Implications of Recent Rulings on the Research & Development Tax Credit
By Karim Solanji, J.D. and Saqib Dhanani, J.D.
2009 has been an exciting year for the Research and Development Tax Credit (R&D Tax Credit). The R&D Tax Credit has seen numerous changes due to the following recent court cases: Union Carbide, McFerrin, and FedEx. While these cases have shaped the credit mostly in favor for the taxpayer, there are rulings that are less favorable to taxpayers.
On March 10, 2009, Judge Goeke of the United States Tax Court handed down a lengthy opinion in the Union Carbide and Subsidiaries (UCC) v. Commissioner Case (UCC Decision). Although the decision approved of only a small percentage of the UCC’s sought credit, the ruling included several favorable elements that may benefit taxpayers as well as clarified many longstanding areas of confusion for those claiming the R&D Tax Credit. However, the UCC Decision also included rulings that were more stringent to taxpayers.
The UCC Decision seems to have abolished the “Discovery Test” once and for all. This greatly benefits taxpayers as the IRS has been inconsistent in its treatment of the “Discovery Test”, especially when auditing R&D Tax Credit claims from years prior to the issuing of its 2004 final regulations (T.D. 9104). The Court applied its new “technological information test” and stated that it was satisfied so long as the knowledge sought was technological in nature.
Additionally, the UCC Decision formally rejected the IRS’s more stringent requirements and will now accept estimates based upon employee recollection and extrapolation methods as valid evidence of qualified research expenditures. Further, the Court allowed UCC the “Cohan Rule”. The Cohan Rule as used by the IRS, historically applied only to individuals and small businesses, allows taxpayers under certain circumstances to obtain deductions by submitting reasonable estimates when proof of the exact amounts are unavailable. The Court determined that even a large corporation such as UCC could be afforded the Cohan Rule, and as such, employee interviews and oral testimony corroborated by documentation constituted reasonably sufficient evidence of qualified research activities and expenditures.
Furthermore, the UCC Decision also favored taxpayers by limiting the application of the Consistency Rule, which required taxpayers to calculate base-year and claim-year qualified research expenditures using the exact same method. In short, taxpayers are not required to rely on the same documentation for determining the qualified research expenditures for the claim years as for the base period.
In a slightly more (taxpayer-stringent) ruling/clarification (to taxpayers), the UCC Decision also emphasized the significance and relative requirements of the experimentation process. The ruling specifically states that in order “to satisfy the process of experimentation test, the taxpayer should develop a hypothesis as to how a new alternative might be used to develop a business component, test that hypothesis in a scientific manner, analyze the results of the test, and then either refine the hypothesis or discard it and develop a new hypothesis and repeat the previous steps.” Following this strict guideline, the Court required that qualified research activities must be part of a systematic process of experimentation that had to be developed in advance of performing the activity so as to address the various uncertainties at the project’s outset.
Most importantly as a result of the UCC Decision, taxpayers now benefit from the favorable ruling allowing data extrapolation, employee recollection, and other corroborating documentary evidence for estimation as valid determinations of the R&D Tax Credit in both the claim-year as well as base-year calculations.
Similarly, the court in US v. McFerrin set new precedent for taxpayers applying for the R&D Tax Credit. The crux of the decision rested with the courts ruling on substantiation and oral testimony. The Fifth Circuit found that if a taxpayer can show activities that were "qualified research," then the court could estimate the expenses associated with those activities. The district court need not have credited the taxpayer’s reconstruction of expenses from years after the fact, but the district court ought to have looked to testimony and other evidence, including the institutional knowledge of employees, in determining a fair estimate.
McFerrin provides the following rules:
- The 2004 final regulations apply retroactively to research credits that preceded the regulations, when the taxpayer follows these regulations.
- The Fifth Circuit noted that the former "discovering information test" (also known as the “Discovery Test”) found in prior regulations is superseded by the definition of qualified research as contained in the 2004 final regulations (T.D. 9104). This ruling further shores up the UCC decision that the “Discovery Test” is dead.
- With regards to oral testimony, The Tax Court indicated that it was “more appropriate to accept” the taxpayer’s computation of qualified costs rather than “to reject the [taxpayer’s] efforts as a whole.”
Lastly, the court in FedEx set new precedent in regards to internal use software. Generally, it is very difficult to qualify a taxpayer’s expenditure towards developing “in-house” computer software. The initial guidance in determining QREs (qualified research expenditures) for internal use software can be found in the 2001 regulations. The guidance was very perplexing and later superseded. The restrictive "Discovery Test" also appeared in the 2001 regulations, however the Treasury repudiated the "Discovery Test" in the 2003 final regulations. FedEx argued that the IRS had abandoned the "Discovery Test" because it was inconsistent with Congressional intent, and as such they could use the guidance on internal-use software in the 2001 regulations and the "Discovery Test" could be ignored.
The court agreed with FedEx and ruled completely in their favor. The case established the following positive results:
- The "Discovery Test" is dead, even when relying on other regulations that coexisted during period when the “Discover Test” was valid.
- Taxpayers seeking to claim R&D Tax Credit for the development of internal-use software can rely on the use of the more favorable provisions found in the 2001 regulations.
In summary, 2009 produced several significant court cases that helped clarify the Research & Development Tax Credit. Fortunately, the rulings were mostly favorable for taxpayers.
About the Authors:
The authors are Karim Solanji, J.D. and Saqib Dhanani, J.D. both with Paradigm Partners. Paradigm Partners is a national tax consulting firm specializing in niche tax services such as the R&D Tax Credit, the IC-DISC, WOTC, Cost Segregation and Energy Efficiency Studies. For more information, contact Mark Lauber, VP of Marketing. Mark's email is MLauber@ParadigmLP.com and his phone number is (281) 558-7100 X-105. Our website is www.ParadigmLP.com.