Comments on consistent treatment of qualified research expenditures in the base period for purposes of calculating the research tax credit.

• Author: Ezrati, Lester D.

Comments on Consistent Treatment of Qualified Research Expenditures in the Base Period for Purposes of Calculating the Research Tax Credit

In these comments, Tax Executives Institute addresses the question whether, with respect to pre-1990 years, a taxpayer's base-period qualified research expenditures (QRE) should be determined on a basis consistent with the determination of the QRE for the computation year of the research tax credit. The Institute recommends that the Internal Revenue Service issue a revenue ruling answering the question in the affirmative.

BACKGROUND

The Omnibus Budget Reconciliation Act of 1989 contained a provision relating to the consistent treatment of research and experimental (R&E) expenses. As amended, section 41(c)(4)(A) of the Code states:

Notwithstanding whether the period for filing a claim

for credit or refund has expired for any taxable year

taken into account in determining the fixed base percentage,

the qualified research expenses taken into

account in computing such percentage shall be determined

on a basis consistent with the determination of

qualified research expenses for the credit year.

The legislative history of the provision states that "no inference" is intended whether prior law requires a taxpayer, in calculating its credit amount for pre-1990 years, to determine its base-amount by adjusting QRE for an earlier base-period year for which an assessment of a deficiency or refund of the overpayment is barred by the statute of limitations. H.R. Rep. No. 101-247, 101st Cong., 1st Sess. 1202 n.11 (1989).

Notwithstanding the no-inference clause in the legislative history of the 1989 tax act, TEI believes that, with respect to pre-1990 years, the rule prescribed by section 41(c)(4)(A) should apply with respect to all years - both before and after 1990. Thus, a taxpayer's base-period QRE should be determined on a basis consistent with the determination of the QRE for the computation year of the credit. Regrettably, the IRS apparently takes the opposite view. In Letter Ruling No. 9040002 (June 26, 1990), the IRS denied a taxpayer's request to reduce its base-period research expenses attributable to closed years that were similar to those denied by the IRS in the year under audit. Specifically, the IRS ruled that a taxpayer could not recompute its base-period QRE where the base-period years are barred by the statute of limitations and the taxpayer received a "benefit" from the earlier inclusion of certain costs in its QRE.

SUMMARY OF POSITION

We understand that the IRS is preparing a revenue ruling embodying the holding of the private letter ruling. TEI believes the issuance of such a ruling would be a mistake. We submit that sound tax policy requires the consistent treatment of QRE between the base-period years and the computation year, and we believe the case law and other authorities support recomputation of the base period with respect to the R&E credit.(1) Such a recomputation should occur, moreover, without regard to whether a positive or negative adjustment is required in the base period to be consistent with the computation year and without regard to whether the years in the base period are open or closed under the statute of limitations.(2)

In particular, we believe that the reasoning of the private ruling is flawed and that the supposed "duty of consistency" cannot properly be invoked to justify the IRS's position. Indeed, we submit that it is the IRS, not the taxpayer, that seeks inconsistency and skewed results by refusing to permit the computation of base-period QRE on a basis consistent with the determination of QRE in the computation year. What is more, the mitigation provisions of the Code clearly operate to forestall any "gaming" of the system. Indeed, even in the absence of the mitigation provision, it is doubtful that a taxpayer could truly "game" the computation of its R&E credit since it would have to be prescient to know whether to "gamingly" include certain expenditures in, or exclude them from, QRE. Consequently, we strongly recommend that the IRS issue a published ruling repudiating the result reached in Letter Ruling No. 9040002 and confirming that, with respect to pre-1990 years, the taxpayer's base-period QRE will be determined on a basis consistent with the determination of the QRE for the computation year.

TAX POLICY CONSIDERATIONS: DOES

IT MAKE SENSE TO RECOMPUTE

BASE-PERIOD QRE?

TEI believes that it represents unsound tax policy to base the calculation of the R&E credit upon mistaken information from prior years. The policy underlying the R&E credit calculation can best be illustrated by the following examples. In each example, all years are closed except for 1985.

1. Example 1: Positive Adjustment to Base

   Period Required

   T failed to include attorney wages for patent prosecution in its QRE for the years 1982, 1983, and 1984. Assume that these wages are properly QRE. In 1985, T does include the wages in its QRE and the IRS allows the expense. The amounts are, as follows:

   Year QRE other Patent Total than Patent Prosecution QRE Prosecution Wages Wages

   1982 2000,000 20,000 220,000 1983 200,000 20,000 220,000 1984 200,000 20,000 220,000 1985 200,000 20,000 220,000 If T is not required to adjust its base period, the computation of T's R&E credit for 1985 would be as shown in column 1 below:

   Column 1 Column 2 (unadjusted (adjusted base period) base period) 1. QRE in base period

   (1982-1984) $600,000 $660,000 2. Divided by 3 $200,000 $220,000 3. QRE in tax year (1985) $220,000 $220,000 4. Incremental QRE (3-2) $ 20,000 0 5. R&E credit @ 25% $ 5,000 0 The column 1 computation clearly produces the wrong result. In 1985, T has not increased its QRE over its base-period QRE and, therefore, is not entitled to receive an R&E credit in 1985 merely because it failed to report all of its QRE on its tax returns for the base-period years. The correct computation is set forth in column 2, and T should receive no R&E credit in 1985.

2. Example 2: Negative Adjustment to Base Period

   Required - Level Costs

   T included certain utility expenditures in QRE for the years 1982 through 1985. In its audit of T's 1985 tax return, the IRS determines that those expenditures were not QRE. The amounts involved are, as follows:

   Year QRE other than Utility Total Utility Expenditures Expenditures

   1982 $200,000 $15,000 $215,000 1983 $220,000 $15,000 $235,000 1984 $240,000 $15,000 $255,000 1985 $320,000 $15,000 $335,000 Since T claimed the utility expenditures as QRE on its return in 1985, it calculated its R&E credit as shown in column 1:

   [Tabular Data Omitted]

   If the IRS disallows as QRE the $15,000 utility expenditures in 1985 without adjusting the base period, T's R&E credit will be computed as shown in column 2.

   Again, this is clearly the wrong result. As shown by columns 1 and 3, T's R&E 1985 credit is not increased by the inclusion of the utility expenditures. Extension of this example will demonstrate that similar results will occur in prior years that include utility expenditures. The proper computation of T's 1985 R&E credit should be as shown in column 3.

   Example 2 exposes the flaw in the IRS's argument that there should be no negative adjustment to the base period because the taxpayer has somehow received a "benefit from including the costs in its QRE. In the example, T received no benefit from the inclusion.

3. Example 3: Negative Adjustment to Base

   Period Required - Declining Expenditures

   T included utility expenditures in QRE for the years 1980(3) through 1985. In its audit of T's 1985 tax return, the IRS determines that these expenditures were not QRE. The amounts are, as follows:

   Year QRE other Utility Total than...