The Cost of Exclusion: Analyzing the Disallowance of Personal Property Lease Costs in the Iowa R&D Tax Credit (Post-2022)

Effective for tax years beginning on or after January 1, 2023, Iowa law eliminated the inclusion of rental or lease costs of personal property as Qualified Research Expenditures (QREs) for the Research Activities Credit (RAC).1 This legislative restriction specifically targets expenses for the use of a third party’s computers, including cloud computing and leased server costs, which previously qualified under Federal Internal Revenue Code (IRC) Section 41(b)(2)(A)(iii).2

This disallowance represents a fundamental divergence from the federal framework for calculating research credits and is the cornerstone of major structural changes enacted by the state to manage fiscal exposure associated with the Research Activities Tax Credit. The change was implemented via the 2022 tax reform bill, House File 2317 (HF 2317).2 The legislative intent behind HF 2317 was to introduce system-wide limitations designed to curtail the state’s budget exposure to the credit, particularly given its historical refundable nature.5 Consequently, the modifications apply not only to current-year QREs but also necessitate mandatory adjustments to prior-year QREs used in the calculation of the credit’s incremental base amount, substantially increasing the complexity of compliance for taxpayers.3

II. Foundational Review: The Structure of the Iowa R&D Tax Credit

A. Federal Nexus and the “Four-Part Test”

The Iowa Research Activities Credit (RAC) is highly dependent on the taxpayer’s standing at the federal level. Eligibility for the Iowa credit is conditional upon the taxpayer being eligible for and claiming the Federal Credit for Increasing Research Activities under IRC Section 41 for the same taxable year.6 This linkage means that any qualified research activity in Iowa must satisfy the fundamental federal “four-part test” for defining qualified research.7 This test requires that activities be technological in nature, performed for a permitted purpose (such as improving functionality or quality), aimed at eliminating uncertainty, and carried out through a process of experimentation.1

The Iowa RAC is available only to businesses conducting qualified research within specific industries deemed strategic by the state, including manufacturing, life sciences, agriscience, software engineering, and the aviation and aerospace industry.1 Businesses in sectors such as retail, wholesale, finance, and agricultural production are explicitly ineligible.1

B. Defining Historical Iowa QREs (Pre-2023)

Prior to the enactment of HF 2317, Iowa QREs incurred within the state traditionally mirrored the federal definition, encompassing four primary categories of expenditures: Wages for qualified research services; the Cost of Supplies used in research; Contract Expenses (generally 65% of amounts paid to qualified organizations); and the Rental or Lease Cost of Personal Property used in conducting qualified research.1

The critical shift introduced by HF 2317 was the removal of the rental or lease cost of personal property from this definition. The exclusion applies to tax years beginning on or after January 1, 2023.1

C. The Incremental Calculation Mechanism

The Iowa Research Activities Credit is, fundamentally, an incremental credit, meaning that only research expenditures that exceed a historical Base Amount are eligible for the credit calculation.1

The calculation of the Base Amount is performed using the product of the fixed-based percentage multiplied by the average annual gross receipts of the taxpayer for the four taxable years preceding the credit year.6 A crucial provision in Iowa law clarifies that in no event shall the Base Amount be less than fifty (50) percent of the qualified research expenses for the current credit year.6 This provision, which establishes a 50% QRE floor for the base, applies to all tax years, past and present.

The mechanism by which the QRE reduction impacts the credit calculation extends beyond merely reducing the current-year expenditures. The reduction of a major QRE category—leased property costs—directly reduces the total current Iowa QREs. If the taxpayer’s calculation results in the Base Amount being determined by the 50% QRE floor, a reduction in current QREs may simultaneously result in a proportional reduction of the Base Amount. While this 50% floor mechanism can potentially mitigate some negative impact of the exclusion, the taxpayer must first determine if the fixed-base method, using historical gross receipts, yields an even higher base amount. Taxpayers must now carefully model which Base Amount test they satisfy after applying all state-specific QRE exclusions.

III. Legislative Context: HF 2317 and the Revenue-Raising Mandate

A. Background on the 2022 Tax Reform

House File 2317 was signed into law by Governor Kim Reynolds on March 1, 2022.4 Although the bill’s primary public policy goal was to reduce individual and corporate income tax rates, it relied on incorporating “revenue-raising measures” that significantly modified and scaled back existing tax credits, making the Research Activities Credit a major target for fiscal constraint.2 The changes generally took effect for tax years beginning on or after January 1, 2023.2

B. Fiscal Rationale for Disallowing Leased Computer Costs

The state’s decision to disallow leased computer costs stemmed from an administrative and budgetary response to an unexpected surge in claims. When Iowa made its R&D credit refundable around 2019, this liquidity benefit coincided with a massive increase in R&D activities migrating to cloud-based platforms and large data centers operating within Iowa.5 Expenses related to cloud computing and the lease of server infrastructure, which qualified federally under IRC 41(b)(2)(A)(iii), constituted a substantial and growing component of QREs.

The combination of high-volume claims for leased computer infrastructure and the full refundability of the Iowa RAC led to what the state perceived as an unsustainable “flood of cash claims,” even from companies reporting losses.5 This dynamic prompted the Iowa Department of Revenue (IDR) to initially engage in aggressive auditing and disallowance of these cloud costs. To standardize enforcement and establish a clear fiscal boundary, the legislature formally retained the refundable nature of the credit but systematically excluded leased computer costs starting in 2023.5

The legislative action, by explicitly removing a federally allowed expense category, confirms that state tax policy was forced to react defensively to the economic consequences of modern technological adoption and highly mobile, third-party infrastructure. The elimination of these costs signals the state’s intent to limit incentives for research heavily reliant on outsourced digital infrastructure, effectively addressing the unanticipated budgetary drain caused by the confluence of full refundability and expansive cloud adoption.

IV. Dissecting the Exclusion: Personal Property Lease Costs Post-2022

A. Definitive Exclusion Language

The statutory amendment definitively removed “the rental or lease cost of personal property” from the list of allowable QREs for tax years beginning on or after January 1, 2023.1

Crucially, implementing guidance from the Iowa Department of Revenue (IDR) and analysis of HF 2317 clarified that the restriction specifically targets costs defined under Internal Revenue Code Section 41(b)(2)(A)(iii). The IDR instructions state that “Expenses for the use of a third party’s computers in the conduct of qualified research under Internal Revenue Code section 41(b)(2)(A)(iii) no longer qualify as Iowa qualified research expenses”.3

B. Scope and Interpretation of “Third-Party Computers”

The reference to IRC 41(b)(2)(A)(iii) ensures the exclusion covers all typical modern methods by which R&D taxpayers access external computing power. This includes:

1. Infrastructure as a Service (IaaS): Leasing virtual machines, servers, and storage capacity from providers like Amazon Web Services or Microsoft Azure.
2. Platform as a Service (PaaS): Using specialized development or testing environments hosted by a third party.
3. Leased Hardware: Traditional rental costs for physical servers or equipment housed in co-location facilities.

For any expense that meets the federal definition of costs for the use of a third party’s computer, the disallowance in Iowa is 100%.3

It is important to recognize that while the focus of the policy change was heavily weighted toward high-cost cloud computing, the statutory language governing the definition of Iowa QREs removes the entire category of “rental or lease cost of personal property”.1 This broad stroke affects traditional manufacturing and life sciences R&D as well, meaning the cost of leasing any specialized physical testing equipment, machinery, or industrial components temporarily used in qualified research is also barred, expanding the scope of the reduction beyond purely digital R&D claims.

C. Key Comparison Table (Federal vs. Iowa QREs Post-2022)

The legislative changes have fundamentally created a mandatory compliance divergence, requiring taxpayers to treat their federal QRE calculation as a mere starting point that must be reduced significantly for state purposes. The table below illustrates the mandatory reductions required for tax years beginning in 2023:

Disallowance of Leased Personal Property: Comparison of Federal and Iowa Treatment (Post-2023)

V. Compliance and Administrative Guidance from the Iowa Department of Revenue (IDR)

A. IDR Form Instructions and Required Methods

The Iowa Department of Revenue formally implemented the HF 2317 changes through updated instructions for its research credit forms, including IA 128 (Regular Credit) and IA 128S (Alternative Simplified Credit), which apply to the 2023 tax year and onward.3

A significant procedural requirement introduced by the IDR guidance is the mandate that the researching business must utilize the same calculation methodology—either the Regular Credit method or the Alternative Simplified Credit (ASC) method—for the Iowa RAC as was elected or required for the federal research credit calculation.3 This requirement ensures consistency in the methodological application between the federal and state claims.

B. Mandatory Base Period Adjustments (The Critical Nuance)

The fundamental challenge posed by these legislative changes is not merely the reduction of the current year’s QREs, but the necessity of making equivalent adjustments to the historical QREs used to establish the Base Amount. Failure to adjust the Base Amount downward to account for the newly disallowed expenses would artificially inflate the historical base, significantly minimizing or eliminating the current-year incremental credit.

To address this, the IDR guidance explicitly requires taxpayers to adjust their historical QRE data. The instructions for the Alternative Simplified Credit (IA 128S) state that for computing the prior-year QREs used in the base calculation, “Prior-year qualifying rental or lease costs of computers in conducting qualified research in Iowa may be excluded”.3

This mandate effectively forces a retroactive application of the new law to historical data. Taxpayers must look back to the QREs reported in their base period (which typically includes the three or four preceding years, depending on the calculation method) and meticulously remove all amounts previously claimed for leased personal property, specifically third-party computer costs. This requirement creates a substantial administrative compliance burden for firms that may not have maintained granular historical QRE tracking segregated by these specific components, demanding a re-litigation of prior-year data solely for the purpose of the current state calculation.3

C. Required Adjustment for Supplies in Base Period

In addition to the adjustments for leased personal property, the IDR also requires corresponding adjustments for supplies QREs used in calculating the Base Amount. This is necessary because HF 2317 mandated that only 80% of supplies costs qualify as Iowa QREs for 2023.3 To maintain calculation integrity, the IDR instructions state that “20% of prior-year qualifying Iowa supplies expenses may be excluded” when calculating the base amount.3 This adjustment aligns the historical base period supplies QREs with the current-year 80% inclusion rate, further confirming the state’s intent to consistently apply the reduced QRE definition across both the current year and the base period.

VI. Systemic Impact: Broader Limitations Imposed by HF 2317

The disallowance of leased personal property costs is not an isolated change but rather one element of a comprehensive strategy under HF 2317 designed to constrain the overall economic value of the Iowa RAC.

A. Declining Inclusion Rate for Supplies QREs

Concurrent with the elimination of leased personal property QREs, HF 2317 introduced a phased reduction in the allowable inclusion rate for supplies QREs. For the 2023 tax year, only 80% of amounts paid for supplies related to research performed in Iowa qualified as Iowa QREs.3 This allowable percentage is legislated to decrease in future years, guaranteeing a progressive erosion of the overall Iowa QRE base, regardless of the taxpayer’s reliance on third-party computing costs.

B. Phased Reduction of Refundability

Perhaps the most significant constraint on the credit’s value is the phased reduction of its refundable portion. Starting in 2023, the refundable portion of the credit that exceeds a taxpayer’s liability began to decrease incrementally over five years.2 For the 2023 tax year, a taxpayer could only receive a refund for 90% of the amount of the regular Iowa RAC and 95% of the Supplemental RAC that exceeded their Iowa tax liability.2 This systematic reduction will continue by 10% each year, ultimately lowering the maximum refundability to 50% for the regular RAC in 2027 and subsequent years.2

C. Disallowance of Carryforwards

A severe constraint on unused credit value is the elimination of credit carryforwards. Any credit amount that exceeds the newly limited refundable percentage for the tax year cannot be carried forward to offset tax liability in future periods; it must be forfeited.2 This policy dramatically reduces the liquidity and the total economic value of the credit, as taxpayers cannot recover the non-refundable portion if their tax liability is zero or minimal.

The combined impact of these measures—the reduction of the QRE base due to exclusions and the systematic reduction in cash refundability—means the Iowa R&D credit, which was previously a robust source of cash flow for R&D-intensive companies, is rapidly losing its economic appeal and liquidity. Companies must now model not only the QRE calculation divergence but also the time-value-of-money implications imposed by the capped refundability.

VII. Illustrative Example: Calculating the Iowa RAC Post-Exclusion

This detailed example demonstrates the required adjustments, assuming the taxpayer is a C-Corporation that elected the Alternative Simplified Credit (ASC) method federally, which is then mandated for Iowa calculation.3

A. Scenario Parameters (2023 Tax Year)

• Taxpayer: Iowa Manufacturer, Inc. (Eligible Industry, uses Federal ASC).
• Current Year (2023) Federal QREs: $1,200,000.
• Prior 3-Year Average Federal QREs (2020-2022): $1,100,000.
• 2023 Iowa Tax Liability: $0 (Credit is fully refundable, subject to limits).

B. Step 1: Segregating and Adjusting Current Year (2023) QREs

The first step requires the taxpayer to take their total Federal QREs and apply all Iowa-specific limitations, including the 100% exclusion for leased computer costs and the 20% exclusion for supplies (leaving 80% included).3

The Iowa QRE base is reduced by $250,000, decreasing from $1,200,000 to $950,000.

C. Step 2: Adjusting the Base Period QREs

The prior 3-year average Federal QRE of $1,100,000 must be adjusted to remove the average historical amount of disallowed costs, as required by IDR guidance.3

• Assume the historical average adjustment for computer leases and the supplies exclusion is $200,000.
• Adjusted Prior 3-Year Average Iowa QREs: $\$1,100,000 – \$200,000 = \$900,000$.

D. Step 3: Calculating the Incremental Credit (ASC Method)

The Alternative Simplified Credit (ASC) Base Amount is calculated as 50% of the adjusted prior 3-year average.9

• ASC Base Calculation: $\$900,000 \times 50\% = \$450,000$ (Base Amount)
• Excess QREs: Current Iowa QREs minus the Base Amount.

• $\$950,000$ (Current) – $\$450,000$ (Base) = $\$500,000$ (Excess QREs)

• 2023 Iowa RAC: Calculated using the ASC rate of 4.55%.9

• $\$500,000 \times 4.55\% = \$22,750$ (Iowa RAC)

E. Step 4: Applying Refundability Limits (2023)

For the 2023 tax year, the credit is subject to the phased refundability limits.2

• Total Credit Calculated: $22,750.
• 2023 Refund Limit: 90% of the excess credit is refundable.2
• Refundable Amount: $\$22,750 \times 90\% = \$20,475$.
• Disallowed/Non-Refundable Amount: The remaining $\$2,275$ (10%) is non-refundable and, because carryforwards are disallowed, this amount is forfeited entirely.3

This example confirms that the elimination of $200,000 in QREs led to a substantial reduction in the calculated credit, and the subsequent application of the refundability cap further constrained the cash benefit, resulting in a dual constraint on the incentive’s financial value, particularly for technology-intensive research.

VIII. Conclusion and Strategic Recommendations

The disallowance of rental or lease costs of personal property, particularly third-party computer expenses, represents a clear and forceful policy shift by Iowa to curb escalating costs associated with its highly refundable Research Activities Credit. This change, enacted through HF 2317, systematically reduces the QRE base for Iowa purposes and creates a permanent divergence from federal calculation methodologies.

A. The Mandate for Detailed QRE Segregation

The absolute disallowance of third-party computer lease costs demands immediate and granular adjustments to internal accounting and documentation practices. Taxpayers must implement robust, real-time tracking systems to segregate R&D expenses, distinguishing between allowable costs (wages, contract research) and the now-disallowed computing infrastructure costs.5 Special attention must be paid to invoices from cloud service providers to ensure costs for disallowed computer use are separated from costs for qualified technical services or other acceptable supplies.

B. Strategic Consideration of the Base Period

Compliance complexity is centered on the mandated retrospective adjustment of historical QREs. Taxpayers must proactively ensure they correctly implement the IDR guidance regarding the exclusion of prior-year computer lease costs and the corresponding supplies adjustment when calculating the Base Amount.3 A failure to accurately reduce the historical base period QREs to reflect these exclusions will result in an artificially inflated base, minimizing the current year’s incremental credit and effectively double-penalizing the taxpayer.

C. Future Outlook and Planning Considerations

The incremental reduction of the QRE inclusion rate for supplies and the rapid phase-out of refundability through 2027 significantly diminish the economic value of the Iowa RAC.2 Businesses heavily reliant on cloud computing or equipment leasing for their R&D must recognize that Iowa’s tax policy environment has become significantly less favorable for digitally focused R&D activities post-2022. Long-term strategic planning should involve modeling the reduced return on the Iowa credit alongside the incentives offered by other states. The clear legislative trend indicates a move toward converting the RAC from a robust, refundable cash incentive into a smaller, contained, non-refundable tax benefit, necessitating a re-evaluation of R&D location and investment decisions within the state.

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