Eleventh Circuit: Research tax credit denied

Eleventh Circuit: Research tax credit denied

The U.S. Court of Appeals for the Eleventh Circuit today affirmed a federal district court’s grant of summary judgment for the government, finding that the taxpayer was not entitled to research tax credits under section 41 for research expenses incurred on certain client projects during tax years 2002 to 2005.

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The case is: Geosyntec Consultants, Inc. v. United States, No. 14-11107 (January 29, 2015)

The work was performed under “capped contracts,” under which the taxpayer was paid for its labor and expenses, plus a mark-up, subject to an agreed-upon maximum price. The appeals court agreed with the government that this was funded research for the taxpayer.

Read the Eleventh Circuit’s decision [PDF 121 KB]

Background

In 2012, the taxpayer filed suit in federal district court for a refund of tax, based on research credits for qualified research expenses incurred on client projects in 2002 through 2005.

At issue was whether the research performed by the taxpayer in conducting its performance under its contracts was funded by the clients, and thus ineligible for the research tax credit.

The district court examined six representative contracts—three were fixed-price contracts, under which the taxpayer was paid a fixed total price for its work, and the other three were capped contracts.

As to the three capped contracts, the district court agreed with the government and found those contracts had been client funded. As to the three fixed- price contracts, the district court agreed with the taxpayer and found that those contracts were not funded, and the taxpayer was eligible for the research tax credit for any qualifying research expenses it incurred under the contracts. Rather than litigate other issues that could have affected the taxpayer’s claim, the parties settled on the credit allowed for the fixed-price contracts, and agreed that the taxpayer could appeal the decision on the capped contracts. Therefore, the finding of the district court that the fixed-price contracts were not considered funded was not an issue before the Eleventh Circuit.

Eleventh Circuit

The appeals court’s 29-page decision was issued less than two months after oral arguments, and affirms the district court’s findings with respect to the capped contracts.

The Eleventh Circuit was asked to issue a decision on only two of the three capped contracts. It focused on a statement in the research credit regulations that amounts payable under a contract that are contingent on the success of the research are considered to be paid for the product or result of the research and are not treated as funding. The appeals court applied the standard articulated in Fairchild Industries, Inc. v. United States—the leading court case on funding issues for the research credit—noting that the inquiry “turns on who bears the research costs upon failure.” 71 F.3d 868 (Fed. Cir. 1995).

That 1995 decision found that the taxpayer was ultimately at risk because its contract with the government did not require payment if the research failed to produce the product contracted for; while the taxpayer received progress payments, and there was evidence that the government did not customarily require repayment, the contract made the taxpayer’s right to its payments contingent on success and acceptance of the research.

KPMG observation

The Fairchild case is the seminal case regarding analysis of fixed-price contracts and, as noted above, the finding of the district court that fixed-price contracts were not considered funded was not an issue before the Eleventh Circuit—so Fairchild is still the leading authority in this area and still stands for the general proposition that fixed-price contracts are not funded research.

Discussion of Eleventh Circuit’s decision

In today’s case, the taxpayer’s capped contracts specified a number of tasks to be performed, some of which included testing to evaluate the feasibility and performance of certain processes. The taxpayer warranted that it would perform the tasks in accordance with professional engineering standards. If the tasks were performed, and accepted, the other party to the contract was obligated to pay the taxpayer’s costs, plus a markup, subject to a dollar limitation. In certain situations (e.g., when environmental authorities imposed additional requirements) the payments could be increased.

The Eleventh Circuit rejected the taxpayer’s arguments that the capped contracts imposed general economic risk on it that satisfied the standard in Fairchild. Although the taxpayer might incur costs of performance that would prevent it from making a profit, the appeals court said that financial risk was separate from the issue of whether the payment was contingent on the success of the research. The appeals court found, rather, that the taxpayer would be paid for its research and work product even if it did not produce the desired outcome.

Neither contract, according to the appellate court, expressly mandated a successful outcome to the work to be performed by the taxpayer. While Fairchild dealt with contracts that specified quality assurance procedures, and specific standards of what a “successful” performance would be, the Eleventh Circuit found that the taxpayer was entitled to payment if it performed the task, and that the contracts “provided no barometer by which [the taxpayer’s] performance could be considered ‘successful’.”

The Eleventh Circuit concluded, therefore, that the district court correctly applied section 41 and the regulations to the capped contracts, and held the taxpayer was not eligible for the research tax credit because such research was client funded.

KPMG observation

Questions about whether research is funded are often raised in IRS examinations, and close analysis of contract language is often presented in IRS Appeals’ hearings. Court decisions involving the issue have been rare.

 

For more information, contact a tax professional with KPMG’s research credit practice:

David P. Culp | +1 (202) 533-4104 | dculp@kpmg.com

Tyrone Montague | +1 (212) 954-6818 | tmontague@kpmg.com

Christine Kachinsky | +1 (212) 872-2187 | ckachins@kpmg.com

Michael Brossmer | +1 (408) 367-4127 | mbrossmer@kpmg.com

Richard G. Blumenreich | +1 (202) 533-3032 | rblumenreich@kpmg.com

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