New R&D Tax Credit Regs – Intercompany Gross Receipts / Foreign Gross Receipts

The Internal Revenue Service (IRS) and Department of Treasury (Treasury) have proposed new regulations regarding the calculations of gross receipts in relation to intra-group transactions between members of a controlled group claiming the research and development (R&D) tax credit, as well as the rule in 1.41-6(i)(4) that disregards lease payments between group members when calculating qualified research expenditures (“QREs”).  The proposed regulations seek to address what the IRS and Treasury view as an inconsistent and disparate application of the Congressional intent of the research credit.  The inclusion of gross receipts in the calculation of the R&D credit were intended to incentivize taxpayers to increase their domestic research activities, as Congress believed businesses determine their research budgets as a percentage of gross receipts.  The proposed regulations seek to achieve a level of consistency in the interaction of section 41(f)(1) and section 41(c)(7) by providing a narrow exception to the current rule that excludes all intra-group transactions from the R&D credit calculation, and it completely removes the lease payment restriction of 1.41-6(i)(4).  The current rules create a situation in which the QREs attributed to a piece of property or service are included in the credit calculation, yet the gross receipts from the sale of the same property or service to a party outside the controlled group are excluded.

The proposed regulations apply to controlled groups with intra-group transactions between domestic and foreign corporate members that are followed by an external transaction, involving the same property or service, that does not give rise to gross receipts that are “effectively connected with the conduct of a trade or business within the United States, the Commonwealth of Puerto Rico, or any possession of the United States.”  The modification of the property or service, the form of the receipts (royalties, interest, or other cash or non-cash payments), and the number of internal transactions are irrelevant to the application of this exception.  If multiple internal transactions occur, “only the last transaction giving rise to gross receipts (within thin the meaning of 1.41-3(c)) is taken into account in the credit computation.”  This situation is illustrated by Examples 3 and 4 in the proposed regulations. 

R&D Base Period Consistency

The proposed regulations create a narrow exception to the rule excluding intra-group transactions from gross receipts for the R&D tax credit.  It is important to note that the year in which the external transaction occurred is the year in which the gross receipts will be included by the appropriate controlled group member, regardless of the year the internal transaction occurred.  Once the proposed regulations are in effect, this exception will apply to the gross receipts for prior years used in calculating the credit.  The IRS and Treasury realize the burden this imposes, as taxpayers may not have sufficient records to apply the new exception when calculating gross receipts in prior years.  Accordingly, the proposed regulations “are intended to capture some measure of intra-group gross receipts… but are not intended to preclude research credit claims for taxpayers that do not have adequate information” in their records [emphasis added].  Therefore, they have requested “a rule or safe harbor for the purposes of determining the base amount.”  It is unclear, but can be presumed that if the taxpayer does have sufficient records, they cannot simply choose to ignore the new exception’s application to prior years.  They may have to establish that the burden was too great, in order to take advantage of the safe harbor and apply the prior year gross receipts as determined before the new exception was in effect.

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