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Tax Court Says Pollution Control Systems Are Not Pilot Models, Rejects Tax Research Credits

On July 6, 2023, the US Tax Court issued its decision in Betz v. Commissioner, T.C. Memo. 2023-84. Betz considers the application of the pilot model supply rule to expenses incurred by a designer (CPI[1]) of made-to-order air pollution control systems called oxidizers. At issue was approximately $500,000 of research and development tax credits pursuant to Internal Revenue Code (IRC) Section 41 on wage and supplies expenses for 19 different oxidizers that CPI produced under various purchase agreements or purchase orders. Generally, IRC Section 41 grants qualifying taxpayers federal income tax credits for increasing research activities, calculated with respect to the amount of “qualified research expenses” (QREs) incurred by the taxpayer during the tax year over a base amount. The statute is complex and has been the subject of substantial controversy between the Internal Revenue Service (IRS) and taxpayers since its enactment in 1981.

In Betz, CPI generally oversaw the component fabrication process and the assembly of the systems at its subcontractor facilities and then installed or oversaw installation of the oxidizer at the customer’s location. Testing of the oxidizers generally occurred after assembly or after installation. The supply expenses generally included the major components of the various oxidizers, all of which were fabricated by subcontractors. CPI claimed the credit based on a study performed by a tax consultancy group, the fees for which were capped at a percentage of the research credits identified.

The IRS challenged whether the taxpayer met the test in IRC Section 41 that the research must be research “with respect to which expenditures may be treated as expenses under [IRC] section 174.” (See IRC Section 41(d)(1)(A).) The Tax Court found that CPI failed to substantiate that the claimed wages and supplies constituted IRC Section 174 “investigative” activities. CPI’s primary evidence was in the form of testimony from CPI executives and supervisory personnel whom the Tax Court found to be “vague, in conflict with the record, and lacking in credibility[.]” Alternatively, the Tax Court found that, even assuming CPI engaged in IRC Section 174 research activities that gave rise to IRC Section 41 creditable expenses, five of the projects constituted funded research given CPI’s complete transfer of rights in the results of any such research to its customers.

Regarding the supply QREs, the Tax Court held that taxpayer intent was essential to determining whether its efforts to create a pilot model satisfy the “uncertainty” standard in IRC Section 174 regulations. In that regard, the taxpayer had to show “that its purpose in producing that representation or model was to evaluate and resolve uncertainty about the product (i.e., to obtain unavailable information necessary to establish capability, method, or appropriate design).” The taxpayer failed to make this showing. The Tax Court pointed to the lack of “early-stage” testing as an indication that the oxidizers were not used as pilot models but were, in fact, final products.

Practice Point: Betz demonstrates that the IRS continues to scrutinize claims of qualified research expenses. The Tax Court’s [...]

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UTP Filings Continue to Rise

The IRS has released statistics for the 2010 to 2014 tax years relating to Schedule UTP (Uncertain Tax Position) filings, showing that there were 6,320 uncertain tax positions reported in 2014. The statistics show a steady increase in the reported positions, which totaled 4,740 in 2010, although this may also be attributed to the fact that the number of Schedule UTP filers has increased from 2,143 in 2010 to 2,747 in 2014. It is not surprising that the number of Schedule UTP filers have increased from 2010 to 2014 since reporting requirement has decreased from corporations with at least $100 million in assets (2010) to $10 million in assets (2014). However, the increase in filers has not affected the average number of uncertain tax positions per filer, which remains stable at 2.3. The most common types of UTPs reported continues to be IRC section 41 research credit and IRC section 482 transfer pricing, which collectively account for over half of all reported uncertain tax positions. The chart is available here for your consideration.

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