Research and Experimentation Credits: Unraveling research, risk, documentation, and litigation.

• Date: 01 November 2020
• Author: King, Kathleen

After COVID-19 forced the cancellation of TEI's 70th Midyear Conference in March, we explored different ways to deliver content to our members and meet their continuing professional education (CPE) needs. With the support of several dedicated TEI sponsors, we launched our first-ever virtual midyear conference--a series of free CPE webinars open to all TEI members and in-house tax professionals worldwide--and this roundtable is, we hope, a productive by-product of that webinar. The presenters for this webinar, sponsored in July by Mayer Brown, were Kathleen King, a managing director at Alvarez & Marsal, and Alex Sadler, a partner at Morgan, Lewis & Bockius LLP. Doug Rodolph, director of federal controversy at Walmart, moderated the webinar.

Doug Rodolph: I'm going to turn it over to Kathleen to get us kicked off with the R&D campaign and the LB&I [Large Business & International Division] directive.

Kathleen King: Thank you, Doug. Good morning and good afternoon to everyone joining us today. I certainly appreciate the opportunity to speak again with Doug and with Alex. The first section that we're going to talk about is a fairly new development. The IRS announced a new campaign around research issues in early 2020. The IRS campaign program is an audit technique that was first created back in 2017. The stated goal for the program is to focus IRS resources on what [are] deemed to be significant compliance issues or risks. When they first announced the IRS campaign program, I know many of the people that I work with in the research credit space anticipated that research credits would at some point be added to the program. I've been dealing in this space for almost thirty years now, and it's always been a very contentious area, as [is] just about any issue that's really factually intensive. So, not a surprise, I would say. The one thing that was a little bit surprising is that they added not only Section 41 issues but also Section 174 expense issues to the list of campaigns. If you look back over the history of research credits, in particular going back to the discovery test regime and the number of unfavorable court cases that came out during that timeline, all the cases determined that the projects at issue met the 174 test. So, by and large, 174 has been a test that's primarily been accepted by the courts. I think that what we're seeing here is a little bit of an overall change in tone and process coming from the IRS. I know that Alex and I recently heard some interesting observations from an IRS appeals officer. First, he was emphasizing how it was important for the appeals team, both the appeals officer as well as the engineering resource for the appeals team, to be able to explain how they got to the settlement amount. He noted that the number of formal dissents that were being filed for an appeal settlement was the highest that he's ever seen. This is a very experienced IRS appeals officer. So, it was an interesting observation that he thought the overall tone was evolving. It's a little bit early in the IRS campaign program, so it's still difficult at this point to fully appreciate what the potential impact is going to be from this campaign designation. I think it's fair to assume that additional audit resources will be issued, though, and it's not too early to start assessing what your potential areas of risk may be should an IRS exam start.

Closely on the heels of the announcement of the IRS campaign on research issues, there was another release that came out on the centralized risk assessment of research credits. Research issues were very broadly defined as part of LB&I centralized risking process. I would say, by and large, they defined the research issues wide enough to fit in just about any potential issue that you can think of in this area. They specifically called out three areas as [being] in the scope of the guidance: 1) qualifying research activities; 2) qualifying research expenditures; and 3) substantiation requirements related to research credits. The couple points I would observe as the way these issues were worded were, first of all, as it defined qualifying research activities, it used the words "performed by the taxpayer." I thought that was an interesting choice of wording, considering that you can have subcontractors that are also performing research on your behalf. I don't know if there was any intent by that language, but as I looked at those words, that stood out to me. I think that on the topic of research issues related to expenditures, I thought it was interesting that they used the words "estimated" and "allocated," because over the years, one of the IRS' strongest concerns is that there's a lack of precision. They like project accounting. They have concerns about cost center methodologies because they're not as precise as they otherwise expect them to be. They want this really tight nexus of the expenditure. So, their focus on the words "estimated" and "allocated" [was] interesting. Then, finally, on the substantiation requirement, I thought it was interesting that they pointed specifically to the base amount. Because, again, as we're going to talk about a bit later in the presentation, I do believe that there will be an increased focus through the campaign process and the centralized risk assessment process on really being able to substantiate your base amount and the incremental piece of the credit.

So, what's the impact of this designation as a campaign? I think that there is clearly a stigma that comes with a campaign designation. There is a tendency for the IRS to view things that are campaigns as being subject to abuse and akin to a tax shelter. So that really creates some skepticism on the part of the IRS team. I think one thing that may actually benefit taxpayers as a part of this process is a renewed standardization of IRS audit tools, such as mandatory IDRs [information document requests]. It would be helpful if that information was published when taxpayers were preparing their claims and return work papers. It is often more challenging to document responses a couple years after the tax year is over and the return is being examined. I think it would be very helpful to have updated audit technique guides. It's been at least fifteen years since any substantive changes have been made to the research credit audit technique guides. The LB&I directive on centralized risking provided some framework on the centralized risking process and how it was going to be applied to research credits. This is not applicable to CAP [Compliance Assurance Process] taxpayers, who have to go through a different process. If you file amended returns, or if you're otherwise selected for IRS examination, then you should expect those filing to fall within the scope of the centralized risking process. There are a lot of questions as to what this really means for the scope of the audit. However, it is fair to assume that it will start with some kind of questionnaire, likely driven by an IDR that will be used to assess your risk in the research credit space.

Once a questionnaire or an initial IDR response is received by the IRS, there will likely be some type of centralized review by a research risk team. That team is going to be composed of subject-matter experts within the IRS, engineers with the IRS, other revenue agents. It's supposed to be a collaborative-type process with the Exam team and national office, but it's something where, based on your responses, they'll make a determination whether or not it makes sense for the research credit to be reviewed. Based on our recent experience, this assessment is all about common areas of risk in the research credit area. Many of these are risk areas going back many, many years. Despite new regulatory guidance that's come out on Section 174 on supply costs and internal use software, very little has changed on these primary areas of risk. Alex, I know that you spend a lot of your time supporting taxpayers in especially contentious areas; any thoughts or experiences you've had on some of these risk areas?

Alex Sadler: Yes, and before I give them I would also like to thank TEI and Mayer Brown and the membership for the opportunity to speak today. I would completely echo your list here as potential areas of risk in the current environment. I would say ninety percent or even more of the controversies that we get involved with have one of these issues. Substantiation, for years now, is a continuing issue for the majority of taxpayers who use cost center accounting, and the issue is simply whether the documentation and information collected is good enough to support the claimed credit. The standards that the government applies relative to the taxpayers' standards sometimes are different, and that leads to disputes over proof. Relatedly, it's a pretty common audit technique for engineers, for taxpayers who use cost center accounting, or sometimes project accounting, to run stat samples of what they consider to be high-risk job tides, like high-level VPs or administrative support. We're seeing more and more process of experimentation challenges in light of a case that we'll talk about, Siemer Milling, which holds the taxpayers to pretty high standards. That's again a very factual issue. For heavy manufacturers who make large volumes of products and spend a lot of resources on process and product development and treat supplies that otherwise would be production-side costs, we see a lot of challenges as to whether those costs, those heavy-supply costs, qualify. For government contractors, engineering firms, and supply chain participants, there's a lot of funded research activity, which is a very contract-based review. Lastly, pilot models, I consider that to be the next frontier. Those regulations were finalized in 2014; there's been a lot of positions being taken over the ensuing years, and those are working their way through the system. I anticipate...