[IMGCAP(1)]The widely followed R&D Tax Credit case involving Union Carbide Corporation and the cost of supplies used during production has finally come to an end. On March 18, the Supreme Court denied review of the Second Circuit Court of Appeals decision, which had affirmed the earlier Tax Court ruling.
In the case, Union Carbide contended that it was developing and improving multiple manufacturing processes. During the evaluation of the new and improved processes, the taxpayer manufactured the product and claimed that the raw materials used to produce goods in testing the processes were supply costs that qualified for the research credit.
Union Carbide’s position was that Section 41(b)(2)(A)(ii) of the Tax Code entitled it to a “credit for the cost of all supplies used in the production of the product even though those supplies would have been used regardless of any research performed.” (Union Carbide Corp. & Subsidiaries v. Comm’r, 110 AFTR 2d 2012-5837, 5838 (9/7/2012))
However, the Tax Court disagreed and held that only those additional costs related to the conduct of evaluating the new or improved process were qualified. The Tax Court also held that the cost of the raw material, which would have been purchased and used in normal production, were “[a]t best, … indirect research costs excluded from the definition of qualified research expenses under Reg. Section 1.41-2(b)((2).” (Union Carbide Corp. & Subsidiaries V. Comm’r, TC Memo 2009-50, 276 (3/10/2009)). The Second Circuit agreed with the Tax Court on both issues.
A key take-away from this case is how you examine supply costs when a taxpayer seeks a research credit related to its production process. One must examine separately those costs related to the production process versus those related to the product produced. Each is considered a separate business component. Section 41(d)(2)(C) provides, “Any plant process, machinery, or technique for commercial production of a business component shall be treated as a separate business component (and not as a part of the business component produced).”
Notwithstanding the recent Supreme Court refusal to hear the case, the Tax Court opinion, which is 298 pages, has been viewed favorably by taxpayers in that it rejected several common IRS positions asserted during audits. The Tax Court opinion issued by Judge Goeke addressed issues such as allowing cost accounting-based records along with business records regularly produced to substantiate costs, acceptance of the “Cohen Rule” to estimate wage and supply expenses, and the use of testimonial evidence supported by documentary evidence to support prior year qualified expenses.
The Tax Court opinion also provided some clarification and guidance on the consistency rules, the discovery test and the process of experimentation.
Bruce Stubbs, JD, LL.M., is the practice leader of R&D tax credits services for KBKG. He has over 18 years of legal and tax consulting experience and significant experience dealing with IRS audits of R&D Credits. KBKG is a national firm specializing in tax credits, incentives and value-add tax services.