California Office of Tax Appeals denies research credit refund

Jun 19, 2020
Jun 19, 2020
0 min. read

The California research and development tax credit as it relates to the process of experimentation requirement has become significantly more stringent by the newly established California Office of Tax Appeals in a recently issued precedential decision, In re Swat-Fame, Inc., 2020-0TA-046P; 2020-OTA-045P, June 1, 2020).  

The California Office of Tax Appeals

California’s The Taxpayer Transparency & Fairness Act of 2017 established the Office of Tax Appeals (OTA) at the state level to handle appeals regarding personal and corporate income/franchise, sales and use, and fuel taxes.  The OTA replaces the California Board of Equalization, as was previously the appeal procedure. A three-member panel of administrative law judges acts in a quasi-judicial manner to hear cases appealed to the OTA.  

Similar to that of an IRS examination, the outcome of a California Franchise Tax Board (FTB) examination has three potential outcomes; no change, a Notice of Proposed Overassessment – the state owes the taxpayer a refund, or a Notice of Proposed Assessment – the taxpayer owes additional tax. If the taxpayer disagrees with the notice, it can first file a protest with the FTB. The taxpayer can request an oral hearing with an FTB hearing officer, or rely solely on its written protest. The FTB hearing officer will determine the amount of tax the taxpayer owes. The FTB will then issue a Notice of Action, which notifies the taxpayer if the FTB affirms, revises or withdraws the proposed assessment.

If a taxpayer disagrees with the Notice of Action, he or she can file an appeal with the OTA within 30 days. The OTA is an independent governmental body that handles all personal and business entity income tax appeals. The taxpayer has a right to request an oral hearing if he or she chooses. Following the OTA’s review, it will issue a decision in writing that the OTA can designate as ‘precedential‘ or ‘non-precedential.’ Either the taxpayer or the FTB may petition for a rehearing within 30 days. An OTA petition for rehearing will only be granted if the OTA determines there are grounds for a rehearing, such as irregularity in the proceedings, which prevented the party making the petition for rehearing from having a fair consideration of its case or an error in law. If no petition for rehearing is filed, OTA’s decision becomes final in 30 days. Throughout the process at OTA, a taxpayer may request a settlement, which will stop the case from proceeding through a hearing or appeal. A taxpayer then has 90 days to appeal the decision to the California Superior Court, although the FTB cannot appeal an unfavorable determination.

Process of Experimentation

Swat-Fame is an S corporation operating as an apparel designer for women and girls clothing. The company’s clothing designs are available at major retailers, and its design staff develops and refines thousands of new clothing designs each year. The company filed R&D tax credit claims of approximately $2.4 million for tax years 2008 – 2012, and following denial by the Franchise Tax Board, the company appealed to the California Office of Tax Appeals.

Like the federal research and development tax credit, the California credit requires that each business component claimed by a taxpayer is considered as qualified research, and meets the four-part test of section 41 of the Internal Revenue Code. In Swat-Fame, the OTA focused on the process of experimentation aspect of the four-part test. In doing so, the OTA heavily relied on the analysis of the process of experimentation as developed in Union Carbide Subsidiaries v. Commissioner, T.C. Memo. 2009-50, affd. (2d Cir. 2012) 697 F.3d. 104.

The court in Union Carbide held that the process of experimentation of the research credit requires a “structured method of discovering information” and the use of the scientific method. A taxpayer applying a simple trial and error process is not engaged in a process of experimentation. Rather, the taxpayer must apply a systematic trial and error methodology. Additionally, while a taxpayer need not test more than one alternative, the taxpayer must conduct a series of experiments with the single alternative in order for the taxpayer to have undertaken a process of experimentation.

In reviewing the evidence presented, the OTA found that Swat-Fame’s activities did not rise to the level of a systematic trial and error methodology as required in Union Carbide. The OTA reviewed four sample projects. One of the sample projects involved the manufacturing process of denim Bermuda shorts. Swat-Fame attempted to resolve shrinkage issues that occurred when the shorts were manufactured. The OTA determined that Swat-Fame did not demonstrate that it performed a systematic trial and error process of experimentation. The OTA found that while some of the fabric treatments undertaken by Swat-Fame may have utilized a trial and error process, a significant portion of the project was for the purpose of aesthetics. As a result, the OTA found that the taxpayer was not engaged in qualified research activities in its attempts to design the manufacturing process for the shorts.

The OTA made similar determinations for the other three research projects that it reviewed. The taxpayer did not demonstrate that substantially all of its activities constituted a process of experimentation. Swat-Fame’s refund claims were denied in full.

Impact on the California Research and Experimentation Tax Credit

The Swat-Fame case is important both for its substantive ruling and for the process of appeal. The newly established Office of Tax Appeals operates in a quasi-judicial capacity, and will render opinions with precedential impact. The opinion in Swat-Frame establishes OTA’s interpretation of the statutory requirements for the California research tax credit, and has been designated as a ’precedential’ opinion. The OTA’s interpretation of the process of experimentation requirement is a strict standard requiring evidence of a systematic process based on Union Carbide. Consequently, a taxpayer filing an appeal with the OTA will need to demonstrate that is has met the strict standard for process of experimentation based on the precedent established by the OTA in the Swat-Fame opinion.            

RSM contributors

  • Rory Bertiglia
    Senior Director

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