Tech Law Journal Daily E-Mail Alert
December 17, 2002, 9:00 AM ET, Alert No. 569.
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7th Circuit Disallows R&D Tax Credit In Software Development Case
12/13. The U.S. Court of Appeals (7thCir) issued its opinion [PDF] in Nicholas Eustace v. IRS, holding that the research and development tax credit set forth in Section 41 of the Internal Revenue Code is not available for expenses incurred in software improvement.

Background. The six page opinion of the Appeals Court is brief on the facts. The sixteen page opinion [PDF] of the U.S. Tax Court provides more details. Nicholas Eustace and other members of the Eustace family are shareholders of Applied Systems, a Subchapter S corporation formed in 1980 to develop software that independent insurance agencies use to manage their businesses.

Applied Systems improved its software in the early 1990s, and its investors claimed a tax credit under 26 U.S.C. § 41 based on the amount by which Applied Systems increased its research and development (R&D) expenses during these years. The Tax Court did not allow the tax credit. The Eustaces appealed.

Statute. Basically, under the current scheme, corporations receive a 20% tax credit for qualified research and development expenditures (QREs) in excess of a calculated base amount. The subsection of the R&D tax credit provision of the Internal Revenue Code that is at issue, 26 U.S.C. § 41(d), provides as follows:
"Qualified research defined
For purposes of this section --
(1) In general
The term ''qualified research'' means research --
(A) with respect to which expenditures may be treated as expenses under section 174,
(B) which is undertaken for the purpose of discovering information (i) which is technological in nature, and (ii) the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, and
(C) substantially all of the activities of which constitute elements of a process of experimentation for a purpose described in paragraph (3)."

Appeals Court. Judge Frank Easterbrook wrote the opinion for the Appeals Court. He wrote that "Taxpayers who have sought a credit under §41 for commercial software development have been uniformly unsuccessful. See, e.g., Tax & Accounting Software Corp. v. United States, 301 F.3d 1254 (10th Cir. 2002); Wicor, Inc. v. United States, 263 F.3d 659 (7th Cir. 2001); United Stationers, Inc. v. United States, 163 F.3d 440 (7th Cir. 1998); Norwest Corp. v. CIR, 110 T.C. 454 (1998). The only exception -- on which the taxpayers in this case principally rely -- is the district court’s decision in Tax & Accounting, 111 F. Supp. 2d 1153 (N.D. Okla. 2000), which the tenth circuit reversed after they filed their brief."

(See also, TLJ story titled "10th Circuit Disallows R&D Tax Credit for Software Development Costs", August 30, 2002. It covers the opinion in Tax & Accounting Software.)

Easterbrook noted that the IRS found that Applied Systems met all but two of the § 41 requirements: "that the research be ``undertaken for the purpose of discovering information which is technological in nature´´ (§41(d)(1) (B)(i)), and that the activities ``constitute elements of a process of experimentation´´ (§41(d)(1)(C))." He added that "The Tax Court concluded that Applied Systems flunked both tests -- the former because it did not produce an ``innovation in underlying principle´´ and the latter because the research in question was not designed to dispel uncertainty about the technological possibility of developing software of this kind." The Appeals Court affirmed.

Easterbrook reasoned that "Although the word ``experiment´´ has many shadings in common speech, we held that as used in §41 it has the scientific sense of forming and testing hypotheses rather than the lay (or even engineering) sense of trial and error. Galileo engaged in experiments about acceleration when he rolled balls down an inclined plane. An auto manufacturer trying different nozzles from those on hand to find the one that applies the smoothest coat of paint is not engaged in ``experimentation´´ under this view, nor is a software developer trying different methods to implement a feature accompanied by maximum execution speed and minimum demand on system resources such as RAM."

"Tinkering differs from experimentation in the vocabulary of research -- and §41 is about research, and thus about use of the scientific method", opined Easterbrook.

He continued that "Authors and movie makers playing with sentences and scenes to find what most impresses the public are not doing scientific research using ``experimentation´´. Just so with software. Developers are authors too; that they write lines of code readable by machines rather than lines of words readable by people does not fundamentally change the nature of the task and make one form of writing ``experimentation´´ when the other is not. Experimentation is a subset of all steps taken to resolve uncertainty; otherwise searching for a place to park a car would be a ``process of experimentation´´."

IRS Rulemaking Proceeding. The Appeals Court also noted that the IRS is in the process of promulgating regulations implementing § 41. The Court rejected that argument that it should apply the draft language. The Court wrote that "In the long run, neither our view nor the tenth circuit’s has staying power."

Section 41, adopted in 1986, provides that the IRS is to promulgate implementing regulations. The IRS has not yet done so. However, it is in the process of doing so. The IRS published a notice of a proposed rulemaking in the Federal Register (December 26, 2001, Vol. 66, No. 247, at Pages 66362 - 66375).

This notice states that "This document contains proposed regulations relating to the computation of the research credit under section 41(c) and the definition of qualified research under section 41(d). In addition, this document contains proposed regulations describing when computer software that is developed by (or for the benefit of) a taxpayer primarily for the taxpayer's internal use is excepted from the internal-use software exclusion contained in section 41(d)(4)(E)."

Congress. The R&D tax credit is also a perennial issue in Congress. The credit was first enacted in 1981 as a temporary measure, and has been extended temporarily on many occasions since then. The Congress passed, and President Clinton signed, a bill which extends the R&D tax credit for another five years at the end of 1999. However, efforts to make the credit permanent continue.

5th Circuit Rules in Brittan v. Southwestern Bell
12/16. The U.S. Court of Appeals (5thCir) issued its split opinion [16 pages in PDF] in Brittan Communications v. Southwestern Bell, affirming the District Court's dismissal of a suit brought by a reseller of long distance telephone service (Brittan) against an incumbent local exchange carrier (Southwestern Bell) for suspending billing services.

Background. Brittan Communications International Corporation is a bankrupt switchless reseller of long distance telephone services. It leased long distance access from two existing long distance carriers, and then then resold the leased services to its customers. Southwestern Bell Telephone Company (SWBT) is a local exchange carrier. Brittan billed its customers through local exchange carriers, such as SWBT. SWBT suspending billing services for Brittan, citing complaints of slamming (changing a customer's long distance provider with authority of the customer) and cramming (adding unauthorized items to bills).

The Federal Communications Commission (FCC) has taken action against Brittan. See, for example, FCC release announced Notice of Apparent Liability for slamming.

District Court. Brittan filed a complaint in Texas state court against SWBT alleging violation of the common carrier duties under the Communications Act, common law fraud, and violations of the Texas Deceptive Trade Practices Act (DTPA). SWBT removed the case to the U.S. District Court (SDTex). The District Court granted SWBT's motion for judgment on the pleadings with regarding the Communications Act claim, and granted SWBT's motion for summary judgment regarding Brittan's fraud and DTPA claims. Brittan appealed.

Appeals Court. A three judge panel of the Court of Appeals affirmed. 47 U.S.C. § 202 provides in part that "It shall be unlawful for any common carrier to make any unjust or unreasonable discrimination in charges, practices, classifications, regulations, facilities, or services for or in connection with like communication service, directly or indirectly, by any means or device, or to make or give any undue or unreasonable preference or advantage to any particular person, class of persons, or locality, or to subject any particular person, class of persons, or locality to any undue or unreasonable prejudice or disadvantage."

Judge Stewart, who was joined by Judge DeMoss, wrote that it was appropriate for the District Court grant judgment on the pleading on the Section 202 claim. Judge Dennis dissented. Judge Dennis also dissented on the common law fraud issue. All three judges joined in affirming the District Court's summary judgment as to the DTPA claim.

Tuesday, December 17
9:00 AM. The Securities and Exchange Commission (SEC) will hold a roundtable meeting to discuss the international impact of proposed rules to be promulgated under the Sarbanes Oxley Act of 2002 on auditor independence. Audio of the meeting will be web cast. See, SEC release. Location: SEC headquarters, 450 Fifth Street, NW.

10:00 AM - 12:00 NOON. The Department of State's (DOS) U.S. International Telecommunication Advisory Committee (ITAC) will hold a meeting to discuss matters related to the World Summit on the Information Society (WSIS) scheduled for December 2003. See, notice in the Federal Register, December 3, 2002, Vol. 67, No. 232, at Page 72018. Location: National Academy of Sciences, 2100 C St. NW.

1:30 - 3:30 PM. The FCC's WRC-03 Advisory Committee, Informal Working Group 7, Regulatory Issues and Future Agendas, will meet. Location: Boeing Company, Arlington, VA.

2:00 PM. The Securities and Exchange Commission (SEC) will hold a roundtable meeting to discuss the international impact of proposed rules to be promulgated under the Sarbanes Oxley Act of 2002 on attorney conduct. Audio of the meeting will be web cast. See, SEC release. Location: SEC headquarters, 450 Fifth Street, NW.

Wednesday, December 18
Deadline to submit comments to the FCC regarding AT&T's petition for declaratory ruling that its phone to phone Internet protocol telephony services are exempt from access charges. AT&T filed the petition on October 18, 2002. This is WC Docket No. 02-361. For more information, contact Kathy O’Neill at 202 418-1520 or Julie Veach at 202 418-1558. See, FCC notice [4 pages in PDF].
Thursday, December 19
Deadline for the FCC to rule on SBC's Section 271 application with the FCC to provide in region interLATA service in the state of California. This is WC Docket No. 02-306. See, FCC notice [PDF].

Deadline for the FCC to rule on BellSouth's Section 271 application with the FCC to provide in region interLATA service in the states of Florida and Tennessee. This is WC Docket No. 02-307. See, FCC notice [PDF].

1:00 - 4:00 PM. The U.S. Patent and Trademark Office (USPTO) will host a roundtable meeting. The USPTO has offered two descriptions of the purpose of this meeting. It stated in an October 28 notice in the Federal Register that the meeting will address small business views on foreign patent challenges. It stated in a December 9 notice that the meeting will address harmonization of patent laws. This roundtable, along with two others in Los Angeles and Chicago, are being held pursuant to a recommendation contained in a General Accounting Office (GAO) report [PDF] titled "Federal Action Needed to Help Small Businesses Address Foreign Patent Challenges". This report was released on August 22, 2002. See also, story titled "GAO Reports Foreign Patent Challenges Facing Small Businesses" in TLJ Daily E-Mail Alert No. 497, August 23, 2002. December 19 is also the deadline to submit written comments. To make reservations to attend, contact Velica Steadman at 703 305-9300 or velica.steadman Location: Crystal Park 2, 2121 Crystal Drive, Arlington, VA.

Friday, December 20
Deadline to submit comments to the Office of the U.S. Trade Representative (USTR) regarding its proposed free trade agreement (FTA) negotiations with Botswana, Lesotho, Namibia, South Africa and Swaziland. The proposed negotiations will address, among other things, electronic commerce, intellectual property rights (IPR), and access to telecommunications markets. See, notice in Federal Register, November 15, 2002, Vol. 67, No. 221, at Pages 69295 - 69297. See also, letter [PDF] from USTR Robert Zoellick to Sen. Robert Byrd (D-WV).
Monday, December 23
Deadline to submit reply comments to the Federal Communications Commission's (FCC) Wireline Competition Bureau (WCB) regarding AT&T's October 15 Petition for Rulemaking to Reform Regulation of Incumbent Local Exchange Carrier Rates for Interstate Special Access Services [118 pages in PDF]. This is RM No. 10593.

Deadline to submit notices of intent to participate to the Copyright Office regarding its request for "written comments and proposals for the scheduling of Copyright Arbitration Royalty Panel (CARP) proceedings to adjust royalty rates and terms under provisions of the Copyright Act governing ephemeral recordings and digital transmissions of performances of sound recordings, as well as notices of intent to participate in the CARP to set rates and terms under the statutory license for eligible nonsubscription services to make certain digital audio transmissions of sound recordings for the 2003-2004 period." See, notice in the Federal Register.

People and Appointments
12/13. Michele Davis, Assistant Secretary of the Treasury for Public Affairs, will leave at the end of the year. See, Treasury release. Rob Nichols will become the Acting Assistant Secretary. See, Treasury release.

12/16. Raymond Gifford will replace Jeffrey Eisenach as President of the Progress and Freedom Foundation (PFF), effective February 1, 2003. Gifford is currently Chairman of the Colorado Public Utilities Commission. Eisenach will become executive vice chairman of CapAnalysis, a Washington DC consulting firm affiliated with the law firm of Howrey & Simon. The PFF is a Washington DC based think tank which usually advocates free market positions on telecommunications and technology related issues. See, PFF release and Howrey release.

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