Posted by Jeffrey M. Feingold on 10.18.12
A U.S. district court has denied the IRS's motion for partial summary judgment in the ongoing research and development (R&D) tax credit litigation in Bayer Corp. v. United States (No. 2:09-cv-00351). In the ruling, the U.S. Western District Court of Pennsylvania disagreed with the IRS's arguments that Bayer substantially varied the factual basis for the R&D credits at issue.
Bayer claimed approximately $175 million of R&D credits from 1990 to 2006. To compute its credit, Bayer used an accounting system that was based on the nature of the activities performed rather than individual projects. Similar activities (e.g., clinical studies for pharmaceuticals or formulation development for crop protection agents) were grouped into more than 1,300 cost centers for which eligible qualified research expenses (QREs) were compiled for the credit.
Section 41(d)(2) requires that the test for determining whether an expense is incurred in connection with qualified research be applied separately to each business component of the taxpayer. A business component is defined as "any product, process, computer software, technique, formula or invention" that is either (1) held for sale, lease or license; or (2) used by the taxpayer in its trade or business. Bayer estimated it had developed more than 100,000 business components during the years at issue. While Bayer provided extensive information on its products, processes, formulas, and so forth, the company made no attempt to segregate costs by business component, arguing that its books and records do not track costs by individual business component, and are not required to do so.
In preparing its R&D study for some of the years at issue, Bayer delivered a draft of the study and asked the IRS for feedback before finalizing the report. In subsequent meetings, the IRS asked numerous questions but did not object to the methodology used and did not ask that additional types of information be collected. During the detailed audit that preceded this litigation, the IRS never asked Bayer to identify or list the business components to which the claimed QREs related.
During the discovery phase of this case, the IRS issued an interrogatory that asked Bayer to identify and describe "each new or improved business component Bayer contends it incurred qualified research expenses to develop during the credit years." Bayer argued that the request was "overbroad and burdensome without the adoption of a suitable sampling method." The vast scope of the enterprise was demonstrated by the fact that Bayer had collected more than 1 billion pages of potentially relevant electronic records from just four of its 49 sites at issue. In addition, more than 3 million pages of documents had already been provided to the IRS. Bayer filed a motion requesting a discovery plan based on statistical sampling, but the court denied the motion in February (for more on this motion information, see Tax Insights: District court ruling highlights need for taxpayers to substantiate R&D credit claims). After the sampling motion was denied, Bayer was directed to fully respond to a similar, but much narrower, interrogatory.
The IRS then filed the motion for partial summary judgment on the grounds that in gathering and providing information to respond to the interrogatory, Bayer was substantially varying the factual basis for its refund claim (citing Lockheed Martin Corp. v. United States, 210 F.3d 1366, 1371). The "substantial variance" rule bars a taxpayer from presenting claims in a tax refund suit that substantially vary the legal theories or factual bases set forth in the refund claim. One purpose of the substantial variance rule is to limit litigation to those grounds that the IRS had an opportunity to consider and is willing to defend. In siding with Bayer, the court ruled that "Bayer has been compelled to engage in Herculean efforts to comply with the government's demand in this litigation for a list of the business components to which the claimed QRE credits relate....The Government will not be permitted to demand a list of business components for the first time in this Court and then object based on the substantial variance rule to Bayer's need to gather significant, additional evidence to comply with the demand when the QRE credits underlying Bayer's refund claim have not changed."
The original Bayer ruling from February highlighted the need for taxpayers to identify business components and produce documentation that creates nexus between the business components and qualified costs. In its most recent decision, the court acknowledged the challenges taxpayers face in producing business component listings and related documentation to meet IRS demands. The decision further demonstrates the IRS's shifting focus to business component-based (i.e., project-based) R&D documentation.