Texas: Proposed Rule Addresses Franchise Tax Research and Development Activities Credit

On April 16, 2021, the Texas Comptroller published proposed amendments to 34 TAC §3.599, which addresses the franchise tax research and development activities tax credit, and 34 TAC §3.340, which addresses the research and development sales tax exemption. Recall, taxpayers may claim either a sales tax exemption or a franchise tax credit for qualifying research expenses that occur in Texas.   The proposed franchise tax amendments are extensive, include numerous examples, and, in certain instances, will limit a taxpayer’s ability to qualify for credits. There is no specific effective date for the proposed rule changes and, as clarifying amendments, they will likely be applied retroactively. Importantly, the proposed franchise tax regulation addresses the disconnect between federal and state law that exists because Texas adopts the Internal Revenue Code as of December 31, 2011 for purposes of the research and development activities tax credit. The proposed rule clarifies that federal regulations adopted after that date are applied for Texas purposes only to the extent that the federal regulation is made to apply to the 2011 federal tax year.

Some key highlights of the proposed rule are as follows:

• The rule adopts the federal Four-Part test that determines whether research activities are “qualified research” conducted in Texas;
• The definition of “qualified research expense” is expanded to include lengthy definitions of “in-house research expenses” and “contract research expenses”;
• The new list of excluded research activities specifically includes any research with respect to internal use software and provides guidance on certain types of software that are not excluded as internal use software;
• The proposed rule clarifies that the federal section 1.174-2 regulations regarding, inter alia, pilot models / prototypes is not applicable to the Texas credit;
• A taxpayer cannot claim a manufacturing or resale sales tax exemption for tangible property claimed as a research expense;
• A taxpayer must establish that the expenses claimed are eligible for the credit with clear and convincing evidence supported by contemporaneous documentation; and
• Taxpayers claiming a carryforward of unused credit must be able to prove the credit was correctly established, even it was established outside of the statute of limitations.

Stakeholders may submit comments on the Comptroller’s proposed amendments through May 16, 2021. Please contact Jeff Benson with questions and stay tuned to TWIST for updates on the proposed regulations.