Recent rulings by the US Tax Court illustrate a novel approach in the interpretation of contracts related to research and development (R&D) tax credits, underscoring the importance of local governing law provisions. Two decisions, Smith v. Commissioner and System Technologies v. Commissioner, provide clear examples where taxpayers successfully leveraged choice-of-law clauses to argue their cases, overcoming IRS motions for summary judgment.
The hub of the issue lies within the “funding exclusion” of Section 41 of the tax code, which delineates whether research can be classified as funded, impacting eligibility for the R&D tax credit. Traditionally, courts have confined their contract analysis to the explicit language and conditions stipulated in the agreements. However, these recent cases introduce a broader examination of relevant local laws and their implications on funding analyses.
In Smith v. Commissioner, involving an architectural firm with projects governed by foreign law, the court acknowledged the necessity of applying corresponding foreign laws regarding contract terms, impacting pertinent determinations on research funding. This rebuffed the government’s summary judgment plea, with the court recognizing that prior notice of these foreign law provisions to the IRS was already inferable via the taxpayer’s choices within the contract.
Meanwhile, in System Technologies v. Commissioner, the Tax Court highlighted Indiana’s state law as governing, showcasing the protective statutory remedies available if contractual terms proved insufficient. The court’s deliberation underscored Indiana’s predisposition against contractual limitations on remedy, further refining the understanding of funding coverage in the tax credit context.
These cases signal a procedural inclination toward classical contract law analysis over the specialized R&D tax credit-centric examination, allowing choice-of-law provisions to guide judgments on funding exclusions. Tax professionals should reassess the strategic use of such provisions, particularly when looking to defend or challenge R&D credit claims rooted in local legal standards and remedies. For further reading and legal analysis, consult the Bloomberg article by Dean Zerbe.