Like many foundries and diecasters, your company may be making substantial investments in time and resources to develop and improve casting designs and metalcasting processes. Do you realize that there are federal and state research and experimentation tax credits that reward companies for those efforts?
The Research & Experimentation tax credit, also referred to as “R&E” or “research” tax credit, is designed to incentivize companies to invest in people and technology that can lead to growth in revenues and profitability, as well as to promote job retention and expansion. These credits focus on qualified wages, supply costs, and contract research.
When first enacted in the 1980s the R&E credit was available only to companies that fit the more traditional definition of research, including those in pharmaceutical and defense-related industries. This was because of a requirement called the “Discovery Test,” which stipulated that the research had to expand or refine the level of knowledge within the particular industry wherein the research was being conducted. This level of innovation was so strict that a patent or at least a patent application usually was required to demonstrate the achievement of the threshold for this definition of research.
In 2004, the discovery test was removed1, and since then the requirement for the credit is only for the innovation to be new to the company, meaning that metalcasters can take advantage of the R&E tax credit using technologies that may have been available for many years. Companies in industries not previously thought to be eligible for the R&E tax credit now can realize these benefits.
Identifying Qualified Projects — Now, projects must pass what is referred to as the “four-part” test to be eligible for the R&E tax credit. The four parts are:
1. The “business component” test: the projects can be a product, process, formula, technique, software, or invention;
2. The “uncertainty” test: this requirement is met if at the outset of the project there is uncertainty as to the capability of the method (process) for developing or improving the business component, or of the appropriate design of the product;
3. The “technological information” test: the research conducted must fundamentally rely on the physical or biological sciences or on the engineering disciplines;
4. The “process of experimentation” test: substantially all of the activities designated as qualified must involve a process of experimentation. Examples of acceptable forms of experimentation include modeling, simulation, or systematic trial and error.
According to the regulations governing the R&E tax credit2, the time associated with the development and improvement of the manufacturing processes for qualified projects can be claimed for the credit. This time is related to the wages of the employees engaged, supervising, or supporting these activities, a percentage of which is returned to the taxpayer as a credit. Examples of these types of activities include development of gating and risering systems for new castings, improvement of foundry processes, such as coremaking, molding, and melting; and experimentation with different binders, refractories, and alloying materials.
2. T.G. Missouri Corp. v. Commissioner, 133 T.C. No. 13
Three Categories for Eligibility
But, as previously mentioned, qualified wages are only one of three eligible categories for the R&E tax credit.
Qualified Supply Costs — There have been two changes to the treatment of supply costs that have been beneficial to the metalcasting industry. In November 2009, the U.S. Tax Court issued an opinion in the T.G. Missouri case3 that has had a profound effect on tooling-intensive industries, including foundries and diecasters, specifically related to claiming credits for the cost of production tooling.
Consider a wood pattern and urethane core box used during the development of the manufacturing process for a complex casting. If this tooling was expensed and scrapped once the process was accepted (or abandoned), under the old rules this could have qualified as a supply cost for the R&E tax credit. But the production tooling, consisting of a tool steel pattern with iron shell core boxes, would not qualify as a supply cost no matter how much additional trial-and-error and testing took place using the tooling. The T.G. Missouri case identified circumstances wherein there are exceptions to the treatment of production tooling as qualified supply costs.
The key element of the T.G. Missouri case centers on the phrase “property of a character subject to the depreciation allowance.” Tooling purchased or produced by the foundry (the taxpayer in this case) on which experimentation is performed during the development or improvement of the process, and for which the taxpayer is at economic risk, now can be classified as a qualified supply cost for purposes of the R&E tax credit.
The determining factor regarding the depreciation is that even though the foundry may retain possession of the pattern equipment, the ownership of the tooling transfers to the customer, who eventually capitalizes and depreciates the pattern equipment. This has potentially huge implications, especially for jobbing foundries with many “one-offs” or small production runs, where the cost of the tooling is high relative to the overall costs of producing the casting.
The other change has to do with the new regulations that were issued in late 2014 for the treatment of supply costs4. Previously, supply costs for the research credit were restricted to those materials and supplies consumed during the development of the manufacturing process, and not used on a “post commercial production” basis. If the end result of the experimentation ending up being sold (e.g., the resulting casting), the expenditure(s) were ineligible.
However, if at the onset the outcome was uncertain and payment for the casting was contingent on providing a product that met the customer’s requirements (dimensional and mechanical specifications), then the cost of the supplies and materials used to produce the first casting in the run could be classified as a qualified supply cost for the R&E tax credit.
Contract Research — The third category for qualified expenditures for the Research & Experimentation tax credit is contract research. In short, any activities that if conducted by employees of the taxpayer could be included as qualified research wages potentially can be counted toward contract research if performed by a third-party contractor. Two caveats to this are:
1) The taxpayer must retain “substantial rights” to the outcome of the research; and
2) The taxpayer must be at economic risk for the payments to the third party, essentially by paying the subcontractor on an hourly or time and materials basis.
An example of contract research is the outsourcing of solidification simulation modeling to assist in the development of gating and risering systems to optimize the casting process.
There have been many changes to the R&E tax credit in the last year alone. If your company has never taken advantage of the research credit, now is a great time to take a closer look. Even if you have been taking the credit in the past, make certain you are in compliance with all recent changes and are maximizing the available credits.
Richard Wile, MBA, is the partner-in-charge of RubinBrown’s Research & Experimentation Tax Credit Services Group. He has a degree in Metallurgy and Materials Science and spent over 25 years in the foundry industry. Contact him at [email protected]