Expert Report on Indiana R&D Tax Incentives: Analysis of Sales Tax Exemption (Ind. Code $\S 6-2.5-5-40$)

I. Executive Summary and Statutory Overview

Indiana Code $\S 6-2.5-5-40$ provides a 100% exemption from the state’s gross retail (sales) and use tax on qualifying tangible personal property. This critical incentive is strictly limited to newly acquired property used directly and exclusively in experimental or laboratory research and development activities within the State of Indiana.

The statute, titled “Research and Development Property” [1, 2], is strategically positioned within Indiana’s Title 6 (Taxation), Article 2.5 (State Gross Retail and Use Taxes), Chapter 5 (Exempt Transactions of Retail Merchant) 1. Its purpose is to reduce the capital cost burden for companies engaged in innovation by eliminating the 7% statewide sales tax rate on eligible acquisitions [3, 4].

1.1. Strategic Context: Indiana’s Dual Incentive Approach to R&D Investment

Indiana employs a dual incentive structure to encourage investment in research and development activities within the state [5, 6, 7]. This approach consists of:

1. The Research Expense Income Tax Credit (IC 6-3.1-4): This incentive provides a non-refundable credit against state income tax liability based on qualified research expenses (QREs) [5, 8].
2. The Research and Development Sales and Use Tax Exemption (IC 6-2.5-5-40): This incentive provides a direct, 100% exemption from sales tax on tangible personal property purchases [5, 6].

The sales tax exemption offers a distinct and often superior financial advantage for businesses undertaking significant capital expenditures for R&D. While the income tax credit is realized against a potentially future income tax liability, calculated against a complex base-period amount [5, 8], the sales tax exemption provides an immediate 7% reduction in the cost of qualifying capital equipment. This distinction provides immediate financial leverage and a direct improvement to cash flow, making the exemption a foundational tool for optimizing capital investments in R&D-intensive sectors, such as life sciences and advanced manufacturing.

1.2. Regulatory Authority: Indiana Department of Revenue Guidance

The effective and compliant utilization of the R&D Sales Tax Exemption is governed almost entirely by the interpretive guidance issued by the Indiana Department of Revenue (DOR). The primary authoritative document is Sales Tax Information Bulletin Number 75 (SIB #75), titled “Sales Tax Exemption for Research and Development Property” 9. The guidance provided in SIB #75 is essential for determining eligibility, defining key terms, and navigating the significant compliance pitfalls inherent in the statute 10.

II. Regulatory Interpretation: Indiana Department of Revenue (DOR) Guidance

The DOR’s interpretation, as articulated in SIB #75 (last updated January 2023, referencing an effective date of July 1, 2013) [9, 10, 11], provides the crucial framework for applying Ind. Code $\S 6-2.5-5-40$.

2.1. Definitional Requirements for “Research and Development Property”

The exemption applies exclusively to “research and development property,” which is defined as tangible personal property (TPP) meeting two core requirements 10:

1. Tangible Personal Property (TPP): The property must be physical in nature, encompassing equipment, machinery, consumables, and certain supplies used in the research process 10. This definition explicitly excludes intangible assets, such as intellectual property acquisition costs, most software classified as intangible, and fees for contract research services or labor—all of which must be evaluated under the distinct criteria of the Income Tax Credit statute (IC 6-3.1-4), if at all.
2. The Crucial Restriction: No Prior Use in Indiana: The property “has not previously been used in Indiana for any purpose” [10, 12]. This is perhaps the most restrictive and unique qualification for the Indiana sales tax exemption.

The “no prior use” criterion fundamentally links the sales tax incentive to net new capital investment within the state. If a multi-state company transfers a piece of equipment previously used in another Indiana facility (even for a non-R&D purpose like standard inventory control or administrative work) into a new R&D lab, that asset is immediately disqualified from the sales tax exemption. The implication is that compliance must be integrated into the company’s capital procurement and fixed asset tracking systems from the initial purchase order. The taxpayer must demonstrate that the property was either purchased new or, if purchased used, acquired from a location outside of Indiana and imported directly for the dedicated R&D purpose.

2.2. Acquisition Purpose

The second critical requirement dictates the intended function of the acquisition. The TPP must be acquired by the purchaser for the purpose of research and development activities devoted to experimental or laboratory research and development [10, 12]. This research must aim toward:

• New products.
• New uses of existing products.
• Improving or testing existing products [10, 12].

The definition of “Research and development activities” under SIB #75 includes “the design, refinement, and testing of prototypes of new or improved commercial products conducted before sales have begun.” The core objective is to determine facts, theories, or principles, or to increase scientific knowledge 10. The emphasis on the “experimental or laboratory” nature restricts the exemption to the pre-commercial phase of development.

III. Detailed Criteria: Direct Use and Exclusions under SIB #75

3.1. The Direct Use Test: Essential and Integral Requirement

Beyond the definition of the property itself, the use of the property must satisfy a strict nexus test. The TPP must be used directly in R&D activities 10.

The DOR requires that the property be considered “essential and integral” to the experimental or laboratory research and development process. Qualifying examples of property, when used directly, include:

• Office supplies (e.g., paper, pens) used in experimental data recording.
• Consumables (e.g., chemicals, reagents, raw materials consumed in building prototypes).
• Hand-powered tools used directly for assembly or disassembly of prototypes.
• Repair parts for otherwise exempt R&D equipment 10.

3.2. Explicitly Non-Qualifying Activities (The Exclusion List)

SIB #75 establishes a comprehensive list of activities that are explicitly not considered “research and development activities” for the purpose of the sales tax exemption 10. This list is critical because equipment purchased for these purposes will not qualify, regardless of the property’s potential technical sophistication:

The explicit exclusion of Quality Control (QC) testing represents a significant compliance vulnerability, particularly for manufacturing and life science firms. This exclusion implies that equipment used for both exempt experimental refinement and non-exempt routine quality assurance is susceptible to high audit scrutiny. Taxpayers must be prepared to demonstrate that the testing equipment’s purchase and primary function are tied to the experimental phase—the modification and refinement of a prototype—rather than the post-production assurance of a mature product. If co-mingling of use exists, the DOR could deny the exemption entirely based on the initial acquisition purpose, or potentially subject the asset to a proportional use tax calculation based on the non-exempt percentage.

3.3. Excluded Property: Incidental Functions

Property used for functions incidental to experimental or laboratory R&D is also excluded from the exemption. These include functions related to the general operation of the business or facility that do not directly involve the physical execution of the experiment:

• Heating, cooling, or illumination of administrative office buildings.
• Capital improvements to real property (e.g., new lab walls, plumbing).
• Janitorial or personnel services.
• Inventory control or management/supervisory functions.
• Marketing, training, or accounting functions 10.

This exclusion requires businesses to draw a clear line between the physical infrastructure of scientific discovery (exempt) and the administrative or commercial infrastructure necessary to operate the business (taxable). For instance, office furniture, standard furnishings, or data storage equipment used primarily by R&D management or administrative staff are taxable, even if housed within an R&D facility, because they do not meet the “direct use” test 10.

IV. Comparative Analysis: Sales Tax Exemption vs. Income Tax Credit

A crucial strategic point for any Indiana taxpayer is recognizing that the Sales Tax Exemption (IC 6-2.5-5-40) and the Income Tax Credit (IC 6-3.1-4) operate under entirely separate and non-identical legal frameworks 10.

4.1. Structure of the Income Tax Credit (IC 6-3.1-4)

The Indiana Research Expense Credit is structured similarly to its federal counterpart, providing a credit against state income tax liability based on qualified research expenses (QREs) incurred in Indiana 5. The definition of QREs is drawn directly from Section 41(b) of the Internal Revenue Code (IRC) [5, 8, 13]. QREs generally include:

• Wages paid to employees conducting research.
• Costs of supplies consumed in R&D activities.
• Costs for contract research services 8.

The credit calculation involves a complex determination of a base period amount, with the current structure allowing a credit percentage of up to 15% on the first $1 million of QREs exceeding the base amount, and up to 10% on the excess amount [5, 6, 8].

4.2. Material Differences and Strategic Disconnects

The Indiana DOR explicitly states that the rules for the two incentives “are not identical, meaning an expense might qualify for one but not both” 10. This divergence necessitates a bifurcated approach to eligibility analysis.

Property vs. Expense Coverage

The sales tax exemption focuses solely on Tangible Personal Property (TPP) 10. Conversely, the Income Tax Credit principally targets high-value, non-taxable research costs, such as wages and contract research services 8. This structural difference creates an “intangibles gap.” High-value R&D investments, such as purchased software licenses or fees for complex modeling services, may constitute QREs eligible for the income tax credit, but because they are often classified as intangible property or services, they are entirely excluded from the sales tax exemption 10.

The Prior Use Hurdle

The most significant divergence is the restrictive “no prior use in Indiana” test for TPP purchased under IC 6-2.5-5-40 [10, 12]. No such restriction exists in the definition of QREs under IRC $\S 41$ used for the income tax credit.

If a company incurs QRE costs (e.g., labor and supplies) using equipment that fails the sales tax exemption’s prior-use test (because it was repurposed from a non-R&D function in Indiana), the supplies may still qualify as QREs for the income tax credit. However, the capital investment in the equipment itself remains fully taxable under the sales and use tax regime. This scenario demonstrates the decoupled nature of the two incentives, requiring taxpayers to treat the incentives as two distinct eligibility programs rather than two facets of a single program.

Table I summarizes the key structural differences between the two R&D incentives offered by Indiana:

Table I: Comparison of Indiana R&D Incentives

V. Compliance and Administrative Procedures

Compliance with IC 6-2.5-5-40 involves strict procedural requirements to either secure the exemption at the point of sale or claim a refund afterward.

5.1. Securing the Exemption at the Point of Sale

The most straightforward method to realize the 7% savings is to utilize an exemption certificate at the time of purchase. When acquiring R&D property from an Indiana vendor or a registered out-of-state vendor, the purchaser is required to complete the appropriate exemption certificate, certifying that the purchased TPP meets the strict criteria outlined in SIB #75 10. This procedure ensures that the 7% sales tax is not collected by the vendor, maximizing the immediate cash flow benefit.

5.2. Post-Transaction Remediation: Filing a Claim for Refund (Form GA-110L)

If a taxpayer erroneously pays Indiana sales or use tax on exempt R&D property, they retain the right to file a claim for refund [5, 10]. This claim must be made using DOR Form GA-110L, the official general claim for refund request [10, 14].

The refund process is administratively rigorous and demands exceptional documentation. The DOR’s standard checklist for refund claims emphasizes the level of detail required for R&D claims:

• Submission of the Refund Claim Request (Form GA-110L) 14.
• Purchase invoices demonstrating that Indiana tax was charged or use tax was paid 14.
• A spreadsheet summarizing the requested amount by period 14.
• A detailed “Description of how each item is specifically used in the production process” (or R&D process) 14.

The requirement for a highly detailed description of the property’s use means that the refund application must function as a preemptive audit defense. Taxpayers cannot rely on general accounting records; they must explicitly demonstrate that the item’s function is integral to experimental research and that its purpose does not fall into any of the non-qualifying activities listed in SIB #75 (such as quality control or administrative support) 10. Many businesses that rely solely on documentation compiled for the federal R&D tax credit (IRC $\S 41$) find this insufficient, as federal documentation does not prove the mandatory “no prior use” status in Indiana or the necessary separation from state-specific excluded activities like routine QC.

5.3. Record Keeping Requirements for Audit Defense

To sustain the exemption upon audit, taxpayers must maintain detailed records that unequivocally substantiate the three core criteria: (1) that the purchase constitutes TPP, (2) that the TPP had no prior use in Indiana, and (3) that its use was directly, exclusively, and integrally devoted to experimental or laboratory R&D, separated from all excluded functions (e.g., QC, marketing, general administration) 10. Establishing dual audit trails—one for the Income Tax Credit based on QREs and one for the Sales Tax Exemption based on TPP procurement and usage—is considered a strategic necessity.

VI. Case Study: Application of the Exemption and Credit

To illustrate the application of Ind. Code $\S 6-2.5-5-40$ and highlight potential compliance failures, consider the example of an Advanced Manufacturing Firm (AMF) based in Indianapolis that initiates a project in 2024 to develop a new proprietary composite material.

6.1. Scenario Definition: Advanced Manufacturing Firm (AMF)

AMF commits $1.5 million to the project. This total expenditure is divided into:

• Income Tax Credit Expenses: $1,000,000 in QREs (wages, contractor fees for simulation).
• Sales Tax Exemption Purchases: $500,000 in capital expenditures for TPP.

The analysis focuses on the $500,000 in TPP, which is subject to the 7% sales tax [3, 4].

6.2. Mapping Specific Purchases Against SIB #75 Criteria

A strict review of AMF’s capital purchases against the SIB #75 criteria reveals the necessity of rigorous functional and historical asset analysis:

1. Purchase A: New Testing Apparatus ($200,000). This specialized equipment was purchased new from a supplier in Ohio and shipped directly to the Indiana lab. It is used 95% of the time for experimental stress testing of composite prototypes during the pre-commercial development phase. The remaining 5% of time is spent generating internal management reports.

• Analysis: This item is TPP and satisfies the “no prior use in Indiana” rule. Its primary and integral function is experimental research. While the 5% management demonstration introduces a fractional risk, the R&D purpose dominates. This purchase is generally considered Exempt 10.

1. Purchase B: Used Robotic Arm ($150,000). This robotic arm was previously used for three years on AMF’s standard production line in Muncie, Indiana, for routine quality control measurements. It is now repurposed for experimental handling and assembly of composite material samples in the new R&D lab.

• Analysis: Despite its new function being R&D, this asset fails the mandatory “no prior use in Indiana for any purpose” test 10. Furthermore, its prior use was in routine Quality Control, which is an explicitly excluded activity. The purchase is Taxable. If AMF had purchased this used arm from an out-of-state facility, it might have qualified.

1. Purchase C: Consumables (Chemicals and Reagents – $50,000). These are chemicals, resins, and specialized materials consumed directly during the experimental process to create and refine prototypes.

• Analysis: As TPP used directly and essentially in the experimental process, these consumables are Exempt 10.

1. Purchase D: Office Furniture and Storage Equipment ($10,000). These items were purchased for the R&D Director’s office within the laboratory building.

• Analysis: These items are explicitly excluded by SIB #75, as they are not used directly in the experimental process; rather, they relate to administrative and supervisory functions 10. The purchase is Taxable.

6.3. Summary of Exemption Application (AMF)

The analysis demonstrates that the strict eligibility criteria significantly reduce the total amount of capital expenditure that can be claimed as exempt, even within a dedicated R&D effort.

Table II: Application Example: Exempt vs. Taxable R&D Purchases (AMF)

VII. Conclusion and Strategic Recommendations

The Indiana R&D Sales Tax Exemption (IC 6-2.5-5-40) represents a powerful tool for reducing the upfront cost of innovation capital. However, its effectiveness is intrinsically tied to a taxpayer’s ability to comply with criteria far more stringent than those governing the parallel Income Tax Credit (IC 6-3.1-4).

7.1. Summary of Key Compliance Risk Areas

Based on DOR guidance (SIB #75), compliance vulnerabilities center on two primary areas:

1. The Prior Use Prohibition: The requirement that property must not have been previously used in Indiana for any purpose is a non-negotiable threshold requirement. Failure to track and certify the origin and use history of the asset within the state will immediately invalidate the exemption.
2. The Direct Use Test and Quality Control Exclusion: The exemption is confined strictly to experimental or laboratory use. The explicit exclusion of routine Quality Control (QC) and the stringent direct use test creates significant audit exposure where R&D testing and routine QC are performed using the same personnel or equipment, necessitating clear operational and documentation boundaries between these functions.

7.2. Recommendations for Strategic Tax Planning

To maximize the benefits of the Sales Tax Exemption while mitigating audit risk, corporations engaged in R&D in Indiana should implement the following strategic steps:

1. Establish Dual and Separate Audit Trails: Taxpayers must recognize the explicit non-identity of the two R&D incentives. Maintain a dedicated documentation system for the Income Tax Credit (IC 6-3.1-4) based on IRC $\S 41$ QREs, and a separate, rigorous system for the Sales Tax Exemption (IC 6-2.5-5-40) focused on TPP, prior-use certification, and direct functional use documentation adhering to SIB #75.
2. Optimize Procurement for Prior Use Compliance: Procurement policies must be designed to satisfy the “no prior use in Indiana” rule. For high-value capital assets, companies should structure purchases to ensure the TPP is demonstrably new or acquired used from a location demonstrably outside of Indiana and imported directly for the R&D purpose. Repurposing existing in-state assets should be avoided where the tax exemption is sought.
3. Ensure Functional and Physical Segregation: Minimize the potential for co-mingling exempt and non-exempt activities. Physically and operationally segregate exempt experimental testing from non-exempt activities such as routine production Quality Control (QC), general administrative functions, and post-commercial market testing. If co-mingling is unavoidable, the taxpayer must establish detailed usage logs and time allocations to substantiate the property’s dominant and integral use in experimental R&D, although the denial of the full exemption remains a risk under strict interpretation of the “direct use” requirement.
4. Prioritize Exemption Certificates and Prepare for GA-110L Remediation: Taxpayers should strive to secure the exemption at the point of sale using the requisite exemption certificate. If, for administrative reasons, the sales tax is paid, the taxpayer must proactively compile the rigorous documentation required for Form GA-110L remediation. This documentation must include clear, detailed narratives of the equipment’s use, explicitly cross-referencing against the exclusions listed in SIB #75 to establish the essential and integral nature of the property to the experimental R&D process.

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