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In Technical Advice Memorandum (TAM) 202327015, the Associate Chief Counsel's Office concluded that the "mere fact that" some activities of a retail apparel company (Taxpayer) were not conducted for a permitted purpose under IRC Section 41(d)(3) did not preclude Taxpayer from satisfying the process of experimentation test under IRC Section 41(d)(1)(C) for its activities in the development of a business component of a product line. Associate Chief Counsel did not rule, however, on whether Taxpayer qualified for the research credit, finding that the statements of fact provided by the taxpayer and the IRS Independent Office of Appeals (Appeals) did not establish whether substantially all of the taxpayer's activities relating to the business component of a product line were conducted for a permitted purpose.

Facts

Taxpayer is a retail apparel company that sells its own private label products and designs and develops new or revised product lines for each season. To develop its product lines, Taxpayer employs cross-functional product development teams, which are categorized by their functional specialties within the product development process.

After undertaking a project to develop a business component that would be part of a product line, Taxpayer determined that changing the base and specification formula, without compromising the product's performance standards, created development challenges. Taxpayer ran numerous tests on various prototypes to obtain qualitative and quantitative data about the business component before settling on the component's final design.

For the tax years at issue, Taxpayer claimed the research credit under IRC Section 41 and included a portion of the wages paid to its product development teams as qualified research expenses (QREs). To determine the wages includable in its QREs, Taxpayer relied on activity listings in its internal development calendars. Taxpayer reduced the wages included as QREs by a certain percentage to account for time associated with style, taste and cosmetic-design activities.

The IRS examination team (IRS Exam) entirely disallowed Taxpayer's research credit claims, asserting that Taxpayer's development activities for the business component were "non-qualified activities undertaken for purposes of style, taste, cosmetics or season design factors." After appealing to Appeals, which tentatively agreed with IRS Exam's proposed disallowance, Taxpayer requested technical advice from the Associate Chief Counsel's Office.

The TAM indicates that Taxpayer and Appeals did not agree on the statement of facts submitted to the Associate Chief Counsel's Office, but its conclusions would be the same under either party's represented facts. In its statement of facts for the technical advice, Appeals asserted that Taxpayer did not completely describe the activities conducted by its product development teams as part of the project and failed to identify which activities undertaken as part of the project qualified for purposes of IRC Section 41.

Analysis

Referencing the parties' statements of facts, including Taxpayer's claim that its business component had to meet certain performance criteria, the Associate Chief Counsel's Office observed that some of Taxpayer's research activities may have been for a permitted purpose under IRC Section 41(d)(3) and some may have been for a non-permitted purpose. Taxpayers engaging in activities that are not for a qualified purpose under IRC Section 41(d)(3), the Associate Chief Counsel's Office noted, may still satisfy the process of experimentation test under IRC Section 41(d)(1)(C), provided they can show that substantially all (i.e., 80% or more) of their activities constitute elements of a process of experimentation for a qualified purpose under IRC Section 41(d)(3)(A). The statements of fact submitted by Taxpayer and Appeals, however, did not establish whether substantially all of Taxpayer's activities were for a qualified purpose; as such, the Associate Chief Counsel's Office did not conclude on whether Taxpayer qualified for the IRC Section 41 research credit. Citing Max v. Commissioner, T.C. Memo. 2021-37 at 43 (which involved a retail apparel company's research-related activities), the Associate Chief Counsel's Office reiterated that Taxpayer must substantiate that substantially all its activities relating to the business component were for a qualified purpose.

Observations

This TAM is unusual in a few respects. First, the request for technical advice occurred at the Appeals' level, rather than during IRS examination, which suggests Appeals' willingness to engage in the TAM process. That willingness could help taxpayers resolve technical disputes that were unresolved during their examination. The redactions to the TAM, however, preclude taxpayers from knowing whether Appeals' willingness to seek technical advice arose from the specific issues in the case or another reason.

Next, the TAM does not rule on the central issue of whether Taxpayer may claim its research credits. Considering that taxpayers request technical advice for the express purpose of getting an answer, the absence of an answer raises questions about why Counsel's Office did not conclude on this issue. Unfortunately, the TAM's extensive redactions make the answer generally unknowable. The demonstrated flexibility in the TAM process, however, suggests that Counsel's Office could have concluded that the facts, as developed at the IRS exam level, were too insufficient to rule on the issue. If so, Appeals may not refer the case back to the IRS Large Business and International (LB&I) division; under Section 8.7.11.8.4(2) of the Internal Revenue Manual (IRM), it must attempt to resolve the case on "factual hazards," if the case was "not fully developed" during examination.

The TAM also does not discuss the basis for determining that some of Taxpayer's activities were undertaken for a non-permitted purpose. Given the nature of Taxpayer's industry, the Associate Chief Counsel's Office might have considered style, taste, cosmetic or seasonal design factors under IRC 41(d)(3)(B) (the basis for IRS Exam's disallowance), even though Taxpayer apparently reduced its QREs to exclude these activities.

In questioning whether Taxpayer established that substantially all of its activities were for a permitted purpose under IRC Section 41(d)(1)(C) and IRC Section 41(d)(3), the Associate Chief Counsel's Office appears to raise an issue that neither Taxpayer nor Appeals presented. Based on the TAM, neither Taxpayer nor Appeals appears to have provided facts establishing or challenging Taxpayer's satisfaction of the substantially all requirement under IRC Section 41(d)(1)(C); similarly, neither Taxpayer, Appeals nor the Associate Chief Counsel's Office appears to have cited failure to satisfy the substantially all requirement as a basis for IRS Exam's disallowance. Considering that IRM Section 8.6.1.7.1(2)) precludes Appeals from raising new issues (defined as "a matter not raised during Compliance's consideration"), it is unclear why the Associate Chief Counsel's Office raised this issue.

With no answer from the Associate Chief Counsel's Office on whether Taxpayer may claim a research credit, it is unclear how Appeals will resolve this case if IRS Exam based its disallowance solely on its determination that Taxpayer's activities related to style, taste, cosmetic or seasonal design factors. Given IRM restrictions, it would seem that Appeals would have to deal with the facts it has, no matter how inadequate. If so, the decision should arguably lean in the taxpayer's favor, as the IRM also places the onus of absent facts on the government, rather than taxpayers.

TAMs, which are taxpayer-specific and cannot be cited as precedent, generally offer low authoritative value. However, they do reflect the opinion of the Associate Chief Counsel's office, which is useful insight for taxpayers in similar circumstances.

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Published by NTD’s Tax Technical Knowledge Services group; Maureen Sanelli, legal editor