The court ruled that chemical manufacturer Union Carbide Corporation (UCC), a wholly owned subsidiary of Dow Chemicals, was not entitled to claim R&D credits for the costs of supplies involved in a research production process, because the process produced a saleable product.
Background
The dispute concerned whether supplies eligible for R&D credits for research relating to an improved manufacturing process, included the cost of the raw materials that are run through the experimental process – where the taxpayer was able to sell the product of the experimental process.
The court was asked to decide whether the cost of the components used in the experimental process was a direct research expenditure, which is eligible for R&D credits, or an indirect expenditure, which is not eligible.
UCC's claim related to three production processes for three chemicals it was manufacturing. UCC was experiencing some issues with their processes and experimented with a new approach for a limited number of production runs and analysed the impact.
However, since this R&D did not alter the quality of the chemicals produced, UCC was able to sell them.
An earlier decision by the US Tax Court had held that UCC was not entitled to claim R&D credits for the entire amount spent on the supplies, reasoning that UCC would have ordinarily have incurred these costs in normal production.
Ruling
The appeals court agreed with the Tax Court that the costs of the supplies UCC was claiming for are “at best indirect research costs” and therefore could not be characterised as qualified research expenses, which would have been eligible.
The court said it agreed with the position of the IRS, stating the purpose of R&D credits “is to provide a credit for the cost that a taxpayer incurs in conducting qualified research that he would not otherwise incur”.
Roseann Cutrone, of Skadden, Arps, Slate, Meagher & Flom, said the ruling will greatly impact credit claims of manufacturing companies doing manufacturing process research in the second circuit.
“For now the decision technically only impacts companies within the second circuit but practically, it will impact the IRS's position in settling these claims throughout the country,” said Cutrone.
“I think the case only applies to manufacturing process research. If the taxpayer were developing a product and buying supplies to make the product in order to conduct research, it is hard to say that they would have incurred these expenses anyway. It is possible, however, that the IRS could attempt to extend this decision to the cost of prototypes that are intended for sale, if the research proving that the product works is successful,” she added.
Implications
Michael Solomon, of Fenwick & West, said few companies will adopt such an extended position as UCC, but the court’s ruling still leaves an unanswered question regarding the application of R&D credits when manufacturing a product is entwined with research activities.
“The section 174 regulations clearly provide that producing a ‘onesy’ where research is necessary to develop the product/process often involves qualifying 174 research,” said Solomon.
There is no specific guidance on where or how to draw the line but in the Tax Court’s ruling on UCC, it said the activities of UCC in the two projects where process research was found to occur were “primarily” production activities.
“What is produced in the primary production activity is unlikely to be a supply as that term is defined in our tax law. A supply is consumed in the research activity, not produced and available for sale to customers,” said Solomon.
“The comment, however, leaves open the question of whether supply costs in an activity that is primarily a research activity can qualify even if there is incidental production. There is a compelling position that if one needs to produce a product, or develop a production process, to determine through a process of experimentation if the product design or process works, then the activity may be primarily research, and the UCC decision may not control in such a case,” he added.
Taxpayers will clearly be in a stronger position to make a claim if the items produced in the research activity cannot be sold as a finished product, but require the supply item to be remanufactured after testing.
Solomon said where the line between research and production is blurred, the IRS has often allowed taxpayers to carve out the research costs by attributing the standard cost of production to the finished goods and thereby treating any variance in total cost to standard as a supply cost of researching better product or process design.
“To achieve this result, it is necessary to show that the incremental costs are due to research in process or product components and that the incremental costs were consumed in the research effort and not really delivered to the customer as a finished product,” said Solomon.
“Bottom line is that UCC tried to take too much in the supply category rather than make a good faith effort to bifurcate the supply costs consumed in the research and the production costs embedded in the produced end-items,” he added.
One of the judges added a concurring opinion which made a case that Congress had perhaps intended for such supplies to be included in the R&D credit.
“The concurring opinion said it is possible that Congress wanted to include these costs in the credit when it drafted the legislation but had it intended this, it needed to be more careful in making the statute reflect this,” said Cutrone.
“It almost gives an invitation to Congress to address this if it was indeed its intention,” she added.
Union Carbide declined to comment on the ruling. They would need to take the case to the Supreme Court if they wished to appeal, however Cutrone said it is highly unlikely they will do so.
“If we had a decision going the other way in another circuit, then I could see an appeal to the Supreme Court considered, but it is likely too early for such an appeal to be considered by the Supreme Court,” said Cutrone.
The taxpayer was represented by Harold Heltzer, of Crowell & Moring.
