Comprehensive Analysis of Computer Usage Expenses within the Minnesota Credit for Increasing Research Activities

In the context of the Minnesota research and development tax credit, the use of computers refers to payments made to third parties for the right to utilize off-site server capacity or cloud infrastructure for qualified research, excluding any hardware owned or depreciated by the taxpayer. This statutory category captures the operational costs of high-performance computing, cloud-based simulations, and legacy time-sharing arrangements essential for modern technological experimentation.1

The evolution of the “Use of Computers” provision reflects a broader shift in the industrial landscape from physical laboratories to digital environments. When the Credit for Increasing Research Activities was first established by the 1981 Minnesota Legislature, it was patterned after the federal credit under Section 41 of the Internal Revenue Code (IRC) to incentivize high-technology investment and the creation of STEM-related jobs within the state.3 In that era, the high cost of mainframe computers necessitated a provision that allowed small and mid-sized firms to include the rental of computer time as a qualified research expense (QRE). Today, this same provision provides the legal basis for claiming cloud computing costs, which have become the backbone of innovation in sectors ranging from medical device manufacturing to artificial intelligence development.1

Statutory and Regulatory Foundations of the Minnesota Credit

The Minnesota research credit is primarily governed by Minnesota Statutes Section 290.068. The legislative intent behind this credit is to create or retain high-paying jobs, increase the overall volume of research activity in the state, and attract or retain innovative businesses.4 To achieve these goals, the state provides an incremental tax benefit that targets spending above a historically determined “base amount,” ensuring that the credit rewards growth rather than static business operations.3

Incorporation of the Internal Revenue Code

A cornerstone of the Minnesota credit is its heavy reliance on federal definitions. Specifically, Minnesota Statutes Section 290.068, subdivision 2, defines “qualified research expenses” by direct reference to IRC Section 41(b) and (e).8 This means that the categories of eligible expenses—wages, supplies, contractor costs, and the right to use computers—are interpreted according to federal Treasury Regulations, provided the research itself is conducted within Minnesota.2

The “Use of Computers” category is explicitly mentioned in IRC Section 41(b)(2)(A)(iii) as “any amount paid or incurred to another person for the right to use computers in the conduct of qualified research”.1 This federal language is adopted in full by the Minnesota Department of Revenue, creating a pathway for businesses to monetize their digital infrastructure costs.2

The Tiered Rate Structure

Minnesota employs a tiered credit rate that offers a higher percentage for the initial portion of research spending, which disproportionately benefits smaller and emerging companies while providing a lower constant rate for large-scale industrial projects.9 For taxable years beginning after December 31, 2016, the credit calculation follows the parameters outlined in the table below.

This structure is designed to maximize the economic efficiency of the tax expenditure by providing a robust incentive for the first $2 million of incremental investment.9 The calculation requires a taxpayer to first determine their “base amount,” which is a percentage of their Minnesota gross receipts from the prior four years.3 The credit is then applied to the amount by which current-year Minnesota QREs exceed that base.8

Detailed Analysis of “Use of Computers” in the Digital Age

The phrase “right to use computers” serves as a bridge between legacy operational models and the current paradigm of cloud computing. To distinguish these costs from ordinary business expenses or ineligible capital investments, the Minnesota Department of Revenue and the IRS apply strict criteria found in Treasury Regulation Section 1.41-2(b)(4).1

The Off-Premises and Ownership Requirements

The fundamental requirement for an expense to fall under the “Use of Computers” category is that the computers must not be owned or operated by the taxpayer.1 If a business in St. Paul purchases a server farm to conduct pharmaceutical modeling, the purchase price and maintenance costs are generally treated as capital equipment. Such equipment is subject to depreciation and is expressly excluded from the definition of QREs under both state and federal law.2

Conversely, if that same business pays a third-party data center to host their modeling software, those payments qualify as “Use of Computers” expenses.1 The regulations specify that the computer processing must be located off the taxpayer’s premises and the taxpayer must not be the “primary user” of the hardware.1 This standard is typically met in shared hosting environments where resources are dynamically allocated by a provider.

Cloud Computing: Standard vs. Private Infrastructure

The rise of cloud computing has made this provision more relevant than ever. For tax purposes, cloud services are generally classified into three models, each with varying degrees of complexity regarding credit eligibility.1

• Infrastructure as a Service (IaaS): This model, involving the rental of processing, storage, and networking, has the strongest case for QRE treatment. Because the servers are owned by a provider (e.g., AWS or Azure), located off-site, and the taxpayer’s workload is dynamically routed across shared hardware, the taxpayer is rarely the “primary user” of any specific server.1
• Platform as a Service (PaaS): These expenses also typically qualify, as they represent the use of a third-party environment to develop and test new software components. The key is ensuring the platform usage is tied directly to a qualified research project.1
• Software as a Service (SaaS): Standard SaaS costs, such as monthly subscriptions for office productivity tools, generally do not qualify because they are used for general administrative functions rather than the conduct of research.1 However, if a specialized SaaS tool is used specifically for simulation or as a research tool, the portion of the cost attributable to that research may be defensible.1

The analysis of “primary user” often hinges on whether the taxpayer consumes more than 50% of the hardware’s useful life or capacity.1 In standard public cloud environments, this is virtually never the case. In private cloud environments, where a taxpayer has dedicated hardware within a third-party data center, the arrangement must be more carefully scrutinized to ensure it does not function as a disguised lease of tangible property, which would disqualify the expense from the R&D credit.1

Computer Usage vs. Supply Costs

An emerging strategy for taxpayers involves the classification of cloud costs as “supplies” rather than “use of computers” in specific scenarios.1 If a company uses cloud infrastructure to run a “pilot model”—for example, a prototype software platform or a virtual representation of a physical product—some advisors suggest these costs can be treated as supply costs incurred in the conduct of research.1

The benefit of this classification is that it may bypass some of the narrow “primary user” restrictions associated with computer rentals.1 However, the Minnesota Department of Revenue requires clear technical documentation to support such a position, demonstrating that the cloud usage was a consumed component of the experimental process.2

The Four-Part Test as Applied to Computer-Based Research

For any computer-related expense to be included in the Minnesota R&D credit, the underlying project must satisfy the standard “Four-Part Test” mandated by IRC Section 41(d).2 This is particularly challenging in the digital domain, where the line between routine engineering and innovative research is often thin.

1. Permitted Purpose (The Business Component Test)

The research must be intended to develop a new or improved business component, which includes products, processes, and computer software.2 The focus must be on enhancing function, performance, reliability, or quality.2 In the context of computer usage, this often involves the development of new algorithms, the improvement of data processing speeds, or the creation of more reliable software architectures.17 Aesthetic improvements or the simple adaptation of existing systems do not qualify.2

2. Elimination of Uncertainty

The taxpayer must face technical uncertainty at the outset of the project regarding the capability or method for developing the component, or the appropriateness of the design.2 For computer-intensive projects, this uncertainty must be technical rather than economic. For example, uncertainty about whether a specific machine learning model can reach 98% precision is a technical unknown, whereas uncertainty about whether customers will buy the software is a business unknown.19

3. Process of Experimentation

The activity must involve a systematic process to evaluate one or more alternatives to resolve the uncertainty.2 This is where the “Use of Computers” becomes most evident. Using off-site compute power to run thousands of iterations of a design, conducting Finite Element Analysis (FEA), or using Computational Fluid Dynamics (CFD) are all examples of an experimental process that utilizes computers to test hypotheses.1

4. Technological in Nature

The research must fundamentally rely on the principles of computer science, engineering, or physical/biological sciences.2 Projects that rely on social sciences, market research, or management efficiency studies are expressly excluded from the Minnesota credit.2

Internal Use Software and connectivity Considerations

Software developed by a company primarily for its own internal operations (Internal Use Software or IUS) faces an even higher barrier to entry.6 The Minnesota Department of Revenue, mirroring federal policy, generally excludes IUS unless it satisfies a “High Threshold of Innovation” (HTI) test.2

Identifying Internal Use Software

Software is considered IUS if it supports general and administrative functions of the business, such as financial management, human resources, or data processing support services.15 Examples include customized Enterprise Resource Planning (ERP) systems or payroll management platforms.15

However, software is not treated as IUS if it is 6:

• Developed to be commercially sold, leased, or licensed to third parties.
• Developed for use in an otherwise qualified research activity (e.g., software that controls a laboratory test).
• Part of an integrated hardware-software package developed as a single product (e.g., the operating software for a medical imaging device).

The Three-Prong High Threshold of Innovation Test

If the software is classified as IUS, it must pass the following three tests in addition to the standard four-part test to qualify for the Minnesota credit 16:

1. Innovation: The software must be significantly different from other existing methods and result in a measurable cost or time benefit.
2. Economic Risk: The taxpayer must commit substantial resources and face technical risk, meaning there is significant uncertainty that the project can be completed within a reasonable timeframe.
3. Commercial Availability: Comparable software must not be available for purchase or lease in the commercial market in a form that could be used for the taxpayer’s purposes without substantial modification.

Dual-Function Software and the Safe Harbor

Modern business environments often feature “dual-function” software that serves both internal administrative needs and external customer-facing needs (e.g., a banking app that allows customers to pay bills while also managing the bank’s internal ledger).6 Under federal and state rules, if the internal and external functions are interwoven and cannot be easily separated, a safe harbor allows 25% of the development costs to be treated as non-internal use and thus eligible under the standard four-part test.15

Local State Revenue Office Guidance and Compliance

The Minnesota Department of Revenue (DOR) provides specific guidance on the documentation required to substantiate claims for computer-related research expenses. During a review or audit, the state’s examiners will look beyond simple accounting ledgers to determine if the expenses were truly incurred in the pursuit of qualified innovation.2

Specific Documentation for Computer Usage

To validate “amounts paid or incurred for the right to use computers,” the DOR specifies that taxpayers should maintain two primary sets of records generated at the time the research was performed 2:

1. Lease and Rental Agreements: The actual legal contract with the third-party computer provider. This document establishes that the computers were owned and operated by someone other than the taxpayer and located off-site.2
2. Description of Purpose: A narrative or technical log explaining exactly how the compute power was utilized in the research process. This should link specific cloud instances or server time to specific research projects identified in the company’s R&D study.1

General Record-Keeping Best Practices

Because the R&D credit is one of the most frequently audited items in the Minnesota tax code, businesses are advised to maintain a contemporaneous “R&D Study” for each tax year.2 The DOR expects documentation to include 2:

• Project Authorization Records: Documents showing when and why a research project was initiated.
• Procedural Manuals and Checklists: Records of the experimental methods used.
• Lab Schedules and Reports: Evidence of the testing performed, including iterative failures and refinements.
• Employee Time Records: Detailed logs showing the name, location, and specific activities of each individual involved in research.2

Solely interviewing employees after the tax year has ended to “reconstruct” their activities is generally considered insufficient and can lead to the disallowance of the entire credit.2

The 2025 Pivot: Transition to Partial Refundability

One of the most consequential changes to the Minnesota research credit was signed into law by Governor Tim Walz in June 2025 through House File 9.10 For decades, the credit was nonrefundable, meaning it could only be used to reduce a taxpayer’s corporate franchise or individual income tax liability.3 While a temporary refundability window existed from 2010 to 2012, the credit reverted to a nonrefundable carryforward model in 2013.11

The New Refundability Mechanism

Effective for taxable years beginning after December 31, 2024, taxpayers with credits that exceed their tax liability can now elect to receive a portion of the excess as an immediate cash refund.2 This shift is particularly vital for the technology sector, as many startups incur significant computer-usage and wage expenses before they generate a taxable profit.18

The amount of the refund is determined by a specific “refundability rate” applied to the excess credit remaining after the tax liability has been reduced to zero.10

Beginning in 2028, the Commissioner of Revenue will annually calculate the rate to ensure that the total amount of refunds paid does not exceed $25 million per year, based on November revenue forecasts.8 This budget cap ensures the long-term fiscal stability of the program while providing a reliable liquidity mechanism for innovative firms.

Election and Carryforward Rules

The election to receive a refund is irrevocable once made and must be filed with the taxpayer’s original return (including extensions) on Schedule RD.9 Any portion of the credit that is not refunded or used against current-year liability can be carried forward for up to 15 years.2 For S corporations and partnerships, the election is made at the level of the individual partners or shareholders.2

Statistical Insights and Fiscal Impact

The Minnesota Credit for Increasing Research Activities represents a major component of the state’s economic development strategy. Statistics from the Minnesota Department of Revenue’s Tax Expenditure Budget reveal the significant and growing cost of the incentive, as well as its concentration in specific sectors.3

Fiscal Expenditure Data

The total value of credits claimed has increased sharply in recent years, driven by the expansion of the technology and manufacturing hubs in the Twin Cities and Rochester.3

The substantial jump in the 2024 estimates reflects the growth in corporate franchise tax liability and the increasing intensity of investment in R&D.3 Despite this investment, the Office of the Legislative Auditor (OLA) has noted that the largest 20% of C corporation claimants (measured by national sales) receive roughly two-thirds of the total tax credit benefits.4

Sectoral Distribution

The manufacturing industry remains the dominant beneficiary of the Minnesota credit, accounting for approximately 65% of all credits claimed by C corporations.4 However, the professional and technical services sector—which includes software development and computer systems design—has seen the fastest growth, particularly as the “Use of Computers” provision enables these firms to capture a larger share of their operational overhead as QREs.17

Example: Practical Application to a Minnesota Biotech Firm

To demonstrate the application of the “Use of Computers” meaning and the corresponding law, consider a hypothetical biotechnology company, “Gopher Genomics,” headquartered in Rochester, Minnesota.

The Research Objective

In 2025, Gopher Genomics initiates a project to develop an automated protein-folding prediction system (a business component) aimed at accelerating drug discovery for rare neurological disorders. The project meets the technical uncertainty requirement because existing models cannot predict certain complex protein interactions with the necessary precision.2

Operational Expenses

Gopher Genomics utilizes a variety of resources to conduct this research, all of which are performed within Minnesota:

1. Wages: $2,500,000 for a team of bioinformatics scientists and computational engineers.9
2. Supplies: $400,000 for laboratory chemical reagents and high-capacity storage drives consumed during the process.2
3. Use of Computers: The company lacks an on-site supercomputer, so it pays $800,000 to an off-site cloud provider for the right to use their high-performance GPU instances specifically for protein modeling.1
4. Contract Research: $500,000 paid to the University of Minnesota for specialized data analysis (65% or $325,000 qualifies).9

Total 2025 Minnesota QREs: $2,500,000 + $400,000 + $800,000 + $325,000 = $4,025,000.

The Credit Calculation

Assume Gopher Genomics has a computed Minnesota base amount of $1,500,000.9

• Step 1: Determine Excess QREs.
  $4,025,000 (\text{Current QREs}) – 1,500,000 (\text{Base Amount}) = 2,525,000 (\text{Excess QREs})$.
• Step 2: Apply Tiered Rates.
  $0.10 \times 2,000,000 = 200,000$ (First Tier).
  $0.04 \times 525,000 = 21,000$ (Second Tier).
  Total R&D Credit: $221,000$.

The Refundability Election

For the 2025 tax year, Gopher Genomics has a Minnesota tax liability of $50,000.10

• The credit first reduces the tax liability to $0.
• Remaining Excess Credit: $221,000 – 50,000 = 171,000$.
• The company elects the partial refund at the 2025 rate of 19.2%.10
• Cash Refund: $171,000 \times 0.192 = 32,832$.
• Unused Carryforward: $171,000 – 32,832 = 138,168$, which can be used to offset taxes over the next 15 years.8

Lessons from Case Law and Regulatory Challenges

The interpretation of the Minnesota research credit has been significantly shaped by several high-profile legal challenges in the Minnesota Tax Court and the State Supreme Court.

The Minimum Base Amount Dispute

In the consolidated cases of IBM v. Commissioner of Revenue and General Mills, Inc. v. Commissioner of Revenue (2019), the Minnesota Supreme Court addressed a fundamental ambiguity in the credit’s calculation.32 The central issue was whether the Minnesota statute incorporated the federal “minimum base amount” limitation found in IRC Section 41(c)(2), which mandates that the base amount cannot be less than 50% of the current-year QREs.9

The court ruled in favor of the Department of Revenue, holding that the state’s reference to the federal definition of “base amount” included this 50% floor.32 This ruling prevents taxpayers from claiming disproportionately large credits during years of massive spending spikes if their historical base is very low.

Documentation Failures in Phoenix Design Group

While a federal case, Phoenix Design Group, Inc. v. Commissioner (2024), provides a stark warning to Minnesota businesses.20 The U.S. Tax Court disallowed millions in credits and imposed 20% accuracy-related penalties because the taxpayer failed to provide contemporaneous, activity-level documentation.20

The court held that performing “routine calculations on available data” does not constitute a process of experimentation.20 For the “Use of Computers” category, this reinforces that simple invoices from a cloud provider are insufficient; a company must prove that the computer time was used for hypothesis testing and the evaluation of alternatives, rather than just routine data storage or standard business processing.1

Evolving Issues in Digital Sourcing and Nexus

As computer usage becomes increasingly decentralized, the question of where a “Use of Computers” expense is actually incurred has become a point of regulatory focus.

Sourcing of Digital Products

The Minnesota DOR has issued updated guidance on the sourcing of digital products and services, which impacts how cloud-based R&D costs are apportioned.35 Generally, the sale or purchase of a digital product occurs at, or is sourced to, the purchaser’s address the seller has on file.35 For R&D purposes, this means that even if the physical server is located in an AWS data center in Virginia, if the Minnesota-based business “uses” that server time from their office in Bloomington, it counts as a Minnesota-based expense.14

The Attributional Nexus Theory

The state has also developed theories of “attributional nexus,” allowing it to tax out-of-state entities that perform activities in support of a Minnesota taxpayer’s operations.36 While this primarily affects sales and use tax, it provides the legal framework for how the DOR views interstate technology agreements. Taxpayers claiming the R&D credit must ensure that their “Use of Computers” documentation clearly establishes the link between the out-of-state resources and the Minnesota-based innovation effort.14

Future Outlook and Strategic Recommendations

The 2025 legislative reforms, combined with the accelerating pace of digital transformation, suggest that the Minnesota Credit for Increasing Research Activities will remain a focal point of state tax policy.

Impact of the Infrastructure Investment and Jobs Act

The monumental $65 billion federal investment in broadband infrastructure through the Infrastructure Investment and Jobs Act (IIJA) is expected to significantly enhance connectivity in Minnesota, particularly in rural and underserved areas.39 Improved high-speed access will likely drive an increase in computer-based research activity among Greater Minnesota businesses, expanding the volume of “Use of Computers” claims in future tax years.39

Recommendations for Minnesota Businesses

Given the rigorous audit environment and the new complexities of refundability, businesses should consider the following strategic actions:

• Establish a Formal R&D Study: Move beyond year-end accounting reconciliations. Implement a system that captures technical project milestones, uncertainty statements, and experimental logs as they happen.2
• Audit Cloud Contracts: Review AWS, Azure, or private cloud agreements to ensure they clearly separate qualified computing time from general storage or SaaS fees.1
• Coordinate with Engineering and IT: Tax teams must work closely with technical subject matter experts to “map” cloud spend to specific business components.1
• Evaluate the Refundability Election Early: With the 2025 tax season approaching, firms should model their cash flow needs to determine if the 19.2% immediate refund is more valuable than a 100% carryforward to be used against future profits.10

Conclusion

The “Use of Computers” provision in the Minnesota research and development tax credit framework is a powerful but nuanced tool for modern innovative firms. By allowing businesses to claim the costs of third-party server capacity and cloud infrastructure, the state acknowledges the reality of 21st-century experimentation, where the digital laboratory is as essential as the physical one. However, the path to successfully claiming these credits is paved with rigorous documentation requirements and a demanding “high threshold of innovation” for internal systems.

The transition to partial refundability in 2025 represents a landmark shift in Minnesota’s economic policy, effectively turning the R&D credit into a liquidity instrument for the state’s burgeoning startup community. To fully realize this benefit, Minnesota businesses must adopt sophisticated compliance strategies that link every dollar spent on computer time directly to the resolution of technical uncertainty. As the state continues to manage its $25 million refund target and adjust to a cloud-dominated economy, firms that master the intersection of tax law and digital architecture will be best positioned to lead Minnesota’s next wave of technological advancement.

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