HONOLULU - The State Department of Taxation has announced a new enforcement program aimed at taxpayers who have been overly aggressive in claiming tax credits for research activities.
The potential abuses involve a law that was enacted in 1999, and expanded greatly in subsequent years.
As originally enacted, taxpayers could claim a credit of 2.5% on research expenditures in excess of what they had spent the year before, and the credit could only be used to offset a tax that would otherwise have to be paid.
Currently, taxpayers may claim a credit of 20% on the entire amount spent in the current year. Even if those taxpayers owe no Hawaii income tax, they can still obtain a refund equal to the credit. If, for example, a new technology company spent $1 million on qualified research but has not yet turned a profit, it will not owe any income tax to Hawaii, but will nonetheless get a $200,000 (20% of $1 million) refund check from the State of Hawaii as a result of this law.
According to the Council on Revenues, the research credit is costing the state in excess of $20 million per year.
This law was intended to be generous, but certain taxpayers apparently are taking positions that go well beyond what was intended by the legislature. "Qualified research," for purposes of this credit, conforms to the federal definition in §41(d) of the Internal Revenue Code.
For example, qualified research must be for the purpose of discovering, through a process of experimentation, information that is technological in nature and that is intended to be useful in the development of a new or improved business component. Some taxpayers, however, have based their credit on amounts spent for routine items such as programming or debugging computer software that do not qualify.
Qualified research also must be conducted in the course of a taxpayer's trade or business, but there are reports of the credit being claimed by tax-exempt organizations that by their very nature generally do not engage in a trade or business activity.
The research credit is an income tax credit, yet there are reports of the credit being claimed by a financial institution against its franchise tax.
Others have found ways to artificially inflate the numbers, and still others have engaged in related party transactions and claimed both this credit and the 100% investment credit that was the subject of the Department of Taxation's Tax Information Release No. 2003-1, which was released earlier this month.
"The Lingle administration supports high-technology business development in Hawaii," said State Tax Director Kurt Kawafuchi, "but abusive transactions and overly aggressive positions will not be allowed."
According to Director Kawafuchi, the Department of Taxation will audit certain returns on which potentially abusive research credits have been claimed, and will disallow any claims that do not comply with both the spirit and letter of the law. Penalties will be assessed in appropriate cases.
"When certain taxpayers become greedy, it's our job to just say no. That's what we are doing here," said Director Kawafuchi.