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TAX CLINIC

“capped” contracts evaluated in Geosyntec standard is arbitrary in substance be- constitute substantial rights in the re-
and noting that Geosyntec and Dynetics cause of Congress’s failure to include search, and Dynetics, in which the court
considered the extent to which clients any reference or discussion of substantial stipulated that skills and advancements
could reject work by comparing the facts rights in its directive to promulgate developed while working on a contract
against Fairchild, the IRS contended regulations implementing the research are incidental benefits from performance
that a rejection clause in an agreement credit, which Perficient concluded was of the research.
is irrelevant when there are no detailed evidence that Congress did not intend to
specifications on which to measure expand the meaning of “funded.” Grigsby and contract language
conformity and base the rejection. No- The IRS disputed Perficient’s The recent holding in Grigsby provides
tably, Perficient and the IRS agreed that analysis and asserted that Treasury is further insight regarding the district
certain warranty provisions, including not required to address all comments court’s application of the funded-research
warranties relating to general standards provided in response to proposed regula- exclusion. This case involved Cajun
of care and assurances that performance tions, noting that one comment that Industries LLC, a construction com-
will be free from negligence, are not Perficient referenced in its challenge pany taxed as an S corporation that had
relevant to determining whether a pay- of procedural validity was sent ap- claimed the research credit for work per-
ment is contingent on the success of proximately six years after the close of formed under contractual agreements.
the research. the notice-and-comment period. With In total, four sample projects were evalu-
With respect to the substantial-rights respect to the substantive validity of the ated, two of which consisted of “capped”
standard, Perficient cited Oakbrook Land substantial-rights standard, the IRS con- contracts subject to an agreed-upon
Holdings, LLC, 154 T.C. 180 (2020), tended that Congress left it to Treasury maximum price and two of which con-
which provides that courts must gener- to define funded research and did not sisted of fixed-price agreements.
ally give deference to agency regulations address whether research was “funded” The first item at issue in this case was
if the statute is ambiguous and the based on which party retains the rights related to the definition of Cajun’s busi-
agency’s interpretation is “rational” or in the research. ness components in accordance with Sec.
reasonable. Perficient contended that the Lastly, Perficient contended that even 41(d)(2)(B), which provides context for
substantial-rights standard is procedur- if the substantial-rights standard is valid, applying the funded-research exclusion.
ally defective under the APA because each of its 24 sample projects satisfied Cajun argued that its business compo-
of Treasury’s failure to discuss, address, the standard because Perficient retained nents associated with the sample proj-
or provide any reasoned explanation in the rights to use the research; know- ects were construction processes that it
response to all comments questioning how; and improvements, modifications, used when constructing items for its cli-
the inclusion of the substantial-rights and derivatives to preexisting intellectual ents. The court rejected Cajun’s position,
standard in the 1983 proposed regula- property developed or refined in connec- pointing out that Cajun had previously
tions. Perficient further claimed the tion with the sample project. Perficient claimed during the discovery process
substantial-rights standard is substan- pointed out that Examples 1–4 in Regs. of the proceedings that it developed
tively defective under the two-step Sec. 1.41-4A(d)(6) clearly establish that a product (rather than a construction
standard for determining deference to the taxpayer’s retention of the right to process) for each of the sample projects
regulations under Chevron. Concerning use the results of the research is a sub- and failed to supplement its discovery
step one of the Chevron analysis, Perfi- stantial right and cited the court’s hold- responses. The court also reasoned that
cient asserted that Congress explicitly ing in Lockheed Martin that a substantial Cajun’s assertion failed due to a lack of
(and unambiguously) addressed the right does not require the right to ex- specificity, as Cajun did not identify any
meaning of qualified research to exclude clude others from using the research and new or improved construction processes.
funded research in Sec. 41, and the in- the holding in Populous that the right With respect to the funded-research
sertion of the substantial-rights standard to use research without paying for it is exclusion item at issue, the court found
in the regulations directly conflicts with a substantial right. The IRS countered that three of Cajun’s sample projects did
congressional intent, in part because that know-how is not a substantial right not meet the substantial-rights standard,
there is no evidence that demonstrates but rather an incidental benefit that does citing guidance provided in Lockheed
the meaning of the word “funded” not constitute a substantial right in the Martin, which requires a taxpayer to, at
requires a taxpayer to retain substantial research. The IRS’s position is aligned a minimum, maintain the right to use
rights to research. Regarding the second with Regs. Sec. 1.41-4A(d)(2), which its research without having to pay for it.
step of the Chevron analysis, Perficient states as an example that “increased ex- The court referred to language in each
asserted that the substantial-rights perience in a field of research” does not of Cajun’s three projects’ agreements,

14 March 2023 The Tax Adviser