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The California Research and Development Credit – is there a documentation requirement?
In the June issue of Tax News, we discussed the types of documentation you need to support the research credit. This month we continue the discussion by answering additional audit-related questions like, "What are the specific documentation requirements for the California research credit? Weren't the documentation requirements removed from the final federal regulations? Are we required to provide contemporaneous support? Can we use estimates?" Here are answers to these questions:
What are the specific documentation requirements for the California research credit?
With few exceptions, the State of California conforms to the federal research credit computation. Treasury Decision 9104 eliminated the "unique" documentation requirements to define qualified research under Treasury Regulation Section 1.41-4(d). However, taxpayers are obligated to follow the broader language of the current Treasury Regulation Section 1.41-4(d), the requirements of Internal Revenue Code (IRC) Section 6001, and established case law related to record keeping (Revenue and Taxation Code Section 19504; New Colonial Ice Co v. Helvering, 292 US 435 [78 L.Ed. 1348](1934)).
Weren't the documentation requirements removed from the final federal regulations?
A taxpayer must maintain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit (Current Treasury Regulation Section 1.41-4(d)). Treasury Regulation Section 1.6001-1 requires the taxpayer to clearly establish full compliance with all of the relevant statutory and regulatory requirements. The regulation requires taxpayers to keep permanent books and records sufficient to establish the amount of gross income, deductions, credits, or other matters for as long as the contents thereof may become material in the administration of any internal revenue law, or in California's case the revenue and taxation law. Simply put, taxpayers must retain all relevant documentation for as long a period as may be required to address a material item: in this case the research credit and its related expenditures and components. Failure to maintain records in accordance with these rules is a basis for disallowing the credit.
Are we required to provide contemporaneous support?
It is also clear from the above regulation and case law that contemporaneous documentation and support are generally required. Contemporaneous means the documentation or support should be from the time period of the underlying transactions, services, or activities. While the state can provide taxpayers with some degree of flexibility in substantiating their credit, this flexibility does not relieve the obligation to keep and provide a record of their qualified research and research expenditures. Extrapolations based upon data from a later period, or estimated qualifying percentages developed years later are not contemporaneous and do not have probative value. For example, if a taxpayer contemplates filing a research credit claim as an existing research entity, for income years after 12/31/99, the taxpayer will need to establish and provide contemporaneous documentation to support the qualified research expenditures and gross receipts from the base period of 1984 through 1988.
Can we use estimates?
As with the IRS, the State of California is not required to accept estimates of qualified research expenses if documentation exists, or should exist, to verify the actual amount. Taxpayers are required to keep records substantiating the amount of any reported, claimed, or affirmatively raised deductions or credits (Appeal of Don A. Cookston, 83-SBE-048 (January 3, 1983)). Failure to maintain records in accordance with the above requirements is a basis for disallowing the credit.
However, the courts may allow the use of an estimation method, but only where the taxpayer can prove contemporaneous records do not exist and then only as long as the following two conditions are satisfied:
- The taxpayer must establish that it engaged in qualified research activities as defined in IRC Section 41(d).
- The failure to maintain a proper system to capture relevant information cannot be an "inexactitude of their own making." (Cohan v. Commissioner, 39 F.2d 540, 544 (2d Cir. 1930.))
Estimation is a method of last resort, in cases where the sole issue is the exact amount paid or incurred in the qualified research activity, and after supporting evidence has been provided showing a material research activity did, in fact, occur. Accordingly, taxpayers must have factual support for every assumption underlying their estimates to meet their burden of proof. At a minimum, a valid estimation requires some indirect basis.
The Research and Development Credit is a valuable tax incentive benefiting many California business entity taxpayers. In exchange for this tax incentive, a taxpayer must maintain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit. Presenting detailed, well-maintained records to us upon request will help taxpayers in audits of the Research and Development Credit.