Maximize Tax Savings: R&D Credits for Foreign-Owned U.S. Subsidiaries

Flags from many countries against a blue sky The Research & Development (R&D) tax credit is a federal tax incentive designed to encourage innovation through qualifying research activities. While many U.S. companies have utilized the incentive for years, U.S. subsidiaries of foreign companies can also benefit. Eligibility requirements are generally the same, including the need to pass the four-part test and claim Qualified Research Expenses (QREs). However, foreign-owned subsidiaries may only apply the credit to gross receipts tied to their U.S. trade or business. The rules can be complex, but the potential tax savings are substantial.To help clients, prospects, and others, JLK Rosenberger has provided a summary of the key details below.

Four Part Test

To qualify for the credit, a research activity must meet all four of the following criteria:

Permitted Purpose
The purpose of the research must be towards the creation of a new or improved product, process, technique, invention, software, or formulation (or “business component”) aimed at increased functionality, performance, quality, or reliability. Activities conducted solely for aesthetic reasons (e.g., style, taste, or cosmetics) do not qualify.
Uncertainty
The research must eliminate uncertainty regarding the capability, design, or method related to the development of a new or improved product, process, or business component.
Technological in Nature
The research must rely on principles of hard sciences such as engineering, physics, chemistry, biology, or computer science.
Process of Experimentation
The activity must involve a process of experimentation, which may include an iterative process, trial and error, the use of the scientific method, simulation, modeling, or any approach that involves analyzing alternatives.

Activities That Do Not Qualify

Research conducted after commercial production begins
Adaptation or duplication of existing business components
Market research, consumer surveys, or focus groups
Research performed outside the United States
Funded research (e.g., under a grant or contract)

The foreign corporation’s gross receipts must be effectively connected with the trade or business activities of its U.S. subsidiary. According to the IRS, this includes sales of services, products, or merchandise conducted by the subsidiary, subject to certain exceptions. Importantly, it is the U.S. subsidiary that is eligible to claim the R&D tax credit, not the foreign parent.