Change eases eligibility for technology tax credits
By Sean Hao
Advertiser Staff Writer
A recent change in federal requirements that made it easier to qualify for research tax credits may explain why so many companies have claimed millions in state technology research tax credits although they are not technology businesses.
That's because Hawai'i tries to conform to the federal tax code, and a looser definition of what qualifies as research has meant more non-tech companies in the state may be eligible for Act 221 research credits.
State Tax Director Kurt Kawafuchi said it is logical to conclude that the recent federal tax changes could have led many non-tech companies to ask for Act 221 research credits, which are far more generous than the federal tax breaks.
The cost of Act 221 and benefits to Hawai'i's high-tech industry have been highly debated, with Gov. Linda Lingle pushing for tighter qualifications and high-tech representatives defending the credits as necessary to grow their industry and diversify the economy away from tourism.
However, last month the state Department of Taxation said about $10 million or nearly 69 percent of an estimated $14.5 million in tax credits claimed for research expenses in 2001, the act's first year, went to non-high-tech companies including nonprofits, tour operators, travel agencies and financial institutions.
In December of that year, the Internal Revenue Service proposed a set of rules making it easier for companies to qualify for the federal tax credits. One significant change freed companies from having to prove that their qualifying research was "groundbreaking." Instead the research need only be technological in nature and involve sufficient uncertainty in development or application. The proposed rules also reduced record-keeping to qualify for the federal tax break, which amounts to a 20 percent income-tax credit on increased research costs.
Passed in 2001, Act 221 provides a 20 percent tax credit on all technology research costs. The credit is refundable, meaning a company can receive a refund even if it pays no taxes. For months, the Lingle administration called for stricter qualifications to reduce the high cost of the credits and address concerns of their suspected misuse.
Millions of taxpayer dollars are at stake. The cost of the research credits outstripped the state's original estimates and now is expected to grow from $14.5 million in its first year to $22 million this fiscal year and $24 million next year.
When coupled with Act 221's other major component, a 100 percent tax credit for investments in technology companies, tech tax credits are expected to cost the state $48.4 million this year and grow to $76.7 million in fiscal 2005, according to state estimates.
Act 221 sunsets at the end of 2005.
The Lingle administration has blamed credits such as Act 221 for a sharp drop in state tax collections leading to a significant budget shortfall.
In defending use of the credits, technology-industry representatives predict Act 221 will generate nearly 7,500 new jobs statewide by 2006. Proponents of the act also said the cost of technology tax credits is small compared with other tax incentives, such as the state home construction and remodeling tax credit, which is expected to amount to $60 million this year. That tax credit sunsets June 30.
"We want to stay the course on diversifying the economy so that our young people can stay in Hawai'i and work in high-quality jobs," said state Rep. Brian Schatz, D-25th (Makiki, Tantalus). "That's what 221 is about, and the facts show that reports of the negative revenue impact were exaggerated."
Taking advantage
No doubt state research credits are a boon to Hawai'i business, but if the state's intent is to spur just the high-tech industry, then tying Act 221's definition of research to the federal tax credit was a mistake, said Mark Andrus, national director for the research tax credit practice of the Grant Thornton accounting firm. Grant Thornton provides research credit consulting to businesses including those in Hawai'i.
"The federal credit is not necessarily a high-technology credit," Andrus said. When the proposed federal guidelines were released, "it lowered a very significant hurdle in claiming the credits on the federal side. Since the state adopted that hurdle, now the only question is, are you doing qualified research?" and not whether you're a technology or biotechnology company.
The IRS has said it will allow companies to use the new standard, though the rules have yet to be formally adopted. Because of relaxed guidelines, all types of companies nationwide are increasingly taking advantage of the federal credit, Andrus said. Claims have risen from $2.1 billion to nearly $5.3 billion in 1999, the most recent year for which IRS data is available.
Companies in Hawai'i have an even greater incentive to meet federal research guidelines. That's because once they qualify for the federal tax credit, which is nonrefundable and only provides a tax break based on increased research spending, they can seek the Act 221 credits that provide a tax break for a company's entire research budget.
For example, a company that increased its research budget from $100,000 to $110,000 could be eligible for a $2,000 federal tax credit. The same company could also qualify for a $22,000 tax credit under Act 221.
Earlier this year when Lingle tried to limit state research credits to companies that increased research spending above a base amount established in a prior year, lawmakers turned her down.
"The governor understood the issue when she did what she did," Andrus said. "If the state of Hawai'i had a base-amount hurdle, we wouldn't be having this conversation."
The state could save $55 million over two years if the governor's proposed changes, which included making the credits nonrefundable, were implemented, her administration has estimated.
Despite easing of federal research guidelines, state technology research tax credits are still difficult to get, said David Watumull, president for Hawai'i Biotech. He agrees the credits should be geared for technology companies, but technology research by non-tech companies is still a good thing to encourage, Watumull said.
He said whether the state should subsidize "research" at travel agencies, banks and other non-technology industry companies "comes back to what was the (act's) original intent?"
That's also a question the tax department is wrestling with. Kawafuchi said some non-high-tech companies are suspected of claiming the credits for hardware and software upgrades rather than cutting-edge research. "The question is should the public be subsidizing that?" he said.
Officially, the department has no position on whether it will allow state research credits based on the new federal guidelines. However, Andrus said the new rules will make it harder for the tax department to deny research claims by non-tech companies. Tax officials now are auditing some of those claims.
"We're going to give them a fair chance," Kawafuchi said. "If it's something cutting edge — never been done before — then the odds are it might qualify."
Uncertainty brings difficulty
When it comes to deciding what to do if anything about Hawai'i's research credits, lawmakers have three choices, Andrus said. They can leave them alone, they can adopt Lingle's proposals, or they can limit the credits only to high-tech companies.
For example, Oregon ties its definition of qualified research to the federal standard. However, Oregon officials only allow certain kinds of companies to claim the credits, such as computing, biotechnology, advanced materials and electronics companies.
"That's certainly an option, a middle ground," Kawafuchi said, though he said the administration still wants to limit the credits to cover increased research costs.
Whichever tactic Hawai'i chooses, the sooner it makes a decision the better, Andrus said. That's because the uncertainty created by the Act 221 debate amendments makes it difficult for companies to commit long term to moving to Hawai'i so they can take advantage of the credits.
"You either need to fish or cut bait," Andrus said.
Reach Sean Hao at shao@honoluluadvertiser.com or 525-8093.
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