R&D Tax Credit Opportunities for Video Game Developers28 Feb 2022
Stay-at-home orders during COVID-19 accelerated video game sales drastically and this unprecedented growth is projected to continue. The global gaming market size is estimated to reach $545.98 billion by 2028 with a CAGR of 13.20% between 2021 and 2028, which will further intensify the market’s competition.
Facing competitive pressures, many game developers have leveraged advanced technology such as gesture control, facial recognition, AR, VR, stunning graphics, and wearable gaming to bring their products to the next level and thrive in the market. Fortunately, many of these innovations and advancements could qualify for R&D tax incentives that allow companies to reduce their tax liability significantly.
As tech giants like Google, Meta, and Apple expand their footprint in the gaming sector, it’s now more important than ever for game developers, especially newer or smaller ones, to increase their bottom line for continuous innovations. Staying on top of the underutilized R&D tax incentives to save thousands of dollars every tax year could make the difference between going big or going under.
The R&D tax incentives are available to game developers across the world
Currently, over 50 jurisdictions offer some form of R&D incentives, including the R&D tax credit, R&D grants, tax deductions, and payroll-related incentives. Since each R&D tax incentive and its requirements significantly vary, game developers must fully understand what opportunities are available. For example, some jurisdictions offer multiple R&D incentives, while others even provide tax relief exclusively for video game developers.
Here we will primarily focus on the R&D tax incentives offered in the U.S. However, you can find more information about the tax incentives available in other countries, including Canada, Australia, China, Japan, Korea, and the UK here.
What is the U.S. R&D Tax Credit?
The U.S. R&D tax credit is a dollar-for-dollar tax saving that directly reduces a company’s tax liability. Initially introduced in 1981, the R&D tax credit incentivizes U.S. businesses to invest in new ideas, processes, and technology to stay competitive in the global market. In 2018, the U.S. government allocated 22 billion dollars for this incentive. Eligible companies can recover up to 10% of their qualified R&D expenses.
In addition to the federal R&D tax credit, approximately 39 states provide their version of R&D credit programs. Depending on the state, qualifying companies can recover up to 12% of their expenses to offset their various tax liabilities. If they are eligible, businesses can claim both federal and state-level credits, allowing them to save millions of dollars and reinvest in their business growth.
What types of activities qualify?
R&D tax credit eligibility is much broader than many companies and their advisors realize. More often than not, we associate the term “R&D” with laboratory research conducted by scientists in white lab coats. However, when it comes to the R&D tax credit, nearly any activities developing or improving products, software, platforms, processes, formulas, inventions, or techniques are classified as R&D.
In other words, as long as your company is solving a problem that involves a process of experimentation, it most likely qualifies for the R&D tax credit.
Here is the breakdown of the game development process that is likely to contain qualifying research activities.
- Evaluating the technical feasibility of producing new products;
- Coming up with conceptual models for new games;
- Researching the suite of software and platforms to improve the games.
- Designing instructional graphics and the user interface;
- Sound designing (e.g., field recording, Foley, library-work);
- Designing graphics of characters.
- Deploying game engine as well as audio engine;
- Developing or improving cloud infrastructure;
- Implementing Virtual Reality (VR) experiences.
- Alpha/beta testing to ensure the quality of products;
- Providing feedback to developers after QA analysis;
- Improving novel or existing prototypes.
- Reducing latency or lag in gaming;
- Enhancing gameplay experience (e.g., levels, awards, teams);
- Improving manufacturing processes for hardware components.
What kind of expenses can qualify?
According to IRS Section 41(b), qualified research expenses (QREs) are the sum of in-house research expenses and contract research expenses, which are broken down into the following four categories:
Under Section 41(b)(2)(A)(i), any wages paid to employees who directly work on, supervise, or support qualifying activities are classified as QREs. Typically, the majority of credits fall within this category.
For example, here are qualifying job titles in the game development industry:
- Audio Engineers
- Computer Programmers
- Game Designers
- Quality Assurance (QA) Engineers
- Software Developers
- User Interface/User Experience (UI/UX) Developers
On top of these technical teams and individuals above, the wages of product managers, Chief Product Officers, or even the CEO could qualify. For example, suppose they are involved in technical meetings to plan conceptual models, provide feedback on new prototypes, or directly oversee cross-functional teams. In that case, you could expect to get a portion of their wages/salaries back in R&D tax credits.
Under Section 41(b)(2)(C), “supply” is defined as any tangible property other than (1) land or improvements to land and (2) property of a character subject to the allowance for depreciation. For example, if your developers use stand-alone computers that are depreciated over five years, the expenses won’t qualify for the R&D tax credit.
With that being said, here are examples of supplies that potentially qualify for the R&D tax credit:
- Video game consoles (e.g., Xbox One, Nintendo Switch, PlayStation 5)
- Mobile gaming devices (e.g., iPhone 13, iPad, Samsung Galaxy phones)
- Any other testing devices or platforms (e.g., VR Headsets, KAI Gaming Controller)
The IRS Section 1.41-2 (b)(4) spells out the rules for “computer rental expenses”. To qualify, taxpayers must meet the following requirements:
- The computer must be owned and operated by someone other than the taxpayer;
- The computer must be located off the taxpayer’s premises; and
- The taxpayer must not be the computer’s primary user.
Cloud computing services, such as Amazon Web Services (AWS) and Microsoft Azure, meet these criteria. With more than 90 percent of the world’s largest game companies using AWS, game developers shouldn’t overlook this category.
Contract Research Expenses
Under Section 41(b)(3), 65% of any expense paid or incurred in carrying on a trade or business to any person other than an employee of the taxpayer for qualifying activities can qualify for the tax credit.
For contract research expenses to qualify, a taxpayer must meet the following criteria:
- Maintain substantial rights to the research performed by the contractor;
- Bear the economic risk of the contractor’s development.
It’s also important to keep in mind that any research activities that your offshore contractors/vendors conduct beyond the border of the U.S. would not qualify for the credit.
How much can a company save with R&D tax credits?
For example, let’s say if your company determined to have the qualifying wages of $700,000 in 2021 for producing new or improved games, you could expect to save approximately $70,000, or about 10% on your federal income taxes.
Furthermore, you can claim the R&D tax credit retroactively. So, if you have never taken advantage of the R&D tax credit, you could look back three years and claim refunds for each tax year that you overpaid federal income tax.
What if your company is not profitable?
Even if you’re not yet profitable and don’t pay federal tax credit, you can still qualify for R&D tax credits. In 2016, under the Protecting Americans From Tax Hikes (PATH) Act, the IRS created a provision that allows startups to use the federal credits to offset their payroll taxes with an annual cap of $250,000. This means that businesses can offset the Social Security taxes they are paying on behalf of their employees.
To qualify, a small business must meet the following requirements:
- Less than $5M in gross receipts in one calendar year;
- Five or fewer years of gross receipts.
How can you claim the R&D tax credit?
Taxpayers can apply for the R&D tax credit by filing Form 6765 along with their federal income return for the corresponding tax year. To meet the standards outlined by the IRS and apply for the credit on a timely filed return, preparing for the financial and project-related documentation is crucial. The necessary documentation includes but is not limited to:
- Employee payroll & expense reports
- Project lists, designs, and testing reports
- Contracts with customers and vendors
- Supporting documentation, such as employee timesheets or WIP reports
Since the R&D tax credit is one of the most complicated parts of the tax form, the best practice is to work with a specialty tax consultant who has the experience and knowledge to conduct comprehensive studies for the R&D tax credit.
Take advantage of the massive tax incentives that are available to video game developers.
Most game developers are unaware that their innovation efforts can be rewarded through R&D tax incentives. By understanding the R&D tax incentives available in your jurisdiction and taking full advantage of them, you could save millions of dollars that you can reinvest in the continuous development of products.
Interested in learning more about the R&D tax credit?
Join our free webinar as IGDA welcomes Strike Tax Advisory, the industry’s best tax credit consulting firm, to discuss the gravely underutilized tax credit program. You’ll learn about easy steps game developers can take to maximize their growth opportunities.
R&D Tax Credit | The IRS Gives Video Game Developers Up To $250K to Reinvest in Innovation
Date: Thursday, 10 March, 2022 at 11:30am EST
Webinar link: https://twitch.tv/igda
Posted by Tyler Kem
Tyler is the Co-Founder & President at Strike Tax Advisory with eight years of public accounting experience. He has specialized in R&D tax credit consulting for the last five years, starting his own R&D consulting firm in 2018. Tyler enjoys educating CPAs, EAs, CFOs, attorneys, and industry leaders about THE tax credit that can make a difference.
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