Review of Opinion Union Carbide and Subsidiaries v. Commissioner Research & Development Tax Credit

May, 2009

Review of Opinion Union Carbide and Subsidiaries v. Commissioner Research & Development Tax Credit

Prepared by
Karim Solanji, J.D. and Mark Lauber

On March 10, 2009, Judge Goeke of the United States Tax Court handed down a lengthy opinion in UnionCarbide Corporation v. Commissioner, T.C. Memo. 2009-50. Although the decision approved of only a small percentage of the UCC’s sought credit, the ruling included several favorable elements that may benefit taxpayers as well as clarified many longstanding areas of confusion for those claiming the Research and Development Tax Credit (R&D Tax Credit). However, the UCC Decision also included several rulings that were unfavorable to taxpayers. This is a review of the Opinion.

Background

Union Carbide sought to include 106 projects for additional R&D Tax Credit performed at their manufacturing facilities in 1994 and 1995. This case was brought about as a result of the IRS contesting these claims. The Court arrived at the UCC Decision by examining the five largest projects and determining the eligibility of their claimed expenditures. Ultimately, the Court determined that two of the five projects counted as qualified research activities.

Discovery Rule

The UCC Decision seems to have abolished the Discovery Test once and for all. This greatly benefits taxpayers as the IRS has been inconsistent in its treatment of the Discovery Test, especially when auditing R&D Tax Credit claims from years prior to the issuing of its 2004 final regulations (T.D. 9104). In past cases, the Court applied the Discovery Test requiring taxpayers to discover knowledge beyond the field’s current state. However in the UCC Decision, the Court applied the final regulations under T.D. 9104 even though this case involved the 1999 amendment of R&D Tax Credit for tax years 1994 and 1995. The Court applied its new “technological information test” and stated that it was satisfied so long as the knowledge sought was technological in nature.

Substantiating R&D Credit

Although UCC was allowed only $1,045 of the more than $20 million it claimed in supply costs, the UCC Decision offered taxpayers helpful insight regarding proper substantiation for claimed R&D Tax Credits. Although the Tax Code never intended for taxpayers to satisfy unreasonable recordkeeping requirements or provide contemporaneous documentation to substantiate their R&D Tax Credit claims, the IRS has on many occasions disallowed employee testimony and various other attempts to reasonably estimate the amounts of qualified research expenditures.

The UCC Decision formally rejects the IRS’s more stringent requirements and accepts estimates based upon employee recollection and extrapolation methods as valid evidence of qualified research expenditures. Further, the Court allowed UCC the “Cohan Rule”. The Cohan Rule, historically applied by the IRS only to individuals and small businesses, allows taxpayers under certain circumstances to obtain deductions by submitting reasonable estimates when proof of the exact amounts are unavailable. In the UCC Decision, the Court applied the “Cohan Rule” for accepting UCC’s estimates “as a close approximation of all of the qualified research activities that occurred during the base period.” As a result, the Court determined that even a large corporation such as UCC could be afforded the Cohan Rule, and as such, employee interviews and oral testimony corroborated by documentation constituted reasonably sufficient evidence of qualified research activities and expenditures.

Consistency Rule

The UCC Decision also favored taxpayers by limiting the application of the Consistency Rule, which required taxpayers to calculate base-year and claim-year qualified research expenditures using the exact same method. Specifically, the UCC Decision ruled that a taxpayer need not “use the same types of documents to identify qualified research in the base period as it used to identify qualified research in the claim year if the taxpayer can otherwise show that it has satisfied the consistency requirement.” In short, taxpayers are not required to rely on the same documentation for determining the qualified research expenditures for the claim years as for the base period. The UCC Decision further stated that “there is no support in the statute or the legislative history for the application of the consistency rule at the controlled group level.”

Product/Manufacturing Process Development and Supply Costs

The UCC Decision also ruled that because UCC could not adequately identify which supply costs were consumed in the development of its manufacturing process versus production, the Court disallowed UCC’s entire supplies claim. However, the ruling both accepted and highlighted that qualified research expenditures could be incurred during both product development as well as manufacturing process development. Specifically, the UCC Decision states that “even after a product is ready for commercial sale, activities relating to the development of the manufacturing process may constitute qualified research.” It is evident from the UCC Decision that it is vitally important that adequate documentation of supply costs consumed during manufacturing process development be maintained in such a manner as to be clearly distinguishable from production supply costs.

Experimentation

The UCC Decision also emphasized the significance and relative requirements of the experimentation process. The ruling specifically states that in order to “satisfy the process of experimentation test, the taxpayer should develop a hypothesis as to how a new alternative might be used to develop a business component, test that hypothesis in a scientific manner, analyze the results of the test, and then either refine the hypothesis or discard it and develop a new hypothesis and repeat the previous steps.” Following this strict guideline, the Court required that qualified research activities must be part of a systematic process of experimentation that had to be developed in advance of performing the activity so as to address the various uncertainties at the project’s outset.

It is also important to note that despite such strict construal of the experimentation process, the Court concluded that there existed no specific requirement to record the experimental results.

Conclusion

Most importantly as a result of the UCC Decision, taxpayers now benefit from the favorable ruling allowing data extrapolation, employee recollection, and other corroborating documentary evidence for estimation as valid determinations of R&D Tax Credit in both the claim-year as well as base-year calculations.

The UCC Decision also seemingly puts to rest the Discovery Rule as it applied the 2004 final regulations from T.D. 9104 as in the case regarding a 1999 amendment for R&D Tax Credits claimed in 1994 and 1995.

Most manufacturing taxpayers will also greatly benefit from the affirmed distinction between product development and manufacturing process development. However in order to benefit from supply costs, accurate recordkeeping of supplies consumed during process development as opposed to production must be adequately maintained.

Please contact Karim Solanji (281-558-7100 X-109) if you would like to discuss this further.