2014 - Issue 14—Last year we discussed an area where taxpayers often leave Section 41 research expenditures on the table: contract research (see Tax Advisor Weekly, “Maximize Your Research Credit With Non-Traditional R&D Groups,” Issue 23, June 4, 2013). As we noted, research that is reimbursed by your customers can qualify if, pursuant to the contract, you are economically at risk and you retain substantial rights in the research conducted. This classification generally includes fixed-price or milestone-based contracts. We often find many companies dismiss these contracts and don't include the associated expenses in their research credit calculation. The result is a large amount of eligible research expenses go unclaimed.
A recent district court decision, Geosyntec Consultants, Inc. v. U.S., No. 12-80334 (S.D. Fla. 2013), provides further support for taxpayers who claim fixed-price contract expenses. In Geosyntec, the court held, via a summary judgment, that research expenses incurred by a taxpayer under its fixed-price contracts were not “funded research” under Section 41 and were eligible for the research credit.
Funded Research — A Review
It’s been a few years since we discussed the “funded research” exclusion under Section 41 with you, so it might be time for a quick refresher (see Tax Advisor Weekly, "Is Your Research Funded," July 19, 2006). Under Section 41(d)(4)(H), the R&D tax credit is not available to a taxpayer for any research activity to the extent such research is "funded" by a grant, contract or other arrangement. Congress enacted the funding limitation to restrict research credit benefits to a single taxpayer in a given transaction. That said, the limitation is imperfect in that two parties often claim the same costs as qualified research expenses (QREs). Alternatively, in some transactions, no party is allowed to claim the expenditures.
The Section 41 regulations provide a major exception to the "funding" exclusion (in Treas. Reg. Section 1.41-4A(d)). Under the regulations, research performed by a taxpayer on behalf of another is not funded if both:
(1) The payment to the taxpayer is contingent on the success of the research (i.e., the taxpayer is "at risk" of bearing the research costs upon failure of the project); and
(2) The taxpayer retains "substantial rights" in the research.
Is your research "at risk?"
Amounts paid to a taxpayer under an agreement that are contingent on the success of the research (and thus considered to be payments for the product or research results rather than for research performed on the payor's behalf) are not treated as funding of the research. According to Fairchild (71 F.3d 868 (Fed. Cir. 1995 )), the seminal case on the subject, the determination of whether you are at risk turns on which party bears the research costs upon failure of the project. When retention of payments to you is contingent on performance, such as the successful design and/or development of a new product or process, you bear the risk of failure.
Did you retain "substantial rights" in your research?
If your company performs research on behalf of another entity and retains no "substantial rights" to the research results under the terms of the contract, the research is treated as funded. Although the Section 41 regulations do not define "substantial rights," they do state that a taxpayer does not retain substantial rights when the party for whom the research is performed has the exclusive right to exploit the results of the research and the taxpayer must pay for the right to use the research results (Treas. Reg. Section 1.41-4A(d)(2)). As the court held in Lockheed Martin v. U.S., 210 F.3d 1338 (Fed. Cir. 2000), the right to use research results without paying for such right, even if not an exclusive right, is substantial. Still, if your company must pay a royalty to obtain a non-exclusive license to use the research results, then you do not retain substantial rights in the research.
Thus, so long as exclusive rights are not vested in another party, you can "share" substantial rights in the research results. For example, under the terms of many contracts, taxpayers performing development on behalf of another entity often retain the right to use any knowledge gained while conducting the research in future applications. This is the case even though the technical drawings, blueprints or product specification sheets generated during the research activities remain the property of the customer.
Although Treas. Reg. Section 1.41-4A(d)(2) states that incidental benefits retained by a taxpayer (e.g., increased experience in a field of research) do not constitute substantial rights in the research, the Tax Court in Union Carbide (97 T.C.M. 1207, 1259 (2009)), when discussing whether Union Carbide’s research was funded, stated that the taxpayer had retained all rights to use the results of its plant tests and “that the information the taxpayer gained from the research was valuable to the researcher irrespective of whether the resulting product was ultimately licensed or not.”
Geosyntec — Fixed-Price Contracts Generally Place the Maximum Economic Risk on Contractors
Geosyntec is a consulting and engineering firm specializing in the environment, natural resources and geologic infrastructure. The firm enters into the following types of contracts with its customers:
(1) Fixed-price, including milestone payment arrangements, where Geosyntec performs work for a fixed total price specified at the outset;
(2) Capped cost-plus, where Geosyntec is paid for labor and other expenses, plus a mark-up, subject to an agreed-upon maximum; and
(3) Cost-plus, where Geosyntec is paid for all time and material costs incurred during the project.
Geosyntec filed suit seeking a tax refund of approximately $1.6 million for qualified research expenses it incurred between 2002 and 2005. The research occurred on 370 client projects covered by various fixed-price and capped cost-plus contracts. During the time frame, Geosyntec performed work on over 4,500 total projects. As the client assumes the economic risk under cost-plus contracts, it agreed with the government that such contracts do not qualify for the Section 41 credit. Therefore, only fixed-price and capped cost-plus contracts were at issue in this proceeding.
Additionally, at the request of the parties, the court did not consider the retention of substantial rights under these contracts, but instead limited its analysis to which party bore the economic risk under the contracts’ payment terms. The court did note that the retention of rights issue is a significant one that could change the analysis of some of the contracts reviewed. To expedite the proceedings, the parties agreed to present six representative contracts to the court for review. Three contracts were fixed-price contracts, and three were capped cost-plus contracts.
Geosyntec asserted that the contract principles of risk allocation, including payment mechanisms, conditional acceptance terms and warranty provisions, placed the financial risk of research failure on it. Therefore, the research expenses were not funded. The IRS argued that whether research is funded does not turn on routine business risks or potential for financial loss. Instead, the regulations contemplate only excess research costs (i.e., those costs above any funding received) as being unfunded. Further, the IRS contended that the ultimate goal of the contracts was irrelevant and because Geosyntec did not guarantee success under the contracts, it would be paid for its work regardless of ultimate success.
The court relied on Fairchild in order to determine if payment to Geosyntec under each contract was contingent upon the successful development of a specified product or result. If payment is contingent, then Geosyntec bears the risk of failure and the contract costs are eligible Section 41 expenses. Whether Geosyntec was likely to succeed in performing the project is not determinative. The court found that Geosyntec was at risk under the fixed-price contracts, but not under the capped cost-plus contracts.
The court held that the
“nature of fixed price contracts makes them inherently risky to contractors. Under these contracts, to the extent a contractor’s performance is unsuccessful, the contractor must remedy the performance without additional compensation. Thus, these contracts generally place maximum economic risk on contractors who ultimately bear responsibility for all costs and resulting profit or loss.” (Geosyntec Consultants, Inc. v. U.S., No. 12-80334 (S.D. Fla. 2013), at page 8)
The decision quoted the IRS Aerospace Industry Research Credit Audit Technique Guide, which acknowledges that fixed-price contracts place risk on the contractor (pages 15-16). Interestingly, the court noted that conditional acceptance terms, which make client payments conditional on acceptance of performance, place additional risks on contractors above and beyond the cost overrun risk they already face under fixed-price arrangements.
In contrast, the court held that capped cost-plus contracts are not different enough from cost-plus contracts to move them into the “realm” of fixed-price contracts. The court decided that capped cost-plus contracts, which obligate clients to make payments for predefined tasks at predefined rates in accordance with a detailed project budget, places minimal risk on the contractor and are, therefore, funded research.
Significance of Geosyntec
Geosyntec stands for the proposition that under Section 41, your specific contract terms determine funding. The decision also provides significant support for the argument that, in general, fixed-price contract terms place maximum economic risk on the contractor.Geosyntec can also be seen as a broadening of the types of contracts that may qualify for the research credit as “not funded.” As mentioned above, Fairchild relied on the contract’s default terms, which expressly provided that the taxpayer might have to repay unliquidated progress payments, while Geosyntec focuses on the general economic risks of fixed-price contracts.
A common perception is that all fixed-price-type contracts are, by definition, not funded while all cost-type contracts are funded for the party performing the work. This is not always true. To determine if amounts are "at risk" and whether you retain "substantial rights," it isn't the contract type that controls. Instead the specific contractual terms are crucial. These terms describe if your company is at risk of bearing the research costs if the project fails and whether you retain substantial rights in the research results.
We often see IRS exam teams applying a restrictive formulation as to what types of contracts are funded under Section 41. Similar to their stance in Geosyntec, the IRS often ignores the specific contract terms at issue and argues that the regulations provide that only costs above the funding actually received by a taxpayer are eligible for the credit. Hopefully the Geosyntec decision will reduce these types of disputes during future exams.
Further, the Geosyntec summary judgment decision did not address situations where contract costs exceed the cap under capped cost-plus contracts. In such a situation, it would appear that risk shifts back to the contractor once the cap is exceeded. By the logic of the decision, those costs above the cap would qualify for the research credit. Again, a contract’s “cap” terms should be reviewed to determine if this is actually the case in any particular instance.
Interestingly, the court downplayed contract default and warranty provisions, describing them as playing a “minor” role in evaluating the allocation of risk. However, we consider the default provisions to be of the utmost importance when reviewing terms in order to determine which party bears the risk of failure under a contract. Specifically, knowing that it is the default provision that usually enables a customer to demand the return of any progress payments, these terms seem to squarely meet the “contingent on the success of the research” requirement as articulated in Fairchild. Thus, such provisions tend to place the economic risk on the contractor and are an important piece of your unfunded contract analysis.
Alvarez & Marsal Taxand Says:
What is the takeaway? You may be excluding qualifying research expenses from your Section 41 credit calculation if you do not consider contract expenses. Most taxpayers are usually very surprised to see the significance of this amount. To expedite your review, you should initially segregate your contracts by type (fixed-price, cost-plus, etc.) in order to begin the task of reviewing terms, especially if you issue fairly standard contracts to your customers.
But remember; it isn’t the contract type that controls. Instead it is which party bears the economic risk within the terms, as well as the retention of substantial rights. Geosyntec should provide some comfort that your fixed-price development contracts will likely qualify for the research credit and should give the IRS pause before they make an “excess research cost” argument during an exam.
Finally, if you have the option as to which contract type to issue to clients, you should consider the potential benefit of the research credit when making your business decision as to whether the risk is worth it.
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Other Related Issues
Maximize Your Research Credit With Non-Traditional R&D Groups
Tax Credits and Incentives — A Practical Guide to Managing an Effective Program
Is Your Research "Funded... (Plus a Brief Update on Current R&D Credit Legislation)
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