Are R&D Tax Credits Available in Texas?

Yes. Beginning with tax returns filed after January 1st, 2014 (for tax years ended in 2013), Taxpayers in Texas state can claim the Research Development (R&D) Tax Credit to offset a portion of their franchise tax or use it towards a sales and use tax exemption on the purchase or lease of depreciable tangible personal property used in qualified research in Texas. Some highlights of the Texas Research and Development Tax Credit include:

  • Qualified Research Expenses (QREs) have the same meaning as in IRC § 41, except that such expenses must be for research conducted within Texas.
  • The credit amount is 5% of the excess amount of qualified research expenses in the current period over the base amount (50% of the average of the previous three years).
  • The allowable Franchise Tax Credit in any one period, including carryforward amounts, cannot exceed 50% of the franchise tax due for the period.
  • Unused credits can be carried forward for up-to 20 consecutive report years.
  • The sales and use tax exemption is effective for activities beginning after January 1st, 2014.
  • Any entity (including combined group) creating or claiming a research and development activities credit in Texas must file a Texas franchise tax report.
  • Any amount spent with a public or private institution of higher education will be able to generate a 25% higher Texas R&D tax credit. This will increase the percentage of the credit eligible for the Texas R&D tax credit from 5% to 6.25%.
  • NEW: On October 15, Texas promulgated significant amendments to the Texas research and development activities franchise tax credit. The main highlights from the amendments are noted below:
    • The internal use software (IUS) exclusion in Texas does not apply to software used in an activity that constitutes qualified research, or in a production process that meets the requirements of the 4-Part Test. Texas now defines IUS as it was defined federally before final internal use software regulations were released in November of 2016.
    • Any item of tangible personal property where the taxpayer would not have paid Texas sales and use tax due to the manufacturing exemption or the sale for resale exemption is excluded from qualified research. This treatment requires taxpayers to choose either a sales and use tax exemption or a research and development supplies credit.
    • Although Texas incorporates IRC Section 41 into its R&D credit rule, the burden of proof does not align with the federal standard. The final rule provides that while case law on various issues is persuasive, however, it is not binding on the Texas Comptroller.
    • If a combined group changes (e.g., loses a member), the credit carryforward will be attributed to each member of the combined group that was included on the report of the report year that the carryforward relates. Each member of the combined group that has a carryforward attributed to it (including the member that leaves), may use the carryforward on future franchise tax reports. The combined group with a membership change may only carryforward the R&D credit on future franchise tax reports if the member(s) who were attributed a carryforward remain part of the combined group on the last day of the accounting period on which the report is based.

Texas R&D Tax Credit Case Study

An Austin-based software developer began operations in 2006. The Company has steadily increased its research expenditures primarily through the addition of both experienced and inexperienced developers. The client has been claiming the federal R&D Tax Credit since 2009 and the Texas R&D Tax Credit beginning for tax year ended December 31, 2013.

Total QREs
Total QREs
Total $2,300,000 $230,000 $2,300,000 $47,083

You can read more about this Texas tax credit case study here.

Four-Part Test

Qualified research activities are defined by the four-part test outlined below

Technological in Nature
Activities must fundamentally rely on the principles of physical or biological science, engineering, or computer science.

Permitted Purpose
Activities must be performed in an attempt to improve the functionality, performance, reliability, or quality of a new or existing business component.

Eliminate Uncertainty
Activities intended to discover information that could eliminate technical uncertainty concerning the development or improvement of a product.

All activities must include a process of experimentation including testing, modeling, simulating, and systematic trial and error.