A. Introduction
The Economic Recovery Tax Act of 1981 (ERTA) established a research tax credit (RTC),1 allowing a taxpayer to claim a credit of 20 percent for qualified research expenses in a given tax year over a statutorily defined base amount.2 Congress has continually extended this credit, emphasizing that ''research is the lifeblood of our economic progress [and] effective tax incentives for research and development must be a fundamental element of America's competitiveness strategy.''3 However, there is uncertainty about the implementation of some aspects of the RTC.4 This article focuses on uncertainty surrounding the ineligibility of ''any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).''5 This ''funded research'' exclusion has been a frequent topic of dispute between the IRS and taxpayers, beginning with the seminal case of Fairchild Industries Inc. v. United States6 and more recently in an order on summary judgment in Geosyntec Consultants Inc. v. United States.7 These two cases share the common element of rare taxpayer-favorable findings but leave unresolved key factors concerning funding and the later allocation of qualified credits.8 Clarity is needed to provide incentives for legitimate investments in research as contemplated by the congressional intent behind the RTC.
This article addresses the funding of research and experimental activities in a manner consistent with the legislative purpose of the RTC, case law, basic contract principles, and economic theory. Although Geosyntec has helped clarify the proper implementation of the funding standards, it does not fully assess how different contractual terms allocate the risks of failure among the parties in contracts requiring research expenditures. A research provider's RTC claim is deemed unfunded if the qualified research was conducted under a fixed-fee contract rather than other contracts containing similar fee arrangements (for example, cost-plus contracts with capped fees). We propose a more logical basis for assessing the risk/reward calculus underlying contracts requiring research using the principles of risk allocation found in microeconomic theory and contract law. This approach could bring logical cohesion to future RTC cases, allowing for the rightful ability of a researcher and its clients to claim the credits for qualified research expenditures based on concrete indicia of intent expressed in the language of the underlying contract.
B. Legislative Intent
Congress first enacted legislation under ERTA to provide an income tax credit as an incentive for U.S. businesses to increase their qualified research expenditures. The RTC was designed to address a market failure that leads to underinvestment in research by private investors. As explained in the legislative history to the recent renewal of the RTC in the American Taxpayer Relief Act of 2012:
Congress acknowledges that research is important to the economy. Research is the basis of new products, new services, new industries, and new jobs for the domestic economy. There can be cases where an individual business may not find it profitable to invest in research as much as it otherwise might because it is difficult to capture the full benefits from the research and prevent such benefits from being used by competitors. At the same time, the research may create great benefits that spill over to society at large. To encourage activities that will result in these spillover benefits to society at large, the government does act to promote research. Therefore Congress believes it appropriate to extend the present-law research credit.9
The RTC has been a subject of debate. Many have argued that the policy has been a cost-effective means of stimulating research that is necessary to keep U.S. enterprises competitive, given similar tax incentives provided in other countries. Others view the credit as nothing more than a corporate handout and as subject to corporate overreach. The effectiveness of the RTC as a tax incentive is an important policy question but beyond our scope here. The legislative intent behind the RTC is clear — subsidization of qualified research investments through tax credits. That was first affirmed in 1981, and it has since been reaffirmed by the legislative and executive branches 15 times despite the program's detractors. Although there are expectations that Congress will extend the RTC retroactively for 2014 — and perhaps go further by expanding it10 and making it permanent11 — this is unlikely until after the 2014 midterm elections.12
ERTA defined the term ''qualified research'' to exclude ''research to the extent funded by grant, contract, or otherwise by another person (or governmental entity).''13 The legislative history to ERTA explained that Congress intended the funded research exclusion to apply in the following situation:
The credit is not available for any activity performed for another person (or governmental entity), whether pursuant to a grant, contract, or otherwise. Thus, if a taxpayer contracts with a research firm, university, or other person for research to be performed on the taxpayer's behalf, only the taxpayer which makes payments under the research contract and on whose behalf the research is conducted can claim the credit as those expenditures; the research firm, university, or other person which conducts the research on behalf of the other taxpayer cannot claim any credit for its expenditures in performing the contract.14
The above legislative history addresses a classic research contract in which the performance of the research is the deliverable. Research contracts can be differentiated from contracts that do not specifically require the performance of research as the deliverable but in which research may be required by the contractor to provide the products or services that constitute the deliverables. Congress did not explain to what extent, if at all, the funded research exclusion was intended to apply to the latter contracts.
The RTC statute does not define the term ''funded'' or explain how the exclusion would apply to research performed by a taxpayer under a contract or grant with a third party. Rather, Congress left the scope of the funded research exclusion to be addressed by the IRS in regulations. The funded research regulation is reg. section 1.41- 4A(d). This regulation ties the concept of funding to (1) whether the customer has agreed to pay the researcher to perform research on its behalf unconditionally (that is, even if the research fails to achieve its objectives); and (2) whether the taxpayer retains substantial rights in the research results. These criteria are akin to the considerations in an investment decision — that is, the researcher expects that the current and future benefits from its investment in the contract will exceed its expected costs but is subject to the risk that they will not.
The remainder of this article focuses on whether the past application of these regulations, along with later judicial precedent, is consistent with the economic rationale implied by the original congressional intent in excluding funded research as a qualified research expense.
Reprinted from Tax Notes, September 29, 2014, p. 1593
Footnotes
1 Section 221 of ERTA. The RTC is codified at section 41. Although section 41's formal title is ''Credit for Increasing Research Activities,'' tax practitioners refer to the credit by various short forms, including the RTC.
2 Section 41(a)(1). Research is qualified for purposes of the RTC if (1) the expenses connected with the research are eligible for treatment as research and experimental expenditures under section 174; (2) the research is undertaken to discover technological information; (3) the information to be discovered is useful in the development of a new or improved business component of the taxpayer (e.g., a new product or process); and (4) substantially all of the research activities constitute elements of a process of experimentation. Section 41(d)(1)(A)-(C); reg. section 1.41-4(a).
3 H.R. Rep. No. 100-1, pt. 2, at 88 (1988).
4 Section 41(d)(4)(A)-(H).
5 Section 41(d)(4)(H).
6 71 F.3d 868 (Fed. Cir. 1995).
7 2013 U.S. Dist. LEXIS 140185 (S.D. Fla. 2013).
8 Note that for the purposes of this article, we will assume that all research discussed herein meets the eligibility requirements of section 41 and its regulations except for the issue of whether the research is funded within the meaning of section 41(d)(4)(H) and reg. section 1.41-4A(d).
9 Joint Committee on Taxation, ''General Explanation of Tax Legislation Enacted in the 112th Congress,'' JCS-2-13, at 140 (Feb. 1, 2013).
10 See Dean Zerbe, ''Happy Days for Research: Tax Extenders Clear Senate Finance With Expanded R&D Tax Credit,'' Forbes, Apr. 4, 2014.
11 See Jia Lynn Yang, ''There's a War Over R&D Tax Credits. And Companies Keep Winning,'' The Washington Post, Jan. 24, 2014.
12 See David Malakoff, ''U.S. House Passes Permanent R&D Tax Credit,'' Science, May 9, 2014.
13 Section 41(d)(4)(H).
14 H.R. Rep. No. 97-201, at 116 (1981).
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