Research Tax Credit

In TG Missouri Corp. v. Commissioner, 133 T.C. 13, the U.S. Tax Court recently found that property purchased from a third party qualifies as a supply expense for purposes of the research tax credit even though the taxpayer retains possession of the property. TG Missouri Corp is in the business of of manufacturing injection-molded products, such as steering wheels, air bags, and body side molding for the automotive industry. TG Missouri Corp hired a third party toolmaker to make production molds. It then sold the molds to its clients, but retained possession of the molds so that it could manufacture parts for its clients — the owners of the molds — using the molds. The government concluded that the molds were depreciable property in the hands of TG Missouri Corp and, therefore, are not qualified research expenses. The court considered the depreciation rules outside of the context of the research tax credit in concluding that the depreciation rules are the same for purposes of the research tax credit.

The U.S. Tax Court recently issued its opinion in Deere & Co. et. al. v. Commissioner, 133 T.C. 11 (2009), holding that the taxpayer must include its foreign branch income in its research tax credit calculation. Deere & Co. received income from its branches in Germany, Italy and Switzerland. Deere & Co. filed a consolidated tax return to report its combined income. Deere & Co. did not include its foreign branch receipts in the calculation for its U.S. research tax credit, believing that the research tax credit calculation does not require the inclusion of income from its foreign branches. The calculation for the research tax credit is, in part, based on the taxpayer’s average gross receipts for the four year period leading up to the year in which the taxpayer claims the credit. The Code does not specify whether foreign branch income is to be included in the calculation. Deere & Co. argued that the research tax credit is a domestic credit and that the calculation, and the credit in general, is structured such that foreign activities are to be excluded from consideration. The court rejected this argument, concluding that Congress would have specifically excluded foreign branch income from the calculation if it intended the amount to be excluded.

The Treasury Department released a new regulation to make it easier for taxpayers to claim a reduced research tax credit. While the two tax provisions are not identical, expenses that qualify for the research tax credit may also qualify for the research tax deduction. Taxpayers can claim both; however, a taxpayer must make an election to reduce its research tax credit to claim the research tax deduction. Currently, a taxpayer must make this election on an original tax return. The proposed regulation will allow a taxpayer to make the election directly on the Form 6765 – which is the form filed with an income tax return used to claim a research tax credit. The proposed regulation is effective when it is published in the Federal Register.

In United States v. McFerrin, 570 F.3d 672 (5th Cir. 2009), the Fifth Circuit vacated the opinion of the lower court which concluded that the taxpayer was not entitled to the research tax credit claimed. McFerrin, a prominent chemical engineer, owns several chemical companies. McFerrin hired a tax consulting firm to prepare a research tax credit study for his companies. McFerrin filed an amended tax return to claim a research tax credit based on the study. The IRS issued a refund and, later, brought suit to recover the refund. The District Court sided with the government. It concluded that McFerrin’s research did not “discover” new information and McFerrin’s evidence supporting its claim, which consisted primarily of employee testimony, was not sufficient. The Fifth Circuit disagreed with both of these conclusions as they are based on incorrect law. The Fifth Circuit remanded the case back to the District Court with instructions for the lower court to consider employee testimony to determine how much, if not all, of the research tax credit claim is allowable.

In FedEx Corp. v. United States, 2009 U.S. Dist. LEXIS 59856 (W.D. Tenn. 2009), a district court in Tennessee rejected the government’s interpretation of its research tax credit regulations for internal use software. In the late 1990’s, FedEx embarked on designing a new client-server billing system that could handle a large number of transactions. FedEx ended up abandoning the project in 2001 due to technical challenges. FedEx claimed credit for the research on its 1997 through 2000 federal income tax returns for this project. The government denied FedEx’s research tax credits because, according to the government, the research did not satisfy the requirements set out in the regulations. The court examined the regulations, noting that the government issued (1) final regulations in 2001 that addressed “internal use software” and contained a strict “discovery test” requirement and (2) final regulations in 2003 that had a more lenient “discovery test,” but did not address “internal use software.” The government had previously conceded that the higher “discovery test” requirement is invalid (after being prompted by Congress to do so); however, the government took the position in this case that the taxpayer must choose to apply either the 2001 regulations (which included “internal use software” rules and the invalid “discovery test”), or the 2003 regulations (which contained a less rigid “discovery test,” but not the “internal use software” rules). The court disagreed with the government. It said that taxpayers can use the “internal use software” rules from the 2001 regulations and the more lenient “discovery test” rules in the 2003 regulations.

In Union Carbide Corporation and Subsidiaries v. Commissioner, T.C. Memo. 2009-50 (2009), the U.S. Tax Court examined the taxpayer’s research tax credits. The taxpayer determined its research tax credits to be $18 million. The IRS conceded these amounts in a negotiated settlement; however, the taxpayer believed it was entitled to an additional $8 million in research tax credits for supply costs it incurred. The IRS did not agree. The Tax Court reviewed a small sample of five of the taxpayer’s research projects for purposes of the trial. A mere 298 pages later, the taxpayers multimillion dollar research tax credits were reduced to a mere thousand dollars. This is the first time a court has provided a comprehensive review of how research tax credits are computed. This is one court case that is well worth reading in full. You can find a copy of the court’s opinion on the U.S. Tax Court website.

President Bush signed HR 1424 into law to extend the research tax credit. Since first enacted in 1981, the research tax credit has never been made a permanent part of our tax law. This most recent extension is valid for expenses paid or incurred on or before December 31, 2009. The law also increased the Alternative Simplified Credit (ASC) percentage to 14 percent (from 12 percent) for tax year 2009 and eliminates the Alternative Incremental Reseasrch Tax Credit (AISC) for tax years beginning after December 31, 2008.

The Social Science Research Network (SSRN) website has posted an article by a tax attorney that explains how business mergers and dispositions impact research tax credits. The paper provides an excellent overview of this complex and important area of law. The article can be downloaded directly from the SSRN website.

The IRS released a new audit techniques guide for the research tax credit. This new audit guide explains how IRS revenue agents are to conduct audits of research tax credits. This audit guide supplements the prior audit techniques guide released by the IRS approximately three years ago. This new audit guide can be found on the IRS website.