Contractors, Remote Employees, and the R&D Credit
Two of the most common questions with distributed or international workforces:
1. Do our offshore contractors count toward the R&D tax credit?
2. Do remote employees based outside the United States count toward the R&D tax credit?
The short answer: where the work is performed determines whether it qualifies. The employment structure, tax treatment, and business arrangement are all secondary to geography.
Understanding the rules governing foreign research contract research expenses under IRC §41 essential for any company with development workhappening outside U.S. borders.
The Foreign Research Exclusion
IRC §41(d)(4)(F) excludes any research conducted outside the United States, the Commonwealth of Puerto Rico, or any possession of the United States from the definition of qualified research.
The exclusion applies regardless of who is performing the research. This includes:
- An American employee working remotely from another country
- A U.S.-based company directing a foreign contractor
- U.S. Citizens on a temporary international assignment
The IRS Audit Techniques Guide states clearly: “The foreign research disallowance applies even if the research is done by American researchers, or performed for an American Taxpayer."
The exclusion applies to in-house research expenses and contract research expenses; there is no mechanism in the statue to include foreign research costs in a company’s qualified research expenses (QREs), regardless of how the work is structured or invoiced.
The Location Test
For W2 employees, wages paid for qualified services constitute in-house research expenses under IRC §41(b)(2)(A)(i). But wages only qualify to the extent the underlying research is performed within the U.S.
A U.S.-based company employing a software engineer who is physically located in Germany while performing development work cannot include that engineer’s wage as QREs for the time spent working outside of the U.S. The research is being conducted elsewhere, regardless of where the employment relationship is domiciled or where the wages are reported for tax purposes.
Tres. Reg. §1.41-2(d) requires wages to be allocated based on the portion of an employee’s time spent performing qualified services. In cases where an employee performs work inside and outside the U.S., only the portion of wages attributable to work performed within the U.S. is eligible to be treated as a QRE.
For companies who split their time between domestic and international locations, this means the portion calculation will matter. A qualified R&D tax credit specialist will be able to distinguish time records combined with project documentation and work location records to calculate what share of an employee’s wages qualifies.
Domestic Remote Workers Are Not Affected
An employee working remotely from a home office in Texas, a co-working space in Colorado, or rented office in New York would be performing research inside of the U.S. The geographic test would be satisfied in these cases. The remote nature has no effect on the QRE analysis if the remote work is performed domestically.
Offshore Contractors: the 65% Rule
When a company pays an independent contract or third-party firm to perform qualified research, the resulting expenses are treated as a contract research expense under IRC §41(b)(3). Key features of this treatment are:
- Only 65% of contractor payments count toward QREs. IRC §41(b)(3) generally limits contract research expenses to 65% of qualifying amounts paid to nonemployees.
- The foreign research exclusion applies to contract research as well. A company cannot include any portion of payments to an offshore contractor performing research outside the U.S. in its QREs, even at the 65% rate. The geographic exclusion operates independently of the 65% limitation.
- The taxpayer must bear the economic risk. For contract research to qualify even at 65%, the taxpayer must bear the financial risk of the research regardless of the outcome. If a contractor is paid a fixed fee and retains rights to the results, or if the research is funded by a third party who bears the risk, the funded research exclusion under IRC §41(d)(4)(H) may eliminate the credit.
- The taxpayer must retain substantial rights to the results. Contract research qualifies only if the taxpayer retains substantial rights to the research product. If the taxpayer does not retain substantial rights, the contract research may fail to qualify. This is a distinct requirement from the economic risk test, and both must be satisfied.
Mixed Arrangements: Domestic & Offshore Work on the Same Project
Many companies use development teams that include both domestic and offshore contributors working on the same project. This is one of the more complex QRE scenarios in practice.
The rules require apportionment in these cases. From a contractor standpoint, Treas. Reg §1.41-4A(b) provides that only a portion of a contract amount attributable to research performed within the U.S. is eligible to be treated as a contract research expense. The 65% limitation then applies to that U.S. attributable portion.
For practical purposes this mean the company needs documentation that can differentiate domestic from offshore work on a project level. That documentation doesn’t need to follow any prescribed format, but it does need to support that allocation, which is something an R&D tax credit consultant can assist with.
Common approaches include time-tracking systems that capture work location, project management platforms that log where contributors are located and what they are working on, and contractor agreements or statements of work that include geographic scope of said activities.
What This Means in Practice
A few examples of how common scenarios may play out:
1. U.S. company, offshore development team doing all feature development: If the dev team is completely offshore, there are generally no QREs attributable to that team’s work. The company may still qualify based on domestic employees who provide direct supervision, provide technical direction, conduct code review, perform quality testing, or management of the dev process within the U.S, but only for the domestic portion of that work.
2. U.S. company, remote U.S. employee who spends several months abroad: The wages for the period worked outside the U.S. are excluded, and the wages for the period worked within the U.S. qualify, assuming the work performed meets the four-part test. Location records and documentation of each period of work will be important for this employee.
3. U.S. company, hybrid team with both U.S. and offshore contracts: The U.S. based contractors’ work qualifies at the 65% rate, assuming the economic risk and substantial rights conditions are met. The offshore contractors’ work does not qualify. Apportionment documentation is necessary if the project cannot be separated into domestic and offshore segments cleanly.
4. U.S. company, domestic SaaS product maintained by a mix of in-house U.S. engineers and an offshore QA firm: The in-house engineers’ wages may qualify at 100% dependent on the amount of work time spent on qualifying activities. The offshore QA firm’s fees do not qualify for any of the credit. If a domestic QA firm is also performing any of the QA work, those fees may qualify at 65%.
Supply Costs – Even Foreign-Sourced – Can Count
Wages usually make up a large share of a QRE calculation, but supplies are in the category businesses can overlook, especially when those supplies come from overseas vendors.
Under IRC §41, QREs include any amount paid or incurred for supplies used in the conduct of qualified research. The statute defines supplies as any tangible properly other than land or improvements to land, and property of a character subject to the allowance for depreciation. In plain terms, that means raw materials, components, prototype parts, test batches and other consumable items your team uses up in the research process.
Why does this matter? Because some business owners assume that supplies purchased overseas will not count because of the foreign research exclusions. This is not true. What matters is where the research is performed, not where the supplies are purchased. If the research is performed domestically, the supplies’ origins will not affect the claim.
Of course, the credit will only apply to the supplies used in qualified activities; materials purchased for routine production runs, general inventory, or overhead do not belong in your claim. Capital equipment also does not qualify; depreciable property is excluded from the definition of supplies. The same documentation applies to supplies as wages: track the materials that went into qualifying activities versus routine to ensure the claim can withstand scrutiny.
The Documentation Requirement
The foreign research exclusion is examined by the IRS, meaning the documentation will remain important when filing for R&D tax credits. Regulations in Form 6765, required for 2026 filings, asks for QREs to be reported by business component with wages categorized by research role, which will make domestic and foreign apportionment have been tracked at the project or component level, no reconstructed in aggregate at year-end.
Documentation does not have to be overly scientific, and while it may seem complicated, this is where a qualified R&D tax credit expert is helpful; they have been specifically trained to find and organize these for clients.
Key Takeaways
The rules around foreign research and contract research expenses are straightforward and directly determine how much of a company’s workforce activity generates a credit. The questions to resolve are:
1. Where is the research physically performed? If outside the U.S. it will not qualify.
2. Is the worker an employee or contractor? In-house employees generate in-house research expenses at 100%, while contractors generate 65%, with the geographic exclusion still applying.
3. Does the company bear the economic risk and retain substantial rights? If not, the contract research exclusion may eliminate the credit.
4. Can the allocation between domestic and foreign work be documented? If not, you may leave money on the table.
RK Partners
RK Partners specializes in R&D tax credit documentation and compliance for companies in a wide range of industries. If your business employs people domestically and offshore, and you’re uncertain about whether you qualify, or which work may qualify, we are happy to talk through it with you on a risk-free consultation.
