Draft r n d Study Xx Fund v1

8/13/2019 Draft r n d Study Xx Fund v1

1/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

"

2012 R&D Tax Credit Study XX-XXCO

Part One: Summary Report and Tax Opinion

Part Two: Research and Development Tax Credit Calculations

Part Three: Supporting Schedules In Compliance with IRS Audit Procedures

EXHIBIT A: DETAILED LISTING OF PRODUCTS/CONTRACTS

EXHIBIT B: ENGAGEMENT LETTER

EXHIBIT C: ELECTION TO TAKE REDUCED CREDIT (F6765)

EXHIBIT D: CONTROLLED GROUP/TRADE OR BUSINESSES INFO

EXHIBIT E: GROUP CREDIT INFORMATION

EXHIBIT F: ACCOUNTING FOR ACQUISITIONS AND DISPOSITIONS

EXHIBIT G: FINANCIAL COST ACCOUNTING FOR R&D

EXHIBIT H: DESCRIPTION OF QREs

EXHIBIT I: TECHNICAL ANALYSIS OF QREs

EXHIBIT J: CONTRACT QRE ANALYSIS

EXHIBIT K: SUMMARY OF EMPLOYEE DESCRIPTIONS AND SURVEYS

EXHIBIT J: METHODS USED TO CALCULATE QREsEXHIBIT L: BASE PERCENTAGE CALCUALTIONS

EXHIBIT M: EMPLOYEE DESCRIPTIONS SUPPORTING BASE PERIOD

EXHIBIT N: BASE PERIOD CALCUALTION METHODOLOGY

EXHIBIT O: EXPLANATION OF BASE PERIOD ESTIMATES

EXHIBIT P: SAMPLING MEHTODOLOGY

EXHIBIT Q: METHODOLGY USED TO MEET CONSITENCY RULES


2/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

#

DESCRITPION OF MATERIAL INCLUDED SUPPORTING THIS REPORT ASREQUIRED BY THE IRS TO THE EXTENT APPLICABLE TO THE FACTS ANDCIRCUMSTANCES DESCRIBED HEREIN

1. Copy of the engagement letter pursuant to which the thirdparty provided the assistance. SEE EXHIBIT B.

2. Copy of I.R.C. 280C(c)(3) election. SEE EXHIBIT C.

3. Controlled Group information:

a. List of the controlled group members and other trades orbusinesses which are under common control.

b. Other members or trades or businesses been notified ofrecomputation of the research credit and the effect of thecredit allocation on their credit?

c. Effect of allocated portion of the credit.d. Effects of any adjustments on allocated portions of thecredit.

SEE EXHBIT D.

4. Information used in computing the group credit for the credityear, which includes computation of the base amount and tradesor businesses which are under common control, in accordance withthe aggregation rules of I.R.C. 41(f)(1). SEE EXHIBIT E.

5. Accounting all acquisitions or dispositions of a majorportion of a trade or business or major portion of a separateunit of a trade or business, as required by I.R.C. 41(f)(3)(A)or 41(f)(3)(B). SEE EXHIBIT F.

6. Explanation of accounting used to capture costs in financialbooks and records. Description of method used to identify andcapture the QREs and describe how this method connects QREs withthe financial books and records. SEE EXHBIT G.

7. Method of accounting for treatment of research andexperimental expenditures for the particular project orprojects. Description of the claimed as research andexperimental expenditures for a particular project or projectsas current expenses under section 174(a) or deferred expensesunder section 174(b), or as capital expenditures under section263(a), section 263A and regulation section 1.174-1).Description the QREs treatment on the tax return including theentry line(s) and dollar amount included on each line of the


3/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

$

income tax return to reflect how the QREs were originallyreported and characterized to compute taxable income, i.e.,salaries and wages, depreciation, cost of goods sold, otherdeductions entry lines. SEE EXHIBIT H.

8. The following information related to QREs has been included:

a. Identification and listing of each new or improvedbusiness component for which the QREs are being claimed.

b. Schedule showing for each business component identifiedin item a. above; the QRE wages by employee, the QREsupplies, and the contract QREs by contract, and areconciliation of the QREs by business component to thetotal QREs reported on your Form 6765.

c. With respect to each QRE amount identified in item b.;contemporaneous documentation substantiating the claimedamount including for each new or improved businesscomponent a list of the documents available thatsubstantiates:

i. Qualification of each business component,

ii. Determination and quantification of qualifiedwages by employee,

iii. Determination and quantification of qualifiedsupplies (including the general ledger accountincluding the supply costs) and

iv. Determination and quantification of contractresearch by contract (include a list of the contractsand the QRE amount for each contract).

SEE EXHIBIT I.

9. For research you performed as a contractor, contemporaneousdocumentation that identifies the claimed research expenses by

contract, QRE amount and each new or improved businesscomponent?

a. Copies of all the contracts for which such researchexpenses have been claimed

b. Description of the terms of each contract for which theresearch expenses have been claimed describing:


4/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

%

i. the performance of qualified research;

ii. how the payment(s) to you (the contractor) werecontingent on success of the research;

iii. why substantial rights to the results of theresearch were retained

c. List of the contracts and the QRE amount for eachcontract.

SEE EXHIBIT J.

10. Summary oral testimony or employee surveys to determine theQREs in the credit year including:

a. Total dollar amount of QREs that were determined, inwhole or in part, by oral testimony and employee surveys;

b. List of employees and job titles of those youinterviewed or surveyed, including the credit year QREwages associated with each employee, segregated betweenengaging in qualified research, direct support and directsupervision.

c. Copies of all original (vs. summary or transcribed)records from each employee interview/survey.

d. Identify the number of months that transpired betweenthe claim year and the time the oral testimony or employeesurvey took place.

SEE EXHIBIT K.

11. The methodology by which estimates or extrapolations wereused to determine the QREs for the credit year, and provide thedollar amount of the QREs which were estimated or extrapolatedto the extent applicable.

SEE EXHIBIT J.

12. Detailed calculation of the fixed-base percentage and thebase amount including the computations on a spreadsheet.Identification of each new or improved business component forwhich the base years QREs were incurred. For each such businesscomponent, a listing of the QRE wages by employee, the QREsupplies, and the contract QREs by contract, reconciling to thetotal QREs used to compute your fixed-base percentage. A


5/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

&

separate list for each base year. If your fixed-base percentageis based upon being a start-up company, identify the first yearthat any entity first paid or incurred QREs, and identify thatentity.

SEE EXHIBIT L.

13. Description of any oral testimony or employee surveys todetermine QREs in the base years including:

a. The total dollar amount of QREs in the base years thatwere determined, in whole or in part, by oral testimony oremployee surveys;

b. A list of the employees and job titles of those youinterviewed/surveyed including the base years QRE wagesassociated with each employee in each base year segregated

between engaging in qualified research, direct support anddirect supervision.

c. Copies of all original records from each employeeinterview/survey.

d. Identification of the number of months that transpiredbetween the base years and the time the oral testimony oremployee survey took place.

SEE EXHIBIT M.

14. Description of the methodology by which estimates orextrapolations were used to determine the QREs for the baseyears, and the dollar amount of the QREs, by base year, whichwere estimated or extrapolated.

SEE EXHBIT N.

15. Description the methodology by which estimates orextrapolations were used to determine the gross receipts for thefixed base percentage and the base amount, and the dollar amountof the gross receipts, by year, which were estimated orextrapolated.

SEE EXHBIT O.

16. The form of sampling used to determine any QREs including:

a. Description of the statistical sampling population;

b. Detailed description of the sampling method used;


6/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

'

c. Identification of the population(s) to which eachsampling method was applied;

d. Identification of the dollar amount of the QREs whichwas determined based upon each sampling method used.

SEE EXHBIT P.

17. Description of methodology for meeting the consistencyrequirement in determining the fixed-base percentage that wasreported on Form 6765.

SEE EXHBIT Q.

NOTE: Reference above to the term base years refers to theyears used to compute the fixed-base percentage relating to thecalculation of the regular credit under section 41(a)(1) or thethree preceding years relating to the election and calculationof the alternative simplified credit under section 41(c)(5).


7/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

(

INTRODUCTION

XX-XX (also referred to hereinafter as the Company) hasachieved and maintained its position as one of the world'sleading hedge fund managers.

Types of Hedging Strategies Employed by CompanyCharting terms and Indicators

Concepts

Average true range averaged daily trading range, adjusted for pricegaps

Breakout the concept whereby prices forcefully penetrate an area ofprior support or resistance, usually, but not always, accompaniedby an increase in volume

Chart pattern distinctive pattern created by the movement ofsecurity prices on a chart

Cycles time targets for potential change in price action (priceonly moves up, down, or sideways)

Dead cat bounce the phenomenon whereby a spectacular decline in theprice of a stock is immediately followed by a moderate andtemporary rise before resuming its downward movement

Elliott wave principle and the golden ratio to calculate successiveprice movements and retracements

Fibonacci ratios used as a guide to determine support andresistance

Momentum the rate of price change

Point and figure analysis A priced-based analytical approachemploying numerical filters which may incorporate timereferences, though ignores time entirely in its construction

Resistance a price level that may prompt a net increase of sellingactivity


8/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

)

Support a price level that may prompt a net increase of buyingactivity

Trending the phenomenon by which price movement tends to persist inone direction for an extended period of time

Types of Charts

Candlestick chart Of Japanese origin and similar to OHLC,candlesticks widen and fill the interval between the open andclose prices to emphasize the open/close relationship. In theWest, often black or red candle bodies represent a close lowerthan the open, while white, green or blue candles represent aclose higher than the open price.

Line chart Connects the closing price values with line segments.

Open-high-low-close chart OHLC charts, also known as bar charts,plot the span between the high and low prices of a trading periodas a vertical line segment at the trading time, and the open andclose prices with horizontal tick marks on the range line,usually a tick to the left for the open price and a tick to theright for the closing price.

Point and figure chart a chart type employing numerical filterswith only passing references to time, and which ignores time

entirely in its construction.

Overlays

Overlays are generally superimposed over the main price chart.

Bollinger bands a range of price volatility

Channel a pair of parallel trend lines

Ichimoku Kinko Hyo a moving average-based system that factors intime and the average point between a candle's high and low

Moving average the last n-bars of price divided by "n"where "n" isthe number of bars specified by the length of the average. Amoving average can be thought of as a kind of dynamic trend-line.


9/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

*

Parabolic SAR Wilder's trailing stop based on prices tending tostay within a parabolic curve during a strong trend

Pivot point derived by calculating the numerical average of aparticular currency's or stock's high, low and closing prices

Resistance a price level that may act as a ceiling above price

Support a price level that may act as a floor below price

Trend line a sloping line described by at least two peaks or twotroughs

Breadth Indicators

These indicators are based on statistics derived from the broadmarket:

Advancedecline line a popular indicator of market breadth

McClellan Oscillator - a popular closed-form indicator of breadth

McClellan Summation Index - a popular open-form indicator of breadth

Price-based Indicators

These indicators are generally shown below or above the main pricechart.

%C denotes current markets environment as range expansion or arange contraction, it also forecast when extremes in trend orchoppiness are being reached, so the trader can expect change.

Average directional index a widely used indicator of trend strength


10/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

"+

XX-XX Research and Development

XX-XX's research and development efforts are dedicated toproviding innovative back tested strategies to trade profitably.

The research and development employs the above described

strategies overlayed with both technical and fundamentalanalysis as described below.

In finance, technical analysis is a security analysismethodology for forecasting the direction of prices through thestudy of past market data, primarily price and volume.Behavioral economics and quantitative analysis use many of thesame tools of technical analysis, which, being an aspect ofactive management, stands in contradiction to much of modernportfolio theory. The efficacy of both technical and fundamentalanalysis is disputed by the efficient-market hypothesis which

states that stock market prices are essentially unpredictable.

The principles of technical analysis are derived from hundredsof years of financial markets data. Some aspects of technicalanalysis began to appear in Joseph de la Vega's accounts of theDutch markets in the 17th century. In Asia, technical analysisis said to be a method developed by Homma Munehisa during early18th century which evolved into the use of candlesticktechniques, and is today a technical analysis charting tool.

In the 1920s and 1930s Richard W. Schabacker published several

books which continued the work of Charles Dow and William PeterHamilton in their books Stock Market Theory and Practice andTechnical Market Analysis . In 1948 Robert D. Edwards and JohnMagee published Technical Analysis of Stock Trends which iswidely considered to be one of the seminal works of thediscipline. It is exclusively concerned with trend analysis andchart patterns and remains in use to the present. As is obvious,early technical analysis was almost exclusively the analysis ofcharts, because the processing power of computers was notavailable for statistical analysis. Charles Dow reportedlyoriginated a form of point and figure chart analysis.

Dow Theory is based on the collected writings of Dow Jones co-founder and editor Charles Dow, and inspired the use anddevelopment of modern technical analysis at the end of the 19thcentury. Other pioneers of analysis techniques include RalphNelson Elliott, William Delbert Gann and Richard Wyckoff whodeveloped their respective techniques in the early 20th century.More technical tools and theories have been developed and


11/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

""

enhanced in recent decades, with an increasing emphasis oncomputer-assisted techniques using specially designed computersoftware.

Fundamental analysts examine earnings, dividends, new products,research and the like. Technicians employ many methods, toolsand techniques as well, one of which is the use of charts. Usingcharts, technical analysts seek to identify price patterns andmarket trends in financial markets and attempt to exploit thosepatterns.

Technicians using charts search for archetypal price chartpatterns, such as the well-known head and shoulders or doubletop/bottom reversal patterns, study technical indicators, movingaverages, and look for forms such as lines of support,resistance, channels, and more obscure formations such as flags,pennants, balance days and cup and handle patterns.[11]

Technical analysts also widely use market indicators of manysorts, some of which are mathematical transformations of price,often including up and down volume, advance/decline data andother inputs. These indicators are used to help assess whetheran asset is trending, and if it is, the probability of itsdirection and of continuation. Technicians also look forrelationships between price/volume indices and marketindicators. Examples include the moving average, relativestrength index, and MACD. Other avenues of study includecorrelations between changes in Options (implied volatility) andput/call ratios with price. Also important are sentimentindicators such as Put/Call ratios, bull/bear ratios, shortinterest, Implied Volatility, etc.

There are many techniques in technical analysis. Adherents ofdifferent techniques (for example, candlestick charting, DowTheory, and Elliott wave theory) may ignore the otherapproaches, yet many traders combine elements from more than onetechnique. Some technical analysts use subjective judgment todecide which pattern(s) a particular instrument reflects at agiven time and what the interpretation of that pattern shouldbe. Others employ a strictly mechanical or systematic approachto pattern identification and interpretation.

Contrasting with technical analysis is fundamental analysis , thestudy of economic factors that influence the way investors pricefinancial markets. Technical analysis holds that prices alreadyreflect all the underlying fundamental factors. Uncovering thetrends is what technical indicators are designed to do, although


12/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

"#

neither technical nor fundamental indicators are perfect. Sometraders use technical or fundamental analysis exclusively, whileothers use both types to make trading decisions.[12]

Technical analysis employs models and trading rules based onprice and volume transformations, such as the relative strengthindex, moving averages, regressions, inter-market and intra-market price correlations, business cycles, stock market cyclesor, classically, through recognition of chart patterns.

Technical analysis stands in contrast to the fundamentalanalysis approach to security and stock analysis. Technicalanalysis analyzes price, volume and other market information,whereas fundamental analysis looks at the facts of the company,market, currency or commodity. Most large brokerage, tradinggroup, or financial institutions will typically have both atechnical analysis and fundamental analysis team.

Technical analysis is widely used among traders and financialprofessionals and is very often used by active day traders,market makers and pit traders. In the 1960s and 1970s it waswidely dismissed by academics. In a recent review, Irwin andPark[13] reported that 56 of 95 modern studies found that itproduces positive results but noted that many of the positiveresults were rendered dubious by issues such as data snooping,so that the evidence in support of technical analysis wasinconclusive; it is still considered by many academics to bepseudoscience.[14] Academics such as Eugene Fama say theevidence for technical analysis is sparse and is inconsistentwith the weak form of the efficient-market hypothesis.[15][16]Users hold that even if technical analysis cannot predict thefuture, it helps to identify trading opportunities.[17]

In the foreign exchange markets, its use may be more widespreadthan fundamental analysis.[18][19] This does not mean technicalanalysis is more applicable to foreign markets, but thattechnical analysis is more recognized as to its efficacy therethan elsewhere. While some isolated studies have indicated thattechnical trading rules might lead to consistent returns in theperiod prior to 1987,[20][21][22][23] most academic work hasfocused on the nature of the anomalous position of the foreignexchange market.[24] It is speculated that this anomaly is dueto central bank intervention, which obviously technical analysisis not designed to predict.[25] Recent research suggests thatcombining various trading signals into a Combined Signal


13/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

"$

Approach may be able to increase profitability and reducedependence on any single rule.[26]

A fundamental principle of technical analysis is that a market'sprice reflects all relevant information, so their analysis looksat the history of a security's trading pattern rather thanexternal drivers such as economic, fundamental and news events.Therefore, price action tends to repeat itself due to investorscollectively tending toward patterned behavior hence technicalanalysis focuses on identifiable trends and conditions.[27][28]

Market action discounts Everything

Based on the premise that all relevant information is alreadyreflected by prices, technical analysts believe it is importantto understand what investors think of that information, knownand perceived.

Prices move in Trends

Technical analysts believe that prices trend directionally,i.e., up, down, or sideways (flat) or some combination. Thebasic definition of a price trend was originally put forward byDow Theory.

An example of a security that had an apparent trend is AOL fromNovember 2001 through August 2002. A technical analyst or trendfollower recognizing this trend would look for opportunities tosell this security. AOL consistently moves downward in price.Each time the stock rose, sellers would enter the market andsell the stock; hence the "zig-zag" movement in the price. Theseries of "lower highs" and "lower lows" is a tell tale sign ofa stock in a down trend.[29] In other words, each time the stockmoved lower, it fell below its previous relative low price. Eachtime the stock moved higher, it could not reach the level of itsprevious relative high price.

Note that the sequence of lower lows and lower highs did notbegin until August. Then AOL makes a low price that does notpierce the relative low set earlier in the month. Later in thesame month, the stock makes a relative high equal to the mostrecent relative high. In this a technician sees strongindications that the down trend is at least pausing and possiblyending, and would likely stop actively selling the stock at thatpoint.

History tends to repeat Itself

Technical analysts believe that investors collectively repeat


14/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

"%

the behavior of the investors that preceded them. To atechnician, the emotions in the market may be irrational, butthey exist. Because investor behavior repeats itself so often,technicians believe that recognizable (and predictable) pricepatterns will develop on a chart. Recognition of these patterns

can allow the technician to select trades that have a higherprobability of success.

Technical analysis is not limited to charting, but it alwaysconsiders price trends. For example, many technicians monitorsurveys of investor sentiment. These surveys gauge the attitudeof market participants, specifically whether they are bearish orbullish. Technicians use these surveys to help determine whethera trend will continue or if a reversal could develop; they aremost likely to anticipate a change when the surveys reportextreme investor sentiment Surveys that show overwhelming

bullishness, for example, are evidence that an uptrend mayreverse; the premise being that if most investors are bullishthey have already bought the market (anticipating higherprices). And because most investors are bullish and invested,one assumes that few buyers remain. This leaves more potentialsellers than buyers, despite the bullish sentiment. Thissuggests that prices will trend down, and is an example ofcontrarian trading.

Recently, Kim Man Lui, Lun Hu, and Keith C.C. Chan havesuggested that there is statistical evidence of association

relationships between some of the index composite stocks whereasthere is no evidence for such a relationship between some indexcomposite others. They show that the price behavior of theseHang Seng index composite stocks is easier to understand thanthat of the index.

Industry

The industry is globally represented by the InternationalFederation of Technical Analysts (IFTA), which is a Federationof regional and national organizations. In the United States,

the industry is represented by both the Market TechniciansAssociation (MTA) and the American Association of ProfessionalTechnical Analysts (AAPTA). The United States is alsorepresented by the Technical Security Analysts Association ofSan Francisco (TSAASF). In the United Kingdom, the industry isrepresented by the Society of Technical Analysts (STA). InCanada the industry is represented by the Canadian Society ofTechnical Analysts.[34] In Australia, the industry is


15/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

"&

represented by the Australian Technical Analysts Association(ATAA),[35] (which is affiliated to IFTA) and the AustralianProfessional Technical Analysts (APTA) Inc.[36]

Professional technical analysis societies have worked oncreating a body of knowledge that describes the field ofTechnical Analysis. A body of knowledge is central to the fieldas a way of defining how and why technical analysis may work. Itcan then be used by academia, as well as regulatory bodies, indeveloping proper research and standards for the field.[37] TheMarket Technicians Association (MTA) has published a body ofknowledge, which is the structure for the MTA's Chartered MarketTechnician (CMT) exam.[38]

Neural Networks

Since the early 1990s when the first practically usable types

emerged, artificial neural networks (ANNs) have rapidly grown inpopularity. They are artificial intelligence adaptive softwaresystems that have been inspired by how biological neuralnetworks work. They are used because they can learn to detectcomplex patterns in data. In mathematical terms, they areuniversal function approximators, meaning that given the rightdata and configured correctly, they can capture and model anyinput-output relationships. This not only removes the need forhuman interpretation of charts or the series of rules forgenerating entry/exit signals, but also provides a bridge tofundamental analysis, as the variables used in fundamentalanalysis can be used as input.

As ANNs are essentially non-linear statistical models, theiraccuracy and prediction capabilities can be both mathematicallyand empirically tested. In various studies, authors have claimedthat neural networks used for generating trading signals givenvarious technical and fundamental inputs have significantlyoutperformed buy-hold strategies as well as traditional lineartechnical analysis methods when combined with rule-based expertsystems.

While the advanced mathematical nature of such adaptive systemshas kept neural networks for financial analysis mostly withinacademic research circles, in recent years more user friendlyneural network software has made the technology more accessibleto traders. However, large-scale application is problematicbecause of the problem of matching the correct neural topologyto the market being studied.


16/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

"'

Backtesting

Systematic trading is most often employed after testing aninvestment strategy on historic data. This is known asbacktesting. Backtesting is most often performed for technicalindicators, but can be applied to most investment strategies(e.g. fundamental analysis). While traditional backtesting wasdone by hand, this was usually only performed on human-selectedstocks, and was thus prone to prior knowledge in stockselection. With the advent of computers, backtesting can beperformed on entire exchanges over decades of historic data invery short amounts of time.

The use of computers does have its drawbacks, being limited toalgorithms that a computer can perform. Several tradingstrategies rely on human interpretation,[44] and are unsuitablefor computer processing.[45] Only technical indicators which areentirely algorithmic can be programmed for computerisedautomated backtesting.

Combination with other market forecast Methods

John Murphy states that the principal sources of informationavailable to technicians are price, volume and open interest.Other data, such as indicators and sentiment analysis, areconsidered secondary.

However, many technical analysts reach outside pure technicalanalysis, combining other market forecast methods with theirtechnical work. One advocate for this approach is JohnBollinger, who coined the term rational analysis in the middle1980s for the intersection of technical analysis and fundamentalanalysis. Another such approach, fusion analysis, overlaysfundamental analysis with technical, in an attempt to improveportfolio manager performance.

Technical analysis is also often combined with quantitativeanalysis and economics. For example, neural networks may be usedto help identify intermarket relationships. A few marketforecasters combine financial astrology with technical analysis.Chris Carolan's article "Autumn Panics and Calendar Phenomenon",which won the Market Technicians Association Dow Award for besttechnical analysis paper in 1998, demonstrates how technicalanalysis and lunar cycles can be combined. Calendar phenomena,such as the January effect in the stock market, are generallybelieved to be caused by tax and accounting relatedtransactions, and are not related to the subject of financial


17/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

"(

astrology.

Investor and newsletter polls, and magazine cover sentimentindicators, are also used by technical analysts.

Empirical Evidence

Whether technical analysis actually works is a matter ofcontroversy. Methods vary greatly, and different technicalanalysts can sometimes make contradictory predictions from thesame data. Many investors claim that they experience positivereturns, but academic appraisals often find that it has littlepredictive power. Of 95 modern studies, 56 concluded thattechnical analysis had positive results, although data-snoopingbias and other problems make the analysis difficult.

Nonlinear prediction using neural networks occasionally producesstatistically significant prediction results. A Federal Reserveworking paper regarding support and resistance levels in short-term foreign exchange rates "offers strong evidence that thelevels help to predict intraday trend interruptions," althoughthe "predictive power" of those levels was "found to vary acrossthe exchange rates and firms examined".

Technical trading strategies were found to be effective in theChinese marketplace by a recent study that states, "Finally, wefind significant positive returns on buy trades generated by thecontrarian version of the moving-average crossover rule, thechannel breakout rule, and the Bollinger band trading rule,after accounting for transaction costs of 0.50 percent."

An influential 1992 study by Brock et al. which appeared to findsupport for technical trading rules was tested for data snoopingand other problems in 1999; the sample covered by Brock et al.was robust to data snooping.

Subsequently, a comprehensive study of the question by Amsterdameconomist Gerwin Griffioen concludes that: "for the U.S.,Japanese and most Western European stock market indices therecursive out-of-sample forecasting procedure does not show to

be profitable, after implementing little transaction costs.Moreover, for sufficiently high transaction costs it is found,by estimating CAPMs, that technical trading shows nostatistically significant risk-corrected out-of-sampleforecasting power for almost all of the stock marketindices."[16] Transaction costs are particularly applicable to"momentum strategies"; a comprehensive 1996 review of the dataand studies concluded that even small transaction costs would


18/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

")

lead to an inability to capture any excess from such strategies.

In a paper published in the Journal of Finance, Dr. Andrew W.Lo, director MIT Laboratory for Financial Engineering, workingwith Harry Mamaysky and Jiang Wang found that "

Technical analysis, also known as "charting," has been a part offinancial practice for many decades, but this discipline has notreceived the same level of academic scrutiny and acceptance asmore traditional approaches such as fundamental analysis. One ofthe main obstacles is the highly subjective nature of technicalanalysis the presence of geometric shapes in historical pricecharts is often in the eyes of the beholder. In this paper, wepropose a systematic and automatic approach to technical patternrecognition using nonparametric kernel regression, and applythis method to a large number of U.S. stocks from 1962 to 1996to evaluate the effectiveness of technical analysis. Bycomparing the unconditional empirical distribution of dailystock returns to the conditional distribution conditioned onspecific technical indicators such as head-and-shoulders ordouble-bottoms we find that over the 31-year sample period,several technical indicators do provide incremental informationand may have some practical value.

In that same paper Dr. Lo wrote that "several academic studiessuggest that ... technical analysis may well be an effective

means for extracting useful information from market prices."[57]Some techniques such as Drummond Geometry attempt to overcomethe past data bias by projecting support and resistance levelsfrom differing time frames into the near-term future andcombining that with reversion to the mean techniques.

Efficient Market Hypothesis

The efficient-market hypothesis (EMH) contradicts the basictenets of technical analysis by stating that past prices cannotbe used to profitably predict future prices. Thus it holds thattechnical analysis cannot be effective. Economist Eugene Fama

published the seminal paper on the EMH in the Journal of Finance in 1970, and said "In short, the evidence in support of theefficient markets model is extensive, and (somewhat uniquely ineconomics) contradictory evidence is sparse."

Technicians say [ who? ] that EMH ignores the way markets work, inthat many investors base their expectations on past earnings ortrack record, for example. Because future stock prices can be


19/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

"*

strongly influenced by investor expectations, technicians claimit only follows that past prices influence future prices. Theyalso point to research in the field of behavioral finance,specifically that people are not the rational participants EMHmakes them out to be. Technicians have long said that irrational

human behavior influences stock prices, and that this behaviorleads to predictable outcomes.[61] Author David Aronson saysthat the theory of behavioral finance blends with the practiceof technical analysis:

By considering the impact of emotions, cognitive errors,irrational preferences, and the dynamics of group behavior,behavioral finance offers succinct explanations of excess marketvolatility as well as the excess returns earned by staleinformation strategies.... cognitive errors may also explain theexistence of market inefficiencies that spawn the systematic

price movements that allow objective TA [technical analysis]methods to work.

EMH advocates reply that while individual market participants donot always act rationally (or have complete information), theiraggregate decisions balance each other, resulting in a rationaloutcome (optimists who buy stock and bid the price higher arecountered by pessimists who sell their stock, which keeps theprice in equilibrium). Likewise, complete information isreflected in the price because all market participants bringtheir own individual, but incomplete, knowledge together in the

market.Random Walk Hypothesis

The random walk hypothesis may be derived from the weak-formefficient markets hypothesis, which is based on the assumptionthat market participants take full account of any informationcontained in past price movements (but not necessarily otherpublic information). In his book A Random Walk Down Wall Street ,Princeton economist Burton Malkiel said that technicalforecasting tools such as pattern analysis must ultimately beself-defeating: "The problem is that once such a regularity isknown to market participants, people will act in such a way thatprevents it from happening in the future." Malkiel has statedthat while momentum may explain some stock price movements,there is not enough momentum to make excess profits. Malkiel hascompared technical analysis to "astrology".[64]

In the late 1980s, professors Andrew Lo and Craig McKinlaypublished a paper which cast doubt on the random walk


20/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

#+

hypothesis. In a 1999 response to Malkiel, Lo and McKinlaycollected empirical papers that questioned the hypothesis'applicability that suggested a non-random and possiblypredictive component to stock price movement, though they werecareful to point out that rejecting random walk does not

necessarily invalidate EMH, which is an entirely separateconcept from RWH. In a 2000 paper, Andrew Lo back-analyzed datafrom U.S. from 1962 to 1996 and found that "several technicalindicators do provide incremental information and may have somepractical value".[57] Burton Malkiel dismissed theirregularities mentioned by Lo and McKinlay as being too smallto profit from.

Technicians say [ who? ] that the EMH and random walk theories bothignore the realities of markets, in that participants are notcompletely rational and that current price moves are not

independent of previous moves.[29][66] Some signal processingresearchers negate the random walk hypothesis that stock marketprices resemble Wiener processes, because the statisticalmoments of such processes and real stock data vary significantlywith respect window size and similarity measure.[67] They arguethat feature transformations used for the description of audioand biosignals can also be used to predict stock market pricessuccessfully which would contradict the random walk hypothesis.

The random walk index (RWI) is a technical indicator thatattempts to determine if a stocks price movement is random in

nature or a result of a statistically significant trend. Therandom walk index attempts to determine when the market is in astrong uptrend or downtrend by measuring price ranges over N andhow it differs from what would be expected by a random walk(randomly going up or down). The greater the range suggests astronger trend.

Scientific Technical Analysis

Caginalp and Balenovich in 1994 used their asset-flowdifferential equations model to show that the major patterns of

technical analysis could be generated with some basicassumptions. Some of the patterns such as a trianglecontinuation or reversal pattern can be generated with theassumption of two distinct groups of investors with differentassessments of valuation.The major assumptions of the models arethat the finiteness of assets and the use of trend as well asvaluation in decision making. Many of the patterns follow asmathematically logical consequences of these assumptions.


21/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

#"

One of the problems with conventional technical analysis hasbeen the difficulty of specifying the patterns in a manner thatpermits objective testing.

Japanese candlestick patterns involve patterns of a few daysthat are within an uptrend or downtrend. Caginalp and Laurentwere the first to perform a successful large scale test ofpatterns. A mathematically precise set of criteria were testedby first using a definition of a short term trend by smoothingthe data and allowing for one deviation in the smoothed trend.They then considered eight major three day candlestick reversalpatterns in a non-parametric manner and defined the patterns asa set of inequalities. The results were positive with anoverwhelming statistical confidence for each of the patternsusing the data set of all S&P 500 stocks daily for the five yearperiod 1992-1996.

Among the most basic ideas of conventional technical analysis isthat a trend, once established, tends to continue. However,testing for this trend has often led researchers to concludethat stocks are a random walk. One study, performed by Poterbaand Summers, found a small trend effect that was too small to beof trading value. As Fisher Black noted, "noise" in tradingprice data makes it difficult to test hypotheses.

One method for avoiding this noise was discovered in 1995 byCaginalp and Constantine[73] who used a ratio of two essentiallyidentical closed-end funds to eliminate any changes invaluation. A closed-end fund (unlike an open-end fund) tradesindependently of its net asset value and its shares cannot beredeemed, but only traded among investors as any other stock onthe exchanges. In this study, the authors found that the bestestimate of tomorrow's price is not yesterday's price (as theefficient market hypothesis would indicate), nor is it the puremomentum price (namely, the same relative price change fromyesterday to today continues from today to tomorrow). But ratherit is almost exactly halfway between the two.

A survey of modern studies by Park and Irwin showed that mostfound a positive result from technical analysis.

In 2011, Caginalp and DeSantis have used large data sets ofclosed-end funds, where comparison with valuation is possible,in order to determine quantitatively whether key aspects oftechnical analysis such as trend and resistance have scientificvalidity. Using data sets of over 100,000 points theydemonstrate that trend has an effect that is at least half as


22/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

##

important as valuation. The effects of volume and volatility,which are smaller, are also evident and statisticallysignificant. An important aspect of their work involves thenonlinear effect of trend. Positive trends that occur withinapproximately 3.7 standard deviations have a positive effect.

For stronger uptrends, there is a negative effect on returns,suggesting that profit taking occurs as the magnitude of theuptrend increases. For downtrends the situation is similarexcept that the "buying on dips" does not take place until thedowntrend is a 4.6 standard deviation event. These methods canbe used to examine investor behavior and compare the underlyingstrategies among different asset classes.

In 2013, Kim Man Lui and T Chong pointed out that the pastfindings on technical analysis mostly reported the profitabilityof specific trading rules for a given set of historical data.

These past studies had not taken the human trader intoconsideration as no real-world trader would mechanincially adoptsignals from any technical analysis method. Therefore, to unveilthe truth of technical analysis, we should get back tounderstand the performance between experienced and novicetraders. If the market really walks randomly, there will be nodifference between these two kinds of traders. However, it isfound by experiment that traders who are more knowledgeable ontechnical analysis significantly outperform those who are lessknowledgeable. [76]

Ticker Tape Reading

Until the mid-1960s, "tape reading" was a popular form oftechnical analysis. It consisted of reading market informationsuch as price, volume, order size, and so on from a paper stripwhich ran through a machine called a stock ticker. Market datawas sent to brokerage houses and to the homes and offices of themost active speculators. This system fell into disuse with theadvent of electronic information panels in the late 60's, andlater computers, which allow for the easy preparation of charts.

Quotation board.Another form of technical analysis used so far was viainterpretation of stock market data contained in quotationboards, that in the times before electronic screens, were hugechalkboards located into the stock exchanges, with data of themain financial assets listed on exchanges for analysis of theirmovements. It was manually updated with chalk, with the updates


23/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

#$

regarding some of these data being transmitted to environmentsoutside of exchanges (such as brokerage houses, bucket shops,etc.) via the aforementioned tape, telegraph, telephone andlater telex.

This analysis tool was used both, on the spot, mainly by marketprofessionals for day trading and scalping, as well as bygeneral public through the printed versions in newspapersshowing the data of the negotiations of the previous day, forswing and position trades.

Despite to continue appearing in print in newspapers, as well ascomputerized versions in some websites, analysis via quotationboard is another form of technical analysis that has fallen intodisuse by the majority.

SPECIFIC STRATEGIES EMPLOYED BY COMPANY AND BACKTESTING METHODOLOGIES

XXXXXXXXXXXXXXX

XXXXXXXXXXXXXXX

XXXXXXXXXXXXXXXXX

The accumulated costs for the R&D cost center includes anallocation of salaries and wages based on the percentage thatthe specific employees engaged in R&D projects and activitiesthroughout the year (ie for example mechanical design engineerspent 80% of their time doing new product design and developmentfor R&D efforts, and 20% of their time in current productsupport efforts).

Also included in the accumulated costs for the R&D cost centerwould be other allocated payroll expenses, supplies, computerand equipment costs as well as applicable contract researchexpenses.

LAW AND ANALYSIS

A. Overview of IRC Section 41 and Section 174 In order forexpenditures to qualify for the research and development (R&D)tax credit under IRC Section 41, they must first meet the


24/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

#%

definition of research and experimentation (R&E) expendituresunder IRC Section 174. The regulations under IRC Section 174define R&E expenses as "expenditures incurred in connection withthe taxpayer's trade or business which represent research anddevelopment costs in the experimental or laboratory sense."

The regulation further explains "costs are in the experimentalor laboratory sense if they are for activities intended todiscover information that would eliminate uncertainty concerningdevelopment or improvement of a product" The overridingqualification of IRC Section 174 is that the developmentactivities must intend to eliminate uncertainty.

1. "Eliminating Uncertainty" Test

Uncertainty exists if information available to the taxpayer doesnot establish the capability or method for developing or

improving a business component. To qualify as a research orexperimental expenditure for purposes of IRC Section 174, theexpenditure must (1) be incurred in connection with thetaxpayer's trade or business and (2) represent a research orexperimental cost in the experimental or laboratory sense (Reg.Sec. 1.174-2(a)(1)).

Expenditures are incurred in the " experimental or laboratory"sense if they are incurred in the conduct of activities that areintended to discover information that would eliminateuncertainty concerning the development or improvement of aproduct (Reg. 51.174-2(a)(1)). A product, for these purposes,includes a pilot model, process, formula, invention, technique,patent or similar property that is either used by the taxpayerin its trade or business or held for sale, lease or license bythe taxpayer (Reg. Section 1.174-2(a)(2)). The nature of theproduct or improvement being developed or the level oftechnological advancement that the product or improvementrepresents is not relevant in determining whether the relatedexpenditure qualifies as an IRC Section 174 research orexperimental expenditure. Instead the focus is on the nature of

the activities that the expenditures relate to, namely, whetherthe activity is intended to eliminate uncertainty concerning thedevelopment or improvement of the product (Reg. Section 1.174-2(a)(1)).

Uncertainty exists if the information available to the taxpayerdoes not establish either (1) the capability or method for


25/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

#&

developing or improving the product or (2) the appropriatedesign of the product (Reg. Section 1.174-2(a)(1)).

Thus, expenditures incurred by a taxpayer to determine theappropriate design of a product can qualify as research andexperimental expenditures even though the taxpayer has knowledgethat a product development project will be successful (Reg.Section 1.174-2(a)(4); T.D. 8562).

a. Ineligible activities: Items ineligible for the IRC Section174 election and items specifically excluded under IRC Section4l may not be taken into account for purposes of the credit.

These are:

1) Research done outside the United States, the Commonwealth ofPuerto Rico or any possession of the United States (IRC Section

41(d)(4), as amended by the Tax Relief Extension Act of 1999(P.L. 106-170); Reg. Section 1.41-4(c)(7)).

2) Research in the social sciences, arts or humanities (IRCSection 41(d)(4); Reg. Section 1.41.-4(c)(8)).

3) Ordinary testing or inspection of materials or products forquality control (Reg. Section 1.174-2(a)(1)).

4) Market and consumer research (Reg. Section 1.174-2(a)(1)).

5) Advertising or promotion expenses (Reg. Section 1.174-2(a)(1)).

6) Management studies and efficiency surveys (IRC Section41(d)(4); Reg. Section 1.414(c)(6)).

7) Research to find and evaluate mineral deposits, including gasand oil (IRC Section 174(d)).

8) Acquisition or improvement of land or of certain depreciableor depletable property used in research (IRC Section 174(c)).

9) Acquisition of another person's patent, model, production orprocess (Reg. Section 1.174-2(a)(1)).

10) Research funded by another person, or any governmentalentity, by means of a grant or contract (IRC Section41(d)(4);Reg. Section 1.41-4(c)(9)).

11) Research conducted after commercial production (IRC Section41(d)(4)(A); Reg. Section 1.41-4(c)(2)).


26/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

#'

12) Research for the adaptation of existing business componentsIRC Section 41(d)(4)(B); Reg. Section 1.41-4(c)(3)).

13) Research for the duplication of an existing businesscomponent (IRC Section 41(d)(4)(C); Reg. Section 1.41-4(c)(4)).

14) Except to the extent provided in regulations, research withrespect to internal-use software (IRC Section 41(d)(4)(E)). See"Internal-use software, below.

b. Funded research exclusion: For purposes of item (10),above(research funded by grants, contracts, or governmentalentities), amounts payable that are contingent on the success ofthe research (and thus considered as paid for the product orresult of the research) are not treated as funding (Reg. Section1.41-4A(d)(1)).

If a taxpayer performing research for another person retains nosubstantial rights in the research, the research is treated asfully funded, and none of the expenses paid or incurred by thetaxpayer in performing the research are considered qualifiedresearch expenses (Reg. Section 1.41-4A(d)(2)).

Moreover, if the payments to the researcher are contingent uponthe success of the research under such circumstances, thetaxpayer (where the taxpayer is paying a third party to performcontract research) may not treat the expenses as qualifiedresearch expenditures.

In contrast, if the payments are guaranteed, for example, undera time and materials contract, the taxpayer performing contractresearch for another may not treat the expenses as qualifiedresearch expenses.

Substantial rights in the research are not retained if thecontract provides that the payer (where the taxpayer isperforming the research for another) or the contractorperforming the research (where the taxpayer is paying forcontract research) retains exclusive rights to the intellectualproperty or the results of the research. If a taxpayerperforming research for another person retains substantialrights in the research, the research is considered funded to theextent of payments (and the fair market value ofproperty)received (Reg. Section 1.41-4A(d)(3)).


27/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

#(

DETAILED ANALYSIS OF FUNDED RESEARCH

Under Internal Revenue Code ("IRC") 41(d)(4)(H), the R&D taxcredit is not available to a taxpayer for any research activityto the extent such research is "funded" by a grant, contract, orother arrangement. Congress enacted the funding limitation inorder to restrict research credit benefits to a single taxpayerin a given transaction (although the limitation is imperfect inthat two parties often claim the same costs as QREs, and in sometransactions, no party is allowed to claim the expenditures).

The IRC 41 regulations provide a major exception to "funding."Research performed by a taxpayer on behalf of another is notfunded if both: (1) the payment to the taxpayer is contingent onthe success of the research (i.e., the taxpayer is "at risk" ofbearing the research costs upon failure of the project) and (2)the taxpayer retains "substantial rights" in the research. Notethat it isn't a contract's payment terms alone that determinewhether contract research is funded - retention of substantialrights is essential.

Is research "at risk?"

Amounts paid to a taxpayer under any agreement that arecontingent on the success of the research (and thus consideredto be payments for the product or research results rather thanfor research performed on the payor's behalf) are not treated asfunding of the research. The determination of whether you are atrisk turns on which party bears the research costs upon failureof the project contemplated under the terms of the contract.When payment to you is contingent on performance, such as thesuccessful design and development of a new product or process,you bear the risk of failure.

A common perception is that fixed price-type contracts are, bydefinition, not funded while cost-type contracts are funded forthe party performing the work. This is clearly not always true.To determine if amounts are "at risk" and whether you retain"substantial rights," it isn't the contract type that controlsbut the specific contractual terms. These terms describe if yourcompany is at risk of bearing the research costs if the projectfails and whether you retain substantial rights in the researchresults.


28/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

#)

Did taxpayer retain "substantial rights" in research?

If the taxpayer company performs research on behalf of anotherentity and retains no "substantial rights" to the researchresults under the terms of the contract, the research is treatedas funded. Although the IRC 41 regulations do not define"substantial rights," they do state that a taxpayer does notretain substantial rights when the party for whom the researchis performed has the exclusive right to exploit the results ofthe research and the taxpayer must pay for the right to use theresearch results. Generally, the right to use research resultswithout paying for such right, even if not an exclusive right,is substantial. However, if the taxpayer must pay a royalty (orsimilar fee) in order to obtain a non-exclusive license to usethe research results, then you do not retain substantial rightsin the research.

Thus, as long as exclusive rights are not vested in another, thetaxpayer can "share" substantial rights in the research resultswith other parties. For example, under the terms of manycontracts, taxpayers performing research on behalf of anotherentity often retain the right to use any knowledge gained whileconducting the research in future applications even though thetechnical drawings, blueprints, or product specification sheetsgenerated during the research activities remain the property ofthe customer. In such a case, substantial rights in the researchcould be shared between you and your customer. As long as youare at risk under the terms of the contract, the research is notfunded and you may claim the qualified research costs as QREs.

Treasury Regulation Section 1.41-4(c)(9) applicable to qualifiedresearch expenditures paid or incurred in taxable years endingon or after December 31, 2003, defines the extent to whichresearch is so funded. Since the periods at issue are tax yearending after 2003, 2004, Treasury Regulation Section 1.41-4A(d)is applicable.

Research performed for a customer under a contract is considered

funded unless two requirements are met by the taxpayer: (1) theamounts payable under the agreement are contingent on thesuccess of the research and thus considered to be paid for theproduct or result of the research; and (2) the taxpayer retainssubstantial rights in the research. Treas. Reg. 1.41-4A(d).


29/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

#*

Contingent on the Success of the Research

Amounts payable under any agreement that are contingent on thesuccess of the research and thus considered to be paid for theproduct or result of the research are not treated as funded.Treas. Reg. 1.41-4A(d)(1). If an expense is paid or incurredpursuant to an agreement under which payment is contingent onthe success of the research, then the expense is considered tobe paid for the product or result rather than the performance ofthe research. Treas. Reg. 1.41-2(e)(2). This test is appliedto each expenditure and not to the agreement as a whole. SeeTreas. Reg. 1.41-2(e)(5). Therefore it is possible for ataxpayer to perform some research where the client pays for theend product and some research where the client is paying for theresearch itself within the same contractual agreement. Allagreements and not only research contracts entered into between

the taxpayer performing the research and other persons areconsidered in determining the extent to which the research isfunded. Treas. Reg. 1.41-4A(d)(1).

The Court in Fairchild Industries, Inc. v. United States, 71F.3d 868 (Fed. Cir. 1995), revg 30 Fed. Cl. 839 (1994), heldthat research is not funded by a contract if the taxpayer bearsthe research costs upon failure to successfully complete theproject for which it is doing the research. In FairchildIndustries, the taxpayer entered into fixed price incentivecontracts with the United States Air force. The Air Force wasobligated to pay for the research only if the taxpayer producedresults that met the contract specifications and certainprovisions of the Defense Acquisition Regulations. The contractsprovided that the Air Force could terminate the Contract eitherfor default or for the convenience of the government. The AirForce would pay bi-monthly refundable advanced payments,calculated as a percentage of the expenditures the taxpayeractually incurred. The United States argued and the Court ofFederal Claims agreed that the availability of the creditdepends on the relative likelihood that the contracting entity

would pay.The Court of Appeals disagreed and held that whether research isfunded by a contract depends on who bears the research costsupon failure, not on whether the researcher is likely to succeedin performing the project. Since the Air Force was only liablefor payment of the contract when the project succeeded and wasaccepted, the Court determined that the taxpayer bore the


30/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

$+

financial risk of failure and could claim the credit. The factthat the taxpayer received advanced payments from the Air Forcethat were calculated as a percentage of the taxpayers costs didnot change the result because the advanced payments wererefundable if the project was not successful. The Courts test

applies to all contracts and not just to unusually risky oruncertain contracts. The result is the same even if thecontractor expects to perform as the contract contemplates.

In other advice, the Service has stated that contracts are notconsidered contingent on the success where the standard ofperformance is that of a similar qualified design professionalexercising due care. 2002 IRS NSAR 20350. Where the contractrequires substantial performance, warrants results, or thecontract is governed by local law that applies a warranty ofresults standard, then the contract is contingent on results,

and is therefore not funded.

Substantial Rights

If the taxpayer performs research on behalf of another entityand does not retain substantial rights in the research, then theexpenses paid or incurred by taxpayer are not qualified researchexpenses and the research is treated as fully funded by acontract. Treas. Reg. 1.41-2(a)(3)(i); Treas. Reg. 1.41-4A(d)(2). Incidental benefits to the taxpayer from performanceof the research, such as increased experience in a field of

research, do not constitute substantial rights in the research.Treas. Reg. 1.41-4A(d)(2).

If the taxpayer in carrying on a trade or business performsresearch on behalf of another person, but retains substantialrights in the research under the agreement providing for theresearch, then the research is funded, but only to the extentthe payments to which the taxpayer becomes entitled byperforming the research. Treas. Reg. 1.41-2(a)(3)(ii); Treas.Reg. 1.41-4A(d)(3). The taxpayer must reduce the amount paidor incurred for research that would otherwise constitute

qualified research expenses of the taxpayer, but for therestriction in Section 41(d)(4)(H) by the amount of the researchfunded by a contract. Treas. Reg. 1.41-4A(d)(3).

A taxpayer does not retain substantial rights in the research ifthe taxpayer must pay for the right to use the results of theresearch. Treas. Reg. 1.41-4A(d)(3). Whether a taxpayer has


31/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

$"

retained substantial rights is applied on a project by projectbasis. Treas. Reg. 1.41-4A(d)(3)(iii).

The issue in Lockheed Martin Corp. v. Unites States, 210 F.3d1366 (Fed. Cir. 2000), rev. in part 42 Fed. Cl. 485 (1988), waswhether the taxpayer retained substantial rights in the researchso that it could claim the research tax credit. The taxpayerentered into many substantially similar fixed price contractswith the United States. The Court of Federal Claims found thatthe taxpayer did not retain substantial rights because under thecontracts (1) the government had unlimited right to use thetaxpayers technical data and disclose it to third parties; (2)the taxpayer had to seek approval from the State Departmentprior to entering into licensing agreements or discussing withother customers technical information not in the public domain;(3) the government had veto power over the taxpayers right to

file patent applications and could require the taxpayer totransfer title to a subject invention if the taxpayer failed tofile a patent application within a specific period of time; and(4) the recoupment provisions in the contracts required thetaxpayer to pay the government for certain costs for eachcommercial sale made by the taxpayer of technology that utilizedthe research results attained under the government contracts .Id. at 1369-70. The Court of Federal Claims characterized theprofits the taxpayer received on private sales of relatedtechnology as incidental benefits. Id. at 1370.

The government argued that a taxpayer only retains substantialrights if the taxpayer retains the right to exclude others,including the government, from its research and in which otherparties do not also have the right to use or disclose thetaxpayers research, including patented inventions.

The Court of Appeals disagreed and held that the taxpayerretained substantial rights in the research. The right to usethe research results, even without the exclusive right, is asubstantial right. The Court found that under the agreements,the taxpayer was able to use the results of its research in itsbusiness without paying for it and this was a substantial rightthat allowed the taxpayer to manufacture and sell up-to-dateproducts meeting the needs of its customers. The Court foundthat the recoupment provision that required the taxpayer toreimburse the government for research costs each time it madeuse of the government research results in a commercial sale didnot restrict the taxpayers use of the technology. This


32/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

$#

recoupment provision did not amount to the taxpayer paying forthe use of the research and so the taxpayer retained substantialrights under the contracts. Id. at 1377.

In 2002 IRS NSAR 20350, the Service noted that except where acontract has explicit provisions granting ownership of allintangible or intellectual property (not merely designs,specifications, blueprints and the like) to the client, [thecontactor] retains substantial rights.

Examples

Project No. 1

Project No. 1 is funded up to the extent the Taxpayer is notreimbursed for its expenses because payment is not contingent onthe success of the research.

The contract is a cost-plus fixed-fee contract, the Taxpayerwill be reimbursed for costs up to the ceiling of $ .

The Taxpayer contractual obligation is to performsatisfactorily, which is a promise to use a standard of care.This does not imply a warranty or guarantee the success of aproject. Even if the Taxpayer defaults on the contract, theTaxpayer will be reimbursed for the work performed.

Regarding rights, Client does not retain exclusive rights to theresearch. Although Client retains the rights to all reports,

calculations, and materials, the agreement does not convey toClient ownership of the underlying information or ideas.

Accordingly, the Taxpayer has substantial rights to make use ofthe research in accordance with Lockheed.

Project No. 2

Under Project No. 2, payment to the Taxpayer is not contingenton the success of the research because Taxpayer will bereimbursed for work performed regardless of whether the researchis successful.

Project No. 2 is a fixed-fee contract, under which the Taxpayerwill invoice Client 2 monthly. Upon completion of the contract,Client 2 will pay retained amounts if the work is acceptable.Thus, the Taxpayer could receive payment even though Client 2ultimately deems the work unacceptable.


33/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

$$

Because the Taxpayer must correct any deficiencies in its workwithout additional compensation pursuant to the warranty and thecompensation is capped, the Taxpayer could be at risk for anyamounts over the fixed fee or for expenditures incurred duringthe correction of deficiencies in its work.

The Taxpayer appears to retain sufficient rights to theresearch. Under the contact, the Client 2 retains the writtendocuments and designs, but not exclusive rights to the research.

Project No. 3

The payment to the Taxpayer is not contingent on the results ofthe research. Project No. 3 relates to a capped time-and-materials contract. The Taxpayer does not warrant its work andthere is no acceptance or inspection requirements. If theTaxpayer incurs expense in excess of the cap, it will assume the

risk for such amounts.

With respect rights, Client 3 does not retain exclusive rights,and therefore, the Taxpayer will retain a substantial right tothe research for the purpose of 41.

Project No. 4

Under project no.4, payment to the Taxpayer is not contingent onthe success of the research. This is a capped time-and-materialscontract. The contract is essentially for services and not theresults of the research; the Taxpayer offers only to perform toa standard of care and does not warrant its work. In addition,the contract does not include acceptance or inspectionrequirements.

However, as the case with other capped time-and-materialscontracts, the Taxpayers expenditures in excess of the cap maybe at risk.

With respect rights, Client 4 does not retain exclusive rights,and therefore, the Taxpayer will retain a substantial right tothe research for the purpose of 41.

Project No. 5

All rights to research are retained by the Client.

Accordingly, the contract is funded though if under local lawretaining the rights is a legal impossibility, this result maynot obtain.


34/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

$%

Project No. 6

Project No. 6, a capped time-and-materials contact, is fundedbecause payment to the Taxpayer is not contingent on the resultsof the research.

Although work must be deemed satisfactory prior to payment, theTaxpayer will be paid in the event of default under thetermination/cancellation terms of the contract.

Further, the Taxpayer does not offer a warranty for the workprovided.

With respect to rights, the contract does not bestow all rightsto the research to Client. Thus, the Taxpayer will retain asubstantial right to the research.

If the Taxpayer incurs costs over the capped amount, suchexpenditures may be included in the credit calculation, providedthe other provisions of 41 are satisfied.

Project No. 7

Project No. 7 is a fixed fee contract, where payment is notcontingent upon the success of the research.

Even if the Taxpayer defaults, the Taxpayer will receive paymentfrom Client.

In addition, the Taxpayer only warrants ordinary care and skill.

Although Client may perform evaluations of the servicesprovided, such evaluations will only be used for future

solicitations. As the case with other capped or fixed fees, theTaxpayer may be at risk for amounts incurred over the cap.

With respect to rights, the contract does not bestow all rightsto the research to Client. Thus, the Taxpayer will retain asubstantial right to the research.


35/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

$&

It seems clear under the UCC rules alone XX XX has an impliedwarranty of merchantability and thus, its research could not befunded as described above based on our discussions with companypersonnel.

General analysis of IMPLIED Warranties UCC 2-314 & 2-315(NOTE: you can express a warranty for services, but you cantimply one.

Implied warranties apply only to goods.

A. General - Arise under the UCC. You do not need a statementof warranty or representation for these.

1. Two types

a. Implied Warranty of Merchantability - UCC 2-314

(1) Most important warranty - It provides that goods must befit for the ordinary purposes for which such goods are used.Ordinary use of the trade.

(2) Attached automatically; doesn't have to be expressed ifyou're a merchant selling goods of that kind.

(3) Strict Liability because it doesn't require a demonstrationof fault or negligence or who is negligent.

(4) The UCC doesn't give firm and clear guidelines for whatmerchantability is, so the court or jury defines it. This is

problematical to the seller of complex technical goods. Theywill try to disclaim as will sellers in general.

(5) Food Items - Court uses reasonable expectation test.

b. Implied Warranty of Fitness for a particular purpose - UCC 2-315 (dont have to be a merchant seller; as opposed toimplied warranty of merchantability)

(1) Where the seller knows or has reason to know of aparticular purpose that the goods are to be used for and thebuyer relies on seller's skill and judgement to select orfurnish the goods; the goods must be fit for the particularpurpose.

(2) Buyer must prove three things and goods must be unfit:

(a) Seller had reason to know of buyer's purpose

(b) Seller knew the buyer was relying or had reason to know.


36/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

$'

(c) That the buyer relied on the seller's knowledge.

(3) Under this warranty goods may be fit for "ordinarypurposes" but not for the "particular purpose" envisioned by theparties. (like sail boat for ocean-going voyage)

c. Warranties in the Market Place

(1) Soft Goods (food, clothes): sellers of soft goods aregenerally content to rely on the UCC for implied warranty; and

(2)Hard Goods (furniture, cars): there is an unwillingness todo business on the implied warranty business; the market placewill force someone to make a warranty.

d. Magnusson-Moss Warranty Act: Federal Leg. Disclosure law;

Doesn't require warranty but when warranty given cant disclaiman implied warranty; can only limit the duration of an expresswarranty.

B. Disclaimers and other defenses of sellers

1. UCC 2-316 - Disclaimer

a. Express warranty - The disclaimor can't be inconsistentwith express warranty given. If not are consideredunreasonable.

a. Implied warranty of merchantability - The disclaimer must:

(1) mention merchantability (2-316(2))

(2) be conspicuous if in writing (2-316(2))

b. Implied warranties of fitness for purpose, disclaimer must:

(1) must be in writing and conspicuous. (2-316(2)).

The following apply to both merchantability and fitness:

c. "Magic Words" - all implied warranties can be disclaimed by

such words as "with all faults" or "as is," they call fact thatthere is no warranty to buyer's attention. (2-316 (3) (a)). AND

d. Seller must demand Buyer examine goods or sample or modelfor reasonable defect, if he refuses to examine, there is noimplied warranty for defects he ought to have found. Also, ifhe fully examined sample or model there is no implied warranty -


37/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

$(

> express warranty instead. (2-316 (3) (b)). {no warranty ifexamination should reveal defect.}

e. Implied can also be excluded or modified by prior course ofdealing, course of performance or usage of trade. (UCC Sections2-316 (3) (c)).

NOTE: It appears as though a seller can get out of a warrantywith a few "magic words" - however, the courts have leeway infinding what is "conspicuous" , and can revert to UCC 2-302,which is "unconscionable disclaimer" provision. You must lookat whether disclaimer is one-sided; surprise or in actualcontract; or leaves parties without a remedy.

f. UCC Sections 2-316 (2) & (3) seen in sections a-e above,make it seem like an easy formula to follow to disclaim, BUT ifyou go to the court decisions, it is not necessarily the case.

It depends on the circumstances as to how the court decides.

g. When the disclaimer was introduced is important. If it'sin a warranty booklet not opened until after the goods arebought, it doesn't count.

h. There is also a problem for the seller because if somethingis disclaimed too much, it's hard to sell.

2. UCC 2-607 (3)(a) - Notice of breach required

a. After a buyer discovers a problem (breach of warranty) he

must notify the seller within a reasonable period of time or bebarred from remedy.

c. After commercial production, adaptation and duplicationexclusions: With respect to the after commercial production,adaption" and "duplication" exclusions (items (11),(12) and(13), above), the preamble to T.D. 9104 indicates that the IRSbelieves these particular exclusions do not apply to researchactivities that otherwise satisfy the requirements for qualifiedresearch. This represents a change in the IRS's interpretationof these exclusions. For example, in the preamble

to T.D. 8930, the IRS indicates that the adaptation exclusioncould apply in situations where the other requirements forqualified research had been satisfied.

DETAILED ANALYIS OF PROTOTYPES


38/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

$)

In general, when a prototype is placed in inventory for sale tocustomers, the wages, contract research (for which the taxpayerbears the risk), and supply costs incurred to develop theprototype are qualified research expenditures (QREs), but thewages and contract research related to construction and the

supply costs for component parts are not. The same is true whena prototype is used for rotable spare parts or is used asdepreciable property by the taxpayer.

However, when a prototype is scrapped by the taxpayer, all ofthe wages, contract research (for which the taxpayer bears therisk), and supply costs incurred to develop and construct theprototype are QREs. Similarly, when the taxpayer pays a thirdparty to develop a prototype and does not obtain an ownershipinterest in the prototype all of the costs incurred by thetaxpayer to develop the prototype are QREs.

Finally, when the taxpayer develops the prototype for a customerand does not obtain an ownership interest in a prototype, all ofthe costs incurred by the taxpayer to develop the prototype areQREs as long as the taxpayers compensation for services iscontractually subject to performance guarantees relating to theprototype.

Under section 174(a), a taxpayer may treat research orexperimental expenditures which are paid or incurred by himduring the taxable year in connection with his trade or business

as expenses which are not chargeable to capital account. Theexpenditures so treated shall be allowed as a deduction.However, under section 174(c) no deduction is allowed for anyexpenditure for the acquisition or improvement of property of a character which is subject to the allowance under section167.

The regulations clarify that expenditures for depreciableproperty are not subject to an allowance for depreciation evenif the property that is acquired or improved is used forresearch and development; however, expenditures that result in

depreciable property to be used in the taxpayer's trade orbusiness may be allowable as a current expense deduction. QREsfor the acquisition or production of depreciable property do notinclude the cost of component materials, construction labor, orother costs attributable to acquisition/ improvement.Additionally, the regulations provide that expenditures paid tothird parties for the construction of depreciable property that


39/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

$*

is acquired by the taxpayer are deductible if such constructionis done at the taxpayers specification and risk.

Any amount paid or incurred for supplies used in the conduct ofqualified research is a qualifying in-house research expense.However, property of a character subject to the allowance fordepreciation is excluded from qualifying as supplies. Thelegislative history of the section 41 credit suggests that thecosts of component parts could be included in the creditcalculations as qualifying supply expenditures; however, neitherthe IRS nor the courts have taken this approach.

Revenue Rulings

In general, Revenue Rulings have been favorable regarding thedeductibility of costs incurred to develop prototypes, butsomewhat limited in their reasoning and discussion of the law.

Rev. Rul. 69-484 held that payments made by a taxpayer airline,in concert with other airlines and the Federal AviationAdministration, to an aircraft manufacturer to design, develop,and test a supersonic transport aircraft were deductible undersection 174. These payments did not entitle the taxpayer to anyrights in the prototype and were made because the development ofthe aircraft would benefit the taxpayer in general.

Rev. Rul. 73-20, which cited Rev. Rul. 69-484 as precedent,similarly held that payments made by a taxpayer utility to anon-profit research and development organization formed todevelop a model that would benefit the utility field weredeductible under section 174. Notably, the Ruling held that eventhe portion of the payments that were administrative andoperating expenses were deductible. Like the payments in Rev.Rul. 69-484, the payments in Rev. Rul. 73-20 did not entitle thetaxpayer to any rights in the prototype and no mention was madeabout the eventual use or disposition of the prototype.

Similarly, Rev. Rul. 73-324 determined that payments made by ataxpayer in concert with other industry members and a governmentagency for the development of a product, were deductible undersection 174.

Rev. Rul. 73-275 considered whether a taxpayer was entitled to asection 174 deduction for costs incurred in constructing special


40/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

%+

order manufacturing systems for its customers. The Ruling heldthat the product engineering expenses qualified under section174, but the production costs did not. The Ruling emphasizedthat section 174 covers costs incurred in developing theconcept of a product as opposed to the product itself.

Rev. Rul. 75-122 considered whether the taxpayer miningcompanys costs to access a previously unexploited mineraldeposit, develop equipment to mine that deposit, and developequipment and processes to extract the mineral from the ore weredeductible under section 174. The Ruling held that the costs tolocate and access the ore were explicitly disallowed by section174(d). However, the costs for developing new mining equipment,developing new refining processes and equipment, and shippingore samples to the lab were deductible under section 174.

Private Letter Rulings

A number of private letter rulings (PLRs) have also beenfavorable to the taxpayer.

In PLR 7921037, the Service ruled a taxpayer utility companythat participated in a coal gasification plant project funded byseveral utility companies was entitled to a deduction undersection 174.

PLR 7948031 was issued to a taxpayer chicken farmer that engagedan engineer to develop an advanced system to extract uric acidfrom chicken manure so that the manure could be used for animalfeed. The Letter Ruling held that the engineering and plantcosts incurred that related to removing the uric acid from themanure were not deductible because that process had already beentested and developed, but the plant and development costsattributable to conversion of uric acid into fertilizer weredeductible under section 174 except to the extent that thosecosts were for the acquisition or improvement of land orproperty that were subject to the allowance for depreciation

under section 167.

PLR 8138145 was issued to a taxpayer partnership that was in theprocess of developing a pilot residential energy efficiencyprogram that would pay the taxpayer if it could provide energycost savings to customers that were greater than the cost to theutility of providing energy. The Letter Ruling held the


41/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

%"

partnership may deduct all amounts which qualify as research andexperimental expenditures in connection with the pilot test.

In a slightly different situation, PLR 8835002 was issued to ataxpayer that developed a prototype that used a new constructionmethod in a laboratory. The Letter Ruling held that thefollowing constituted QRE under section 41: 1) wages andsupplies used for research and development in taxpayer'sresearch and development department both prior to and after theinstallation of the first prototype; 2) wages for on-sitemonitoring of the prototype installations; 3) supplies formodifying the prototype installations; and, 4) 65 percent of theamounts relating to the testing of the prototypes paid tosubcontractors to replace the original prototypes due to methodmodifications and damage to the extent that these expenses wereincurred during the period the taxpayer was developing its new

method.

Similarly, in TAM 199927001, a taxpayer that constructed moldsand other tools for the manufacture of plastic products wasallowed to deduct the costs incurred in designing the tools, butthe costs incurred in constructing the tools were not deductibleeven though they would not be depreciated by the taxpayer.

Court Cases

In Honeywell Inc. & Subsidiaries,1 the Court held that rotablespare parts were depreciable assets rather than inventory.Honeywell used such parts to service computers owned by itscustomers as part of its computer maintenance and servicebusiness. Honeywell consistently capitalized cost of rotableparts and depreciated them over the same life span assigned tothe related computers. The parts were provided by Honeywell toits customers under computer lease or maintenance agreements andwere repaired after removal from customer's machines to be usedagain. There was no direct relationship between the fixed feecharged to maintain the computers and the price or cost of partsin taxpayer's replacement parts pool; thus, parts were notconsidered an income-producing factor that would requiretreatment as inventory. The pool of parts was necessary forHoneywells maintenance business and the fixed asset method ofaccounting used by Honeywell properly matched the cost ofestablishing the pool with revenue earned from maintenanceagreements.


42/65

!"#"$%& $() *+,)- +./ !$0,1 %#+"$#.+%0#.2

%#

In Trinity Industries, Inc. v. US2, the Court held that underthe substantially all rule, if 80 percent of the activities todevelop a prototype constituted a process of experimentat

Documents

Draft r n d Study Xx Fund v1