R&D Tax Opportunities to Consider for Government Contractors
Rights & Risks Analysis and the impact on R&D Tax Credit Claims
INSIGHT ARTICLE |
As the federal government makes significant investments into innovating the nation’s defense, infrastructure and technologies, government contractors that are agile in navigating the rapidly changing technological environment may have significant opportunities to participate in research and development (R&D) projects. Many government contractors performing R&D may be eligible for a Federal R&D Tax Credit. In December 2017, President Trump signed into law the Tax Cuts and Jobs Act (TCJA). While there were no direct changes to the R&D tax credit regulations, changes in the corporate tax rate have made the R&D tax credit more valuable as a percentage reduction of a corporation’s tax liability. Prior to 2018, for every dollar spent on qualified U.S.-based research and development activities, a company could typically realize a net 4.5 to 6.5 percent return. For tax years 2018 and forward, taxpayers may see an increase in the typical net R&D tax credit of closer to 7.9 percent. In addition, the TCJA repealed the corporate alternative minimum tax (AMT) which further reduces the hurdles of claiming the R&D credit as the IRC Sec. 41 credit formerly could only be used to offset regular tax liability (other than for qualified small businesses which received an AMT waiver in the PATH Act of 2015).
Areas of opportunity for defense contractors include, but are not limited to:
- New product development or improvements to pre-existing products such as: the design and development of new military products, parts and equipment; design and development of new mechanical systems and components; designing and fabricating specialized tooling; designing new communication and navigation equipment and systems; integration of products/systems; prototyping efforts; and experimenting with new materials to optimize equipment or components.
- Process developments or improvements such as: experimenting with ways to improve product yield and reduce scrap and/or cycle times; research and process development for ISO or other industry or regulatory certifications; automation of processes; design and development of new or improved methods or techniques for improving performance, reliability, or quality; and research and experimenting with new technologies for use in process development.
- Software development such as: developing unique software applications or embedded software for use in development efforts; developing new features or functionality in pre-existing software solutions; and improvements and innovation in systems integration.
For the U.S. based research and development activities to qualify for the R&D credit, there is a four part test that must be met:
- A permitted purpose to create or improve upon an existing product that results in improved function, performance, reliability, or quality.
- Discovering information that is technological in nature while relying on principles of a hard science.
- Technical uncertainty at the project’s outset regarding capability, method or appropriate design.
- A process of experimentation to eliminate or resolve the technical uncertainty identified.
Once projects are identified that meet the qualification criteria, contract terms should be analyzed to determine if a project is considered “funded” by some other person. 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:
A. Pursuant to the contract, payment is not contingent on the success of the research. Treas. Reg. Sec. 1.41-4A(d)(1); or
B. A taxpayer performing research for another person retains no substantial rights in the research under the agreement providing for the research. Treas. Reg. Sec. 1.41-
In order to meet the requirements of Treas. Reg. Sec. 1.41-4A(d)(1), the taxpayer must bear financial risk through either a success-based fee or fixed-fee contract. In addition, pre-award work performed during the bid and proposal stage and internal R&D (IR&D) efforts may also qualify as the research expenses are typically self-funded. 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. 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.
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. 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. In Dynetics (see Dynetics, Inc. and Subsidiaries v. U.S., 12-576 (Fed. Cl. 2015)), 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. Per Treas. Reg. Sec. 1.41-4A(d), 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. Dynetics tried to make an analogy that certain contracts under question by the IRS were similar to contracts analyzed 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 did not agree with this analogy and denied the claim citing that Fairchild explicitly accepted responsibility for meeting contract specifications; whereas, 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.
On October 18, 2007, the IRS issued a Coordinated Issue Paper (CIP) on Nonrefundable upfront fees, technology access fees, milestone payments, royalties and deferred income under collaboration agreement, LMSB-04-1007-073. In this CIP, the IRS concludes that upfront payments are not allowable under IRC Sec. 174 (and by extension IRC Sec. 41) because they represent payments (a) to participate (entry fees) in the research endeavor, (b) for already developed know-how or processes, or (c) for research that is not to be performed at the taxpayer’s risk. While the IRS’s response should give taxpayers insight into how the IRS may analyze contracts to determine if a taxpayer bears economic risk, it is important to note that the CIP completely ignores the analysis and conclusion of Fairchild, wherein the Court concluded that the focus of the At Risk test is the successful development of the product, rather than some intermediate research goal.
While the regulations do not specifically define substantial rights, Treas. Reg.1.41-4A(d)(2) states that if the contract stipulates that another person holds exclusive rights to exploit the results of the research, the taxpayer does not retain substantial rights. As such, the research is funded and the taxpayer is precluded from including these expenses for the research credit.
Further clarification as to the definition of substantial rights is provided in case law. For example, 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 the regulations state 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.”
To contrast, in Dynetics (see Dynetics, Inc. and Subsidiaries v. U.S., 12-576 (Fed. Cl. 2015)), the Court found that one of the contracts under question had 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 determined that Dynetics did not retain substantial rights in the results of the research, and as such, Dynetics could not claim the research expense related to this contract for the research credit.
FAR specific regulations in relation to finacial risk and substantial rights
The Federal Acquisition Regulations (FAR) and Defense Acquisition Regulations (DAR) are the overseeing authorities for government contractors. This method of utilizing uniform policies and procedures ensures all government contractors are treated equally and, while at first glance may appear to limit contractor rights, may actually increase the validity of R&D credit claims.
FAR parts 16, 32, and 35 are key in identifying the party at risk as these sections cover contract types, contract financing, and policies on research and development contracting, respectively. In addition, FAR part 36 delves into the methods of contracting and related policies for construction and architect-engineer contracts. While the abovementioned sections focus mostly on payment terms which are useful in determining who bears economic risk, the following regulations focus more on rights – an area of the IRC Sec. 41 code and regulations that is less clear due to the lack of a specific definition for “substantial rights.”
252.227-7022 Government Rights (Unlimited) (MAR 1979)
“The Government shall have unlimited rights, in all drawings, designs, specifications, notes and other works developed in the performance of this contract, including the right to use same on any other Government design or construction without additional compensation to the Contractor. The Contractor hereby grants to the Government a paid-up license throughout the world to all such works to which he may assert or establish any claim under design patent or copyright laws…”
Although this specific regulation grants the government “unlimited rights”, it does not grant “exclusive rights” to the work product. The contractor’s use of the product is not impaired and as such, this clause does not restrict substantial rights to the research efforts performed.
252.227-7023 Drawings and Other Data to Become Property of Government (MAR 1979)
“All designs, drawings, specifications, notes and other works developed in the performance of this contract shall become the sole property of the Government and may be used on any other design or construction without additional compensation to the Contractor. The Government shall be considered the “person for whom the work was prepared” for the purpose of authorship in any copyrightable work under 17 U.S.C. 201(b). With respect thereto, the Contractor agrees not to assert or authorize others to assert any rights nor establish any claim under the design patent or copyright laws. The Contractor for a period of three (3) years after completion of the project agrees to furnish all retained works on the request of the Contracting Officer. Unless otherwise provided in this contract, the Contractor shall have the right to retain copies of all works beyond such period”.
The “know-how” gained from the research efforts performed are not limited by this regulation. Instead, the contractor maintains possession of the drawings and other data without a given contractual obligation to the government after the three year period. For these reasons, this clause does not necessarily restrict substantial rights to the research efforts performed; however, due to the strong language regarding rights, it will be important for taxpayers to have other documentation supporting the taxpayer’s substantial rights in the resulting research.
252.227-7033 Rights in Shop Drawings (APR 1966)
“(a) Shop drawings for construction means drawings, submitted to the Government by the Construction Contractor, subcontractor or any lower-tier subcontractor pursuant to a construction contract, showing in detail (i) the proposed fabrication and assembly of structural elements and (ii) the installation (i.e., form, fit, and attachment details) of materials or equipment. The Government may duplicate, use, and disclose in any manner and for any purpose shop drawings delivered under this contract”.
The government is allotted the right to “duplicate, use, and disclose” the shop drawings but the clause does not bestow “exclusive rights”. The contractor may maintain “substantial rights” to the shop drawings covered under the contract.
252.204-7000 Disclosure of Information (OCT 2016)
“(a) The Contractor shall not release to anyone outside the Contractor's organization any unclassified information, regardless of medium (e.g., film, tape, and document), pertaining to any part of this contract or any program related to this contract, unless ...”
This specific clause provides the Government with the ability to restrict the release of any unclassified information. The clause, however, does not preclude a contractor from utilizing the unclassified information or “know-how” on unrelated projects in the future. Substantial rights remain intact under this clause.
Government Contracting is a growing market with increasing development activities that gives way to significant tax saving opportunities to claim the R&D credit. Far more businesses qualify for the R&D credit than actually claim the benefit. At first glance, contract terms may seem to preclude taxpayers from claiming the R&D credit. In order to properly evaluate the inclusion of R&D expenditures towards the credit, taxpayers should closely evaluate contract terms to determine which party bears the economic risk and retains substantial rights in the research.
With recent legislation making the R&D tax credit more accessible and even more lucrative than before, taxpayers that currently have federal income tax liability or anticipate owing tax in the foreseeable future should work with their tax advisor to determine eligibility.