US Court Upsets Research Credit Deductibility Rules

Tax-News.com, New York

16 September 2002

Professor David Harvesty, writing in ecommercetax.com, quotes a recent case in the US Appeals Court which seems to have tightened the rules governing the deductability of software development costs for companies taking advantage of the research credit programme.

In the District Court, the plaintiff, Tax and Accounting Software Corporation had won a decision permitting it to claim the costs of developing new accounting software as qualified research under the Section 41 research credit programme. The lower court adduced statements made by Congress when it extended the credit in 1998 and 1999, and its decision was apparently also in accord with proposed IRS guidelines.

The Appeals Court has ignored both the statements made in Congress and the IRS guidelines in reaching its tentative decision; and has brought back to life the 'discovery' test, which even the IRS had abandoned.

The Appeals Court set up five tests to determine whether a given expense constitutes 'qualified research' for purposes of Section 41:

• The research must qualify as expenses under IRC § 41(d)(1)(A);
• The research must be "undertaken for the purpose of discovering information" (§ 41(d)(1)(B));
• The information discovered must be "technological in nature" (§ 41(d)(1)(B)(i));
• The "application" of the information described above must be "intended to be useful in the development of a new or improved business component of the taxpayer" (§ 41(d)(1)(B)(ii));
• "Substantially all" of the research must "constitute elements of a process of experimentation" for a valid purpose under the tax credit ( § 41(d)(1)(C)).

The district court said that Section 41(d) does not require the taxpayer to expand or refine principles of science or engineering in order to qualify for the tax credit. The court said, “emphasis should be on whether the information qualifies as being ‘technological in nature’ . . ., not whether the work could be considered a revolutionary discovery in the scientific sense.” The district court found that there is no separate “discovery” test.

The Court of Appeals however disagreed with the district court’s holding that there is no separate “discovery” test. The Court of Appeals said, “[t]he term ‘discovery’ means that the researcher must find new information or, in other words, must expand existing knowledge.” “[T]he ‘discovering information’ language of § 41 establishes a separate requirement that the taxpayer must meet in order to qualify for the tax credit. Under that requirement, the taxpayer must show that he discovered new information and that information must be separate from the product that is actually developed.”

The Court also thought that the 'experimentation' test was unsatisfied.

The court concluded its analysis by saying, “a crucial question, as shown by our analysis of the plain language of the statute, is whether any new information . . . discovered in the course of research was independent and separate from the new products that (were) developed. This issue was never developed by either party below, and thus summary judgment (for the plaintiff) was inappropriate on this issue.”

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