Franchise Tax Credit for Certain R&D Activities

The legislative landscape of research and development (R&D) incentives in Texas is currently characterized by a significant transition from a dual-choice temporary system to a consolidated permanent structure. Since 2014, the state has operated under Chapter 171, Subchapter M of the Texas Tax Code, which was established to encourage economic development and foster high-paying jobs in the technology and manufacturing sectors. This system required taxpayers to make an annual election between claiming a franchise tax credit or a sales and use tax exemption on depreciable property used in research. However, with the passage of Senate Bill 2206 during the 89th Legislative Session, Texas is overhauling this regime to eliminate the sales tax exemption and significantly enhance the franchise tax credit, moving it into a new, permanent Subchapter T. This evolution reflects a broader policy objective of the Texas Comptroller’s office and the state legislature to align state incentives more closely with federal standards while reducing the administrative and audit complexities inherent in the previous dual-track system.

The Evolution of Statutory Frameworks: From Subchapter M to Subchapter T

The primary mechanism for rewarding R&D in Texas has historically been found in Subchapter M of Chapter 171 of the Tax Code. This subchapter was designed to mirror the federal R&D tax credit found in Section 41 of the Internal Revenue Code (IRC), but with specific Texas-centric limitations and requirements. Under the original 2013 legislation, the credit was set to expire on December 31, 2026. The decision to allow the credit to expire or to renew it became a central focus for policymakers, leading to the enactment of the new permanent framework.

The transition to Subchapter T, effective for reports originally due on or after January 1, 2026, represents a fundamental shift in how the state incentivizes innovation. The legislature determined that the sales tax exemption, while beneficial for capital-intensive startups, was difficult for the Comptroller’s office to monitor and often led to protracted audit disputes over the “direct use” of equipment. By repealing the exemption and increasing the franchise tax credit rate from 5% to 8.722%, the state aims to provide a more predictable and lucrative benefit for a wider range of businesses.

Statutory Feature	Subchapter M (Effective through 2025)	Subchapter T (Effective 2026+)
Credit Rate (Standard)	5% of excess QREs over base amount	8.722% of excess QREs over base amount
University Partnership Rate	6.25% of excess QREs over base amount	10.903% of excess QREs over base amount
Incentive Options	Choice: Franchise Credit OR Sales Exemption	Franchise Credit only (Sales Exemption Repealed)
Federal Conformity	IRC Section 41 as of Dec. 31, 2011	Rolling conformity to current federal Form 6765
Refundability	Generally non-refundable	Refundable for entities with no tax due
Base Amount Floor	50% of the 3-year QRE average	50% of the 3-year QRE average
Expiration Date	December 31, 2026	No expiration (Permanent)

Defining Qualified Research Under Texas Law

The meaning of “qualified research” is the cornerstone of eligibility for the credit. Texas law adopts the federal definition found in IRC Section 41(d), but with critical timing and location distinctions. For reports due before 2026, the state is tied to the version of the IRC in effect on December 31, 2011. This “fixed-date conformity” often creates a compliance gap where federal changes to R&D rules do not immediately apply to Texas. However, Subchapter T changes this to “rolling conformity,” where the state follows the federal law for the year in which the credit is claimed, specifically linking the Texas calculation to Line 48 of federal Form 6765.

The Four-Part Test for Eligibility

To be considered qualified research for the Texas franchise tax credit, an activity must meet all four parts of the federal test.

First, the research must be undertaken for a “permitted purpose.” This means the objective must be to create a new or improved business component, defined as a product, process, computer software, technique, formula, or invention. The focus must be on enhancing function, performance, reliability, or quality. Activities related to style, taste, or cosmetic design are explicitly disqualified.

Second, the activity must involve the “elimination of uncertainty.” At the beginning of the research project, the information available to the taxpayer must be insufficient to determine the capability or method of developing the component, or the appropriate design of the final product. This requirement filters out routine engineering or data collection that does not involve genuine technological risk.

Third, the research must be “technological in nature.” The process must fundamentally rely on the principles of the hard sciences, such as physical or biological sciences, engineering, or computer science. Research in the social sciences, arts, or humanities is strictly excluded from the Texas R&D credit.

Fourth, the taxpayer must engage in a “process of experimentation.” This involves a systematic evaluation of one or more alternatives to achieve the desired result. This process typically involves modeling, simulation, systematic trial and error, or other scientific methods designed to resolve the technological uncertainty identified at the project’s inception.

Specific Exclusions and Limitations

Texas law and Comptroller guidance provide a list of activities that, while they may seem research-oriented, do not qualify for the franchise tax credit. Research conducted after the start of commercial production is a primary exclusion. Once a business component is ready for commercial sale or use, any further refinements are generally viewed as routine maintenance rather than qualified research.

Other major exclusions include:

• Adaptation: Modifying an existing product for a specific customer’s requirements.
• Duplication: Reverse-engineering or duplicating an existing product or process from blueprints or physical examination.
• Management and Market Research: Efficiency surveys, management studies, consumer surveys, and advertising or promotions are ineligible.
• Funded Research: Research to the extent it is funded by any grant, contract, or otherwise by another person or governmental entity.
• Location: Only research conducted within the State of Texas is eligible for the Texas credit.

Qualified Research Expenses (QREs): The Basis of the Credit

The credit is calculated based on Qualified Research Expenses (QREs). Under Subchapter M, these are defined by IRC Section 41, but restricted to expenses incurred in Texas. Under the incoming Subchapter T, the state will use the portion of the federal Form 6765, Line 48, that is attributable to research in Texas.

Wages and Labor Costs

Wages paid to employees performing “qualified services” constitute the largest portion of QREs for most businesses. The Texas Comptroller provides specific guidance in Rule 3.599 regarding what constitutes qualified services. These services are divided into three tiers:

1. Engaging in Qualified Research: This is the actual conduct of the research, such as a scientist performing experiments in a lab or a software engineer writing code to resolve a complex architectural uncertainty.
2. Direct Supervision: This refers to the “first-line management” of individuals conducting research. A research director who oversees the daily experiments of a team of scientists qualifies. However, higher-level executives (e.g., a CEO or CFO) who only review financial reports or high-level project milestones generally do not qualify unless they are directly managing the technical aspects of the experimentation.
3. Direct Support: This includes personnel providing immediate assistance to researchers. Examples include a lab technician cleaning specialized equipment used in an experiment, a secretary typing a technical report describing the results of a specific experiment, or a machinist creating a prototype part for testing. General administrative support, such as payroll processing, accounting, or janitorial services for a general facility, is explicitly excluded.

Supplies and Tangible Property

Supplies are defined as any tangible property used in the conduct of qualified research, provided the property is not land or improvements to land and is not “property of a character subject to the allowance for depreciation.” The distinction between a “supply” and a “depreciable asset” is a frequent point of audit controversy.

The Comptroller has issued policy memoranda clarifying that if an expense for property is allowed under IRC Section 174 (research and experimental expenditures), it does not automatically mean it is a “supply” for the purposes of the R&D credit under IRC Section 41. If the property is of a type that could be depreciated (meaning it has a useful life of more than one year), it is excluded from QREs, even if the taxpayer chooses to expense it for federal purposes. This interpretation is significant because it prevents taxpayers from “double-dipping” by claiming a franchise tax credit on assets that would have been eligible for the sales tax exemption under the old law.

Contract Research and Computer Lease Costs

Contract research expenses represent amounts paid to third parties for performing qualified research on the taxpayer’s behalf in Texas. Generally, only 65% of these expenses are includable in the credit calculation. If the research is conducted by certain qualified research consortia, the includable amount increases to 75%.

Additionally, the cost of leasing or renting computers used in research—such as cloud computing services dedicated to running simulations or hosting developmental software environments—is an eligible QRE. As businesses move away from on-premise hardware toward Infrastructure-as-a-Service (IaaS) models, this category of expense is becoming increasingly prominent in Texas R&D claims.

Local State Revenue Office Guidance: The Comptroller’s STAR System

The Texas Comptroller’s State Tax Automated Research (STAR) system provides the most granular guidance on how the R&D credit laws are applied in practice. These documents, ranging from policy memos to hearing decisions, clarify the “grey areas” of the tax code.

Credit Ordering and Application (STAR 202501001M)

One of the most critical pieces of recent guidance is the memo regarding the proper order of application for franchise tax credits. This is vital because the total amount of R&D credit that can be claimed is limited to 50% of the franchise tax due before any other credits are applied.

According to the Comptroller, if a taxable entity has multiple credits or carryforwards, they must be taken in a specific sequence to ensure the 50% cap is correctly calculated.

Priority	Credit Type	Statutory Reference
1	Temporary Credit for Business Loss Carryforwards	Section 171.111
2	Research and Development Activities Credit	Subchapter M / Subchapter T
3	Certified Rehabilitation of Certified Historic Structures	Chapter 172
4	Clean Solar and Wind Energy Credit	Subchapter L
5	Qualifying Research and Development Credit (Legacy)	Subchapter O (Repealed 2008)
6	Economic Development Credits (Investment/Jobs)	Former Chapter 171 sections
7	Pre-1992 Credits	Various legacy statutes

This hierarchy ensures that credits with shorter carryforward periods or more restrictive rules are not unfairly displaced by the R&D credit, which has a generous 20-year carryforward.

Intra-Group Transactions and Combined Reporting (STAR 202503004M)

Texas requires “combined reporting” for unitary business groups. This means that a parent company and its subsidiaries are treated as a single “taxable entity” for franchise tax purposes.

Comptroller guidance emphasizes that while federal R&D rules (IRC Section 41(f)) treat a “controlled group” as a single taxpayer, the definitions of a “controlled group” for federal purposes and a “combined group” for Texas purposes are fundamentally different. The Comptroller has clarified that federal intra-group transaction regulations do not apply when determining the Texas R&D credit. For instance, if one member of a Texas combined group pays another member for research services, those intra-group payments must be analyzed under Texas-specific unitary business principles rather than simply being disregarded as they might be on a federal consolidated return.

Statute of Limitations and Refund Claims (STAR 202301007M)

The Comptroller takes a strict stance on the creation of credits in “closed” tax years. A tax year is typically closed four years after the report was due. STAR Memo 202301007M clarifies that a taxpayer cannot file an amended report to “create” an R&D credit in a year that is outside the statute of limitations, even if they have eligible expenses.

However, the memo allows for a “look-back” for the purpose of calculating carryforwards. If a taxpayer correctly claimed a credit in a closed year, the Comptroller may verify the QREs from that closed year to ensure that the carryforward being used in a current, “open” year is accurate. This distinction prevents taxpayers from claiming “new” benefits for old years while allowing the state to audit the historical basis of long-term carryforwards.

The Calculation of the Texas R&D Credit

The calculation of the Texas R&D credit is an incremental process, meaning it is designed to reward companies for increasing their research spending relative to their own historical average.

The Incremental Formula Structure

The credit is generally based on the difference between the current year’s QREs and 50% of the average QREs from the three preceding tax years.

The standard formula for Subchapter T (Post-2025) is:

Credit = 8.722% x (QRE_current – (50% x QRE_average_prior_3))

For businesses that have no QREs in one or more of the three preceding tax years (such as new startups or companies just beginning R&D in Texas), the state provides a simplified “no-prior” rate. This rate is exactly half of the standard rate and is applied directly to the current year’s total QREs without a base deduction.

Scenario	Subchapter M Rate (2025)	Subchapter T Rate (2026+)
Standard Incremental Credit	5.0%	8.722%
No Prior QREs (Startups)	2.5%	4.361%
University Partnership (Standard)	6.25%	10.903%
University Partnership (No Prior)	3.125%	5.451%

The “50% Tax Due” Limitation

The most significant constraint on the credit’s immediate utility is the 50% tax liability cap. Regardless of how much research a company conducts, it cannot use the R&D credit to eliminate more than half of its franchise tax bill for any given year.

Any excess credit is not lost; it is carried forward to the next year’s report. This carryforward period lasts for up to 20 years. This long-term carryforward is particularly beneficial for businesses in the pharmaceutical or aerospace sectors, which may spend heavily on R&D for many years before generating significant taxable revenue.

Numerical Example: InnovaTex Solutions

To understand the application of these rules, consider “InnovaTex Solutions,” a Texas-based software firm that is transitioning from the old R&D regime to the new one.

Part 1: Calculating the Credit under Subchapter M (2025)

In 2025, InnovaTex decides to claim the franchise tax credit rather than the sales tax exemption on its new servers.

• Current Year QREs (2025): $2,000,000
• Prior 3-Year QRE History:
  • 2024: $1,500,000
  • 2023: $1,200,000
  • 2022: $900,000
• Average Prior 3 Years: $1,200,000
• Base Amount (50% of Average): $600,000
• Incremental QREs: $2,000,000 – $600,000 = $1,400,000
• Tentative Credit (5%): $1,400,000 x 0.05 = $70,000

If InnovaTex has a 2025 franchise tax liability of $100,000:

• 50% Limitation: $100,000 x 0.50 = $50,000
• Credit Claimed on 2025 Report: $50,000
• Carryforward to 2026: $20,000 ($70,000 – $50,000)

Part 2: Calculating the Credit under Subchapter T (2026)

In 2026, the new law takes effect. The rate increases to 8.722%.

• Current Year QREs (2026): $2,200,000
• Prior 3-Year QRE History (2023-2025): Average of $1,200,000, $1,500,000, and $2,000,000 = $1,566,667
• Base Amount (50% of Average): $783,334
• Incremental QREs: $2,200,000 – $783,334 = $1,416,666
• Tentative Credit (8.722%): $1,416,666 x 0.08722 = $123,562

The company also has the $20,000 carryforward from 2025. Per STAR 202501001M, the older credits are used first.

If 2026 franchise tax liability is $200,000:

• 50% Limitation: $200,000 x 0.50 = $100,000
• Total Available Credits: $123,562 (Current) + $20,000 (Carryforward) = $143,562
• Credit Claimed on 2026 Report: $100,000
• Carryforward to 2027: $43,562

Part 3: The Refundable Credit Scenario

If InnovaTex Solutions had a 2026 revenue below the “no tax due” threshold (currently ~$2.47M), it would not be required to pay franchise tax. Under Subchapter T, the company can apply for a refund of the full $123,562 credit (plus the carryforward) instead of carrying it forward to future years. This is a landmark change that provides liquidity to growing tech firms that are reinvesting all their profits back into research.

The Repeal of the Sales and Use Tax Exemption

A critical component of understanding the R&D Tax Credit’s context is the role of the sales and use tax exemption for depreciable property. Through the end of 2025, businesses have a choice. If a company chooses the sales tax exemption for a specific period, it and all other members of its combined group are strictly prohibited from claiming the franchise tax credit for that same period.

“Direct Use” Requirement

For the sales tax exemption, the property must be “directly used” in qualified research. The Comptroller defines “directly” as having an immediate effect on the research activity without an intervening, ancillary, or prior effect. For example, a specialized microscope used to view cellular changes during an experiment is “directly used.” A computer used by an accountant to track the budget for that lab is not “directly used” and remains taxable.

Strategic Transition to 2026

Because the sales tax exemption disappears on January 1, 2026, many businesses are being advised to accelerate their equipment purchases into 2025. By purchasing R&D equipment before the year-end deadline, they can secure the 6.25% state sales tax savings (plus up to 2% local tax) while knowing that in 2026, they will be eligible for the higher 8.722% franchise tax credit on their labor and supply costs.

Audit Defense and Documentation Requirements

The Texas Comptroller’s office has grown increasingly sophisticated in auditing R&D claims. Because the state adopts federal definitions, a federal IRS audit that reduces a taxpayer’s R&D credit will almost always result in a corresponding reduction in the Texas credit.

The Importance of Contemporaneous Records

The “burden of establishing the credit” lies entirely with the taxpayer. To survive an audit, a company must provide more than just financial spreadsheets. They must provide a “technical narrative” for each project or business component claimed.

The Comptroller’s audit manual and hearing decisions emphasize “contemporaneous” documentation—records created at the time the research was performed.

Category	Recommended Evidence
Technical Activity	Lab notebooks, white papers, prototype designs, CAD drawings, testing logs, bug tracking reports (for software), meeting minutes, and internal emails discussing technical hurdles.
Labor Costs	Timesheets (ideally with project codes), payroll registers, and W-2 forms.
Supplies	Invoices and receipts that clearly describe the items purchased and their use in a specific R&D project.
Contracts	Signed agreements with third-party researchers and proof of payment (1099s).

Statistical Sampling in Audits (Rev. Proc. 2011-42)

For large taxpayers with hundreds of research projects, documenting every single hour is often impossible. Both the IRS and the Texas Comptroller allow for the use of statistical sampling to estimate QREs.

Under a “Managed Audit” agreement, a taxpayer may perform their own audit of a sample of transactions, which is then reviewed and projected by the Comptroller. If the initial review of the taxpayer’s schedules reveals an error rate greater than 25%, the Comptroller may return the schedules for correction and potentially deny interest waivers. This process requires the taxpayer to have a deep understanding of both statistical theory and Texas tax law.

Strategic Implications of University Collaborations

One of the most unique aspects of the Texas R&D credit is the significant “bonus” provided for research conducted through Texas institutions of higher education. By increasing the credit rate from 8.722% to 10.903% (a 25% increase in value), the state incentivizes a “knowledge ecosystem” between private industry and the state’s university system.

To qualify for this higher rate:

1. The research must be conducted under a contract with a Texas public or private institution of higher education.
2. The research must be performed in Texas.
3. The institution must be an “accredited” entity as defined by the Education Code.

For companies in the biotech, semiconductor, and energy sectors, these partnerships not only provide access to world-class talent and facilities but also significantly lower the net cost of innovation through the enhanced tax credit.

Combined Reporting and Unitary Business Groups

As previously noted, Texas is a combined reporting state. This has specific implications for the R&D credit.

The combined group is the “taxable entity” for purposes of the credit. If one member of the group has qualified expenses but no tax liability, and another member has high tax liability but no research, the credit earned by the first member can be used to offset the tax of the second member on the combined report.

This “consolidation” of credits is a powerful tool for large corporate structures. However, it requires careful tracking of where research occurs. If a member of the group is conducting research outside of Texas, those expenses must be excluded from the state credit calculation, even if they are included on federal Form 6765. The Comptroller requires a “Texas-apportioned” version of the federal QREs to ensure the state is only subsidizing local innovation.

Final Thoughts: A New Era for Texas Innovation

The Texas Franchise Tax Credit for Certain R&D Activities is no longer a temporary, elective incentive. With the enactment of Subchapter T and the sunset of the sales tax exemption, it has become a permanent, integral part of the state’s tax landscape. The increased rates, the shift to rolling federal conformity, and the introduction of refundability for small and growing businesses demonstrate a clear intent by the state to remain competitive with other technology hubs like California, Massachusetts, and Michigan.

For businesses, this new era requires a more rigorous approach to compliance. The alignment with federal Form 6765 simplifies the initial calculation, but the Comptroller’s focus on contemporaneous documentation and “direct services” means that companies must still maintain detailed records of their technical activities. As the January 1, 2026, transition date approaches, Texas businesses should conduct a comprehensive review of their R&D procurement and documentation strategies to ensure they are positioned to capture the full value of these enhanced state incentives.