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Investment Tax Credit

Moneyzine Editor
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Moneyzine Editor
2 mins
January 23rd, 2024
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Investment Tax Credit

Definition

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.

Explanation

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.

Related Terms

Income Taxes
The term income tax is used to describe federal and state tax obligations payable on individual or business income. Income taxes are computed by completing tax forms available from the Internal Revenue Service.
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Assets
The accounting term used to describe an economic resource, which is owned by the corporation and expected to provide future benefits to its operation, is asset. Appearing on the balance sheet, assets are typically broken down into two categories:
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Depreciation
The financial accounting term depreciation is sometimes defined as a decline in tangible plant's service potential. Depreciation is a method of allocating the cost of a tangible asset in a systematic manner to those time periods that benefit from the use of the asset.
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Amortization
The accounting term used to describe the expiration of intangible assets such as patents or goodwill is amortization. As is the case with the depreciation of a tangible asset, the amortization of an intangible asset is shown on the income statement as an expense of the company; thereby reducing net income over the years this benefit is realized.
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Depreciable Base
The financial accounting term depreciable base is used to describe the value that is divided by the service life of the asset to determine the annual depreciation expense under the straight line method. The depreciable base is the value of the asset to be written off over time.
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The financial accounting term service life is used to describe the period of time over which an asset can be expected to perform its intended use. Service life is typically limited by two factors: physical wear and obsolescence.
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The financial accounting term research and development costs refer to those expenses associated with investigations into new processes or techniques (research) and the translating of this information into new designs, products, or processes (development).
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