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The research tax credit, first enacted in 1981 to encourage research and development (R&D) spending by big business, is in serious need of reform. In addition to making the credit permanent and at least partially refundable, Congress needs to amend the definition of “qualified research” so the credit will benefit the fastest-growing source of modern innovation-newer, smaller companies on the cutting edge of technology. According to the Small Business Innovation Research program, 75% of all innovations come from small businesses. Small biotechnology companies, for example, are responsible for the R&D behind an estimated one-third of the drugs on the market today. An updated tax credit with fewer built-in disincentives would reward today’s true innovators. First, the research tax credit should be made permanent. Since its enactment in 1981, the tax credit has expired four times, once resulting in a one-year gap. It will again expire on Dec. 31, unless Senate Bill 14 passes. S.14 includes a provision to extend the credit and make it permanent, but it also includes an increase in the minimum wage. The risk of an unrelated veto, as well as the other risks inherent in passing legislation every year or two, creates a level of uncertainty that often deters businesses from undertaking long-term R&D projects. Second, the research tax credit should be fully or partially refundable. The tax credit is currently nonrefundable, which means it only benefits companies with a positive federal income tax liability. Technology-driven companies with new ideas under development need the credit most during the first few years, when research is intense, funds are scarce and the sales (if any) are not yet sufficient to generate a profit. When profits finally arrive, the tax credit would then have a real effect, but only if the venture survives. Third, Congress should broaden or at least delineate the definition of “qualified research” so ordinary companies can know what type of research meets the standard. The term “qualified research” was defined generally in the tax act of 1981 establishing the credit, but was not further clarified with final regulations until December 2003, in T.D. 9104. Which activities meet the standard of qualified research remains unsettled, often requiring extensive analysis by accounting and legal professionals who must analyze a variety of R&D activities in various sciences. According to regulations proposed before T.D. 9104, the development of software for internal use is eligible for the credit only if it differs in a “significant and inventive” way from previous software. The final regulations offer no additional guidance on this question. The uncertainty surrounding which activities qualify undermines the efficiency of the credit and inflates the cost of obtaining it. Under Section 41(d) of the Internal Revenue Code, research must satisfy three tests to qualify for the tax credit. First, the research must be “experimental” in the laboratory sense. Second, the subject or discovery must be “technological in nature” and useful in the development of a new or improved “business component.” Finally, the activities must constitute a “process of experimentation” characterized by uncertainty at the outset, an evaluation of alternatives and a goal of developing a “new or improved function, performance or reliability or quality.” Practical work should qualify In practice, the final requirement often limits the tax credit to ivory-tower projects more akin to exploration than R&D. If the tax credit is going to spur business investment in the development of new products and useful technologies, then the experimentation test should be eliminated or broadened to include the practical work required to bring a product or technology to the public. The research tax credit system actually involves three separate tax credits, all due to expire on Dec. 31. In any tax year, a business may claim the basic research credit, for joint research with nonprofits, and either the regular research credit or the alternative incremental research credit (AIRC). The regular research credit is equal to 20% of a company’s qualified research expenses (QREs) in excess of a base amount. The AIRC also depends on the company’s QREs, but uses a more complex set of formulas. S.14 would establish a new “alternative simplified credit” equal to 12% of the company’s QREs in excess of its average QREs during the three previous tax years. For companies without QREs in one or more of the three previous tax years, the credit would be equal to 6% of the company’s QREs. Although S.14 offers a simpler alternative and would extend the tax credit permanently, it fails to make the credit fully or at least partially refundable, and it does nothing to update “qualified research” to include the activities actually needed to develop new technology. S.14 has been referred to the Senate Finance Committee to await further action. The research tax credit was enacted in 1981 to help reverse a decline in domestic R&D spending, particularly among large U.S. industries. Making the tax credit an effective and powerful incentive for modern R&D projects will require a new focus on smaller, newer companies, which need to see a bottom-line effect from a refundable credit, early in the development process, using a scheme that is simplified and permanent. J. Scott Anderson is a senior associate and a registered patent attorney in the Atlanta office of Alston & Bird. He can be reached at [email protected].

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