Authors: Danielle Kaufman, Partner, RSM US, Naveen Pasala, Senior Manager, RSM US, and Ramiro S Montero Barragan, Partner, RSM Mexico.
In previous articles we considered how a multinational enterprise (MNE) can benefit from carrying out Research and Development (R&D) activities in Canada, Ireland, and the United Kingdom, in order to optimise tax incentives as part of their global investment decisions. We will now consider a neighbouring pair of countries and look to answer some key questions around the opportunities for R&D incentives in Mexico and the United States.
What is the local definition of R&D?
In the United States, for purposes of the R&D tax credit, qualified research is defined as research that satisfies all of the following four points:
- Technological in nature; relying on the physical or biological sciences, computer science, or engineering.
- Undertaken to eliminate uncertainty, relating to capability, methodology, or product/process design.
- Undertaken for a permitted purpose; relating to function, performance, reliability or quality, as opposed to a cosmetic or aesthetic purpose.
- Substantially all of which consists of a process of experimentation, evaluating one or more alternatives.
In Mexico, to qualify as R&D the project has to be seeking an advance in science or technology through the resolution of scientific or technological uncertainty. All the activities that contribute to the resolution of the scientific or technological uncertainty will be R&D.
Why do countries introduce and regularly change R&D incentives?
The reasons for implementing and changing R&D programmes are consistent globally with the aim to:
- Encourage economic growth and job creation.
- Maintain technological competitiveness.
- Attract domestic and foreign investment.
- Provide support for companies R&D activities that might not otherwise take place.
What are the key considerations when looking to optimise business growth from R&D incentives?
Growth from R&D may be through the development of new products or services, an enhancement to existing products or services or, most frequently, a combination of both. It is important to consider:
- Where the relevant work will be carried out (with the consideration of the availability and cost of expertise).
- How to safeguard and monetise ownership of any intellectual property (IP) used in or developed in the process.
- The potential routes to market (e.g., location of new and current customers, and the access to, and use of, online channels).
- The extent to which the MNE has sufficient internal funding to meet the project requirements or will be requiring external sources. The impact of current and future supply chain shortages, disruptions and need for flexibility.
- How long the project will take and whether is it part of a larger ongoing development plan.
- Future scenario planning (such as the impact on tax incentives of the proposals for a global minimum tax rate of 15%.
There are also a number of operational matters to consider. Although Mexico and the United States have some differences in their own rules, we will provide an overview of the key considerations that will help you create a robust process that could be applied whether your R&D activities takes place in either region.
Can the development of internal-use software qualify as R&D?
In the US, the following three tests must be satisfied if your activity involves the development of internal-use software in order to qualify:
- Innovation test: the software must be innovative in that it is intended to result in an improvement that is substantial and economically significant.
- Significant economic risk test: the software development must involve significant economic risk and uncertainty due to technical risk.
- Commercially available test: the software must not already be commercially available for use by the taxpayer without modifications.
How are R&D tax incentives delivered?
In both the United States and Mexico, the federal incentive is a tax credit for R&D activities. Several state and regional jurisdictions also offer varying programmes including tax credits, grants, and other opportunities.
What is the applicable headline rate?
As there are two credit methodologies available to US taxpayers, both of which are incremental in nature, there is no fixed percentage to define the credit benefit. In typical cases, the resulting credit is approximately 7-10% of total qualified spend. Here is a brief outline of the two US credit methodologies:
1. The traditional or regular research credit (RRC)
The RRC provides for a 20% gross credit on the excess of the current year’s qualifying research expenditure (QRE) over the base amount. Subject to the Section 280C(c)(1) reduced credit election being made, the RRC is 15.8% of the excess of the current year QREs over the base amount.
2. The alternative simplified credit (ASC)
The ASC provides for a 14% gross credit on the excess of the current year QREs over the base amount. As above, subject to the Section 280C(c)(1) reduced credit election being made, the net ASC is 11.06% of the excess of the current year QREs over the base amount.
Section 280C(c)(1) requires a taxpayer to reduce its deductions (or capital account if the taxpayer capitalises expenditures) in computing taxable income by the amount of any research credit claimed. The reduced credit election, when made on a timely filed original return, allows a taxpayer to avoid reducing its deductions/amounts charged to a capital account for the tax year if, instead, it reduces the credit determined by 21%.
The Mexican R&D tax credit is similar in nature to that of the US’ ASC method described above. It provides a credit equal to 30% of expenses and investments in excess of the average R&D expenses incurred in the prior three years for technological R&D carried out in Mexico. These must represent scientific or technological breakthroughs. The incentive is capped at 10% of the total income tax of the prior year.
What is the process for filing an R&D claim?
There is no advance R&D credit registration or claim process in the US. The R&D credit is claimed using form 6765 (Credit for Increasing Research Activities) filed with the taxpayer’s annual tax return. While amended claims are permitted, depending on the taxpayer’s facts, additional detail and documentation may be required alongside the claim.
The process to claim the state R&D credit benefits varies by jurisdiction. While some states mimic the federal credit, several states have a pre-defined total credit amount which is allocated to awardees based upon an application process. While no specific registration or certification is required in the US, it is increasingly important to work with tax professionals who can assist the taxpayer in maximising the credit while limiting risk by making appropriate judgments.
In Mexico, the R&D Tax Credits Program is managed by the National Council of Science and Technology (CONACYT). CONACYT annually announces a public call for submissions “Convocatoria Pública” inviting individuals and companies to apply for financial support or a fiscal stimulus in the form of a tax credit for projects that meet specific objectives. These public calls are valid only during specific open filing periods.
Applications must be submitted electronically, along with PDFs of the required documentation, which includes proof of tax compliance, a breakdown of R&D expenses and investments for the prior three fiscal years, patents and IP registrations, as well as registration in the National Registry of Scientific and Technological Institutions and Companies (RENIECYT). Once the beneficiary has submitted all the resources in the approved R&D programme, they must obtain a report form a registered public accountancy firm to review the accuracy of the expenses incurred. As projects have become more complex in nature, tax professionals are increasingly supported by scientists and engineers in the drafting of technical reports, to better articulate a company's eligibility.
When is the cash benefit from an R&D claim obtained?
In the US, realisation of benefit is dependent upon taxpayer circumstances. If the filer is in a taxable income position, the credit is a direct reduction of taxes due upon their filing of the respective year tax return. The credit is not refundable but may be carried back one year or forward twenty, to the earliest year that the credit may be utilised. In some situations, qualified small businesses are eligible to make an election on form 6765 to utilise the credit to offset the employer share of payroll taxes, allowing them to monetise the credit before they are profitable. Further, there are many state and local credits which are either refundable or permitted to be sold to a third party or the state in order to monetise immediately.
Mexico similarly does not offer a refundable R&D tax credit, but the awarded credit may carry forward up to ten years. With regards to R&D grants, there may be differing opportunities based upon company size.
Does the IP need to be owned by the company that carries out the R&D work?
In the US, there is no restriction on the location of any resulting IP. Qualifying activities must be performed within the US and a US taxpayer must incur the related qualifying costs, although such costs may be reimbursed by a foreign affiliate. In the event the research is performed on behalf of a customer, the taxpayer or a related entity under common control must retain at least substantial rights to the IP developed; exclusive rights are not required.
Similarly, there are no jurisdictional requirements related to IP in Mexico. While a percentage of R&D activities can be outsourced offshore, most qualified R&D activities must be performed within Mexico.
What is the tax authority review process for claims?
Subsequent to the filing of tax returns in the US, the Internal Revenue Service (IRS) selects tax returns for examination. If a research credit was claimed in a tax return that is later selected for examination, it is highly likely that the credit will be flagged and then reviewed in detail during the examination. The extent of the examination will vary in size, scope, and complexity and, as such, the level of detail and documentation requested will differ. More significant credits’ examinations may need to be supported by the input of an expert engineer in addition to the tax agent. Based upon the examination results, the credit may be sustained in full, in part, or denied.
As noted above, amended refund claims filed after January 10, 2022, require additional specific detail and documentation to be considered for refund. Filings not containing the requisite details may be denied outright.
In Mexico, the CONACYT will assess the R&D projects, and the Inter-agency Committee will decide which projects should be granted the tax credit, considering factors such as the continuity of the project, patent and IP registration, prototype development, collaboration with Mexican higher education institutions (HEIs) and public research centres (PRCs), etc. The credit may be revoked if the taxpayer provides false information or documentation, does not incur the relevant expenses, or make the investment in the approved period, or has committed tax infractions or crimes.
This is part of a series of insights on innovation tax credits around the globe.
If you have any questions around the insights shared in this article, please contact us.