M·CAM Research Tax Credit Study Discussed in Congressional Quarterly

Date:  Mon, 2005-04-04

CQ Weekly — In Focus Jill Barshay, CQ Staff April 4, 2005 The fourth-largest subsidy in the corporate tax code, a credit for research and development expenses, is designed to reward companies for boosting their research spending. Drugmakers, software developers and other high-tech interests in Washington say the credit keeps R&D at home and keeps U.S. companies on the cutting edge of the global economy. Spurring innovation: It’s as American as apple pie. But this $6 billion a year transfer from taxpayers to corporations does not always deliver what it promises. It often pays for mundane – even redundant – work. Companies regularly claim the credit for rediscovering patents they already own, expired patents that are in the public domain and activities for which the label “research” is dubious at best. Defense contractors, in particular, sometimes claim it for research that was financed by Uncle Sam and not out of their own pockets. No one can point to an academic or government study that proves the credit has actually stimulated extra research. To the contrary, accounting firms frequently help companies look back through their books to find prior-year expenses that qualify for the credit under the vague rules issued by the IRS. And there are serious concerns about how accountants numerically calculate the payout for clients. “This story unfortunately has epic qualitites about it,” said David Martin, a patent consultant who has become a self-styled R&D whistleblower. “We think we’re funding innovation, but we’re not.” Nevertheless, Republicans and Democrats in Congress are eager to preserve the tax break, and President Bush has called for making it permanent at a 10-year cost of $76 billion. The combination of special interests that back the credit is a potent one: pharmaceutical companies, software makers, defense contractors and automakers. Together, they donated $39 million to candidates for federal office in the last election cycle. In a 14-page study supporting renewal of the credit in 2004, the industry coalition that lobbies for it on Capitol Hill focused its arguments on how many companies benefit and the states where they are based. Not one word was devoted to their innovations. Because the credit is expensive, Congress keeps it on a short leash, renewing it every year or two to keep a check on deficit estimates. The tax break currently expires at the end of 2005, and a bill to extend it is one of the few tax measures almost certain to be enacted this year. Top Senate tax writers want to make the credit even more generous than it already is. The credit operates by giving companies 20 cents in cash for each research dollar spent above a threshold. That is in addition to the deduction businesses already take for all research expenses. The idea behind the credit is to encourage companies to take the risks inherent in research and development of products and ideas that may or may not someday yield profits. But among those who most benefit from the credit are federal government contractors, whose work is funded by taxpayers. “There are some instances where the entirety of the company is government research and they’re claiming the credit,” said Martin, the whistleblower. His company, M-CAM, studied publicly traded firms that disclose use of the credit in their financial filings. Of those, 20 percent reported that government contracts and grants were a major source of research funding. When asked, several large government contractors said they took the credit on U.S. government-financed work. One that does is Electronic Data Systems Corp., the Texas-based information technology company founded by Ross Perot. EDS, along with Microsoft Corp., spearheads the industry coalition that lobbies for the credit on Capitol Hill. Also claiming the credit for government-backed research are Alliant Techsystems Inc., a Minnesota missile and munitions maker, and Computer Sciences Corp., a prominent California supplier of software to businesses and governments. “We factor in our ability to claim the credit on those research activities when we bid for the contract,” said David Hernandez, vice president for taxes at EDS. In the mid-1990s, the IRS argued that companies were double-dipping on government-financed work and tried to stop them from claiming the credit. But U.S. courts sided with the companies under the rationale that in cases where they were required to produce the research for a fixed price, the credit was a valid claim. The tax court ruled that under fixed-price contracting, companies were liable for cost overruns and at risk for having to return the contract money if they did not produce the research in the end. Since that ruling, the number of fixed-price government research contracts has grown. According to Eagle Eye Inc., a Virginia-based publisher, the federal government signed more than $4 billion in such contracts in fiscal 2003. If the credit was claimed on all of those contracts, the companies involved might have pocketed an extra $800 million from taxpayers. Looking Backward Meanwhile, in San Antonio, Texas, Shai Wood, a tax manager at the accounting firm of Padgett, Stratemann & Co. specializes in helping financially struggling companies find research expenses they didn’t know existed. Wood digs through the three more recent years of financial statements, easily finds research expenses and refiles amended tax returns for clients. “There’s the misperception that you have to have a research lab. But you can just be making product improvements,” Wood said. “Once we go in and explain, they go, ‘oh yeah, we do that.'” Wood said she helped a bank claim the credit for upgrading its customer Web site. She also worked with a company that makes furniture for jails and dormitories, the kind that is anchored to the floor to withstand jumping and bouncing. When the company changed some of its designs from steel to aluminum, Wood helped them claim the R&D credit. “I might spend 10 percent of my time doing retroactive claims,” said Wood, adding that she thinks the number of companies claiming the credit retroactively is on the rise. That’s a far cry from the original vision of the credit, which was included in the 1981 tax cut bill, enacted during President Ronald Reagan’s first year in office, as a way to induce high-tech companies to launch innovative research projects. “There are a lot of problems” with the credit, said former IRS Commissioner Donald C. Alexander, now a lobbyist at teh law firm Akin Gump. “It’s very hard to say where research ends and where practical applications begin.” Companies and accountants are not necessarily to blame for the confusion. The credit has been a part of the tax code for more than two decades, but the Treasury Department didn’t issue final regulations defining research until 2004. Even tax lawyers say it still isn’t clear which activities qualify and which don’t. “It is difficult to come up with a test of what is phony research and what is true,” said Alexander. “I don’t have any magic solution.” Another problem is how companies crunch the numbers to calculate the credit. The basic formula allows companies to reduce their tax bill by 20 percent of what they spend on research in excess of their average research budget from the 1980s. But companies and their accountants work to recalculate that base number to increase the amount of credit they can take today. “Is this whole R&D credit an accountant-driven exercise?” asked a Senate GOP tax aide after meeting with the IRS in late March. “We are taking this very seriously.” Former Treasury Secretary Paul H. O’Neill, a one-time chief executive officer at Alcoa Inc., shares that view. In his book, “The Price of Loyalty,” Ron Suskind quotes O’Neill as saying, “Go talk to people who make practical business decisions about how much tax credits influence the level of R&D that they invest in. You find somebody who says, ‘I do more R&D because I get a tax credit for it,’ you’ll find a fool.” Recycled Research Martin said his interest in the research credit was piqued after a potential client asked him to assist with a patent problem on a $40 million federal contract. The company hoped to claim the credit on a Homeland Security contract to research technology to protect drinking water systems against terrorist attacks. A database search revealed that the patent had expired and was in the public domain. “The rule should be [that] you’re doing this for the first time and others don’t already have it,” said Martin. In fact, the Treasury rules don’t require companies claiming the credit to do work that hasn’t already been patented or published. Treasury considered it too burdensome to ask companies to review scholarly journals to make sure their research wasn’t already available, according to a senior Treasury official. And the IRS didn’t want its auditors, who typically don’t have scientific expertise, to evaluate research. “The rules say, if you undertake experimentation, you can take the credit. The rules don’t say you have to do something really cool,” said Chris Ohmes, a former Treasury official who oversaw use of the R&D credit. In the past, scant media attention has focused on the opaque process of periodically renewing the R&D credit. Committee aides readied extensions behind closed doors and slipped them into unrelated legislation near the end of each session. (The credit was last renewed as part of a middle-class tax cut bill in September 2004). Until Senate Finance Chairman Charles E. Grassley, R-Iowa, called a hearing last month, none had been held in years and debates were rarely heard on the merits of the policy. Grassley is eager to extend the research credit again. The only change he is mulling so far would be to ask companies to get a prior blessing from the IRS before claiming the credit – a notion sure to provoke consternation on K Street – and one Grassley is unlikely to press too hard if it means letting the credit lapse. Source: CQ Weekly The definitive source for news about Congress. © 2005 Congressional Quarterly Inc. All Rights Reserved