What Can Apparel Manufacturers and Retailers Gain From the R&D Tax Credit?

Despite a number of positive economic indicators, including increasing consumer confidence and decreasing unemployment, apparel and retail companies continue to face a challenging business environment. Competition and consolidation are requiring businesses to develop enhanced financial strategies to protect and improve their bottom lines.  At the same time, many have needed to invest in new technologies to eke out a competitive advantage and keep pace with rapidly changing consumer needs. The Research & Development (R&D) Tax Credit is frequently a huge missed opportunity for retail and apparel companies.

Designed to encourage and offset costs incurred for innovation, R&D credits represent both dollar-for-dollar offsets against regular income tax liability as well, in some cases, as grants or subsidies when a company isn't paying taxes because, for example, it's in a loss position. Companies that claim R&D credits, therefore, have more cash, increased earnings per share, lower effective tax rates, and the opportunity to increase their investments in areas including personnel, research and equipment.

These credits can be substantial: the latest IRS statistics estimate total 2012 federal R&D tax credits at more than $10.8 billion, a 17 percent increase from the prior year. Apparel manufacturers made up $9.5 million of these credits, with an average of over $350,000 per claim.

Importantly, however, most apparel manufacturers are not aware or taking full advantage of the R&D credit, either because they don't know about the R&D credit or they don't know about recent developments that make the credit easier and more beneficial to claim. 

Taking full advantage of the R&D Tax Credit: an overview

The R&D credit is an activity-based credit. Eligible expenses include (1) taxable wages paid to employees who perform or directly supervise or directly support qualified research, (2) payments to contractors and outside consultants for qualified research, and (3) expenses for supplies used in qualified research.

Broadly, activities that qualify must:

Attempt to develop or improve the functionality, performance, reliability or quality of a product, process, software, invention, technique or formula ("business component");
Encounter uncertainty regarding either the company's capability or methodology to develop or improve the component, or its appropriate design;
Include a process of evaluating alternatives to eliminate the uncertainty; and
Fundamentally rely on technological principles, i.e., those of engineering or the computer, physical or biological sciences.

Unless otherwise excluded — see below — activities that meet these tests constitute "qualified research."

Many apparel manufacturers and retailers already perform qualifying activities. For example, although aesthetic changes do not typically qualify, activities related to developing or improving the construction or integrity of fabrics, dye formulas, weather-resistant clothing and footwear and material-changing technologies (sealing and sewing, etc.), comfort and shoe fit techniques, and manufacturing processes, among other activities, can qualify. If an activity is directed to improving a garment's functionality or performance and the other three criteria above are met, the activity may well qualify.

Software development may also qualify. Apparel companies are increasingly developing software to increase efficiency and improve (1) customer-facing channels, such as e-commerce and point-of-sale solutions, and (2) internal processes, such as supply chain and warehouse management systems.

Another way to determine if your company may have qualified activities is to think about the type of employees and contractors you engage. If you're paying designers, textile specialists, chemists or lab technicians, packaging engineers, sample makers and testers, process engineers, or lean manufacturing employees, you have an R&D credit opportunity worth looking into.

Finally, as observed in an Apparel Magazine article , technological advancements in such areas as smartphone commerce, wearable technology, and 3D printing are sparking correlative and derivative investments in R&D activities. The use and further development of innovative materials such asTyvek, Aerogel, Cuben Fiber, Nanofabrics, and Phase Change Materials are also likely to lead to further activities that qualify for the R&D credit. These kinds of activities are very likely to qualify.

Recent developments enhancing the R&D Tax Credit benefit

Many apparel manufacturers and retailers attempt to develop or improve software used internally to improve their manufacturing, distribution and other processes. One development helping taxpayers came earlier this year in the form of IRS-proposed regulations that make claiming software development expenses easier.

Historically, internal use software ("IUS") development had to meet a higher standard than just the four criteria outlined above. By narrowing the definition of "IUS," the proposed regulations broaden considerably the range of software development activities that are eligible for the R&D tax credit.

Under the proposed regulations, a taxpayer's software will not be treated as IUS—and thus not be subject to the higher standards — if it is developed to either (1) be commercially sold, leased, licensed, or otherwise marketed to third parties, (2) enable the taxpayer to interact with third parties, or (3) allow third parties to initiate functions or review data on the taxpayer's system.

Another development enhancing the R&D credit's benefit came last July, again in the form of IRS regulations. The new regulations allow taxpayers to elect, on an amended tax return, a simpler method of claiming the credit, the Alternative Simplified Credit ("ASC"). Previously, if the ASC wasn't elected on an original return, it could not later be elected, even on an amended tax return. The Regular Credit had to be claimed.

This development is significant because the ASC sometimes can be significantly larger than the Regular Credit, which can be zero, while the ASC can be in the hundreds of thousands or even millions of dollars. It is significant, too, because, as its name implies, the ASC is generally easier to calculate and support than the Regular Credit, which in some cases requires financial and accounting data from the 1980s. The ASC calculation requires only accounting data and only from the prior three tax years.

Select apparel businesses have already taken advantage of these developments and the R&D credit. Others are threading them into their tax strategy, and thereby reducing their taxes, freeing up their capital, and increasing their competitive edge in an increasingly competitive market.

Chris Bard is the national leader for BDO's Specialized Tax Services Research and Development (R&D) practice and chairman of BDO International's Global R&D Center of Excellence. Since 1993, Bard has worked full time in the area of U.S. federal, state, and non-U.S. R&D tax credit and incentives services, helping companies of all sizes and in virtually every industry identify more than $2 billion in R&D benefits. He can be reached at [email protected].

Chai Hoang  is a senior associate with BDO's R&D Tax Services Practice for the Northeast U.S. region. She helps clients identify R&D opportunities across a variety of industries, including manufacturing, consumer products, financial services, technology and software. Hoang can be reached at [email protected].

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