IRS positions threaten RTC under fixed-price contracts.

• Author: Ruge, Richard B.
• Position: Research tax credit, Fairchild Industries decision

Recent IRS positions on the exclusion of "funded" research from eligibility for the research tax credit (RTC) could have adverse consequences for companies that claimed credits for work under certain government contracts widely used in the 1980s, and also may have ramifications for determining credit eligibility when two businesses enter into a research contract.

In Fairchild Industries, Ct. Fed. Cl., 1994, the taxpayer claimed RTCs on expenses generated under a fixed-price, full-scale development and production contract with the Air Force to design, develop, test and produce two prototypes of a new trainer aircraft. The Service disallowed some $6 million of the claimed credits, arguing that expenditures under such contracts are excluded as "funded" research within the meaning of Sec. 41(d)(4)(H).

In granting summary judgment to the government on the funding issue, the Court of Federal Claims focused on Regs. Sec. 1.41-5(d)(1), which states in part, "Amounts payable under any agreement that are contingent on the success of the research and thus considered to be paid for the product or result of the research ... are not treated as funding." The court first rejected the IRS interpretation (also set forth in Letter Ruling (TAM) 9410007) that payments are contingent on the success of the research only if the payment conditions are such that it is not "expected and likely" that payments will be made in the normal course of events.

The court also rejected the taxpayer's argument that the detailed specifications and performance requirements in defense contracts, including possible termination for default, meant payment was contingent; that is, the taxpayer argued that unless the company produced a useful product, the government had no contractual obligation to pay. Instead, the court went beyond the terms of the contract to examine what actually happened "as the contract performance was ongoing," with particular emphasis on the progress payments.

Under the court's test of whose "bank account" paid for the research, the taxpayer was viewed as spending the government's money paid over the course of the contract, not "betting its own money" up front. While the contractor runs a risk that it will not be paid if the government is not completely satisfied with the product, the court acknowledged that the credit is not available when the contractor's research expenditures "exist as a grace of a government financing arrangement." In short, the court said...