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R&D tax credit and fixed-price contracts - when risk is worth it
An area where taxpayers often leave Section 41 research expenditures on the table is contract research. Taxand USA examines the implications of this in light of a recent court case.
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. 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.
The recent court case concerning Geosyntec Consultants provides further support for taxpayers who claim fixed-price contract expenses. In Geosyntec, the court held that research expenses incurred by a taxpayer under its fixed-price contracts were not “funded research” under Section 41 and were eligible for research credit. 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. 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 (ie 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.
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Multinationals may be excluding qualifying research expenses from their Section 41 credit calculation if they do not consider contract expenses. To expedite the review process, contracts should be segregated by type (fixed-price, cost-plus etc) in order to begin the task of reviewing terms, especially if fairly standard contracts are issued to customers. During this process, it’s imperative to remember that 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.
The Geosyntec case provides some comfort that fixed-price development contracts are likely to qualify for the research credit. Furthermore, the case highlights that if there is an option as to which contract type to issue to clients, the potential benefit of the research credit and whether the risk is worth it should be considered.