On January 11, 2021 the United States Tax Court issued a partial summary judgment against Enercon Engineering, Inc. as to expenses incurred due to lack of substantial rights in research it performed in fulfilling its contract with a third party and held that Enercon was not entitled to the associated research credit.
The Tax Court cited Section 41(d)(4)(H) which provides that “any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity)” is not a qualified activity for purposes of the research credit as well as Section 1.41-4A(d) (2) & (3) that outline the requirement to retains substantial rights in the research under the agreement providing for the research. The court also cited relevant court cases Lockheed Martin Corp. v. U.S., 210 F.3d 1366 (Fed. Cir. 2000) and Fairchild Indus., Inc. v. U.S., 71 F.3d 868 (3d Cir. 1995) which both dealt with the taxpayer’s right under the research agreements being a determinative factor in whether the taxpayer could claim these activities.
The Tax Court reviewed the contract between Enercon (“Taxpayer” or “Seller”) and the third-party Buyer and noted the following facts:
- Taxpayer designs and produces integrated controls and switchgears for custom applications in the power generation industry. Taxpayer was hired by third party to develop, according to existing designs a new enclosure for turbine power generation.
- Technical Designs, Drawings and Data supplied to Seller or designed by Seller was at Buyer’s expense
- Seller has designed specifically to meet Buyer-furnished technical requirements
- Seller, in consideration of Buyer’s furnishing of such Information and/or design funding, agrees that it will not use, or assist others in using, such Information, design funding or tooling to develop or sell such Articles (or similar interchangeable or substitute Articles, or parts thereof) to anyone other than Buyer, either as production, spare or repaired Articles, without Buyer’s prior written consent.
- Information prepared by Seller specifically in connection with performance of this Order, including original works of authorship created by Seller, are considered “works made for hire” within the meaning of the U.S. Copyright Laws. Buyer shall be deemed the author of such works.
- Designs, Drawings, and Data
- All information and equipment supplied by Buyer remain in Buyers ownership
- All information generated as a result of this order are owned by Buyer only — “works for hire”
Tax Law and Court Precedent
When a contractor such as Enercon performs research in fulfilling a contract with its customer, each party may have a possible claim to the research credit: Enercon’s credit would be based on its in-house research expenses and Buyer’s credit would be based on its contract research expenses. To prevent double claiming of the credit and to determine which contracting party is entitled to the credit, the statute provides that qualified research does not include “funded research” under Sec. 41(d)(4)(H). “Funded research” is defined as any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).”
The regulations governing “funded research” appear in Treas. Reg. Sec. 1.41-4A(d). To determine whether research is “funded,” the regulations direct our focus to the agreement(s) executed by the contracting parties: “All agreements (not only research contracts) entered into between the taxpayer performing the research and other persons shall be considered in determining the extent to which the research is funded.”
The regulations specify two main factors (Risk and Rights) as relevant in ascertaining whether research is “funded.”
Risk – payment that is contingent on the success of the research are not treated as funding, while payments that are made regardless of success are considered funded. Generally, this means that payments that are fixed would be considered “at risk” while payments that are made on a time and materials are not “at risk”.
Tax courts have historically looked to the following contract clauses to determine who held financial risk
- Payment procedures,
- Quality and performance standards,
- Termination clauses,
- Warrant and default provisions,
- Right to review and approve design documents,
- Invoice dispute provisions, and
- Revision obligations and covering related costs.
Rights – the regulations provide that a taxpayer is entitled to the credit only if it “retains substantial rights in the research.” Sec. 1.41-4A(d)(3)(i) “If a taxpayer performing research for another person retains no substantial rights in research under the agreement providing for the research, the research is treated as fully funded.”
Tax courts have looked to the following contract details to determine who held substantial rights:
- Restrictions from using the research it performed,
- Cost or license needed to pay for the use of research, and
- If the right to use the research was exclusive to the buyer.
Similar court cases[2] found that the Taxpayer retained sufficient rights to its research and results if there were no provisions in the contracts that prohibited petitioner from using the research it performed or that required it to pay the client for use of the research.
A taxpayer must pass both of these tests in order to treat the activities as non-funded. In this case the Enercon did not retain substantial rights to the research performed.
Looking Ahead
Where contracts or agreements for research are in place, extra care should be taken to determine which party bears the economic risk and owns the resulting IP when seeking to claim a research credit for expenses associated with the research contract. As well, taxpayers may be able to negotiate how those provisions are drafted when entering into such arrangements thereby preserving the ability to claim a research credit.
With the research credit as a priority audit area for the IRS, it’s important to properly consider whether activities are considered funded and taxpayers should continue to monitor court cases in applying the rules to their fact pattern.
For additional assistance or if you have questions contact:
Matt Neuenswander, Tax Manager, Tanner LLC
801-924-5120 | mneuenswander@tannerco.com
Shawn Marchant, Tax Principal, Tanner LLC
801.990.5928 | smarchant@tannerco.com
[1] Tangels were shareholders in Enercon Engineering (an S corporation) and reported flow-through research credits on their tax return.
[2] Populous Holdings, Inc. v. Commissioner, (T.C. 2019, Docket No. 405-17).