Contract Research Expenses

Contract research expenses represent sixty-five percent of the payments made to third-party consultants or organizations for qualified research activities physically conducted within the state of North Dakota. To qualify for the state’s research and experimental expenditure tax credit, the taxpayer must maintain substantial rights to the resulting intellectual property and bear the primary financial risk associated with the research outcome.

The North Dakota Research and Experimental Expenditure Tax Credit, codified under North Dakota Century Code (N.D.C.C.) § 57-38-30.5, functions as a critical fiscal instrument designed to incentivize high-level technological innovation and economic diversification. By allowing businesses to offset a portion of their state income tax liability based on qualified research expenditures (QREs), the state fosters an environment conducive to long-term capital investment in primary sectors such as agriculture, energy, and advanced manufacturing. The inclusion of contract research expenses within this framework is particularly significant for small to medium-sized enterprises (SMEs) that may lack the internal infrastructure to perform complex laboratory or engineering tasks and must therefore rely on external expertise. However, the administrative and legal requirements for claiming these expenses are more stringent than those for in-house wages, requiring a nuanced understanding of both federal definitions under Internal Revenue Code (I.R.C.) Section 41 and the specific geographical limitations imposed by the North Dakota Office of State Tax Commissioner.

The Legal and Statutory Evolution of N.D.C.C. § 57-38-30.5

The origins of North Dakota’s research credit date back to 1987 with the passage of House Bill No. 1645. At its inception, the credit was perceived by the Legislative Assembly as a tool to stimulate economic development and encourage both new and existing corporations to undertake research and development within the state. The original provision was narrower in scope, providing a corporate income tax credit equal to 8 percent of the first $1.5 million of North Dakota qualified research expenses in excess of base period expenses, and 4 percent for amounts exceeding that threshold. This early structure laid the groundwork for the state’s “piggyback” relationship with federal tax law, a relationship that has become increasingly complex as both the federal and state governments have sought to refine the definitions of innovation.

Throughout the 1990s and early 2000s, the statute underwent several technical corrections and structural modifications. In 1993, Senate Bill Nos. 2222 and 2223 referenced the newly created Limited Liability Company Act, expanding the credit’s applicability beyond traditional C corporations. A more fundamental restructuring occurred during the 2007 legislative session with the passage of House Bill Nos. 1412 and 1018. This legislation expanded the availability of the research expense tax credit to passthrough entities and established a clear distinction for taxpayers beginning research in North Dakota after December 31, 2006. For these “modern” claimants, the legislature removed the annual $2 million cap that continues to apply to taxpayers who first earned the credit before 2007.

In 2009, House Bill No. 2207 added a vital safeguard to the section, ensuring that North Dakota’s references to federal definitions would remain effective even if the federal research tax credit were temporarily discontinued or significantly altered. This decoupling mechanism allows the state to maintain a stable incentive environment regardless of federal legislative volatility. Most recently, the 2019 introduction of the Alternative Simplified Computation (ASC) method further aligned North Dakota with modern federal tax reporting practices, providing taxpayers with more flexibility in how they benchmark their incremental research growth.

Qualifying Contract Research Under the Federal-State Nexus

North Dakota’s tax code defines “qualified research” and “qualified research expenses” by direct reference to I.R.C. § 41(d) and § 41(b), respectively. This adoption means that to be eligible for the North Dakota credit, a contract research expense must first satisfy the federal “Four-Part Test.” This test ensures that the activities being funded are truly innovative and not merely routine engineering or cosmetic improvements.

The Four-Part Test Applied to Contractors

When a North Dakota taxpayer engages a contractor, the taxpayer must ensure that the contractor’s activities meet the following criteria:

1. Permitted Purpose: The research must be intended to create a new or improved “business component” in terms of functionality, performance, reliability, or quality. In the context of contract research, this often involves the taxpayer hiring an external laboratory to develop a more efficient chemical process or an engineering firm to design a specialized prototype.
2. Elimination of Uncertainty: The research must be intended to discover information that would eliminate uncertainty concerning the capability, method, or design for developing or improving the business component. If the contractor is merely applying known solutions to a problem, the expense does not qualify.
3. Process of Experimentation: Substantially all (at least 80 percent) of the contractor’s activities must involve a process of experimentation, which typically includes the evaluation of alternatives through modeling, simulation, or systematic trial and error.
4. Technological in Nature: The research must fundamentally rely on principles of physical or biological science, engineering, or computer science.

The integration of these federal standards into North Dakota law means that the taxpayer cannot simply claim all payments to a “research firm.” The taxpayer must maintain documentation—such as technical reports or meeting minutes—proving that the contractor’s personnel were actively engaged in resolving technical uncertainties using hard sciences.

The 65%, 75%, and 100% Inclusion Rates

The North Dakota credit identifies three distinct tiers of inclusion for contract research expenses, reflecting federal statutory haircuts designed to remove the contractor’s profit margin and overhead from the credit base.

Contractor Category	North Dakota Inclusion Rate	Statutory Reference
General Third-Party Contractor	65%	I.R.C. § 41(b)(3)(A)
Qualified Research Consortium	75%	I.R.C. § 41(b)(3)(C)
Energy Research (Small Biz/Uni/Lab)	100%	I.R.C. § 41(b)(3)(D)

The standard 65 percent rate applies to most commercial contracts. However, North Dakota’s significant investment in energy innovation makes the 100 percent inclusion rate particularly relevant. If a North Dakota company pays a qualifying university—such as the Energy & Environmental Research Center (EERC) at the University of North Dakota—for energy-related research, the state allows the full 100 percent of those payments to be included in the QRE calculation, provided the research is conducted in North Dakota.

The “North Dakota Only” Mandate and Contractor Sourcing

The most critical departure from federal law is found in N.D.C.C. § 57-38-30.5(5)(d), which states that “qualified research” does not include research conducted outside the state of North Dakota. For contract research expenses, this imposes a geographic “nexus” requirement that can be difficult to manage in an era of remote work and interstate consultancy.

Proving Physical Presence

To claim the North Dakota credit, the taxpayer must demonstrate that the contractor’s employees were physically present in North Dakota while performing the research services. If a North Dakota company hires a Minnesota-based engineering firm to design a new piece of agricultural machinery, the fees paid for work performed at the firm’s St. Paul office are ineligible for the North Dakota credit, even though they might qualify for the federal credit. Conversely, if that same firm sends engineers to a farm in Grand Forks to conduct field trials and collect data, the portion of the contract fees attributable to that Grand Forks site work is eligible.

Sourcing Strategies and Documentation

The North Dakota Office of State Tax Commissioner expects taxpayers to “segment” their contract research payments based on location. Professional guidance for North Dakota businesses typically recommends including a “location of performance” clause in all R&D-related contracts. This clause requires the contractor to provide detailed time logs or “activity certificates” that specify where each hour of research was performed. Without this evidence, the state may disqualify the entire contract during an audit, as the burden of proof rests solely with the taxpayer.

Strategic Contractual Considerations: Risk and Rights

Beyond the technical and geographical tests, contract research expenses must survive the “Funded Research” analysis. Under I.R.C. § 41, research is considered “funded” (and thus ineligible for the credit) if the researcher (contractor) is paid regardless of success or if the taxpayer does not retain rights to the results.

The Economic Risk Test

The North Dakota Tax Commissioner follows the federal standard requiring the taxpayer to bear the financial risk of failure. In a qualified contract research arrangement, the taxpayer must pay the contractor for the work performed even if the research does not yield a usable product or patent. If the contract is structured as a “pay-upon-success” or “contingent fee” arrangement, the contractor is deemed to be bearing the risk, and the taxpayer cannot claim the credit.

The Substantial Rights Test

To claim the credit, the taxpayer must retain “substantial rights” to the research results. While these rights do not have to be exclusive—the contractor can retain the right to use the underlying science—the taxpayer must have a legal right to use the research in its own business without paying an additional royalty to the contractor. This requirement is often a point of contention in university research contracts, where institutions may attempt to retain all IP rights. North Dakota businesses must ensure that their agreements with entities like the North Dakota University System clearly grant the business the right to use the research outcomes for commercial purposes.

Calculation Methodologies: Regular vs. Alternative Simplified Computation

The North Dakota credit is an “incremental” credit, meaning it is designed to reward companies for increasing their research spending relative to a historical baseline. Taxpayers must choose between two calculation methods, each of which handles contract research expenses differently within the base-period benchmarking.

The Regular Method

The Regular Method is the default calculation and is particularly beneficial for established companies with relatively stable research budgets. Under this method, the credit is based on the amount of qualified research expenses incurred in North Dakota that exceed the “North Dakota base amount.”

The state applies a tiered percentage to this excess:

• Tier 1: 25 percent of the first $100,000 of excess QREs.
• Tier 2: 8 percent of any excess QREs over $100,000.

The “base amount” is calculated using a “fixed-base percentage” of the taxpayer’s average gross receipts for the prior four years. Crucially, the North Dakota base amount cannot be less than 50 percent of the current year’s qualified research expenses. This 50 percent floor acts as a limiter, ensuring that even companies with zero historical spending cannot claim the full 25 percent credit on their entire research budget; they can only claim it on the half that is considered “incremental.”

The Alternative Simplified Computation (ASC) Method

For tax years beginning after 2018, North Dakota introduced the ASC method, which eliminates the need for historical gross receipts and complex fixed-base percentage calculations. The ASC method is often preferred by startups or rapidly growing companies whose revenue is increasing faster than their R&D spending.

Under the ASC method, the credit is equal to:

• Tier 1: 17.5 percent of the first $100,000 of “alternative excess research and development.”
• Tier 2: 5.6 percent of alternative excess over $100,000.

“Alternative excess research and development” is the amount by which current North Dakota QREs exceed 50 percent of the average North Dakota QREs for the three preceding tax years. If the taxpayer had zero research spending in any of those three years, the credit rate is adjusted to 7.5 percent of the first $100,000 of total QREs and 2.4 percent of the remainder.

Method	Benchmark Basis	Tier 1 Rate	Tier 2 Rate
Regular	4-Year Gross Receipts	25.0%	8.0%
ASC	3-Year Average QREs	17.5%	5.6%

Taxpayers are permitted to elect the ASC method regardless of whether they use it for their federal return. This election is made annually and is binding for the specific tax year.

Transferability and the Primary Sector Business Advantage

One of the most distinctive features of North Dakota’s R&D tax credit is the provision allowing certain small businesses to sell or transfer their unused credits. This mechanism is essentially a “cash-back” program for startups that have significant research costs—including heavy contractor payments—but have not yet reached profitability and therefore have no tax liability to offset.

Certification as a Qualified R&D Company

To be eligible to sell credits, a business must meet the strict definition of a “qualified research and development company” as certified by the North Dakota Department of Commerce. The requirements include:

1. Primary Sector Certification: The business must be certified as a primary sector business, meaning it adds value to a product, process, or service that produces new wealth in the state (e.g., manufacturing or energy production).
2. Revenue Threshold: The company must have annual gross revenues of less than $750,000.
3. New Research: The company must have begun its research and development in North Dakota for the first time after December 31, 2006.

The $100,000 Transfer Limit

A qualified company may sell, transfer, or assign up to $100,000 of its unused credits over any combination of taxable years. The original purchaser of the credit may not further sell or assign it. For the transfer to be valid, both the seller (transferor) and the buyer (transferee) must jointly file Form CTS—Credit Transfer Statement—with the Office of State Tax Commissioner within 30 days after the purchase agreement is fully executed.

Furthermore, the transferor must report the gross proceeds from the sale of the credit as North Dakota income on their Form 40 (Corporate) or ND-1 (Individual) return. This ensures that the state recovers a portion of the value through income tax while still providing the startup with immediate liquidity.

Practical Application: Comprehensive Example and Calculation

To illustrate the interplay between contract research expenses and the North Dakota credit, we can examine a hypothetical scenario involving “Dakota Bio-Tech,” a manufacturing startup based in Minot.

Scenario: Dakota Bio-Tech’s 2024 Research Activity

In 2024, Dakota Bio-Tech engaged in three primary projects to improve its enzyme production process. The company has $500,000 in gross revenues and is certified as a primary sector business. Its expenses for the year were as follows:

1. In-House Wages: $200,000 paid to lab technicians in Minot.
2. Contract Research (University): $100,000 paid to NDSU for energy-related enzyme studies performed in Fargo.
3. Contract Research (Commercial): $50,000 paid to a consulting firm in Minot for mechanical engineering.
4. Contract Research (Out-of-State): $40,000 paid to a California firm for software development performed in San Diego.

Step 1: Segregate Qualified Research Expenses (QREs)

The company must first filter these expenses through the North Dakota nexus and inclusion rate rules.

Expense Category	Total Paid	ND Qualification Rule	ND QRE Amount
In-House Wages	$200,000	100% (All in ND)	$200,000
NDSU (University)	$100,000	100% (Energy/Uni in ND)	$100,000
Minot Consultant	$50,000	65% (Commercial in ND)	$32,500
CA Software Firm	$40,000	0% (Performed Outside ND)	$0
Total ND QREs	$390,000		$332,500

Step 2: Determine the Benchmark (Base Amount)

Assume Dakota Bio-Tech has zero previous research spending. Under the Regular Method, its base amount would be 50 percent of its current QREs.

• Base Amount: $332,500 × 0.50 = $166,250
• Excess QREs: $332,500 – 166,250 = $166,250

Step 3: Calculate the Credit

Using the Regular Method’s tiered rates:

• Tier 1 Credit: $0.25 × $100,000 = $25,000
• Tier 2 Credit: $0.08 × ($166,250 – $100,000) = 0.08 × $66,250 = $5,300
• Total 2024 Credit: $25,000 + $5,300 = $30,300

Because Dakota Bio-Tech is a primary sector business with under $750,000 in revenue, it can apply to the Department of Commerce to sell this $30,300 credit to another North Dakota taxpayer for cash, providing immediate funding for its 2025 research goals.

Local State Revenue Office Guidance and Reporting Compliance

The North Dakota Office of State Tax Commissioner provides specific administrative guidelines to ensure that R&D claims are filed correctly. Unlike federal filing, where Form 6765 is a standardized attachment, North Dakota requires taxpayers to attach their own detailed schedules or worksheets.

Form-Specific Instructions

The reporting requirements vary significantly based on the taxpayer’s legal structure:

• Corporations (Form 40): The credit is entered on Schedule TC, line 6. If the corporation is part of a consolidated return, the credit may be used to offset the aggregate tax liability of the entire group.
• Individuals (Form ND-1): The credit is claimed on Schedule ND-1TC.
• Passthrough Entities (Form 58/60): The entity calculates the total credit and reports it on Schedule K. Each partner or shareholder then receives their pro-rata share, which they claim on their own income tax return.

The Property Tax Clearance Prerequisite

One of the most frequently overlooked local requirements is the Property Tax Clearance. Under North Dakota law, a taxpayer must be “in good standing” regarding their property taxes to be eligible for state income tax credits.

When claiming the research credit, the taxpayer must often include a “Property Tax Clearance Record” form. This document must be certified by the treasurer of each county where the business (or any owner of at least a 50 percent interest) owns real property. This requirement links income tax incentives to local property tax compliance, creating a cross-departmental administrative hurdle that businesses must clear annually.

Carryover Provisions and Long-Term Credit Management

For companies that cannot immediately utilize or transfer their research credits, North Dakota provides robust carryback and carryforward rules. These rules are designed to accommodate the long-tail nature of R&D investments, where the costs are incurred years before the resulting products generate significant tax liability.

Three-Year Carryback

Any research credit that exceeds the current year’s tax liability must first be carried back to each of the three preceding taxable years. To claim a carryback refund, the taxpayer must file a claim within three years of the due date (including extensions) for the return of the year in which the credit was earned.

Fifteen-Year Carryforward

Unused credits that remain after the carryback period may be carried forward for up to 15 succeeding taxable years. For a taxpayer beginning research in 2024, any unused credits generated this year could potentially offset North Dakota income tax as late as 2039. This 15-year window is particularly valuable for companies in the energy and biotech sectors, where the regulatory approval process can extend for a decade or more.

Contemporary Challenges: Federal Conformity and the Impact of Section 174

A significant development for North Dakota businesses is the recent change to the federal treatment of R&D expenses under the Tax Cuts and Jobs Act (TCJA). Effective for tax years beginning after December 31, 2021, I.R.C. § 174 now requires that research and experimental (R&E) expenditures—including contract research—be capitalized and amortized over five years for domestic research (15 years for foreign).

State-Level Conformity and “Phantom” Income

Because North Dakota uses federal taxable income as its starting point, the state generally conforms to the Section 174 capitalization requirement. This means that while a business can still claim the North Dakota R&D credit based on its 2024 spending, it can no longer deduct the full amount of those expenses on its North Dakota return in the same year. Instead, it must amortize them, which can lead to higher-than-expected taxable income in the short term.

The Role of Section 280C

Historically, taxpayers claiming the federal research credit were required to reduce their R&D expense deduction by the amount of the credit under I.R.C. § 280C. North Dakota’s guidance on whether it conforms to federal 280C “add-backs” is critical for accurate modeling. If the state conforms, the business may have to add the value of its federal R&D credit back to its North Dakota taxable income, further increasing the effective tax rate.

Statistical Context: The Macroeconomic Impact in North Dakota

The North Dakota research credit is part of a broader “tax expenditure” portfolio aimed at maintaining the state’s competitive position. While the state does not release a line-item annual total for the R&D credit in real-time, historical data and related programs highlight its importance.

Economic Indicators and Incentives

The state’s economic health is a primary driver of incentive policy. For instance, the 2023-2025 Biennial Report notes that North Dakota’s taxable sales and purchases totaled approximately $7.22 billion in the third quarter of 2025. In this context, the R&D credit acts as a stabilization tool, encouraging companies to maintain investment during periods of commodity price volatility in the oil and agriculture markets.

Furthermore, the state’s commitment to primary sector businesses—those eligible for the $100,000 credit transfer—is reflected in the $3.5 million annual aggregate cap for the related Seed Capital Investment Tax Credit. These programs work in tandem to create a life cycle of support for innovation, where the R&D credit rewards the activity of research, and the seed capital credit rewards the investment in the companies performing that research.

Audit Readiness: Best Practices for Substantiating Contract Research

As the North Dakota Office of State Tax Commissioner increases its scrutiny of business credits, “audit-ready substantiation” has become a necessity. For contract research expenses, the documentation must go beyond a simple invoice.

The “Nexus File” Checklist

A robust defense for a contract research claim should include the following for every major vendor:

1. Fully Executed Master Service Agreement (MSA): Including specific language on intellectual property rights and financial risk.
2. Statement of Work (SOW): Detailing the specific technological uncertainties the contractor was hired to resolve.
3. Contemporaneous Project Records: Such as white papers, testing logs, or software commit histories provided by the contractor.
4. Vendor Location Certification: A signed statement from the vendor confirming the physical location (address and city) where the services were performed.
5. Payment Verification: Cancelled checks or wire transfer confirmations matching the invoices claimed.

Final Thoughts

The North Dakota Research and Experimental Expenditure Tax Credit provides a powerful, if administratively complex, incentive for businesses to integrate external research expertise into their innovation strategies. By leveraging contract research expenses, North Dakota companies can access specialized knowledge while benefiting from one of the most generous Tier 1 credit rates in the nation. However, the unique “North Dakota Only” geographic restriction, the requirement for Property Tax Clearance, and the stringent tests for economic risk and substantial rights necessitate a proactive and highly documented approach to tax planning. As the state continues to refine its primary sector focus, the ability for small businesses to monetize their research through credit transfers remains a cornerstone of the North Dakota innovation economy, providing essential support for the next generation of technological breakthroughs in agriculture and energy.