Taxes June 2, 2023

What You Need to Know About Texas’ R&D Tax Credit

Like the federal government, the state of Texas offers some generous tax breaks to encourage companies to pursue research and development (R&D) activity. While both might pay off for your business, some significant differences exist between the federal research and development (R&D) credit and the Texas version. And the state amended its R&D laws in both 2021 and 2022.

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Here’s what you need to know if you think you might perform qualified research in Texas.

What is the Texas R&D credit?

Although Texas doesn’t have an income tax, it offers two tax incentives to businesses that conduct qualified research in the state:

A sales and use tax exemption on the purchase, lease, rental, storage, or use of certain types of property used for qualified research, and
A franchise tax credit based on qualified research expenses (QREs).

You can’t claim both incentives for the same period, but your election to choose one or the other isn’t permanent. You can change the incentive in future tax periods.

What is qualified research?

For both the sales tax exemption and the franchise tax credit, Texas generally applies the IRS’s four-part test for qualifying research:

1. The research is performed to eliminate technical uncertainty about the development or improvement of a product or process, including computer software, techniques, formulas, and inventions (the Section 174 test),

2. The research is undertaken to discover information that’s technological in nature. That is, it relies on physical, biological, engineering, or computer science principles. (the discovering technological information test),

3. The research is intended for use in developing a new or improved business product or process, including any product, process, computer software, technique, formula, or invention (the business component test), and

4. Substantially all (generally, at least 80 percent) of the research activities are elements of a process of experimentation relating to a new or improved function, performance, reliability, or quality (the process of experimentation test).

If your business has pursued such research, you’re probably qualified for the R&D credit.

Note: Unlike the IRS, Texas specifically excludes 1) services provided to a customer, and 2) designs from the definition of “business component.”

Does Texas law exclude any activities?

Yes. The following don’t qualify for either the exemption or the tax credit:

Research conducted after the beginning of a business component’s commercial production,
Adaptation of existing business components,
Duplication of existing business components,
Efficiency surveys,
Activity relating to management function or technique,
Market research, testing, or development (including advertising or promotions),
Routine data collection,
Routine or ordinary testing or inspection for quality control,
Research activities related to internal-use software (software developed by, or for the benefit of, the taxpayer primarily for its own internal use),
Social sciences, and
Funded research.

Note: Any research relating to style, taste, cosmetic, or seasonal design factors will fail the process of experimentation test.

If my federal R&D credit passes muster in an IRS audit, can I assume I’m also eligible for the Texas incentives?

No. For both the sales tax exemption and the franchise tax credit, the Texas Comptroller has stated that an IRS audit determination of eligibility isn’t binding on its determination of eligibility.

Taxpayers must establish their eligibility for the exemption or credit with clear and convincing evidence. All qualified research activities and QREs must be supported by contemporaneous business records.

Am I eligible for the sales tax exemption?

The exemption is available for “depreciable tangible personal property” that’s directly used in qualified research if the property is sold, leased, rented to, or stored by a person who:

Is engaged in qualified research,
- Won’t claim the franchise tax credit for the period the property would first be subject to Texas sales or use tax, and
Registers with the state Comptroller’s office.

What is “depreciable tangible personal property”?

This is tangible personal property that:

Has a useful life of more than one year, and
And is subject to depreciation under either generally accepted accounting principles or the federal tax code (even if you don’t actually depreciate the property).

How does the “directly used in qualified research” requirement work?

Depreciable tangible personal property is directly used in qualified research if it’s used in the actual performance of activities that are part of the qualified research. For example, if used by personnel in the process of experimentation, the following are “directly used” and can qualify for the exemption:

Machinery
Equipment
Computers
Software
Tools
Laboratory furniture (for example, desks, laboratory tables, stools, benches, and storage cabinets)

But tangible personal property isn’t directly used in qualified research if it’s used in ancillary or support activities such as administration, maintenance, marketing, distribution, or transportation activities. Or if it’s used in activities excluded from qualified research (see above).

How do I claim the sales tax exemption?

It’s a two-step process. First, you register online with the Comptroller’s office — before you claim the exemption on qualifying purchases. The office will issue a Texas Qualified Research Number, which you use to complete Form 01-931, Texas Qualified Research Sales and Use Tax Exemption Certificate.

You’ll then give that form to retailers when claiming the exemption on eligible items. Remember to always include your registration number on the exemption certificate.

What happens if we purchased something using the sales tax exemption that doesn’t end up being used for qualified research?

You’ll be liable for the sales tax, as well as the applicable penalty and interest, based on the fair market rental value of the property during the period it was used.

What is the Annual Information Report?

This is a form required if you claim the sales tax exemption. You must file the form with the Comptroller’s office on or before March 31 of each calendar year in which you claim the exemption. If you don’t, your registration can be canceled.

To complete the form, you’ll need information about:

The amount of qualified research you conducted in Texas,
The number of employees engaged in R&D in the state, and
Sales tax revenue.

What if my registration number is canceled?

If you receive a notice of cancellation from the Comptroller, you can’t claim the exemption during the period for which the number is canceled. Intentionally or knowingly trying to use a canceled number to make a purchase is considered a refusal to pay tax and a criminal offense.

You can request that a canceled registration number be reinstated, though. You also can ask that the number be given retroactive effect.

How do I claim the R&D franchise tax credit?

You must file a Long-Form Franchise Tax Report (Form 05-158A and Form 05-158B) with two schedules: Credits Summary Schedule (05-160) and Research and Development Activities Credit Schedule (05-0178).

Which expenses can I count as QREs?

Texas uses the federal definition for QREs. Under that definition, QREs are the sum of in-house research expenses and contract research expenses.

In-house research expenses include:

Wages for employees who perform qualified services (engaging in qualified research or directly supervising or supporting research activities),
Supplies to conduct the research (for example, supplies used for prototypes), and
Rental costs for computers used in qualified activities, including cloud computing used to perform research.

You can include 65 percent of contract research expenses paid or incurred for any person other than an employee for qualified research. If the research is performed by a qualified research consortium, however, you can claim 75 percent of the expenses. Research consortiums are generally 1) tax-exempt and 2) organized, and operated primarily to conduct scientific research.

Note: You can’t include in your QREs any supplies for which you wouldn’t have paid sales or use tax because of the manufacturing exemption or sale-for-resale exemption. This means you have to choose between an exemption or the R&D credit for such supplies.

How much is the franchise tax credit worth?

The credit generally is a percentage of the excess of your QREs in Texas for the tax year over a base amount. The base amount is 50 percent of your average QREs in Texas in the three previous tax years.

If you have QREs in the three previous tax years, the percentage is:

5 percent, or
6.25 percent if you contracted with one or more public or private institutions of higher education for the performance of qualified research, and the institution had QREs in Texas during the relevant period.

If you didn’t have QREs in Texas in one or more of the preceding three tax years, the credit equals:

2.5 percent of your QREs for the tax period, or
3.125 percent of all QREs for the tax period if you contracted with one or more public or private institutions of higher education for the performance of qualified research and the institution had QREs in Texas during the relevant period.

The R&D franchise tax credit you claim in a tax year is limited to 50 percent of your tax due before any credits are applied.

Does Texas provide the “alternative simplified credit” (ASC) option that’s available under fexderal tax law?

No.

What if I can’t use all of my franchise tax credit in a particular tax year?

If you’re eligible for a credit that exceeds the 50 percent limitation (see above), you can carry forward the unused credit for not more than 20 consecutive years. Claiming a carryforward of an unused franchise tax credit won’t affect your ability to claim the sales and use tax exemption.