The Future of the R&D Credit

For most companies, the current environment is turbulent for determining whether they satisfy the requirements for a Sec. 41 research and development (R&D) credit. Taxpayers are unsure as to whether to rely on the rules set forth in proposed regulations or to follow the case law in determining whether they meet the Sec. 41(d) discovery test.

Background

Norwest Corp., 110 TC 454 (1998), and United Stationers, Inc., 163 F3d 440 (7th Cir. 1998), set the standard for the discovery test. Those cases held that software development will satisfy Sec. 41s technological/information requirement only if the research intends to expand or refine existing principles of computer science and has a broad effect.

As to experimentation, the courts held that mere trial and error was inadequate to qualify for the test; they required a more rigorous standard of forming and testing hypotheses. The discovery test, later codified in the 2000 final regulations (TD 8930) as Regs. Sec. 1.41-4(a)(3)(i), allowed a credit only if the taxpayer undertook a research activity to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering. (Emphasis added.) This tends to bias the availability of the R&D credit toward research that is revolutionary instead of evolutionary, and to limit companies ability to take a credit.

Prop. Regs.

In December 2001, many taxpayers proclaimed victory when new Sec. 41 proposed regulations (REG-112991-01) omitted the controversial discovery test, including its common knowledge standard. Those regulations also included a definition of what constitutes qualified research. They were supposed to replace final regulations published in early 2001, which Treasury unofficially withdrew for review shortly thereafter. Reflecting the review and input of the current Administration, the proposed regulations significantly changed some parts of the withdrawn regulations. Unfortunately, Treasury has yet to finalize them, more than a year later.

In support of the proposed regulations, former Treasury Secretary ONeill said, We need to use every tool available to encourage growth, investment and job creation in our economy...The elimination of the discovery test will make it easier for businesses to qualify for the credit in the course of developing new products.

To taxpayers dismay, the regulations have no legal effect in their proposed state. This was highlighted when the Seventh Circuit affirmed Eustace (7th Cir., 12/13/02), in which it refused to accept the taxpayers reliance on them. The court determined that the proposed regulations are not legally valid and, according to their effective date, apply only to tax years ending after Dec. 25, 2001. In any case, the court doubted the regulations would help taxpayers, because they essentially track the United Stationers definition of experimentation.

The Tenth Circuit followed the same reasoning in Tax and Accounting Software Corp., 301 F3d 1254 (2002), which had originally struck down the discovery test. In that case, the court ruled that the district court improperly granted the software company summary judgment on its Sec. 41 R&D credit claim for the cost of developing commercially licensed accounting software. The court opined that neither the taxpayers nor the governments interpretation of the discovering information requirement comported with the statutes plain language, which required the discovery of new information with an independent value applicable to new product development. The court indicated that the taxpayer had to show that it discovered new information that it could separate from the product developed; essentially, the court modified the discovery test.

In the foregoing cases, both courts ruled that the taxpayers could not use the proposed regulations to support their positions. They focused on the proposed regulations effective date, which, although technically correct, ignored Treasurys explicit guidance that the discovery text was being interpreted too restrictively. The decisions also ran contrary to the Services own internal memorandum, Sec. 41 Credit for Increasing Research Activities: Current Audit Inventory Guidelines and Claim Processing, issued to executives, managers and examiners of its Large and Mid-Size Business and Small-Business/Self-Employed operating divisions on July 24, 2002. In the memorandum, the IRS said:

The proposed regulations, as they relate to the definition of qualified research under section 41(d), are also proposed to be applicable to taxable years ending on or after December 26, 2001. However, for all open taxable years, we will not challenge return positions consistent with the proposed regulations and taxpayers may rely on proposed regulations until they are finalized. We are adopting this position notwithstanding the provisions of T.D. 8930, as well as recent court opinions that provide different criteria for research credit qualifications. (Emphasis added.)

Conclusion

The proposed regulations provided taxpayers with guidance on the Sec. 41 R&D credit rules. Former Treasury Secretary ONeills statement and the Services own internal memorandum appear to signal that the IRS intends to follow the guidance provided in the proposed regulations for all open tax years. However, the Services litigating position in Eustace and Tax and Accounting Software Corp. raises a serious question as to whether its intent is true. Not only does this raise the issue of whether the discovery test still lives, it also casts doubt on the remaining new provisions contained in the proposed regulations. Until the proposed regulations become final, taxpayers will be left with contradictory guidance.

From Dan Fuller, CPA, Grand Rapids, MI