Behind the Big Profits: A Research Tax Break

Strong first-quarter corporate profits may not be quite as good as they look.

An analysis by The Wall Street Journal shows that the extension of a big tax credit quietly boosted the profits of dozens of companies. Under accounting rules, the companies reported a year’s worth of benefits from the research-and-development tax credit in their first-quarter results, lifting profits for many of them by more than 10%.

With first-quarter results nearly complete, 465 participants in the Standard & Poor’s 500-stock index cumulatively reported that revenue increased 2.1% from the same period a year earlier. Expenses grew slightly faster, so pretax profit rose only 0.9%, according to the Journal’s analysis.

But the S&P-500 companies also set aside 5.6% less money for taxes, and that helped their cumulative profits grow a robust 6.7%, the Journal found.

The biggest reason they took that action: the extension of the research credit and other tax breaks in January, said Jeffrey Hoopes, a lecturer in accounting at Ohio State University whose recent doctoral dissertation examined the issue.

For some companies, the effect was dramatic. Internet giant Google Inc. GOOG +0.53%reported spending $6.8 billion on research and development in 2012, making it one of the nation’s biggest corporate research spenders.

The company set aside less than half as much money for first-quarter taxes as it did a year earlier even as its pretax income increased 2%, to $3.6 billion. Its effective tax rate fell to 7.9% from 18.5%. In a securities filing, Google said the drop was “primarily” due to the extension of the tax credit. If Google’s profit had been taxed at the same rate as last year, the company would have had to set aside an additional $380 million for income taxes.

“This tax credit was introduced over 25 years ago to stimulate innovation—and that’s exactly what we use it for,” a Google spokeswoman said.

Behind the Big Profits: A Research Tax Break

The first-quarter tax rate of semiconductor maker Intel Corp.INTC +0.36% also declined, to 16.3% from 28.2%, in the 2012 first quarter. Intel reported $10.1 billion in research spending last year, more than any other publicly traded U.S. company. It said the “substantial majority” of the decline stemmed from extension of the research credit. If Intel’s profits had been taxed at last year’s rate, it would have set aside an additional $290 million.

Big companies cited a variety of reasons for reporting smaller first-quarter tax bills. In addition to the tax-credit extension, pharmaceutical maker Merck MRK +0.73% & Co. reported a $160 million benefit from resolving an old tax dispute between the Internal Revenue Service and Schering-Plough Corp., which Merck acquired in 2009. Insurance company Cigna Corp. CI -0.16% said its tax rate declined because of changes to its reinsurance and disability businesses.

But extension of the research credit weighed heavily. The credit, which applies to increases in research spending, costs the federal government more than $7 billion annually, according to the Senate Finance Committee. First adopted in 1981, the credit has been extended 15 times, but it has never been made a permanent part of the tax code.

The previous extension expired at the end of 2011, meaning that companies couldn’t claim the credit last year. That quietly increased tax rates—and hurt earnings—last year. Under the measure approved in January, the research credit will again expire at the end of this year, raising the prospect of future distortions in corporate earnings.

Research-heavy technology and pharmaceutical companies benefit most from the credit. In 2009, the latest year for which statistics are available, the Internal Revenue Service said that more than half the $7.7 billion in credit was claimed by companies in three industries: computer and electronics manufacturing, chemical and pharmaceutical manufacturing, and transportation manufacturing.

Within those industries, said Nirupama Rao, an economics professor at New York University, the bulk of the credits are claimed by the largest companies. “It’s big corporate America,” Ms. Rao said of the beneficiaries. “Small firms aren’t profitable enough to get the credit.”

For example, aircraft-maker Boeing Co. BA +0.77% said that extension of the credit reduced its first-quarter income-tax provision by $145 million. Boeing’s tax rate fell to 23.1% from 36.8% in the first quarter a year earlier. Boeing reported spending $3.3 billion on research and development in 2012.

It’s unclear how well investors anticipated the additional tax benefits. The accounting implications were known when Congress approved the extension as part of a deal to resolve the so-called fiscal cliff on Jan. 1. But a spot check by Thomson Reuters found that, of a dozen big beneficiaries of the credit, analysts excluded the impact from their earnings estimates at only one: Texas Instruments Inc. TXN +0.14%

Looking ahead, the unusual benefit from extension of the tax credit won’t help corporate profits for the rest of this year. Analysts surveyed by Thomson Reuters project that S&P 500 earnings will rise 2.7% in the second quarter, about half the growth rate of the first quarter.

“The effective tax rate we saw in the first quarter is not representative of what we’ll see in the rest of the year,” said Alex Morozov, head of the health-care analyst team at Morningstar.