Recent court decisions addressing companies’ research and development tax credit claims illustrate challenges taxpayers face in documenting qualified research expenses (QREs) and meeting associated nexus requirements, practitioners told BNA in October interviews.
Practitioners said the litigation in Union Carbide Corp. v. Commissioner and Bayer Corp. v. United States also illustrates the aggressive stance the Internal Revenue Service has taken in challenging R&D credit claims. Taxpayers should be proactive and prepare as though an audit is inevitable, they said.
The U.S. Court of Appeals for the Second Circuit, in September’s Union Carbide Corp. v. Commissioner, held that Union Carbide Corp. (UCC) could not claim the federal research credit under tax code Section 41 for supplies that were used in process research and development activities.
The Second Circuit held that UCC’s cost for the supplies used during such projects that would have been used in the course of UCC’s manufacturing process regardless of any research performed are not eligible for the credit (
An R&D tax credit for the cost of supplies that would have been incurred regardless of any research being conducted, the Second Circuit explained, “simply creates an unintended windfall.”
`UCC’ Ruling’s Effect on Documentation
Moving forward in the wake of the UCC decision, companies seeking R&D tax credits must consider many issues about documentation, including contemporaneous documentation and post-project documentation of qualified research, and whether the documentation will stand up to Internal Revenue Service scrutiny if the credits are audited.
Jeffrey R. Malo, a director at WTP Advisors in White Plains, N.Y., told BNA Oct. 2 that the UCC decision “is the latest authority to reiterate the importance of contemporaneous documentation in substantiating research credit claims.”
Malo explained that the Tax Court decision “was, in part, regarded as a taxpayer victory over the contemporaneous documentation requirement because the Tax Court allowed the taxpayer to offer after-the-fact oral testimony from employees who were involved in research projects completed long ago, to prove that qualified research activity occurred.”
“However,” he said, “even with the benefit of oral testimony trumping the contemporaneous documentation requirement, the Tax Court found little or no evidence that the expenses included in UCC’s research credit claim were distinguishable from ordinary production expenses.”
That was the basis of UCC’s appeal, said Malo, with UCC arguing that there is no primary purpose test for expenses incurred for R&D. “Even if the research expenses related to materials ultimately incorporated into products offered for sale to customers,” Malo noted, “UCC argued that the expenses should be allowed as QREs.”
The Second Circuit rejected UCC’s argument, explained Malo, “concluding that QRE can only result from expenses that would not be incurred in the absence of qualified research.” The UCC decision will require taxpayers that have dual purpose expenses to distinguish and document which expenses are specifically related to qualified research activity, and which are related to other ordinary business activities, he said.
Malo noted that Reg. Section 1.41-2(b)(2)(ii) provides the example of “extraordinary utility expenses” to illustrate how taxpayers can document dual purpose expenses. “In general, taxpayers are not allowed to count overhead allocations for utility expenses as QREs,” said Malo, “however, if the taxpayer is engaged in research that requires an extra consumption of utilities, the additional utility expense can be counted as a materials and supplies QRE, as long as the taxpayer establishes the special character of the expense and documents the excess margin over its normal utility cost.”
So the electric utility expense for normal lighting in a research lab is not a QRE, but an increase in the expense for conducting research on lasers may constitute a QRE if the taxpayer establishes a baseline for normal electrical expense and documents the fact that the increased expense is incurred in conjunction with its qualified research on laser technologies, he said.
“In light of the Second Circuit’s decision,” said Malo, “taxpayer documentation of dual purpose R&D expenses should look more like the extraordinary utility example in the regulations.”
Joe Stoddard, senior manager of the Washington National Tax Office of Grant Thornton, told BNA Oct. 3 the most direct impact of the UCC decision will be on how companies document the incremental cost of process research supply costs beyond regular production costs; “however, the decision will likely be interpreted broadly by the IRS to apply to all types of research expenses,” he said.
“The UCC ruling highlights the need for companies to show that they would not have incurred the research expenses absent the research project and that the primary purpose of the costs was for the research activity,” explained Stoddard, “and the decision also reinforces the importance of carefully documenting how the costs were incurred during the research process.”
Jeremy Fingeret, senior managing director at Alliantgroup in Houston, told BNA Oct. 9 that the UCC decision focuses on whether the supplies allocated were qualified costs. Fingeret noted that the Tax Court’s decision provided significant guidance on the type of substantiation necessary. “The good news is that nothing appears to have changed with this ruling—the bottom line continues to be reasonable flexibility,” he said. Fingeret went on to observe that, “this is especially good news for small and medium businesses that often face greater challenges on substantiation.”
“The UCC decision is a blow to manufacturers hoping for a broader reading of the R&D credit,” Alan Horowitz, an attorney with Miller & Chevalier in Washington, noted in the firm’s Tax Appellate blog. Horowitz said “the extent of the impact remains to be seen.”
Documentation by Engineers or Accountants?
A company’s accountants usually provide the documentation for claiming R&D tax credits. But are accountants the best choice for documenting research they may not understand, or is documentation best left to engineers who are conducting the research?
Malo said that ideally research personnel should be documenting their qualified research activities on a real-time basis, but many companies “treat the research credit as a compliance exercise, documenting and quantifying qualified activity for the prior tax year up to 20 months after the research occurred, or longer if multiple years are involved in the analysis (assuming a corporate taxpayer who files by the extended due date, 8.5 months after the tax year end).”
“The best practice around the contemporaneous documentation requirement is periodic communication between research personnel and the tax department to maximize the opportunities to capture and create the documentation needed to substantiate both the qualitative and quantitative components of the research credit,” he said.
Fingeret said the R&D credit “is a marriage of tax and technical information.” He said companies should ensure that they have both knowledgeable tax professionals and technical professionals like engineers, biologists, chemists, or software professionals working on their calculations.
Fingeret explained that in practice he has found that having “a technical professional is invaluable in ensuring that the business gets the maximum credit because often accountants or tax lawyers just look at the numbers provided and that is the end of the discussion.”
Stoddard said that while it is important for accounting personnel to work closely with the engineers to produce good documentation, accountants cannot be expected to understand all of the technical aspects of the research, just as engineers should not be expected to fully understand all of the nuances of the tax law.
Contemporaneous Documentation
Seen as Key
Ideally a company seeking R&D tax credits should keep contemporaneous documentation of research expenses. While many companies find this requirement burdensome, it may keep IRS happy in the long run.
“Most companies do have contemporaneous documentation of their research expenses,” said Stoddard, “however, that documentation is often not in line with what the IRS requests during R&D credit examinations.”
Stoddard noted that the legislative history of the R&D tax credit statute has clear statements that eligibility for the credit is not intended to be contingent on meeting unreasonable recordkeeping requirements, but IRS often imposes a standard well beyond the statutory requirements. He warned that “companies should be prepared to provide documentation to the IRS on a project-by-project basis whenever possible.”
Fingeret said most companies do not document their research based on Section 41—companies document their research as necessary to successfully complete the research and advance their business goals. “[T]he tail shouldn’t wag the dog,” he said.
He said in his experience working with IRS, “a well-documented R&D tax credit will be accepted even if it is not supported by traditional `research’ type documentation.”
Malo said IRS has been advancing the contemporaneous documentation requirement for more than a decade but taxpayers and practitioners have objected to the requirement as an unduly burdensome recordkeeping obligation. He explained that when a lookback study is conducted to support a credit claim, R&D personnel are required to produce documentation and expense data related to events that occurred long ago.
Malo said the problem is compounded by organizational changes that frequently occur between the time research is conducted and the time the expenses are included in a research credit claim.
“I regularly work with clients to transition them from a look back analysis of their research activities to a forward-facing, real-time methodology for substantiating research credit claims,” he said, “and I expect to see this trend continue as additional courts lend their support to the contemporaneous documentation requirement.”
`Bayer’ Case Raises Nexus Issue
The U.S. District Court for the Western District of Pennsylvania issued two decisions during 2012 in Bayer Corp. v. United States, a case in which Bayer sued the government over the denial of R&D tax credits for QREs totaling more than $49 million for the years 1990-2006.
In a February decision, the court denied Bayer’s motion to use a sampling method to assess the accuracy of QREs (
Malo said the September Bayer decision addresses the nexus requirement for substantiating research credit claims, and nexus is the other major substantiation requirement for the research credit that has been advanced by IRS for many years. IRS prefers contemporaneous documentation of credit claims, and this requirement is best satisfied through project accounting, where expenditures are tracked on a project-by-project basis, he said.
In spite of this preference, Malo explained that many taxpayers use a cost center method of accounting for R&D expenses and these taxpayers typically allocate cost center expenses to individual projects they identify as qualified research activities. “It is more difficult to examine a claim if the expenses related to claimed projects are allocated from a larger pool of potentially qualified and unqualified expenses,” he said.
In the September Bayer decision, the government attempted to require the taxpayer to identify all research projects—business components—giving rise to QREs in its cost centers, said Malo, and the court refused to issue such a mandate. The court concluded instead that Bayer had identified business components through its contemporaneous documentation, he said, and Bayer simply organized the expenses related to these business components by cost center, which the court noted is not prohibited by the tax code.
“The court did not enforce a strict nexus requirement that would have required the taxpayer to align specific projects with direct expenses recorded in a cost center,” Malo said.
According to Malo, the decision follows the earlier decision, in which the court refused to compel the government to accept Bayer’s statistical sampling methodology for identifying projects, or business components, that were credit eligible. In the earlier decision, he said, the court concluded that the Cohan rule could not be applied until qualified research projects (business components) were identified, and that decision led to the government’s motion to compel Bayer to identify all projects in its cost centers, which was then denied.
The Cohan rule, derived from Cohan v. Commissioner,
“It is not clear how the business component issue will be resolved,” said Malo, “now that the taxpayer’s and the government’s preferred approach to identifying projects that can be tested for credit eligibility have been denied.” Malo suggested that the parties will have to compromise on a sampling methodology, or else face a battle-of-the-experts at trial to determine what methodology should be used to identify the business components to which the Cohan rule might be applied.
Stoddard said the original Bayer ruling from February highlighted the need for taxpayers to identify business components and produce documentation that creates nexus between the business components and qualified costs. In the September decision, the court acknowledges the “Herculean efforts” that Bayer was required to make to comply with the government’s demands during the discovery process, he said. “The decision further demonstrates the IRS’s shifting focus to business component-based (i.e., project-based) R&D documentation,” Stoddard said.
Fingeret said that “the new Bayer case confirms that the playing field is broader than some at the IRS might suggest, and that cost center based studies have been used by [Big Four accounting firms] for many years.”
“Though not the methodology of choice for the IRS (the IRS prefers the project-based methodology),” he observed, “cost center based studies can effectively identify QREs when properly conducted. … Though Bayer is being forced to conduct extensive additional due diligence during their discovery in that case—it does not mean that the QREs were not properly identified,” he said.
Documentation Demands Can Outweigh Value
In the Bayer case, the company spent several years and millions of dollars seeking additional tax credits for the years 1990-1997 and increased tax refunds for 1987-1990 and 1995. Companies seeking R&D tax credits face substantial costs in documenting the credit, particularly in light of IRS elevating R&D tax credits claims to Tier 1 audit status. For many large companies there comes a point when documentation costs and probable audit cost may outweigh the value of claiming the credit.
Stoddard noted that “Congress’ intended incentive effect of the credit is often dampened by the high cost of defending the credit because of the drawn out and contentious IRS audit and appeals process.” Stoddard suggested that any company claiming the R&D credit should consider the cost of documenting and defending it against the tax benefit derived from the claim.
“If the anticipated costs exceed the benefit, it does not make sense to claim the credit,” he said.
Malo said such a cost/benefit analysis can lead to unfortunate decisions about documentation of qualified research activities. “[I]f a taxpayer expects to be in a loss position for an extended period of time, current credit eligible activity may be of little interest or value to the taxpayer since the benefit of the credit will only be realized through a carry-forward of the claim to the first year(s) in which the taxpayer has taxable income,” he said.
Malo explained that the issue “can be particularly acute for start-up companies,” which are frequently tight on resources that can be directed to anything other than the core business. Companies “should at least understand that the cost/benefit analysis is increasingly becoming a question of incurring some cost today to secure a future benefit, or incurring no cost today and foregoing a future benefit,” he said.
“The option of deferring the cost of documenting qualified activity through a retroactive analysis to be conducted only when it is clear that the research credit can be claimed is becoming obsolete,” Malo concluded.
Fingeret noted small businesses, with potentially small claims, often forgo the benefit of the credit. “Despite the fact that Congress has specifically cautioned against unduly burdensome record keeping for the R&D tax credit some taxpayers still shy away,” he said.
Use of `Cohan’ Rule
In 1930, the U.S. Board of Tax Appeals issued its decision in Cohan v. Commissioner, in which the board held that entertainer George M. Cohan should be allowed to estimate his tax deductible expenses for money he spent for travel, entertaining actors, employees, “and, as he naively adds, dramatic critics” as part of his work in producing his plays around the country.
Cohan did not keep any account of his expenses but estimated the amounts, which the board found reasonable. The Cohan rule has been applied in many R&D tax credit cases in the eight decades since, when contemporaneous documentation is not available.
“Cohan is, and will remain, good law,” said Malo, adding that “recent judicial decisions, including UCC, Trinity Industries [Trinity Industries v. United States,
Malo explained that a taxpayer must prove that a QRE was incurred, but the Cohan rule is not relevant to proving this fact. “Rather, a taxpayer must produce sufficient evidence (contemporaneous documentation) of qualified activity to prove that it is entitled to claim the research credit,” said Malo. Once the qualified research is established, he said, a taxpayer may invoke the Cohan rule to estimate the amount of QREs.
But the Cohan rule is a double-edged sword, Malo said: Once it is invoked, the government is empowered to make its own estimate of the taxpayer’s QREs.
Fingeret observed that the Cohan case and its progeny have proved a workable solution for small and medium-sized businesses that are clearly engaged in R&D but need to justify their credit claims.
Stoddard said the Cohan rule is still good law and the UCC court, in upholding the Tax Court’s decision, also upheld the lower court’s general acceptance of the validity of employee recollections and data extrapolation to estimate qualified research expenses. But application of the rule will likely be rejected where there is insufficient evidence to provide a reasonable basis to make an estimate, he said.
Advice to Clients
Tax practitioners face many challenges in claiming R&D credits, including documentation issues and intense scrutiny by IRS in audits. Malo urged taxpayers to consider that “better processes today can create better outcomes tomorrow.”
For any taxpayer claiming the research credit, he said the best practice for protecting its claim is to abandon lookback analyses that treat the credit as a compliance exercise, and instead adopt a forward-focused, real-time analysis of its activities “that treats the credit as an exercise in contemporaneous documentation of the qualitative and quantitative components of the credit.”
He explained that this approach best enables taxpayers to “capture and create the contemporaneous documentation they need to demonstrate the qualified nature of their research activities, and illustrate the nexus between their qualified research and its related expenses.”
This approach also enables taxpayers to implement changes to cost accounting policies in response to new case law, he said.
Stoddard noted that planning and documentation is key, and that waiting until an IRS audit or even litigation is not the ideal time to try to gather detailed documentation to support an R&D credit. Companies intending to claim the credit should identify relevant business components, associated costs, and supporting documentation on an annual basis to adequately prepare for an eventual IRS exam, he said.
“Companies may also consider participating in the Compliance Assurance Process (CAP) program to get the IRS’ agreement on appropriate credit documentation before the filing of the tax return,” said Stoddard. He warned though that taxpayers participating in the program have reported mixed results.
Fingeret said, “You can’t just whistle by the graveyard hoping that you will pass muster with the IRS.” A company seeking R&D credits should have a robust study performed by both accountants and technical experts, he said, adding, “I’m stunned how many times we are called in to review a company’s R&D credit and they have left significant tax savings on the ground.”
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