Cloud computing is changing all aspects of business from operations to collaboration. Getting the most out of cloud computing often takes some heavy lifting in the research and development department. These platform innovation costs may be qualified research expenses (QREs) and eligible for research & development (R&D) federal and state credits.
How we got here
The idea of expensing “leased” computing power dates back to the introduction of R&D credits in 1981. Back then, few companies had computers. It was standard practice to “lease” computer time from the government, using mainframe supercomputers for experimentation and discovery. These huge computers took up entire floors and required additional air conditioners to cool the room. Thus, legislators included leased computer costs (LCC) as part of the credit as evidence in IRC Sec. 41(b)(2)(A)(iii) Under regulations prescribed by the Secretary, any amount paid or incurred to another person for the right to use computers in the conduct of qualified research.
As more computing power made its way into desktop computers, taxpayers shifted away from LCC to buying computers used for research and development. And now, a reversal is taking place to cloud computing. It is now cheaper and easier to innovate by leasing cloud computing time than to purchase servers and outfit data centers. Here too taxpayers may be able to take advantage of R&D credits.
Federal credits
The total economic impact of cloud-based innovation is expected to be between $1.7 trillion and $6.2 trillion annually by 2025, according to McKinsey & Co. Companies are using this pooled computing power to drive innovation at generally three different service levels:
- Servers (IaaS)
- Platform (PaaS)
- Software application (SaaS)
The cloud computer costs associated with innovation using these services may be eligible for federal tax R&D credits when:
- The cloud is operated by someone other than the taxpayer and located off the taxpayer’s premises; and,
- The taxpayer is not the primary user of the computer.
QREs specifically include computer costs used for in-house research as a platform for business innovation. This includes cloud hosted development platforms and beta testing of pre-released software programs. It does not include operating platforms.
To qualify for the federal credit, LLC servers must be located in the United States and the taxpayer must properly document where the developmental cloud costs are occurring. The taxpayer may further benefit from state-level credits, where available, in the state where computing takes place and LCC is defined as a qualified research expense.
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Jamie Overberg can be reached at joverberg@taxops.com.
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