Funded Research R&D Tax Credit – Dynetics, Inc. v. United States New Case on Risk and Rights

A new decision from the Court of Federal Claims in Dynetics v. United States asks the question what type of research is considered funded research for the R&D tax credit. In Dynetics, the taxpayer did not retain substantial rights to the research or was not considered at financial risk. The taxpayer, Dynetics, developed components of weapons systems for the government under contract and claimed it retained substantial rights to portions of the research and it was at financial risk and could claim the R&D credit.

As to risk, the taxpayer’s main arguments were (1) Course of Dealings – meaning that outside of the contract itself, the taxpayer claimed it was obligated to successfully build the weapons systems in order to receive payment (although the written contract terms did not support this); (2) inspection or warranty clauses – the taxpayer claimed that the inspection clauses providing the government the right to inspect the deliverables, or the general warranty clauses, supported the Dynetics’ position that they were obligated to successfully deliver and retain payments, entitling them to claim the R&D credit. The Federal Court rejected both claims. First the Court looked only to the 4 corners of the contract itself and not to parole evidence in the form of verbal or course of dealings terms between the parties.

As to written terms, Dynetics also argued entitlement to the R&D tax credit because of warranty and inspection clauses, as well as FAR clauses incorporated by contract. However, the Court distinguished the leading case in this area Fairchild v. U.S. in that unlike Fairchild, Dynetics did not expressly accept written responsibility for ensuring that all specifications and milestones would be met as a condition of payment. The Court also rejected an argument that the Government could terminate a contract and thus Dynetics would not be paid the full contract amount. This also did not constitute financial risk accounting to the Court of Claims.

To claim the R&D tax credit, a taxpayer cannot fail either the risk or rights criteria. Nevertheless, the Court continued to review the substantial rights criteria for completeness, even though it could have rested upon concluding that Dynetics was not at financial risk.

In reviewing the substantial rights criteria for the R&D credit, the Court reviewed a contact with a university which vested all rights in the work to the University and no clause seemed to reserve any rights with the contractor. Thus, the Court denied the R&D credit to Dynetics on the basis of failing to retain substantial rights in the research, as required under the R&D rules.

In another contract, Dynetics argued that the FAR clause 52-227-11 on Patent Rights was nearly identical to the FAR patent clause in Lockheed Martin v. U.S. (the leading R&D tax credit case on the rights issue). Although the Court in Dynetics agreed that it retained patent rights, the Court still denied the R&D credit in that Dynetics could not show that its engineering drawings or reports would be the type of property that was patentable. Those types of deliverables, the Court concluded, were not patentable, and thus the patent clause didn’t help the taxpayer.

In sum, a careful review of contracts, including clauses incorporated by reference in the case of FAR and DFAR clauses is critical to a proper R&D tax credit claim.

 

Warner Robinson recommends having an experienced professional review contract terms specific to claiming the R&D tax credit as this area is complex, contract terms can be complex, and there is a mix of Court cases (Dynetics, Fairchild, Lockheed) in applying these rules (it should be noted that Fairchild and Lockheed were taxpayer favorable and Dynetics must be weighed against these 2 longstanding cases).

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