Second Circuit Upholds Denial of R&E Credit Claims in Union Carbide

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.

Union Carbide – Second Circuit Opinion