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IRS targets taxpayer's right to credit for contract R & D.

Sec. 41(d)(4)(H) disallows the research credit for "[a]ny research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity)." In recent years, these few words have given rise to considerable uncertainty and controversy, including key litigation now pending in the Federal Circuit (Fairchild Industries). The IRS Industry Specialization Program has identified the question of whether expenditures under a fixed-price contract are eligible for the research credit as a "significant issue" for both the aerospace and data processing industries, and has raised similar issues in other industries.

In Fairchild, 30 Ct. Fed. Cl. 839 (1994), the taxpayer argued that since under the contract terms it would be paid only for successfully delivering the result or product of the research, the research was not "funded" within the meaning of Regs. Sec. 1.41-5(d). The Service denied the taxpayer the credit, arguing that since payment was expected and likely, the research should be considered funded. The lower court ruled for the IRS on the basis of whose "bank account" paid for the research, emphasizing that the taxpayer had received progress payments; the taxpayer appealed this decision. Taxpayers involved in contract research and development (R&D) activities believe the appellate decision should be important, not only for the many government contractors who have claimed the credit under the type of fixed-price contract involved, but also on a broader scale to assist in analyzing which party (if any) can claim the credit under R&D contract arrangements.

The issues of who gets the credit and what activities qualify also arose in Letter Ruling (TAM) 9449003, in which the taxpayer, a computer game publisher, contracted with independent software developers for computer software game programs. The taxpayer provided the developers with game design and detailed product specifications and deliverables, which had to be satisfied before the taxpayer had to pay the developers advance royalties. Although the agreements provided that the programs produced became the taxpayer's exclusive property, the developers retained ownership of the programming techniques embodied in the programs. Nonetheless, the Service concluded that the developers did not retain any ownership rights in the programs.

The taxpayer had deducted its associated expenditures as costs of developing computer software. The IRS rejected this approach, ruling the development agreements were contracts for the purchase of computer software and the advance royalty payments were expenditures for purchased software, which must be capitalized according to Rev. Proc. 69-21. The Service determined that the developers were responsible for the operability of the game software, retained no interest in the software and bore the risk of developing the games. The ruling concluded that the taxpayer did not bear any risk and, in fact, purchased the completed computer software under a performance guarantee.

The taxpayer argued that because it had funded the independent developers' R&D expenditures, it had assumed the risk of developing the programs. The IRS disagreed, stating:

It is not axiomatic that research and experimental expenditures are deductible by either the taxpayer funding the research or the taxpayer performing the research. Research and experimental expenditures are not deductible under [sections] 174 by the taxpayer funding the research if the taxpayer's only risk is the economic utility of the research. Likewise, research and experimental expenditures are not deductible under [sections] 174 by the taxpayer performing the research if the taxpayer does not retain rights to the results of the research.

The letter ruling outlines what the Service believes is a comprehensive evaluation of an R&D contract, but fails to highlight that the holding would result in neither party's being eligible to take credit for the research performed pursuant to the contract. Taxpayers entering into such contracts are at risk to lose any otherwise available research credit unless special care is taken in determining who will bear the risk.

The issue (similar to that in Letter Ruling 9449003) of whether the costs of outside consultant services for systems integration, reengineering or similar services are deductible software development costs under Section 3.01 of Rev. Proc. 69-21, or represent purchased software that must be capitalized in accordance with Section 4.01 of Rev. Proc. 69-21, has been listed by the Service as a "significant issue." The availability of the credit for "technical writers" has been listed as a "coordinated issue" (i.e., an issue that must be raised on examination and resolved consistently with the relevant Coordinated Issue Paper), while the treatment of costs associated with user manuals as currently deductible or amortizable is classified as a significant issue.

The IRS positions taken in these, and other, rulings make clear the importance of structuring R&D contracts to maximize the taxpayer's credit-eligible expenditures. The Service continues to place heavy emphasis on matching the allowable R&D expenditures with the party who assumed the risk of the research. Additionally, the position taken in Fairchild indicates a broad reading of the meaning of "funded research," which could result in taxpayers losing anticipated credits.
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Title Annotation:research and development
Author:Bridgham, Bethany J.
Publication:The Tax Adviser
Date:Jul 1, 1995
Previous Article:U.K. taxation: a quiet revolution.
Next Article:Recent changes to accuracy-related penalty rules.

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