Tangel v. Commissioner—Works for Ire

Written by John Bohannon. Updated Jan 29, 2021.

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On January 11, 2021, the tax court issued a new opinion concerning the application of the Federal Credit For Increasing Research Activities. In Tangel v. Commissioner, the taxpayer—a designer and manufacturer of integrated controls and switchgears utilized in power generation—was denied its claimed R&D credit by the IRS. After receiving its notice of deficiency, the taxpayer brought suit in the tax court seeking a redetermination. For procedural reasons, the court limited its opinion and ruling to a single project performed under contract by the taxpayer. The Service argued that the research performed by the taxpayer under this third-party contract was “funded” as defined under section 41 of the code. Specifically, the government contended that under the contract, the taxpayer retained no substantial rights in the results of the research.

Under section 41, “funded research” is defined as:

"[a]ny research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity)."

Section 41’s accompanying regulations expand on this by defining two prerequisites necessary for research performed under contract to be considered “unfunded”:

1) The amounts payable under the agreement are contingent on the success of the research and thus considered to be paid for the product or result; and

2) The taxpayer performing the research for another person retains substantial rights in the research results.

Ultimately, the court was persuaded by the government’s position. The court’s analysis centered primarily on a single paragraph in the governing agreement concerning the disposition of rights. The court observed that under this paragraph, the taxpayer agreed not to use any “Information” produced as a result of the “goods and/or services being procured and described” under the agreement in order to develop or sell similar goods or services without the buyer’s written consent. Under this clause, “Information” was defined as either:

1) technical information supplied to the taxpayer by the buyer; or

2) technical information designed by the taxpayer at the buyer’s expense; or

3) technical information designed by the taxpayer specifically to meet buyer furnished technical requirements.

In addition, the court identified in the agreement that the “information” produced under the contract was to be considered “works made for hire” within the meaning of U.S. copyright laws. This clause operated to vest copyright interests in the buyer with respect to original works of authorship. It also contained a catchall provision stating that in the event that any “Information” was determined not to be a “work made for hire,” the taxpayer nevertheless irrevocably assigned all right, title, and interest in and to such work.

Notably, Judge Albert Lauber conceded that some of the research performed by the taxpayer conceivably could have been useful in developing business components other than those being procured under the contract. This concession could have allowed the taxpayer to argue it retained substantial rights in the “Information” it generated under the contract for use in developing goods or services unrelated to those procured under the agreement as this was not prohibited by the first provision of the paragraph. However Judge Lauber noted that the latter half of the paragraph contained a broader prohibition, which stated that the taxpayer:

“[s]hall not use…such Information except in the performance of Orders for Buyer, and, upon Buyer’s request, such Information and all copies thereof shall be returned to Buyer.”

From the cumulative effect of these provisions, the court found that the taxpayer did not retain substantial rights in the research. Consequently, the research performed by the taxpayer under the agreement was deemed to be funded research and therefore could not be included in calculating the taxpayer’s research credit.

While this case does not make new law, it provides valuable insight into what kinds of contractual language and provisions the court is most persuaded by when performing its analysis as to whether substantial rights are retained by a taxpayer. With such a fact-intensive evaluation, the court’s analysis of specific provisions help provide critical signposts needed for understanding the full landscape of the test’s application.

Most importantly, this case demonstrates the potential complexities that can be encountered in accurately determining a taxpayer’s research credit. Determining whether a given project performed under contract qualifies for the credit can ultimately require an extensive legal analysis of the contract’s terms and conditions. Accordingly, having an expert versed in the intricacies of the credit’s rules and regulations is paramount in ensuring an accurate and well substantiated credit. 

For more information on the research credit or other tax questions, please consult a tax specialist.

 

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Topics: R&D Tax Credit, Manufacturing, Legal News

John Bohannon

Written by John Bohannon

Graduating from South Texas College of Law Houston, John acts as CTI’s chief R&D legal researcher. His focus on tax law research combined with his years of experience performing R&D tax credit studies and providing audit support affords unique insight into the research credit’s application and other evolving areas of tax law.