An Appeals Settlement Guideline for Qualified Research Expenses – Extraordinary a for Utilities, UIL 41.51-01 was released in late March that provides guidance on whether amounts incurred by a taxpayer for utilities expenses in buildings in which qualified research was conducted (“Research Buildings”) are qualified research expenses as defined in I.R.C. Sec. 41(b).
Background:
Taxpayers who have incurred utility expenses, such as water, electricity and natural gas in the Research Buildings have claimed such amounts as qualified research expenses under I.R.C. Section 41. These taxpayers rely on Treas. Reg. Sec. 1.41-2(b)(2)(ii) which provides that to the extent the taxpayer can establish that the special character of the qualified research required additional extraordinary expenditures for utilities, the additional expenditures are treated amounts paid or incurred for supplies used in conduct of qualified research.
Discussion:
The taxpayer, in this case, calculated the average cost of utilities per square foot of the Research buildings and compared that with the average cost of utilities for other company non-Research buildings. The taxpayer then claimed the incremental cost of providing utilities to the Research buildings over the corresponding costs of providing utilities to the non-Research buildings as a qualified research expense eligible for the credit.
In general, the Treasury Regulations provide that the amounts paid or incurred for utilities such as water, electricity, and natural gas used in the building in which qualified research is performed are treated as expenditures for general and administrative expenses. The exception to this general rule found in Treas. Reg. Sec. 1.41-2(b)(2)(ii) provides that to the extent the taxpayer can establish that the special character of the qualified research required additional extraordinary expenditures for utilities, the additional expenditures shall be treated as amounts paid or incurred for supplies used in the conduct of qualified research. Therefore to qualify, a taxpayer must establish the following:
- That the qualified research is of a “special character”
- That the special character of the qualified research “required” the utilities expenses, and
- That the required utilities expenses are both “additional” and “extraordinary”
Appeals concluded that even though the method used by taxpayers establishes that on a square foot basis additional utilities were consumed in the Research Buildings, it does not establish that the additional utilities were actually in the conduct of qualifying research. In order to treat the additional utilities as qualified research expenses, the taxpayer must establish that they were actually used in the conduct of qualifying research and meet the requirements found in Treas. Reg. Sec. 1.141-2(b)(2)(ii). Appeals stated that the case history and regulations makes it clear that only in very limited and specific situations will utility expenses be allowed to be treated as a qualified research expense pursuant to I.R.C. Sec. 41(b). Therefore, Compliance’s position should be sustained unless the taxpayer can establish that it incurred additional extraordinary utilities unless the taxpayer can establish that it incurred additional extraordinary utilities expenses that were required by the special character of the research it was conducting.
Implications:
If a taxpayer intends on claiming utilities in its R&E claim, there are several lessons to be applied from this Appeals Settlement Guideline. In the case as provided, BCP would recommend the following:
- Better upfront communication to identify potential “extraordinary” projects before the project is initiated so that appropriate systems can be put in place to support R&E claims
- Track utility usage for Research Buildings as compared to historical usage rates. Look for periods of spikes that may indicate “extraordinary” usage. Tracking usage is a better indicator since costs can fluctuate due to a number of outside factors none of which are related to usage.
Additionally, this Appeals settlement guideline appears to reconfirm the “project approach” preferred by the IRS, in that the utilities needed to be tied to an “extraordinary” research project.
I would like to thank Mr. Raymond Dacek, Troutman Sanders, for providing me the Appeals Settlement Guideline.
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