Federal R&D Tax Credit: Required Documentation & IRS Safe Harbors

Gathering Contemporaneous Documentation:
Record-keeping to Support R&D Tax Credit Claims

Treasury Regulations § 1.41-4(d) provides taxpayers claiming a R&D tax credit must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit pursuant to general record retention requirements found in Treas. Reg. § 1.6001-1. 

Treas. Reg. § 1.6001-1(a) states, in general, any person subject to income tax or required to file a return of information with respect to income, shall keep such permanent books of account or records, including inventories, as are sufficient to establish the amount of gross income, deductions, credits, or other matters required to be shown by such person in any return of such tax or information. Treas. Reg. § 1.6001-1(e) further provides the books or records required shall be kept at all times available for inspection by authorized internal revenue officers or employees, and shall be retained so long as the contents thereof may become material in the administration of any internal revenue law.

However, § 1.41-4(d) also states, to facilitate compliance and administration, the IRS and taxpayers may agree to guidelines for the keeping of specific records for purposes of substantiating research credits.

To summarize, taxpayers must generally provide quantitative and qualitative details to substantiate claimed qualified research expenses (i.e., wages, supplies, and contract research) and qualified research activities (i.e., at the project / "business component" level). As such, it is often essential that sufficient contemporaneous documentation be identified, gathered, properly compiled, and retained to ensure that the IRS does not disallow any reasonably claimed portions of the R&D credit should a particular tax period incur examination.

Below are general background and examples on documenting R&D credit claims considering quantitative (accounting and financial records, etc.) and qualitative (i.e. development agreements, design models, test logs, contract agreements) analysis, including qualified research activity ("4-Part Test") criteria. However, each taxpayer will likely have unique facts and circumstances, including tax law and/or accounting positions in support of their benefit claims and nexus between qualified research activities (QRA) and qualified research expenses (QRE). As such, certain areas may be more pertinent to document than others, depending on your situation.

Quantitative Documentation

Wage Qualified Research Expense (QRE) Documentation

Establishing a methodology for quantifying wages related to qualified services is usually the most critical area to document for most taxpayers. Preferably, quantifying wages through a time tracking system (e.g. Oracle's Peoplesoft) that tracks qualified research (labor codes) hours to qualified projects (activity codes) more accurately helps a taxpayer to create nexus between wage QRA and QRE.

However, most taxpayers don’t use a time tracking system, or their time tracking system implemented is not fully utilized nor consistently completed by its employees throughout the entire year, to sufficiently establish annual qualified research time. As a reasonable alternative, the method employed by these types of companies to quantify qualified wages relies on estimates through oral testimony or time allocation questionnaires. In Cohan v. Commissioner of Internal Revenue, 39 F.2d 540 (2d Cir. 1930), the court allowed for the use of reasonable estimates through credible testimony (known as the “Cohan Rule”). Moreover, in Suder v. Commissioner of Internal Revenue, T.C. Memo. 2014-201, the court stated it was appropriate to rely on credible subject matter expert testimony to support QREs and that it wasn’t required to establish nexus between wage QREs to specific business components. Though its important to note the Cohan Rule does not have to be applied if sufficient evidence isn’t produced upon IRS request. In Shami v. Commissioner of Internal Revenue, T.C. Memo. 2012-78, the court disallowed QREs derived from executive employees due to lack of substantiation of qualifying time and lack of credible testimony.

In general, taxpayers are required to include taxable wages (See IRC 41(b)(D); IRC 3401(a)) in the R&D tax credit calculation. Nontaxable items, such as 401(k) contributions, health insurance contributions and other pretax benefit deductions, should be excluded. Box 1, W-2 wages for employees are generally used to identify taxable wages.

The following are examples of the types of documentation that can be used to substantiate qualified research wages:

  • Employee W-2s

  • Payroll registers

  • Time tracking data

  • Time questionnaires

  • Interview notes for oral testimony

  • Job descriptions

  • Department / Cost Center descriptions

  • Meeting minutes

Supply Qualified Research Expense (QRE) Documentation

Treas. Reg. § 1.174-2(a) has expanded the definition of experimental expenditures and the types of expenses which may be included as QREs in the R&D tax credit computation. For example, developmental prototypes ("pilot models") used in R&D and subsequently sold to customers may be included in the tax credit calculation. In Trinity Industries, Inc. v. United States, 691 F. Supp. 2d 688 (N.D. Tex. 2010), the taxpayer successfully argued millions of dollars invested in developing first-in-class ships were in fact prototypes eligible as QREs.

As such, it's important to review and gather all potentially eligible supply expenses supportable to maximize the credit benefit. Taxpayers should also develop a systematic protocol to track or allocate qualified supply expenses to applicable qualified business components (i.e. "R&D projects") if possible. The following are examples of the types of documentation that can be used to substantiate qualified supply expenses:

  • Chart of accounts

  • General ledger

  • Purchase orders

  • Invoices

Contract Research Qualified Research Expense (QRE) Documentation

The location of the third party consultant is important in establishing QREs. The federal R&D tax credit requires the R&D to be conducted within the U.S., and states that offer similar state-level R&D credit benefits may also require the R&D to be conducted within their respective jurisdictions. In general, all offshore R&D should be excluded from R&D credit claims. 

 

Similar to qualified supply expenses, taxpayers should track or allocate contract research expenses to applicable qualified business components if possible. The following are examples of the types of documentation that can be used to substantiate qualified contract research expenses:

  • Chart of accounts

  • General ledger

  • Third-party contracts

  • Purchase orders

  • Invoices

  • Form 1099 (for individual contractors)

Computer Rental or Lease Qualified Research Expense (QRE) Documentation

If the company is undertaking qualified research activities under § 41(d)(1), the associated expenses related to the lease of server space from cloud service providers to facilitate the software development should be classified as rental or lease costs of computers for the R&D tax credit.

Not only software companies, but other industries such as natural resources, manufacturing, banking, insurance, and public sectors, also engage cloud service providers to build platforms, design solutions, testing, migration, mobile development, and integration with enterprise systems. Companies with less-developed IT infrastructures tend to leverage cloud service providers to foster R&D activities. However, even companies with established IT infrastructure migrate their applications to cloud service providers to resolve issues concerning scalability.

Once development has concluded, many companies continue to lease cloud services for commercial hosting purposes. These types of expenses generally are not qualified and should be segregated from developmental cloud hosting costs.

When evaluating the potential qualified research activities for companies using cloud services for development, it is important to further investigate with software development managers and review the associated contracts regarding the nature of the payments between development or post-development product release and commercial support (e.g. routine simple file storage, system maintenance, mail hosting).
 

The following are examples of the types of documentation that can be used to substantiate qualified contract research expenses:

  • Chart of accounts

  • General ledger

  • Third-party contracts

  • Invoices (e.g. breakout between developer tools services v. post-production release support services)

Qualitative Documentation:

While traditional accounting and financial systems may capture QRE amounts from a quantitative viewpoint, they generally do not capture the information needed to substantiate the facts and circumstances meeting the QRA "four-part test" and other applicable rules required under the code.

In the absence of records specifically created to document the research tax credit, taxpayers often have to rely on estimates and an assortment of documents, interviews, and other evidence to substantiate their expenditures that qualify for the research tax credits. This has resulted in controversy between taxpayers and the IRS as to what documentation is sufficient to substantiate expenditures.

Companies operating in highly government regulated areas, such as life science companies (e.g., pharmaceuticals, biotechnology, and medical devices), then the Food and Drug Administration recordkeeping requirements can be leveraged to support research activities. Similarly, as with aerospace and defense companies, the Federal Aviation Administration and Defense Contract Audit Agency recordkeeping requirements can also be used to support the research and development activities. In other situations, when applying for a patent or a patent being granted, the associated forms may also represent contemporaneous support and often serve as the strongest forms of documentation for qualification.

Overall from a qualitative perspective, the following forms of contemporaneous documentation are general examples of substantive support the IRS generally requests during the course of an examination:

  • Patents or patent applications;

  • Complete project lists identifying current and ongoing R&D projects claimed;

  • Annual R&D or technology proposal plans;

  • Research project authorization requests (e.g. Authorization For Expenditures, "AFEs");

  • Internal (e.g. emails, calendar appointments) and/or external (e.g. R&D contract agreements) correspondence on R&D activities;

  • Design requirements, functional specifications, modeling simulation documentation;

  • Testing scripts or testing logs (e.g. JIRA records);

  • Modifications reports or error logs;

  • Technical reports or plans;

  • Laboratory experimentation reports; or

  • Material consumption/usage worksheets.

IRS Areas of Concern & Examination Background

As outlined and referenced above concerning documentation requirements under the code and treasury regulations, a taxpayer must retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit. However, as also previously mentioned, the IRS does not have to accept estimates ("Cohen Rule") of qualified research expenses if documentation exists to verify the actual amount of such expenses. Estimation methods are permitted in general only in cases where the sole issue is the exact amount paid or incurred in the qualified research activity. Accordingly, taxpayers must generally retain factual support for every assumption underlying their estimates to meet their burden of proof. As such, taxpayers are required to keep records substantiating the amount of any claimed deductions or credits.

The IRS’s preferred method for capturing QREs is a project-based approach where taxpayers can create nexus between QREs and QRAs. However, in Suder, the court held taxpayers aren’t required to provide a factual nexus bridge between claimed QREs and specific business components as long as there’s reliable evidence to support the QREs. See Suder v. Commissioner of Internal Revenue, T.C. Memo. 2014-201. Some taxpayers attempt to make qualified R&D time percentage allocation estimates from its higher level subject matter experts (e.g. chief financial officer, chief executive officer) for everyone in the organization without consulting with individuals closer to understanding the day-to-day activities to confirm the appropriate QRA. The further removed a subject matter expert from the actual qualified research services being performed, when providing assigned qualified research activity percentages, the more likely those percentages may be scrutinized by the IRS. 

Upon commencement of an audit, the IRS generally schedules a meeting with the taxpayer to discuss what type of contemporaneous books and records are available to substantiate the research credit claimed prior to sending an initial Information Documentation Request (IDR) regarding the R&D credit claim and computation mechanics. The IDR from the IRS may generally include the following:

  • Taxpayer’s base amount and fixed base percentage calculations

  • General information: chart of accounts, organization charts, etc.

  • Acquisitions and dispositions from 1984 (if applicable) through the tax year under audit

  • Accounting method:  Are costs accumulated by department or by project?

  • Activities:  What was performed, and why are they eligible for the R&D credit?

  • Wages:  Employee Names / Identification, wage amounts included, % of annual wages qualified, departments, job titles & descriptions, additional supporting documentation for high-level employees performing qualified research activities

  • Supplies:  Categories, how the amounts included reconcile to the general ledger, amounts by category/ functional area / department

  • Contracts:  Specific Consultants, contract agreements, amounts paid and % qualified, activities performed

In general, the IRS will send several piecemeal IDR requests regarding specific areas under review concerning the R&D credit claim. Subsequent interviews by the IRS to knowledgeable company personal (technical or supervisory interviewee) who assisted with the R&D credit claim may be deemed necessary by the IRS to gather new information, or to confirm, clarify or refute other documentary or testimonial evidence.     

The IRS has instructed its examining agents the following information is helpful in understanding the appropriation of company resources or details of research projects the taxpayer conducted during the examination year:

  • Materials explaining research activities, including brochures, pamphlets, press releases, and other similar documents.

  • Submissions to management, the board of directors, review committees or other similar groups regarding research projects, activities, expenditures, and the research credit.

  • Documents prepared by, or on behalf of, internal audit, including quarterly and annual reports that refer in any manner to research activities.

  • Minutes, notes, or other similar recordings from budget, board of directors, managerial or other similar meetings concerning research activities.

  • Project authorizations, budgets, or work orders that initiates a research project.

  • The internal authorization policies for approving a research project.

  • Project summaries and/or progress reports and project meeting minutes.

  • Field and lab verification data/summary data.

  • Research credit studies conducted by outside consultants.

  • Papers, treatises, or other published documents regarding the taxpayer’s research.

  • Complete copies of contracts (including all modifications), letter agreements, memoranda of understanding, or similar documents for research performed by, or on behalf of, a third party.

Wherever possible, all activities should be documented contemporaneously. This should include project descriptions that address all four of the tests and the other limiting rules in real time as the activity occurs. The focus should be on the quality of information rather than on the volume. The information should be organized by project and on an employee-by-employee basis. The time spent performing qualified and nonqualified activities should be well-documented.

IRS R&D Credit QRE Safe Harbors & Recordkeeping Agreements: Large Business and International (LB&I) Division Taxpayers​​

IRS Directives - Qualified Research Expense (QRE) Safe Harbors

These IRS Directives noted below provide Large Business & International (“LB&I”) examiners with guidance regarding examination of the credit for increasing research activities under §41 (“Research Credit”) claimed by LB&I taxpayers.  Independently determining the correct amount of Research Credits claimed by LB&I taxpayers imposes a significant burden on those taxpayers and LB&I examiners.  As such, the IRS Directives are intended to provide an efficient manner of determining QREs for LB&I taxpayers and streamline LB&I’s audit resources.

It's important to note other offices outside of the LB&I Division (e.g. Appeals, Small Business & Self-Employment) may not  be subject to the Directive. And although IRS Directives are not an official pronouncement of law, and cannot be used, cited, or relied on as such, it is generally accepted Appeals will respect the Directive and hold the LB&I exam team to its terms.

The IRS Directives listed below allow a safe harbor for certain costs and provides guidance to examiners concerning examinations of Internal Revenue Code (IRC) Section 41 credits for increasing research activities (Research Credit).

(1) ASC 730 LB&I Directive - IRC 41 QREs Safe Harbor

On September 22, 2017, the IRS publicly released guidance for large business and international (LB&I) examiners regarding the examination of certain R&D expenses under Financial Accounting Standards Board Accounting Standards Codification Topic 730, Research and Development. The directive (LB&I-04-0917-005) indicates the IRS won’t challenge certain qualified research expenses (QREs) that are a taxpayer’s adjusted ASC 730 financial statement R&D costs, as the starting point for computing QREs. Any QRE claimed falling outside the ASC 730 IRS directive may still be claimed to calculate the applicable period's credit, however, will be subject to traditional examination and documentation rules upon a potential audit.

This directive is intended to eliminate duplicate efforts and reduce the work required to document and substantiate qualified research costs. With this guidance, taxpayers now have the option to reconcile ASC 730 with the QRE claimed on their tax return by adjusting ASC 730 financial statement R&D costs to arrive at the amount the IRS considers as qualifying for safe harbor. 

The ASC 730 LB&I Directive does not require a formal election. It only requires that taxpayers satisfy the conditions in the Directive. Taxpayers who satisfy the conditions of the Directive may attach the completed disclosure statements at the time of filing of the Federal income tax return or may provide the completed disclosure statements at the outset of the examination. Because the Directive provides an opportunity for a company to not ‘‘declare’’ on its timely filed tax return that it intends to claim the benefits of the Directive, and then decide whether to use the Directive at the outset of an audit, it provides companies time to further evaluate the benefits and assess its strategy.

ASC 730 IRS Directive - applies only to LB&I taxpayers which requires the following:

  • taxpayers [balance sheet] assets equal or exceed $10,000,000;

  • follow U.S. Generally Accepted Accounting Principles (GAAP) to prepare their Certified Audited Financial Statements; 

  • who show, as a separate line item or in a separately stated note to their Certified Audited Financial Statements, the amount of their currently expensed ASC 730 R&D costs; 

  • Provide completed disclosure statements contained in Appendices A through D of the Directive; and

    • ​Appendix A – Certification Statement Claiming the Adjusted ASC 730 as QREs.

    • Appendix B – Reconciliation of Form 6765 QREs to the Adjusted ASC 730

    • Appendix C – Computation of Adjusted ASC 730 Amount

    • Appendix D – Adjusted ASC 730 Financial Statement R&D Wage Detail

  • to support the adjusted ASC 730 amount, taxpayers are required to retain and make available upon request the underlying books and records that support the amount of credits claimed under the Directive, including but not limited to the following:

    • a. Certified Audited Financial Statement for the Credit Year including auditor’s certifying opinion;

    • b. Taxpayer’s Chart of Accounts;

    • c. List of U.S. ASC 730 Financial Statement Cost Centers that make up the ASC 730 Financial Statement R&D amount shown in Step 1 of Appendix C;

    • d. All ASC 730 R&D GL Accounts with account balance details that make up the ASC 730 financial statement R&D amount shown in Step 1 of Appendix C;

    • e. List of ASC 730 R&D GL Accounts with account balances that make up the adjustments in Steps 2 through 4 of Appendix C;

    • f. Taxpayer’s organization chart showing employees and levels of management for the credit year;

    • g. Executed contracts pursuant to which Taxpayer is performing ASC 730 research in order to comply with the terms of the contract;

    • h. Executed contracts pursuant to which persons other than employees of 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.; and

    • i. 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.​

Applying the Directive

The safe harbor is limited to certain specific costs:

  • Qualified Wage Expenses

    • Wage Qualified individual contributors: 95% of the taxable wages of qualified individual contributors whose wages are charged to Topic 730 cost centers;

    • First-level supervisor managers: 95% of the taxable wages of first-level supervisor managers whose wages are charged to Topic 730 cost centers; and

    • Upper-level managers: Up to 10% of the amount computed above for qualified individual contributors and first-level supervisor managers or 100% of wages and stock options for upper-level managers, defined as those who directly supervise any employee other than qualified individual contributors and whose wages are charged to ASC 730 cost centers, is eligible as a safe harbor for upper-level managers. Whichever amount is lower can be included. 

  • Qualified Supplies & Qualified Computer Rental Costs

    • The directive also allows for inclusion of amounts expensed in ASC 730 R&D accounts related to development supplies used and consumed in the US, affording safe harbor treatment to these supply amounts.

    • Similarly, the directive allows for inclusion of amounts expensed in ASC 730 R&D accounts relating to development-based computer rental costs as covered by the safe harbor.

  • Costs not falling within the safe harbor (may be allowable for the credit but are still subject to traditional exam procedures) include:

    • Research conducted for others under contract (contract research performed by or on behalf of the taxpayer);

    • Prototype overhead costs;

    • Costs to improve existing products, production processes, and manufacturing processes;

    • Full-scale pilot model costs; and

    • Development of internal-use software.

FIN 48 Impact

  • A common consideration raised by this directive is the impact of FASB Interpretation No. (FIN) 48, Accounting for Uncertainty in Income Taxes, under ASC Topic 740, Income Taxes, which comprises two components: recognition and measurement.

  • Taxpayers following U.S. GAAP will recognize a tax position if the position meets the "more likely than not" (or over 50%) level of authority. A determination of more likely than not relies solely on the technical merits of the position, which are determined based on sources of authority (legislation, regulations, case law, etc.). Since the directive is not authoritative, taxpayers should not use it as the only factor in the recognition analysis.

  • Once a tax position is recognized, the next step in the FIN 48 analysis is the measurement component, which determines how much of the position should be recognized on the financial statements. The amount recognized is the amount determined to be greater than 50% likely to be realized upon settlement with a taxing authority. The taxpayer makes this determination by weighing several factors, including expectations regarding the taxing authority's willingness to settle the issue. The directive may be one of several relevant data points for some taxpayers when making this determination.

Depending on your company’s circumstances, the ASC 730 Directive provides various benefits including, protection from IRS examination of certain components of its R&D credits, potentially increased credits claimed, and possible reduction in future tax expense through overall increased R&D tax credits or reduction in FIN 48 / ASC 740-10 reserves against this amount.

ASC 730 Directive Safe Harbor Applicability to State R&D Credits

  • Currently, not all states have confirmed adoption of the ASC 730 Directive for calculating credits at the state level. However, in February 2018, the California Franchise Tax Board announced that it will fully adopt the ASC 730 directive method, provided that additional adjustments are made to include only those costs incurred that relate to activities or services performed in California.

See IRS links for additional background:

(2) IRS "Life Sciences" Directive - IRC 41 QRE Safe Harbor During Stages 1 & 2

On December 12, 2012, the IRS release (LB&I-04-1212-014) "Guidance for Computing and Substantiating the Credit for Increasing Research Activities under Section 41 of the Internal Revenue Code for Activities involved in Developing New Pharmaceutical Drugs and Therapeutic Biologics," the Commissioner of the Large Business & International Division released a pharmaceutical and biotechnology industries directive memo to Large Business & International examiners in determining whether a taxpayer in the pharmaceutical and biotechnology industries has appropriately computed the credit for increasing research activities under section 41 of the Internal Revenue Code (research credit) for activities involved in developing new pharmaceutical drugs and therapeutic biologics.

Here, the Directive provides IRS examiners should not challenge the amount of QREs taken by a taxpayer:

  • (i) to the extent that the QREs, within the meaning of section 41(b) of the Code, are for “qualified research” activities (as defined in section 41(d)(1) and not excluded by section 41(d)(4)) that occur during stages 1 (Discovery and Preclinical Stage) and 2 (Clinical Trial Stage) of the Pharmaceutical Drug and Therapeutic Biologics Development Process and clinical trials required by the FDA relating to Accelerated Approvals; and

  • (ii) the taxpayer provides the Certification Statement (see below). 

 

In general, the development of pharmaceutical drugs and therapeutic biologics (collectively “medicine”) may be broken down into four stages described below. However, these stages do not always progress linearly. For example, a taxpayer may enter Stage 3 or 4 and then return to Stage 1 or 2.  If this occurs, the amounts related to Stage 1 or 2 should still be classified as such.

Pharmaceutical Drugs and Therapeutic Biologics Development Process:

  • Stage 1. Discovery and Preclinical Stage.  During the discovery and preclinical stage of the development process, scientists identify and perform initial tests on molecules or new compounds that may be viable candidates for the treatment of a specific condition or disease.  Scientists also conduct extensive laboratory testing of the identified promising molecules or compounds to determine their safety for testing in humans, the possibility of increasing their production, and the potential routes of administration to humans.  Generally, this work is conducted in the biology, chemistry, pharmacology, toxicology, and drug metabolism departments of pharmaceutical and biotechnology companies. 

  • Stage 2. Clinical Trial Stage. In general, clinical trials occur in three generally-accepted phases after a company files an Investigational New Drug Application (INDA) with the Food and Drug Administration (FDA) and the FDA approves the INDA.  Generally, these three phases are carried out consecutively such that a subsequent stage is reached only after successful completion of the preceding phase; however in some cases, a taxpayer may enter Phase II or III and then return to an earlier phase.  These three phases can be summarized as follows:

    • a. Phase I. The trials in this phase usually involve 20 to 80 healthy volunteers. The candidate medicine is tested in humans for the first time to determine if it is safe for humans.

    • b. Phase II. During this phase, the candidate medicine is administered to approximately 100 to 500 patients with the disease or condition to determine effectiveness, safety, and proper dosages.

    • c. Phase III. During this phase, researchers typically perform large-scale studies with approximately 1,000 to 5,000 patients to gather more information about the safety, effectiveness, and overall benefits and risks of the candidate medicine.

    • As an alternative to the three phase traditional clinical trial stage, an accelerated approval process may be applicable to new medicines intended for use in treating serious, rare, or life-threatening diseases that lack satisfactory treatments.  Under the accelerated approval process, the FDA may approve a medicine upon successful completion of Phase I and II clinical trials, but before the Phase III clinical trials are concluded.  Because, in these cases, the FDA approval comes before certain measures of the medicine’s effectiveness are established, the accelerated approval is contingent upon further post-approval commitment clinical trials to establish the medicine’s effectiveness and benefits and risks profile.   Phase III work may be required even after the accelerated approval by the FDA.  If the required clinical trials do not confirm the initial results upon which the accelerated approval was granted, the FDA may withdraw the approval. 

  • Stage 3Regulatory Review Stage. If the clinical trials show that the candidate medicine is safe and effective, the sponsor company files with the FDA a New Drug Application (NDA) for a pharmaceutical drug or a Biologics License Application (BLA) for a therapeutic biologic to obtain the FDA’s approval for marketing and manufacturing of the new medicine for the specified indications.  Upon review of a NDA or BLA, the FDA may either: (1) approve the medicine, (2) send a letter indicating that the medicine is approvable but require additional information or studies before approval may be granted, or (3) deny approval.  The FDA may also require additional studies after an approval. In addition, after a denial, the process may revert to Stage 2 for new clinical trials. 

  • Stage 4Post Approval Stage. Once the FDA grants approval, the medicine may be manufactured and marketed for the approved indications.  In the post approval stage, companies continue to monitor medicines and submit periodic reports to the FDA on the medicine’s newly identified side effects and performance.  Sometimes these activities are referred to as the post-marketing surveillance program.  Companies perform additional studies, generally known as Phase IV Clinical Trials, to evaluate long term effects of the medicine, including how the medicine affects a specific subgroup of patients.  Additionally, at this stage, companies may perform comparison studies with other products. 

​​

Certification Statement:

  • If the amount of the QREs taken by the taxpayer is under examination at the date of this Directive, the taxpayer should provide the signed Certification Statement to the examiner within sixty days of the effective date of this Directive.

  • Other than for instances described in 1 above, the taxpayer should provide the signed Certification Statement to the examiner within thirty days of the date that an information document request (“IDR”) is issued to the taxpayer with respect to the amount of QREs taken by the taxpayer. 

  • A separate Certification Statement must be submitted for each taxable year under audit.  For a consolidated Federal income tax return, the common parent is the sole agent for the group and it will sign the Certification Statement for each member of the group.  An examiner will consider any taxpayer not in compliance with these requirements ineligible for this Directive and subject to regular audit procedures.

  • For this Directive to apply, a taxpayer must complete all sections of the Certification Statement.

    • The Certification Statement must be signed by an individual who is authorized to execute the taxpayer’s Federal income tax return for the taxable year under audit, and must certify, under penalty of perjury that, for the taxable year under audit, the taxpayer’s computation of QREs is consistent with section 41 of the Code.

    • Pursuant to section 6001 of the Code, the taxpayer should retain the underlying documentation that would permit the Examiner to make a determination that the taxpayer’s computation of QREs meets the requirements of section 41 of the Code.

    • Prior to requesting the underlying documentation, the examiner must receive approval from the territory manager.  

    • If a taxpayer fails to properly and timely submit the requested documentation, then the Industry Director or his/her delegate may determine that this Directive does not apply to the taxpayer.

See IRS link for additional background:

(3) IRS Recordkeeping Agreements - Application & Certification Prior to Filing

A. Compliance Assurance Process​​ 

The Compliance Assurance Process (CAP) was developed by the Large Business and International (LB&I) Division to improve the federal tax compliance of large corporate taxpayers by employing real-time issue resolution tools and techniques. In CAP, the IRS and taxpayer work together to achieve tax compliance by resolving issues prior to the filing of the tax return. CAP allows the IRS to achieve an acceptable level of assurance regarding the accuracy of the taxpayer’s filed tax return and to substantially shorten the length of the post filing examination. CAP started as a pilot program in 2005 and became permanent in 2011 as a way for resolving tax issues through open, cooperative and transparent interactions between the IRS and taxpayers before the filing of a return. The program began with 17 taxpayers and currently has 169 taxpayer participants.

 

On August 28, 2018, the IRS announced the changes to its recalibrated CAP Program for the 2019 CAP year and that new taxpayers may be accepted for the 2020 CAP year. On September 12, 2019, the IRS announced that new large corporate taxpayers interested in participating in the CAP program may apply for the 2020 CAP year. A taxpayer interested in applying for the 2020 CAP year that meets the eligibility and suitability criteria must complete and submit the required CAP application during the application period that starts on September 16, 2019 and ends on October 31, 2019.

To be eligible for participation in the CAP Program, a taxpayer must meet the following criteria:

  • Have assets of $10 million or more;

  • Be a U.S. publicly traded corporation with a legal requirement to prepare and submit Forms 10-K, 10-Q, and 8-K to the Securities & Exchange Commission or an entity that was accepted into the 2019 CAP Program and agree to provide the IRS with quarterly financial statements and audited annual financial statements for the entity that was accepted into the Program.

  • Not be under investigation by, or in litigation with, the IRS or another government agency that would limit the IRS’ access to current corporate tax records; and

  • If currently under examination, must not have more than one filed return and one unfiled return open on the first day of the applicant’s CAP year.

For a new applicant currently under examination to be eligible for participation in the CAP Program, the current cycle must be closed and the subsequent cycle not started on the first day of the applicant’s CAP year.

For all new applicants, any unexamined return with an open statute will be risk assessed as part of the required compliance check for the first CAP year. If the examination team determines that a material issue should be examined, the return with that issue may be placed under examination. Any unexamined returns that are placed under examination will be treated as ‘one filed’ return for purposes of the return criterion. These returns must be closed by the end of the second CAP year or the applicant may not be eligible to participate in the third CAP year.

2020 CAP Application and Related Documents:

  • Form 14234 - CAP Application (PDF)

  • Form 14234-A - CAP Research Credit Questionnaire (CRCQ) (PDF)

  • Form 14234-B - Material Intercompany Transactions Template (MITT) (PDF)

  • Form 14234-C - Taxpayer Initial Issues List (TIIL) (PDF)

  • Form 14234-D - Tax Control Framework Questionnaire (TCFQ) (PDF)

  • CAP Application and Selection Process

  • CAP Eligibility and Suitability Criteria

  • MITT Submission Process for New Applicants

  • MITT Submission Process for Returning Applicants

Pre-2020 CAP Information Resources: 

  • 2019 CAP Memorandum of Understanding (MOU)(PDF)

  • 2019 CAP Recalibration Discussion Document (PDF) – September 28, 2018

  • 2019 MITT and Other CAP Recalibration Frequently Asked Questions

  • Pre-2019 CAP Internal Revenue Manual (IRM)

  • Pre-2019 CAP Frequently Asked Questions (FAQ)

See IRS link for additional background:

B. Research Credit Recordkeeping Agreement Program  

Notice 2004-11, (published in the Internal Revenue Bulletin on February 9, 2004), permits the Internal Revenue Service, and Large and Mid-Size Business (LMSB) taxpayers to enter into research credit recordkeeping agreements (RCRAs).  The Research Credit Recordkeeping Agreement program was developed to help reduce recordkeeping issues by allowing both taxpayers and the IRS to agree upfront what records are necessary to support a taxpayer’s research credit claim.  If the taxpayer keeps these records, then disallowance for lack of substantiation will generally not be an issue.

An RCRA applies to future years and, in this way, the taxpayer can take steps to ensure that its research is properly documented before it ever takes place.  Often the IRS may propose such an agreement upon completion of the current examination cycle. However, entering this agreement may require the taxpayer to create new records for future years that previously did not exist.  In addition, it may be determined that records presently kept, may no longer be needed. 

See IRS links for additional background:

Conclusion:

The IRS's expectation of sufficient documentation to substantiate R&D tax credits has evolved over the years. In general, documentation may be held insufficient because it is too generic or disorganized.

As such, taxpayers claiming R&D tax credits should ensure that their research tax credits are properly documented in advance of filing their tax returns. This should include documenting the progression of information that is discovered while performing the research activities, to satisfy the four-part test. To ensure all relevant information is captured, it is best to document research activities contemporaneously.

When identifying, gathering, and documenting a an R&D tax credit claim, both the qualitative and quantitative aspects are equally important, in order to meet all applicable statutory, administrative, and judicial interpretations in supporting the benefits claimed.

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