South Carolina currently has both a property tax, as well as a sales and use tax, incentive for Research & Development ("R&D"). We have no income tax incentive, unlike some of our neighboring states as well as the Internal Revenue Code.
Below you will find a discussion of our current state and federal law as well as suggestions for proposed legislation.
A. Sales Tax Exemption: Research And Development Machinery
South Carolina Code '12-36-2110(D) imposes a maximum sales or use tax of $300 on the purchase of machinery for research and development. (By contrast, manufacturers have a complete exemption for purchases of eligible machinery.)
"Machinery for research and development" means machinery used directly and exclusively in research and development in the experimental or laboratory sense for new products, new uses for existing products, or for improving existing products. Machinery includes machines and the parts of machines, attachments, and replacements used or manufactured for use on or in the operation of the machines and are customarily so used. The exemption does not include machinery used in connection with efficiency surveys, management studies, consumer surveys, economic surveys, advertising, promotion, or research in connection with literary, historical, or similar projects.
The requirements of this statute are twofold:
1.The property must be used directly and exclusively in research and development.
2.The property must be located in a separate facility devoted exclusively to research and development.
These two requirements were reviewed in South Carolina Private Letter Ruling #93-6 and South Carolina Private Letter Ruling #94-11. The Department, in South Carolina Private Letter Ruling #93-6, determined that a large computer system purchased for use exclusively to develop highly sophisticated computer software to aid scientists and engineers was machinery for research and development. The physical location of the computer was in a portion of the second floor of a computer building. Entrances to the facility were limited by a keyless entry system which restricted access only to approved researchers. The computer had its own dedicated staff person who was not integrated with the other staff of the computer division. The same conclusion was reached in South Carolina Private Letter Ruling #94-11 concerning the qualification of an electron microscope as research and development machinery.
B. Property Tax Exemption: Research And Development Facilities
South Carolina Code '12-37-220(B)(34) provides a 5 year exemption from county property taxes (the exemption does not apply to school or municipal taxes) for the facilities of all new enterprises and additions valued at $50,000 or more to existing facilities of enterprises which are engaged in research and development activities. Further, South Carolina Code '12-37-220(B)(39) provides that the governing body of a municipality may by ordinance exempt from municipal property taxes for not more than 5 years property located in the municipality receiving the exemption from property taxes allowed under '12-37-220(B)(34).
Facilities of enterprises engaged in research and development activities are defined in South Carolina Code '12-37-220(B)(34) as facilities devoted directly and exclusively to research and development in the experimental or laboratory sense for new products, new uses for existing products, or for improving existing products. To be eligible for the exemption, the facility must be a separate facility devoted exclusively to research and development as defined in this section. The exemption does not include facilities used in connection with efficiency surveys, management studies, consumer surveys, economic surveys, advertising, promotion, or research in connection with literary, historical, or similar projects. (You will note that this definition is quite similar to the sales tax definition.)
The Department reviewed the "separate facility" requirement for purposes of the $300 sales and use tax cap on research and development machinery in Commission Decision #92-61. This analysis of "separate facility" also applies for purposes of the property tax exemption for research and development facilities. The facts in this decision included: (1) the plant contained manufacturing, administrative, and research and development divisions under the same roof, (2) research and development was separated from manufacturing by a firewall and from administrative functions by partitions and a hallway, (3) there was no integration of machinery or personnel between the administration and research and development divisions, and (4) research and development continued at the plant during the two-year period when manufacturing ceased.
The Department held that each case must be decided based on the facts of each facility and concluded that the research and development function at the South Carolina plant was secluded, set apart, and kept apart from other functions. It was installed to serve a particular distinct purpose. It was autonomous with its own director and separate management and specific employees. Its space was separated from other functions. It was accounted for separately and treated as a separate operating entity by management. Considering all of the factors a separate facility exists.
The Federal government does not impose a sales or a property tax so it consequently has no incentives in this regard. As stated below, it does have two R&D income tax incentives.
Under IRC ' 174, a taxpayer can elect either to deduct research or experimental expenditures paid or incurred "in connection with" a present or future trade or business or to amortize these costs over a period of not less than 60 moths. Eligible research costs include research conducted by the taxpayer as well as research conducted on the taxpayer.s behalf.
IRC ' 41 provides for a nonrefundable credit for certain qualified research or experimental expenditures to the extent the current year.s research expenditures exceed a base amount of expenditures. For research expenditures incurred after June 30, 1981, and before January 1, 1986, the amount of the credit is 25% of the incremental research expenditure amount. The credit for research expenses incurred after December 31, 1985, and before July 1, 1995, is 20%. The Small Business Job Protection Act of 1996 extended the 20% research credit from July 1, 1996 through May 31, 1997. In addition to other provisions the 1996 legislation incorporates an elective alternative incremental research credit regime. The 1998 Tax Extension Act further extended the termination date of the research credit to June 30, 1999. The 1998 Act also amended the period for which the alternative credit regime will apply from 24 months to 36 months to include the 12-month extension.
Section 174 contains no definition of the term "research or experimental expenditures." Rather, the meaning of research or developmental expenditures has been fleshed out by regulations. Regulations were promulgated in 1957. In addition, proposed regulations were issued in 1983 and 1989. As stated below, Regulations proposed in 1993 were adopted, with modifications, in 1994. The 1994 regulations amend 1957 Regs. ' 1.174-2(a)(1). The 1983 and 1989 proposed regulations were withdrawn in 1993.
In October 1994, the IRS issued final regulations under ' 1.174-2(a) clarifying the definition of research or experimental expenditures and providing guidance regarding the reasonableness requirement of ' 174(e). The 1994 regulations define research or experimental expenditures, as used in ' 174, as expenditures incurred in connection with the taxpayer.s trade or business which represent research and development costs in the experimental or laboratory sense.
The term includes all such costs incident to the development or improvement of a product. It generally includes the costs of obtaining a patent, such as attorney.s fees incident to the making and perfecting a patent application.
1994 Regs. ' 1.174-2 (a)(1) clarifies that expenditures represent research and development costs in the experimental or laboratory sense if the expenditures are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capacity or method for developing or improving the product or the appropriate design of the product.
Pursuant to 1994 Regs. ' 1.174-2 (a)(3), costs paid or incurred for the following activities do not constitute research or experimental expenditures:
The ordinary testing or inspection of materials or products for quality control (quality control testing);
. Efficiency surveys;
. Management studies;
. Consumer surveys;
. Advertising or promotions;
. The acquisition of another.s patent, model, production, or process; or
. Research in connection with literary, historical or similar projects.
Legislative options include (1) adoption of a state income tax credit; (2) amending sales and use tax law to substitute a complete exemption (similar to what manufacturers receive) for the current $300 cap; (3) abolishing the "separate facility" requirement which is contained in both the sales and property tax exemptions, but is not contained in Federal law; and (4) perhaps conforming the state law definition of qualifying R&D machinery and equipment to that contained in federal law.
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