Average Annual Research and Development Expenses

The Average Annual Research and Development Expenses represent the mathematical mean of qualified research costs incurred within Ohio over the three preceding taxable years, serving as the baseline for credit calculation. Under Ohio law, this figure is subtracted from the current year’s qualified research expenses to determine the incremental investment eligible for a seven percent nonrefundable tax credit.

The Ohio Research and Development Investment Tax Credit, authorized under Section 5751.51 of the Ohio Revised Code, is a cornerstone of the state’s economic development strategy, designed to incentivize businesses to maintain and expand their innovation-driven footprints within the state. This credit functions as a nonrefundable offset against the Commercial Activity Tax, a gross receipts tax that replaced the corporate franchise tax for most businesses during the sweeping tax reforms of 2005. Unlike some state credits that provide a benefit based on total research spending, Ohio’s credit is strictly incremental; it rewards companies only for increasing their research and development investments beyond their established historical baseline. This baseline, defined as the Average Annual Research and Development Expenses, is the most critical variable in the credit calculation, representing the average of the qualified research expenses incurred in Ohio during the three preceding taxable years. For businesses operating in high-growth sectors like advanced manufacturing, biotechnology, and software development, understanding the nuances of this average is essential for accurate tax planning and maximizing the return on innovation investments.

Legislative Foundations and the Transition to the Commercial Activity Tax

The current regulatory environment for Ohio’s R&D tax credit is the result of a significant shift in the state’s tax philosophy that began in 2005 with the enactment of House Bill 66. Prior to this period, Ohio relied heavily on a corporate franchise tax and a tangible personal property tax, both of which were seen as impediments to capital-intensive businesses like manufacturers and technology firms. The introduction of the Commercial Activity Tax (CAT) fundamentally changed how businesses were taxed, moving from a tax on net income or net worth to a tax on the privilege of doing business in the state, measured by gross receipts.

As part of this transition, the existing research and development credits were migrated into the CAT framework. The law provided that beginning in calendar year 2008, taxpayers would compute the R&D credit on a calendar year basis, regardless of their fiscal year-end for federal purposes. This alignment was crucial for the state’s revenue office, as it simplified the administration of the CAT, which is primarily a quarterly filing system for larger taxpayers. The legislative intent was to create a “piggyback” system where Ohio’s definitions of qualified research would mirror those of the Internal Revenue Code, specifically Section 41, while adding a strict jurisdictional requirement that the expenses must be incurred within Ohio’s borders.

Key Statutory Milestone	Description of Legislative Change	Impact on R&D Credit
House Bill 66 (2005)	Enacted the Commercial Activity Tax (CAT) and phased out the Franchise Tax.	Established the R&D credit as a nonrefundable offset against CAT.
Rule 5703-29-22 (2007)	Administrative guidance promulgated by the Tax Commissioner.	Defined the procedural requirements for claiming and calculating CAT credits.
House Bill 33 (2023)	2024-2025 Biennial Budget Bill.	Increased CAT exclusions and codified the Commissioner’s audit sampling authority.

Defining Qualified Research Expenses (QREs)

To understand the Average Annual Research and Development Expenses, one must first master the definition of the component parts: the Qualified Research Expenses (QREs). Ohio law, specifically Ohio Revised Code Section 5751.51(A), explicitly incorporates the definition of QREs found in Section 41 of the Internal Revenue Code. This means that for an expense to be included in either the current year’s claim or the three-year historical average, it must satisfy the rigorous federal “Four-Part Test” while also meeting Ohio’s geographical nexus requirements.

The Four-Part Test for Qualified Research

Under federal guidelines adopted by Ohio, research activities must meet four distinct criteria to qualify:

The Section 174 Test: The expenditures must be eligible for treatment as expenses under Section 174 of the IRC, meaning they are research and development costs in the experimental or laboratory sense, intended to discover information that would eliminate uncertainty concerning the development or improvement of a business component.

Technological in Nature: The research must rely on the principles of the physical or biological sciences, engineering, or computer science.

The Business Component Test: The research must be undertaken for the purpose of discovering information intended to be useful in the development of a new or improved business component, such as a product, process, software, technique, formula, or invention.

The Process of Experimentation: Substantially all of the activities must constitute elements of a process of experimentation, which involves the systematic evaluation of alternatives through modeling, simulation, or trial-and-error to resolve a technical uncertainty.

Eligible Expense Categories in Ohio

Once the activities are qualified, the specific costs associated with those activities are aggregated into four primary categories, provided they were incurred in Ohio:

• Wages: This is the most common component of the credit and includes salaries and wages paid to employees who are directly performing, supervising, or supporting the qualified research. In Ohio, these wages must be prorated based on the time the employee spent physically working in Ohio on the qualified projects.
• Supplies: These are tangible, non-depreciable items used or consumed in the research process, such as chemicals for lab tests or materials used to build prototypes.
• Contract Research: Taxpayers may include 65% of the amount paid to third parties for research performed on their behalf. A critical distinction for the Ohio credit is that the third-party research must be performed at a location within the state of Ohio to be eligible for inclusion in the calculation.
• Computer Rental and Lease Costs: Expenses paid for the use of computers, including cloud computing environments used specifically for qualified research, are eligible.

The Calculation of the Three-Year Average

The Average Annual Research and Development Expenses serve as the “threshold” or “base amount” that a company must exceed to earn a credit in any given year. The calculation is mathematically straightforward but requires meticulous record-keeping over a multi-year period.

The Mathematical Formula

The Ohio R&D Investment Tax Credit is equal to seven percent of the excess of the current year’s Ohio QREs over the average annual Ohio QREs for the three preceding taxable years.

Scenarios for New and Developing Businesses

For companies that are new to Ohio or are just beginning their research activities, the calculation of the average can be particularly advantageous.

• Zero-Base Year Scenarios: If a company had no research activities in Ohio during one or more of the three preceding years, those years are treated as zero in the calculation. For example, a company that started R&D in 2023 would have zero expenses for 2021 and 2022. The 2024 credit would be based on the average of (0 + 0 + 2023 expenses) divided by three.
• Rapidly Scaling R&D: Because the average is a lagging indicator based on the prior three years, a company that is aggressively increasing its research budget each year will consistently generate a credit, as the current year’s spend will naturally exceed the average of the lower-spend prior years.

Year	Ohio QREs	3-Year Average Calculation	Excess Over Average	7% Credit Amount
2021	$500,000	N/A (Base Period)	N/A	N/A
2022	$600,000	N/A (Base Period)	N/A	N/A
2023	$700,000	N/A (Base Period)	N/A	N/A
2024	$1,200,000	($500k + $600k + $700k) / 3 = $600,000	$600,000	$42,000

Revenue Office Guidance and Administrative Compliance

The Ohio Department of Taxation provides specific procedural rules for taxpayers through the Ohio Administrative Code (OAC) and Information Releases. Compliance with these rules is mandatory to sustain a credit claim upon audit.

Ohio Administrative Code Rule 5703-29-22

Rule 5703-29-22 is the primary administrative guidance for all Commercial Activity Tax credits. It establishes several critical requirements:

• Calendar Year Basis: Taxpayers must compute the credit for qualified research expenses based on expenses incurred during the calendar year, regardless of their federal taxable year or their CAT filing frequency.
• Filing Deadlines: For quarterly filers, the credit must be claimed on the fourth-quarter return, which is due in February of the following year. Annual filers (though annual filing was largely eliminated in 2024) historically claimed the credit on the annual return due in May.
• Carryforward Limits: If the credit exceeds the taxpayer’s tax liability for the period, the excess may be carried forward for up to seven years. Any credit not used within this seven-year window is lost.
• The Ordering Rule: Ohio Revised Code Section 5751.98 dictates the order in which taxpayers must apply their credits. The R&D credit is nonrefundable and must be taken in its specific statutory order among other incentives like the Jobs Retention Credit or the Ohio Historic Preservation Tax Credit.

Filing Documentation: Form CAT CS

To claim the credit, taxpayers are required to complete and maintain Form CAT CS (Commercial Activity Tax Credit Schedule). This form acts as the primary calculation worksheet and provides the state with the necessary data to verify the claim. The form requires the disclosure of:

Current calendar year expenses.

Expenses for each of the three preceding calendar years.

The specific address where the research expenses were incurred.

Identification numbers (FEIN or SSN) and CAT account numbers for the entity entitled to the credit.

In the case of consolidated elected or combined taxpayer groups, each person in the group must separately calculate the credit using the expenses they incurred. However, the total credit generated by all members can be applied against the combined group’s tax liability.

The Geographical Imperative: “Incurred in This State”

One of the most frequent points of contention during Ohio Department of Taxation audits is the determination of whether an expense was truly “incurred in this state”. While Ohio adopts the federal definition of what constitutes research, it applies its own jurisdictional filter to where that research happens.

Jurisdictional Nuances for Wages

The Tax Commissioner has ruled in multiple final determinations that simply being employed by an Ohio company is not enough to qualify an employee’s wages for the credit. The taxpayer must demonstrate that the qualified services were physically performed within the borders of Ohio. This creates a complex burden for companies with remote workers or employees who travel between facilities in different states. If a lead engineer is based in Ohio but spends three months of the year at a testing site in Indiana, the taxpayer must exclude 25% of that engineer’s wages from the Ohio R&D credit calculation.

Nexus for Contract Research

Similarly, for contract research expenses, the location of the activity is paramount, not the location of the vendor. If an Ohio company hires a specialized lab in Pennsylvania to conduct tests, those expenses are generally excluded from the Ohio credit because the research was not performed in-state. Conversely, if a national engineering firm sends a team to an Ohio facility to perform qualified research on behalf of the taxpayer, 65% of those contract costs are eligible for the Ohio credit.

The Impact of 2024-2025 Tax Reforms

The landscape of the Ohio Commercial Activity Tax underwent a radical transformation in the 2024-2025 biennial budget (House Bill 33), which has direct implications for how businesses utilize the R&D credit.

Elimination of the Annual Minimum Tax (AMT)

Effective January 1, 2024, the Annual Minimum Tax—which previously ranged from $150 to $2,600 based on the prior year’s gross receipts—was eliminated. This simplifies the filing process for all businesses but also changes the tax liability threshold at which an R&D credit becomes necessary or useful.

Increased Exclusion Thresholds

The most significant change is the dramatic increase in the annual exclusion amount. For nearly two decades, the first $1 million in taxable gross receipts were excluded from the CAT. Under the new law, this exclusion increases to $3 million for the 2024 tax year and to $6 million for 2025 and beyond.

Tax Year	Gross Receipts Exclusion Amount	Impact on R&D Credit Utilization
Prior to 2024	$1,000,000	Broadly applicable to most mid-sized businesses.
2024	$3,000,000	Smaller innovators may no longer have a CAT liability to offset.
2025+	$6,000,000	Only larger innovators with significant Ohio revenue will utilize the credit.

For businesses that no longer have a CAT liability due to these higher exclusions, the R&D credit remains valuable as a carryforward. A company may still calculate and claim the credit on its return to establish the “seven-year clock” for usage in future years when its revenue might exceed the $6 million threshold.

Audit Climate and Record Retention

The Ohio Department of Taxation has recently adopted an “aggressive” audit policy regarding R&D credits, leading to increased scrutiny of the documentation used to substantiate both the current year claim and the three-year historical average.

Statutory Authority for Sampling

House Bill 33 codified the Tax Commissioner’s authority to audit a “representative sample” of the taxpayer’s qualified research expenses over a specified period to ascertain the valid credit amount. While the law requires the Commissioner to make a “good faith effort” to reach an agreement with the taxpayer on the sample, the state may proceed with its own sampling methodology if an agreement is not reached. This shift emphasizes the need for companies to have standardized, project-based tracking for their R&D activities across all years included in the calculation.

Contemporaneous Documentation Requirements

To survive an audit, businesses must maintain records for at least four years from the date the return was filed or the tax was due, whichever is later. Required documentation generally includes:

• Project Lists and Descriptions: A comprehensive record of every research project claimed, detailing the technical uncertainties and the process of experimentation.
• Time Tracking and Payroll Records: Evidence linking specific employees and their time spent on qualified activities within Ohio.
• Vendor Contracts and Invoices: Documentation proving the nature of third-party research and the location where the work was performed.
• Historical Average Data: Because the credit is based on the prior three years, the taxpayer must be able to substantiate the expenses for the entire four-year window (current year plus three base years).

Strategic Implications of the 3-Year Average

The “incremental” nature of the Ohio credit creates unique strategic challenges and opportunities for tax directors. Because the credit is only earned on the “excess” over the average, the timing of research expenditures can have a profound impact on the total credit generated over a decade.

The “Innovation Cycle” Effect

For companies with cyclical research budgets—such as those developing major new product lines every few years—the 3-year average can act as a significant hurdle. If a company spends $1 million annually for three years (Average = $1M) and then ramps up to $2 million in the fourth year, it generates a credit on the $1 million excess. However, that $2 million spike will then sit in the 3-year average for the next three years, making it much harder to generate a credit in the subsequent period unless spending continues to rise.

Mergers and Acquisitions

Ohio law provides that when a business is acquired or merged, the historical QRE data of the predecessor entity must generally be factored into the successor’s 3-year average. This “consistency requirement” prevents companies from erasing their high-spend history simply by restructuring. Conversely, if an Ohio company acquires a firm with no previous Ohio R&D history, the acquisition may dilute the group’s average, potentially making it easier to generate credits as the newly acquired team’s activities are integrated into the Ohio footprint.

Statistical Insights into Ohio’s Innovation Economy

The fiscal scale of the R&D credit is detailed in the Ohio Department of Taxation’s biennial Tax Expenditure Report. These reports estimate the amount of revenue the state “forgoes” to support various incentives, providing a proxy for the total volume of research activity being incentivized.

Fiscal Year	Total Estimated Revenue Forgone (R&D Credit)	Status
FY 2022	$52.1 Million	Actual/Estimated
FY 2023	$55.5 Million	Actual/Estimated
FY 2024	$58.9 Million	Projected
FY 2025	$62.4 Million	Projected

The steady upward trajectory of these estimates suggests that despite the rigorous 3-year average requirement, Ohio businesses are consistently increasing their R&D investments. Furthermore, the R&D credit is part of a broader “Business & Economic Development” category that accounts for roughly 62% of all state tax expenditures, highlighting its role as a primary lever for state growth.

Interaction with Other Ohio R&D Programs

The QRE-based tax credit is not the only incentive available to Ohio innovators. Understanding how the CAT R&D credit interacts with other programs is essential for a holistic tax strategy.

The Research and Development Investment Loan Repayment Credit

Under Ohio Revised Code Section 5751.52, a separate nonrefundable credit is available for “borrowers” who take out loans from the state for eligible R&D projects. This credit is equal to the principal and interest repaid on the loan during the taxable year, up to a maximum of $150,000 annually. Unlike the QRE credit, which has a 7-year carryforward, the loan repayment credit has an unlimited carryforward period, making it a powerful tool for projects with long-term debt obligations.

The R&D Sales Tax Exemption

As previously noted, Section 5739.02(B)(42)(i) of the Ohio Revised Code provides a full exemption from sales and use tax for machinery and equipment used primarily for research and development. This exemption applies to both “direct” research (creating new products) and “pure” research (scientific inquiry in the physical sciences). For capital-intensive R&D facilities, the sales tax exemption can provide immediate cash savings that often exceed the value of the incremental CAT credit in the early years of a project.

Comprehensive Example: Tech-Fabricate LLC

To visualize the full application of the law and revenue office guidance, consider the case of “Tech-Fabricate LLC,” a mid-market engineering firm specializing in advanced composite materials for the aerospace industry, located in Dayton, Ohio.

Data Collection: The 4-Year Window

Tech-Fabricate must first audit its records to determine its Ohio-only qualified research expenses for the claim year (2024) and the three preceding base years.

Calendar Year	Total QREs (All States)	Ohio-Only QREs	Reason for Exclusion (Non-Ohio)
2021	$1,500,000	$1,200,000	Testing performed at a facility in Florida.
2022	$1,700,000	$1,300,000	Consultant wages for a firm in California.
2023	$1,800,000	$1,400,000	Remote software developer in Michigan.
2024	$2,800,000	$2,400,000	Prototyping performed at a subsidiary in Texas.

Step 1: Calculate the Average Annual Research Expenses

Tech-Fabricate takes the Ohio-only QREs from the three prior years to establish its baseline.

Average = 1,200,000 + 1,300,000 + 1,400,000 divided by 3 = $1,300,000

Step 2: Determine the Incremental Investment

The credit is only earned on the amount that the current year (2024) exceeds this average.

Excess = 2,400,000 – 1,300,000 = $1,100,000

Step 3: Compute the Final Credit

The 7% rate is applied to the excess over the baseline.

Credit = 1,100,000 x 0.07 = $77,000

Step 4: Administrative Application

Tech-Fabricate generates $12,000,000 in Ohio gross receipts in 2024. The CAT calculation would proceed as follows:

Gross Receipts: $12,000,000

Exclusion (2024): ($3,000,000)

Taxable Base: $9,000,000

Tax Rate (0.26%): $9,000,000 x 0.0026 = $23,400

Apply R&D Credit: $23,400 – $77,000 = ($53,600)

Carryforward: Because the credit is nonrefundable, Tech-Fabricate pays $0 in CAT for the period (excepting any other prior credits) and carries forward the remaining $53,600 to 2025.

Final Thoughts: Navigating the Future of Innovation in Ohio

The Ohio Research and Development Investment Tax Credit remains a vital, if complex, tool for businesses committed to high-growth innovation within the state. By grounding the credit in an incremental model—using the Average Annual Research and Development Expenses as a rolling baseline—Ohio ensures that the incentive rewards genuine progress rather than stagnant spending. However, this model places a heavy burden of proof on the taxpayer, requiring precise geographical tracking of labor and contract services across a four-year window.

As the state transitions into a new era of the Commercial Activity Tax, defined by much higher exclusion thresholds, the R&D credit will increasingly become a strategic asset for mid-market and large-scale enterprises. Smaller firms, while perhaps no longer owing CAT, should still diligently track their R&D averages to bank carryforward credits for future scaling. In an environment of heightened audit scrutiny and legislative reform, the most successful companies will be those that integrate their R&D tax strategy directly into their operational workflows, ensuring that every dollar of innovation is backed by the contemporaneous records necessary to withstand state review. Ultimately, the Average Annual Research and Development Expenses are more than just a line item on a tax form; they are a mathematical reflection of a company’s commitment to pushing the boundaries of technology in the State of Ohio.