On January 3, 2022, the IRS Office of Chief Counsel released an interim guidance memorandum (the Interim Guidance), along with a set of FAQs, to provide IRS Examining Agents with procedural guidance for applying Field Attorney Advice 20214101F (the Field Advice) in an examination of a taxpayer’s refund claim under Section 41. In the Field Advice, the Service not only outlined the information that must be included in a valid administrative claim for refund of the Section 41 research credit, but revised the historic review of a research credit claim. The Field Advice relies on the specificity requirement of Treas. Reg. § 301.6402-2(b)(1) and how it has been applied by the courts to research credit claims rather than focusing on the substantiation requirements set forth in the current research credit regulations.
The Field Advice, and corresponding Interim Guidance, are significant in three main respects.
First, the Field Advice sets forth detailed instructions for filing a refund claim under Section 41, which the Service characterizes as valid. The new rules reflect a departure from current practice under which a taxpayer may file a claim and then respond to specific inquiries regarding the claim during the course of an IRS Examination. Instead, the Field Advice and Interim Guidance require a taxpayer to provide greater detail about the claim from the onset. These changes will be administratively burdensome to many taxpayers and potentially claim-prohibitive to others. Moreover, this approach may adversely affect the use of statistical sampling information to support a research credit claim.
Second, although the Interim Guidance provides taxpayers with a 45-day period to perfect non-compliant claims during the first year of implementation, the Field Advice indicates that in subsequent tax years, such claims will be denied altogether. The Field Advice reflects a concern by the Service that a court may find that allowing taxpayers time to correct claims may be viewed as a waiver of the specificity requirement of Treas. Reg. § 301.6402-2(b)(1). To avoid this result, the Field Advice indicates that a claim failing to satisfy the new standards will be rejected altogether with no examination initiated, rather than allowing a taxpayer to perfect a research credit claim after the statute of limitations has passed.
Third, these apparent policy changes have been implemented with non-authoritative Field Advice rather than through the more formal notice and comment process, which would have allowed stakeholder input under the Administrative Procedure Act, as well as enhanced consideration of how to resolve issues that the Service has identified with the processing of research credit claims under Section 41.
Because the updated requirements are applicable to refund claims made beginning January 10, 2022, taxpayers will need to act quickly to review the new requirements to ensure that any upcoming refund claim is compliant.
Why the uproar over Field Service Advice 20214101F?
Section 41 provides a credit for a portion of the increased expenses incurred and attributable to qualified research activities (QRAs). To be considered a QRA, Section 41 requires each of a taxpayer’s business components to satisfy a four-part test:
- the research and experimental expenditures test, whereby research expenses are “incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense” (the Section 174 test),
- the technological information test, whereby research results in information that is “technological in nature,”
- the business component test, in which the information is “intended to be useful in the development of a new or improved business component of the taxpayer,” and
- the process of experimentation test, which “relates to a new or improved function, performance, reliability, or quality.”
Under current regulatory guidance, whether a research credit is claimed on an originally-filed return or an amended return, no qualitative information is explicitly required by Section 41. Treas. Reg. § 1.41-4(d) merely requires a taxpayer to “retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit.” Thus, although a taxpayer must retain records to substantiate the research credit, no specific documentation is concurrently required with a filing.
Additionally, the specificity requirement of Treas. Reg. § 301.6402-2(b)(1) is a jurisdictional prerequisite to filing a suit for refund. When evaluating refund claims, courts have held that a taxpayer must indicate both the grounds (e.g., the legal theory upon which the refund is claimed) and sufficient facts that form the basis for the refund claim. See Lockheed Martin Corp. v. United States, 210 F.3d 1366, 1371 (Fed. Cir. 2000). Further, the Service may reject refund claims that fail to satisfy the specificity requirement as deficient and refuse to consider them on their merits. For example, in Stoller v. United States, 444 F.2d 1391, 1393 (5th Cir. 1971), the court noted the importance of the specificity requirement, providing that the “Commissioner does not possess the time or resources to perform extensive investigations into the precise reasons and facts supporting every taxpayer's claim for refund. The need for investigation can be easily obviated by a taxpayer who takes the proper care in preparing his claim for refund.”
In the Field Advice, the Service concludes that the specificity requirement mandates that a taxpayer must provide sufficient facts in a research credit refund claim or risk that such a claim will be rejected. The enhanced documentation requirement focuses on aligning qualified research expenses to business components and the employees performing the research. Relying on the specificity requirement of Treas. Reg. § 301.6402-2(b)(1), the Field Advice notes that taxpayers must identify “in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof.” In particular, the Field Advice requires the following information to be identified when the refund claim is filed:
- All the business components to which the Section 41 research credit claim relates for that year;
- all research activities performed by the business component;
- all individuals who performed each research activity by business component;
- all the information each individual sought to discover by business component; and,
- the total qualified employee wage expenses, supply expenses, and contract research expenses for the claim year, which may be provided using Form 6765, Credit for Increasing Research Activities.
The Field Advice clarifies that a taxpayer providing documents with its refund claim must identify where in the documents the facts responsive to each of the five requirements listed above can be found as the Service “has no affirmative obligation to sort through a taxpayer’s records.” In comparison to Treas. Reg. § 1.41-4(d), which provides that “sufficient” records must be kept substantiating a claim for refund under Section 41, the Field Advice represents a significant change in the required documentation when a claim is filed.
ES Observation: The Field Advice represents a departure from existing requirements for filing a research credit claim under Section 41. As noted, current regulations provide that a taxpayer may claim the research credit on an originally-filed return or an amended return absent any qualitative information supporting the research credit. Treas. Reg. § 1.41-4(d) merely requires taxpayers to retain records to substantiate the credit.
When these regulations were published in 2004, the accompanying preamble explained that a broad approach regarding required documentation was being implemented because of “the high degree of variability in the objectives and conduct of research activities in the United States compels a conclusion that taxpayers must be provided reasonable flexibility in the manner in which they substantiate their research credits.” See REG-112991-01, 2002-4 IRB 404, 409. These regulations loosened documentation requirements consistent with the expressed legislative intent of Section 41 in which Congress indicated concern about costly and unnecessary record keeping burdens for research credits. See H.R. Rep. No. 478, 106th Cong. 1st Sess. (Conf. Rep. 1999). Thus, the preamble suggests an explicit policy determination that taxpayers should be provided flexibility in substantiating research credit claims, whether on an originally-filed return or a refund claim, even going so far as to provide “that the failure to keep records in a particular manner (so long as such records are in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit) cannot serve as a basis for denying the credit.”
The recent Field Advice appears to suggest a policy change with respect to research credit claims. As the test for the viability of a Section 41 refund claim is multi-part, the documentation requirement is complicated and more extensive than previously required and, therefore, is likely to impose great burdens on taxpayers seeking refund claims under Section 41. Further, the Field Advice may also signal a policy change regarding how the specificity requirement of Treas. Reg. § 301.6402-2(b)(1) should be interpreted. By reading Treas. Reg. § 301.6402-2(b)(1) as requiring the level of detail indicated in the Field Advice, the new requirements may exceed the established standards of Treas. Reg. § 301.6402-2.
Interim guidance and FAQs provide little reprieve
Concurrent with the release of the Field Advice in October 2021, the Service announced that it planned to use the Field Advice to “improve tax administration with clearer instructions for eligible taxpayers to claim the credit while reducing the number of disputes over such claims.” The announcement also provided for a one-year transition period wherein taxpayers would have 30 days to perfect a research credit claim for refund prior to the IRS' final determination on the claim. Following the release of the Interim Guidance on January 5, 2022, the Service announced that the timeframe for perfecting research credit claims has been modified to 45 days.
|ES Observation: For research credit claims filed January 10, 2022 through January 9, 2023, taxpayers will be given an opportunity to submit additional documentation to “perfect” deficient claims. If further information is not received within the 45-day period, IRS examiners have been instructed not to consider the claim. Given the enhanced information required under the updated guidance, taxpayers will welcome the additional 15 days, however, once the grace period expires, the Field Advice seems to indicate that the Service should reject a deficient claim prior to initiating an examination to avoid having a court find that the Service waived the specificity requirement under Treas. Reg. § 301.6402-2(b)(1).
The Interim Guidance, applying the Field Advice, provides that for a Section 41 research credit claim for refund to be considered a valid claim, taxpayers are required to provide, under declaration of penalties of perjury, the five requirements detailed in the Field Advice.
Section 6511(a) provides a claim for refund must be filed within three years from the time the return was filed or 2 years from the time the tax was paid, whichever is later. During the transition period, a claim that includes a claim for research credit that would otherwise be considered timely pursuant to Section 6511(a) but does not meet the requirements of the updated guidance, will be considered timely filed if perfected within the 45-day timeframe. For claims filed during the one-year transition period, IRS examiners will evaluate the refund claim under the five criteria identified above.
ES Observation: The Interim Guidance further provides that the Service plans to deny refund claims filed too close in time to a statute of limitation deadline (as provided in Section 6511). Notably, the guidance allows for taxpayers to perfect a refund claim after a statute of limitation has expired if such claim is perfected in the 45-day period during the one-year transition period.
The Interim Guidance goes so far as to recommend that the Service “reject a deficient refund claim (i.e., a claim non-compliant with the enhanced requirements of the Interim Guidance) before initiating an audit (or otherwise actively considering the refund claim on its merits)… to eliminate the likelihood that a court will find the Service waived the specificity requirement under Treas. Reg. § 301.6402–2(b)(1).” Therefore, beyond the one-year transition period, taxpayers must not only comply with enhanced substantiation requirements with respect to a Section 41 refund claim, but will lack the opportunity to provide follow-up substantiation in the event that an IRS agent determines that the provided documentation is lacking.
Further, in conjunction with the interim guidance, the Service released a set of FAQs to address Section 41 amended return questions. Notably, the FAQs provide that the Service will make determinations on refund claims within six months of receipt.
|ES Observation: The FAQs note that refund claims will be processed within 6 months. The interplay this 6-month lag may have with the aforementioned 45-day perfection period could have dramatically differing result depending on the timing of the taxpayer’s initial claim. For example, consider a taxpayer that files a claim for refund nine months into the one-year transition period. Six months later, the Service has processed the claim and requires further information. Because the claim was made in the transition period, the taxpayer has 45-days to perfect its claim. However, in the event the same taxpayer also filed a claim for refund one-month past the one-year transition period, and two months before the taxpayer learns that its first claim for refund was not sufficient. Because the taxpayer is outside of the one-year transition period, it does not have the opportunity to perfect its claim if determined deficient. In fact, as stipulated in the Interim Guidance, the Service would reject the deficient claim. This stark difference in result brought on by refund claims made a few months apart emphasizes the lack of notice taxpayers have to implement the new requirements and the challenges that may arise with the more burdensome requirements being imposed without proper notice-and-comment rulemaking.
The FAQs also provide certain clarifications:
- If a group of individuals performed research activities and sought to discover the same information for a business component, the taxpayer may list all employees by name or title/position for that one business component and describe the information such employees sought to discover.
- If taxpayers utilize a statistical sample to compute their Research Credit, as allowed by the Field Advice, the documentation for all units in the sample must contain the first four items of information and be provided with the claim for refund. Taxpayers utilizing a statistical sample to compute their credit are still required to provide the total qualified employee wage expenses, supply expenses, and contract research expenses, as computed pursuant to Rev. Proc. 2011-42, for the claim year with the claim for refund.
ES Observation: Although the aggregation of individuals performing the same activities and seeking the same information is helpful, it is not as significant as the Service may expect, particularly in light of the other burdens imposed by the new requirements. Further, the FAQ discussing statistical sampling seems to raise greater uncertainty than clarity. While it appears a taxpayer may perform a statistical sampling on its own to determine what additional information to provide, it also seems that there is a risk the Service may, to the extent they disapprove of the methodology, potentially make the entire claim invalid.
As with much Service guidance, interested parties may submit comments to the Service for consideration. Although the effective date is imminent, the receipt of additional public comment may further inform and emphasize to the government how significant the Field Advice, Interim Guidance, and FAQs differ from the historic application of Section 41 and procedural rules to file for such refund claims. During the initial one-year transition period, it will be interesting to learn what the Service gleans while closely monitoring the refund claim process to determine if any modifications are necessary. Based on first impressions, it is clear both taxpayers and practitioners would like, at a minimum, to participate in the guidance process and more closely align the new requirements with the historic application of the rules.
Looking forward, taxpayers should, as always, carefully consider available information to substantiate any available research credit under Section 41. However, with the new requirements for refund filings, taxpayers must now fully evaluate documentation that is included with a refund claim to ensure that it satisfies the Service’s criteria for a valid filing. Moreover, it will be especially important to consider the statute of limitations when a research credit claim is filed to avoid a rejection. Although a grace period exists for current filings, such filings may become more challenging in subsequent tax years. Finally, because the Service has requested comments, it may be beneficial to make suggestions for Service consideration with research credit claims.