Every industry has special circumstances that influence whether or not the development projects they spend time on can qualify for R&D tax credits.
Today we will take a look at some of the special circumstances that impact the Aerospace and Defense industries and their ability to take a federal or state R&D tax credit.
While there are many issues facing the Aerospace & Defense industries as they document and monetize research tax credits, our discussion today will focus on a few of the issues specific to the industries-funded research, substantial rights and contractual language.
Funded Research – Who is at risk for the development?
What is the definition of Funded Research? Under Internal Revenue Code Section 41(d)(4)(H), research that is funded by any grant, contract, or otherwise by another person or government entity is excluded from the definition of qualified research. A significant component to the assessment of whether a project falls under the definition of funded research is whether the payments made are for a product or for the research conducted.
If payments are contingent on the success of the project and are for the final product, the project would most likely not be considered funded because the researcher retains the risk of development and may not be paid if the project does not produce the final product.
If, however, the payments are paid regardless of the outcome of the project, the payments would be considered funding research rather than a final product and the project would be excluded from qualified research. The researcher would not bear the financial risk of development.
Substantial Rights – What do you really own when the development is done?
The substantial rights test is another provision that attempts implement or enforce the funded research rule. In order for research to be qualified (in the hands of the researcher), the researcher must retain substantial rights to the results of the research. Therefore, if the agreement between the researcher and payer confers the results and rights to use the research to the payer, the researcher would not be able to claim expenses for the project as qualified research (Treasury Regulations Section 1.41-4A(d)(2)).
It is also possible for a researcher to retain substantial rights and be required to offset research costs against revenue received specifically for the project. In a case where the researcher retains substantial rights to the results of the research and is paid for the research conducted, the regulations require the researcher to offset the research costs against revenue received for the research conducted (Treasury Regulation Section 1.41-4A(d)(3)).
As we will discuss in the next section, the agreement between the researcher and payer is important and will be considered if the tax return is audited.
Contract provisions – Are they important beyond the project?
The regulations governing funded research and the substantial rights test highlight the need for the agreement signed between the researcher and payer to clearly identify what is being purchased. If the agreement shows payments will occur regardless of the outcome of the research, the research will be considered funded and must be excluded from qualified research.
On the other hand, if the agreement clearly states the work being performed is for a finished product and payments are contingent on the success of the project, then the development project and expenses should be considered qualified research.
Central to this agreement is also the ownership of the rights to use the results of the research. The researcher must retain substantial rights in order to include the project in their qualified research for the tax year (assuming it meets all other tests).
Application to Aerospace and Defense Contracts
Many government contracts written in the Aerospace and Defense industries are written for research to be conducted as well as for the delivery of a final product. Additionally, the contract provisions will include both milestones to be achieved in order to receive payment and may include “claw-back” provisions in the event the contractor does not meet the quality standards set by the government agency. These components (milestones and claw-back provisions) typically provide enough foundation to demonstrate that the contractor holds significant risk in the development project. Most government contracts also address the ability of the contractor to use the results of their research for commercial products after they have delivered on the contract.
To the extent these contractual provisions are present; the contractor should be able to include these projects as part of their qualified research.
What say you my friends?
As a contractor in the Aerospace or Defense industries, are you maximizing your R&D tax credit?
How are your government contracts structured?
Do you know what to document and whether your projects qualify for research tax credits?
Randy Eickhoff, CPA is President of Acena Consulting. With more than 20 years of tax and consulting experience, Randy focused on helping companies successfully document and secure tax incentives throughout the US. He has been a long-time speaker nationally as well as conducted numerous training sessions on R&D tax credits and other US tax incentives.