Examining the Legitimacy of R&D Tax Incentives

In our previous articles, we encouraged businesses to identify and recognize activities within their operations that may qualify as research and development (R&D) projects and to make use of the available tax incentives to help finance those activities. We continue to support this approach; however, in this article, we would also like to urge caution.

As with any form of state support or tax relief, R&D incentives may only be claimed for costs incurred in projects that genuinely meet the criteria of R&D activities. Furthermore, these activities and expenses must be accurately documented with a view to potential future audits. To avoid penalties, it is advisable to have projects assessed by experts and to seek professional tax advice regarding documentation requirements and tax calculations.

Tax Audits of Corporate R&D Projects

The most common form of review is a retrospective audit of the legitimacy of R&D tax incentives; however, compliance reviews of ongoing projects are also possible.

What Is the Difference Between a Tax Audit and a Compliance Review?

A compliance review may be initiated before the end of the tax period concerned and can therefore relate to an ongoing period. In addition, compliance reviews are generally more targeted and faster.

A compliance review does not result in a final, closed tax period, meaning that such reviews may be repeated. By contrast, a tax audit can generally only be initiated once for the same period, except in rare cases of supervisory or repeated audits. Taxpayers may submit self-revisions during or after a compliance review. If the tax authority identifies deficiencies during the review, it records them in a report but cannot make adverse tax assessments or determine a tax shortfall. At most, it may impose a procedural penalty. However, it may initiate a subsequent tax audit. Any difference between the tax declared and the tax that should have been declared (or any budgetary support claimed incorrectly) can only be established during a formal tax audit.

The type of procedure chosen by the tax authority depends on the level of risk identified and the taxpayer’s willingness to comply with tax regulations. Regardless of the type of review, the burden of proof lies with the taxpayer. Businesses must demonstrate that they were entitled to claim the tax incentives and that the activities concerned genuinely qualified as R&D.

Audit Methods

The tax authority may:

• Conduct on-site inspections;
• Request statements from taxpayers, subcontractors, or non-profit organizations involved;
• Carry out related audits of project participants;
• Review R&D documentation.

What Does the Authority Examine in Relation to R&D Incentives?

The authority typically assesses whether:

• The R&D activity genuinely qualifies as in-house R&D, including a review of the relevant R&D agreements and contracts;
• The R&D costs claimed for the relevant period are accurate and properly allocated.

Typical Questions Asked During a Tax Audit

• Who proposed the R&D project?
• Was the initiative formally documented?
• What were the technical, financial, and strategic objectives of the R&D activity?
• How does the R&D project fit into the company’s strategic goals?
• Does the company have a strategic plan, and if so, is the R&D project included in it?
• How is the R&D activity financed?
• How many individuals were involved, and how much time did each spend on specific tasks?
• How was the project documented?
• How was the completed successful activity finalized and documented, and does this comply with professional standards? (Not every result is patented; in some cases, companies choose trade secret protection instead.)
• Did the taxpayer conduct any internal review of the project, and were any observations documented?
• Were the underlying business transactions recorded properly and in accordance with accounting and tax regulations?

Support of R&D activities through tax incentives and direct funding

Incentives in the Hungarian tax system and direct funding for R&D projects

How Can You Identify R&D Activities Within Your Business Operations?

The Most Common Errors in R&D Projects

• Certain costs are not directly connected to the R&D activity.
• The completed R&D study does not demonstrate sufficient novelty.
• The expenditure was not incurred in the interest of the business.
• The resulting asset or intellectual property was capitalized. In such cases, only depreciation expenses may generally be claimed as a tax base reduction.

Opportunities Most Frequently Missed by Businesses

The issues listed below do not typically lead to tax authority penalties, but they mean that the company has failed to take advantage of available risk-management or financing opportunities.

• The company does not obtain an official R&D qualification ruling, even though this could significantly reduce future audit risks.
• The company does not capitalize eligible costs, despite the fact that loss carryforward limitations may make capitalization advantageous by deferring the recognition of costs.
• In addition to expensing R&D costs against pre-tax profit, further tax base reduction opportunities may be available, but companies fail to utilize them because they are uncertain about the R&D classification of their activities.

At the end of our article series, it is worth revisiting what research and development actually means. R&D is creative work aimed at expanding knowledge, developing new applications, and resolving scientific or technological uncertainty. To qualify as R&D, the activity must be novel and must be carried out systematically, using scientific methods, appropriate expertise, proper planning, and thorough documentation. By keeping these criteria in mind, businesses can identify genuine R&D projects within their operations. Overlooking such projects and missing out on available tax incentives can be just as costly as mistakenly classifying routine business activities as R&D. With the support of an experienced advisor, both mistakes can be avoided.