Second Circuit Considering Important Research Credit Issue in Union Carbide
April 2, 2012
We present here a guest post by our colleague Patricia Sweeney:
On March 29, 2012, the Second Circuit heard oral arguments in Union Carbide Corp. & Subsidiaries v. Commissioner, No. 11-2552 (Judges Straub, Pooler & (visiting district court Judge) Korman on the panel ). The case involves Union Carbide Corp’s (“UCC’s”) claim for research and experimentation credits with respect to 106 research projects. In order to resolve the issues expeditiously, the parties agreed that the Tax Court would limit trial to the five largest projects. All five projects involved process experimentation after products were placed in commercial operation. For two of the five projects, the Tax Court held that the projects involved qualified research, but it determined that the costs of materials incurred to produce the commercial product necessary for UCC to conduct the process research were not eligible for the credit. UCC has appealed this holding, as well as the Tax Court’s separate conclusion that one of the other projects did not involve a process of experimentation because UCC did not conduct additional post-test analysis after it determined that the test was successful. The Second Circuit’s decision with respect to the costs of materials issue could have widespread implications for taxpayers claiming the research credit.
Background Regarding the R&E Credit. To be eligible for the research credit under section 41(a)(1) of the Code, a taxpayer must show that it has performed “qualified research.” To be qualified research: (1) the research must be eligible as research under section 174 of the Code; (2) the research must be undertaken for the purpose of discovering technological information; (3) the taxpayer must intend for the discovered information to be useful in the development of a new or improved business component; and (4) substantially all of the research activities must constitute elements of a process of experimentation. These tests are applied separately to each “business component.” Section 41(d)(2)(C) provides that the development of an improved process is a separate business component from the product being produced. At the same time, the Code generally provides in section 41(d)(4)(A) that research conducted after the beginning of commercial production of the business component is not eligible for the research credit. Because the products in issue were all in commercial production, the “improved process” rule is critical to UCC’s position to avoid the expenses from being declared ineligible for the research credit under section 41(d)(4)(A).
The research credit is computed by reference to qualified research expenses (“QREs”), including “any amount paid or incurred for supplies used in the conduct of qualified research . . .” other than land, improvements to land, and depreciable property. I.R.C. § 41(b)(2)(A). In a post-Union Carbide decision, TG Missouri v. Commissioner, 133 T.C. 278 (2009), the IRS did not challenge, and the Tax Court allowed without discussion, the inclusion in the QREs of material costs for production molds sold to clients. In Trinity Industries v. United States, 691 F.Supp. 2d 688, 697 (2010), the U.S. District Court for the Northern District of Texas expressly allowed the material costs incurred to construct ships because it concluded that the costs “are properly considered research expenditures in that the business component – the ship – could not have been developed without them.”
The Parties’ Briefs with Respect to the Supplies Argument. As previously noted, although the Tax Court agreed that 2 of the 5 projects in issue were qualified research and that the experiments could not have occurred without the supplies claimed by UCC (a process cannot be tested unless it is applied to the production of the product), it concluded that the supplies were not “used in the conduct of” the process of experimentation with respect to process development. Instead, the court allocated the supply costs to the product business component and disallowed all the supplies claimed. In essence, the court established a primary purpose test, and concluded that the primary purpose of the expenditures was to produce the commercial product, not to conduct research. In this context, the Tax Court noted that the supply costs in issue were “at best, indirect research expenditures excluded from the definition of QREs.”
In its briefs, UCC argues that the Tax Court has created an inappropriate distinction between product and process experimentation. It maintains that the Tax Court erred when it created two new requirements, i.e., that in addition to being used in the conduct of research, the costs must have been “primarily” incurred as a result of the process experimentation, and that supplies incurred both to produce a product and to be used in process experimentation are not primarily incurred in process experimentation. There is nothing in the Code, regulations or legislative history to indicate that the qualification of supplies as QREs turns on whether they are incurred with respect to process or product experimentation. Moreover, there is nothing in the Code, regulations or legislative history that either creates a hierarchy that would allocate the costs solely to the production of the product or disallows such costs as “indirect costs.” UCC argues that the Second Circuit should apply the plain meaning of the statute, which provides that costs “used in the conduct of qualified research” qualify for the credit. There is no dispute that UCC could conduct its process experimentation only if it produced the product in issue. As a result, UCC maintains that the material costs were necessary for the process experimentation, were at risk in that experimentation, and therefore, must be included in the QREs.
As noted by UCC, the government in its brief did not attempt to reconcile the Tax Court’s decisions in UCC and TG Missouri, or the Trinity decision. It distinguished these other two decisions as involving product rather than process experimentation, stating “in each of these cases . . . the supply costs found to be eligible for the credit were the direct, incremental cost of performing the qualified research.” The focus of the government’s argument in its brief is that the costs of supplies to produce goods for sale are “indirect research expenses,” which are excluded from the definition of QREs under Treas. Reg. § 1.41-2(b)(2) because they are expenses that would have been incurred regardless of any research activities. The government argues that Congress intended that only the incremental costs arising from the research are sufficiently “direct” to qualify as QREs. For support, it cites other limitations restricting the availability of the credit – such as the limitations on qualified research to a discrete business component or to pre-commercial production. It further asserts that it is unreasonable to claim supply costs that otherwise would have been incurred in commercial production.
The Potential Impact. As noted in an amicus brief filed by the National Association of Manufacturers, the American Chemistry Council, and the Chamber of Commerce of the United States, the Second Circuit decision could have a wide impact on U.S. manufacturers. If the Tax Court’s decision is sustained, the incentive that Congress intended by allowing the research credit could be significantly curtailed. Moreover, as pointed out by both the amicus brief and UCC, such a decision would ignore the significant risks associated with process research and create an inappropriate distinction between product and process research. However, there could be an even worse result for taxpayers than an affirmance of the Tax Court decision. As noted by UCC in its briefs, the government’s argument that production costs are not QREs could be extended to product research. If the Second Circuit accepted that extension, it could conclude that only incremental production costs qualify as QREs, a decision that would have much broader ramifications and that would be at odds with the decisions in both TG Missouri and Trinity. Time will tell.
We will return soon with a report on the oral argument.