Expert Analysis: Wages for Qualified Services (Hawaii) in Context with the R&D Tax Credit (HRS §235-110.91)

Section 1: Executive Summary and Definitional Clarity

1.1 Simple Meaning of Wages for Qualified Services (WQS)

Wages for Qualified Services (WQS) are the salaries and compensation paid to employees of a Qualified High Technology Business (QHTB) for time spent directly engaged in, supervising, or supporting qualified research activities within the State of Hawaii.

WQS constitute the single most significant component of Qualified Research Expenses (QREs) used to calculate the Hawaii Tax Credit for Research Activities (TCRA) under Hawaii Revised Statutes (HRS) §235-110.91.

1.2 Detailed Context of WQS as a Qualified Research Expense (QRE)

The determination of eligible WQS is fundamental to claiming the Hawaii Tax Credit for Research Activities (TCRA), a significant financial incentive designed for Qualified High Technology Businesses (QHTBs) involved in the development of new products or services.1 The state legislature, through HRS §235-110.91, deliberately aligns the Hawaii TCRA with the federal Credit for Increasing Research Activities governed by Section 41 of the Internal Revenue Code (IRC).2 This alignment mandates that the specific definition and qualification of WQS directly follow federal guidelines and regulations.

WQS must be quantified and reported on Line 1c of Hawaii Form N-346, mirroring the structure found on Federal Form 6765.4 This explicit reliance on the federal methodology underscores the principle that proper claim substantiation must satisfy stringent federal standards first before the expenses can be sourced and apportioned to Hawaii. The total WQS claimed federally establishes the maximum pool of expenses eligible for state-level apportionment.

The Hawaii TCRA is structured as a refundable income tax credit.1 Unlike a non-refundable credit, a refundable credit often translates into a cash payment from the state if the credit amount exceeds the taxpayer’s liability. This financial structure imposes an exceptionally high burden of proof on the taxpayer to ensure that every dollar of WQS claimed as a QRE is rigorously substantiated. Since the state is effectively issuing a cash disbursement, any review or audit by the Department of Taxation (DOTAX) is highly likely to scrutinize the foundational documentation of employee time and activity, making robust WQS records crucial for audit defense.

The causal relationship between federal law and Hawaii compliance means that any changes or clarifications established at the federal level—whether through subsequent legislation, IRS regulations, or definitive case law that further defines “qualified services” or the four-part research test—automatically flow through and impact Hawaii’s compliance burden.3 Therefore, QHTBs claiming the Hawaii TCRA must maintain continuous vigilance over evolving federal tax guidance, as this forms the underlying regulatory framework for expense eligibility in Hawaii, even without specific, corresponding DOTAX administrative rules.

Section 2: The Statutory Foundation and Eligibility Requirements

2.1 Hawaii Revised Statutes §235-110.91: Adoption of IRC §41 Framework

Hawaii Revised Statutes §235-110.91 explicitly states that the Tax Credit for Research Activities (TCRA) is equal to the credit for research activities provided by Section 41 of the Internal Revenue Code (IRC).2 This legislative action incorporates the entire federal framework, including the rigorous definition of Qualified Research Activities (QRAs) guided by the federal four-part test, as well as the detailed categories of Qualified Research Expenses (QREs).3 These QRE categories include WQS, costs of supplies, and rental or lease costs of computers.4

The federal four-part test, which has been significantly defined and refined by litigation since the credit’s inception in 1981, requires that the research activity be undertaken to (1) be technological in nature, (2) involve a process of experimentation, (3) be aimed at developing a new or improved business component’s function, performance, reliability, or quality, and (4) eliminate uncertainty.3 Services related to activities that satisfy this test are eligible to be included in WQS.

2.2 Mandatory Eligibility: The Qualified High Technology Business (QHTB) Status

Crucially, the Hawaii TCRA is not available to all businesses that qualify for the federal R&D credit. Access is restricted solely to businesses designated as Qualified High Technology Businesses (QHTBs).1 This distinction imposes specific operational requirements that must be continuously met:

1. Activity Threshold: The business must conduct more than 50% of its activities in qualified research within the State of Hawaii.2
2. Size Limitation: The company must employ no more than 500 employees.2

The documentation of WQS serves a critical dual function beyond just credit calculation. The detailed accounting of employee time and effort, required for WQS substantiation, also acts as the primary evidence used by the taxpayer to demonstrate that the business meets the stringent 50% activity threshold required for QHTB status. If a regulatory body challenges the overall eligibility of the QHTB, the meticulous records defining the allocation of employee time (WQS documentation) provide the core evidentiary support. Consequently, the meticulous tracking of WQS is not merely an exercise in maximizing the credit, but a requirement for maintaining statutory eligibility for the TCRA itself.

2.3 The Re-Imposition of the Incremental Base Rule (Post-Act 139)

For a period, the Hawaii statute allowed the credit to be calculated based on all qualified research expenses incurred in the state, without regard to the base amount of expenses incurred in previous years.7 However, recent statutory amendments, such as those referenced in SB2497 CD1, have reversed this measure.2 Current guidance confirms that the base amount calculation defined in IRC §41 now applies to the Hawaii TCRA.2

The re-imposition of the incremental calculation means that the credit is generally limited to incremental QREs—those expenses, including WQS, that exceed a baseline calculated using a fixed-base percentage derived from the average annual gross receipts and QREs from the four preceding tax years.6 This change significantly increases the complexity and compliance burden, especially for QHTBs with long operating histories. Taxpayers must now perform the full, multi-step federal base calculation, ensuring accurate historical records (QREs and gross receipts) are maintained for the required look-back period.

Tax professionals must recognize the previous temporary exemption from the incremental base rule when reviewing historic claims.7 For current tax years, however, the calculation must be based on the incremental method, using the apportionment ratio applied to the calculated federal credit.6 Failure to adhere to the current incremental rule constitutes a significant compliance risk, potentially leading to the denial of a claim that relies on a simple 20% multiplication of all Hawaii QREs.4

Section 3: Detailed Analysis of Wages for Qualified Services (WQS) Definition

The definition and quantification of WQS rely entirely on federal regulations, specifically Treasury Regulation §1.41-2(d)(2), which mandates that wages are only eligible if paid for services consisting of engaging in qualified research, or engaging in direct supervision or direct support of such research.10

3.1 Statutory Definition: The Three Functional Categories

To be included in WQS (Form N-346, Line 1c), employee activities must satisfy one of the following three functional categories:

1. Engaging in Qualified Research: This involves the direct, hands-on performance of the core research activities, such as experimental work, testing, software coding for qualified projects, or engineering activities that meet the four-part test.
2. Direct Supervision: This category is strictly defined as immediate, first-line management of qualified research.11 For example, a research scientist who directly oversees laboratory experiments would qualify. However, the definition explicitly excludes supervision by higher-level management to whom the first-line managers report, even if that higher-level manager is a qualified research expert.11
3. Direct Support: These services must directly aid or contribute to the research effort but do not necessarily involve the research activity itself. Examples include the wages of administrative staff whose duties are confined to tracking research project budgets, individuals maintaining specialized research equipment, or technicians generating documentation required for intellectual property filings associated with the research.10

3.2 The “Substantially All” Rule (The 80% Threshold)

A crucial provision that simplifies documentation and maximizes WQS claims is the “substantially all” rule. If an individual performs qualified services for the taxpayer for 80% or more of their total time during the tax year, then the entirety of that individual’s wages (100%) for that year is treated as WQS.10 This rule acts as a powerful planning tool, as achieving the 80% threshold eliminates the need for fractional time tracking for highly dedicated employees.

3.3 Fractional Allocation, Sourcing, and Officer Compensation

3.3.1 Fractional Allocation

For employees who do not meet the 80% threshold, only the specific percentage of their annual wages corresponding to the time spent on qualified activities is eligible for inclusion as WQS.10 This fractional allocation requires taxpayers to maintain precise, contemporaneous records, such as time sheets or project logs, demonstrating the specific hours dedicated to QRAs versus non-qualifying activities (e.g., routine maintenance, sales, non-research administrative tasks).12

3.3.2 Sourcing Principle for Hawaii (N-346 Column B)

While the fractional allocation determines the amount of WQS eligible for the federal credit (reported on Form N-346, Column A), a critical second layer of qualification applies to the Hawaii TCRA. For the expense to be included in the Hawaii QRE calculation (reported on Form N-346, Column B), the wages must be incurred for services physically performed in Hawaii.4

If an employee performs qualified research services both inside and outside of Hawaii, the QHTB must implement a mechanism to source the wages accurately to the portion of the activity conducted within the state. This strict sourcing principle ensures that Hawaii’s incentive supports research activity specifically generating economic activity within the jurisdiction.

3.3.3 Officer Compensation

Compensation paid to corporate officers is includible in WQS, provided the officer performs qualified services. However, the determination of who qualifies as an officer is established not by federal law, but by the laws of the state where the entity is incorporated.11 Taxpayers must verify this legal status alongside documenting the officer’s direct involvement in the qualified research activities, supervision, or support.

Table 1: Definition of Qualified Services for WQS Inclusion and Sourcing Requirements

Section 4: Hawaii State Revenue Office Guidance and Compliance (DOTAX/DBEDT)

The administration of the Hawaii TCRA is unique in that it involves mandatory interaction with two distinct state agencies: the Department of Business, Economic Development, and Tourism (DBEDT) for certification, and the Department of Taxation (DOTAX) for filing and collection. This dual framework imposes stringent administrative deadlines and requirements that must be met regardless of the technical accuracy of the WQS calculation.

4.1 The DBEDT Certification Mandate (Form N-346A)

Certification by DBEDT is a mandatory prerequisite for claiming the tax credit with DOTAX.5 This process is governed by two critical constraints: a monetary cap and a strict timeline.

The maximum annual aggregate credit available across all QHTBs is capped at $5 million.2 Furthermore, certifications are provided on a strictly first-come, first-served basis.2 Historically, this cap has been reached almost immediately upon the opening of the application window (typically March 3 to March 31).2

This administrative constraint fundamentally transforms the timeline for tax preparation. Because the credit is awarded based on filing time rather than tax filing deadlines, QHTBs must strategically prioritize the completion and submission of the certified application (Form N-346A) well in advance of the typical corporate tax filing schedule. This requires finalizing the underlying WQS/QRE calculations months ahead of time to ensure a position near the front of the queue before the cap is reached. Technical accuracy is meaningless if the administrative deadline is missed due to delayed calculation of the supporting WQS.

4.2 Mandatory Annual Survey and Economic Data Reporting

In addition to the certification requirement, QHTBs that claim the TCRA must complete a mandatory annual survey or questionnaire prescribed by DBEDT.5 The information must be completed before the application will be reviewed, and the deadline for this submission is typically June 30th.2 Failure to complete the questionnaire by this deadline results in the denial of the credit.5

The survey requires QHTBs to report detailed economic data, which includes information beyond the scope of a standard tax form, such as 13:

• Hawaii employment and wage data, detailing the numbers of full-time and part-time employees retained, new jobs created, and total payroll taxes.
• External services procured by the business.
• Filed intellectual property (IP), including patents issued or granted.
• Revenue, operating costs, and capital expenditure data.14

This rigorous data collection serves a distinct policy purpose: DBEDT uses the WQS and related employment data to produce annual reports to the legislature, assessing the economic efficacy and impact of the tax incentive on sectors such as biotech and technology employment.7 This linkage creates an overriding requirement for data consistency. The aggregated employment and payroll figures submitted to DBEDT for economic analysis must align mathematically with the specific WQS breakdown utilized for the tax claim on Form N-346. Disparities between the survey data and the claimed tax credit amount create a substantial risk of audit and potential denial, as inconsistent reporting signals internal control weakness or misallocation of expenses.7

For the 2023 tax year, for example, 31 QHTBs submitted the survey, reporting total aggregated revenue of $275.8 million and total operating expenses of $273.6 million, demonstrating a tight margin of operation across the sector.14 Furthermore, the data showed significant reliance on intellectual property-based sales, with 25.7% of aggregated revenue coming from IP, and 25.9% of companies relying highly (over 80%) on out-of-state sales.14 The WQS figures must support this operational profile.

4.3 DOTAX Form N-346 and Documentation for Sourcing WQS

The final step is submitting Form N-346 to DOTAX, attached to the relevant Hawaii income tax return (e.g., N-11, N-35), along with the certified N-346A and Federal Form 6765.4

The primary challenge imposed by DOTAX instruction involves accurately sourcing the wages for the “IN HAWAII” calculation (Column B). While Line 1c requires the “Wages for qualified services” attributable to research activity conducted in Hawaii 4, the instruction set for Form N-346 does not provide detailed administrative guidance on how a QHTB should calculate the fractional allocation of wages for an employee who conducts qualified services both within Hawaii and out of state.4

This absence of specific state guidance forces taxpayers to rely entirely on the robust, contemporaneous documentation standards established by federal tax law and case precedent. To withstand scrutiny, QHTBs must utilize internal records (such as calendars, detailed job descriptions, and project time tracking) to prove the specific percentage of time and location of the services rendered by each employee to justify the WQS amount claimed in Column B. The lack of specific state guidance on fractional time allocation heightens the audit risk for multi-state QHTBs, demanding absolute fidelity to federal substantiation requirements.

Section 5: Calculation Methodology: The Apportionment Mechanism

The Hawaii TCRA calculation methodology is defined by an apportionment mechanism, which multiplies the calculated federal credit by the ratio of Hawaii QREs to total federal QREs. The Hawaii credit is not calculated independently by multiplying Hawaii QREs by 20%—though this method was temporarily utilized under older laws and sometimes appears in basic summaries.4

5.1 The Calculation Flow

The finalized, legally compliant formula integrates WQS as the most significant factor in both the numerator (HI QREs) and the denominator (Total Federal QREs):

$$\text{Hawaii TCRA} = \text{Federal Credit (RC)} \times \frac{\text{Hawaii QREs}}{\text{Total Federal QREs}}$$

6

The process requires strict adherence to sequential steps, with WQS determination being the input for the entire formula.

Table 2: Hawaii TCRA Calculation Flow and WQS Integration

5.2 Impact of Federal Calculation Method (RRC vs. ASC)

The foundation of the Hawaii credit rests on the calculated Federal Credit (RC).9 This federal amount can be derived using one of two primary methodologies:

1. Regular Research Credit (RRC) Method: This method calculates the credit as 20% of current-year QREs that exceed a base amount. Calculating the base amount is complex, requiring documentation of average annual gross receipts and aggregate QREs over a historic period (often four preceding years).8
2. Alternative Simplified Credit (ASC) Method: The ASC method calculates the credit as 14% of current-year QREs that exceed 50% of the average QREs from the three prior years.16 This method is often preferred by companies that lack the extensive historical data required for the RRC base calculation.

Because the Federal Credit (RC) serves as the primary multiplier for the refundable Hawaii TCRA, QHTBs must strategically choose the federal calculation method (RRC or ASC) that yields the maximum possible RC. While only Hawaii-sourced WQS are used in the apportionment ratio numerator, maximizing the federal starting point directly results in a larger potential Hawaii refund.

Section 6: Practical Example: Calculating Hawaii WQS and Final Credit

This detailed example demonstrates the critical steps required for a QHTB to calculate eligible WQS and determine the final refundable Hawaii TCRA, emphasizing the distinction between federal and state-sourced expenses.

6.1 Scenario and Assumptions

• QHTB Profile: A Qualified High Technology Business located in Honolulu, involved in optical communications research.5
• Federal Credit Pre-Calculated (RC): $1,000,000 (Calculated via RRC method, accounting for the incremental base).
• Non-Wage QREs (Supplies, Contract Research): $100,000, all incurred and used in Hawaii.

The following table illustrates how employee time is tracked and sourced, differentiating the total eligible QREs (Column A) from the Hawaii-sourced QREs (Column B).

Table 3: Illustrative Example of WQS Fractional Allocation and Sourcing

• Analysis of Employee A: Since 95% of time is spent on QRAs, the 80% rule is met, allowing 100% of the salary to be claimed as Federal WQS. Since all work occurred in Hawaii, the HI WQS is also 100%.
• Analysis of Employee B: This employee does not meet the 80% rule and performs some QRA work outside of Hawaii (15% difference between total QRA time and HI QRA time). Only the fraction of time spent on QRA (75%) qualifies federally, and only the time spent in Hawaii (60%) qualifies for the state calculation.

6.2 Calculation of Apportionment Ratio

The apportionment ratio is calculated using the total QREs (WQS + Other QREs) determined in the previous step:

1. Total Federal QREs (Denominator):
   
   $$\text{WQS} \ \$262,500 + \text{Other QREs} \ \$100,000 = \mathbf{\$362,500}$$
2. Total Hawaii QREs (Numerator):
   
   $$\text{HI WQS} \ \$240,000 + \text{Other HI QREs} \ \$100,000 = \mathbf{\$340,000}$$
3. Apportionment Ratio:
   
   $$\frac{\$340,000}{\$362,500} \approx \mathbf{93.79\%}$$

6.3 Determination of Final Hawaii TCRA

Using the pre-calculated Federal Credit (RC) as the multiplier:

• Federal Credit (RC) = $1,000,000
• Hawaii TCRA = $1,000,000 \times 93.79% = $937,900

This calculated refundable amount must then be submitted to DBEDT via Form N-346A during the limited application window to secure a portion of the $5 million annual cap.2

Section 7: Documentation and Audit Defense Strategies for WQS

The administrative structure of the Hawaii TCRA places an exceptional premium on the quality and integrity of documentation supporting WQS claims. Because the state relies on federal definitions but mandates strict local sourcing and high-stakes administrative compliance, a multi-faceted approach to documentation is required.

7.1 Required Documentation for WQS Claims

The lack of specific DOTAX guidance on fractional wage allocation 4 forces taxpayers to adhere to the extensive contemporaneous documentation standards established under IRC §41 regulations and federal case law. These records must establish not only the quantum of time spent but also the qualitative nature of the activities to prove they meet the statutory four-part test for qualified research.

Recommended documentation includes:

• Time Tracking Systems: Detailed, contemporaneous time sheets or project management software logs that clearly distinguish between qualified and non-qualified activities and, crucially, the physical location (in-state vs. out-of-state) of the work.
• Payroll Records: W-2s and associated payroll documentation substantiating the total wages paid to the claimed employees.
• Organizational and Functional Records: Employee job descriptions, performance evaluations, and organizational charts that demonstrate the reporting hierarchy, particularly to defend claims related to “Direct Supervision” and ensure compliance with the exclusion of higher-level management.11

For any employee whose time is fractionally claimed (below the 80% threshold), the documentation must clearly demonstrate entitlement to that specific fraction. The most effective audit defense relies on records established as the research activities occurred, rather than documentation compiled retroactively.

7.2 Alignment of WQS Data with DBEDT Survey Requirements

The mandatory annual DBEDT survey acts as a regulatory checkpoint on the data used for the tax claim.13 The collected economic data, which includes detailed employment and payroll statistics, is used to assess the overall efficacy of the credit.15 This creates a vital obligation for taxpayers to ensure mathematical harmony between the high-level payroll data reported in the DBEDT survey and the detailed, project-specific WQS claimed on DOTAX Form N-346.

Any significant discrepancy between the overall payroll figures reported to DBEDT and the WQS amounts claimed for tax reduction provides a clear administrative red flag for both state agencies. Maintaining this data consistency is essential for mitigating audit exposure and ensuring the integrity of the claim throughout the administrative review process.7

7.3 Compliance Deadlines and the Sunset Provision

Compliance for the Hawaii TCRA is equally dependent on administrative timeliness and technical accuracy. Failure to meet the mandatory deadlines will render a technically flawless WQS calculation void.

Key deadlines include:

• DBEDT Certification (Form N-346A): Must be submitted within the narrow application window (typically March 3 to March 31) to secure a portion of the $5 million annual cap.2 The WQS calculation must be completed before this window opens.
• DBEDT Annual Survey: Must be completed by June 30th following the taxable year.5

The critical sequence required for compliance dictates that the technical calculation of WQS must be fully integrated into a rigid administrative schedule governed by DBEDT, placing a significant burden on corporate tax planning teams to act months before the final tax return filing date.

Finally, the Tax Credit for Research Activities is scheduled to be repealed from statute and does not apply for tax years beginning after December 31, 2029.2 This hard sunset date necessitates immediate forward-looking tax planning for QHTBs to maximize the capture of remaining refundable credits before the expiration of the program, thereby placing greater urgency on the rigorous calculation and substantiation of WQS in the intervening years.

Section 8: Conclusion and Strategic Recommendations

The Hawaii Tax Credit for Research Activities (TCRA) is a crucial, refundable incentive that successfully supports research-intensive Qualified High Technology Businesses (QHTBs) in the state. The effectiveness of the credit mechanism hinges entirely on the proper identification, documentation, and sourcing of Wages for Qualified Services (WQS).

The analysis confirms that the compliance environment is governed by a dual regulatory system where the technical definition of WQS is derived from the complex and evolving federal framework (IRC §41), while the utilization and timing are subject to strict state administrative controls (DBEDT and DOTAX). The most pressing risk to QHTBs is not technical miscalculation, but administrative failure—specifically, missing the first-come, first-served application window or failing to submit the mandatory annual economic survey.

Strategic Recommendations

1. Prioritize Pre-Calculation and Certification: QHTBs should complete the rigorous calculation of WQS and supporting QREs no later than February preceding the March application window. This proactive approach is necessary to secure DBEDT certification (Form N-346A) before the $5 million annual cap is exhausted.2
2. Maintain Federal Documentation Standards for Sourcing: Given the administrative guidance gap from DOTAX regarding fractional wage allocation for out-of-state workers, QHTBs must rely entirely on robust, contemporaneous federal documentation standards (time tracking, calendars) to justify the WQS claimed in Form N-346, Column B (In Hawaii).4
3. Ensure Data Consistency Across Agencies: Personnel responsible for tax filing must coordinate directly with those completing the DBEDT annual survey to ensure that the employment, payroll, and expense data are mathematically consistent. Inconsistent reporting between the economic survey and the tax claim is an established audit trigger that undermines the integrity of the WQS claim.5
4. Acknowledge the Incremental Rule: Tax preparation must rigorously apply the current requirement to calculate the federal credit based on incremental QREs over historical averages, as mandated by recent legislative changes. Reliance on older interpretations that allowed a simple 20% calculation on all Hawaii QREs poses a significant compliance risk.2
5. Focus on the Sunset Date: QHTBs should engage in proactive, multi-year strategic planning to ensure maximum credit utilization before the TCRA expires on December 31, 2029.2

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