Taxpayer Can Pick & Choose Between Regulations

In FedEx Corporation v. United States, Dkt. No. 08-2423, the U.S. District Court for the Western District of Tennessee concluded that FedEx could rely on the internal use software provisions in the 2001 Final Regulations and the taxpayer-favorable discovery test in the 2003 Final Regulations in computing its research tax credit. The taxpayer did not have to pick and rely on just one set of regulations.

Facts & Procedural History

You already know what FedEx Corporation (“FedEx”) does. It is in the shipping and logistics business.

FedEx’s management identified a need for a new computer business system with better revenue controls to ensure timely and accurate billing and to eliminate “revenue leakage.”

No existing client-server system was capable of processing data at volumes comparable to FedEx transaction volumes, so FedEx embarked on a research project to develop a new and innovative database. The technological challenges associated with the project were too great to overcome and FedEx abandoned the project in 2001.

FedEx included the expenses for the project in its research tax credits for 1997 through 2000.

The IRS disallowed the research tax credits and FedEx brought suit to obtain the resulting tax refunds of $11 million dollars.

The Varying Regulations

This case turns on the application of two different, but overlapping regulations.

The Treasury Department issued final regulations in January of 2001 that included a higher discovery test requirement for research tax credits. It required taxpayers to discover information that went beyond the common knowledge of experts in a particular field.

The January 2001 regulations also addressed internal use software (“IUS”). This is software that the taxpayer designs and develops for its own use, rather than for customer use. It sets out rules that say that IUS can qualify for the credit if certain standards are met.

The Treasury Department eventually pulled the January 2001 regulations after considerable pressure from Congress, with the Treasury Department admitting that the January 2001 regulations conflicted with the Congressional intent for the research tax credit.

The Treasury issued proposed regulations in December 2001 to fix its higher standard for the discovery test in the January 2001 regulations. The proposed regulations said that the government would not challenge positions taken consistent with the December 2001 proposed regulations. The December 2001 proposed regulations were made final in 2003.

The 2003 final regulations did not include the IUS rules. Instead, they said that taxpayers could rely on the 2001 proposed regulations for IUS, but it said that the taxpayer had to apply the higher discovery test standard in the 2001 regulations as well.

Picking & Choosing Regulations

The IRS’s position was that the taxpayer cannot rely on the discovery test from the final 2003 regulations and, also, the IUS rules from the 2001 regulations.

The court starts the analysis with the rule that the agency’s interpretation of its own regulation is owed substantial deference. It goes on to note that this only applies if the interpretation is consistent with the regulations.

In this case, the Treasury had said that the discovery test conflicted with Congressional intent and it set out to correct the regulations. According to the court, for the Treasury to later say that taxpayers have to still use the old discovery test that violated Congress’ intent is not consistent with the regulations.

As such, the court held that taxpayers can apply the more lenient discovery test from the 2003 final regulations and the IUS rules from the 2001 proposed regulations. The taxpayers are not locked into the old discovery test if they want to use the IUS rules.

The Takeaway

The Treasury Department and IRS do not like the research tax credit. They have gone to considerable lengths to stimy it and undermine the research tax credit. This case highlights the effort in the Treasury to concede to pressure to do the right thing by acknowledging the correct discovery test, but in doing so, trying to set a trap for those who also want to take credit for IUS. It is equivalent to a retreating army that lays landmines and booby traps for the advancing army. The court did not accept this approach.