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Contract research and the R&D credit.

Sec. 41(a)(1) provides a tax credit for increasing research activity, generally equal to 20% of the excess (if any) of the qualified research expenses over a base amount. Sec. 41(a)(2) provides a credit for the incremental payments made to qualified organizations for basic research. Separate rules determine which expenses qualify for these credits and how to calculate the base period and respective incremental amounts. As such, the "qualified research credit" under Sec. 41(a)(1) and tire "basic research credit" under Sec. 41(a)(2) are separate and distinct.

Basic vs. Contract Research

Under Sec. 41 (e)(7)(a), basic research is "any original investigation for the advancement of" scientific "knowledge not having a specific commercial objective." Generally, basic research expenditures include the three general categories of in-house research costs specified in Sec. 41(b)(2)(A)--wages, supplies and certain lease payments.

Conversely, qualified research includes both basic research expenditures and an amount for contract research; under Sec. 41(b)(3)(A), this equals "65 percent of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research."

Under Sec. 41(b)(3)(A), if an expenditure were to be classified as a basic research expenditure, the amount that exceeds the qualified organization's base-period amount is not treated as a qualified research expense, nor is it used in the computation of the base-period amount. However, if a particular payment fails to meet the basic research rules, the taxpayer may treat it as contract research for qualified research credit purposes it" it otherwise qualifies under the applicable rules.

Contract Research Expenditures

Typically, a contract research expense would be qualified research under Regs. Sec. 1.41-2(e)(2) if the contract: (1) is entered into prior to the performance of the research; (2) provides that research be performed on the taxpayer's behalf and; (3) requires the taxpayer to bear the expense, even if the project is unsuccessful. Based on this guidance, it is possible for certain contract research payments to be deemed qualified research expenditures for the contractor/funder, researcher, neither or both.

Based on the terms of the arrangement between the funder and the researcher, there are two primary questions: who retains "substantial rights" to the research results and who bears the economic risk of the project (i.e., will payment be made if the project is unsuccessful?).

Substantial Rights

Regs. Sec. 1.41-4A(d)(2) treats qualified research as being performed on a taxpayer's behalf only if the taxpayer has a "right to the research results." The regulations and guidance are somewhat unclear on this; apparently, the taxpayer is not required to have exclusive rights to the research results. For example, it is nebulous whether a right to the research results short of a formal license of patents or know-how (such as a right of access to the research as it proceeds, the right to learn of new developments in advance of their commercial application, or the right to purchase products developed from the research at a discount) would satisfy the requirement.

Economic Risk

Amounts paid under any agreement that are contingent on successful research are payments for the product or result of the research, rather than for the research performed. Regs. Sec. 1.41-2(e)(2) does not treat these payments as "funding" of the research by another person and, thus, does not consider them to be qualifying contract research payments. If the amount paid is not contingent on successful research (i.e., the funder will pay the researcher regardless of the results), the research would be deemed "funded," without regard to whether the amount paid is determined by the researcher's cost or some other formula, or is contractually fixed.


If the researcher does not retain substantial rights in the research results and the funder's payments are contingent on successful research, neither the researcher nor the funder would be entitled to treat any of the expenditures as paid or incurred for qualified research. Regs. Sec. 1.41-4A(d)(2) provides that this applies whether or not the researcher is paid an amount equal to the costs incurred. Researchers incurring losses in performing contract research are not entitled to any R&D credit on their costs, as long as they retain no substantial rights to the research.

If the researcher retains substantial rights, the research would be deemed to be funded to the extent of the total payments received. Even though the funder may only receive a 65% benefit for the amounts paid to the researcher, the researcher is generally eligible for the credit only on the qualified costs in excess of the total received from the funder. In some limited circumstances, a payment allocation rule alleviates this otherwise harsh result.

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Article Details
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Title Annotation:reseach and development
Author:O'Connell, Frank J., Jr.
Publication:The Tax Adviser
Date:Sep 1, 2003
Previous Article:"Green" charitable contributions.
Next Article:Depreciation method changes.

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