Research credit: No tax credit allowed

Research credit: No tax credit allowed

The U.S. Court of Federal Claims granted partial summary judgment for the government in a case concerning a claim for research tax credits under section 41, finding that the taxpayer was not entitled to credits for research expenses incurred on certain client projects for 2003, 2004, and 2005.

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The case is: Dynetics Inc. v. United States, 2015-1 U.S.T.C. ¶50,322 (May 31, 2015)

The work in the projects was performed under contracts with various payment arrangements, including cost-plus fixed fee, fixed-price level of effort, cost-plus fixed-fee level of effort, and time and materials—all of which the claims court deemed funded.

Read the claims court decision [PDF 468 KB]

Summary

The taxpayer, an engineering company headquartered in Huntsville, Alabama, filed amended tax returns for 2003, 2004, and 2005. The amended returns claimed a refund related to a research tax credit for its expenses of developing unmanned, highly technological systems used in national security matters. The IRS disallowed the research credit claims, and the taxpayer filed a complaint that the returns were valid and the refund was justified.

At issue was whether the research performed by the taxpayer under its third-party contracts was funded, and thus ineligible for the research tax credit under section 41(d) (4)(H).

Although the taxpayer based its tax refund claim on the research it performed in more than 100 contracts, the court examined a sample set of seven representative contracts. The contracts included cost-plus fixed fee, fixed price level of effort, and time and materials payment terms. The contracts were for various services, including the development of missile defense systems, ammunition deployment systems, equipment calibration techniques and aerodynamic vehicles.

Both the government and the taxpayer filed motions for partial summary judgment, but the court granted only the government’s motion. The government and the taxpayer will presumably apply the court’s holdings to the remaining contracts to determine what part, if any, of the refund claim will be allowed. Further court proceedings could still occur.

Requirements for research tax credit

Under section 41(d)(4)(H), a taxpayer may not claim a research tax credit if that research was "funded by any grant, contract, or otherwise by another person (or governmental entity).”

Under Reg. section 1.41-4A(d), all agreements (not only research contracts) entered into between the taxpayer performing the research and other persons are considered in determining the extent to which the research is funded.

Research is considered funded under either of two circumstances.

  • First, research is funded if the taxpayer receives a payment that is not "contingent on the success of the research." So, if a payment is contingent on success, the payee is at risk, and this first funded research criteria is not met.
  • Second, research is funded if the taxpayer performing research for another person or governmental entity "retains no substantial rights" in the research. So, if the payee under a research contract is at risk if the research is not successful, and the payee retains substantial rights to the results of the research, the research is not considered funded.

Claims court’s decision

The U.S. Court of Federal Claims 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 amounts paid for the product or result of the research and are not treated as funding. In this case, no other risk factor was considered an appropriate determination of funding.

The taxpayer relied most heavily on two main arguments to prove it was expected to produce a successful result to receive payment—“course of dealing” and the contract’s inspection and/or warranty clause.

Course of dealing

The taxpayer argued that regardless of the language in the contracts, it had established a course of dealing with six of the seven contracting partners through their long- term customer relationship. Because of this, the taxpayer argued, these six sample contracts functioned as fixed price contracts under which the taxpayer was obligated to produce successful results for a fixed price, no matter the taxpayer’s cost.

The claims court agreed with the government that the course of dealing argument is parol evidence, and as a matter of law can only be considered if the terms of contracts fall under the legal definition of ambiguous (which, per the Dynetics decision, they do not).

Also, the taxpayer could not show a joint understanding as to that different construction between both parties of this agreement. Instead, it seemed to be a unilateral policy of the taxpayer.

Inspection and warranty clause

The taxpayer argued that in each of the seven contracts, there was an inspection or warranty clause that expressly put it at financial risk of not being paid unless the results of the research were successful.

The court agreed with the government that whether the taxpayer would be paid for the overall contract work did not specifically depend on whether the research it needed to perform was successful. The logic was thus:

  • In the definition of a firm fixed price, level of effort contract, payment is based on the effort expended rather than on the results achieved. Because of this, no inspection clause could put the taxpayer at financial risk for these contracts.
  • Loss of profit (i.e., receiving full hourly rates excluding the portion of the rate attributable to profit or additional fees) is not considered financial risk. This applies to numerous rejection and warranty clauses. Only loss of a recovery of costs can be considered as financial risk.
  • Reimbursement to the contracting party for replacement services is not considered financial risk if it is only required when the taxpayer fails or refuses to correct or re- perform work.
  • Determination of risk must be made solely on the research agreement between the parties, with no consideration of any external statute not expressly in that agreement. Therefore, if the contract does not contain an inspection clause, general state contract law may not be relied upon for financial risk arguments.

Substantial rights

In order not to be considered funded research, when the taxpayer’s risk has been established, the payee must retain substantial rights to the results of the research. The taxpayer maintained that it retained the rights to “skills and advancements” it developed while working on task orders. The taxpayer argued:

 

[A]ny capabilities developed in the analysis of the Vorlon system, such as advancements in preparing engineering drawings or improving the method of identifying radio frequency, could be reused in subsequent work performed by [the taxpayer] because those skills and advancements are not necessarily particular to the specific classified weapons system.

 

The government noted that Reg. section 1.41-4A(d)(2) provides that "incidental benefits to the taxpayer from performance of the research (for example, increased experience in a field of research) do not constitute substantial rights in the research." Based on the regulation, the Court of Federal Claims held that the taxpayer did not retain substantial rights.

Other arguments

In addition, the taxpayer argued that termination clauses in all seven contracts put it at risk of nonpayment. It also discussed three contracts that were initially issued as “undefinitized.”

Again, the court and the government agreed that the taxpayer had failed to show evidence it would not be paid regardless of the success of the research with these arguments.

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 Office hearings. For example, the Court of Federal Claims distinguished the “fixed-price-level-of-effort” contracts at issue in Dynetics from those that were at issue in the leading decision on research credit funding, Fairchild Industries, Inc. v. United States, 71 F.3d 868 (Fed. Cir. 1996). In Fairchild the contracts were “fixed-price incentive*” type of contracts that also had inspection, rejection, and payment clauses incorporated into them. The Dynetics court said:

 

*A fixed-price incentive contract is described in the Fairchild opinion, citing 48 C.F.R. §16.403(a) (1994), as:

 

A fixed-price contract that provides for adjusting profit and establishing the final contract price by application of a formula based on the relationship of total final negotiated cost to total target cost. The final price is subject to a price ceiling, negotiated at the outset.

Thus according to the contract language, Fairchild explicitly accepted responsibility for doing whatever was necessary to produce prototype aircraft in compliance with the contract specifications. . . . Unlike the contractor in Fairchild, Dynetics makes no assertion that it expressly accepted contractual responsibility for producing any product. * * * The Federal Circuit in Fairchild also relied on two [Defense Acquisition Regulations (DAR)] provisions that were incorporated into the contract: one governing inspection and rejection, DAR 7-302.4, and the other covering payments, DAR 7-302.2.

 

Thus, the Dynetics court found numerous distinctions between Fairchild and the contracts under present consideration, and the holding of Dynetics does not alter any conclusions of the Fairchild case.

Court decisions involving funding issues have been rare. The Dynetics opinion is a low level of judicial pronouncement. When conducting rights and risks analyses, taxpayers need to be better guided by considering the higher level Federal Circuit analyses in Fairchild Industries as well as in Lockheed Martin v. United States, 210 F.3d 1366 (Fed. Cir. 2000).

However, the specific points of contract interpretation in Dynetics and another recent funding issue decision, Geosyntec Consultants, Inc. v. United States, 776 F.3d 1330 (11th Cir. 2015), also need to be considered. The courts made some nuanced statements that IRS examiners are likely to focus on in other funding situations.

 

For more information, contact a tax professional with KPMG’s Research Credit practice:

Deborah Heard | +1 (415) 963-7565 | dheard@kpmg.com

Ed Jankun | +1 (704) 371-8090 | ejankun@kpmg.com

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

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

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

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

 

 

 

 

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