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By David I. Kempler, Esq. and Elizabeth Carrott Minnigh, Esq.
Buchanan Ingersoll & Rooney PC, Washington, DC
In Union Carbide Corp. v. Comr., No. 11-2552 (2d Cir. 9/7/12), the Second Circuit affirmed the Tax Court's decision (T.C. Memo 2009-50) that disallowed research credits under §41, for costs of supplies utilized in connection with qualified research on the grounds that those costs would have been incurred in the absence of the research. The Union Carbide decision effectively limits the research credits to direct expenditures for research, and may be costly for manufacturers who previously relied upon a broad reading of §41.
Union Carbide Corporation (UCC) conducted three research projects at two production plants during the 1994 and 1995 tax-credit years. UCC conducted research on products that were in the process of being manufactured for sale and were in fact sold. Rather than merely claiming a research credit for the additional costs of supplies associated with the research, UCC claimed research credits totaling more than $18 million for the costs of all the supplies used in the production of the product even though those supplies would have been used regardless of any research performed.
Section 41(a)(1) and (b)(2)(A)(ii) allows a credit for the cost of supplies "used in the conduct of qualified research." Section 41(d)(1) provides that to be a qualified research: (i) the research must be eligible as research under §174; (ii) the research must be undertaken for the purpose of discovering information that is technological in nature; (iii) the taxpayer must intend for the discovered information to be useful in the development of a new or improved business component; and (iv) substantially all of the research activities must constitute elements of a process of experimentation. Section §41(d)(2) provides that tests must be applied separately to each "business component." Under §41(d)(2)(C), the development of an improved process is a separate business component from the product that is being produced.
After a bench trial, the Tax Court held that a portion of the costs for supplies used by UCC for two of the projects were not creditable as an "amount paid or incurred for supplies used in the conduct of qualified research" because they were "[r]aw materials used to make finished goods that would have been purchased regardless of whether [UCC] was engaged in qualified research." The Tax Court also held that the third project did not fulfill "the process of experimentation test" because UCC did not perform any post-testing analysis or comparisons of the data collected.
UCC appealed the two denials of the research credit for the two projects are deemed to be qualified research. UCC argued that, under the plain language of §41(b)(2)(A)(ii), it was entitled to the cost of all supplies "used in the conduct of qualified research." Specifically, citing Webster's Third New International Dictionary, UCC argued that, "the plain and ordinary meaning of the term "use" is to "put into action or service," "employ," "carry out a purpose or action by means of," "make instrumental to an end or process," "utilize," "expend or consume by putting to use," "apply," and "any putting to service of a thing." "
The Second Circuit held that this language was not sufficiently clear as to be determinative without further inquiry. Firstly, the Second Circuit rejected the proposition that the dictionary definition was dispositive. Secondly, the Second Circuit stated that UCC's analysis improperly focused on the meaning of a single word "used," rather than the complete phrase "used in the conduct of qualified research."
The Second Circuit agreed with the Tax Court and the IRS that the costs for which UCC sought a research credit were "indirect research costs," that were excluded from the definition of qualified research expenses under Regs. §1.41-2(b)(2). The Second Circuit acknowledged that the regulation, however, was not clear as to how one distinguishes between direct and indirect research expenses. However, the Second Circuit concluded that it must "ordinarily give deference to an agency's interpretation of its own ambiguous regulations,"1 unless the interpretation is "plainly erroneous or inconsistent with the regulation," "conflict[s] with prior interpretation" of the same regulation or is a "convenient litigating position" or a "post hoc rationalization advanced by an agency seeking to defend past agency action against attack."2 Here, the Second Circuit found that was none of the foregoing justifications for withholding deference. Moreover, the Second Circuit concluded that the interpretation was consistent with the legislative history on the purposes for the enactment of §41, which the Second Circuit perceived as providing "a credit for the cost that a taxpayer incurs in conducting qualified research that he would not otherwise incur."3
The Second Circuit further concluded that if the research credit included the costs of supplies that the taxpayer would have incurred regardless of any qualified research it was conducting it would create "an unintended windfall." Citing Cabell v. Markham,4 the Second Circuit reasoned that the IRS could not be compelled to adopt a construction that was not necessarily consistent with the purpose of the credit for increasing research activities. Accordingly, the Second Circuit affirmed the decisions of the Tax Court and upheld the disallowance of UCC's claimed research credits.
The Union Carbide decision effectively limits the costs allowed as process qualified research expenditures to the direct costs incurred as a result of the research element, without including a portion of the production costs themselves. Although the extent of the impact of the Union Carbide decision remains to be seen, the decision may be costly to manufacturers who have claimed research credits based on a broader reading of the statute. However, the applicability of the research credit is a very fact-intensive analysis. The facts of Union Carbide were unsympathetic in that UCC sought a credit for costs that unquestionably would have been incurred without the research and the processes were used to produce products which were sold.
For more information, in the Tax Management Portfolios, see Fox, Bowers, Shanahan and Maselli, 556 T.M., Research and Development Expenditures, and in Tax Practice Series, see ¶3160, Research Credit.
3 H.R. Rep. No. 97-201, at 111 (1981) (stating that this "substantial tax credit for incremental research and experimentation expenditures will overcome the resistance of many businesses to bear the significant costs of staffing, supplies, and certain computer charges which must be incurred in initiating or expanding research programs.")
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