Texas proposes significant changes to research and development tax treatment

The Texas Comptroller has proposed amendments to the Texas Admin Code Sec.3.599. These proposed changes will apply to the research and development tax credit, and aims to offer better guidance regarding eligible franchise tax R&D activities.

The Comptroller believes these changes will not only provide greater clarity for R&D tax specialists, but also to the general public, allowing businesses to have a better understanding of how this R&D tax credit is calculated and applied. Greater clarity can improve the accuracy of claims and reduce the number of claims denied by encouraging more accurate submissions.

The full list of proposed changes can be found here, but let’s look into the most important changes.

Conformity to Federal Regulations

Texas law defines the Internal Revenue Code (IRC) as the code in effect December 31, 2011. With the proposed amendments, Texas will interpret conformity to federal regulations by providing that a federal regulation adopted after December 31, 2011, is included only “to the extent that the regulation requires a taxpayer to apply the regulation to the 2011 federal income tax year”

So this means any changes to the IRC following December 31, 2011 may not be conformed to by Texas. 

Example: A change to the IRC provided regulatory guidance for internal-use software applies to tax years beginning on or after October 4, 2016. Since this regulation would not be in effect for 2011 tax years, it will not be incorporated into the definition of the IRC for Texas purposes.

Requirements for Claims

Clarifications and amendments would result in the following:

  • It is the burden of the taxpayer to provide proof of entitlement to the credit, and proof that they are entitled to the value claimed. This proof is provided from clear and convincing evidence.
  • All QREs must be connected to specific qualified research activities
  • All QREs must be supported by contemporaneous business records
  • If the IRS finds an entity is entitled to the Federal R&D tax credit, the Comptroller is not bound to this when examining the state credit.

An amendment will allow the Comptroller to review the QRE used to calculate the prior year average even if these prior years have a closed statute of limitations. It will not be able to result in tax adjustments, penalties, or interest for any of these prior years if the statute of limitations is closed, but will allow better review of the calculations used in current years. It may, however, impact your credit carryforward if found that prior years were miscalculated. The carryforward is the only component subject to impact here.

Software and the Four Part Test

The comptroller reiterates how the four-part test applies to software development activities and identifies a list of likely eligible and likely ineligible activities. These changes and this list are adapted from the IRC’s Audit Guidelines on the Application of Process of Experimentation for all Software, but here is a quick overview.

Likely EligibleLikely Ineligible
  • Initial development and release of a new software product
  • Development of new system softwares
  • Development of specialized technologies (eg. AI, speech recognition, image processing)
  • Software developed as part of a hardware product, interacting directly with that hardware
  • Maintenance of existing software applications/products 
  • Software Application Configuration
  • Reverse engineering
  • Detecting Flaws and bugs in software
  • Modifying existing software to make use of new or existing standards or devices, or to be compliant (i.e., certified, validated, etc.) with another product or platform.
  • Developing a business component that is substantially similar in technology, functionality and features to the capabilities already in existence at other companies.
  • Upgrading to newer versions of hardware/software, or installing vendor fix releases.
  • Re-hosting or porting an application to a new hardware/software platform or rewriting an existing application in a new language
  • Writing hardware device drivers to support new hardware (e.g., disks, scanners, printers, modems, etc.).
  • Data quality, data cleansing, and data consistency activities.
  • Bundling existing individual software products into product “suites”
  • Expanding product lines by purchasing other products.
  • Interfaces, Graphical User Interfaces
  • Y2K Program Changes.
  • Vendor Product Extensions.
Possibly Eligible
  • Functional enhancements to existing software applications/products.
  • Software developed as an embedded application (eg in cell phones, automobiles, airplanes.
  • Development of software utility programs, such as debuggers, backup systems, performance analyzers, data recovery, etc.
  • Changing from a product based on one technology to a product based on a different or newer technology (e.g., switching from a hierarchical database technology to a relational database technology).
  • Adaptation and commercialization of a technology developed by a consortium or an open software group.


Exclusion of Internal-Use Software

The proposed changes would exclude internal-use software from qualified research. IUS is developed for the internal use of the taxpayer/developer. This exclusion does not apply to software used in 

  1. An activity that constitutes qualified research
  2. A production process that meets the requirements of the four part test

There is no strict definition included to define what is considered IUS. The Comptroller did include a definition of what is not IUS:

Software that is “sold, leased, licensed, or otherwise marketed for separately stated consideration to unrelated third parties.”

So in effect, it is up to the discretion of the Comptroller to determine if software is deemed IUS or not, and up to the taxpayer to provide information supporting their claim either way.

Exclusion of Supplies In a Manufacturing Product or Process Improvement 

Proposed changes would exclude any item of tangible personal property where the taxpayer would not have paid Texas sales and use tax due to the manufacturing exemption or the sale for resale exemption.

This means the taxpayer can no longer double dip on these benefits and must choose either the tax exemption or the R&D supplies credit. This change is due to the Comptroller’s stance that the manufacturing exemption was not intended to apply to R&D and that items used in qualified research “are not resold.”

For reference, the tax exemption reduces tax by approximately 8% while the credit under this section of expenditures usually results in a 2.5% credit, making the tax exemption much more beneficial.

Exclusion of Funded Research

Research is considered funded if 

  1. The taxpayer retains no substantial rights to the research and;
  2. The payments to the researcher are not contingent upon the success of the research

These conditions remove the financial risk from the taxpayer. If the taxpayer does retain substantial rights, then the research is funded to the extent of the payments and fair market value of any property that the taxable entity becomes entitled to by performing the research. If the expenses of the research exceed the payments received, the excess expenses are eligible for R&D credit claims.

By excluding funded research, the Comptroller is attempting to prevent the double counting of R&D expenses by various parties involved who do not retain rights to the research. For instance, if company x pays company y to conduct research and company x retains all substantial rights then onl company x can claim the credit.

Combined Reporting

With these amendments, combined reporting will see some changes as well. Combined groups would be directed to do the following:

  • Each member of a combined group determines the amount of R&D credit separately and includes the credits of each member on the combined report.
  • Prorate any carryforward of the credit among the members of the combined group and remain with the member of the combined group for future tax periods regardless of if they remain in the same combined group.

Are you developing new technology for an existing application? Did you know your development work could be eligible for the R&D Tax Credit and you can receive up to 14% back on your expenses? Even if your development isn’t successful your work may still qualify for R&D credits (i.e. you don’t need to have a patent to qualify). To find out more, please contact a Swanson Reed R&D Specialist today or check out our free online eligibility test.

Who We Are:

Swanson Reed is one of the U.S.’ largest Specialist R&D tax advisory firms. We manage all facets of the R&D tax credit program, from claim preparation and audit compliance to claim disputes.

Swanson Reed regularly hosts free webinars and provides free IRS CE and CPE credits for CPAs. For more information please visit us at www.swansonreed.com/webinars or contact your usual Swanson Reed representative.

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