The real cost of the R&D tax credit expiration

The R&D tax credit expired at the end of 2013 … again. It was the ninth time this has happened since the credit was first enacted in 1981. Although Congress is widely expected to renew it, uncertainty around the timing and length of that renewal is posing big challenges for tax and finance departments.

As in years past, the expiration of the credit has sparked a litany of commentary about the inability of the U.S. government to pass a law. Some have argued that the lapse in the credit will hurt U.S. job creation. Others have used it as a political pawn to deflate President Obama’s State of the Union proclamation that: “We know that the nation that goes all-in on innovation today will win the global economy tomorrow.”

While these knee-jerk reactions are to be expected, they don’t get to the heart of the matter. The real issue here is: How, exactly, does the expiration of the R&D tax credit (temporary or not) affect businesses that invest heavily in R&D?

We have a unique perspective on this because our software is used by these businesses’ tax departments to calculate their various tax exposures around the world. Based on our conversations with these clients and our own software updates to accommodate the lapse of the R&D credit, the real challenge posed by this situation is accurate forecasting.

Consider the standard month-end workflow for a large corporate tax department. Whether the company is following GAAP or IFRS accounting standards, it would be expected to accrue its monthly results based on expected earnings and tax rate for the next 12 months.

The idea is that they will be simultaneously accruing and forecasting to create a smooth set of monthly results that will roll-out predictably over the course of the year. No one – least of all the IRS, SEC or investors – likes to see wild volatility in these monthly numbers, which are used to inform everything from quarterly earnings projections to HR planning.

Now, imagine trying to reconcile these numbers without knowing whether you’re going to get a major tax credit.

This is where some tough questions come into play. Should the tax team use history as a guide and book the credit in their accruals, assuming that it will be reinstated and made retroactive to the beginning of the year? Should they play it conservatively and do their planning based on zero R&D tax credit and risk more volatile monthly accruals if the credit is reinstated later this year? Or, should they play it down the middle, booking the credit along with an uncertain tax position as a sort of hedge on the possibility of the credit not being reinstated?

According to a recent Wall Street Journal story, research on the eight previous lapses in the R&D tax credit has shown that public companies often experience decreased accuracy in earnings estimates. The study’s author Jeffrey Hoopes, assistant professor at Ohio State, said that lapses in the credit create confusion among Wall Street analysts, some of whom revise their earnings estimates to include the extension of the credit and others who do not.  Ultimately, his research found that earnings expectations become incrementally less accurate by about 4 cents per share due to the expiration of the R&D credit.

The real cost of the R&D tax expiration is that it introduces more uncertainty and variability into an already complex process that is supposed to foster stability. By allowing this kind of legislative uncertainty to exist in our economy, Congress has unwittingly put the burden on tax professionals to justify positions on which they have no solid information. It’s asking corporations with revenues greater than the GDP of some small countries to effectively manage their budgets based on a best guess.

A business’ decision to invest and drive innovation isn’t just driven by tax credits. The equation also factors in simplicity, stability and predictability of financial forecasting.  Uncertainty here is the enemy and having the innovation credit up in the air is a double whammy for businesses that are already dealing with a highly unpredictable marketplace.

This post originally ran on Forbes.com.

Joe Harpaz is the head of the Corporate Market for the Tax & Accounting business of Thomson Reuters that builds the corporate tax software used by many of the world’s largest multinationals, as well as the Big 4 accounting firms. He works closely with global business leaders to set up their tax technology. In this blog, he analyzes the connections between economics and business opportunities, highlighting examples of where tax helps or hinders growth.

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