The Localization Mandate: Defining and Apportioning “Research Activity Conducted IN HAWAII” for Tax Credit Compliance
The term “Research Activity Conducted IN HAWAII” refers to Qualified Research Expenses (QREs) sourced within the state, serving as the basis for a highly beneficial refundable tax credit.
This localized activity must meet dual criteria: first, ensuring the business qualifies as a Qualified High Technology Business (QHTB) by conducting more than 50% of its total research activity locally, and second, precisely calculating the ratio of Hawaii QREs to total federal QREs for the final credit amount.
The Hawaii Tax Credit for Research Activities (TCRA), codified under Hawaii Revised Statutes (HRS) §235-110.91, represents a vital mechanism for incentivizing the development and expansion of the high-technology sector within the state. This credit is available to Qualified High Technology Businesses (QHTBs) and is structured as a refundable income tax credit.1 The total amount of certified credits is capped at $5 million annually and is set to be repealed from statute on December 31, 2029.1 Compliance requires rigorous adherence to statutory requirements regarding the scope and location of research expenditures, which are subject to a joint administrative process involving the Department of Business, Economic Development, and Tourism (DBEDT) for initial certification and the Department of Taxation (DOTAX) for auditing and final adjustment.3
I. Executive Overview: The Hawaii R&D Credit and the Local Research Mandate
A. Key Regulatory Milestones and the 2024 Conformance Shift (Act 139)
The Hawaii TCRA is modeled directly after the federal credit for research activities provided by Section 41 of the Internal Revenue Code (IRC).1 However, key legislative changes have profoundly altered the credit calculation. Effective for tax year 2024, the state legislature extended the credit through 2029 and crucially revised the base amount calculation to align completely with the federal methodology.5
This updated guidance mandates that the base amount defined in IRC §41 now applies to the Hawaii calculation.1 Consequently, the credit is limited only to incremental QREs—those expenses exceeding the federally determined base amount calculated using the taxpayer’s fixed-base percentage and average annual gross receipts for the four preceding tax years.4
The shift to an incremental base significantly affects companies with stable research budgets. For established companies that consistently maintain a high level of research spending, this rule change means that a substantial portion of their current QREs may no longer qualify for the credit, even if all those expenses are incurred in Hawaii. This regulatory alignment explains the sharp observed reduction in the average credit claimed per QHTB. For the 2024 tax year, the average credit claimed per QHTB dropped significantly to $0.15 million, compared to the $0.33 million to $0.46 million range seen during the 2020–2023 tax years when the credit was calculated based on the total amount rather than only incremental increases.5 This reduction demonstrates that the determination of research activity conducted “in Hawaii” must now be preceded by a mastery of the complex federal base calculation, as this calculation sets the overall maximum quantum of eligible expenses before state apportionment occurs.
II. The Statutory and Administrative Definition of “Research Activity Conducted IN HAWAII”
The legal interpretation of “in Hawaii” research is applied at two critical junctures: initial business eligibility and final credit calculation.
A. Requirement 1: QHTB Status Threshold (The >50% Activity Test)
To be certified as a QHTB, a business must satisfy operational requirements demonstrating its commitment to the state. Specifically, the company must conduct more than 50% of its activities in qualified research in the state of Hawaii and must be registered to do business in the state.1
DBEDT’s administrative review of QHTB status focuses on the operational center of gravity. Although the exact metric for defining “activities” is not detailed in the provided guidance, it inherently encompasses the location of primary research personnel, administrative functions, and specialized research assets. The tightening of this threshold is reflected in the 2024 data: all eighteen certified QHTBs were local companies headquartered in Hawaiʻi, a marked departure from previous years where up to 20% of applicants were based outside the state.5 This shift underscores the rigorous interpretation of the “activities” requirement, ensuring the credit serves businesses whose core operations and strategic decision-making are fundamentally rooted in Hawaii. A multi-state entity with a small research satellite in the state will find it extremely difficult to meet this primary qualification threshold, regardless of its total national QREs.
B. Requirement 2: Qualified Expense Attribution (The Apportionment Numerator)
After QHTB status is secured, the precise calculation of the credit relies on accurately sourcing expenses to the state. The final Hawaii TCRA is determined by a proportional allocation formula 4:
$$\text{Hawaii TCRA} = \text{Federal R\&D Credit} \times \frac{\text{Hawaii QREs}}{\text{Total Federal QREs}}$$
The numerator, Hawaii QREs, must consist solely of expenses tied to research activities physically conducted within the geographical boundaries of Hawaii.4 This necessitates a precise separation of expenses, as expenses attributed to research activities outside Hawaii do not qualify for the state credit.7 Consequently, QHTBs must institute robust tracking systems to distinguish local expenditures from those incurred globally, down to the level of individual payroll entries or supply consumption records.
III. Hawaii Department of Taxation (DOTAX) and DBEDT Guidance on Apportionment
Compliance with the Hawaii TCRA is uniquely challenging due to the strict annual cap and the requirement for pre-certification, which demands immediate, accurate reporting of localized QREs.
A. DBEDT Certification and the $5 Million Cap Constraint
DBEDT manages the certification process through Form N-346A. Every QHTB must submit a written, certified statement identifying its qualified expenditures before March 31 of the year following the taxable year in which the activity was conducted.2
Crucially, the total amount of credits is capped at $5 million annually, and certifications are provided on a first-come, first-served basis until the cap is reached.1 DBEDT has emphasized that in recent years, the $5 million cap was reached almost immediately upon the application window opening.1 The official application date/time is determined by the moment the completed and signed N-346A form is received by DBEDT.1
This stringent first-come, first-served mechanism elevates the importance of timely preparation. Taxpayers cannot afford to treat the R&D credit calculation as a post-year-end activity; data aggregation and apportionment calculations must be integrated into real-time operational expense systems to ensure the N-346A can be prepared and submitted immediately during the application period (typically March 3 to March 31).1 Any delay risks losing the ability to claim the credit entirely for that tax year.
B. DOTAX Scrutiny and Apportionment Methodology
While DBEDT issues the initial certification, the Director of Taxation retains the authority to audit and adjust the tax credit amount to conform to the facts.3 This oversight is applied through the filing of Form N-346 (the tax return form) based on the certified amount from Form N-346A.
Form N-346A specifically requires the taxpayer to enter the eligible research expenses attributable to research activity conducted IN HAWAII in a separate column from the total federal eligible expenses.7 Although the statutory requirement for separation is clear, detailed, explicit guidance from DOTAX (such as specific technical information releases or administrative rules) regarding the precise apportionment methodology for multi-state QREs (especially wages) is not readily available in the general instructions.7
In practice, the sourcing of QREs must align with general state tax sourcing principles, meaning the expense is generally attributable to the state where the service or consumption physically takes place. For the most significant category of QREs—wages—this means robust physical presence tracking is essential to withstand a DOTAX audit.
IV. Detailed Sourcing Rules for Hawaii QRE Categories
Accurate determination of Hawaii QREs requires meticulous tracking across the three primary categories: wages, supplies, and contract research.
A. Qualified Wages (The Dominant Expense Factor)
For tax year 2024, over 80% of the total research expenses incurred in Hawaiʻi by certified QHTBs were spent on wages.5 This fact highlights the pivotal role of payroll sourcing in maximizing the TCRA claim.
Wages paid for the performance, supervision, or direct support of qualified research are sourced to Hawaii only if the employee is physically located in the state while performing those services.
For highly compensated research employees, who often travel or split their time between Hawaii and mainland offices, strict time-tracking documentation is mandatory. QHTBs must maintain records such as detailed time logs, electronic clock-in data, or verified travel reports to apportion the employee’s qualified wages based on the ratio of time spent conducting qualified research within Hawaii versus time spent outside the state. Only the calculated in-state portion of the wages may be included in the Hawaii QRE numerator.
The economic implications of this sourcing rule are profound: the state credit fundamentally functions to subsidize high-wage, high-skill employment within the islands. The weighted average annual wage for full-time research employees certified in 2024 was high, at $117,972.5 Consequently, maximizing the TCRA is directly dependent on ensuring the physical work location of the most valuable research personnel is demonstrably in Hawaii.
B. Qualified Supplies and Rental Costs
Qualified supplies are materials consumed or used directly in the conduct of qualified research.4 These costs are sourced to Hawaii if the supplies are physically consumed or utilized within the state. This requires internal inventory tracking to link supply purchases—even if procured outside the state—to the specific lab or facility in Hawaii where the materials are ultimately expended in the research process.
Similarly, costs related to the rental or lease of tangible property, such as computers or lab equipment, are included as Hawaii QREs only if the property is physically located and utilized in the conduct of qualified research within the state.5
C. Contract Research Expenses
Payments made to third-party contractors for qualified research services are subject to the 65% limitation under federal law. The Hawaii localization rule applies to the performance location of the contractor. Thus, 65% of contract research expenses may be sourced to Hawaii if the research services are physically performed by the contractor within the State of Hawaii.
This rule places an additional documentation burden on the QHTB, requiring it to secure verification from the contract researcher specifying the location where the contracted work was executed. If a mainland contractor is hired but performs 100% of the services from their non-Hawaii location, none of the payment qualifies as a Hawaii QRE, even if the contracting QHTB is based in Honolulu.
V. Detailed Calculation Example: Multi-Jurisdictional Apportionment
The Hawaii R&D Tax Credit calculation is a derivative process, using the federally determined eligible credit as its base and then applying a state apportionment factor based on local activity.
A. Hawaii R&D Tax Credit Calculation Framework
The table below summarizes the crucial differences in scope and methodology between the federal and state credits, illustrating how the definition of “in Hawaii” activity fits into the overall financial framework.
Hawaii R&D Tax Credit Calculation Comparison
| Calculation Component | Federal (IRC §41) | Hawaii (HRS §235-110.91) |
| Base Amount Used | Calculated (Fixed-Base Percentage $\times$ Avg. Gross Receipts). | Applies: Only incremental QREs qualify (Post-2024 Act 139).1 |
| QRE Scope (The Denominator) | Worldwide QREs (Wages, Supplies, Contract Research).4 | Only QREs performed and sourced in Hawaii (The Numerator).7 |
| Final Credit Determination | Calculated using Form 6765 (Regular or ASC). | Federal Credit $\times$ (Hawaii QREs $\div$ Total Federal QREs).4 |
| Refundability Status | Generally non-refundable. | Refundable for certified QHTBs (up to the $5M cap).1 |
B. Calculation Example: TechCo Hawaii (Tax Year 2024)
Consider TechCo Hawaii, a QHTB with research operations both in Honolulu and California, using the Regular Method for its federal R&D tax credit calculation.
- Federal Calculation (IRC §41):
TechCo first computes its federal credit, which establishes the maximum potential benefit.
| Metric | Value | Rationale/Calculation |
| Total Federal QREs (Denominator) | $2,000,000 | Total worldwide QREs eligible under IRC §41. |
| Federal Base Amount | $500,000 | Calculated from prior gross receipts (e.g., 5% $\times$ $10M average).4 |
| Federal Excess QREs (Incremental) | $1,500,000 | $2,000,000 (Total QREs) – $500,000 (Base Amount). |
| Total Federal R&D Credit (Line 1, N-346) | $300,000 | $1,500,000 (Excess QREs) $\times$ 20% (Federal Regular Rate). |
- Hawaii QRE Sourcing (HRS §235-110.91):
TechCo isolates the research expenses strictly attributable to activity conducted in Hawaii.
- Hawaii QREs (Wages): $750,000 (Based on time-tracking of local staff)
- Hawaii QREs (Supplies Consumed): $40,000
- Hawaii QREs (Contract Research): $10,000 (Representing 65% of $15,385 paid to a local consultant for in-state work)
- Total Hawaii QREs (Numerator): $800,000
- Hawaii Tax Credit Calculation:
The Hawaii Tax Credit for Research Activities is then calculated by multiplying the Federal Credit by the Hawaii Apportionment Ratio:
- Hawaii Apportionment Ratio: $\frac{\$800,000 \text{ (Hawaii QREs)}}{\$2,000,000 \text{ (Total Federal QREs)}} = 40\%$
- Hawaii TCRA: $\$300,000 \text{ (Federal Credit)} \times 40\% = \textbf{\$120,000}$
The resulting $120,000 is the amount TechCo may claim as a refundable credit on Form N-346, provided it successfully obtained certification (N-346A) from DBEDT before the annual cap was exhausted. This process confirms that the state definition of “in Hawaii” QREs directly determines the fraction of the federally subsidized research activity that benefits the state economy.
VI. Strategic Insights and Economic Context for QHTBs
The aggregated data on QHTB utilization of the credit reveals important trends about the nature of research activity conducted in Hawaii and the credit’s strategic significance.
A. High Research Concentration and Industry Trends
The research activity receiving the most support in Hawaii is highly concentrated in specific, high-tech areas. In 2024, the most popular research areas were ‘Computer software’ and ‘Biotechnology’.5 Within broader business categories, the ‘Information and Communication Technology’ sector was the most prevalent, with subsectors like Specialty Software Development and Remote Sensing being key areas of focus.5
The expense profile of these businesses demonstrates that the state’s incentive is primarily targeting human capital investment. Over 80% of the $29.5 million in total research expenses incurred in Hawaii in 2024 were allocated to wages.5 The average wage for full-time research employees among certified QHTBs was $117,972.5 This strong correlation between the credit and high payroll expenses indicates that the tax policy is intentionally structured to subsidize high-value, highly compensated local jobs, rather than being skewed toward material supplies or capital expenditures. Therefore, a QHTB’s ability to maximize its credit claim is intrinsically linked to the size and consistent physical presence of its local, high-skill research workforce.
B. Policy Efficacy and Future Considerations
The Hawaii TCRA is not merely an incremental incentive; it provides crucial financial support to the local tech ecosystem. Data shows that 50% (9 out of 18) of the certified QHTBs stated that they would have either significantly reduced or ceased their research spending without the state tax credit.5 This demonstrates a high degree of economic dependency on the TCRA to maintain local R&D operations.
However, the credit is scheduled for repeal on December 31, 2029.1 Given the high reliance on this refundable subsidy, QHTBs must strategically factor the impending sunset date into their long-term R&D planning. The finite life of the credit necessitates the aggressive use of the remaining compliance years to execute high-cost research projects that feature a high Hawaii QRE profile. Failure to account for the termination of this subsidy could result in substantial financial challenges and potential operational restructuring or cessation of research activities following the 2029 tax year.
VII. Conclusion
The concept of “Research Activity Conducted IN HAWAII” dictates a company’s eligibility and the ultimate value of its tax credit claim. To successfully navigate the HRS §235-110.91 compliance regime, a business must first establish itself as a QHTB by proving that more than 50% of its overall activities are locally sourced.
Second, the company must accurately calculate its Hawaii QREs, strictly based on the physical location of the services performed (for wages and contract research) or the supplies consumed (for materials). The 2024 mandate to use the federal incremental base means that only growing research efforts are rewarded, making the detailed, line-by-line sourcing of activities critical not only for maximizing the numerator of the apportionment fraction but also for justifying the incremental increase over the federal base.
Due to the intense competition driven by the $5 million annual cap and the first-come, first-served application rule, QHTBs must integrate meticulous, real-time tracking of localized payroll and expenditures into their financial operations. This level of granular documentation is the cornerstone of a defensible claim under DOTAX audit and the prerequisite for timely DBEDT certification. For the remaining years of the credit’s existence, strategic compliance around the localization mandate is essential for the continued viability and growth of Hawaii’s certified high-technology sector.
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What is the R&D Tax Credit?
The Research & Experimentation Tax Credit (or R&D Tax Credit), is a general business tax credit under Internal Revenue Code section 41 for companies that incur research and development (R&D) costs in the United States. The credits are a tax incentive for performing qualified research in the United States, resulting in a credit to a tax return. For the first three years of R&D claims, 6% of the total qualified research expenses (QRE) form the gross credit. In the 4th year of claims and beyond, a base amount is calculated, and an adjusted expense line is multiplied times 14%. Click here to learn more.
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