December 8, 2022
December 8, 2022
If Congress creates a tax break to encourage businesses to conduct research that benefits society, should Netflix be eligible for it? There is no shame in binge-watching Stranger Things or Bridgerton or The Crown, but how many of us really think Netflix deserves a tax break for whatever “research” the company did to provide this entertainment? And does it matter that over the past four years, Netflix has paid less than 1 percent – just 0.8 percent, to be precise – of its profits in federal corporate income taxes?
Few lawmakers have asked such questions about a popular proposal to extend the rule allowing businesses to “expense” their research activities. Netflix is just one of many corporations that has openly lobbied for this break, which is one of several expiring business-friendly tax provisions that could be extended as part of a year-end legislative package. Every lawmaker wants to express support for research and innovation, but very few seem to be asking what exactly this tax break has accomplished.
Research Expensing vs. Research Amortization
In the 1950s, Congress enacted a rule allowing research expensing, meaning businesses could immediately deduct the costs of research activities when calculating the taxable income they report to the IRS. This deviated from economic logic, which would require businesses to deduct these costs over time (to amortize them) until the fruits of that research lose value and stop generating income. A new rule that came into effect for 2022 more closely follows economic logic by requiring businesses to amortize research expenditures over 5 years.
Income tax rules generally try to match business expenses with the income they produce, but the research expensing provision has long been an exception without a coherent justification. To take a straightforward example, a pharmaceutical company could conduct research that results in a new drug and then procure a patent from the government that gives it the exclusive right to sell that drug for 20 years. The company’s goal is clearly to generate income from this patented drug for 20 years. So, why should the company be allowed to deduct the costs of that research all in one year, as was the case until this year?
The answer, according to supporters of the expensing provision, is that research produces benefits that spill beyond the person or company conducting it and that flow to the greater society. This sounds plausible in theory. But in practice, the positive impact of this tax break is less clear. What about corporations that use the research tax break, in combination with other tax breaks, to avoid most of their income tax liability? Do lawmakers really believe that profits of companies should not be taxed if the companies claim to do research? And what exactly constitutes “research” anyway?
Some Corporations Lobbying for Research Expensing Pay Very Little in Taxes
Big companies have come together as the R&D Coalition to lobby Congress to retroactively repeal the research amortization provision (and therefore extend the more generous research expensing rule).
The federal statutory corporate income tax rate is 21 percent, which means that if corporations received no special breaks or loopholes at all, they would pay 21 percent of their profits in taxes. But many of the companies involved in this lobbying campaign have effective income tax rates that are much lower, sometimes in the single digits thanks to extensive tax breaks and loopholes. This raises the question of whether lawmakers believe corporations claiming to conduct research should be effectively exempt from most of the corporate income tax.
Of the dozen companies on the Coalition’s leadership committee, the biggest is Amazon, which reported $78.6 billion in profits to investors from 2018 through 2021 and paid just 5.1 percent of that amount in federal corporate income taxes.
Beyond the dozen companies leading the coalition, many more have joined the lobbying blitz. For example, Verizon signed onto the R&D Coalition’s letters urging Congress to extend research expensing in October and November and also signed a similar letter from the Business Roundtable. From 2018 through 2021, Verizon paid federal corporate income taxes equal to just 8.4 percent of the $88.2 billion in profits it reported during that period.
Honeywell joined all these letters, plus another letter that the R&D Coalition sent to Congress in March. With calculations we have not published previously from Honeywell’s corporate 10-Ks, we conclude that the company paid federal corporate income taxes equal to just 5.9 percent of the $14 billion in profits it reported to shareholders from 2018 through 2021.
Perhaps the biggest winner is Netflix, which paid federal corporate income taxes equal to just 0.8 percent of its $10.5 billion in profits from 2018 through 2021 thanks to the many tax breaks it enjoyed, including the research expensing provision. Perhaps Netflix has tried until recently to avoid calling attention to itself as a company lobbying for tax breaks, but by November it had openly joined the R&D Coalition’s efforts.
What Constitutes Research That Deserves a Tax Break?
Netflix is also an example of a company that poses another quandary. What research should be subsidized through our tax code? To most Americans, the term “research” probably involves people in laboratories handling test tubes or someone figuring out how to build a smaller microchip. But many of the companies and business associations lobbying for the extension of research expensing do nothing like that. Below are some examples of companies that have signed onto at least one of the letters mentioned above and apparently have claimed the tax break for activities that most Americans would not call “research.”
Request Foods Inc. develops and creates frozen and packaged food for national food brands and food services. Request signed onto the Business Roundtable letter calling Congress to extend research expensing as well as the R&D Coalition’s October letter. Its website says, "Request Foods is your co-packing partner. With 600,000 sq. ft. of cooking, blending, freezing and packing capacity, we are your one-stop resource for R&D and processing.” It does research and development – in a test kitchen. Of course, we are all overworked and who has not resorted to frozen dinners and processed foods more than they want to admit? But whether this particular R&D warrants a tax subsidy seems like a different question entirely.
Other food companies have joined some of these letters as well, ranging from massive corporations like the Kraft Heinz Company and Tyson Foods to smaller businesses like Glier's Meats. Glier’s, which joined the BRT letter and the R&D Coalition’s October letter, sells a sausage that is popular in Cincinnati. According to all reports the sausage is pretty good, but what exactly is the sausage-related research requiring assistance from the Treasury of the United States?
Or how about the New Holland Brewing Company, which is the largest craft brewery in the state of Michigan? Shouldn’t lawmakers ask what exactly is the beer-related research that will benefit society only if it receives a subsidy through our tax code? What innovation will we be deprived of if such support is not forthcoming?
Nor should lawmakers limit themselves to examining food and beverage companies. The BRT letter and one of the R&D Coalition letters was signed by the International Sleep Products Association (ISPA), which describes itself as a “united, outspoken voice for the mattress industry.” It is quite possible that research carried out by the members of this association has made some of us happier. It certainly seems that there are more mattress options than existed 30 years ago, and who does not like a comfortable mattress? But do lawmakers touting research and innovation have any idea that they are directing resources to support the development of another layer of memory foam?
Or maybe Congress should look into the Fragrance Creators Association, which also joined the BRT letter and an R&D Coalition letter. This entity is “an association of creators grounded in safety and passionate about making our world a better place through the power of scent.”
Another company worth examining is Galaxy Gaming, a developer of electronic games for casinos, which signed the R&D Coalition’s November letter.
Someone should probably also find the time to ask 365 Retail Markets, which also signed the R&D Coalition’s November letter, how exactly their research is benefiting the society that is paying for its tax breaks. The company calls itself “the global leader in unattended retail technology.” That sounds like a way to describe a company that develops machines to replace human workers. Research and innovation are good for society, but it might be worth occasionally questioning whether the research we subsidize through our tax code in some cases destroys more jobs than it creates.
The Definition of Research
According to the IRS, section 174 of the tax code, the provision that until recently allowed research expensing, could be used for business expenses that “represent a research and development cost in the experimental or laboratory sense.” (Another section of the tax code, section 41 provides a tax credit for research activities that meet this standard and also meet other requirements.)
The IRS explains that “Expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.”
This is an extremely vague standard, but at least certain activities have been clearly ruled out by statute or regulation. Research, for the purposes of section 174, does not include quality control or management studies, for example. It does not include advertising or buying a patent from another company. It does not include historical research, so presumably, Netflix did not try to expense the costs of studying the Windsors’ genealogy when it produced The Crown.
But did Netflix do any kind of research that deserves to be rewarded with a tax break? Whatever advances it made in streaming content have certainly made life more pleasurable for many of us. And it is true that the benefits of this research may not be entirely captured by Netflix and its shareholders. Some of its innovations might be copied by other companies or some of Netflix’s staff could defect to its competitors and take with them much of the know-how they developed conducting research.
But one still wonders if subsidizing all the research described here is the best use of national resources that Congress seems to think are in short supply. Congress allowed an expansion of the Child Tax Credit to expire after it lifted 2.1 million children out of poverty. It is impossible to believe that subsidizing Netflix’s research activities is a higher priority than extending some part of the successful Child Tax Credit policy, but this is apparently how many lawmakers feel.