Research Conducted in Texas

Comprehensive Analysis of the Geographic Nexus and Statutory Framework of Research Conducted in Texas within the R&D Tax Credit Regime

Research Conducted in Texas refers to the physical localization of qualified research activities and related expenses within the state borders. For the Texas R&D credit, this means wages, supplies, and contract research are only eligible if the underlying innovation work occurs within the geographic boundaries of Texas.

The requirement for research to be conducted in Texas serves as a critical jurisdictional anchor for the state's Research and Development (R&D) tax incentive program. This geographic nexus distinguishes the Texas R&D credit from its federal counterpart under Internal Revenue Code (IRC) Section 41, which generally permits research conducted anywhere within the United States and its possessions. By narrowing the scope of eligibility to activities physically occurring within the Lone Star State, the Texas Legislature intended to maximize the local economic impact of tax expenditures, ensuring that high-paying technical jobs and scientific infrastructure remain within state lines. This policy objective is reflected in the evolving statutory language from the enactment of House Bill 800 in 2013, which established Subchapter M, to the sweeping permanent reforms introduced by Senate Bill 2206 in 2025, which enacted Subchapter T. The distinction between "total" qualified research expenses (QREs) reported for federal purposes and the "Texas portion" of those expenses is the fundamental mechanism through which the state manages its fiscal responsibility while incentivizing localized innovation.

The Statutory Evolution of Texas R&D Incentives

The history of R&D tax incentives in Texas is characterized by periods of experimentation, repeal, and ultimate permanence. Before the current regime, Texas maintained an R&D credit under Chapter 171, Subchapter O, which was repealed effective January 1, 2008. Following the repeal, Texas was one of only a few major states without a specific R&D incentive, which policy analysts argued put the state at an economic disadvantage relative to innovation hubs like Massachusetts or California. To address this gap, the 83rd Texas Legislature passed House Bill 800 in 2013, creating a new R&D framework under Chapter 171, Subchapter M, effective January 1, 2014. Subchapter M introduced a choice for taxpayers: they could either claim a franchise tax credit or a sales and use tax exemption for depreciable tangible personal property directly used in qualified research.

This bifurcated system remained in place for over a decade, but it was often criticized for its administrative complexity and the sunset provisions that created uncertainty for long-term corporate planning. The 89th Legislature resolved these concerns with the passage of Senate Bill 2206, signed by Governor Greg Abbott on June 22, 2025. This legislation marked a pivotal shift by repealing the elective sales tax exemption and the temporary Subchapter M credit, replacing them with a permanent, enhanced franchise tax credit under Subchapter T, effective for reports due on or after January 1, 2026. The transition to Subchapter T signifies a commitment to rolling conformity with federal standards, moving away from the "fixed-date" conformity to the 2011 IRC that plagued Subchapter M.

Defining the Geographic Nexus: What Constitutes Research Conducted in Texas

The core of the Texas R&D tax credit is the requirement that research must be conducted in Texas. This requirement applies to every dollar included in the credit calculation, regardless of the expense category. The Texas Tax Code and the Comptroller’s administrative rules establish that "qualified research" is research conducted in Texas that meets the federal definition in the IRC. For an expense to be "attributable to research conducted in Texas," the physical activity underlying the expense must have occurred within the state's geographic boundaries.

Wage Allocation and the Location of Service

Wages typically represent the most significant component of qualified research expenses. Under both Subchapter M and Subchapter T, wages qualify only if they are paid for research services physically performed in Texas. The location of the employee at the time the work is performed is the governing factor. This creates a rigorous documentation requirement for businesses with multi-state operations or remote workforces.

If an employee performs research both inside and outside of Texas, the employer must use a reasonable method to apportion the wages. This often involves tracking the physical work location of researchers on a project-by-project basis. Administrative guidance from the Comptroller suggests that merely having a Texas payroll or being a Texas-based company is insufficient; the taxpayer must prove that the actual conduct of research—such as laboratory experimentation, software coding, or technical design—occurred within state lines.

Supply Expenses and In-State Usage

Supplies used in research are also subject to the geographic nexus requirement. For purposes of the R&D credit, "supplies" are defined as any tangible property other than land, improvements to land, or property subject to an allowance for depreciation. To be eligible for the Texas credit, these supplies must be used or consumed in the actual conduct of qualified research within Texas.

A significant development in the law, codified in Subchapter T, addresses the historical conflict regarding the taxability of supplies. Historically, the Comptroller attempted to exclude supplies from the R&D credit if they were also subject to sales and use tax. Senate Bill 2206 explicitly provides that expenses for supplies properly reported as QREs on IRS Form 6765 may not be excluded from the Texas credit calculation based on their sales tax treatment. This ensures that the characterization of an item for sales tax purposes does not impair its eligibility for the franchise tax credit, provided the supply was consumed in research conducted in Texas.

Contract Research and Third-Party Performance

Contract research expenses represent 65% of the amounts paid to third parties for qualified research services. For these expenses to qualify for the Texas credit, the taxpayer must demonstrate that the third-party contractor performed the research within the state of Texas. This is a more complex evidentiary burden than in-house wages, as it requires the taxpayer to obtain location-based performance documentation from external vendors.

Furthermore, Texas adheres to the federal "funded research" exclusion. Research is not considered qualified if it is funded by another person or governmental entity. Rule 3.599 specifies that research is funded if the researcher does not retain substantial rights to the results or if payments are not contingent on the success of the research. In the context of "research conducted in Texas," even if the work is done in the state, it will be disqualified if the economic risk and rights do not reside with the taxpayer claiming the credit.

Expense Category	Nexus Requirement	Attribution Method
In-House wages	Physical performance in Texas.	Time-tracking by work location.
Supplies	Usage/Consumption in Texas.	Invoices and usage logs at Texas facilities.
Contract Research	Performance by contractor in Texas.	Contracts and certificates of performance.
Computer Time	Lease/Rental of hardware in Texas.	Server logs and lease location data.

Comparative Analysis: Subchapter M vs. Subchapter T

The transition from Subchapter M to Subchapter T represents a fundamental restructuring of the R&D credit. While both subchapters share the core requirement of research conducted in Texas, the mechanics of calculation, the applicable rates, and the administrative procedures differ significantly.

Credit Rate Enhancements

One of the primary motivations for Senate Bill 2206 was to make Texas more competitive relative to other states. The new law significantly increases the base credit rates. Under Subchapter M, the standard credit was 5% of the excess QREs over the base amount. Subchapter T increases this to 8.722%. For partnerships with institutions of higher education, the rate increases from 6.25% under Subchapter M to 10.903% under Subchapter T.

Conformity to Federal Law

A major administrative hurdle under Subchapter M was its "fixed-date" conformity to the Internal Revenue Code as it existed on December 31, 2011. This required taxpayers to maintain separate sets of R&D records—one for federal purposes using current IRC standards and another for Texas purposes using obsolete 2011 standards. Subchapter T implements "rolling conformity," meaning the Texas credit will follow the federal law in effect for the tax year in which the credit is claimed. This alignment dramatically reduces the compliance burden for businesses operating in Texas.

Refundability for Low-Tax Entities

Perhaps the most significant change for the startup ecosystem is the introduction of refundability. Under Subchapter M, the credit was generally non-refundable and could only be carried forward to offset future franchise tax liability. Subchapter T allows entities that owe no franchise tax—such as pre-revenue startups, small businesses below the "no tax due" threshold, or new veteran-owned businesses—to receive the credit as a cash refund.

Administrative Guidance and Local Revenue Office Interpretation

The Texas Comptroller of Public Accounts is responsible for the administration and enforcement of the R&D tax credit. Through the State Tax Automated Research (STAR) system, the Comptroller provides various forms of guidance, including administrative rules, policy memoranda, and private letter rulings.

Rule 3.599: The Primary Regulatory Framework

Rule 3.599, "Margin: Research and Development Activities Credit," is the central regulation governing the credit. This rule establishes the foundational definitions of qualified research, QREs, and the "conducted in Texas" requirement. It also details the "Four-Part Test" adapted from federal law:

1. Permitted Purpose: The research must relate to a new or improved business component's function, performance, reliability, or quality.
2. Elimination of Uncertainty: The activity must be intended to discover information that would eliminate uncertainty regarding the capability or method of developing the component.
3. Process of Experimentation: Substantially all of the activities must constitute a process of experimentation involving the evaluation of alternatives.
4. Technological in Nature: The research must rely on principles of physical or biological sciences, engineering, or computer science.

Internal Use Software and the High Threshold of Innovation

Internal Use Software (IUS) has historically been a source of controversy in Texas tax law. Rule 3.599 was amended in 2022 to provide more detailed guidance on when software development qualifies as R&D. The Comptroller recognizes two different versions of Treasury Regulations for determining IUS eligibility, allowing taxpayers to elect the version that best fits their facts. Generally, software is considered IUS if it is developed for use in general administrative functions or in providing non-computer services. To qualify for the credit, IUS must meet the "High Threshold of Innovation Test," requiring the software to be innovative, involve significant economic risk, and not be commercially available.

Memo 202503004M: Disregarding Federal Intra-Group Rules

A critical piece of local revenue office guidance is found in Memo 202503004M, issued on March 24, 2025. This memo clarifies that federal intra-group transaction regulations—which generally disregard transfers between members of a controlled group—do not apply when determining the Texas R&D credit. This distinction is vital because a federal "group under common control" is not treated as a single taxpayer for either Texas franchise or sales tax purposes. Consequently, transactions between members of a combined group must be evaluated based on the specific definitions of "taxable entity" and "combined group" in the Texas Tax Code.

Computational Mechanics of the Texas R&D Credit

The calculation of the Texas R&D credit relies on an incremental method that compares current-year expenditures to a base period. While the basic formula remains consistent across subchapters, the specific variables have evolved.

The Standard Incremental Formula

The standard credit amount is calculated as a percentage of the difference between current-year Texas QREs and 50% of the average Texas QREs over the preceding three tax periods. The formula can be expressed as:

Credit = Rate × (QRE_current - 0.5 × Average_QRE_prior_3)

If a taxable entity has no QREs in one or more of the preceding three tax periods, a reduced rate is applied directly to the current year's Texas QREs.

Combined Reporting and Tiered Partnerships

For businesses operating as a combined group, the credit must be claimed on the combined report required by Section 171.1014. The combined group is considered the "taxable entity" for purposes of the credit. In tiered partnership arrangements, an upper-tier entity that includes the revenue of a lower-tier entity for margin purposes may claim the credit for QREs incurred by that lower-tier entity, proportionate to the upper-tier's ownership interest.

Feature	Subchapter T Variable (Post-2026)
General Credit Rate	8.722%.
University Partnership Rate	10.903%.
No Prior Period Rate	4.361% (or 5.451% with university).
Base Amount	50% of 3-year average.
Refundability Threshold	Available for entities with zero franchise tax.

The Role of Higher Education in Research Conducted in Texas

The Texas R&D tax credit regime places a deliberate premium on collaboration between the private sector and academia. By offering a significantly higher credit rate—currently 6.25% under Subchapter M and rising to 10.903% under Subchapter T—the state incentivizes businesses to utilize the research capabilities of Texas universities.

Defining Eligible Institutions

For purposes of the enhanced credit, a "public or private institution of higher education" is defined by reference to the Education Code Section 61.003. This includes public universities, health-related institutions, community colleges, and private or independent institutions accredited by recognized agencies. The research must be performed under a documented contract, and the associated expenses must be attributable to research conducted in Texas under that contract.

Economic and Educational Rationale

The higher credit rate for university-led research is intended to foster an innovation ecosystem where academic breakthroughs can be more rapidly commercialized by private industry. This partnership accelerates the development of new technologies while providing students and faculty with exposure to real-world industrial challenges. From a policy standpoint, this mechanism ensures that state tax benefits also support the long-term vitality of the public education system.

Procedural Compliance: Forms, Reporting, and the Burden of Proof

Taxpayers seeking the Texas R&D credit must navigate a specific set of procedural requirements established by the Comptroller and the Tax Code. Failure to meet these requirements can result in the denial of the credit during audit.

The Burden of Establishing the Credit

The burden of establishing eligibility for the credit rests solely with the taxable entity. Under Texas law, a taxpayer must prove by a preponderance of the evidence that they are entitled to a tax credit or refund. This requires "contemporaneous records" and supporting documentation for the transactions in question. Factual assertions in pleadings or uncorroborated testimony from employees are generally insufficient to meet this burden.

Mandatory Filing Requirements

To claim the franchise tax credit, a taxable entity must file their Long Form Franchise Tax Report along with the specialized R&D schedules. For report years beginning in 2026, these forms include:

• Form 05-181: Texas Franchise Tax Credits Summary Schedule.
• Form 05-182: Texas Franchise Tax Subchapter T Research and Development Activities Credit Schedule.
• Form 05-183: Application for Subchapter T Refundable Credit.

For entities previously claiming the sales tax exemption under Subchapter M, an "Annual Information Report" (AIR) was required to maintain registration. With the repeal of the sales tax exemption in 2026, this requirement sunsets, but businesses must transition their record-keeping to support the franchise tax credit path.

Statute of Limitations and Refund Claims

Refund claims related to the R&D credit are subject to the standard four-year statute of limitations under Tax Code Section 111.104. The Comptroller clarified in STAR Document 202301007M that if a tax year in which eligible R&D expenditures occurred is closed by the statute of limitations, a taxpayer is barred from creating a credit for that year. Furthermore, there can be no carryforward of a credit that was not timely created in an open period. However, the Comptroller may verify QREs in a closed year for the sole purpose of assessing the available carryforward for an open period.

Example: Comprehensive Multi-Year R&D Lifecycle in Texas

To illustrate the application of "Research Conducted in Texas" across the transition from Subchapter M to Subchapter T, consider the hypothetical case of "Lone Star Aerospace, LLC" (LSA). LSA is a high-tech manufacturing firm based in Fort Worth that develops specialized drone navigation systems.

Scenario 1: Subchapter M (2024 Report Year)

In the 2023 calendar year (for the 2024 report), LSA has the following expenditures:

• Total Federal QREs: $2,000,000.
• Texas-Attributable Wages: $1,200,000 (all employees work in Fort Worth).
• Non-Texas Wages: $300,000 (employees based in a Seattle software hub).
• Texas-Attributable Supplies: $200,000 (materials consumed in Fort Worth prototyping).
• University Contract (Texas A&M): $300,000 (research performed in College Station).
• Average Texas QREs (2020-2022): $1,000,000.

Determination of Texas Portion:

The wages for the Seattle-based hub are excluded as they do not constitute research conducted in Texas. The remaining $1,700,000 constitutes the Texas QREs.

Calculation:

1. Base Amount: $1,000,000 × 0.5 = $500,000.
2. Excess QREs: $1,700,000 - $500,000 = $1,200,000.
3. University Portion Credit: $300,000 × 6.25% = $18,750.
4. Standard Portion Credit: ($1,200,000 - $300,000) × 5% = $45,000.
5. Total Credit: $63,750.

Scenario 2: Subchapter T (2027 Report Year)

By 2026, LSA has consolidated all operations in Fort Worth. They have no franchise tax liability for the 2027 report year due to previous business losses.

• Line 48 of Form 6765: $2,500,000.
• Texas-Attributable QREs: $2,500,000 (100% of federal amount).
• University Contract (Texas A&M): $500,000.
• Average Texas QREs (2023-2025): $1,800,000.

Calculation:

1. Base Amount: $1,800,000 × 0.5 = $900,000.
2. Excess QREs: $2,500,000 - $900,000 = $1,600,000.
3. University Portion Credit: $500,000 × 10.903% = $54,515.
4. Standard Portion Credit: ($1,600,000 - $500,000) × 8.722% = $95,942.
5. Total Refundable Credit: $150,457.

Because LSA has no tax due, they apply for the credit as a cash refund using the new procedures under Subchapter T.

Audit Risks and Strategic Documentation

The rigorous nature of Texas tax audits requires a proactive approach to documentation. The Comptroller's Audit Division frequently challenges the "Nexus" of remote employees and the "Directness" of supply usage.

Managing the Remote Worker Challenge

As remote work becomes a permanent fixture of the economy, the Comptroller’s guidance on "Research Conducted in Texas" remains steadfastly location-dependent. Taxpayers must be prepared to provide IP address logs, VPN data, or other electronic evidence to substantiate that a remote researcher was physically present in Texas while performing qualified services. Failure to maintain this level of detail can lead to the disqualification of a significant portion of the wage claim.

The Importance of the Technical Narrative

Modern Texas audits increasingly focus on the "Business Component" level. Auditors expect to see a technical narrative for each project that explains how it satisfies the four-part test. This narrative should link specific technical challenges (Uncertainty) to the systematic evaluation of alternatives (Experimentation) and the ultimate resolution of those challenges using scientific principles (Technological Nature). Generic project descriptions or marketing materials are typically rejected.

Final Thoughts: The Future of Texas R&D Policy

The evolution of the Research Conducted in Texas standard reflects a broader national trend toward more robust and permanent state-level innovation incentives. By repealing the sales tax exemption and focusing on an enhanced, refundable franchise tax credit, Texas has signaled its intent to become the premier destination for R&D investment in the United States. The shift to rolling conformity and the alignment with federal Form 6765 provide much-needed clarity, but the underlying requirement for physical localization within Texas remains the bedrock of the program. Businesses that master the geographic attribution and documentation requirements of the new Subchapter T will be well-positioned to leverage these generous incentives for decades to come.