Changes to the tax treatment of research and experimentation expenses, under Internal Revenue Code (IRC) Section 174, make the Research and Development (R&D) Tax Credit more beneficial for many banks.
Beginning January 1, 2022, as part of the Tax Cuts and Jobs Act (TCJA), businesses are required to begin capitalizing and then amortizing research and experimentation costs, changing the previous treatment that allowed an immediate deduction. As a result, many businesses, including banks, have realized additional tax liabilities.
The new capitalization requirements do not prohibit businesses from claiming the R&D Tax Credit (IRC Section 41). The credit can still be used to reduce income tax liabilities and increase cash flows.
The R&D tax credit provides a dollar-for-dollar reduction in tax liability based on “qualified activities” undertaken by a company each tax year. The primary requirement for activities to qualify is that they be consistent with the purpose of the incentives: to promote design and development activities within the United States and the subsequent hiring and retention of technical staff to accomplish these tasks.
This credit can be beneficial to companies across many industries. However, those in the financial services industry are often hesitant to utilize this credit because they likely do not understand they may qualify.
Many financial institutions invest significantly in software development and/or enhancement. This may include software to stay up to date with current trends and cybersecurity, development of online and mobile banking applications, or software targeted at automating various processes.
Also, financial institutions often develop or customize software to increase productivity/security, develop new functionality, edit current algorithms, or make other changes in an attempt to improve company operations.
The activities that many financial institutions perform on a day-to-day basis may qualify for the R&D Tax credit could include, but are not limited to:
Upon determining a company is engaged in qualifying R&D tax credit activities, certain costs related to those activities must be identified and allocated to the qualifying R&D tax credit activities.
The three areas of qualifying expenses include:
The R&D tax credit is based upon a percentage of the qualifying expenses, meaning a larger allocation of qualified expenditures generates an increased credit.
Regulations dealing directly with “internal use software” were finalized in 2016 and provide guidance for financial institutions undertaking software development efforts. The rules outlined in the regulations are very favorable for taxpayers and loosen prior restrictions on claiming R&D credits for internal use software development.
Eligible small businesses may use the R&D Tax Credit to offset Alternative Minimum Tax. An eligible small business is defined as a corporation whose stock is not publicly traded, a partnership or sole proprietor and whose average annual gross receipts for the three-year period preceding the tax year do not exceed $50 million.
R&D tax credit claims are extremely complex and are generated using the unique facts and circumstances of each company. In order to maximize available credits, it is recommended that companies seek the assistance of knowledgeable specialists who have technical, tax and legal expertise in this area.
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