Sec. 41 offers a credit for increasing research activities. It is an incremental credit in that a taxpayer must have current-year qualified research expenses (QREs) that exceed a base amount in order to claim the credit. The base amount for taxpayers claiming the regular Sec. 41 credit (and neither the alternative incremental research credit nor the alternative simplified credit) is the product of the fixed base percentage and the average annual gross receipts for the four years preceding the current tax year. Thus, the credit itself is determined by a calculation that is dependent not only on current-year QREs but also prior years’ activity. (Note that Sec. 41 has been extended through December 31, 2011, by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312.)
Sec. 41(f)(1) and Regs. Sec. 1.41-6 provide additional rules for computing the Sec. 41 credit for controlled groups of corporations and trades or businesses under common control. The rules are based upon determining that a controlled group of corporations exists (or a group of trades or businesses under common control) based upon application of the Sec. 1563(a) rules (or Regs. Sec. 1.52-1, respectively). The rules provide, in essence, that all members are treated as a single taxpayer, and a single research credit is calculated for the entire group. The credit is then apportioned to the group members. Thus, the computations regarding QREs, the fixed base percentage, and average annual gross receipts are determined by aggregating such amounts from the group members. Regs. Sec. 1.41-6(d) further provides that all members of a consolidated group are treated as a single member of a controlled group of corporations.
Acquisition of a Target Entity During the Tax Year
Sec. 41(f)(3)(A) provides a special rule for acquisitions, stating that when
a taxpayer acquires the major portion of a trade or business of another person (hereinafter in this paragraph referred to as the “predecessor”) or the major portion of a separate unit of a trade or business of a predecessor, then, for purposes of applying this section for any taxable year ending after such acquisition, the amount of qualified research expenses paid or incurred by the taxpayer during periods before such acquisition shall be increased by so much of such expenses paid or incurred by the predecessor with respect to the acquired trade or business as is attributable to the portion of such trade or business or separate unit acquired by the taxpayers, and the gross receipts of the taxpayer for such periods shall be increased by so much of the gross receipts of such predecessor with respect to the acquired trade or business as is attributable to such portion.
The above rule is based upon and consistent with the rules for determining the work opportunity credit under Secs. 51 and 52. Regulations issued under Sec. 52 define what an acquisition is, what a major portion is, and what a separate unit is, with regard to a trade or business (Regs. Sec. 1.52-2(b)). The regulations do not appear to differentiate between whether the acquisition is of an entity recognized for federal income tax purposes (e.g., a corporation, partnership, nondisregarded limited liability company (LLC), etc.) or not (e.g., a disregarded LLC, division of a corporation, sole proprietorship, etc.).
An affiliated group can elect to file a single return for federal income tax purposes instead of separate tax returns for each member of the group by electing to file a consolidated return. The common parent of the group must include all its income, gains, deductions, losses, and credits for the entire consolidated return tax year. In addition, each other member of the group must include these same items for the portion of such tax year for which that member was a member of the parent’s consolidated group.
Thus, the consolidated return is based on the tax year of the common parent. Each other member of the consolidated group must adopt the common parent’s annual accounting period (with a small carveout for certain 52-53-week tax-year members that obtain special permission from the IRS and whose years all end within the same seven-day period).
Thus, a consolidated group can include only the items of income, gain, deduction, loss, and credit for periods in which the member was a part of the group. However, the Sec. 41 credit for a consolidated group is determined as if it were a single member. Moreover, the credit itself is based upon a mathematical formula dependent on current-year QREs that must exceed an increment based upon prior four-year annual gross receipts. Thus, the question arises of how a consolidated group calculates the credit when one of its members was acquired midway through the common parent’s tax year.
The special rule under Sec. 41(f)(3)(A), which requires that the preacquisition QREs and gross receipts of the target corporation be added to the acquiring corporation’s base amount computation, may also be read to require that the QRE calculation for a target corporation after a qualifying acquisition should include not only the QREs generated after such acquisition but also the QREs for the prior period of the acquiring corporation’s tax year. Thus, on the face of the statute, it appears that a given dollar of QRE might be included in both the acquiring corporation’s credit computation and the predecessor’s credit computation. This implication appears to be the case regardless of whether either or both the acquiring corporation or predecessor corporation is a member of a consolidated group.
The above rule appears to potentially be in conflict with the consolidated return rule that only the income, gain, deduction, loss, and credit items for the period in which a member is part of the group are to be included in the consolidated return. While QREs are not an item of income, gain, deduction, or loss, they are the critical component for determining the research credit. Thus, it could be argued that following the rule under Sec. 41(f)(3)(A) results in a credit a portion of which is allocable to the period prior to which the predecessor was a member of the consolidated group. This seeming conflict was first addressed in Chief Council Advice (CCA) 200234063.
In CCA 200234063, the common parent of a consolidated group acquired all the stock of a target corporation (which was a stand-alone corporation) midway through the common parent’s tax year via a Sec. 368(a)(1)(B) reorganization that was not a reverse acquisition. The common parent was computing its credit under the regular methodology (neither the alternative incremental research credit nor the alternative simplified credit). The CCA concludes that the acquisition was a qualifying acquisition under Sec. 41(f)(3)(A). Therefore, all the QREs of the target corporation must be included in the credit computation, including those QREs allocable to the period from the beginning of the common parent’s tax year until the day of the acquisition. The CCA notes that the short tax year provisions under the Sec. 41 rules do not apply because the taxpayer is the consolidated group and there is no short tax year. The CCA also concludes that the common parent cannot deduct the expenses that are part of the QREs for the preacquisition period because the target company incurred them prior to its becoming part of the common parent’s group. The CCA’s guidance results in those preacquisition QREs being includible in both the common parent’s consolidated return credit calculation and the final, short-year return for the target corporation.
In Technical Advice Memorandum (TAM) 200330001, issued almost a year later, the IRS addressed a different fact pattern, but one with somewhat similar implications as the CCA. On one side of a transaction was D, the common parent of one consolidated group. On the other side was A, the common parent of an unrelated consolidated group. A merged with and into D in a Sec. 368(a)(1)(A) reorganization, with D surviving. However, the shareholders of A received more than 50% of the D stock due to their ownership of A stock. Thus, the transaction was a reverse acquisition for consolidated return purposes, meaning that although A was no longer in existence, the A group’s tax year was controlling. For consolidated return purposes, D and its subsidiaries are treated as the target.
The question the TAM addressed was whether these consolidated return rules mandate treating A as the acquiring entity for purposes of applying Sec. 41(f)(3). The TAM concludes that they do not. It determines that only the QREs of D and its subsidiaries from the date of acquisition through the end of A’s tax year should be included in calculating the consolidated group’s research credit. Thus, the TAM declines to extend the special rule under Sec. 41(f)(3)(A) for reverse acquisitions. Instead, since D was not the target but the legal acquirer, the TAM declined to rule that the consolidated return rules trumped this to mandate that A be treated as the substantive common parent of the consolidated group such that it would be the acquirer for purposes of Sec. 41(f)(3)(A).
In TAM 201034017, the IRS addressed a third fact pattern but appears to have reached a different conclusion than either the one facially reached by the CCA or potentially the one intimated by the earlier TAM. The taxpayer was a consolidated group that acquired a target common parent of another consolidated group for consideration of both cash and stock of the taxpayer’s common parent. (It is not clear if this was a taxable or tax-free transaction.) The acquisition occurred partway through the taxpayer’s fiscal year. The taxpayer included the QREs for the target and target subsidiaries for both the period from the acquisition date through the end of the taxpayer’s fiscal year and the period from the beginning of the taxpayer’s fiscal year until the acquisition date. Unlike the CCA, the recent TAM concludes that this methodology is incorrect. The memorandum states in a footnote that it did not consider the application of the special rule under Sec. 41(f)(3) but, regardless of the results of such an analysis, it would not change the results by operation of the consolidated return rules.
Thus, it appears that the memorandum treats the potential conflict between the consolidated return rules and the research credit statute as resolving in favor of following the consolidated return rules. To that end, the analysis provides that the preacquisition QREs of the target and its subsidiaries are not includible in the taxpayer’s research credit calculation because those QREs were not paid or incurred during the period in which those entities were members of the taxpayer’s consolidated group. Instead, the memorandum concludes that the taxpayer should apply the short tax year rules in determining the gross receipts for purposes of determining the prior four years’ average gross receipts. (Thus, if the postacquisition period was only one-third of the taxpayer’s fiscal year, only one-third of the prior four tax years’ annualized gross receipts would be used for the base amount calculation.)
The recent technical advice appears to take a very different approach from the prior chief counsel advice with regard to calculating the research credit for a consolidated group where the group acquires a member partway through the tax year. The chief counsel advice applied the special rule under Sec. 41(f)(3)(A), held the short tax year rules inapplicable since the common parent taxpayer has a complete tax year, and by implication did not consider QREs to be an item of income, loss, deduction, or credit subject to the Regs. Sec. 1.1502-76(b) rules. The technical advice declines to consider the special rule under Sec. 41(f)(3)(A), applies the short tax year rules, and expressly considers QREs to be an item subject to the Regs. Sec. 1.1502-76(b) rules. However, neither method necessarily produces a larger or smaller credit every time. While the more recent technical advice may signal a change in the methodology of computing the credit for a consolidated group, it is not necessarily a more conservative or restrictive answer; it appears to be more a change in interpretation of the overlap of the special rule under Sec. 41(f) and the consolidated return regulations.
Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, DC.
For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.