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Federal Research Tax Credit: Maximizing Your Company's Tax SavingsTax Court's Union Carbide Decision Creates New Opportunities, New Limitations

A Live 100-Minute Audio Conference with Interactive Q&Apresents

Today's panel features:

Bruce Warner, President, Warner Tax Consulting, Kansas City, Mo.

Kendall Fox, Tax Partner and Leader, U.S. National Research and Development Team, PricewaterhouseCoopers, Los Angeles

Kathleen King, Managing Director, Research Credit and Incentive Services, Alvarez & Marsal Taxand, Vienna, Va.

Joseph Maselli, Director, Washington National Tax Services, PricewaterhouseCoopers, New York

Christine Kachinsky, Federal Tax Partner, Accounting Methods and Credits, KPMG, New York

David Culp, Senior Manager in Pass-Throughs Group, Washington National Tax Practice, KPMG, Washington, D.C.

Tuesday, May 26, 2009

The conference begins at:1 pm Eastern12 pm Central

11 am Mountain10 am Pacific

The audio portion of this conference will be accessible by telephone only. Please refer to the dial in instructions emailed to registrants to access the audio portion of the conference.

1

Federal Research Tax Credit Teleconference

May 26, 2009Christine Kachinsky and David Culp

[email protected], [email protected]

Kathleen King Bruce WarnerAlvarez & Marsal Taxand Warner Tax Consulting

[email protected] [email protected]

Kendall Fox and Joseph MaselliPricewaterhouseCoopers

[email protected], [email protected]

2

Today’s Program

• Review Of The Union Carbide Decision, slides 4 through 25 (Christine Kachinsky and David Culp)

• Favorable And Unfavorable Aspects Of The Union Carbide Decision, slides 26 through 48 (Kathleen King, Bruce Warner, Kendall Fox and Joseph Maselli)

• Other Relevant Topics On The Research Credit, slides 49 through 52 (Kathleen King, Joseph Maselli and Bruce Warner)

3

ANY TAX ADVICE IN THIS ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED COMMUNICATION IS NOT INTENDED

OR WRITTEN TO BE USED, AND OR WRITTEN TO BE USED, AND CANNOT BE USED, BY A CLIENT OR CANNOT BE USED, BY A CLIENT OR

ANY OTHER PERSON OR ENTITY FOR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING THE PURPOSE OF (i) AVOIDING

PENALTIES THAT MAY BE IMPOSED ON PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, ANY TAXPAYER OR (ii) PROMOTING,

MARKETING OR RECOMMENDING TO MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ANOTHER PARTY ANY MATTERS

ADDRESSED HEREIN.ADDRESSED HEREIN.

The information contained herein is general in nature and based on

authorities that are subject to change. Applicability to specific situations is to

be determined through consultation with your tax adviser.

4

Review Of The Union Carbide Decision

5

Overview

Union Carbide Corporation v. CommissionerT.C. Memo. 2009-50 (March 10, 2009)

• Taxpayer (“UCC”) was under examination for calendar tax years 1994 and 1995

• UCC claimed $14.1M and $4.1M of research credits on its original returns, using the traditional research credit methodology

• UCC is engaged in the trade or business of processing raw hydrocarbon feedstocks into “basic building-block” chemicals (olefins)– Olefins are converted into derivatives – plastics and other chemicals –

that are used in manufacturing products and applications or as raw materials in more complex chemicals

– UCC also licenses olefins-based process technologies to third parties

6

Overview (Cont.)• IRS mailed notice of deficiency in 1999• UCC filed its original Tax Court petition on June 17, 1999 • IRS and UCC negotiated an agreement that resolved most issues, including

the research credits• In an amended petition, UCC claimed additional credits of $3.66M and

$4.73M, for 106 projects– The 106 projects were activities intended to improve various aspects of

the production of various chemicals and plastics in UCC’s trade or business

– Generally, these activities were conducted during runs at the UCC’s production facilities

– The additional QREs had been reported as cost of goods sold• Raw materials used to produce goods for sale

7

Overview (Cont.)

• The parties agreed the Tax Court would try five of the largest projects– Nine days of testimony in June 2006 on the eligibility of the projects as

qualified research– 14 days of testimony in November–December 2007 on the Section

41(c) base amount– UCC introduced expert testimony from seven witnesses– The IRS introduced expert testimony from three witnesses, affiliates of

LEGC LLC, a global expert services and consulting firm• Judge Goeke’s 298-page memorandum opinion was filed on March 10,

2009– The judge expects the parties to resolve any issues regarding the

remaining 101 projects in a manner consistent with the opinion

8

The Five Projects: No.1Amoco Anticoking Project

• Coke builds up in the furnaces used in the cracking process used to produce oleofins– Reducing coke would reduce shutdowns and maintenance, and increase

productivity• UCC evaluated a new decoking technology developed by Amoco• The technology was used in two otherwise-normal production runs

– UCC paid for its feedstocks, fuel gases, and ordinary production wages– Amoco paid for the pre-treatments, the costs of its technology and any

overtime wages– UCC sold the materials produced in the ordinary course of its business

• UCC assessed the effects of the technology and ultimately determined that the Amoco technology did not effectively reduce coke formation

• QREs claimed– Supplies: Portion of total ethylene production cost allocated to project– Wages for hours the specific employees involved estimated for project

9

The Five Projects: No. 2The UCAT-J Project

• UCC was developing a new catalyst, UCAT-J, for its production of polyethylene, as an alternative to M-1, in hopes that UCAT-J could be used in a new facility and commercialized

• UCC described the anticipated advantages of UCAT-J to potential licensees• UCC tested UCAT-J in experimental production runs at two existing

reactors, alternating with M-1 (an established catalyst) beginning in 1992• In 1994 and 1995, there were 19 experimental runs, each with specific

objectives to be evaluated• The experimental runs generally produced commercial product that was

sold in the course of business, though some of it was “off-grade” and sold at a lower price

• The reactors were in operation fulltime, and there was no significant additional employee time to operate a reactor for an experimental run

• QREs: The cost of production materials and wages allocated to the experimental runs

10

The Five Projects: Nos. 3 And 4

• The spuds project– At the advice of a vendor, UCC substituted one-hole “spuds” for four-

hole spuds in its furnace, to reduce “plugging”– UCC tried the one-hole spuds for 90 days during its normal production

processes, and determined the problem was resolved• The sodium borohydride project

– UCC had used sodium borohydride to reduce acid gases in its furnace, but not in its “scrubbers”

– Based on a 1/9/95 R&D report, beginning in 6/05 UCC began a testduring production runs and monitored the results, but did not document the results in a final report

– The decision to convert to sodium borohydride was based on the 1/9/95 report and a determination that the product produced in the 6/05 tests was on-spec

11

The Five Projects: No. 5

• The UOP GA-155 project – A vendor, UOP, recommended that UCC use a new product, GA-155,

as an inhibitor to reduce fouling in its ethylene units– UCC conducted a test by injecting GA-155 into its C3 column and

measuring the effects during normal production runs– UCC recorded data closely for three months (the normal run length

before a shutdown without an inhibitor), and the column successfully continued in operation for three additional months

12

What The Court Decided• The 2003 final Section 41 regulations (T.D. 9104) may be relied on, even

though UCC’s research occurred in 1994 and 1995• The four-part test for qualified research is applied separately to each

business component– If a project involves both the development of the concept of a new or

improved process and the use of the process in production, only the activities related to the development of the concept satisfy the Section 174 test

– If a business component fails the process of experimentation test because of the “substantially all” requirement, the taxpayer may apply the shrinking-back rule until an element that satisfies the test is reached

– For each of UCC’s projects, there are two business components:• A process business component• A product business component

• For each of UCC’s five projects, the inquiry was “shrunk back” to the process business component

13

Was It Qualified Research?

Amoco Anticoking Project• The project satisfied the four-part test• Process of experimentation

– Ordinary production activities that would have occurred even if the taxpayer was not conducting an experiment do not constitute elements of a process of experimentation

– However, by limiting the project to the process research activities, substantially all of the activities do satisfy the process of experimentation requirement

• This was not research funded by Amoco (the proprietor of the technology tested by UCC)

• This was not research after commercial production; the Amoco technology was not ready for commercial use at the time of the tests

14

Was It Qualified Research? (Cont.)

UCAT-J Project• Each of the 19 experimental production runs constituted qualified research

on the process• The Section 174 test

– UCC had confidence that UCAT-J could be successfully developed, but there were numerous issues about the design of the process

– Even though UCC had commercial objectives in the experimental runs – Producing product for sale and training employees in using UCAT-J – The primary objective of the runs was to resolve uncertainties about the process

• Process of experimentation test– Even though there were no formal project reports, there was credible

testimony that UCC data was collected during the runs, was analyzed, and used to further refine the process using UCAT-J

• The production process using UCAT-J did not satisfy UCC’s basic functional and economic requirements during the credit years

15


The Spuds Project• UCC conceded this was not qualified research

• Court: Section 174 requires that “an objective uncertainty exist”

• UCC had sufficient information to be certain that one-hole spuds were capable of improving its production process

16


Sodium Borohydride Project• The activities failed the process of experimentation test

– The project must be designed not only to test whether the sodium borohydride satisfied UCC’s needs, but also to evaluate its use through a sequential process of experimentation

– Data collection is insufficient if it is not followed by a meaningful analysis

– The 1/9/95 R&D report on which UCC relied for this project was prepared before the 6/95 test began, so any test data was not used in the analysis

17


UOP GA-155 Project

• The activities failed the Section 174 test• UCC already had sufficient information available to eliminate any

objective uncertainties about using GA-155 as an inhibitor• UOP – the vendor – had already performed the research to establish that

GA-155 was effective• UCC was confirming UOP’s assertions with its own testing• UCC had no doubt that injecting an inhibitor into the C3 column was the

appropriate method to reduce fouling

18

Base Period

• UCC relied extensively on its expert witnesses to determine the activities conducted during the 1984-1988 base period that were qualified research, and the costs of those projects

• The court emphasized the consistency requirement in the determination of qualified research for the credit year projects and the base period projects– There is no requirement that a taxpayer use the same types of

documents to identify qualified research in the base period that it uses in the claim year, if the consistency requirement can be satisfied in other ways

• The court held that the consistency requirement must be applied to the activities conducted by each member of a controlled group, not to the controlled group as a whole

19

What QREs Were Allowed?

• Only the Amoco anti-coking project and the UCAT-J project were found to be qualified research

• Because the business component is the process, not the production, supplies and wages that relate to production activities are not QREs– Thus, the materials used in the production operations while the research

activity was conducted are not QRE

• UCC argued that the research projects could not have occurred without these supplies and materials

• The court said that raw materials used to make finished goods that would have been purchased regardless of the research activity are not used in the conduct of qualified research– Such supplies “are, at best, indirect research costs”

20

What QREs Were Allowed? (Cont.)

Amoco Anticoking Project• All supply expense was disallowed ($3.186M)

• The court accepted the “credible testimony” of three employees as to the time they spent on the projects; but a fourth employee did not testify to his time, and there was no other substantiation, so his wages were disallowed

• $835 of the $873 of the claimed 1994 wage QRE was allowed, and all $210 of the 1995 wage QRE

21


UCAT-J Project• All supply expense was disallowed ($6.68M)

• The wage QRE claimed was a percentage of total wages for the production by the reactors.

• There was no substantiation of how much time was spent by these employees engaging in qualified research

• All of the wage QRE was disallowed ($519K)– Wages of the personnel planning and analyzing the research had

already been counted as QREs in UCC’s original credit claim

22


Base Period Costs• The court found, generally, that UCC used the same methodology to

calculate credit-year costs and base-year costs

• The court said the base-year costs reflected the same flaw – that production costs were counted as QREs

• Generally, however, the court did not adjust UCC’s computation to exclude these costs

23

Some General Observations

Substantiation• The IRS argued that UCC did not produce sufficient documentary evidence

to corroborate testimony that the UCAT-J project was qualified research• The court accepted UCC’s substantiation, considering the record in its

entirety– There were three fact witnesses who discussed the project and were

corroborated by documentary evidence that provided the objectives, risks and results of the runs.

• The Tax Court indicated that it will apply Cohan to accept the taxpayer’s evidence and oral testimony and concessions “as a close approximation of all the qualified research activities” and expenses that occurred during the credit years and the base period – The Cohan rule was applied, however, in circumstances that would

likely minimize UCC’s research credit

24

Some General Observations (Cont.)Production Runs Vs. Experimental Runs

• The court seemed to apply a “primary purpose” approach to determining whether the costs of a run would be QRE – The primary purpose of the run was production of salable goods, and

the run would have taken place regardless of the research • The court distinguished Fudim v. Commissioner, T.C. Memo. 1994-235, as

a case where the taxpayer was allowed QRE for the supply costs incurred in developing a process of designing and producing plastic objects – The Fudim supply costs were “devoted to research”; they would not

have been incurred except as part of the research, and very little of the product was sold

• There are many types of trial production runs related to processexperimentation that will fit, factually, somewhere between a run conducted to produce commercial product (as the Tax Court would characterize the situation in UCC) and a run where the supplies are entirely devoted to research, as it characterized Fudim

25

Summing Up• In its first research credit decision since the 2003 final regulations, the Tax

Court analyzed five projects, only two of which were held to be constitute qualified research

• The taxpayer’s claim to treat as QRE the costs of supplies and general labor in conducting research during a production run that would have occurred anyway was denied.

• The taxpayer’s characterization of such costs as QRE in the base period was called “flawed,” but the court did not make any adjustment because such an overstatement was “harmless error”

• Ten years of docket time, 23 days of testimony, countless hours of expert witness time, and a 298-page opinion

• The taxpayer was allowed $1,045 of additional QRE in the sample of five of the 106 projects

26

Favorable And Unfavorable Aspects Of The Union Carbide Decision

27

Overview Of Scale-Up Activities In UCC

• Development activities under review in UCC occurred within a production environment.– Key issue: Did the sample projects relate to qualifying research

activities?• Disallowed costs were primarily materials used within a production

environment.– Key issue: Did the supplies relate to a qualifying research activity?

• Used vs. consumed• Incremental• Size of expenditures • Primary purpose

– Key issue: Did the labor relate to a research activity? • Engineering vs. production labor

28

What Are “Scale-up” Activities?• Scale-up activities are often the final step in the development process and

frequently require large supply dollars that may be eligible for the research credit

• Understanding the nature and purpose of these costs relative to the research process is critical to factually differentiating these costs from those in the UCC case

• Positives from case related to scale-up:– UCC case determined two of five sample projects satisfy the definition

of qualifying research– Certain labor costs were determined to qualify for the two projects– Court did not conclude that supply costs don’t qualify at a large scale– No specific restriction on supplies used in research, if products are

ultimately sold (i.e., primary purpose seems to trump sale)

29

Typical Development Process• The R&D process for many industries includes the following steps:

– Discovery– Laboratory research– Pilot plant– Full-size scale-up batches

• Technical uncertainty is frequently present in all stages of the research process

• Uncertainty in scale-up batches may exist because of:– Molecular complexity of materials (relevant for food, chemical and

pharmaceutical industries)– Varying environmental factors (relevant for plant, animal or

construction product industries)– Physical phenomena related to unique equipment or processing

parameters (relevant for any manufacturing industry)

30

Experimentation In Scale-Up Batches• Because of the uncertainty, scale-up batches are an important part of the

process of experimentation – Activities that otherwise satisfy the four-part test should not be subject

to the exclusion for after-commercial production • A good understanding of the experimental design is also critical

– Why did the experiment need a scale-up batch trial?– Why wouldn’t a smaller-size run satisfy the experimental

requirements?– Why was more than one batch required?– How were the results tracked? – If more than one batch was run, how were the tests different? – Did the trial result in a formula or product change?

• Documentation of trial and results is extremely helpful (though specific form of documents should be flexible)

31

Important Facts For Scale-Up Based On UCC

• Important to identify the objective of the research – Is the objective of the research a product or process (business

component test)?• Helpful to identify technical background of those involved in the

development effort– Was the core R&D team involved?

• Valuable if you can demonstrate that scale-up is part of the typical development process– Is the primary purpose: R&D vs. production.– Did you intend to sell the product? Why were you uncertain that the

product would be saleable?

32

Discovery Test Vs. Technological In Nature• History – 1986 Tax Reform Act

Targets the credit toward research undertaken for the purpose of discovering information that is technological in nature, and when applied is intended to be useful in developing a new or improvedbusiness component for sale or use in carrying on the taxpayer'strade or business

• Bifurcation into separate “discovery test” and “technological in nature” test• Norwest Corp. v. Commissioner, 110 T.C. 454 (1998)

– Discovery test language adopted by the Tax Court– New “academic” standard applied: Knowledge must exceed, expand or

refine the common knowledge of a skilled professional within the field of the hard science involved

– Note 3 from Conference Report 99-841• Tax Court in Norwest concluded that the taxpayer must discover

information about the principles of the hard sciences, and the discovery must go beyond the existing principles

33

Administrative Challenges And Regulation Projects

• Government’s expert witness (a university professor) set forth the “skilled professional” test adopted by the Tax Court in Norwest

• Fine in academic circles, but difficult to prove within applied or commercial R&E

• How to prove the negative – proving that knowledge didn’t exist• Administratively difficult for IRS as well; many cases went to appeals on

this one issue• Congress even steps in:

– 1999 extender bill; Congress expressed its concern over application of the common knowledge standard

• T.D. 8930 “final” regs– This version of the regs was revoked but stated the IRS position that the

discovery test was a “separate substantive requirement”• Proposed regs issued in December 2001

– IRS changed its position and eliminated “common knowledge of skilled professionals” criteria

34

Administrative Challenges And Regulation Projects (Cont.)

• Shouldn’t the December 2001 regs have been the end of the discovery test?– For internal use software, IRS still applied the discovery test if the

taxpayer was using the legislative history definition of the internal use software rules (reduction in costs, improvement in speed). The IRS forced taxpayers to apply the revoked regulations (T.D. 8930), and thus the discovery test lived on

– MITRE experts were also applying versions of the old discovery test

• Final Regs T.D. 9104 (December 2003)– Still called the test the “discovering information” test in the heading– Regs reinforced that there was no exceeding common knowledge

requirement; but, agents and MITRE experts were still applying some version of the higher threshold discovery test

– No final regs on internal use software; IRS still forcing taxpayers on to the revoked T.D. 8930 regs and its common knowledge discovery test

35

Review Of Other Court Cases• Adding to confusion over the discovery test, courts were concerned over

lack of guidance coming out of Treasury and IRS on final Section 41 regs

• Court applying various versions of a “higher threshold” discovery test– Norwest, 110 T.C. 454 (1998)– United Stationers, 982 F. Supp. 1279 (N.D. Ill. 1997) – Wicor, 116 F. Supp. 2d 1028 (E.D. Wis. 2000) – Eustace, T.C. Memo 2001-66– McFerrin, 2008-2 USTC ¶50,583

• Significance of Union Carbide: First Tax Court case on the R&E credit since Norwest and since the December 2003 final regs were issued

36

Technological Information Test• Union Carbide holding: Discovery test is now the “technological

information” test– IRS conceded this issue– Language from the case - Respondent conceded that UCC satisfies the

“technological in nature” test as long as the information sought to be discovered is in fact technological, and we accept this concession. In light of the change to the test, we find that it is more appropriate to refer to this test as the “technological information test”

• Cite both final regs and Union Carbide in applying the technological in nature test

• TSR Inc. v. Commissioner, 96 T.C. 903 (1991), is even helpful– First Tax Court case discussing the “technological in nature” test– Congress intended to reward technological or scientific research

involving the physical sciences– Plain meaning of technology: The application of scientific knowledge

to practical purposes in a particular field

37

Favorable Procedural Implications

• Discovery test for pre-2004 years– IRS agreed to abandon discovery test in Union Carbide for years prior

to the effective date of final regs (i.e. pre-2004 years)– Current final regs cover the outcome of the Union Carbide case, even

though years involved were prior to the effective date– IRS won’t challenge return positions that are consistent with the final

regs, even for pre-2004 years; so, this would include application of the discovery test to pre-2004 years

38

Substantiation, Estimates And The Cohan Rule

Burden of proof: Credit claimed in amended petition criticized• Overall, UCC court did not like that the

UCC projects had not been claimed on the original return, BUT:

• Court did qualify two of the five projects

• Court did accept significant evidence:- Base years - QRE provided by witnesses- Various combinations of documents

and estimation methodologies

Burden of proof: Failure of taxpayer to meet burden• Refund claim; burden of proof is

higher than if the items are claimed on an original return

• R&D refund claims as Tier 1 issue• Appeals treats all R&D issues as

“coordinated issues”

39

Substantiation, Estimates And The Cohan Rule (Cont.)

Estimation allowed• Estimates of supply and wage data for

anti-coking project accepted under Cohan

• Estimates and assumptions allowed for base

• Cohan allowed for base determination • Use of employee experts to establish

base (Wadia)– Substantiation - see prior slide

Estimation not allowed• Current vitality of the Cohan rule

is open to question• IRS focus on contemporaneous

documentation• Tyson-emphasized taxpayer’s

status in the industry and its employment of in-house and outside accountants and tax preparers

• Boddie-Noell: Reconstruction of evidence not allowed. Also cites Eustace & McFerrin

40


Variety of evidence established creditUnion Carbide accepted a wide variety of documentation and testimony

The court accepted:• Reconstruction methodologies for both the claimed QREs and base-year information • The use of historical data • Testimony corroborated by documents • Testimony taken alone, and • When necessary, estimation under the principles of Cohan v. Commissioner, 39 F.2d at 540 (2d Cir 1930)

McFerrin: Failure of recordsTotal recordkeeping failure:

It was clear that the taxpayers had:• No records showing how many hours each employee worked on any given project

• No records of how many hours any employee’s work involved activities

that might have constituted research, let alone qualified research

• No records showing what supplies were used during 1999 in activities that might constitute research

41


Witness testimony admissible to prove qualification•Three fact witnesses were produced to

discuss the UCAT-J project. and their testimony was corroborated by “sufficient documentary evidence”

•Court found that testimony from Hyde and Tregre was credible, despite the fact that they testified about QREs from 1994 and 1995

•To establish the duration of a particular anti-coking test, the taxpayer offered, and the court accepted, four witnesses who corroborated that a second test occurred

Witness recollection: Not accepted to prove qualification• Recollection of witnesses took

place several years ago, and such testimony is inherently unreliable

42


Reconstruction methodologies of employee expert allowed•Two employees were qualified as experts

and testified extensively: Ms. Hinojosa, a former cost accountant for UCC, and Dr. Wadia, a 30-year UCC employee

•The court accepted methodology based upon UCC’s reliance upon PCDs (product cost detail reports) and MASes (material accounting summary reports), which did not tie to the particular projects but were part of its cost accounting system

Taxpayer methodology based on old records, and company expert not allowed • Cite Boddie-Noell for

proposition that methodology employed by company’s expert to substantiate 12-year-old expenditures was inadequate

43


Testimony can supplement contemporaneous documentation– “Many of the documents in evidence list

the objectives and the risks involved in the runs, and UCC confirmed through testimony that each of the runs was conducted for the purpose of discovering information that would help eliminate uncertainties as to how UCC could improve its PE production process using UCAT-J. Therefore, we find that the testimony does not conflict with the documentary evidence.”

Contemporaneous documentation required• Taxpayer has maintained no

contemporaneous records regarding the credit, which is fatal to taxpayer’s refund claim

• Cites to IRC § 6001

44


Process of experimentation conducted•Anti-coking: UCC collected and analyzed

data that could be used to compare the technology with alternatives

•UCAT-J: UCC conducted a series of trials using UCAT-J and analyzed the results of each trial to develop and improve its process

– UCC was testing hypotheses and forming new hypotheses based on each succeeding run, in order to solve some of the chemical and physical problems it had experience.

– UCC was comparing UCAT-J’s and M-1’s performances on a variety of criteria related to reactor operability, reactor continuity and product properties (emphasis added)

No process of experimentation• Routine application of

engineering principles and routine data gathering and studies

• IRS often contends that activities were not sufficiently scientific to constitute research

45


Cost accounting acceptable• Cost accounting and business records produced

monthly and annually (not for particular projects) were held to be valid documentation of the costs incurred

• “Cost accounting records were PCDs and material accounting summary reports”

• Government argued UCC was using an “ad hoc” methodology. BUT, the court held:

- Regs do not require substantiation of research credit claim with particular types of documents

- Taxpayer must “retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit”

- Thus, cost accounting based records allowed to establish base- and credit-year expenditures

Need for project accounting• “Like McFerrin, Taxpayers

have not provided any records showing how many hours each employee worked on any given project during Year 1.”

• “… no link between the amount of research claimed to have been performed by an employee and the projects which allegedly resulted in alleged research activity.”

46

IRS Exclusion Arguments RejectedFunded research• Amoco and UCC each paid their own costs during the Amoco anti-coking project. While Amoco covered the cost of applying the pre-treatment and was contractually obligated to pay for any overtime worked by UCC employees, UCC did not include any of these costs in its QRE calculations• UCC was not seeking credit for the costs that Amoco incurred to develop the technology, BUT was seeking credit for research that UCC performed for its own benefit and at its own cost • UCC did not gain any rights to Amoco’s technology by conducting the project, BUT retained all rights to its own research. UCC produced credible evidence at trial that the information it gained during the Amoco anti-coking project was valuable regardless of whether it licensed Amoco’s technology

Funded researchAny research to the extent funded by any grant, contract or otherwise by another person (or government entity) is not qualified

47

IRS Exclusion Arguments Rejected (Cont.)

Research after commercial production• UCC argues that the Amoco anti-coking project was a process of experimentation that UCC had to conduct before deciding whether to license Amoco's technology. Only the Amoco anti-coking research activities were examined, not UCC’s entire olefins process• Court stated that the Amoco technology was not yet ready for commercial use at the time UCC undertook the Amoco anti-coking project • Amoco’s technology failure was a clear indication that it did not meet UCC’s needs • Amoco anti-coking project was not a “trial production run,” because it was conducted before the potential process improvement – the Amoco technology – was satisfactorily tested and proven

Research after commercial ProductionActivities conducted after the beginning of commercial production of a business component are not qualified

48

IRS Exclusion Arguments Rejected (Cont.)

Other exceptionsData collection and routine testing• UCC collected some data that it did not normally measure and took other measurements more frequently than normal

• UCC analyzed the collected data, which it did not normally do • UCC took many more measurements for the purpose of determining whether Amoco’s anti-coking technology actually reduced the formation of coke and whether the technology could improve UCC’s production process • Court held that UCC’s activities went beyond routine data collection and that the Amoco anti-coking research activities are not excluded from the definition of qualified research by Section 41(d)(4)(D)

Other exceptionsData collection and routine testingRoutine or ordinary inspections for quality control are not qualified

49

Other Relevant Topics On The Research Credit

50

Research Credit Statistics• According to the IRS, tax stats for the 2006 research credit include:

– 10,788 companies claimed the credit, for a total $7.31 billion – 88% of claimants had $250 million or less of gross receipts, thus

showing the importance to small businesses. More than 50% of claimants had $1 million to $50 million of gross receipts

– The leading three industry sectors claiming the credit were manufacturing, information systems, and professional scientific and technical services

• Projected cost of making credit permanent is $74B (FY2010 – FY2019)• Current budget plans are to nearly double funds for IRS enforcement of

U.S. tax laws in 2010, and more than quadruple funding for tax compliance to $2.1 billion over the next five years

• The research and experimentation (R&E) tax credit has been extended 13 times

51

Software Cases and Union Carbide• Union Carbide didn’t involve any software projects . . . but:• Tax Court’s decision in Union Carbide on the 4 part test still applies to all

R&E including software projects:– Elimination of the discovery test is favorable– MITRE reports were relying upon discovery test– MITRE expansion to more than just internal-use software cases– More structured process of experimentation must be established

52

Internal Use Software - Regulations

• The internal use software regulations were included in the regulations that were re-proposed in 2001

• BUT this portion of the regulations was not finalized in 2004

• Treasury issued a notice that until further guidance is issued, taxpayers must rely on provisions in the 2001 proposed regulations or the provisions of the January 2001 final regulations (which applied the discovery test)

http://www.ustaxcourt.gov/InOpHistoric/UCC.TCM.WPD.pdf

Documents

Federal Research Tax Credit: Maximizing Your Company's Tax ...media.straffordpub.com/products/federal-research...May 26, 2009 · David Culp, Senior Manager in Pass-ThroughsGroup,