Limits of tax regulation: Evidence from strategic R&D classification and the R&D tax credit

We investigate a tax avoidance strategy where firms use the ambiguity inherent in tax reporting to classify indirect costs as research and development (RD) expenditures to take advantage of the RD tax credit. We label this tax practice “strategic RD classification”. We find a one standard deviation increase in strategic RD classification leads, on average, to a 1.7% (1.5%) reduction in GAAP (cash) effective tax rates, suggesting this practice provides significant tax savings. However, we also find strategic RD classification is related to both the level and changes in uncertain tax benefit liabilities required to be recognized under FIN 48, suggesting this practice comes with financial reporting costs. Our study contributes to the literature by documenting some of the costs and benefits associated with a previously unexplored tax strategy, and highlights the limitations faced by tax authorities in monitoring firms’ RD tax credit.