Guidance for Allowance of the Credit for Increasing Research Activities Under I.R.C. Section 41 for Taxpayers That Expense Research and Development Costs on Their Financial Statements Pursuant to ASC 730

 

September 10, 2020

Frequently Asked Questions (FAQs)

Control Number: LB&I-04-0820-0016

Affected IRM: 4.51.2

 

MEMORANDUM FOR ALL LARGE BUSINESS AND INTERNATIONAL DIVISION  EMPLOYEES

FROM: Douglas W. O'Donnell
Commissioner, Large Business & International Division
SUBJECT: Guidance for Allowance of the Credit for Increasing Research Activities Under I.R.C. Section 411 for Taxpayers That Expense Research and Development Costs on Their Financial Statements Pursuant to ASC 730.

 

PART I. INTRODUCTION

This Directive revises and clarifies the Directive signed on September 11, 2017.

This Directive provides Large Business & International (LB&I) examiners with guidance regarding examination of the credit for increasing research activities under section 41 (Research Credit) of the Internal Revenue Code. IRS's independent determinations of the correct amount of Research Credit imposes a significant burden on LB&I taxpayers and examiners. This Directive is intended to provide an efficient methodology for determining qualified research expenses (QREs) for LB&I taxpayers that meet the requirements of this Directive and to more efficiently manage LB&I's audit resources.

If the IRS determines that a taxpayer has satisfied all the requirements of this revised Directive, then this Directive provides an administrative solution for LB&I examiners to accept, as sufficient evidence of QREs, the Adjusted ASC 730 Financial Statement R&D for the Credit Year. Adjusted ASC 730 Financial Statement R&D is made up of the research and development costs currently expensed on a taxpayer's Certified Audited Financial Statements pursuant to ASC 730 for U.S. GAAP purposes (U.S. ASC 730 Financial Statement R&D) and includes certain specified adjustments made to Financial Statement R&D.

This Directive only applies to LB&I taxpayers (i.e. assets equal to or greater than $10,000,000) who follow U.S. GAAP to prepare their Certified Audited Financial Statements showing the amount of currently expensed Financial Statement R&D either as 1) a separate line item on the income statement included in their Certified Audited Financial Statements, or 2) separately stated in a note to their Certified Audited Financial Statements. In addition, this Directive does not apply to any taxpayer unless the taxpayer uses these same U.S. GAAP financial statements to reconcile book income to federal tax income on Schedule M-3.

This Directive is not an official pronouncement of law, and cannot be used, cited, or relied on as such. In addition, nothing in this Directive should be construed as affecting the operation of any other provision of the Internal Revenue Code, Treasury Regulations or guidance thereunder.

1  Subsequent section references are to the Internal Revenue Code of 1986, as amended and in effect during the tax years at issue and to the Treasury regulations promulgated thereunder, unless otherwise specified.

PART II. ELIGIBLE QRES IN COMPUTING THE RESEARCH CREDIT

A. Background:

Section 41 of the Internal Revenue Code provides a credit for increasing research activities. A taxpayer's research credit is based, in part, on QREs paid or incurred by a taxpayer during the taxable year in carrying on any trade or business of the taxpayer.

B. Issue Tracking:

LB&I Examiners should use the Project and Tracking codes below for each taxable year a taxpayer follows this Directive.

Project Code 6750 – LB&I Research and Experimentation Credit IIR

Tracking Code 1511 – LB&I Directive – Credit for Increasing Research Activities under IRC 41

C. Examination Guidance:

Taxpayers may have voluntarily attached the completed and signed Certification Statement Claiming Adjusted ASC 730 Financial Statement R&D as QREs ("Certification Statement") (Appendix A) and Appendices B, C, & D (below) to their Federal income tax return to demonstrate their eligibility under the provisions of this Directive. If these documents were not voluntarily attached to the return, the audit team at the beginning of the examination of the Research Credit will verify whether the taxpayer followed the Directive. For taxpayers who followed the Directive and did not voluntarily attach the documents to their return, the exam team will request the taxpayer provide the completed Appendices (Appendices A – D) below:

Appendix A – Certification Statement Claiming Adjusted ASC 730 Financial Statement R&D as QREs (PDF) PDF

Appendix B – Reconciliation of Form 6765 QREs to Adjusted ASC 730 Financial Statement R&D (PDF) PDF .  (Reconciliation should include a breakdown of costs as detailed in Appendix B).

Appendix C – Computation of Adjusted ASC 730 Financial Statement R&D (PDF) PDF

Appendix D – Adjusted ASC 730 Financial Statement R&D Wage Detail (PDF) PDF

Taxpayer must properly retain and timely submit (within a time period subject to LB&I IDR enforcement process) the documentation listed in Part V of this Directive. This documentation must support, to the satisfaction of the exam team, that the amounts reported on Appendices C & D are true, correct and complete.

If the exam team determines the requirements of this Directive have not been satisfied, the exam team may request information in addition to the documentation requested in Part V of this Directive. The exam team must receive approval from the Territory Manager or his/her delegate to request additional information not listed in Part V of this Directive.

If a taxpayer fails to provide the underlying books and records (as noted in Part V) or to substantiate its U.S. ASC 730 Financial Statement R&D amount per Line 4 of Appendix C to the satisfaction of the exam team, the Territory Manager or his/her delegate may determine this Directive does not apply to the taxpayer.

Any additional amounts of QREs claimed by the taxpayer, on its Form 6765 "Credit for Increasing Research Activities" (Form 6765) for the Credit Year, that exceeds the Adjusted ASC 730 Financial Statement R&D amount are subject to risk assessment to determine the scope of an examination, if warranted.

D. Implementation:

The Directive signed September 11, 2017 continues to apply to LB&I taxpayers who chose to calculate their QREs using the requirements of that Directive on original returns timely filed (including extensions) on or after September 11, 2017 for tax periods ending prior to July 31, 2020.

This revised Directive applies to LB&I taxpayers who choose to calculate their QREs using the requirements of this Directive on original returns timely filed (including extensions) for tax periods ending on or after July 31, 2020.

E. Additional Resources:

Questions concerning this Directive should be directed to the General Business Credit Practice Network. Frequently Asked Questions and LB&I Concept and Process Practice Units for this Directive are available at irs.gov.

PART III. DEFINITIONS

Appendix E contains the Definitions that apply solely for the purposes of this Directive.

PART IV. CERTIFICATION STATEMENT

The Certification Statement must be signed by an individual who is authorized to execute the taxpayer's Federal income tax return for each taxable year under audit, and must certify, under penalty of perjury that, for the applicable taxable year, the Adjusted ASC 730 Financial Statement R&D has been computed in accordance with the definitions and methodology set forth in this Directive and that all information provided by the taxpayer in accordance with this Directive, to the best of the authorized individual's knowledge and belief, is true, correct and complete. For a consolidated Federal income tax return, the common parent is the sole agent for the group and will sign the Certification Statement on behalf of the consolidated group.

Part V. DOCUMENTATION

Documents that taxpayers must retain and make available upon request relating to Appendices C and D are:

  1. Certified Audited Financial Statement for the Credit Year including auditor’s certifying opinion;
     
  2. Taxpayer’s Chart of Accounts;
     
  3. List of Financial Statement Cost Centers that make up the Financial Statement R&D amount shown in Step 1 of Appendix C;
     
  4. All R&D GL Accounts with account balance details that make up the Financial Statement R&D amount shown in Step 1 of Appendix C;
     
  5. List of R&D GL Accounts with account balances that make up the adjustments in Step 2 of Appendix C;
     
  6. List of U.S. ASC 730 R&D GL Accounts with account balances that make up the adjustments in Steps 3 and 4 of Appendix C;
     
  7. Taxpayer’s supporting documentation showing all employees and levels of management included in the total QREs for the Credit Year;
     
  8. Executed contracts pursuant to which the taxpayer is performing ASC 730 research in order to comply with the terms of the contract;
     
  9. Executed contracts pursuant to which persons other than employees of the taxpayer are performing ASC 730 research on behalf of the taxpayer. This would include sufficient information to show what research was performed outside the U.S.;
     
  10. List of employees with their respective W-2 Wage amounts claimed as additions to U.S. ASC 730 Financial Statement R&D in Step 4 of Appendix C, which list would also identify for the applicable taxable year each employee’s job title and reporting level and the cost center where each of those employees worked;
     
  11. A written narrative of the methodology and calculations for determining the amounts listed on Appendix C Lines 3a and 3b of this Directive. If no amounts are listed on Appendix C Lines 3a and/or 3b of this Directive, the taxpayer must provide an explanation of the methodology utilized to verify none of these expenses are present in the U.S. Financial Statement R&D amount. The explanation should include sufficient information to show that the taxpayer made a reasonable effort to quantify non-ASC 730 Financial Statement R&D; and
     
  12. Substantiation of Internal Control Over Financial Reporting (ICFR) designed to mitigate material misstatement of the taxpayer’s expenses reported per financial statements.  Substantiation may be provided by a presentation or in writing.

APPENDICES

Appendix A – Certification Statement Claiming Adjusted ASC 730 Financial Statement R&D as QREs (PDF) PDF

Appendix B – Reconciliation of Form 6765 QREs to Adjusted ASC 730 Financial Statement R&D (PDF) PDF

Appendix C – Computation of Adjusted ASC 730 Financial Statement R&D (PDF) PDF

Appendix D – Adjusted ASC 730 Financial Statement R&D Wage Detail (PDF) PDF

Appendix E – Directive Definitions (PDF) PDF