Union Carbide Corporation (UCC) claimed additional research credits in a U.S. Tax Court petition (primarily centered on other issues) filed in June 1999. In a 298-page opinion filed almost 10 years later, the Tax Court has ruled on the main elements of that research credit claim. Union Carbide Corporation v. Commissioner, T.C. Memo. 2009-50 (March 10, 2009).
In dollar terms, the ruling was an overwhelming victory for the Commissioner. The Tax Court examined approximately $55 million of the more than $200 million claimed as additional qualified research expenses (QREs) for tax years 1994-95 and found only $1,045 to be qualified. Further, the Tax Court held UCC to its admission of approximately $135 million of additional base period QREs (determined in a manner consistent with UCC’s claim), since the record was insufficient to ascertain what portion of those additional base period expenditures met the qualification standards as interpreted by the Tax Court.
In terms of legal principles relevant to other taxpayers, the result was less lopsided. The five projects examined by the Tax Court represented manufacturing process research conducted in tandem with production runs at UCC’s plants. The Tax Court found two of those five projects to be qualified: experimental tests on the application of an anti-coking process that was under development by a third party (Amoco), and experimental full-scale testing of a new catalyst (UCAT-J) that had been developed by UCC and previously tested at a pilot plant. The Tax Court rejected the Commissioner’s argument that the claimed research was excluded under I.R.C. § 41(d)(4)(A) as “research after commercial production,” noting that research with respect to manufacturing processes was distinct from research with respect to new or improved products. The same distinction, however, disqualified the supply expenditures claimed by UCC, which represented almost all of the additional claim. UCC had claimed as qualified supplies a ratable share of the raw materials consumed in the plant’s production activities (based on the relative duration of production runs on which process research activities were conducted). While such raw materials were necessary for the conduct of the research, they were also necessary for the ongoing production activities and, according to the Tax Court, could not be described as “supplies used in the conduct of qualified research.”
The Commissioner repeatedly challenged the adequacy of UCC’s documentation, most notably with respect to base period activities, for which there were no summary documents that would demonstrate that the UCC’s experts had captured all of the qualified research activities during the base period. The Tax Court, however, noted that the regulations do not require that a taxpayer retain or provide any particular type of records, and held that the methodology and assumptions used by UCC’s experts were sufficient to allow for “reasonable determinations” as to the scope of research activities and expenditures.
One surprising holding of the case was that the consistency requirement (§ 41(c)(6)) should be applied at the entity level, rather than to the controlled group of corporations that are aggregated (under § 41(f)(1)) for purposes of computing the credit. While this result will be welcomed by many taxpayers as reducing the burden of demonstrating consistency between the credit and base years, the Commissioner may be unwilling to acquiesce to such an exemption from the general rule that the credit should be computed by treating all members of the same group of controlled corporations as a single taxpayer.