If research is considered to be "funded research" within the meaning of Section 41(d)(4)(H) of the Tax Code, then it is not eligible for the research credit. Research is considered to be funded if payment is not contingent on the success of the research.
Two recent cases before the Tax Court — Systems Technologies Inc. and Smith, et al. — flesh out the meaning of funded research by turning to local law in their analysis of whether the research was funded or not.
In both cases, the Tax Court denied the Internal Revenue Service's motion for summary judgment.
System Technologies, located in Indiana, engineers and manufactures industrial finishing systems, primarily for use in the automotive industry. The purchase agreements for these systems generally require payments as the projects are underway. Those agreements are also subject to a choice-of-law provision requiring they be construed under and governed by Indiana law.
The Tax Court said that Indiana law would require Systems Technologies to refund payments to a customer "if Systems Technologies fails to deliver the product. Accordingly, ultimate payment to Systems Technologies is contingent on the success of the research and is not funded," the court found. Therefore the motion for partial summary judgment was denied.
In the Smith case, Adrian Smith, Carlisle Gill and Robert Forest were shareholders of Adrian Smith + Gordon Gill Architecture LLP, a company that provides innovative architectural design services to clients worldwide. AS+GG claimed research credits based on a number of projects for tax years 2008, 2009 and 2010 of roughly $3,000,000, $550,000 and $500,000, respectively. The projects included several buildings that were, at the time of their design, intended to be the tallest in the world. Of the research projects at issue, each contract contained choice-of-law provisions that supported their contention that the funding exclusion did not apply to the research projects.
To determine whether the research is funded, Reg. Section 1.41-4A(d) provides that amounts payable under any agreement that are contingent on the success of the research are not treated as funded. Under such circumstances, the party performing the research is entitled to the credit because it bears the risk of failure. The regulations also provide that a taxpayer is entitled to the credit only if it "retains substantial rights in the research."
"The taxpayer argued that the contracts were each incorporated under the laws of various foreign countries such as Dubai, Saudi Arabia and the U.K., so the governing foreign laws in those countries is relevant in the court's funding analysis," said Dean Zerbe, national managing director at Alliant and former senior counsel to the Senate Finance Committee.
"We find [taxpayer's] arguments to be somewhat compelling with respect to the rights retained under the [Masdar HQ] agreement and [the IRS] does not rebut these arguments in its reply. Accordingly, we do not find summary judgment … to be appropriate to whether AS+GG performed funded research related to the Masdar HQ project," the Court stated, denying summary judgment regarding one of the projects.
"Ultimately, the decisions in Smith, et al. and System Technologies, Inc. are a positive result for taxpayers going forward, with the Tax Court continuing to give significant weight to the choice of law provisions within contracts," said Zerbe. "Contractual funding analysis has now been shifted back toward a traditional contract analysis."
