Evolving tax credits: keeping up with the ever-changing R&D tax credits.

• Author: Crabtree, Randy
• Position: Taxcredits

the research and development tax credit has seen important developments over the past few years stemming from case law, IRS pronouncements and legislative action. Indeed, the Emergency Economic Stabilization Act of 2008 most recently extended the credit through Dec. 31.

The credit is designed to stimulate increased company spending on R&D activities over time by reducing taxes. In general, a qualifying company is eligible to deduct from corporate income taxes an amount equal to 20 percent of qualified research expenses above a base amount.

The base amount is a calculation of a company's ratio of qualified research expenses to gross receipts during a given time period multiplied by current gross receipts, dependent on the year the business was founded.

Qualified research expenses include wages, supplies and contract research expenditures.

Qualified activities for the research credit must pass a four-part test:

* Permitted purpose.

* Technological in nature.

* Elimination of uncertainty.

* Process of experimentation.

Recent Case Law: U.S. v. McFerrin A June ruling by the Fifth Circuit Court of Appeals in U.S. v. McFerrin established new guidance and precedence for the examination of R&D tax credit claims and will likely be heavily relied upon by taxpayers in future examinations.

In its decision, the original district court cited several issues that indicated it was not persuaded that qualified research for the purposes of the research tax credit took place.

First, the court took issue with the fact that the evaluation of qualified activities and the calculation of the credit were not conducted by engineers or anyone with meaningful scientific experience. Second, the company was unable to produce any records of the hours worked on any given project or the hours worked or supplies used that involved research. Third, and most significantly the court held that research only qualified if it expanded or refined the existing principles in a technical field and had a high threshold of innovation (known as the "discovery test"). Finally, the court held that qualified research only applied if a process of experimentation occurred that involved the forming and testing of a hypothesis, rather than "trial and error" testing.

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The appellate court found that the:

* District court had used incorrect applications of the discovery test and process of experimentation by applying the wrong legal standards and failing to consider all the...