Source: https://www.irs.gov/businesses/corporations/aerospace-industry-audit-techinques-guide-january-2005
Timestamp: 2020-01-27 01:44:59
Document Index: 542224937

Matched Legal Cases: ['§ 174', '§ 41', '§ 1', '§ 1', '§ 1', '§ 1', '§ 1', '§ 1', '§ 1', '§ 174', '§ 1', '§ 1', '§ 174', '§ 1', '§ 174', '§ 1', '§ 1', '§ 1', '§ 1', '§ 41', '§ 1', '§ 41', '§ 1', '§ 1', '§ 41', '§ 1', '§ 41', '§ 1', '§ 1', '§ 41', '§ 1', '§ 41', '§ 41', '§ 41', '§ 41', '§ 41', '§ 41', '§ 301', '§ 6110', '§ 41', '§ 41']

Aerospace Industry Audit Techinques Guide January 2005 | Internal Revenue Service
Aerospace Industry Audit Techinques Guide January 2005
An expenditure must be treated as an expense under IRC § 174 to be a qualified research expenditure. IRC § 41(d)(1)(A). Treas. Reg. § 1.174-2(a)(1) defines the term "research and experimental expenditures" as:
Note that testing to determine if the design of a product is appropriate is not considered "quality control testing," and thus is not excluded from the definition of research and experimental expenditures by Treas. Reg. § 1.174-2(a)(3). Rather, quality control testing is testing or inspection to determine whether particular units of materials or products conform to specified parameters. Treas. Reg. § 1.174-2(a)(4).
The expenditures must be reasonable in amount under the circumstances. Treas. Reg. § 1.174 - 2(a)(6).
Research and experimental expenditures include costs incident to the development or improvement of a product. The term "product" includes any pilot model, process, formula, invention, technique, patent, or similar property, and includes products to be used by the taxpayer in its trade or business as well as product to be held for sale, lease, or license. Treas. Reg. § 1.174-2(a)(2). However, research or experimental expenditures do not include expenditures for the acquisition of another's patent, model, production or process. Treas. Reg. § 1.174-2(a)(3)(vi).
Research and experimental expenditures can also include expenditures paid or incurred for research or experimentation carried on in the taxpayer's behalf by another person or organization. Treas. Reg. § 1.174-2(a)(8).
However, expenditures for research or experimentation carried on in the taxpayer's behalf by another person are not eligible for IRC § 174 treatment, to the extent that they represent expenditures for the acquisition or improvement of land or depreciable property, used in connection with the research or experimentation, to which the taxpayer acquires rights of ownership. Treas. Reg. § 1.174-2(a)(8).
Expenditures for research or experimentation which result, as an end product of the research or experimentation, in depreciable property to be used in the taxpayer's trade or business may, subject to the limitations of Treas. Reg. § 1.174-2(b)(4), are allowable as a current expense deduction under IRC § 174(a). Treas. Reg. § 1.174-2(b)(2).
Expenditures for research and experimentation that are incurred in connection with the construction or manufacture of depreciable property by another are deductible under IRC § 174(a) only if made upon the taxpayer's order and at his risk. Treas. Reg. § 1.174-2(b)(3).
However, no deduction is allowed if the taxpayer purchases another's product under a performance guarantee (whether express, implied, or imposed by local law) unless the guarantee is limited, to engineering specifications or otherwise, in such a way that economic utility is not taken into account. Treas. Reg. § 1.174-2(b)(3).
Deductions for expenditures in connection with the acquisition or production of depreciable property to be used in the taxpayer's trade or business are limited to amounts expended for research or experimentation. Amounts expended for research or experimentation do not include the costs of the component materials of the depreciable property, the costs of labor or other elements involved in its construction and installation, or costs attributable to the acquisition or improvement of the property. Treas. Reg. § 1.174-2(b)(4)
Supplies = tangible property other than land, improvements to land and property of a character subject to the allowance for depreciation. Special consideration for utilities - generally considered G&A (not QREs), but it is possible that extraordinary expenditures for utilities may qualify.
Performed "on behalf of” taxpayer.
Contingent on Success - The regulations provide that amounts payable under any agreement that are contingent on the success of the research, and thus paid for the product or result of the research, are not treated as funding. Treas. Reg. § 1.41-4A(d)(1). Therefore, if the taxpayer performing the research is paid for its research, regardless of whether the research is successful, then the research is funded and is excluded from the definition of qualified research by IRC § 41(d)(4)(H). On the other hand, if the taxpayer performing the research is paid for its research only if it’s successful, the research is not funded under this test.
Substantial Rights - If the taxpayer performing research for another retains no substantial rights in the research under the agreement providing for the research, the research is treated as fully funded, and no expenses paid or incurred by the taxpayer in performing the research are qualified research. Treas. Reg. § 1.41-4A(d)(2). If the agreement confers exclusive rights to exploit the research on someone other than the taxpayer, the taxpayer does not have substantial rights in the research and the research is treated as fully funded. A taxpayer does not retain substantial rights to the research if it must pay for the right to use the results of the research. Incidental benefits to the taxpayer from performance of the research, e.g., increased experience in a field of research, do not constitute substantial rights in the research.
The Lockheed contracts also included a recoupment provision, which the Service argued required Lockheed to pay the government for the right to use the results of its research. The appellate court disagreed, finding that the recoupment provision did not restrict Lockheed's right to use the results of its research. Rather, the court found that the provision was a cost recovery mechanism, by which the government recovered some of the cost of its research and development. In contrast, the court determined that a provision requiring payment for the right to use research is generally a royalty, based on sales of the product. The appellate court reversed the lower court, finding that Lockheed had retained the right to use its research without paying for that right.
The agent should determine whether the research performed by the taxpayer is funded whenever it is performed pursuant to a contract. Following are some considerations which may impact the agent's review:
Progress payments are made by the U.S. Government as the contractor's work progresses, typically based on the percentage of work completed or the attainment of a contract milestone or phase. A progress payment becomes "liquidated" upon acceptance and delivery of the property contracted for by the government. Prior to liquidation, the contractor is at risk and may be required to refund unliquidated progress payments if the contract is terminated for default or convenience of the government. Accordingly, such payments may be viewed as a form of non taxable financing. Given that the progress payments were potentially refundable to the government, the appellate court in Fairchild determined that research related progress payments received by the taxpayer were not subject to the funded research exclusion. The taxpayer still had performance risk and if unsuccessful may have been required to refund the unliquidated progress payments to the government. Thus, the receipt of progress payment is not a barrier to the research credit if qualifying activities are performed.
The term "cascading research credit" is typically used by Service personnel to refer to situations where more than one taxpayer claims the research credit for the same item. This typically occurs when the prime contractor subcontracts work to another:
Example: A enters into a contract with the government for the design, development, manufacture and delivery of a developmental jet aircraft. A, as the prime contractor, subcontracts a subcomponent of the aircraft to B for a fixed price. A treats the amount paid for the subcomponent as an amount paid for supplies used in the conduct of qualified research, and claims the research credit on this amount. B engages in qualified research to design and develop the subcomponent, and likewise claims the research credit with respect to its development effort. The research credit with respect to the subcomponent is said to have "cascaded" from A to B.
The agent should verify the taxpayer's claimed supply expense to ensure that the amount only includes non depreciable tangible property acquired by the taxpayer that was used in the performance of qualified services by an employee of the taxpayer. There has been a trend to include a myriad of non-qualified costs in the research credit computation by claiming such costs are supplies. The examiner should carefully scrutinize prototype expenditures to determine whether the prototype is (or contains) property of a character subject to an allowance for depreciation. Additionally, taxpayers often incorrectly treat as a supply expense the general and administrative costs related to self constructed supplies.
Often, cascading credit situations at the prime contractor level involve fixed-price contracts with milestone payments, one of which is for the delivery of an intangible design, and a subsequent payment for the delivery of the tangible embodiment of the design. Given that the prime contractor is paying for the subcontractor's research, the prime contractor is at best limited to claiming the intangible design as a contract research expense (not a supply expense). However, the prime may likewise be unable to claim the expense as contract research due to the funded research exclusion, if the milestone payment for the intangible design is contingent on success of the subcontractor's research. The tangible embodiment is the product of contract research undertaken on behalf of the prime by the subcontractor, and must be evaluated as such, i.e., it is not a supply expense. However, given that payment for the tangible embodiment was contingent on the success of the subcontractor's research, i.e., the intangible design, the cost of the tangible embodiment is excluded as funded research. This analysis is typical for cascading credit situations involving fixed-price contracts at the prime contractor level.
At the subcontractor level, the chief consideration in the context of the cascading credit is typically whether the funded research exclusion of IRC § 41(d)(4)(H) applies. This requires a determination as to whether: 1) payment for the subcontractor's research was contingent on its success; and 2) the subcontractor retained substantial rights to its research. If the amounts payable to the subcontractor are contingent on the success of its research, then the payment is for the product or result of the research and the payment is not treated as funding. However, if the subcontractor is paid for its research, regardless of whether the research is successful, the research is funded. Treas. Reg. § 1.41-4A(d)(1). Under the substantial rights test, if the subcontractor retains no substantial rights in the research under the agreement providing for the research, the research is treated as fully funded, and no expenses paid or incurred by the taxpayer in performing the research are qualified research expenses. Treas. Reg. § 1.41-4A(d)(2).
Activities conducted after the beginning of commercial production of a business component are not qualified research. Activities are conducted after the beginning of commercial production of a business component if such activities are conducted after the component is developed to the point where it is ready for commercial sale or use, or meets the basic functional and economic requirements of the taxpayer for the component's sale or use. IRC § 41(d)(4)(A); Treas. Reg. § 1.41-4(c)(2)(i).
For example, even after a product meets the taxpayer's basic functional and economic requirements, activities relating to the development of the “manufacturing process” still may constitute qualified research, provided that the development of the “process” itself separately satisfies the requirements of section 41(d), and the activities are conducted before the process meets the taxpayer's basic functional and economic requirements or is ready for commercial use. Id.
The question of when research ends is closely tied to the research after commercial production exclusion under IRC § 41(d)(4)(A) and Treas. Reg. § 1.41-4(c), discussed above. That is, the research phase of a project is generally concluded once the business component (i.e., the product or process) is developed to the point where it is ready for commercial sale or use, or meets the basic functional and economic requirements of the taxpayer for the component's sale or use. Any activities which occur after this point generally will not constitute qualified research.
In order to apply this cut-off point for when research ends, the examiner needs to determine when the product is developed to the point where it is ready for commercial sale or use by the taxpayer, or when the product meets the taxpayer's basic functional and economic requirements. The regulations do not define any of these terms, but, as shown above, they do give six examples of activities which are “deemed” to occur after commercial production, and thus excluded from credit eligibility.
Moreover, since the exclusion for research after commercial production provides two tests ((1) ready for commercial sale or use or (2) meets basic functional and economic requirements), the cut-off point for when research ends is the earlier of the two tests. For example, assume a widget manufacturer engages in research in developing a new kind of widget. The company then builds a model widget which is found to meet the taxpayer's basic needs. Once this occurs, the research has ended, despite the fact that no commercial production or use has yet occurred. On the other hand, if the company rushes their new widget to market and begins to commercially produce the item before ensuring that the design meets the taxpayer's basic functional and economic needs, then the research would be deemed to have ended upon the first production run (even if it was a trial production run).
There is no general rule as to when a product is ready for commercial sale or use, or meets the taxpayer's basic functional and economic requirements. However, by focusing on the activities in a chronological order and applying the factors listed below, examiners should be able to determine whether the research phase of a project has ended:
Assume in the widget example above that the company rushed the initial widget design to market and started selling units. As stated above, research would have ended upon that first production run even though the product may not have met the taxpayer's basic functional and economic requirements.
Even where a product meets the taxpayer's basic functional and economic requirements (and thus research has ended with respect to development of the product), the taxpayer may still be able to establish that the manufacturing process qualifies, if the requirements for qualified research are met with respect to the manufacturing process. In this case, the research after commercial production exclusion is to be applied separately with respect to the development of the product and the development of the manufacturing process.
However, if after production of the widget, the taxpayer merely engages in activities that fall under the research after commercial production exclusion, then the activities are excluded from credit eligibility. For example, if the taxpayer's post-production activities merely involved trouble shooting, data collection, or debugging of their original widget design or manufacturing process, then these activities are excluded.
Activities relating to adapting an existing business component to a particular customer's requirement or need are not qualified research. Treas. Reg. § 1.41-4(c)(3). This exclusion does not apply merely because a business component is intended for a specific customer.
An activity must be intended to be useful in the development of a new or improved “business component” of the taxpayer to be considered qualified research. IRC § 41(d)(1)(B)(ii). The term "business component" means any product, process, computer software, technique, formula, or invention which is to be:
Even after a “product” meets the taxpayer's basic functional and economic requirements, activities relating to the development of the manufacturing “process” still may constitute qualified research, provided that the development of the process itself separately satisfies the requirements of section 41(d) and the activities are conducted before the process meets the taxpayer's basic functional and economic requirements or is ready for commercial use. Treas. Reg. § 1.41-4(c)(2)(iii).
To extend the missile example, let's say that the taxpayer manufactures ten "prototype" missiles under the contract. Five of these missiles are intended to be fired in tests representing various potential battlefield conditions (i.e. daylight, night, smoke) to test the accuracy of the missile's guidance system. One is to be retained by the taxpayer in the taxpayer's research laboratories as a "baseline" for further development and improvement of the basic design. One is to be transferred to the military to be retained by the military’s program office as a "baseline". The final three are to be delivered to the military where they will be used to train the crews servicing the missile in how to properly handle and store the weapon.
Since the first five missiles are consumed in a process of experimentation, testing simulating battle conditions, they qualify as QRE. The sixth missile retained by the TP as “baseline” for further development or for improvement to the basic design would not qualify as supply QRE. However, if the TP incurs additional cost with respect to further development or for improvements to the basic design etc., then those costs probably would qualify as additional QRE. The seventh through tenth missiles transferred to the military either as "baseline" or for training purposes are merely commercial production deliveries of the missiles which are of a character subject to the allowance for depreciation.
Examiners should review position descriptions or evaluations of managers whose wages are included in the credit computation. However, one has to look beyond the title or the job description to see what activities an individual actually performs. Taxpayers often claim that theirs is a "flat organization," whereby titles are not that important, e.g., the president of the company allegedly performs hands-on research working side-by-side with the employees. In some cases, higher level managers (above first line managers) may be directly involved in qualified research due to their technical background, but their qualified research activities only constitute a small portion of their overall work responsibilities. Conversely, there may be individuals working in a traditional research department who are not engaged in qualified activities.
The "direct support" argument is frequently encountered with respect to wages paid to patent attorneys, claiming that patent attorneys directly support the research effort through their efforts. While the activities of patent attorneys are generally indirectly beneficial to the research effort, their activities generally do not have any impact upon whether the research can, in fact, be completed. Accordingly, patent attorney activities most often do not constitute direct support.
The research credit as computed under IRC § 41(a)(1) is equal to the sum of: 1) 20 percent of the excess (if any) of the taxpayer's QREs for the taxable year over the base amount and 2) 20% of the basic research payments determined under IRC § 41(e)(1)(A) . For tax years beginning after December 31, 1989, the base amount is equal to the product of the taxpayer's fixed-base percentage multiplied by the taxpayer's average annual gross receipts for the preceding four years1. IRC § 41(c)(1). However, in no event is the base amount to be less than 50 percent of the QREs for the year of the credit. IRC § 41(c)(2). In general, the fixed-base percentage is equal to the aggregate QREs of the taxpayer for taxable years beginning after December 31, 1983, and before January 1, 1989, divided by the aggregate gross receipts of the taxpayer for such taxable years. IRC § 41(c)(3)(A). The base amount establishes the research intensity of a taxpayer’s research effort during specific base years, which is then compared to the current year’s level of research, i.e., the current year's QREs. Taxpayers are entitled to a research credit whenever their rate or level of research activity increases relative to prior levels of research activity, thus reflecting the incremental nature of the credit.
3.2 percent of so much of the QREs for the taxable year such as exceeds 1.5 percent of taxpayer's average annual gross receipts for the preceding four years. However, this amount cannot exceed 2 percent of taxpayer's average annual gross receipts for the four preceding taxable years.
In cases where the examiner decides to conduct a comprehensive examination of the base period years, the examiner should make sure that the same type of expenditures reflected in the claim year are also reflected in the base years. The purpose of the base period inquiry is to verify that the taxpayer has determined the research expenses in the base period on a basis consistent with the determination of research expenses for the credit year and to ascertain the reasons for any increases in a taxpayer's research expenses.
In Research Inc. v. United States, 95-2 U.STC. 50,407 (DC Minn.), the Government contended that the taxpayer was not entitled to the research credit because it was unable to accurately document its base year QREs. The Government argued that where the taxpayer cannot substantiate the base period amounts, it cannot qualify for the credit because there is no indication of the amount of increase involved. The Court ruled in favor of the Government, holding that the taxpayer must be able to prove the correct amount of its base period QREs to qualify for the credit. The Court quoted Justice Holmes’ observation that "Men must turn square corners when they deal with the Government." The Court found this case to be one in which the corners were plainly required to be squared and all the formalities complied with.
Notwithstanding whether the period for filing a claim for credit or refund has expired, taxpayers must determine the QREs for the base years in a manner which is consistent with the method used for current taxable year, for purposes of computing the fixed base percentage. IRC § 41(c)(5). Similarly, it is important that gross receipts be computed in a consistent manner for purposes of computing the base amount - for both the fixed base percentage and the "four prior years" components of the base amount. Distortions may arise when the taxpayer's method of calculating either QREs or gross receipts change from year-to-year. Taxpayers should fully explain their method of determining QREs and gross receipts. Summary work papers should be secured and traced to books and records. Taxpayers should be made aware that base year records must be maintained for all years that the research credit is claimed.
No refund or credit will be allowed after the expiration of the statutory period of limitation applicable to the filing of a claim therefore except upon one or more of the grounds set forth in a claim filed before the expiration of such period. Proc. and Admin. Reg. § 301.6402-2(b)(1). A "claim must set forth in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof. . . . A claim which does not comply with this paragraph will not be considered for any purpose as a claim for refund or credit." Id.
1. Notice 2002-44 - Research Credit Claim vs. Original Return Filing
It is well-settled that after the statute of limitations has expired, a timely refund claim based upon a specific item or items (i.e., a specific claim), whether deemed "protective" in nature or not, may be amended to claim a higher refund amount only where the facts alleged in the amendment necessarily or naturally would have been discovered by the Service in any investigation of the original, timely refund claim. See, e.g., Pink v. United States, 105 F.2d 183 (2d Cir. 1939); Lockheed Martin Corp. v. United States, 39 Fed. Cl. 197 (1997), rev'd on other grounds, 210 F.3d 1366 (Fed. Cir. 2000); cf. Honeywell Inc. v. United States, 973 F.2d 638 (8th Cir. 1992) (holding that a taxpayer could not amend a refund claim that was based on a credit for hiring welfare recipients because the amendment involved a new factual basis, namely, the hiring of 622 employees not involved in the original claim). See FSA 200211006 (October 23, 2001) (under IRC § 6110, FSAs may not be used or cited as precedent). The Service cannot waive the bar to untimely amendments of specific claims. Angelus Milling Co., 325 U.S. at 296; Garbutt Oil Co. 302 U.S. at 532-35.
[t]he showing should be unmistakable that the Commissioner has in fact seen fit to dispense with the formal requirements and to examine the merits of the claim.... The Commissioner's attention should have been focused on the merits of the particular dispute. The evidence should be clear that the Commissioner understood the specific claim that was made even though there was a departure from form in its submission. Id. at 297-98.
The Federal Circuit addressed these rules in its Lockheed Martin decision, where it affirmed the Court of Federal Claim's conclusion that the taxpayer's claims for increased refunds, based upon the research credit, were new, untimely claims:
The Court of Federal Claims denied Lockheed Martin's motion, concluding that the "clarifications" sought were new, untimely refund claims barred by the statute of limitations, as the additional amounts sought from the same contracts could have been separately raised as sole or independent claims for refunds, and thus were not factually integral to or subsidiary of plaintiff's timely refund claims. The Court of Federal Claims rejected Lockheed Martin's reliance on cases where the legal and factual bases asserted had been identified in the claim, but only the amount claimed had been miscalculated. Notably, it held that as a matter of law, the facts alleged in support of greater refunds would not necessarily have been discovered by the Service in auditing the original, timely refund claims. Lockheed Martin, 39 Fed. Cl. at 197. The Federal Circuit affirmed on this issue. Lockheed Martin, 210 F.3d at 1366.
1110 Wing 3.1 Air Vehicle (WBS 1000)
2. Proposal briefings -- Bid Decision and Kickoff Briefings
Design risk - low risk means the taxpayer knows how to make changes from the outset;
For taxable years beginning before 1990, the above rules do not apply. Instead, for such years the research credit was equal to 20 percent of the excess of qualified research expenses for the determination year over "base period research expenses" plus 20% of the basic research expenses as determined under IRC § 41(e)(1)(A). "Base period research expenses" were the average qualified researach expense paid or incurred for each year in the base period. In general, the base period was the three taxable years immediately before the "determination year." Contact a Research Credit Technical Advisor or assistance with pre-1990 computational issues.
The Tax Relief Extension Act of 1999 amened IRC § 41(c)(4)(A) by striking 1.65 percent and inserting 2.65 percent, by striking 2.2 percent and inserting 3.2 percent, and by striking 2.75 percent and inserting 3.75 percent". This change applies to taxable years beginning after June 30, 1999.