Overview of Changes to the Texas R&D Credit

1. Increased Credit Rates and New Tiers

• Standard Credit Rate: The R&D franchise tax credit rate increases from 5% to 8.722% of the difference between current-year qualified research expenses (QREs) and 50% of the average QREs for the three preceding tax periods. This substantial increase is intended to make Texas more competitive and attractive for R&D investment.
• Enhanced Rate for University Research: Taxpayers that contract with Texas public or private institutions of higher education for qualified research are eligible for an even higher credit rate of 10.903%. This is a significant incentive for companies to collaborate with Texas universities and colleges.
• No Prior QREs (Base Rate): For businesses with no QREs in one or more of the prior three years, a base rate of 4.361% applies (or 5.451% with a university partnership). This provision is particularly beneficial for startups and new entrants to R&D activity in Texas, allowing them to access the credit even without a multi-year R&D history.

2. Alignment with Federal Law and Enhanced Definitions

• Definition of QREs: The new law directly ties the definition of QREs to the amount reported on line 48 of IRS Form 6765, but only for research conducted in Texas. This change provides clarity and consistency, reducing disputes over which expenses qualify for the Texas R&D credit.
• Reference Year for Federal Law: The Texas R&D credit calculation will now follow federal law as in effect for the federal tax year for which the federal credit is claimed, rather than being tied to a fixed version of the Internal Revenue Code. This dynamic linkage ensures that Texas R&D credit rules remain current with federal changes.
• Federal Audit and Amended Return Adjustments: If a taxpayer files an amended federal Form 6765 or is subject to an IRS audit that changes the amount of QREs, the Texas R&D credit calculation will automatically follow the federal outcome. This includes both increases and decreases in QREs and applies whether the change is due to an amended return or a final IRS audit determination. This provision is intended to streamline compliance and reduce administrative burdens for taxpayers and the state.

3. Carryforward and Refund Provisions

• Carryforward: Unused credits may be carried forward for up to 20 consecutive franchise tax reports. This long carryforward period allows taxpayers to maximize the benefit of the credit, even if their tax liability is low in a given year.
• Refundable Credit: For entities that owe no franchise tax (including those below the “no tax due” threshold and new veteran-owned businesses), the credit is refundable. This is a major change from prior law and is designed to ensure that startups, small businesses, and veteran-owned businesses can benefit from the credit even if they are not currently paying franchise tax. The application for a refundable credit must be submitted on or before the due date for the report for the period in which the credit is claimed.

4. Combined Reporting and Tiered Partnerships

• Combined Groups: Credits for QREs incurred by a member of a combined group must be claimed on the group’s combined report. The combined group is treated as the taxable entity for purposes of the credit.
• Tiered Partnerships: Upper-tier entities may claim credits for QREs incurred by lower-tier entities, proportionate to their ownership interest. This provision ensures that the benefit of the credit flows appropriately through complex business structures.

5. Limitations, Assignment, and Administrative Provisions

• Credit Limitation: The total credit claimed (including carryforwards) may not exceed 50% of the franchise tax due for the report before other credits. This limitation is unchanged from prior law and is intended to ensure that the credit does not eliminate a taxpayer’s entire franchise tax liability.
• Assignment/Transfer: Credits may not be assigned or transferred except in the case of a transfer of substantially all assets of the taxable entity. This restriction prevents trading of credits and ensures that the benefit remains with the entity that incurred the R&D expenses.
• Statistical Sampling and Evidence: The law allows the use of statistical sampling procedures, as permitted by IRS Revenue Procedure 2011-42, for determining QREs. If the IRS or the Texas Comptroller accepts a taxpayer’s adjusted ASC 730 financial statement R&D costs as sufficient evidence for federal credit purposes, the Texas portion of those costs is also sufficient for the Texas R&D credit.
• Transition for Existing Credits: The repeal of the prior R&D credit regime does not affect unused credits authorized to be carried forward under the old law. Taxpayers may continue to apply those credits on each consecutive report until the date the credit would have expired under the prior law.

6. Elimination of the R&D Sales and Use Tax Exemption

• The sales and use tax exemption for depreciable tangible personal property used in qualified R&D activities (Texas Tax Code Sec. 151.3182) is repealed effective January 1, 2026. This means that, going forward, taxpayers will no longer be able to claim a sales tax exemption for R&D equipment and must instead rely on the enhanced franchise tax credit.

Implications for Taxpayers

The new permanent R&D credit provides a more predictable and generous incentive for R&D investment in Texas. Taxpayers should review their R&D activities and consider the impact of these legislative changes and increased credit rates. Additionally, the new refundable credit will be particularly important for entities with no franchise tax liability, such as startups and small businesses, that likely were utilizing the sales tax exemption for R&D equipment before its repeal. Lastly, because the Texas R&D credit is now closely tied to the federal Form 6765, maintaining robust federal R&D documentation is critical. Taxpayers should ensure that their Texas QREs are properly tracked and documented, and that any changes to federal returns or audit outcomes are properly reflected in Texas franchise tax reports. We have put together a one-page summary table comparing the Texas R&D credit under the old and new versions. 

Client Alert 2025-166