Annette Nellen
Annette Nellen

Tax Reform Options: Incentives for Innovation

What would you tell the Senate Finance Committee at a hearing on tax reform and incentives for innovation?

September 29, 2011
by Annette Nellen, CPA, Esq.

The tax-writing committees of both houses of Congress have collectively held more than 20 hearings so far this year on various aspects of tax reform. Topics explored include lessons learned from other countries, international taxation, energy policy, retirement savings, job creation, equity, changes since the Tax Reform Act of 1986 and consumption taxes. On September 20, 2011, the Senate Finance Committee held a tax reform hearing to explore incentives for innovation. The author was invited to testify. Following is a description of the process and the text of the oral testimony delivered.

View a list of tax reform hearings and links of the 112th Congress here.

Process and Time Commitment

An e-mail was received from a staff member on September 8, 2011 to determine if I was available to testify. A conference call with two staff members was followed by an official invitation (letter signed by Chairman Max Baucus (D-MT)) on September 9. Per the letter, oral testimony would be limited to five minutes and written testimony was due on September 16. Despite much prior research and writing on the research credit and tax considerations for high technology companies, at least 25 hours were devoted to preparing written testimony (21 pages). Another few hours were devoted to preparing the oral testimony and ensuring that it could be delivered in less than five minutes. Travel arrangements took about one hour. The trip lasted from a red eye flight from San José the night of September 18, returning at 11 pm on September 20.

The Hearing

There were four witnesses at the hearing, each delivering a short statement. Each committee member had five minutes to ask questions. Only five committee members (out of 24) were present for the questioning. Many staff members were present. Witnesses focused on the benefits of the research credit, some structural issues with the credit, tax law changes that could help promote innovation including some changes to the international tax rules, and what some other countries do to encourage and support R&D. Following the hearing, the witnesses were invited to continue the discussion with a few staff members at lunch in the Dirksen Senate Office Building cafeteria. This discussion was engaging and both staff and witnesses shared information and ideas.

Senate Finance Committee website with written testimony and hearing webcast here.

Author's Complete Oral Testimony

Good morning Chairman Baucus, Ranking Member Hatch and members of the Committee. My name is Annette Nellen. I am a tax professor at San José State University. I am both a CPA and attorney. My testimony today is based on over 20 years of experience working with the tax law, particularly time devoted to understanding the tax treatment of R&D, software, intangibles and the Internet, as well as tax policy and reform. Much of my writing (including blogging) is focused on promoting tax reforms that follow principles of good tax policy and reflect 21st century ways of living and doing business.

Thank you for the opportunity to testify today.

The topic of this hearing is a welcome one in that it carries with it at least two messages. First, our federal tax system is in need of reform. Second, a tax system should be designed to support the taxing jurisdiction's economic, societal and environmental goals. Innovation is a hallmark of our country and a key driver of economic growth, improvement in living standards and a better environment. Innovation must be considered in tax reform, at least to be sure the tax law does not hinder innovation, thereby harming economic growth.

Tax reform should also consider whether there are economic reasons for the tax system to help support innovation. I believe such reasons exist. The question then, becomes, how? This is a complicated question involving various aspects of the tax law including depreciation, treatment of investment, AMT (alternative minimum tax), international tax rules, and direct financial support in the form of tax credits. Innovation should also be considered in administration of the tax system. Too often, tax reform focuses only on the base and rates rather than also on administrating the system.

Tax and innovation brings to mind the research credit. But there are additional provisions relevant to innovation such as the deduction for R&D under Section 174 and the capital gains incentive for inventors under Section 1235. There are also provisions that potentially hinder innovation. I will point out a few of these obstacle provisions and suggest some improvements. I will also note a few possible improvements for the research credit. My written testimony includes further details.

First, any incentive offered as a tax credit will not help companies, such as start-ups, operating at a loss or a business that owes AMT. Thus, any credit intended as an incentive or to provide financial support, should be useable against AMT and refundable. Alternatively, for start-ups, a grant type program, similar to that used for certain energy credits in the American Recovery and Reinvestment Act of 2009 (ARRA) should be considered.

Next, depreciation. Many MACRS (Modified Accelerated Cost Recovery System) lives, such as for computers, are too long. Also, R&D leads to new and better computers, cars, and equipment. If there are limitations on claiming depreciation for these items, such as the Section 280F limit on car depreciation, there will be a reluctance for businesses to purchase the innovative products.

Improvements include a review of MACRS lives and repeal or cut back of the Section 280F limitations, particularly for cars that use new technologies to achieve high mileage rates.

Also, the Section 179 expensing election should be brought into the 21st century by also applying to the purchase of intangible assets.

Next, consider targeted incentives to help provide funds to companies engaged in innovation, particularly small start-up ventures. Section 1202 provides a benefit to individuals investing in qualified C corporations. Why not a similar benefit to encourage equity investment in partnerships and S corporations?

Innovators with a great idea need funding beyond the maxing out of their credit cards. More individuals would be willing to fund emerging innovators if any possible bad debt could be treated as ordinary loss, such as has been allowed for certain equity investments under Section 1244 for over 50 years. Tax-based approaches used in some states to incentivize angel investors or the innovators themselves, should also be considered.

Finally, I offer a few suggestions for improving the research tax credit so that it can better reach its goal of supporting more R&D activities in the U.S.

The research credit will expire for the 15th time at the end of this year. Research activities involve a long-term view; thus, research incentives that focus on the short term cannot be fully beneficial and effective. Short-lived incentives compare unfavorably to permanent incentives offered by other countries. Temporary incentives, even if likely to be renewed, can't factor into the long-term research and financial planning decisions that companies must make. The short-term perspective of the current credit diminishes the benefits our economy could otherwise achieve through a tax credit. The research credit should be made permanent.

Next, the credit was created in the industrial era. It needs to be brought into the information age, such as by reconsidering the exception for internal-use software, which is a key component of web-based products and services that didn't even exist in 1981. Finally, as corporate tax reform discussions focus on reducing the corporate tax rate, consideration should be given to the global competitive realities that not only do other OECD (Organisation for Economic Co-operation and Development) countries have a lower statutory rate, they also tend to offer tax incentives for R&D.

Thank you. I look forward to your questions.

Getting Involved

It was an honor to have an opportunity to testify before the Senate Finance Committee. While such direct opportunities are limited, there are always opportunities to present views for hearings. Typically, when a committee announces a hearing, there are instructions on how to submit testimony for the written record and the due date. The Senate Finance Committee website has instructions and notes that comments are due within two weeks of a hearing date. Sharing such testimony with your own elected officials would also be worthwhile.

Share your comments on tax incentives for innovation here.

Looking Forward

Given an overly complex tax system, large tax gap, inequities and inefficiencies in our tax system, along with structural problems with the budget and expiring tax cuts, tax reform seems likely. The long slate of congressional hearings along with numerous reports may offer some hints as to possible reforms, they also remind us that tax practitioners have numerous opportunities to provide input into the process.

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Annette Nellen, CPA, Esq., is a tax professor and director of the MST Program at San José State University. Nellen is an active member of the tax sections of the AICPA, ABA and California State Bar. She chairs the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.