Is it R & D when my customer wants a new product?

4 Minute Read
Posted by Randy Eickhoff on Dec 8, 2011 2:00:00 AM

Customer-driven-product-development-can-qualify-for-tax-creditsIn order to develop new products many companies turn to their current customers for design ideas or improvements to existing products. So how can a company qualify for R and D tax credits if a customer signs a contract to produce a new product? The devil is in the details of the contract and who will retain substantial rights following development.

Contractual Terms Matter

How a contract is structured makes a big difference when determining if a project may qualify for R&D tax credits. Section 41 (d)(4)(H) specifically excludes from qualified research “any research to the extent funded by any grant, contract, or otherwise by another person or governmental entity.” So, if the contract signed between you and your customer includes charges related to design and engineering that are separately stated, the fees received under that contract may need to offset your research expenses or the project may be completely excluded from qualified research.

If, however, the contract between you and your customer was to deliver a finished product with no breakout of engineering costs, it would likely be considered a production contract rather than a contract to perform research and development. Are we splitting hairs? Probably but production is not the same as research and development.

Funded Research & Substantial Rights

Contract manufacturers, software development companies and companies that build-to-print need to understand who retains rights to any research completed for new products or software. If your company is contracted to design and build a new product for a customer and you retain no rights to the research conducted, the research would not be considered qualified research to you. Your customer, however, may be able to consider the fees paid to you as qualified research expenditures assuming they meet the 4-part test (for a discussion of the 4-part test, see Navigating the R&D Tax Credit Minefield (Part 2)).

In Lockheed v. US (39 Fed. Cl. 197 (1997)), the IRS contended that research conducted byLockheed-versus-US Lockheed was “funded” because payments were not contingent on the success of the research and that Lockheed did not retain “substantial rights” to the research. Without going into a lot of depth, Lockheed won the case on appeal. The Appellate Court reasoned that because Lockheed could sell products developed under the various contracts and use the results of the research in future development, they met the definition of retaining substantial rights. In addition, the Appellate Court also concluded that because Lockheed retained substantial rights and did not have to pay the government for that right, the research did not fall under the “funded” exclusion.

What can we take from this court case? Simply that maintaining the right to use the results of research conducted critical when analyzing whether or not activities are qualified research.  

Adaptation versus New Product Development

In some cases, customers want minor changes or upgrades to a particular product. If the improvement can be completed without uncertainty, the improvement would likely be considered an adaptation rather than an improvement. Adaptations are specifically excluded from qualified research. How can you tell the difference? If your efforts to make the improvement can meet the 4-part test on their own as a stand-alone project, the project may qualify for R&D tax credits. If, however, they cannot, then the time and effort will most likely be considered an adaptation and be excluded from qualified research.

So is the new product development qualified? Or not?

Project by project determination will dictate whether each effort conducted on behalf of a customer will qualify for R&D tax credits. A carefully constructed contract and retention of rights to use the research will help secure the project as qualified research.

What say you friends?

Does your company conduct research on behalf of customers that could be qualified?

When was the last time to reviewed your standard contracts to assess your rights?

Are you maximizing the available R&D credits available to your company?

Recent and Related Articles

Navigating the R&D Tax Credit Minefield (part 2)

How Can Management Qualify for R&D Tax Credits?

10 Reasons Not to Take R&D Tax Credits (part 2)

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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.


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