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

Tax Executive, The, May-June, 1996

In this regard, we believe that the plans unnecessarily remind examining agents that taxpayers have the burden of proof. Although such reminders are accurate (inasmuch as taxpayers have the burden with respect to all matters reported on their returns), the pointed language (combined with the rather exhaustive list of documents that examining agents should seek) sends a strong signal that taxpayers may well be unable to sustain their burden. We do not believe a hard-line approach to the research tax credit is justified.

5. The Shortcomings of the Bottom-Up Approach: The audit plans state that examining agents should adopt a two-part audit strategy: First, they should examine the underlying expenditures in respect of which the credit is claimed, and then they should examine the activity in respect of which those expenditures were incurred. With due respect, TEI submits that the proposed sequence of events is precisely and absolutely wrong. If an activity does not qualify as a research activity, why should the agents expend the time and effort (and require the taxpayer to expend the time and effort) auditing the precise numbers? We submit that they should not.

Instead of adopting a "bottom-up approach," pursuant to which the agent scrutinizes the expenses claimed before determining whether the activity to which those expenses relate constitute qualified research, the audit team should employ a top-down approach. The first determination should be whether an activity is prrly characterized as qualified research. If it is not so characterized, the agents need go no further; if it is, then the audit team can undertake to determine which expenses are properly taken into account in calculating the research tax credit. We recognize that a company's ability to document its qualified expenditures is an indispensable part of substantiating its entitlement to the credit. At the same time, the fundamental question whether a particular project is a research activity for purposes of section 41 does not turn -- and should not turn -- on the quality of the taxpayer's bookkeeping. In other words, although the taxpayer's ability to sustain a particular deduction may turn in part on the quality and sufficiency of its records, the basic issue whether an activity qualifies as research should not depend on this matter.

6. The Need for Flexibility and Taxpayer Involvement: TEI is concerned that many agents may interpret the plans as prescribing a "one-size-fits-all" approach. The plans seemingly instruct examining agents to always do this or always do that, and they strongly intimate that a taxpayer's inability to provide particular information (or to provide it in a particular format) should always lead to a disallowance of a credit claim. For example, the plans are replete with phrases like "all employees," "each account," "all entities," "all activities," "each qualifying project," "each project or activity," "in almost all software development activity," and "must" (or "MUST").