United States

Court invalidates R&D claim that relied on consulting firm testimony

Previous R&D activities requires use of earlier base period


A recent case from the Southern District of Ohio (US vs. Quebe, No. 3:15-cv-00294) discusses limitations on a taxpayer’s ability to claim research and development tax credits (R&D credits) that rely solely on inadmissible testimony for base period data from 1984 through 1988 (1980s base period). In the order for summary judgement in favor of the government, the court finds that:

  • The taxpayer’s calculation of its base amount under section 41 incorrectly relies on the start-up method under section 41(c)(3)(B)
  • The taxpayer failed to properly substantiate their credit claim

Generally, taxpayers may calculate their R&D credit using the start-up base period if a taxpayer either had no gross receipts or qualified research expenses (QREs) before 1984, or if the taxpayer had fewer than three tax years with both gross receipts and QREs during the 1980s base period. For tax years after 1993, the start-up base period allows the taxpayer to use a three percent fixed-base percentage for the first five years, and a sliding fixed-base percentage for the following sixth through tenth years. This sliding fixed-base percentage begins with one-sixth of the QREs to gross receipts ratio in the sixth year, and ends with five-sixths of the ratio in its 10th year. For all subsequent years, the taxpayer’s fixed-base percentage is the QREs to gross receipts ratio for any five year period between years five through ten.

Facts of the case

The taxpayer in the case at hand filed R&D credit claims for tax years 2009 and 2010 using the start-up base period calculation method, resulting in a significant benefit. They argued that although they were in business during the 1980s base period, that they had no QREs and were therefore entitled to use the start-up method. The taxpayer argued that any research they were engaged in during the 1980s base period was properly excluded from the R&D credit calculation as funded research.

Generally, otherwise qualified research projects will be excluded as funded if a taxpayer is paid for the actual time and materials the project took to complete, as opposed to a fixed-fee payment structure, which is treated as unfunded. The taxpayer argued that the contracts for tax years 2009-2010 were includable in the R&D credit calculation as fixed-fee, but all contracts from the 1980s base period were ineligible as time and materials structured.

To support their use of the start-up method, the taxpayer pointed only to deposition testimony from a consulting firm that was engaged by the taxpayer to conduct an R&D study for 2009-2010. Unfortunately, the court ruled this testimony as hearsay that is inadmissible to demonstrate the existence of a genuine issue of material fact. Ruled as inadmissible, the testimony regarding the 1980s base period could not be considered by the court in support of the taxpayer’s position.

Defendants also argued unsuccessfully that the burden is on the Government to prove that a taxpayer was engaged in qualified activities during the 1980s base period. Importantly, the court notes that although the, “Government has the ultimate burden of proving its claim,” it may do so, “by proving that [taxpayers] have not substantiated their right to the claimed tax benefit.” The court points to the record keeping rules of section 41, discussing the requirement to establish the amount of R&D credit claimed.

This line of reasoning is somewhat counterintuitive, as the court is basically ordering a taxpayer to retain records showing they were not engaged in qualified activities; proof of a negative that many taxpayers would not be able to produce. Regardless, the Government draws an important comparison between the activities that resulted in QREs for 2009-2010, and similar activities related to developing means and methods the taxpayer was engaged in during the 1980s base period. Citing deposition testimony of the business owner, the court finds this comparison to establish that QREs likely also occurred in the 1980s base period, making the taxpayer ineligible for the start-up calculation method.

Ultimately, the court finds that because the only contrary evidence presented by the taxpayer was inadmissible, the taxpayer has not effectively rebutted the Government’s positon. The court therefore granted the motion for summary judgement in favor of the Government because 1) the taxpayer was not permitted to use the start-up method, and 2) the taxpayer generally failed to substantiate their claim for the R&D credit.

Key takeaways

Companies using the start-up calculation method must have credible evidence that they meet the requirements from section 41. This may include establishing that no QREs existed during the 1980s base period. As noted above, the documentation produced must meet the record keeping requirements of 41 as well as admissibility requirements for consideration by the appropriate authority.  If there is information available to the public which appears to indicate that products were being developed during the 1980s base period, then it would be very difficult to argue that there were no QREs in the 1980s base period, unless the taxpayer can produce evidence that the research in the 1980’s base period was not qualified research.

Establishing base period QREs can be difficult for a taxpayer, especially if acquisitions or ownership changes have occurred. Although taxpayers are not permitted to extrapolate current data back to prior years, a taxpayer’s good faith estimate will be considered if it is reasonable and supported by oral testimony from the taxpayer. For example, a taxpayer may be able to estimate QREs based on their recall of the number of R&D employees in the base years and use Labor Dept statistics to determine the average salary for the base year R&D employees based on job titles.

As with all R&D credit claims, a taxpayer should carefully consider the documentation required for all tax years relied on in a calculation. As seen above, these considerations are even more important as they relate to base periods from the 1980s.


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