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Aiming for a More Perfect World — IRS Reaches Out on R&D Credit and Nexus
In an effort to resolve some of the long-standing controversies between taxpayers and the IRS on research credit issues, the IRS hosted a discussion forum with tax practitioners on 5 January and 6 January 2011 in Washington, D.C. The primary focus of the workshop was the nexus issue for the research credit. The IRS dedicates significant resources to auditing research credit amounts each year. The stated purpose of the meeting was to better understand documents that taxpayers (and practitioners) rely on to document the research credit, as well as to discuss ways the IRS can be more effective in resolving issues. Taxand US reviews some of the discussion points raised at the meeting and presents potential approaches that taxpayers (and the IRS) may be able use to bridge the divide.
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Acknowledgement should be given by all parties involved in research credit examinations that there is no one-size-fits-all solution. The research credit, like many tax planning opportunities, is factually intensive, and is further complicated by being one of the few tax incentives that has broad application to taxpayers of all sizes and across a wide range of industries.
Taxpayers should generally reference the following key points when dealing with difficult examinations around the nexus issue:
- There is no requirement in the statute or regulations that QREs must be accumulated by project.
- Cost center accounting has been successfully audited by the IRS for many years.
- A specific research project documentation requirement included within the January 2001 final regulations was subsequently withdrawn after the regulatory comment period.
- The IRS's own Audit Technique Guides, which are publicly available on the irs.gov website, provide that an analysis of a taxpayer's cost center records may be acceptable in analysing the taxpayer's research credit computation. Why has that position changed? Why can't a cost center be a business component?
- The Treasury Department has also acknowledged in the preamble to Section 41 regulations that taxpayers must be allowed reasonable flexibility in recordkeeping relevant to the research credit, and that the taxpayer's particular form of recordkeeping "cannot serve as a basis for denying the credit." Given the IRS's further acknowledgment of the use and permissibility of cost center accounting in the field directive and its research credit audit plan, there can be no question that taxpayers are not required to maintain project accounting for purposes of the research credit, and that taxpayers may maintain such records on a cost center basis.
- Several recent court cases have affirmed that the Cohan standard is relevant and applicable to the determination of QREs and that oral testimony is an appropriate form of documentation.
Even though there is no support for a project allocation methodology in the law, taxpayers should be prepared to receive questions during an IRS exam if they don't apply a project approach. If a project accounting system is not in place, taxpayers should identify and use other types of documentation to support the qualifying research expenditures.
We encourage the IRS to provide both their engineers and taxpayers with guidance that provides clearer direction on sufficiency of documentation and cost-collection methods. This should save time and money for all involved and hopefully make audits less contentious. The directives will need to be in the form of guiding principles or safe harbors because the variability in taxpayer size, industry and scope of research activities is too prohibitive for specific documentation requirements.
Until the IRS issues more guidance on the nexus requirement, taxpayers should consider the following IRS preferences for costing information:
- Timeliness is important. The IRS is much more likely to accept time surveys and allocations prepared on a contemporaneous basis (i.e., filed on an originally filed return and within a year of the activity).
- Supporting cost documentation prepared for a non-tax purpose is preferred. One objection the IRS has to time surveys is that they are self-serving for tax purposes. Using any of a wide range of existing source documents prepared for other business reasons as the basis for costing will gain better acceptance.
- Try not to rely solely on the supervisor to prepare time reports. The IRS has expressed concerns when a supervisor prepares time surveys for large (and even smaller) groups of individuals that report to them. Given this concern, encourage the supervisor to reach out to their direct reports on time spent on projects (and document those discussions).
- Challenge exact roll-forwards of time. The IRS has also expressed concerns when time spent on business components and activities doesn't seem to change over time. Although it makes sense that an employee's role will not change dramatically over time, some variability based on the evolution of projects and employee job changes will demonstrate that it's not just a "same as last year" approach.
Wouldn't it be of benefit to all parties to narrow some of the questions that exist in research credit methodologies? Many options are available. One example would be general guidance on factors that reflect the sufficiency of documentation (such as those noted above). Another idea would be a program for closing agreements for costing methodologies. A more sweeping change would be the implementation of a program similar to the reporting system for the Canadian research credit system.
The IRS is asking for taxpayer and practitioner input on the process. This initiative gives all sides an opportunity to shape the direction of future research credit guidance. As President Obama has recently alluded, innovation is the future. Strengthening the value of the research credit should foster innovation as a means of spurring job creation and boost US global competitiveness -- the research credit's original intent.