Texas comptroller clarifies research and development credit

On March 24, 2025, the Texas Comptroller of Public Accounts issued two policy memoranda providing guidance on the computation of the Texas research and development (R&D) credit and sales tax exemption. In the first memorandum, for purposes of the R&D credit, the Comptroller explains that if an expense for depreciable property is allowed under Internal Revenue Code (IRC) Section 174, the expense cannot be considered a “supply” eligible as a qualified research expense (QRE) under IRC Section 41.¹ In the second memorandum, the Comptroller clarifies that the federal intra-group transaction regulations do not apply when determining the Texas R&D credit or sales tax exemption.²

Texas R&D credit and adopted federal definitions³

Texas allows taxpayers to take an R&D credit against the Texas franchise tax through Dec. 31, 2026. For purposes of the Texas credit, the terms “qualified research” and “qualified research expense” are defined by IRC Section 41,⁴ except that the research must be conducted in Texas. IRC Section 41(d)(1)(A) defines “qualified research” to include research expenditures that may be treated as expenses under IRC Section 174. A taxpayer may deduct expenses under IRC Sec. 174 that qualify as “research or experimental expenditures.”

Under IRC Section 41(b)(1), “qualified research expense” means the sum of in-house research expenses and contract research expenses. IRC Section 41(b)(2) defines “in-house research expenses” to include any amount paid or incurred for supplies used in the conduct of qualified research. The term “supplies” is defined by IRC Section 41(b)(2)(C) as any tangible property other than: (i) land or improvements to land; and (ii) “property of a character subject to the allowance for depreciation.”

Depreciable property not a supply QRE

The Comptroller explained in the first memorandum that the federal definition of “supplies” excludes depreciable property, and an expense being deductible under IRC Section 174 does not affect the definition. The Comptroller noted that some taxpayers currently under audit or the refund verification process unsuccessfully argued that supplies are not depreciable for purposes of the definition of “supplies” under IRC Section 41 when their acquisition expenses may be deducted under IRC Section 174. Under this argument, those expenses would be allowed as QREs for the Texas R&D credit.

In response to the taxpayers’ argument, the Comptroller issued this memorandum. The Comptroller first considered the qualification requirements for “supply” QREs. If the claimed expenses are eligible for a deduction under IRC Section 174, the taxpayer must show under IRC Section 41(b)(2)(C) the expense cannot be incurred for depreciable property. The determination of whether property is depreciable is made under IRC Section 167, which considers a particular taxpayer’s use of the property.

The Comptroller explained that deductions under IRC Section 174 generally exclude costs for the acquisition or improvement of property that is depreciable under IRC Sec. 167. However, there are certain circumstances where an expense that should be recovered through depreciation is allowed under IRC Section 174.⁵ The Comptroller concluded that qualification as an IRC Section 174 expense is a necessary, but not sufficient, condition for an expense to be a QRE. All other requirements of IRC Section 41 must be met, including that the expense not be for depreciable property.

Federal intra-group transaction regulations do not apply⁶

The Comptroller clarified in the second memorandum that the federal intra-group transaction regulations do not apply when determining the Texas franchise R&D credit or sales tax exemption. After noting that the Texas franchise tax R&D credit adopts the federal definitions of “qualified research” and “qualified research expense” from IRC Section 41, the Comptroller explained that the sales tax R&D exemption incorporates by reference the term “qualified research” from the same source. Treas. Reg. Section 1.41-6 (aggregation of expenditures) provides the corresponding regulations for IRC Section 41(f), which governs the computation of credits for members of a controlled group. Under the intra-group transactions provision in Treas. Reg. Section 1.41-6(i)(1), “[b]ecause all members of a group under common control are treated as a single taxpayer for purposes of determining the research credit, transfers between members of the group are generally disregarded.”

As explained by the Comptroller, a federal “group under common control” is not considered to be a single taxpayer for either the Texas franchise tax or sales tax. Rather, for purposes of the Texas franchise tax and the associated R&D credit, all members of a combined group are treated as a single taxpayer. The Comptroller noted that the respective rules for determining the Texas combined group and the federal controlled group are fundamentally different. Because the federal intra-group transaction regulation treating all members of a controlled group as a single taxpayer does not directly correlate to the Texas combined group as constituted for purposes of determining the Texas R&D credit, the federal treatment of disregarding transfers between members does not apply. Further, the intra-group transaction regulations do not apply to the R&D exemption from sales tax, as each person or entity subject to the sales tax is treated as a single taxpayer and combined reporting is not a recognized concept in the sales tax realm.

Commentary

The Comptroller’s memoranda addressing the computation of the Texas R&D credit and exemption were released on the same day and should be considered by taxpayers. The first memorandum is noteworthy because it considers the interplay between IRC Sections. 41 and 174. Because IRC Section 41(d)(1)(A) provides that “qualified research” means research expenditures that may be treated as expenses under IRC Section 174, and because IRC Section 174 allows certain depreciable property to be expensed, an argument can be made that certain supply expenditures subject to depreciation should be deductible. However, the Comptroller determined that IRC Section 41(b)(2)(C), providing that “supplies” excludes “property of a character subject to the allowance for depreciation,” is controlling. Taxpayers claiming a Texas franchise tax R&D credit that have been deducting certain supply expenditures that are depreciable should consider the potential adverse effect of the Comptroller’s memorandum. Furthermore, this guidance could have relevance to other state R&D credit / deduction mechanisms, as it considers the relationship between IRC Sections 41 and 174.

The second memorandum may be problematic for some taxpayers because it disallows the application of the federal intra-group transaction regulations that generally require transfers between group members to be disregarded. It should be noted, however, that the second memorandum may allow taxpayers to claim more expenses under certain circumstances. For federal purposes, a controlled group is defined as an entity with 50% direct or indirect ownership, with no consideration of unity. Even if a group of taxpayers either does not meet the federal consolidated return requirements or meets the requirements but does not elect to file on a consolidated basis, the federal R&D credit rules require taxpayers to consider QREs on a controlled group basis and thus disregard or eliminate intercompany transactions. Because the Texas franchise tax return recognizes the concepts of unity and mandatory combined reporting but does not adopt the federal controlled group rules, the Texas group is fundamentally different and may be smaller. If the Texas unitary group is smaller, it is possible that transactions eliminated or disregarded under the federal rules are not eliminated for Texas. Therefore, the fact that an expenditure was ineligible for federal R&D purposes due to the controlled group regulations does not mandate that the same expenditure is ineligible for Texas purposes. In this situation, it is possible to have more Texas QREs than federal QREs. Regarding the sales tax benefit, because there is no concept of group reporting, the transactions are all considered as though they are with a third party.

Further complexity is added to the Texas R&D credit computation because the state generally conforms to the IRC as in effect for the federal tax year beginning on Jan. 1, 2007, and selectively to Dec. 31, 2011, with respect to the R&D credit. Accordingly, any changes resulting from more recent legislative amendments or regulatory revisions may not apply to Texas unless they are retroactively applied to the federal credit as of Dec. 31, 2011. This became important approximately 10 years ago when the Internal Revenue Service issued additional guidance and began to allow internally developed software and pilot models that are not applicable to Texas due to the earlier IRC conformity date. Also, changes to IRC Section 174 made by the Tax Cuts and Jobs Act of 2017 (TCJA)⁷ beginning with the 2022 tax year may produce differences because Texas has not adopted these provisions. Finally, taxpayers should consider that there is proposed legislation⁸ in Texas to extend the R&D credit so that it does not expire at the end of 2026 and more closely follows the federal R&D credit.

1 Comptroller Letter No. 202503003M, Texas Comptroller of Public Accounts, March 24, 2025.
2 Comptroller Letter No. 202503004M, Texas Comptroller of Public Accounts, March 24, 2025.
3 TEX. TAX CODE ANN. §§ 171.651-171.662; 34 TEX. ADMIN. CODE § 3.599.
4 Texas adopts the IRC as in effect on Dec. 31, 2011 with respect to the R&D credit. Taxpayers should consider potential differences between the federal and Texas R&D credit provisions that result from Texas’ decision not to advance the IRC adoption date.
5 For example, as noted by the Comptroller, some expenses which result in depreciable property to be used in the taxpayer’s trade or business, as an end product of the research or experimentation, are allowed under IRC Sec. 174 although these expenses usually would be recovered through depreciation.
6 TEX. TAX CODE ANN. §§ 151.051, 151.101, 151.3182, 171.651-171.662.
7 P.L. 115-97.
8 H.B. 4393/S.B. 2206, introduced March 11, 2025, and referred to House Ways and Means Committee on April 30, 2025.