In a precedential ruling, the California Office of Tax Appeals held that the research and development tax credit is only available for activities “engaging in the scientific method.”  The decision, In re Swat-Fame, Inc., 2020-0TA-046P (June 1, 2020), found that trial-and-error modifications to garments did not constitute “qualified research” under R&TC section 23609.

Swat-Fame, Inc. designs clothing for women and girls.  Every year, its staff develops and refines many new and improved garment designs.  As part of this process, the staff employ certain methods to perfect the design of their products (e.g., fit tests before and after washing the garment and the evaluation of alternative designs for fit and functionality).

To be eligible for the California R&D credit, a company must be able to show that they performed, or paid someone else to perform, “qualified research” under IRC section 41(a)(1), as modified by R&TC section 23609. For research to be deemed “qualified research,” it must meet four tests.  Most relevant for the In re Swat-Fame, Inc. decision was the process-of-experimentation test, which requires that substantially all of the research activities constitute elements of a process of experimentation relating to a new or improved function, performance, reliability, or quality.

Swat-Fame, Inc. argued that its design and sewing process constituted a process of experimentation and was therefore “qualified research.”  In making this argument, the company emphasized the presence of uncertainty as to the method or design required to achieve a desired result.  However, the Office of Tax Appeals applied the standard in a 2009 U.S. Tax Court case, Union Carbide Corp. and Subsidiaries v. Commissioner, 110 T.C. 375 (1998), whereby the process-of-experimentation test “requires the use of the scientific method sense, not merely taking steps to resolve uncertainty or to improve a product.”

The Office of Tax Appeals was unpersuaded that Swat-Fame, Inc.’s design and sewing process involved the scientific method generally.  And even if some of Swat-Fame, Inc.’s activities may have met the process-of-experimentation test, the Office of Tax Appeals found that the company did not demonstrate that at least 80% of its activities constituted elements of a process of experimentation for a qualified purpose.  Similarly, the Office of Tax Appeals found that Swat-Fame, Inc. did not provide evidence allowing the application of the shrinking-back rule, which limits the IRC section 41(d)(1) requirements to a portion of a project.  Accordingly, the Office of Tax Appeals denied Swat-Fame, Inc.’s use of the California R&D credit in its entirety.

Contact the Authors:  Trevor Mauck