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One of the most common questions foreign-owned companies ask when operating in the U.S. surrounds whether or not they can claim the Research and Development (R&D) Tax Credit, and the answer is often yes. U.S. tax law does not disqualify companies from claiming the federal R&D Tax Credit based on its ownership structure, meaning foreign ownership does not automatically prevent eligibility.
What really matters is where the research takes place and whether it meets the specific IRS requirements. Foreign ownership does, however, add layers of complexity and structuring considerations that businesses need to address to claim the credit properly and confidently.
Eligibility Depends on U.S.-Based Activities
The core requirement for claiming the R&D Tax Credit as a foreign-owned business is simple. Qualified research must be conducted within the United States or a US territory (e.g., Puerto Rico). It does not matter whether the parent company is based in Germany, Japan, or Brazil. If the U.S. entity is performing qualified research activities domestically, it may be eligible.
The Four-Part Test includes:
- Permitted Purpose: Activities must be performed in an attempt to improve the functionality, performance, reliability, or quality of a new or existing business component.
- Technological Uncertainty: Activities intended to discover information that could eliminate technical uncertainty concerning the development or improvement of a product.
- Process of Experimentation: All of the activities must include a process of experimentation including testing, modeling, simulating, systematic trial and error.
- Technological in Nature: Activities must fundamentally rely on the principles of physical or biological science, engineering, or computer science.
If the U.S.-based operations meet these standards, where the parent company is owned and located is irrelevant when it comes to federal R&D credit eligibility.
Key Complexities to Address
While eligibility is possible, foreign-owned businesses must navigate some unique challenges when it comes to compliance and structuring. KBKG has listed out some of the most common challenges below:
- U.S.-Sourced Expenses Only: One of the biggest limitations for foreign-owned entities is that only R&D performed physically within the United States qualifies for the credit. If your teams abroad, such as in Europe or Asia, are performing the bulk of the research, those expenses will not be eligible, even if the work is later implemented or commercialized in the U.S. It’s important to carefully segregate U.S.-based wages, supply costs, and contractor expenses from those incurred overseas to ensure proper credit calculation and avoid disallowed claims.
- Funded Research Nuance: If the U.S. subsidiary’s research is funded by a related party (e.g., the foreign parent) and the U.S. entity does not bear financial risk and/or lacks substantial rights in the results, those activities are excluded from the U.S. entity’s qualified research activities under the Funded Research exclusion. Meticulous contracts and IP/risk allocations are essential for R&D credit claims.
- Documentation & Substantiation: Contemporaneous documentation is essential to substantiate an R&D credit claim, especially for foreign-owned businesses. IRS examiners expect clear proof of the research activities. This means maintaining detailed contracts and cost records that separate eligible domestic-based expenses from foreign costs. For arrangements with related foreign entities, a well-prepared Transfer Pricing study can further support the reasonableness of intercompany charges and help defend the credit in an audit.
- Control Group Aggregation Rules: Foreign-owned corporations with multiple U.S. subsidiaries must evaluate whether they are part of a controlled group of corporations. Under IRS rules, such groups are required to aggregate their qualified research expenditures when computing the R&D credit. This has implications for how the credit is calculated and allocated. Companies need to assess ownership thresholds, control structures, and coordination across related U.S. entities to comply with aggregation rules.
Conclusion
The R&D Tax Credit can be a powerful tool for foreign-owned businesses with U.S. operations, but success depends on getting the details right. Focus on qualifying U.S.-based activities, maintaining strong documentation, and addressing the unique complexities of multinational structures. With proactive planning, companies can maximize the credit’s value, reduce U.S. tax liability, and drive ongoing innovation, while staying compliant with IRS requirements.
Businesses needing help navigating these complexities are encouraged to contact a tax professional, like KBKG today. KBKG and its experts work with international entities to structure and document R&D efforts in a way that maximizes tax savings and minimizes risk.