Depreciable Property (IRC § 167 or 168)

Depreciable property under Internal Revenue Code Sections 167 and 168 constitutes tangible assets used in trade or business with a useful life exceeding one year that decline in value through wear, tear, or obsolescence. Within the Texas research and development tax incentive structure, this classification determines eligibility for sales tax exemptions on equipment and specifically excludes such assets from supply-based franchise tax credit calculations.

The Federal Foundation: Internal Revenue Code Sections 167 and 168

The federal conceptualization of depreciation serves as the cornerstone for Texas state tax law, providing the criteria for identifying assets that qualify for research-related incentives. Internal Revenue Code (IRC) Section 167 provides the general rule allowing for a depreciation deduction, which represents a reasonable allowance for the exhaustion, wear and tear, and obsolescence of property used in a trade or business or held for the production of income. This allowance is not merely a tax benefit but a structural recognition that capital assets are consumed over time as they contribute to the revenue-generating activities of a taxable entity. The basis for this deduction is generally the adjusted basis provided in Section 1011, which is the same basis used to determine gain or loss upon the sale or disposition of the property.

IRC Section 168 establishes the Modified Accelerated Cost Recovery System (MACRS), which dictates the specific methods, recovery periods, and conventions for tangible property. Under Section 168, property is classified into recovery periods ranging from 3-year property to 50-year property, based primarily on its class life. For property to be depreciable, the taxpayer must demonstrate that the asset is subject to exhaustion and has a determinable estimated useful life. This requirement has led to complex litigation and administrative rulings, such as Revenue Ruling 2015-11, which addresses the depreciable nature of unrecoverable precious metals used in manufacturing processes. The ruling clarifies that while precious metals like platinum are generally not depreciable because they can be recovered and recycled, they become depreciable if they are lost or unrecoverable during a process, as this constitutes "exhaustion" in the statutory sense.

The federal courts, including the Eighth Circuit, have reinforced that whether an asset is depreciable depends on the taxpayer’s showing that the asset is subject to physical exhaustion or functional obsolescence. For example, tin used in a glass manufacturing process that declines in volume and purity over time is considered property of a character subject to the allowance for depreciation under Section 167, and thus recovered under Section 168. This distinction is critical in Texas, where the state tax code explicitly adopts the federal characterization of property to define the boundaries of its Research and Development (R&D) incentives.

Texas Statutory Adoption and the Dual-Incentive Mechanism

The Texas Legislature, through House Bill 800 in 2013, established a dual-incentive framework to encourage R&D activities within the state, consisting of a franchise tax credit and a sales and use tax exemption. Both incentives rely on the definitions provided in IRC Section 41, but they apply differently to depreciable property. Texas Tax Code Section 151.3182 defines "depreciable tangible personal property" as tangible personal property that has a useful life exceeding one year and is subject to depreciation under either Generally Accepted Accounting Principles (GAAP) or IRC Sections 167 or 168.

Under the current legal structure, which remains effective until December 31, 2025, taxpayers engaged in qualified research must choose between the two incentives for any given tax period. This election is mutually exclusive: a taxpayer cannot claim a sales tax exemption on equipment and also claim a franchise tax credit on the same research activities for the same period. The following table outlines the structural differences between these two incentives as they relate to depreciable property.

The adoption of the 2011 version of the IRC means that Texas law does not automatically incorporate subsequent federal changes, creating a "frozen" statutory environment for R&D purposes. However, administrative rules like 34 Texas Administrative Code § 3.599 and § 3.340 provide the Comptroller’s interpretation of how these federal standards apply to Texas-specific scenarios.

Administrative Guidance on Depreciable Property and "Direct Use"

The Texas Comptroller of Public Accounts provides rigorous guidance on what constitutes the "direct use" of depreciable property in qualified research. This is the primary standard for the sales tax exemption. According to the Comptroller, "directly" means having an immediate effect on an item or in an activity, without an intervening, ancillary, or prior effect.

Depreciable tangible personal property is considered directly used if it is employed in the actual performance of activities that are part of the qualified research, such as the process of experimentation. This includes machinery, equipment, computers, software, tools, and laboratory furniture like benches and storage cabinets. Conversely, property used in ancillary or support activities—such as administration, maintenance, marketing, distribution, or transportation—does not qualify. For instance, a high-performance computer used by an engineer to run fluid dynamics simulations is exempt, while a computer used by the same engineer for administrative reporting or time-tracking is not.

The Comptroller’s interpretation of depreciable property often hinges on the physical nature of the asset and its role in the "Four-Part Test" for qualified research. The Four-Part Test, adopted from IRC Section 41(d), requires that research be:

1. Conducted to eliminate technical uncertainty (Section 174 Test).
2. Technological in nature, relying on physical or biological sciences, engineering, or computer science.
3. Intended for a new or improved business component.
4. Part of a process of experimentation.

Property that satisfies these tests and is depreciable may be exempt. However, the Comptroller has issued specific warnings regarding certain types of property. For example, electricity and natural gas are never considered depreciable tangible personal property for the R&D exemption, as they are consumed instantly and do not have a useful life exceeding one year. Furthermore, materials used to build improvements to real property—such as specialized laboratory walls or built-in ventilation systems—are excluded if they are categorized as real property rather than personal property. Under Rule 3.340, property must be tangible personal property subject to depreciation at the time of purchase to qualify; if non-depreciable materials are later incorporated into depreciable real property, they remain taxable.

The Statutory Tension Between IRC Section 174 and Section 41

A significant area of policy conflict and administrative guidance involves the interaction between IRC Section 174 and the definition of supplies for the franchise tax credit. IRC Section 41(b)(1) defines qualified research expenses as the sum of in-house research expenses and contract research expenses. In-house expenses include "supplies," defined in Section 41(b)(2)(C) as any tangible property other than land or improvements to land and "property of a character subject to the allowance for depreciation".

Taxpayers have argued that because IRC Section 174 allows for the immediate expensing of certain research and experimental expenditures, those items are no longer "of a character subject to the allowance for depreciation" and should therefore be includable as supplies for the credit. The Comptroller addressed this in a March 2025 memorandum, clarifying that an item's status as a Section 174 expense does not change its character as depreciable property under Section 167. The Comptroller noted that whether property is depreciable is determined by its inherent nature and use by the taxpayer; if the acquisition of property would generally be recovered through depreciation, it is excluded from the definition of "supplies" for the Texas credit, regardless of whether the taxpayer chooses to expense it under Section 174.

This distinction is vital for compliance. If a taxpayer improperly includes the cost of a depreciable laboratory centrifuge as a "supply" in their franchise tax credit calculation, the Comptroller will likely disallow that expense upon audit, citing the property's depreciable character under Section 167. The taxpayer’s only remedy for such an asset is the sales tax exemption, which must have been elected at the time of purchase and supported by an RD registration number.

Judicial Interpretations: The Silicon Labs Case and Beyond

Texas courts have been called upon to interpret the application of these rules, particularly regarding the "direct use" of technological property. In Silicon Labs v. Hegar, the dispute focused on Electronic Design Automation (EDA) software tools used to design and develop semiconductor chips. Silicon Labs argued that the EDA tools were directly used in qualified research because they allowed engineers to create and verify chip designs in a virtual environment, simulating the physical manufacturing process.

The court’s analysis centered on whether these software tools had an "immediate effect" on the research activity as required by Rule 3.340. The case underscored that in high-technology industries, "direct use" may occur in a virtual or digital space, provided the software is essential to the experimentation process and is of a character subject to depreciation under Section 167. This judicial trend supports a broader reading of the R&D exemption for specialized software that functions as a research instrument.

However, the Comptroller remains strict regarding software activities that do not meet the "Process of Experimentation" test. Rule 3.340(a)(6)(C) lists 21 software activities unlikely to qualify for the exemption, including configuring purchased software, reverse engineering existing applications, and routine data quality activities. These exclusions highlight that while the software itself may be depreciable, its use must align with the rigorous technological discovery requirements of the law.

Comparative Analysis of Federal and State Taxpayer Entities

A complex layer of local revenue office guidance involves the treatment of related entities and combined groups. In a 2023 private letter ruling (PLR 202302017L), the Comptroller addressed whether a subsidiary that owns land and facilities could use its parent company's RD registration number to claim sales tax exemptions on equipment purchases. The Comptroller ruled that the entity claiming the exemption must be the same entity engaged in the qualified research.

The Comptroller’s 2025 memorandum further clarified that federal "controlled group" regulations under Treas. Reg. § 1.41-6, which treat all members of a group as a single taxpayer for the federal R&D credit, do not apply to the Texas sales tax exemption. For Texas sales tax purposes, each legal entity is a separate taxpayer. Therefore, if Parent Co. performs the research but Subsidiary Inc. buys the equipment, Subsidiary Inc. cannot claim the R&D exemption because it is not the "person" engaged in qualified research. This creates a significant trap for corporate groups that separate asset ownership from operational activities.

The Impact of the 2026 Legislative Transformation: SB 2206

The landscape for depreciable property in Texas R&D will undergo a fundamental change starting January 1, 2026, due to the passage of Senate Bill 2206. This bill repeals the current dual-incentive system—including the sales tax exemption for depreciable property—and replaces it with an expanded, permanent franchise tax credit under a new Subchapter T of Chapter 171.

The most critical change is the repeal of Texas Tax Code Section 151.3182, which provided the sales tax exemption for R&D equipment. Starting in 2026, research equipment purchases will be subject to state and local sales tax at the point of sale. To compensate for this loss, the Legislature significantly increased the franchise tax credit rates.

The new Subchapter T credit adopts "rolling conformity" to the federal IRC, moving away from the frozen 2011 date. It also ties the credit calculation directly to line 48 of IRS Form 6765 for research conducted in Texas. This shift is intended to reduce administrative burdens by allowing the Comptroller to follow federal audit outcomes and recognition of QREs.

Furthermore, SB 2206 introduces a refundable credit for entities that owe no franchise tax, such as startups, veteran-owned businesses, and small businesses under the "no tax due" threshold. This ensures that businesses can benefit from the R&D credit even during loss years, a significant improvement over the current "carryforward-only" system for the franchise credit.

Transitional Guidance and Compliance for 2025

As taxpayers prepare for the 2026 transition, the Comptroller has issued guidance regarding the "ordering rules" for credits and the continued applicability of prior law. Unused franchise tax credits from the current Subchapter M can be carried forward for up to 20 years and must be used before applying the new Subchapter T credits.

Importantly, the repeal of the sales tax exemption does not affect liability for sales tax accruing before January 1, 2026. Businesses planning major equipment purchases are encouraged to accelerate those acquisitions into 2025 to take advantage of the expiring sales tax exemption while they still can.

In a landmark update on December 1, 2025, Acting Comptroller Kelly Hancock announced that Texas would finally align its franchise tax depreciation rules with current federal law, specifically to accommodate bonus depreciation under the One Big Beautiful Bill (OBBB) Act of 2025. Historically, the Comptroller required businesses to use the 2007 IRC for calculating the Cost of Goods Sold (COGS) deduction, which led to significant disparities between federal and state tax books.

Beginning with the 2026 franchise tax report, businesses can apply the current IRC to calculate depreciation for COGS purposes. This allows for the full expensing of qualifying fixed assets—such as research machinery and furnishings—acquired after January 19, 2025. While this update applies broadly to the franchise tax, its integration with the R&D credit framework creates a more cohesive tax environment where the "depreciable character" of property is determined using the same federal standards for both operational expensing and incentive eligibility.

Practical Example and Comparative Calculation

To demonstrate the application of these principles, consider a Texas-based biotechnology firm, "AeroBio Labs," which performs qualified research in the field of synthetic heart valves. In the tax year 2024, AeroBio Labs incurs the following expenses:

• Purchase of a specialized 3D bioprinter (useful life: 5 years): $500,000.
• Research scientist wages (100% time spent on research): $1,000,000.
• Laboratory supplies (consumable reagents): $200,000.
• Base Amount (50% of 3-year average Texas QREs): $400,000.

AeroBio Labs must choose between the Sales Tax Exemption and the Franchise Tax Credit.

Scenario 1: Electing the Sales Tax Exemption

1. Sales Tax Savings: The 3D bioprinter is depreciable property under IRC Section 168 and is directly used in experimentation. Using a combined state and local rate of 8.25%, the upfront savings is $41,250.
2. Compliance: AeroBio must provide Form 01-931 to the vendor and file an AIR report by March 31 of the following year.
3. Credit Result: By electing the exemption, AeroBio cannot claim the franchise credit for 2024.

Scenario 2: Electing the Franchise Tax Credit (Subchapter M)

1. Sales Tax Paid: AeroBio pays the $41,250 in sales tax.
2. Qualified Research Expenses (QREs):
• Wages: $1,000,000.
• Supplies: $200,000.
• Note: The $500,000 bioprinter is excluded because it is depreciable property and not a "supply" under IRC 41(b)(2)(C).
• Total QREs: $1,200,000.
3. Credit Calculation:
• Excess QREs over Base: $1,200,000 - $400,000 = $800,000.
• Credit Amount (5% rate): $40,000.
4. Result: AeroBio would likely choose Scenario 1 to gain the immediate $41,250 benefit, especially as the credit in Scenario 2 is capped at 50% of franchise tax liability.

Assuming the same expenditures in 2026:

1. Sales Tax: AeroBio must pay the $41,250 sales tax. The exemption is repealed.
2. Franchise Credit Calculation (Subchapter T):
• Total Texas QREs (IRS Form 6765, Line 48): $1,200,000.
• Excess QREs over Base: $800,000.
• New Credit Rate (8.722%): $800,000 x 0.08722 = $69,776.
3. Total Benefit: AeroBio receives a $69,776 credit. If they owe no franchise tax, this amount is refundable. The total net benefit (Credit minus Sales Tax Paid) is $28,526, which is an enhancement over the pre-2026 credit but a shift in cash flow timing.

Detailed Analysis of Procedural Compliance and Audit Risk

The Comptroller of Public Accounts emphasizes that the burden of proof for establishing entitlement to any R&D incentive lies with the taxpayer. Under Rule 3.340(a)(6), a taxpayer must establish entitlement by "clear and convincing evidence". This is a higher standard than the "preponderance of the evidence" typically used in tax disputes.

For the sales tax exemption, the local state revenue office requires documentation that connects each piece of equipment to a specific research project. This includes:

• Capital asset ledgers showing the useful life and depreciation method (consistent with IRC 167/168 or GAAP).
• Project narratives describing the technical uncertainties being addressed.
• Detailed employee time tracking to prove that the equipment was "directly used" in experimentation rather than administrative support.
• Invoices matching the RD registration number provided to the vendor.

For the franchise tax credit, especially under the new SB 2206 regime, the most critical document is a completed federal Form 6765. The state law allows the use of statistical sampling procedures as permitted by IRS Revenue Procedure 2011-42 to determine QREs, provided the methodology is robust and documented.

Comptroller audits frequently focus on the "Supply vs. Depreciable Property" distinction. One recurring issue is the treatment of "prototypes." If a company builds a prototype that it intends to eventually sell or use in its own production, that prototype may be considered depreciable property rather than a supply QRE. If the prototype is never sold or used as a capital asset, it may qualify as a supply. The character of the asset at the beginning of its life determines its tax treatment.

Another common audit controversy involves the "80% Rule" for wages. Under Rule 3.599, if an employee spends at least 80% of their time on qualified research, 100% of their wages can be included as QREs. However, if that employee is also using depreciable property for non-research purposes, the "direct use" status of that equipment for the sales tax exemption may be jeopardized. Auditors will look for consistency between wage allocations and equipment use.

Summary of Legislative and Regulatory Evolution

The meaning of depreciable property in Texas has evolved from a simple federal reference to a complex pivot point for billion-dollar state incentives. The transition from the dual-incentive system of HB 800 (2013) to the single, permanent credit system of SB 2206 (2025) reflects a policy desire to simplify administration while deepening the state’s commitment to innovation.

The following table summarizes the key milestones in this regulatory journey.

The ongoing modernization of Texas tax law, specifically the move toward rolling conformity with the IRC and the adoption of bonus depreciation, represents a significant victory for taxpayers who have long struggled with the "double bookkeeping" required by the state’s previous adherence to the 2007 IRC. By aligning the definitions of depreciable property more closely with federal standards, Texas is positioning itself as a more predictable and attractive environment for technological research. However, the elimination of the upfront sales tax exemption requires businesses to re-evaluate their capital acquisition strategies, potentially favoring leasing or university collaborations to maximize the enhanced credits available under the new permanent regime.