The Comptroller of Public Accounts adopts amendments to §3.599, concerning margin: research and development activities credit, with changes to the proposed text as published in the April 16, 2021, issue of the Texas Register (46 TexReg 2565). The comptroller amends this section to provide guidance regarding the franchise tax research and development activities credit.

Throughout the section, the comptroller adds titles to statutory citations and makes minor revisions to improve readability.

The comptroller received comments regarding the proposed amendments from: Shannon Rusing of Texas Oil & Gas Association (TXOGA); Dale Craymer of Texas Taxpayers and Research Association (TTARA); Patrick Reynolds of Council on State Taxation (COST); Shane Frank of alliantgroup, LP (alliantgroup); Michael Thompson of Ryan; Kreig Mitchell of Kreig Mitchell LLC; Ronnie Berry of Celanese Corporation (Celanese); Jennifer Woodard of Associated General Contractors of Texas (AGC of Texas); and Mike Williams of RSM US LLP (RSM).

Ronnie Berry of Celanese and Jennifer Woodard of AGC of Texas requested a public hearing on the proposed amendments. The comptroller held the public hearing on Monday, June 28, 2021, at 9:00 a.m. in Room 170 of the Stephen F. Austin Building, Austin, Texas 78701. Benjamin Barmore of alliantgroup, Michael Thompson of Ryan, Alyssa Honnette of RSM, Dale Craymer of TTARA, Carolyn Labatt of Great South Texas Corporation (GSTC), and John Ferris of RealPage, Inc. (RealPage) testified at the hearing.

Shannon Rusing of TXOGA, Dale Craymer of TTARA, Patrick Reynolds of COST, Ronnie Berry of Celanese, Jennifer Woodard of AGC of Texas, Alyssa Honnette of RSM, and Carolyn Labatt of GSTC suggested that the amendments be applied prospectively. The comptroller disagrees that the additions or revisions in the adopted rule are retroactive changes in law. The additions or revisions are expositions of existing Comptroller policy regarding Tax Code, Chapter 171, Subchapter M (Tax Credit for Certain Research and Development Activities), a statute that was adopted by the Legislature in 2013, rather than changes. At the same time, these same commenters encouraged the Comptroller's office to recognize Treasury Regulations that were adopted after the effective date of Internal Revenue Code (IRC), §41 as clarifications that should be applied retroactively to the 2011 federal income tax year, even when the IRS does not require that those regulations apply to the 2011 federal income tax year. As discussed in more detail below, with the exception of regulations that are not required to be applied to the 2011 federal income tax year, the comptroller does recognize Treasury Regulations that were adopted as clarifications. The comptroller does not view the amendments to this section any differently than the amendments to the Treasury Regulations that are applicable to the 2011 federal income tax year.

Shannon Rusing of TXOGA, Dale Craymer of TTARA, Patrick Reynolds of COST, and Shane Frank of alliantgroup each requested that the comptroller provide additional affirmative examples where a taxable entity qualified for the credit. These requests were for general examples, examples related to the Oil and Gas industry, and examples related to software development. The comptroller declines to provide additional examples in the rule because the current examples are sufficient.

Shane Frank and Benjamin Barmore of alliantgroup and Michael Thompson of Ryan commented that the proposed rule would eliminate entire industries from having any qualified research activities. The comptroller declines to modify the rule based on these comments. This is not the intent of the rule and there is no language in the rule that prevents a taxable entity from being engaged in qualified research based on the industry of the taxable entity.

The comptroller amends subsection (b)(1) by deleting the term "affiliated group" and adding a new term, "business component." The comptroller deletes the term "affiliated group" because the definition of combined group refers to Tax Code, §171.1014 (Combined Reporting; Affiliated Group Engaged in Unitary Business), which provides sufficient guidance. The comptroller defines the term, "business component," and bases this term on IRC, §41(d)(2)(B) (Business component defined), with non-substantive changes.

The comptroller adds new paragraph (4) to define the term "Four-Part Test" and renumbers subsequent paragraphs. The comptroller derives this term from IRC, §41(d) (Qualified research defined) and the regulations applicable to that section.

The comptroller amends the definition of "Internal Revenue Code (IRC)" in renumbered paragraph (5) to explain that a regulation adopted after December 31, 2011 must require a taxable entity to apply that regulation to the 2011 federal income tax year to be included in this definition. The definition of IRC in Tax Code, §171.651(1) states: 'Internal Revenue Code' means the Internal Revenue Code of 1986 in effect on December 31, 2011, excluding any changes made by federal law after that date, but including any regulations adopted under that code applicable to the tax year to which the provisions of the code in effect on that date applied."

The current version of Treasury Regulation, §1.41-4 (Qualified research for expenditures paid or incurred in taxable years ending on or after Dec. 31, 2003), adopted on November 3, 2016, is an example of a regulation that does not fully apply to the 2011 federal income tax year. With respect to its applicability, Treasury Regulation, §1.41-4(e) provides: "Other than subsection (c)(6) of this section, this section is applicable for taxable years ending on or after December 31, 2003. Paragraph(c)(6) of this section is applicable for taxable years beginning on or after October 4, 2016. For any taxable year that both ends on or after January 20, 2015 and begins before October 4, 2016, the IRS will not challenge return positions consistent with all of subsection (c)(6) of this section or all of subsection (c)(6) of this section as contained in the Internal Revenue Bulletin (IRB) 2015-5 (see www.irs.gov/pub/irs-irbs/irb15-05.pdf). For taxable years ending before January 20, 2015, taxpayers may choose to follow either all of §1.41-4(c)(6) as contained in 26 CFR part 1 (revised as of April 1, 2003) and IRB 2001-5 (see www.irs.gov/pub/irs-irbs/irb01-05.pdf) or all of §1.41-4(c)(6) as contained in IRB 2002-4 (see www.irs.gov/pub/irs-irbs/irb02-04.pdf)." The first sentence quoted above shows that, other than paragraph (c)(6), the current version of Treasury Regulation, §1.41-4 applies to the 2011 federal income tax year. With respect to subsection (c)(6), the second sentence quoted above shows that the current language in Treasury Regulation, §1.41-4(c)(6) does not apply to the 2011 federal income tax year. The fourth sentence quoted above allows taxable entities to choose one of two proposed regulations described in the Internal Revenue Bulletins incorporated by reference. The proposed regulations referenced in those Internal Revenue Bulletins were not part of the Treasury Regulations in effect on December 31, 2011. Although the federal regulations allow taxable entities to choose whether they follow this prior IRS guidance, the options are not included in the term "Internal Revenue Code" because Treasury Regulation, §1.41-4(e) does not require taxable entities to follow either of those options.

Another example of a regulation that does not apply to the 2011 federal income tax year is Treasury Regulation, §1.174-2 (Definition of research and experimental expenditures), adopted July 21, 2014. With respect to its applicability, Treasury Regulation, §1.174-2(d) provides: "The eighth and ninth sentences of §1.174-2(a)(1); §1.174-2(a)(2); §1.174-2(a)(4); §1.174-2(a)(5); §1.174-2(a)(11) Example 3 through Example 10; §1.174-2(b)(4); and §1.174-2(b)(5) apply to taxable years ending on or after July 21, 2014. Taxpayers may apply the provisions enumerated in the preceding sentence to taxable years for which the limitations for assessment of tax has not expired." While the federal statute of limitations for the assessment of tax for the 2011 federal income tax year had not expired at the time this regulation was adopted, the provisions enumerated in this applicability provision are not included in the term "Internal Revenue Code" because the regulation does not require taxable entities to apply those provisions to the 2011 federal income tax year.

Shannon Rusing of TXOGA, Dale Craymer of TTARA, Patrick Reynolds of COST, Michael Thompson of Ryan, Ronnie Berry of Celanese, Jennifer Woodard of AGC of Texas, Carolyn Labatt of GSTC, and John Ferris of RealPage suggested that the Treasury Regulations that taxable entities had the option to apply to the 2011 federal income tax year, such as Treasury Regulation, §1.41-4(c)(6) and Treasury Regulation, §1.174-2, should be included in the definition of "Internal Revenue Code." For the reasons described above, the comptroller declines this suggestion.

The comptroller amends the definition of "qualified research" in renumbered paragraph (7) to explain that qualified research must satisfy the Four-Part Test.

Shane Frank of alliantgroup and Michael Thompson of Ryan commented that the redefinition of qualified research is unnecessary, will cause confusion for taxpayers, and does not conform to IRC, §41. The comptroller declines to modify the rule based on these comments. The amendments to this definition are intended to provide additional guidance to taxable entities regarding how the definition of qualified research was incorporated into Texas law. The new definition is not intended to, and does not, conflict with the IRC that was incorporated into Texas law. Any part of the rule that does not have a direct basis in federal law was included to address ambiguities that are not addressed in IRC, §41 or any applicable Treasury Regulations.

The comptroller amends the definition of "qualified research expense (QRE)" in renumbered paragraph (8) based on IRC, §41(b) (Qualified research expenses) and Treasury Regulation, §1.41-2 (Qualified research expenses). The amended definition of QREs does not limit the applicability of any provisions of IRC, §41(b) or Treasury Regulation, §1.41-2. Rather, the amended definition describes the basic requirements for an expense to be a QRE. QREs are the sum of all in-house research expenses and contract research expenses.

The comptroller adds subparagraph (A) to explain that in-house research expenses include wages paid to an employee for qualified services, supplies, and amounts paid to another person for the right to use computers. The comptroller adds clause (i) to explain that qualified services include engaging in qualified research, or the direct supervision or direct support of qualified research. In subclauses (I) through (III), the comptroller defines the terms "engaging in qualified research," "direct supervision," and "direct support."

The comptroller adds clause (ii) to explain that supplies include any tangible personal property other than land, improvements to land, or property of a character subject to the allowance for depreciation.

The comptroller adds clause (iii) to explain that certain items purchased without paying sales or use tax are not included in the definition of in-house research expenses. This is because certain sales or use tax exemptions require that the item be used in specific ways that are not compatible with the item's use in qualified research. The comptroller provides two examples illustrating this clause.

Subclause (I) contains examples illustrating this clause. Item (-a-) identifies two sales or use tax exemptions which are excluded under this clause: the manufacturing exemption under Tax Code, §151.318 (Property Used in Manufacturing) and the sale for resale exemption under Tax Code, §151.302 (Sales for Resale). To qualify for the manufacturing exemption, items used by a manufacturer must be used in or during the actual manufacturing, processing, or fabricating of tangible personal property for ultimate sale. IRC, §41(d)(4)(A) excludes: "any research conducted after the beginning of commercial production of the business component." A taxable entity cannot claim both the franchise tax credit and sales tax exemption for the same purchases or activities. The sales tax manufacturing exemption applies to items used to produce items for ultimate sale to a customer, while the franchise tax R&D credit excludes items that are ready for commercial sale or use. Thus, a taxable entity cannot claim both the credit and exemption for the same activities. Furthermore, under Tax Code, §151.318(c)(3), the manufacturing exemption excludes "equipment or supplies used in research or development of new products." While this exclusion to the manufacturing exemption is not directly tied to the definition of qualified research applicable to the franchise tax R&D credit, it does indicate that the manufacturing exemption was not intended to apply to research and development activities. To qualify for the sale for resale exemption, an item must be purchased with the intent to resell it to someone else, either in the form or condition in which it is acquired or as an attachment to or an integral part of other tangible personal property or taxable service. See Tax Code, §151.006 ("Sale for Resale."). Items used in qualified research are not resold and do not qualify for the sale-for-resale exemption.

Item (-b-) identifies three types of purchases that are not excluded under this clause: purchases of water, Sulphur, and items for which sales or use tax was paid to another state. These items are not taxable for reasons unrelated to the use of the items so there is not an inherent conflict with these items being used in qualified research, unlike the manufacturing or resale exemptions.

Subclause (II) explains that if the item were actually used in qualified research after claiming an exemption, that item may be included as an in-house research expense if sales or use tax, penalty, and interest is paid on the item.

Dale Craymer of TTARA, Patrick Reynolds of COST, and Michael Thompson of Ryan commented that subsection (b)(8)(A)(iii) should be eliminated because purchasing items using a sales tax exemption should not result in those items being excluded from being supplies. The comptroller declines this suggestion. As described above, supplies only qualify for the franchise tax R&D credit if they are used in qualified research. Some sales tax exemptions are allowed for activities that cannot be qualified research.

The comptroller adds clause (iv) to explain that wages are defined by reference to IRC, §3401(a) (Definitions). The comptroller adds clause (v) to explain how to allocate wages between qualified services and nonqualified services when an employee performs both types of services. The comptroller adds clause (vi) to explain that if over 80% of the services an employee provides are qualified services, then all of the services provided by that employee are qualified services.

The comptroller adds subparagraph (B) to provide that contract research expenses are 65% of any amount paid by the taxable entity to another person for qualified research. In this subparagraph, the comptroller explains: the type of agreement that is necessary for an expense to be a contract research expense; that payments contingent upon the success of the research are not contract research expenses; that qualified research is performed on behalf of a taxable entity if that taxable entity has a right to the research results; and with respect to which report year the contract research expenses can be taken. The comptroller cross-references IRC, §41(b), which provides that the allowable percentage of contract research expenses can change in certain circumstances.

The comptroller deletes paragraph (10), which contained a definition for the term research and development credit. This term is only used once in the section, in subsection (j)(2)(A), which includes information concerning the January 1, 2008 repeal of Tax Code, Chapter 171, Subchapter O (Tax Credit for Certain Research and Development Activities). This information sufficiently distinguishes the prior credit from the current credit without the need for a separate definition.

The comptroller adds new subsections (c) and (d) and reletters subsequent subsections.

In new subsection (c), the comptroller discusses the application of the Four-Part Test to explain the basic requirements for research activities to be qualified research. The comptroller bases this subsection primarily on IRC, §41(d) and Treasury Regulation, §1.41-4.

In new paragraph (1), the comptroller describes the four individual components of the Four-Part Test: subparagraph (A) describes the Section 174 Test; subparagraph (B) describes the Discovering Technological Information Test; subparagraph (C) describes the Business Component Test; and subparagraph (D) describes the Process of Experimentation Test. In subparagraph (D), the comptroller provides several examples illustrating the Process of Experimentation Test.

Michael Thompson of Ryan and Kreig Mitchell of Kreig Mitchell LLC suggested that services should be allowed to be business components and that subsection (c)(1)(C)(i) should be removed. The comptroller declines this suggestion. The term "business component" is defined by IRC, §41(d)(2)(B) as "any product, process, computer software, technique, formula, or invention which is to be"" (i)held for sale, lease, or license, or (ii)used by the taxpayer in a trade or business of the taxpayer." Services do not fit within this definition. Concerns regarding taxable entities that provide services are addressed by this subsection by providing that a taxable entity may have qualified research activities for research related to business components that are used to provide services.

Shannon Rusing of TXOGA, Dale Craymer of TTARA, Patrick Reynolds of COST, Shane Frank of alliantgroup, Michael Thompson of Ryan, Kreig Mitchell of Kreig Mitchell LLC, Ronnie Berry of Celanese, and Jennifer Woodard of AGC of Texas suggested that designs should be allowed to be business components and that subsection (c)(1)(C)(ii) should be removed. The comptroller declines this suggestion. The term "business component" is defined by IRC, §41(d)(2)(B) as "any product, process, computer software, technique, formula, or invention which is to be"" (i)held for sale, lease, or license, or (ii)used by the taxpayer in a trade or business of the taxpayer." The commenters suggested that a "design" can be produced and is included in the term "product." The surplusage canon of statutory construction requires that statutory provisions not be read in a way that would render any word redundant. An interpretation of the term "product" that is broad enough to include the term "design" would also include the terms "process," "computer software," "technique," "formula," and "invention." Such an interpretation would render all those terms redundant. The commenters also suggested that excluding a design from being a Cont'd...