Previous issues of Tax Advisor Weekly have highlighted not only the 2009 Union Carbide ("UCC") memorandum decision by the Tax Court, but also the subsequent Second Circuit Court of Appeals hearing in New York City on March 29, 2012. (See Tax Advisor Weekly Issue 44, November 5, 2009, "Wins of Change for the R&D Tax Credit," and Issue 16, April 17, 2012, "Research Credit Supply Expenses at Risk in Union Carbide Appeal.") This appeal was decided on September 7, 2012, and is the focus of this article.
UCC may be the most significant guidance involving the Internal Revenue Code Section 41 research credit since the final Section 41 regulations were issued in December 2003. Although the lower Tax Court's opinion provided some positive precedent for taxpayers, Union Carbide Corporation itself gained little benefit. As a result, UCC appealed the decision, maintaining that the Court incorrectly disallowed millions of dollars in supply expenses related to qualified process improvement research activities. What follows is a brief recap of the history of the case followed by a summary of the recent Appellate Court decision. This decision may have broad implications across all industries for creditable supply costs.
2009 Original Tax Court Decision
Union Carbide Corporation, which became a wholly owned subsidiary of the Dow Chemical Company in 2001, was engaged in the business of processing raw hydrocarbon feedstocks into building-block chemicals called olefins. UCC claimed nearly $18 million of research credits on its originally filed 1994 and 1995 federal income tax returns using the regular research credit methodology. It later claimed additional credits of over $8 million for those years relating to an additional 106 manufacturing process improvement projects. In a long, complicated and sometimes confusing opinion (Union Carbide v. Commissioner, TC Memo. 2009-50), the Tax Court held in relevant part:
- The supply expenses incurred during the two reviewed qualified research projects were not qualified research expenses (QREs) because the Tax Court found that the supplies could have been used in ordinary production; and
- One project did not satisfy Section 41's "process of experimentation" requirement, and taxpayers must complete more than simple validation testing in order to engage in a process of experimentation.
As a result, the Tax Court found that UCC was not entitled to supply expenses related to qualified Section 41 manufacturing process research. The Court, relying on an expansive reading of Section 41(d)(2)(C), disallowed these supply costs because they were incurred "primarily" in the production of goods for sale. The Tax Court reasoned that the supply costs at issue would have been incurred even if qualifying process research had not been conducted by UCC.
The Court held that these supply costs were direct costs of the product business component and were at most "indirect" costs of UCC's process business component. The Court reasoned that if such costs were "indirect" (even though the statute does not mention direct versus indirect supplies), the regulations specify that indirect supplies are ineligible. Neither Union Carbide's nor the government's appeals briefs directly supported the "used 'primarily' in production" logic of the Tax Court.
Union Carbide Appeals Position
In its reply brief, UCC's central argument was that the cost of supplies "used" to conduct research at a production facility in order to improve manufacturing processes constitute QREs (Reply Brief for the Appellant, Union Carbide Corporation and Subsidiaries, No. 11-2552, 2nd Cir. Jan. 18, 2012). This is confirmed by Section 41's clear and unambiguous language.
UCC argued that its manufacturing process research activities could not have been conducted without the claimed supplies. Thus, the supplies are direct, not indirect. Further, Section 41(b)(2)(A)(ii) clearly provides that qualifying supply expenses include any amounts incurred for "supplies used in the conduct of qualifying research." UCC indicated that it was not claiming all costs related to the process improvement projects (e.g., the electricity required to run the plant and equipment during the project), only the costs of supplies that were required to be part of the project in order for it to be conducted (i.e., supplies that directly benefited the project).
Despite the clear language of Section 41, UCC believed the Tax Court added a new requirement to Section 41 ---- namely, that supplies used for process improvement research can only be treated as QREs if they relate "primarily" to the process business component. The "primarily" language is not found in Section 41, but was inserted by the Tax Court.
IRS Appeals Position
In its appellee brief, the IRS provides two major arguments as to why the Tax Court was correct in denying UCC's research credit claims. First, UCC's claimed process improvement supply costs were "indirect expenses," which are excluded from the definition of qualified research expenses. Second, one of the five projects clearly did not satisfy Section 41's process of experimentation requirement.
The IRS agreed with the Tax Court that "indirect research expenses" are expenses that would have been incurred regardless of any research activities. As UCC would have incurred its claimed process improvement supply costs to produce inventory had it not conducted qualified process research, the supply costs are indirect research expenses ineligible for the credit (i.e., they are ordinary production costs). The IRS disagreed with UCC's contention that indirect research expenses under Section 41 mean only general, administrative or overhead costs.
March 29 Appeals Hearing
The Appeals Court for the Second Circuit heard UCC's appeal. Interestingly, throughout the hearing, the panel focused primarily on the statute as opposed to either the regulations or legislative history. The Court also focused on how supply expenses are specifically limited within the code (beyond the regulation language the IRS briefs cite regarding "indirect" or "general and administrative" in nature) and concentrated on the word "used" in the statute. The Court noted that Congress could have easily placed "solely" or "primarily" in the statute as a limitation before "used," yet it did not. Near the conclusion of the hearing, Judge Edward R. Korman raised the policy question of whether it made sense to grant a credit for the cost of materials that would eventually be sold and whether allowing the credit for manufacturing supply costs would be an "absurd result."
Appellate Court's Decision
The Court of Appeals reviewed what in its opinion were the most relevant findings of the Tax Court regarding the two aforementioned projects. The Appeals Court's main focus was generally on the following language in the Tax Court's opinion:
"The definition of supplies [qualified research expenses] includes only amounts paid or incurred for supplies used in the conduct of qualified research. Sec. 41(b)(2)(A)(ii) (emphasis added). Petitioner now seeks to include as qualified research expenses amounts incurred during the production process upon which the qualified research was conducted, not during the conduct of qualified research itself. These costs are, at best, indirect research costs excluded from the definition of qualified research expenses under section 1.41-2(b)(2) of the Treasury Regulations."
The Appeals Court underscored that the fundamental issue was whether UCC's costs for the supplies used during manufacturing process improvement projects would have been used in the course of its manufacturing regardless of any research performed. In turn, the questions became whether these costs would qualify as "an amount paid or incurred for supplies used in the conduct of qualified research."
The decision examined UCC's argument that under the plain language of Section 41(b)(2)(A)(ii) it is entitled to the cost of all supplies used in the conduct of qualified research. UCC cited Webster's dictionary in arguing that "the plain and ordinary meaning of the term 'use' is to 'put into action or service,' 'employ,' 'carry out a purpose or action by means of,' 'make instrumental to an end or process,' 'utilize,' 'expend or consume by putting to use,' 'apply,' and 'any putting to service of a thing.'"
This definition was in support of UCC's position that it should be "entitled to a credit for supplies that it would not have purchased absent any research and for supplies that it would have purchased in any event and that were used to make a product for sale." (emphasis added). The Appeals Court rejected this argument stating that "the dictionary definition of a particular word does not necessarily constitute the beginning and the end of statutory construction."
Setting aside UCC's application of the word "used," the Court stipulated that its primary responsibility was to determine "whether the language at issue has a plain and unambiguous meaning with regard to the particular dispute in the case." In determining that UCC incorrectly focused on the word "used" in isolation, the decision examined the meaning of the phrase "used in the conduct of qualified research" in total. Under this approach, the decision found that the more critical component of the phrase was "in the conduct of qualified research," which in its determination specified "the type of use creditable supply costs may be put towards." The decision even appeared to suggest that UCC's argument was a stretch of interpreting the statutory language, stating that "it would not have occurred to us that this credit applies to costs of supplies that UCC would have purchased and used in any event."
The decision also gave credence to the fact that the phrase "supplies used in the conduct of qualified research" appears in a statutory section titled, "Credit for increasing research activities." The Court concluded that this suggests that supplies that were used in the ordinary process for producing goods for sale are not to be credited. Thus, the Appeals Court agreed with the Tax Court that the costs for which UCC sought a research credit were "at best, indirect research costs excluded from the definition of qualified research expenses under section 1.41-2(b)(2) of the Treasury Regulations." The decision then turned to differentiating between direct and indirect costs, stating that the regulations do not clearly distinguish the two.
The decision noted that the Commissioner argued in its brief that "supply costs are 'indirect research expenditures' if they would have been incurred regardless of any research activities." Finding that the courts ordinarily give deference to an agency's interpretation of its own ambiguous regulation, the decision concluded that the Commissioner's interpretation did not fall into any of the enunciated categories where the courts would withhold such deference. As the Court stated, "the Commissioner's interpretation is entirely consistent with the purpose of the research tax credit, which is to provide a credit for the cost that a taxpayer incurs in conducting qualified research that he would not otherwise incur."
The Court ruled that the purpose of the credit was to overcome the resistance of many businesses to bear the significant costs of initiating or expanding research programs. This is served by affording taxpayers a credit for costs they would not otherwise have incurred to conduct qualified research. The Court ruled, "affording a credit for the costs of supplies that the taxpayer would have incurred regardless of any qualified research it was conducting simply creates an unintended windfall." Thus, the Court found its decision to be consistent with the purpose of the credit and that "the Commissioner reached a result that is rational, prudent, and consistent with the legislative history and congressional purpose."
As a result, the Court of Appeals affirmed the decision of the Tax Court in that UCC was not entitled to research credits for the entire amount spent for the process improvement supplies. Instead, it was entitled to a credit for only those additional supplies that were used to perform the research (emphasis added).
Note that the Appellate Court also affirmed the Tax Court's holding that "UCC's sodium borohydride project was not qualified research under Section 41(d) for the reasons stated in its comprehensive review of the record." Also note the Judge Rosemary Pooler wrote an interesting concurring opinion stating that "Congress may well have intended to give a tax credit for those supplies which would have been purchased absent any qualified research," but the statute was not written precisely enough if that is the case.
Alvarez & Marsal Taxand Says:
Once the Second Circuit reasoned that the plain dictionary definition of the word "use" was not conclusive, the court was ready and willing to defer to the IRS's interpretation of its own regulations. UCC isn't the only taxpayer that claims supply costs used in process improvement research as qualified research expenses. Thus, it should be expected that a variety of fact patterns will emerge as the IRS tests the limits of this case. The dollars at issue can be large, so it is also probable that another circuit will be asked to weigh in on how to interpret the phrase "used in the conduct of qualified research."
In the meantime, the Court's decision could have a significant impact on many taxpayers conducting manufacturing process improvement research. UCC has not yet petitioned the Supreme Court to hear an appeal. And as we all know, the Supreme Court seldom grants certiorari for tax cases.
Notably, the Second Circuit did not appear to directly adopt the Tax Court's "primarily used" requirement for process improvement supplies. The "primarily used" standard would have effectively codified a new requirement found nowhere in Section 41. Instead, adopting the Tax Court's distinction between indirect supply costs and direct supply costs will greatly expand the population of supply expenses that the IRS may attempt to disallow during exam. Our view has always been that "indirect," as used in Section 41 and the regulations to describe supply expenses, relates to general, administrative and overhead costs (such as utilities, accounting services, etc.).
These types of costs only indirectly benefit research activities, as opposed to the costs of direct supplies, which are those supplies actually used in experimentation (e.g., the materials used to build prototypes or test articles). The conclusion of both the Tax Court and the Appeals Court relative to "indirect" research expenses is a unique interpretation of Section 41's supply expense language. It places a greater burden on taxpayers attempting to support their supply QREs.
Upon audit, taxpayers should be adequately prepared to defend their research credit claims. It is imperative that taxpayers thoroughly examine the nature of each qualified activity's business component (i.e., product vs. process). Taxpayers, especially those using a cost center approach, have not necessarily differentiated between product and process improvements. To the extent that taxpayers conduct manufacturing process improvements, they should expect an audit examination more in line with the analysis employed in the UCC decision. Therefore, to the extent taxpayers have a product business component, they should attempt to distinguish their facts from UCC.
Finally, it should not be overlooked that as UCC and other recent cases have demonstrated, documentation continues to be heavily emphasized. This means taxpayers should properly distinguish and support each business component through contemporaneous research credit documentation.
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