Investment Tax Credit
The term investment tax credit refers to a number of business credits characteristically used by government entities to stimulate an economy. Typical credits include disaster relief, research and development, non-petroleum fuels, and alternative fuel vehicles.
Unlike a tax deduction, which serves to reduce taxable income, a tax credit reduces the actual amount of taxes owed on a dollar-for-dollar basis.
Typically, the types of investments or expenditures that qualify for an investment tax credit, or ITC, will depend on government policy and will vary over time. By providing a tax credit, government bodies (federal, state) can incent businesses to increase their investments in certain geographies, industries, and technologies.
Unlike a tax deduction, which lowers a company’s taxable income, a credit reduces the taxes owed on a dollar-for-dollar basis. For example, a one dollar tax deduction provides a savings of $0.40 for companies in the 40% incremental tax bracket, while a credit provides a savings of $1.00.
Generally, there are two ways a company can account for an investment tax credit:
- Flow Through / Tax Reduction Method: the credit is viewed as a selective tax reduction that applies at the time of purchase and the income tax expenses for that period are reduced by the credit. Companies that advocate this method believe the purchase creates the credit.
- Deferral / Cost Reduction Method: the credit is allocated to the accounting periods over which the asset is depreciated. Companies that advocate this method believe the asset creates the credit.
The flow through method is used when tax credits are related to expenses (non-asset purchases); thereby flowing directly to the income statement in the year of the purchase. An investment tax credit can be recognized either by directly reducing income tax expense or by providing an offset to the accounting expense that provided the credit.
Under the cost reduction method, whereby the credit was provided when the company purchased an asset, the credit is amortized over the same accounting periods as the asset is depreciated. Here again, a company has two choices. They can deduct the credit from the asset base and calculate the depreciation expense on the net amount. Alternatively, the company can amortize the tax credit over the asset’s serviceable life.