An Economic Evaluation Of ‘Funding’ For Research Tax Credits

1. Introduction

   The Economic Recovery Tax Act of 1981 (ERTA) established a research tax credit (RTC),1 allowing a taxpayer to claim a credit of 20 percent for qualified research expenses in a given tax year over a statutorily defined base amount.2 Congress has continually extended this credit, emphasizing that ''research is the lifeblood of our economic progress [and] effective tax incentives for research and development must be a fundamental element of America's competitiveness strategy.''3 However, there is uncertainty about the implementation of some aspects of the RTC.4 This article focuses on uncertainty surrounding the ineligibility of ''any research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).''5 This ''funded research'' exclusion has been a frequent topic of dispute between the IRS and taxpayers, beginning with the seminal case of Fairchild Industries Inc. v. United States6 and more recently in an order on summary judgment in Geosyntec Consultants Inc. v. United States.7 These two cases share the common element of rare taxpayer-favorable findings but leave unresolved key factors concerning funding and the later allocation of qualified credits.8 Clarity is needed to provide incentives for legitimate investments in research as contemplated by the congressional intent behind the RTC.

   This article addresses the funding of research and experimental activities in a manner consistent with the legislative purpose of the RTC, case law, basic contract principles, and economic theory. Although Geosyntec has helped clarify the proper implementation of the funding standards, it does not fully assess how different contractual terms allocate the risks of failure among the parties in contracts requiring research expenditures. A research provider's RTC claim is deemed unfunded if the qualified research was conducted under a fixed-fee contract rather than other contracts containing similar fee arrangements (for example, cost-plus contracts with capped fees). We propose a more logical basis for assessing the risk/reward calculus underlying contracts requiring research using the principles of risk allocation found in microeconomic theory and contract law. This approach could bring logical cohesion to future RTC cases, allowing for the rightful ability of a researcher and its clients to claim the credits for qualified research expenditures based on concrete indicia of intent expressed in the...