A recent decision by the U.S. District Court for the Northern District of Texas (Unites States v. Davenport, No. 3:09-cv-02455-L) held that costs for modifying a commercially available software package did not qualify for the research and development (R&D) tax credit.
The case addressed members of the Davenport family, who own Burly Corporation. Burly Corporation manufactures metal roofing and standalone metal buildings through its subsidiary, Mueller Supply Company. In 2006, the Davenports filed refund claims for the 2002 and 2003 tax years for the "OneWorld" software project developed to manage, automate and integrate all aspects of Mueller's business, including the automation and integration of manufacturing, design, sales, accounting and shipping. The Mueller OneWorld system was created using the J.D. Edwards OneWorld commercially available enterprise resource planning (ERP) software application suite. Mueller also purchased a license from IBM for an ERP bridge (which consists of base code that is used as a starting point) and contracted with both IBM and other contractors to modify the software for its specific needs.
The IRS sought the return of $292,095 in erroneously issued refund checks to the Davenports for the 2003 tax year, while the Davenports claimed the IRS had wrongfully disallowed its R&D tax credits totaling $196,898 for the 2002 tax year.
The IRS argued that the Mueller OneWorld project involved "mere adaptation of existing commercially available software and quality control type testing" that was not eligible for the credit. The Davenports contended that the project involved a complex process of custom software design, customization, testing and implementation that met the R&D credit qualification tests. The court sided with the IRS in determining that the software project did not meet the requirements for qualified research.
Specifically, in granting the motion for summary judgment, the court ruled that the Mueller OneWorld project did not involve a process of experimentation. In its decision, the court cited the Tax Court decision in Union Carbide Corp. v. Commissioner (T.C. Memo 2009-50, discussed below). The court reasoned that to constitute qualified research, a valid process of experimentation must have a result that was uncertain at the beginning of the research. In reaching this finding, the court noted that "although the Project may have taken a considerable amount of man hours to complete, there is no indication that it involved anything other than a straight-forward configuration of JDE OneWorld and ERP Bridge as contemplated by IBM's proposals to Mueller."
While the IRS made many arguments regarding why the project did not qualify for the credit, the court focused only on the process of experimentation requirement and did not address the other IRS arguments.
The court also noted that the taxpayers relied "solely on conclusory arguments and neither offer any evidence nor cite to any evidence in the record in response to the government's motion." The IRS provided more than 500 pages of documentation to support its assertions.
The court's ruling highlights the need for companies claiming the R&D credit to pay special attention to documenting how the activities claimed as qualified research constitute a valid process of experimentation and to gathering evidence that substantiates the qualification of specific R&D projects.
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