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Federal Research Tax Credit: Maximizing Your Company's Tax SavingsTax Court's Union Carbide Decision Creates New Opportunities, New Limitations
A Live 100-Minute Audio Conference with Interactive Q&Apresents
Today's panel features:
Bruce Warner, President, Warner Tax Consulting, Kansas City, Mo.
Kendall Fox, Tax Partner and Leader, U.S. National Research and Development Team, PricewaterhouseCoopers, Los Angeles
Kathleen King, Managing Director, Research Credit and Incentive Services, Alvarez & Marsal Taxand, Vienna, Va.
Joseph Maselli, Director, Washington National Tax Services, PricewaterhouseCoopers, New York
Christine Kachinsky, Federal Tax Partner, Accounting Methods and Credits, KPMG, New York
David Culp, Senior Manager in Pass-Throughs Group, Washington National Tax Practice, KPMG, Washington, D.C.
Tuesday, May 26, 2009
The conference begins at:1 pm Eastern12 pm Central
11 am Mountain10 am Pacific
The audio portion of this conference will be accessible by telephone only. Please refer to the dial in instructions emailed to registrants to access the audio portion of the conference.
1
Federal Research Tax Credit Teleconference
May 26, 2009Christine Kachinsky and David Culp
[email protected], [email protected]
Kathleen King Bruce WarnerAlvarez & Marsal Taxand Warner Tax Consulting
[email protected] [email protected]
Kendall Fox and Joseph MaselliPricewaterhouseCoopers
2
Today’s Program
• Review Of The Union Carbide Decision, slides 4 through 25 (Christine Kachinsky and David Culp)
• Favorable And Unfavorable Aspects Of The Union Carbide Decision, slides 26 through 48 (Kathleen King, Bruce Warner, Kendall Fox and Joseph Maselli)
• Other Relevant Topics On The Research Credit, slides 49 through 52 (Kathleen King, Joseph Maselli and Bruce Warner)
3
ANY TAX ADVICE IN THIS ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED COMMUNICATION IS NOT INTENDED
OR WRITTEN TO BE USED, AND OR WRITTEN TO BE USED, AND CANNOT BE USED, BY A CLIENT OR CANNOT BE USED, BY A CLIENT OR
ANY OTHER PERSON OR ENTITY FOR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING THE PURPOSE OF (i) AVOIDING
PENALTIES THAT MAY BE IMPOSED ON PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, ANY TAXPAYER OR (ii) PROMOTING,
MARKETING OR RECOMMENDING TO MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ANOTHER PARTY ANY MATTERS
ADDRESSED HEREIN.ADDRESSED HEREIN.
The information contained herein is general in nature and based on
authorities that are subject to change. Applicability to specific situations is to
be determined through consultation with your tax adviser.
4
Review Of The Union Carbide Decision
5
Overview
Union Carbide Corporation v. CommissionerT.C. Memo. 2009-50 (March 10, 2009)
• Taxpayer (“UCC”) was under examination for calendar tax years 1994 and 1995
• UCC claimed $14.1M and $4.1M of research credits on its original returns, using the traditional research credit methodology
• UCC is engaged in the trade or business of processing raw hydrocarbon feedstocks into “basic building-block” chemicals (olefins)– Olefins are converted into derivatives – plastics and other chemicals –
that are used in manufacturing products and applications or as raw materials in more complex chemicals
– UCC also licenses olefins-based process technologies to third parties
6
Overview (Cont.)• IRS mailed notice of deficiency in 1999• UCC filed its original Tax Court petition on June 17, 1999 • IRS and UCC negotiated an agreement that resolved most issues, including
the research credits• In an amended petition, UCC claimed additional credits of $3.66M and
$4.73M, for 106 projects– The 106 projects were activities intended to improve various aspects of
the production of various chemicals and plastics in UCC’s trade or business
– Generally, these activities were conducted during runs at the UCC’s production facilities
– The additional QREs had been reported as cost of goods sold• Raw materials used to produce goods for sale
7
Overview (Cont.)
• The parties agreed the Tax Court would try five of the largest projects– Nine days of testimony in June 2006 on the eligibility of the projects as
qualified research– 14 days of testimony in November–December 2007 on the Section
41(c) base amount– UCC introduced expert testimony from seven witnesses– The IRS introduced expert testimony from three witnesses, affiliates of
LEGC LLC, a global expert services and consulting firm• Judge Goeke’s 298-page memorandum opinion was filed on March 10,
2009– The judge expects the parties to resolve any issues regarding the
remaining 101 projects in a manner consistent with the opinion
8
The Five Projects: No.1Amoco Anticoking Project
• Coke builds up in the furnaces used in the cracking process used to produce oleofins– Reducing coke would reduce shutdowns and maintenance, and increase
productivity• UCC evaluated a new decoking technology developed by Amoco• The technology was used in two otherwise-normal production runs
– UCC paid for its feedstocks, fuel gases, and ordinary production wages– Amoco paid for the pre-treatments, the costs of its technology and any
overtime wages– UCC sold the materials produced in the ordinary course of its business
• UCC assessed the effects of the technology and ultimately determined that the Amoco technology did not effectively reduce coke formation
• QREs claimed– Supplies: Portion of total ethylene production cost allocated to project– Wages for hours the specific employees involved estimated for project
9
The Five Projects: No. 2The UCAT-J Project
• UCC was developing a new catalyst, UCAT-J, for its production of polyethylene, as an alternative to M-1, in hopes that UCAT-J could be used in a new facility and commercialized
• UCC described the anticipated advantages of UCAT-J to potential licensees• UCC tested UCAT-J in experimental production runs at two existing
reactors, alternating with M-1 (an established catalyst) beginning in 1992• In 1994 and 1995, there were 19 experimental runs, each with specific
objectives to be evaluated• The experimental runs generally produced commercial product that was
sold in the course of business, though some of it was “off-grade” and sold at a lower price
• The reactors were in operation fulltime, and there was no significant additional employee time to operate a reactor for an experimental run
• QREs: The cost of production materials and wages allocated to the experimental runs
10
The Five Projects: Nos. 3 And 4
• The spuds project– At the advice of a vendor, UCC substituted one-hole “spuds” for four-
hole spuds in its furnace, to reduce “plugging”– UCC tried the one-hole spuds for 90 days during its normal production
processes, and determined the problem was resolved• The sodium borohydride project
– UCC had used sodium borohydride to reduce acid gases in its furnace, but not in its “scrubbers”
– Based on a 1/9/95 R&D report, beginning in 6/05 UCC began a testduring production runs and monitored the results, but did not document the results in a final report
– The decision to convert to sodium borohydride was based on the 1/9/95 report and a determination that the product produced in the 6/05 tests was on-spec
11
The Five Projects: No. 5
• The UOP GA-155 project – A vendor, UOP, recommended that UCC use a new product, GA-155,
as an inhibitor to reduce fouling in its ethylene units– UCC conducted a test by injecting GA-155 into its C3 column and
measuring the effects during normal production runs– UCC recorded data closely for three months (the normal run length
before a shutdown without an inhibitor), and the column successfully continued in operation for three additional months
12
What The Court Decided• The 2003 final Section 41 regulations (T.D. 9104) may be relied on, even
though UCC’s research occurred in 1994 and 1995• The four-part test for qualified research is applied separately to each
business component– If a project involves both the development of the concept of a new or
improved process and the use of the process in production, only the activities related to the development of the concept satisfy the Section 174 test
– If a business component fails the process of experimentation test because of the “substantially all” requirement, the taxpayer may apply the shrinking-back rule until an element that satisfies the test is reached
– For each of UCC’s projects, there are two business components:• A process business component• A product business component
• For each of UCC’s five projects, the inquiry was “shrunk back” to the process business component
13
Was It Qualified Research?
Amoco Anticoking Project• The project satisfied the four-part test• Process of experimentation
– Ordinary production activities that would have occurred even if the taxpayer was not conducting an experiment do not constitute elements of a process of experimentation
– However, by limiting the project to the process research activities, substantially all of the activities do satisfy the process of experimentation requirement
• This was not research funded by Amoco (the proprietor of the technology tested by UCC)
• This was not research after commercial production; the Amoco technology was not ready for commercial use at the time of the tests
14
Was It Qualified Research? (Cont.)
UCAT-J Project• Each of the 19 experimental production runs constituted qualified research
on the process• The Section 174 test
– UCC had confidence that UCAT-J could be successfully developed, but there were numerous issues about the design of the process
– Even though UCC had commercial objectives in the experimental runs – Producing product for sale and training employees in using UCAT-J – The primary objective of the runs was to resolve uncertainties about the process
• Process of experimentation test– Even though there were no formal project reports, there was credible
testimony that UCC data was collected during the runs, was analyzed, and used to further refine the process using UCAT-J
• The production process using UCAT-J did not satisfy UCC’s basic functional and economic requirements during the credit years
15
Was It Qualified Research? (Cont.)
The Spuds Project• UCC conceded this was not qualified research
• Court: Section 174 requires that “an objective uncertainty exist”
• UCC had sufficient information to be certain that one-hole spuds were capable of improving its production process
16
Was It Qualified Research? (Cont.)
Sodium Borohydride Project• The activities failed the process of experimentation test
– The project must be designed not only to test whether the sodium borohydride satisfied UCC’s needs, but also to evaluate its use through a sequential process of experimentation
– Data collection is insufficient if it is not followed by a meaningful analysis
– The 1/9/95 R&D report on which UCC relied for this project was prepared before the 6/95 test began, so any test data was not used in the analysis
17
Was It Qualified Research? (Cont.)
UOP GA-155 Project
• The activities failed the Section 174 test• UCC already had sufficient information available to eliminate any
objective uncertainties about using GA-155 as an inhibitor• UOP – the vendor – had already performed the research to establish that
GA-155 was effective• UCC was confirming UOP’s assertions with its own testing• UCC had no doubt that injecting an inhibitor into the C3 column was the
appropriate method to reduce fouling
18
Base Period
• UCC relied extensively on its expert witnesses to determine the activities conducted during the 1984-1988 base period that were qualified research, and the costs of those projects
• The court emphasized the consistency requirement in the determination of qualified research for the credit year projects and the base period projects– There is no requirement that a taxpayer use the same types of
documents to identify qualified research in the base period that it uses in the claim year, if the consistency requirement can be satisfied in other ways
• The court held that the consistency requirement must be applied to the activities conducted by each member of a controlled group, not to the controlled group as a whole
19
What QREs Were Allowed?
• Only the Amoco anti-coking project and the UCAT-J project were found to be qualified research
• Because the business component is the process, not the production, supplies and wages that relate to production activities are not QREs– Thus, the materials used in the production operations while the research
activity was conducted are not QRE
• UCC argued that the research projects could not have occurred without these supplies and materials
• The court said that raw materials used to make finished goods that would have been purchased regardless of the research activity are not used in the conduct of qualified research– Such supplies “are, at best, indirect research costs”
20
What QREs Were Allowed? (Cont.)
Amoco Anticoking Project• All supply expense was disallowed ($3.186M)
• The court accepted the “credible testimony” of three employees as to the time they spent on the projects; but a fourth employee did not testify to his time, and there was no other substantiation, so his wages were disallowed
• $835 of the $873 of the claimed 1994 wage QRE was allowed, and all $210 of the 1995 wage QRE
21
What QREs Were Allowed? (Cont.)
UCAT-J Project• All supply expense was disallowed ($6.68M)
• The wage QRE claimed was a percentage of total wages for the production by the reactors.
• There was no substantiation of how much time was spent by these employees engaging in qualified research
• All of the wage QRE was disallowed ($519K)– Wages of the personnel planning and analyzing the research had
already been counted as QREs in UCC’s original credit claim
22
What QREs Were Allowed? (Cont.)
Base Period Costs• The court found, generally, that UCC used the same methodology to
calculate credit-year costs and base-year costs
• The court said the base-year costs reflected the same flaw – that production costs were counted as QREs
• Generally, however, the court did not adjust UCC’s computation to exclude these costs
23
Some General Observations
Substantiation• The IRS argued that UCC did not produce sufficient documentary evidence
to corroborate testimony that the UCAT-J project was qualified research• The court accepted UCC’s substantiation, considering the record in its
entirety– There were three fact witnesses who discussed the project and were
corroborated by documentary evidence that provided the objectives, risks and results of the runs.
• The Tax Court indicated that it will apply Cohan to accept the taxpayer’s evidence and oral testimony and concessions “as a close approximation of all the qualified research activities” and expenses that occurred during the credit years and the base period – The Cohan rule was applied, however, in circumstances that would
likely minimize UCC’s research credit
24
Some General Observations (Cont.)Production Runs Vs. Experimental Runs
• The court seemed to apply a “primary purpose” approach to determining whether the costs of a run would be QRE – The primary purpose of the run was production of salable goods, and
the run would have taken place regardless of the research • The court distinguished Fudim v. Commissioner, T.C. Memo. 1994-235, as
a case where the taxpayer was allowed QRE for the supply costs incurred in developing a process of designing and producing plastic objects – The Fudim supply costs were “devoted to research”; they would not
have been incurred except as part of the research, and very little of the product was sold
• There are many types of trial production runs related to processexperimentation that will fit, factually, somewhere between a run conducted to produce commercial product (as the Tax Court would characterize the situation in UCC) and a run where the supplies are entirely devoted to research, as it characterized Fudim
25
Summing Up• In its first research credit decision since the 2003 final regulations, the Tax
Court analyzed five projects, only two of which were held to be constitute qualified research
• The taxpayer’s claim to treat as QRE the costs of supplies and general labor in conducting research during a production run that would have occurred anyway was denied.
• The taxpayer’s characterization of such costs as QRE in the base period was called “flawed,” but the court did not make any adjustment because such an overstatement was “harmless error”
• Ten years of docket time, 23 days of testimony, countless hours of expert witness time, and a 298-page opinion
• The taxpayer was allowed $1,045 of additional QRE in the sample of five of the 106 projects
26
Favorable And Unfavorable Aspects Of The Union Carbide Decision
27
Overview Of Scale-Up Activities In UCC
• Development activities under review in UCC occurred within a production environment.– Key issue: Did the sample projects relate to qualifying research
activities?• Disallowed costs were primarily materials used within a production
environment.– Key issue: Did the supplies relate to a qualifying research activity?
• Used vs. consumed• Incremental• Size of expenditures • Primary purpose
– Key issue: Did the labor relate to a research activity? • Engineering vs. production labor
28
What Are “Scale-up” Activities?• Scale-up activities are often the final step in the development process and
frequently require large supply dollars that may be eligible for the research credit
• Understanding the nature and purpose of these costs relative to the research process is critical to factually differentiating these costs from those in the UCC case
• Positives from case related to scale-up:– UCC case determined two of five sample projects satisfy the definition
of qualifying research– Certain labor costs were determined to qualify for the two projects– Court did not conclude that supply costs don’t qualify at a large scale– No specific restriction on supplies used in research, if products are
ultimately sold (i.e., primary purpose seems to trump sale)
29
Typical Development Process• The R&D process for many industries includes the following steps:
– Discovery– Laboratory research– Pilot plant– Full-size scale-up batches
• Technical uncertainty is frequently present in all stages of the research process
• Uncertainty in scale-up batches may exist because of:– Molecular complexity of materials (relevant for food, chemical and
pharmaceutical industries)– Varying environmental factors (relevant for plant, animal or
construction product industries)– Physical phenomena related to unique equipment or processing
parameters (relevant for any manufacturing industry)
30
Experimentation In Scale-Up Batches• Because of the uncertainty, scale-up batches are an important part of the
process of experimentation – Activities that otherwise satisfy the four-part test should not be subject
to the exclusion for after-commercial production • A good understanding of the experimental design is also critical
– Why did the experiment need a scale-up batch trial?– Why wouldn’t a smaller-size run satisfy the experimental
requirements?– Why was more than one batch required?– How were the results tracked? – If more than one batch was run, how were the tests different? – Did the trial result in a formula or product change?
• Documentation of trial and results is extremely helpful (though specific form of documents should be flexible)
31
Important Facts For Scale-Up Based On UCC
• Important to identify the objective of the research – Is the objective of the research a product or process (business
component test)?• Helpful to identify technical background of those involved in the
development effort– Was the core R&D team involved?
• Valuable if you can demonstrate that scale-up is part of the typical development process– Is the primary purpose: R&D vs. production.– Did you intend to sell the product? Why were you uncertain that the
product would be saleable?
32
Discovery Test Vs. Technological In Nature• History – 1986 Tax Reform Act
Targets the credit toward research undertaken for the purpose of discovering information that is technological in nature, and when applied is intended to be useful in developing a new or improvedbusiness component for sale or use in carrying on the taxpayer'strade or business
• Bifurcation into separate “discovery test” and “technological in nature” test• Norwest Corp. v. Commissioner, 110 T.C. 454 (1998)
– Discovery test language adopted by the Tax Court– New “academic” standard applied: Knowledge must exceed, expand or
refine the common knowledge of a skilled professional within the field of the hard science involved
– Note 3 from Conference Report 99-841• Tax Court in Norwest concluded that the taxpayer must discover
information about the principles of the hard sciences, and the discovery must go beyond the existing principles
33
Administrative Challenges And Regulation Projects
• Government’s expert witness (a university professor) set forth the “skilled professional” test adopted by the Tax Court in Norwest
• Fine in academic circles, but difficult to prove within applied or commercial R&E
• How to prove the negative – proving that knowledge didn’t exist• Administratively difficult for IRS as well; many cases went to appeals on
this one issue• Congress even steps in:
– 1999 extender bill; Congress expressed its concern over application of the common knowledge standard
• T.D. 8930 “final” regs– This version of the regs was revoked but stated the IRS position that the
discovery test was a “separate substantive requirement”• Proposed regs issued in December 2001
– IRS changed its position and eliminated “common knowledge of skilled professionals” criteria
34
Administrative Challenges And Regulation Projects (Cont.)
• Shouldn’t the December 2001 regs have been the end of the discovery test?– For internal use software, IRS still applied the discovery test if the
taxpayer was using the legislative history definition of the internal use software rules (reduction in costs, improvement in speed). The IRS forced taxpayers to apply the revoked regulations (T.D. 8930), and thus the discovery test lived on
– MITRE experts were also applying versions of the old discovery test
• Final Regs T.D. 9104 (December 2003)– Still called the test the “discovering information” test in the heading– Regs reinforced that there was no exceeding common knowledge
requirement; but, agents and MITRE experts were still applying some version of the higher threshold discovery test
– No final regs on internal use software; IRS still forcing taxpayers on to the revoked T.D. 8930 regs and its common knowledge discovery test
35
Review Of Other Court Cases• Adding to confusion over the discovery test, courts were concerned over
lack of guidance coming out of Treasury and IRS on final Section 41 regs
• Court applying various versions of a “higher threshold” discovery test– Norwest, 110 T.C. 454 (1998)– United Stationers, 982 F. Supp. 1279 (N.D. Ill. 1997) – Wicor, 116 F. Supp. 2d 1028 (E.D. Wis. 2000) – Eustace, T.C. Memo 2001-66– McFerrin, 2008-2 USTC ¶50,583
• Significance of Union Carbide: First Tax Court case on the R&E credit since Norwest and since the December 2003 final regs were issued
36
Technological Information Test• Union Carbide holding: Discovery test is now the “technological
information” test– IRS conceded this issue– Language from the case - Respondent conceded that UCC satisfies the
“technological in nature” test as long as the information sought to be discovered is in fact technological, and we accept this concession. In light of the change to the test, we find that it is more appropriate to refer to this test as the “technological information test”
• Cite both final regs and Union Carbide in applying the technological in nature test
• TSR Inc. v. Commissioner, 96 T.C. 903 (1991), is even helpful– First Tax Court case discussing the “technological in nature” test– Congress intended to reward technological or scientific research
involving the physical sciences– Plain meaning of technology: The application of scientific knowledge
to practical purposes in a particular field
37
Favorable Procedural Implications
• Discovery test for pre-2004 years– IRS agreed to abandon discovery test in Union Carbide for years prior
to the effective date of final regs (i.e. pre-2004 years)– Current final regs cover the outcome of the Union Carbide case, even
though years involved were prior to the effective date– IRS won’t challenge return positions that are consistent with the final
regs, even for pre-2004 years; so, this would include application of the discovery test to pre-2004 years
38
Substantiation, Estimates And The Cohan Rule
Burden of proof: Credit claimed in amended petition criticized• Overall, UCC court did not like that the
UCC projects had not been claimed on the original return, BUT:
• Court did qualify two of the five projects
• Court did accept significant evidence:- Base years - QRE provided by witnesses- Various combinations of documents
and estimation methodologies
Burden of proof: Failure of taxpayer to meet burden• Refund claim; burden of proof is
higher than if the items are claimed on an original return
• R&D refund claims as Tier 1 issue• Appeals treats all R&D issues as
“coordinated issues”
39
Substantiation, Estimates And The Cohan Rule (Cont.)
Estimation allowed• Estimates of supply and wage data for
anti-coking project accepted under Cohan
• Estimates and assumptions allowed for base
• Cohan allowed for base determination • Use of employee experts to establish
base (Wadia)– Substantiation - see prior slide
Estimation not allowed• Current vitality of the Cohan rule
is open to question• IRS focus on contemporaneous
documentation• Tyson-emphasized taxpayer’s
status in the industry and its employment of in-house and outside accountants and tax preparers
• Boddie-Noell: Reconstruction of evidence not allowed. Also cites Eustace & McFerrin
40
Substantiation, Estimates And The Cohan Rule (Cont.)
Variety of evidence established creditUnion Carbide accepted a wide variety of documentation and testimony
The court accepted:• Reconstruction methodologies for both the claimed QREs and base-year information • The use of historical data • Testimony corroborated by documents • Testimony taken alone, and • When necessary, estimation under the principles of Cohan v. Commissioner, 39 F.2d at 540 (2d Cir 1930)
McFerrin: Failure of recordsTotal recordkeeping failure:
It was clear that the taxpayers had:• No records showing how many hours each employee worked on any given project
• No records of how many hours any employee’s work involved activities
that might have constituted research, let alone qualified research
• No records showing what supplies were used during 1999 in activities that might constitute research
41
Substantiation, Estimates And The Cohan Rule (Cont.)
Witness testimony admissible to prove qualification•Three fact witnesses were produced to
discuss the UCAT-J project. and their testimony was corroborated by “sufficient documentary evidence”
•Court found that testimony from Hyde and Tregre was credible, despite the fact that they testified about QREs from 1994 and 1995
•To establish the duration of a particular anti-coking test, the taxpayer offered, and the court accepted, four witnesses who corroborated that a second test occurred
Witness recollection: Not accepted to prove qualification• Recollection of witnesses took
place several years ago, and such testimony is inherently unreliable
42
Substantiation, Estimates And The Cohan Rule (Cont.)
Reconstruction methodologies of employee expert allowed•Two employees were qualified as experts
and testified extensively: Ms. Hinojosa, a former cost accountant for UCC, and Dr. Wadia, a 30-year UCC employee
•The court accepted methodology based upon UCC’s reliance upon PCDs (product cost detail reports) and MASes (material accounting summary reports), which did not tie to the particular projects but were part of its cost accounting system
Taxpayer methodology based on old records, and company expert not allowed • Cite Boddie-Noell for
proposition that methodology employed by company’s expert to substantiate 12-year-old expenditures was inadequate
43
Substantiation, Estimates And The Cohan Rule (Cont.)
Testimony can supplement contemporaneous documentation– “Many of the documents in evidence list
the objectives and the risks involved in the runs, and UCC confirmed through testimony that each of the runs was conducted for the purpose of discovering information that would help eliminate uncertainties as to how UCC could improve its PE production process using UCAT-J. Therefore, we find that the testimony does not conflict with the documentary evidence.”
Contemporaneous documentation required• Taxpayer has maintained no
contemporaneous records regarding the credit, which is fatal to taxpayer’s refund claim
• Cites to IRC § 6001
44
Substantiation, Estimates And The Cohan Rule (Cont.)
Process of experimentation conducted•Anti-coking: UCC collected and analyzed
data that could be used to compare the technology with alternatives
•UCAT-J: UCC conducted a series of trials using UCAT-J and analyzed the results of each trial to develop and improve its process
– UCC was testing hypotheses and forming new hypotheses based on each succeeding run, in order to solve some of the chemical and physical problems it had experience.
– UCC was comparing UCAT-J’s and M-1’s performances on a variety of criteria related to reactor operability, reactor continuity and product properties (emphasis added)
No process of experimentation• Routine application of
engineering principles and routine data gathering and studies
• IRS often contends that activities were not sufficiently scientific to constitute research
45
Substantiation, Estimates And The Cohan Rule (Cont.)
Cost accounting acceptable• Cost accounting and business records produced
monthly and annually (not for particular projects) were held to be valid documentation of the costs incurred
• “Cost accounting records were PCDs and material accounting summary reports”
• Government argued UCC was using an “ad hoc” methodology. BUT, the court held:
- Regs do not require substantiation of research credit claim with particular types of documents
- Taxpayer must “retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit”
- Thus, cost accounting based records allowed to establish base- and credit-year expenditures
Need for project accounting• “Like McFerrin, Taxpayers
have not provided any records showing how many hours each employee worked on any given project during Year 1.”
• “… no link between the amount of research claimed to have been performed by an employee and the projects which allegedly resulted in alleged research activity.”
46
IRS Exclusion Arguments RejectedFunded research• Amoco and UCC each paid their own costs during the Amoco anti-coking project. While Amoco covered the cost of applying the pre-treatment and was contractually obligated to pay for any overtime worked by UCC employees, UCC did not include any of these costs in its QRE calculations• UCC was not seeking credit for the costs that Amoco incurred to develop the technology, BUT was seeking credit for research that UCC performed for its own benefit and at its own cost • UCC did not gain any rights to Amoco’s technology by conducting the project, BUT retained all rights to its own research. UCC produced credible evidence at trial that the information it gained during the Amoco anti-coking project was valuable regardless of whether it licensed Amoco’s technology
Funded researchAny research to the extent funded by any grant, contract or otherwise by another person (or government entity) is not qualified
47
IRS Exclusion Arguments Rejected (Cont.)
Research after commercial production• UCC argues that the Amoco anti-coking project was a process of experimentation that UCC had to conduct before deciding whether to license Amoco's technology. Only the Amoco anti-coking research activities were examined, not UCC’s entire olefins process• Court stated that the Amoco technology was not yet ready for commercial use at the time UCC undertook the Amoco anti-coking project • Amoco’s technology failure was a clear indication that it did not meet UCC’s needs • Amoco anti-coking project was not a “trial production run,” because it was conducted before the potential process improvement – the Amoco technology – was satisfactorily tested and proven
Research after commercial ProductionActivities conducted after the beginning of commercial production of a business component are not qualified
48
IRS Exclusion Arguments Rejected (Cont.)
Other exceptionsData collection and routine testing• UCC collected some data that it did not normally measure and took other measurements more frequently than normal
• UCC analyzed the collected data, which it did not normally do • UCC took many more measurements for the purpose of determining whether Amoco’s anti-coking technology actually reduced the formation of coke and whether the technology could improve UCC’s production process • Court held that UCC’s activities went beyond routine data collection and that the Amoco anti-coking research activities are not excluded from the definition of qualified research by Section 41(d)(4)(D)
Other exceptionsData collection and routine testingRoutine or ordinary inspections for quality control are not qualified
49
Other Relevant Topics On The Research Credit
50
Research Credit Statistics• According to the IRS, tax stats for the 2006 research credit include:
– 10,788 companies claimed the credit, for a total $7.31 billion – 88% of claimants had $250 million or less of gross receipts, thus
showing the importance to small businesses. More than 50% of claimants had $1 million to $50 million of gross receipts
– The leading three industry sectors claiming the credit were manufacturing, information systems, and professional scientific and technical services
• Projected cost of making credit permanent is $74B (FY2010 – FY2019)• Current budget plans are to nearly double funds for IRS enforcement of
U.S. tax laws in 2010, and more than quadruple funding for tax compliance to $2.1 billion over the next five years
• The research and experimentation (R&E) tax credit has been extended 13 times
51
Software Cases and Union Carbide• Union Carbide didn’t involve any software projects . . . but:• Tax Court’s decision in Union Carbide on the 4 part test still applies to all
R&E including software projects:– Elimination of the discovery test is favorable– MITRE reports were relying upon discovery test– MITRE expansion to more than just internal-use software cases– More structured process of experimentation must be established
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Internal Use Software - Regulations
• The internal use software regulations were included in the regulations that were re-proposed in 2001
• BUT this portion of the regulations was not finalized in 2004
• Treasury issued a notice that until further guidance is issued, taxpayers must rely on provisions in the 2001 proposed regulations or the provisions of the January 2001 final regulations (which applied the discovery test)