Contract Research Expenses

Contract research expenses represent sixty-five percent of the total payments made by a taxable entity to third parties for conducting qualified research activities physically within the borders of the state of Texas. To be eligible, the entity must retain substantial rights to the research outcomes and bear the financial risk of failure under an agreement established before the performance of the research begins.

The Theoretical and Statutory Foundation of the Texas Research and Development Credit

The Texas Research and Development (R&D) tax credit, currently governed by Texas Tax Code Chapter 171, Subchapter M, serves as a primary fiscal incentive designed to stimulate innovation, technological advancement, and high-skilled employment within the state. At its core, the credit allows taxable entities to offset a portion of their franchise tax liability based on qualified research expenses (QREs) incurred in Texas. These expenses are categorized into two primary types: in-house research expenses and contract research expenses. While in-house expenses focus on the internal costs of labor and supplies, contract research expenses address the modern reality of decentralized innovation, where companies outsource complex technical challenges to specialized vendors, laboratories, and academic institutions.

The statutory framework for these credits is inherently complex because it relies on a dynamic integration of state law and federal definitions. For reports due under Subchapter M, Texas law incorporates by reference the definitions of "qualified research" and "qualified research expense" from Section 41 of the Internal Revenue Code (IRC) of 1986 as it existed on December 31, 2011. This "frozen" conformity date is critical for tax practitioners, as it means that subsequent changes to federal law—such as those introduced by the Tax Cuts and Jobs Act (TCJA) regarding the amortization of R&D expenses under Section 174—do not automatically alter the eligibility criteria for the Texas credit under Subchapter M.

However, the landscape is shifting with the enactment of Senate Bill 2206, which repeals Subchapter M and replaces it with Subchapter T effective January 1, 2026. Subchapter T moves toward "rolling" conformity, meaning the state will follow the federal law in effect for the tax year in which the credit is claimed, specifically tying the definition of QREs to the amount reported on line 48 of IRS Form 6765. This transition signifies a legislative intent to simplify administration and reduce the disparity between federal and state audits, though it also introduces new complexities regarding the sourcing of these expenses to Texas.

Statutory Authority	Effective Period	Conformity Basis	Primary Reference
Subchapter O (Repealed)	Before 2008	Historical IRC	Section 171.111
Subchapter M (Current)	2014 – 2025	IRC as of Dec. 31, 2011	Section 171.651
Subchapter T (New)	2026 – Permanent	Rolling IRC (Current Year)	Section 171.9201

Defining Contract Research Expenses under Texas Law

Under both current and future iterations of the Texas R&D credit, contract research expenses (CREs) are defined as a specific percentage of payments made to any person, other than an employee of the taxable entity, for qualified research. The standard inclusion rate is 65%, a figure derived directly from IRC Section 41(b)(3). This reduction—often referred to as a "haircut"—is intended to reflect the reality that a contractor’s fee includes overhead and profit margins that do not directly represent the "hard" costs of research such as wages and supplies.

The Standard 65% Rule

For the vast majority of outsourced research, the 65% rule applies. This includes payments to third-party engineering firms, software development shops, testing laboratories, and individual consultants. The legal standard for these payments to qualify as CREs is rigorous. The services performed by the contractor must be of such a nature that they would constitute "qualified services" if performed by the taxpayer’s own employees. This means the contractor must be engaged in the direct conduct, direct supervision, or direct support of qualified research.

Enhanced Percentages for Research Consortia

Texas law and the IRC provide for higher inclusion rates in specific circumstances to encourage collaborative innovation. If a taxable entity satisfies the requirements of IRC Section 41(b)(3)(C), the percentage of allowable contract research expenses is increased to 75%. This higher rate applies to amounts paid to a "qualified research consortium," which is generally a tax-exempt organization (under IRC 501(c)(3) or 501(c)(6)) that is organized and operated primarily to conduct scientific research and is not a private foundation.

The 100% Rule for Energy Research

While less common in the general business context, IRC Section 41(b)(3)(D) allows for a 100% inclusion rate for amounts paid for qualified research which is "energy research" conducted by certain federal laboratories or institutions. Given Texas’s dominant position in the global energy sector, this provision can be particularly potent for entities engaged in advanced carbon capture, hydrogen production, or renewable grid integration technologies, provided the work is performed by qualified federal entities or research organizations.

Expense Type	Inclusion Percentage	Authority
Standard Third-Party Contractor	65%	IRC §41(b)(3)(A); TAC §3.599(b)(8)(B)
Qualified Research Consortium	75%	IRC §41(b)(3)(C); TAC §3.599(b)(8)(B)
Energy Research (Selected Entities)	100%	IRC §41(b)(3)(D)

The Three-Part Test for Contractual Eligibility

For a payment to be recognized as a contract research expense, the underlying agreement between the taxpayer and the contractor must satisfy a three-part test established in federal Treasury Regulations and adopted by the Texas Comptroller. This test ensures that the taxpayer is the true "funder" and "owner" of the research, rather than merely purchasing a finished product or a standard service.

1. The "Prior to Performance" Mandate

The agreement must be entered into prior to the performance of the qualified research. This requirement is strictly enforced by the Texas Comptroller. If an entity engages a contractor on a handshake basis and formalizes the contract midway through the project, the expenses incurred prior to the signature date are generally disqualified from being treated as QREs. This emphasizes the need for contemporaneous legal documentation that specifically outlines the research objectives and the nature of the technical uncertainties to be resolved.

2. The "On Behalf Of" Requirement

The research must be performed on the taxpayer’s behalf. This means the taxpayer must have the right to direct the research and must be the primary beneficiary of the knowledge generated. If a contractor is conducting research to develop their own proprietary tool and merely provides the taxpayer with a license to use that tool, the payments likely do not qualify as CREs. The taxpayer must be the one who "commissioned" the innovation.

3. The "Financial Risk" Condition

The taxpayer must bear the financial risk of the research. This is perhaps the most scrutinized element of the test during a Texas franchise tax audit. Financial risk is demonstrated when the taxpayer is obligated to pay the contractor even if the research is unsuccessful—that is, if the contractor fails to achieve the desired technical result. Conversely, if a contract is structured such that payment is contingent upon the contractor delivering a "working product" or meeting a specific performance guarantee, the contractor is the one bearing the risk of failure. In such contingent arrangements, the payments are viewed as the purchase of a result rather than the funding of research, and the expenses are ineligible for the credit.

Local State Revenue Office Guidance: The Texas Comptroller’s Interpretation

The Texas Comptroller of Public Accounts (CPA) provides the definitive interpretation of how these federal rules apply in the context of the Texas Franchise Tax. This guidance is disseminated through the Texas Administrative Code (TAC), specifically Rule 3.599, and the State Tax Automated Research (STAR) system.

Rule 3.599: The Administrative Anchor

Rule 3.599, "Margin: Research and Development Activities Credit," is the primary regulatory document for the credit. The rule underwent significant and controversial amendments in 2021, which were applied retroactively to January 1, 2014. These amendments clarified several key points regarding contract research:

• Contemporaneous Documentation: Taxpayers are required to maintain business records that were created at the time the research was performed. For contract research, this includes not just the executed contracts, but also invoices that detail the hours worked and the specific tasks performed, as well as progress reports or technical deliverables that prove the research occurred in Texas.
• The Burden of Proof: The 2021 rule changes established that a taxable entity has the burden of establishing its entitlement to the credit by "clear and convincing evidence". This is a higher legal standard than the "preponderance of the evidence" typically used in civil tax matters, making the quality of contractual and technical documentation for CREs paramount.
• Qualified Services Check: The Comptroller explicitly states that if an expense is paid to another person, it is only a CRE if that person is performing "qualified research". If the contractor is providing general administrative services, payroll processing, or routine quality control testing, those payments are excluded.

STAR System Memoranda and Private Letter Rulings

The STAR system provides a window into the Comptroller’s specific policy stances on complex CRE issues. Two recent memoranda from March 24, 2025, are of particular importance:

• Memorandum 202503004M (Federal Intra-group Transactions): This guidance clarifies that federal "group under common control" rules, which generally disregard transfers between members for federal R&D credit purposes, do not apply to the Texas credit. Because the Texas combined group is the taxable entity, research performed by one member for another within the same combined group is treated as in-house research (wages and supplies) rather than contract research. However, if research is performed by an entity outside the Texas combined group for a member of the group, it must be analyzed under the contract research rules.
• Memorandum 202501001M (Order of Application): This memo provides the hierarchy for applying various credits. It specifies that R&D credits, including those derived from CREs, must be applied after considering certain other credits but before others. It also dictates the internal order of R&D credits: Subchapter O carryforwards first, followed by Subchapter M carryforwards, and finally the current year Subchapter M credit.

The Geography of Innovation: The "In Texas" Sourcing Requirement

Perhaps the most significant difference between the federal R&D credit and the Texas credit is the geographic limitation. While the federal credit applies to research conducted within the United States, the Texas credit is strictly limited to qualified research "conducted in Texas".

Physical Work vs. Benefit Location

For contract research, the question arises: where is the research "conducted"? The Texas Supreme Court decision in Sirius XM Radio, Inc. v. Hegar and subsequent Comptroller rule changes (Rule 3.591) have clarified that a service is performed at the location where the taxpayer’s personnel or property are doing the work. For CREs, this means the contractor’s employees must be physically located in Texas while performing the research.

If a Texas-based company hires a California-based laboratory to perform testing, even if the results are sent to Texas and the benefit of the research is felt in Texas, the expenses are ineligible for the Texas R&D credit because the research was not "conducted in Texas". Conversely, if a multi-national corporation hires a contractor to work at its facility in Houston, those payments can qualify, regardless of where the contractor’s headquarters is located.

Apportionment of Contractor Costs

In cases where a contractor performs work both inside and outside of Texas, the taxable entity must apportion the expenses. The Comptroller requires a reasonable method for this apportionment, typically based on the fair value of the services rendered in Texas or the direct costs incurred by the contractor in the state. Taxpayers must be prepared to provide evidence, such as contractor time logs or geolocation data, to support the "In Texas" portion of their CREs.

Scenario	Location of Contractor	Eligibility for Texas R&D Credit
Contractor works at Texas site	Texas	Eligible (at 65%)
Contractor works at out-of-state lab	California	Ineligible
Contractor works remotely from Texas home	Texas	Eligible (at 65%)
Contractor splits time between TX and OK	Mixed	Apportion based on TX work days

The Funded Research Exclusion: Economic Risk and Substantial Rights

A fundamental principle of the R&D credit is that the same research cannot be claimed by two different taxpayers. To prevent this, the IRC and Texas law exclude "funded research" from the definition of qualified research.

Rights and Risks for the Researcher vs. the Funder

When a contractor (the researcher) performs work for a client (the funder), the determination of who gets the credit hinges on the concepts of "substantial rights" and "economic risk".

• The Funder's Perspective: To claim the CRE, the funder (taxable entity) must show they retain substantial rights to the results and bear the economic risk if the research fails.
• The Researcher's Perspective: If the contractor (researcher) retains substantial rights and the payments from the client are contingent on success, the research is not considered funded from the contractor’s perspective, allowing the contractor to claim the credit for their own in-house wages and supplies.

Defining "Substantial Rights"

"Substantial rights" do not necessarily mean exclusive rights. A taxable entity retains substantial rights if it has the right to use the research results in its own business without paying an additional fee. If the agreement requires the taxpayer to pay the contractor a royalty or a licensing fee to use the very research they just funded, the taxpayer does not have substantial rights, and the research is considered funded (meaning the contractor, not the client, might be eligible for the credit).

Economic Risk and Contingency

The "economic risk" analysis focuses on the payment structure.

• Time and Materials Contracts: These generally place the risk on the funder (client), as they must pay for the hours worked regardless of the outcome. This supports a CRE claim for the client.
• Fixed-Fee Contracts: These are more complex. If the contract specifies that the researcher will be paid the fixed fee only upon the delivery of a successful result, the risk is on the researcher. If the fee is payable upon the performance of specified research tasks, regardless of whether a discovery is made, the risk remains with the client.

Synergies with Higher Education: Enhanced Rates and Collaboration

Texas provides a significant incentive for entities to collaborate with academic institutions. Under Subchapter M, the credit rate increases from 5% to 6.25% of the excess QREs if the entity contracts with a public or private institution of higher education for the performance of qualified research in Texas.

Definition of Higher Education Institutions

"Public or private institution of higher education" is defined by Section 61.003 of the Texas Education Code. This includes public universities, health-related institutions, community colleges, and accredited private colleges and universities located within the state.

Impact on Combined Groups

For a combined group, the enhanced rate applies to the entire group’s QREs if any member of the group incurs QREs under a contract with a Texas institution of higher education during the report period. This is a strategic advantage for large corporate groups; a single research partnership between a subsidiary and a Texas university can lift the credit rate for all qualifying R&D activity conducted by every member of the group across the state.

The SB 2206 Shift to 10.903%

The legislative overhaul under SB 2206 dramatically increases these incentives. Beginning in 2026, the general credit rate jumps to 8.722%, and the enhanced rate for university-contracted research increases to 10.903%. This enhancement is intended to bridge the gap between academic theory and commercial application, fostering innovation hubs in cities like Austin, Dallas, and Houston.

Feature	Subchapter M (Pre-2026)	Subchapter T (Post-2026)
Standard Credit Rate	5.0%	8.722%
University Contract Rate	6.25%	10.903%
Rate for "No Prior QREs"	2.5% / 3.125%	4.361% / 5.451%

Calculation Methodology and the Incremental Approach

The Texas R&D credit is an incremental credit, meaning it rewards companies for increasing their R&D spend rather than just maintaining a static level.

The Base Amount Calculation

The credit is generally calculated as a percentage of the difference between the QREs in the current year and a "base amount". The base amount is defined as 50% of the average QREs incurred in Texas over the three tax periods immediately preceding the report year.

The formula for the credit calculation is as follows:

$$ \text{Credit} = \text{Rate} \times \left( \text{Current Year Texas QRE} - \left( 0.5 \times \frac{\sum \text{Prior 3 Years Texas QRE}}{3} \right) \right) $$

Treatment of Entities with No Prior QREs

If a taxable entity (or a member of a combined group) had no QREs in one or more of the three preceding tax periods, a simplified "flat" rate is applied to the current year’s total QREs. Under Subchapter M, this rate is 2.5% (or 3.125% for university contracts). Under the new Subchapter T, these base rates will increase to 4.361% and 5.451%, respectively. This provides an immediate benefit for startups and companies newly relocating their R&D centers to Texas.

The 50% Liability Limitation

A critical constraint on the credit is the 50% cap. The total credit claimed for a report, including current year credits and carryforwards, cannot exceed 50% of the amount of franchise tax due for the report before any other applicable tax credits. Any unused credit can be carried forward for up to 20 consecutive reports.

Documentation Standards and Audit Readiness for CREs

The Texas Comptroller’s Audit Division is known for its rigorous examination of R&D credits, particularly regarding the "clear and convincing" standard. For contract research, documentation must go beyond the "Accounting Method" to the "Project Method".

Essential Contractual Evidence

• Master Service Agreements (MSAs) and Statements of Work (SOWs): These must pre-date the research and explicitly state that the taxpayer retains rights to all developed intellectual property.
• Risk Allocation Clauses: Audit defense is strengthened by clauses that explicitly place the risk of failure on the taxpayer—e.g., "Contractor makes no guarantee of outcome, and all fees are payable based on efforts expended".

Proving Sourcing

• Contractor Attestations: For remote or distributed teams, a signed letter from the contractor stating the percentage of hours worked physically within Texas is often required.
• Project Tracking: Invoices should be broken down by project and location. If a vendor provides both qualified research and routine maintenance, only the research portion (subject to the 65% haircut) should be included.

The Role of Statistical Sampling

Starting with Subchapter T in 2026, the law explicitly allows the use of statistical sampling procedures, as permitted under IRS Revenue Procedure 2011-42, to determine the amount of QREs. This provides a more efficient path for large companies with thousands of contractor invoices to estimate their Texas-based research spend without a line-by-line audit of every transaction.

Comprehensive Example: Applied Contract Research Credit Calculation

Consider "TechInnovate LLC," a Texas-based software engineering firm that files a franchise tax report for the 2025 period (under Subchapter M rules).

Step 1: Identify Expenditures

During 2024 (the period on which the 2025 report is based), TechInnovate LLC had the following expenses:

1. Texas Employees: $1,000,000 in wages for engineers developing a new AI-driven encryption protocol.
2. External Lab (Austin, TX): $200,000 paid to a security testing firm under a time-and-materials contract signed in Jan 2024.
3. External Consultant (California): $50,000 paid to a cloud specialist for remote consultation.
4. University Collaboration (University of Texas): $100,000 paid for a joint research project on quantum computing.

Step 2: Determine Qualified Research Expenses (QREs)

• In-house Wages: $1,000,000 (100% included).
• Austin Lab (CRE): $200,000 x 65% = $130,000 (included because it is in Texas and satisfies the risk/rights test).
• CA Consultant: $0 (excluded because the work was not conducted in Texas).
• UT Contract (CRE): $100,000 x 65% = $65,000 (qualifies for the enhanced 6.25% rate because of university involvement).

Total Current Year Texas QREs: $1,195,000.

Step 3: Calculate the Base Amount

Assume TechInnovate's Texas QREs for the three preceding years were:

• Year -1: $800,000
• Year -2: $900,000
• Year -3: $700,000

Average Prior QRE = ($800,000 + $900,000 + $700,000) / 3 = $800,000.

Base Amount = 50% of Average = $400,000.

Step 4: Compute the Credit

Because the entity has a university contract, the 6.25% rate applies to the excess.

Excess QRE = $1,195,000 - $400,000 = $795,000.

Tax Credit = $795,000 x 6.25% = $49,687.50.

Step 5: Application of Limit

If TechInnovate LLC owes $80,000 in franchise tax, the credit is limited to 50% of the tax due: $80,000 x 0.50 = $40,000.

• Credit Claimed: $40,000.
• Credit Carryforward: $9,687.50 (available for the next 20 years).

Legislative Evolution: From Subchapter M to Subchapter T

The transition from Subchapter M to Subchapter T marks a profound shift in Texas's economic strategy. For over a decade, Subchapter M provided a stable but somewhat rigid framework based on 2011 federal definitions. This "frozen" baseline meant that newer technological categories—such as certain types of cloud-based development tools and advanced "internal use software" (IUS)—often sat in a grey area where federal law had evolved but Texas law had not.

The Internal Use Software Contours

One of the most litigated aspects of Rule 3.599 was the exclusion of IUS from "qualified research". The 2021 amendments defined IUS as computer software developed for use in the operation of the business, rather than for sale or lease. This definition was more restrictive than the post-2011 federal regulations, which offer broader safe harbors for IUS that is innovative and involves significant economic risk. For contractors working on internal systems, this meant that their fees were often excluded from the credit unless the software was "marketed for separately stated consideration". Subchapter T’s move to rolling conformity in 2026 is expected to resolve this disparity, bringing Texas law in line with the more modern and inclusive federal IUS standards.

Amortization and Section 174 Complexity

The Tax Cuts and Jobs Act of 2017 introduced a requirement for companies to capitalize and amortize R&D expenses under Section 174 over five years for domestic research and fifteen years for foreign research. Because Subchapter M is tied to the 2011 IRC, Texas taxpayers were largely spared the administrative nightmare of reconciling state tax credits with federal amortization schedules. However, as Subchapter T adopts rolling conformity, the interplay between Section 41 (the credit) and Section 174 (the expense) becomes a central concern. The Texas Comptroller’s March 2025 memo clarified that just because an expense is allowed under Section 174 does not automatically make it a QRE under Section 41. This is particularly relevant for contractors who may be providing "depreciable property" as part of their services; such property is generally excluded from QREs even if it is expensed under Section 174.

Future Outlook: Refundability and the 2026 Horizon

The most transformative change on the horizon is the introduction of refundability for certain entities. Historically, the Texas R&D credit was non-refundable; if a company had no franchise tax liability (e.g., due to losses or being under the no-tax-due threshold), the credit merely sat as a carryforward.

Refundability for Entities Owing No Tax

Under Subchapter T (effective 2026), a taxable entity that incurs QREs during a period for which it is not required to pay franchise tax—such as a startup below the $2.47 million revenue threshold or a new veteran-owned business—can apply for a cash refund of the credit. This essentially turns the R&D credit into a direct subsidy for early-stage innovation, making the correct classification of contract research expenses more valuable than ever for pre-revenue companies.

Repeal of the Sales Tax Exemption

Taxpayers must also prepare for the repeal of the sales and use tax exemption for R&D equipment (Section 151.3182). Currently, taxpayers must choose each year between the franchise tax credit and the sales tax exemption. By 2026, the franchise tax credit will be the sole remaining R&D incentive in Texas. This consolidation emphasizes the importance of understanding the CRE rules, as the "enhanced" 8.722% credit is designed to compensate for the loss of the sales tax exemption.

Final Thoughts

The meaning of contract research expenses within the Texas R&D tax credit is a function of both the mathematical percentage (65%, 75%, or 100%) and the legal substance of the underlying agreement. Taxable entities must navigate a complex landscape of historical and rolling federal conformity, stringent "In Texas" sourcing rules, and high evidentiary standards set by the Comptroller. As Texas transitions from the Subchapter M framework to the more aggressive and potentially refundable Subchapter T, the ability to properly structure third-party contracts and maintain contemporaneous proof of work becomes a critical component of corporate tax strategy. By aligning contractor agreements with the "rights and risks" framework and prioritizing collaborations with Texas institutions of higher education, businesses can maximize their credit potential and solidify their position within the state's growing innovation economy.