First, the “what”—what are research and development (R&D) tax breaks or credits? Glad you asked. At the highest level, they’re a slate of tax incentives designed to attract firms with high R&D expenditures to one country or another.
Since 1954, Section 174 and its related regulations have allowed businesses to expense qualified research spending in year one, rather than needing to capitalize and amortize such expenses in a way similar to more general business expenses. So-called qualified research spending encompasses expenditures incurred in connection with a trade or business and representing research and development costs—things like the development, improvement, production, and patenting of a product.
In addition, there are R&D tax credits. First established in the US in 1981 via the Economic Recovery Tax Act, or ERTA, they were temporary credits that were extended mostly without exception through 2015. In 2015, the credits were made permanent, and breaks expanded in the Protecting Americans From Tax Hikes Act. The goal in both the deduction and credit case was and has remained to make US businesses more competitive in fields with high research costs.
Some changes came to the R&D deduction in the 2017 Tax Cuts and Jobs Act, which contained a provision that, starting in 2022, would require companies seeking deductions for research and development investments to do so over five years instead of expensing them in the first year. This change has been viewed by some as reducing American competitiveness in R&D.
At the outset, a distinction must be made between the two R&D tax breaks: the R&D tax credit and the expensing of R&D expenditures. The former is a more targeted R&D break that is tied to direct research expenses and in situations where R&D expenditures exceed a threshold; the latter is what is at issue here.
In sum, starting this tax year (2022), Section 174 expenses will need to be amortized over five years rather than taken as a deduction in year one if no change is made to the current law.
How does the US stack up in terms of R&D competitiveness?
Not well—or at least, not as well as it once did. In 1981, when the credit was first established via ERTA, it was among the first of its kind—placing the US ahead of the pack in R&D. In 2018, the US spent about $607 billion on research and development, with China coming in second at about $465 billion. In 2019, the gap was closed to $657 billion and $525 billion, respectively. As a share of gross domestic product, US R&D expenditures is good for 10th place overall. Now, according to a 2020 Information Technology and Innovation Foundation report, the United States ranks 24th out of 30 in terms of combined federal and state research subsidies—well below both Russia and China.
It is partially this closing, or closed, gap that gives rise to the bipartisan support for repealing the five-year amortization requirement on R&D investments.
What would repealing the amortization requirement do?
In terms of its financial effect, according to a 2019 EY study commissioned by the R&D Coalition, it would reduce R&D expenditures in the US by $4.1 billion annually for the first five years and $10.1 billion annually for the second five years and would significantly reduce jobs in sectors affected.
Administratively, it would remove the burden to track and capitalize research costs for many businesses—a not-insignificant cost in and of itself, thought to be in the vicinity of $8 billion 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.) with 67 other lawmakers, sent to House Speaker Nancy Pelosi (D-Calif.) and Minority Leader Kevin McCarthy (R-Calif.). The letters are intended to target the so-called “China Competition Bill” or “America COMPETES Act,” which is being reconciled between the House and the Senate.
The bill is intended to subsidize domestic semiconductor manufacturing, first and foremost, and benefit other nascent domestic technology sectors. The Biden administration has explicitly stated that it is critical to remain competitive with China in these markets.
Who will it benefit?
Those who oppose the repeal of the amortization requirement would contend expensing redounds chiefly to the benefit of large corporations. Those who support the repeal point to research indicating R&D investment creates and maintains jobs. The truth is likely somewhere in between—the amortization requirement doesn’t eliminate the ability to deduct R&D expenses but merely requires that the deduction be taken over a period of five years. While this can be used to make the argument that the amortization doesn’t hinder R&D spending, it also doesn’t increase tax revenue by very much. Even a small disincentive to private R&D spending is detrimental if there is no corresponding benefit.
Not everyone agrees; the Committee for a Responsible Federal Budget contends that repealing the amortization requirement would add an additional $150 billion in deficit spending related to the competitiveness bill—but this is somewhat misleading. This “cost” appears to encompass the initial year-one gain as expenses are amortized. But over the length of the bill and amortization, the added cost would be significantly less—all before calculating the impact on private R&D spending.
Private R&D spending appears to follow positive R&D tax treatment. There is no question that in the years since the R&D tax credit was first introduced, the US has lost ground on R&D in terms of raw spending and spending as a percentage of GDP. However, the R&D year-one expense versus amortization debate is not taking place in a vacuum—and there are political ramifications to saving corporations like Intel, Ford, and Lockheed Martin $29 billion in a year where the Child Tax Credit expired and inflation soared. If the broader policy of improving US competitiveness in R&D is to be furthered, steps backward—even small ones—will need to be minimized.
This is a regular column from tax and technology attorney Andrew Leahey, principal at Hunter Creek Consulting and a sales suppression expert. Look for Leahey’s column on Bloomberg Tax, and follow him on Twitter at @leahey.