TAM 1034017: Research-credit expenses and gross receipts after a consolidated-group acquisition

Plain-English summary

The IRS Technical Advice Memorandum addressed how a parent should calculate the research credit after acquiring the common parent of another consolidated group. It concluded that the parent could not include the target group’s qualified research expenses from before the acquisition in the parent group’s research-credit calculation because those expenses belonged in the target group’s return. The parent could include the target group’s relevant average annual gross receipts in its base amount, but had to apply a short-year reduction for the period during which the target was a member of the parent group. The analysis applied the consolidated-return rules and the research-credit rules to prevent duplication or elimination of the target’s items.

Ruling snapshot

• Question: How are a target group’s qualified research expenses and average annual gross receipts treated after the target joins a parent’s consolidated group?
• Outcome: Advice given
• Key authorities: IRC §§ 41, 383, 1502, 1563, and 6110; Treas. Reg. §§ 1.41-3, 1.41-6, 1.1502-76, and 1.1502-80

Full text (IRS public release)

                    INTERNAL REVENUE SERVICE
          NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

                                     May 24, 2010

Number: 201034017
Release Date: 8/27/2010
Third Party Communication: None
Date of Communication: Not Applicable

Index (UIL) No.: 41.00-00, 1502.00-00
CASE-MIS No.: TAM-107730-10

Maria S. Hwang
LMSB:CTM:DFOW

  Taxpayer’s Name:                        ------------------------------------------------
  Taxpayer’s Address:                     --------------------
                                          -----------------------------------------
  Taxpayer’s Identification No            ----------------
  Year(s) Involved:                       --------------------------------------------
  Date of Conference:                     ------------------

LEGEND:

Parent = -------------------------
Target = ---------------------------
Fiscal Year = --------------------------------------
Date A = -----------------
Date B = -----------------------
Date C = -----------------------
Date D = ------------------
Month = ------------------
Year 1 = -------
Year 2 = -------
Year 3 = -------
Year 4 = -------

ISSUES:

1. Whether Parent can include Target’s and Target subsidiaries’ qualified research
   expenses (“QREs”) for the period Date A through Date B in Parent’s computation of
   the credit for increasing research activities (“research credit”) under § 41 of the
   TAM-107730-10 2

Internal Revenue Code on Parent’s federal consolidated income tax return for the
taxable year ending on Date D?

2. Whether Parent includes the average annual gross receipts (“AAGRs”) for
   Target’s and Target Subsidiaries’ four taxable years preceding Parent’s taxable year
   ending on Date D in Parent’s base amount when computing the research credit for
   Parent’s federal consolidated taxable year ending on Date D?

CONCLUSIONS:

1. Parent cannot include Target’s and Target subsidiaries’ QREs for the period Date
   A through Date B in Parent’s computation of the research credit on Parent’s federal
   consolidated income tax return for the taxable year ending on Date D.

2. Parent includes the AAGRs for Target’s and Target subsidiaries’ four taxable
   years preceding Parent’s taxable year ending on Date D in Parent’s base amount
   when computing the research credit for Parent’s federal consolidated taxable year
   ending on Date D. However, because Target and Target subsidiaries are members
   of the Parent consolidated group for only a portion of Parent’s taxable year
   beginning on Date A and ending on Date D, the portion of the base amount
   determined under § 41(c)(1) of the Internal Revenue Code attributable to Target and
   Target subsidiaries must be reduced by multiplying such amount by the number of
   months in the period from Date C through Date D and dividing the result by twelve.

FACTS:

   Parent is the common parent of a consolidated group filing federal income tax

returns on a Fiscal Year basis. Target was the common parent of its own unrelated
consolidated group that filed federal income tax returns on a calendar year basis. On
Date B, Parent acquired the stock of Target in exchange for stock and cash in a
transaction that did not constitute a reverse acquisition within the meaning of
§ 1.1502-75(d)(3) of the Income Tax Regulations, thus terminating the Target
consolidated group.

    Parent included Target’s and Target subsidiaries’ QREs for the period Date A

through Date B in its computation of the Parent group’s research credit for its taxable
year ending on Date D. Parent did not include Month in its original computations, but
did file an informal amended claim to include Month. Parent did not deduct any QREs
for the period Date A through Date B and is not claiming any deduction for these QREs.
In calculating the research credit for Parent’s group for the taxable year ending Date D,
Parent included Target’s and Target subsidiaries’ gross receipts for the period Date A
through Date B in the computation of Parent’s base amount. Additionally, Target
included the same QREs for the period Date A through the end of Year 4 and for Month
in its computation of the Target group’s research credit for the Year 4 taxable year and
the short taxable year ending on Date B, respectively. However, because these years
TAM-107730-10 3

were both loss years for the Target group, none of the credits were utilized to offset
income tax of the Target group. Instead, Parent carried or intends to carry the credits
forward to Parent’s consolidated return years, subject to limitation under § 383. Thus,
Parent and Target both included Target’s and Target subsidiaries’ QREs for the period
Date A through Date B in the computation of the research credit.

LAW:

   Section 41(a)(1) provides, in part, that the research credit for the taxable year is

an amount equal to the sum of 20 percent of the excess (if any) of the QREs for the
taxable year over the base amount.

    Section 41(b)(1) provides that the term “qualified research expenses” means the

sum of the in-house research expenses and contract research expenses that are paid
or incurred by the taxpayer during the taxable year in carrying on any trade or business
of the taxpayer.

    Section 41(c)(1) provides that the term “base amount” means the product of

(A) the fixed-base percentage, and (B) the AAGRs of the taxpayer for the four taxable
years preceding the taxable year for which the credit is being determined (that is, the
“credit year”).

   Section 41(c)(3) provides that the “fixed-base percentage” is the percentage that

the aggregate QREs of the taxpayer for taxable years beginning after December 31,
1983, and before January 1, 1989, is of the aggregate gross receipts of the taxpayer for
such taxable years.

  Section 41(f)(1)(A) provides that in determining the amount of the credit (i) all

members of the same controlled group of corporations shall be treated as a single
taxpayer, and (ii) the credit allowable to each member shall be its proportionate share of
the QREs.

   Section 1.41-6(b)(1) provides that all members of a controlled group are treated

as a single taxpayer for purposes of computing the research credit. The group credit is
computed by applying all of the § 41 computational rules on an aggregate basis.

   Section 41(f)(5) provides that the term “controlled group of corporations” has the

same meaning given to such term by § 1563(a), except that “more than 50 percent”
shall be substituted for “at least 80 percent” each place it appears in § 1563(a)(1), and
the determination shall be made without regard to § 1563(a)(4) and (e)(3)(C).

  Section 1563(a)(1) provides that the term “controlled group of corporations”

means any group of one or more chains of corporations connected through stock
ownership with a common parent corporation if (A) stock possessing at least 80 percent
TAM-107730-10 4

of the total combined voting power of all classes of stock entitled to vote or at least 80
percent of the total value of shares of all classes of stock of each of the corporations,
except the common parent corporation, is owned by one or more of the other
corporations; and (B) the common parent corporation owns stock possessing at least 80
percent of the total combined voting power of all classes of stock entitled to vote or at
least 80 percent of the total value of shares of all classes of stock of at least one of the
other corporations, excluding, in computing such voting power or value, stock owned
directly by such other corporations.

   Section 41(f)(4) provides that in the case of any short taxable year, QREs and

gross receipts shall be annualized in such circumstances and under such methods as
the Secretary of Treasury may prescribe by regulation.

   Section 1.41-3(b)(1) provides that if a credit year is a short taxable year, then the

base amount determined under § 41(c)(1) shall be modified by multiplying that amount
by the number of months in the short taxable year and dividing the result by 12.

  Section 1.41-3(b)(2) provides that if one or more of the four taxable years

preceding the credit year is a short taxable year, then the gross receipts for such year
are deemed to be equal to the gross receipts actually derived in that year multiplied by
12 and divided by the number of months in that year.

   Section 1.41-3(b)(3) provides that no adjustment shall be made on account of a

short taxable year to the computation of a taxpayer’s fixed-base percentage.

     Section 1502 provides that the Secretary of Treasury shall prescribe such

regulations as he may deem necessary in order that the tax liability of any affiliated
group of corporations making a consolidated return and of each corporation in the
group, both during and after the period of affiliation, may be returned, determined,
computed, assessed, collected, and adjusted, in such manner as clearly to reflect the
income tax liability and the various factors necessary for the determination of such
liability, and in order to prevent avoidance of such tax liability. In carrying out the
preceding sentence, the Secretary of Treasury may prescribe rules that are different
from the provisions of chapter 1 that would apply if such corporations filed separate
returns.

   Section 1.1502-76(b)(1)(i) provides that a consolidated return must include the

common parent’s items of income, gain, deduction, loss, and credit for the entire
consolidated return year, and each subsidiary’s items for the portion of the year for
which it is a member. If the consolidated return includes the items of a corporation for
only a portion of its taxable year determined without taking this section into account,
items for the portion of the year not included in the consolidated return must be included
in a separate return (including the consolidated return of another group). The rules of
TAM-107730-10 5

this paragraph (b) must be applied to prevent the duplication or elimination of the
corporation's items.

   Section 1.1502-76(b)(1)(ii)(A)(1) provides that if a corporation, other than one

described in paragraph (b)(1)(ii)(A)(2) of this section (concerning subchapter S
corporations), becomes or ceases to be a member during a consolidated return year, it
becomes or ceases to be a member at the end of the day on which its status as a
member changes, and its taxable year ends for all federal income tax purposes at the
end of that day.

   Section 1.1502-80(a), as it applied for the years at issue, provided that the

Internal Revenue Code, or other law, shall be applicable to the group to the extent the
regulations do not exclude its application.

ANALYSIS:

   The QREs at issue were paid or incurred between Date A and Date B. These

are dates in which Target was the common parent of its own consolidated group. When
Parent acquired the stock of Target, Target’s tax year ended for all federal income tax
purposes. Section 1.1502-76(b)(1)(ii)(A). Target included the QREs it incurred
between Date A and Date B in its own consolidated return. However, Parent has also
included Target and its subsidiaries’ QREs from Date A through Date B in Parent’s
consolidated return.

   As more fully discussed below, Target’s and Target subsidiaries’ QREs from the

period Date A through Date B should not be included in Parent’s consolidated return for
the tax year ending Date D because those QREs were not paid or incurred during the
portion of Parent’s tax year in which Target and Target subsidiaries were members of
the Parent consolidated group, but instead were paid or incurred during the portion of
the year in which Target was the common parent of its own group. Under the
consolidated return regulations, those QREs must be included only in the Target’s
group’s consolidated return for the Year 4 tax year or the tax year ended Date B,
whichever is appropriate, and not in the Parent group’s consolidated return for the tax
year ended Date D.1

   The Parent consolidated group is a controlled group of corporations under

§ 41(f)(1)(A). Under § 41(f)(1)(A)(i), all members of the Parent consolidated group shall
be treated as a single taxpayer for purposes of computing the research credit. The
Parent consolidated group must aggregate each member’s credit year QREs under
§ 41(b). The Parent consolidated group must aggregate each member’s base year
QREs and base year gross receipts under § 41(c)(3).
1
We note that we considered the potential application of § 41(f)(3); however, irrespective of § 41(f)(3) the
results do not change under the consolidated return rules as discussed in this technical advice
memorandum.
TAM-107730-10 6

   Under § 1.1502-76(b)(1)(ii)(A)(1), Target’s consolidated group terminated at the

end of the day on Date B and Target and its subsidiaries became members of the
Parent consolidated group on Date C.

   Under § 1.1502-76(b)(1)(i), Target’s and Target subsidiaries’ QREs for the period

Date A through the end of Year 4 and for Month must be included in the Target
consolidated group’s QREs for Year 4 and Target’s short taxable year ending on Date
B, respectively. The Target consolidated group must use the short taxable year
provision of § 1.41-3(b)(1) to compute its research credit for its short taxable year
ending on Date B.

   Under § 1.1502-76(b)(1)(i), Target’s and Target subsidiaries’ QREs for the period

Date C though Date D must be included in the Parent consolidated group’s QREs for
the taxable year ending on Date D. The Parent consolidated group must aggregate
each member’s AAGRs for the four taxable years preceding the credit year under
§ 41(c)(1). For Parent, the four taxable years preceding the credit year are the fiscal
years ending in Year 1, Year 2, Year 3, and Year 4. For Target and its subsidiaries, the
four taxable years preceding the credit year are the calendar years Year 2, Year 3, and
Year 4, and the short taxable year ending on Date B. Parent must use the short
taxable year provision of § 1.41-3(b)(2) to compute Target’s and Target subsidiaries’
gross receipts for the short taxable year ending on Date B. Therefore, Target and its
subsidiaries’ gross receipts derived in Target’s short taxable year are deemed to be
equal to the gross receipts actually derived in that year multiplied by twelve and divided
by the number of months in the short taxable year ending on Date B. Pursuant to
§ 1.41-3(b)(1), because Target and Target subsidiaries were members of the Parent
consolidated group for less than 12 months, in determining the Parent consolidated
group’s base amount, Parent must multiply the portion of the base amount determined
under § 41(c)(1) attributable to Target and Target’s subsidiaries by the number of
months in the period from Date C to Date D and divide the result by twelve.

CAVEAT(S):

  A copy of this technical advice memorandum is to be given to the taxpayer(s).

Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.