Property of a Character Subject to Depreciation (Exclusion)

Property of a character subject to depreciation refers to tangible assets used in a trade or business that possess a determinable useful life of more than one year and are subject to exhaustion, wear, tear, or obsolescence. Within the context of the Texas Research and Development (R&D) tax credit, this property is categorically excluded from the definition of “supplies,” ensuring that the credit is applied only to consumable items and labor rather than capitalized equipment.

Theoretical and Statutory Foundations of the Depreciable Character Exclusion

The fundamental exclusion of “property of a character subject to depreciation” from the Texas Research and Development tax credit is a cornerstone of state tax policy, designed to distinguish between immediate operational expenditures and long-term capital investments. This distinction is rooted in the legislative intent to provide a targeted incentive for the high-risk, variable costs associated with innovation, while leaving the recovery of fixed asset costs to traditional depreciation schedules or specialized exemptions. To understand the “character” of property in this context, one must look to the intersection of the Texas Tax Code and the federal Internal Revenue Code (IRC), as the state system is historically tied to federal definitions of qualified research.

The term “character subject to depreciation” is a term of art that describes an asset’s inherent nature and its relationship to the taxpayer’s business operations rather than its current accounting status. Under IRC Section 167 and Section 168, which are incorporated by reference into the Texas R&D framework, property possesses this character if it is used in a trade or business or held for the production of income and has a determinable useful life that extends beyond a single tax year. This “character” is measured specifically in the hands of the taxpayer, meaning the same physical object could be a non-depreciable supply for a retailer (who holds it for sale) but property of a character subject to depreciation for a manufacturer (who uses it as a tool).

In the Texas tax landscape, the exclusion serves as a jurisdictional boundary. Historically, the state has offered taxpayers a binary choice: they could either claim a sales and use tax exemption for depreciable tangible personal property directly used in qualified research or they could claim a franchise tax credit based on qualified research expenses (QREs). By excluding depreciable property from the franchise tax credit’s “supply” category, the law prevents a “double dip” where a taxpayer might seek a credit on the full purchase price of a piece of equipment that is also eligible for a sales tax exemption or long-term depreciation deductions.

Legislative Evolution: From Subchapter M to the Subchapter T Reform

The Texas R&D tax credit has undergone significant shifts since its inception by the 83rd Texas Legislature in 2013 via House Bill 800. For over a decade, the credit was governed by Chapter 171, Subchapter M of the Tax Code, which defined QREs by referencing IRC Section 41 as it existed on December 31, 2011. This “frozen” conformity created an administrative environment where state-specific interpretations often diverged from evolving federal standards, leading to significant controversy regarding the classification of supplies versus depreciable assets.

In June 2025, Governor Greg Abbott signed Senate Bill (SB) 2206, which fundamentally overhauls the state’s R&D incentives. Effective January 1, 2026, Subchapter M and the associated sales tax exemption for R&D equipment are repealed. In their place, the legislature established Subchapter T, a permanent franchise tax credit that moves from frozen conformity to “rolling” conformity by tying the definition of QREs directly to Line 48 of IRS Form 6765.

This transition has profound implications for the depreciable property exclusion. Under the old Subchapter M regime, taxpayers frequently engaged in litigation and administrative hearings with the Comptroller over whether items expensed under IRC Section 174 (such as pilot models) could be treated as non-depreciable supplies for the Texas credit. SB 2206 attempts to mitigate these disputes by streamlining the definition of QREs to match federal filings. However, because the federal definition of “supplies” in IRC Section 41(b)(2)(C) continues to explicitly exclude property of a character subject to depreciation, the exclusion remains a fundamental part of the Texas tax calculation.

Local Revenue Office Guidance and the Comptroller’s Interpretive Stance

The Texas Comptroller of Public Accounts has issued critical guidance to clarify the boundary between supplies and depreciable property. This guidance is primarily contained in formal rules (Title 34 of the Texas Administrative Code) and STAR (State Tax Automated Research) system memoranda. These documents provide the “local” interpretation of the law that state auditors apply during examinations.

The 2021 Regulatory Amendments and the “Substantially All” Test

In 2021, the Comptroller adopted revised versions of Rule 3.599 (Franchise Tax) and Rule 3.340 (Sales Tax), which significantly tightened the requirements for claiming the R&D credit. These rules clarify that “qualified research” must involve a process of experimentation intended to discover information that is technological in nature and intended for a new or improved business component.

A pivotal aspect of this guidance is the “substantially all” test, which requires that at least 80% of a taxpayer’s research activities (measured by cost) constitute elements of a process of experimentation. When property of a character subject to depreciation is involved in a research project, it must be excluded from the 80% calculation of qualifying costs. The Comptroller’s guidance explicitly states that federal regulations regarding pilot models and prototypes (IRC Section 1.174-2) do not automatically apply to the Texas credit, which has historically allowed the state to exclude production costs that the federal government might permit.

STAR Memorandum 202503003M: The Supply Exclusion Controversy

On March 24, 2025, the Comptroller issued Memorandum 202503003M to address a specific strategy used by taxpayers to circumvent the depreciable property exclusion. Many taxpayers argued that if an item of property was fully expensed under IRC Section 174 (Research and Experimental Expenditures) in the year of purchase, it was no longer “of a character subject to depreciation” because there was no remaining basis to depreciate under Sections 167 or 168.

The Comptroller’s memorandum rejected this reasoning in no uncertain terms. The guidance establishes that:

• Character is Inherent: The determination of whether property is depreciable is based on the nature of the asset and its useful life in the taxpayer’s business, not the specific section of the tax code used to deduct its cost.
• Section 41 Controls: While Section 174 allows for the expensing of certain capital-like items, Section 41 (the basis for the credit) contains a specific, restrictive definition of “supplies” that excludes depreciable property.
• Audit Directive: Auditors are instructed to exclude any property from the supply category if it would normally be subject to depreciation, regardless of whether the taxpayer elected to expense it under Section 174 for federal purposes.

This memorandum is a crucial piece of revenue office guidance because it prevents the recharacterization of equipment (like CNC machines or specialized lab tools) as “supplies” simply because they were bought for a specific research project.

STAR Memorandum 202503004M: Intra-Group Transactions and Combined Reporting

A second memorandum issued the same day, 202503004M, addresses how property is treated when transferred between affiliated companies. In the federal system, a “group under common control” is treated as a single taxpayer, and transfers of property between members are generally disregarded. However, the Comptroller clarified that a federal controlled group is not equivalent to a Texas combined group.

For the Texas R&D credit, the combined group is the taxable entity. Transactions involving depreciable property between members of a federal controlled group that are not members of the same Texas combined group must be accounted for as third-party transactions. This means that if a parent company in another state sells a depreciable testing rig to its Texas subsidiary, the character of that property in the subsidiary’s hands must be independently evaluated, and the transaction cannot be disregarded under federal consolidation rules.

Applying the Law: Distinguishing Supplies from Capital Assets

The practical application of the depreciable property exclusion requires a granular analysis of how assets are used in the research process. The distinction often hinges on whether an item is “consumed” during the research or remains as a functional asset of the business after the specific project is completed.

The “Useful Life” Barrier

The primary metric used by the Comptroller to identify property subject to the exclusion is the “useful life” test. Tangible personal property with a useful life of more than one year is generally considered depreciable under both GAAP and the Internal Revenue Code.

In a manufacturing or engineering context, this creates a clear divide:

• Qualifying Supplies: Raw materials such as chemicals, scrap metal, breadboarding components, and 3D printing resins that are transformed or destroyed during an experiment.
• Excluded Property: Tools, machinery, computers, and furniture that are used to conduct the research but remain intact and functional for future use.

The Prototype and Pilot Model Distinction

The treatment of prototypes and pilot models is perhaps the most complex area of the depreciable property exclusion. Under federal Section 174, a pilot model is a representation of a product used to resolve uncertainty. While the costs of building a prototype are often qualifying research expenditures, the “character” of the resulting prototype determines its eligibility for the Texas credit.

If a company builds an experimental engine and destroys it during a “test to failure,” the materials used to build it are non-depreciable supplies because they were consumed in the research. However, if the company builds an experimental turbine and then uses it as a demonstration unit for customers over several years, the turbine becomes property of a character subject to depreciation. The Comptroller’s 2021 regulatory updates specifically targeted this area by stating that the federal safe harbor for pilot models does not apply to the Texas credit, allowing auditors to scrutinize whether a prototype has become a functional asset of the business.

Administrative and Procedural Compliance

Claiming the Texas R&D credit requires rigorous adherence to procedural requirements, especially concerning the substantiation of supplies versus excluded property. The Comptroller expects a “clear and convincing” level of evidence for expenses claimed.

Registration and Reporting Requirements

To claim either the sales tax exemption or the franchise tax credit, a person must be “engaged in qualified research”. Under current law, those seeking the sales tax exemption must register with the Comptroller’s office and obtain an RD registration number.

When filing the Franchise Tax Report, the credit is claimed on Form 05-178 (Research and Development Activities Credits Schedule). Taxpayers must provide:

• Total amount of purchases in Texas that qualify for the sales tax exemption (if applicable).
• Total qualified research expenses (QREs) in Texas.
• Number of full-time and part-time employees engaged in research.
• Detailed payroll expenses for those employees.

Starting in 2026 under Subchapter T, the administrative burden will shift toward federal documentation. Taxpayers will be required to file an amended Texas report if their federal QREs are changed as a result of an IRS audit or a federal amended return. This ensures that the state’s exclusion of depreciable property—now managed via Line 48 conformity—remains consistent with federal determinations.

The Role of Statistical Sampling

Both the IRS and the Texas Comptroller permit the use of statistical sampling to determine QREs, as outlined in IRS Revenue Procedure 2011-42. This is particularly relevant for the depreciable property exclusion because it allows large taxpayers with thousands of supply purchases to use a representative sample to prove that their claimed supplies are not property of a character subject to depreciation.

If an auditor finds that a sample of “supplies” actually contains depreciable tools or equipment, they will extrapolate that error rate across the entire population of claimed supplies, leading to significant disallowances. Therefore, the internal controls used to flag depreciable property at the point of purchase are vital for the integrity of the credit claim.

Detailed Industry Example: Aerospace Component Development

To illustrate the nuanced application of the depreciable property exclusion and the relevant local guidance, consider the case of “AeroTex Innovation,” a fictional aerospace engineering firm based in Fort Worth.

The Project: Next-Generation Wing Actuators

AeroTex is developing a new hydraulic actuator designed to reduce weight in commercial aircraft. The project involves iterative design, material stress testing, and the construction of several functional models.

Expense Breakdown and Tax Treatment

During the 2024 tax year (under Subchapter M), AeroTex incurs the following costs:

1. Specialized Titanium Alloy ($250,000): Used to fabricate various versions of the actuator. These versions are subjected to “destructive testing” where they are pressurized until they explode to determine the material’s limit.

• Treatment: This qualifies as a supply QRE. The alloy is tangible property that is not depreciable because it is consumed during the research.

2. High-Precision Milling Machine ($400,000): Purchased specifically to mill the titanium alloy to the precise tolerances required for the project. The machine has an expected life of 10 years and will be used for future projects.

• Treatment: This is property of a character subject to depreciation. It is categorically excluded from the franchise tax credit. However, AeroTex may claim the sales tax exemption on this purchase, provided they do not claim the franchise tax credit for the period in which the machine was first used.

3. Experimental Actuator Prototype ($100,000): A fully functional actuator that is not destroyed but is instead installed in a flight simulator used for pilot training and long-term reliability monitoring.

• Treatment: Because this prototype is retained as a functional asset of the business with a useful life exceeding one year, it takes on the character of depreciable property. Under the guidance of STAR 202503003M, the costs to build this prototype—even if expensed under Section 174—must be excluded from the credit calculation as a non-qualifying supply.

4. University Research Contract ($150,000): AeroTex pays a Texas university to perform computational fluid dynamics (CFD) modeling of the actuator’s hydraulic flow.

• Treatment: This is a Contract Research Expense. 65% of the cost ($97,500) qualifies for the credit. Under the 2026 rules (Subchapter T), the credit rate for this specific expenditure would be higher (10.903%) than for internal research.

Comparative Financial Impact (Subchapter M vs. Subchapter T)

If AeroTex chooses the Franchise Tax Credit in 2024, they would lose the sales tax exemption on the $400,000 machine (approximately $33,000 in Fort Worth). They would then calculate their credit based on the $250,000 in supplies and $97,500 in contract research.

In 2026, under Subchapter T, AeroTex would no longer have the choice. They would pay the sales tax on the milling machine upfront and would be eligible for a significantly higher credit rate (8.722%) on their qualifying expenses, helping to offset the loss of the sales tax benefit.

Strategic Implications of the 2026 Transition

The repeal of the sales tax exemption for R&D equipment in 2026 represents a major shift in the “cash flow” profile of Texas innovation. Previously, the sales tax exemption provided an immediate, front-end benefit at the moment of purchase, which was particularly valuable for capital-intensive industries like semiconductor manufacturing or aerospace.

The “Game-Changer” for Small Businesses and Startups

One of the most significant aspects of the new Subchapter T is the introduction of refundability for certain entities. Historically, many startups and small businesses chose the sales tax exemption because they had no franchise tax liability to offset with a credit. With the sales tax exemption disappearing, the legislature added a mechanism where businesses with “no tax due” (including new veteran-owned businesses and low-revenue entities) can receive their R&D credit as a cash refund.

This change ensures that the exclusion of depreciable property from the credit base does not unduly penalize young companies that are investing heavily in the “character” of their business assets before they become profitable.

Audit Readiness in the Era of Rolling Conformity

The shift to “rolling conformity” means that Texas taxpayers will now be more vulnerable to federal changes in tax law. If the federal government were to further restrict the definition of “supplies” or expand the definition of what constitutes “property of a character subject to depreciation,” those changes would immediately apply to the Texas credit.

Taxpayers should focus on:

• Documentation Alignment: Ensuring that the internal “R&D study” used to support federal Form 6765 is robust enough to meet Texas Comptroller standards, which have historically been higher than the IRS standard in areas like internal-use software and pilot models.
• Asset Lifecycle Tracking: Maintaining detailed records of how prototypes and pilot models are used after the research phase to defend against “recharacterization” by state auditors.
• Intercompany Transaction Clarity: Following the guidance of STAR 202503004M, businesses must carefully document transfers of research property between affiliates to ensure that the Texas combined group’s credit is not improperly based on federal “single taxpayer” assumptions.

Final Thoughts

The exclusion of “property of a character subject to depreciation” from the Texas R&D tax credit is a sophisticated mechanism that aligns state incentives with a specific definition of operational risk. By distinguishing between long-lived capital assets and consumable research supplies, Texas has created a framework that encourages innovation while maintaining a traditional approach to capital recovery. The 2025 Comptroller memoranda and the subsequent SB 2206 overhaul represent the most significant changes to this policy since its inception, moving the state toward a permanent, federally-aligned system that values consistency over individual choices. For the Texas taxpayer, success in this environment requires not only a high degree of technical innovation but also a precise legal and accounting understanding of the “character” of the property that drives that innovation. As the state enters the Subchapter T era in 2026, the ability to differentiate between a depreciable tool and a qualifying supply will remain the primary factor in maximizing the value of the Texas Research and Development tax credit.