Affect of research credit final regs. on documentation.

The research credit final regulations (TI) 9104, 12/31/03) are a major step forward in defining "qualified research" for Sec. 41 purposes. The changes to these regulations primarily relate to the so-called "process of experimentation" (PE) requirement. Most notably, the final rules describe four core elements of this process and eliminate some restrictive language from the 2001 proposed regulations (REG-112991-01, 12/26/01). Further, they effectively limit the application of certain exclusions from qualified research (e.g., after commercial production, duplication and adaptation) and provide helpful guidance on the Sec. 41(d)(1)(C) "substantially all" rule.

Although the final regulations resolve many questions on defining qualified research, they provide minimal guidance to taxpayers struggling to substantiate their qualifying research activities and expenditures during IRS examinations. Given the emphasis of the final regulations, the PE requirement will probably often be the focal point of these examinations. Taxpayers should expect additional guidance on how to satisfy the PE requirement (likely on an industry basis) but, in the interim, should consider updating their documentation procedures to reflect the final regulations.

Background

Prior versions of the research credit regulations contained specific documentation requirements that elicited significant negative comments from taxpayers. The 1998 proposed regulations (REG-10570-97, 12/2/98) required taxpayers to record the results of their research to satisfy the PE requirement. The 2001 final regulations (TD 8930, 1/3/01) eliminated the specific recordkeeping requirement, but created even more controversy; they required tax payers to prepare documentation at the outset of their research projects describing information they were seeking to exceed or refine the common knowledge of skilled professionals in their field.

Both of these requirements were dropped from later versions of the regulations. Commentators expressed concern about incorporating specific documentation requirements in the regulations due to significant variations in documentation standards among taxpayers and industries. In place of specific documentation requirements, the proposed regulations (REG-112991-01), issued late in 2001, added a reference to the general Sec. 6001 recordkeeping requirements, which provides that taxpayers have to retain records in "sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit"; see Prop. Regs. Sec. 1.41-4(d).

The research credit final regulations retain this general recordkeeping requirement. Taxpayers from a wide variety of industries had previously objected to a one-size-fits-all documentation standard; it is not surprising that the Service and Treasury declined to give "detailed guidance" on how to apply the PE requirement in specific situations. According to the preamble, application of the PE standards will vary depending on the specific activities being claimed as qualified research, the nature of the particular business and industry and the uncertainties being addressed. The preamble suggests that industry-specific guidance may be appropriate. It requests tax payers to comment on the form of this guidance.

Although the preamble indicates that the clarifications made to the PE requirement do not impose recordkeeping requirements on taxpayers beyond those set out in Sec. 6001, the consequence of failing to keep sufficient records to substantiate a claimed credit may be denial of the credit. Case law has established that the taxpayer bears the burden of proving its qualification for the research credit; see Research, Inc., DC MN, 6/21/95; Welch v. Helvering, 290 US 111 (1933). To meet its burden, the taxpayer must prove it engaged in qualified research, substantiate the expenses incurred and demonstrate that its current-year qualified research expenses exceed its base amount.

This burden can be particularly challenging with a tax incentive that is incremental and depends on the specific facts surrounding research undertaken currently compared to a historic base period. Because the regulations do not give taxpayers any specific guidance as to the form, nature and degree of documentation needed to substantiate research credit claims, taxpayers must look to other IRS programs and documents available to identify and assemble documentation that will support their research credit claims.

The Service has publicly encouraged taxpayers to explore agreements on recordkeeping guidelines. Regs. Sec. 1.41-4(d) specifically provides that, to facilitate compliance and administration, the IRS and taxpayers may agree to guidelines for the keeping of specific records for purposes of substantiating the research credit. This process may become more formalized with the recent issuance of Notice 2004-11, which announced a recordkeeping agreement pilot program for the research credit. If taxpayers comply with the terms, they will be deemed to have satisfied the Sec. 6001 general requirements to support their claims. Although recordkeeping agreements may not provide all of the answers (because the IRS will retain the ability to challenge on substantive grounds whether particular expenses qualify for the research credit), such agreements may be a step in the right direction for taxpayers looking for more assurance on their research credit documentation.

Another useful resource is the IRS's Audit Techniques Guide: Credit For Increasing Research Activities (Research Credit) (ATG), which suggests guidelines for auditing research credit claims. The latest version of the ATG was issued in late 2002, so it does not address the recent changes to the final regulations. Nonetheless, the Service tends to follow the audit procedures fairly closely, so the ATG continues to be an important reference for taxpayers undergoing an examination of the research credit. The ATG also recommends considering, when appropriate, the use of expedited resolution procedures, including advanced issue resolution, prefiling agreements and research credit record retention agreements.

The industry guidance suggested in the preamble to the final research credit regulations may take a variety of forms, but one potential approach would be IRS issuance of additional audit guidance, such as the Research Credit Audit Technique Guide for the pharmaceutical industry (Pharma ATG), introduced in spring 2003. The Pharma ATG does not specifically address the PE requirement (or any other component of the definition of qualified research) but, rather, it assesses the potential audit risk for various drug industry activities likely to be claimed for the credit. Its primary objective appears to be to assist IRS revenue agents and engineers in effectively planning an audit, by assessing the likelihood that activities will (or will not qualify) for the credit.

Another potential approach could mirror the Canada Customs and Revenue Agency (CCRA). The CCRA has worked closely with representatives from industry and government groups to produce sector-specific guides and interpretation bulletins for the Canadian research credit. These published materials focus on how to correctly complete documentation and provide specific examples of how to substantiate particular qualifying activities.

Observations

The key areas to document include the (1) research activity's technical nature (e.g., reliance on principles of physical, rather than social, sciences), (2) type of uncertainty being resolved, (3) alternatives evaluated and (4) source and scope of supporting documentation. Taxpayers should start this process by describing the variables or conditions generally at issue in research projects. Finally, they need to focus on identifying the different types of testing and experimentation actually conducted (e.g., vibration or environmental testing) and, if possible, relate these experiments back to the key challenges or uncertainties they encounter.

Conclusion

Although it is extremely helpful to prepare specific documentation for the research credit, the INS tends to be more accepting of existing technical documentation that a taxpayer prepares for nontax business or regulatory purposes. Thus, the existing technical documentation should be the starting point for substantiating the standards of the new final regulations; any gaps can be filled in or clarifications provided by credit-specific documentation.

David Madden, J.D., LL.M.

Principal

Washington National Tax Service

KPMG LLP 

Washington, DC

FROM KATHLEEN L. KING, CPA, WASHINGTON, DC