When is a supply a supply?
It depends!
Texas recently published two memos addressing questions about the state’s research and development credit. The first answers whether an otherwise qualified expense arises from depreciable property (and allowed under § 174) is permitted under § 41. The state takes a narrow reading of § 41. It concludes that property subject to depreciation cannot be a supply for the research credit, regardless of its treatment under § 174.
Photo by Anamul Rezwan.
Deductions under § 174
First, let’s get the question about amortization out of the way. Texas does not automatically conform to the changes in the Internal Revenue Code. Instead, they have to intentionally update their law to conform to changes in the federal tax code, which has not happened since 2007. As a result, Texas does not require § 174 expenses to be amortized.
Under § 174, a deduction for experimental expenditures not chargeable to a capital account is allowed. However, this does not apply to expenditures associated with acquiring or improving land, or acquiring or improving property which is subject to depreciation under § 167. The regulations for § 174 provide exceptions to this rule, such as if the research produces depreciable property and the creation of depreciable property by a third party (yes, there are nuances there, but that is beyond the scope of this section).
These exceptions are not found in the research credit or its regulations. And that has made all the difference for Texas.
Expenditures under § 41
Supplies under § 41 are defined as “any tangible property other than … property of a character subject to the allowance for depreciation.” Texas then lays out the analysis as follows:
1. Taxpayer determines whether the activity constitutes qualified research.
2. The expense must be allowed under § 174 as an eligible deduction.
3. The expense must also be allowed as a deduction under § 41.
The third step must be determined under § 167, with no consideration for § 174. The state acknowledges that the test depends on the taxpayer’s particular use of the property. The result is that property falling into the 174 exceptions, such as the cost of component materials for research that results in depreciable property, is not eligible for the tax credit.
Does TG Missouri make a difference?
In the Tax Court case of TG Missouri, the taxpayer claimed expenses related to the creation of molds used to create injection mold products. These molds were sold to customers, although the taxpayer retained possession to create the end product. The Tax Court held that the molds were not property subject to depreciation since it was inventory sold to a customer.
The state’s minimal analysis relies on the opinion in TG Missouri to support the requirement that supplies be determined under § 167. The state also uses language similar to the holding in TG Missouri, but that is all. Notably, the Court in TG Missouri did not answer whether the exceptions under § 174 would qualify under § 41.
It seems safe to conclude that if the property in the hands of a taxpayer is similar to that found in TG Missouri, such as the molds being sold to customers, it would still be eligible in Texas.
The full memo can be found here.
The other memo
On the same day, Texas released another memo addressing whether intra-group transactions apply to the TX R&D credit (sales and franchise). The result was a quick “no” because Texas does not have the concept of a “group under common control.”
Wrap-up
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The content of this article is for informational purposes only and should not be taken as tax, legal, benefits, financial, or HR advice. I am a lawyer, but receiving this newsletter does not mean I am your lawyer. Since rules and regulations change over time and can vary by location, consult a lawyer or HR expert for specific guidance.