Navigating the Geographical Constraints of the Indiana R&D Tax Credit (IC 6-3.1-4)

Executive Summary: The Exclusion of Research Outside Indiana

The Indiana Research Expense Credit (REC) is explicitly territorial, granting tax relief solely for qualified research expenses (QREs) that are incurred in Indiana.

This mandate requires multi-state taxpayers to rigorously exclude all wages, supplies, and contract research costs associated with activities physically conducted outside of the state’s borders.

I. Introduction and Statutory Foundation

1.1. Policy Rationale: Encouraging In-State Investment

The State of Indiana utilizes the Research Expense Credit (REC), established under IC 6-3.1-4, as a crucial fiscal tool aimed at encouraging investments in technological advancement and innovation within its borders.1 Economists and policy analysts recognize that government support for research input, such as this tax credit, reduces the financial risk associated with R&D projects and stimulates technological progress, which serves as a powerful input for economic growth and labor productivity.2

The REC allows taxpayers to claim a credit against their Indiana state income tax liability based on a percentage of qualified research expenses incurred.1 The foundational principle guiding this incentive is that the subsidized activity must provide a direct economic benefit to Indiana by being physically executed within the state.

1.2. The Governing Law and the Strict Territorial Mandate

Indiana defines a Qualified Research Expense (QRE) by leveraging Section 41(b) of the Internal Revenue Code (IRC).3 This federal conformity establishes the four fundamental qualification tests for the activity (the Section 174 test, the discovery test, the technological information test, and the process of experimentation test).6

However, the state statute imposes a critical geographical filter. While the federal R&D credit applies to qualified research performed anywhere in the United States, Indiana’s law strictly limits eligible expenses to those “incurred in Indiana”.1 This geographical constraint means that research activities that qualify under federal rules but take place outside of Indiana must be meticulously segregated and excluded from the state credit calculation. The Indiana Department of Revenue (IDOR) handbook confirms that expenses related to “foreign research performed outside of Indiana” must be excluded, confirming the non-qualifying nature of research outside the state.9

1.3. The Dual-Criteria Test and Enhanced Audit Exposure

The imposition of the geographical filter creates a dual-criteria test for taxpayers: the research must satisfy the IRC §41 definition and be physically conducted within Indiana. For multi-state taxpayers, this duality creates a significant compliance challenge.

Many businesses engaged in multi-state operations conduct a single, aggregated federal QRE study. Because the federal credit covers expenses incurred nationally, the process of isolating the location of every qualified hour, supply, or contract payment is often not performed at the federal level. Consequently, when applying for the Indiana REC, if a taxpayer simply transfers their total national QRE amount to the Indiana calculation, they fail the critical “conducted in Indiana” test. Taxpayers must rigorously source their QREs to Indiana to avoid having their claims denied by the IDOR, as confirmed by judicial precedent where projects identified as “non-Indiana projects” were prohibited from claiming the REC.7 The lack of a precise, location-specific QRE study dramatically increases the risk of an unfavorable audit finding.

II. Operationalizing the Geographical Exclusion (IDOR Guidance)

The IDOR has provided guidance through its handbooks and administrative rulings that clarify how the territorial mandate applies to different types of research expenses.

2.1. Defining Research “Conducted in Indiana”

The IDOR’s guidance makes it clear that the state is focused on incentivizing the physical location of the research activity. The research expense credit provides an incentive for increasing qualifying research activities that are done in Indiana.3

• Explicit Exclusionary Scope: The IDOR guidance explicitly excludes research performed outside of Indiana, including foreign research.1 This strict territorial approach means that research conducted in any other U.S. state is treated identically to foreign research for the purpose of the Indiana REC; neither qualifies.
• The Location of Activity: Eligibility hinges on the location where the actual scientific experimentation, testing, or qualified supervisory work occurs. This is further confirmed by state legislation that dictates research expenses must be incurred in qualified research activities being conducted in Indiana.3
• Judicial Affirmation: The Indiana Tax Court has affirmed the Department’s position, holding that taxpayers bear the burden of demonstrating that the research activities were physically performed within Indiana.7 In Tell City Boatworks, Inc., v. Indiana Department of State Revenue, the Tax Court affirmed the denial of credits because the company failed to provide “creditable evidence” to verify that the research met the criteria as qualified research expenses, which includes verification of the location.6

2.2. The High Burden of Proof and Documentation Requirements

To defend a claim during an IDOR review, taxpayers must maintain detailed records that unequivocally validate the expenditure and its location.

Indiana mandates record keeping procedures consistent with IRS requirements (Treasury Regulation Section 1.6001-1). This obligation is critical for multi-state operations, as the records must not only prove the qualified nature of the activity but also precisely locate where that activity took place.1

For businesses with highly mobile personnel or multiple R&D facilities, this requirement means implementing advanced documentation practices:

• Impact of Remote Work: The shift toward remote or hybrid work environments presents a new complexity. An engineer may live in Indiana, but if they perform qualified services for a period while physically located in a non-Indiana jurisdiction (e.g., during temporary assignments or remote work), the wages paid during that period do not qualify for the Indiana REC. To manage this compliance risk, taxpayers must implement time-tracking systems that incorporate geographical data, such as GPS verification or location-verified log-ins, to accurately segregate in-state versus out-of-state qualified labor hours.
• Contractor Oversight: When utilizing third-party contractors, the taxpayer must secure documentation demonstrating that the contractor’s services were physically rendered in Indiana. Simply contracting with an Indiana-based firm is insufficient if the firm performs the actual research in an out-of-state laboratory.

III. Sourcing QREs: Detailed Allocation Rules for Multi-State Taxpayers

The accurate calculation of the Indiana REC requires taxpayers to systematically source each type of QRE—wages, supplies, and contract research—using state-specific allocation methods that isolate the costs associated with in-state research.1

3.1. Sourcing Qualified Wages: The Time-Ratio Methodology

Qualified wages represent compensation paid for qualified services, including direct research, direct supervision, and direct support. For employees engaged in multi-state R&D activities, Indiana specifies a methodology for allocation.

• The IDOR Time-Allocation Rule: Where an employee performs both qualified (R&D) and nonqualified services, the IDOR requires using a time-ratio to determine the allowable wages. The allowable amount is calculated by multiplying the total wages by the ratio of the total time actually spent performing qualified services to the total time spent by the employee for all services during the year.1
• Geographical Refinement: Crucially, this time-ratio methodology must be further restricted to capture only activities performed in Indiana. The statutory mandate is for expenses “incurred in Indiana”.1 Therefore, the calculation effectively becomes:

$$\text{Allowable Indiana QRE Wages} = \text{Total Wages} \times \frac{\text{Time on Qualified Research Activities (QRA) in Indiana}}{\text{Total Compensated Hours}}$$

The necessity of restricting the numerator to in-state activities differentiates the Indiana calculation from the broader federal calculation. While the IDOR Handbook acknowledges the need for allocation, it does not detail every possible scenario for multi-state allocation.1 Tax professionals typically rely on established Indiana apportionment principles, which define payroll sourcing based on where the services are performed, applying those geographical limits to the qualified time study.

3.2. Sourcing Qualified Supplies

Qualified supplies include tangible property other than land or improvements to land, used or consumed in the conduct of qualified research.3

• Location of Consumption: To qualify for the Indiana REC, supplies must be directly consumed in qualified research that is actually conducted in Indiana.1 The purchase location is irrelevant; the location of use is paramount.
• Example of Exclusion: If a corporation purchases specialized materials (e.g., chemicals, prototypes, specific raw materials) in Indiana and includes the cost of these materials in its federal QREs, but then ships and consumes those materials in an R&D pilot plant located just across the state line in Kentucky, the cost of those supplies must be excluded from the Indiana REC calculation.1
• Alignment with Sales Tax Exemption: Indiana’s commitment to incentivizing physical in-state investment is underscored by a parallel policy: a 100% sales tax exemption for qualified R&D equipment and property purchased for use in Indiana.1 This alignment reinforces the territorial requirement for supply sourcing.

3.3. Sourcing Contract Research Expenses

Contract research expenses involve payments to third parties (non-employees) to perform qualified research on behalf of the taxpayer. Federally, 65% of these payments are considered QREs.

• Strict Geographical Enforcement: The IDOR explicitly requires the exclusion of “contract research performed outside of Indiana”.1
• Performance Location Dominates: As with wages, the crucial determinant is the physical location where the contracted research activity is executed, regardless of where the contract was signed or the contractor is headquartered.
• Complexity in Hybrid Contracts: If an Indiana company utilizes a specialized external firm (a Contract Research Organization or CRO) whose work involves qualified research, the company can only claim 65% of the payment attributable to research that the CRO performed within Indiana. If the contract involves mixed locations—such as initial design review in Indiana and subsequent prototyping and testing in the CRO’s facility in California—the taxpayer must obtain verifiable, granular documentation from the contractor to isolate the in-state portion of the activity. Failure to do so requires excluding the entire expense.

Table 2 below summarizes the distinct geographical filters applied by Indiana to QRE components compared to the national standards of the federal IRC §41.

Table 2: Comparison of Federal vs. Indiana QRE Sourcing

IV. Calculation Mechanics and Apportionment Requirements

The geographical exclusion of non-Indiana research impacts the calculation mechanics by reducing the amount of current-year QREs and shaping the historical base used to determine the incremental increase eligible for the credit.

4.1. Calculation of the Base Amount and Indiana-Sourced Data

The Indiana REC is generally calculated using the federal “increasing research” method, which determines a base amount and grants credit on the excess (incremental) QREs.1

• Requirement for Indiana-Specific Data: Indiana explicitly modifies the federal methodology by requiring the use of exclusively Indiana QREs and Indiana gross receipts for all base period calculations.11
• Standard Base Calculation: Under the standard method, the base amount involves multiplying the fixed-base percentage by the average gross receipts for the four preceding tax years. Both the QREs used to derive the fixed-base percentage and the average gross receipts must be sourced only to Indiana activities.11 The base amount is subject to a floor: it cannot be less than 50% of the current year’s Indiana QREs.11
• Alternative Simplified Credit (ASC): For taxpayers with fluctuating QREs, Indiana permits the use of the ASC method, which is available for Indiana qualified research expenses incurred after December 31, 2009.4 The ASC calculates the credit as 10% of the excess of the current year’s Indiana QREs over 50% of the average Indiana QREs for the three preceding taxable years. If the taxpayer had no Indiana QREs in any one of those three years, the credit defaults to 5% of the current year’s Indiana QREs.4

The fundamental importance of the geographical exclusion is amplified in the base calculation. If a multi-state company fails to correctly source its QREs to Indiana in historical years, it may inadvertently inflate its historical base amount, thereby reducing the calculated “excess QREs” in the current year and diminishing the credit benefit. Consistent, accurate geographical segregation across all prior periods is therefore essential for maximizing the credit value.

4.2. Application of Tiered Credit Rates

Once the base amount is established using Indiana-sourced historical data, the Excess Indiana QREs are calculated by subtracting the base amount from the current year’s Indiana QREs.11 The resulting figure is subject to tiered credit rates:

• The credit is calculated at 15% on the first $1 million of excess Indiana QREs over the base amount.3
• A rate of 10% is applied to any amount of excess Indiana QREs greater than $1 million.3

The maximum potential value of the credit using the standard method is 15% on the first $1 million of incremental QREs, and 10% on the remainder.3

V. Practical Application and Case Study: Quantifying the Exclusion

This case study demonstrates the mechanical impact of the geographical exclusion on a multi-state company, highlighting the significant reduction in eligible QREs when moving from a federal calculation base to the Indiana-specific base.

5.1. Case Study Setup

Scenario: TechInnovate, Inc., is a research-intensive technology company with R&D staff and facilities in Indianapolis (Indiana) and Chicago (Illinois). For the 2024 tax year, the company documented $5,000,000 in total Qualified Research Expenses (QREs) across all locations, all of which meet the federal IRC §41 standards.

Historical Data (Sourced only to Indiana operations):

• Current Year (2024) Federal QREs (Total): $5,000,000
• Average Annual Indiana QREs (Prior 3 Years for ASC): $1,200,000
• The company elects to use the Alternative Simplified Credit (ASC) method.

5.2. Step 1: Quantifying the Geographical Exclusion

TechInnovate must conduct a detailed analysis to segregate the costs associated with activities physically conducted in Illinois (non-qualifying) from those conducted in Indiana (qualifying).

Table 3: Geographical Segregation of Qualified Research Expenses

The initial national QRE base of $5,000,000 is reduced by $2,200,000 due to the geographical exclusion, resulting in $2,800,000 of allowable Indiana QREs.

5.3. Step 2: Final Indiana Credit Calculation (Alternative Simplified Credit Method)

The calculation proceeds using the ASC method, relying exclusively on Indiana QRE data.

1. Determine Current Indiana QREs: $2,800,000.
2. Calculate Base Amount (ASC):

• Prior 3-Year Average Indiana QREs: $1,200,000.
• Base = 50% of the Prior 3-Year Average: 0.50 $\times$ $1,200,000 = $600,000.11

1. Calculate Excess Indiana QREs: Current QREs ($2,800,000) – Base Amount ($600,000) = $2,200,000.
2. Apply ASC Rate: The credit is 10% of the excess QREs.4

• Credit = $2,200,000 $\times$ 10% = $220,000.

If TechInnovate had failed to apply the geographical exclusion and had improperly claimed $5,000,000 in Indiana QREs, the base would remain $600,000 (calculated using true Indiana historical data), leading to a claimed excess of $4,400,000 and an inflated credit. This error would be immediately detected during an IDOR examination focusing on the location of activities.

VI. Conclusion and Strategic Compliance Recommendations

The Indiana Research Expense Credit is a valuable tool for businesses investing in innovation, but its inherent territorial limitation—the exclusion of research outside Indiana—is the single most important compliance factor distinguishing it from the federal credit. The law, IC 6-3.1-4, clearly limits eligibility to QREs incurred and activities physically conducted within the state.1

6.1. Nuanced Conclusions and Actionable Recommendations

1. Mandatory Segregation of Expenses: Taxpayers with multi-state operations must implement accounting practices that allow for granular segregation of all QRE components (wages, supplies, and contract research) by physical location. Relying solely on federal documentation standards, which are location-agnostic, constitutes a critical compliance failure for the Indiana REC.
2. Implications for Multi-State Tax Strategy: The exclusion dictates that expenses excluded from Indiana’s credit calculation (e.g., QREs incurred in Illinois or Ohio) are often simultaneously eligible for R&D tax credits in those respective jurisdictions, provided those states offer such incentives.10 A coordinated multi-state tax strategy ensures maximum credit capture across all states where R&D activities occur.13
3. Required Disclosure of Credit Inconsistencies: Since changes enacted under HEA 1001 (effective January 1, 2019), Indiana requires heightened reporting transparency. If a taxpayer claims the Indiana REC but does not claim the federal credit for those same Indiana qualified research expenses, the taxpayer must disclose the reasons for this difference to the IDOR.3 This administrative requirement suggests that the IDOR actively monitors consistency between state and federal claims, increasing scrutiny on the accuracy of the QRE source data.
4. Credit Persistence and Carryforward: Despite the stringent geographical requirements, the Indiana REC provides long-term value. Any unused credits may be carried forward for up to ten taxable years, offering a sustained reduction in future state income tax liability.4 This feature underscores the importance of correctly calculating the credit today to maximize future benefits.

6.2. Documentation Priorities for Audit Defense

To secure and defend the Indiana REC claim, taxpayers must prioritize documentation that specifically validates the geographical element of their QREs:

• Geo-Tagged Time Records: For wages, the use of time-tracking software capable of recording the physical location of R&D personnel is crucial for supporting the time-ratio calculation for services performed within Indiana.1
• Location-Specific Consumption Logs: Supply costs must be linked directly to work orders, material logs, or inventory systems that confirm the physical consumption of the materials at an Indiana R&D facility.
• Contractor Invoicing: Contracts and third-party invoices must provide sufficient detail (e.g., location, hours, services rendered) to enable the taxpayer to verify that contracted research was physically performed within Indiana.1

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