In the past nine months, the U.S. Department of the Treasury issued two sets of regulations that are favorable to plastics manufacturers. These regulations relate to the definition of research expenditures and the ability to elect the simplified method of calculating the R&D tax credit on amended returns.
On Sept. 5, 2013, the Treasury proposed five changes to regulations defining research expenditures under Internal Revenue Code Section 174. As an added bonus, Treasury indicated that taxpayers may rely upon these proposed regulations for all tax years. On July 18, these regulations were finalized with minimal changes.
The first change to the Section 174 regulations likely has the most significant impact for plastics manufacturers. The proposed regulations provide that if expenditures qualify as research or experimental expenditures, it is irrelevant whether a resulting product is ultimately sold or used in the taxpayer’s trade or business. Plastics processors should be considering whether the costs of newly developed molds, prototype parts and machinery or equipment that is developed in-house may qualify as research expenditures.
Other changes include the application of the definition of research to depreciable property, the definition of a pilot model and makes clear that the general rule that the costs of producing a product after uncertainty concerning the development or improvement of a product is eliminated are not eligible expenses under Section 174 because these costs are not for research or experimentation.
Finally, the proposed regulations introduce a shrinking back rule to the Section 174 expenditures, requiring taxpayers to “shrink back” to the subset of activities or expenditures that are directly involved in research, thereby limiting the amount one may classify as research. Historically, the internal revenue code has provided that research expenditures include all such costs incident to the development of a product. However, the shrinking back rule is not a new concept. It has been part of the fabric of IRC Section 41 — The Credit for Increasing Research Activities — for over 15 years. For instance, if a taxpayer is developing a new mold and its research activities relate to the cores and cavities of the mold and not the mold base, the taxpayer may be required to “shrink back” its research supply expenditures to the materials used and tested in the development of the cores and cavities and exclude the cost of the mold base. Contrast this example with a company that designs and develops a custom mold base in conjunction with the cores and cavities. This may be done due to complex venting or water-line designs. In this instance, the mold base is an instrumental part of the design of the mold and may qualify as a qualified research expenditure.
On June 3, the Treasury proposed regulations indicating that the IRS will now begin allowing taxpayers to claim the Alternative
Simplified Credit (ASC) on amended tax returns if the taxpayer had not claimed the research credit on its original tax return. For taxpayers not claiming the credit in prior years, this development can mean significant savings.
The R&D tax credit is meant to encourage taxpayers to increase their research activities. As such, taxpayers must exceed a base amount in order to qualify for the tax credit. Two methods exist: the traditional method and the ASC. The ASC method allows utilization of more recent documentation that may be more readily available than what was previously required. Before these new regulations, taxpayers that amended their return to claim the credit may have been required to rely on information from 1984-1988 to claim the R&D Tax Credit.
The R&D tax credit is one of the most under-utilized tax savings opportunities for companies in the plastics industry. The R&D tax credit rewards companies who invest resources in innovation, product development, mold design, new materials or resins, and process development/improvement. In addition to federal tax savings, over 30 states have a similar program that rewards companies for the development or improvement to its products or processes.
Michael J. Devereux is partner and director of manufacturing and distribution services for Mueller Prost.