Research credit redux: Federal Circuit brings the research credit back to life - Fairchild v. United States.

Editor's Note: This article discusses a recent taxpayer-favorable decision by the United States Court of Appeals for the Federal Circuit about whether research is "funded" for purposes of the research credit. As this issue goes to press, the author has confirmed that the Internal Revenue Service will concede the funded research issue in all pending cases.

In an important case of first impression, on November 29, 1995, the United States Court of Appeals for she Federal Circuit held in Fairchild Industries, Inc. v. United States that research performed pursuant to a fixed price incentive contract with the federal government was not funded for purposes of the research tax credit.(1) Because research was not funded, the taxpayer was entitled to claim the research credit on its tax returns.

Fairchild was watched closely because many government contractors have cases pending in which claims for the research credit have been challenged by the Internal Revenue Service. In virtually all these cases, the so-called funding limitation is one of the principal arguments advanced by the IRS to challenge the credits.

This article describes the legal issue involved in Fairchild, analyzes the decision of the Federal Circuit (which reversed a taxpayer-adverse decision of the Court of Federal Claims), and offers some thoughts on anticipated developments.

The Funding Limitation Issue

In 1981, Congress enacted section 44F of the Internal Revenue Code to give companies that engage in research and experimentation(2) a tax credit for a percentage of the expenses incurred in conducting research. Section 44F was enacted to address Congress's concern that U.S. companies were reluctant to conduct risky industrial research, and the growing view that the resources devoted by U.S. industry to such research efforts lagged behind other industrial nations. Congress designed the tax credit to encourage companies to spend funds in the exploration of new technologies and processes.

Under section 44F, a company that performs otherwise qualified research may claim a research tax credit if its research is not "funded by any grant, contract, or otherwise by another person." I.R.C. [sections] 44F(d)(3) (1982). Research that is performed pursuant to a contract with a customer is not funded if: (1) the researcher's entitlement to payment under the contract is contingent on the success of the research; and (2) the researcher retains substantial rights in its research.(3) Treas. Reg. [subsections] 1.41-5(d)(1) and (2) (1995).

The Trial Court's Decision

The dispute before the Court of Federal Claims related to research credits claimed by Fairchild in connection with a fixed price incentive contract to build a next generation trainer aircraft for the Air Force. The contract commenced in 1982 and was terminated for convenience in 1986 when Congress canceled the program. By the time the contract was canceled, Fairchild had spent $216,056,000 on the contract. The amended ceiling price was $133,485,885. Pursuant to the final termination for convenience settlement, the parties agreed that Fairchild was entitled to receive $120.6 million for successfully completed work.

On its 1982-1985 federal income tax returns, Fairchild reported a total of $109.4 million of qualified research expenses. On audit, the IRS disallowed $19.6 million for reasons unrelated to the credit issue. Of the remaining $89.8 million of qualified expenditures the IRS determined that $50.3 million was funded, and disallowed the research credit associated with this portion. The funded amount was calculated as the ratio of the amount ultimately paid to Fairchild by the Air Force ($120.6 million) to the total amount spent by Fairchild ($216.1 million), or 55.8 percent. The IRS asserted that because it was expected and likely that Fairchild would be compensated under the contract for this portion of its research expenses, the research was funded.

The Court of Federal Claims sided with the IRS, albeit primarily on a different ground than that asserted by the Commissioner. The court ruled that Fairchild's research was funded because during the course of the contract Fairchild received progress payments under the contract.(4) As viewed by the lower court, the receipt of these payments precluded Fairchild from incurring the costs of the research because Fairchild was spending the government's money -- not its own. The lower court also found support for its conclusion in Fairchild's expectation that it would be paid for its research, the existence of a congenial relationship between the parties, and the government's ultimate payment to Fairchild.

The Government's Argument in the Federal Circuit

In the court of appeals, the government's primary argument was that research performed under a contract is funded in all but unusual cases. Hence, a government contractor should ordinarily not be entitled to the credit because payment is virtually assured. Finally, the government argued that the so-called wait-and-see rule of Treas. Reg. [sections] 1.41-5(d)(5),5 Supported the proposition that eligibility for the credit should not be determined until contractual performance was complete and actually payment made; if, at this stage, the contractor was not paid, the credit would be appropriately claimed for research for which payment was not received.

Interestingly, the government did not argue, as the lower court had held, that the receipt of progress payments, per se, constituted funding. Instead, the government said the receipt of progress payments was only one of several circumstances to be considered in determining that there was no significant risk of nonpayment.

The Federal Circuit's Decision

The court of appeals reversed the lower court's decision, concluding that Treas. Reg. [subsections] 1.41-2(e)(2) and 1.41-5(d)(1) operate to allocate the credit to the party to a contract that, under the contract, bears the risk of failure of the research to produce the desired product. Deciding that the terms of the contract between Fairchild and the Air Force expressly authorized the government to decline payment if Fairchild's research efforts were not successful court held that Fairchild's research was not funded.

The opinion is organized in four sections. The first section describes the statute, the regulations, and the legislative history. The second describes Fairchild's fixed price incentive contract with the Air Force and the applicable Defense Acquisition Regulations. The third section sets forth the court's analysis. The final section is a summary of the court's conclusion. The critical components of the decision are in the third section, headed "Discussion," which itself is divided into two parts; part A focuses on the lower court's opinion, whereas part B addresses the government's position on the wait and see regulation.

The single, most salient feature of the court's analysis is its repeated emphasis on the contract between Fairchild and the Air Force as determinative. The opinion leaves no doubt that whether research is funded is determined by reference to the agreement between the parties. Thus, whether payment is contingent upon success is determined by the terms of the contract:

The availability of the credit ... depends ... on whether,

by the terms of the research agreement [i.e.,

the contract], payment is contingent upon the development

of a specified product or result.

Repeatedly, the court emphasized the importance of the contract:

* The Court of Federal Claims incorrectly construed the CONTRACT between Fairchild and the Air Force.

* It is incorrect for the Court to change ... the allocation of risk that was established in the CONTRACT...

* The CONTRACT explicitly places solely on Fairchild the risk of failure....

* That Fairchild received ... progress payments ... did not alter the CONTRACT provision that Fairchild was not entitled to retain any such payments if it did not successfully produce the product....

* [T]he CONTRACTUAL relationship that establishes the funding also controls who is entitled to the credit....

* [The] CONTRACT controls who bears the financial risk of failed research.

* Whether ... a congenial relationship between the parties might lighten the contractor's risk ... the CONTRACT itself does not reflect this possibility.

Relying on the terms of the contract, the court found that the risk of failed research rested solely on Fairchild and unmistakably held that the receipt of progress payments neither shifted that risk nor constituted funding.

Part B of the opinion addresses the government's attempt to use the wait-and-see regulation to deny the credit to Fairchild. The court makes short shrift of this argument, noting that the regulation was designed for a different purpose -- joint ventures -- and that to interpret the regulation to deny the credit would eviscerate the incentive provided by the credit.

Commentary

It would be difficult to argue that the decision of the Court of Federal Claims should have been affirmed. The reliance by the lower court on the receipt of progress payments as determinative of funding was clearly contrary to well-established precedent. That progress payments are a form of financing by the government has been established law for years. To hold that Fairchild was not entitled to the credit because it received financing from the government would also vitiate a claim for the credit when research is financed by third-party lending. Because money is fungible, the government's argument might even lead to the denial of the credit whenever the party performing the research has outstanding indebtedness since the unrelated indebtedness frees up other cash to pay for the research. The Federal Circuit was clearly correct in concluding that there is nothing in the statute or the regulations that justifies this result or anything close to it.

The scope of the government's argument is astounding. If sustained, each taxpayer claiming the credit would be compelled (to quote the government's brief) "to demonstrate that [its] payment and performance contingencies rise to such a level of uncertainty that payment is truly doubtful and it therefore is committing its own funds to the research." Thus, the trier of fact would be required to analyze an undefined amalgamation of facts about the contract, the contractor, the customer, and their respective contracting practices in general to determine whether there was sufficient uncertainty about ultimate payment to justify a claimed research credit. Not only would this be unmanageable, but such a standard would effectively emasculate the incentive effect of the credit because the party conducting the research could not possibly know in advance whether the credit will be available and, indeed, would know that a lengthy judicial proceeding would be a prerequisite to a successful claim.

At the same time, the Federal Circuit's decision appears to go further than required to reverse the Court of Federal Claims. The lower court's erroneous characterization of and reliance on the receipt of progress payments, standing alone, was sufficient error to justify reversal. Reversal on such a narrow point, however, would have resolved very little about the ultimate issue whether research conducted pursuant to fixed price incentive government contracts is funded.

Whether Judge Newman, who wrote for the court, was compelled to address broader issues to gain the support of the other two panel members is not known, but the court undeniably went far beyond simply reversing the lower court on the progress payment issue. Instead, the Federal Circuit essentially addressed all the arguments put forward by the government, expressly rejected each one, and propounded a standard that should consign to oblivion most future disputes about funding and fixed price government contracts (at least in the Court of Federal Claims).(6)

Summarized, the standard established by the Federal Circuit is the following:

1. The term funded as used in section 44F(a) is defined by Treas. Reg. [sections] 1.41-5(d)(1).

2. Treas. Reg. [sections] 1.41-5(d)(1) states that research in not funded if the amounts payable under the contract are contingent upon the success of the research.

3. Treas. Reg. [subsections] 1.414-5(d)(1) and 1.41-2(e)(2) allocate the tax credit to the party that bears the financial risk of failure of the research to produce the desired product or result.

4. Treas. Reg. [sections] 1.41-2(e)(2) dictates that the contractual arrangement between the parties determines who is entitled to the tax benefit.

5. The standard provisions of fixed price incentive government contracts and the applicable provisions of the Defense Acquisition Regulations place the risk of research failure on the contractor.

6. Progress payments constitute a financing arrangement and do not affect the allocation of risk established by the contract.

7. The allocation of risk is not affected by the likelihood that the contractor is likely to succeed in performing the research.

8. The presence of a congenial relationship between the parties does not effect the allocation of risk established by the contract.

9. Requiring taxpayers to wait until after contractual performance is complete to determine the availability of the credit would undermine the incentive effect of section 44F. Therefore, the wait-and-see provisions of Treas. Reg. [sections] 1.41-5(d)(5) should not be applied to research credit claims arising from the performance of standard fixed price incentive contracts. Moreover, by its terms, Treas. Reg. [sections] 1.41-5(d)(5) is limited circumstances of the sort illustrated in the regulation. See, e.g., Treas. Reg. [sections] 1.41-5(d)(6), Example (5).

There can be no doubt that the standard articulated by the court's comprehensive opinion will provide clear guidance for all parties with research credit disputes in the Court of Federal Claims. In most instances, the contractual terms, as elucidated by the relevant Defense Acquisition Regulations, will leave no question about the allocation of risks. The progress payment argument will have no continuing vitality, and the only future for the wait-and-see regulation will be to wait and see if it applies in some other context.

Where Do We Go From Here?

Continuing Litigation. While one might hope that the IRS would conclude that the funding issue should no longer be litigated in light of the Fairchild decision, history suggests that such an outcome is unlikely. Because precedent established by the Federal Circuit is not binding in the Tax Court or any other circuit court, the odds are high that the IRS will continue to litigate the precise issue in Fairchild case. At present, at least five cases involving the same issue are docketed in the Tax Court. More than one of these cases is scheduled for trial within the next six months. Thus, until this litigation is completed, the funding issue will not be settled.

Amount of the Credit Claims. In addition to the likelihood of continued litigation of the funding issue, an inevitable table precipitate of the Fairchild decision is likely to be an increased focus by the IRS on the amount of research credit being claimed. If the IRS had prevailed in Fairchild, the amounts at issue in many of the pending cases would have been dramatically reduced. Thus, a consequence of the adverse Fairchild decision is that the stakes have been raised in all pending cases, and the amount of the credit is much more important. If the IRS continues on its course of a concentrated, nationwide challenge to research credit claims, it should be expected that challenges to the amount of the credit and the methodology by which the credit was computed will increase.(7)

Commercial Contracts. The IRS may also concentrate future litigation on research credits associated with commercial contracts. More than one case has been docketed in the Tax Court involving commercial contracts between unrelated parties. It has been reported that the IRS plans to make arguments similar to those made in Fairchild with respect to commercial contracts.

Substantial Rights. In Fairchild whether the taxpayer retained substantial rights in the research was not an issue because the parties had stipulated that Fairchild retained such rights. Whether the retention of substantial rights will become an issue in future controversies remains to be seen.

Standard contractual terms and in the relevant Treasury regulations would seem to preempt most controversies, on this issue. On their face, the regulations appear to vest substantial rights in any person who retains any rights whatsoever to use the results of the research. Treas. Reg. [subsections] 1.41-(d)(2) and (3). Joint rights to use the results of research confer substantial rights on both parties. Treas. Reg. [subsections] 1.41-5(d)(6), Examples (1) and (5). The Treasury regulations neither state nor imply that some sort of comparative or qualitative analysis of the value of the retained rights to use is required. In fact, the only circumstances described in the regulations in which substantial rights are not retained are instances where the taxpayer performs the research under an agreement that confers on another person the exclusive right to exploit the results of the research (Treas. Reg. [sections] 1.41-5(d)(2)) or the taxpayer must pay for the right to use the results of the research (Treas. Reg. [sections] 1.41-5(d)(3)). In light of these regulations and the usual clarity of most contracts on this issue, the retention of substantial rights does not seem a likely source of future controversy.

Conclusion

It is too early to pass judgment on the final outcome of the IRS challenges to the research credit. It is not too early, however, to ask whether the IRS's all-out assault on the research credit reflects sound judgment and good administration.

It is undeniable that from the time the research credit statute was enacted in 1981, an atmosphere of apparent hostility to the statute seems to have pervaded the IRS response to section 44F. The earliest proposed regulations were unduly restrictive and, at least in the view of some, in direct conflict with clearly expressed congressional intent.(8) In addition, there is no satisfactory explanation for the government's delay in promulgating final regulations under such a relatively uncomplicated statute.

In the Fairchild litigation, the expected-and-likely standard advanced by the government in the Court of Federal Claims was totally subjective and completely unmanageable for tax planning, for tax administration, and for controversy resolution at any level. Acceptance of the standard would foment uncertainty, controversy, and a spate of very complicated litigation.

The standard advanced by the government before the Federal Circuit that contract research is funded in all but unusual cases is equally amorphous and, had it been accepted, would have resulted in an almost irrebuttable presumption against the credit -- a presumption for which there is not a scintilla of support anywhere other than in the government's arguments. Similarly, the proposed application of the wait-and-see regulation would strip the incentive features enacted by Congress from the statute. Surely, Congress did not intend to enact a statute designed to provide an incentive for research only to have the IRS remove the incentive.

A related question is whether there is any sound basis for the apparent target of the IRS challenge -- all research performed under fixed price contracts. Has someone in the government decided that such research is somehow less deserving of the research credit than other types of research? Upon reflection, a strong argument can be made that the type of research performed by Fairchild is more risky than other types of research. For example, when a company embarks upon an independent research project, it can presumably terminate the expenditures at any time and limit the losses to the dollars expended to date; in other words, the company performing independent research can always contain the magnitude of the financial risk. In the case of Fairchild's research, however, the option to staunch the flow of losses by terminating the project did not exist. For all intents and purposes, Fairchild had to continue to completion regardless of the cost. Why else would Fairchild have overspent the fixed price contract by almost 100 percent and continued to spend more? Thus, if the rationale for the IRS attack is one of comparative risk, perhaps the IRS should rethink its position.(9) Research undertakings of the type evidenced in Fairchild may be the type for which the credit is most appropriate.

(1) The research tax credit was added to the Internal Revenue Code by the Economic Recovery Act of 1981 as section 44F. The Tax Reform Act of 1984 redesignated section 44F as section 30, and the Tax Reform Act of 1986 redesignated section 30 as section 41. For clarity, all references herein will be to section 44F. The applicable Treasury regulations were promulgated asneas. Reg [sections] 1.41-5(d)(1) and expressly made applicable to the years at issue in Fairchild. (2) Unless otherwise noted, whenever the term 'research" is used in this article, it includes experimentation. (3) The sole issue in Fairchild was whether payment under the contract was contingent upon the success of the research. The parties stipulated that Fairchild retained substantial rights in the research. (4) Fairchild Industries, Inc. v. United States, 30 Fed. Cl. 839 (1994). (5) The regulations provide that if the taxpayer cannot determine the extent to which research is funded at the time the taxpayer files its return, the research should be treated as completely funded, and an amended return should be filed when the extent of the funding is ultimately determined. (6) Presumably, disputes affecting commercial contracts will be rare because the contractual provisions assigning risks and defining the consequences of failure are as clear in such contracts as in government contracts. Moreover, arguments based on the "contracting practices" of the parties would seem inapplicable in the private sector. (7) Shortly after the decision in Fairchild was published, at least one proposed stipulation regarding the amount of the credit in a docketed case was withdrawn by the government. (8) For an excellent discussion of the evolution of the regulations, see P.A. Stoffregen, Giving Credit Where Credit Is Due: A Brief History Of The Administration Of The R&D Credit, Tax Notes 403 (Jan. 16, 1995). (9) Nothing in the statute or the legislative history suggests that the credit was intended only for high-risk research. In fact, the applicable Treasury Regulations refute any such argument. See PA. Stoffregen, supra note 8, at 409.

McGEE GRIGSBY practices tax law with Latham & Watkins in Washington, D.C. He is chairman of the firm's D.C. Tax Department. He received his L.L.M. from harvard Law School and specializes in tax controversy practice.