LUBICK CRITICIZES 'RETENTION OF SUBSTANTIAL RIGHTS' TEST FOR R&D CREDIT.

Lubick maintains that the "substantial rights" test improperly excludes certain businesses that are both operating and at risk from receipt of the research credit. He gives the example of a defense contractor that performs research at its own expense and transfers the result of that research to the Department of Defense in the reasonable expectation of receiving a follow-on contract to manufacture the developed product. Such a contractor should be allowed to claim a research credit, Lubick asserts. He includes a suggested amendment to the proposed regulation to provide the credit to such businesses.

As we discussed on the telephone last week, I enclose a summary memo on the funding definition in the proposed regulations. I would appreciate talking to you briefly either by telephone or in person after you have looked at it.

If it stimulates your curiosity further, I have enclosed also the original memorandum that makes the same points and contains draft language.

Sincerely,

The credit for increasing research activities under Sec. 41 was enacted to stimulate active operating businesses (as opposed to exclusively research entities carrying on contract research for others) to increase research activity as a part of their active operations. The credit, by making R & D less costly, reduced the risk of undertaking new R & D at the margin.

To target the R & D credit to cases where it will be most effective, it is limited to cases where an operating business performing the research bears the risk of failure.

Thus a purchaser whose liability to make payment to the researcher is contingent upon success is not to that extent at risk and is not eligible for the credit. Such a taxpayer is under the proposed regulation (Sec. 1.44F-2(e)(2)) paying for a product, not research.

Research funded by another person is under the same principle not eligible for the credit to the extent funded because the researching organization is not at risk to the extent it is assured of receiving funding.

The critical tests are therefore two:

1. The research must be part of an OPERATING business because Congress wanted this credit to apply to encourage operating businesses to perform research. In that way operating businesses would become more innovative and competitive.

2. The desired encouragement to innovation is needed only where the operating business is AT RISK. Funding by another party relieves the necessity of an additional incentive through a tax credit.

The proposed regulation seems to require in addition that the operating business, even if at risk, retain substantial rights in the research. Sec. 1.44F-4(d)(2). Retention of substantial rights is an appropriate test in distinguishing joint ventures of operating businesses (eligible for credit) from purely research partnerships (not eligible, as not operating businesses). Prop. Reg. Sec. 1.44F- 2(a)(4).* Sharing of rights is appropriate in the joint venture of operating businesses as an indicium that all the venturers are operating partners, and as a showing that none of the partners is simply a contract researcher. It is in that context appropriate to assure compliance with the operating business test. It is not necessary to examine the question of rights retention if an operating business is clearly involved. It has no relevance to the question of funding. The only issue in the single operating business is risk, if the research is carried on as part of the operating business.

To illustrate the problem, take the case of an operating business engaged to perform research to develop an unmanned target vehicle for the DOD. The risk of success of the research is on the business. If it fails, it must absorb the cost. If it succeeds, it is as a practical matter almost guaranteed to receive the follow on production contracts because of its learning and know-how in designing the vehicle. The operating business is at risk in undertaking the research and the credit is useful to encourage it to assume the risk by reducing its cost. The issue of retained rights in the event of success is irrelevant to funding since the business remains at risk. The research is clearly part of the operating business and so is exactly the case Congress wished to encourage, innovative risk in an operating business.

There are also cases where research is only partially reimbursable and where the taxpayer is at risk for a significant portion of the expenses of research. The same principles should apply to allow the credit for the non-reimbursable portion of the research cost, if the operating business test is met. Of course, the operating business would receive no credit for the reimbursable amount. The funded and non-funded portions should be separated for applying the regulations tests.

COMMENTS ON PROPOSED REGULATIONS UNDER SEC. 41 (FORMER SEC. 44F) -- CREDIT FOR INCREASING RESEARCH ACTIVITIES

Since a notice of proposed rulemaking published proposed regulations under former Sec. 44F, practical experience has indicated a need for clarifying modifications that should be reflected in the final regulations in the determination of when research is funded by a party other than the taxpayer claiming the credit and the extent to which a taxpayer performing research related to its active business must retain substantial rights in research that is not otherwise funded.

The credit was enacted in order to stimulate active operating businesses (as opposed to exclusively research entities carrying on contract research for others) to increase research activity related to the "carrying on" of their operating businesses. The only exception to the "carrying on a trade or business" limitation is the grant of regulatory authority to permit a joint venture to claim a credit for the venture if it is between taxpayers who both satisfy the "carrying on" test (i.e., the research is part of an operating business of each) and if both taxpayers share the research results. See Prop. Reg. Sec. 1.44F-2(a)(4). The "carrying on" and "sharing of results" tests are designed to preclude the credit otherwise being available for partnerships formed solely to perform research as an end in itself and not as part of an operating business, yet to permit joint research projects of two or more operating businesses.

Additionally, in the case of businesses benefiting from research activities carried on as part of active business operations, the taxpayer must be at risk as to the success of the research. A taxpayer may contract to purchase a product (as opposed to contracting for the conduct of the research) by imposing on the supplier the risk of whether the R & D necessary to get the product developed is successful. The taxpayer may do this by making payment contingent on success of the research. In such case, the taxpayer purchaser is not entitled to the credit. See the last sentence of Prop. Reg. Sec. 1.44F-2(e)(2), which appropriately states this principle.

On the other hand, the contractor who is at risk ought to get the credit, assuming the research relates to the contractor's active business so that the operating business test is met, since the R & D risk (which is what Congress sought to stimulate) is his. There should not be double credits for the same activity; at the same time there should be one credit for the operating business that undertakes the R & D credit at its risk of success.

The funding rules of Prop. Reg. Sec. 1.44F-4(d) should be consistent with these principles. The researcher is not at risk if the researcher is funded by another person. In that case, the person providing the funding should be entitled to the credit. If, however, the payment to the researcher is contingent on the success of the research, it is the researcher that bears the risk that the research will be unsuccessful. Hence, the researcher should get the credit. Prop. Reg. Sec. 1.44F-4(d)(1) expresses this concept in the third sentence in not treating amounts paid as funding if the payment is contingent on success of the research.

Paragraph (2) of Proposed Reg. Sec. 1.44F-4(d) goes on to deal with questions of retention of rights in research by a taxpayer performing it. In a case where a taxpayer contracts for a product with payment contingent on success of the R & D by the performing contractor (as part of its active business) the purchasing taxpayer is not entitled to a credit because it is purchasing only a developed product. The performing contractor should get no credit if it is not at risk as to payment for its work without regard to the question of substantiality of retained rights in the research. The retained rights issue, which is relevant in the joint venture situation as indicated in the legislative history and Proposed Reg. Sec. 1.44F- 2(a)(4) to deal with joint research partnerships and ventures, is not a significant criterion in the determination of whether research is funded as between contracting active operating businesses. Rather there are two critical standards. The first is that the research be carried on in active business to avoid giving the credit to entities exclusively engaged in performing contract research for others. The second critical factor is that the credit be granted to the party who is bearing the risk of the research, since it is that party who needs the incentive of the credit. A taxpayer performing research relevant to its own operating business and at risk as to receipt of payment should receive the credit even if it does not retain substantial legal rights to the research. Hence, Prop. Reg. Sec. 1.44F-4(d)(2) should be modified to read:

"If a taxpayer performing research for another person retains no substantial rights in the research under the agreement providing for the research and the taxpayer's payment for performance is not contingent upon success, the research is treated as fully funded for purposes of section 44F(d)(3) to the extent of those payments guaranteed to the taxpayer under the agreement. See Sec. 1.44-2(a)(3)(i).

Similarly, the first sentence of Prop. Reg. Sec. 1.44F- 4(d)(3)(i) should be clarified to read:

"If a taxpayer is performing research for another person, the research is funded to the extent of the payments (and fair market value of any property) to which the taxpayer becomes entitled by performing the research if such payments are not contingent on the success of the research. See section 1.44F-4(d)(1)."

In a situation where research is carried on as part of an operating business, it may be partly funded. The credit should be shared according to the risk. For example, A contracts with B for B to perform research. The research is carried on as part of the operating business of each, but not as a joint venture. A agrees to reimburse B for 100X of expenses, but B is to absorb all costs in excess of 100X. B's costs are 125X. A's credit should be based on 100X and B's credit should be based on 25X, in each case reflecting the amount at risk. Retention of substantial rights is not relevant in this case. Otherwise, credit for a part of the research expense will fall between the cracks.

To clarify this situation and the preceding ones Prop. Reg. Sec. 1.44F-2(a)(3)(i) should read:

"(i) Taxpayer not entitled to results. If the taxpayer performs research on behalf of another person and retains no substantial rights in the research, that research shall not be taken into account by the taxpayer for purposes of section 44F except to the extent the cost of such research is borne by the taxpayer and the taxpayer reasonably intended the research to directly result in an economic benefit to the particular trade or business of the taxpayer to which the research relates. Such research, if otherwise qualified, shall be taken into account by the taxpayer for purposes of section 44F to the extent provided in Sec. 1.44F-4(d). For example, if a taxpayer, engaged in the business of developing and manufacturing products for its customers, performs otherwise qualifying research at its own expense for a customer and transfers to that customer exclusive rights to exploit the results of the research, the research will be taken into account by the taxpayer for purposes of section 44F if the taxpayer entered into that contract with the reasonable belief that the research could result in a follow-on contract with the customer to manufacture the developed product. Incidental benefits to the taxpayer from the performance of the research (for example, increased experience in a field of research) do not constitute substantial rights in the research, nor do they constitute an economic benefit directly resulting from the research.

One other point should be made to clarify Prop. Reg. Sec. 1.44F- 4(d)(4). The proposed regulation denies credit for allocation of independent research expense as part of overhead for cost plus and incentive contracts. Commentators have suggested that this rule is inappropriate since the contractor is at risk as to such independent research. In any event, however, clarification should be made to assure that if the rule suggested in paragraph (4) is not deleted, it has no application to fixed price contracts. Even if the cost of such independent research is allocated to overhead of the contractor, if the contract is for a fixed price such allocation to overhead does not constitute funding since the contractor is totally at risk.

"The conferees also intend that the Treasury will issue regulations, for credit purposes only, which will allow the credit in the case of joint ventures by taxpayers who otherwise satisfy the 'carrying on' test and who are entitled to the research results."