Dow Chemical Co. is appealing a tax-court ruling that said the Internal Revenue Service correctly disallowed several research and experimentation (R&E) credits the company claimed for process improvements at its Union Carbide subsidiary. If Dow wins the appeal, the IRS says, the limits on what qualifies as R&E costs would be “eviscerated” and other companies might use the research credit to subsidize operations instead of to support legitimate research spending.
Dow is arguing in the U.S. Court of Appeals for the Second Circuit that it should be allowed to take an R&E credit for the costs of several process improvements made during the 1990s. One of the process improvements was a new way of making polyethylene resin, a chemical used in dry cleaning and produce bags. The new method saved costs, Dow says, because it required less of some of the other ingredients used in the bags and produced better bags. The IRS ruled that some of the costs did not qualify as R&E, and in 2009, a lower tax court agreed.
The cost of supplies Dow used for the process improvements does not qualify as R&E, according to the IRS, because those supplies would have been used in production whether or not the company was doing R&E, says Mike Silvio, managing director at CBIZ MHM, an accounting and tax advisory firm. Rather, the IRS says these costs should be considered “indirect research expenses,” which are excluded from the credit.
But Dow argues that the supply costs it claimed for the credit were an integral part of its R&E process. “[Union Carbide] does not contend that every condition that must pre-exist in order for an experiment to take place” should qualify as a cost for the R&E credit, Dow writes in its brief. “Rather, it continues to be [Union Carbide’s] position that supplies that are physically part of and necessary to conduct a qualified experiment” are R&E costs.
The IRS says ruling in Dow’s favor would expand the credit to include almost all costs of manufacturing. This approach “would eviscerate the limits on costs eligible for the credit in the context of plant research, and transform the role of the research credit from encouraging increased research spending, as Congress intended, to subsidizing operations, which Congress sought to avoid,” the IRS brief adds.
Indeed, the outcome of this case, in either direction, “might redefine how supplies are considered in a research and development process,” Silvio says. But “people who are reading about the case should be very careful not to react too strongly,” says John Dies, attorney at alliantgroup, a tax advisory firm. “These are very fact-intensive investigations. So don’t panic and don’t celebrate.”
The lesson from the Dow case is to keep meticulous paperwork that drills down to the details on R&E eligible costs, Dies says. One of Dow’s challenges in the original case was to prove through its records that its expenditures qualified as R&E, he says.
Many companies, particularly small ones, do not apply for the R&E credit because they don’t consider process improvement “research and experimentation.” The R&E tax credit expires this year, but as in the past it will likely be renewed. President Obama has proposed making the tax credit permanent.