Business owners who design products or processes may qualify for the research tax credit. This tax credit provides a real economic incentive as it can significantly reduce tax liability for companies investing in innovation. But what happens when the research is conducted under contract with another business? Who gets the credit–the business funding the research or the one performing it?
This question turns on whether the research is considered “funded research” under Section 41(d)(4)(H). A key factor in this is whether the party performing the research retains “substantial rights” in the research it conducts. If it doesn’t, the research is deemed “funded” and the performer cannot claim the credit.
The tax court’s decision in Tangel v. Commissioner, T.C. Memo. 2021-1 (2021), offers an opportunity to examine what constitutes “substantial rights” in research for purposes of the research credit.
Facts & Procedural History
The taxpayers in this case were shareholders of an engineering company that designs and produces integrated controls and switchgears for custom applications in the power generation industry. In February 2009, the engineering company was hired by another business to develop a new enclosure for turbine power generation and to redesign three existing turbine units.
The parties negotiated detailed contract terms, which were recorded in a document they referred to “Terms and Conditions.” The other business was the primary drafter of the document.
After receiving the proposed Terms and Conditions, the engineering company sent an offer letter summarizing its understanding of the project, which the business accepted. The business then submitted a series of purchase orders totaling $1,423,847.
For tax years 2008-2010, the engineering company claimed research credits of $929,668 based on “qualified research expenses” incurred in connection with 142 different projects, including the project for the business noted above. These credits flowed through to the engineering company’s shareholders as it was taxed as an S corporation.
On audit, the IRS disallowed all flow-through research credits, determining that the taxpayers had not provided sufficient documentation to establish that the requirements of Section 41 had been met.
Understanding Section 41 Research Credits
Section 41 allows taxpayers who increase their research expenses above a base amount to claim a tax credit. “Qualified research expenses” or QREs include in-house research expenses (such as wages paid to employees engaged in qualified research) and contract research expenses.
When a contractor performs research in fulfilling a contract with a customer, both parties potentially have a claim to the research credit. The party performing research may have wage QREs for amounts it pays to its employees. Whereas, the party paying for the research may have contract QREs for amounts it pays to the contractor business.
The “funded research” rules are thought to be an allocation rule to prevent double claiming and determine which party is entitled to the credit. This rule isn’t intended to be an allocation rule, however. It is an exclusion or limitation rule. It excludes or limits the credit. This is evident in situations where both parties are eligible for the credit after applying the funded research rules.
What Constitutes “Funded Research”?
So what constitutes “funded resarch?” Funded research is defined in Section 41(d)(4)(H) as any research funded by a grant, contract, or otherwise by another person or governmental entity.
The regulations provide additional clarity on when research is considered “funded.” According to Treasury Regulation § 1.41-4A(d), two main factors determine whether research is “funded:”
- Whether payments under the agreement are contingent on the success of the research
- Whether the taxpayer performing the research retains substantial rights in the research
If payment is contingent on success, the research is not considered funded because the performer bears the risk of failure. However, if the taxpayer does not retain substantial rights in the research, the research is treated as fully funded, and no expenses paid by the taxpayer in performing the research qualify for the credit.
Note how the second factor, the substantial rights, only applies to the researcher. It does not apply to the party paying for the research.
What Are “Substantial Rights” in Research?
So when does the researcher retain “substantial rights” in the research? The regulations provide the answer.
The regulations say that the researcher does not retain substantial rights in research if it performs research under an agreement that confers on another person the exclusive right to exploit the results of the research. Similarly, a researcher does not retain substantial rights if it must pay for the right to use the results of the research.
The rules have also clarified that incidental benefits to the taxpayer from performance of the research, such as increased experience in a field, do not constitute substantial rights.
The Court’s Analysis of the Tangel Agreement
This brings us to the contract terms in this case. The U.S. Tax Court focused on Paragraph 15 of the “Terms and Conditions” to determine whether the engineering company retained substantial rights in the research it performed for the other business.
This paragraph defined “Information” to include any technical information that the engineering company designed at the other business’s expense or specifically to meet the other business’s technical requirements. The engineering company agreed that it would not use such information to develop or sell articles without the other businesses prior written consent.
Furthermore, the agreement stipulated that the engineering company “shall not use or disclose such Information except in the performance of Orders for Buyer.” Upon the other business’s request, all such information and copies had to be returned to the other business.
The agreement also included a “work made for hire” provision, stating that information prepared by the engineering company specifically in connection with performance of the order, including original works of authorship, belonged to the other business.
Interpreting Contract Terms in Research Agreements
The U.S. Tax Court determined that the agreement conferred on the other business the exclusive right to exploit the results of the research. Although the engineering company could conceivably re-use the research results with the other business’s prior written consent, the court found that having to secure permission to use the research, with no conditions limiting the other party’s ability to withhold consent, prevented the engineering company from possessing substantial rights.
The court also rejected the engineering company’s argument that it retained the right to use the “institutional knowledge” gained from the research. Citing the regulations, the court noted that mere incidental benefits from performing the research, such as having more experienced staff, do not constitute substantial rights.
Why the Tangel Case Differs from Lockheed Martin
The U.S. Tax Court distinguished this case from Lockheed Martin Corp. v. United States. The Lockheed case is the leading case for substantial rights for this tax credit. In Lockheed, the Federal Circuit held that the taxpayer retained substantial rights in its research as the government had conceded that the contract gave the taxpayer the right to use its research in its business.
In contrast, the agreement in the current case prevented the engineering company from using the research results without the other business’s permission. The court emphasized that the parties’ agreement controls in determining whether the taxpayer performing the research has retained substantial rights.
The Takeaway
This decision underscores the importance of contract language when determining whether research is “funded” for purposes of the research credit. Companies performing research under contract should carefully review agreement terms regarding their rights to use the research results. If the agreement requires prior consent from the customer to use the research, with no limits on the customer’s ability to withhold consent, the research performer likely has not retained “substantial rights” and cannot claim the research credit. This means that taxpayers seeking to claim research credits must pay careful attention to intellectual property provisions in their contracts and negotiate terms that preserve their rights to use the research they perform.
