FAQs - IRC 41 QREs and ASC 730 LB&I directive

These frequently asked questions (FAQs) supplement the information contained in both the Large Business & International (LB&I) Directive "Guidance for Allowance of the Credit for Increasing Research Activities Under IRC Section 41 for Taxpayers That Expense Research and Development Costs on Their Financial Statements Pursuant to ASC 730" signed on September 11, 2017 and the revised Directive signed on September 10, 2020 (collectively referred to as "Directive"). In this document, the term "Revised Directive" identifies FAQs that apply only to the Directive signed on September 10, 2020. The FAQs are intended to be read and applied in conjunction with the Directive. The questions and answers contained in these FAQs apply solely to the use of the Directive. Further, the intent of this document is to clarify the methodology followed in the Directive and the costs allowed within. These FAQs do not provide a complete analysis of all relevant law under IRC 41 or 174. This document is not an official pronouncement of law and it cannot be used, cited or relied on as such.

Index

Accounting Standard Codification (ASC) 730
Software development activities
Certified Audited Financial Statements
ASC 730 Directive
ASC 730 Directive Appendix B
ASC 730 Directive Appendix C
ASC 730 Directive Appendix D
Interaction with Code sections
Substantiation
Directive audit steps
Penalties

Accounting Standard Codification (ASC) 730

Q1. Are taxpayers required to report research and development (R&D) on their financial statements under Accounting Standards Codification (ASC) 730?

A1. Yes. Taxpayers who follow U.S. Generally Accepted Accounting Procedures (GAAP) for book shall disclose their R&D costs on their financial statements. ASC 730-10-50-1 states that: "Disclosure shall be made in the financial statements of the total research and development costs charged to expense in each period for which an income statement is presented. Such disclosure shall include research and development costs incurred for a computer software product to be sold, leased, or otherwise marketed." (See Qs 1 & 2 within section on Software Development Activities for software sold, leased, or otherwise marketed.)

Q2. Does the Directive treat the research activities under ASC 730 as qualified research activities under IRC 41 and IRC 174?

A2. No. The Directive does not determine whether ASC 730 research activities are qualified research (commonly referred to as qualified research activities) under IRC 41 and IRC 174. If the IRS determines that a taxpayer has satisfied all of the requirements of the Directive, then the Directive provides an administrative solution to accept the Adjusted ASC 730 Financial Statement R&D (ADJ ASC 730 FS R&D) as sufficient evidence of qualified research expenses (QREs) for the credit year.

Q3. Where can I find the ASC?

A3. All the ASCs are available through Westlaw.

Q4. Are there other ways to obtain ASC 730 if I don't have Westlaw Access?

A4. Yes. ASC is available for free at fasb.org once you register for the Basic View.

Go to fasb.org
On the top line menu click on STANDARDS.
Then Accounting Standards Codification
Next click Go To Codification
Under "Basic View" check the I am not a Robot box and Access the Basic View

Read and accept the License Agreement. This will bring you to Basic View.

To get to ASC 730, click on Expenses and scroll across to ASC 730 Research and Development.

You must click through each paragraph separately. When finished with a subject area, click on "10 Overall" and pick the next paragraph you want to review. Currently there is not an option available under the Basic View to print the documents.

The paragraphs under ASC 730-10 Overall include the following:

00 Status
05 Overview and Background
10 Objectives
15 Scope and Scope Expectations
20 Glossary
25 Recognition
50 Disclosure
55 Implementation Guidance and Illustrations
60 Relationships
75 XBRL Elements

Software development activities

Q1. What is software developed for sale, lease or otherwise marketed under GAAP?

A1. ASC 985 is the U.S. GAAP accounting standard for software marketed externally. Under this standard, selling, leasing or otherwise marketing software requires more than simply planning to generate revenue with the software. Software developed for customers who have the contractual right and ability to take possession of the software and run it on their own hardware (or hardware of another party unrelated to the vendor) rather than simply accessing it online is software for sale, lease or otherwise marketed. For such software marketed externally, the vendor follows ASC 985 to record their software development costs.

If a vendor of online software or software subject to a hosting arrangement (see Q3 within this section) does not sell, lease or separately market the software according to a contractual or licensing arrangement that meets the criteria specified under ASC 985-20-15-5 through 15-7 (See Q5 within this section), then the vendor utilizes the software in providing services. Vendors account for the costs associated with the development of such software used in the provision of services under ASC 350-40. Accordingly, taxpayers account for the software development costs for most online software and cloud computing services software under ASC 350-40, rather than the externally marketed software standard under ASC 985-20.

Computer software to be sold, leased, or otherwise marketed also includes software that is part of a product or process to be sold to a customer. For example, the scope of the externally marketed software standard under ASC 985-20 includes software designed for and embedded in a semiconductor chip because it is an integral part of the product. By contrast, software for internal use, though possibly used in developing a product, is not part of or included in the actual product or service sold.

Q2. Are all the costs associated with the development of software for sale, lease or otherwise marketed included in the ASC 730 costs expensed as R&D on the Certified Audited Financial Statements?

A2. No. Not all costs associated with the development of software the taxpayer intends to sell, lease, or market are ASC 730 costs.

ASC 985-20 is the U.S. GAAP accounting standard for Costs of Software to Be Sold, Leased, or Marketed (see Q1 within this section). Under this standard, taxpayers book specified costs up to the point of establishing technological feasibility as ASC 730 R&D costs. ASC 985-20-25-1 states: "All costs incurred to establish the technological feasibility of a computer software product to be sold, leased, or otherwise marketed are research and development costs. Those costs shall be charged to expense when incurred as required by Subtopic 730-10."

However, ASC 985-20-25-2 further states, "for purposes of this Subtopic, the technological feasibility of a computer software product is established when the entity has completed all planning, designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions, features, and technical performance requirements."

At the point the software meets technological feasibility, the activities and costs are no longer ASC 730 activities and costs.

Q3. ASC 985-20-15-5 through 15-7 addresses Software Subject to a Hosting Arrangement. What is a hosting arrangement?

A3. Currently, there are two different definitions for a hosting arrangement based on entity and reporting period. Subject to phase-in of the pending definition based on entity and reporting period, both the current and pending definitions for a hosting arrangement are contained in ASC 985-20-20 and ASC 350-40-20.

The current definition for hosting arrangement states:

In connection with the licensing of software products, an arrangement in which an end user of the software does not take possession of the software; rather, the software application resides on the vendors or a third party's hardware, and the customer accesses and uses the software on an as-needed basis over the Internet or via a dedicated line.

The following definition is Pending Content; see Transition Guidance in ASC 350-40-65-3:

In connection with accessing and using software products, an arrangement in which the customer of the software does not currently have possession of the software; rather, the customer accesses and uses the software on an as-needed basis.

Pending Content regarding the definition of hosting arrangement is effective for public business entities for annual periods, including interim periods within those annual periods, beginning after December 15, 2019. For all other entities, the Pending Content is effective for annual periods beginning after December 15, 2020, and interim periods beginning after December 15, 2021. Earlier application of the Pending Content is also permitted per rules provided in the Transition Guidance.

Although these definitions differ slightly, both definitions include that in a hosting arrangement the customer does not currently have possession of the software. The fact that a software application is on a phone or electronic device does not mean that a taxpayer has possession of the software. Possession of the software includes the ability to use the software separately from other software components or applications without a significant diminution in utility or value.

Q4. Is software present in a hosting arrangement considered software for sale, lease or otherwise marketed?

A4. Typically, no. Hosting arrangements are considered software for sale, lease, or otherwise marketed only as provided in ASC 985-20-15-5 through 15-7. (See Q5 within this section.)

Q5. When is software subject to a hosting arrangement considered to be within the scope of ASC 985-20 software, i.e. software for sale, lease or otherwise marketed?

A5. Under ASC 985-20-15-5, software offered as part of a hosting arrangement is subject to the rules in ASC 985-20 when both of the following criteria are met:

The customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty.
It is feasible for the customer to either run the software on its own hardware or contract with another party unrelated to the vendor to host the software.

If one or both of these criteria are not met, the software is treated as internal-use software, i.e. ASC 350-40.

Under ASC 985-20-15-6, the term "significant penalty" in the context above contains two distinct concepts:

The ability to take delivery of the software without incurring significant cost
The ability to use the software separately without a significant diminution in utility or value.

As explained in ASC 985-20-15-7, software subject to a hosting arrangement that does not meet the requirements discussed therein is not software for sale, lease or otherwise marketed. The development costs of such software are accounted for as software used in providing services under ASC 350-40 (Internal-Use Software).

Q6. When reviewing the taxpayer's Certified Audited Financial Statements does the amount reported as R&D include the taxpayer's costs associated with the development of internal-use software or web development costs?

A6. Possibly. The amount reported as R&D on the financial statements sometimes includes a portion of taxpayer's costs for the development of internal-use software and web development activities. (See Q7 within this section to determine whether these costs qualify as ADJ ASC 730 FS R&D.)

Q7. Are internal-use software or web development costs included in the ADJ ASC 730 FS R&D amount?

A7. Generally, no. If the taxpayer includes costs associated with internal-use software or web development activities as R&D on their Certified Audited Financial Statements, and the costs do not meet the exceptions specified in ASC 350-40-15-7, then taxpayer must remove these amounts from the Appendix C, ADJ ASC 730 FS R&D amount. For the Revised Directive, these amounts are removed on Line 3a of Appendix C. If the taxpayer determines the internal-use software or web development costs not meeting the exceptions specified in ASC 350-40-15-7 are for qualified research activities under IRC 41, then the taxpayer may report these costs on the appropriate lines on column C of Appendix B. (For examination of these costs, see Q3 within section on Directive Audit Steps).

Q8. What accounting pronouncement under GAAP explains internal-use software and for GAAP, what is meant by internal-use software?

A8. ASC 350-40 provides guidance on accounting for the costs of developing or obtaining computer software for internal use and for determining whether software is for internal use.

Under ASC 350-40-15-2A internal-use software has both of the following characteristics:

The software is acquired, internally developed, or modified solely to meet the entity's internal needs, and
During the software's development or modification, no substantive plan exists or is being developed to market the software externally.

Additionally, ASC 350-40-15-5 specifies that if using software in the production of a product or in providing a service when the customer does not acquire the software or the future right to use it, the software is internal-use software and follows the guidelines under ASC 350-40 for reporting software development costs.

ASC 350-40-55 provides 21 examples illustrating when computer software is for internal use or not for internal use.

For the purposes of this Directive, LB&I considers any software that is not for sale, lease or otherwise marketed by the taxpayer per the criteria in ASC 985-20-15 (see Qs 1 and 5 within this section) as internal-use software under ASC 350-40.

Q9. Are there any exceptions to the general rule under ASC 350-40 (see Q8 within this section) which require accounting treatment for internal-use software under ASC 730?

A9. Yes. ASC 350-40-15-7 provides that taxpayers account for the following R&D activities of internal-use software (which are relatively rare and immaterial in comparison to other internal use software development activities) under Subtopic 730-10:

Purchased or leased computer software used in research and development activities where the software does not have alternative future uses, or
All internally developed internal-use computer software (including software developed by third parties, for example, programmer consultants) in either of the following circumstances:
- The software is a pilot project (that is, software of a nature similar to a pilot plant as noted in paragraph 730-10-55-1(h)). (In general, such pilot projects are separate and specialized endeavors within an organization intended to explore and demonstrate new concepts and applications of new technology for internal use. It is important not to confuse a pilot project with an early stage of a standard internal-use software project, or with other common activities in standard internal-use software projects such as iterative prototyping or beta testing.)
- The software is used in a particular research and development project, regardless of whether the software has alternative future uses. (This situation is similar to the exception from Internal Use Software (IUS) treatment for software developed for use in an activity that constitutes qualified research (other than the development of the IUS itself), Treas. Reg. 1.41-4(c)(6)(ii)(A)).

Q10. For internal-use software development costs determined as ASC 730 research, does ASC 730 have requirements like those in the 3-part High Threshold of Innovation test?

A10. No. In general, the amount reported as ASC 730 R&D does not include costs associated with the purchase or development of internal-use software. Accordingly, ASC 730 does not have specialized requirements or tests like the High Threshold of Innovation test.

For the definition of Internal-use-software under ASC 350-40, see Q8 within this section. For a review of Internal-use software reporting for U.S. GAAP, see ASC 350-40.

Q11. For the purposes of the Directive, are website development costs treated differently than internal-use software?

A11. No. All costs related to software used to operate a website are accounted for under ASC 350-40 unless a plan exists to market the software externally. The Directive treats website development costs similar to costs incurred in developing internal-use software. For the Revised Directive, if the costs associated with website development are included in the Financial Statement R&D amount, these costs are removed on Appendix C, Line 3a.

Certified audited financial statements

Q1. What are Certified Audited Financial Statements?

A1. As defined in the Directive, a Certified Audited Financial Statement is "A financial statement that is accompanied by the report of an independent (as defined in the American Institute of Certified Public Accountants Professional Standards, Code of Professional Conduct, Rule 101 and its interpretations and rulings) Certified Public Accountant. A financial statement is certified audited' for purposes of this Directive if it is:

Certified to be fairly presented (an unqualified or "clean" opinion),
Subject to a qualified opinion that such financial statement is fairly presented subject to a concern about a contingency (a qualified "subject to" opinion) other than a concern relating to ASC 730 reporting,
Subject to a qualified opinion that such financial statement is fairly presented, except for a method of accounting with which the accountant disagrees (a qualified "except for" opinion) where such disagreement does not relate to ASC 730, or
Subject to an adverse opinion not relating to ASC 730, but only if the accountant discloses the amount of the disagreement with the statement.

Any other statement or report, such as a review statement or a compilation report that is not subject to a full audit is not a certified audited statement."

Q2. Taxpayers use other words to describe R&D activities on their Certified Audited Financial Statement. Will the Directive apply to taxpayers who identify development activity using other names?

A2. Not necessarily. ASC 730-10-50-1 states: "Disclosure shall be made in the financial statements of the total research and development costs charged to expense in each period for which an income statement is presented."

Taxpayers sometimes report their R&D costs with other categories of expenditures on the Income Statement included with their Certified Audited Financial Statements. For example, taxpayers use the terms Product Development, Software Development, Engineering Research, etc., to report R&D, as well as other development expenses.

However, the Directive only applies to LB&I taxpayers who show the amount of currently expensed Financial Statement R&D as either 1) a separate line item on the Income Statement included in their Certified Audited Financial Statements, or 2) separately stated in a note to the Certified Audited Financial Statements. Taxpayers who fail to separately identify the Financial Statement R&D costs currently expensed on their Certified Audited Financial Statements are not eligible for the Directive. (See Q6 within this section for additional eligibility requirements for the Revised Directive. Also see Q1 within the section Directive Audit Steps for guidance in reviewing taxpayer's Financial Statement R&D).

Q3. In the notes to the Certified Audited Financial Statements, the taxpayer separately identified R&D credits as deferred income tax assets. Does this meet the requirement for separately showing the R&D expenses?

A3. No. Credits are different from ASC 730 R&D expenses. The Directive only applies to ASC 730 R&D expenses.

Q4. If changes occur to the Sarbanes-Oxley Act of 2002 (SOX) or the U.S. Securities Exchange Commission (SEC) regulations, etc., will LB&I's reliance on the ASC 730 costs expensed as R&D on Certified Audited Financial Statements to determine QREs continue?

A4. Possibly. LB&I may reconsider its reliance on U.S. GAAP standards for ASC 730 R&D if changes to the SOX or SEC regulations occur. More importantly, if the Financial Accounting Standards Board makes significant changes to the U.S. GAAP standards for ASC 730 R&D, LB&I will consider revisions to the Directive and the templates contained within it.

Q5. Is the Directive applicable to taxpayers who prepare their Certified Audited Financial Statements following International Financial Reporting Standards?

A5. No. The Directive only applies to taxpayers who follow U.S. GAAP accounting for book and the preparation of their Certified Audited Financial Statements.

Q6. Is the Revised Directive applicable to taxpayers who file their federal income tax return, Schedule M-3, Part I using a method other than GAAP?

A6. No. The Revised Directive only applies to taxpayers who report their worldwide consolidated net income (loss) on Schedule M-3, Part I, Line 4a using GAAP, i.e., the taxpayer should have checked the box for GAAP accounting on Line 4b of the Schedule M-3.

Q7. What prevents non-public companies from overstating ASC 730?

A7. The accounting profession has several oversight review boards related to the preparation of Certified Audited Financial Statements. The Public Company Accounting Oversight Board (PCAOB) establishes auditing and related professional practice standards for registered public accounting firms to follow in the preparation and issuance of audit reports. The PCAOB oversees public accounting firm compliance with Generally Accepted Auditing Standards and ensures that these firms conduct audits with professional skepticism and remain independent.

In addition, the American Institute of Certified Professional Accountants (AICPA) established the Code of Professional Conduct (Code). This Code provides that accounting firms must establish a set of internal quality control policies and procedures as well as a system to monitor and report on compliance.

AICPA members in public practice should follow "due care" which requires providing services with competence and diligence whether the service involves publicly held or non-publicly held entities.

Significant oversight and accountability exists in the audit of financial statements. This reasonably ensures that the financial statements are free from material misstatements and represent the true economic picture of the taxpayer.

Falsifying ASC 730 on the financial statements can equate to fraud. Most Certified Professional Accountants (CPAs) will not risk their certification or that of their business to falsify the ASC 730 amounts.

Q8. Who are third party auditors? Can they be the same individuals who prepared the research credit studies?

A8. Third party auditors are CPAs who attest to the financial statements. There are rules regarding what a CPA can or cannot do in other capacities for a taxpayer. Typically, the functions between Accounting/Auditing and Tax are separate and distinct. In addition, since Auditors cannot opine on their own work/study, it is unlikely they would prepare research credit studies.

ASC 730 Directive

Q1. To whom does the Directive apply?

A1. This Directive only applies to LB&I taxpayers (i.e. assets equal to or greater than $10,000,000) who follow U.S. GAAP to prepare their Certified Audited Financial Statements which show the amount of currently expensed Financial Statement R&D either as 1) a separate line item on the income statement included in their Certified Audited Financial Statements, or 2) separately stated in a note to their Certified Audited Financial Statements. In addition, the Revised Directive does not apply to any taxpayer unless the taxpayer uses these same U.S. GAAP financial statements to reconcile book income to federal tax income on Schedule M-3.

Q2. Could the Directive apply to a taxpayer in the Compliance Assurance Program (CAP)?

A2. Yes, if the CAP taxpayer meets the requirements in Q1 within this section.

Q3. Can a taxpayer amend their return to follow the Directive to compute QREs?

A3. No. A taxpayer may not amend their return to follow the Directive if the taxpayer did not originally follow the Directive to compute QREs on their originally filed return.

Q4. If the taxpayer followed the Directive to compute their ADJ ASC 730 FS R&D amount on an originally filed return, can the taxpayer amend the return to correct an error in the computation of their ADJ ASC 730 FS R&D amount?

A4. Yes. If the taxpayer followed the Directive on an originally filed return and upon subsequent review identifies an error in the computation of their ADJ ASC 730 FS R&D amount, the taxpayer can correct the error to accurately follow the Directive. Changes to the ADJ ASC 730 FS R&D amount are subject to risk assessment and audit by the Exam team. Taxpayers must follow the guidelines for amended returns under Internal Revenue Notice 2008-39.

Q5. Can taxpayers change their research credit carryforward(s) using the Directive?

A5. No. A taxpayer may not change their research credit carryforward(s) using the Directive unless the research credit carryforward(s) originated in taxable year(s) in which the Directive was effective and for which the taxpayer filed original return(s) following the requirements of the Directive.

Q6. If an employee has wages reported both inside R&D cost centers and outside R&D cost centers, are both amounts eligible for the Directive?

A6. No. The Directive only applies to wages separately reported as Financial Statement R&D on the Certified Audited Financial Statements. Any wages reported in cost centers other than Financial Statement R&D costs centers are not eligible for the Directive.

Q7. Are wages reported outside of the Certified Audited Financial Statement R&D included in determining the ADJ ASC 730 FS R&D amount?

A7. No. Only those employees' wages reported as R&D on the Certified Audited Financial Statements are considered in determining the ADJ ASC 730 FS R&D amount.

Q8. For the benefits of the Directive to apply, must a taxpayer attach the Certification Statement and the additional required Appendices to the taxpayer's filed federal income tax return?

A8. No. The taxpayer is not required to attach the Certification Statement and the additional required Appendices to the return.

Q9. How do taxpayers choose to participate in the Directive?

A9. Taxpayers may participate in the Directive either by voluntarily attaching the Certification Statement and the additional required Appendices to their originally filed tax return, or upon notification of audit, by informing the exam team that they followed the Directive in computing the QREs on their originally filed return.

Q10. For the benefits of the Directive to apply, when must the taxpayer provide the completed Certification Statement and the additional required Appendices?

A10. If the taxpayer does not voluntarily attach the Certification Statement and the additional required Appendices to the tax return, Exam should verify with the taxpayer at the beginning of the audit whether they followed the Directive. If the taxpayer followed the Directive in computing their QREs per the return, taxpayer must provide the Certification Statement and the additionally required Appendices upon Exam's request.

Q11. Can small business self-employed taxpayers who have Financial Statement R&D on their Certified Audited Financial Statements receive the benefits of the Directive?

A11. No. The Directive only applies to LB&I taxpayers and LB&I examiners.

Q12. Does a taxpayer who follows the Directive still report an Uncertain Tax Position (UTP) for the Research Credit?

A12. Possibly. An UTP may still exist if the taxpayer:

Reports QREs in columns B or C of Appendix B or
Is uncertain about the types of accounts included or excluded in the adjustments on Appendix C of the Directive.

Q13. Once a taxpayer chooses to follow the Directive, must the taxpayer follow the Directive in all subsequent years?

A13. No. A taxpayer makes a tax year by tax year choice whether to follow the Directive.

ASC 730 Directive Appendix B

Q1. May taxpayers claim QREs in addition to the ADJ ASC 730 FS R&D amounts included in the Directive?

A1. Yes. The Directive only applies to the ADJ ASC 730 FS R&D Costs, i.e., the costs determined from Appendix B, column A. Taxpayers may report additional QREs they believe qualify as research expenditures in columns B & C of Appendix B. (See Q1 & Q4 within section on ASC 730 Directive Appendix C.) Taxpayers then total rows A, B & C and report the appropriate costs on the Form 6765.

ASC 730 Directive Appendix C

Q1. In computing the ADJ ASC 730 FS R&D amount, must the taxpayer remove costs that might otherwise qualify as IRC 41 QREs?

A1. Yes. A taxpayer choosing to follow the Directive must adhere to the steps in Appendix C and D and the definitions in Appendix E of the Directive to properly calculate its ADJ ASC 730 FS R&D amount. The taxpayer must appropriately remove costs not eligible for the benefits of the Directive. However, if the taxpayer determines that the costs removed from Appendix C qualify under IRC 41, the taxpayer may report the appropriate amounts in columns B or C of Appendix B.

Q2. Does Appendix C adjust for indirect costs reported in ASC 730 accounts?

A2. Yes. On Lines 5 and 6 of Appendix C, the taxpayer reduces U.S. ASC 730 Financial Statement R&D by the indirect costs not eligible under IRC 174 & 41. Then, on Line 10, the taxpayer subtracts costs such as prototype overhead, patent costs, or severance payments.

Q3. Why are all contract costs removed on Lines 7 & 8 of Appendix C?

A3. Determining the allowance of contract costs requires an in-depth review of the costs claimed to determine potential funding issues. Therefore, the Directive removes all contract costs from the computation of the ADJ ASC 730 FS R&D amount.

Q4. Does the removal of contract costs prevent the taxpayer from claiming any costs associated with contract research as QREs on the Form 6765?

A4. No. If the taxpayer determines that a contract involves qualifying research activities not otherwise excluded (including rights and risks), the taxpayer reports the IRC 41(b) costs in Appendix B, columns B or C.

ASC 730 Directive Appendix D

Q1. Is the taxpayer required to claim both the 95% limitation and the 10% limitation when calculating the taxable W-2 wages allowed as part of the ADJ ASC 730 FS R&D amount?

A1. No. There is no requirement to claim either or both limitations. However, if the taxpayer chooses not to take the 95% limitation for the Qualified Individual Contributors (QIC) and 1st Level Supervisor Managers, then the QIC, 1st Level Supervisor Managers and Upper Level Managers wages are zero for purposes of the Directive.

For example, if the taxpayer had (before the 95% or 10% limitation):

$100,000 in QIC Base & Stock Option W-2 wages
$50,000 in 1st Level Supervisor Managers Base & Stock Option W-2 wages, and
$1,000,000 in Upper Level Managers W-2 wages, they would report $95,000 ($100,000 * 95%) and $47,500 ($50,000 * 95%) respectively on lines 3 & 6 of Appendix D.

Following the instructions in Appendix D, the taxpayer then calculates the Upper Level Managers wages by limiting the amount allowed to the lesser of 10% of the combined amounts on lines 3 & 6 (10% of $142,500, i.e. $14,250) or the W-2 wages paid to Upper Level Managers ($1,000,000). In this example the Upper Level Managers wage limit is $14,250 since it's less than the $1,000,000.

If a taxpayer wants to claim an amount above 95% of both their QIC and 1st Level Supervisor Managers W-2 wages as QREs, the taxpayer reports zero wages on line 3 and 6 of Appendix D. Zero wages reported on both these lines means zero Upper Level Managers wages allowed.

Thus, if the taxpayer chooses not to take the 95% limitation for the QIC and 1st Level Supervisor Managers, no wages are eligible for the benefits of the Directive.

In addition, if the taxpayer claims 95% for the QIC and 1st Level Supervisor Managers, they may not claim the remaining 5% as QREs on columns B or C of Appendix B.

See Q2 within this section regarding the 10% Upper Level Managers limitation.

Q2. What steps must a taxpayer follow to claim (as QREs) more Upper Level Managers wages than the limitation imposed by Appendix D?

A2. If the taxpayer wants to claim more than the limitation calculated on Appendix D for the Upper Level Managers wages, the taxpayer must not claim any of the Upper Level Managers wages as part of the ADJ ASC 730 FS R&D amount. The taxpayer reports $0 Upper Level Managers wages on line 7 of Appendix D and line 17 of Appendix C.

The taxpayer then determines under IRC 41, the qualifying Upper Level Managers wages (from ASC 730 accounts) in column B, Appendix B. Exam may conduct risk analysis on this amount.

Q3. May the taxpayer claim the remaining Upper Level Managers wages in excess of the limit from Appendix D as QREs in column B, Appendix B?

A3. No. If the taxpayer claims the limit per Appendix D, the taxpayer does not claim any additional Upper Level Managers wages on Appendix B as part of the ADJ ASC 730 FS R&D amount.

Q4. How was the 10% Limit for the allocation of Upper Level Managers wages determined?

A4. During the Industry Issue Resolution process, the team evaluated different ways of capturing the appropriate costs to include in the Directive. Based on the analysis of data from taxpayers who volunteered data, examination results, and the information gained during discussions with externals, the team determined that the 10% limit on the allowed QIC and 1st Level Supervisor Managers wages appropriately limited the allowable Upper Level Managers wages for purposes of the Directive.

Interaction with Code sections

Q1. Does the consistency rule under IRC 41(c)(5) apply to the Directive? Is there a requirement for the base years to follow the methodology outlined in the Directive? If so, are certifications required for the prior/base years?

A1. The Directive is silent regarding the statutory consistency rule. Therefore, in determining QREs, the consistency rule applies. Since the incremental research credit applies only to the increase in research spending over the base amount, accurate measurement of the increase only exists if the taxpayer includes all the same type of expenses in the credit computation for both the base years and the credit year. The consistency rule ensures that there is an accurate determination of the relative increase in research.

IRC 41(c)(5) requires consistent treatment of expenses. QREs considered in computing the fixed-base percentage must be consistent with the determination of the QREs for the credit year. Treas. Reg. 1.41-3(d) further emphasizes that a taxpayer must consistently determine QREs in the fixed-base percentage or base amount on a basis consistent with the definition of QREs for the credit year. When computing the research credit, a taxpayer must consider the same types of QREs included in the credit year as considered in the base or preceding years.

That does not mean that a taxpayer who chooses to follow the Directive must go back to the base years and compute the QREs following the Directive template. However, the taxpayer needs to consider the types of activities and associated costs included in the current year and whether the taxpayer included those same types of activities and associated costs in the base years.

The fact that a taxpayer elects to adopt the Directive methodology to capture QREs in the current year does not necessarily mean that the taxpayer didn't capture and claim the same type of QREs in the base period using a different methodology.

It's important for the exam team to discuss with the taxpayer the types of activities and associated costs used in the current year and whether the taxpayer had those same types of costs and activities in the base years.

Q2. May the taxpayer still apply the "substantially all" rule under IRC 41(b)(2)(B) to wages before computing the 95% limitation under Appendix D?

A2. No, the "substantially all" rule does not apply to the wage QREs determined under the Directive.

IRC 41(b)(2)(B) provides that if substantially all of the services performed by an individual for the taxpayer during the taxable year consist of services meeting the requirements of IRC 41(b)(2)(B)(i) and (ii), then the term "qualified services" means all the services performed by the individual for the taxpayer during the taxable year.

Treas. Reg. 1.41-2(d)(2) provides that services performed under IRC 41(b)(2)(B) constitute substantially all of the services performed by the individual if at least 80% of the wages paid or incurred by the taxpayer for the individual during the taxable year were for services meeting the requirements of IRC 41(b)(2)(B).

However, the Directive specifically states that W-2 wages for employee compensation added to the U.S. ASC 730 FS R&D in Step 4 of Appendix C should not include any amounts relating to the subtractions in Steps 1 - 3.

For example, if the FS R&D accounts on the Certified Audited Financial Statements include 100% of a QIC's wages ($50,000), and 15% of those wages ($7,500) were for services performed abroad, then the taxpayer only includes 85% of those W-2 wages ($42,500) in the 95% limitation for QICs, i.e. Step 1 of Appendix D. As a result, only $40,375 (95% of $42,500) versus the $50,000 (100% per the substantially all rule) of the employee's wages qualify as QREs under the Directive. The taxpayer may not claim any of the remaining 15% as QREs on columns B or C of Appendix B.

Q3. How does the Orphan Drug Credit (ODC) impact the Directive?

A3. A taxpayer may choose to claim a tax credit for qualifying clinical testing expenses that also qualify as QREs either under IRC 45C or under IRC 41 but may not claim both credits for the same expenses.

Q4. Can taxpayers use the Directive to compute their IRC 45C qualified clinical testing expenses?

A4. No. The Directive only applies to determining QREs under IRC 41, not qualified clinical testing expenses under IRC 45C. Taxpayers may not use the Directive in determining their IRC 45C expenses.

Q5. If the taxpayer chooses to follow the Directive in calculating its QREs, is this a change in their method of accounting?

A5. No. Changing the methodology to calculate QREs is not a change in accounting method.

Substantiation

Q1. Is the taxpayer required to provide the information identified in the Directive to the exam team upon request? Is this the only information the taxpayer must provide to the exam team?

A1. To be eligible for the benefits of the Directive, the taxpayer must provide the documents identified in the Directive. This documentation must support, to the satisfaction of the exam team, that the amounts reported on Appendices C & D are true, correct and complete. If the exam team determines the requirements of the Directive have not been satisfied, the exam team may request additional information. For the Revised Directive, the exam team must receive approval from the Territory Manager or his/her delegate to request additional information not listed in Part V.

Q2. For taxpayers using the Directive signed on September 11, 2017, what happens if the taxpayer fails to properly retain and timely submit the documentation requested by Exam in Part IV?

A2. Taxpayers must retain and make available upon request the underlying books and records that support the amounts claimed on the Appendices C & D, inclusive. If the taxpayer fails to properly retain and timely submit the requested documentation, the applicable Director of Field Operations or his/her delegate may determine that the Directive does not apply to the taxpayer.

Q3. For taxpayers using the Revised Directive, what happens if the taxpayer fails to provide their underlying books and records or fails to substantiate their U.S. ASC 730 Financial Statement R&D Expense per Line 4 of Appendix C to the satisfaction of exam?

A3. If a taxpayer fails to provide the underlying books and records (as noted in Part V Documentation of the Revised Directive) or to substantiate U.S. ASC 730 Financial Statement R&D Expense per Line 4 of Appendix C to the satisfaction of exam, the Territory Manager or his/her delegate may determine the Revised Directive does not apply to the taxpayer.

Q4. What is the meaning of account balance detail?

A4. The account balance details are the transaction details (i.e. debit and credit entries) recorded in all R&D GL accounts that comprise the Financial Statement R&D.

Q5. What constitutes substantiation of Internal Control Over Financial Reporting (ICFR) designed to mitigate material misstatement of the taxpayer's expenses reported per financial statements as required in Part V, Item l of the Revised Directive?

A5. Substantiation of Internal Control Over Financial Reporting (ICFR) designed to mitigate material misstatement of the taxpayer's expenses reported per financial statements as required in Part V, Item l of the Revised Directive may include, but is not limited to:

Internal audit processes (briefly discuss the following):
- Detail how often internal controls are tested
- Identify who performs the testing
- Describe documentation requirements associated with the testing

The extent of recent changes, if any, in the company, its operations or its internal control over financial reporting, e.g. management culture, restructuring, mergers, etc.
Procedures related to the application of accounting policies
Procedures related to the addition and deletion of accounts and cost centers (or equivalent)
Procedures related to the addition, removal or allocation of employees from accounts and cost centers (or equivalent)
Procedures used to initiate, authorize, record and process journal entries in the general ledger, e.g. procedures to determine costs are classified appropriately
Procedures used to record recurring and nonrecurring adjustments to the annual and quarterly financial statements
Procedures related to management override
General discussion related to preparing annual and quarterly financial statements and related disclosures relevant to research and development line items, e.g., review of budgeted to actual research and development spending

Q6. Part V, Item l of the Revised Directive states that substantiation may be provided by a presentation or in writing. What should the presentation entail?

A6. The presentation of the information included in Q4 within this section should provide Exam with an understanding of the transaction flow, including how these transactions are initiated, authorized, processed, and recorded. In the presentation, the taxpayer should "walk-through" transactions related to research and development costs. A "walk-through" represents a start-to-finish review of how a transaction begins (e.g., initiation of a purchase), how it is recorded on the company's books and how the transaction flows through to the financial statements.

Directive audit steps

Q1. What audit steps should Exam take in reviewing Financial Statement R&D?

A1. Exam should obtain an understanding of taxpayer's business model along with the policy and procedures effecting R&D activities. This includes internal use software development and post development activities. In addition, Exam should tie the amount claimed as Financial Statement R&D to taxpayers' books and records.

Q2. What audit steps should Exam take in reviewing the amounts determined as ADJ ASC 730 FS R&D?

A2. Examinations under the Directive involve reviews of the adjustments made to the taxpayer's R&D costs separately reported on their Certified Audited Financial Statements. Exam should verify the starting point number (Financial Statement R&D) and the required adjustments made on each line of Appendices C & D. Exam can request from the taxpayer the information used to compute the adjustments made on Appendix C and D and the other required information outlined in the Directive.

Exam can request information in addition to the documentation identified in the Directive. (See Q3 within the Substantiation section.)

Q3. What audit steps should Exam take in reviewing the amounts determined as QREs outside the ADJ ASC 730 FS R&D amount, i.e., Appendix B, columns B & C?

A3. The exam team should risk the QREs in columns B & C of Appendix B to determine the scope of the examination. These QREs are outside of the scope of the Directive and are subject to the same risk assessment as other research credit QREs.

Q4. How does Exam verify that the taxpayer correctly identified an employee's job position in the R&D cost centers, i.e., Upper Level managers not recorded as 1st Level Supervisor Managers or QICs?

A4. The Directive requires the taxpayer to provide a list of employees with the respective W-2 wage amounts the taxpayer reported as additions to U.S. ASC 730 FS R&D in Step 4 of Appendix C. This list should also identify for the applicable taxable year each employee's job title, reporting level, and cost center where each of those employees worked. To verify the accuracy of the reporting levels, the exam team can sample the employees and request supporting documentation.

Q5. Can a MITRE referral still be made for a taxpayer following the Directive?

A5. Yes. In general, ASC 730 does not include the costs for developing internal-use software. Therefore, since ASC 730 costs rarely include internal-use software development costs, a referral to MITRE is unlikely for these software development costs. However, if the taxpayer is reporting sufficient costs outside of ASC 730, (i.e., in column C of Appendix B) involving software development activities, a MITRE referral may still be appropriate.

Q6. How does management plan to track taxpayers who follow the Directive?

A6. To aid in measuring the effectiveness of the Directive, exam teams should input the following for each taxable year the taxpayer follows this Directive:

Project Code 6750
Tracking Code 1511

If the tax return already has a Project and/or Tracking Code on it, keep the project code but override the tracking code and enter 1511 e.g. for Joint Committee Cases, keep the 077 project code but input the Directive tracking code 1511.

Penalties

Q1. Is there any penalty protection for taxpayers who try to follow the Directive?

A1. No, there is no penalty protection. The same penalty rules apply when following the Directive as for any other examination.