:: Aerospace Industry - Audit Techniques Guide - January 2005
NOTE:This guide is
current through the publication date. Since
changes may hav occurred after the
publication date that would affect the
accuracy of this document, no guarantees are
made concerning the technical accuracy after
the publication date.
This Audit Techniques Guide
is presented in several chapters. These
chapters can be accessed and then printed by
following the links in the Table of Contents
below. To print the entire ATG follow this
link to the
pdf version.
This document is not legal
precedent and should not be relied upon as
such.
A.
Contracting Stages
1. Request for Proposal
2. Bid & Proposal
3. Awards / Authorization B. Development
Activities
1. Design Phase
2. Development Testing
3. Certification
4. Preparation for Production
5. Deliverable Production Units per CLIN
Why is there a need for an
Aerospace Research Credit Audit Technique
Guide (“ATG”)? The Aerospace Industry is
unique. It has its own activities, terms,
definitions, acronyms, documentation
requirements, procedures, and regulations,
which are peculiar only to the Aerospace
Industry. Because the ATG zeroes in on
industry specific matters, it gives
background and analysis in addressing
research credit issues specific to the
Aerospace industry and therefore provides
direction to the Aerospace examiner not
covered in other audit technique guides.
A. Focus of Aerospace
ATG
The focus of this
document is to highlight proven audit
techniques to assist those individuals who
are responsible for the examination of the
research credit claimed by taxpayers in the
Aerospace Industry. The ATG focuses on those
items an examiner would typically encounter
in the review of Aerospace research credit
activities. Ultimately, the goal of the ATG
is to provide the reader with industry
related information and tools to make an
informed research credit analysis and
determination.
This document is
not legal precedent and should not be relied
upon as such. Also, the ATG is not designed
to remove the discretion given to managers
and/or agents in the application of a
variety of audit techniques or procedures
appropriate to any given examination.
Rather, the ATG is designed to increase the
efficiency of the examination team by (1)
providing an overview of pertinent Aerospace
activities which may be the subject of
claimed research, (2) identifying audit
areas which historically have proven to
contain the highest probability for taxpayer
errors, and (3) providing suggested steps
which may be useful in determining whether
an expenditure meets the requirements of a
qualified research expenditure.
B. Applicability of Aerospace ATG
The ATG applies
to those companies that contract with the
U.S. Government and/or the commercial sector
to design, develop, manufacture and deliver
Aerospace products. The contracted for items
in many instances are tailor made to meet
the customer’s unique requirements,
specifications or needs.
Aerospace
contractors conduct both independent
research and research that is directly
related to performance pursuant to a
contract.
C. Industry
Overview/Description
The term
Aerospace Industry is a misnomer in the
sense that the industry includes more than
just aircraft airframe manufacturers. The
industry also includes, in part,
manufacturers of aircraft engines, avionics,
electronic systems, radar, missiles,
satellites, spacecraft, satellite and
spacecraft launch vehicles and even
shipbuilding. This would include manufacture
for military or commercial application.
While Aerospace
contractors conduct independent research, a
substantial portion of the research claimed
by Aerospace contractors is research that is
performed pursuant to contracts. Because the
aerospace products listed above are
generally not purchased as
commercial-off-the-shelf (“COTS”) items, the
customer must contract for the products’
design, development, and production. At a
minimum, customization is usually involved.
The issue
confronting Aerospace examiners is whether
the contracted for activities are qualified
research. An understanding of the
contracting process is a useful tool in
assisting the examiner in answering the
contracting activity issue.
When Aerospace
contractors contract with the U.S.
Government, the contracts are generally
governed by the Federal Acquisition
Regulations System. Contracts with
non-Government customers are generally
governed by State law.
1.
Government Contracting
The Federal
Acquisition Regulations System is
established for the codification and
publication of uniform policies and
procedures for acquisition by all United
States Government executive agencies.
The Federal Acquisition Regulations
consist of the Federal Acquisition
Regulation (“FAR”), which is the primary
document, and agency acquisition
regulations that implement or supplement
the FAR.
An agency
head may issue or authorize the issuance
of agency acquisition regulations that
implement or supplement the FAR and
incorporate, together with the FAR,
agency policies, procedures, contract
clauses, solicitation provisions, and
forms that govern the contracting
process or otherwise control the
relationship between the agency and
contractors or prospective contractors.
Agency
acquisition regulations implementing or
supplementing the FAR are for:
(a) The
military departments and defense
agencies, issued subject to the
authority of the Secretary of
Defense (Defense Federal Acquisition
Regulation Supplement [“DFARS”];
(b) NASA
activities, issued subject to the
authorities of the Administrator of
NASA; and
(c) The
civilian agencies other than NASA,
issued by the heads of those
agencies subject to the overall
authority of the Administrator of
General Services or independent
authority the agency may have.
The FAR
System does not include internal agency
guidance where an agency head issues or
authorizes the issuance of internal
agency guidance at any organizational
level (e.g., designations and
delegations of authority, assignments of
responsibilities, work-flow procedures,
and internal reporting requirements).
Knowledge of
the FAR, DFARS and, to a lesser extent,
NASA’s procurement regulations is
fundamental to interpreting Aerospace
Government contracts for which the
research credit has been claimed.
2.
Commercial Contracting
State law,
including the Uniform Commercial Code as
adopted by the States, is generally the
legal framework that controls and sets
forth the rules or requirements for
contracting among private parties. The
FAR and DFARS are not applicable to
commercial contracting, unless the
contracting parties agree to incorporate
into the contract FAR and/or DFARS
provision(s).
B. Contract Types
Contract
Categories - There are two broad
categories of contracts: (1) fixed price
contracts and (2) cost reimbursement
contracts. The specific contract types,
within the broad categories, range from
Firm-Fixed-Price (FFP), in which the
contractor has full responsibility for the
performance cost and the resulting profit
(loss), to Cost-Plus Fixed-Fee (CPFF), in
which the contractor has minimal
responsibility for the performance cost and
the negotiated fee is fixed. In between are
various incentive contracts, in which the
contractor’s responsibility for the
performance cost and the profit or fee
incentives offered are tailored to the
uncertainties involved in contract
performance.
1.
Fixed-Price Family of Contracts
A type of
contract which provides for a firm price
or, in appropriate cases, an adjustable
price.
Firm-Fixed-Price (FFP) -
Provides for a price that is not subject
to any adjustment on the basis of the
contractor’s cost experience in
performing the contract. This type of
contract places upon the contractor
maximum risk and full responsibility for
all costs and resulting profit or loss.
Provides maximum incentive for the
contractor to control costs, and imposes
a minimum administrative burden on the
customer.
Fixed-Price Incentive Fee (FPIF)
- Uses an incentive whereby the
contractor’s profit is increased or
decreased by a predetermined share of an
overrun or under run. A firm target is
established from which to later compute
the overrun or under run. A ceiling
price is set as the maximum amount the
customer will pay. Necessary elements
for this type of contract are:
target cost
- best estimate of expected
cost;
target
profit - fair profit at
target cost; share ratio(s)
- to adjust profit after
actual costs are documented;
and,
ceiling
price - limit the amount the
government will pay.
Fixed-Price Award Fee (FPAF) –
Establishes a fixed price (including
normal profit) for the effort. This
price will be paid for satisfactory
contract performance. An award fee can
also be earned based upon a judgmental
evaluation by the customer, sufficient
to provide motivation for excellence in
contract performance.
Fixed
Price With Economic Price Adjustment (FPEPA)
- A type of contract providing for
upward or downward revision of the
stated contract price upon the
occurrence of a specified contingency.
Adjustments may reflect
increases/decreases in actual costs of
labor or material, or in specific
indices of labor or material costs.
2.
Cost-Plus Family of Contracts
A type of
contract which provides for payment to
the contractor of allowable costs
incurred in the performance of the
contract, to the extent prescribed in
the contract. This type of contract
establishes an estimate of total cost
for the purpose of obligation of funds
and establishing a ceiling which the
contract may not exceed (except at the
contractor’s own risk) without prior
approval or subsequent ratification by
the contracting officer.
Cost
Plus Fixed-Fee (CPFF) - A cost
reimbursement type contract which
provides for the payment of a fixed fee
to the contractor. The fixed fee once
negotiated, does not vary with actual
cost, but may be adjusted as a result of
any subsequent changes in the scope of
work or services to be performed under
the contract.
Cost
Plus Incentive-Fee (CPIF) - A
cost reimbursement type contract with
provision for a fee which is adjusted by
formula in accordance with the
relationship which total allowable costs
bear to target costs. The provision for
increase or decrease in the fee,
depending upon allowable costs of
contract performance, is designed as an
incentive to the contractor to increase
the efficiency of performance.
Cost
Plus Award Fee (CPAF) – A cost
reimbursement contract that provides for
a fee consisting of (a) a base amount
(which may be zero) fixed at inception
of the contract and (b) an award amount,
based upon a judgmental evaluation by
the customer, sufficient to provide
motivation for excellence in contract
performance.
3.
Other
Letter Contract – A letter
contract is a written preliminary
contractual instrument that authorizes
the contractor to begin immediately
manufacturing supplies or performing
services. While a set price for contract
performance has not been agreed to, the
letter contract usually contains an
overall contract price ceiling.
Time
and Materials contracts (T&M) –
A time and materials contract provides
for acquiring supplies or services on
the basis of (1) direct labor hours at
specified fixed hourly rates that
include wages, overhead, general and
administrative expenses, and profit and
(2) materials at cost, including, if
appropriate, material handling costs as
part of material costs.
Basic
Ordering Agreement (BOA) - An
instrument executed between a customer
and a contractor which sets forth
negotiated contract clauses that will be
applicable to future procurements
entered into between the parties during
the term of the agreement. It includes
as specific a description as possible of
the supplies or services and a
description of the method for
determining pricing, issuing, and
delivery of future orders.
C. Standard Sections
of a Contract
The following
discussion lists the major clauses found in
a Government contract. While the structure
of commercial contracts can vary from
Government contracts, the following basic
structural requirements are found in both
types of contracts.
Government
contracts normally contain the following
standard sections:
Section B (Supplies
or Services) – Contains the contract
line item number (CLIN), Description
of Supply or Service ordered,
Quantity, Unit Price and Total
Price.
Example:
Section B
CLIN/
Item number
0001
0002
Supply/Service
Radar
Feasibility Study (see special
provision H-3)
Quantity
4
Unit Price
$xxx
Total Price
$xxxx
Section C
(Description or Specifications) –
This section more fully describes
the specifications and requirements
of each line item which must be met
in order to comply with the
contract. Section may refer to the
Statement of Work (“SOW”), which is
a separate document incorporated
into the contract by reference.
The SOW gives a
complete description of performance
required under the contract. It
further describes work to be
performed and establishes and
defines all non-specification
requirements for contractor’s
efforts either directly or with the
use of specific cited documents.
Example:
Section C
CLIN 0001 must
meet Air Force specification
xx-xx-xx
Section D
(Packaging and Marking) –
This section indicates how
CLIN deliverable is to be
packed and preserved and how
the container is to be
marked.
Section E
(Inspection and Acceptance)
– Gives the Government’s
inspection and acceptance
criteria for the ordered
item. Once acceptance is
made the contractor is
entitled to payment or to
keep (“liquidate”) progress
payments.
Section F
(Deliveries or Performance)
– Gives date that CLIN item
must be delivered or
performed. Also gives
shipping instructions.
Section G
(Contract Administrative
Data) – Gives various
administrative data such as
the name and address of the
contracting officer who will
administer the contract and
where to send invoices for
payment.
Section H
(Special Provision) – This
section contains various
specific provisions that
relate to the specific
contract. This is an
important section in that it
contains clauses that
further describe performance
criteria, acceptance
criteria and payment
criteria.
Section I
(General Provisions) –
Contains cites to specific
FAR and DFARS. These
regulations are incorporated
into the contract by
reference. Typical
regulation subjects are
payment clauses, default
clauses and termination
clauses.
Contract Work
Breakdown Structure (“WBS”) –
The WBS is an organized method to break
down a project (contract) into logical
subdivisions or subprojects at lower and
lower levels of detail. It is very
useful in organizing a project. The WBS
can assist the Aerospace examiner in
evaluating whether various components of
contract activity are qualified
research. The WBS includes all the
elements for the products (hardware,
software, data, or services) which are
the responsibility of the contractor.
This comprehensive WBS forms the
framework for the contractor’s
management control system.
Before there
is a contract, there must be a need for
the subject matter of the contract. In
the realm of negotiated Government
contracting, the need is conveyed by the
Government to potential contractors in
the form of a Request For Proposal
(“RFP”). RFPs are used in negotiated
acquisitions to communicate Government
requirements to prospective contractors
and solicit proposals. The RFP includes,
in part, the Government’s requirement;
anticipated terms and conditions that
will apply to the contract; information
required to be in the offeror’s proposal
and significant factors that will be
used to evaluate the proposal and their
relevant importance.
A Request for
Quotation (“RFQ”) is sometimes used by
the Government in negotiated
acquisitions to communicate Government
requirements to prospective contractors
and to solicit a quotation. A response
to an RFQ is only informational in
nature and not a contractor’s offer. If
applicable, the RFQ and contractors
quotation are potential documents for an
examiners analysis.
2.
Bid & Proposal
In response
to the RFP, the contractor is required
to submit a description of the
techniques that will be used to
accomplish the Government’s
requirement(s), along with a submission
of related cost and pricing data. The
contractor’s response is generally
called the Bid & Proposal (“B&P”).
Depending on the subject matter of the
contract, the B&P can be quite
extensive.
The RFP and
B&P package can provide valuable insight
for the Aerospace examiner in his effort
to interpret the ultimate activities
subsequently performed by the contractor
pursuant to the resulting contract.
3.
Awards / Authorization
a) Concept
Exploration and Definition Phase During this phase, program
alternatives are identified based
upon initial studies and analyses of
design concepts, alternative
acquisition strategies, expected
operational capabilities, industrial
base capacity, readiness, support,
personnel requirements, and cost
estimates. If the requirement is
determined to be valid, authority is
granted to proceed to the next
phase. b) Demonstration/Validation
Phase (Dem/Val) When competitive
exploration of alternative system
concepts is completed to the point
where the selected alternatives
warrant system demonstration, the
next phase is the demonstration and
validation effort. During this
phase, prototype systems may be
constructed to validate the proposed
concepts. Department of Defense
policy encourages granting
competitive contracts to two or more
industrial developers who are given
latitude in design subject to
service defined performance
requirements. The demonstration and
validation phase ends with a
decision to proceed to the next
phase, generally Full Scale
Development (“FSD”). c) Full Scale Development
Phase (FSD) When the demonstration and
validation action has been
completed, a recommendation is made
for the preferred systems for FSD.
This may include approval for long
lead production items and limited
production for operational test and
evaluation. In this phase, an FSD
prototype system is designed,
developed and tested. A complete
system is constructed, including
tools and test equipment, training
devices, and logistic support. At
the conclusion of FSD a production
decision is normally made. d) Low-Rate Initial
Production Phase (LRIP) LRIP is the first effort of
the Production and Deployment phase.
The purpose of this effort is to
establish an initial production base
for the system, permit an orderly
ramp-up sufficient to lead to a
smooth transition to Full Rate
Production, and to provide
production representative articles
for Initial Operational Test and
Evaluation. This effort concludes
with a Full Rate Production Decision
Review to authorize Full Rate
Production and Deployment. e) Full Production
Contracting for economic production
quantities following stabilization
of the system design and validation
of the production process.
B. Development
Activities
This section
contains a brief discussion of aerospace
development activities which may contain
qualified research. The subject activities
must be analyzed in conjunction with the
requirements of IRC § 41(d) to determine if
the activities are qualified research. The
development activities must constitute
elements of a process of experimentation
relating to a new or improved function,
performance, reliability or quality of a
product or process.
1.
Design Phase
The
acquisition process begins with the
identification and evaluation of a
mission need by the customer. The design
phase occurs from identification of
mission need, through pre-contract
research activity (company or Government
sponsored research [“Independent
Research & Development” (“IR&D”)]) to
full production. See Treas. Reg. §
1.41-4A(d)(4) which addresses IR&D.
a) Preliminary Design Review (“PDR”) PDR is a formal design
review which is normally conducted
during the early part of system
development. It is conducted for
each contracted for end item to
evaluate early progress and
technical adequacy of the selected
design approach. PDR, which follows
preliminary design efforts, allows
the customer to observe the
contractor’s hardware and software
design for the first time. During
the review, the contractor generally
discloses any changes to its
originally proposed designs, along
with the rational for the changes.
Generally, the design and
engineering efforts leading up to
and including PDR include QRE. b) Critical Design Review
(“CDR”) CDR is a formal design
review which takes place after PDR.
CDR is conducted for each contracted
for end item before the design is
approved for manufacturing. The
review attempts to determine that
the design will meet cost, schedule,
and performance requirements. Risk
assessments, produce-ability
analyses, and integration
compatibility analyses are all
performed during CDR.
Essentially, the design is “frozen”
following a successful CDR.
Therefore, research credit claimed
for the engineering effort following
CDR should be closely scrutinized
for non qualifying expenditures. It
is the responsibility of
Configuration Management to keep
track of any changes to the design.
The
“Master Program Schedule” (“MPS”)
for the contracted for end item
should identify the PDR and CDR
dates. Because the MPS is not part
of the contract for the end item,
the agent should request this
document if it is not provided with
the contract file. The absence of
PDR and CDR is an indication that
there was “no design effort” and
generally no qualified research
activity.
2.
Development Testing
Development
testing occurs throughout the design
process leading up to and including CDR.
Development testing is not “routine or
ordinary testing or inspection for
quality control” (i.e., testing
procedures that are not QRE).
Development testing is performed to
prove the adequacy of the design.
Qualified research expenditures for
development testing may occur after CDR
and prior to production, as long as the
testing expenditures meet the
requirements of IRC §41(d).
3.
Certification
While
certification costs are not normally
encountered in the examination of
Government Contracts, expenditures
relating to Federal Aviation
Administration (“FAA”) certification
will be found in the area of commercial
manufacture of airframes, engines and
parts. As discussed below, FAA
certification costs are generally not
considered QRE. Any certification costs
must meet the four part test of IRC §
41(d). Research credit claimed for
certification costs should be closely
scrutinized for non qualifying
expenditures.
4.
Preparation for Production
a) Production Readiness Review Production Readiness Review
(“PRR”) is used to access a
contractor’s readiness to transition
from design to production. Some
pre-production activities may occur
prior to the PRR. The PRR is
normally performed during FSD phase.
“Preproduction planning for a
business component” is deemed to
occur after the beginning of
commercial production and therefore,
is not qualified research. Treas.
Reg. §1.41-4(c)(2)(ii)(A). b) Tooling up Tooling up refers to the
process of acquiring or
manufacturing sufficient production
capable tooling (“rate tooling”) in
preparation for production. Tooling
up is a specifically excluded
activity under Treas. Reg. §
1.41-4(c), and thus is not qualified
research. c) Qualification Testing Qualification Testing
should be distinguished from
“Routine or ordinary testing or
inspections for quality control.”
“Qualification testing is performed
on initial items produced
(engineering development units or
prototypes), in order to determine
if the item meets the design and
performance specifications. Quality
Assurance or Quality Control are
tests performed after the
commencement of commercial
production, on selected production
items, to determine if the
production process is working
properly. Qualification Testing is
qualified research while Quality
Control Testing is generally not
qualified.
5.
Deliverable Production Units per CLIN
The costs
associated with the production of
Deliverable Production Units per
Contract Line Item Number (CLIN) are not
allowed as qualified research.
A. Research &
Experimental Expenditures IRC § 174 Overview
An expenditure
must be treated as an expense under IRC §
174 to be a qualified research expenditure.
IRC § 41(d)(1)(A). Treas. Reg. §
1.174-2(a)(1) defines the term "research and
experimental expenditures" as:
Expenditures
incurred in connection with the
taxpayer’s trade or business which
represent research and development costs
in the experimental or laboratory sense.
The term includes all such costs
incident to the development or
improvement of a product. The term
includes the cost of obtaining a patent,
such as attorneys fees expended in
making and perfecting a patent
application. Expenditures represent
research and development costs in the
experimental or laboratory sense if they
are for activities intended to discover
information that would eliminate
uncertainty concerning the development
or improvement of a product. Uncertainty
exists if the information available to
the taxpayer does not establish the
capability or method for developing or
improving the product or the appropriate
design of the product. Whether
expenditures qualify as research or
experimental expenditures depend on the
nature of the activity to which the
expenditures relate, not the nature of
the product or improvement being
developed or the level of technological
advancement the product or improvement
represents.
Expenditures for
the following are specifically excluded from
the definition of research and experimental
expenditures by Treas. Reg. § 1.174-2(a)(3):
The ordinary
testing or inspection of materials
or products for quality control
(quality control testing);
Efficiency surveys;
Management studies;
Consumer surveys;
Advertising or
promotions;
The acquisition of
another’s patent, model, production
or process, or
Research in
connection with literary,
historical, or similar projects.
Note that testing
to determine if the design of a product is
appropriate is not considered "quality
control testing," and thus is not excluded
from the definition of research and
experimental expenditures by Treas. Reg. §
1.174-2(a)(3). Rather, quality control
testing is testing or inspection to
determine whether particular units of
materials or products conform to specified
parameters. Treas. Reg. § 1.174-2(a)(4).
Other rules
regarding IRC § 174 expenses:
The
expenditures must be reasonable
in amount under the
circumstances. Treas. Reg. §
1.174 - 2(a)(6).
Research and
experimental expenditures
include costs incident to the
development or improvement of a
product. The term "product"
includes any pilot model,
process, formula, invention,
technique, patent, or similar
property, and includes products
to be used by the taxpayer in
its trade or business as well as
product to be held for sale,
lease, or license. Treas. Reg. §
1.174-2(a)(2). However, research
or experimental expenditures do
not include expenditures for the
acquisition of another's patent,
model, production or process.
Treas. Reg. § 1.174-2(a)(3)(vi).
Research and
experimental expenditures can
also include expenditures paid
or incurred for research or
experimentation carried on in
the taxpayer's behalf by another
person or organization. Treas.
Reg. § 1.174-2(a)(8).
However,
expenditures for research or
experimentation carried on in
the taxpayer's behalf by another
person are not eligible for IRC
§ 174 treatment, to the extent
that they represent expenditures
for the acquisition or
improvement of land or
depreciable property, used in
connection with the research or
experimentation, to which the
taxpayer acquires rights of
ownership. Treas. Reg. §
1.174-2(a)(8).
Expenditures
for the acquisition or
improvement of land or for the
acquisition or improvement of
other property which is subject
to allowances for depreciation
or depletion are not research
and experimental expenditures.
Treas. Reg. § 1.174-2(b)(1).
However, the annual allowances
for depreciation or depletion
may be considered research and
experimental expenditures to the
extent that the property to
which the allowances relate is
used in connection with research
or experimentation. Treas. Reg.
§ 1.174-2(b)(1).
Expenditures
for research or experimentation
which result, as an end product
of the research or
experimentation, in depreciable
property to be used in the
taxpayer's trade or business
may, subject to the limitations
of Treas. Reg. § 1.174-2(b)(4),
are allowable as a current
expense deduction under IRC §
174(a). Treas. Reg. §
1.174-2(b)(2).
Expenditures
for research and experimentation
that are incurred in connection
with the construction or
manufacture of depreciable
property by another are
deductible under IRC § 174(a)
only if made upon the taxpayer's
order and at his risk. Treas.
Reg. § 1.174-2(b)(3).
However, no
deduction is allowed if the
taxpayer purchases another's
product under a performance
guarantee (whether express,
implied, or imposed by local
law) unless the guarantee is
limited, to engineering
specifications or otherwise, in
such a way that economic utility
is not taken into account.
Treas. Reg. § 1.174-2(b)(3).
Deductions for
expenditures in connection with
the acquisition or production of
depreciable property to be used
in the taxpayer's trade or
business are limited to amounts
expended for research or
experimentation. Amounts
expended for research or
experimentation do not include
the costs of the component
materials of the depreciable
property, the costs of labor or
other elements involved in its
construction and installation,
or costs attributable to the
acquisition or improvement of
the property. Treas. Reg. §
1.174-2(b)(4)
B. Qualified
Research Expense & Activities Flowchart (IRC
§ 41(b) & (d))
EXCLUSIONS:
I.R.C. § 41(d)(4)
Are ANY of the
following activities present? If
so, activity is not qualified
research.
Research After
Commercial Production (I.R.C. §
41(d)(4)(A); Treas. Reg. §
1.41-4(c)(2)).
Adaptation of
Existing Business Component
(I.R.C. § 41(d)(4)(B); Treas.
Reg. § 1.41-4(c)(3)).
Duplication of
Existing Business Component
(I.R.C. § 41(d)(4)(C); Treas.
Reg. § 1.41-4(c)(4)).
Surveys,
Studies, Etc. (I.R.C. §
41(d)(4)(D); Treas. Reg. §
1.41-4(c)(5)).
Internal Use
Software (some exceptions apply)
(I.R.C. § 41(d)(4)(E)).
Foreign
Research (I.R.C. § 41(d)(4)(F);
Treas. Reg. § 1.41-4(c)(7)).
Social
Sciences, Etc. (I.R.C. §
41(d)(4)(G); Treas. Reg. §
1.41-4(c)(8)).
Funded Research
(I.R.C. § 41(d)(4)(H); Treas.
Reg. § 1.41-4(c)(9)).
QUALIFIED
RESEARCH: I.R.C. § 41(d)(1) ALL criteria must apply. If not met
at business component level, “shrink back”
(Treas. Reg. § 1.41-4(b)(2))
Expenditures may be
treated as an expense under I.R.C. §
174 (I.R.C. §§ 41(d)(1)(A) and 174;
see Treas. Reg. § 1.174-2)).
Undertaken for the
purpose of discovering information
which is technological in nature,
the application of which is intended
to be useful in the development of a
new/improved business component of
the taxpayer (I.R.C. §
41(d)(1)(B)(1); Treas. Reg. §
1.41-4(a)(3) and (4)).
Substantially all
of the activities of which
constitute a process of
experimentation for a new or
improved function, performance,
reliability or quality (does NOT
include activities related to style,
taste, cosmetic, or seasonal design
factors) (I.R.C. § 41(d)(1)(C) and
(d)(3); Treas. Reg. § 1.41-4(a)(5).
QUALIFIED
RESEARCH EXPENSES: I.R.C. § 41(b) Sum of amounts paid/incurred by a
taxpayer in the credit year in carrying on
the taxpayer’s trade/business:
Wages paid/incurred
for the performance of qualified
services by an employee (I.R.C. §
41(b)(2)(A)(i)). Qualified services
consist of engaging in qualified
research, or engaging in the direct
support of qualified services, or
direct supervision of activities
constituting qualified research
(I.R.C. § 41(b)(2)(B), (D); Treas.
Reg. § 1.41-2(d)).
Supplies used in
the conduct of qualified research
(I.R.C. § 41(b)(2)(A)(ii)). Supplies
are tangible property used in the
conduct of qualified services, other
than land/improvements to land, and
property of a character subject to
the allowance for depreciation
(I.R.C. § 41(b)(2)(C); Treas. Reg. §
1.41-2(b)).
Amount paid for the
right to use computers in the
conduct of qualified research
(I.R.C. § 41(b)(2)(A)(iii)).
Contract research
expense (I.R.C. § 41(b)(1)(B)).
Amounts paid or incurred by the
taxpayer to any person (other than
an employee of the taxpayer) for the
performance of qualified
research/qualified services (I.R.C.
§ 41(b)(3); Treas. Reg. §
1.41-2(e)).
Qualified
Research Expenses, IRC § 41(b)(1) & (2)
Quick References
QRE = in-house
research expense + contract research
expense.
In-house research
expense = Wages + Supplies +
Computer Usage.
Wages = IRC §
3401(a) & IRC § 401(c)(1).
Supplies = tangible
property other than land,
improvements to land and property of
a character subject to the allowance
for depreciation. Special
consideration for utilities -
generally considered G&A (not QREs),
but it is possible that
extraordinary expenditures for
utilities may qualify.
Qualified Services
means: engaging in qualified
research, or the direct supervision
or direct support of research
activities which constitute
qualified research.
Contract
Research Expense, IRC § 41(b)(3) Quick
References
First review Treas.
Reg. § 1.174 -2.
Treas. Reg. §
1.41-2(a)(3) and Treas. Reg. §
1.41-4A(d)(2): Must retain
substantial rights in research
performed for others.
Treas. Reg. §
1.41-2(e) Contract research expense
requirements:
Expense paid or
incurred in carrying on a trade
or business to any person other
an employee of taxpayer.
For qualified
research or services which would
qualify under IRC § 41(b)(2)(B).
Performance of qualified
research only to the extent
pursuant to an agreement entered
into prior to performance.
Performed "on
behalf of” taxpayer.
Taxpayer bears
the expense even if research
unsuccessful.
If payment is
contingent on success, the
transaction may be considered paid
for product or result, rather than
performance of the research, and
payment is not a contract research
expense.
“On behalf of”
means taxpayer has right to the
research result.
Prepaid amounts
must be deducted in year research is
conducted.
Qualified
Research, IRC § 41(d) Quick References
Qualified research
must meet all tests under IRC §
41(d)(1). If not, taxpayer must
shrink back to the next level of the
discrete business component.
Patent safe-harbor
is conclusive evidence of meeting
the “discovery” test only.
Substantially all
(80% or more) of the activities must
constitute elements of a process of
experimentation. See Treas. Reg. §
1.41-4(a)(5) which discusses the
elements of a process of
experimentation.
Tests are applied
separately to each business
component.
Distinguish
separate business components when
assessing activities related to
product vs. processes development.
Qualified Purpose
“… relates to a new or improved
function, performance, or
reliability or quality…. Not
qualified…style, taste, cosmetic or
seasonal design factors.”
Certain activities
are always excluded activities under
IRC § 41(d)(4).
Certain research
activities are specifically excluded from
the definition of qualified research by IRC
§ 41(d)(4). One of these excluded activities
is funded research. Funded research is any
research to the extent funded by any grant,
contract, or otherwise by another person or
governmental entity. IRC § 41(d)(4)(H). The
rules of Treas. Reg. § 1.41-4A(d) govern the
extent to which research is considered
funded. Treas. Reg. § 1.41-4(c)(9).
1.
Two-Part Test
The Two-Part
Test of Treas. Reg. § 1.41-4A(d)(1) and
(2): Contingent on Success -
The regulations provide that amounts
payable under any agreement that are
contingent on the success of the
research, and thus paid for the product
or result of the research, are not
treated as funding. Treas. Reg. §
1.41-4A(d)(1). Therefore, if the
taxpayer performing the research is paid
for its research, regardless of whether
the research is successful, then the
research is funded and is excluded from
the definition of qualified research by
IRC § 41(d)(4)(H). On the other hand, if
the taxpayer performing the research is
paid for its research only if it’s
successful, the research is not funded
under this test.
Substantial
Rights - If the taxpayer
performing research for another retains
no substantial rights in the research
under the agreement providing for the
research, the research is treated as
fully funded, and no expenses paid or
incurred by the taxpayer in performing
the research are qualified research.
Treas. Reg. § 1.41-4A(d)(2). If the
agreement confers exclusive rights to
exploit the research on someone other
than the taxpayer, the taxpayer does not
have substantial rights in the research
and the research is treated as fully
funded. A taxpayer does not retain
substantial rights to the research if it
must pay for the right to use the
results of the research. Incidental
benefits to the taxpayer from
performance of the research, e.g.,
increased experience in a field of
research, do not constitute substantial
rights in the research.
Note that the two-part
test of Treas. Reg. § 1.41-4A(d)(1) and
(2) applies to the person performing the
research and the person paying for the
research. If the person performing the
research does not retain substantial
rights to the research and if the
payments for the research is contingent
on its success, then neither researcher
nor the person paying for the research
is entitled to treat any portion of the
expenditures as qualified research. If
the taxpayer performing the research
retains substantial rights in the
research under the agreement, the
research is funded to the extent of the
payments and the fair market value of
any property to which the taxpayer
becomes entitled by performing the
research.
a)
Contingent on Success Test (Fairchild
Industries, Inc.) The appellate court in
Fairchild Industries, Inc. v. United
States, 71 F.3d 868, (Fed. Cir.
1995), reversing, 30
Fed. Cl. 839 (1994) found that research
conducted by Fairchild under a
fixed-price contract with the U.S. Air
Force was not funded because payment was
contingent on success. The court found
that Fairchild bore the risk of failure
under the contract, in that the Air
Force was liable for payment, on a line
item-by-line item basis, only upon
success of the research and its
acceptance. At the time the contract was
entered, it was not known whether the
research would be successful or whether
the Air Force would accept the research.
The court also found that progress
payments provided for under the contract
did not commit the Air Force to accept
unsuccessful performance, or to make
partial payment if the product was not
successfully produced. b) Substantial Rights Test
(Lockheed Martin Corp.) In Lockheed Martin
Corporation v. United States,
210 F.3d 1366 (Fed. Cir. 2000), the
appellate court concluded that Lockheed
retained substantial rights in the
research performed by it under
fixed-price contracts with the
government even if it did not have the
right to exclude others from using its
research. The court found that the right
to use the research, even if not
exclusive, is a substantial right.
The Lockheed
contracts also included a recoupment
provision, which the Service argued
required Lockheed to pay the government
for the right to use the results of its
research. The appellate court disagreed,
finding that the recoupment provision
did not restrict Lockheed's right to use
the results of its research. Rather, the
court found that the provision was a
cost recovery mechanism, by which the
government recovered some of the cost of
its research and development. In
contrast, the court determined that a
provision requiring payment for the
right to use research is generally a
royalty, based on sales of the product.
The appellate court reversed the lower
court, finding that Lockheed had
retained the right to use its research
without paying for that right.
(1) Limited Rights
The
appellate court in Lockheed
determined that Lockheed had
substantial rights to the research,
based in part on the fact that the
government contracts at issue
allowed the taxpayer to enter into
commercial contracts with third
parties for the sale of items
containing technology developed
under the government contracts, and
Lockheed could also enter into
license or technical assistance
agreements for the technology
developed under the contracts. What
if the taxpayer had the right to use
its research, but only with respect
to products subsequently produced in
filling new orders by the same
customers who had originally paid
for the research. Does the taxpayer
who performed the research have
substantial rights in such research?
Can a taxpayer have substantial
rights to research if it cannot
otherwise use such research in its
business, or sell any products to
third parties resulting from such
research? This question is currently
at issue in the Tax Court case Rohr,
Inc. v. Commissioner, Docket No.
498-01.
2. Funded Research Considerations
The agent should
determine whether the research
performed by the taxpayer is funded
whenever it is performed pursuant to
a contract. Following are some
considerations which may impact the
agent's review:
a) Cost Reimbursement Contracts The cost reimbursement
family of contracts generally
provides that the customer will
reimburse the contractor for all or
a portion of the allowable costs
incurred by the contractor. For
example, in the case of a costs-plus
contract, the contractor is
reimbursed for all allowable costs
incurred, plus a profit as
determined per contract.
Accordingly, risk of failure of the
research performed under a cost
contract is borne by the customer,
not the contractor, to the extent
funded by the customer. Therefore,
as a general rule, research under a
cost contract is considered funded
to the extent of the cost
reimbursement. b) Fixed-Price Contracts A fixed-price contract is
one where the price for performance
is fixed by the contract at the
inception of the contract. The price
is not subject to adjustment solely
by reason of the cost of
performance. The contractor is
obligated to perform and is at risk
in the event of a cost overrun. The
Fairchild case involved the question
of whether research performed under
a fixed-price contract was funded.
The appellate court determined that
Fairchild bore the risk of failure
under the contract, in that the Air
Force was liable for payment, on a
line item-by-line item basis, only
upon success of the research and its
acceptance. Moreover, the court
found that payment for the research
was contingent on success even
though Fairchild received progress
payments during the life of the
contract. c) Contract Line Item Number
Analysis
The examining agent should review
the individual contract line item
numbers (CLINs) to determine if the
activities at the CLIN level qualify
as research credit activities, and
if so, whether the CLINs are
separately funded. It is not unusual
for some CLINs to be funded while
other CLINs are not funded. d) Progress Payments
Progress payments are made by the
U.S. Government as the contractor's
work progresses, typically based on
the percentage of work completed or
the attainment of a contract
milestone or phase. A progress
payment becomes "liquidated" upon
acceptance and delivery of the
property contracted for by the
government. Prior to liquidation,
the contractor is at risk and may be
required to refund unliquidated
progress payments if the contract is
terminated for default or
convenience of the government.
Accordingly, such payments may be
viewed as a form of non taxable
financing. Given that the progress
payments were potentially refundable
to the government, the appellate
court in Fairchild determined that
research related progress payments
received by the taxpayer were not
subject to the funded research
exclusion. The taxpayer still had
performance risk and if unsuccessful
may have been required to refund the
unliquidated progress payments to
the government. Thus, the receipt of
progress payment is not a barrier to
the research credit if qualifying
activities are performed. e) Independent Research &
Development Costs and Bid Costs In general, any independent
research and development costs and
bid and proposal costs paid to a
taxpayer by reason of a government
contract shall not be treated as
funding the underlying research
activities except to the extent the
independent research and development
costs and bid and proposal costs are
properly severable from the
contract. Treas. Reg. §
1.41-4A(d)(4). f) No Contracts There are many instances
where taxpayers undertake certain
activities at a time when no
contract exists. If research
activities are performed, it would
not be unusual for a taxpayer to
claim research credit associated
with these activities. There may be
a funding question, however, if
these costs become reimbursable
contract costs upon contract award
or pursuant to a Memorandum of
Understanding (MOU). The examination
agent should consider whether the
MOU or the subsequent contract award
results in funding of the
expenditures incurred prior to
contract award.
Treas. Reg. § 1.41-4A(d)(5) states
that if at the time the taxpayer
files its return for a taxable year
it is impossible to determine to
what extent particular research
performed by the taxpayer during the
year may be funded, then the
taxpayer shall treat the research as
completely funded for purposes of
completing that return. When the
amount of funding is finally
determined, the taxpayer should
amend the return and any interim
returns to reflect the proper amount
of funding.
(1) Pre-Contract
Activities
Contractors sometime incur costs
in anticipation of contract
awards to comply with the
proposed contract delivery
schedule. For government
contracting purposes, these
pre-contract activity costs
become allowable costs to the
extent they would have been
allowable if incurred after the
date of the contract award. See
FAR 31.205-32. Again, it would
not be unusual for a taxpayer to
claim the research credit with
respect to those activities if
research was performed. However,
if these costs become
reimbursable contract costs upon
contract award, the agent should
consider whether it was proper
for the taxpayer to have claimed
research credit associated with
the pre-contract costs incurred.
See Treas. Reg. § 1.41-4A(d)(5). (2) Special Project
Authorization Costs
“Special project authorization
costs” is merely another name
for pre-contract activity costs
which are incurred with an
informal understanding that a
contract may be awarded at a
future point in time perhaps
when funding becomes available.
Management may budget company
funds to conduct certain
activities to a point, pending
contract award. Again, there may
be a funding question and a
timing issue if research
activities were in fact
incurred. See Treas. Reg. §
1.41-4A(d)(5).
g) Letter Contracts
A letter contract is a preliminary
written contractual instrument that
authorizes the immediate start of
manufacture of supplies pending
definitization of a fixed-price or
cost reimbursement contract. A
letter contract is usually awarded
when work must begin immediately and
timely negotiation of a definitive
contract is not possible. A letter
contract must include, among other
things, a provision for
definitization by a target date, a
provision for unilateral
determination of the contract price
by the government if agreement to a
definitive contract cannot be
reached, and a limitation on
government liability for costs
incurred by the contractor prior to
definitization. See FAR 16.603
The agent should consider whether
the research authorized by the
letter contract is an excluded
activity, e.g., research after
commercial production. Further, if
the activities are qualifying, the
agent should consider the impact of
Treas. Reg. § 1.41-4A(d)(5), since
generally a determination as to
whether the contract is funded can
be made only when the letter
contract is finally definitized,
which may not occur until a
subsequent tax year. h) Cost Sharing Contracts
A cost-sharing contract is a type of
cost reimbursement contract in which
the contractor receives no fee and
is reimbursed only for an
agreed-upon portion of its allowable
costs. FAR 16.303(a). As discussed
above, research by a contractor
under a cost type contract is
typically subject to the funded
research exclusion because
reimbursement of the contractor for
research costs incurred is not
contingent on whether its research
is successful. Treas. Reg. §
1.41-4A(d)(1). However, in a cost
share contract, the government only
pays for a portion of the contract
costs, and the contractor bears the
cost of the unreimbursed portion. As
such, the contingent on success test
of Treas. Reg. § 1.41-4A(d)(1) has
no application to the portion of the
costs borne by the contractor and
not reimbursed by the government.
See Treas. Reg. § 1.41-4A(d)(3)(i)
and (ii) on how to allocate funding
between non-qualified and qualified
research expenditures.
If the contractor has no substantial
rights to the research performed
under a cost share contract, then
any otherwise qualified research
expenses are likewise considered
funded, by operation of the
substantial rights test of Treas.
Reg. § 1.41-4A(d)(2). i) Level of Effort
Some contracts provide for payment
based on the effort expended rather
than results achieved. For example,
the contract may provide that the
taxpayer will be paid an hourly
labor rate for its research. The
contract provides that the taxpayer
merely certifies hours expended in
performing the requested effort. In
such cases, the research is funded
because payment is contingent only
on the level of effort expended, and
not on whether the research is
successful.
B. Cascading Credit
The term
"cascading research credit" is typically
used by Service personnel to refer to
situations where more than one taxpayer
claims the research credit for the same
item. This typically occurs when the prime
contractor subcontracts work to another:
Example: A enters into a
contract with the government for the
design, development, manufacture and
delivery of a developmental jet
aircraft. A, as the prime contractor,
subcontracts a subcomponent of the
aircraft to B for a fixed price. A
treats the amount paid for the
subcomponent as an amount paid for
supplies used in the conduct of
qualified research, and claims the
research credit on this amount. B
engages in qualified research to design
and develop the subcomponent, and
likewise claims the research credit with
respect to its development effort. The
research credit with respect to the
subcomponent is said to have "cascaded"
from A to B.
There is nothing
in IRC § 41 or the regulations hereunder
specifically denying a prime contractor and
subcontractor from both claiming the
research credit with respect to the same
item. Rather, whether the prime contractor
and/or subcontractor may claim the credit
will depend upon various provisions of the
statute and the regulations and the
particular facts of the case.
1. Prime
Contractor Level At the prime contractor level,
cascading credits typically involve a
supply or contract research item. In the
example given above, the prime
contractor treated the subcomponent as a
supply expense. Alternatively, the
expenditure could have been cast as a
contract research expense. a) Supplies A taxpayer may claim the
research credit for amounts paid or
incurred for supplies used in the
conduct of qualified research. IRC §
41(b)(2)(C). A supply includes any
tangible property other than 1) land or
improvements to land; and 2) property of
a character subject to the allowance for
depreciation. Supplies are used in the
conduct of qualified research if they
are used in the performance of qualified
services by an employee of the taxpayer.
The supply must be directly related to
the performance of qualified services.
Expenses for property used in general
and administrative activities are not
qualified research expenses. Treas. Reg.
Sec. 1.41-2(b)(1).
The agent should verify the taxpayer's
claimed supply expense to ensure that
the amount only includes non depreciable
tangible property acquired by the
taxpayer that was used in the
performance of qualified services by an
employee of the taxpayer. There has been
a trend to include a myriad of
non-qualified costs in the research
credit computation by claiming such
costs are supplies. The examiner should
carefully scrutinize prototype
expenditures to determine whether the
prototype is (or contains) property of a
character subject to an allowance for
depreciation. Additionally, taxpayers
often incorrectly treat as a supply
expense the general and administrative
costs related to self constructed
supplies.
b) Contract
Research
Contract research expense is defined as
65% of any expense paid or incurred in
carrying on a trade or business to any
person, other than an employee of the
taxpayer, for the performance on behalf
of the taxpayer of qualified research,
for services which, if performed by
employees of the taxpayer, would
constitute qualified services within the
meaning of IRC § 41(b)(2)(B). Treas.
Reg. § 1.41-2(e)(1). An expense is paid
or incurred for the performance of
qualified research only to the extent
that it is paid or incurred pursuant to
an agreement that–
(i) is entered into
prior to the performance of the
qualified research;
(ii) provides that research be
performed on behalf of the taxpayer;
and
(iii) requires the taxpayer to bear
the expense even if the research is
not successful.
Treas. Reg. §
1.41-2(e)(2). Qualified research is
performed on behalf of the taxpayer if
the taxpayer has a right to the research
results. Note, however, that qualified
research can be performed on behalf of
the taxpayer notwithstanding the fact
that the taxpayer does not have
exclusive rights to the results. Treas.
Reg. § 1.41-2(e)(3). If an expense is
paid or incurred pursuant to an
agreement under which payment is
contingent on the success of the
research, then the expense is considered
paid for the product or result rather
than the performance of the research,
and the payment is not a contract
research expense. Treas. Reg. §
1.41-2(e)(2). If any contract research
expense is attributable to qualified
research to be conducted after the close
of the taxable year, it shall be treated
as paid or incurred when the qualified
research is conducted. IRC §
41(b)(3)(B).
The agent should request a list of all
contracts, along with the dollar amount
of the claimed contract research
expense. The contracts should be
reviewed to determine whether the
requirements of the contract research
rules have been satisfied. Local Counsel
can be helpful in interpreting the
provisions of these agreements.
Often, cascading credit situations at
the prime contractor level involve
fixed-price contracts with milestone
payments, one of which is for the
delivery of an intangible design, and a
subsequent payment for the delivery of
the tangible embodiment of the design.
Given that the prime contractor is
paying for the subcontractor's research,
the prime contractor is at best limited
to claiming the intangible design as a
contract research expense (not a supply
expense). However, the prime may
likewise be unable to claim the expense
as contract research due to the funded
research exclusion, if the milestone
payment for the intangible design is
contingent on success of the
subcontractor's research. The tangible
embodiment is the product of contract
research undertaken on behalf of the
prime by the subcontractor, and must be
evaluated as such, i.e., it is not a
supply expense. However, given that
payment for the tangible embodiment was
contingent on the success of the
subcontractor's research, i.e., the
intangible design, the cost of the
tangible embodiment is excluded as
funded research. This analysis is
typical for cascading credit situations
involving fixed-price contracts at the
prime contractor level.
2.
Subcontractor Level At the subcontractor level, the
chief consideration in the context of
the cascading credit is typically
whether the funded research exclusion of
IRC § 41(d)(4)(H) applies. This requires
a determination as to whether: 1)
payment for the subcontractor's research
was contingent on its success; and 2)
the subcontractor retained substantial
rights to its research. If the amounts
payable to the subcontractor are
contingent on the success of its
research, then the payment is for the
product or result of the research and
the payment is not treated as funding.
However, if the subcontractor is paid
for its research, regardless of whether
the research is successful, the research
is funded. Treas. Reg. § 1.41-4A(d)(1).
Under the substantial rights test, if
the subcontractor retains no substantial
rights in the research under the
agreement providing for the research,
the research is treated as fully funded,
and no expenses paid or incurred by the
taxpayer in performing the research are
qualified research expenses. Treas. Reg.
§ 1.41-4A(d)(2).
C. Other Issue
Analysis
1. After
Commercial Production Activities conducted after the
beginning of commercial production of a
business component are not qualified
research. Activities are conducted after
the beginning of commercial production
of a business component if such
activities are conducted after the
component is developed to the point
where it is ready for commercial sale or
use, or meets the basic functional and
economic requirements of the taxpayer
for the component's sale or use. IRC §
41(d)(4)(A); Treas. Reg. §
1.41-4(c)(2)(i).
The following activities are “deemed” to
occur after the commencement of
commercial production and therefore do
not constitute qualified research:
(A) Preproduction
planning for a finished business
component;
(B) Tooling up for production;
(C) Trial production runs;
(D) Trouble shooting involving
detecting faults in production
equipment or processes;
(E) Accumulating data relating to
production processes; and
(F) Debugging flaws in a business
component.
Treas. Reg. §
1.41-4(c)(2)(ii)
In cases involving
development of both a product and a
manufacturing or other commercial
production process for the product, the
exclusion of activities commenced after
the beginning of commercial production
applies separately for: (1) the
activities relating to the development
of the product; and (2) the activities
relating to the development of the
process. Treas. Reg. §
1.41-4(c)(2)(iii).
For example, even after a product meets
the taxpayer's basic functional and
economic requirements, activities
relating to the development of the
“manufacturing process” still may
constitute qualified research, provided
that the development of the “process”
itself separately satisfies the
requirements of section 41(d), and the
activities are conducted before the
process meets the taxpayer's basic
functional and economic requirements or
is ready for commercial use. Id.
See Examples 1
and 2 of Treas. Reg. § 1.41
4(c)(10) which illustrate whether
activities were incurred after
commercial production.
a) Cut-off
of Development Phase The question of when
research ends is closely tied to the
research after commercial production
exclusion under IRC § 41(d)(4)(A)
and Treas. Reg. § 1.41-4(c),
discussed above. That is, the
research phase of a project is
generally concluded once the
business component (i.e., the
product or process) is developed to
the point where it is ready for
commercial sale or use, or meets the
basic functional and economic
requirements of the taxpayer for the
component's sale or use. Any
activities which occur after this
point generally will not constitute
qualified research.
In order to apply this cut-off point
for when research ends, the examiner
needs to determine when the product
is developed to the point where it
is ready for commercial sale or use
by the taxpayer, or when the product
meets the taxpayer's basic
functional and economic
requirements. The regulations do not
define any of these terms, but, as
shown above, they do give six
examples of activities which are
“deemed” to occur after commercial
production, and thus excluded from
credit eligibility.
Moreover, since the exclusion for
research after commercial production
provides two tests ((1) ready for
commercial sale or use or (2) meets
basic functional and economic
requirements), the cut-off point for
when research ends is the earlier of
the two tests. For example, assume a
widget manufacturer engages in
research in developing a new kind of
widget. The company then builds a
model widget which is found to meet
the taxpayer's basic needs. Once
this occurs, the research has ended,
despite the fact that no commercial
production or use has yet occurred.
On the other hand, if the company
rushes their new widget to market
and begins to commercially produce
the item before ensuring that the
design meets the taxpayer's basic
functional and economic needs, then
the research would be deemed to have
ended upon the first production run
(even if it was a trial production
run).
b) When
Commercial Production Begins There is no general rule as
to when a product is ready for
commercial sale or use, or meets the
taxpayer's basic functional and
economic requirements. However, by
focusing on the activities in a
chronological order and applying the
factors listed below, examiners
should be able to determine whether
the research phase of a project has
ended:
(1) When did
the taxpayer resolve the
uncertainties that existed at
the outset of the project?
(2) Is the taxpayer producing
units of the product?
(a) How many?
(b) For what purpose?
(3)Are the units being sold?
(4) When was the first unit
sold?
(5) Are there contemporaneous
documents where employees have
signed off indicating that the
product met the basic
functionality as of a certain
date?
(6) When did the project go into
the testing phase?
(7) What type of testing was
involved?
(8) When was the first trial
production run?
(9) Is the activity excluded
under any of the IRC § 41(d)(4)
exclusions?
(10) Does the activity at issue
fall under one of the
post-production excluded
activities listed above?
c)
Engineering Change Proposals (ECPs)
Consideration Assume in the widget
example above that the company
rushed the initial widget design to
market and started selling units. As
stated above, research would have
ended upon that first production run
even though the product may not have
met the taxpayer's basic functional
and economic requirements.
If, however, the taxpayer later
decides to halt production and
qualify for the research credit,
without running afoul of the
research after commercial production
exclusion, the taxpayer’s new
activities must be considered to be
activities to design a new or
improved business component. This is
because Congress intended that
research geared toward the
development of a new or improved
business component should be
eligible for the credit (if the
other requirements are also met).
See IRC § 41(d)(1)(B)(ii). Thus, if
the redesigned widget is considered
a new or improved business component
of the taxpayer, then the examiner
should treat those activities as a
separate activity in determining:
(1) whether the activities meet the
tests for qualified research; and if
so, (2) when research ends with
respect to those activities.
In the aerospace industry, this
issue often arises in the context of
engineering change proposals (ECPs)
occurring in a production contract.
In general, an ECP is defined as a
proposed engineering change and the
documentation by which the change is
described, justified, and submitted
for approval or disapproval. See 48
C.F.R. 1852.243-70. Activities
undertaken in furtherance of an ECP,
like any other activities, must: (1)
be individually evaluated to
determine whether the activities
meet the tests for qualified
research; and if so, (2) when
research ends with respect to those
activities. In our experience, we
have found that many activities
undertaken in furtherance of an ECP:
(1) Are not
geared toward functional
improvements to the business
component;
(2) Are conducted by the
customer, not the contractor;
(3) Do not involve the conduct
of a process of experimentation;
and/or
(4) Are excluded under one or
more of the exclusions under IRC
§ 41(d)(4).
Accordingly, ECPs
should be carefully scrutinized.
Where the number of ECPs is
significant, the use of statistical
sampling may be appropriate.
Even where a product meets the
taxpayer's basic functional and
economic requirements (and thus
research has ended with respect to
development of the product), the
taxpayer may still be able to
establish that the manufacturing
process qualifies, if the
requirements for qualified research
are met with respect to the
manufacturing process. In this case,
the research after commercial
production exclusion is to be
applied separately with respect to
the development of the product and
the development of the manufacturing
process.
However, if after production of the
widget, the taxpayer merely engages
in activities that fall under the
research after commercial production
exclusion, then the activities are
excluded from credit eligibility.
For example, if the taxpayer's
post-production activities merely
involved trouble shooting, data
collection, or debugging of their
original widget design or
manufacturing process, then these
activities are excluded.
2. Adaptation /
Duplication (e.g. Reverse Engineering) Activities relating to adapting
an existing business component to a
particular customer's requirement or
need are not qualified research. Treas.
Reg. § 1.41-4(c)(3). This exclusion does
not apply merely because a business
component is intended for a specific
customer.
Adaptation involves making changes to an
existing business component that do not
improve the function, performance,
reliability, or quality of that existing
business component.
Applying the “shrinking-back rule,”
pursuant to Treas. Reg. § 1.41-4(b)(2),
will assist the examiner in determining
whether the taxpayers efforts are merely
adaptation. The requirements of section
41(d) are to be applied first at the
level of the discrete business component
(i.e. the product) to be held for sale.
If these requirements are not met at
that level, then they apply at the most
significant subset of elements of the
product. This shrinking back of the
product is to continue until either a
subset of elements of the product that
satisfies the requirements is reached,
or the most basic element of the product
is reached and such element fails to
satisfy the test. This shrinking-back
rule is applied only if a taxpayer does
not satisfy the requirements of IRC §
41(d)(1) with respect to the overall
business component. The shrinking-back
rule is not itself applied as a reason
to exclude research activities from
credit eligibility.
Activities relating to reproducing an
existing business component (in whole or
in part) from a physical examination of
the business component itself or from
plans, blueprints, detailed
specifications, or publicly available
information about the business component
are not qualified research. Treas. Reg.
§1.41-4(c)(4). This exclusion does not
apply merely because the taxpayer
examines an existing business component
in the course of developing its own
business component.
Reverse Engineering (the taking apart of
something to determine how it is built)
is not a qualifying research activity.
a) Version
– Foreign Customers In certain instances U.S.
military hardware sold to foreign
countries do not contain various
critical technologies that are
contained on the military hardware
sold to the U.S. armed services.
Critical technology can be found on
the Militarily Critical Technologies
List (“MCTL”). The MCTL is a
detailed collection of information
on technologies which the Department
of Defense assesses as critical to
maintaining superior U.S. military
capabilities.
The cost of modifying military
hardware to facilitate foreign sales
is generally considered an
adaptation activity that is not
qualified research.
In addition to the above exclusions,
Section 41(d)(4) excludes activities
such as efficiency or management
surveys, market research, routine
data collection or routine or
ordinary testing, or inspection for
quality control. Also excluded are
activities relating to style, taste,
cosmetic or seasonal design factors.
3.
Business Component An activity must be intended to
be useful in the development of a new or
improved “business component” of the
taxpayer to be considered qualified
research. IRC § 41(d)(1)(B)(ii). The
term "business component" means any
product, process, computer software,
technique, formula, or invention which
is to be:
(i) held for sale,
lease, or license, or
(ii) used by the taxpayer in a trade
or business of the taxpayer,
IRC § 41(d)(2)(B).
a) Product
vs. Process Distinction
Any plant process, machinery, or
technique for commercial production
of a business component shall be
treated as a separate business
component (and not as part of the
business component being produced).
IRC § 41(d)(2)(C).
Even after a “product” meets the
taxpayer's basic functional and
economic requirements, activities
relating to the development of the
manufacturing “process” still may
constitute quali
