Research tax credit audit plan and audit plan for internal-use software

Tax Executive, The, May-June, 1996

TEI believes that the two audit plans provide much useful information, and although we believe the plans can be improved, we commend the IRS's research credit issue specialist for his efforts to bring a greater measure of certainty and uniformity to this area. Notwithstanding our support for the issuance of audit plans, we believe it necessary to say that they are no substitute for formal guidance upon which taxpayers may rely. Indeed, we believe that many of the problems in administering the research tax credit --for taxpayers and examining agents -- could be ameliorated by the issuance of formal guidance. Accordingly, we continue to believe that tax administration would be well served by the promulgation of revised regulations that fully take into account Congress's intent in enacting and modifying the research tax credit and, obviously, reflect and comport with the most recent statutory amendments to section 41. In this regard, we are pleased to note that a project to provide additional guidance under section 41 (presumably through the issuance of regulations) is included on the Treasury Department and IRS's 1996 priorities list.

3. A Question about Process: We understand that the two audit plans were developed with the assistance of major accounting firms whose clients include many companies with experience under section 41. To our knowledge, however, comments were not solicited from other qualified and interested stakeholders, including affected taxpayers themselves, taxpayer groups such as TEI, industry associations, and law firms whose client bases may well duplicate or complement those of the accounting firms. We recommend that the views of these other stakeholders be sought in revising the research tax credit audit plans (or, for that matter, in developing any other such plans).(1)

4. A Comment on Tone: TEI regrets to report that many TEI members have interpreted the audit plans as hostile to the allowance of additional research tax credits. Our members' perceptions have undeniably been influenced by their experiences with section 41 since the research tax credit was enacted in 1981. The Institute itself has long perceived a historical reluctance by the IRS to implement the research tax credit in a manner consistent with Congress's intent to provide an incentive for increasing research activities. We are concerned that, unless tempered, the restrictive language and tone of the plans will unfairly communicate that reluctance to examining agents. For example, the plans state that examining agents should "challenge" expenses, instead of using the more neutral term "review"; they similarly instruct agents to develop a "strategy" for their audits rather than a "plan." There is nothing wrong with these terms in the abstract, but we suggest that they convey a more adversarial than cooperative tone.

We recognize that the IRS must ensure that the varying requirements of the Code are satisfied; in applying the research tax credit, however, the IRS should not adopt strained interpretations of section 41's varied requirements, erect artificial barriers to a taxpayer's claiming the credit, or betray a philosophical disagreement with Congress's policy decision to provide taxpayers with an incentive for increasing research activities. Unfortunately, it does all of these, especially in respect of internal-use software. The suggested approach -- to challenge the taxpayer's characterization of software development activities and require the taxpayer to prove why each such activity meets the definition of research -- seems at odds with the underlying intent of section 41 because it leaves taxpayers in doubt whether the tax credit will in fact be available and that doubt may well vitiate section 41's incentive effect. It also seems potentially at odds with the IRS's own mission -- to determine the taxpayer's correct amount of tax liability.