IRS targets taxpayer's right to credit for contract R & D.

• Author: Bridgham, Bethany J.
• Position: Research and development

Sec. 41(d)(4)(H) disallows the research credit for "[a]ny research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity)." In recent years, these few words have given rise to considerable uncertainty and controversy, including key litigation now pending in the Federal Circuit (Fairchild Industries). The IRS Industry Specialization Program has identified the question of whether expenditures under a fixed-price contract are eligible for the research credit as a "significant issue" for both the aerospace and data processing industries, and has raised similar issues in other industries.

In Fairchild, 30 Ct. Fed. Cl. 839 (1994), the taxpayer argued that since under the contract terms it would be paid only for successfully delivering the result or product of the research, the research was not "funded" within the meaning of Regs. Sec. 1.41-5(d). The Service denied the taxpayer the credit, arguing that since payment was expected and likely, the research should be considered funded. The lower court ruled for the IRS on the basis of whose "bank account" paid for the research, emphasizing that the taxpayer had received progress payments; the taxpayer appealed this decision. Taxpayers involved in contract research and development (R&D) activities believe the appellate decision should be important, not only for the many government contractors who have claimed the credit under the type of fixed-price contract involved, but also on a broader scale to assist in analyzing which party (if any) can claim the credit under R&D contract arrangements.

The issues of who gets the credit and what activities qualify also arose in Letter Ruling (TAM) 9449003, in which the taxpayer, a computer game publisher, contracted with independent software developers for computer software game programs. The taxpayer provided the developers with game design and detailed product specifications and deliverables, which had to be satisfied before the taxpayer had to pay the developers advance royalties. Although the agreements provided that the programs produced became the taxpayer's exclusive property, the developers retained ownership of the programming techniques embodied in the programs. Nonetheless, the Service concluded that the developers did not retain any ownership rights in the programs.

The taxpayer had deducted its associated expenditures as costs of developing computer software. The IRS rejected this approach, ruling the...