Funded Research Evolves

An important but complicated step

The Tax Court took another look at funded research in the case of System Technologies. It simultaneously made it harder to analyze contracts and more equitable and reasonable. Following behind seminal cases such as Lockheed and Dynetics, the System Technologies Court had made a strong effort to leave its imprint on the funded research discussion. Before diving into the current case, some context is needed.

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History of the Four-Corner Rule in R&D

The question of what laws govern a research contract has been reviewed before in the Lockheed case. In that case, the Court was tasked with determining whether Lockheed Martin had rights and risks under the related research contracts with the Government. As part of its review, the Appeals Court noted: “that the determination whether the taxpayer had the right to use the results of its research without paying for that right must be determined by reference to the research agreements.” And that reference is made to the contracts alone, not information outside the agreements. Despite being subject to export control laws and other restrictions, Lockheed’s contract did not refer to them, so the Court did not consider them in its analysis. This idea is also called the four-corners rule since you must only consider what is within the four corners of the document.

Later, the Court in Dynetics would use the same logic, citing the prior decision: “Under Lockheed Martin, the court is precluded from considering the impact of any statute outside of the . . . contract.” As a result, only the provisions in the contract that explicitly referenced laws were considered in the Court’s analysis.

As a result, taxpayers and the IRS are left with what is essentially a bright-light test. If a law, regulation, or restriction is not incorporated by reference, it should not be considered when determining rights and risks. This makes it relatively easy to review for rights and risks; the reviewer does not have to be an expert in all the potential laws associated with the taxpayer but leaves something to be desired.

Uniform Commercial Code (the other UCC)

Let’s take a detour for a second. The Uniform Commercial Code (UCC for today’s purposes) is a set of laws designed to give businesses a uniform backdrop to conduct business. This is not a federal law but more of a set of ideals developed and adopted by all 50 states. It provides consistency for businesses when contracts are unclear or vague or don’t address a situation. It brought significant advancements, such as limiting the ‘battle-of-the-forms.’ In other cases, it provides a baseline for understanding who owns a product in transit.

The actual agreement can modify all of this. Still, without such an agreement, the UCC is the controlling law (assuming it applies).

Unfortunately, the reasoning in Lockheed and Dynetics has limited the ability to rely on the UCC in research contracts. This is despite the perverse result that the UCC would be the starting place for most rights and risks analysis if there is no contract.

The System Technologies case

So now we come to the present case of System Technologies, a company that engineers and manufactures industrial finishing systems for the automotive industry. The Government filed a (partial) motion for summary judgment, claiming that the company did not have financial risk under the agreements. This argument was based mainly on the fact that no express term or clause in the purchase orders would make payment conditions on successful completion.

The Taxpayer did not attempt to produce evidence of an express provision that the Government failed to identify. Instead, it pointed to the choice of law provision. System Technologies is an Indiana company. As part of its standard contract, it incorporated a choice of law provision that made Indiana law controlling. Choice of law provisions are relatively standard, generally chosen for the convenience of one party or another, and sometimes selected for specific favorable laws.

But, if you will recall, all 50 states have adopted the UCC, including Indiana. Because the choice of law provision in these agreements references Indiana law, the Court opened the door to examine any of Indiana’s laws, including Indiana’s enactment of the Uniform Commercial Code. Under the UCC, if the seller (here, System Technologies) fails to deliver a product, then the buyer can, at minimum, recover as much of the price that had already been paid. Despite receiving payment throughout the research process and not having a provision in the contract that explicitly makes payment contingent on success, the buyer still had the option to recover all of its payments if System Technologies failed to deliver.

Conclusion

While this is not a far leap by the Court, it is important. The IRS has generally relied on Lockheed and Dynetics to limit contract analysis to the document before it. While this remains a significant limitation for both parties, remember Lockheed won because it did not have to incorporate the export restrictions. Neither party should ignore the fundamental legal premises that govern all parties, at least if there is a choice of law provision. I would have liked to see the Court take it a step further and declare that some fundamental laws, such as UCC and the copyright statutes, should always apply; this is a step in the right direction.

Wrap-up

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The content of this article is for informational purposes only and should not be taken as tax, legal, benefits, financial, or HR advice. I am a lawyer, but receiving this newsletter does not mean I am your lawyer. Since rules and regulations change over time and can vary by location, consult a lawyer or HR expert for specific guidance.