The tax concept of funding was essentially created to eliminate the ability for two taxpayers to claim the R&D credit on the same costs. Seminal questions to ask:
In order for a taxpayer to be eligible for the R&D credit the related activity cannot be funded. Activity is not funded if: The taxpayer is deemed to be at risk for the costs incurred and retains substantial rights.
The questions of adequate risk and retention of rights typically arise when one party hires a contractor to perform qualifying research on a product, process, or other development.
According to the IRS, if a contractor hired to perform research for another company retains no substantial rights to the research developed under the terms of their agreement, the research is treated as “funded” to the contractor and no expenses paid or incurred by the contractor in performing the research qualify for the R&D credit. This would be the case even if the contractor was deemed to be at economic risk for the costs incurred.
Retention of substantial rights does not require that the taxpayer retain exclusive rights to the research. However, a taxpayer does not retain substantial rights in the research if the taxpayer must pay for the right to use the results of the research. Basically, “substantial rights” is interpreted to mean the right to use the research.
For example, does the contract say the research is exclusive to the company that the contractor is under contract with, or can the contractor use the research and resulting technology for other companies/industries without paying royalties?
The concept of substantial rights and risk relies heavily on specific contractual language. If a contract is poorly written, possibly neither the contractor or the company can qualify for the R&D Credit. If there is potential for significant R&D credit in connection with a contract, it is prudent to carefully review the language in the agreement and speak with tax advisors to ensure the intended party or at least one party can claim the credit.
Generally, a contractor who is paid regardless of the success of the project does not bear the economic risk and cannot claim the R&D Credit (i.e. the research is “funded” to the contractor for purposes of the credit). However, if payment will only be made contingent on the success of the efforts, then the contractor bears the economic risk and may potentially claim the credit if it also retains substantial rights to the results.
Courts have held that research expenses incurred by a contractor under fixed-price contracts were not “funded research” under the R&D credit rules because the contractor was at risk for the costs unless the project was successful. Thus the qualifying costs incurred were eligible for the R&D credit to the contractor performing the research, assuming it also retained substantial rights to the results.
For cost plus arrangements on the other hand the contractor is not generally deemed to be at economic risk since it is guaranteed to be paid for its efforts. Therefore, it is not eligible for the credit. On the other hand the company paying a contractor is at economic risk and could the claim the credit on the costs paid to the contractor if this company also retained substantial rights.
Other types of contractual payment arrangements can generate costs eligible for the credit to the contractor. For instance, a cap cost-plus margin pay arrangement may allow for the contractor to claim the credit for the qualifying costs incurred. Again, the major issues are whether the taxpayer is at economic risk contingent on the success of the project and whether the taxpayer retains substantial rights to use the work, which are dependent on the terms of the contract.