Research tax credit audit plan and audit plan for internal-use software.

On March 29, 1996, Tax Executives Institute submitted the following comments to the Internal Revenue Service on two audit plans developed by the IRS's Research Credit Issue Specialist. The two plans are entitled "Research Tax Credit: Audit Plan for Examination of the Research Tax Credit" and "Research Tax Credit: Internal Use Software Audit Plan." TEI's written comments, which elaborate on issues discussed during a March 15 meeting between representatives of TEI's IRS Administrative Affairs Committee and the Internal Revenue Service, were submitted to David G. Harris, Director, Coordinated Examination Programs, and Ray Presley, Director, Industry Specialization Branch.

TEI's submission on the research tax credit audit plans were prepared under the aegis of TEI's IRS Administrative Affairs Committee, whose chair is Robert L. Ashby of Northern Telecom Inc. In addition to Mr. Ashby, the following individuals contributed to the preparation of the Institute's comments: Marc C. Filut of MCI Communications Corporation, Sheldon A. Kimel of Brunswick Corp., Kelly A. Nall and Karyn Ward of Electronic Data Systems Corp., Thomas B. Rogers of Apple Computer, Inc., Richard C. Sammut of Whirlpool Corporation, Paul J. Schaffhausen of McDonald's Corporation, and John P. Shepherd of PacifiCorp.

Background

Tax Executives Institute is a volunteer, professional association of approximately 5,000 accountants, lawyers, and other professionals who are responsible for managing the tax affairs of their companies. TEI members must contend daily with the recordkeeping and other compliance challenges associated with the business tax laws. TEI represents a cross-section of the business community, including companies that engage in all levels of research activities. We are dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and the government alike.

The Institute is firmly committed to maintaining a tax system that works -- both for taxpayers and tax administrators. We believe the diversity and training of our members enable us to bring a unique, balanced, and practical perspective to your attention.

General Comments

1. Overview of the Research Tax Credit: The research tax credit was enacted by Congress in 1981 in order to provide an incentive to taxpayers for increasing their research activities. Now contained in section 41 of the Internal Revenue Code, the research tax credit is equal to the sum of (i) 20 percent of the excess of the taxpayer's qualified research expenses for the taxable year over a base amount and (ii) 20 percent of the taxpayer's basic research payments. "Qualified research expenses" include in-house expenses for wages paid and supplies used in the conduct of qualified research, and 65 percent of any contract expenses for qualified research.

   The definition of "qualified research" was amended by Congress in 1986. Section 41 provides that, to be eligible for the research tax credit, an activity must do more than satisfy the definition of research and experimental expenditures for purposes of section 174; it must also be undertaken for the purpose of discovering information that is technological in nature, the application of which is intended to be useful in development of a new or improved business component of the taxpayer. In addition, an activity is eligible for the research tax credit only if substantially all of the activities of the research constitute elements of a process of experimentation for a new or improved function, performance, reliability, or quality.

   Given the menagerie of complicated concepts and terms in the research tax credit, it is not surprising that many disputes arise between taxpayers and the Internal Revenue Service concerning the meaning and application of section 41. The number and extent of disputes has no doubt been exacerbated by the lack of formal guidance from the IRS. Hence, although the IRS issued final regulations under section 41 in 1989, those regulations do not address themselves to the 1986 changes in the definition of qualified research and basic research, nor to the amended rules for computing the credit in respect of basic research payments. (The regulations similarly do not reflect changes made to section 41 in 1989 and 1993.) Without formal guidance, IRS agents have adopted differing views of what constitute qualified research activities and expenditures. TEI sincerely believes that the promulgation of regulations on the definition of credit-eligible activities and expenses would bring salutary clarity to the area, enhance the ability of taxpayers to voluntarily comply with the Internal Revenue Code's complicated requirements in respect of the research tax credit, and materially reduce the number and magnitude of disputes between taxpayers and the IRS in respect of the credit.

2. Issuance of Research Tax Audit Plans: Into the void created by the lack of current regulations, the IRS's research credit issue specialist in 1995 propounded two audit plans for use by examining agents. One of the two plans released by the issue specialist is addressed to general research tax credit issues, and is captioned "Research Tax Credit: Audit Plan for Examination of the Research Tax Credit" (10/12/95). The second plan addresses itself to software developed for the taxpayer's internal use, and is captioned "Research Tax Credit: Internal Use Software Audit Plan" (10/23/95).

   TEI believes that the two audit plans provide much useful information, and although we believe the plans can be improved, we commend the IRS's research credit issue specialist for his efforts to bring a greater measure of certainty and uniformity to this area. Notwithstanding our support for the issuance of audit plans, we believe it necessary to say that they are no substitute for formal guidance upon which taxpayers may rely. Indeed, we believe that many of the problems in administering the research tax credit --for taxpayers and examining agents -- could be ameliorated by the issuance of formal guidance. Accordingly, we continue to believe that tax administration would be well served by the promulgation of revised regulations that fully take into account Congress's intent in enacting and modifying the research tax credit and, obviously, reflect and comport with the most recent statutory amendments to section 41. In this regard, we are pleased to note that a project to provide additional guidance under section 41 (presumably through the issuance of regulations) is included on the Treasury Department and IRS's 1996 priorities list.

3. A Question about Process: We understand that the two audit plans were developed with the assistance of major accounting firms whose clients include many companies with experience under section 41. To our knowledge, however, comments were not solicited from other qualified and interested stakeholders, including affected taxpayers themselves, taxpayer groups such as TEI, industry associations, and law firms whose client bases may well duplicate or complement those of the accounting firms. We recommend that the views of these other stakeholders be sought in revising the research tax credit audit plans (or, for that matter, in developing any other such plans).(1)

4. A Comment on Tone: TEI regrets to report that many TEI members have interpreted the audit plans as hostile to the allowance of additional research tax credits. Our members' perceptions have undeniably been influenced by their experiences with section 41 since the research tax credit was enacted in 1981. The Institute itself has long perceived a historical reluctance by the IRS to implement the research tax credit in a manner consistent with Congress's intent to provide an incentive for increasing research activities. We are concerned that, unless tempered, the restrictive language and tone of the plans will unfairly communicate that reluctance to examining agents. For example, the plans state that examining agents should "challenge" expenses, instead of using the more neutral term "review"; they similarly instruct agents to develop a "strategy" for their audits rather than a "plan." There is nothing wrong with these terms in the abstract, but we suggest that they convey a more adversarial than cooperative tone.

   We recognize that the IRS must ensure that the varying requirements of the Code are satisfied; in applying the research tax credit, however, the IRS should not adopt strained interpretations of section 41's varied requirements, erect artificial barriers to a taxpayer's claiming the credit, or betray a philosophical disagreement with Congress's policy decision to provide taxpayers with an incentive for increasing research activities. Unfortunately, it does all of these, especially in respect of internal-use software. The suggested approach -- to challenge the taxpayer's characterization of software development activities and require the taxpayer to prove why each such activity meets the definition of research -- seems at odds with the underlying intent of section 41 because it leaves taxpayers in doubt whether the tax credit will in fact be available and that doubt may well vitiate section 41's incentive effect. It also seems potentially at odds with the IRS's own mission -- to determine the taxpayer's correct amount of tax liability.

   In this regard, we believe that the plans unnecessarily remind examining agents that taxpayers have the burden of proof. Although such reminders are accurate (inasmuch as taxpayers have the burden with respect to all matters reported on their returns), the pointed language (combined with the rather exhaustive list of documents that examining agents should seek) sends a strong signal that taxpayers may well be unable to sustain their burden. We do not believe a hard-line approach to the research tax...