Expert Panel: New Tax Strategies for Technology Companies

- RevenueRecognition.com

RevenueRecognition.com interviewed three experts from Grant Thornton, one of the world's leading accounting, tax and business advisory organizations, to discuss tax strategies that leverage these changes. Our panel members are:

Mark Andrus, Practice Leader, R&D, Strategic Federal Tax Services
Allen Wilson, Partner-in-Charge, Strategic Federal Tax Services
Eric Anderson, Greater Bay Area, State and Local Tax Practice Leader

For more information, please view the webcast "Good News On the Tax Front for Tech Companies."

MARK ANDRUS ON R&D CREDITS:

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RevRec.com:
What's changed in the way R&D qualifies for tax credit?

Mark Andrus:
New regulations came out in December 2003. The key change is that in the past companies had to meet a discovery test for their R&D projects. Now, that discovery test is gone. As a result, the research credit is available to a much broader range of activities and expenditures associated with developing new or improved products or processes. That's a key difference. So if you were developing a product similar to something another company has already delivered to market, they got the tax relief, but you did not. Now, both companies can get equal treatment as long as the second company independently develops its knowledge about how to build the product.

RevRec.com:
What's new for companies that have taken the credit under the old rules?

Mark Andrus:
If you have taken the credit in the past you have probably worked with an outside firm that produced a full report for your research credit. A core element of the report is a methodology memo that outlines the law and how it relates to your specific fact pattern, it also outlines the process followed to identify qualified activities and related costs. Other core elements of the report are activity summary memos that explain the qualified research activities present in your company.

With the change in the regulations, the core elements of the report may need to be modified, particularly with the perceived emphasis by the IRS to tie qualified costs to the process of experimentation and further to the resolution of uncertainty. We are working with our clients to enhance the documentation that ties costs to specific actions, to revise time reporting mechanisms, and to train employees on the changes in the definition of qualified activities.

If you've taken the credit in the past we suggest that you have someone take a look at what you've done and help you modify that approach so you're up to speed now on how you can defend against this new attack coming on the process of experimentation test.

RevRec.com:
What about companies that have not been able to qualify under the old rules?

Mark Andrus:
Many companies have not taken the credit in the past for two reasons; they felt they did not meet the discovery test, or they felt they did not have detailed contemporaneous documentation. With the new regulations, more research and development is going to qualify, especially for companies that are not the industry leader in new product releases or size. So it's a good time to reevaluate whether your activities can meet the new lower hurdle and qualify.

For example, take the airline reservations software industry. Years ago some of the big airlines invented the ability to allow customers to interface with their reservations systems. The first person that came to market with this product clearly forged new ground and discovered new information it was a new market, a new product. Now let's consider a competitor that wants to create a niche product in this established industry. Even though they know that they are capable of achieving their desired result, they don't know the appropriate design of the software or the required detail. In the past, the IRS would have said that you don't qualify because online reservations systems already exist. But with the discovery test gone, it allows other companies in the industry to take a credit. While they don't need to discover the technology, they do need to discover information that is useful in resolving capability, methodology, or appropriateness of design issues.

RevRec.com:
What risks or limitations should financial executives consider regarding research credits?

Mark Andrus:
If a company claims more than $2 million in a three-year period and the claims are audited, the audit will be reviewed by Joint Committee. Further, the credit is a credit against regular tax, not AMT, and the classifications used for the credit may also impact foreign tax credits.

ALLEN WILSON ON SECTION 382 STRATEGIES:

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RevRec.com:
What are some of the new developments regarding how companies can treat their net operating losses (NOLs) for tax purposes?

Allen Wilson:
Section 382 imposes an annual limitation on the use of a NOL after an ownership change. The opportunity is you can increase your 382 limitation following an ownership change if the company had a net unrealized built in gains at the day of the ownership change. In the appropriate fact pattern, a company can recognize these built in gains and "supercharge" their NOL limitation without disposing of the built in gain asset by using a technique that Grant Thornton has previously used and that was formally approved by the IRS in September 2003.

RevRec.com:
Why isn't a company using this technique if they qualify for it?

Allen Wilson:
The idea of "supercharging" the 382 limitation is a fairly new concept and in today's tax sensitive environment, people are reluctant to use tax strategies that they may be unfamiliar with. The IRS has approved this technique, so companies should not be worried about how the IRS may view this planning strategy. There is really no reason that a company that has had a loss and a change of ownership can't pursue this "supercharged" 382 strategy and, with the proper facts, accelerate an NOL or save an NOL that may otherwise not be used because of the limitation. We have consulted with several major corporations, including a couple Fortune 1000 companies that are considering this strategy.

RevRec.com:
Do NOL carry forwards benefit companies in an acquisition?

Allen Wilson:
It is applicable to acquisitions, and it can be a significant factor. If the NOL is sufficiently large and valid, it may affect how much a buyer may be willing to pay for a company. The "supercharged" 382 concept is valuable because if a buyer can access the NOLs quicker, they will pay less tax in the early years, and from a cash flow standpoint that deferral increases the value of the acquired company.

We are working on a deal currently involving multi-billion dollar NOLs where a profitable company is buying a loss company and a major question is: How quickly can this technique accelerate the use of NOLs? In this situation it will prevent some of the NOL from being lost due to the 382 limitation and carry forward period.

ERIC ANDERSON ON USING PASSIVE INVESTMENT COMPANIES FOR MINIMIZING STATE AND LOCAL TAXES:

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RevRec.com:
What's the background on royalty companies and how is the environment changing?

Eric Anderson:
Very broadly the way a royalty company or passive investment company (PIC) is used to minimize taxes is to shift revenue to states that have more favorable tax structures. This is done by establishing an intellectual property (IP) licensing agreement between one or more operating companies that employ the company's IP and an IP holding company. But states are starting to pass legislation that impacts how companies can use intellectual property for tax planning purposes. This is especially significant for technology companies that have a lot of their value in IP and we can expect the changes to continue as states respond to budgetary pressures.

RevRec.com:
What are the current opportunities for PIC structures?

Eric Anderson:
There are still some safe harbors for anti-PIC legislation. For instance payments to a royalty or IP company in a foreign country are generally not subject to the add-back provision. With that being said, Maryland has a pending house bill that will subject all revenue to state tax—it's an add-back for all expenses to any affiliate wherever located. Texas and Virginia are both on the path to passing similar bills. Unfortunately that is usually an indication of the direction that the rest of the country will go. We see this sweeping across states that tax corporations on a separate company basis. However, some states like Florida have rejected employing anti-PIC legislation.

RevRec.com:
What are the implications for revenue accounting practices?

Eric Anderson:
One of the things we really have to be mindful of when we're doing any type of royalty planning strategy is that any kind of inter-company transactions are booked appropriately. The revenue accounting is very important to substantiate that these companies are really being treated separately. A lot of times companies will think they've implemented a good strategy only to find that they don't have the right booking of the revenues and expenses in the different corporations.

The technique that we employ to get around some of the anti-PIC provisions bears on the relationship between the two entities. You have to make sure that you really can have an appropriate separation of what is now a royalty expense that we may want to reform into a different type of contractual relationship between the companies. But you have to be able to appropriately account for revenue in order to support this strategy.

RevRec.com:
What are the key risks and issues to consider before embarking on royalty companies?

Eric Anderson:
One of the key questions to consider is: what is this going to do to my books? Generally we try to set it up so that everything is consolidated, so for financial reporting it is inconsequential. Now we definitely have to be mindful of how the structure is set up and make sure that the revenue accounting for book purposes does get to a consolidation. That is one risk area, but one that we can mitigate with proper planning.

If companies are trying to fit into these anti-PIC safe harbors, they have to be very careful to understand that they may end up in a controversy with the state where the standard is subjective. Employing an anti-PIC strategy to get into a good position initially may avoid some fights that states are likely to levy.

RevRec.com:
With the legislative environment in flux, should these strategies include a sunset plan?

Eric Anderson:
We always have an exit in mind. We have to plan for future events like what if Florida, two or three years down the road, passes anti-PIC legislation. What does that mean for the royalty company strategy we set up and what does it take to get out of it? Generally it is fairly simple to liquidate the royalty entity and put all the pieces back where they were before.

The basic royalty strategy should be set up to have the flexibility to anticipate the anti-PIC in the future. The states will continue to chip away at this issue especially if their budget problems continue. But if the revenue picture for the states improves, in places that have not enacted the anti-PIC, it will probably fall by the wayside. Of course, if the picture gets worse, the anti-PIC trend will probably accelerate.

Note: The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice or opinion provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, specific circumstances or needs, and may require consideration of non-tax factors and tax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to "Section," "Sec.," or "§" refer to the Internal Revenue Code of 1986, as amended.