A recent U.S. District Court ruling in Bayer Corp. v. United States (No. 2:09-cv-00351) underscores the importance of tying research expenses used to qualify for the research and development (R&D) tax credit to identifiable "business components." In the ruling, the U.S. Western District Court of Pennsylvania denied Bayer's motion to use a statistical sampling to assess the accuracy of the company's R&D tax credit claim, holding that the identification of business components is a critical step in substantiating R&D credits.
Motion
The motion centered on the IRS's request during discovery for sweeping information on the business components associated with Bayer's R&D credit claims of approximately $175 million from 1990 to 2006. Bayer had used an accounting system that was based on the nature of the activities performed rather than individual projects. Similar activities (e.g., clinical studies for pharmaceuticals or formulation development for crop protection agents) were grouped into more than 1,300 cost centers for which eligible qualified research expenses (QREs) were compiled for the credit.
Section 41(d)(2) requires that the test for determining whether an expense was incurred in connection with qualified research be applied separately to each business component of the taxpayer. A business component is defined as "any product, process, computer software, technique, formula or invention" that is either (1) held for sale, lease or license; or (2) used by the taxpayer in its trade or business.
Bayer estimated it had developed more than 100,000 business components during the years at issue. The company made no attempt to segregate costs by business component, which it argued its books and records do not, and are not required to, track individually. During discovery, the IRS asked Bayer to identify and describe "each new or improved business component Bayer contends it incurred qualified research expenses to develop during the credit years." Bayer argued that the request was "overbroad and burdensome without the adoption of a suitable sampling method." The vast scope of the enterprise was demonstrated by the fact that Bayer had collected more than 1 billion pages of potentially relevant electronic records from just four of its 49 sites at issue. In addition, more than 3 million pages of documents had already been provided to the IRS.
A recent U.S. District Court ruling in Bayer Corp. v. United States (No. 2:09-cv-00351) underscores the importance of tying research expenses used to qualify for the research and development (R&D) tax credit to identifiable "business components." In the ruling, the U.S. Western District Court of Pennsylvania denied Bayer's motion to use a statistical sampling to assess the accuracy of the company's R&D tax credit claim, holding that the identification of business components is a critical step in substantiating R&D credits.
Motion
The motion centered on the IRS's request during discovery for sweeping information on the business components associated with Bayer's R&D credit claims of approximately $175 million from 1990 to 2006. Bayer had used an accounting system that was based on the nature of the activities performed rather than individual projects. Similar activities (e.g., clinical studies for pharmaceuticals or formulation development for crop protection agents) were grouped into more than 1,300 cost centers for which eligible qualified research expenses (QREs) were compiled for the credit.
Section 41(d)(2) requires that the test for determining whether an expense was incurred in connection with qualified research be applied separately to each business component of the taxpayer. A business component is defined as "any product, process, computer software, technique, formula or invention" that is either (1) held for sale, lease or license; or (2) used by the taxpayer in its trade or business.
Bayer estimated it had developed more than 100,000 business components during the years at issue. The company made no attempt to segregate costs by business component, which it argued its books and records do not, and are not required to, track individually. During discovery, the IRS asked Bayer to identify and describe "each new or improved business component Bayer contends it incurred qualified research expenses to develop during the credit years." Bayer argued that the request was "overbroad and burdensome without the adoption of a suitable sampling method." The vast scope of the enterprise was demonstrated by the fact that Bayer had collected more than 1 billion pages of potentially relevant electronic records from just four of its 49 sites at issue. In addition, more than 3 million pages of documents had already been provided to the IRS.
Bayer's motion requested a discovery plan based on statistical sampling that would examine only a subset of the cost centers and research activities conducted during the credit years, with the results of the sampling being extrapolated to all of Bayer's claims without the requirement to introduce further evidence at trial. The IRS did not want to be bound by Bayer's sampling approach and "vigorously opposed" the idea that it could be forced to accept statistical sampling during discovery or at trial.
Both Bayer and the IRS hired statistical sampling experts in an attempt to work out an acceptable sampling plan to streamline the discovery process. Bayer proposed a plan that would select 50 cost centers from a sample of eight research sites to examine for each of two years (for a total of 100 sample units). The IRS's expert proposed using a pilot sample that he described as a "dress rehearsal" for a full sampling plan that would facilitate a settlement of this dispute. Bayer and the IRS could not agree on a mutually acceptable sampling approach.
Ruling
The court denied Bayer's motion, noting that it would eliminate Bayer's burden of proof regarding all QREs claimed at 41 of the 49 research sites during the credit years, as well as the QREs not selected for analysis in the eight sample research sites. The court said it could "find no authority for the extraordinary relief sought by Bayer" and said such relief would "constitute a reward to Bayer for failing to keep evidence regarding research expenses in 'sufficiently usable form and detail.' "
The ruling highlights the need for taxpayers to identify the specific business components giving rise to their R&D credits and to make every effort to tie QREs to these identified business components. The court agreed with the IRS that the identification of business components was a critical step in substantiating R&D credits. Recent court cases involving the R&D tax credit have cited the Cohan doctrine, which allows the court to estimate QREs in the absence of documentation to prove the exact amount of expenses. However, the court in Bayer reasoned that Cohan did not automatically apply, because Bayer had not first met its burden of identifying business components for the credit years. Until this burden is satisfied, the court said, "quantifying the amount of QRE credits to which Bayer is entitled is premature." The Cohan doctrine "could only be applied after the taxpayer has clearly shown that he is entitled to some deduction and that uncertainty exists only as to the exact amount thereof."
The court concluded that Bayer's proposed sampling plan could not be forced on the IRS. Because this case is still in the discovery stage, the question remains whether Bayer and the IRS can reach some sort of agreement on the use of sampling in the case to avoid an extremely lengthy discovery and trial process.
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