A pair of taxpayer legal victories related to the research and development tax credit show how the US Tax Court approaches contract reviews when funding is a potential bar for federal tax credits.
Smith v. Commissioner and System Technologies v. Commissioner are the first cases to consider the local, governing law when conducting a funding analysis related to R&D tax credits. In both disputes, the taxpayers overcame IRS motions for summary judgment due to key questions remaining in both disputes.
There are exceptions in situations where taxpayers qualify for the R&D tax credit under Section 41 of the tax code, including the “funding exclusion.” Here, the analysis of whether specific research is considered funded is split into two parts: first, whether the research is contingent on the success of the research; and second, whether the taxpayer retains any substantial rights to the research.
Traditionally, courts have limited their funding analysis to the four corners of relevant contracts, and the terms and conditions of the agreement between the taxpayer and the contracting party. The rulings in Fairchild Industries v. US and Lockheed Martin v. US bear this out.
However, the Tax Court’s rulings in Smith and System Technologies made clear that taxpayers and tax practitioners should consider embracing arguments rooted in the Uniform Commercial Code and the applicable law of the jurisdiction, or as denoted by a choice-of-law provision, one that allows parties to agree to a particular domicile’s laws when interpreting the agreement, in the contract.
In both cases, the taxpayers used the choice-of-law provisions contained within each of their contracts to support their argument that the funding exclusion didn’t apply to the relevant research projects.
Smith dealt with an architectural firm based in Chicago known for designing complex physical structures. Six research projects were at issue, with each contract containing a choice-of-law provision within it, designating various foreign countries as governing law.
Here, the taxpayer argued, the contracts were each incorporated under the laws of Dubai, Saudi Arabia, and the UK, so the governing laws in those countries should be relevant in the court’s funding analysis. The taxpayer analyzed foreign laws related to the sale of goods and copyright protections that were unique to each of the relevant countries.
In its decision, the Tax Court agreed that the question of whether the foreign laws applied to the funding analysis was correct, rejecting the government’s motion for summary judgment. It also clarified that the notice requirement under Tax Court Rule 146 didn’t require the taxpayer to issue an additional formal written notice of its intent to use foreign law when the IRS already knew the laws applied.
According to the opinion, the IRS’s knowledge of the foreign law provisions reduced the need to provide formal written notice through pleadings because there was no prejudice imposed on the agency for having to acknowledge the choice-of-law provisions.
In System Technologies, the taxpayer engineers and produces custom finishing systems for the automotive industry. The six projects at issue were subject to purchase orders containing additional terms and conditions, including a choice of law provision that designated Indiana state law as governing.
The Tax Court definitively decided that the contracts at issue weren’t funded, highlighting that Indiana law required the contracting parties to default to the statutory remedy if their contract failed to provide adequate recovery.
This decision recognized that contract’s built-in protections doesn’t foreclose other remedies in the event of a total breach. Specifically, Indiana law disfavors limitations on remedies and strictly construes them against the seller based on public policy.
The court found that if System Technologies was unable to deliver its product, any warranty in the related contract would need to give way to remedies provided under Indiana law, including a refund of amounts paid.
In both cases, the court showed a willingness to consider protections built into a contract by governing law in instances where contracting parties demonstrated an intent to rely on an incorporated choice of law provision when determining whether to fund research.
The decisions in Smith and System Technologies are a win for future taxpayers due to the significant weight now placed on choice-of-law provisions within contracts. A contractual funding analysis has shifted back toward a traditional contract analysis, rather than a review specific to R&D tax credit claims.
The cases are Smith v. Commissioner, T.C., 12/18/24 and Sys. Techs. v. Comm’r, 2025 BL 2013, T.C., 12211-21, 1/3/25
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Dean Zerbe is a partner at Zerbe, Miller, Fingeret, Frank & Jadav. His law firm represented the taxpayers in both Smith v. Commissioner and System Technologies v. Commissioner.
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