The Court this morning denied Union Carbide’s petition for certiorari that sought review of the Second Circuit’s denial of claimed research and experimentation credits for the costs of certain supplies used in production process experiments. The petition had also asked the Court to consider the court of appeals’ application of Auer deference principles. See our prior reports here.
The Court also entered an order denying a motion by the National Association for Manufacturers to file an untimely brief as amicus curiae in support of the petition. Although the Court routinely grants motions for leave to file timely amicus briefs, it does take its time limits seriously. In this case, the amicus brief was due January 3 and the brief was actually filed (with an accompanying motion for leave to file out of time) on January 15.
The Court took no action on the government’s petition for certiorari in Woods, a penalty case. See our prior report here. It was scheduled to consider the case at last Friday’s conference, but apparently decided that it needed more time to decide what to do. The case will be rescheduled to be considered again at a future conference, possibly this Friday. So there could be an order in the case next Monday.
To close the loop on yesterday’s post on the Union Carbide certiorari petition, the taxpayer has now filed its reply brief in support of the petition. The reply brief focuses primarily on the Auer deference issue, distinguishing the cases cited by the government in its defense of the application of Auer deference. The reply brief also vigorously disputes the government’s contention that the Second Circuit would have reached the same result if it had not deferred to the government’s interpretation of the regulation.
The government has filed a brief in opposition to Union Carbide’s request for review of the Second Circuit’s decision denying its research credit claim. See our prior reports on the cert petition and the court of appeals’ decision here and here. With respect to the basic legal issue, the government’s concise analysis tracks that of the Second Circuit, arguing that the taxpayer would get a “windfall” if it received “a credit for the cost of supplies that the taxpayer would have incurred regardless of any qualified research.” The government emphasizes that there is no circuit conflict on this issue that warrants Supreme Court review, describing this as “the first case since the enactment of the research credit in 1981 that has presented the question of what supply costs are eligible for the credit when a taxpayer simultaneously performs research on a production process and produces products for sale in the ordinary course of its business.”
The government spills more ink addressing Union Carbide’s argument that Supreme Court review is appropriate in order to reject the Second Circuit’s allegedly overbroad application of “Auer deference” to the government’s interpretation of its research credit regulations. Clearly unenthused about the prospect of the Court re-examining this issue, the government gives a plethora of reasons why it should stay away: (1) the taxpayer did not raise in the court of appeals its objection that the government should not be entitled to Auer deference when it has a financial interest in the outcome of the case (because the government had not explicitly requested Auer deference in its brief); (2) no other court of appeals has “expressly addressed” this argument; (3) although the Second Circuit invoked Auer deference, that did not affect its decision because it would have interpreted the regulation the same way even without resort to deference principles; (4) Union Carbide’s argument is wrong; and (5) Union Carbide did not claim the credit in question on its tax return and therefore the agency could not apply its interpretation of the regulations until after litigation had commenced.
Given the absence of a conflict and the government’s strong opposition, Union Carbide’s petition faces a steep,a nd likely insurmountable, uphill climb. The Court is expected to act on the cert petition on March 18.
Union Carbide has filed a petition for certiorari, docketed as No. 12-684, asking the Supreme Court to review the Second Circuit’s rejection of its research credit claim. See our prior reports describing the issue and reporting on the decision.
The petition articulates two questions presented: 1) the basic substantive tax question whether, in the context of a production process experiment, the research credit is limited to the costs of supplies that would not have been incurred but for the experiment; and 2) whether the court erred in deferring to the IRS’s proffered interpretation of its own research credit regulations. These two questions are related, of course, as the taxpayer argues that the court’s error in deferring to the IRS’s interpretation led it to misapply those regulations and deny the credit.
With respect to the first question, the petition emphasizes the importance of the decision. It states that production process experiments must be done in the production plant itself and create the risk that the output will be “off-grade scrap” if the experiment does not go well. Therefore, the costs of the supplies that would not be incurred but for the experiment are “trivial in comparison to the supplies that must be placed at risk of loss when conducting this type of research.” The result of the Second Circuit’s decision, the petition continues, “is that the credit is rendered trivial for the type of plant-scale production process research that is so important to manufacturing industries generally, and the chemical industry in particular.” Absent this deference, the petition argues, the regulation is most reasonably construed in accordance with the taxpayer’s broader reading of the term “indirect” expenses.
With respect to the second question, the petition argues that the Second Circuit stretched the concept of “Auer deference” (that is, deference to an agency’s interpretation of its own regulations) too far. The petition asserts that the court mistakenly applied Supreme Court precedent “as requiring a seemingly extraordinary deference to the government’s interpretation of a regulation in a case in which the government itself is a financially interested party, [which] amounts to affording a naked preference to a government litigant over its non-governmental adversaries — permitting the government to place its thumb on the scales of justice.”
As noted in our prior post, the Second Circuit’s opinion did extend the concept of Auer deference beyond the specific situations in which it has thus far been applied by the Supreme Court. In Auer v. Robbins, 519 U.S. 452 (1997), the Court had deferred to an agency’s interpretation when it was set forth in an amicus brief filed by a non-party; here, the court deferred to the IRS’s interpretation presented in a brief in which the IRS was a litigant. Justice Scalia has suggested that he would be open to reconsidering even Auer itself in an appropriate case (even though he authored the Auer opinion). Union Carbide is hoping that other Justices share that view or that they will be troubled by the apparent expansion of the doctrine here, and that enough of them will believe that this is an appropriate case to revisit the question of agency deference to its own regulations. Whether or not that turns out to be the case, the petition’s focus on the broadly applicable deference issue certainly gives the Court something to think about beyond whether it wants to hear the substantive tax issue. Ordinarily, taxpayers have a hard time persuading the Court to hear a technical tax question on which there is no circuit conflict.
The government’s brief in response to the petition is currently due January 3. The government often obtains at least a 30-day extension to file such responses.
The Second Circuit today affirmed the Tax Court’s decision in Union Carbide denying the research and experimentation credit for the costs of certain supplies used in production process experiments that sought to improve a process that was already in use for producing products. The court concluded that the credit is available only for the costs of supplies that would not have been incurred but for the experiment; hence, it disallowed the credit claim for the costs of other supplies that concededly were necessary for the experiment because they are otherwise necessary for the production process, but would have been incurred anyway if production had proceeded without the experimental process.
As discussed in our prior post, the taxpayer’s argument rested primarily on the plain meaning of the statute, which states that the credit is available for the cost of supplies “used in the conduct of qualified research.” 26 U.S.C. § 41(b)(2)(A)(ii). The Second Circuit held that this language is not sufficiently clear to carry the day without further inquiry. First, the court rejected the general proposition that dictionary definitions are dispositive. Second, the court stated that the taxpayer’s analysis improperly focused on the single word “used,” when it should have looked to the meaning of the more ambiguous complete phrase “used in the conduct of qualified research.”
The court then stated that it agreed with the Tax Court that the taxpayer was seeking a credit for “indirect research costs,” which are excluded from qualified research expenses under Treas. Reg. § 1.41-2(b)(2). The court did not find the regulation itself conclusive, recognizing that the regulation did not clearly explain “how one distinguishes between direct and indirect research expenses.” But the court found that this clarity was supplied by the government’s brief, stating that, on the authority of Auer v. Robbins, 519 U.S. 452, 461-62 (1997), courts “ordinarily give deference to an agency’s interpretation of its own ambiguous regulations, even if that interpretation appears in a legal brief.” (We note that Justice Scalia, the author of Auer, recently remarked that this approach is problematic because it encourages agencies to issue vague regulations and then obtain deference to their own interpretations of those regulations without subjecting the interpretations to notice-and-comment review. No other Justice, however, joined Justice Scalia’s statement that he would be open to reconsidering Auer. See Talk America, Inc. v. Michigan Bell Tel. Co., 131 S. Ct. 2254, 2266 (2011) (Scalia, J., concurring)) The Second Circuit in this respect is taking a step beyond Auer, where the agency’s interpretation was found in an amicus brief filed by a non-party rather than by a party trying to defend a particular result that is in its pecuniary interest.
The Second Circuit added that deference to this interpretation was appropriate because, based on a House Report, the court perceived the purpose of the credit to be “to provide a credit for the cost that a taxpayer incurs in conducting qualified research that he would not otherwise incur.” According to the court, “[a]ffording a credit for the costs of supplies that the taxpayer would have incurred regardless of any qualified research it was conducting simply creates an unintended windfall.” Judge Pooler did not embrace this part of the opinion, writing separately to note her “view that Congress may well have intended to give a tax credit for those supplies which would have been purchased absent any qualified research.” Because Congress had not expressed that intent clearly enough “so as to preclude either the Commissioner’s regulations or his interpretations,” however, she joined the majority in affirming the Tax Court.
The Union Carbide decision is a blow to manufacturers hoping for a broader reading of the R&E credit. The extent of its impact remains to be seen. R&E credit cases are fact-intensive, and the facts of this case were relatively unsympathetic to the taxpayer in that it sought a credit for costs that unquestionably would have been incurred anyway – even without the experiment – and that produced a product that was sold. Other cases involving less established processes could yield different results. And, as noted in Judge Pooler’s concurring opinion, Congress has the last word on this topic if it determines that the Second Circuit’s approach does not create a sufficient incentive for research and experimentation.
A petition for rehearing would be due on October 22.
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.