The Texas Research and Development tax incentive provides an elective choice between a sales and use tax exemption for depreciable equipment and a franchise tax credit based on qualified research expenses. Effective January 1, 2026, the state will repeal the sales tax exemption while transitioning the franchise tax credit into a permanent, enhanced, and potentially refundable incentive structure for innovation.

The legal architecture of these incentives represents a strategic effort by the Texas Legislature to foster a competitive environment for technological advancement and high-value job creation. Historically, this has been achieved through a dual-path mechanism where taxpayers engaged in qualified research must choose annually between immediate sales tax relief on capital investments or a deferred franchise tax credit primarily benefiting labor-intensive research activities. This choice is governed by an "anti-double dipping" provision, which prevents an entity from claiming both the sales tax exemption and the franchise tax credit in the same reporting period. As the state moves toward a consolidated model under Senate Bill 2206, understanding the historical interplay between these two paths, the rigorous definitions of qualified research, and the specific guidance provided by the Texas Comptroller of Public Accounts is essential for regulatory compliance and strategic tax planning.

Historical Context and Legislative Intent

The modern era of Texas research incentives began with the enactment of House Bill 800 by the 83rd Legislature in 2013, which became effective for reports due on or after January 1, 2014. This legislation was designed to fill a vacuum left by the 2008 repeal of a prior version of the R&D credit (Subchapter O), which had left Texas at a disadvantage compared to approximately 29 other states offering similar incentives. The policy objective was clear: to incentivize the location and expansion of R&D activities in Texas, thereby promoting the creation of high-paying jobs and complementing the state’s massive manufacturing base through innovation-driven efficiency.

Under this framework, the state explicitly aligned its definitions with the federal standards found in Section 41 of the Internal Revenue Code (IRC). However, the Texas application of these rules introduced unique administrative requirements, such as the mandatory registration for sales tax exemptions and the annual filing of information reports to monitor the fiscal impact of the program. This dual structure was originally set to expire on December 31, 2026, but the success of the program led to the comprehensive overhaul in 2025 via Senate Bill 2206, which sought to remove the "either-or" administrative hurdle and provide a more robust, permanent incentive.

The Sales and Use Tax Exemption: Section 151.3182

The sales and use tax exemption is a powerful tool for capital-intensive R&D operations, particularly those in the semiconductor, biotechnology, and aerospace sectors. Under Texas Tax Code Section 151.3182, the sale, storage, or use of "depreciable tangible personal property" is exempt if it is directly used in "qualified research" by a person engaged in such research.

The threshold requirement for the sales tax exemption is the characterization of the property as depreciable. The statute defines this as tangible personal property that has a useful life exceeding one year and is subject to depreciation under Generally Accepted Accounting Principles (GAAP) or IRC Sections 167 or 168. This creates a meaningful distinction between the sales tax exemption and the franchise tax credit, as the latter can include "supplies" which are specifically defined by the IRC as non-depreciable property.

Taxpayers must be cautious when property is expensed for federal income tax purposes under IRC Section 174. The Texas Comptroller has clarified in policy memoranda that even if an item is allowed to be expensed under Section 174, it remains "property of a character subject to the allowance for depreciation" if its inherent nature meets the criteria of IRC Sections 167 or 168. Consequently, such items qualify for the sales tax exemption but are excluded from the "supplies" category of the franchise tax credit.

To qualify for the exemption, the property must be "directly used" in qualified research. The Comptroller’s office defines "directly" as having an immediate effect on an item or activity without an intervening, ancillary, or prior effect. This is a strict interpretation that excludes many types of property used in the general vicinity of research but not in the research itself.

Administrative Code Rule 3.340 provides specific examples to delineate the boundaries of direct use. For instance, laboratory machinery, experimental equipment, computers used for simulations, and laboratory furniture like benches and stools are considered directly used. In contrast, property used in "ancillary or support activities" does not qualify.

The following table summarizes the distinctions drawn by the Comptroller and administrative rules regarding the application of the sales tax exemption:

A person cannot claim the sales tax R&D exemption without first registering with the Comptroller’s office to obtain a Qualified Research Registration Number. This eight-character number, beginning with "RD," must be included on the Qualified Research Sales and Use Tax Exemption Certificate (Form 01-931) provided to vendors at the time of purchase.

Registration is achieved by filing Form AP-234. The application requires detailed information about the taxpayer, including their federal employer identification number (FEIN) and a certification that they will not claim the franchise tax credit for any period in which they utilize the sales tax exemption. Furthermore, the registrant is legally obligated to file an Annual Information Report (AIR) by March 31 of each year. The AIR serves as a data collection tool for the Comptroller to evaluate the economic impact of the exemption and requires reporting on the number of research employees and the total value of exempt purchases. Failure to file the AIR can lead to the immediate cancellation of the RD registration number, making any subsequent tax-free purchases a criminal offense.

The Franchise Tax Credit: Chapter 171, Subchapter M and T

The alternative path, the Research and Development Activities Credit, provides a credit against the Texas franchise tax. While the sales tax exemption focuses on capital equipment, the franchise tax credit is largely driven by labor costs (wages) and contract research expenses.

Under the rules prevailing for reports due before 2026, the credit amount is calculated as 5% of the excess of qualified research expenses (QREs) over a base amount. The base amount is defined as 50% of the average QREs incurred during the three preceding tax years. For entities with no prior QRE history in Texas, the credit is 2.5% of the current year’s QREs.

The credit is significantly enhanced for taxpayers who partner with public or private institutions of higher education in Texas. In such cases, the rate increases to 6.25% (pre-2026) or 10.903% (post-2026).

Texas incorporates the federal definition of QREs from IRC Section 41(b). These expenses are categorized into two primary types:

1. In-House Research Expenses:

   • Wages: Payments to employees for "qualified services," which include the actual conduct of research, direct supervision of research, and direct support of research (e.g., lab technicians or clerks compiling data).
   • Supplies: Tangible property used in the conduct of research, excluding land, land improvements, and any property subject to depreciation.
   • Computer Use: Amounts paid for the right to use computers in the conduct of research.

2. Contract Research Expenses:

   • Typically, 65% of the amount paid to third parties for research performed on the taxpayer's behalf.

The exclusion of depreciable property from "supplies" is the cornerstone of the dual-path choice. If a company spends $1 million on lab equipment and chooses the sales tax exemption, they save the 6.25% sales tax but cannot use those expenditures to increase their QREs for a franchise tax credit.

For franchise tax purposes, the credit must be claimed on the combined report of a combined group. The combined group is considered a single taxable entity for the purpose of the credit calculation and the 50% liability cap. In tiered partnership arrangements, an upper-tier entity can claim the credit for QREs incurred by a lower-tier entity to the extent of its ownership interest, provided the upper-tier entity includes the lower-tier entity’s total revenue in its own taxable margin calculation.

The transition rules for combined groups are particularly complex. If a member joins or leaves a combined group, their historical QREs may stay with the group or move with the entity depending on the circumstances, but the credit carryforward generally requires the member who generated the credit to remain part of the group.

Revenue Office Guidance and the STAR System

The Texas Comptroller’s State Automated Tax Research (STAR) system provides critical interpretations that define the boundaries of the law. These rulings often address the intersection of state-specific franchise tax rules and federal income tax principles.

A pivotal ruling issued in 2023 addressed whether a company could claim the R&D sales tax exemption for property used by a related entity. In this case, a subsidiary purchased equipment that its parent company used in qualified research. The Comptroller, citing the case Laredo Coca-Cola Bottling Co. v. Combs, ruled that the exemption must be strictly construed. The person claiming the benefit of the exemption (the purchaser) must be the same person who is using the property in qualified research activities. Because the subsidiary made the purchase but did not perform the research, the exemption was denied. This "entity isolation" principle is a trap for unwary taxpayers who do not align their purchasing entities with their operational research entities.

In a 2025 policy memorandum, the Comptroller clarified that federal intra-group transaction regulations (Treas. Reg. §1.41-6(i)(1)), which generally disregard transactions between members of a controlled group, do not apply to the Texas R&D credit or exemption. The rationale is that a federal "group under common control" is not equivalent to a Texas "combined group." Therefore, if one member of a Texas combined group performs research for another member, the state will not automatically disregard the transaction in the same way the IRS might. Taxpayers must substantiate these transactions based on Texas-specific rules, ensuring that expenses are not double-counted or excluded inappropriately across the combined group.

One of the most litigated areas of R&D tax law in Texas concerns internal use software. In 2021, the Comptroller adopted amendments to Rule 3.599 that created a significantly higher bar for IUS to qualify as research. These rules specifically excluded software developed for general and administrative functions (like payroll or accounting) from being qualified research.

The Comptroller’s rule establishes a "High Threshold of Innovation" test for IUS, requiring the software to be unique or novel, involve significant economic risk, and not be commercially available. Furthermore, the 2021 amendments introduced a "discovery test" for certain types of software, requiring it to expand the "common knowledge of skilled professionals" in the field. This standard is more restrictive than the modern federal standard, although Senate Bill 2206 aims to mitigate this discrepancy by aligning the definition of QREs with Federal Form 6765 for periods after 2026.

Senate Bill 2206: The 2026 Overhaul

Senate Bill 2206, signed into law in June 2025, represents a fundamental shift in Texas’s approach to R&D. The legislation addresses two primary criticisms of the existing regime: its temporary nature and the administrative complexity of the sales tax vs. franchise tax election.

Effective January 1, 2026, Texas Tax Code Section 151.3182 is repealed. From that date forward, businesses will no longer be able to purchase research equipment tax-free. This repeal is designed to simplify the state's tax code by funneling all innovation incentives through a single, more valuable franchise tax credit. Taxpayers are encouraged to accelerate planned equipment purchases into the 2025 calendar year to take advantage of the final months of the exemption.

The legislation makes the franchise tax credit permanent and increases the rates significantly. The base rate increases from 5% to 8.722%, and the university partnership rate increases from 6.25% to 10.903%. This represents an increase of nearly 74% in the value of the credit relative to the prior law.

Perhaps the most significant change for the startup community is the introduction of refundability. Under the old law, a pre-revenue startup with no franchise tax liability could only carry their credits forward. Under SB 2206, entities that owe no franchise tax (including those under the "no tax due" threshold of approximately $2.65 million for the 2026-2027 biennium) can receive the credit as a cash refund. This provides immediate liquidity to innovative firms that are not yet profitable.

SB 2206 ties the definition of QREs directly to Line 48 of IRS Form 6765. This move toward "rolling conformity" means that Texas will automatically follow the latest federal standards, including any changes to the IRC or adjustments made during federal audits. If the IRS accepts a taxpayer's adjusted ASC 730 financial statement R&D costs, the Texas portion of those costs is also considered sufficient evidence for the state credit. This significantly reduces the documentation burden and the risk of divergent audit outcomes between the state and federal governments.

Comparison and Modeling: A Practical Example

To understand the financial implications of these changes, consider "Apex Robotics," a mid-sized firm conducting advanced automation research in Texas.

• Current Period QREs (Wages/Supplies): $4,000,000
• Average QREs for Previous 3 Years: $3,000,000
• Depreciable Equipment Purchase Plan: $2,000,000
• University Contracted Research: None
• Texas Franchise Tax Due (Before Credits): $500,000

Apex must choose between Path A and Path B.

Path A: The Sales Tax Exemption (Section 151.3182)

• Apex saves the 6.25% state sales tax on the equipment: $2,000,000 x 0.0625 = $125,000.
• By choosing this path, they cannot claim the franchise tax credit.
• Total Benefit: $125,000.

Path B: The Franchise Tax Credit (Subchapter M)

• Apex pays the $125,000 in sales tax.
• Calculated Credit: 5% of ($4,000,000 - (0.5 x $3,000,000)) = 5% of $2,500,000 = $125,000.
• Apex also qualifies for local sales tax relief if applicable, but for state purposes, the benefit is equivalent.
• Total Benefit: $125,000.

In 2024, Path A is more attractive because it provides immediate cash flow relief at the point of purchase, whereas Path B is a deferred credit taken on the subsequent year's tax return.

In 2026, the sales tax exemption is gone, but the credit is significantly larger.

• Sales Tax Paid on Equipment: $125,000.
• Calculated Credit (Subchapter T): 8.722% of ($4,000,000 - $1,500,000) = 8.722% of $2,500,000 = $218,050.
• Credit Cap: The credit is limited to 50% of the $500,000 tax due = $250,000.
• Apex can use the full $218,050 credit because it is below the $250,000 cap.
• Net Benefit: $218,050 (Credit) - $125,000 (Sales tax paid) = $93,050 net savings.

While Apex pays more sales tax upfront, the net financial benefit from the enhanced credit is significantly higher than the pre-2026 options. Furthermore, if Apex's research had been conducted with a Texas university, the credit would have risen to 10.903% of $2,500,000 = $272,575, of which $250,000 would be used and $22,575 would be carried forward for up to 20 years.

Audit and Substantiation Requirements

The alignment with federal Line 48 reduces but does not eliminate audit risk. The Texas Comptroller retains the authority to verify that the research was actually conducted in Texas and that the expenses claimed are attributable to that Texas-based research.

Taxpayers should maintain a "research folder" for each business component being developed. This folder should include:

1. Project Descriptions: Outlining the technical uncertainty being addressed and the process of experimentation.
2. Labor Allocation: Time-tracking records or statistical sampling data (permitted under IRS Revenue Procedure 2011-42) showing the percentage of employee time spent on qualified activities.
3. Invoices and Receipts: Dated evidence for supplies and equipment, which is especially critical if claiming the final 2025 sales tax exemptions.
4. University Contracts: Documentation proving the partnership with an accredited Texas institution of higher education to justify the higher credit rate.

The Comptroller is authorized to verify QREs in "closed" years for the purpose of verifying credit carryforwards available in "open" periods. This means that even if a tax year is beyond the statute of limitations for a refund, the Comptroller can still audit the activities of that year if those activities generated a credit being used in a current year. Taxpayers must therefore preserve their R&D records for as long as the 20-year carryforward period remains active.

Final Thoughts

The overhaul of the R&D incentive program fundamentally changes the tax planning horizon for Texas companies. The move to a permanent, refundable credit is a signal that Texas intends to compete with high-tech hubs like California and Massachusetts by providing a more stable and generous incentive for early-stage innovation.

For large manufacturers, the repeal of the sales tax exemption may increase the upfront cost of modernization, but the nearly double credit rate for QREs provides a powerful long-term ROI. For startups, the introduction of refundability is a "game-changer" that converts paper credits into tangible capital. As January 1, 2026, approaches, businesses must reevaluate their purchasing schedules and ensure their internal tracking systems are aligned with the new federal-conformity requirements of Senate Bill 2206.