Background & Discussion: Bayer had 49 facilities in the United States during the years in question. A small number of those facilities were almost entirely dedicated to R&D activities. In earlier years, these facilities were the only ones that had been included in the R&D tax credit calculation. Those earlier claims had been audited by the IRS and accepted. After a review, Bayer realized that it had not included QREs for many other facilities that were also conducting qualified R&D activities. As such, they undertook a study in order to include QREs from the additional facilities. However, rather than gather all of the documentation to support QREs for the remaining facilities, Bayer used a sampling approach to test those facilities. It then extrapolated those results in order to determine its total QREs.

There were 17 tax years included in the case (i.e. 1990 – 2006). Bayer estimated that it spent $6 billion in qualified research, 10,000 US employees had been involved in its R&D efforts, and over 3 million separate documents had already been turned over to the IRS. They incurred nearly $4 million in costs while conducting these efforts. Bayer did not produce or maintain project accounting records. Rather, its accounting system accumulated costs in approximately 1,300 separate cost centers. Further, Bayer reported that it had expended 13,000 man hours on documenting the R&D credits thus far and it further estimated that it would take decades to fully document all R&D activities at all affected US locations.

Upon examination, the IRS disallowed all of the claimed R&D credit including those that had been previously accepted in prior audit cycles. The IRS vigorously objected to Bayer’s approach and contended that, without documentation of all claimed expenditures, there was no way to determine if the claimed R&D credits were valid. The Service further insisted that actual business components or projects must be used. However, eventually, the IRS proposed the use of a “pilot sample”. The results of the pilot were then to be used to determine a means of documenting the remainder of the cost center population through further sampling.

Bayer proposed its own statistical sampling plan that would have limited the scope of documentation to 8 of its 49 research sites. For those randomly selected 8 sites, 2 tax years would be randomly selected, and then 50 cost centers would also be randomly selected for each year.

The amount at stake was $175 million. The arguing, posturing, and disagreements went on for years.

Court Decision: Ultimately, the court determination that was handed down supported the IRS stating “the court is not persuaded that the time spent and expenses incurred are “undue”.” Even though Bayer quoted that it had taken 13,000 hours in document retrieval to support the currently calculated R&D credit, the court noted that over 7,000 hours of that was a one time effort to back up an outdated mainframe. Additionally, the court noted that the remaining 6,000 hours were related to documenting the primarily research facilities. It assumed the lesser facilities would take a commensurately lesser effort to document.

The court also noted that it has a responsibility to limit the extent of discovery only if it finds that “the burden of expense of the proposed discovery outweighs its likely benefit, considering the needs of the case, the amount in controversy, the parties’ resources, the importance of the issues at stake in the action, and the importance of the discovery in resolving the issues.” The court determined that Bayer’s identification of all business components is critical to proving its claim. With Bayer having $175 million at stake, the court could not find evidence of insufficient resources to pursue a claim of such magnitude.

Bayer cited several types of tax cases in which statistical sampling had been found to be acceptable. The court determined that the crux of the first type of cases is that statistical methods were used by the government to determine tax liabilities in cases where complete and adequate records were non-existent or unavailable. In the court’s opinion, Bayer has the documentation; they simply did not wish to spend the time and money necessary in order to gather and produce it.

The court determined that the second type of cases reveals that taxpayers are not relieved of the burden of providing evidence to support tax credits prior to estimation. One may argue that the court missed the point in analyzing these cases because Bayer quite clearly has shown that it conducts qualified activities that are at least, if not more so, as significant and substantial in nature as those that were shown in such cited cases that then prompted prior courts to estimate QREs. However, the court found that Bayer must satisfy its burden to identify its claimed business components / projects.

In the third and final type of case, the court noted that the US government agreed to try only the taxpayer’s 5 largest R&D projects. In the Bayer case, the IRS did not agree to a limited scope and the court found that it has no authority to compel them to do so.

The ending line in this decision is poignant and telling. “As noted by the Government, Bayer’s arguments regarding the burden presented to large research corporations by the recordkeeping requirements applicable to Section 41 of the Internal Revenue Code should be directed to the Legislative Branch, not this Court.”

In light of this newly decided tax case, taxpayers are advised to re-examine how thoroughly they are documenting their R&D activities. If you have any questions about such matters, please contact Bryan Valencia at bvalencia@heincpa.com or Mark Myers at mmyers@heincpa.com. Both can be reached via phone at 713-850-9814.

Discussion
Zimmer claimed that the instruments are exempt for two reasons, one, under Texas Tax Code Ann. § 151.313(a)(5) as orthopedic devices and that they are “related components and supplies” for the exempt prosthetics provided by Zimmer.  The second is because they are orthopedic devices as defined in 34 TAC § 3.284(a); Orthopedic appliance–Any appliance or device designed specifically for use in the correction or prevention of human deformities, defects, or chronic diseases of the skeleton, joints, or spine. 

The Comptroller argues that these instruments would only be exempt if they were implanted into the body and supported, corrected, or replaced parts of the body on an ongoing basis.  The contention that it must be part of the body on an ongoing basis is only mentioned under the definition of “prosthetic device” but is not mentioned in the definition of an “orthopedic appliance”.  The Comptroller also contends that the instruments under review are not an “appliance or device” activated by the human body. The Comptroller has historically taken this position as documented in various letter rulings. 

The TCOA determined that the plain language of Texas Tax Code Ann. § 151.313(a)(5) does not define items listed under the exemption and therefore, must look to 34 TAC § 3.284(a)(12) for clarification.  The TCOA also notes that previous rulings are not binding, even if they have been longstanding.

What does this mean?
This case holds that certain surgical instruments are exempt from tax under the plain language of Texas Tax Code Ann. § 151.313(a)(5) and 34 TAC § 3.284(a).  Other taxpayers may qualify for refunds of sales or use tax paid on similar instruments. 
 
Contact Bill Mueldener or Robin Klinghagen with any questions.

 Background

Nestle filed suit with the Texas Supreme Court as a result of H.B. 3, 79th Leg. §24 which states, “The supreme court has exclusive and original jurisdiction over a challenge to the constitutionality of this Act or any part of this Act and may issue injunctive or declaratory relief in connection with the challenge.”

Nestle’s claimed that the Texas franchise tax does not treat similarly situated taxpayers equally and uniformly. NSBMA, for example, rents massive generators and HVAC units for use at constructions sites but was not permitted to use the cost of goods sold (“COGS”) deduction, while a company that rents heavy construction equipment (as defined in the rules) is allowed to use the COGS deduction. A company such as Switchplace, providing similar services as a management company, but not meeting the qualifications as a management company is not afforded certain deductions as that of a management company. Finally, Nestle engages only in wholesale operations in Texas, although does have manufacturing outside of the state. Nestle is not permitted to use the .5% rate in Texas because it is not primarily engaged in wholesale trade as a taxable entity. As a result of these examples, Nestle believed Article VIII, Section 1(a) of the Texas Constitution was violated. It argued that for the tax to be equal and uniform the tax must be commensurate with the privilege of doing business in Texas. While the tax should not be expected to perfectly reflect the value of each taxpayer’s privilege of doing business in Texas, but the value at a minimum must be based on economically relevant factors.

In bringing the case before the court, the petitioners requested that the Texas franchise tax be declared unconstitutional, an injunction prohibiting its collection, and mandamus relief compelling the Comptroller to refund the taxes they paid from 2008 through 2011. It is important to note that the petitioners did not pay their taxes under protest or request a refund from the Comptroller.

Discussion

Chapter 112 of the Texas Tax Code allows taxpayers to bring suit against the state to recover franchise taxes paid. Under chapter 112, the district courts of Travis County have exclusive, original jurisdiction of a taxpayer suit brought under this chapter. In order to file suit the taxpayer must have first paid the tax under protest. The protest must be in writing and must state fully and in detail each reason for recovering the payment. Since the petitioners did not pay taxes under protest as required under Chapter 112 the case could not be brought before the district court. Petitioners contend that §24 creates the right to sue independent of chapter 112. The Texas Supreme court disagreed. The court also stated in Allcat that §24 only confers original jurisdiction over challenges to the constitutionality, it does not authorize the Supreme Court to exercise original jurisdiction over challenges to how the Comptroller assesses, enforces, or collects the tax. Section 24 is simply a “specific, limited exception” to section 112.001, in all other respects, the Texas Supreme Court observed, a taxpayer suit “is subject to chapter 112”. Therefore, the Texas Supreme Court barred this lawsuit as Nestle did not comply with the Tax Code. It further stated in the opinion that:

“A section 24 action brought originally in this Court, free of chapter 112’s restrictions, would severely disrupt that scheme. If a taxpayer were not required to lodge its complaints first by protest or a refund claim, the Comptroller would lack notice of the assertion of illegality, perhaps — as this case illustrates — for years. From the first Suspense Statute, it has been important that the tax collector know of disputes and their potential effect on revenues. Were taxpayers permitted to delay in suing for a refund, the monetary burden of a loss on the State could be greatly increased. In this case, petitioners acknowledge that if they were to prevail and all franchise taxes determined to be illegal were refunded to all similarly situated taxpayers, the impact on the state fisc would be enormous. “

Unlike the Allcat case, the Texas Supreme Court did not refer this issue to a district court as the requirements for chapter 112 were not met.

What does this mean?

It is likely that taxpayers seeking refunds or disputing the treatment of the various components of the franchise tax may find it easier to take a claim through the district court, despite the fact that these will likely take a much longer time to resolve.

The Health Care and Education Reconciliation Act of 2010 in conjunction with the Patient Protection and Affordable Care Act added Section 4191 to the Internal Revenue Code, imposing an excise tax on the sale of certain medical devices. The manufacturer, producer, or importer of each taxable medical device must pay an amount equal to 2.3% of the sale price. The new excise tax applies to sales of such devices occurring after December 31, 2012.

Taxable medical devices include any “instrument, apparatus, implement, machine, contrivance, implant, in vitro reagent, or other similar or related article.” Accessories and component parts are also included. Such devices are those intended for diagnosis, cure, treatment, affecting bodily function, etc. There are also exempt devices such as eyeglasses, contact lenses, hearing aids, and the like that are normally purchased and used by the public for personal use.

The proposed regulations more clearly define which devices are and are not included. The regulations can be found here: REG-113770-10

If you need additional information or have questions, please contact your local Hein tax partner for assistance.

The Tax Court released an opinion on January 12 granting partial summary judgment to the IRS in a dispute involving the economic performance rules.  The court found that an accrual-basis partnership could not fully deduct intangible drilling costs (IDC) in the year it entered into a turnkey contract as the actual drilling had not occurred.  The court also found that two exceptions, a 90 day rule, and a 3 ½ month rule didn’t apply.

Background
The 1999 turnkey contract assigned the taxpayer interests in two wells, and the taxpayer paid $5.1 million (cash and note) for the drilling of the two wells, where no drilling took place in 1999.  The taxpayer claimed a $5.1 million deduction for nonproductive IDCs on the 1999 return. The IRS disallowed the deduction, claiming that the taxpayer had not satisfied the economic performance requirement of Code Sec. 461(h).

Analysis
The 90 day rule under Code Sec. 461(i)(2)(A) allows a taxpayer to deduct IDCs in full prior to economic performance if “drilling of the well commences” within 90 days after the close of the tax year when the taxpayer prepaid the IDCs and which the taxpayer is seeking to claim the deduction.  The court agreed with the IRS that drilling begins when the drill bit penetrates the ground, which did not happen within 90 days of the end of the tax year.

The 3 ½ month rule of Reg. 1.461-4(d)(6)(ii) allows a taxpayer to treat a liability as having been economically performed at the time of payment if the taxpayer reasonably expected the services to be provided within 3 ½ months after the date of payment. The 3 ½ month rule contemplates that all the services called for under an undifferentiated, non-severable contract must be provided within 3 ½ months of payment.  This rule only applies to actual cash or cash-equivalent payments and not notes.  Thus, the taxpayer could not deduct the full $5.1 million even if the 3 ½ month rule applied.

The court did not address if the taxpayer may be entitled to deduct some of its IDCs for 1999 on the basis of general economic performance rule of Code Sec. 461(h).