As part of the Protecting Americans from Tax Hikes (PATH) Act of 2015, the research and development (R&D) tax credit under Internal Revenue Code (IRC) section 41 was made a permanent provision. The federal R&D credit generally results in companies receiving a 4.5 to 6.5 cent return on qualifying dollars spent on research and experimental activities. For an activity to qualify for the R&D tax credit, it must meet a four-part test which requires
- A permitted purpose (which includes a new or improved function, performance, reliability or quality) related to a product or process.
- An intent to discover information that is technological in nature by relying on principles of a hard science: engineering, computer science, biological or physical science.
- Technical uncertainty at the project’s outset regarding capability, method or appropriate design.
- A systematic, trial and error process of experimentation to attempt to resolve technical uncertainties.
IRC section 41(d)(4)(H) provides that qualified research excludes “[a]ny research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).” Research is considered to be funded if either of the following two circumstances are met as set forth in Reg. Sec. 1.41-4A(d):
- Risk – If a taxpayer receives payment that is not contingent on the success of the research, the research is funded and the taxpayer is precluded from including these expenses for the research credit. The taxpayer must bear financial risk through either a success-based fee or fixed-fee contract. If a contract stipulates that the taxpayer is required to succeed or return funds, or incur additional costs beyond what the client is paying, the taxpayer is at financial risk. The research process typically begins in the pre-award (or bid and proposal) phase. As pre-award work is typically self-funded, research expenses associated with these efforts may qualify towards the research credit. Along the same lines, internal R&D (IR&D) efforts may also qualify. Contract types generally excluded from the research credit are:
o Cost plus
o Cost reimbursable
o Time and materials
o Cost plus fixed fee
o Force account
o Cost plus guaranteed max (see Geosyntec Consultants, Inc. v. United States, 11th Circuit)
o Projects performed outside the United States or U.S. possessions such as Puerto Rico.
- Rights – If a taxpayer performing research for another person or governmental entity retains no substantial rights in the research, the research is funded and the taxpayer is precluded from including these expenses for the research credit. For example, if the contract stipulates that another person holds exclusive rights to exploit the results of the research, the taxpayer does not retain substantial rights.
Several court cases provide insight into the appropriate treatment of funded contracts. In Geosyntec (see Geosyntec Consultants, Inc. v. U.S., 112 AFTR2d2013-5488, 2013-2 USTC P50, 498 (2013)), the U.S. District Court for the Southern District of Florida ruled that research expenses incurred by a taxpayer under fixed-price contracts do not fall within the “funded research” exclusion and, as such, are eligible for the R&D tax credit. In addition, the court also ruled that research expenses incurred under “capped contracts” or “cost plus subject to a maximum” fall within the “funded research” exclusion and are not eligible for the research credit as the taxpayer does not bear financial risk. Based on the court’s findings, when a contractor performs research for another party, the key to whether a contractor is eligible to claim the R&D tax credit is whether the contractor bears the risk of failed research.
In Dynetics (see Dynetics, Inc. v. U.S.), the Court of Federal Claims held that research performed by the taxpayer was “funded research” because payment was not contingent on the success of the research and the company did not retain substantial rights in the research results. Dynetics claimed that certain contracts that the IRS considered funded were similar to the contract at issue in Fairchild Industries v. U.S. (Fed. Cir. 1996), which was found by the Federal Circuit to shift the risk to the contractor. The Court, however, denied this claim citing that under the Fairchild contract, Fairchild explicitly accepted responsibility for meeting contract specifications. Unlike the contractor in Fairchild, Dynetics made no assertion that it expressly accepted contractual responsibility for producing any product. The Court followed the ruling in Lockheed Martin v. U.S., 210 F. 3d 1338 (Fed. Cir. 2000), in that any determination of risk must be made solely on the “research agreement” between the parties, with no consideration of external statutes not otherwise expressly incorporated into that agreement. In Dynetics, the Court also analyzed Dynetics’ rights to the results of the research. For one of the contracts under question, the Court reviewed the plain text of the contract under the following provision: “All rights, title and interest in and to inventions or other intellectual property rights conceived or reduced to practice in the course of performance of the work called for by this Contract are hereby vested in the University.” The Court found that since Dynetics did not carry its burden to show that it retained substantial rights in the results of the research, Dynetics could not claim the research expense related to this contract for the research credit.
In Lockheed Martin, the Court held that the right to use research results without paying for such right, even if not an exclusive right, is substantial. As long as exclusive rights are not vested in another party, substantial rights in the research results may be shared. While Treas. Reg. Section 1.41-4A(d)(2) states that incidental benefits retained by a taxpayer (such as increased experience in a field of research) do not constitute substantial rights, the Court stated in Union Carbide (97 T.C.M. 1207, 1259 (2009)) “that the information the taxpayer gained from the research was valuable to the researcher irrespective of whether the resulting product was ultimately licensed or not.”
In some cases, taxpayers may be claiming less of an R&D credit than they should due to the exclusion of qualifying research expenses to which they are entitled if consideration is not given to contract expenses. In other cases, taxpayers may be including expenses that are not eligible for the R&D credit, opening themselves up to IRS exam risk which could lead to a reduction of their credit. In all cases, the terms of the contract should be evaluated to determine which party bears the economic risk, as well as the retention of substantial rights.