The Mandate of Independence: Detailed Analysis of the “Independently Owned and Operated” Requirement for the Hawaii Research Activities Tax Credit (HRS § 235-110.91)

The term “Independently Owned and Operated” (IO&O) mandates that an eligible business concern is free from external control or influence, certifying that it is not functionally dominant and does not maintain an affiliation relationship with larger, non-local entities. This criterion functions as a rigorous gatekeeper for the Hawaii R&D credit, requiring firms to pass qualitative control tests, primarily derived from Federal Small Business Administration (SBA) standards, to ensure compliance with the mandatory employee size limitation of fewer than 500 employees, including affiliates.

Section I: The Statutory Foundation and Legislative Context

The Hawaii Tax Credit for Research Activities (TCRA), codified in Hawaii Revised Statutes (HRS) § 235-110.91, provides a refundable income tax credit intended to incentivize qualified research activity within the state.1 The prerequisite of being “Independently Owned and Operated” is central to the legislative intent of this credit, ensuring that benefits are channeled toward specific segments of the technology sector that contribute to local economic growth and social spillovers.2

1.1. Context and Policy Goal of the Hawaii R&D Tax Credit (HRS § 235-110.91)

The Hawaii TCRA is fundamentally linked to the federal Credit for Increasing Research Activities found in Section 41 of the Internal Revenue Code (IRC), specifically referencing the version of IRC § 41 as it was enacted on December 31, 2011, and subsequently modified by Hawaii statute.1 The credit amount itself is calculated by multiplying the federal credit amount (Form 6765) by a fraction representing the eligible research expenses (QREs) attributable to activities conducted solely in Hawaii.3

While the federal credit primarily focuses on the incremental increase in QREs, Hawaii’s state policy imposes stringent eligibility requirements focused on the nature and location of the business undertaking the research, referred to as the Qualified High Technology Business (QHTB). This structure ensures that only firms committed to conducting a substantial portion of their core research activities within the state qualify for the tax incentive.3 The inclusion of the IO&O requirement serves a clear economic targeting purpose: to confine the benefit to small, genuinely independent enterprises domiciled in Hawaii, maximizing the marginal social return on R&D investment within the state economy.2

1.2. The Evolving Definition of a Qualified High Technology Business (QHTB)

The eligibility for the TCRA rests entirely upon a claimant meeting the definition of a QHTB. HRS § 235-110.91(o), as recently amended, provides the explicit criteria.6 A QHTB must be a for-profit corporation, limited liability company, partnership, limited partnership, sole proprietorship, or other legal entity that satisfies four primary conditions:

1. Is domiciled and registered to do business in the State.
2. Is independently owned and operated.
3. Employs fewer than five hundred full-time or part-time employees in the State, including affiliates.
4. Conducts more than fifty per cent of its activities in qualified research.3

This definition resolves a statutory conflict that historically existed in discussions regarding what constitutes a “small business” in Hawaii for regulatory purposes. The general definition of a small business found in HRS § 201M-1, often referenced in earlier legislative discussions concerning the R&D credit, previously limited the employee count to fewer than one hundred full-time or part-time employees and required IO&O status.8 However, recent legislative bills and testimony, such as those related to SB 2497 and HB 1957, confirm that the specific tax credit statute, HRS § 235-110.91, dictates the current threshold of fewer than 500 employees, including affiliates, thereby superseding the general 100-employee limit for the purposes of the R&D tax credit.6

1.3. IO&O as a Condition Precedent for QHTB Status

The “Independently Owned and Operated” provision is not a secondary characteristic or a modifier of the employee count, but rather an essential, non-negotiable condition precedent for achieving QHTB status.6 An entity that fails the independence test is fundamentally disqualified from claiming the credit, irrespective of whether it meets the 500-employee cap or conducts the requisite percentage of research activities. This emphasis underscores the policy decision to direct tax expenditures solely towards genuinely independent firms, rather than subsidiaries or entities functionally controlled by larger, established enterprises.11

Section II: Deconstructing “Independently Owned and Operated” Through Federal Standards

To accurately determine compliance with the IO&O mandate, it is essential to establish the legal standard for interpretation. Since the Hawaii tax code is silent on the internal mechanics of defining “independently owned and operated,” standard legal practice dictates relying on the well-established meaning of the term within analogous regulatory frameworks, specifically the Federal Small Business Administration (SBA) standards.

2.1. Interpretation in the Absence of Explicit Hawaii Tax Code Definition

A comprehensive review of the Hawaii Revised Statutes (HRS) and the Hawaii Administrative Rules (HAR) under Chapter 235 confirms that the Hawaii Department of Taxation (DoTax) has not promulgated specific rules, nor have Technical Information Releases (TIRs) been issued, that define “Independently Owned and Operated” or detail the relevant affiliation rules for HRS § 235-110.91.1

The critical implication of this regulatory void is the necessary adoption of extrinsic interpretation. The term IO&O originates in small business policy legislation, which throughout the United States consistently defers to the standards set forth by the SBA, codified in Title 13, Code of Federal Regulations (CFR), Part 121.11 The SBA defines a small business as one that is “independently owned and operated, and which is not dominant in its field of operation”.16 Utilizing the SBA’s extensive body of law regarding ownership, control, and affiliation provides the only mechanism to give the Hawaii statutory language a meaningful, enforceable, and technically robust definition. Failure to adopt this standard would render the provision ambiguous and difficult to audit or enforce.

2.2. The Control Test: Adopting Federal SBA Affiliation Standards

The concept of IO&O is inextricably linked to the SBA’s “control test.” The fundamental guiding principle is that affiliation exists when one entity controls or has the power to control another, or a third party controls both, regardless of whether that power is actively exercised.16

The SBA, through 13 CFR § 121.103, considers a variety of factors in determining if the power to control exists, thus destroying the independent nature of the applicant:

• Ownership: Control is generally presumed if one entity owns 50% or more of the other, but minority ownership can also establish control under certain circumstances.18 The SBA reviews equity ownership on a fully diluted basis, including potential conversion from preferred stock, warrants, or options, to determine the totality of control.16
• Common Management: Affiliation can be established through shared officers, directors, or key employees who manage the daily business operations of both concerns.18
• Contractual Relationships: Control can be found where agreements, such as financing agreements or shareholder covenants, grant one entity veto power or functional control over the other’s operational decisions.18

The Critical Distinction: Negative Control

One of the most frequent failure points for Qualified High Technology Businesses (QHTBs), particularly those receiving early-stage funding, lies in the area of “negative control.” Negative control occurs when a minority shareholder (such as a venture capital fund) possesses the ability, through the company’s charter, bylaws, or shareholder agreements, to prevent a quorum or otherwise block actions by the board of directors or shareholders.18

Compliance requires a careful review of all investor rights to distinguish between prohibited operational control and acceptable protective rights. The SBA provides specific safe harbors, stating that minority shareholder authority to block actions related to extraordinary circumstances does not, by itself, constitute negative control. These extraordinary circumstances are strictly defined and include actions such as: adding new equity stakeholders, dissolution of the company, sale of the company or all assets, merger, bankruptcy, or amendment of corporate governance documents to remove these protective rights.18 If investor rights extend beyond these safe harbors to operational matters (e.g., vetoing the annual budget, hiring and firing management, setting compensation), affiliation is established, and the IO&O requirement is violated.

2.3. The Dominance Factor and Field of Operation

Although the specific text of HRS § 235-110.91 does not explicitly repeat the federal mandate that a small business must not be “dominant in its field of operation,” this factor is an integrated component of the legal concept of independence used by the SBA.11 A QHTB claiming IO&O status must implicitly satisfy this criterion. The purpose of the IO&O test is to ensure that the R&D credit supports entities that genuinely require the tax incentive for growth, rather than firms that already command a dominant market position, irrespective of their local employee count.

Section III: The Technical Compliance Challenge: Affiliation and Aggregation

The IO&O requirement operates in tandem with the employee size cap, creating a mechanism that ensures the intended beneficiaries are not merely shell companies or minority interests of significantly larger, non-independent enterprises. The linkage between the qualitative control test and the quantitative employee count is the most technically challenging aspect of compliance.

3.1. The Interdependence of IO&O and the Employee Cap

The statute requires the QHTB to employ fewer than 500 full-time or part-time employees in the state, and crucially, this count must include employees of “affiliates”.6 The affiliation determination is entirely governed by whether the applicant is deemed IO&O. If the business fails the IO&O test (i.e., if external control is established), affiliation is triggered, and the employees of the controlling entity and all its controlled subsidiaries must be aggregated for the 500-employee size test.6 For any small business that is venture-backed, or is a subsidiary of a national corporation, this aggregation requirement often leads to immediate disqualification.

3.2. Contradicting Tax Code Affiliation Definitions

A serious legal consideration arises from the existence of differing affiliation definitions within the Hawaii tax code. For purposes of filing consolidated Hawaii income tax returns, Chapter 235 cross-references the federal definition of an “affiliated group” found in IRC § 1504, which requires at least 80% ownership.13

However, applying the IRC § 1504 standard to the IO&O test would severely undermine the legislative intent of the R&D credit. If only an 80% ownership stake triggered affiliation, a massive multinational corporation could legally hold a 79% non-controlling stake in a Hawaii QHTB, exercise extensive financial and operational influence, and yet avoid aggregation of its global employee base. This structure would violate the clear policy goal of the R&D credit to target true small, independent firms.2 Consequently, for the purpose of validating QHTB eligibility and the “Independently Owned and Operated” mandate, the strict, qualitative SBA control test (which can find affiliation based on contractual control rights, regardless of majority ownership percentage) must be the superior and controlling interpretive rule.

3.3. Employee Aggregation and Interpretive Ambiguity

Once affiliation is established via the control test, the aggregation of employees is mandatory. The Hawaii statute requires aggregation for employees “in the State, including affiliates”.6 This wording creates an interpretive ambiguity regarding the scope of the affiliate’s employee count:

• Interpretation A (Narrow): This interpretation suggests aggregating only the affiliate’s employees physically located in Hawaii.
• Interpretation B (Broad/Risk-Averse): This interpretation suggests aggregating the affiliate’s total global employee count because the IO&O test is fundamentally concerned with the economic scale and dominance of the controlling organization, irrespective of where those employees are geographically situated.11

Given the punitive consequence of failing the size test (complete credit disallowance), the risk-averse legal strategy demands using Interpretation B (global aggregation). The policy rationale behind the IO&O and 500-employee cap is to exclude large enterprises, and the scale of the controlling entity is best measured by its global or total operational size. Until definitive DoTax guidance is issued, taxpayers must assume the global employee count of all affiliates applies to the 500-employee threshold.

The table below summarizes the appropriate application of affiliation standards for the Hawaii R&D credit:

Table 1: Comparative Analysis of Affiliation Standards for Hawaii R&D Credit

Section IV: Local State Revenue Office Guidance and Compliance Gaps

Effective compliance relies on explicit administrative guidance. However, the regulatory environment in Hawaii regarding the precise application of IO&O and affiliation remains underdeveloped.

4.1. DoTax Guidance Status and Regulatory Silence

The Hawaii Department of Taxation (DoTax) has historically delegated the certification process for the R&D credit to the Department of Business, Economic Development, and Tourism (DBEDT).1 Taxpayers must apply to DBEDT and receive a certified statement (Form N-346A) indicating the approved QREs.20

While DBEDT handles the initial certification, the ultimate authority for audit and enforcement of tax statutes rests with DoTax. DoTax has not issued any specific administrative rules (HAR Chapter 18-235-110.91) 12 or formal technical releases (TIRs) that interpret the IO&O requirement or define the method for calculating affiliated employees under HRS § 235-110.91.1 References in historical regulatory review documents confirm the existence of the IO&O standard derived from HRS § 201M-1, but these documents do not provide the detailed interpretive guidelines necessary for complex corporate structures.9

4.2. Implication of Administrative Silence

The lack of formal administrative interpretation by DoTax represents a significant transfer of compliance risk to the taxpayer. Even if DBEDT issues the required certification (Form N-346A) based on a general review, a subsequent audit conducted by DoTax years later could challenge the QHTB status if the underlying corporate control structure is found to violate the strict SBA standards for affiliation, which DoTax is expected to adopt retroactively as the governing rule.

Without an official position, a taxpayer may reasonably, but erroneously, assume that the IRC § 1504 80% ownership test applies, or that the narrow interpretation of employee aggregation is appropriate. Such assumptions expose the taxpayer to potential retroactive credit disallowance, interest, and penalties. To rectify this systemic risk, DoTax is urgently recommended to issue a Technical Information Release (TIR) explicitly adopting the SBA standards (13 CFR § 121.103) for IO&O and confirming the methodology for employee aggregation under the “including affiliates” clause.

4.3. Documentation Protocols for Compliance

Given the high exposure resulting from the lack of explicit guidance, comprehensive internal documentation is paramount for any claimant. Taxpayers must proactively prepare documentation that demonstrates, at a minimum, the following points for both the DBEDT certification phase and any potential DoTax audit:

1. Detailed organizational charts illustrating the full ownership structure, including all parent companies, subsidiaries, and common owners.
2. Copies of all governing legal documents (articles of incorporation, operating agreements, shareholder agreements, and loan covenants) demonstrating that no external entity or minority investor possesses prohibited operational negative control rights. Specific focus must be placed on validating that any veto rights fall strictly within the SBA’s safe harbor exceptions for extraordinary corporate events.18
3. A clear, auditable calculation of aggregated employee counts across the entire control group, including a justification for the IO&O status and the rationale used for excluding employees of entities deemed non-affiliates.

Section V: Practical Compliance Example: The Affiliation Failure

The most direct way to illustrate the operational significance of the IO&O mandate is through a common scenario involving venture capital investment, which often introduces negative control and triggers affiliation.

5.1. Case Study Parameters: AlohaTech LLC (Venture-Backed)

The applicant is AlohaTech LLC, a promising software development firm seeking the Hawaii R&D credit.

• Applicant Status: QHTB Candidate.
• Hawaii Employees: 50 Full-Time Equivalent (FTE) employees.
• Ownership Structure: Founder/CEO (55% equity), Venture Capital (VC) Fund Beta (45% equity).
• Goal: Claim the R&D credit, requiring IO&O status and total aggregated employees of less than 500.

5.2. Test 1: Operational Negative Control (Failure to be IO&O)

In exchange for capital, VC Fund Beta (the 45% minority owner) is granted substantial protective rights codified in the LLC’s Operating Agreement and a Shareholder’s Rights Agreement. Specifically, the VC Fund is given the right to:

1. Veto the appointment or termination of key executive officers (e.g., the CEO or CTO).
2. Veto the company’s annual operating budget.
3. Veto any commitment of capital exceeding $\$200,000$.

While the VC Fund holds less than a majority interest, the power to control day-to-day operational decisions (hiring management, setting the budget) extends beyond the SBA’s safe harbors for “extraordinary circumstances”.18 Because the VC Fund can block fundamental operational actions, it is deemed to possess negative control. Under the SBA Affiliation Rules, AlohaTech LLC is therefore Not Independently Owned and Operated and is deemed affiliated with VC Fund Beta.

5.3. Test 2: Aggregated Employee Failure

The failure of the IO&O qualitative test immediately triggers the quantitative employee aggregation requirement. Assume VC Fund Beta, in addition to controlling AlohaTech, also controls a much larger mainland portfolio company, Mainland Research Corp (MRC).

• Mainland Research Corp (MRC): Employs 2,000 FTEs globally (0 in Hawaii).

Since AlohaTech and MRC are both controlled by the common owner, VC Fund Beta, they are deemed affiliates under the SBA rules.18 Employee aggregation is required:

• AlohaTech employees (in Hawaii): 50
• MRC employees (Worldwide Count): 2,000 (Based on the broad, risk-averse interpretation necessary for compliance)
• Total Aggregated Employees: 2,050.

The threshold for a QHTB is fewer than 500 employees, including affiliates.6 AlohaTech’s aggregated employee count of 2,050 exceeds this threshold. The qualitative failure (lack of IO&O) directly resulted in a quantitative size disqualification. AlohaTech is not a QHTB and is Disqualified from the Hawaii R&D Tax Credit.

Table 2: Affiliation Test Failure Analysis (Venture-Backed Example)

Section VI: Conclusion and Recommendations

6.1. Recapitulation of the IO&O Mandate

The “Independently Owned and Operated” prerequisite in HRS § 235-110.91 is a fundamental, substantive requirement designed to limit the benefits of the Hawaii R&D tax credit to genuinely small, local enterprises. Its primary function is to trigger the rigorous affiliation rules necessary to determine the business’s true economic size. The failure to meet this qualitative standard results in the mandatory aggregation of employees with the controlling parent or related entities, often leading to an immediate breach of the 500-employee cap and subsequent credit disallowance.

Due to the absence of specific interpretive guidance from the Hawaii Department of Taxation (DoTax), compliance hinges on adopting the stringent affiliation rules established by the Federal Small Business Administration (SBA), particularly 13 CFR § 121.103. These rules emphasize the power to control, rather than mere majority ownership, making minority shareholder agreements, especially those involving venture capital, a high-risk area for compliance failure.

6.2. Actionable Compliance Recommendations

To mitigate the substantial compliance risk inherent in the current regulatory environment, claimants of the Hawaii R&D Tax Credit must adhere to the following principles:

1. Mandatory Internal Adoption of SBA Standards: Taxpayers must utilize the strict SBA affiliation rules (13 CFR § 121.103) as the binding compliance benchmark for IO&O status, regardless of the lack of explicit DoTax confirmation. This standard is superior to, and operates independently of, the 80% ownership test used for consolidated returns under IRC § 1504.
2. Mitigation of Negative Control Risk: Companies seeking the credit must carefully review and structure all governing and investment documents. Minority investor rights must be strictly limited to the SBA-defined safe harbors for extraordinary corporate events, explicitly avoiding any provisions that grant operational negative control, such as veto power over hiring, budgets, or strategy.
3. Risk-Averse Employee Aggregation: When determining the employee count for affiliated entities, the taxpayer should, as a matter of prudent risk management, aggregate the total worldwide employee count of all affiliated entities, rather than limiting the count only to employees physically located within Hawaii, until DoTax provides clear guidance confirming a narrower interpretation.
4. Prioritized Documentation: Comprehensive legal documentation proving the independence of the entity and the non-affiliation of potential controlling parties is the primary and essential defense against future audit adjustments. This documentation must justify the application of the SBA standards to the corporate structure and affirm that the total aggregated employee count remains below the 500-employee statutory limit.

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