Key insights
- Taxpayers will be required to provide additional documentation when submitting an R&D credit claim for refund.
- IRS will offer a grace period and a transition period before the requirements become mandatory.
- The new guidance is meant to create more effective and efficient tax administration.
- Taxpayers not meeting the new requirements may be left with no remedy to cure a deficient claim.
Are you fully documenting your company’s research activities?
On October 15, 2021, the IRS announced it is requiring additional documentation to be submitted by taxpayers seeking refunds attributable to the research and development (R&D) tax credit under Internal Revenue Code §41. The Chief Counsel memo issued by the IRS spells out the new requirements, which generally involve the taxpayer’s underlying research activities and projects. Although routinely requested during IRS audits, these items have not previously been required when submitting a valid R&D credit claim for refund.
Commentators quickly expressed concern that the new requirements are overly burdensome and will discourage taxpayers from filing legitimate refund claims. There will be both a grace period and a transition period before the requirements become mandatory for all R&D credit refund claims.
Why is this change happening?
Treasury Regulations set forth procedural requirements for tax refund claims. Treasury Regulation §301.6402-2 provides that refund claims must include sufficient information regarding the grounds and facts upon which the claim is based — known as the specificity requirement. Claims for refund not meeting the specificity requirement may be rejected by the IRS; this is significant because federal courts do not have jurisdiction to review a denied claim that was procedurally deficient.
In its news release, the IRS said that it receives thousands of R&D credit claims each year for credits in the hundreds of millions of dollars, and such claims consume substantial agency and taxpayer resources. The new guidance is intended to create more effective and efficient tax administration, according to the agency.
New requirements for a valid refund claim
The Chief Counsel memo states that taxpayers must now provide “essential pieces” of information that will apprise the IRS of the basis for an R&D credit refund claim. These items are described as “foundational criteria” that will allow the IRS “to screen a refund claim for potential validity or audit necessity …”
To comply with the specificity requirement per the memo, taxpayers must (at a minimum):
- Identify all business components to which the R&D credit claim relates for the tax year
- For each business component:
- Identify all research activities performed
- Identify all individuals who performed each research activity
- Identify all the information each individual sought to discover
- Provide the total qualified research expenses being claimed, which may be done using Form 6765, Credit for Increasing Research Activities
The memo goes on to say that taxpayers who have a credit study prepared need not submit it with their claims. However, if one is submitted, the taxpayer must identify the specific facts and pages in the study that address the required information outlined above.
When a claim is filed not meeting the minimum requirements, the memo directs the IRS to reject it as invalid. Such a rejection may preclude the taxpayer from perfecting the claim. In effect, the IRS is saying that a deficient claim may leave the taxpayer with no remedy whatsoever to amend or perfect it, or for judicial review.
Effective date
The IRS release states that a grace period is being given to taxpayers until January 10, 2022, before inclusion of the new information will be required. Additionally, there will be a one-year transition period following the grace period during which taxpayers will have 30 days to perfect a refund claim. In other words, assuming the IRS’s position is enforceable, taxpayers will have one shot at making a valid refund claim beginning in January 2023.
Recent court decisions
Interestingly, the government recently lost in federal district court in Premier Tech, Inc. v. United States when it argued that the taxpayer’s amended tax return did not meet the specificity requirement because it failed to include information similar to what the Chief Counsel memo is now requiring. The court flatly rejected the government’s argument, stating:
“… the United States offers no authority for imposing such a requirement. Form 6765 does not ask taxpayers to provide any of these details. If the IRS wants more information about the research tax credits, the IRS could require that information on Form 6765. It does not, and the IRS cannot now say its own forms are not sufficient to constitute claims for refunds. That would lead to absurd and patently unfair results for taxpayers.”
The IRS acknowledges this case in a footnote to its memo merely by saying it is aware of the decision and is currently evaluating it.
Another case decided recently, Harper v. United States, held that the IRS waived the specificity requirement when it conducted an audit of the taxpayer’s underlying R&D credit claim. The new guidance seeks to avoid such a waiver by summarily rejecting deficient claims upon filing without initiating a substantive review of the underlying claim.
What does this mean for taxpayers?
There has been swift criticism from commentators over the punitive impact this guidance may have on taxpayers trying to file legitimate refund claims, and more disapproval is likely on the way as practitioners and industry groups coordinate their opposition. Although many questions are left unanswered in the memo, taxpayers must nonetheless — for the time being — consider it when pursuing R&D refund claims.
How we can help
Our dedicated team of R&D professionals continually monitors these developments in order to provide updates as new information is learned. We believe it is critical to take time to fully understand your business and your research activities so we can help you identify how this development may impact your organization.