Detailed Analysis of Purchases of Services in the Context of the Georgia R&D Tax Credit

Purchases of Services, commonly known as Contract Research Expenses (CRE), are amounts paid to third-party, non-employee firms for conducting qualified research. For the Georgia Research and Development (R&D) tax credit, eligibility is strictly limited to 65% of the expense, and crucially, the research activity must be physically conducted within the State of Georgia.

This dual limitation—coupling the federal reduction factor with a strict state-level geographical sourcing test—transforms Purchases of Services into a high-compliance category. While the state credit aims to incentivize investment (offering 10% of qualified expenses over a base amount), taxpayers must provide meticulous documentation proving that outsourced research labor occurred within Georgia borders to successfully claim the benefit under O.C.G.A. § 48-7-40.12.1

I. Statutory Foundation: Defining Qualified Research Expenditures (QREs) in Georgia

The Georgia Research Tax Credit is a vital incentive available to eligible business enterprises engaged in sectors such as manufacturing, warehousing and distribution, processing, telecommunications, broadcasting, tourism, and research and development industries.3 The definition of what constitutes an eligible expenditure is highly dependent on federal law, but critically modified by Georgia statute.

A. Federal Alignment and the Scope of QREs

Georgia law explicitly adopts the definition of “Qualified research expenses” used in Section 41 of the Internal Revenue Code (IRC).1 This alignment mandates that any activity claimed for the state credit must first satisfy the strict criteria established at the federal level, commonly known as the four-part test. Furthermore, claiming the state credit is contingent upon the business enterprise claiming and being allowed the research credit under IRC Section 41 for the same taxable year.4

QREs generally fall into three categories: wages for qualified services, costs of supplies consumed in research, and Contract Research Expenses (CRE) or Purchases of Services.8 The state’s reliance on the federal standard ensures uniformity in defining the technical nature of the research itself, but divergence arises when addressing where that research occurs.

B. Deconstructing Contract Research Expenses (CRE)

For federal purposes, the cost of research contracted to third parties is subject to a mandatory reduction factor.

The Federal 65% and 75% Rules

IRC § 41 defines “contract research expenses” as 65 percent of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research.9 This 65% rule applies specifically to payments made to unrelated third parties and is intended to capture only the direct research costs, effectively excluding the contractor’s potential profit margin and administrative overhead. Since Georgia adopts the federal definition of QREs, this 65% factor is mandatory when calculating the state-level research expense.6

An exception to the 65% rule exists for payments made to a qualified research consortium. The allowable percentage increases to 75% for amounts paid to organizations described in IRC § 501(c)(3) or 501(c)(6) that are organized primarily to conduct scientific research.10 Both the 65% and 75% limitations are applied before the Georgia-specific sourcing rule is considered.

C. The Strict Sourcing Rule: Research Must Be Conducted Within Georgia

The statutory mandate concerning location is the critical state-level compliance hurdle for all QRE categories, but particularly for outsourced services. O.C.G.A. § 48-7-40.12 explicitly states that “all wages paid and all purchases of services and supplies must be for research conducted within the State of Georgia“.1 This mandate means that the eligibility of a Purchase of Service is determined entirely by the location where the third-party research activity physically took place.11

The strict language “conducted within” dictates a physical activity test. This methodology is often counter-intuitive for taxpayers accustomed to general state apportionment rules. For receipts from services, Georgia’s standard approach for corporate income tax apportionment often utilizes a market-sourcing method, attributing receipts based on where the customer receives the economic benefit of the service.12

However, the R&D statute overrides this general market-sourcing principle. For Contract Research Expenses, the determining factor is not where the final report or product was delivered, but the physical location of the research labor itself. For instance, if an engineering firm is contracted for software development, the time spent coding or testing in Atlanta qualifies, but time spent by the same engineer on the same project in a neighboring state does not, even if the result benefited the Georgia taxpayer.12 This location requirement necessitates granular, time-based tracking of contractor activity.

II. Local State Revenue Office Guidance and Compliance Requirements

Effective compliance with the Georgia R&D tax credit requires careful adherence to the administrative guidance issued by the Georgia Department of Revenue (GDOR), particularly Revenue Regulation 560-7-8-.42.

A. GDOR Regulatory Authority and Filing Procedures

The administration and implementation of the income tax credit under O.C.G.A. § 48-7-40.12 are governed by Revenue Regulation 560-7-8-.42.7 While the regulation itself is highly technical, it forms the basis for the necessary filing steps and documentation standards.

The credit calculation yields 10% of the additional research expense over the statutorily defined “base amount”.2 To claim this credit, businesses must adhere to specific GDOR procedures 4:

1. Electronic Pre-Approval: Taxpayers are required to request preapproval electronically from the Department through the Georgia Tax Center (GTC).
2. Required Forms: The credit must be claimed on the dedicated state Form IT-RD. Furthermore, since the state credit is contingent upon the federal allowance, taxpayers must attach federal Form 6765 (the form used to report the federal research credit) to their state return.4

B. The Challenge of Documenting In-State Conduct for Third Parties

The strict location mandate for Purchases of Services significantly elevates the documentation burden and represents the primary compliance challenge in this category. Unlike employee wages, where the location of W-2 payroll is generally clear, verifying the precise geographic location of a third-party contractor’s time is complex.

Taxpayers must prepare for audit defense by proving that the contracted research time was genuinely “conducted within” Georgia. In an audit scenario, a simple invoice for research services is insufficient because it does not prove where the service was delivered.11 Therefore, the taxpayer must proactively secure location-specific records from the vendor. This may include detailed time reports, project management logs, or even physical sign-in sheets demonstrating that the contractor’s personnel were performing qualified research activities at a Georgia facility (such as the taxpayer’s site or a verified Georgia laboratory). The failure to obtain or maintain this forensic documentation risks the disallowance of the entire expense, even if the expense otherwise satisfied the federal 65% rule and the four-part test.

C. Utilization Limits and Forward Planning

The Georgia R&D tax credit provides substantial utilization flexibility, although strategic planning is essential due to legislative changes.

The credit may not exceed 50% of the business’s Georgia net income tax liability after all other credits have been applied in any one year.4 Any unused credit can be carried forward, offering a crucial long-term benefit. Historically, this carryforward period has been ten years.4

However, legislative changes significantly affect future value. For credits generated in taxable years beginning on or after January 1, 2025, the carryforward period is reduced to five years.4 This shortening of the credit’s lifespan doubles the pressure on taxpayers to utilize accumulated credits efficiently. Businesses that anticipate large contracted research expenditures should assess the potential for incurring those costs in a 2024 tax year to secure the more favorable 10-year carryforward period, providing greater flexibility for use during non-profitable years or slow growth periods.

Furthermore, any excess research tax credit earned beyond the 50% income tax offset can be used to offset state payroll withholding, effectively converting a deferred income tax benefit into an immediate cash-flow advantage.4 This payroll offset is a particularly attractive feature of the Georgia R&D incentive program.

III. Practical Application: Case Study in Sourcing Contract Research

Determining the final Qualified Research Expense for Purchases of Services in Georgia requires a mandatory two-step reduction process. The following case study illustrates the necessity of applying both the federal 65% rule and the Georgia in-state sourcing rule sequentially.

A. Scenario Setup: Applying Dual Limitations to CRE

A Georgia-based manufacturing enterprise, qualifying as an eligible business enterprise, enters into a contract with an unrelated software development firm for $\$300,000$ to create proprietary manufacturing control software. This activity satisfies the federal four-part research test.

Upon review of the contractor’s time logs, the taxpayer determines the following:

• Total Contract Payment: $\$300,000$.
• Physical Activity Location: 40% of the development labor was performed remotely from outside Georgia, and 60% was performed by engineers physically located at the manufacturer’s facility in Georgia.

B. Calculation Walkthrough: The Dual Reduction

The final amount qualifying for the Georgia R&D credit must undergo two distinct proportional reductions: the fixed federal reduction and the variable state geographic reduction.

Table 1: Calculation Flow for Georgia Purchased Services QRE

In this scenario, only $\$117,000$ of the original $\$300,000$ contract payment is permitted to be included in the calculation of the Georgia QRE base. This result demonstrates the stringent nature of the Georgia sourcing requirement; the 65% federal limit is applied first, and the resulting amount is then proportionally sourced based strictly on the geographical location of the research activity. If the taxpayer cannot furnish the documentation supporting the 60% in-state activity, the GDOR is likely to reject the entire $\$195,000$ federally qualified amount, severely impacting the credit value.

IV. Strategic Compliance and Risk Mitigation

Given the complexity introduced by the in-state sourcing requirement for Purchased Services, businesses must integrate tax compliance directly into their procurement process to mitigate audit risk.

A. Contractual Planning and Mandates

A key element of audit defense is controlling the data from the source. Businesses are strongly advised to include mandatory language in service contracts with third-party researchers that dictates the location of service performance and mandates the provision of detailed location-specific documentation.

This contractual framework should require the third-party contractor to provide time logs or equivalent geographical allocation summaries identifying the specific hours spent on qualified research activities within Georgia. Simply asking the contractor for a “Georgia expense report” is insufficient; the documentation must be granular enough to tie labor hours to physical locations to satisfy the “conducted within” requirement.1

B. Related Party Considerations

While the 65% limitation applies to payments made to unrelated third parties, special rules apply to research conducted by related entities. Under IRC § 41, costs incurred by a related party are generally tracked as if they were incurred directly by the taxpayer (100% of the underlying wages and supplies, not 65% of the contract price).10 However, even when dealing with related entities, the fundamental Georgia mandate remains non-negotiable: the underlying research wages and supplies expense must still be 100% sourced to activities physically conducted within the State of Georgia to qualify for the state credit.1

C. Comprehensive Audit Documentation

For Purchased Services, audit documentation must exceed the standards typically accepted for federal research credit claims. The following elements are critical for establishing defensibility under O.C.G.A. § 48-7-40.12:

1. Contractual Evidence: The executed Statement of Work (SOW) or master services agreement, clearly defining the research scope.
2. Payment Verification: Proof of amounts paid to the contractor and verification of the contractor’s legal status (related or unrelated) to determine the applicability of the 65% or 75% rule.
3. Physical Location Records: The most critical component is objective evidence, such as time sheets, geo-location data, or facility access logs, produced by the contractor to verify that the research labor was physically performed in Georgia.
4. Allocation Methodology: A calculation summary demonstrating how the federally qualified amount (65% or 75%) was multiplied by the verified Georgia sourcing percentage to arrive at the final Georgia QRE.1

V. Conclusion: Maximizing In-State R&D Investment

The Georgia R&D tax credit provides an important incentive for eligible businesses to increase their investment in research and development activities within the state.2 The ability to claim a 10% credit on incremental qualified research expenditures, coupled with the potential to offset up to 50% of the net Georgia income tax liability and utilize excess credits against state payroll withholding, makes this a highly valuable benefit.4

For Purchased Services (Contract Research Expenses), the key to maximizing the credit and ensuring compliance lies in reconciling the federal IRC § 41 requirement (specifically the 65% or 75% reduction) with Georgia’s unique statutory sourcing rule that research must be “conducted within the State of Georgia”.1 This necessitates shifting focus from merely documenting the research intent and expense to forensically proving the geographic location of the contracted labor.

Given the scheduled reduction in the carryforward period from ten years to five years starting with the 2025 tax year, strategic tax planning that maximizes Georgia-sourced Purchased Services in 2024 is advisable to secure the longest available credit utilization window.4 Businesses that implement stringent contractual requirements and robust, location-specific documentation protocols for third-party research will be best positioned to realize the full financial benefit of this state incentive while successfully navigating regulatory scrutiny from the Georgia Department of Revenue.

R&D Tax Credit Preparation Services

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