ACCOUNTING DAY 2007: Charting a course to claim the Research and Development Tax Credit

1. ACCOUNTING DAY 2007:Charting a course to claim the Research and Development Tax Credit

2. Today’s presenters Raj Rajan, JD MBT Director, R&D Tax Services RSM McGladrey, Inc. Irvine, CA Director in RSM McGladrey’s R&D practice in Southern California; over 200 research credit studies; R&D Credits for agricultural businesses, Hi-Tech manufacturers, food manufacturers/processors, government contractors, etc.

3. Professional Standards Disclosure This document supports RSMM’s marketing of professional services, and is not written tax advice directed at the particular facts and circumstances of any person or company. If you are interested in the subject we encourage you to contact RSMM or an independent tax advisor to discuss the application of these issues to your situation. Nothing herein shall be construed as a limitation on our ability to disclose the tax treatment or tax structure of any matter addressed. To the extent considered tax advice, any advice contained herein or attached hereto is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.

4. Why have a credit for Research & Development? • The credit was originally enacted in 1981 to promote innovation and help businesses in the United States become more competitive • Congress wanted to encourage companies to keep high-tech jobs in the United States • State credits serve the same purpose • While the credit has lapsed many times, there continue to be efforts to make it stronger and permanent

5. Why take the R&D tax credit? • Research & Development (R&D) credit • R&D Credit (IRC § 41) reduces tax liability dollar for dollar • May file refund claims for all open tax years to generate cash! • Taxpayers may amend returns up to three years after original filing

6. Who benefits from the R&D credit? • Historically, large businesses have received the bulk of R&D credits in total, but we have seen the credit spread further through the business community to medium and smaller firms • This trend may accelerate with the new ASC • This is a beneficial trend, because, according to DOL: • Most new jobs are created by smaller businesses, including jobs for women, first jobs, and both ends of the age spectrum • Most innovations come from smaller businesses • If the credit were stronger and simpler: • More of the credit’s jobs and innovation goals would be advanced, and • An additional support bloc – small and medium-sized businesses – could be enlisted in the policy debates • “Keeping Research and Leadership at Home,” BusinessWeek.com 1/18/07 • Several commentators (Sun, IBM, Microsoft, IEEE) urged making the credit permanent for corporate planning purposes • Over 60% of U.S. R&D spending is from the manufacturing sector

7. Aerospace Automotive Biotech Food processing Healthcare Furniture Specific Industries • Equipment • Paper Products • Adhesives • Lubricants • Medical Devices … and more

8. Contract/Niche Manufacturers Process Manufacturers Government Contractors Job Shops Software Developers High Tech ….any innovation-based manufacturer Case-by-case analysis Types of Manufacturers

9. Joint Committee on Taxation Report: March 11, 2005 • In 2002, More than 15,000 taxpayers claimed research tax credits in excess of $5.8 billion • In 2002, Manufacturers claimed $3.9 billion of these credits • R & D Credits produce a dollar-for-dollar increase in reported R & D spending

10. Percentage Distribution of Firms Claiming R & D Credits-2002                               Percent of Firms       Percent of      Asset Size ($)           Claiming Credit            Credit Claimed____________________________________________________0                                     2.84             0.591 to 99,999                          12.47                    0.26100,000 to 249,999                    2.3                    0.18250,000 to 499,999                     7.04                   0.35500,000 to 999,999                     8.25                   0.631,000,000 to 9,999,999              34.85               5.3810,000,000 to 49,999,999         17.21               7.6850,000,000 +                       14.95                 84.94Note: Totals may not add to 100 percent due to roundingSource: Joint Committee on Taxation calculations from InternalRevenue Service, Statistics of Income data. Approx. 5,200 companies Approx. 2,550 companies

11. R & D Expenditures by Country Source: Joint Committee On Taxation, March 11, 2005

12. Costs included in credit calculation (QREs) • Wages • Direct labor • Supervisory • Support • Supplies used or consumed in process • Prototypes • Outside research (limited by statute to 65%) • Special rules for research paid to universities, scientific research organizations, energy research consortia Domestic costs only (remember, part of the incentive is domestic jobs creation)

13. Scope of the credit Broad, • The credit applies to research aimed at new or improved business “components,” which means both products and processes But not limitless: • Not market research or artistic/historical research • To take the credit, it must not be “funded;” This involves two concepts: • The business must be at risk on its investment in the research (no guarantees), and • The business must retain substantial rights in the results of the research

14. Permitted purposes The activity must relate to a new or improved business component’s: Function - Performance Reliability - Quality Elimination of uncertainty The activity must be intended to discover information to eliminate uncertainty concerning the capability or method for developing or improving a product or process, or the appropriateness of the product design. Technological in nature The activity performed must fundamentally rely on principles of: Physical science Biological science Computer science Engineering Process of experimentation Substantially all of the activities must be elements of a process of experimentation involving: Evaluation of alternatives Confirmation of hypotheses through trial & error, testing and/or modeling Refining or discarding of the hypotheses What qualifies as research? – The “4-part test”

15. Some questions to ask yourself Technological in nature • What was not known at the outset that required R&D to learn? • As a result of performing the R&D, what was learned or discovered? • Was the information as to the result freely available to the public? • Describe new features, functions, capabilities or other enhancements. Discuss the process of experimentation in the following context • Was one or more hypotheses developed? • What type of experimentation was used to test and analyze the hypothesis (e.g. modeling, simulation, or trial and error methodology)? • Were the results recorded and the documentation retained? • How were the hypotheses refined or discarded as part of a sequential design process to develop the business component, and what was the final hypothesis selected?

16. Pitfalls, exceptions • There are special rules to qualify “internal use software” for the R&D credit (discussed later) • Many elections that can affect the amount of the credit cannot be made on amended returns, so the sooner these are evaluated for your business, the better • AIRC • Reduced credit (explain)

17. Additional internal use software tests If a project’s primary purpose is to create software to support the operations of the business, it is considered internal use software and is subject to the following additional tests. • Innovativeness test • Significant economic risk test • Not commercially available (w/o substantial alteration) While IRS has never lost a reported software R&D case, we are noting significant success where taxpayers can document the above three additional elements.

18. General Structure of R&D Credit Calculations • Always compares current year qualified research expenditures (CY QREs) against some base • Historically, the “base” was either a ratio of historical QREs to gross receipts (GR) history (Traditional method), or simply some percentage of recent years’ GRs (“Start up,” AIRC methods) • Most recent method (ASC) abandons GRs as a measure of comparison and uses recent years’ QREs as the base for comparison • Subtract base from CY QREs = increment • Increment x credit % = CY credit

19. R&D credit calculation methods, summary MethodPercentageActivityIncrement/LimiterBase Definition (notes) Traditional 20% CY QREs greater than ’84-’88 QRE ’84-’88 GR times 4Yr Avg GRs (’84-‘88% cannot exceed 16%, Base cannot < 50% CY QREs) Start up 20% CY QREs greater than 3% recent year Avg GRs (This base cannot < 50% CY QREs) AIRC 3% CY QREs greater than 1% of 4 Yr Avg GRs but not greater than 1.5% of 4 Yr Avg GRs plus 4% CY QREs greater than 1.5% of 4 Yr Avg GRs but not greater than 2% of 4 Yr Avg GRs plus 5% CY QREs greater than 2% of 4 Yr Avg GRs ASC (new!) 12% CY QREs greater than 50% of 3 Yr QRE Avg or 6% CY QREs greater than 50% whatever QRE Avg history avail. Note: ASC requires no GR data at all.

20. R&D credit calculation methods, observations • There are different ways to compute the R&D credit, and several elections that can impact the calculations • However, all the methods have several factors in common: • All require gathering information on current year R&D spending (CY QREs). • All require information from the past several years – GRs and QREs back, sometimes, 4 years. • The oldest version of the credit (“traditional”) requires financial digging/reconstructing both QREs and GR back into the ’84-’88 tax years. • The newest credit calculation method doesn’t require any GR at all to compute the credit. (Remember, the credit is nonrefundable, so it still can’t be used until there is taxable income and a tax liability against which the credit can apply.) • Historically our experience has been that the simpler calculations can shortchange the taxpayer and not maximize the benefit, while the more sophisticated methods can maximize the credit and make the extra effort worthwhile. However, with the advent of the ASC, it is anticipated this trend may reverse.

21. R&D credit calculation methods, choosing yours Which method is best for you? • If you have long/deep records, and your history of R&D is that it grows regularly, the traditional method is probably best (maxes out at 6.5% of CY QREs) • If your history is that receipts growth is outpacing R&D growth, the AIRC may work best (but some policy analysts expect that AIRC companies will eventually migrate to the ASC, since AIRC tops out at 3.25% of CY QREs) • If you are just starting out, consider the “start up” rules or the new ASC (ASC generates the highest maximum credit, at 7.8% of CY QREs, which is why analysts predict it will eventually displace other methods) If you have the data, run the calculations each way to determine what produces the maximum benefit to you – that’s what spreadsheets are for

22. Review – what to look for Process improvements Product development • Low hanging fruit (includes software, if that’s your product) Product enhancements • Pilot plant activities • Manufacturing prototypes • Increasing automation • Designing and fabricating tools and dies • Development of production equipment • Incremental enhancement or product redesign. Internal use software (big $ - don’t let IRS scare you away)

23. Manufacturing trends • Many manufacturers conduct qualifying research due to increasing competitive pressures • Trends over the last 20 years: • Increase in number of products developed and level of innovation • Decrease in manufacturing costs from process improvements • Research related to changes in regulatory environment • Research on waste disposal and other environmental issues • All qualify

24. Challenges to claiming credit • No bright line test to determine qualifying research activities • Final regulations published in January 2004 and court cases provide guidance • Analysis of technical facts necessary to determine if an activity qualifies • Difficulty of finding/preserving older financial records

25. Features of the credit • The credit is an incremental credit designed to reward a business’ increase in R&D activities • The credit is not refundable – therefore you must be earning taxable income and paying tax to utilize it • but it carries back one year and forward twenty • and owners of pass-thrus can take advantage of it, too • The credit does not offset AMT

26. Common issues “We do not have good records from 1984-1988” • Many taxpayers do not have strong records from the base • Generally, can calculate a base if: • People can discuss the company’s qualifying activities • Certain financial information exists • We can order the 1984-1988 tax returns from the IRS • Estimations are usually part of the calculation • Example: • Engineering manager x Est. Salary x QRE % • Process engineer x Est. Salary x QRE % • Engineer x Est. Salary x QRE %

27. Common issues “Our base amount is high!” • Reduce 1984 and 1985 QREs for change in definition of research in 1986 Act • Prior to 1986, qualifying research was defined by Section 174, but after the definition was more limited • Adjust for final regulations issued on 1/2/04 • Clarification on definition of qualifying research under Section 41 • Expanded definition of gross receipts • Adjust prior four years gross receipts for acquisitions/dispositions

28. Legislative update/outlook • Credit again extended through 2007 by Pub. L. 109-432, which also: • Increased the rates for the Alternative Incremental Credit (AIRC) (these higher rates are reflected in the one-sheet comparison) • Created a new Alternative Simplified Credit (ASC) • ASC is equal to 12% of QREs that exceed 50% of the average QREs for the three preceding years • If the taxpayer does not have QREs in any of prior three years, then the ASC is 6% of current year QREs • Credit expires again 12/31/07, but • SFC Chairman Baucus has introduced a bill to make the R&D credit stronger and permanent

29. Financial Reporting and the R&D Credit – 2006, 2007 • Because the credit lapsed and was reenacted very late in 2006, financial statements for quarters and FYs ending before 12/20/06 (effective date of Pub. L. 109-432) can’t show effect of R&D credit • Quarter including 12/20/06 will be odd because of a “catch up” recognition of the R&D credit (particularly so for reporters with FYs ending pre-12/20/06) • Post-12/20/06, fiscal year reporters should likely re-compute their ETR and carry this forward in computing later tax provisions (current ETR is likely too high) • All businesses should re-compute tax provisions using the new ASC method to determine whether this can further reduce their post-2006 effective tax rates (FY businesses can “split” their tax year to take advantage of new ASC, under the transitional rules) • Remember FIN 48, which began for all fiscal years beginning after 12/15/06

30. Thank you for attending!Questions and comments