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Non Docketed Service Advice Review 2002 IRS NSAR 20350, 2002 WL 32168014
2002 IRS NSAR 20350 August 21, 2002 (Approx. 21 pages)
Internal Revenue Service (I.R.S.) IRS NSAR Non Docketed Service Advice Review August 21, 2002 Section 41 -- Employee Stock Owner Credit (Repealed 1984 Act) (See Also 48.11-00) 41.00-00 Credit for Increasing Research Activities
CC:LM:NR:***:TL-N-POSTF-145498-01 ***
to: *** LMSB Group ***, *** from: *** Special Litigation Assistant (***) subject: Request for Assistance: ***, Inc. This supplements our memorandum dated August 2, 2002, regarding ***. As we mentioned, the memorandum was subject to post-review by the National Office. This review has been completed and has not resulted in any modification of the conclusions expressed in the memorandum. The National Office wishes us to add that the memorandum is not intended to address all possible areas of controversy between the Service and the taxpayer with respect to the taxpayer's claimed R&D credits, and that no inference should be drawn from the omission of other issues from the memorandum. We noted at page five of the memorandum that the audit team is considering other serious issues with respect to ***s R&D claim, such as whether the R&D activities are duplications, adaptions, or mere surveys and whether they qualify under the process of experimentation requirement of I.R.C. 174. We encourage the audit team to develop and consider all such issues, and not rely solely on the issues addressed in the memorandum as the basis for allowance or disallowance of the R&D under consideration. Also please note that several words were inadvertently omitted from the last sentence in the fourth paragraph on page 21. The sentence should have read: The taxpayer pointed to the contract terms that provided that progress payments could not be retained unless the work for which those progress payments were made was delivered and accepted by the Air Force. The underlined words were omitted from the text. If you have any questions about this or need any other assistance in this matter, please feel free to contact the undersigned at ***. *** ***ecial Litigation Assistant CC:LM:NR:***:POSTF-145498-01 *** date: August 2, 2002 to: ***, Team Manager LMSB Group ***, *** from: *** Special Litigation Assistant (***) subject: Request for Assistance *** By memorandum dated August 23, 2001, our assistance was requested in regard to certain issues concerning the taxpayer's entitlement to I.R.C. 41 research credits. Particularly, we were asked whether the taxpayer's contracts pursuant to which it provides various
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ISSUES
1. Whether *** incurred costs under contracts for architectural, engineering, construction management, and other consulting services that are contingent on success and therefore not funded within the meaning of Treas. Reg. 1.41-5(d)(1). 2. Whether *** incurred costs under contracts that retained substantial rights so that the requirements of Treas. Reg. 1.41-5(d)(1)(D)(4)(H) for a funded contract are met in regard to these contracts. 3. Whether *** incurred costs under contracts that were undertaken in regard to the development or improvement of a business component, as that term is defined in I.R.C. 41(d)(2)(B), and that are incident to the development or improvement of a product, as that term is defined in Treas. Reg. 1.174-2(a)(2).
PROPOSED CONCLUSIONS
1. Except for the contracts with *** and ***, *** incurred costs under contracts that are not contingent on success, so that they are funded within the meaning of Treas. Reg. 1.415(d)(1). 2. Except for the *** contract, *** incurred costs under contracts in which it retained substantial rights to use the research within the meaning of Treas. Reg. 1.41-5(d)(2). 3. With respect to all the contracts discussed in this memorandum except for the *** and *** contracts, ***'s costs were not incurred in regard to a business component, as that term is used in I.R.C. 41(d)(2)(B), and are not incident to the development of a product, as that term is defined in Treas. Reg. 1.174-2(a)(2).
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Year Claim Year Claim *** $ *** *** *** *** *** *** *** $ *** *** *** *** ***
The *** study primarily involved internal use soft ware. One engineering design project was included. These amounts were included on amended or filed returns. In ***, *** commissioned *** (***) to perform a study of R&D. This study resulted in the following amounts of additional research credit claimed:
*** $ *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** *** $ *** *** *** *** *** *** *** *** *** *** *** *** *** *** ***
Total $ ***
*** has filed claims for refund for *** and *** and has included the above amounts in its filed returns for *** and ***. It is assumed that there probably remain carryover research credits in years after ***.
V. Terminology
In the years covered by this memorandum, the *** group consisted of ***, Inc. and a number of subsidiaries. As a result of consolidation, a number of the subsidiaries were merged into ***, Inc. While some contracts are in the name of ***, Inc., a number of contracts are in the names of other subsidiaries. For convenience, we will refer to the consolidated group as ***. We will use this same term as the party to various contracts, although individual contracts were in the name of ***, Inc. or another subsidiary. The party with whom *** contracted will be referred to as the owner or client. Providers of services such as architects and engineers will be referred to as design professionals. Their services will be referred to as design work or consulting services. The work product of design professionals, such as blue prints, plans, specifications, drawings,
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2. Judicial Interpretation.
This funding provision of the statute and regulation was interpreted by the Court of Appeals for the Federal Circuit in Fairchild Ind., Inc. v. United States, 71 F.3d 868 (Fed. Cir. 1995) rev'g 30 Fed. Cl. 839, 94-1 U.S.T.C. 50,164 (Ct. Fed. Cl. 1994). The taxpayer, Fairchild Industries, Inc., was a defense contractor for the Air Force. It entered into a fixedprice incentive contract to design and produce a new aircraft. The contract had two phases, a development phase and a production phase. In the design phase, the taxpayer was to develop and deliver a prototype aircraft and necessary support systems. Under the contract, the Air Force was obligated to pay for research only if the taxpayer produced results that met the contract specifications in accordance with certain provisions of the Defense Acquisition Regulation (DAR). The taxpayer was entitled to payment only for work product delivered and accepted. If the work was deemed unacceptable, the Air Force could either reject it or require correction by the taxpayer at its own expense, or accept the work subject to equitable price reduction. 71 F.3d at 871. The contract also provided that if the taxpayer made satisfactory progress, the Air Force would pay bimonthly refundable expenditures, denominated progress payments. The taxpayer could not retain these progress payments unless the Air Force accepted the work to which they pertained was delivered and accepted by the Air Force. 71 F.3d at 871-72. The taxpayer argued that none of the research was funded by the government because payment was contingent on success. The taxpayer urged that this question should be answered by looking to the four corners of the contract only. The taxpayer pointed to the contract terms that provided that progress payments could not be retained unless the work for which those progress payments was delivered and accepted by the Air Force. The government argued that under government defense contracts and the parties' course of conduct, repayment of progress payments was generally not expected. The government argued that the test should be that research is funded where repayment is likely or expected in the normal course of events. Fairchild at 872. The Court of Federal Claims agreed with the government, Fairchild Ind., Inc. v. United States, 30 Fed. Cl. 839, 94-1 U.S.T.C. 50,164 (1994). The Claims Court rejected the taxpayer's test and looked to both the contract and how the parties actually conducted their transactions . 94-1 U.S.T.C. at 83,715. The Court also rejected the government's proposed expected and likely test. Id. The Court found that at bottom the research was conducted with the government's money and that it was the government that bore the risk, notwithstanding that the ultimate payment might be subject to equitable readjustment. Id. The appellate court rejected the Claims Court's interpretation of the statute and regulation and essentially adopted the taxpayer's test. The Court reasoned as follows: Treasury Regulation 1.41-5(d)(1) provides that for the researcher to claim the credit, the amounts payable under the agreement must be contingent on success. The inquiry turns
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B. ***'s Position.
The position of the taxpayer is that all of the selected contracts are unfunded because *** bears the ultimate risk of liability if *** failed to perform. In other words, the taxpayer argues that *** is liable for breach of contract if it fails to perform pursuant to the terms of its contracts. *** derives this position from the general law of contracts, which is essentially derived from the common law. This position is described in the taxpayer's Response to ICR # 12, ***. According to the taxpayer, this liability does not need to be specifically described in its contracts because it is made a part of all contracts by the common law. As the Response states, ***, citing the Restatement (Second) of Contracts 346. Response at ***. The taxpayer views this liability as if it is an unwritten, implied term in all contracts. Response at ***. The taxpayer then makes the point that in order to avoid this liability it must substantially perform in accordance with the contract by providing a product that is free from defects and is fit for the intended purpose. It cites several cases, including Newcomb v. Shaeffer, 279 P.2d 409 (Colo. 1955) for this. Newcomb states, [t]he general rule is that a builder must substantially perform his contract according to its terms, and in the absence of contract governing the matter, he will be excused only by acts of God, impossibility of performance, or acts of the other party to the contract, preventing performance. Id. at 411. The taxpayer maintains that its position is fully supported by the Fairchild case. Fairchild Ind., Inc. v. United States, 30 Fed. Cl. 839, 94-1 U.S.T.C. 50,164 (1994). Implicit in Fairchild is that the government's right to refuse to make a progress payment or recover progress payments previously made is that such rights are enforceable. Enforceability is implied in law, even if not stated in the contract. Similarly, with respect to ***'s contracts, Enforceability is implied in law. The taxpayer's position is further explained in a letter to the examining agent dated ***, regarding the *** clauses found in many of the contracts. The response notes that the agent appeared to be concerned that the clause limited ***'s duties under the contracts to something less than success. The letter essentially reiterates the taxpayer's state contract law analysis described above. The letter cites additional cases for support.
D. Service Position.
While the contracts contain differing provisions and contractual language, such as differing payment obligations, acceptance provisions, provisions regarding progress payments, and insurance provisions, ***'s contracts may be grouped into two salient types. The first calls for the provision of ***. The second type calls for a combination of ***. All of the selected contracts call for design and consulting only, except for the contracts with *** and ***. *** is a ***. The *** contract includes the delivery of a ***.
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2. Judicial Interpretation.
The right to use requirement was interpreted by the Court of Appeals for the Federal Circuit in Lockheed Martin Corp. v. United States, 210 F.3d 1366 (Fed. Cir. 2000) rev'g 42 Fed. Cl. 485 (1997) in the context of a federal defense contract. The defense contracts in issue gave the government a nonexclusive right to use the research and a veto power over Lockheed Martin's right to transfer the research to third parties. The Court of Federal Claims found that Lockheed Martin's residual rights to use the research were incidental benefits rather than a substantial right. Reversing, the Federal Circuit found that the determination of whether a researcher retains substantial rights to use research must be made by reference to the contracts alone. Id. at 1376. The Court then found that the agreements gave Lockheed Martin the right to use the research. Id. Further, it found this right to be substantial because it permit[ted] Lockheed Martin to manufacture and sell up-to-date products meeting the needs of its clients. Id. Finally, the Court rejected an argument based on the recoupment provisions in the contracts. These provisions provided that Lockheed Martin would reimburse the government for a share of research costs if Lockheed Martin sold to third parties. The court held that these provisions did not bear on Lockheed Martin's own right to use. The Court thought that these provisions differed from a royalty based on sales and did not otherwise restrict the contractor's use of the items or technology. Id. at 1377.
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C. Conclusion
We conclude that, except for the *** contract, *** retained the right to use non-design and consulting product intangible property under the contracts. Furthermore, we believe that this right is substantial within the meaning of Treas. Reg. 1.41-5(d)(2). Blue prints, drawings specifications and the like are developed for a single purpose and may not be reusable or may require substantial modification. Know-how and discoveries may be reused in taxpayer's business and incorporated in other design work for other clients. The *** contract presents a different picture. It vests ownership of all intellectual property developed under the contract in *** except for a limited residual right to know how. The contract appears to reserve to *** something akin to the benefit of its experience, an incidental benefit under Treas. Reg. 1.41-5(d)(2). Consequently, except for the *** contract, we believe that *** retained the right to use the product of its research and that such right is substantial.
CONCLUSION
As stated, we conclude that, in general, ***'s contracts are not contingent on success where the standard of performance is that of a similar qualified design professional exercising due care. Where the contract requires substantial performance, warrants results, or the contract is governed by local law that applies a warranty of results standard, then the contract is contingent on results, and is therefore not funded. Also, it is our conclusion that,
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