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By Kendall B. Fox, Paul W. Eldridge, and Joseph F. Maselli PricewaterhouseCoopers, LLP Los Angeles, CA and New York, NY
An IRS Audit Techniques Guide on Research Tax Credit Claims (“ATG”) and the recently released “Attachment E” to the Guide, LMSB-04-0508-030, calls into question the amount and nature of substantiation that a taxpayer must produce in order to support a credit for increasing research activities. The ATG seeks to require taxpayers to utilize what is characterized as “contemporaneous” documentation as the only way to support the credit.
This ATG constitutes a change to a long established IRS policy of accepting the cost center or departmental approach to establish the credit. Prior ATGs specifically recognized the use of cost center accounting as a prevalent business practice, and the use of after-the-fact surveys as an acceptable method of making required allocations.
The prior ATG's directed examiners to focus on:
• the nature of the research activities;
• the reasonableness of the survey allocations;
• interviewing the engineers to understand specific roles in research and the basis for the allocations; and
• the availability of other records to support the allocations.
The ATG now takes the positions that a taxpayer is ineligible for a credit unless a taxpayer:
• Accounts for research activities on a project basis; and
• Contemporaneously records time spent on research activities as those activities occur.
In an attempt to support these two new positions, three court cases are cited in the ATG for the proposition that a taxpayer must meet a contemporaneous recording of employee time requirement and maintain contemporaneous accounting records in a project accounting format in order to satisfy the recordkeeping requirements of §6001. The ATG, however, appears to be directly contrary to Treasury's final regulations and legislative history of the credit.
Final Regulations and Recordkeeping Requirements
The ATG's conclusion that the failure of a taxpayer to contemporaneously account for its activities on a project basis (the recording of engineering activities by employees in a time system) precludes the taxpayer from claiming the credit is incorrect.
In various versions of proposed regulations and the 2001 final regulations that were subsequently withdrawn, Treasury considered and rejected a requirement that contemporaneous records be created and kept by taxpayers to prove entitlement to the research credit.1 Treasury has specifically acknowledged that a requirement to keep such records (any regulatory requirement for contemporaneous research credit specific documentation) would be additive to, rather than embedded within, the general recordkeeping requirement under §6001.
The final regulations recognize that substantiating the research credit can be difficult for a taxpayer, and that the administration of the credit may be difficult for examination. Nonetheless, Treasury made clear that this difficulty does not preclude taxpayer entitlement to the credit. What is clear from the history to the final regulations and the legislative history is that the focus should be on the nature of the taxpayer's activities, not on the types of records that are kept, so long as the records are usable enough to form a reasonable basis for calculating the research credit.2
The ATG uses the term contemporaneous documentation as synonymous with project accounting. However, there is no authority found in the statute, regulations, or legislative history to support such a contention. In fact, recognition that capturing costs in departmental cost centers as one way to support research activities is well documented in the history to the regulations.3 It is also recognized on page 6 of the Research Credit Audit Techniques Guide, dated June of 2005, that a departmental or cost center approach is acceptable.4
The IRS has provided little guidance or otherwise put taxpayers on notice as to the types of records that must be kept to support the credit.5 Any such requirement imposed upon a taxpayer by the IRS that they must now have a specific type of record (contemporaneous timekeeping) that is not kept by most taxpayers in the ordinary course of business is not only unfounded, but directly contradicted by, the extensive discussion of, and changes to, the recordkeeping rules in the legislative and regulatory history. In fact, Treasury expressly requested comments on establishing recordkeeping rules to facilitate compliance. Since such additional guidance did not previously exist, and has never been published, a taxpayer could not have been put on notice as to the types of records that need to be kept.
Treasury specifically acknowledged that the general recordkeeping requirement would apply to the “process of experimentation” test; and, that no additional contemporaneous records would be required.6
Clearly, the fact that a taxpayer utilizes cost center accounting does not preclude that taxpayer from claiming the credit.
Fudim, McFerrin and Eustace
The IRS presents the position that the type of evidence produced by a taxpayer prevents taxpayers from claiming the credit. The IRS seeks to use the Fudim v. Comr.,7 U.S. v. McFerrin,8 and Eustace v. Comr.,9 to support this position.
In Fudim, the IRS argued that the taxpayer, his wife and his daughter were not entitled to the credit due to the lack of contemporaneous recording or logging of time to the research project. Mr. Fudim and his wife were noted scientists who had developed a unique modeling process for fabricating plastic objects. The Tax Court in Fudimrejected the IRS position and allowed the time spent on the project on the basis of all of the records presented, including his and his wife's educational background, patents, contemporaneous articles and technical documents, and his oral testimony of his and his wife's activities. The Tax Court did not allow the activities of the daughter to qualify, but only because Fudim did not present any evidence of what her activities entailed that would be eligible for the credit (not because she didn't maintain time records).
In Eustace, the Tax Court did not allow the credit for work performed by employees of an S corporation engaged in computer software development. The taxpayer sought to establish the credit based upon a reconstruction of the projects by a tax director who conducted oral interviews of the company employees. The Tax Court found that:
petitioners' reconstruction of qualifying expenses was unreliable, inaccurate, incomplete, and wholly insufficient to establish what various workers did and whether such expenses qualify for the research credit. In addition, petitioners failed to have their computer expert address technical issues relevant to the case, and, as noted below, the testimony of petitioners' witnesses further supports our conclusion that work performed by Applied Systems' employees, during the years in issue, does not qualify for the research credit. [Emphasis added.]
The IRS, ignoring the factual basis for the opinion, misconstrued the finding of the Tax Court and asserted that the case was a condemnation of the methodology used by the taxpayer. This IRS interpretation does not properly account for several significant factors which must be understood in order to put the case in its proper context. These factors are:
• The Tax Court accepted the testimony of taxpayer's employees, including the individual who prepared the claim as evidence.
• The court, however, found the evidence to be unpersuasive (not inadmissible).
• A review of the transcript of the testimony of the individual that prepared the claim reveals that:
• The Tax Director conducted oral interviews of department level managers.
• The Tax Director only asked the manager questions related to the permitted purpose of the credit, he did not ask detailed questions regarding all of the elements necessary to establish that research occurred.
• It is unclear, but it does not appear that the research credit rules were explained to the technical employees who were interviewed.
• The results of the interviews were entered into the spreadsheet as an overall qualified research percentage, with no explanation as to what were the underlying activities of the employees.
• There were no surveys or other allocations of time completed by the cost center managers with first-hand knowledge of the research activities.
• There was no preparation of narratives discussing each of the research projects and a related technical discussion concluding that each of the four tests of §41(d) were met by the taxpayer.
• The testimony of Eustace's own witnesses directly contradicted and undermined the credibility of the qualified research percentages entered into the spreadsheet.
The Seventh Circuit in affirming Eustace specifically acknowledged that its decision was made, “without the benefit of the regulations that are supposed to illuminate the path to decision.” The Seventh Circuit went further and indicated once regulations were issued the tests the Tax Court had evaluated to deny the credit could be different and the outcome of future cases could also be different as a result. As the Seventh Circuit put it: “in the long run, neither our view nor the [T]enth circuit's has staying power.”10
Finally, the IRS cites McFerrin, an unpublished decision, as support for its contention that contemporaneous records must be kept in order to successfully support the credit.
However, the McFerrin case is of little help to the IRS for the following reasons:
• The court failed to follow the final regulations 11 and uses the discovery test, and other provisions, rejected by the final regulations.
• Despite the erroneous application of law, once the court found no qualifying research, by logic, any cost reconstruction concluding that qualified expenditures were incurred is by definition moot.
• The court misquoted Eustaceby stating that the Eustace court concluded that “[i]nterviewing employees to reconstruct activities believed to qualify is [an] 'unreliable, inaccurate, incomplete and wholly insufficient’ method of determining what employees did and whether such expenses qualify for the research credit” -- Eustace reached no such conclusion, instead the court focused on the “petitioner's reconstruction” as being inaccurate and unreliable, not that any process that in whole or in part relies upon interviews is “unreliable, inaccurate, incomplete, and wholly insufficient.”
• The fact that the court found that the reconstruction and witness testimony used by the taxpayer in Eustace was unreliable does not extend to whether the admissibility and weight of such evidence in other situations could or would sustain the credit. In short, the case must be limited to its facts.
• The Federal Rules of Evidence allow for the admission of a wide variety of oral and documentary evidence.12 Testimonial evidence and evidence seeking to reconstruct qualified research activities is admissible. The teaching of Eustace is that the weight given such evidence depends on its credibility.
• The IRS ignored an important statement by the McFerrin court that estimates can be acceptable once a taxpayer has met its burden proving that qualified research has taken place. Contrary to what the IRS has tried to argue, the Cohan13 rule still lives and should be utilized in appropriate situations.
Based upon the above discussion of the facts and holdings in Fudim, Eustaceand McFerrin the following conclusions apply:
• A methodology of calculating the research credit that relies upon:
• well conducted and documented interviews;
• supported by the attestations from individuals in the form of Surveys that detail the activities of the employees;
• supplemented with additional evidence (patents, technical articles and documents); and
• credible oral testimony that corroborates (rather than undermines the evidence (Eustace)) that the taxpayer in fact engaged in qualified research, will be acceptable by a court (just as this evidence was accepted by the court in Fudim).
• Likewise, poorly documented research activities with evidence that does not establish that qualified research took place, will not be allowed by a court, similar to the findings in McFerrin and Eustace.
The IRS in its latest ATG appears to be focused on disallowing credits based upon a bright-line test that attempts to limit and mandate the only type of evidence that can be presented by a taxpayer. This position results from a complete misreading of the authorities cited in the ATG. Rather, the courts look to the quality of the evidence presented, not the quantity or type of evidence. Additionally the IRS has sought to implicitly require that taxpayer records be maintained through use of project accounting; however, there is no authority to support this view.
For more information, in the Tax Management Portfolios, see Cohen, 556 T.M., Research and Development Expenditures, and in Tax Practice Series, see ¶3160, Research Credit.
1 Preamble to the 2003 final regulations, T.D. 9104, 2004-6 I.R.B. 406.
3 Preamble to the 2001 proposed regulations, 2002-4 I.R.B. 404.
4 Audit Techniques Guide: Credit for Increasing Research Activities (i.e. Research Tax Credit) IRC §41 - Substantiation and Recordkeeping, Publication Date - June 2005.
5 Id. at 3 and Preamble to the 2003 final regulations, T.D. 9104, 2004-6 I.R.B. 406.
6 Preamble to the 2003 final regulations, T.D. 9104, 2004-6 I.R.B. 406.
7 T.C. Memo 1994-235.
8 2008-2 USTC ¶50,583 (S.D. Tex. 2008).
9 T.C. Memo 2001-66, aff'd, 312 F.3d 905 (7th Cir. 2002).
10 312 F.3d at 908.
11 Both Eustaceand Fudim were decided before the final regulations were adopted.
12 Fed. Rul. Evid. 401.
13 Cohan v. Comr., 39 F.2d 540 (2d Cir. 1930).
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