The Sixth Circuit Court of Appeals issued a ruling in the case in Audio Technica U.S. Inc. v. U.S., No. 19-3469. The decision may give pause to research credit claimants who wish to rely on prior settlements with the Internal Revenue Service. The case involved the appeal of a case from the United States District Court of Northern Ohio.
A jury trial in District Court
The taxpayer, Audio Technica (AT), is well known in the field of high performance audio products. During the District Court proceedings, the Justice Department challenged AT’s calculation of the research tax credits. In addition to challenging AT’s qualified research expenses for the tax years at issue, the Justice Department specifically challenging AT’s base calculation. AT had calculated a fixed base percentage under section 41(c)(3)(A) by comparing research expenses and gross receipts from 1984 through 1989 resulting in a fixed base percentage of 0.92%.
In the district court case, the taxpayer successfully convinced a jury that it was engaged in research activities. However, prior to the start of the trial, the taxpayer filed a Motion in limine – a motion filed prior to the start of a trial intended to resolve an issue on which the parties disagree – to limit the government from challenging the fixed base percentage. The taxpayer argued that in reaching settlements in the Tax Court for 2002 through 2005 and 2011, the government and court implicitly accepted a fixed base percentage of 0.92% to calculate the allowable research tax credits. Consequently, the taxpayer argued, that the government was estopped in the District Court litigation from challenging the fixed base percentage previously relied upon in the Tax Court settlements. The District Court agreed with the taxpayer that the government could not challenge the fixed base percentage and allowed a tax refund based on the credit.
On appeal – the fixed base percentage
The government appealed the case, in part, on the grounds that the trial court incorrectly limited the government from challenging the fixed base calculation. The government argued that the Tax Court settlement neither relied upon nor adapted the 0.92% fixed base percentage when it approved the settlements between the parties. The Tax Court settlements only stipulated to the amount of the tax deficiency – there was no specific stipulation in the agreements as to the fixed base percentage or the method of computing the research tax credit.
The appellate court determined that the Tax Court’s order memorializing the settlement was not judicial acceptance of the 0.92% fixed base percentage, and the government was not estopped from arguing the fixed base percentage amount. The case was remanded back to District Court to hear evidence to support the fixed base percentage of 0.92%.
Calculating a Research Credit with historical data
The research credit is an incremental credit; a tax credit is determined once research expenses exceed a base amount. Generally, the research tax credit base amount can be calculated in two ways – using historic data potentially going back as far as 1984, or the alternative simplified credit calculation using the prior three years of research expenses to calculate a base. While this case likely will not significantly alter how taxpayers calculate their research credit, it does suggest there is risk related to using a research credit calculation that utilizes distant tax years for calculating the base amount.
With the method relying on historic data, the taxpayer calculates a base amount consisting of a percentage, the fixed base percentage, of its average annual gross receipts from the four tax years prior to the credit year. The fixed base percentage the taxpayer must use is based either on a formula of its qualified research expenses divided by its gross receipts for the period of 1984 to 1988. If the taxpayer did not have research expenses during that period, it is through an even more complex formula using what is called ‘the start-up method,’ also using historic research expenses and gross receipts.
The alternative simplified method is a more straightforward calculation method. That calculation method looks at a base amount that is effectively half of the taxpayer’s average research expenses for the three years prior to the credit year. The alternative simplified credit calculation is considerably easier to defend during an examination by the IRS because a taxpayer needs tax records only for the tax year at issue plus the three prior years.
A taxpayer relying on the historic method may need to support its credit with records from as far back as 1984, a time 36 years ago. The Audio Technica case illustrates that taxpayer will need documentation of its fixed base percentage: a taxpayer cannot rely on past examination experiences or settlements. Taxpayers that claim the research credit should talk to their tax advisor about the IRS exam risks surrounding their research credit.