In an effort to resolve some of the long-standing controversies between taxpayers and the IRS on research credit issues, the IRS hosted a discussion forum with tax practitioners on January 5 and January 6, 2011 in Washington, D.C. The primary focus of the workshop was the nexus issue for the research credit. Heather Maloy, Large Business and International Division (LB&I) Commissioner, attended the meetings along with numerous other representatives from LB&I, Counsel, Appeals and Treasury. The meetings were a follow-up to meetings held on August 27, 2010 between IRS representatives and practitioners on research credit matters.
The IRS dedicates significant resources to auditing research credit amounts each year. The stated purpose of the meeting was to better understand documents that taxpayers (and practitioners) rely on to document the research credit, as well as to discuss ways the IRS can be more effective in resolving issues. This edition of Tax Advisor Weekly reviews some of the discussion points raised at the meeting and presents potential approaches that taxpayers (and the IRS) may be able use to bridge the divide.
Understanding the Nexus Requirement
Although the term “nexus” is not used in the statute or regulations related to the research credit, it refers to a direct connection between a business component (i.e., a qualifying activity) and qualifying research expenses. The IRS wants a clear and direct connection between costs claimed and the documentation supporting the activities. The nexus issue is a key area of debate, as taxpayers continue to be challenged during audit when using cost center accounting methodologies.
The nexus concept was first given significant focus with an IRS white paper on costing methodologies released in May 2004. This white paper listed several concerns about methods taxpayers were using to calculate expenditures for the research credit, including “lack of nexus between the business component and qualified research expenses (QREs).” The white paper noted particular frustration with so-called hybrid methods that appeared to be a blend of a cost center and project methodology.
The nexus issue was later raised in the Research Credit Claims Audit Techniques Guide released in 2008 that provided that QREs were generally not traceable to a specific research activity (project) when taxpayers use a departmental or hybrid accounting method. The document concluded that disallowance of the research tax credit claim might be appropriate with these costing methodologies.
IRS Position on Nexus Requirement
The IRS opened the recent research credit workshop with a high-level overview of their perspective on the nexus requirement. At the heart of their position is the Section 41(d) requirement that the “four-part test” defining qualifying research must be satisfied by each business component. In their view, the audit team must be able to tie employees to business components (projects) and then substantiate how much of that time qualifies. Section 41(d)(2) outlines tests to be applied separately to each business component in order to claim costs as qualified research expenses. Section 41(d)(2)(B) defines the business component as any product, process, computer software, technique, formula or invention which is to be held for sale, lease, or license, or used by the taxpayer in a trade or business of the taxpayer.
The expressed IRS position is that they do not require specific project timesheets, but the general substantiation requirements in Section 41 requires that the allocation of QREs to business components be corroborated through some form of documentation. For example, time surveys completed by technical representatives will continue to be of question unless supporting documentation (e.g., diaries, logs, budget requests, etc.) can be provided to help verify the percentages. It is not clear what value oral testimony is given, even though several recent court cases have continued to confirm the significance of oral testimony.
The IRS’s role is as an auditor, so they will first and foremost be looking for workpapers that allow them to audit the reported QREs and credit amount. It appears that workpapers are considered auditable if all costs claimed tie to a specific project and the method used to allocate costs to projects can be demonstrated. The IRS position is that the project method of accounting captures research costs at the qualified activity level (i.e., business component) and, therefore, generally establishes the required nexus between the qualified research activity and the qualified research expenditure.
Areas of Disagreement
All parties (IRS, taxpayers and practitioners) acknowledge the business component requirement. The disagreement appears to revolve around how a business component is defined and what (and how much) documentation is required to support the qualifying research expenditures. For example, why aren’t oral testimony and time surveys sufficient documentation if provided by knowledgeable technical representatives on a timely basis?
Although it is not required in research credit audit guidelines or IRC Section 41, or supported by legislative history, the IRS has expressed a strong preference that taxpayers account for qualified research expenditures on a project-by-project basis. They have issued audit technique guides, industry director directives and other guidance for IRS agents on how to limit taxpayers’ ability to claim credits. They have issued very limited guidance to taxpayers on how to properly substantiate their research credit.
Even taxpayers and practitioners seem to have differing opinions as to the type and amount of guidance on documentation standards that would be helpful. Some practitioners are concerned that more specific guidance on documentation would serve as a basis for disallowance of credit amounts if an IRS engineer interprets the guidance as “the only way” to qualify amounts. The Section 41 Regulations clearly provide that a taxpayer’s particular form of recordkeeping “cannot serve as the basis for denying the credit.”
It is the IRS position that most accounting systems contain information to identify and measure expenditures without considering whether research and development activities meet the statutory requirements under Section 41. However, even if taxpayers use available source documentation, there will likely not be a perfect fit between the tax and business definition of research and development. Questions may arise about the precision of the accounting link, even when source documentation is used as the basis for the costing analysis.
As a follow-up from the meeting, the IRS welcomed suggestions from taxpayers and practitioners. They also indicated that they are internally looking at several projects, including updates to the Research Credit Claims Audit Techniques Guide and an updated version of the Recordkeeping Agreement Pilot Program originally announced in Notice 2004-11.
Alvarez & Marsal Taxand Says:
Acknowledgement should be given by all parties involved in research credit examinations that there is no one-size-fits-all solution. The research credit, like many tax planning opportunities, is factually intensive, and is further complicated by being one of the few tax incentives that has broad application to taxpayers of all sizes and across a wide range of industries.
Taxpayers generally reference the following key points when they deal with difficult examinations around the nexus issue:
- There is no requirement in the statute or regulations that QREs must be accumulated by project.
- Cost center accounting has been successfully audited by the IRS for many years.
- A specific research project documentation requirement included within the January 2001 final regulations was subsequently withdrawn after the regulatory comment period.
- The IRS’s own Audit Technique Guides, which are publicly available on the irs.gov website, provide that an analysis of a taxpayer’s cost center records may be acceptable in analyzing the taxpayer’s research credit computation. Why has that position changed? Why can’t a cost center be a business component? (For more details, see A&M Taxand’s .)
- The Treasury Department has also acknowledged in the preamble to Section 41 regulations that taxpayers must be allowed reasonable flexibility in recordkeeping relevant to the research credit, and that the taxpayer’s particular form of recordkeeping “cannot serve as a basis for denying the credit.” Given the IRS’s further acknowledgment of the use and permissibility of cost center accounting in the field directive and its research credit audit plan, there can be no question that taxpayers are not required to maintain project accounting for purposes of the research credit, and that taxpayers may maintain such records on a cost center basis.
- Several recent court cases have affirmed that the Cohan standard is relevant and applicable to the determination of QREs and that oral testimony is an appropriate form of documentation.
Even though there is no support for a project allocation methodology in the law, taxpayers should be prepared to receive questions during an IRS exam if they don’t apply a project approach. If a project accounting system is not in place, taxpayers should identify and use other types of documentation to support the qualifying research expenditures.
We encourage the IRS to provide both their engineers and taxpayers with guidance that provides clearer direction on sufficiency of documentation and cost-collection methods. This should save time and money for all involved and hopefully make audits less contentious. The directives will need to be in the form of guiding principles or safe harbors because the variability in taxpayer size, industry and scope of research activities is too prohibitive for specific documentation requirements.
Until the IRS issues more guidance on the nexus requirement, taxpayers should consider the following IRS preferences for costing information:
- Timeliness is important. The IRS is much more likely to accept time surveys and allocations prepared on a contemporaneous basis (i.e., filed on an originally filed return and within a year of the activity).
- Supporting cost documentation prepared for a non-tax purpose is preferred. One objection the IRS has to time surveys is that they are self-serving for tax purposes. Using any of a wide range of existing source documents prepared for other business reasons as the basis for costing will gain better acceptance.
- Try not to rely solely on the supervisor to prepare time reports. The IRS has expressed concerns when a supervisor prepares time surveys for large (and even smaller) groups of individuals that report to them. Given this concern, encourage the supervisor to reach out to their direct reports on time spent on projects (and document those discussions).
- Challenge exact roll-forwards of time. The IRS has also expressed concerns when time spent on business components and activities doesn’t seem to change over time. Although it makes sense that an employee’s role will not change dramatically over time, some variability based on the evolution of projects and employee job changes will demonstrate that it’s not just a “same as last year” approach.
Wouldn’t it be of benefit to all parties to narrow some of the questions that exist in research credit methodologies? Many options are available. One example would be general guidance on factors that reflect the sufficiency of documentation (such as those noted above). Another idea would be a program for closing agreements for costing methodologies. A more sweeping change would be the implementation of a program similar to the reporting system for the Canadian research credit system.
The IRS is asking for taxpayer and practitioner input on the process. This initiative gives all sides an opportunity to shape the direction of future research credit guidance. As President Obama has recently alluded, innovation is the future. Strengthening the value of the research credit should foster innovation as a means of spurring job creation and boost U.S. global competitiveness — the research credit’s original intent.
See Industry Director Directive #1 on Research and Experimentation Credit Claims LMSB 4-0307-025 (April 2007); Industry Director Directive #2 on Research Claims, LMSB 4-0608-035 (January 15, 2009); Audit Technique Guide: Credit for Increasing Research Activities, Section 41 (June 2005); Doc 2007-27518, 2007 TNT 244-29 (2005 Audit Techniques Guide); Doc 2008-12059, 2008 TNT 107-41 (2008 Audit Techniques Guide)
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