In US v. Quebe, No. 3:15–cv–294 (S.D. Ohio Jan. 17, 2019), the US District Court for the Southern District of Ohio has granted the government’s motion for summary judgment in a Section 41 research credit case, holding that the taxpayer failed to establish that it was permitted to use an alternative base period in computing a research credit for the years at issue. 

Facts and procedural history

Quebe Holdings, Inc., (QHI) operates three separate electrical contracting companies (Chapel, Romanoff and CRT) that design and develop electrical systems for commercial complexes. QHI was founded in 2002 and acquired Chapel and Romanoff in the same year. For purposes of the Section 41 research credit, QHI and its subsidiaries are a controlled group treated as a single taxpayer.

In 2012, QHI hired a tax services provider to perform a study on its eligibility to claim a research credit for tax years 2008–2011. The provider determined that QHI was eligible to claim credits for qualified research expenses under Section 41 for tax year 2009 and 2010. QHI and its pass–through shareholders filed amended returns claiming the credits and corresponding tax refunds.

The IRS initially issued the refunds claimed in connection with QHI’s amended research credit claims. However, in 2015, the government brought an action seeking return of the refunds, alleging that they were issued erroneously. The government ultimately filed a motion for summary judgment with respect to QHI’s claim for the research credit.

Court’s analysis and order

At the outset, the court noted that while the government bears the ultimate burden of proving that a tax refund was erroneous, the taxpayer has the burden of establishing its right to any claimed tax benefit. While the government made several arguments regarding QHI’s research credit claim, the court focused on two such arguments that it considered to be intertwined: (1) that QHI’s calculation of its base amount under Section 41 was invalid because it was not permitted to use the “start–up” method under Section 41(c)(3)(B); and (2) that QHI failed to substantiate its claim for the research credit.

As legal background, the court explained that the Section 41 research credit is available only for an increase in spending on qualifying research as compared to a “base amount” spent in an earlier period (the fixed–base period). The statute generally defines the base period as 1984–1988, with an alternative base period available in the case of “start–up” companies not operating in that period. Specifically, a taxpayer may use an alternative base period only if the first tax year in which it had both gross receipts and qualified research expenses was after 1983, or if there were fewer than three years in which it had both gross receipts and qualified research expenses during the base period of 1984–1988.

QHI had used the alternative “start–up” base period in calculating its research credit, and the government contended that the QHI controlled group was not permitted to do so. Specifically, the government argued that QHI had gross receipts and qualified research expenses, both before 1984 and during the 1984–88 period, through its subsidiaries Chapel and Romanoff. Through deposition testimony, the government attempted to show that the subsidiaries were engaged in the same activities in 1984–1988 that QHI claimed constituted its research activities in tax year 2009–2010.

For its part, QHI argued that the subsidiaries were not engaged in research activities and that the government failed to prove that they were. However, the court stated that QHI’s arguments fail, because QHI misunderstood the burden of proof. The government’s burden, the court explained, is not to prove that QHI was not entitled to use an alternative base period, but rather that QHI failed to establish that it was entitled to use an alternative base period.

The court noted that the government presented evidence (including the testimony of the taxpayer, Mr. Quebe) that QHI’s subsidiaries were engaged in activities in the 1980s that would preclude it from using an alternative base period. The court added that the only evidence QHI presented to refute the government’s evidence was the deposition testimony of its tax services provider – who had no actual knowledge of QHI’s subsidiaries’ activities in the 1980s. Dismissing that testimony as hearsay, and finding no other evidence from QHI to refute the government’s showing, the court granted summary judgment for the government on its claim that QHI was not entitled to the Section 41 research credit claimed for tax years 2009–2010.

Implications

This decision generally does not create an unfavorable precedent for taxpayers claiming the regular credit under Section 41(a) when they have credible evidence to support the base amount, but it reinforces the general principle that taxpayers must be able to support their base amount computation. What should be noted is that the court’s rationale was twofold – it found that the taxpayer failed to substantiate that it did not have qualified research activities before or during the 1984–88 base period, and further found that its failure to substantiate this was due to its sole reliance on the testimony of its tax services provider (a third party with no actual knowledge of its research activities). However, there is a risk that the first part of this rationale may be what the government will focus on going forward, and taxpayers claiming the regular credit under Section 41(a) could find an increased focus on their fixed–base percentages during IRS examinations. This may not be limited to start–up companies that rely on their 1984–88 tax years to compute the fixed–base percentage, but could even be expanded to question the fixed–base percentages of companies computing the regular credit. The concern is that the government may see this case as requiring that a taxpayer prove a negative or substantiate its fixed–base percentage with a higher degree of accuracy than is practicable, without giving any weight to the court’s assertion that the taxpayer’s failure to substantiate its position that it was a start–up was due to its reliance on hearsay and no other testimony. The fact remains that had the taxpayer provided some admissible evidence to the 1980s activities of the acquired entities, the outcome of this case could have been very different. 

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