Expert Report: Cost of Supplies and Geographic Sourcing in the Hawaii R&D Tax Credit (HRS §235-110.91)

The Cost of Supplies, within the context of the Hawaii Tax Credit for Research Activities (TCRA), comprises expenses for tangible property, excluding land, improvements, and depreciable assets, that are consumed directly in the research process. These costs qualify for the Hawaii credit only if the qualified research activity, and the physical consumption of the supplies, occur entirely within the geographical boundaries of the State of Hawaii.

I. Executive Summary: Defining the Cost of Supplies (Hawaii)

The Hawaii Tax Credit for Research Activities (TCRA), codified under Hawaii Revised Statutes (HRS) §235-110.91, is a critical mechanism designed to incentivize investment in innovative research conducted exclusively within the state. This incentive takes the form of a refundable credit against Hawaii income tax, available to Certified Qualified High Technology Businesses (QHTBs).1

This report provides an in-depth analysis of the “Cost of Supplies” as a Qualified Research Expense (QRE) under the Hawaii statute. While Hawaii aligns its definition of QREs with the federal framework (Internal Revenue Code, IRC §41), the state imposes a strict geographic sourcing requirement that is the primary point of differentiation and compliance complexity for taxpayers. Therefore, successfully claiming the credit necessitates satisfying both federal definitional rigor and strict state jurisdictional proof.

II. Statutory and Regulatory Foundation of the Hawaii TCRA

The framework for the Hawaii TCRA is characterized by its dependence on federal law for definition combined with severe local restrictions for eligibility, creating a unique, hybrid compliance environment.

A. Core Requirements for the Hawaii R&D Tax Credit

The TCRA targets specific business activities and sizes to maximize its economic impact. The credit is currently set to expire and does not apply to tax years beginning after December 31, 2029.3

• Qualified High Technology Businesses (QHTBs): Eligibility is limited to QHTBs, defined as businesses conducting more than 50% of their activities in specific fields of qualified research. These high-technology fields include biotechnology, software development for commercial sale, ocean sciences, astronomy, sensor and optic technologies, and non-fossil fuel energy-related technology.1
• Credit Structure and Cap: The credit is high-value because it is refundable against Hawaii income tax.1 However, the total amount of credit claimed by all taxpayers is constrained by a $5 million annual aggregate cap.1 Furthermore, the credit is typically limited to small businesses, defined as companies with no more than 500 employees.3

B. Integration with the Internal Revenue Code (IRC §41)

The Hawaii statute links directly to the federal R&D tax credit provisions. A taxpayer must claim the federal tax credit for the same research activities under IRC Section 41 to qualify for the Hawaii credit.4

• Definition of QREs: The definitions of Qualified Research Expenses (QREs), including wages, contract research, leased computer costs, and the Cost of Supplies, mirror those found in IRC §41.1 QREs are fundamentally the sum of in-house research expenses (including supplies) and contract research expenses paid or incurred in carrying on a trade or business.7
• Calculation Methodology: Hawaii employs a proportional calculation method. The final state credit is determined by multiplying the calculated federal credit amount by a ratio: Hawaii QREs divided by total Federal QREs.1 This method necessitates calculating the federal base amount (fixed-base percentage multiplied by the average annual gross receipts of the preceding four years, or a 3% rate for startups) to determine the incremental federal credit first.1

This structural reliance on IRC §41 imposes a dual-tiered compliance responsibility on taxpayers. The taxpayer must first ensure the research activities and expenditures meet the substantive, detailed documentation requirements of the federal tax code regarding the definition and use of the supplies. Only after meeting this primary federal threshold can the secondary layer of restriction—the Hawaii geographic sourcing rule—be applied. A deficiency in documentation at the federal level invalidates the expense for both federal and state purposes.

III. Federal Criteria for Qualifying Cost of Supplies

The definition of supplies is critical to distinguishing between immediately consumable items (supplies) and capitalized assets (equipment).

A. Statutory Definition and Explicit Exclusions (IRC §41)

The Cost of Supplies constitutes a component of “in-house research expenses”.7 IRC §41 offers a concise definition and key exclusions that narrow the scope of eligible costs.9

• Definition of Supplies: Supplies are defined as “any tangible property”.9 This establishes the physical nature required for the expense to qualify, differentiating it from costs associated with services or intangible rights.
• Non-Qualifying Tangible Property: The definition explicitly excludes two categories of tangible property, regardless of their use in research: (1) land and (2) improvements to land.9 Consequently, costs related to purchasing, constructing, or significantly improving research facilities are not includible as a Cost of Supplies.

B. The Consumable Requirement and Asset Differentiation

Beyond the statutory definition, regulatory guidance dictates that qualifying supplies must be consumed, expended, or lose their identity in the performance of qualified research. This consumption test effectively excludes durable property subject to depreciation, such as scientific instruments, machinery, or tools with a useful life extending beyond the taxable year.

Furthermore, a specific category of QREs relates to the rental or lease costs of computers.1 These costs, while eligible QREs, are reported separately on Form N-346, Line 2e.6 Taxpayers must be careful not to misclassify the rental expense of a computer exclusively used in R&D as a Cost of Supply (Line 2d), which would be an error in categorization.

C. Exclusion of Indirect and Overhead Costs

Standard federal regulations exclude costs that are deemed general or indirect, even when incurred within a research facility.10 These non-qualified items include general and administrative expenses, typical office supplies, and standard utility costs.10

For QHTBs involved in high-energy or controlled-environment research, such as those focused on non-fossil fuel energy-related technology or ocean sciences 1, energy costs can be substantial. While general utilities are excluded, an exception exists for extraordinary utilities.10 To utilize this exception and include high-cost utilities as qualified expenses, the taxpayer bears a very high burden of proof. The utility usage must be substantially and directly linked to the research process and disproportionate to standard facility operations. Simply allocating utility costs based on the square footage difference between an administrative area and a research area is explicitly deemed insufficient for compliance.10 Therefore, demonstrating the extraordinary nature of utilities requires advanced resource metering and rigorous cost segregation, linking the metered consumption directly to specific qualified research activities.

IV. The Hawaii Sourcing Mandate: Geographic Localization

The crucial statutory restriction under HRS §235-110.91 is that QREs are only eligible for the TCRA if they are strictly attributable to research activities conducted in Hawaii.4

A. The Requirement for In-State Consumption

The Hawaii Department of Taxation (DOTAX) compliance framework dictates that the qualification of supplies relies entirely on the location of the activity where the tangible property is utilized and consumed. The purchase location or the taxpayer’s headquarters address is irrelevant.

DOTAX Form N-346 instructions clarify this absolute exclusion: “Expenses attributable to research activities OUTSIDE HAWAII do not qualify for the credit”.6 For Cost of Supplies, this means that every dollar claimed on the state return must correspond to materials physically consumed by personnel performing qualified research within the geographical limits of the state.

B. Documentation Requirements for Multi-Jurisdictional Entities

Businesses, particularly QHTBs that might conduct centralized procurement or operate research facilities in multiple jurisdictions, face elevated compliance risks regarding Cost of Supplies. The strict sourcing rule necessitates robust supply chain and inventory controls that serve a critical tax function.

Generic methods of allocating expenses (such as allocations based on employee headcount or revenue ratios) are not sufficient to substantiate the direct consumption of supplies in Hawaii. Taxpayers must implement detailed, project-level inventory tracking systems that document the specific path of each qualifying supply item: from its entry into inventory, to its issuance for a designated qualified research project, and its eventual consumption at a Hawaii research facility. The ability to demonstrate this traceable path is essential to prove to the DBEDT and DOTAX that no commingling of in-state and out-of-state supply costs has occurred.

V. DOTAX Compliance and Reporting Procedures

The process for claiming the Hawaii R&D Tax Credit is mandatory and two-phased, involving both the Department of Business, Economic Development, and Tourism (DBEDT) for certification and the Department of Taxation (DOTAX) for the final credit claim.

A. The DBEDT Certification Process

The initial and most time-sensitive step involves obtaining certification from DBEDT.

• Application Timelines: Taxpayers must submit Form N-346A (Certified Statement of Research and Development Costs) and an associated questionnaire to DBEDT. The deadline for this mandatory application is March 31 following the close of the taxable year in which the research was conducted.1
• DBEDT Role: DBEDT reviews the application to verify the nature of the research activities and the amount of the underlying qualifying costs or expenditures.11 DBEDT’s certified findings, which include the verified amount of costs, are summarized in a certificate that the taxpayer must attach to their final tax return.1 Due to the $5 million annual cap on total credits claimed, timely and accurate certification is crucial to secure the taxpayer’s claim against the cap.1

B. Reporting on DOTAX Form N-346

The final claim is made using DOTAX Form N-346 (Tax Credit for Research Activities).4 The instructions for this form emphasize the required segregation of costs. Cost of Supplies is reported on Line 2d.6

The form uses a mandatory dual-column reporting structure to enforce the sourcing rule 6:

• Column A (Federal QREs): This column reports the total eligible expenses, including supplies, as claimed on the federal Form 6765.6 This figure is constrained by the definitions and exclusions of IRC §41.
• Column B (Hawaii-Sourced QREs): This column reports the subset of costs from Column A that are specifically attributable to research activity conducted IN HAWAII.6

This structure mandates strict synchronization. If the taxpayer’s federal claim (Column A) is later adjusted or disallowed by the IRS, the corresponding Hawaii claim (Column B) is immediately compromised because the state claim is contingent upon a valid federal QRE foundation. This structure heightens the necessity of meticulous documentation that satisfies both federal audit standards and Hawaii’s geographical sourcing requirements.

VI. Case Study: Application of Cost of Supplies Sourcing

The following example illustrates how a hypothetical Qualified High Technology Business (QHTB) must allocate and source its supply costs to comply with the Hawaii TCRA.

A. Hypothetical Scenario: OceanTech Hawaii

OceanTech Hawaii, LLC, is a QHTB engaged in developing sensor and optic technologies for ocean sciences.1 The company maintains a small administrative office in Seattle (Washington) and a primary, certified research laboratory in Hilo (Hawaii).

B. Computational Impact

Assuming OceanTech has $1,500,000 in total Federal QREs (Column A) and $1,200,000 in total Hawaii QREs (Column B, incorporating the $300,000 in supplies):

1. Federal Credit Calculation: OceanTech calculates its incremental Federal Credit amount (based on its federal base amount) to be $250,000.
2. Sourcing Ratio Determination:
   
   $$\text{Sourcing Ratio} = \frac{\text{Hawaii QREs}}{\text{Federal QREs}} = \frac{\$1,200,000}{\$1,500,000} = 80\%$$
3. Hawaii Credit Calculation:
   
   $$\text{Hawaii Credit} = \text{Federal Credit} \times \text{Sourcing Ratio} = \$250,000 \times 80\% = \$200,000$$

The Cost of Supplies represents a crucial portion of the Hawaii QREs numerator. If OceanTech had mistakenly included the $150,000 in Seattle-consumed supplies, they would risk an audit adjustment that could jeopardize not only the $150,000 but potentially the entire claim, resulting in the need to return the refundable credit. Compliance requires the explicit exclusion of all out-of-state consumption.4

VII. Conclusion and Strategic Recommendations

The Cost of Supplies is a fundamental QRE category within the Hawaii TCRA, but its utility is severely restricted by the state’s geographic sourcing mandate. Successful compliance requires taxpayers to move beyond basic financial accounting and implement robust inventory and expense tracking controls that specifically address the consumption location and the federal definition requirements.

A. Critical Compliance Directives for QHTBs

1. Strict Definitional Adherence: Taxpayers must ensure all claimed supplies meet the IRC §41 definition of tangible, consumable property, strictly excluding land, improvements, depreciation, and general overhead. Special scrutiny must be given to the utility exception, requiring advanced measurement and direct linkage to research activity.
2. Unwavering Geographic Sourcing: The only criterion for claiming the Cost of Supplies on Form N-346, Column B, is verified consumption within Hawaii. Companies with multi-state activities must adopt internal controls to document the specific Hawaiian facility where the tangible supplies were expended, treating inventory management as a critical tax compliance function.
3. Proactive Certification Strategy: Due to the $5 million annual aggregate cap, QHTBs must prepare their Cost of Supplies documentation (Form N-346A data) and secure DBEDT certification by the March 31 deadline promptly. Delays in certification increase the risk of the annual cap being reached before the credit can be claimed.1
4. Synchronization of Returns: Given that the Hawaii credit is derived proportionally from the Federal credit calculation, any adjustments or failure to sustain the federal Form 6765 claim directly impacts the validity and size of the Hawaii refundable credit. Maintaining synchronization between federal and state documentation is non-negotiable for audit preparedness.

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