United States: An Economic Evaluation Of ‘Funding’ For Research Tax Credits

Last Updated: October 23 2014
Article by Darrell B. Chodorow and Shaun D. Ledgerwood

A. 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 language of the underlying contract.

B. Legislative Intent

Congress first enacted legislation under ERTA to provide an income tax credit as an incentive for U.S. businesses to increase their qualified research expenditures. The RTC was designed to address a market failure that leads to underinvestment in research by private investors. As explained in the legislative history to the recent renewal of the RTC in the American Taxpayer Relief Act of 2012:

Congress acknowledges that research is important to the economy. Research is the basis of new products, new services, new industries, and new jobs for the domestic economy. There can be cases where an individual business may not find it profitable to invest in research as much as it otherwise might because it is difficult to capture the full benefits from the research and prevent such benefits from being used by competitors. At the same time, the research may create great benefits that spill over to society at large. To encourage activities that will result in these spillover benefits to society at large, the government does act to promote research. Therefore Congress believes it appropriate to extend the present-law research credit.9

The RTC has been a subject of debate. Many have argued that the policy has been a cost-effective means of stimulating research that is necessary to keep U.S. enterprises competitive, given similar tax incentives provided in other countries. Others view the credit as nothing more than a corporate handout and as subject to corporate overreach. The effectiveness of the RTC as a tax incentive is an important policy question but beyond our scope here. The legislative intent behind the RTC is clear — subsidization of qualified research investments through tax credits. That was first affirmed in 1981, and it has since been reaffirmed by the legislative and executive branches 15 times despite the program's detractors. Although there are expectations that Congress will extend the RTC retroactively for 2014 — and perhaps go further by expanding it10 and making it permanent11 — this is unlikely until after the 2014 midterm elections.12

ERTA defined the term ''qualified research'' to exclude ''research to the extent funded by grant, contract, or otherwise by another person (or governmental entity).''13 The legislative history to ERTA explained that Congress intended the funded research exclusion to apply in the following situation:

The credit is not available for any activity performed for another person (or governmental entity), whether pursuant to a grant, contract, or otherwise. Thus, if a taxpayer contracts with a research firm, university, or other person for research to be performed on the taxpayer's behalf, only the taxpayer which makes payments under the research contract and on whose behalf the research is conducted can claim the credit as those expenditures; the research firm, university, or other person which conducts the research on behalf of the other taxpayer cannot claim any credit for its expenditures in performing the contract.14

The above legislative history addresses a classic research contract in which the performance of the research is the deliverable. Research contracts can be differentiated from contracts that do not specifically require the performance of research as the deliverable but in which research may be required by the contractor to provide the products or services that constitute the deliverables. Congress did not explain to what extent, if at all, the funded research exclusion was intended to apply to the latter contracts.

The RTC statute does not define the term ''funded'' or explain how the exclusion would apply to research performed by a taxpayer under a contract or grant with a third party. Rather, Congress left the scope of the funded research exclusion to be addressed by the IRS in regulations. The funded research regulation is reg. section 1.41- 4A(d). This regulation ties the concept of funding to (1) whether the customer has agreed to pay the researcher to perform research on its behalf unconditionally (that is, even if the research fails to achieve its objectives); and (2) whether the taxpayer retains substantial rights in the research results. These criteria are akin to the considerations in an investment decision — that is, the researcher expects that the current and future benefits from its investment in the contract will exceed its expected costs but is subject to the risk that they will not.

The remainder of this article focuses on whether the past application of these regulations, along with later judicial precedent, is consistent with the economic rationale implied by the original congressional intent in excluding funded research as a qualified research expense.

Download article here.

Reprinted from Tax Notes, September 29, 2014, p. 1593


1 Section 221 of ERTA. The RTC is codified at section 41. Although section 41's formal title is ''Credit for Increasing Research Activities,'' tax practitioners refer to the credit by various short forms, including the RTC.

2 Section 41(a)(1). Research is qualified for purposes of the RTC if (1) the expenses connected with the research are eligible for treatment as research and experimental expenditures under section 174; (2) the research is undertaken to discover technological information; (3) the information to be discovered is useful in the development of a new or improved business component of the taxpayer (e.g., a new product or process); and (4) substantially all of the research activities constitute elements of a process of experimentation. Section 41(d)(1)(A)-(C); reg. section 1.41-4(a).

3 H.R. Rep. No. 100-1, pt. 2, at 88 (1988).

4 Section 41(d)(4)(A)-(H).

5 Section 41(d)(4)(H).

6 71 F.3d 868 (Fed. Cir. 1995).

7 2013 U.S. Dist. LEXIS 140185 (S.D. Fla. 2013).

8 Note that for the purposes of this article, we will assume that all research discussed herein meets the eligibility requirements of section 41 and its regulations except for the issue of whether the research is funded within the meaning of section 41(d)(4)(H) and reg. section 1.41-4A(d).

9 Joint Committee on Taxation, ''General Explanation of Tax Legislation Enacted in the 112th Congress,'' JCS-2-13, at 140 (Feb. 1, 2013).

10 See Dean Zerbe, ''Happy Days for Research: Tax Extenders Clear Senate Finance With Expanded R&D Tax Credit,'' Forbes, Apr. 4, 2014.

11 See Jia Lynn Yang, ''There's a War Over R&D Tax Credits. And Companies Keep Winning,'' The Washington Post, Jan. 24, 2014.

12 See David Malakoff, ''U.S. House Passes Permanent R&D Tax Credit,'' Science, May 9, 2014.

13 Section 41(d)(4)(H).

14 H.R. Rep. No. 97-201, at 116 (1981).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

In association with
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement

    Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of www.mondaq.com

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .


    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at enquiries@mondaq.com.

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.

    By clicking Register you state you have read and agree to our Terms and Conditions