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IRS Rejects Process R&D Credit Claim
By Patrick Donahue

Another tax court case, another taxpayer loss; new fears.

Union Carbide Corporation v. Commissioner was litigated to determine if Union Carbide’s process development and improvement projects qualified for the IRC §41 tax credit. The tax court’s ruling against a majority of Union Carbide’s claim led to clients, accounting firms, and contemporaries to say:

“I am concerned over ... credits generated from expenses attributed to improved production processes instead of product development in light of the [Union Carbide Corporation v. Commissioner of Internal Revenue Service] outcome.”

But hold on, taxpayers can take a lot of positives from the ruling if you look into the courts analysis. The judgment addresses three issues that are points of contention during IRS audits.

Qualified nature of production process development
The tax court’s findings¹ do not say that production process development is not qualified for the IRC §41. In fact, one of the five production process development projects in question is recognized as qualified research by the court. The court states in the summary,

“...the technology need not be in the very beginning stages of development; the taxpayer need only be uncertain as to whether the technology would improve a product or process... Because the tests were met and the corporation adequately substantiated its testing, the project qualified for the credits.”

Essentially, this statement demonstrates the court recognizes improvements to mature production processes may involve technological uncertainty and a process of experimentation. 

Although, this does not mean every process improvement project qualifies for the credit. Three of the five litigated projects were rejected outright. Two of these three projects involved implementing existing technologies that did not rise to the “level of uncertainty” that is required by IRC §174. The third project is a little bit more unclear as to why it was rejected. The court states,

“The third project's research activities were designed to resolve uncertainty; however, the activities did not constitute a process of experimentation because the project did not sufficiently evaluate the results beyond the conclusion that the process satisfied the company's needs. Although the data collection was extensive, it did not constitute a process of experimentation because it was not followed by meaningful analysis.”

It looks like Union Carbide did follow an evaluation process of determining what they needed to do, much like a company does to spec out new equipment. The problem is that they did not follow this research up with subsequent design work. The rest of the activities were given to another group to perform. Therefore, while they were part of the development process they did not actually perform the qualified research themselves. Their only role in the process was a defining role which is characterized as routine engineering.

Companies and accounting firms should understand that while production process development can qualify for the credit, it is still difficult to substantiate. R&E credit service providers need to understand production process development qualifies for the IRC §41 only if the process of experimentation follows a DMAIC model and the project has a “level of uncertainty”. The level of uncertainty test is the most difficult test to overcome because many engineering functions rely on existing technologies. Union Carbide’s lost two of the projects because they did not fully understand this test’s requirements. 

Oral Testimony Validity
The focus of the April 2007 Tier 1 memo issued by the IRS was to increase the documentation threshold for substantiating research credit claims. Since then IRS auditors have almost completely discounted the validity of oral testimony to aid in substantiating qualified wages. 

The court in the Union Carbide case recognized that the IRS’s stance on this issue did not mirror the legislative intent for reasonable substantiating documentation. The court specifically referenced Cohan v. Commissioner. That court ruled that a “close approximation” of qualified research wages supported by oral testimony that is supplemented with contemporaneous engineering documentation is sufficient. 

The Cohan and Union Carbide rulings endorse oral testimony as credible evidence for quantifying research wages; as long as it is supported by engineering documentation providing nexus between individuals and qualified activities. 

Base Period Documentation
Traditional and Start-up Rules calculation methods for IRC §41 require taxpayers to establish qualified research expenditures that were incurred anywhere from five to twenty-five years ago. During this time these taxpayers have almost undoubtedly changed their accounting methods/systems. 

Since Union Carbide does not have the same documentation for the base period as they do for current claims, the IRS argued this violates the “consistency rule” for substantiating a claim. The court discounted this argument, stating that while the documentation was different the quantification of qualified research expenditures remained consistent. 

Union Carbide was able to provide the court with substantial engineering documentation to substantiate the technical merits of qualified and non-qualified activities. Since this documentation could be coupled with accounting documentation that quantified the expenses related to each activity, the court ruled that the documentation was sufficient. This decision gives taxpayers freedom to produce the most accurate argument for base period qualified research expenditures regardless of current year documentation availability. 

Conclusion
While this decision is a big hit for companies that claim significant credits for production process development activities, it also provides stronger support for other claims. Production process improvements from kaizen events or 6Ò projects do not provide safe harbor for IRC §41. The projects must meet the technical standards established by the regulations. But taxpayers are provided with some additional ways to establish these claims with the reinforced validity of oral testimony and more lax documentation consistency requirements.

¹TC findings

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