In more detail
A taxpayer may generally claim credits for up to 20% of qualified research expenses in excess of a base amount defined in section 41. Expressly excluded from the definition of qualified research in section 41 is "funded research," or any research to the extent funded by any grant, contract, or otherwise by another person or governmental entity. However, the Treasury regulations explain that a taxpayer can still claim the credit for research funded by another party if payment for the research is "contingent on the success of the research."
System Technologies, Inc. ("System Technologies") is an Indianapolis-based engineering firm that specializes in automative coating designs and applications, such as pre-treatment solutions, ultraviolet curing systems, automatic liquid or powder systems, and robotic paint application systems. System Technologies claimed research credits totaling USD 99,304 for expenses related to six different finishing systems that the company developed during 2016. The contracts for each of the six projects contained a choice of law provision stating that Indiana law was controlling. Furthermore, all the contracts contained a warranty provision that provided that the exclusive remedy in the event of defective or damaged parts was that System Technologies would repair or replace those defective parts free of charge.
The Commissioner disallowed the company's research credits in full and, in a motion for partial summary judgment, argued that System Technologies was ineligible for the research credit because it did not bear the financial risk in the event of failed research, and so the company's research was "funded" within the meaning of section 41. The Commissioner contended that System Technologies' contracts limited its customers' remedies to repair or replacement of defective parts and did not include a broad remedy in the event that the research was unsuccessful.
The court disagreed and held that under the choice of law provisions incorporated into the purchase orders, payment was contingent on successful research. The court focused on a provision of Indiana's enactment of the Uniform Commercial Code (UCC), which states that if a seller fails to deliver a product, then the buyer is entitled to various remedies, including at a minimum, "recovering so much of the price as has been paid." Ind. Code § 26-1-2-711(1). The court found this to "fit directly within the Commissioner's regulatory definition of what is not funded research," as Reg. § 1.41-4(A)(d) states that amounts payable under any agreement that are contingent on the success of the research and thus considered to be paid for the product or result of the research are not treated as funding.
The court then delved further into Indiana law to address the Commissioner's contention that the contracts' warranty provisions overrode these statutory remedies. While the parties were allowed to limit their remedies under Indiana law, the court found that the scope and effect of the warranty provisions were not as broad as the Commissioner read them. In particular, the court held that if System Technologies failed in its research and was unable to deliver a product, then the exclusive warranty in the contract must give way to the Indiana state law remedy of a refund of the amounts paid; repair or replacement of defective parts would not be a sufficient remedy in the event that the company were completely unable to deliver what it promised.
The Commissioner argued in turn that the parties to the contracts had no doubt that the products would be delivered, noting the delivery of progress payments. The court held that it could not rely on such factual suppositions in deciding a motion for summary judgment but instead must draw factual inferences in the light most favorable to the non-moving party. Furthermore, the court noted that the Commissioner's argument concerning this certainty may be better directed at the question of whether System Technologies' research was "qualified research" in the first place—i.e., whether there was the uncertainty at the outset of the research that is required by the section 174 test (one prong of the four-part test that research must meet to be eligible for the Section 41 credit)—but that question was not presently before the court.
The Commissioner's argument that the taxpayer's research was "funded" fell apart because the limited remedies under the contracts did not foreclose other remedies under state law for nondelivery of the promised product. The court ultimately concluded that payment was contingent on the success of the research, culminating in delivery of the product, and therefore the research was not "funded" for purposes of section 41.
For taxpayers expecting to claim research credits under Section 41, System Technologies serves as one more case demonstrating the importance of fully considering the state law implications of language used in research-related contracts when seeking to avoid falling into the "funded research" exclusion. When determining whether the payment is contingent upon the success of its research activities, the Tax Court has shown not only a willingness to carefully scrutinize the payment and remedy provisions in the pertinent contracts, but also to thoroughly analyze the state law that controls those contracts to fully understand what those contractual provisions do—and do not—mean.
