remain competitive with China in these markets.
Who will this benefit?
Those who oppose repeal of the depreciation requirement would argue that redundant spending primarily benefits large corporations. Those who support repeal cite research indicating R&D investments creates and maintains jobs. The truth is probably somewhere in between: the depreciation requirement does not eliminate the possibility of deducting R&D expenses, but simply requires that the deduction be made over a five-year period. While this can be used to argue that depreciation does not hinder R&D spending, it also does not increase tax revenue much. Even a weak disincentive to private R&D spending is detrimental if there is no corresponding benefit.
Not everyone agrees; the Committee for a Responsible Federal Budget argues that repealing the depreciation requirement add another $150 billion in deficit spending related to the Competitiveness Bill, but that is somewhat misleading. This “cost” appears to encompass the initial gain in the first year as the expenses are amortized. But over the duration of the invoice and the amortization, the additional cost would be much lower, all before calculating the impact on private R&D expenditure.
Private R&D expenditure seems to follow positive tax treatment for R&D. There is no doubt that in the years since the introduction of the R&D tax credit, the United States has lost ground in R&D in terms of gross expenditure and expenditure as a percentage of GDP. However, the debate over R&D spending versus depreciation does not take place in a vacuum – and there are political ramifications to the $29 billion-a-year economy of companies like Intel, Ford and Lockheed Martin. where the Child tax credit expired and inflation soared. If the broader policy of improving US competitiveness in R&D is to be pursued, even small setbacks will need to be minimized.
This is a regular column by tax and technology lawyer Andrew Leahey, director of Hunter Creek Consulting and sales suppression expert. Look for Leahey’s column on Bloomberg Tax and follow him on Twitter at @leahey.