Chief Counsel's Field Attorney Advice - Research Credit
IRS Chief Counsel's Office, In a Field Attorney Advice, addresses what research activities conducted by a contractor are "unfunded activities" eligible for the research credit.
Research credit. Code Sec. 41 allows a credit for qualified research expenses above a certain base amount. These expenses can be incurred for either in-house or contracted research. Qualified research doesn't include any research funded by a grant, contract, or otherwise by another person (such as a government grant or contractual payments).
Requirements for unfunded research expenses. Generally, research performed for a client or customer under a contract is "unfunded research" when:
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the amounts payable to the contractor under the contract are contingent on the success of the research (i.e., the customer is paying for the product or result of the research); and
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the contractor retains substantial rights in the research (i.e., the contractor retains patent rights or other rights to the research). (Reg. § 1.41-4A(d))
According to the Advice, each project expense must be considered when determining whether research is funded or unfunded. This is because a contractor may, in the same contract, agree to perform some research in which the client pays for the resulting product and some research in which the client pays only for the research itself.
The Advice also said that whether a contractor has retained substantial rights to the research is determined on a project-by-project basis. However, substantial rights don't include incidental benefits to the contractor, such as increased experience in a field of research. In addition, the contractor does not have substantial rights to the research if they must pay for the right to use the research.
Conclusions: The Advice concluded that the contractor wasn't entitled to claim a research credit because none of the research the contractor provided was unfunded. Although the contract details were redacted, the Advice found that either the amounts payable to the contractor weren't contingent on successful research or the contractor didn't retain substantial rights to the research.