IRS positions threaten RTC under fixed-price contracts.

Recent IRS positions on the exclusion of "funded" research from eligibility for the research tax credit (RTC) could have adverse consequences for companies that claimed credits for work under certain government contracts widely used in the 1980s, and also may have ramifications for determining credit eligibility when two businesses enter into a research contract.

In Fairchild Industries, Ct. Fed. Cl., 1994, the taxpayer claimed RTCs on expenses generated under a fixed-price, full-scale development and production contract with the Air Force to design, develop, test and produce two prototypes of a new trainer aircraft. The Service disallowed some $6 million of the claimed credits, arguing that expenditures under such contracts are excluded as "funded" research within the meaning of Sec. 41(d)(4)(H).

In granting summary judgment to the government on the funding issue, the Court of Federal Claims focused on Regs. Sec. 1.41-5(d)(1), which states in part, "Amounts payable under any agreement that are contingent on the success of the research and thus considered to be paid for the product or result of the research ... are not treated as funding." The court first rejected the IRS interpretation (also set forth in Letter Ruling (TAM) 9410007) that payments are contingent on the success of the research only if the payment conditions are such that it is not "expected and likely" that payments will be made in the normal course of events.

The court also rejected the taxpayer's argument that the detailed specifications and performance requirements in defense contracts, including possible termination for default, meant payment was contingent; that is, the taxpayer argued that unless the company produced a useful product, the government had no contractual obligation to pay. Instead, the court went beyond the terms of the contract to examine what actually happened "as the contract performance was ongoing," with particular emphasis on the progress payments.

Under the court's test of whose "bank account" paid for the research, the taxpayer was viewed as spending the government's money paid over the course of the contract, not "betting its own money" up front. While the contractor runs a risk that it will not be paid if the government is not completely satisfied with the product, the court acknowledged that the credit is not available when the contractor's research expenditures "exist as a grace of a government financing arrangement." In short, the court said, the credit is not available on research expenses the contractor "did not itself incur."

Comment: Many government contractors have claimed research credits under the type of fixed-price contract involved in Fairchild, based on analysis similar to that propounded by the taxpayer. The Claims Court decision and the Service's position in TAM 9410007 suggest as a general rule that the IRS may challenge such credits to the extent payments have been received under the contract.

The Service's expansive reading of the exclusion for funded research in Fairchild and in the TAM could have implications outside the context of government contracts. For example, the question of whether research is considered funded can arise under a contract between two businesses when research expenditures are incurred by one of the parties to the contract. Taxpayers will want to watch for other possible litigation as well as further developments in the Fairchild case.

TAM 9410007 also discussed the rules in the credit regulations concerning a researcher's retention of "substantial rights" in research. Regs. Sec. 1.41-5(d)(2) provides that research expenditures are fully funded (and hence no credit is available) if the taxpayer performing the research for another person does not retain substantial rights in the research under the contract. Regs. Sec. 1.41-5(d)(3) provides that if the taxpayer retains substantial rights, the research is funded to the extent of the payments to which the taxpayer becomes entitled by performing the research.

The TAM did not reach a conclusion as to whether the taxpayer retained substantial rights under the particular fixed-price government contract involved. The IRS stated that the issue depends on the particular facts and circumstances surrounding the contract, but did list various limitations in government contracts that presumably might be deemed inconsistent with retaining substantial rights. In Fairchild, the court indicated that the government had agreed that the contractor retained substantial rights because the contract did not give the government exclusive rights and did not deny the company licensing rights to technology resulting from the research.