The Court of Federal Claims has ruled in Dynetics Inc. v. United States (No. 12-576T) that Dynetics didn't qualify for an R&D credit because its research was funded by another party. The court took an expansive view of the 1995 Federal Claims decision in Fairchild Industries Inc. v. United States (71 F.3d 868) in holding that the payments to Dynetics weren't contingent on the success of the research and that Dynetics didn't retain substantial rights to the research.
The decision was based on a sample of seven contracts, and the IRS and Dynetics asked the court to determine if under the regulations the contract language indicated the research was considered "funded." The regulations under Section 41 generally bar any R&D credit from qualified research "funded by any grant, contract, or otherwise by another person." Any payments contingent on the success of the research aren't treated as funded under the rules, but research is considered funded if the taxpayer doesn't retain any substantial rights to the research.
Dynetics argued that it was under substantial financial risk of not being paid unless its research was successful. It based its argument on termination and inspection clauses, and a general expectation under "a course of dealing" that it would need to be successful to be paid. The court ruled that a course of dealing can be considered only if the contract language is ambiguous and that the contract itself was unambiguous. Dynetics then cited the finding in Fairchild that an inspection clause shifted the risk to the contractor. The court rejected this argument, holding that the court in Fairchild based its decision on more than just the inspection clause. It then ruled that neither the inspection clauses nor the termination clauses were enough to shift the risk of failure to Dynetics.
The court also rejected Dynetics' claim to substantial rights of the research under the analysis in the 2000 Federal Claims decision in Lockheed Martin Corp. v. United States (210 F.3d 1375). The court held that Lockheed stands only for the proposition that government security laws outside of a contract do not invalidate a taxpayer's substantial rights to the research for purposes of the R&D credit, and that the contract agreements themselves govern. The court found that Dynetics' actual research agreements didn't give it substantial rights to the research.
The decision is important for any taxpayers performing research under contract. Taxpayers should expect the IRS and courts to parse and examine the contract language closely to determine who bears the financial risk of failure and holds the rights to the research.
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