Strategic Alignment of the Hawaiʻi Tax Credit for Research Activities: Resolving the In-State Spend Mandate to Accelerate Small and Medium Business Innovation

1. Introduction and Macroeconomic Context

The State of Hawaiʻi stands at a critical macroeconomic juncture in the first quarter of 2026. The economic landscape is currently characterized by a highly uneven recovery, systemic structural vulnerabilities, and shifting federal policy winds that threaten the state’s traditional revenue engines. Projections released by the University of Hawaiʻi Economic Research Organization (UHERO) and the Department of Business, Economic Development and Tourism (DBEDT) indicate that the state is navigating a tepid emergence from a mild jobs recession, constrained heavily by external macroeconomic factors.¹ While the broader United States domestic economy has demonstrated unexpected resilience—bolstered by robust consumer spending and aggressive corporate investments in artificial intelligence and automation—Hawaiʻi’s unique dependency on international visitor markets and federal defense appropriations has severely insulated the state from these national gains.³

The tourism sector, the historical bedrock of the state’s general fund, has stagnated. Adverse reactions to evolving federal trade policies, shifting currency valuations, and localized capacity constraints have resulted in a sharp decline in arrivals from international markets outside of Japan.¹ Furthermore, the introduction of the 2025 One Big Beautiful Bill Act (OBBBA) has introduced severe fiscal headwinds for the state. The OBBBA mandates broadened work requirements for the Supplemental Nutrition Assistance Program (SNAP) and stricter Medicaid enrollment protocols, threatening to shift substantial uncompensated care and social safety net costs directly onto the state budget.³ Concurrently, widespread “tariff vertigo” has paralyzed business planning, with local enterprises facing heavily inflated costs for imported materials and hardware components necessary for local manufacturing and service delivery.⁵ As these federal actions depress the state’s economic velocity, it has become irrefutably clear that Hawaiʻi can no longer rely on a monolithic, tourism-centric economic model.

The imperative for aggressive, sustainable economic diversification has never been more urgent. Strategic state policy has correctly identified the advanced technology sector—encompassing biotechnology, marine sciences, cybersecurity, renewable energy, and aerospace—as the primary vehicle for high-wage job creation and structural resilience.⁶ However, public aspiration has outpaced industrial reality. Hawaiʻi’s technology sector currently faces profound structural hurdles. Over the decade preceding 2024, Hawaiʻi’s technology sector grew 1.1 percentage points more slowly than the national average, with highly specialized, high-paying sub-sectors such as Biotechnology and Chemical Manufacturing experiencing outright contractions of -3.2% and -3.0% respectively.⁸ The Hamilton Index, a comprehensive metric assessing state-level performance in advanced, globally competitive industries, currently ranks Hawaiʻi among the lowest in the nation with a score of 0.22, trailing far behind innovation leaders like Massachusetts and California.⁹

The primary catalyst available to the state government to reverse this trend and stimulate advanced industrial growth is the Hawaiʻi Tax Credit for Research Activities (TCRA).¹⁰ While the TCRA serves as the foundational incentive for corporate innovation in the state, it is currently hindered by an antiquated, rigidly enforced localization mandate. The statutory requirement that penalizes Small and Medium Businesses (SMBs) for utilizing necessary, highly specialized out-of-state laboratories and contractors is actively sabotaging the growth of the state’s most promising startups.¹⁰ This whitepaper provides an exhaustive, expert-level analysis of this specific policy failure. It details the precise mechanics of the in-state spend mandate, contextualizes the infrastructure gaps driving out-of-state spending, evaluates comparative state policy models, and proposes two comprehensive, executable legislative solutions to modernize the TCRA. Furthermore, it outlines robust administrative frameworks designed to prevent fraud, models the long-term fiscal benefits utilizing UHERO economic multipliers, and defines the severe economic consequences of maintaining the status quo.

2. The Hawaiʻi TCRA Framework and Federal Intersections

To fully understand the destructive nature of the current policy issue, one must first dissect the intricate statutory framework that governs the Hawaiʻi Tax Credit for Research Activities. Codified under Hawaiʻi Revised Statutes (HRS) § 235-110.91, the TCRA is a refundable income tax credit specifically targeted at Qualified High Technology Businesses (QHTBs) operating within the state.¹⁰ The architectural foundation of the Hawaiʻi credit is intricately bound to the federal research and development tax credit framework, specifically Section 41 and Section 174 of the Internal Revenue Code (IRC).¹⁰

The Federal Baseline: IRC Section 41 and Section 174

The Hawaiʻi TCRA does not invent its own definition of research; rather, it fully adopts the federal definitions established under IRC Section 41.¹⁰ For any expenditure to be eligible for the state credit, it must first successfully navigate the rigorous “Four-Part Test” mandated by federal law to be classified as a Qualified Research Expense (QRE).¹⁴

1. First, the expenditure must satisfy the Section 174 Test. This requires that the cost be incurred in connection with the taxpayer’s active trade or business and represent a true research and development cost in the experimental or laboratory sense, aimed at eliminating technical uncertainty regarding the development or improvement of a product or process.¹⁴
2. Second, the Discovering Technological Information Test mandates that the research must be undertaken to discover information that is fundamentally technological in nature, relying on principles of the physical or biological sciences, engineering, or computer science.¹⁵
3. Third, the Business Component Test requires that the application of this discovered information be intended for use in the development of a new or improved business component (a product, process, software, technique, formula, or invention) of the taxpayer.¹⁵
4. Finally, the Process of Experimentation Test requires that substantially all of the activities constitute a systematic process of evaluating alternatives to achieve the desired result, including modeling, simulation, and systematic trial and error.¹⁵

When a business successfully demonstrates that its activities meet these four tests, it may capture specific expenditures as QREs. The federal code generally limits these eligible expenditures to three primary categories: in-house wages paid to employees directly performing, supervising, or supporting the qualified research; the cost of supplies and raw materials consumed directly in the research process; and a statutorily reduced percentage—typically 65%—of contract research expenses (CREs) paid to unaffiliated third parties to perform qualified research on the taxpayer’s behalf.¹²

The Hawaiʻi-Specific Localization Mandates

While the federal government establishes the baseline definition of what constitutes valid research, the State of Hawaiʻi imposes severe geographical overlays that dictate whether those valid research activities are eligible for state-level financial support. These localization mandates operate on two distinct levels: the entity-level qualification threshold and the expense-level geographical exclusion.

At the entity level, a business cannot claim the TCRA simply by being headquartered in Hawaiʻi. Under HRS § 235-110.91, the enterprise must meet the rigorous statutory definition of a Qualified High Technology Business (QHTB).¹⁰ To achieve QHTB certification, a company must prove that it conducts more than 50% of its total activities in qualified research within the State of Hawaiʻi.¹⁰ This is an all-or-nothing threshold; a business conducting 49% of its research in Hawaiʻi and 51% elsewhere is entirely disqualified from the program, receiving zero state support for the portion of the research it does conduct locally.¹⁰

At the expense level, the localization mandate becomes even more granular. Assuming a company successfully secures its QHTB status, it cannot simply calculate its credit based on its total global or national QREs. The TCRA requires a strict apportionment calculation where the credit is ultimately based only on the ratio of Hawaiʻi-sourced QREs to total federal QREs.¹¹ For in-house wages and supplies, the location is relatively easy to determine. However, for Contract Research Expenses (CREs), the law strictly dictates that the 65% eligible portion of payments made to unaffiliated third parties can only be claimed if those qualified services are physically performed within the boundaries of Hawaiʻi.¹¹

The 2026 Legislative Reforms and Remaining Bottlenecks

The administration of the TCRA has historically been a point of friction for the local technology community. Prior to 2026, the credit was constrained by a hard $5 million aggregate annual statewide cap, distributed by DBEDT on a first-come, first-served basis.¹⁰ This structure inherently favored highly capitalized corporations with dedicated compliance and grant-writing departments, who routinely exhausted the annual cap within hours of the application window opening.²⁰ Small, engineering-focused startups were consistently shut out of the funding pool.²⁰

Recognizing this systemic inequity, the 2026 legislative session saw the introduction and advancement of House Bill 2546 (HB2546). This transformative legislation radically restructured the TCRA by eliminating the punitive base-amount calculation, thereby allowing taxpayers to claim credits for all qualified research expenses without reduction for prior-year spending.²¹ Furthermore, HB2546 tripled the annual statewide cap from $5 million to $15 million and, crucially, replaced the first-come, first-served model with a proportional distribution mechanism, ensuring that all certified QHTBs receive an equitable share of the available credit pool if the aggregate cap is exceeded.²⁰ The provisions of this bill are designed to apply retroactively to taxable years beginning after December 31, 2024.²²

While HB2546 successfully addresses the issues of funding volume and distributive equity, it notably fails to address the underlying geographical constraints of the statute. The strict in-state spend mandate remains entirely intact. Therefore, while more funds may be available, they remain inaccessible for the subset of highly advanced SMBs whose innovation cycles force them to cross state lines for specialized technical services.

3. The Core Policy Issue: The In-State Spend Mandate and the Innovation Infrastructure Gap

The fundamental policy failure addressed in this report is the unintended, catastrophic penalization of Hawaiʻi-based SMBs caused by the rigid enforcement of the in-state requirement for Contract Research Expenses under HRS § 235-110.91. This policy operates under the assumption that Hawaiʻi possesses a fully matured, self-sufficient technological ecosystem. This assumption is demonstrably false. Hawaiʻi’s geographic isolation from the contiguous United States is a double-edged sword; while it offers unique advantages in fields like astronomy and oceanography, it results in profound infrastructure gaps that local businesses cannot overcome without external assistance.

The Reality of Advanced Research Infrastructure

Modern technological innovation requires access to hyper-specialized, capital-intensive infrastructure. While the State of Hawaiʻi has made commendable strides in developing foundational research centers—such as the Biosafety Level 3 (BSL-3) laboratories and accredited vivaria at the John A. Burns School of Medicine (JABSOM) ²⁴, and the Hawaiʻi State Veterinary Laboratory in ʻAiea ²⁵—it fundamentally lacks the multi-billion-dollar, hyper-niche facilities required for late-stage commercialization in advanced industries.

An examination of Hawaiʻi’s targeted emerging sectors reveals the depth of this infrastructure gap:

• Aerospace and Hypersonics: The state, through the High Technology Development Corporation (HTDC), is actively working to establish a statewide innovation corridor for next-generation aviation and space technologies, including plans for an aerospace port at the Pacific Missile Range Facility (PMRF) on Kauaʻi.²⁶ However, local startups designing advanced propulsion systems, hypersonic glide vehicles, or orbital deployment mechanisms face a severe bottleneck. Hawaiʻi possesses no localized hypersonic wind tunnels, zero-gravity simulation chambers, or advanced thermal vacuum facilities. To validate their engineering models and satisfy the federal Process of Experimentation requirement, these startups must contract with specialized aerospace testing facilities located in states like California, Texas, or Ohio.
• Biotechnology and Pathogen Research: A Hawaiʻi-based biomedical firm developing novel diagnostics for zoonotic diseases may utilize local facilities for initial in-vitro studies.²⁴ However, if their research requires validation testing against highly restricted, high-consequence pathogens that demand Biosafety Level 4 (BSL-4) containment, they must outsource this phase. They are legally and practically forced to send samples to mainland facilities, such as the National Veterinary Services Laboratories (NVSL) operated by the USDA in Ames, Iowa, or the Foreign Animal Disease Diagnostic Laboratory at Plum Island, New York.²⁷
• Semiconductor and Advanced Hardware Manufacturing: Hardware startups in Honolulu designing custom Application-Specific Integrated Circuits (ASICs) or advanced robotics components face a total absence of local silicon foundries (fabs). While software development and basic Printed Circuit Board (PCB) assembly can occur locally, the actual physical prototyping of advanced silicon wafers requires contracting with tier-one foundries located on the mainland or internationally.

The Mechanics of the Unintended Penalty

When a Hawaiʻi-based SMB is forced by the laws of physics, engineering, or federal regulation to utilize these mainland facilities, the current TCRA framework actively punishes them. This punishment manifests in two distinct, compounding penalties.

First is the immediate financial penalty regarding the exclusion of QREs. The capital expended on these highly specialized mainland tests—which often represent the most expensive single line item in a startup’s R&D budget—is entirely excluded from the state R&D tax credit calculation.¹¹ If a local aerospace firm spends $500,000 on necessary hypersonic wind tunnel testing in California, that entire amount is voided from the Hawaiʻi TCRA calculation. This dramatically increases the effective burn rate for the local startup, placing them at a severe competitive disadvantage compared to a rival firm based in California or Massachusetts, where such infrastructure exists locally and the expenses would qualify for state-level credits.

Second, and far more devastating, is the structural threat to the company’s QHTB status. The “50% Cliff” represents a mathematical trap for local SMBs. Because HRS § 235-110.91 requires that more than 50% of a company’s total research activities be conducted in Hawaiʻi to maintain QHTB status ¹⁰, a single, highly expensive out-of-state testing phase can destroy the company’s entire tax strategy.

Consider a hypothetical Hawaiʻi-based marine robotics firm. The company employs five local engineers, spending $300,000 annually on local wages and supplies (Hawaiʻi QREs). However, to validate their deep-sea pressure housings, they are forced to contract a specialized deep-water simulation facility in Massachusetts for $350,000 (Out-of-State CRE). Under the current law, their out-of-state research activity now accounts for 53.8% of their total research activity. Consequently, the firm loses its QHTB certification entirely. Not only is the $350,000 mainland expense disqualified, but the $300,000 spent locally on Hawaiʻi residents is also disqualified. The state policy, designed to encourage local spending, has just wiped out the entire tax incentive for a company that was attempting to grow a local workforce, simply because Hawaiʻi lacks a deep-sea pressure testing chamber.

This dynamic creates a perverse economic incentive. By refusing to accommodate necessary out-of-state infrastructural linkages, the TCRA actively discourages advanced, capital-intensive innovation in Hawaiʻi. It inadvertently signals to high-growth startups that their safest financial strategy is to relocate their corporate headquarters and engineering teams to the mainland before entering the advanced testing phases of their product development lifecycles.

4. Comparative State Policy Analysis and Benchmarking

To engineer a durable legislative solution for Hawaiʻi, it is essential to analyze the broader landscape of geographic R&D restrictions across the United States. Currently, 35 states offer some form of an R&D tax credit.²⁹ An examination of these diverse regulatory frameworks, as well as federal analogues, reveals a spectrum of approaches regarding out-of-state expenditures.

4.1 The Federal Precedent and the False Equivalency of Borders

At the federal level, the United States Congress established a definitive geographic boundary. Under IRC Section 41(d)(4)(F), research conducted outside the United States, the Commonwealth of Puerto Rico, or any U.S. possession is explicitly excluded from the definition of qualified research.³⁰ This federal statute is rooted in national economic protectionism; the U.S. Treasury will not subsidize the offshoring of high-value intellectual property development to foreign jurisdictions.

State legislatures, including Hawaiʻi’s, frequently attempt to mirror this logic, drawing hard lines at their state borders. However, applying national logic to state geography creates a false equivalency. The United States, in the aggregate, possesses the most comprehensive and diverse technological infrastructure on the planet. It is exceptionally rare that an American corporation must outsource a technical procedure to Europe or Asia because the capability simply does not exist domestically. Conversely, individual states—and especially an isolated archipelago like Hawaiʻi—frequently lack specific, highly specialized infrastructural capabilities.

Table 1: State Geographic Frameworks

4.2 The Spectrum of State-Level Approaches

State policies regarding the geographic sourcing of QREs generally fall into three distinct archetypes:

• The Strict Localization Mandates: States with massive, diverse economies frequently employ rigid in-state mandates identical to Hawaiʻi’s current system. California, for instance, explicitly excludes any research that occurs outside of the state, requiring consultants to perform their research physically within California to qualify for the 15% credit.²⁸ Similarly, Louisiana provides a generous tiered credit system (up to 30% for businesses with under 50 employees) but strictly mandates that only expenditures incurred within Louisiana qualify, and that outside consultants must perform the research within state borders.³⁵ This protectionist approach is highly effective for California and Louisiana because they already possess massive, deeply integrated technological hubs (Silicon Valley, aerospace manufacturing corridors, massive petrochemical R&D facilities).⁹ They can afford to be strict because the infrastructure exists natively.
• The Apportionment and Base-Level Models: Other states utilize more flexible apportionment formulas. Maryland’s Growth R&D Tax Credit, for example, calculates a base amount by dividing aggregate QREs by aggregate Maryland gross receipts, applying a 10% credit to the Maryland-qualified R&D expenses that exceed that base.³⁶ While the credit is still ultimately applied to local spend, the calculation mechanics are designed to accommodate companies with a multi-state footprint without triggering total disqualification cliffs like Hawaiʻi’s 50% rule.
• The Specialized Exemption Model: Massachusetts provides a highly compelling precedent for targeted regulatory flexibility. Under the Massachusetts Code of Regulations (830 CMR 63.38M.1), the state allows taxpayers to elect to calculate their research credit separately for “defense-related activities” versus other qualified activities.³⁸ The state recognizes that defense contracting involves unique, federally mandated supply chains and inter-state collaborative requirements that do not apply to standard commercial R&D. By creating a distinct accounting track for a specialized sector, Massachusetts demonstrates that state revenue departments can engineer flexible, industry-specific rules that accommodate complex operational realities without abandoning the state’s broader economic goals.

4.3 The Medicaid Analogy: A Framework for “Not Available In-State” Waivers

Perhaps the most elegant and directly applicable administrative precedent for Hawaiʻi to adopt does not originate from corporate tax law, but rather from state-level healthcare administration.

Across the country, state Medicaid programs operate under strict budgets designed to serve their local populations using in-state provider networks. However, these programs universally recognize the reality of medical specialization. In states like Arizona and South Carolina, the Medicaid policy manuals contain explicit provisions for “out-of-state” waivers.⁴² When a patient requires a highly specialized, life-saving medical procedure (such as a rare pediatric organ transplant) that is fundamentally unavailable within the state’s borders, the state authorizes an out-of-state waiver, ensuring the cost of the procedure at a mainland facility is covered by the state program.⁴²

The underlying logic of the Medicaid waiver is profound and highly applicable to economic development: a state should not deny critical, necessary services to its constituents simply because the local market lacks the scale to support a hyper-specialized facility. This exact philosophy should be ported to the administration of the TCRA. If a Hawaiʻi-based startup requires a hyper-specialized technological procedure that is demonstrably unavailable in Hawaiʻi, the state should not deny the tax incentive critical to that company’s survival and growth.

5. Proposed Policy Solutions for the Hawaiʻi Legislature

To rectify the severe penalization of local SMBs while maintaining the fundamental integrity of the TCRA—which is to cultivate a robust, localized technology sector—the Hawaiʻi State Legislature and DBEDT should implement one or both of the following comprehensive policy modifications.

Solution 1: The “Infrastructure Gap” Safe Harbor Waiver

The most direct and immediate legislative remedy is to amend HRS § 235-110.91 to create a statutory exception for out-of-state Contract Research Expenses (CREs) when no viable in-state alternative exists. This solution directly addresses the physical limitations of island geography while heavily regulating the outflow of tax-subsidized capital.

Mechanics of the Policy:

• The Exemption Criterion: If a certified QHTB requires a specific testing facility, specialized laboratory, or highly niche contract engineering service to satisfy the federal criteria for a QRE under IRC § 41, and the entity can definitively prove that no commercial or academic facility within the State of Hawaiʻi is technically capable of performing the service, the expense paid to the out-of-state vendor shall be legally treated as an eligible Hawaiʻi QRE.
• Abolishing the 50% Cliff: Crucially, the legislation must dictate that any out-of-state CREs formally approved under this waiver must be mathematically excluded from the denominator when calculating the “50% of activities” rule for QHTB eligibility.¹⁰ This ensures that an SMB is not stripped of its foundational high-technology status simply because it was forced to procure a specialized, high-cost mainland service.
• The Tiered Credit Rate (A Fiscal Compromise): To ensure that the primary economic incentive remains heavily skewed toward localized spending and local infrastructure development, the legislature should implement a tiered reimbursement system. While localized contract research would continue to be applied at the standard 65% eligible rate dictated by federal baseline rules ¹², out-of-state contract research approved under the waiver could be applied at a structurally reduced rate (e.g., 35% or 40%). This mechanism provides critical financial relief and operational runway to the SMB without creating absolute parity between local and out-of-state investment, thereby continuing to incentivize the eventual development of local infrastructure.

Solution 2: The Intellectual Property (IP) Retention and Commercialization Nexus

The second proposed solution represents a fundamental paradigm shift in how the State of Hawaiʻi conceptualizes economic development. Rather than focusing exclusively on the input of the research (the physical location where a chemical is mixed or a wind tunnel is activated), the state should pivot to capturing the output of the research (the ownership of intellectual property and the locus of commercialization).

This approach aligns perfectly with the evolving doctrines surrounding federal R&D tax law. Under IRS regulations and the stringent guidelines governing both IRC § 174 and § 41 (specifically clarified in recent IRS Notices 2023-63 and 2024-12 regarding “funded research”), the right to exploit the results of the research is paramount.⁴⁴ To claim the federal credit, a taxpayer must bear the economic risk of the research and, crucially, must retain substantial rights to the resulting intellectual property.⁴⁴

Mechanics of the Policy:

• The IP Nexus Exemption: Hawaiʻi should adopt an “IP Nexus” model for SMBs. Under this statutory rule, out-of-state CREs would be fully eligible for the Hawaiʻi TCRA provided that the intellectual property, patents, trade secrets, or exclusive commercial rights resulting directly from that specific contracted research are legally retained by a corporate entity domiciled in the State of Hawaiʻi.⁴⁶
• Economic Rationale: This policy acknowledges the reality of distributed global engineering. It ensures that while the immediate testing dollars may temporarily flow to a laboratory in New York or a testing range in New Mexico, the resulting multi-million dollar intangible asset (the patent or the finalized product design) remains registered in Honolulu. When that IP is subsequently manufactured, licensed, or commercialized, the resulting corporate income, the highly lucrative General Excise Tax (GET) receipts, and the associated local executive and administrative jobs are captured entirely by the State of Hawaiʻi. It prioritizes the long-term capture of massive commercial revenues over the short-term micromanagement of testing expenditures.

Table 2: Policy Solutions Summary

6. Implementation Guidelines: Fraud Prevention and Wastage Avoidance

Expanding the geographic eligibility of any tax credit program inherently introduces sophisticated risks regarding tax base erosion, fraudulent vendor schemes, and out-of-state wastage. To ensure the absolute fiscal integrity of the state budget, the legislative adoption of either proposed solution must be inextricably linked to a rigorous, adversarial administrative framework. This framework must be overseen jointly by DBEDT, which handles the initial commercial certification, and the Department of Taxation (DOTAX), which executes the fiscal audits.¹¹

6.1 DBEDT Pre-Approval and the “Market Test”

To utilize the “Infrastructure Gap” waiver (Solution 1), QHTBs cannot be permitted to simply claim the exemption retroactively on their N-346A forms at the end of the tax year.¹⁰ The process must be gated by prospective evaluation.

• Advance Certification: SMBs must be required to submit a prospective “Statement of Infrastructural Unavailability” to DBEDT prior to the execution of the out-of-state contract and the disbursement of funds.
• The Market Test Requirement: The burden of proof must fall entirely on the applicant. The SMB must provide documented, verifiable evidence that they queried the local Hawaiʻi market—including the University of Hawaiʻi system, local defense contractors, and state-operated laboratories ²⁵—and received formal confirmation that the specific technological capability does not exist locally or lacks the required regulatory accreditations (e.g., specific ISO certifications or FDA approvals). DBEDT, leveraging its deep network within the High Technology Development Corporation (HTDC), will be tasked with maintaining an active, dynamic registry of local technical capabilities to independently cross-reference and validate these applicant claims.¹⁷

6.2 Combating Vendor Fraud and Shell Company Schemes

A primary vector for financial fraud in out-of-state incentive programs involves the creation of out-of-state shell companies. Unscrupulous taxpayers may establish a hollow LLC in Nevada or Delaware, route “contract research” payments to that entity, and claim the tax credit, effectively engaging in self-dealing while siphoning state funds.

• Vendor Master File Validation: DOTAX must implement stringent, continuous authentication techniques for all out-of-state vendors associated with TCRA claims.⁴⁸ Drawing upon best practices from the Association of Certified Fraud Examiners (ACFE) and state-level models like the Pennsylvania R&D tax credit system—which requires rigorous state tax clearance and explicitly reserves the right for onsite, out-of-state audits—Hawaiʻi must require out-of-state vendors to provide federal Employer Identification Numbers (EINs) and attest under penalty of perjury to their independent operational status.⁴⁹
• Affiliation Cross-Checks: Under federal law (IRC § 41(b)(3)), contract research must be paid to unaffiliated third parties to qualify.¹² DOTAX auditors must utilize automated data-screening tools to ensure the out-of-state vendor does not share beneficial ownership, executive leadership, shared physical addresses, or overlapping corporate holding structures with the Hawaiʻi QHTB.
• Phishing and Impersonation Defenses: State agencies must be hyper-vigilant regarding communication security. As highlighted by the Texas Comptroller’s office, fraudsters frequently target state vendor certification systems using sophisticated phishing and spoofing campaigns to alter payment routing or falsify certifications.⁵¹ DBEDT and DOTAX must employ secure, encrypted, multi-factor authenticated portals for all vendor validation communications, strictly prohibiting email-based certification requests or verifications.

6.3 Alignment with Federal Audits and Form 6765

The Hawaiʻi TCRA is, by design, intimately tethered to the federal R&D credit framework. Current Hawaiʻi Form N-346 instructions explicitly state that the state credit may not be claimed if the taxpayer is not concurrently claiming the federal tax credit for research activities under IRC § 41.¹⁸ This linkage provides a powerful, pre-existing layer of audit protection.

• Federal Reciprocity: DOTAX should mandate that any specific out-of-state expenses claimed under the Hawaiʻi waiver mechanism must also be explicitly reported and claimed as eligible QREs on the taxpayer’s federal Form 6765 (Credit for Increasing Research Activities).⁵³ This ensures that the expenses are subject to the intense scrutiny of the Internal Revenue Service.
• Contemporaneous Documentation: Utilizing the IRS Audit Techniques Guide for Research Credit Claims as the gold standard ¹⁵, DOTAX must strictly enforce requirements for contemporaneous documentation. Taxpayers must provide highly detailed testing logs, raw laboratory data reports, time-tracking software exports, and granular vendor invoices proving that the out-of-state research was actually performed, was technological in nature, and that the resulting data was physically or digitally transmitted back to the Hawaiʻi QHTB. Post-hoc estimates, high-level summaries, and retroactive extrapolations must be strictly prohibited and immediately disqualified.⁵⁵

6.4 Enforcing the IP Retention Nexus

If the legislature opts to adopt the IP Retention Nexus model (Solution 2), the state must establish mechanisms to ensure that the highly valuable intellectual property does not subsequently “leak” to out-of-state holding companies once the state has subsidized its creation.

• Strict Liability Recapture Provisions: DOTAX must implement a powerful recapture provision. If a Hawaiʻi SMB claims out-of-state QREs based specifically on the IP retention nexus, but subsequently sells, transfers, or permanently licenses the resulting IP to a non-Hawaiʻi entity within a defined period (e.g., five years) without generating corresponding state commercialization revenue, the state must retain the statutory right to recapture the issued tax credits in full, plus significant statutory penalties.
• Deterrence Modeling: Washington State utilizes a highly effective strict liability model for the misuse of reseller tax permits, imposing an automatic 50% penalty on the tax due even if no intentional fraud was committed by the taxpayer.⁵⁶ Applying a similar strict liability penalty for the unauthorized transfer of state-subsidized IP will serve as a massive deterrent against corporate restructuring designed to evade state taxation.

7. Dynamic Cost Analysis and the UHERO Economic Multiplier Effect

A persistent, and highly valid, legislative hesitation regarding the expansion or modernization of any tax credit program is the perceived “cost” to the state treasury. In an era of constrained budgets and looming federal funding cuts, fiscal conservatism is necessary.³ However, evaluating the fiscal impact of an R&D tax credit requires moving beyond rudimentary, static revenue scoring. The state must embrace dynamic economic modeling to understand the true return on investment (ROI).

7.1 Recontextualizing the Initial Cost Outlays

Under the newly proposed framework of HB2546 in the 2026 session, the total aggregate statewide cap for the TCRA is slated to increase to $15 million annually.²⁰ It is vital to understand that implementing the “Infrastructure Gap” waiver does not increase this aggregate statutory cap. The state’s maximum financial exposure remains mathematically locked at $15 million.

Instead of expanding the cost, the proposed policy changes ensure that the available funds are distributed efficiently to the high-growth, high-potential SMBs that most desperately need them to overcome geographical barriers. Under the status quo, the funds are frequently absorbed entirely by entities whose operations simply happen to be 100% localized, regardless of whether those entities possess the highest potential for global scaling. If the state opts to remove the aggregate cap entirely in future legislative sessions to mimic federal unbounded models, the initial outlay will indeed represent a larger direct tax expenditure. However, even in an uncapped scenario, the expenditure acts as an economic catalyst.

7.2 The Mechanics of the UHERO Multiplier Effect

To accurately quantify how this initial tax expenditure pays for itself over time, policymakers must rely on the rigorous input-output economic modeling provided by the University of Hawaiʻi Economic Research Organization (UHERO).

• The Output Multiplier: According to UHERO’s comprehensive economic impact studies, the weighted average economic output multiplier for the Hawaiʻi economy is 1.93.⁵⁷ In macroeconomic terms, this means that every $1.00 of final demand, fiscal support, or incentivized corporate spending injected into the local economy results in $1.93 of total economic activity. This total encompasses the direct effect of the initial dollar, the indirect effects of supply chain purchases, and the induced effects of household spending by the newly compensated workers.⁵⁷
• The Research Spending Premium: Crucially, UHERO data reveals a distinct hierarchy in the quality of economic multipliers. While standard operational or non-research expenditures may have larger immediate, short-term direct impacts, research spending generates significantly larger multiplier effects over the long term.⁵⁹ Every state dollar invested specifically in advanced research generates disproportionately more secondary business sales, downstream earnings, aggregate state tax revenue, and high-quality jobs than standard infrastructure or administrative spending.⁵⁹

7.3 The Long-Term Return on Investment (ROI) Pipeline

When the Department of Taxation allows a Hawaiʻi SMB to claim a $100,000 credit to subsidize a highly specialized, necessary out-of-state aerospace test, the state is not “losing” $100,000 to the mainland economy. Rather, it is providing the critical financial runway that allows that specific SMB to survive the “valley of death” inherent in hardware and biotech development, enabling it to remain headquartered in Honolulu.

This dynamic ROI manifests through a sequential, compounding economic pipeline:

1. Direct High-Wage Employment Retention: By surviving the testing phase, the company retains its localized workforce of software developers, systems engineers, and project managers. The salaries of these individuals—which are typically vastly higher than the state median income—are continuously taxed via the Hawaiʻi state individual income tax, providing immediate, ongoing revenue to the state.
2. Venture Capital Infusion: Successful R&D milestones are the primary prerequisite for institutional investment. A Hawaiʻi company that successfully completes a critical testing phase at a recognized mainland facility is exponentially more likely to secure Series A or Series B venture capital funding. This dynamic draws tens of millions of dollars of out-of-state private equity into the Hawaiʻi banking system, triggering the UHERO 1.93 output multiplier without requiring further state tax subsidies.⁵⁷
3. Commercialization and General Excise Tax (GET): When the out-of-state testing proves successful and the product is finalized, the company commercializes the technology from its Hawaiʻi headquarters. All subsequent global sales, licensing agreements, and gross receipts generated by the company are subject to Hawaiʻi’s General Excise Tax (GET).
4. Organic Secondary Infrastructure Growth: As these SMBs scale into mid-market enterprises or large corporations due to successful commercialization, they generate sufficient internal capital to eventually build the missing infrastructure locally. A successful aerospace firm will eventually construct its own local testing facilities, closing the state’s infrastructure gap organically and permanently, without requiring direct state capital improvement grants.

By employing dynamic economic scoring, it becomes unequivocally clear that the initial tax outlay required to fund out-of-state testing waivers acts as a highly efficient, targeted loss-leader. The future corporate income taxes, GET revenues, and localized payroll taxes generated by a successful, Hawaiʻi-domiciled advanced technology firm will aggressively outpace the initial credit outlay, rendering the modernized TCRA program fully self-sustaining and revenue-positive over a standard five-to-ten-year economic horizon.

8. The Cost of Inaction: Severe Negative Consequences for Hawaiʻi

While the cost of modernizing and expanding the TCRA can be modeled dynamically and justified economically, the cost of legislative inaction is absolute, immediate, and highly detrimental to the long-term viability of the State of Hawaiʻi. Failing to resolve the in-state spend mandate will entrench the state’s structural economic weaknesses and accelerate its decline in the global advanced industries sector.

8.1 The Acceleration of Capital Flight

Advanced technology startups are inherently hyper-mobile. Unlike traditional agriculture or brick-and-mortar retail, intellectual property and software engineering teams can be relocated with minimal friction. If the executive team of a Hawaiʻi-based biomedical or aerospace firm determines that their home state will actively penalize them through the tax code for utilizing necessary, unavoidable mainland testing facilities, their fiduciary duty to their investors will dictate a single course of action: relocation.

The firm will simply move its legal domicile, its intellectual property, and its executive engineering operations to a state with a more sophisticated, accommodating tax environment—such as Massachusetts, Maryland, Texas, or Colorado.⁹ This capital flight is not theoretical; it is the standard operating procedure for startups facing hostile tax environments. When a firm relocates, Hawaiʻi suffers the immediate, permanent loss of all future GET revenues, corporate income taxes, and high-wage payroll taxes associated with that enterprise.

8.2 Exacerbating the “Brain Drain” Phenomenon

The State of Hawaiʻi has historically struggled with a massive “brain drain,” unable to retain its top STEM (Science, Technology, Engineering, and Mathematics) graduates produced by the University of Hawaiʻi system. As explicitly noted in the legislative findings of HB2546, the state has a fleeting opportunity to create careers that allow its young people to build their futures at home.²³

However, if local SMBs are structurally inhibited from scaling their operations because the in-state spend mandate bankrupts them during their advanced testing phases, these companies cannot hire local graduates. Consequently, the state is effectively subsidizing the world-class education of engineers and scientists who immediately leave the islands upon graduation to work for competitors in Silicon Valley, Seattle, or Boston. The failure to reform the TCRA represents a massive, compounding loss on the state’s public educational investments.

8.3 Permanent Stagnation in the Hamilton Index

The Information Technology and Innovation Foundation (ITIF) utilizes the “Hamilton Index” to objectively track and rank state-level economic performance in advanced, globally competitive, tech-driven industries.⁹ The data paints a bleak picture for the state. Currently, Hawaiʻi ranks among the absolute lowest states in the nation, scoring a dismal 0.22 on the index, trailing vastly behind innovation leaders.⁹

The ITIF report explicitly identifies that a primary driver of this severe underperformance is a combination of high operational costs and structural challenges in building tech-driven scale.⁹ By stubbornly refusing to subsidize the out-of-state infrastructural links that are absolutely necessary to connect isolated Hawaiʻi companies to national innovation hubs, the state guarantees that it will remain anchored to the bottom of the Hamilton Index. Inaction ensures that Hawaiʻi will remain perpetually reliant on the highly volatile, low-wage tourism sector, vulnerable to every shift in global trade policy or currency fluctuation.¹

8.4 The Failure of the Aerospace and Defense Corridor

The state government, via DBEDT and HTDC, has aggressively promoted the development of a statewide innovation corridor specifically designed to position Hawaiʻi as a globally competitive hub for next-generation aviation, space technologies, and defense applications.²⁶

However, aerospace and defense are uniquely reliant on highly specialized, heavily regulated, multi-state supply chains and extremely complex testing regimens.²⁶ The current TCRA framework, with its rigid 100% in-state physical mandate, is fundamentally incompatible with the harsh operational realities of modern aerospace R&D. Without the legislative adoption of the policy changes proposed in this report—specifically the Safe Harbor Waiver or a defense-related exemption akin to the Massachusetts model ³⁸—the strategic vision of a robust Hawaiʻi aerospace sector will fail to materialize. This failure will strand millions of dollars in existing economic development efforts and permanently lock Hawaiʻi out of the trillion-dollar global space economy.²⁶

9. Conclusion

The Hawaiʻi Tax Credit for Research Activities (TCRA) represents the most potent statutory tool available to the state for diversifying its economy, moving beyond its dangerous reliance on the hospitality sector, and fostering a resilient ecosystem of high-wage, high-impact technology firms. However, the rigid statutory mandate requiring 100% of qualified research expenses to be physically incurred within the state’s borders represents a catastrophic policy failure. It is a well-intentioned protectionist measure that has resulted in a devastating unintended consequence: the structural, mathematical penalization of Hawaiʻi’s most innovative Small and Medium Businesses.

Hawaiʻi’s profound geographic isolation naturally creates an innovation infrastructure gap. When local SMBs are forced by the laws of physics or federal regulation to bridge this gap by contracting with out-of-state specialized laboratories—whether for BSL-4 pathogen testing, aerospace hypersonic wind-tunnel validation, or advanced semiconductor fabrication—they must be supported by their home state, not punished.

By implementing an “Infrastructure Gap” Safe Harbor Waiver, or by establishing a modernized Intellectual Property Commercialization Nexus, the Hawaiʻi State Legislature can immediately realign the TCRA to reflect the complex realities of 21st-century global R&D supply chains. When supported by rigorous DBEDT market certification processes, robust DOTAX vendor authentication, and strict liability recapture provisions, these solutions will completely mitigate the theoretical risks of fraud, shell companies, and out-of-state wastage.

The initial tax expenditure required to facilitate these modernizations is not a sunk cost, but a highly targeted, high-yield economic investment. Backed by UHERO’s robust input-output economic multiplier data, the modernization of the TCRA will ensure that Hawaiʻi retains its homegrown STEM talent, attracts critical external venture capital, and ultimately builds a resilient, diversified economy capable of withstanding the macroeconomic shocks of the future. The cost of legislative inaction is the continued stagnation of the state’s technology sector and the acceleration of corporate flight; the reward for bold, technical reform is a thriving, globally connected innovation hub in the Pacific.

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