IT Officials to Congress: New Economy Leaves Old Tax Laws in Dust

By Kerry Gildea, Contributing WriterHigh-tech industry officials told a congressional panel that federal tax laws are not keeping pace with the new economy, and that the Internal Revenue Service is not following the correct procedures on grant-ing research and development tax credits.Industry officials told the House Ways and Means Oversight subcommittee at a Sept. 28 hearing they are not being treated fairly as the IRS interprets eligibility for research and development tax credits. IT officials are lobbying for changes that would clarify rules on R&D eligibility before a permanent tax credit is made into law, which could happen in the next Congress.Rep. Amo Houghton, R-N.Y., chairman of the House Ways and Means Oversight subcommittee, said he is holding hearings now because many of the nation's tax rules pre-date the new economy."The strength of the economy may be masking underlying inadequacies in our tax laws. We shouldn't wait for an economic downturn to take a look at the current rules," Houghton said. "The new economy uses high-tech equipment, so we need to look at the cost-recovery rules for physical capital," he said. "It relies on research and development, so we need to look at the tax treatment of intangible capital. And it is driven by a skilled work force, so we need to look at how our tax laws treat investment in human capital."Rep. William Coyne, D-Pa., ranking minority member of the subcommittee, agreed this Congress and the next must take a more aggressive look at tax laws and the new economy."The relationship between the tax laws and the ability of this country to maintain a skilled work force is a timely issue for discussion," Coyne said. "All one has to do is look in the classified employment section of the newspaper to see the vast number of workers sought and the technical skills needed for the jobs. News reports indicate that currently there are about 300,000 high-tech job vacancies. Importantly, the number of highly skilled jobs is increasing at an annual rate of 10 percent, and it is unclear whether the positions can be filled."Congress needs to focus on what can be done in the short and long term to prepare future generations for the new economy, and "the tax laws are one important and successful tool for encouraging business innovation and jobs training in today's new economy environment," Coyne said.William Sample, chairman of the R&D credit coalition and senior director of domestic taxes for Microsoft Corp., Redmond, Wash., was among those from the IT industry who told lawmakers that IRS agents are misapplying the regulations related to tax credits for high-tech industry. Last year, as part of the Tax and Trade Extension Act of 1999, Congress extended the R&D tax credit for five years through June 30, 2004."Despite the broad support for this tax incentive, and additional guidance by the Congress on the proper administration of the credit, there remain significant problems with the manner in which the IRS administers the law and interprets the application of R&D credit eligibility rules to corporate research activities," Sample said.One key controversy is how the IRS is interpreting definitions used to determine if a company is eligible for a tax credit. The tax credit, according to Congress, would be granted if it is proven "that qualified research is research undertaken for the purpose of discovering new information, which is technological in nature," and that "new information that is new to the taxpayer, is not freely available to the general public."Congressional staffs are in the midst of reviewing proposed R&D regulations and how to include such definitions should a permanent tax credit move forward.While industry officials said they are encouraged that those reviews are ongoing, there is still a near-term problem."We are encouraged by such actions," Sample said. "At the same time, we remain concerned that during this comment period, IRS agents are misapplying the regulations or misinterpreting the clear statutory intent of the definition of 'qualified research.' " Given the unique nature of these proposed R&D regulations, the controversy reflected in public comments on the issue, and the problems the regulations are causing in the tax examination and audit process, industry is urging that the final R&D regulations do not contain rules inconsistent with congressional intent."Left unchanged and outstanding, any rules that incorporate the 'common knowledge' test contained in the proposed regulations will cause more confusion, controversy and administrative burdens, without furthering the underlying legislative intent of the R&D tax credit," Sample said. "We believe such results will harm rather than help the administration's efforts to encourage R&D investments and to support the R&D tax credit."Joseph Mikrut, tax legislative counsel for the Treasury Department, told the panel the administration recognizes the importance of the R&D credit for encouraging technological development and has supported its extension. Mikrut steered clear of the specifics on IRS interpretation of the credit and issues, but said special flexible tax accounting rules are provided to encourage taxpayers to make investments in research and experimentation."The research credit fosters new technology by encouraging private-sector investment in research that can help improve U.S. productivity and economic competitiveness," Mikrut said. "For that reason, the administration has supported an extension of the research credit."Under law, the research credit is equal to 20 percent of the amount by which a taxpayer's qualified research expenditures exceed a base amount, Mikrut said. The base amount for the taxable year is computed by multiplying a taxpayer's fixed-base percentage by the average amount of the taxpayer's gross receipts for the four preceding years, he said. And, except in the case of certain startup firms, the taxpayer's fixed-base percentage generally is the ratio of its total qualified research expenditures for 1984 through 1988 to its gross receipts for those years, he said.Mikrut said there will continue to be some restrictions on research that is allowed. Certain types of research specifically are excluded, such as research conducted outside the United States; research in the social sciences, arts or humanities; and research funded by another person or governmental entity.Mikrut also placed some blame on industry for not taking full advantage of the availability of R&D tax credits. Some firms underinvest in research because it is difficult to capture the full benefits from their research and to prevent their costly scientific and technological advances from being copied by competitors, he said. "Because other firms and society at large frequently benefit from the spillover of research conducted by individual firms, the private return to research often is lower than the total return," Mikrut said. "In this situation, government action can improve the allocation of resources by increasing research activity."The tax rules provide a number of incentives for research and experimentation. To encourage taxpayers to undertake research and to simplify the administration of the tax laws, special flexible tax accounting rules are provided for investments in the research and experimentation."Still, until a permanent R&D credit is in place, the industry officials predicted there would continue to be problems with IRS and Treasury interpretations. Michael Jalbert, president and chief executive officer of Transcrypt International, who testified before the panel on behalf of the American Electronics Association, urged the Treasury Department to consider proposed recommendations from industry."AEA, along with others in the R&D industries, have filed comments with Treasury expressing serious concern about the proposed regulations," Jalbert said. "Given the strong comments that have been received by Treasury to these regulations, AEA suggests that, at a minimum, Treasury should consider re-proposing these regulations."However, regulation reviews and changes should not stall enactment of a permanent credit, Jalbert and the other IT officials told the panel.Jalbert noted that high tech is an R&D intensive industry, and the R&D credit provides high-tech and other industries with a critical tax incentive to maintain and increase their U.S.-based research and development. He urged lawmakers to make the credit permanent sooner rather than later."The R&D tax credit is responsible for stimulating U.S. investment, wage growth, consumption and exports which all contribute to a stronger economy and a higher U.S. standard of living," Jalbert said. "The R&D tax credit helps most AEA member companies, including hardware, software and manufacturers, regardless of size, who undertake research. Enacting a permanent R&D tax credit "will enable companies to have certainty in their tax planning. AEA strongly supported the five-year extension of this credit last year, and urges Congress to permanently extend this credit now," he said.