Research credit redux: Federal Circuit brings the research credit back to life - Fairchild v. United States.

• Author: Grigsby, McGee

Editor's Note: This article discusses a recent taxpayer-favorable decision by the United States Court of Appeals for the Federal Circuit about whether research is "funded" for purposes of the research credit. As this issue goes to press, the author has confirmed that the Internal Revenue Service will concede the funded research issue in all pending cases.

In an important case of first impression, on November 29, 1995, the United States Court of Appeals for she Federal Circuit held in Fairchild Industries, Inc. v. United States that research performed pursuant to a fixed price incentive contract with the federal government was not funded for purposes of the research tax credit.(1) Because research was not funded, the taxpayer was entitled to claim the research credit on its tax returns.

Fairchild was watched closely because many government contractors have cases pending in which claims for the research credit have been challenged by the Internal Revenue Service. In virtually all these cases, the so-called funding limitation is one of the principal arguments advanced by the IRS to challenge the credits.

This article describes the legal issue involved in Fairchild, analyzes the decision of the Federal Circuit (which reversed a taxpayer-adverse decision of the Court of Federal Claims), and offers some thoughts on anticipated developments.

The Funding Limitation Issue

In 1981, Congress enacted section 44F of the Internal Revenue Code to give companies that engage in research and experimentation(2) a tax credit for a percentage of the expenses incurred in conducting research. Section 44F was enacted to address Congress's concern that U.S. companies were reluctant to conduct risky industrial research, and the growing view that the resources devoted by U.S. industry to such research efforts lagged behind other industrial nations. Congress designed the tax credit to encourage companies to spend funds in the exploration of new technologies and processes.

Under section 44F, a company that performs otherwise qualified research may claim a research tax credit if its research is not "funded by any grant, contract, or otherwise by another person." I.R.C. [sections] 44F(d)(3) (1982). Research that is performed pursuant to a contract with a customer is not funded if: (1) the researcher's entitlement to payment under the contract is contingent on the success of the research; and (2) the researcher retains substantial rights in its research.(3) Treas. Reg. [subsections] 1.41-5(d)(1) and (2) (1995).

The Trial Court's Decision

The dispute before the Court of Federal Claims related to research credits claimed by Fairchild in connection with a fixed price incentive contract to build a next generation trainer aircraft for the Air Force. The contract commenced in 1982 and was terminated for convenience in 1986 when Congress canceled the program. By the time the contract was canceled, Fairchild had spent $216,056,000 on the contract. The amended ceiling price was $133,485,885. Pursuant to the final termination for convenience settlement, the parties agreed that Fairchild was entitled to receive $120.6 million for successfully completed work.

On its 1982-1985 federal income tax returns, Fairchild reported a total of $109.4 million of qualified research expenses. On audit, the IRS disallowed $19.6 million for reasons unrelated to the credit issue. Of the remaining $89.8 million of qualified expenditures the IRS determined that $50.3 million was funded, and disallowed the research credit associated with this portion. The funded amount was calculated as the ratio of the amount ultimately paid to Fairchild by the Air Force ($120.6 million) to the total amount spent by Fairchild ($216.1 million), or 55.8 percent. The IRS asserted that because it was expected and likely that Fairchild would be compensated under the contract for this portion of its research expenses, the research was funded.

The Court of Federal Claims sided with the IRS, albeit primarily on a different ground than that asserted by the Commissioner. The court ruled that Fairchild's research was funded because during the course of the contract Fairchild received progress payments under the contract.(4) As viewed by the lower court, the receipt of these payments precluded Fairchild from incurring the costs of the research because Fairchild was spending the government's money -- not its own. The lower court also found support for its conclusion in Fairchild's expectation that it would be paid for its research, the existence of a congenial relationship between the parties, and the government's ultimate payment to Fairchild.

The Government's Argument in the Federal Circuit

In the court of appeals, the government's primary argument was that research performed under a contract is funded in all but unusual cases. Hence, a government contractor should ordinarily not be entitled to the credit because...