[IMGCAP(1)][IMGCAP(2)]The recently released discussion draft of the Tax Reform Act of 2014 by the House Ways and Means Committee is intended to simplify the existing tax code, make it fairer to taxpayers and strengthen the U.S. economy by lowering tax rates.

Based on the analysis of the discussion draft by the Joint Committee on Taxation, this simplification of the code and lowering of the tax rates will create 1.8 million new jobs and achieve additional economic growth of $3.4 trillion. The discussion draft modifies the current law with changes to a large number of existing tax provisions including the research tax credit, whose benefits have encouraged business taxpayers in a wide variety of industries since its inception.

Historically, the research tax credit has maintained bipartisan support. Making the credit permanent and increasing the rate of the simplified credit from 14 to 17 percent has been proposed by the Obama Administration as well in the recently released budget for the 2015 fiscal year. The importance of scientific discovery and technological breakthroughs is recognized in the budget proposal.

The history of the research tax credit is complex. It has undergone several modifications since it was first enacted in 1981. Seemingly, taxpayers should applaud the proposed simplification. Although the draft calls for making the research tax credit permanent, other recommended changes to the current law are far from what the taxpayers qualifying for the credit would expect.

The most significant change to the current research tax credit law is the proposed elimination of computer software development from the activities that qualify for the credit. The rules guiding software development, especially those conducted by taxpayers to develop software products for their internal use, were complex and have been widely scrutinized by tax examining authorities. The simplification intent of the proposed change is not readily apparent since it eliminates the qualification of computer software development altogether. Over the past three decades software has been one of the fastest-growing industries in the U.S., contributing significantly to the GDP.

Software development, because of its labor-only expenses, has traditionally been considered an area that is ripe for outsourcing. Consequently, eliminating computer software development from the array of qualified activities will only provide further incentive for U.S. businesses to pursue these activities overseas, where labor costs may be much lower.

The proposed law also strikes research supplies as qualified costs eligible for the credit, while contractor expenses continue to remain eligible. Although this proposed change is probably intended to simplify the existing law, it creates significant disadvantages for those industries that rely heavily on supplies and materials. For a number of industries, including pharmaceutical and manufacturing, the cost of supplies significantly outweighs internal labor and contractor expenses.

In today’s global economy, the trend is to move manufacturing activities to parts of the world where the cost of labor is significantly less than the U.S. The intention of the research tax credit, as it was originally introduced, was to ensure that the benefits of economic development, including manufacturing, where possible remain in the United States. Coupled with the intent to repeal the domestic production manufacturing deduction, excluding supply costs from the overall research credit eligible amounts may make it more difficult for U.S. manufacturing firms to remain competitive, even if combined with a concurrent reduction in income tax rates.

Relevant to a discussion of these proposed tax changes is an apparent ambiguity introduced by the proposed supply expense changes in relation to contractor expenses: will all contractor expenses be considered qualified or only the labor portion of the overall costs incurred by a contractor?

Arguably, it is difficult to imagine that the simplification intent can be met when taxpayers are expected to separate labor and supply costs for each of the contractors before filing a credit claim. It would be both simpler and more practical to keep supply costs eligible for the research tax credit but to ease the existing—presently not very well defined—qualification requirements for contract expenses.

The Energy Policy Act of 2005 modified the research tax credit law by introducing a special provision for a 20 percent credit for qualified energy research conducted by energy consortia and inclusion of qualified energy research expenses incurred on behalf of taxpayers by eligible federal laboratories and research centers at 100 percent. The proposed changes to the law seek to eliminate this provision, although taxpayers will still be able to qualify these costs at 65 percent.

It is difficult to understand how this proposed modification helps stimulate research and technological innovation, promotes diversity in energy supply and decreases the dependence of the U.S. on foreign energy sources. Moreover, this will only lessen the investment interest for alternative energy source manufacturers who will find themselves in a more disadvantageous and costly tax situation.

Also noteworthy is placing the orphan drug tax credit on the chopping block. This credit, which heavily relies on the research tax credit law, is meant to provide an incentive for pharmaceutical companies to develop treatments for rare diseases and conditions. Since its inception in 1983, the U.S. Food and Drug Administration has received requests for approval of orphan drug designations for over 3,000 pharmaceutical products, approving more than 450 of them. The FDA issued orphan drug approvals on 30 products in 2013, compared to only two products in 1983.

Eliminating the orphan drug tax credit would not only lead to fewer treatment choices available to those who are affected by rare diseases but would hurt pharmaceutical companies in the United States, another of our most successful industries.

Also worth mentioning is the proposed repeal of the current-law provisions for contractor expenses incurred by small businesses. Under the current law, these expenses are considered qualified at 75 percent, while the proposed changes decrease them to 65 percent—the same as large taxpayers.

Instead of considering making the research tax credit—or at least a portion of it—refundable to small businesses, this proposed change will eliminate the only provision of the research tax credit uniquely advantageous to small businesses. It appears that the proposed draft simply eliminates a number of important provisions of the current law apparently in exchange for lower tax rates.

The increase in the research tax credit rate by one percentage point, from the existing 14 to 15 percent, can hardly be viewed as an accomplishment when compared to similar tax incentives offered to businesses in other countries. The proposed changes will only serve as a detriment to additional economic growth and the creation of jobs in the United States. Without doubt, the relatively high U.S. business tax rates have discouraged investment in this country. However, the research and related orphan drug tax credits have clearly boosted growth in technology, pharmaceutical and related industries so important to ongoing U.S. success in global economy.

The efforts to reduce the clearly non-competitive U.S. corporate tax rates are important; however, achieving that by reducing the advantages the U.S. economy has enjoyed for decades from the federal research tax credit and eliminating the orphan drug tax credit is questionable.

Dr. Alexander Korniakov is senior vice president of research credit and other tax incentives at Fortisure Consulting LP, a consulting firm located in San Francisco. Dr. Korniakov holds a master’s degree in financial engineering and a doctorate degree in chemical engineering, both from New York University School of Engineering. He is licensed as a Certified Public Accountant. Tom Hopkins is the founder and CEO of Fortisure Consulting LP. He is licensed as a CPA and holds degrees from Tulane University and Loyola University.

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