Throughout the existence of the Research and Development Tax Credit, many of the United States’ most innovative companies have restricted themselves from receiving the benefits of the tax credit that is specifically designed to encourage their innovations. It is well established that many companies in various industries believe they do not qualify for the R&D Credit, but rather than take a broad stroke across general industry, this newsletter will specifically address concerns and solutions as they pertain to Defense Contractors.
By lowering the cost of doing business in the United States, the R&D Tax Credit is not only designed to encourage businesses to locate innovation teams on United States soil, but the credit is also intended to ensure that the United States maintains a high level of creative minds who are capable of ensuring the country’s defense in the event of a conflict. To clarify, from a defensive standpoint, the country must not only be prepared to re-tool in the event of a major conflict, but the country must also innovate to stay ahead of any major threats to the safety and well-being of the populous.
The relationship that defense contractors have with the government is specialized and is reserved to very few companies throughout the United States. That being said, there are many companies in this select group who benefit from the credit and who have paved the way for other defense contractors to do so as well.
In Fairchild Industries, Inc. v. United States, 71 F.3d 868 (Fed. Cir. 1995) the Federal Circuit addressed the initial hurdle for contract manufacturers. In Fairchild, the court addressed the issue of a research sponsor who agrees to pay for the costs of research regardless of the success of the project. Fairchild stands for the proposition that in a contractual arrangement, under which a customer agrees to pay a third party to perform research on the customer’s behalf, the party to whom the contract allocates the financial risk that the research will fail to achieve its objectives is entitled to claim the research credit. If the customer must pay for the cost of the services, even if the research does not achieve the hoped-for results, the customer is at risk and the research is funded and excluded from the definition of qualified research. If, however, the contract allows the customer to reject and refuse payment for research that is deemed to be unsatisfactory, then the contractor is at risk and the contract is unfunded. Id. at 873.
Despite Fairchild’s clarification of funded contracts regarding payment terms, many defense contractors remain concerned with taking the R&D Tax credit because they do not believe they can collect a credit from the United States government when the government is also their client. A major reason for this concern is that the United States government often has specific language in contracts that restricts some aspects of the defense contractor’s intellectual property rights. Many inventions or innovations that result from the research performed under a government contract result in a shared ownership right between the contractor and the United States government. There also exist requirements that a defense contractor must obtain permission and reimburse the government for research expenses if the contractor decides to commercialize an aspect of the research.
The above referenced concerns were directly addressed in Lockheed Martin Corp. v. United States, 210 F.3d 1366 (Fed. Cir. 2000). The interpretations of the court in the Lockheed Martin case has led to the case being considered the seminal case to determine when a taxpayer retains “substantial rights” in research. In short, when it is determined that a contractor retains substantial rights the research is considered as an exception to the funded research restrictions; thus being considered unfunded.
The Lockheed Martin cases establishes that a researcher in a contractual arrangement possesses substantial rights in its research for purposes of the funded research exclusion so long as it retains the rights to use the research results in its trade or business without having to pay the customer, even if the researcher’s rights in the research are not exclusive (i.e., the customer also has rights to the research).
To simplify the Lockheed Martin decision as it pertains to defense contractors, one can focus on the fact that the court stated how export control laws and top secret classifications are irrelevant when determining if a defense contractor holds the substantial rights necessary to claim the credit. Id. at 1375. Even if a defense contractor is not permitted to sell the specific product resulting from the contracted research, but is allowed to benefit from the research by using the knowledge gained “to manufacture and sell up-to-date products meeting the needs of its customers”, then it satisfies the requirement of maintaining substantial rights. Id. At 1376.
Since Lockheed Martin was handed down, one Internal Revenue Service advisory and two cases have addressed the substantial rights test. In 2002 NSAR 20350, the IRS interpreted Lockheed Martin as follows: “[I]t is our conclusion that, except where a contract has explicit provisions granting ownership of all intangible or intellectual property (not merely designs, specifications, blueprints and the like) to the client, [the taxpayer] retains substantial rights.” Under the rationale of this IRS advisory, the only instance where a researcher does not have substantial rights is where the relevant contract explicitly grants all ownership rights in the intellectual property resulting from the research to the customer.
In Union Carbide Corp. v. United States, T.C. Memo. 2009-50 (2009), the IRS argued that the taxpayer’s testing of an experimental process inhibitor in one of its manufacturing plants was funded because, had the test been successful, the taxpayer would have been required to license the inhibitor from the inhibitor’s manufacturer in order to use it at the taxpayer’s plants. The Tax Court rejected this argument based on its findings that the taxpayer had retained all rights to use the results of its own research to test the inhibitor, and that the information the taxpayer gained during the plant experiment was valuable regardless of whether it ultimately licensed the inhibitor. Id. at 87.
Most recently, in Dynetics, Inc. v. United States, 121 Fed. Cl. 492 (2015), the Court of Federal Claims addressed whether the taxpayer, an engineering firm, retained substantial rights in its research results in two of seven sample contracts at issue in the case. The information shared with Dynetics to aid in the completion of the project, was top secret and imposed strict security requirements. As a result, it was determined that the classified intelligence information used by Dynetics to perform the contract permeated the work to the extent that Dynetics was prohibited from using or exploiting the results of its research. Due to the atypical nature of this defense contractor’s specific situation, the court summarized its analysis as follows: “The security requirements simply leave Dynetics with no right to use the results that contained intelligence information, without government authorization.” Although, the court did rule that Dynetics was limited in its collection of the R&D Tax Credit, it affirmed prior case law and clarified discrepancies regarding specific compensation structures.
When deciding whether to perform a study within the company, it is understandable that the complex nature of the issue may discourage participation in benefiting from the credit. Contract reviews must be performed to analyze whether the above requirements are met, and these reviews are in addition to the analysis of whether activity meets the basic requirements of the R&D Tax Credit.
Although the topic of defense contractors and the R&D Tax Credit is very technical, defense contractors can and should go after the credit. The above cases show how the courts have become more taxpayer friendly throughout the years, and how the courts presented clarification on complex issues.
To offset any concerns defense contracts may have, Apex Advisors utilizes 20 years of experience, and a team of professionals that includes attorneys and CPAs, as well as professionals who have experience working at the IRS as agents and attorneys. All of Apex’s studies involve a thorough contract review to analyze what projects are qualified under the above rules.
This article was authored by David Porada, J.D. with major contributions from John Kim, J.D., CPA. As this article is intended to be brief, it is not all encompassing. To discuss the topic in more detail, or to discuss other related topics, please call the offices of Apex Advisors, or David Porada directly at 248.259.7421.
