Investors should be aware that first quarter earnings could have a little extra “noise” in them this year, and may not be comparable to previous years.  The problem results from Congress not extending the R&D tax credit again.

The R&D tax credit (formally known as the research and experimentation credit) has been around for decades.  It is basically a 20% tax credit (or an alternative 14% tax credit) linked to increasing research expenses, but is one of the more complicated sections in the tax code.  The credit has a significant impact on the amount of research performed – in February 2013 the Joint Committee of Taxation estimated the amount of credits in fiscal 2012 at $6.1 billion.

The R&D tax credit, however, is one of the “extenders” Congress is required to deal with every year – tax benefits that are renewed for one or two years, but set to expire unless Congress acts to extend them again.  The R&D tax credit expired at the end of 2011, and wasn’t renewed again until January 2013, retroactively to the beginning of 2012.  However, the credit expired again at the end of 2013.

The expiration and retroactive renewal of the tax credit has wreaked havoc on earnings of companies that take the R&D tax credit.  Under U.S. GAAP, companies can only include a tax benefit if they are entitled to it under currently enacted tax law.  That means that the R&D tax benefit reduced tax expense, and increased earnings, for calendar 2011.  But since the R&D credit was not available during calendar 2012, tax expense rose, and earnings were negatively impacted by the lack of the credit.  When Congress retroactively reinstated the credit in the beginning of 2013, first quarter 2013 earnings included not only that quarter’s R&D tax credit, but also the retroactive benefit for all of 2012.  The second, third and fourth quarters of 2013 all included a normal R&D tax credit benefit.  But because it expired at the end of 2013, first quarter 2014 earnings will not include the credit’s benefit.  This lack of consistency has resulted in a lack of comparability between quarters.  Looking just at the first quarter for the past few years:

  • First quarter 2011:  included a normal R&D tax credit benefit
  • First quarter 2012:  included no R&D tax credit benefit
  • First quarter 2013:  included five quarters of R&D tax credit benefit
  • First quarter 2014:  will include no R&D tax credit benefit

Luckily, most companies have, and will continue to provide investors information on this distortion through pro-forma earnings.  However, with the on-again-off-again nature of the credit, there is concern that the amount and timing of company’s R&D expenditures are impacted based on whether the credit is currently available and expectations of whether the credit will be available in the future.

Because of impacts on R&D spending due to the uncertainty of the credit, there are continual proposals to make the R&D tax credit permanent.  There’s one problem with these proposals:  the cost.  Congress needs to come up with offsetting revenues when enacting tax benefits.  The Administration’s most recent budget proposal includes a provision to make the R&D tax credit permanent while also making some changes to enhance the credit, at a ten-year cost of $108 billion.  Since it is usually easier to come up with revenue-raisers of $6-$14 billion for one or two-year extensions, Congress historically temporarily extends the credit.

What should investors do?  Although the R&D tax credit typically is extended for one or two years, it has (so far) always been renewed and is believed to be an important incentive to companies performing important research.  A permanent extension is likely only if Congress is able to pass broad tax reform – which is hard to handicap.  But because, even without tax reform, the credit’s periodic extension is always probable, we believe investors should use the pro forma earnings provided by companies to normalize the uneven GAAP benefits.  And when forecasting earnings, investors should be comfortable assuming a future tax rate that is reduced by the R&D tax credit.

Janet Pegg, CPA, is the Head of Valuation & Accounting at Cornerstone Capital Inc. and former Managing Director and Analyst of U.S. Accounting Research at UBS Investment.