In the case of Tangel v. Commissioner, the court held the taxpayer was not entitled to the R&D tax credit because it did not retain substantial rights to the research it performed. The court analyzed the terms and conditions of the contract between the taxpayer and customer in reaching its determination. Companies performing R&D to fulfill customer requests should carefully analyze all agreements to determine and confirm which party, or parties, retains substantial rights to the research results.
The Tangels, husband and wife, were shareholders of Enercon Engineering, Inc. (Encercon), a company that designs and produces integrated controls and switchgears for custom applications in the power generation industry. Enercon claimed a R&D tax credit based on QREs for 142 projects for the year in question. The court reviewed one project, Project No. 37688, that Enercon had performed for Vericor Power Systems, LLC (Vericor) as part of its analysis. Under this project, Enercon was tasked with providing the assembly, integration, controls, and packaging for one new turbine generator unit and for redesigning (or retrofitting) three existing Vericor turbine units. The court held that under the terms of the agreement between Enercon and Vericor, Enercon did not retain substantial rights in research it performed in fulfilling its contract with Vericor and was not entitled to R&D tax credits. Section 41(d)(4)(H) requires that a taxpayer retain substantial rights to the research results in order for expenses to be eligible for the R&D tax credit.
In its analysis, the court reviewed the contract entered into between Enercon and Vericor and heavily relied on paragraph 15, which provides the following:
The court concluded conditions set forth in paragraph 15(A) “are quite hostile to petitioners’ claim that Enercon retained ‘substantial rights’ in the research it performed for Vericor.” The provisions prohibit Enercon from using any technical information or tooling that was designed during the project to develop or sell Articles or similar items and prevents Enercon from using the results of the research for any purpose outside of the project at issue without Vericor’s prior written consent.
The court also referenced conditions under paragraph 15(B) which illustrate the work as “works made for hire” and Buyer is deemed the author of such works. This paragraph stipulates Buyer has the assignment of all right, title, and interest in and to such work.
Based on the above, the court found the contract prevented Enercon from making independent use of the research results and anything developed belonged to Vericor. The court also rejected the concept that “institutional knowledge” gained from the work on the project constituted substantial rights. The court concluded “it is hard to see what rights – much less what ‘substantial rights’ – Enercon could be viewed as retaining in the research it performed. Rather, this is a situation where ‘the taxpayer perform[ed] research under an agreement that confer[red] on another person the exclusive right to exploit the rights of the research.’”
Companies engaged in research and development related to customer orders or requests should closely examine all agreements in place to determine if they retain substantial rights to the research results. Terms and conditions should be scrutinized to assess if the company can make independent use of the research or if there are restrictions in place. Companies should also be wary of including projects where their customers (or other third parties) own 100% of the research results. Earnd can help you qualify and organize documentary support, including critical contract review, as your company pursues R&D tax credits.