U.S. District Court rules in company's favor and determines all members of a controlled group of corporations should be treated as a single taxpayer when calculating research credits.
On June 25, 2010, the U.S. District Court for Southern District of Ohio in Procter & Gamble Co. and Subsidiaries v. United States, No. 1:08-cv-00608-TSB, granted partial summary judgment in favor of Procter & Gamble (P&G) and denied the government's cross motion in an important tax case involving the computation of the research tax credit under Section 41 of the Internal Revenue Code. The court framed the issue for decision as "whether a taxpayer must include the results of intercompany transactions within its 'Gross Receipts' for purposes of determining the amount of its research credit."
Like many multinational corporations, P&G conducts its business through numerous subsidiary corporations. As part of its business operations, P&G's subsidiary corporations regularly engage in intercompany transactions with one another. For example, one of P&G's subsidiaries manufactures products that it sells to another subsidiary to distribute. The distribution subsidiary then sells the products to unrelated, third-party customers.
P&G also engages in extensive research activities related to the development and improvement of new technologies and products. As a result of these activities, P&G claimed research tax credits. In calculating its research credits, P&G treated all members of its controlled group of corporations as a "single taxpayer," aggregating its research expenditures and gross receipts, but disregarding those gross receipts received by domestic members from intercompany transactions with foreign affiliates. This methodology was accepted by the Internal Revenue Service (IRS) in audits of P&G's returns for prior years and comported with IRS guidance, specifically Chief Counsel Advice 200233011. In late 2005 the IRS accepted P&G's tax credit calculations for the 2001–2005 tax years.
Several months later the IRS issued Chief Counsel Advice 200620023, which reversed earlier guidance by concluding that gross receipts received by domestic members from foreign affiliates with respect to intercompany transactions should not be disregarded from the research credit calculation. The IRS continued to agree, however, that receipts from domestic affiliates should be disregarded. Following the newly issued guidance, P&G's IRS audit team reversed its position and issued a notice of proposed adjustment providing that foreign affiliate gross receipts should be included in the research credit calculation. P&G paid the tax assessed by the IRS and sued for a refund.
In court, both P&G and the government moved for summary judgment. Both P&G and the government argued that the plain language of the statute and regulations compelled the result each was seeking. P&G relied on Code Section 41(f), which provides that all members of a controlled group of corporations should be treated as a single taxpayer. By contrast, the government contended the controlling statutory provision was Code Section 41(c)(6) (now Code Section 41(c)(7)), arguing that this section provided the exclusive definition of gross receipts that includes foreign affiliate gross receipts. The court agreed with P&G that Code Section 41(f) controlled, and further that Code Section 41(c)(6) did not compel a different result.
The court began with the language of Code Section 41(f)(1)(A): "in determining the amount of the credit ... all members of the same controlled group shall be treated as a single taxpayer." The court also relied on U.S. Treasury Department regulations that provide as follows: "[b]ecause all members of a group under common control are treated as a single taxpayer for purposes of determining the research credit, transfers between members of the group are generally disregarded" (Treas. Reg. § 1.41-6T(i) (2005); see also Treas. Reg. § 1.41-6(i)(2010). The court rejected the government's argument that the statute and regulations only applied to the calculation of qualified research expenditures. The court stated "[h]ere, neither the statute nor the regulations distinguish between calculations of Research Expense and Gross Receipts."
Similarly, the court found no basis for distinguishing, as the government did, between domestic and foreign affiliate gross receipts. Further, the court stated that "intercompany sales do not represent sales to the company's customers, but rather, they serve only administrative or legal purposes internal to the business itself." The court recognized that including intercompany transactions could result in "double, triple, or other such multiple counting" of gross receipts.
Even though the court found the plain language of the statute and regulations to be dispositive of the case in favor of P&G, the court also concluded that the legislative history supported P&G's position. The court explained that gross receipts were added as a component to the research credit calculation in 1989 to index "each taxpayer's base amount to average growth in gross receipts." In amending the research credit to include gross receipts as a component of the calculation, Congress recognized that "businesses often determine their research budgets as a fixed percentage of gross receipts." The committee reports indicated that Congress believed adding gross receipts as a component of the research credit would better "achieve its intended purpose of rewarding taxpayers for research expenses in excess of amounts which would have been expended in any case." The court concluded that "[i]ncluding international intercompany transactions is inconsistent with this rationale because it would double count (at least) transactions which are merely administrative or legal in nature, thereby highlighting an irrelevant measurement." As the court stated, "[b]usinesses do not 'determine their research budgets' as a percentage of intercompany sales receipts, and including intercompany transfers in the research tax credit would introduce a factor wholly unrelated both to research expenditure decisions and the credit's incentive effect."
In ruling for P&G, the court distinguished two recent cases relied on by the government. First, the court found that the decision in Deere & Co. v. Commissioner, 133 T.C. No. 11 (2009), is "not directly relevant to this case." Deere held that a taxpayer is required to include sales by foreign branches of domestic subsidiaries in gross receipts. The court concluded that this case was inapplicable because "third party sales by branches are fundamentally different than intercompany sales to foreign affiliates.
Similarly, the court rejected the government's reliance on Union Carbide Corp. v. Commissioner, T.C. Memo. 2009-50, which held that the "consistency" requirement in the statute should be applied to individual members of a controlled group instead of the group as a whole. The court found this holding to be irrelevant and unhelpful as applied to the foreign affiliate gross receipts issue.
Because the P&G case also involves other issues that have not been resolved, it is uncertain when an appealable final decision will be entered in the case. It is also uncertain how the decision might affect this administrative resolution by the IRS of pending cases.
At least two other docketed cases involve the same issue: Roche Holdings, Inc. & Subsidiaries v. United States, No. 2:09-CV-05463 (D. N.J. filed October 27, 2009), and Hewlett-Packard Co. & Consolidated Subsidiaries v. Commissioner, No. 21976-07 (T.C. filed September 28, 2007). The issue is being coordinated by the IRS Appeals Office, which has issued settlement guidelines. See UIL No.: 41.51-11; see also LMSB-4-0510-018 (authorizing exam to resolve cases based on the IRS Appeals Office settlement guidelines).
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