Is a professional employer organization automatically barred from Washington's high-technology R&D B&O tax credit?

Plain-English summary

The Washington Department of Revenue held that being a professional employer organization did not automatically disqualify a company from the high-technology research and development B&O tax credit. The Department remanded the case, however, because it had not yet decided whether the company's software-development activity actually met all substantive credit requirements.

The company operated as a PEO and also developed software that it licensed to an out-of-state software company. The licensee paid a percentage of sublicensing revenue and certain implementation fees. During the appeal, the PEO produced a licensing agreement, financial statements, and canceled checks showing software-license income—evidence that had not been reflected in the audit's conclusion that there were no software sales.

Another Department unit denied the credit based on a Special Notice saying that a PEO's client, rather than the PEO, receives tax incentives resulting from employment of “covered employees” co-employed under a professional employer agreement. The determination read that notice more narrowly. It prevented a PEO from claiming an incentive that belongs to the client because of covered employees, but it did not impose a blanket ban on every PEO credit claim.

The PEO therefore could potentially qualify to the extent the claimed research arose from its own employees who were not covered by the co-employment agreement and the activity satisfied RCW 82.04.4452. The case was remanded to the operating divisions to verify the statutory spending test, qualifying field, personnel, expenditures, and other requirements and to recalculate the assessments if appropriate. The determination did not finally award the credit.

What this means for you

Professional employer organizations

Separate the PEO's own business activities and employees from activities performed for clients through covered employees. PEO status is not a universal disqualification, but the claimant must show that the credit-producing work belongs to the PEO and meets the incentive's substantive rules.

Software companies

Keep agreements, payment records, financial statements, and project documentation that connect software-development work to actual licensing income and qualifying Washington research activity.

Tax professionals

Do not turn an administrative notice about who receives an employee-based incentive into a broader prohibition than its text supports. At the same time, describe this determination as a remand: it resolved eligibility in principle, not the ultimate amount or allowance of the credit.

Common questions

Q: Did the PEO win the R&D credit?

A: Not yet. The Department rejected the categorical PEO disqualification and remanded for the operating divisions to determine whether the company met the substantive credit requirements.

Q: What was the significance of covered employees?

A: A client, not the PEO, receives an incentive arising from employment of workers co-employed under the PEO agreement. The PEO could still potentially claim an incentive based on work by its own non-covered employees.

Q: What evidence supported the PEO's software activity?

A: It supplied the software license agreement, financial statements showing license income, and canceled checks from the licensee.

Q: Did the determination decide how the software income should be classified for B&O tax?

A: No. It expressly said that royalties-versus-wholesaling classification was not at issue.

Q: What spending test did the ruling identify?

A: For the period governed by RCW 82.04.4452, research and development spending had to exceed 0.92% of the claimant's taxable amount for the same calendar year.

Citations and references

• RCW 82.04.4452 (high-technology R&D credit and spending test)
• RCW 82.04.540 (professional employer organizations)
• WAC 458-20-24003 (high-technology R&D incentives)
• WAC 458-20-15501(303)(a) (software wholesale sales and royalties)
• WAC 458-20-100 (Department advice)
• Department Special Notice, “Professional Employer Organizations – Deduction” (June 2, 2006)

Source

• Landing page: Washington Tax Decisions ZIP files
• Original PDF: 32WTD272.pdf
• Source archive: Volume 32 ZIP (member 32 WTD 272.pdf)

Original ruling text

Det. No. 13-0006, 32 WTD 272 (October 29, 2013)

272

Cite as Det No. 13-0006, 32 WTD 272 (2013)

BEFORE THE APPEALS DIVISION
DEPARTMENT OF REVENUE
STATE OF WASHINGTON
In the Matter of the Petition for Correction of
Assessment of
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DETERMINATION
No. 13-0006
Registration No. . . .
Document Nos. . . .
Audit Nos. . . .
Docket No. . . .

RCW 82.04.4452: HIGH TECHNOLOGY R&D CREDIT – PROFESSIONAL
EMPLOYER ORGANIZATIONS. A Special Notice entitled “Professional Employer Organizations – Deduction” does not provide a blanket prohibition against all PEOs from qualifying for a tax credit or incentive. Headnotes are provided as a convenience for the reader and are not in any way a part of the decision or in any way to be used in construing or interpreting this Determination. Sohng, A.L.J. – Professional employer organization (“PEO”) protests denial of high technology research and development credit on the grounds that it isn’t disqualified from the credit solely by virtue of being a PEO. We remand the petition. 1 ISSUE Is a PEO that may meet the substantive requirements of the high technology research and development credit under RCW 82.04.4452 potentially eligible for the credit for its activity involving software development when its only reported income is from acting as a PEO? FINDINGS OF FACT
[Taxpayer] is a Washington corporation engaged in business as a PEO.2 In addition, Taxpayer developed software . . . (the “Software”) . . . . Under a License Agreement . . . (the “License Agreement”), Taxpayer licenses the Software to [Software Company], a corporation headquartered [out of state]. Taxpayer grants [Software Company] the right to use and distribute 1 2

Identifying details regarding the taxpayer and the assessment have been redacted pursuant to RCW 82.32.410. Whether Taxpayer qualifies as a PEO under RCW 82.04.540 is not at issue in this appeal.

Det. No. 13-0006, 32 WTD 272 (October 29, 2013)

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the Software under the names [Name 1] and [Name 2]. [Software Company] markets the licensed software to its own customers. In exchange for the grant of the license, [Software Company] pays Taxpayer [a percentage] of the total gross revenue related to sublicensing the software and [a percentage] of the revenue earned from certain set-up and implementation fees related to the Software.3 During the course of the appeal, Taxpayer provided financial statements for the audit period that show that it earned income from the licensing of the Software, as well as cancelled checks paid by [Software Company] under the License Agreement. The Audit Division examined Taxpayer’s books and records for the period January 1, 2007, through September 30, 2012. The review was a partial audit and was limited in scope to a review of the research and development high technology credit that Taxpayer claimed under RCW 82.04.4452 (the “R&D credit”). On December 23, 2011, the Audit Division disallowed the R&D credit and issued Assessment No. . . . in the amount of $. . . , including $. . . in taxes and $.
. . in interest. The Taxpayer Account Administration Division (“TAA”) performed a desk examination of Taxpayer’s excise tax returns for the period October 1, 2010, through December 31, 2011, and also disallowed the R&D credit. On February 29, 2012, TAA issued Assessment No. . . . in the amount of $. . . , including $. . . in taxes and $. . . in interest. Taxpayer appeals both assessments. ANALYSIS RCW 82.04.4452 provides a B&O tax credit to persons engaged in research and development activities in Washington in one or more of the following high technology fields: (1) advanced computing, (2) advanced materials, (3) biotechnology, (4) electronic device technology, and (5) environmental technology. To be eligible for the credit, the claimant’s “research and development spending” in the calendar year for which the credit is claimed must exceed 0.92 percent of its taxable amount for the same calendar year. RCW 82.04.4452(1). “Research and development spending” is defined as “qualified research and development expenditures plus eighty percent of amounts paid to a person other than a public educational or research institution to conduct qualified research and development.” RCW 82.04.4452(7)(d). The Audit Division disallowed the R&D credit on the grounds that “[a] review of the taxpayer’s records showed no indication of software sales.”4 During the appeals process, Taxpayer provided documentation, including a licensing agreement, financial statements, and cancelled checks that substantiate that it earned income from the licensing of the Software to [Software Company] during the audit period. 5 3

See License Agreement, ¶8.
Auditor’s Detail of Differences and Instructions to Taxpayer, at 5. 5 Whether Taxpayer should have reported under the royalties classification or the wholesaling classification of the B&O tax is not at issue in this appeal. See WAC 458-20-15501(303)(a), which provides: 4

(i) Distinction between wholesale sales of prewritten computer software and royalties received for the licensing of prewritten computer software. Sales of prewritten computer software constitute wholesale sales if the reseller, who has no right to reproduce the software for further sales, sells the same software to

Det. No. 13-0006, 32 WTD 272 (October 29, 2013)

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TAA disallowed the R&D credit on the grounds that PEOs are disqualified from claiming the high tech credit: The first requirement for the eligibility of the High Technology B&O Tax Credit is the person is engaged in the business of a qualifying field. It has been determined that your business is a professional employer organization; therefore you do not qualify for the High Technology B&O Tax Credit. 6 TAA relies on a Special Notice entitled “Professional Employer Organizations – Deduction” (the “Special Notice”) issued by the Department of Revenue (the “Department”) on June 2, 2006. The Special Notice generally provides guidance on the requirements of qualifying as a PEO under RCW 82.04.540. The specific language in the Special Notice upon which TAA relies provides: Eligibility for Tax Incentives The Client (not the PEO) is eligible for any tax credit, exemption, or other tax incentive as the result of the employment of covered employees.”7 (Emphasis added.) We conclude that . . . this language merely mandates that the client, not the PEO, is entitled to take a tax credit or incentive that arises from its employment of covered employees. It does not provide a blanket prohibition against all PEO’s from ever qualifying for any tax credit or incentive.[8] . . . [To the extent the R&D credit] . . . arises from Taxpayer’s [non-covered employees’] activities in the field of advanced computing, as required by RCW 82.04.4452,
[Taxpayer may qualify for the credit]. We remand this case to the Audit and TAA Divisions (the

its customers. The true object of the sale to the reseller is the sale of the software. On the other hand, income received for granting an intangible right to reproduce and distribute copies of prewritten computer software for sale constitutes royalties. The true object of the transaction that generates royalty income is the right to reproduce and relicense the software. See subsection (308) of this section for more information on royalties. If taxpayer is unclear how to report, it can seek a ruling from the Department’s Taxpayer Information and Education section. See WAC 458-20-100. 6 Examiner’s Detail of Differences and Instructions to Taxpayer, at 1. 7 The Special Notice defines a “covered employee” as:
[I]ndividuals who are co-employed by a PEO and the PEO’s client. An employee is a covered employee when:
 The individual has received written notice of co-employment with the PEO, and
 The individual’s co-employment relationship is pursuant to a professional employer agreement between the PEO and its client. 8

[PEOs may qualify for a tax credit, exemption, or other tax incentive as a result of work performed by employees of the PEO only, i.e. employees that are not covered by the co-employment agreement, if the substantive requirements of the tax incentive are met.]

Det. No. 13-0006, 32 WTD 272 (October 29, 2013)

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“Operating Divisions”) to determine whether Taxpayer has met the substantive requirements of the R&D credit under RCW 82.04.4452 and WAC 458-20-24003.

DECISION AND DISPOSITION
We remand this case to the Operating Divisions for possible recalculation of the assessments in accordance with this determination.

Dated this 8th day of January 2013