Funded R&D – Taxpayer Wins Geosyntec Motion on R&D Credits

In another recent R&D tax credit case, upon motion, the U.S. District Court for the Southern District of Florida reviewed the important aspects of ‘funded R&D’ and determining which party obtains the R&D tax credit. The R&D credit is determined in part turns on which party bears the financial risk if the R&D is not successful.  The taxpayer, Geosyntec, an environmental engineering contractor, won the fixed price contracts that were deemed eligible for the R&D credit but did not prevail on cost plus capped contracts.

The single issue was the financial risk of loss – the party bearing this risk is the only party entitled to claim the R&D credit. The Court did not address the ‘substantial rights’ issue where an R&D tax credit claimant must also obtain substantial rights in the R&D.  

The Court determined that two important characteristics in reviewing a contract for the R&D tax credit are: (1) is the payment contingent upon client satisfaction and (2) is there a dispute mechanism in place in the contract to resolve payment issues if the client is not satisfied?  However, Warner Robinson notes here that a general arbitration clause for example or the possibility that the client could sue the contractor in Court to try to recover payments would not be a valid reason for considering the contract ‘funded R&D’ when the contract was entered.

Another relevant point (and one that must be considered in analyzing an R&D contract), is whether the contractor must fix any problems ‘on their nickel’ – this is stated in the Geosyntec case as whether the contractor “must remedy the performance without additional compensation.”  

The Court also briefly discussed warranties and default provisions which should be reviewed, but the Court acknowledged that these types of clauses generally play a minor role in determining which party is ultimately at financial risk if the R&D is not successful.

The Court found many similarities in Geosyntec to the Fairchild case, which is the key case on funded R&D and contract risk. Fairchild Industries, Inc. v. U.S., 71 F.3d 868 (Fed. Cir. 1995). In Fairchild, the company was developing a new version of training airplanes for the Government and claimed the R&D credit. Fairchild was receiving progress payments throughout the contract period. However, these were deemed by the Fairchild Court (on Appeal) to still be contingent upon success of the work; the advanced payments were akin to a loan and could not be liquidated and earned by Fairchild until the Government accepted each detailed milestone under the contract.

The Court in Geosyntec concluded that its fixed price contracts had these same qualities; in particular, the Court concluded that Geosyntec’s client could withhold payment of a milestone if the client determined that the milestone was not met, thus placing the risk squarely on Geosyntec. Secondly the Court reviewed the warranty clause under Geosyntec’s fixed price contract which called for Geosyntec to fix any problems during the warranty period at its own expense.

In sum, with respect to fixed price R&D contracts, the two key aspects to review (per the Geosyntec case) are: (1) the ability of client to withhold payments for non-conforming work, and (2) whether contractor must fix defects at its own expense.

The Court also reviewed several FAR clauses in conjunction with government contracts and cited clauses such as acceptance and inspection clauses showing the Geosyntec was at risk based on incorporation of these key FAR clauses. Thus, in the government contracting context (similar to Fairchild), incorporation by reference of FAR or DFAR clauses (Federal Acquisition Regulations or Defense Federal Acquisition Regulations) are key components to review for both risk and rights for the R&D tax credit.

As to cost plus contracts, Geosyntec included some cost plus contracts in which there was a cap on costs. However it appears the one cost plus capped project selected for sample apparently allowed the taxpayer to apply for additional funds if there were cost overruns (thus it really wasn’t a capped project). The taxpayer lost on this particular contract, thus leaving the issue open where a taxpayer can show there was a definite cap that was exceeded, per the R&D Regulations, those cost overruns should still be considered at risk to the taxpayer. This issue however was not raised, nor was the ‘rights to the research’ topic raised by the parties.

In sum, this case reinforces the key aspects of the Fairchild case in reviewing contracts in determining which party bears the risk if the research is not successful – this ultimately determines which party is entitled to claim the R&D credit.

 

 

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