R&D tax credit update: recent court decisions shed light on key issues.

• Author: Stoddard, Joe

The research and development (R&D) tax credit under Sec. 41 continues to be an important incentive for many companies; however, the incentive effect is often dampened by challenges in identifying, documenting, and defending the credit. These challenges are heightened by the subjective nature of the terms defining qualified research and related expenses, the lack of guidance on what constitutes proper substantiation, and contentious IRS examinations. Court decisions from recent months provide guidance on several important R&D tax credit issues including the qualification of certain supply expenses, proper substantiation and documentation, and the definition of gross receipts. This item explores these cases and the potential impacts on companies claiming the R&D tax credit.

Note: The R&D credit had expired as of Dec. 31, 2011, but the American Taxpayer Relief Act, H.R. 8, which was signed on Jan. 2, extended it through 2013 and introduced modifications that are too extensive to go into for the purposes of this item.

Union Carbide Corp.: Disallowance of Supply Costs

The Second Circuit affirmed the Tax Court's decision in Union Carbide Corp., No. 11-2552 (2d Or. 9/7/12), which disallowed certain supply costs used in process research activities as qualified research expenses (QREs) for purposes of the R&D tax credit. The Second Circuit's decision is a blow to the manufacturing sector, which had hoped for a reversal of the original Tax Court ruling (Union Carbide, T.C. Memo. 2009-50) to allow a broader scope of process research costs to qualify for the R&D tax credit.

Overview: After negotiating an agreement with the IRS on R&D tax credits of $14 million and $4 million on its 1994 and 1995 tax returns, respectively, Union Carbide claimed additional credits arising from 106 projects conducted in the taxpayer's manufacturing facilities during 1994 and 1995. The IRS contested these additional credits, spurring the original Tax Court litigation. The Tax Court analyzed the five largest projects to determine the eligibility of the additional claimed projects and costs.

The Tax Court held that two of the five projects constituted qualified research activities, but it disallowed all of the additional supply costs because they were incurred in producing goods for sale, not in conducting qualified research. In doing so, the Tax Court created a "primary purpose" test, where even if supply costs are essential for process research, they can never be qualified as process research expenses if they are incurred primarily for the production of products. As a result, Union Carbide was entitled to only $1,045 of additional QREs of the more than $200 million in costs at issue.

The appeal: The appeal focused primarily on whether the supply costs had been properly disallowed by the Tax Court. Union Carbide, now owned by Dow Chemical Co., argued that the plain language of Sec. 41 allows the credit for "any amount paid or incurred for supplies used in the conduct of qualified research" and that the production supplies used in process research met the requirement because they were used in the conduct of qualified process improvement research activities. The IRS argued that the "[s] upply costs are 'indirect research expenditures' if they would have been incurred regardless of any research activities," even though it conceded that the production process research could not have been conducted without buying those supplies.

Union Carbide pointed to the plain meaning of the word "use" from Webster's Third New International Dictionary to argue that "used in the conduct of qualified research" encompassed costs of all supplies regardless of whether the supplies were used to make a product for sale. The court disagreed, focusing instead on the whole phrase "used in the conduct of qualified research."

The court pointed to the title of Sec. 41, "Credit for Increasing Research Activities," (emphasis added) which it said suggests that supplies purchased in the ordinary process of producing goods are not allowable for credits.

The Second Circuit agreed with both the IRS and the Tax Court, stating that the costs of supplies were "at best, indirect research costs" and not allowable under Regs. Sec. 1.41-2(b)(2). In doing so, the court agreed that the interpretation of such supplies as indirect costs was consistent with the purpose of the R&D tax credit. Further, in interpreting congressional intent, the Second Circuit found that "[a]ffording a credit for the costs of supplies that the taxpayer would have incurred regardless of any qualified research it was conducting simply creates an unintended windfall." In a concurring opinion, Judge Rosemary Pooler opined that Congress may well have intended for these types of process supplies to qualify for the credit but "failed to write the statute in such precise terms."

Impact: Manufacturing companies involved in process research activities will be directly affected by the Second Circuit's decision because they are most likely to incur supply costs used in process research activities. In fact, according to the most recently published IRS R&D tax credit data (see "Table 1, Corporations Claiming a Credit for Increasing Research Activities on Form 6765," available at tinyurl.com/boo9s6n), manufacturing companies in 2009 claimed approximately 70% of the total dollar amount of R&D tax credits claimed, while qualified supplies accounted for approximately 20% of the total QREs for manufacturing companies.

In an amicus curiae brief, the National Association of Manufacturers, the American Chemistry Council, and the U.S. Chamber of Commerce argued that the Tax Court's interpretation of the process research supply issue would stifle process research and that "Congress has not created distinctions between product and process research for purposes of which costs constitute QREs, and the courts should not insert them." Further, the brief argued that "jiff no credit is available for one of the most important cost components of process research...