Draft r n d Study Generic v1

8/13/2019 Draft r n d Study Generic v1

1/59

GENERIC R&D STUDY

1

2012 R&D Tax Credit Study XX XX

Part One Summary Report and Tax Opinion

Part Two Research and Development Tax Credit Calculations and

Supporting Schedules

1. Federal and Utah 2012 Research and Development Tax

Credit Calculations (Exhibit 1)

2. Qualified Research Expenditure Detail (Exhibit 2)

a. Summary Schedule (Exhibit 2A)

b. Wage QRE Detail (Exhibits 2B & C)

c. Supply QRE Detail

d. Contract Research QRE Detail

3. Federal Base Period Calculations (Exhibit 3)

4. Project Matrix (Exhibit 4)

5. Engineering Support Invoices (Exhibit 5)

6. Organizational Chart (Exhibit 6)


2/59

GENERIC R&D STUDY

2

INTRODUCTION

XX-XX (also referred to hereinafter as the Company)has

achieved and maintained its position as the world's leading

supplier of mechanical solutions to the semiconductor test

industry through hard work, dedication to quality, and providing

total customer satisfaction. XX-XX's success is primarily due to

its ability and willingness to design and develop innovative

equipment and customize existing products in order to best meet

the challenges of our customers' specific test-floor

environments and test-system applications. XX-XX's ongoing

commitment is to provide and support the semiconductor test

community with the finest solutions to this industry's unique

challenges.

XX-XX is a vertically integrated organization, maintaining

control of the entire manufacturing process. All production,

engineering, QA, machine-shop, crating, paint-shop, shipping &

receiving, and main-office functions are located in two

buildings on the 5 acre XX-XX site in St. George, Utah. At the

same time, XX-XX has sales and service personnel around the

world, allowing us to quickly assist our customers with any

issues, whenever and wherever they might arise.

Engineering

XX-XX's engineering department is dedicated to providing

innovative, cost-effective manipulator and interface solutions

to the unique challenges encountered in the semiconductor test

world. With a staff of seasoned mechanical and electrical

engineers, XX-XX is able to provide creative, safe, and reliable

custom designs that exceed the demanding standards required by

our industry.

Quality Assurance

XX-XX demonstrates its commitment to quality through ongoingprocedures set by the Quality Assurance Department. These

procedures are performed throughout the production cycle, from a

detailed inspection of all incoming parts to a thorough and

final inspection before shipment.

The Quality Manager periodically performs audits with XX-XX

suppliers, which helps maintain a high standard of quality parts


3/59

GENERIC R&D STUDY

3

arriving at the plant. XX-XX's goal is to maintain the highest

possible quality of product.

Manufacturing and Production

The XX-XX manufacturing department creates customer value

through innovative and collaborative effort, lean-process

development, and a commitment to continuous improvement and

customer satisfaction.

Machine Shop

XX-XX experienced machinists have the state-of-the-art machinery

and software necessary to create precise, quality parts for XX-

XX products.

Software

Three SURFCAM CAD/CAM seats, two with two-axis modeling and the

third with three-axis.

Lathe and fourth-axis rotary table capabilities, also with

modeling.

Fully networked to all seats and all CNC machines with a link

to engineering to retrieve CAD prints.

DNC capabilities for all VMC's and turning centers using PC-DNC

Plus software from a hub computer.

Machinery

1: HAAS VF-4 Machining Center with fourth-axis rotary table (X

axis-50 inches, Y axis-20 inches, and Z axis-25 inches)

3: HAAS VF-OE Machining Centers, fourth-axis ready (X axis-30

inches, Y axis-16 inches, and Z axis-20 inches)

2: Mori Seiki Turning Centers (SL-1 and SL-2)

1: Mori Seiki DuraTurn Machining Center

1: Alliant CNC two-axis prototyping knee mill with an Anilam

controller (X axis-30 inches, Y axis-16 inches, and Z axis-20

inches)

4: Manual knee mills with high-resolution digital readouts

2: Engine lathes (Mori Seiki and Takasawa)


4/59

GENERIC R&D STUDY

4

1: Tool room lathe with .00002 resolution digital readout

1: Miller 300 amp. M.I.G. and Miller 350 amp. AerowaveT.I.G.

welding with various grinding and saw-cutting machines

1: Plasma cutter (aluminum and steel)

1: 8 x 24 inch hydraulically controlled surface grinder

4: Rockwell three-phase reversible drill presses (two 20-inch

and two 15-inch)

Products

T2000LSMF+26TH+RECT550 OM1740 Universal Manipulator

HM1740 Handler-Dedicated Manipulator

PDT1740 Prober-Dedicated Manipulator

T2000GSMF+13TH+RECT310 HM1340 Handler-Dedicated Manipulator

THS1340 Test Head Stand

OM1340 Universal Manipulator


T2000SPMF+52TH+RECT550 OM1940 Universal Manipulator



T2000LSMF+52TH+RND440 OM1740 Universal Manipulator


PS3040 Prober-Dedicated (Hinge) Manipulator


T2000LSMF+52TH+RECT550 OM1740 Universal Manipulator



T2000MSMF+52TH+RECT550 OM1940 Universal Manipulator



3360-P OM1070 Universal Manipulator


5/59

GENERIC R&D STUDY

5



3500 OM1370 Universal Manipulator



3600 OM1370 Universal Manipulator


PS3070 Prober-Dedicated (Hinge) Manipulator


ETS200 OM1335 Universal Manipulator



ETS200T OM1335 Universal Manipulator









ASL1000 OM1015 Universal Manipulator



ASL3000 PDT1015 Prober-Dedicated Manipulator


OMASL Universal Manipulator

ASL3000RF PDT1015 Prober-Dedicated Manipulator


6/59

GENERIC R&D STUDY

6


OMASL Universal Manipulator

Diamond 10 (D-10) OM1015 Universal Manipulator



Diamond 40 (D-40) OM1315 Universal Manipulator



Falcon (SZ3650) OM1315 Universal Manipulator



Sapphire OM1715 Universal Manipulator



X-Series CX OM1020 Universal Manipulator



X-Series EX OM1320 (LTXCredence) Universal Manipulator



X-Series LX HM1320 Handler-Dedicated Manipulator

X-Series MX THS1320 Test Head Stand

OM1320 Universal Manipulator


Maverick ST Coming Soon

Maverick PT Coming Soon

Maverick SST Coming Soon

Maverick GT Coming Soon


7/59

GENERIC R&D STUDY

7

Magnum iCP Coming Soon

Magnum SV Dual-Chassis PDT1771 Prober-Dedicated Manipulator

Magnum SSV 4-Chassis PDT1771 Prober-Dedicated Manipulator

J750 OM1725 Universal Manipulator




MicroFlex OM1725 Universal Manipulator



IntegraFlex OM1725 Universal Manipulator




UltraFlex 24-Slot OM1725 Universal Manipulator


UltraFlex 36-Slot OM1925 Universal Manipulator



V93000 SOC Coming Soon

V93000 HSM Coming Soon

V5000 Coming Soon

Manipulators By Weight

50 lb - 300 lb (20 kg - 135 kg)

OM1000 SERIES UNIVERSAL OM1070

OM1075

PDT1000 SERIES PROBER-DEDICATED Coming Soon

THS1000 SERIES HANDLER-DEDICATED THS10XX


8/59

GENERIC R&D STUDY

8

THS1320

300 lb - 450 lb (135 kg - 205 kg)


OM1371

PDT1300 SERIES PROBER-DEDICATED PDT1340

HM1300 SERIES HANDLER-DEDICATED HM1340

HM1335

HM1320

450 lb - 750 lb (205 kg - 340 kg)


OM1335

OM1335H

PDT1300 SERIES PROBER-DEDICATED PDT1371H


750 lb - 1350 lb (340 kg - 610 kg)


OM1725

OM1771


PDT1771

PDT1725


HM1725

HM1525

1350 lb - 1850 lb (610 kg - 840 kg)


OM1925

PDT1000 SERIES PROBER-DEDICATED Coming Soon


9/59

GENERIC R&D STUDY

9

HM1000 SERIES HANDLER-DEDICATED Coming Soon

1850 lb - 3000 lb (840 kg - 1361 kg)

OM1000 SERIES UNIVERSAL Coming Soon


HM1000 SERIES HANDLER-DEDICATED Coming Soon

Manipulators By Product Style

Universal

OM1000 Series OM1070

OM1015

OM1020

OM1075


OM1335

OM1350H

OM1370

OM1315

OM1320

OM1335H

OM1371

OM1320 (LTXCredence)


OM1725

OM1715

OM1720

OM1771


OM1925

Handler-Dedicated


10/59

GENERIC R&D STUDY

10

HM1000 Series HM1070

HM1015

HM1020


HM1335

HM1370

HM1315

HM1320

HM1320



HM1715

HM1720

HM1725


HM1925

prober-Dedicated

PDT1000 Series PDT1070

PDT1015

PDT1020


PDT1370

PDT1315

PDT1335

PDT1371H

PDT1320


PDT1771


11/59

GENERIC R&D STUDY

11

PDT1725

PDT1715

PDT1720


PDT1925

Prober Stations (Hinge manipulators) PS3040

PS3070

PS3015

PS3071

Test Head Stands

THS1340

THS1320

THS750

THS1725

THS2071

THS2571

T.I. VLCT Manipulators

Handler-Dedicated THS10XX

Prober-Dedicated PS10XX

Legacy Products

ARM Style

ARM2002 Advantest T5585, T5586, T5592, T5593

HM Style

HM2000 Advantest T5585, T6533, T6563, T6573, T6672

IM3000 Style

IM3000 Teradyne Integra Flex

IM3125 Teradyne Ultra Flex

IM3225 Teradyne Ultra Flex 36-slot


12/59

GENERIC R&D STUDY

12

OMFAST Skyworks Fast

OMNI Style

200 Series (Capacity up to 200 lbs/90 kgs)

OM5400 Analog Devices, Inc., 5400

OM5410 Keithley S600

OM5420 LTX Fusion CX

OM5430 Texas Instruments VLCT


OM5450 Nextest Maverick ST


OMASL Credence ASL 3000, TMT EVE

OMASL1 Credence ASL 1000

OMASL2LF Credence ASL 2000

OMASL3RF Credence ASL 3000RF, ASL 3000MF, TMT EVE

OMPTST Philips TURBO

OMVLCT Texas Instruments VLCT


OM1101 Credence Quartet

OM312 Credence SC312, SCMicro

OM3650 Credence SZ M3650

OM500 Teradyne A510LHS

OM9490 Agilent 9490

OM94K Agilent 94000 Series

OME364 Eagle Test Systems ETS364

OME564 Eagle Test Systems ETS564

OMKALOS Credence Kalos

OMQLC Credence Quartet

OMSC2 Credence SC212, SCMicro


13/59

GENERIC R&D STUDY

13


OM580 Teradyne

OM1215 Credence Cougar, Quartet

OM1220 LTX D50 Series

OM1225 (OM971) Teradyne J971

OM1230 Credence SZ Kodiak

OM1235 Eagle Test ETS600

OM1240 Advantest T6533, T6563, T6573

OM1245 Schlumberger IXK

OM1270 Hitachi Chroma

OME364 Eagle Test Systems ETS-364

OMD50J LTX D50 Series

OMXTS Credence IMS XTS

OM1500 Series (Capacity up to 1200 lbs/540 kgs)

OM1510 Teradyne Catalyst




OM1540 Advantest T6533, T6563, T6573

OM1542 Credence Octet (Cougar)

OM1550 IMS/Credence Electra

OM1555 IMS/Credence Vanguard

OM1560, OM1570 Agilent 93000

OM1571 Verigy 93000

OM1580 Teradyne Integra J750-512

OM1585 Teradyne Integra J750-1024

OM1587 LTX Fusion HF

OM1600 Series


14/59

GENERIC R&D STUDY

14

OM1610 Verigy 93000

OM1615 Credence Kalos

OM1620 LTX Fusion HFi

OM2000 Series (Capacity up to 1300 lbs/589 kgs)

OM2000 Advantest T5591, T5592, T6671, T6672, T6682; Credence

ITS9000 ZX (NP Test Systems)

OM2001 Advantest T6331, T6361, T6371, T6533, T6563, T6573,

T6672, T6682, T6683

OM3000 Series

OM3040 Advantest T2000, T5377

OM3650 Credence Falcon SZ3650

Granite Series (Capacity up to 3500 lbs/1587 kgs)

GM5000 Teradyne Tiger

GM5302 Teradyne Tiger NS5000

GM5510

GM5610

GM5700

GM5301 Teradyne Tiger (Handler-Dedicated)

GM5302

GM5400 Credence Sapphire

GM5600

THS Style

THC350 Credence/SZ Piranha

THC750 Credence/SZ Piranha

THS750 Teradyne J750 Integra

THS84 Hewlett Packard/Verigy 84000

THS94K Hewlett Packard 94000

PS Style

PS1005 Hewlett Packard 4089/EG4085


15/59

GENERIC R&D STUDY

15

PS1006 Hewlett Packard 4089/EG4085

S3071 Nextest Maverick

Other

OM84 Verigy 84000, 84000 "Mini"

OM580xx Teradyne A5 Family

OM971 (OM1225) Teradyne J971

OM973E Teradyne J973EP

OM975 Credence Quartet

OM976 Credence/SZ Kodiak

OM978 Eagle Test Systems ETS600

OM979 Advantest T6533, T6563, T6573

OM1215 Credence/SZ Kodiak

OM1235 Eagle Test Systems ETS600

OMFUSN LTX Fusion HF

GSKALOS Credence Kalos

GSGKALOS Credence Kalos

XX-XX Research and Development

XX-XX's research and development efforts are dedicated to

providing innovative, cost-effective manipulator and interface

solutions to the unique challenges encountered in the

semiconductor test industry. With a staff of seasoned mechanical

and electrical engineers, XX-XX is able to provide creative,

safe, and reliable custom designs that exceed the demanding

standards required by our industry. This is achieved through a

process of development of new functions, better performance, and

greater reliability in order to handle the specific requirement

of newly developed customer semiconductor test systems.

The XX-XX research and development group has designed from the

group up the following products that had new features, unique

parts, and specific customer required design aspects for

specific test system purposes:


16/59

GENERIC R&D STUDY

16

PDT23xx Series Manipulator Prober Dedicated Manipulator

designed to hold up to a 3,000 pound semiconductor test head,

XX-XX had not previously offered a prober dedicated manipulator

solution for test heads in this weight range.

OM11ss Series Manipulator Universal Manipulator designed as

XX-XXsfirst counterweighted only machine to use a knuckle

joint and belts.

PS 17xx Series Manipulator Prober Station Dedicated Hinge

Manipulator that holds test heads in a weight range in which XX-

XX previously had not offered a hinge manipulator for.

PS 23xx Series Manipulator Prober Station Dedicated Hinge

Manipulator that holds test heads in a weight range in which XX-

XX previously had not offered a hinge manipulator for.

PDS 20xx Series Manipulator Prober Dedicated StandManipulator, smaller foot print floor space requirement then a

PS or PDT manipulator of the same test head weight range.

PDS 19xx Series Manipulator - Prober Dedicated Stand

Manipulator, smaller foot print floor space requirement then a


PDS 11xx Series Manipulator- Prober Dedicated Stand

Manipulator, smaller foot print floor space requirement then a


OM 1940 Manipulator redesigned from ground up to replace oldermodel to provide better functionality, improved serviceability,

and lower production cost.

OM 6000 Manipulator-Universal Manipulator using a new modular

design to allow the use with multiple different semiconductor

test heads with simple an arm change (instead of having many

various different models to accommodate similar test heads from

different semiconductor tester system companies).

OM 7000 Manipulator Universal frog leg Manipulator, XX-

XXs firstfrog-leg design incorporating features thatcustomers like about our competitors frogleg designs that

our standard Omni universal manipulators do not have.

HM 17xx Series Manipulator Handler Dedicated Manipulator

that has smaller footprint and specific features for final

package testing that XX-XX didntoffer in this test head weight

range prior to the development of this machine.


17/59

GENERIC R&D STUDY

17

The accumulated costs for the R&D cost center includes an

allocation of salaries and wages based on the percentage that

the specific employees engaged in R&D projects and activities

throughout the year (ie for example mechanical design engineer

spent 80% of their time doing new product design and development

for R&D efforts, and 20% of their time in current product

support efforts).

Also included in the accumulated costs for the R&D cost center

would be other allocated payroll expenses, supplies, computer

and equipment costs as well as applicable contract research

expenses.

XX-XXs Research and Development Group determines their projects

from a variety of sources. A semiconductor test system company

may initiate a R&D job as they look for a partner to develop anew test system with. The sales and marketing department may

request a project to produce a new machine to fit into a product

category in which the company does not have a current offering.

An end user customer may request a product to be designed to

meets a specific set of criteria for size, functionality and a

specific test head for their desired test floor layout and

configuration. In all of these cases, these products are

designed from the ground up a as custom machine, with no or very

few parts in common with existing XX-XX products in production.

Following please find a few product data sheets that show

products that were either in the early design stages during

2009, or were completed, and sold during the same year.

These newly developed products all have specific design and

functionality features that make them significantly different

for existing product at the time of their development.


18/59

GENERIC R&D STUDY

18

LAW AND ANALYSIS

A. Overview of IRC Section 41 and Section 174 In order for

expenditures to qualify for the research and development (R&D)

tax credit under IRC Section 41, they must first meet the

definition of research and experimentation (R&E) expenditures

under IRC Section 174. The regulations under IRC Section 174

define R&E expenses as "expenditures incurred in connection with

the taxpayer's trade or business which represent research and

development costs in the experimental or laboratory sense."

The regulation further explains "costs are in the experimental

or laboratory sense if they are for activities intended to

discover information that would eliminate uncertainty concerning

development or improvement of a product" The overriding

qualification of IRC Section 174 is that the development

activities must intend to eliminate uncertainty.1. "Eliminating Uncertainty" Test

Uncertainty exists if information available to the taxpayer does

not establish the capability or method for developing or

improving a business component. To qualify as a research or

experimental expenditure for purposes of IRC Section 174, the

expenditure must (1) be incurred in connection with the

taxpayer's trade or business and (2) represent a research or

experimental cost in the experimental or laboratory sense (Reg.

Sec. 1.174-2(a)(1)).

Expenditures are incurred in the " experimental or laboratory"

sense if they are incurred in the conduct of activities that are

intended to discover information that would eliminate

uncertainty concerning the development or improvement of a

product (Reg. 51.174-2(a)(1)). A product, for these purposes,

includes a pilot model, process, formula, invention, technique,

patent or similar property that is either used by the taxpayer

in its trade or business or held for sale, lease or license by

the taxpayer (Reg. Section 1.174-2(a)(2)). The nature of the

product or improvement being developed or the level of

technological advancement that the product or improvement

represents is not relevant in determining whether the related

expenditure qualifies as an IRC Section 174 research or

experimental expenditure. Instead the focus is on the nature of

the activities that the expenditures relate to, namely, whether

the activity is intended to eliminate uncertainty concerning the


19/59

GENERIC R&D STUDY

19

development or improvement of the product (Reg. Section 1.174-

2(a)(1)).

Uncertainty exists if the information available to the taxpayer

does not establish either (1) the capability or method for

developing or improving the product or (2) the appropriate

design of the product (Reg. Section 1.174-2(a)(1)).

Thus, expenditures incurred by a taxpayer to determine the

appropriate design of a product can qualify as research and

experimental expenditures even though the taxpayer has knowledge

that a product development project will be successful (Reg.

Section 1.174-2(a)(4); T.D. 8562).

a. Ineligible activities:Items ineligible for the IRC Section

174 election and items specifically excluded under IRC Section

4l may not be taken into account for purposes of the credit.

These are:

1) Research done outside the United States, the Commonwealth of

Puerto Rico or any possession of the United States (IRC Section

41(d)(4), as amended by the Tax Relief Extension Act of 1999

(P.L. 106-170); Reg. Section 1.41-4(c)(7)).

2) Research in the social sciences, arts or humanities (IRC

Section 41(d)(4); Reg. Section 1.41.-4(c)(8)).

3) Ordinary testing or inspection of materials or products for

quality control (Reg. Section 1.174-2(a)(1)).

4) Market and consumer research (Reg. Section 1.174-2(a)(1)).

5) Advertising or promotion expenses (Reg. Section 1.174-

2(a)(1)).

6) Management studies and efficiency surveys (IRC Section

41(d)(4); Reg. Section 1.414(c)(6)).

7) Research to find and evaluate mineral deposits, including gas

and oil (IRC Section 174(d)).

8) Acquisition or improvement of land or of certain depreciable

or depletable property used in research (IRC Section 174(c)).

9) Acquisition of another person's patent, model, production or

process (Reg. Section 1.174-2(a)(1)).


20/59

GENERIC R&D STUDY

20

10) Research funded by another person, or any governmental

entity, by means of a grant or contract (IRC Section

41(d)(4);Reg. Section 1.41-4(c)(9)).

11) Research conducted after commercial production (IRC Section

41(d)(4)(A); Reg. Section 1.41-4(c)(2)).

12) Research for the adaptation of existing business components

IRC Section 41(d)(4)(B); Reg. Section 1.41-4(c)(3)).

13) Research for the duplication of an existing business

component (IRC Section 41(d)(4)(C); Reg. Section 1.41-4(c)(4)).

14) Except to the extent provided in regulations, research with

respect to internal-use software (IRC Section 41(d)(4)(E)). See

"Internal-use software, below.

b. Funded research exclusion:For purposes of item (10),above

(research funded by grants, contracts, or governmental

entities), amounts payable that are contingent on the success of

the research (and thus considered as paid for the product or

result of the research) are not treated as funding (Reg. Section

1.41-4A(d)(1)).

If a taxpayer performing research for another person retains no

substantial rights in the research, the research is treated as

fully funded, and none of the expenses paid or incurred by the

taxpayer in performing the research are considered qualified

research expenses (Reg. Section 1.41-4A(d)(2)).

Moreover, if the payments to the researcher are contingent upon

the success of the research under such circumstances, the

taxpayer (where the taxpayer is paying a third party to perform

contract research) may not treat the expenses as qualified

research expenditures.

In contrast, if the payments are guaranteed, for example, under

a time and materials contract, the taxpayer performing contract

research for another may not treat the expenses as qualified

research expenses.

Substantial rights in the research are not retained if the

contract provides that the payer (where the taxpayer is

performing the research for another) or the contractor

performing the research (where the taxpayer is paying for

contract research) retains exclusive rights to the intellectual

property or the results of the research. If a taxpayer

performing research for another person retains substantial


21/59

GENERIC R&D STUDY

21

rights in the research, the research is considered funded to the

extent of payments (and the fair market value of

property)received (Reg. Section 1.41-4A(d)(3)).

DETAILED ANALYSIS OF FUNDED RESEARCH

Under Internal Revenue Code ("IRC") 41(d)(4)(H), the R&D taxcredit is not available to a taxpayer for any research activity

to the extent such research is "funded" by a grant, contract, or

other arrangement. Congress enacted the funding limitation in

order to restrict research credit benefits to a single taxpayer

in a given transaction (although the limitation is imperfect in

that two parties often claim the same costs as QREs, and in some

transactions, no party is allowed to claim the expenditures).

The IRC 41 regulations provide a major exception to "funding."

Research performed by a taxpayer on behalf of another is not

funded if both: (1) the payment to the taxpayer is contingent onthe success of the research (i.e., the taxpayer is "at risk" of

bearing the research costs upon failure of the project) and (2)

the taxpayer retains "substantial rights" in the research. Note

that it isn't a contract's payment terms alone that determine

whether contract research is funded - retention of substantial

rights is essential.

Is research "at risk?"

Amounts paid to a taxpayer under any agreement that are

contingent on the success of the research (and thus consideredto be payments for the product or research results rather than

for research performed on the payor's behalf) are not treated as

funding of the research. The determination of whether you are at

risk turns on which party bears the research costs upon failure

of the project contemplated under the terms of the contract.

When payment to you is contingent on performance, such as the

successful design and development of a new product or process,

you bear the risk of failure.

A common perception is that fixed price-type contracts are, by

definition, not funded while cost-type contracts are funded forthe party performing the work. This is clearly not always true.

To determine if amounts are "at risk" and whether you retain

"substantial rights," it isn't the contract type that controls

but the specific contractual terms. These terms describe if your

company is at risk of bearing the research costs if the project


22/59

GENERIC R&D STUDY

22

fails and whether you retain substantial rights in the research

results.

Did taxpayer retain "substantial rights" in research?

If the taxpayer company performs research on behalf of another

entity and retains no "substantial rights" to the research

results under the terms of the contract, the research is treated

as funded. Although the IRC 41 regulations do not define

"substantial rights," they do state that a taxpayer does not

retain substantial rights when the party for whom the research

is performed has the exclusive right to exploit the results of

the research and the taxpayer must pay for the right to use the

research results. Generally, the right to use research resultswithout paying for such right, even if not an exclusive right,

is substantial. However, if the taxpayer must pay a royalty (or

similar fee) in order to obtain a non-exclusive license to use

the research results, then you do not retain substantial rights

in the research.

Thus, as long as exclusive rights are not vested in another, the

taxpayer can "share" substantial rights in the research results

with other parties. For example, under the terms of many

contracts, taxpayers performing research on behalf of another

entity often retain the right to use any knowledge gained whileconducting the research in future applications even though the

technical drawings, blueprints, or product specification sheets

generated during the research activities remain the property of

the customer. In such a case, substantial rights in the research

could be shared between you and your customer. As long as you

are at risk under the terms of the contract, the research is not

funded and you may claim the qualified research costs as QREs.

Treasury Regulation Section 1.41-4(c)(9) applicable to qualified

research expenditures paid or incurred in taxable years ending

on or after December 31, 2003, defines the extent to whichresearch is so funded. Since the periods at issue are tax year

ending after 2003, 2004, Treasury Regulation Section 1.41-4A(d)

is applicable.

Research performed for a customer under a contract is considered

funded unless two requirements are met by the taxpayer: (1) the

amounts payable under the agreement are contingent on the


23/59

GENERIC R&D STUDY

23

success of the research and thus considered to be paid for the

product or result of the research; and (2) the taxpayer retains

substantial rights in the research. Treas. Reg. 1.41-4A(d).

Contingent on the Success of the Research

Amounts payable under any agreement that are contingent on the

success of the research and thus considered to be paid for the

product or result of the research are not treated as funded.

Treas. Reg. 1.41-4A(d)(1). If an expense is paid or incurred

pursuant to an agreement under which payment is contingent on

the success of the research, then the expense is considered to

be paid for the product or result rather than the performance of

the research. Treas. Reg. 1.41-2(e)(2). This test is applied

to each expenditure and not to the agreement as a whole. See

Treas. Reg. 1.41-2(e)(5). Therefore it is possible for ataxpayer to perform some research where the client pays for the

end product and some research where the client is paying for the

research itself within the same contractual agreement. All

agreements and not only research contracts entered into between

the taxpayer performing the research and other persons are

considered in determining the extent to which the research is

funded. Treas. Reg. 1.41-4A(d)(1).

The Court in Fairchild Industries, Inc. v. United States, 71

F.3d 868 (Fed. Cir. 1995), revg 30 Fed. Cl. 839 (1994), held

that research is not funded by a contract if the taxpayer bears

the research costs upon failure to successfully complete the

project for which it is doing the research. In Fairchild

Industries, the taxpayer entered into fixed price incentive

contracts with the United States Air force. The Air Force was

obligated to pay for the research only if the taxpayer produced

results that met the contract specifications and certain

provisions of the Defense Acquisition Regulations. The contracts

provided that the Air Force could terminate the Contract either

for default or for the convenience of the government. The Air

Force would pay bi-monthly refundable advanced payments,calculated as a percentage of the expenditures the taxpayer

actually incurred. The United States argued and the Court of

Federal Claims agreed that the availability of the credit

depends on the relative likelihood that the contracting entity

would pay.


24/59

GENERIC R&D STUDY

24

The Court of Appeals disagreed and held that whether research is

funded by a contract depends on who bears the research costs

upon failure, not on whether the researcher is likely to succeed

in performing the project. Since the Air Force was only liable

for payment of the contract when the project succeeded and was

accepted, the Court determined that the taxpayer bore thefinancial risk of failure and could claim the credit. The fact

that the taxpayer received advanced payments from the Air Force

that were calculated as a percentage of the taxpayers costs did

not change the result because the advanced payments were

refundable if the project was not successful. The Courts test

applies to all contracts and not just to unusually risky or

uncertain contracts. The result is the same even if the

contractor expects to perform as the contract contemplates.

In other advice, the Service has stated that contracts are not

considered contingent on the success where the standard ofperformance is that of a similar qualified design professional

exercising due care. 2002 IRS NSAR 20350. Where the contract

requires substantial performance, warrants results, or the

contract is governed by local law that applies a warranty of

results standard, then the contract is contingent on results,

and is therefore not funded.

Substantial Rights

If the taxpayer performs research on behalf of another entity

and does not retain substantial rights in the research, then theexpenses paid or incurred by taxpayer are not qualified research

expenses and the research is treated as fully funded by a

contract. Treas. Reg. 1.41-2(a)(3)(i); Treas. Reg. 1.41-

4A(d)(2). Incidental benefits to the taxpayer from performance

of the research, such as increased experience in a field of

research, do not constitute substantial rights in the research.

Treas. Reg. 1.41-4A(d)(2).

If the taxpayer in carrying on a trade or business performs

research on behalf of another person, but retains substantial

rights in the research under the agreement providing for theresearch, then the research is funded, but only to the extent

the payments to which the taxpayer becomes entitled by

performing the research. Treas. Reg. 1.41-2(a)(3)(ii); Treas.

Reg. 1.41-4A(d)(3). The taxpayer must reduce the amount paid

or incurred for research that would otherwise constitute

qualified research expenses of the taxpayer, but for the


25/59

GENERIC R&D STUDY

25

restriction in Section 41(d)(4)(H) by the amount of the research

funded by a contract. Treas. Reg. 1.41-4A(d)(3).

A taxpayer does not retain substantial rights in the research if

the taxpayer must pay for the right to use the results of the

research. Treas. Reg. 1.41-4A(d)(3). Whether a taxpayer has

retained substantial rights is applied on a project by project

basis. Treas. Reg. 1.41-4A(d)(3)(iii).

The issue in Lockheed Martin Corp. v. Unites States, 210 F.3d

1366 (Fed. Cir. 2000), rev. in part 42 Fed. Cl. 485 (1988), was

whether the taxpayer retained substantial rights in the research

so that it could claim the research tax credit. The taxpayer

entered into many substantially similar fixed price contracts

with the United States. The Court of Federal Claims found that

the taxpayer did not retain substantial rights because under the

contracts (1) the government had unlimited right to use thetaxpayers technical data and disclose it to third parties; (2)

the taxpayer had to seek approval from the State Department

prior to entering into licensing agreements or discussing with

other customers technical information not in the public domain;

(3) the government had veto power over the taxpayers right to

file patent applications and could require the taxpayer to

transfer title to a subject invention if the taxpayer failed to

file a patent application within a specific period of time; and

(4) the recoupment provisions in the contracts required the

taxpayer to pay the government for certain costs for each

commercial sale made by the taxpayer of technology that utilized

the research results attained under the government contracts .

Id. at 1369-70. The Court of Federal Claims characterized the

profits the taxpayer received on private sales of related

technology as incidental benefits. Id. at 1370.

The government argued that a taxpayer only retains substantial

rights if the taxpayer retains the right to exclude others,

including the government, from its research and in which other

parties do not also have the right to use or disclose the

taxpayers research, including patented inventions.

The Court of Appeals disagreed and held that the taxpayer

retained substantial rights in the research. The right to use

the research results, even without the exclusive right, is a

substantial right. The Court found that under the agreements,

the taxpayer was able to use the results of its research in its

business without paying for it and this was a substantial right

that allowed the taxpayer to manufacture and sell up-to-date


26/59

GENERIC R&D STUDY

26

products meeting the needs of its customers. The Court found

that the recoupment provision that required the taxpayer to

reimburse the government for research costs each time it made

use of the government research results in a commercial sale did

not restrict the taxpayers use of the technology. This

recoupment provision did not amount to the taxpayer paying forthe use of the research and so the taxpayer retained substantial

rights under the contracts. Id. at 1377.

In 2002 IRS NSAR 20350, the Service noted that except where a

contract has explicit provisions granting ownership of all

intangible or intellectual property (not merely designs,

specifications, blueprints and the like) to the client, [the

contactor] retains substantial rights.

Examples

Project No. 1

Project No. 1 is funded up to the extent the Taxpayer is not

reimbursed for its expenses because payment is not contingent on

the success of the research.

The contract is a cost-plus fixed-fee contract, the Taxpayer

will be reimbursed for costs up to the ceiling of $ .

The Taxpayer contractual obligation is to perform

satisfactorily, which is a promise to use a standard of care.

This does not imply a warranty or guarantee the success of a

project. Even if the Taxpayer defaults on the contract, the

Taxpayer will be reimbursed for the work performed.

Regarding rights, Client does not retain exclusive rights to the

research. Although Client retains the rights to all reports,

calculations, and materials, the agreement does not convey to

Client ownership of the underlying information or ideas.

Accordingly, the Taxpayer has substantial rights to make use of

the research in accordance with Lockheed.

Project No. 2Under Project No. 2, payment to the Taxpayer is not contingent

on the success of the research because Taxpayer will be

reimbursed for work performed regardless of whether the research

is successful.

Project No. 2 is a fixed-fee contract, under which the Taxpayer

will invoice Client 2 monthly. Upon completion of the contract,


27/59

GENERIC R&D STUDY

27

Client 2 will pay retained amounts if the work is acceptable.

Thus, the Taxpayer could receive payment even though Client 2

ultimately deems the work unacceptable.

Because the Taxpayer must correct any deficiencies in its work

without additional compensation pursuant to the warranty and the

compensation is capped, the Taxpayer could be at risk for any

amounts over the fixed fee or for expenditures incurred during

the correction of deficiencies in its work.

The Taxpayer appears to retain sufficient rights to the

research. Under the contact, the Client 2 retains the written

documents and designs, but not exclusive rights to the research.

Project No. 3

The payment to the Taxpayer is not contingent on the results of

the research. Project No. 3 relates to a capped time-and-materials contract. The Taxpayer does not warrant its work and

there is no acceptance or inspection requirements. If the

Taxpayer incurs expense in excess of the cap, it will assume the

risk for such amounts.

With respect rights, Client 3 does not retain exclusive rights,

and therefore, the Taxpayer will retain a substantial right to

the research for the purpose of 41.

Project No. 4

Under project no.4, payment to the Taxpayer is not contingent onthe success of the research. This is a capped time-and-materials

contract. The contract is essentially for services and not the

results of the research; the Taxpayer offers only to perform to

a standard of care and does not warrant its work. In addition,

the contract does not include acceptance or inspection

requirements.

However, as the case with other capped time-and-materials

contracts, the Taxpayers expenditures in excess of the cap may

be at risk.

With respect rights, Client 4 does not retain exclusive rights,

and therefore, the Taxpayer will retain a substantial right to

the research for the purpose of 41.

Project No. 5

All rights to research are retained by the Client.


28/59

GENERIC R&D STUDY

28

Accordingly, the contract is funded though if under local law

retaining the rights is a legal impossibility, this result may

not obtain.

Project No. 6

Project No. 6, a capped time-and-materials contact, is funded

because payment to the Taxpayer is not contingent on the results

of the research.

Although work must be deemed satisfactory prior to payment, the

Taxpayer will be paid in the event of default under the

termination/cancellation terms of the contract.

Further, the Taxpayer does not offer a warranty for the work

provided.

With respect to rights, the contract does not bestow all rights

to the research to Client. Thus, the Taxpayer will retain a

substantial right to the research.

If the Taxpayer incurs costs over the capped amount, suchexpenditures may be included in the credit calculation, provided

the other provisions of 41 are satisfied.

Project No. 7

Project No. 7 is a fixed fee contract, where payment is not

contingent upon the success of the research.

Even if the Taxpayer defaults, the Taxpayer will receive payment

from Client.

In addition, the Taxpayer only warrants ordinary care and skill.

Although Client may perform evaluations of the services

provided, such evaluations will only be used for future

solicitations. As the case with other capped or fixed fees, the

Taxpayer may be at risk for amounts incurred over the cap.


29/59

GENERIC R&D STUDY

29

With respect to rights, the contract does not bestow all rights

to the research to Client. Thus, the Taxpayer will retain a

substantial right to the research.

It seems clear under the UCC rules alone XX XX has an implied

warranty of merchantability and thus, its research could not be

funded as described above based on our discussions with company

personnel.

General analysis of IMPLIED Warranties UCC 2-314 & 2-315

(NOTE: you can express a warranty for services, but you cant

imply one.

Implied warranties apply only to goods.

A. General - Arise under the UCC. You do not need a statement

of warranty or representation for these.

1. Two types

a. Implied Warranty of Merchantability - UCC 2-314

(1) Most important warranty - It provides that goods must be

fit for the ordinary purposes for which such goods are used.

Ordinary use of the trade.

(2) Attached automatically; doesn't have to be expressed if

you're a merchant selling goods of that kind.

(3) Strict Liability because it doesn't require a demonstration

of fault or negligence or who is negligent.

(4) The UCC doesn't give firm and clear guidelines for what

merchantability is, so the court or jury defines it. This is

problematical to the seller of complex technical goods. They

will try to disclaim as will sellers in general.

(5) Food Items - Court uses reasonable expectation test.

b. Implied Warranty of Fitness for a particular purpose - UCC

2-315 (dont have to be a merchant seller; as opposed to

implied warranty of merchantability)

(1) Where the seller knows or has reason to know of a

particular purpose that the goods are to be used for and the

buyer relies on seller's skill and judgement to select or

furnish the goods; the goods must be fit for the particular

purpose.

(2) Buyer must prove three things and goods must be unfit:


30/59

GENERIC R&D STUDY

30

(a) Seller had reason to know of buyer's purpose

(b) Seller knew the buyer was relying or had reason to know.

(c) That the buyer relied on the seller's knowledge.

(3) Under this warranty goods may be fit for "ordinary

purposes" but not for the "particular purpose" envisioned by the

parties. (like sail boat for ocean-going voyage)

c. Warranties in the Market Place

(1) Soft Goods (food, clothes): sellers of soft goods are

generally content to rely on the UCC for implied warranty; and

(2)Hard Goods (furniture, cars): there is an unwillingness to

do business on the implied warranty business; the market place

will force someone to make a warranty.

d. Magnusson-Moss Warranty Act: Federal Leg. Disclosure law;

Doesn't require warranty but when warranty given cant disclaim

an implied warranty; can only limit the duration of an express

warranty.

B. Disclaimers and other defenses of sellers

1. UCC 2-316 - Disclaimer

a. Express warranty - The disclaimor can't be inconsistentwith express warranty given. If not are considered

unreasonable.

a. Implied warranty of merchantability - The disclaimer must:

(1) mention merchantability (2-316(2))

(2) be conspicuous if in writing (2-316(2))

b. Implied warranties of fitness for purpose, disclaimer must:

(1) must be in writing and conspicuous. (2-316(2)).

The following apply to both merchantability and fitness:

c. "Magic Words" - all implied warranties can be disclaimed by

such words as "with all faults" or "as is," they call fact that

there is no warranty to buyer's attention. (2-316 (3) (a)). AND

d. Seller must demand Buyer examine goods or sample or model

for reasonable defect, if he refuses to examine, there is no


31/59

GENERIC R&D STUDY

31

implied warranty for defects he ought to have found. Also, if

he fully examined sample or model there is no implied warranty -

> express warranty instead. (2-316 (3) (b)). {no warranty if

examination should reveal defect.}

e. Implied can also be excluded or modified by prior course of

dealing, course of performance or usage of trade. (UCC Sections

2-316 (3) (c)).

NOTE: It appears as though a seller can get out of a warranty

with a few "magic words" - however, the courts have leeway in

finding what is "conspicuous" , and can revert to UCC 2-302,

which is "unconscionable disclaimer" provision. You must look

at whether disclaimer is one-sided; surprise or in actual

contract; or leaves parties without a remedy.

f. UCC Sections 2-316 (2) & (3) seen in sections a-e above,

make it seem like an easy formula to follow to disclaim, BUT ifyou go to the court decisions, it is not necessarily the case.

It depends on the circumstances as to how the court decides.

g. When the disclaimer was introduced is important. If it's

in a warranty booklet not opened until after the goods are

bought, it doesn't count.

h. There is also a problem for the seller because if something

is disclaimed too much, it's hard to sell.

2. UCC 2-607 (3)(a) - Notice of breach required

a. After a buyer discovers a problem (breach of warranty) he

must notify the seller within a reasonable period of time or be

barred from remedy.

c. After commercial production, adaptation and duplication

exclusions:With respect to the after commercial production,

adaption" and "duplication" exclusions (items (11),(12) and

(13), above), the preamble to T.D. 9104 indicates that the IRS

believes these particular exclusions do not apply to researchactivities that otherwise satisfy the requirements for qualified

research. This represents a change in the IRS's interpretation

of these exclusions. For example, in the preamble

to T.D. 8930, the IRS indicates that the adaptation exclusion

could apply in situations where the other requirements for

qualified research had been satisfied.


32/59

GENERIC R&D STUDY

32

DETAILED ANALYIS OF PROTOTYPES

In general, when a prototype is placed in inventory for sale to

customers, the wages, contract research (for which the taxpayer

bears the risk), and supply costs incurred to develop the

prototype are qualified research expenditures (QREs), but the

wages and contract research related to construction and the

supply costs for component parts are not. The same is true when

a prototype is used for rotable spare parts or is used as

depreciable property by the taxpayer.

However, when a prototype is scrapped by the taxpayer, all of

the wages, contract research (for which the taxpayer bears the

risk), and supply costs incurred to develop and construct the

prototype are QREs. Similarly, when the taxpayer pays a third

party to develop a prototype and does not obtain an ownership

interest in the prototype all of the costs incurred by thetaxpayer to develop the prototype are QREs.

Finally, when the taxpayer develops the prototype for a customer

and does not obtain an ownership interest in a prototype, all of

the costs incurred by the taxpayer to develop the prototype are

QREs as long as the taxpayers compensation for services is

contractually subject to performance guarantees relating to the

prototype.

Under section 174(a), a taxpayer may treat research or

experimental expenditures which are paid or incurred by him

during the taxable year in connection with his trade or business

as expenses which are not chargeable to capital account. The

expenditures so treated shall be allowed as a deduction.

However, under section 174(c) no deduction is allowed for any

expenditure for the acquisition or improvementof property

of a character which is subject to the allowance under section

167.

The regulations clarify that expenditures for depreciable

property are not subject to an allowance for depreciation even

if the property that is acquired or improved is used for

research and development; however, expenditures that result in

depreciable property to be used in the taxpayer's trade or

business may be allowable as a current expense deduction. QREs

for the acquisition or production of depreciable property do not

include the cost of component materials, construction labor, or

other costs attributable to acquisition/ improvement.

Additionally, the regulations provide that expenditures paid to


33/59

GENERIC R&D STUDY

33

third parties for the construction of depreciable property that

is acquired by the taxpayer are deductible if such construction

is done at the taxpayers specification and risk.

Any amount paid or incurred for supplies used in the conduct of

qualified research is a qualifying in-house research expense.

However, property of a character subject to the allowance for

depreciation is excluded from qualifying as supplies. The

legislative history of the section 41 credit suggests that the

costs of component parts could be included in the credit

calculations as qualifying supply expenditures; however, neither

the IRS nor the courts have taken this approach.

Revenue RulingsIn general, Revenue Rulings have been favorable regarding the

deductibility of costs incurred to develop prototypes, but

somewhat limited in their reasoning and discussion of the law.

Rev. Rul. 69-484 held that payments made by a taxpayer airline,

in concert with other airlines and the Federal Aviation

Administration, to an aircraft manufacturer to design, develop,

and test a supersonic transport aircraft were deductible under

section 174. These payments did not entitle the taxpayer to any

rights in the prototype and were made because the development of

the aircraft would benefit the taxpayer in general.

Rev. Rul. 73-20, which cited Rev. Rul. 69-484 as precedent,

similarly held that payments made by a taxpayer utility to a

non-profit research and development organization formed to

develop a model that would benefit the utility field were

deductible under section 174. Notably, the Ruling held that even

the portion of the payments that were administrative and

operating expenses were deductible. Like the payments in Rev.

Rul. 69-484, the payments in Rev. Rul. 73-20 did not entitle the

taxpayer to any rights in the prototype and no mention was made

about the eventual use or disposition of the prototype.

Similarly, Rev. Rul. 73-324 determined that payments made by a

taxpayer in concert with other industry members and a government

agency for the development of a product, were deductible under

section 174.


34/59

GENERIC R&D STUDY

34

Rev. Rul. 73-275 considered whether a taxpayer was entitled to a

section 174 deduction for costs incurred in constructing special

order manufacturing systems for its customers. The Ruling held

that the product engineering expenses qualified under section

174, but the production costs did not. The Ruling emphasized

that section 174 covers costs incurred in developing theconcept of a product as opposed to the product itself.

Rev. Rul. 75-122 considered whether the taxpayer mining

companys costs to access a previously unexploited mineral

deposit, develop equipment to mine that deposit, and develop

equipment and processes to extract the mineral from the ore were

deductible under section 174. The Ruling held that the costs to

locate and access the ore were explicitly disallowed by section

174(d). However, the costs for developing new mining equipment,

developing new refining processes and equipment, and shipping

ore samples to the lab were deductible under section 174.

Private Letter Rulings

A number of private letter rulings (PLRs) have also been

favorable to the taxpayer.

In PLR 7921037, the Service ruled a taxpayer utility company

that participated in a coal gasification plant project funded by

several utility companies was entitled to a deduction under

section 174.

PLR 7948031 was issued to a taxpayer chicken farmer that engaged

an engineer to develop an advanced system to extract uric acid

from chicken manure so that the manure could be used for animal

feed. The Letter Ruling held that the engineering and plant

costs incurred that related to removing the uric acid from the

manure were not deductible because that process had already been

tested and developed, but the plant and development costs

attributable to conversion of uric acid into fertilizer were

deductible under section 174 except to the extent that those

costs were for the acquisition or improvement of land orproperty that were subject to the allowance for depreciation

under section 167.

PLR 8138145 was issued to a taxpayer partnership that was in the

process of developing a pilot residential energy efficiency

program that would pay the taxpayer if it could provide energy

cost savings to customers that were greater than the cost to the


35/59

GENERIC R&D STUDY

35

utility of providing energy. The Letter Ruling held the

partnership may deduct all amounts which qualify as research and

experimental expenditures in connection with the pilot test.

In a slightly different situation, PLR 8835002 was issued to a

taxpayer that developed a prototype that used a new construction

method in a laboratory. The Letter Ruling held that the

following constituted QRE under section 41: 1) wages and

supplies used for research and development in taxpayer's

research and development department both prior to and after the

installation of the first prototype; 2) wages for on-site

monitoring of the prototype installations; 3) supplies for

modifying the prototype installations; and, 4) 65 percent of the

amounts relating to the testing of the prototypes paid to

subcontractors to replace the original prototypes due to method

modifications and damage to the extent that these expenses were

incurred during the period the taxpayer was developing its newmethod.

Similarly, in TAM 199927001, a taxpayer that constructed molds

and other tools for the manufacture of plastic products was

allowed to deduct the costs incurred in designing the tools, but

the costs incurred in constructing the tools were not deductible

even though they would not be depreciated by the taxpayer.

Court Cases

In Honeywell Inc. & Subsidiaries,1 the Court held that rotable

spare parts were depreciable assets rather than inventory.

Honeywell used such parts to service computers owned by its

customers as part of its computer maintenance and service

business. Honeywell consistently capitalized cost of rotable

parts and depreciated them over the same life span assigned to

the related computers. The parts were provided by Honeywell to

its customers under computer lease or maintenance agreements and

were repaired after removal from customer's machines to be used

again. There was no direct relationship between the fixed fee

charged to maintain the computers and the price or cost of parts

in taxpayer's replacement parts pool; thus, parts were not

considered an income-producing factor that would require

treatment as inventory. The pool of parts was necessary for

Honeywells maintenance business and the fixed asset method of

accounting used by Honeywell properly matched the cost of


36/59

GENERIC R&D STUDY

36

establishing the pool with revenue earned from maintenance

agreements.

In Trinity Industries, Inc. v. US2, the Court held that under

the substantially all rule, if 80 percent of the activities to

develop a prototype constituted a process of experimentation,

then all of the costs associated with the prototype project were

eligible for inclusion in calculating the section 41 credit.

Trinity operated several businesses as divisions, one of which

built work boats for offshore drilling rigs along with other

special purpose boats. This division engaged in research and

development to design and build first in class ships or

prototypes for specific customers. Trinity claimed a credit for

work done to design and build these prototypes. The IRS denied

the claim and argued that the ships developed by Trinity were

not a business component because the prototype ships being

developed were for special orders and not to be sold out ofgeneral inventory. The Court disagreed, finding that after

Trinity completed the ships they were held for sale and thus

satisfied the business component requirement. The Court went on

to hold that under section 41(d), if 80 percent of the cost of

developing a prototype was incurred as part of the process of

experimentation, the entire cost of the prototype qualified as a

research expense. Thus, Trinity was entitled to its claim for a

credit.

In TG Missouri Corp. v. Commissioner, 3 the taxpayer

manufacturer claimed research tax credits for expenditures it

incurred to develop prototypes of production molds used to make

plastic auto parts for customers. These parts were built to

customers specifications and the prototype molds became the

customers property upon completion. The taxpayer manufacturer,

however, retained physical possession after it sold the molds to

customers so the taxpayer could produce auto parts for its

customers. Importantly, the taxpayer guaranteed that the molds

would perform in the manner desired by its customers. The

taxpayer claimed these expenditures on its 1998 and 1999 tax

returns. In 2006, the IRS audited the returns and denied thecredits on the basis that the molds were property of a

character subject to the allowance for depreciation and were

not qualified research expenditures. The taxpayer argued the

expenditures did, in fact, qualify because they were depreciable

in the hands of someone other than the taxpayer. The Court

agreed with the taxpayer and allowed the expenditures to be used

to calculate the research tax credit. The Court noted that the


37/59

GENERIC R&D STUDY

37

statute linked the proper financial accounting treatment of the

molds to the treatment of the expenditures incurred to develop

those molds for purposes of calculating the research tax credit.

Analysis

An overarching theme in the relevant authorities that considerwhether the costs incurred by a taxpayer in developing and

producing prototypes are qualified expenditures for the purpose

of sections 41 and 174 is these sections allow a taxpayer

benefits for developing the concept of a product, but not for

producing the product itself. When the prototype is placed in

inventory for sale to customers, the wages, contract research

(for which the taxpayer bears the risk), and supply costs

incurred to develop the prototype are qualified expenditures,

but the wages and contract research costs related to the

construction of the prototype and the supply costs for componentparts of the prototype are not. In Rev. Rul. 73-275, the IRS

held that a taxpayer was entitled to a section 174 deduction for

the engineering costs incurred in constructing special order

manufacturing systems for its customers, but was not entitled to

deduct the cost to manufacture those systems. Therefore, in the

case where prototypes are placed into inventory, the costs to

develop the prototype are qualified expenditures, but the costs

to construct the prototype are not.

The outcome is the same when the prototype is used for rotable

spare parts; the wages, contract research (for which thetaxpayer bears the risk), supply costs to develop the prototype

are qualified expenditures, but the wages and contract research

related to the construction of the prototype and the supply

costs for component parts of the prototype are not. Under

Honeywell rotable spare parts are depreciable assets rather than

inventory. Generally, under section 174, no deduction is allowed

for any expenditure for the acquisition or improvement of

depreciable property. However, under the section 174

regulations, expenditures for research or experimentation that

result in depreciable property to be used in a taxpayer's trade

or business are deductible. Importantly, the regulations state

that expenditures for component materials, construction labor,

or other costs attributable to acquisition and improvement do

not qualify.

Like in the inventory situation, the distinction in the rotable

spare parts situation is that the cost of developing the

property is deductible while the cost of producing the property


38/59

GENERIC R&D STUDY

38

is not; therefore, the costs to develop the prototypes that

become rotable spare parts are qualified expenditure, but the

costs to construct the prototypes are not. For the same reasons,

when the prototype is kept and used as depreciable property by

the taxpayer, the wages, contract research (for which the

taxpayer bears the risk), supply costs to develop the prototypeare qualified expenditures, but the wages and contract research

related to the construction of the prototype and the supply

costs for component parts of the prototype are not.

When the prototype is scrapped by the taxpayer, all of the

wages, contract research (for which the taxpayer bears the

risk), and supply costs incurred to develop and construct the

prototype are qualified expenditures. Generally, a taxpayer can

take a deduction for research or experimental expenditures that

are paid or incurred in connection with the taxpayers trade or

business. A deduction is not allowed, however, for anyexpenditure made for the acquisition or improvement of

depreciable property. When a taxpayer develops a prototype that

is later scrapped, he or she is not creating depreciable

property; therefore, the costs paid or incurred by the taxpayer

to create the scrapped prototype are deductible. When the

taxpayer develops the prototype for a customer and does not

obtain an ownership interest in a prototype, all of the costs

incurred by the taxpayer to develop the prototype are qualified

expenditures as long as the taxpayer provides its customer with

performance guarantees relating to the prototype. TG Missourishowed that the depreciable property exceptions found in

sections 174 and 41 only apply if the property is depreciable in

the hands of the taxpayer.

When the taxpayer does not obtain an ownership interest in the

prototype as a result of the costs that it incurs, all of the

costs are qualified expenditures. In Rev. Rul. 69-484, Rev. Rul.

73-202, and Rev. Rul. 73-324, taxpayers that made payments to a

third party in concert with other industry members and a

government agency for the development of a product prototype

were deductible under section 174. In these cases, the taxpayerand other industry members did not obtain an ownership interest

in the prototypes that were created as a result of their

payments.

Lockheed Martin

In LOCKHEED MARTIN CORPORATION, No. 8:12-cv-03725 (AW), filed 5-

14-13, Lockheed amended its complaint against the IRS to take


39/59

GENERIC R&D STUDY

39

R&D credits as described by a few examples below for the

following (See Exhibit A copy of amended complaint):

(The disputed QREs include the costs of wages, supplies, and

contract research incurred in connection with the design,

development, testing, integration, and fabrication of innovative

and unproven prototypes, including four different first-

configuration Atlas V launch vehicles and an advanced electronic

surveillance and security system).

1. Atlas V launch vehicle consists of a complex array of

integrated systems, including the propulsion systems, vehicle

and payload structures, and avionics systems. To meet a

particular customers mission specifications, these systems and

their respective components and subsystems must work together

flawlessly under extreme conditions.

Each new configuration of Atlas V components presents new anddifferent engineering and scientific challenges.

Lockheed Martin (previously on its own and now as part of the

ULA joint venture) undertakes extensive preproduction design and

development efforts with respect to each new configuration of

the Atlas V. To the extent feasible, each part, component, and

system is subjected to extensive laboratory testing and

analysis. Throughout the production process and up to launch,

the launch vehicle and its various systems are subjected to

rigorous preflight testing.

A new launch-vehicle-configuration design cannot be proven or

validated until it is actually assembled and successfully

launched.

For each launch, an array of sensors gathers information about

the status of all critical components and systems. This

information is carefully analyzed as part of a formal post

flight review. Anomalies identified through this process are

analyzed in order to understand their causes and to develop

engineering solutions for future missions.

At the time of their respective launches, the four Atlas V

launch vehicles described below represented new and unproven

configurations for which Lockheed Martin claimed QREs.

The costs Lockheed Martin incurred to design, develop, test,

integrate, and fabricate the launch vehicle that would be used

to launch Inmarsats 4-F1 satellite included wages paid to


40/59


41/59

GENERIC R&D STUDY

41

employees for qualified services (as that term is defined in

section 41(b)(2)(B)), amounts paid for supplies (as that term is

defined in section 41(b)(2)(C)) that were used in the conduct of

qualified research, and contract research expenses (as that term

is defined in section 41(b)(3)).

Conclusion

It seems clear that expenditures incurred for prototypes qualify

as R&D to the extent the taxpayer does not retain ownership in

the prototype or if the prototype is not included as inventory.

Further, the legislative history of the section 41 credit

suggests that the costs of component parts could be included in

the credit though the IRS and courts appear reluctant to endorse

this approach to date.

d. Clinical testing of pharmaceutical products:For purposes of

the after commercial production exclusion (item (11)), certain

clinical testing of pharmaceutical products is not considered to

occur after commercial production (Reg. Section

1.414(c)(2)(iv)). The preamble to T.D. 9104 indicates that

clinical trials performed under an arrangement where the Food

and Drug Administration has granted conditional approval for a

pharmaceutical product contingent upon the results of additional

clinical trials is not considered research conducted after

commercial production. This regulation, according to theTreasury decision, is also not intended to exclude otherwise

qualifying activities because the research was not required to

be approved by the Food and Drug Administration.

2. " Technological in Nature" Test

Information is technological in nature if the process of

experimentation used to discover the information fundamentally

relies on principles of the physical or biological sciences,

engineering or computer science. Final regulations clarify that

a taxpayer may use existing technologies and may rely on

existing principles of the physical or biological sciences,

engineering or computer science to satisfy this requirement

(Reg. Section 1.41-4(a)(4), as amended by T D. 9104; Reg.Section

1.41-4(a)(3)(ii)).

The requirement that the research be undertaken for the purpose

of discovering information that is technological in nature does


42/59

GENERIC R&D STUDY

42

not require that the taxpayer seek to obtain information that

exceeds, expands or refines the common knowledge of skilled

professionals in the field of the particular research area (Reg.

Section 1.41-4(a)(3)(ii), as amended by T.D. 9104). Thus, the

fact that the information is known to others will not disqualify

the research. Prior to amendment by T.D. 9104, Reg. Section1.41-4(a)(3)defined the phrase " discovering information" as

obtaining knowledge that exceeds, expands or refines the common

knowledge of skilled professionals in a particular field of

science or engineering. Thus, in order to satisfy the discovery

requirement, research had to be undertaken for the purpose of

discovering information that was beyond the knowledge that

should be known to skilled professionals. The taxpayer was

expected to perform a reasonable investigation of the existing

level of knowledge in the particular field of science or

engineering in order to determine the existing level of

knowledge among skilled professionals

A taxpayer does not need to succeed in developing a new or

improved business component in order to satisfy the discovering

information of a technological nature requirement (Reg. Section

1.41-4(a)(3)(ii), as amended by T.D. 9104).

The amended regulations retain the rule that the issuance of a

patent is conclusive evidence that a taxpayer has discovered

information that is technological in nature (requirement 2,

above) (Reg. Section 1.41-4(a)(3)(iii)).

3. " Process of Experimentation" Test

A process of experimentation is a process designed to evaluate

one or more alternatives to achieve a result where the

capability or the method of achieving that result, or the

appropriate design of that result, is uncertain at the beginning

of the research activities The taxpayer's activities must be

directed at resolving uncertainty regarding the development or

improvement of a business component. A taxpayer is required to

identify the uncertainty regarding the development or

improvement of a business component that is the object of thetaxpayer's research activities. A taxpayer is also required to

identify one or more alternatives intended to eliminate that

uncertainty. Additionally, a taxpayer is required to identify

and to conduct a process of evaluating the alternatives (Reg.

Section 1.41-4(a)(5), as amended by T.D. 9104).


43/59

GENERIC R&D STUDY

43

The final regulations provide that such a process may involve,

for example, modeling simulation, or a systematic trial-and

error methodology. A process of experimentation must be an

evaluative process and generally should be capable of evaluating

more than one alternative (Reg. Section 1.41-4(a)(5), as amended

by T.D. 9104).

So long as the appropriate design of the desired result is

uncertain at the beginning of a taxpayer's research activities,

the process of experimentation requirement can be satisfied even

if there is no uncertainty regarding the capability or method of

achieving the desired result (Reg. Section 1.41-4(a)(5), as

amended by T.D. 9104). In contrast, Reg. Section 1.414(a)(5) as

originally adopted by T.D. 8930, provides that a process of

experimentation does not include the evaluation of alternatives

to establish the appropriate design of a business component if

the capability and method for developing or improving thecomponent is not uncertain.

The final regulations clarify that the mere existence of

uncertainty regarding the development or improvement of a

business component (e.g., its design) does not indicate that all

of a taxpayer's activities undertaken to achieve that new or

improved business component constitute a process of

experimentation, even if the taxpayer does, in fact, achieve the

new or improved business component (Reg. Section 1.41-4(a)(5)).

The IRS includes this clarification in the final regulations outof concern that taxpayers have not been giving sufficient weight

to the requirement that a taxpayer engage in a process designed

to evaluate one or more alternatives to achieve a result where

the capability or the method of achieving that result, or the

appropriate design of that result, is uncertain as of the

beginning of the taxpayer's research activities. In particular,

this clarification is intended to indicate that merely

demonstrating that uncertainty has been eliminated (e.g., the

achievement of the appropriate design of a business component

when such design was uncertain as of the beginning of a

taxpayers activities) is insufficient to satisfy the process of

experimentation requirement (preamble to T.D 9104).

Substantially all of the research activities must constitute

elements of a process of experimentation for a qualified purpose

(IRC Section 41(d)(1)(C)). The " substantially all" requirement

is satisfied only if 80 percent or more of the research

activities, measured on a cost or other consistently applied


44/59

GENERIC R&D STUDY

44

reasonable basis, constitute elements of a process of

experimentation for a qualified purpose. This requirement is

applied separately to each business component (Reg. Section

1.41-4(a)(5)(ii)).

The final regulations provide that the substantially all

requirement is satisfied if 20 percent or less of a taxpayer's

research activities do not constitute elements of a process of

experimentation for a qualified IRC Section 41(d)(3) purpose, so

long as these remaining activities satisfy the requirements of

IRC Section 41(d)(1)(A) (i.e., the expenditures for the

remaining activities are considered expenses under IRC Section

174 and are not ineligible activities under IRC Section

41(d)(4)) (Reg. Section 1.41-4(a)(5)(ii); Reg. Section

1.41..4(a)(8), Example (4)).

4. "Permitted Purpose" Test

The last requirement is that the design or development must be

for a permitted purpose. As defined under IRC Section

41(d)(3)(A), a permitted purpose is a " new or improved

function, performance, reliability, or quality of the business

component" The regulations restrict activities related to

style,taste, cosmetic, or seasonal design from qualifying.

A business component is any product, process, computer software,

technique, formula, or invention that is either (a) held for

sale, lease, or license or (b) used in the trade or business of

the taxpayer. Any plant process, machinery, or technique for

commercial production of a business component is treated as a

separate business component and not as part of the business

component being produced (IRC Section 41(d)).

5. Exceptions to Qualified Research

IRC Section 41(d)(4) indicates that the term " qualified

research" shall not include any of the following:

Research after commercial production - Any research conducted

after the beginning of commercial production of the business

component.


45/59

GENERIC R&D STUDY

45

Adaptation of existing business components - Any research

related to the adaptation of an existing business component to a

particular customer's requirement or need.

Duplication of existing business components - Any research

related to the reproduction of an existing business component

(in whole or in part) from a physical examination of the

business component itself or from plans, blueprints, detailed

specifications, or publicly available information with respect

to such business component.

Surveys, studies, etc. - Any efficiency survey, activity

relating to management function or technique, market research,

testing or development (including advertising or promotions),

routine data collection, or routine or ordinary testing or

inspection for quality control.

Computer software- Except to the extent provided in theregulations, any research with respect to computer software

which is developed by (or for the benefit of) the taxpayer

primarily for the internal use by the taxpayer, other than for

the use in:

- An activity which constitutes qualified research (determined

with regard to this subparagraph), or

- A production process with respect to which the requirements of

paragraph 1 are met.

Foreign research - Any research conducted outside the United

States, the Commonwealth of Puerto Rico or any possession of the

United States.

Social sciences, etc. - Any research in the social sciences,

arts or humanities.

Funded research - Any research to the extent funded by any

grant, contract or otherwise by another person (or governmental

entity).

6. Qualified Costs

The qualified research expenses are outlined under IRC Section

41(b)(1) as amounts paid or incurred by the taxpayer during the

taxable year in carrying on a trade or business relating to

(1)in-house research and (2) contract research. In-house

research is the sum of all amounts paid or incurred for wages


46/59

GENERIC R&D STUDY

46

and supplies, and amounts paid or incurred to another person for

the right to use computers in the conduct of qualified research.

Any wages paid or incurred to an employee in the performance of

qualified research activities can be included in the credit

computation. The term "wages" generally holds the same meaning

as provided under IRC Section 3401 (base wages, direct bonuses,

NSO, etc.). If an employee performs both qualified and

nonqualified activities, only the qualified wages will be

considered. The appropriate method of apportioning wages to the

qualified activities is multiplyin

Draft r n d Study Generic v1

Documents

Transcript of Draft r n d Study Generic v1