Background

United States (“The Government”) claims that Procter and Gamble (P&G) and its subsidiaries improperly excluded receipts from intercompany transfers with the foreign members of its controlled group when determining “Gross Receipts” for the purpose of calculating its research tax credit.

During IRS’ Audit, they issued a notice of proposed adjustment which reversed its prior position that all receipts from intercompany transfers be excluded.  Because of this, the IRS states that P&G’s calculate are incorrect because foreign member s of controlled groups should be included in Gross Receipts.  Procter and Gamble argue that this revision contracts the IRS’ own regulations.

The sole issue in this case is a legal one: whether a taxpayer must include the results of its intercompany transactions within its “Gross Receipts” for the purposes of determining the amount of its research credit.

Basic Facts

• P&G and its affiliates are in the manufacture and and sale of consumer products in the US and throughout the  world operating under a variety of brand names including Charmin, Crest, Pringles, Pantene, Pampers and Bounty
• P&G’s subsidiaries regularly engage in intercompany transactions with one another.  These subsidiaries regularly engaged in in the manufacture and sale of specific P&G products
• P&G also owned additional subsidiaries who sold P&G products and belonged to P&G’s “controlled group of corporations”
• P&G engaged in extensive research activities throughout this time which consisted of activities related to the development and improvement of products and technologies.  P&G claimed research tax credits on its tax returns for the expenses incurred for this research.
• When calculating research, P&G treated all members of its “controlled group of corporations” as a single taxpayer, which was used in P&G’s previous tax returns.
• After the IRS requested P&G’s Gross Receipts and how they got there, the IRS issued a written determination which stated that P&G were correct.
• In 2006, the IRS Chief Counsel revised the agency’s position on Gross Receipts; however this rule only applies to receipts from foreign subsidiaries and not to receipts from domestic subsidiaries.
• In 2007, the IRS now claimed that intercompany transactions with foreign members should no longer be excluded from Gross Receipts and therefore P&G’s Gross Receipts and Base Amount were incorrect.
• The IRS said P&G’s domestic sales continued to be excluded from Gross Receipt as well.
• In turn, P&G’s research credit decreased as their Base Amount and Gross Receipts increased.
• P&G paid that additional tax that was owed and then filed a civil action seeking a refund on those aforementioned amounts.
• P&G’s decision to not include intercompany transfers with its international members is consistent with the credit’s intended effect.  The research credit is intended to reward research expenditures by measuring the expenditures against Gross Receipts.  By including international transactions, this would double count transactions and would create irrelevant measurements.

Court’s Decision

Based on the evidence provided on record, the Court finds that there is no material for trail and the Plaintiff (P&G) is entitled to judgment as a matter of law relating to the Gross Receipts research credit issue.  In turn, the Plaintiff’s motion for partial summary judgment is granted and the Defendant’s cross motion for partial summary judgment is denied.

Click here to view the full case: Procter & Gamble Co. v. United States, 733 F. Supp. 2d 857 (S.D. Ohio 2010).

Background

Apple Computer Incorporated treated incomes they earned from stock options as wages for increasing research activities in 1982, 1982 and 1983.

Basic Facts

The main question for this court case is whether the income generated from stock options is appropriate and constitutes wages paid for increasing research activities.

• Apple Computer Incorporated is a California corporation based in Cupertino, California who designs, produces markets and services computer related products.
• Apple has maintained three employee stock option plans and they have been publicly held and listed since first offering in December of 1980
• During this time, there was an increase in stock price and these spreads were not reported as costs or expenses.  Apple then deducted the spreads as wages and claimed these wages as increasing research activities.
• Qualified research expenses are defined as in-house research expenses and contract research expenses.  Apple and Commissioner dispute over whether the spreads constitute wages for qualified research.
• Apple Computer Incorporated used an accrual accounting method which means that the taxpayer deducts expenses in the year they are incurred regardless of whether or not they are actually paid in that year.  The Commissioner of Internal Revenue is arguing that Federal income tax laws should be controlled by financial accounting conventions.  The Supreme Court rejected this idea and stated that if this were to occur, innumerable difficulties would arise in tax administration.

Court’s Decision

1.  Wages for Qualified Services: Apple Computers Incorporated asked for the spreads from stock options to be excluded from the definition of wages but there is no language to support this.  The Court says that amounts of compensation are not subject to withholding, like certain fringe benefits, do not enter into the credit computation even if they are used in performing research.   The language and legislative history does not allow Apple Computer Inc. to exclude spreads from the definition of wages.
2. Expenses Paid or Incurred: The Respond states that Apple Computer Inc. did not pay or incur any costs when the employees excised their stock options.  There is no requirement that the expense be paid in cash and Apple Computer Inc. recorded a liability when each option occurred.  The Commissioner of Internal Revenue’s argument that Federal income tax laws should be controlled by financial accounting conventions.
3. Expenses Incurred After Services Performed: The Ninth Circuit held that the legislative history does not clearly explain that expenses do not qualify unless paid or incurred in the year the services are performed.  This circuit rejected the respondent’s argument of omitting expenses incurred after services performed.
4. Options Granted Before the Enactment of Section 44F: All the expenses were incurred after June 30, 1981 and before January 1, 1986 and therefore all expenses were incurred when the employees exercised options.

An appropriate order will be issued.

Click here to view the full case: Apple Computer Inc. v. Commissioner 98 T.C. 232 (1992) acq 1992-2 CB 1.

Background

Trinity Industries v. United States (N.D. Tex. 2010) involves Trinity Industries seeking a refund for certain qualified research expenditures (QREs) tax credits claiming they were wrongfully disallowed for the 1994 and 1995 tax year.  This suit was filed in March of 2009 in the U.S. District Court, Northern District of Texas, Dallas Division.

Trinity is involved in a variety of business and some of these expenditures discussed were incurred by a division of Trinity referred to as Trinity Marine Group (TMG).  TMG in the tax years discussed was in the business of shipbuilding.  The claimed QREs are in the nature of construction of “first in class” (new type of design) ships for clients and customers.

Because Trinity did not segregate costs in relation to each new aspect of design, an all or nothing approach to litigation was chosen.  The Court finds that Trinity must stand or fall on an “80% of the whole ship” basis meaning that if Trinity can show that 80% of a first class ship was part of  a process of experimentation, they can claim the entire cost .

There are two elements in dispute for this case:

1. Were the expenditures useful in the development of a new or improved business component?
2. Do the expenditures constitute elements of a process of experimentation?

1) Business Component – The Government argues that because the ships were special order and not “held for sale” they do not qualify as business components. The Court finds that each first class ship was a business component and TMG held the ships for sale.

2) Process of Experimentation – Because Trinity did not provide any evidence in regards to this issue the Court finds there is no evidence from which it can estimate QREs relating to any business component smaller than an entire vessel.

The Projects

The following 6 projects and their description and outcome are listed below:

A. The Mark V – This project was a highly innovative and special operations deployment craft which existed nowhere else in the world at the time of production.  In order to complete this project, TMG built two Mark V prototypes and they were both based on an entirely new design.  With these findings, the Court approves of QREs for TMG.

B. The Dirty Oil Barge – Although oil barges had previously been designed by TMG, double hull oil barges were new and changed the design and approach in its entirety.  The specific requirements and the stability necessary for the barges revealed this was an entirely fresh design.  The Court approves of QREs for this project.

C. XFBB – This project required a process of experimentation however the features and designs of the boat seemed to be too similar to previous projects.  Because of this, the Court had to ascertain whether 80% or more of these costs were dedicated to experimentation.  Due to this uncertainty, the Court finds that Trinity has failed to meet its burden of proof and therefore not entitled to any QRE credit for this project

D. T-AGS 60 – This project involved an oceanographic research ship designed for the US Navy.  Although this project included qualified research, most of the balance of the T-AGS was not new or different and the Court finds that Trinity is not entitled to any QRE credit.

E. Crew Rescue Boat – The Crew Rescue Boat was an offshore oil field service boat.  Much of the construction and development of this ship did not involve the process of experimentation, but rather integrated other capabilities into the single vessel.  The Court finds that Trinity is not entitled to the QRE credit due to having less than 80% of the costs devoted to experimentation.

F. Hurley Dredge – This involved the building of a dredge for the Corps of Engineers in the Mississippi River.  The changes that TMG made to design this boat were small and not in comparison to the general project.  Because of this, the Court found that Trinity is not entitled to any QRE credit for this project.

Court’s Decision

The Court directs both parties to attempt to reach an agreement in terms of the appropriate dollar amount of credit.  If they cannot agree, each party can file briefs based on current evidence no later than March 15, 2010.

Click Here to view the full case: Trinity Industries, Inc. v. United States, 691 F. Supp. 2d 688 (N.D. Tex. 2010).

Background

In 2009, the United States (“the Government”) filed an action to recover erroneously issued refunds to Morris and Cynthia Davenport and Myra Davenport for the 2003 tax year in upwards of $292,095 in total.  The Government claims they are entitled to 10% surcharge and interest for their efforts.  In 2011, the Davenports filed a similar action against the Government for a refund in regards to qualified research tax credits that think the IRS wrongfully disallowed for 2002’s tax year.

Basic Facts

David Davenport and Morris Davenport are 50% shareholders in Burly Corporation. Burly manufacture building parts for residential and stand alone metal buildings through its subsidiary Mueller Supply Incorporated, which the Davenports have owned since 1984.  In 2006 the Davenports amended their tax returns for 2002 and 2003 in conjunction with software developed to manage and integrate all of Mueller’s business aspects.  This device was know as the OneWorld Project and the developed software was known as OneWorld System.  The US refund is based on tax credits in regards to the OneWorld Project.

The Government rejected the research credits claimed by the Davenports for the 2002 tax year and contends that it erroneously refunded the amounts claimed by the Davenports for the 2003 tax year because no audit was performed in processing the Davenports’ 2003 claims. The Davenports contend that the Government’s refund claim as to David and Myra Davenport was badly timed.  The IRS mailed the refund check for the 2003 tax year to to David and Myra Davenports on December 28, 2007 and the refund check to Morris and Cynthia Davenport for the 2003 tax year was mailed on June 27, 2008.  In the instance of the OneWorld application, the Davenports argued that they redesigned and restructured the software whereas the Government claims it was only an adaptation of software instead of an entirely new composite and that is why the tax credits were rejected.

Mueller purchased a license from IBM in regards to an ERP Bridge, which is a collection software used by IBM to organize all of their clients’ data and customize to each customers’s needs.  After filing 1120S tax forms in 2002 and 2003, the Davenports were contracted with alliantgroup to determine if they were eligible for research and development tax credits.  The Government and Mueller agree that the tax credits are in reference to activities performed by Mueller employees including wages and outside employees who helped develop OneWorld software and has nothing to do with IBM or JD Edwards consultants.

Court’s Decision

The court could find no evidence that the Davenports and Mueller’s activities would pass the process of experimentation test.  The evidence to support the Davenports’ claim that the activities would pass the process test was only found in the Davenport’s amended tax returns filed in 2006.  Furthermore, these activities were concluded that they took place after the initial start up of they System by IBM.  Therefore, these aforementioned activities do not satisfy the experimentation test because they did not occur “as of the beginning of the taxpayer’s research activities” but rather in the middle of them.

In 2011 the Government moved for summary judgment for the 2003 refunds claim and the wrongful disallowance of the Davenports’ 2002 tax refund credits that were supposedly wrongfully disallowed.  The Davenports then moved for partial summary judgment in regards to the legal standards that apply to the parties’ claims. In 2012, the court:

• grants the United States’ Motion for Summary Judgment,
• denies Defendants’ Motion for Partial Summary Judgment,
• dismisses with prejudice the Davenports’ claims

The Davenports’ then seek for the reconsideration of the court’s 2012 memorandum opinion and order and judgment pursuant to Federal Rule of Civil Procedure 59(e).

In September 2012 after careful consideration and review of the evidence in both cases, the Court denied the Davenports’ Reconsideration of Summary Judgment on the basis that they have not established a manifest error of law.

Click here to read United States v. Davenport 897 F. Supp. 2d 496 (N.D. Tex. 2012).

 

Background

This case was filed on March 21, 2012 in the United States Tax Court.  The sole issue for decision in this case is whether or not certain wages from Farouk Systems, Inc. (FS) paid to petitioner Farouk Shami (Mr. Shami) for 2003, 2004 and 2005 and petitioner John McCall (Mr. McCall) for 2003 and 2004 qualify as research expenses for purposes of claiming credit and increasing research activities.

Basic Facts

FS was a hair, skin and nail company that sold and developed products.  FS employed hundreds of people who were in several departments like manufacturing, education and research, marketing and sales. Activities involving scientific research and experimentation were conducted by the research and development department, which employed 18-27 staff at any time, or the activities were outsourced.

Mr. Shami was FS’s chief executive officer, president and secretary for 2003 and 2004.  Mr. McCall was a principal for a company who distributed FS products and he was a shareholder in FS in the 1990s.

In order to conduct research and development tax studies, FS contracted with alliantgroup to cover the relevant years.  These studies claimed that FS was able to qualify for research and tax credits from the wages paid to Mr. Shami ($8.7-$9.5 million) and Mr. McCall ($1.8-$5.7 million) on an annual basis.

QREs (Qualified Research Expenses) can include wages paid to employees when performing qualified research activities.  All wages paid to an employee can constitute QREs if 80% of their wages are attributable to qualified services for the taxable year.  Taxpayers must retain records of this qualified research to prove these findings.

Findings

• Taxpayers (FS) must be prove they are entitled to claim tax credits.  Petitioners have not shown that they have provided adequate information to suffice this.
• Mr. Shami and Mr. McCall say that they spent 80% of their time dedicate to product search and development for 2003 and 2004 and Mr. McCall spent 30% of his time in 2005 for these services.  The Commissioner of Internal Revenue argues that they did not provide substantial evidence that these activities corresponded to their wages because Mr. Shami and Mr. McCall failed to provide any documentation that proves these services occurred during the relevant years.
• Several testimony petitioners offered to substantiate this time however they were seen as inadequate and sometimes contradictory to the Mr Shami’s and Mr. McCall’s statements.  Petitioners turned to United States v. McFerrin in saying the Court must make an estimate in regards to the amount of wages allocable to qualified services however, this case argued that the Court will make an estimate if the taxpayer provides adequate documentation to substantiate costs associate with their research activities.  The Court will not make an estimate for the allocation of wages because the plaintiff failed to provide sufficient evidence.
• The Court rejected the petitioners’ argument.

Click here to read the full Tax Court Memorandum: Basim Shami and Rania Ardah, et al. v. Commissioner of Internal Revenue (T.C. Memo 2012-78)

Background

This appeal took place in 2009 in the Fifth Circuit in the Southern District of Texas.

The U.S. brought a suit against Arthur R. McFerrin seeking to recover a tax credit that the government alleges was erroneously paid.  After a six day bench trial the district court ordered a repayment of the erroneously paid refund plus interest.  An appeal was filed from the United States who vacated the district court’s judgment and remand for further proceedings.

Basic Facts

• McFerrin is a prominent chemical engineer who founded KMCO, Inc. which manufactures specialty chemicals for the petrochemical industry.
• This case centers on tax returns filed by McFerrin and Corporations  in the tax year 1999 and tax credits for increasing research activities.
• McFerrin and Corporation filed tax reports in 2000 and did not claim any credits for increasing research activities.  In 2003 they teamed up with alliantgroup and filed amended 1999 tax returns claiming an overall credit of $472,092.00.  Within one month the IRS refunded McFerrin and Corp. $601,228.40 due to a clerical error. In October 2005, the United States filed a suit to recover this amount plus interest due to no documentary proof providing evidence to support these claims.
• On summary judgment, McFerrin and Corp. were order to fulfill this refund with interest.

Court’s Decision

Taxpayers are required to keep documented records in order to prove a claimed credit.  If the taxpayer can provide this information, then the court should estimate the allowable tax credit.

A) McFerrin argues that the substantiation claims tried before the district court should have been dismissed because the government failed to comply with the rules and regulations.  McFerrin stated that the government claimed he misrepresented facts however, the government only alleged a failure to document.  The district court in this case disallowed this complaint from McFerrin and let the case go to trial.

B) The requirements of qualified research expenses(QREs) were argued.  In particular, the “discovering information” requirement states that the information must be new to the taxpayer and research must be undertaken for the purpose of discovering information.  McFerrin was relying on the 2001 Proposed regulations which did not state the importance of research activities to the U.S. economy, instead of following the 2003 Regulations which apply to taxable years ending on or after December 31, 2003.  The government conceded and the district court did not review the evidence under the 2003 Regulations.

C) The government argues that errors made by them were “harmless.”  The district court accepted that a few of McFerrin’s projects may have involved researched but were unpersuaded in that these projects could be deemed “qualified research”.  The government also argues in the case that if there was qualified research, McFerrin did not supply documentation to prove these costs.  If McFerrin can supply this documentation, the Court must estimate the expenses with these activities.  Further proceedings are warranted for this argument.

D) The government claims that McFerrin’s bonus of $6.4 million in 2004 should be refunded as it is not a qualified research expense should there be a remand for a new trial.  The district court determined this bonus was on the basis of profits and cash flow from KMCO rather than research performed in that year.

Findings

The Court used incorrect definitions for several QREs including discovering information and process of experimentation.  Because of these issues, some of the tax credits from McFerrin could be found to be legitimate and the U.S. Court of Appeals for the 5th circuit vacates the judgment of the district court and remands for further proceedings consistent with this opinion.

Click here to read the full case: United States v. McFerrin, 570 F. Supp. 3d 672, 675. (5th Circ. S.D. Tex. 2009).