Food companies are constantly facing increasing costs—raw materials, fuel, regulatory changes—all while trying to stay competitive with pricing and gain market share. Some of these costs stem from research and development (R&D) strategies to develop new products related to food safety, cost reduction, organic/natural products, dietary guidelines, and sustainable resources.
According to Food Processing magazine’s annual R&D survey, 48 percent of respondents selected new product development as their top priority for 2013, up 8 percent from last year. Further, the magazine reported food manufacturers are still spending time on extending product lines, improving existing products, “cleaning up” current products, and controlling costs. And, while the survey found that 22 percent of R&D budgets increased, 51 percent of R&D budgets are about the same as last year.
Fortunately, federal and state governments offer R&D tax credits to food and beverage companies of all sizes to help offset these expenses. The R&D tax credit allows companies that perform technological research (which has a broad definition) to receive tax breaks on certain costs associated with research as long as it was performed in the United States.
Food manufacturers should look closely at this federal incentive even if, in the past, they did not believe their activities in developing new products or processes qualified as technological research.
Often, credits mistakenly are assumed to apply only to the creation of a new product or package, but there are actually a number of ways in which food companies can qualify for research tax credits—including for activities that already regularly occur at the company. Consider the following examples:
- Improving the taste, texture, or nutritional content of food product formulations
- Incorporating new or sustainable ingredients in a formula
- Producing sample batches in a test kitchen or a pilot run
- Developing techniques that will reduce costs and/or improve product consistency
- Redesigning processes to comply with new federal or state regulations
- Improving machinery/equipment to ensure safety for handling food
- Creating new packaging to improve shelf life, durability, and/or product integrity
- Reducing materials or using more environmentally friendly materials in packaging
- Introducing new or alternative materials to improve packaging
- Creating new methods for minimizing contamination, scrap, waste, and spoilage
- Increasing energy efficiency of water, fuel, and utilities through the introduction of new technologies
- Developing processes to convert waste to energy
How does the credit work?
To determine whether your food manufacturing clients are eligible to claim the credit, the first step is to review your clients’ activities and expenditures. Generally speaking, if your clients employ engineers or technical personnel who are developing or improving products or manufacturing processes, they should be able to take advantage of the R&D credit.
Treasury Regulation section 1.41-4(a) provides four government-specified criteria (the four-part test) to consider in determining whether the activities qualify for the R&D credit. The activities must meet each of the criteria in order to include the associated taxable salaries and wages, supplies, and/or contract research in the calculation of the tax credit. These activities need only be evolutionary to the company, not revolutionary to the industry, to qualify for the credit.
- The activity must be technological in nature. (Treasury Regulation section 1.41-4(a)(4))
The activity must be based on principles of the following hard sciences:
- Computer science
- Physical sciences
- Biological science
- The activity must be for a permitted purpose. (Treasury Regulation section 1.41-4(a)(5)(ii))
The activity must involve the creation of a new or improved level of:
- The activity must involve the elimination of uncertainty. (Treasury Regulation section 1.41-4(a)(3)(i))
The activity must explore what was not known at the start of the project:
- Capability uncertainty – Can we develop it?
- Methodology uncertainty – How will we develop it?
- Design uncertainty – What is the appropriate design?
- The activity must involve a process of experimentation. (Treasury Regulation section 1.41-4(a)(5)(i))
Substantially all of the activities must include elements of experimentation:
- Evaluating one or more alternatives
- Performing testing or modeling
- Examining and analyzing hypotheses
- Refining or abandoning hypotheses
Identify and document qualifying activities
Once you have determined that the company is engaged in qualifying activities, the next step is to develop a methodology for identifying, quantifying, and documenting project costs that may be eligible for the R&D credit. Costs that qualify for the credit include wages of employees involved in developing new or improved products or processes, supplies used or consumed during the research process, and 65 percent of fees paid to outside contractors who provide R&D services on behalf of the taxpayer. (Internal Revenue Code section 41(b)(2) and 41(b)(3))
Appropriate documentation may require some changes to the company’s record-keeping processes since the burden of proof regarding all R&D expenses claimed is on the company, the taxpayer. If the company uses project-based accounting rather than cost center accounting, you may find it easier to match qualifying activities to costs. In preparation for claiming the credit, look at how the company records expenses and develop a methodology for associating costs to projects that is aligned with the company’s internal reporting structure. Also, consider whether you may be capturing relevant expenses in the company’s R&D department but missing those associated with eligible activities that occur elsewhere in the company.
How do you compute the credit?
There are two methods for calculating the credit: a traditional incremental research credit and the alternative simplified credit (ASC). The traditional method involves looking at expenses as a percentage of revenue over a historical period (1984 to 1988) and comparing that to current revenues and expenses. The ASC involves a comparison of current-year R&D costs to average annual R&D costs incurred in the prior three years. Companies that have not claimed the research credit in the past or that may have difficulty calculating a historical base amount may find the ASC to be more beneficial.
While claiming the credit requires an investment of time, resources, and expertise, claiming the R&D credit can provide significant monetary and operational benefits to businesses. Even companies currently operating at a loss may benefit since federal R&D credits generated but not used can be carried forward for up to 20 years and used when the company is profitable. And, if the company is acquired in the future, the credits can be considered a valuable future asset in negotiating a selling price for the business. When credits are claimed correctly, companies can reap such benefits as increased cash flow, optimization of engineering investments, and a dollar-for-dollar reduction in tax liability.
The following is a case study that demonstrates how companies can identify and take advantage of R&D credit opportunities in the food and beverage industry.
A privately held manufacturer of processed beef and pork products for the foodservice and retail industries that operates several facilities throughout the US.
Initially, the company was somewhat reluctant to pursue the R&D credit because it, like many food manufacturers, did not believe it was carrying out R&D activities. A common misperception is the R&D credit is applicable only to companies operating in high-tech industries that are developing cutting-edge products or technologies. However, once the company was educated on the IRS’s broad definition of what qualifies, the company realized an opportunity existed to secure R&D tax credits.
Specialized and experienced R&D credit professionals are able to assist clients in identifying and uncovering R&D tax credit opportunities. A critical component of any approach is developing an R&D credit methodology aligned with the company’s operations and internal project reporting processes and procedures. The latter was accomplished primarily through facility tours, interviews with key technical and financial personnel at the company, and a review of project documentation to support the R&D projects and activities.
It was identified that the company engaged in numerous R&D projects, many of which were undertaken within the company’s normal course of operations. The following are examples of qualifying projects:
- Development of new or improved product formulations to meet changing consumer taste preferences
- Development of manufacturing processes to accommodate new products, including optimizing processing parameters
- Modifications to existing manufacturing processes to comply with new regulations
- Continuous improvement projects aimed at reducing scrap, waste, and spoilage and/or conserving water and utilities
- Automation of manufacturing functions to minimize product contamination
- Development of new packaging to extend the shelf life of products
- Plant layout design changes to reduce manufacturing time and increase throughput
The company secured—and sustained under IRS exam—more than $150,000 in federal R&D tax credits. A sustainable methodology was also developed for the company to use on an annual and ongoing basis to identify, document, and substantiate eligible R&D projects and costs.