Expert Regulatory Analysis: The 65% Contract Research Expense Limitation in the Hawaii R&D Tax Credit (HRS §235-110.91)

I. Executive Summary: The Definition of Contract Research Expenses in Hawaii

1.1. The Simple Meaning of 65% CRE

The Contract Research Expenses (CRE) limitation dictates that only 65% of payments made to unaffiliated third parties for qualified research services may be counted toward the total eligible expenses for the Hawaii R&D Tax Credit. This requirement, derived directly from the federal framework (IRC §41), ensures that the refundable state credit subsidizes the direct cost of research activities performed on behalf of the Hawaii taxpayer, rather than covering extraneous profit margins or overhead.

1.2. Hawaii TCRA at a Glance: Key Eligibility Criteria and Administrative Deadlines

The Hawaii Tax Credit for Research Activities (TCRA), codified under Hawaii Revised Statutes (HRS) §235-110.91, provides a crucial refundable tax credit designed to incentivize technological advancement by Qualified High Technology Businesses (QHTBs).1 The structure and availability of this credit are subject to strict parameters enforced by the Department of Business, Economic Development, and Tourism (DBEDT) and the Department of Taxation (DOTAX).

To qualify, a business must be registered in Hawaii, conduct more than 50% of its activities in qualified research within the state, and maintain no more than 500 employees.2 The program operates under a stringent limitation: the total aggregated credit certified statewide is limited to a $5 million annual cap.2 DBEDT allocates this limited funding strictly on a first-come, first-served basis, emphasizing the critical importance of administrative speed.2

Taxpayers seeking the credit must submit the certification application, Form N-346A, to DBEDT by March 31st following the taxable year.2 Once certified, the credit is claimed on the tax return using Hawaii Form N-346. It is important to note that the TCRA is scheduled to sunset, as the credit does not apply for tax years beginning after December 31, 2029.2

1.3. Critical Legislative Update: Reinstatement of the Federal Base Amount (Act 139)

The regulatory landscape for the Hawaii TCRA underwent a material shift with the enactment of updates, including SB2497 CD1 (Act 139 in 2024). Previously, Hawaii allowed credit to be taken on all qualified research expenses (QREs) incurred in the state, disregarding the taxpayer’s historical R&D spending.4 However, per the updated rules, the calculation now mandates the application of the base amount defined in Internal Revenue Code (IRC) Section 41.2

This change imposes the federal incremental calculation requirement on Hawaii taxpayers. Consequently, businesses must now compute the full federal incremental credit calculation—which involves determining the fixed-base percentage and averaging gross receipts from previous years—to establish the amount of “excess QREs” before applying the Hawaii proration ratio.5 The requirement that only incremental QREs qualify significantly raises the computational complexity for compliance and may result in a reduced net credit for established companies compared to claims filed in prior periods.

II. Statutory and Regulatory Basis for Qualified Research Expenses (QREs)

2.1. Nexus to Federal Law: HRS §235-110.91 and the Adoption of IRC §41

The Hawaii TCRA functions as a mirror mechanism to the federal R&D Tax Credit. The state statute (HRS §235-110.91) is explicitly tied to IRC §41, meaning that eligibility for the Hawaii credit is contingent upon the taxpayer first claiming the federal tax credit for the same research activities.1 The ultimate calculation of the Hawaii credit is defined as the amount of the federal tax credit (calculated using Form 6765) multiplied by a proration factor.3

A crucial modification introduced by Hawaii law is the location test. While the definition of Qualified Research Expenses (QREs) largely follows federal guidelines, only expenditures associated with research activities that are physically conducted in Hawaii are eligible for inclusion in the numerator of the proration fraction.4 Therefore, even if an expense qualifies under federal IRC §41, if the activity occurred outside of Hawaii, it cannot contribute to the state credit.

2.2. Defining “Qualified Research” (The IRS Four-Part Test)

For any expenditure to be eligible as a QRE, including Contract Research Expenses, the underlying activity must satisfy the long-established IRS four-part test for qualified research 7:

1. Technological in Nature: The research process must rely on principles of engineering, physics, chemistry, or computer science.
2. Purpose to Improve or Develop: The activity must be intended to develop a new or improved product, process, or software.
3. Elimination of Uncertainty: The activity must be intended to eliminate uncertainty regarding the capability, method, or appropriate design of the product or process.
4. Process of Experimentation: Substantially all the research activities must involve a process of experimentation, such as testing and evaluating alternatives.

2.3. Categories of Qualified Research Expenses (QREs)

Under both federal and Hawaii law, QREs fall into specific categories, each with a defined inclusion rate 5:

• In-House Wages: 100% of salaries paid to employees performing, supervising, or directly supporting qualified research are included, provided the services are rendered in Hawaii for the state credit.
• Supplies: 100% of the cost of materials and prototypes consumed or used in the R&D process are included, provided they are consumed in Hawaii-based activities.
• Computer Rentals: 100% of the costs for leased computers and equipment used exclusively in R&D activities are included, provided they are used in Hawaii.5
• Contract Research Expenses (CRE): Only 65% of payments made to unaffiliated third parties for qualified research services are includible as QREs.5

III. Detailed Analysis of the 65% Contract Research Expense Limitation

3.1. What the 65% Rule Represents

The 65% inclusion rate for Contract Research Expenses is a fundamental limitation embedded in IRC §41(b)(3).8 This percentage is applied directly to the amount paid or incurred by the taxpayer to the research contractor, excluding employees.9 The primary rationale behind limiting CRE is to adjust for the structural differences between conducting research internally versus contracting it externally. When a company pays its own employee (in-house research), 100% of the wages related to qualified services are counted as QREs. However, payments to external contractors typically include elements beyond direct research costs, such as the contractor’s profit margin, general overhead, and administrative costs that are not directly eligible for the credit.10 By allowing only 65% of the contractual payment to qualify, the law makes a presumptive allocation, ensuring that the R&D credit appropriately subsidizes only the direct research costs borne by the taxpayer.10

3.2. Requirements for a Valid Contract Research Expense

To qualify for the 65% inclusion, the contract research arrangement must satisfy several rigorous federal requirements, adopted by Hawaii, that demonstrate the taxpayer maintains both financial and intellectual control over the research. The arrangement must meet the following criteria 10:

1. Unaffiliated Parties: Payments must be made to a person other than an employee of the taxpayer.9 For Hawaii purposes, this payment must be to an unaffiliated third party.5 Controlled group regulations must be reviewed to correctly apply the 65% limit.10
2. Substantial Rights: The contract must stipulate that the research is performed on behalf of the taxpayer, meaning the QHTB must retain substantial rights to the research results.10
3. Economic Risk: The taxpayer must bear the economic risk of the research. This means the taxpayer is required to bear the expense, regardless of whether the research is successful or not.11
4. Timing: The contract must be entered into prior to the performance of the qualified research.11

3.3. The Hawaii Specific Requirement: In-State Performance

The application of the 65% CRE rule for the Hawaii TCRA requires satisfying a critical geographical constraint. For contract research costs to be included in the state’s calculation, the payments must not only meet all the federal 65% criteria, but the resulting qualified research must also be performed within the State of Hawaii.5

The need to isolate in-state activities introduces a significant documentation burden for allocation. If a Hawaii QHTB contracts research services, the taxpayer must be able to prove which portion of the total contract cost—after applying the 65% reduction—is attributable to work physically completed in Hawaii. This contrasts sharply with internal wage QREs, where payroll location is often sufficient. For contracted research, documentation must go beyond general invoices, requiring detailed records such as contractual clauses, contractor work logs, and itemized invoices that explicitly confirm the physical location of the service delivery. Robust substantiation is necessary to support the calculation of the Hawaii QRE numerator and to withstand potential scrutiny during an audit by DBEDT or DOTAX.5

Table 1 outlines the general requirements for all Hawaii Qualified Research Expenses.

Table 1: Definition of Hawaii Qualified Research Expenses (QREs)

IV. Hawaii State Revenue and Agency Guidance (DBEDT and DOTAX)

Effective administration of the Hawaii TCRA requires sequential compliance with guidelines established by DBEDT for certification and DOTAX for tax return filing.

4.1. The Critical Role of DBEDT Certification (Form N-346A)

Certification from DBEDT is a mandatory prerequisite for claiming the refundable credit.5 The process is highly competitive due to the $5 million annual aggregate cap.2 Guidance indicates that this cap has historically been reached almost immediately upon the application window opening.2

The urgency of this competition dictates that taxpayers must treat the submission of the completed and signed Form N-346A as a high-priority, time-sensitive event. The application date is determined by the date and time the N-346A form is received by DBEDT.2 Taxpayers cannot afford to wait for final tax calculations, often requiring robust internal estimates of QREs, including the 65% CRE component, to ensure the application is submitted by the statutory deadline of March 31st following the close of the taxable year.2

Furthermore, subsequent to the initial application, filers are required to complete a detailed online survey or questionnaire (Part B), which requests specific expense, revenue, intellectual property, and related business data.2 This supplementary data is typically due by June 30th. Failure to complete this annual survey by the deadline shall constitute a waiver of the right to claim the credit.6

4.2. DOTAX Filing Requirements and Administration

The Department of Taxation (DOTAX) is responsible for processing the final claim and issuing the refund. To properly claim the credit, the taxpayer must attach several key documents to their Hawaii income tax return 6:

• Federal Form 6765 (used to compute the federal credit).
• The approved certification form from DBEDT (Form N-346A).
• Hawaii Form N-346 (Tax Credit for Research Activities).
• Schedule CR, and copies of Schedule K-1s if the credit is being claimed via a flow-through entity (e.g., partnership or S corporation).6

A critical compliance point is the deadline to claim the credit. The statutory guidance specifies that the deadline to claim the credit, including amended claims, is strictly 12 months after the close of the taxable year.5 This deadline often precedes the extended filing deadline for the underlying income tax return, requiring specific attention from taxpayers.

4.3. Substantiation and Audit Readiness for Contract Research

Taxpayers are required to retain records substantiating their QRE claims for a minimum of four years, as DBEDT and DOTAX may request documentation, particularly expense and payroll substantiation.5 For Contract Research Expenses, the audit focus is concentrated on two areas: ensuring compliance with the federal qualification criteria (economic risk, substantial rights, pre-research agreement) and verifying the correct allocation of services to Hawaii. Businesses contracting services must prepare documentation, such as service contracts and work records, that definitively prove that the physical location of the qualified research aligns with the amount claimed in the Hawaii QRE numerator.5

Table 2 summarizes the critical administrative requirements for the TCRA.

Table 2: Key Administrative Requirements for the Hawaii TCRA

V. Calculation Mechanics: Integrating CRE into the Proration Formula

The Hawaii TCRA calculation methodology involves a two-stage process: first, computing the total incremental federal credit, and second, prorating that amount based on in-state expenditures.3 The 65% CRE rule applies in both stages.

5.1. Federal Base Calculation (Post-Act 139): Determining Incremental QREs

The application of Act 139 necessitates the use of the federal incremental method. The initial step is to determine the Total Federal QREs (F-QREs) by summing worldwide expenditures, including 100% of qualified wages and supplies, and 65% of all worldwide Contract Research Expenses.8

Next, the Fixed Base Amount (FBA) is computed. This involves multiplying the fixed-base percentage by the average annual gross receipts (AGR) of the four preceding tax years.5 The calculated FBA is subject to a limitation: it cannot be less than 50% of the current year’s F-QREs. Subtracting the FBA from the F-QREs yields the Federal Excess QREs. This excess amount is then multiplied by the applicable federal credit rate (typically 20% under the regular method) to determine the Federal Credit amount.5

5.2. The TCRA Proration Ratio: Ensuring Only Hawaii Activity Counts

The state credit is calculated by multiplying the Federal Credit amount by the Hawaii proration ratio.5

The Denominator of this ratio is the Total Federal QREs (F-QREs), which must include 65% of all worldwide CRE.8

The Numerator is the Hawaii QREs (HI-QREs). This figure includes 100% of in-house wages and supplies for research conducted in Hawaii, plus 65% of Contract Research Expenses paid for qualified services physically performed in Hawaii.5

The structure of this calculation means that any error in applying the 65% rule to Contract Research Expenses is compounded. If CRE is misstated, it affects the total F-QREs (the denominator) and, consequently, the calculation of the Federal Credit itself. If the geographic allocation of that 65% CRE portion is misstated, it further distorts the HI-QREs (the numerator), leading to a material misstatement of the final prorated Hawaii TCRA claim.

VI. Case Study Example: Quantifying the Impact of 65% CRE

This example demonstrates the integration of the 65% CRE rule and the new incremental calculation requirement (post-Act 139) for a Qualified High Technology Business (QHTB) operating both in Hawaii and elsewhere.

6.1. Scenario: Advanced Solutions Inc. (ASI)

Advanced Solutions Inc. (ASI), a QHTB, incurred the following QREs in Tax Year 2024:

• Total R&D Salaries (Worldwide): $1,500,000

• Salaries for work performed in HI: $1,200,000

• Total Contract Research Paid (Worldwide): $300,000

• Contract research performed in HI (by unaffiliated third party): $200,000
• Contract research performed outside HI: $100,000

• Total Supplies Consumed (Worldwide): $200,000

• Supplies consumed in HI: $150,000

• Historical Data for Federal Base Calculation: Fixed-Base Percentage (FBP) calculated at 12%. Average Gross Receipts (AGR) for the 4 preceding years: $15,000,000.

6.2. Step-by-Step Federal Credit Calculation (Form 6765)

1. Calculate Total Federal QREs (F-QRE):

• Wages: $1,500,000
• Supplies: $200,000
• CRE: $300,000 paid $\times$ 65% = $195,000
• Total Federal QREs (F-QRE): $1,895,000

1. Calculate Fixed Base Amount (FBA):

• FBA based on history = $15,000,000 (AGR) $\times$ 12% (FBP) = $1,800,000.
• The minimum FBA is 50% of current F-QREs: $1,895,000 $\times$ 50% = $947,500.
• The calculated FBA of $1,800,000 is used as it is greater than the minimum.

1. Calculate Incremental QREs:

• $1,895,000 (F-QRE) – $1,800,000 (FBA) = $95,000

1. Calculate Federal Credit (20% Regular Rate):

• $95,000 $\times$ 20% = $19,000 (Federal Credit amount).

6.3. Step-by-Step Hawaii Proration Calculation

1. Calculate Hawaii QREs (HI-QRE):

• Wages in HI: $1,200,000
• Supplies in HI: $150,000
• CRE in HI: $200,000 (paid for HI work) $\times$ 65% = $130,000
• Total Hawaii QREs (HI-QRE): $1,480,000

1. Calculate Proration Ratio:

• Ratio = HI-QRE / F-QRE = $1,480,000 / $1,895,000 = 78.09%

1. Calculate Hawaii TCRA:

• TCRA = Federal Credit $\times$ Ratio
• TCRA = $19,000 $\times$ 78.09% = $14,837 (Subject to the $5 million annual cap).

Table 3: Calculation Example Summary (Advanced Solutions Inc.)

VII. Strategic Considerations and Conclusion

7.1. Operationalizing Compliance for CRE

The effective management of Contract Research Expenses goes beyond merely multiplying the expense by 65%. For a QHTB operating under the Hawaii TCRA, the greatest regulatory challenge is proving that the contracted work meets both the federal criteria for eligibility and the Hawaii requirement for in-state performance. Since the competitive nature of the $5 million cap dictates extremely rapid filing, taxpayers cannot wait until year-end to gather documentation.2 Best practices require the QHTB to establish contemporaneous documentation protocols, ensuring that contracts are structured to meet the economic risk and substantial rights tests 11, and that detailed work logs or invoicing clearly confirm the physical location of the research services conducted within Hawaii.5

7.2. The Refundable Nature as a Key Incentive

The Hawaii TCRA is a refundable tax credit.1 This feature is of paramount importance, particularly for early-stage QHTBs that are heavily invested in innovation but may generate minimal or no taxable income. Unlike non-refundable credits that only offset current tax liability, a refundable credit provides direct cash flow to the business. The ability to claim a cash refund underscores why securing the DBEDT certification, and winning the race against the $5 million cap, is a critical objective for high-technology companies in the state.3

7.3. Conclusion

The Contract Research Expenses Percentage (65%) is a standardized federal tax concept that, when applied in Hawaii, must be integrated with complex state-specific administrative and geographical requirements. The recent legislative mandate to reinstate the IRC §41 base amount calculation introduces a layer of complexity previously absent, demanding that QHTBs dedicate resources to calculating the incremental federal credit before applying the Hawaii proration. Successful utilization of this credit requires meticulous recordkeeping to substantiate the eligibility (the 65% rule) and the location (the in-state performance) of every contracted research dollar. Given the statutory $5 million annual cap and the looming 2029 sunset date 2, timely, accurate compliance, particularly concerning the critical March 31st DBEDT certification deadline, remains essential for maximizing this valuable state incentive.

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