Research and Experimental Expenditure Tax Credit

The Foundational Logic and Evolution of Research Incentives in North Dakota

The statutory framework governing the North Dakota Research and Experimental Expenditure Tax Credit, primarily located within North Dakota Century Code (N.D.C.C.) § 57-38-30.5, represents a multi-decade commitment by the state to foster an ecosystem of technological advancement and economic diversification. To understand the credit in its current form, one must examine the legislative intent that has guided its development since the late 1980s. The North Dakota Legislative Assembly originally enacted the credit via 1987 House Bill No. 1645 with the express goal of encouraging both new and existing corporations to undertake research and development activities. At that time, the credit was viewed as a strategic tool to help stimulate economic development by rewarding companies that invested in the “knowledge economy” rather than traditional extractive or purely service-based models.

Over the years, the structure of the credit has undergone several significant transformations to mirror changes in the federal tax landscape and to better align with the state’s industrial goals. Initially, the credit was relatively modest, 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 research expenses, and 4 percent of any amount exceeding that threshold. However, as the global competition for high-tech investment intensified, the North Dakota Legislative Assembly recognized the need for a more aggressive incentive structure. This realization led to the substantial restructuring during the 2007 legislative session with the passage of House Bill Nos. 1412 and 1018.

These 2007 amendments were pivotal because they expanded the availability of the research expense tax credit beyond traditional C corporations to include passthrough entities. This change acknowledged the shifting preference of modern startups and small businesses toward structures like S corporations, partnerships, and limited liability companies. By allowing these entities to qualify, the state effectively broadened the incentive’s reach to the very types of agile, innovative firms most likely to be conducting cutting-edge research. Furthermore, the 2007 legislation introduced the tiered percentage system that remains a hallmark of the credit today, significantly increasing the reward for the first $100,000 of excess research spending.

The following table illustrates the historical progression of the credit rates for research expenses exceeding $100,000, demonstrating how the state adjusted its incentives in response to shifting economic conditions and legislative priorities.

The Convergence of Federal Definitions and State Application

A critical aspect of the North Dakota Research and Experimental Expenditure Tax Credit is its heavy reliance on federal tax law. The North Dakota Century Code explicitly states that the definitions of “qualified research expenses” and “base amount” for state purposes share the same meaning as provided in Section 41 of the Internal Revenue Code (IRC). This “federalization” of the credit is a deliberate policy choice intended to simplify compliance for taxpayers. By tethering state definitions to federal ones, the North Dakota Office of State Tax Commissioner allows businesses to leverage their existing federal R&D documentation to substantiate their state-level claims.

However, the North Dakota law adds a vital geographic nexus: all research must be conducted within the state of North Dakota, and all qualifying expenses must be North Dakota-sourced. This means that while the nature of the research follows federal guidelines, the location of the research is the deciding factor for state eligibility. Expenses incurred for research conducted outside of North Dakota, even if qualifying for the federal credit, are strictly excluded from the North Dakota calculation.

Understanding Qualified Research Expenses (QREs)

Under IRC § 41(b), which North Dakota adopts, QREs are generally categorized into three primary buckets: wages, supplies, and contract research. In the North Dakota context, each of these must be carefully tracked to ensure they are attributable to activities occurring within the state.

Wages typically represent the largest portion of any R&D claim. For an employee’s wages to qualify, the employee must be directly engaged in qualified research, or be directly supervising or supporting such research. This includes the work of the researchers themselves, but also the lab technicians and even the supervisors who are managing the specific research projects. In North Dakota, these wages must be reported for employees performing their duties within the state’s borders.

Supplies encompass tangible property, other than land or improvements to real property and property subject to the allowance for depreciation, which is used in the conduct of qualified research. This might include chemicals used in a laboratory, materials consumed in the creation of a prototype, or the energy costs directly associated with running specialized research equipment.

Contract research expenses represent amounts paid to third parties to perform qualified research on behalf of the taxpayer. Under federal rules adopted by North Dakota, only 65 percent of these payments are typically includable as QREs. For North Dakota purposes, the taxpayer must demonstrate that the third-party research was actually performed within the state.

The Four-Part Test: The Qualitative Gateway to Innovation

Simply spending money on “research” is insufficient to qualify for the tax credit. The North Dakota Tax Commissioner, following federal guidance, applies a rigorous qualitative analysis known as the “Four-Part Test” to determine if a business activity constitutes “qualified research” under IRC § 41(d).

The first requirement is the Permissible Purpose Requirement. The research must be intended to discover information that is technological in nature and intended for use in developing a new or improved “business component” of the taxpayer. A business component can be a product, process, computer software, technique, formula, or invention. In North Dakota, this often manifests in the development of new agricultural machinery, improved software for energy grid management, or more efficient processes for value-added agricultural processing.

The second requirement is the Elimination of Uncertainty Requirement. The taxpayer must intend to discover information that would eliminate uncertainty concerning the development or improvement of the business component. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the component, or the appropriate design of the component. This is particularly relevant for North Dakota’s manufacturing sector, where firms often face technical hurdles when scaling prototypes to full production.

The third requirement is the Process of Experimentation Requirement. Substantially all of the activities must constitute a process of experimentation. This involves the evaluation of more than one alternative to achieve a result where the capability or method of achieving that result is uncertain at the outset. This might involve modeling, simulation, or a systematic trial-and-error methodology.

The fourth and final requirement is the Technological in Nature Requirement. The process of experimentation used to discover information must fundamentally rely on principles of the physical or biological sciences, engineering, or computer science. Activities that rely on non-technical disciplines, such as social sciences, arts, or humanities, do not qualify for the credit.

Advanced Calculation Mechanics: Regular vs. Alternative Simplified Methods

North Dakota provides taxpayers with two distinct pathways to calculate their research credit. This flexibility allows businesses to optimize their tax position based on their historical spending patterns and the availability of detailed records.

The Regular Incremental Method

The Regular Method is the traditional approach and is based on a taxpayer’s current-year spending in excess of a “base amount.” The base amount is intended to represent the taxpayer’s “normal” level of R&D spending, ensuring the credit only rewards incremental increases in innovation.

Calculation of the North Dakota Base Amount generally follows the federal calculation under IRC § 41(c), using a fixed-base percentage multiplied by the average gross receipts for the prior four tax years. However, North Dakota law imposes a “floor” on this calculation: the base amount cannot be less than 50 percent of the current year’s qualified research expenses. This floor prevents a taxpayer from receiving a massive credit in a year where their research spending is high but their prior years’ spending or receipts were abnormally low.

For tax years beginning after December 31, 2010, the Regular Method applies the following tiered rates to the “excess” (Current QREs minus Base Amount):

1. 25% on the first $100,000 of excess QREs.
2. 8% on any excess QREs over $100,000.

This structure is highly progressive; it provides a significant 25% “bonus” for the initial threshold of innovation, which is particularly impactful for small to mid-sized firms.

The Alternative Simplified Credit (ASC) Method

Recognizing that many companies—particularly startups or those with fluctuating revenue—struggle to calculate a historical base amount, North Dakota introduced the ASC method for tax years beginning after 2018. This method is designed to be easier to calculate and more accessible for companies that may not have four years of gross receipts history.

Under the ASC method, the credit is based on the “North Dakota alternative excess research and development expenses,” which is the amount by which current-year QREs exceed 50 percent of the average QREs for the three preceding tax years. The ASC rates are lower than the Regular Method rates because the base calculation is typically more favorable to the taxpayer:

1. 17.5% of the first $100,000 of alternative excess.
2. 5.6% of the alternative excess in excess of $100,000.

If a taxpayer has zero qualified research expenses in any of the three preceding tax years, a modified rate applies to the current year’s total QREs: 7.5 percent of the first $100,000 and 2.4 percent of any amount over $100,000.

The decision between these two methods is an annual election. A taxpayer can choose on a year-to-year basis to use either the regular method or the ASC method, but the choice is binding for the specific tax year once made.

The following table provides a direct comparison of the primary variables used in each calculation method, highlighting the differences in base years and percentage rewards.

Illustrative Example: The Impact of Methodology Selection

To visualize the practical application of these rules, consider a hypothetical North Dakota-based energy technology company, “Fargo Power Systems.” This firm is developing new lithium-extraction techniques from oilfield brines, a process that involves significant engineering uncertainty and experimental prototyping.

Scenario: Regular Method Calculation

In 2024, Fargo Power Systems incurs $800,000 in North Dakota QREs. Their average gross receipts for the prior four years (2020–2023) were $10,000,000. They are a “start-up” for federal purposes, using a fixed-base percentage of 3%.

1. Determine Tentative Base: $10,000,000 x 3% = $300,000.
2. Apply 50% Floor: $800,000 x 50% = $400,000. Since $400,000 is greater than $300,000, the base amount for North Dakota purposes is $400,000.
3. Calculate Excess QREs: $800,000 – $400,000 = $400,000.
4. Apply Tiered Rates:
   • 25% of the first $100,000 = $25,000.
   • 8% of the remaining $300,000 = $24,000.
   • Total Regular Credit: $49,000.

Scenario: ASC Method Calculation

Alternatively, if Fargo Power Systems elects the ASC method for 2024, they look back at their QREs from 2021–2023. Suppose their QREs in those years were $500,000, $600,000, and $700,000, respectively.

1. Calculate 3-Year Average: ($500k + $600k + $700k) / 3 = $600,000.
2. Determine ASC Base: $600,000 x 50% = $300,000.
3. Calculate Alternative Excess: $800,000 – $300,000 = $500,000.
4. Apply ASC Tiered Rates:
   • 17.5% of the first $100,000 = $17,500.
   • 5.6% of the remaining $400,000 = $22,400.
   • Total ASC Credit: $39,900.

In this instance, the Regular Method provides a significantly higher benefit ($49,000 versus $39,900), illustrating why companies with steady growth often prefer the regular method despite its more complex base calculation.

Procedural Guidance from the Office of State Tax Commissioner

The process of claiming the Research and Experimental Expenditure Tax Credit requires strict adherence to administrative procedures and documentation standards set by the Office of State Tax Commissioner. Because the credit is nonrefundable, it must be used to offset actual North Dakota income tax liability.

Filing the Claim

Taxpayers do not file a standalone “R&D form” in the same way they file federal Form 6765. Instead, the credit is integrated into the annual income tax return.

• Corporations filing Form 40 must report the credit on Schedule TC (Tax Credits). Line 6 is typically used for credits generated by the taxpayer, while Line 7 is used for credits purchased from other taxpayers.
• Individuals claiming a credit from a sole proprietorship or a passthrough entity must file Schedule ND-1TC with their Form ND-1.
• Passthrough Entities (S Corporations and Partnerships) report the total credit on their respective Schedule K (Form 60 or Form 58) and allocate the credit to their owners via the North Dakota Schedule K-1.

A crucial administrative requirement is the attachment of a schedule or worksheet detailing the computation of the credit. This worksheet must clearly show the current year’s QREs, the base amount calculation, and the application of the tiered rates.

The Property Tax Clearance Prerequisite

One of the more unique hurdles in North Dakota tax law is the property tax clearance requirement. A taxpayer may not claim the research expense credit if they are delinquent in property taxes. Specifically, the Office of State Tax Commissioner requires a “Property Tax Clearance Record” for each county in North Dakota where the corporation (or any individual officer responsible for the corporation’s tax filings) owns at least a 50 percent interest in real property. This record serves as certification that the taxpayer is in good standing with local jurisdictions. Failing to provide this certification can lead to the denial of the credit claim.

Managing Unused Credits: Carrybacks and Carryforwards

For many companies in the research phase, current tax liability may be zero. North Dakota addresses this by providing an 18-year “life cycle” for unused credits.

• Carryback: Unused credits must first be carried back to each of the three preceding taxable years. This can result in a refund of taxes paid in those prior years. A claim to carry back credits must be filed within three years of the due date (including extensions) of the return for the year the credit was earned.
• Carryforward: Any credit remaining after the carryback must be carried forward to each of the next 15 succeeding taxable years.

This extended carryover period is one of the most generous in the United States, providing a long-term tax asset for capital-intensive industries like aerospace or biotechnology.

Strategic Liquidity: The Transfer of Unused Tax Credits

A standout feature of North Dakota’s incentive package is the ability for certain small, early-stage companies to sell their unused research tax credits to other taxpayers. This provision effectively transforms a nonrefundable tax credit into immediate cash liquidity, which is vital for startups that have not yet reached profitability.

Certification as a “Qualified Research and Development Company”

The ability to sell credits is not open to all businesses. A taxpayer must be certified by the North Dakota Department of Commerce as a “Qualified Research and Development Company.” To meet this definition, the taxpayer must satisfy four primary criteria:

1. Primary Sector Business: The company must be certified as a “primary sector business.” This is defined as a business that, through the employment of knowledge or labor, adds value to a product, process, or service that results in the creation of new wealth in North Dakota. This typically excludes retail or traditional service businesses and focuses on manufacturing, processing, and technology.
2. New Research Requirement: The company must not have conducted qualifying research in North Dakota before January 1, 2007. This provision is specifically targeted at “new” entrants to the state’s R&D ecosystem.
3. Revenue Threshold: The company must have annual gross revenues of less than $750,000.
4. Entity Type: The seller must be an individual, a C corporation, an estate, or a trust. Notably, passthrough entities (S-corps, Partnerships) are ineligible to sell the credit at the entity level.

The Mechanics of the Transfer

If a company qualifies, it may sell, transfer, or assign up to a lifetime total of $100,000 of unused tax credits. The process is highly regulated:

• The seller must apply for certification via Form SFN 58638 with the Department of Commerce. This application requires a detailed description of the research and copies of federal tax returns to verify the revenue threshold.
• Once a buyer is found, both parties must jointly complete and file Form CTS (Credit Transfer Statement) with the State Tax Department within 30 days of executing the transfer agreement.
• The seller must report the proceeds from the sale as income, while the buyer can use the purchased credit to offset their own North Dakota income tax liability.

Importantly, credits purchased or received from another taxpayer cannot be carried back or forward by the buyer; they must be used in the tax year of the transfer.

The following table summarizes the key thresholds and limits associated with the credit transfer program.

Industry-Specific Implications: Agriculture and Energy

The Research and Experimental Expenditure Tax Credit plays a disproportionately large role in North Dakota’s two dominant industries: agriculture and energy. Because both sectors are undergoing rapid technological shifts, the credit has become a staple of corporate financial planning in the state.

In the agricultural sector, the credit supports research into “Precision Ag,” which includes the development of autonomous tractors, advanced soil sensor networks, and more efficient fertilizer application processes. These activities frequently meet the technological uncertainty requirement because they involve adapting complex sensors and software to the harsh, unpredictable environmental conditions of the Northern Plains. Furthermore, “Value-Added” processors—those who turn raw North Dakota commodities into refined products—often qualify for both the research credit and other specific investment credits, creating a compounding benefit for industrial expansion.

In the energy sector, the credit is increasingly utilized for carbon capture and storage (CCS) technologies, enhanced oil recovery (EOR) techniques, and grid-scale storage solutions. These projects often represent massive capital investments that require years of experimental testing. The 15-year carryforward provision is particularly valuable here, as it ensures that the tax benefits earned during the loss-heavy research and construction phases remain available once the projects become profitable.

Legislative Oversight and the 2025 Outlook

North Dakota maintains a rigorous review process for its economic development incentives. Under N.D.C.C. § 54-35-26, all major tax incentives must be reviewed at least once every six years by an interim taxation committee.

The research expense credit was most recently reviewed during the 2021-22 interim. The review assessed the credit’s “equity, simplicity, competitiveness, public purpose, and adequacy.” One significant finding of the legislative review was that the tiered credit structure—specifically the 25% rate on the first $100,000—is highly effective at supporting the “innovation floor” of the state, ensuring that even small-scale researchers receive a meaningful incentive. While the committee did not recommend any major changes for the 2023 session, the credit remains part of the ongoing conversation regarding North Dakota’s competitiveness relative to neighboring states like Minnesota or South Dakota.

The Looming Impact of IRC Section 174 Amortization

A major point of concern for North Dakota businesses is the federal change to IRC § 174 capitalization rules. Starting in 2022, the federal government required all research and experimental expenses to be capitalized and amortized over five years, rather than immediately expensed.

Because North Dakota taxable income starts with federal taxable income, this change automatically increased state-level tax liability for many R&D-heavy firms. While recent federal legislation in 2025 has introduced the “Section 174A” option to return to immediate expensing for certain domestic costs, the interplay between these capitalization rules and the research credit remains complex. North Dakota taxpayers must carefully model their “Base Amount” calculations, as the timing of when an expense is “incurred” for credit purposes (IRC § 41) can differ from when it is “amortized” for deduction purposes (IRC § 174).

Final Thoughts: Strategic Value for the North Dakota Business

The North Dakota Research and Experimental Expenditure Tax Credit is more than just a reduction in tax liability; it is a structural component of the state’s industrial policy. By offering a high-percentage reward for the initial tier of research spending and providing a mechanism for small businesses to monetize their credits through transfers, the state has created a multi-layered support system for innovation.

For businesses operating in North Dakota, the credit requires a dual focus: technical compliance with the federal “Four-Part Test” and administrative compliance with state-specific prerequisites like the property tax clearance and the Department of Commerce primary sector certification. As the state moves toward its next legislative cycle, the research expense credit stands as a permanent and robust pillar of the North Dakota tax code, ensuring that the state remains a viable hub for technological advancement in the 21st century.