T.C. Memo. 1996-153
UNITED STATES TAX COURT
GENERAL DYNAMICS CORPORATION AND SUBSIDIARIES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 19202-94. Filed March 26, 1996.
David C. Bohan, James M. Lynch, Richard T. Franch, and
Philip A. Stoffregen, for petitioner.
William H. Quealy, Jr., and Alice M. Harbutte, for
respondent.
MEMORANDUM OPINION
GERBER, Judge: Petitioner moved, in limine, to preclude
respondent from questioning further or litigating the amount of
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research credits claimed under section 411 in connection with
fixed-price Government contracts. For the reasons expressed
hereinafter, petitioner’s motion will be denied.
Background
This case was specially assigned to this division of the
Court by an April 4, 1995, order. The parties were placed under
a pretrial schedule, and trial was set to begin April 29, 1996.
One of the issues involved whether petitioner was entitled to
research credits in connection with fixed-price Government
contracts. Although petitioner had claimed other research
credits on its original returns for the years in controversy, no
research credits had originally been claimed with respect to
fixed-price Government contracts.
The credits claimed on petitioner’s original returns were
examined by respondent’s engineer. During 1991, the engineer
issued a report concerning the credits claimed on the original
returns. Respondent mailed a notice of deficiency during 1994
1
Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the periods under
consideration. The taxable years in this case are 1985 and 1986.
Sec. 41 was added in the Tax Reform Act of 1986, Pub. L. 99-514,
sec. 231(d)(2), 100 Stat. 2085, 2178, as a successor to sec. 30.
Sec. 30 was added by the Tax Reform Act of 1984, Pub. L.98-369,
secs. 471(c), 471(i)(1), 98 Stat. 494, 826, 831, as a successor
to sec. 44F. The research tax credit was established as sec. 44F
in the Economic Recovery Tax Act of 1981, Pub. L. 97-34, sec.
221(a), 95 Stat. 172, 241. Rule references are to this Court’s
Rules of Practice and Procedure.
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that, in part, made adjustments to the originally claimed credits
and was based on the engineer’s 1991 report.
During 1992, petitioner filed administrative claims on Forms
1120X seeking overpayments attributable to research credits in
connection with fixed-price Government contracts (increased
credits). Because petitioner had not originally accounted for or
claimed the increased credits, an accounting firm (accountant)
was engaged to identify and quantify the amount of the increased
credits. It was necessary to determine from among the costs in
fixed-price Government contracts those expenditures which
qualified for the research credit. The accountant was not able
to develop the amount of the research credits based on references
to particular contract line items or based on some method that
was specifically related to the contract terms.
Petitioner has explained that its costs were collected and
accounted for by work orders that were grouped by reference to an
aspect of various products under development or production. By
analyzing work orders and interviewing petitioner’s employees,
the accountant developed an amount that petitioner claimed
qualified for the credit. Respondent assigned the engineer who
had examined the credit claimed on petitioner’s original returns
to examine petitioner’s claim for increased credits. The
engineer, after examining the accountant’s materials and
recommending adjustments, issued a report in 1994 prior to the
issuance of the notice of deficiency, recommending that the
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increased credits be disallowed. In addition, the engineer’s
1994 report reflected an amount that the engineer believed was
allowable if respondent was incorrect regarding the legal theory
for disallowance of the research credits attributable to fixed-
price Government contracts. The 1994 notice of deficiency made
no reference to the increased credits claimed by petitioner.
At the time of the engineer’s 1994 report, the Government
was engaged in litigation with another taxpayer involving a
substantially similar theory for disallowing research credits
attributable to fixed-price Government contracts. At the time of
the issuance of the notice of deficiency and the filing of the
petition in this case, respondent’s legal approach had been
approved by the Court of Federal Claims. See Fairchild Indus.,
Inc. v. United States, 30 Fed. Cl. 839 (1994). The decision in
Fairchild was on appeal during the pendency of this Court’s
pretrial order.
In its petition, petitioner claimed entitlement to the
increased credits, and, in her answer, respondent denied that
petitioner was entitled to such credits. In an October 1995
status report to the Court, respondent stated, concerning the
issue of whether petitioner was entitled to the increased
credits, that “the parties expect to enter into stipulations
which establish the amounts of increase in petitioner’s R&E
[research] Expenses for each period. The issue will be whether
these R&E [research] Expenses were ‘funded’ by the contracts.”
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In other words, respondent reported that it was expected that the
parties would be able to agree on the amount of the expenses and,
hence, the substantiation of the credits, leaving the legal issue
for the Court’s consideration.
The focus of the legal issue was whether petitioner’s
research, which was performed pursuant to fixed-price Government
contracts, was “funded” within the meaning of section
41(d)(4)(H). The question of whether the research was funded is
dependent on whether the amounts petitioner received under the
fixed-price Government contracts were “contingent on the success
of the [petitioner’s] research and thus considered to be paid for
the product or result of the research”. Sec. 1.41-5(d)(1),
Income Tax Regs.
During November 1995, the Court of Appeals for the Federal
Circuit reversed the decision, Fairchild Indus., Inc. v. United
States, 71 F.3d 868 (Fed. Cir. 1995). Following this reversal of
fortune for the parties in this case, respondent advised that she
would concede the legal issue that had been decided by the Court
of Appeals. Respondent’s counsel also advised that they were not
prepared to stipulate to the amount of research credits based on
the engineer’s 1994 report, but that petitioner must quantify the
amount of expenses underlying any credit with respect to fixed-
cost Government contracts by reference to the contract line items
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or other contract provisions.2 The accountant’s methodology,
which had been examined by respondent’s engineer, would not
satisfy the approach that respondent now contends is appropriate.
Respondent does not contend that her method will result in a
larger or smaller credit than the amount reflected in the
engineer’s report. She only argues that it is necessary to
compute the amount of the credit based on the terms of the
contract.
Petitioner objected to respondent’s refusal to stipulate to
the amount of the increased credit contained in respondent’s
engineer’s report, on the following grounds: (1) Respondent
should be held to the amount agreed to by the engineer, and,
further, respondent should be precluded from reauditing3 and
2
Respondent contends that petitioner is required to
identify research expenditures in terms of each contract line
item in the fixed-price Government contracts. Respondent bases
her contention on language in the opinion of the Court of
Appeals, as follows:
The Court of Federal Claims correctly held that the
availability of the credit does not depend on whether the
researcher is in fact paid; it depends, as stated in
Treasury Regulation § 1.41-5(d)(1), on whether, by the terms
of the research agreement, payment is contingent upon
development of a specified "product or result," to be paid
"contingent on the success of the research." [Fairchild
Indus., Inc. v. United States, 71 F.3d 868, 872 (Fed. Cir.
1995), revg. 30 Fed. Cl. 839 (1994).]
We do not intend to decide in this opinion whether
petitioner’s accountant’s approach or the approach that
respondent contends should be followed is the correct approach.
Our focus is solely on the procedural questions raised and relief
sought in petitioner’s motion.
3
Petitioner has couched the language of its motion in terms
(continued...)
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litigating the amount of the increased credit, and alternatively,
(2) if respondent is not precluded from reauditing and/or
litigating the amount of the increased credit, the Court should
exercise its discretion under Rule 142 to shift the burden of
proving any decrease in the amount of the credit to respondent
because respondent’s engineer had agreed to a number in her 1994
report.
Discussion
(1) Is respondent bound by the findings in the engineer’s
report?
Initially, we agree with respondent that no binding
agreement regarding the amount of the increased claims exists
between the parties in this case. The reversal in Fairchild was
the catalyst for the parties’ current disagreement. Respondent’s
engineer likely considered the Government’s pending litigation in
the Court of Federal Claims in the Fairchild case when writing
the report concerning the amount of the research expenses and,
hence, the credit. Respondent’s counsel was aware of the
favorable legal precedent when they advised the Court that the
3
(...continued)
of reauditing the amount of the credit in this Court. The
question is more correctly centered on the issue of whether
respondent is bound or estopped from questioning the amount of
the credit petitioner claimed in its petition. This matter does
not involve a question of whether a second examination was or
should be conducted within the meaning of sec. 7605(b).
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parties were attempting to stipulate to the amount of the credit
and only the legal question would be presented to the Court.
After the Court of Appeals’ reversal of the lower court in
Fairchild, respondent decided to concede the legal issue
(regarding funding). Respondent, for the first time, contended
that, based on the appellate court’s rationale, petitioner was
required to show the amount of research expenses in connection
with a particular line item in the fixed-price Government
contracts. In that regard, petitioner, under respondent’s
approach, would be more specifically required to show that the
contract language for that item supports the conclusion that
payment is contingent on development of a specified product or
result, so as to have been paid contingent on the success of the
research.
We note that petitioner’s grievance is not without
substance. After all, respondent’s engineer had reflected an
adjusted (reduced but apparently agreeable to the engineer)
amount of research credit in her report. Those circumstances had
provided petitioner with comfort concerning the resolution of the
quantitative aspects of the research credit controversy.
Ultimately, however, we view the question here as one of timing
and prejudice. This is so because no enforceable agreement had
been entered into by the parties. Accordingly, we must consider
whether respondent timely raised the requirement and whether
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petitioner has been prejudiced in terms of its opportunity to
have a fair trial on the merits of the items in controversy.
We find that respondent’s action was timely in the setting
of this case. The parties were preparing for a trial to begin
April 29, 1996. The litigation had proceeded only a few months
into the pretrial schedule and was about 6 months from trial date
when the Court of Appeals’ holding changed the slant of the legal
playing field concerning the funding issue. This Court
informally agreed with the parties that they would be given time
to consider the effect of the Court of Appeals’ holding. In
addition, we were disposed to continue the funding issue from the
scheduled April 29, 1996, starting date. Approximately 1 month
after the Fairchild reversal, respondent announced her concession
of the legal issue and that it would be necessary for petitioner
to tie the amount of the credit to the contract language. At
that point, the parties agreed to proceed to trial on the other
unresolved issue(s) beginning April 29, 1996, and that any trial
concerning the funding issue should be delayed. The Court agreed
to continue the funding issue for a reasonable time to give the
parties an opportunity to evaluate the effects of the concession
and respondent’s position on quantification of the research
credit.
Petitioner refers us to Durkin v. Commissioner, 87 T.C.
1329, 1402-1403 (1986), affd. 872 F.2d 1271 (7th Cir. 1989), for
its contention that this Court’s Rules and Procedures are not to
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be used by respondent to conduct an audit. In that case, the
Commissioner had issued notices of deficiency with “little, if
any, prior investigation”, and respondent’s attorney had
attempted, through discovery and subpoenas, to conduct the
investigation ordinarily carried on by respondent’s agents. Id.
at 1402. Reflecting upon that situation, we stated that “The
processes of this Court are simply not designed to be used to
conduct a thorough investigation of a complex tax case.” Id. at
1403.
Respondent counters that Durkin v. Commissioner, supra, is
not applicable here because the increased credits were not
addressed in the notice of deficiency but, instead, were placed
in controversy by petitioner’s allegations in its initial
pleading (petition). Respondent points out that, in her answer,
she denied petitioner’s claim for the increased credits, and that
it remains petitioner’s obligation and burden to show entitlement
to research credits in connection with the fixed-price Government
contracts. We agree with respondent. Based on the foregoing, we
hold that respondent is not bound by the agreement in her
engineer’s report.
(2) Should the burden of proof be shifted to respondent with
respect to the amount of the research credit on fixed-price
Government contracts?
Because we have held that respondent may question the amount
of the credit, we must address petitioner’s alternative request
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that the Court shift the burden of proof to respondent with
respect to the amount of the credit. In this regard, petitioner
refers us to Rule 142(a) and suggests that we use our discretion
to shift the burden to respondent. Petitioner does not provide a
specific reason for our shifting the burden to respondent;
petitioner only argues that it would be appropriate.
Rule 142(a) generally places the burden of proof on
petitioner except as provided by statute or determined by the
Court. In that regard, under Rule 142(a), the burden is shifted
to respondent “in respect of any new matter, increases in
deficiency, and affirmative defenses”. In addition, this Court
has authority to sanction a party in appropriate circumstances,
including shifting of the burden of proof. See Rule 104.
Shifting the burden of proof, in particular, has been described
as a relatively harsh sanction. See, e.g., Estate of Spear v.
Commissioner, 41 F.3d 103 (3d Cir. 1994), vacating and remanding
T.C. Memo. 1993-213.
“The assertion of a new theory which merely clarifies or
develops the original determination without being inconsistent or
increasing the amount of the deficiency is not a new matter
requiring shifting of the burden of proof.” Achiro v.
Commissioner, 77 T.C. 881, 890 (1981) (and cases cited therein);
see also Seagate Tech., Inc., & Consol. Subs. v. Commissioner,
102 T.C. 149, 169 (1994).
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Respondent argues that her contention that the amount of the
credits must be substantiated as described above is a new theory
and not “new matter” within the meaning of Rule 142(a).
Respondent goes on to point out that her new theory “merely
clarifies or develops respondent’s original determination without
requiring the presentation of different evidence, is not
inconsistent with respondent’s original determination, or does
not increase the amount of the deficiency.”
We do not agree with respondent’s statement that the “new
theory” will not require the presentation of different evidence,
because, if respondent is correct about the method of determining
the amount of the credit, petitioner may be required to develop
and employ a different methodology from that used by its
accountants to calculate the credits.
We do agree, however, that respondent’s approach is a
different theory rather than new matter. It represents a new
theory for respondent’s denial of the claim for increased
credits. We note that respondent’s position in this case is not
derived from the notice of deficiency, but from respondent’s
answer in response to petitioner’s allegation in its petition.
In this case, respondent did not make a determination in her
notice of deficiency concerning the increased credits. Instead,
petitioner made allegations in its petition seeking the benefit
of such. The examination of petitioner’s returns that led to the
issuance of the notice of deficiency and this controversy did not
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address the increased credits. The increased credits were part
of a collateral matter in which petitioner had made claim for
overpayments based on its claim for increased credits
attributable to fixed-price Government contracts. That claim has
not been formally acted on by respondent.
Petitioner’s claim for overpayment, involving a series of
years, including the ones at issue here, had proceeded along a
parallel path and was not formally incorporated into this
proceeding until petitioner made its allegations in its petition.
Respondent’s engineer had reviewed the claim and recommended that
it be denied. The engineer, acknowledging that petitioner would
be entitled to some increased credits if successful on the legal
issue, merely made proposed adjustments which reduced the total
amount of the credit petitioner had claimed. That total amount
was reflected in the engineer’s report. Petitioner agrees with
and relies on the amount proposed by the engineer for purposes of
this litigation. However, respondent’s counsel does not agree to
the amount and, instead, contends that petitioner must show a
relation to the contract language to be entitled to the credit.
The key fact here is that the parties did not enter into a
binding agreement with respect to the amount of the increased
credit. Accordingly, petitioner continues to bear the burden of
proving the amount of the credit, and respondent, in the context
of this litigation, has not bound herself to the adjustment that
was proposed by her engineer.
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That scenario leaves respondent free to argue positions or
theories that she believes set the standard that petitioner must
meet to satisfy its burden of proof. As discussed above, the
advancing of theories in that setting is subject to timeliness
and fairness. Accordingly, respondent is not precluded from
contending that petitioner must show the relationship between the
expenditure and the contract provisions is nothing more than
respondent’s theory. Petitioner’s burden of proof on this issue
will not be shifted to respondent.
Finally, respondent has not shown bad faith or any willful
act for which a sanction should be considered. The parties
ideally should develop and adhere to their theories at the
earliest possible time in the controversy process. In practice,
that level of foresight and consistency is not always achieved.
Indeed, petitioner’s claim for the increased research credits was
not part of its original return. Instead, it surfaced near the
end of the administrative process preceding this litigation.
That is a different setting from one where an issue is raised in
a taxpayer’s return and developed in the normal course of an
audit. The circumstances of this case fit within the reasonable
limits of controversy development, and no remedial action to
shift the burden is needed. Petitioner continues to bear the
burden of proving the amount of the increased credit. In that
regard, the Court is prepared to allow an adequate pretrial
period within which the parties may develop their approaches and
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attempt to resolve any differences they may have concerning the
amount of petitioner’s claim.
To reflect the foregoing,
An appropriate order will be
issued.