Outside vendors are often coded as “contractors” by default. For many R&D costs, that label is wrong, and expensive.
Your engineers designed the part. A machine shop in Taiwan built it. Your team tested it in New Jersey. Chances are, your R&D Tax Credit counts that invoice as zero.
When finance teams assemble an R&D claim, anything paid to an outside vendor tends to land in one bucket: “contractor.” No one questions it, because the label seems obvious.
As a Qualified Research Expense (QRE), contract research costs count at just 65% of what you paid. If the work happened overseas, it counts at nothing.
Yet many of those invoices never paid anyone to do your research. They paid for something your team used to do the research itself.
One question separates the two: who did the experimenting? Answer it correctly, and costs that counted at 65%, or not at all, may be able to count in full.
Stop Asking Who You Paid. Ask What You Bought.
The R&D Tax Credit treats outside spending in two very different ways. Contract research is a payment for someone else to perform qualified research on your behalf, and it counts at 65% under IRC §41(b)(3). A supply is tangible property used and consumed in your own research, and it counts in full under §41(b)(2)(C).
The difference comes down to judgment versus execution. If the vendor proposed the design, weighed alternatives, and decided what worked, the vendor did the research. If your team defined the design, the vendor built it to spec, and your team tested it and decided what to change, your team did the research. The vendor supplied what you needed to do it.
| What to look for | Contract research (65% in the U.S.) | Supply (100%) |
| Who defines the design | The vendor | Your team, through drawings, specs, or formulas |
| Who decides what to change | The vendor | Your team, based on your own testing |
| What you receive | Findings, designs, or reports | A physical item: a part, prototype, or batch |
| How the PO reads | A statement of work for design or development, billed hourly or by milestone | Parts built to your drawings, priced per unit or per build |
A vendor’s price always includes its labor. That alone doesn’t make the purchase a service.
The Difference Between 0% and 100%
Geography doesn’t change the test. It changes what’s riding on it.
Research performed outside the U.S. is excluded from the credit entirely under §41(d)(4)(F). A supply works differently. If your research happens in the U.S., it doesn’t matter where the part was made.
| How the cost is classified | U.S. vendor | Foreign vendor |
| Supply used in U.S. research | 100% | 100% |
| Contract research | 65% | 0% |
For a domestic vendor, the right classification raises that cost’s QRE by more than half. For a foreign vendor, it can turn an excluded cost into a fully qualifying one.
Two recent shifts raise the stakes further:
- Deduction timing. Under the One Big Beautiful Bill Act, domestic research costs are deductible immediately under new §174A. Foreign research still has to be amortized over 15 years.
- Reporting. Under Section G of Form 6765, mandatory for many claimants for tax years beginning after 2025, QREs are reported project by project. Examiners will see exactly how vendor costs were classified.
Spotting Supplies in Your Vendor Spend
In our experience, supply costs often sit in the contractor bucket. Consider three common scenarios:
- Medical device maker. The company spends $250,000 on prototype housings machined overseas to its CAD files, then tests them in-house. Coded as foreign contract research, that’s $0 in QREs. As supplies, it’s the full $250,000.
- Food and beverage brand. A co-packer runs pilot batches of a new formulation, and the company’s team runs the shelf-life tests. That spend moves from 65% to 100%, provided no batch is sold.
- Equipment manufacturer. An engineering firm redesigns a component. This one stays contract research at 65%, because the firm did the experimenting.
The goal isn’t to reclassify everything. It’s to classify each cost correctly.
Make It Defensible
A supply position is only as strong as the evidence behind it. The good news: for past years, most of that evidence already exists.
- Looking back. Purchase orders, drawings, and test records from prior years usually show who designed and who built, and whether each item was consumed rather than sold. Because the past three tax years can often still be amended, those records can still improve a claim you’ve already filed.
- Looking forward. A few procurement habits make next year’s claim easier to defend: purchase orders that reference your drawings and price per unit or per build, and separate line items when a vendor provides some engineering as well as the build.
Contract terms support a classification; they don’t create it. Who did the experimenting still decides, and tooling or production materials won’t qualify either way.
Claim the Credit Your Research Has Earned
Go back to that part machined in Taiwan. The research was always your team’s. Classified correctly as a supply rather than foreign contract research, that invoice can count in full instead of not at all.
With deductions and reporting now both turning on how research costs are classified, vendor spend is no longer a back-office detail. Procurement language is now part of your tax position.
Not sure how your vendor costs have been classified? Book a complimentary consultation with our Innovation team. We’ll review how your R&D vendor spend has been treated, including in prior years that may still be open to amendment, and where a supply position may apply. Talk to an expert
This article is for general information only and is not tax advice. The treatment of any cost depends on its specific facts.