R&D Tax Credits Could Kick-Start Your Innovation Programs

For every financial services organization today — from banks to insurance companies— innovation is not just a buzzword. It is critical to future growth.

Disruption is coming from many directions. New competitors are entering the industry, customer behaviors are changing, and regulatory and reporting requirements continue to increase. These and other challenges are spurring traditional financial services firms and FinTechs to achieve innovative breakthroughs at speed and scale. Savvy organizations realize that innovation is the proven path to digital transformation that will drive success.

Fortunately, recent changes in tax regulations favor taxpayers, opening up potentially substantial financial opportunities for firms investing in digital capabilities. Organizations can save significant dollars through research & development (R&D) tax credits under Internal Revenue Code Section 41.

The R&D tax credit is a dollar-for-dollar credit against taxes owed or paid for taxpayers that perform qualifying R&D activities. These tax credits are available to offset US federal income tax, as well as some state taxes, and are also offered by some foreign jurisdictions. At the federal level, taxpayers may be able to recoup 4% to 8% of what are known as qualified research expenditures (QREs). More than 30 states offer credits and incentives enabling a taxpayer to recoup 2% to 8%. Around the world, more than 40 countries offer incentives. If taxpayers plan carefully, they may even be able to “double dip” and “triple dip” to monetize credits from multiple jurisdictions.

“The R&D tax credit is a dollar-for-dollar credit against taxes owed or paid for taxpayers that perform qualifying R&D activities.”

For example, a large bank has invested $200 million for new digital capabilities. Of this total investment, it was determined the bank has $100 million of QREs, including employee salaries and consulting fees incurred in the US and within states that offer additional tax credits. This could result in credits of $4 million to $8 million at the federal level, and an additional $2 million to $8 million at the state level.

There are many potential sources of QREs for organizations to consider, including modifying or customizing off-the-shelf software or developing or upgrading proprietary software. Software can be used internally or externally (e.g., by customers), although different tests apply to measure qualifying expenditures. Other possible QREs include investments in innovation labs and incubators; wages for employees involved in R&D; fees for outside consulting services; and leasing cloud services for an R&D environment.

Two potentially lucrative opportunities should be considered because they are sometimes overlooked. The first is most R&D tax credits normally have a three-year statute of limitations, so taxpayers can apply for them retroactively and file amended returns. Keep in mind a net operating loss can keep the statute of limitations open beyond three years. And the second is for certain small, startup companies that do not pay any federal income tax, the R&D tax credits can be used against payroll taxes. These companies that generally need cash flow can monetize the credit in current years instead of having to carry forward the credits.

To maximize the potential for successfully claiming R&D tax credits, organizations should focus on several factors. They should take a strategic approach to align all key constituents — their tax department, business lines, finance function, IT department, IT procurement and legal teams — with outside tax experts. This is important today because a great deal of innovation happens outside of IT. It’s occurring in the business lines (e.g., product development), so all parties should be aware of R&D investments wherever they are made.

Also, the burden of proof for the R&D tax credit is on the taxpayer, so it is critical that organizations establish a robust process for documentation of activities and costs for which credits are claimed. They must be able to show a clear connection between the qualifying activities and dollars invested — and should do so on an ongoing basis because, for most firms, the R&D credit can be an annual cash benefit, not just a one-time windfall. However, many firms do not have the expertise to manage this process in-house without missing significant opportunity areas; they turn to outside experts that can handle it strategically.