The R&D Tax Credit
The Credit for Increasing Research Activities, otherwise known as the R&D Tax Credit, is governed by Internal Revenue Code (IRC) §41, and has long been used by innovative companies to decrease their tax burden and increase research activities within the business. To qualify for the R&D Tax Credit, the activities performed by a company must meet what is commonly referred to as the “four-part test.” An activity must meet all four criteria for its associated expenses to be used in the calculation of the R&D Tax Credit. Briefly, the IRS four-part test requires that a company: develop a new or improved business component (i.e., product, process, technique, formula, software, etc.) that is either used in the business or held for sale, lease, or license; experience technical uncertainty related to the business component; undergo a process of experimentation to alleviate the aforementioned technical uncertainty; and perform activities that are technological in nature (i.e., rooted in the hard sciences, such as chemistry, engineering, biology, etc.).
There are, however, cases in which a company may perform qualified research activities and meet all requirements of the four-part test, yet still be ineligible to claim the R&D Tax Credit. Specifically, under IRC § 41(d)(4)(H), the R&D Tax Credit is not available to a company for any research activity to the extent such research is “funded” by a grant, contract, or another arrangement. Under Treasury Regulation § 1.41-4A(d), research is considered funded under either of two circumstances: (1) the taxpayer receives a payment that is not “contingent on the success of the research,” or (2) if the taxpayer performing research for another person or governmental entity “retains no substantial rights” in the research.
Restrictions for Contract Manufacturing Organizations
Perhaps the most common companies that have been barred from claiming the R&D Tax Credit by this caveat are Contract Manufacturing Organizations (CMOs). CMOs are generally utilized across a multitude of industries, including pharmaceuticals, food and beverage, biotechnology, and medical devices. A company will approach the CMO with a product that they desire to be manufactured, and provide technical specifications associated with the product. The company and CMO will execute a contract such that the CMO manufactures a certain amount of the company’s product on their behalf. CMOs, however, often carry a heavy burden of working with their clients to adapt, design, and experiment with their manufacturing process to accommodate the client’s request. During this design phase, prior to manufacturing the first batch of product, the CMO usually undertakes substantial research activities that may meet the IRS four-part test. However, the CMO’s ability to take advantage of the R&D Tax Credit depends entirely on the nature of the contract executed with their client.
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- First, the CMO must maintain “economic risk” during their engagement with the client. The determination of whether a company is at risk depends on which party bears the research costs upon failure of the project (Fairchild Industries Inc. v. US, 71 F.3d 868 (Fed. Cir. 1995) and Geosyntec Consultants, Inc. v. US, 112 AFTR 2d 2013-5488 (2013)). For a CMO, this means that they generally must be paid on a flat-fee basis, such that their client pays them a lump sum for the manufacture of their product. Thus, should the CMO fail to successfully manufacture their client’s product to the client’s standards, the CMO has lost the money associated with developing the manufacturing process for their client’s product. The CMO has already expended wages, utilities, supplies, etc., and will not receive payment from their client due to their failure to produce a satisfactory product. This indicates that the CMO bore the economic risk associated with the research activities, and therefore may be eligible to claim the R&D Tax Credit.
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- Second, the CMO must maintain “substantial rights” to the research. A company doesn’t retain substantial rights when the party for whom the research is performed has the exclusive right to exploit the results of the research and the taxpayer must pay for the right to use the research results (Treas. Reg. § 1.41-4A(d)(2)). This means that the CMO must maintain intellectual property for the manufacturing processes and techniques developed on behalf of their client. A great indication of whether a CMO maintains substantial rights, besides the executed contract, is whether the CMO can reuse the manufacturing processes and techniques across multiple clients, making changes and improving the process or technique over time. However, if the CMO’s client retains the intellectual property associated with the development, manufacturing, and final product, it’s unlikely that the CMO may claim the R&D Tax Credit. Rather, the CMO’s client would have the ability to claim the R&D Tax Credit for these activities.
How CMO’s Can Still Claim
Interestingly, there are certain cases where a CMO may hold one, but not both, of the aforementioned requirements. For example, a CMO may be paid on a flat-fee basis, yet still sign away all their intellectual property rights to the processes and techniques developed. In such a case, neither the CMO nor the client-company may claim the R&D Tax Credit for the research activities performed by the CMO.
Despite the above restrictions, it is not well-known that CMOs are able to claim an R&D Tax Credit for research activities dedicated towards internal improvements. Suppose a CMO expands their current manufacturing facility to include an upstream fermentation process that they did not have before. The CMO designed, tested, and evaluated the new fermentation process on their own, and not on behalf of any client, because they wanted to expand their service offerings. The activities associated with this new fermentation process may be used to calculate an R&D Tax Credit that the CMO may claim on their business returns. Additionally, CMOs sometimes structure their contracts on a per-product basis, meaning that they only get paid per product manufactured, and only after successful delivery of the product to the client-company. As such, the CMO funds all the development efforts towards successfully manufacturing the product, and the client only agrees to purchase the products from the CMO. Typically, in these structures, the client-company retains the rights only to the final product, but not to the manufacturing processes and techniques used to produce the good. Therefore, the CMO retains both the economic risk associated with the manufacturing processes and techniques, as well as the intellectual property to those processes and techniques (unless otherwise dictated by a contract). The CMO could therefore claim the R&D Tax Credit for the qualified research activities.
How Leyton Can Help
Navigating the R&D Tax Credit as a CMO can be time-intensive, complex, and difficult. Leyton’s engineers, tax professionals, and tax attorneys have extensive experience reviewing contracts, understanding research activities performed, and navigating the question of who may claim the R&D Tax Credit for the qualified research activities. Working with a company like Leyton to evaluate your potential to claim the R&D Tax Credit can alleviate the heavy burden of contract review and ensure that you are in compliance will all relevant IRS regulations. As CMOs often own their manufacturing facilities, Leyton has an entire division dedicated to commercial real estate that works with owners of commercial buildings to receive deductions such as IRC § 179D for energy efficient commercial buildings, to advance depreciation of building assets through Cost Segregation, and calculate and substantiate green electricity credits such as IRC § 48. Allow Leyton to be your one-stop-shop for specialty tax credits and incentives; contact Leyton’s experts to evaluate your potential tax savings today!
