Text of the 11-page decision: Union Carbide [PDF 32 KB]
A separate concurring opinion is included in today’s decision.
During the 1994 and 1995 tax-credit years, the taxpayer conducted numerous research projects at its production plants, dealing with ways to improve the production process, rather than the products produced. The taxpayer claimed the costs of these projects, including some of the costs of raw materials used in production runs, as qualified costs for research credit purposes.
The IRS disagreed. Before the Tax Court, a sample of these projects was closely analyzed, including the costs of three projects at two production plants in Louisiana. Generally, the output of the production runs was sold by the taxpayer, as would the output of any production run that was not part of a research project.
The research credit statute, and regulations, provide that the costs eligible for the research credit include “any amount paid or incurred for supplies used in the conduct of qualified research.” The regulations include an additional statement that expenditures for supplies that are “indirect research expenditures” do not qualify, but do not further explain the difference between a direct and an indirect expenditure.
The taxpayer requested a research credit not just for the additional costs of supplies associated with the research, but also for the costs of all supplies used in the production runs during which research was conducted. The IRS argued that no research credit is to be allowed for supplies that would have been used regardless of any research performed.
The Tax Court in March 2009, in a 299 -page opinion [PDF 350 KB], held that the taxpayer was not entitled to research credits for the entire amount spent for the supplies, but was entitled to a credit for only those additional supplies that were used to perform the research.
The Second Circuit today affirmed.
The Second Circuit framed the issue as whether the costs for the supplies used during these projects, that would have been used in the course of the taxpayer’s manufacturing process regardless of any research performed, qualified as “an amount paid or incurred for supplies used in the conduct of qualified research.”
Finding that the statutory language under section 41 was not ambiguous, the appeals court held that the costs for these supplies are not creditable. The Second Circuit agreed with the Tax Court that the costs at issue were, at best, “indirect research costs.” The appeals court acknowledged that the regulations do not clearly resolve how to distinguish between expenses that are indirect costs and expenses that are direct costs. However, the court concluded that it would defer to the IRS’s position that such materials are indirect costs if they would have been used in the course of the taxpayer’s manufacturing process regardless of any research performed. The Second Circuit found the IRS position was reasonable, prudent, and consistent with the legislative history and congressional purpose of the research credit.
The concurring opinion noted that if Congress had intended the supplies at issue in this case to be creditable, it failed to write the statute so as to preclude the regulations or the IRS’s interpretation of those regulations.