A taxpayer is challenging key aspects of the research credit regulations under both the Administrative Procedure Act and under the Chevron standard as part of a Tax Court case involving $2.4 million in credits claimed from 2011 to 2013. If successful, the case—Perficient Inc. et al. v. Commissioner (No. 15467-17)—could undermine the “Substantial Rights Standard” in the regulations.
The case was brought by Perficient, Inc., a technology services company that designs, builds, and delivers software technology solutions. In a motion for partial summary judgment, Perficient argues that the research activities associated with its sample projects do not constitute funded research within the meaning of Section 41(d)(4)(H). Therefore, Perficient was permitted to treat the eligible project costs as qualified research expenditures.
Treas. Reg. Sec. 1.41-4A(d) provides that research is not “qualified research” for purposes of the research credit to the extent it is funded by any grant, contract, or otherwise by another person, including any governmental entity. Furthermore, all agreements entered into between the taxpayer performing the research and other persons shall be considered in determining the extent to which the research is funded—not only research contracts.
Generally, to determine if research is funded, taxpayers must evaluate the research activities against two standards:
- Risk standard (“Risk Standard”)
- Substantial rights in the research standard (“Substantial Rights Standard”)
The Risk Standard states that amounts payable under any agreement that are contingent on the success of the research and thus considered to be paid for the product are not treated as funding. The Substantial Rights Standard requires the taxpayer to retain substantial rights in the research to qualify for the research credit.
In its memo, Perficient claims that it is entitled to summary judgment for these three reasons:
- Each of its sample projects satisfied the Risk Standard
- The Substantial Rights Standard is procedurally invalid under the Administrative Procedure Act and substantively invalid under an analysis consistent with that in Chevron USA Inc. v. Natural Resource Defense Counsel, Inc., 467 U.S. 837 (1984) (“Chevron”)
- Even if it were valid, each of its sample projects satisfied the Substantial Rights Standard
With respect to the Risk Standard, Perficient claims that certain provisions included in the contracts of its sample projects—such as requiring the client to review and inspect the deliverables, allowing the client to test the deliverables for functionality, and providing the client the ability accept or reject the deliverables—demonstrates that Perficient was engaged to deliver a solution to a client’s technical issue and was not paid to undertake research. Perficient does not challenge the validity of the Risk Standard in its memo.
Conversely, Perficient challenges the validity of the Substantial Rights Standard. Citing Oakbrook Land Holdings LLC v. Commissioner, 154 T.C. 180 (2020), Perficient argues that the Substantial Rights Standard is procedurally defective under the Administrative Procedure Act because of Treasury’s failure to discuss, address, or provide any reasoned explanation in response to all comments questioning the inclusion of the Substantial Rights Standard in the 1983 proposed regulations. Perficient also claims the Substantial Rights Standard is substantively defective under the two-step standard for determining deference to regulations under the Supreme Court decision in provided in Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc. (468 U.S. 837).
Under Chevron, courts must generally give deference to agency regulations if the statute is ambiguous and the agency’s interpretation is “rational” or reasonable. With respect to Chevron step one, Perficient asserts that Congress explicitly addressed the meaning of qualified research to exclude funded research in Section 41 and the insertion of the Substantial Rights Standard conflicts with congressional intent, in part because there is no evidence that demonstrates the meaning to the word “funded” requires a taxpayer to retain substantial rights to research. Regarding Chevron step two, Perficient contends that Congress’ failure to include any reference or discussion of substantial rights in its Directive to Promulgate Regulations Implementing the Research Credit is evidence Congress did not intend to expand the meaning of funded and the Substantial Rights Standard is therefore arbitrary in substance.
In contrast, the IRS asserts that Treasury is not required to address all comments, noting that one comment which Perficient references in its challenge of procedural validity was sent approximately six years after the close of the notice-and-comment period. Considering the substantive validity of the Substantial Rights Standard, IRS argues that Congress left it to Treasury to define funded research and did not address whether research was “funded” based on which party retains the rights in the research.
Lastly, Perficient contends that even if the Substantial Rights Standard is valid, each of its sample projects satisfied this standard because Perficient retains the rights to use the research, know-how, and improvements, modifications, and derivatives to pre-existing intellectual property developed or refined in connection with the sample project. The IRS counters and asserts that know-how is not a substantial right, but rather an incidental benefit that does not constitute a substantial right in the research.
Although Perficient’s case has yet to be litigated, the taxpayer’s memo in support of a motion for partial summary judgment raises interesting considerations regarding the procedural and substantive validity of the Substant Rights Standard. However, the regulations containing the Substant Right Standard have been relied upon by taxpayers for several years. Further, the assertion that know-how is an incidental benefit to research rather than a substantial right has generally been implemented in practice. A court ruling in favor of Perficient on these matters would be a surprising development with potentially broad implications beyond the research credit.
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