Substantial Rights to the Results of the Research

Substantial rights in research represent the legal authority of a taxpayer to use, exploit, and commercialize the results of their investigative activities without the obligation to pay a third party for such access. Within the Texas franchise tax system, the retention of these rights serves as a critical threshold for determining whether research is considered “funded” by an external entity, thereby dictates the eligibility of related expenditures for state-level tax credits.

The Theoretical and Statutory Foundation of Substantial Rights in Texas

The concept of substantial rights is not an isolated legal artifact but rather a component of the broader “funded research” exclusion established under both federal and Texas state law. To understand the depth of this doctrine, one must examine the intersection of the Internal Revenue Code (IRC) and the Texas Tax Code. Texas, through its franchise tax provisions, has historically sought to incentivize innovation by mirroring federal incentives while maintaining a distinct administrative and evidentiary framework. The significance of substantial rights arises primarily in the context of contract research, where one party performs activities on behalf of another. The law must distinguish between a service provider merely fulfilling a contract and an innovator investing their own intellectual capital into a project.

Under the Texas Tax Code, particularly the longstanding Subchapter M of Chapter 171, “qualified research” is defined by direct reference to IRC Section 41. This reference creates a structural dependency where the meanings of technological discovery, uncertainty, and experimentation are imported from federal regulations. However, the Texas legislature and the Comptroller of Public Accounts have historically applied a “frozen” conformity to the IRC as it existed on December 31, 2011. This temporal anchor means that while federal courts have continued to evolve the definition of substantial rights, Texas taxpayers must navigate the standard through the lens of 2011-era federal guidance and subsequent, often more restrictive, state administrative rules.

The essence of the substantial rights test is found in Treasury Regulation § 1.41-4A(d)(2), which stipulates that if a researcher performs activities for another person and retains no substantial rights in the results, the research is deemed fully funded and ineligible for the credit. The “right to use” the results of the research in the conduct of one’s own trade or business—without being required to pay a fee or royalty—is the hallmark of retaining substantial rights. This does not require the researcher to have exclusive ownership of the intellectual property; concurrent or non-exclusive rights can suffice, provided they are robust enough to allow for commercial exploitation or further internal development.

Legislative Evolution: From Subchapter M to Subchapter T

The Texas R&D credit landscape is currently in a state of significant transition. For the past decade, the credit has operated under Subchapter M, which was characterized by its static conformity to the 2011 IRC and a sunset date of December 31, 2026. However, the 89th Texas Legislature enacted Senate Bill 2206 in 2025, which fundamentally overhauled the regime. This legislation repeals Subchapter M and replaces it with a new Subchapter T, effective January 1, 2026.

One of the most profound changes introduced by SB 2206 is the move toward “rolling conformity.” Instead of a fixed 2011 date, the new law defines qualified research expenses by referencing the amount reported on Line 48 of the federal Form 6765, limited to research conducted within Texas. This shift aligns state definitions with current federal guidance, potentially resolving longstanding disputes over modern research categories like internal-use software (IUS) and cloud computing costs. Despite this modernization, the “funded research” exclusion and its accompanying “substantial rights” analysis remain central to both the old and new statutes.

Legislative Provision	Subchapter M (Pre-2026)	Subchapter T (Post-2026)
IRC Reference Date	December 31, 2011	Rolling Conformity
Credit Rate (Standard)	5.0% of QREs over base	8.722% of QREs over base
University Research Rate	6.25% of QREs	10.903% of QREs
Refundability	Generally non-refundable	Refundable for eligible entities
Carryforward	20 years	20 years
Sales Tax Exemption	Available as alternative	Repealed effective Jan 1, 2026

The transition from a 2011 “frozen” standard to a “rolling” standard in 2026 reflects a policy objective to make Texas more competitive for high-tech investment. By aligning with Line 48 of the federal form, the state reduces the administrative burden on taxpayers who previously had to maintain two sets of R&D calculations. However, this alignment also means that federal audit findings and judicial interpretations of substantial rights will carry even more weight in Texas than they did previously.

Revenue Office Guidance: The 34 TAC § 3.599 Framework

The Texas Comptroller’s primary vehicle for interpreting R&D credit law is Title 34 of the Texas Administrative Code (TAC), Section 3.599. This rule has undergone several iterations, most notably in October 2021, when the Comptroller adopted amendments that applied retroactively to reports due on or after January 1, 2014. These amendments clarified the agency’s stance on several contentious issues, including the funded research exclusion.

Under TAC § 3.599(b)(5), the Comptroller explicitly defines the conditions under which research is considered funded. A project is funded if either the researcher retains no substantial rights to the results or the payments are not contingent upon the success of the research. This “either/or” test is a critical nuance: even if a researcher bears 100% of the financial risk (i.e., payment is contingent on success), they can still be disqualified if they have no substantial rights to the results.

The Exclusion of Incidental Benefits

The Comptroller’s guidance provides a rigorous definition of what does not constitute a substantial right. TAC § 3.599(b)(5)(B)(i) states that incidental benefits to the researcher, such as increased experience in a field of research or general institutional knowledge, do not qualify. This distinction is frequently the focal point of audit disputes. The IRS and the Texas Comptroller often argue that unless a researcher has a specific, documented right to use the research results for other commercial purposes, they have merely gained “experience.”

The guidance further clarifies that a taxpayer does not retain substantial rights if they must pay for the right to use the results. For example, if a developer builds a proprietary software engine for a client and the contract requires the developer to pay a royalty to the client to use that same engine in a future product for a different customer, the developer has not retained substantial rights. The right must be “free” in the sense that no further payment is required to the funder for usage.

Documentation and the Burden of Proof

One of the most significant administrative requirements in Texas is the “clear and convincing evidence” standard. While federal tax law often operates on a preponderance of the evidence, Texas law places a higher burden on the taxpayer to prove their entitlement to the credit. In the context of substantial rights, this means that a silent contract—one that does not explicitly mention IP ownership—is a major risk.

The Comptroller’s rule also requires that “all agreements” between the researcher and the funder be considered. This holistic review prevents taxpayers from pointing to a favorable Master Service Agreement (MSA) while ignoring a restrictive Statement of Work (SOW). Auditors are instructed to look for any language that might “divest” the researcher of their rights, even in ancillary documents.

Economic Risk: The Second Pillar of Funding

While the user’s query focuses on substantial rights, the doctrine is inextricably linked to the concept of economic risk. Under TAC § 3.599(b)(5)(A)(ii), research is funded if payments are not contingent on the success of the research. This creates four possible outcomes for a contract research arrangement:

Contingency on Success	Retention of Substantial Rights	Texas Funding Status
Yes (Risk on Researcher)	Yes (Rights Retained)	Unfunded (Eligible for Credit)
Yes (Risk on Researcher)	No (Rights Transferred)	Funded (Ineligible for Credit)
No (Risk on Client)	No (Rights Transferred)	Funded (Ineligible for Credit)
No (Risk on Client)	Yes (Rights Retained)	Partially Funded (Eligible only for excess expenses)

In the “Partially Funded” scenario, the researcher may have a contract that pays them $100,000 regardless of whether the research succeeds, but they retain the right to use the results. If the researcher spends $150,000 on the project, the $100,000 payment is considered funding, but the $50,000 in excess costs may be treated as qualified research expenses (QREs). This nuance is vital for startups and engineering firms that often over-invest in projects to secure intellectual property rights.

Jurisprudential Analysis: Federal Precedents in the Fifth Circuit

Because Texas law conforms to the IRC, the decisions of federal courts—particularly the U.S. Fifth Circuit Court of Appeals (which covers Texas) and the U.S. Tax Court—are highly influential. The Comptroller has noted that while these decisions are not strictly binding, the agency intends to follow federal case law regarding the definition of funded research.

The Lockheed Martin Standard

The seminal case of Lockheed Martin Corp. v. United States (2000) remains the cornerstone of the substantial rights doctrine. In this case, the court examined government contracts where Lockheed Martin retained the right to use the research results but not the exclusive right to do so. The government also had extensive rights to the technology. The court held that the right to use the results without paying the client is a substantial right, and that exclusivity is not a requirement. This established a pro-taxpayer standard that allowed for shared intellectual property rights.

The Fairchild and Dynetics Contrasts

In Fairchild Industries, Inc. v. United States, the Federal Circuit emphasized the risk prong, ruling that a fixed-price contract where the researcher had to return progress payments if the government rejected the product constituted a risk-bearing arrangement. Conversely, in Dynetics, Inc. v. United States (2015), the court found against the taxpayer, ruling that the right to “know-how” and general experience was insufficient to meet the substantial rights test when the government had the right to prevent the contractor from disclosing the technical data to third parties. These cases illustrate the narrow line between “commercial usage rights” and “incidental experience.”

Recent Interpretations: Populous and Grigsby

The 2023 decision in Grigsby v. United States (also known as the Cajun case) reinforced the strict interpretation of “contingent on success.” The Fifth Circuit affirmed that a construction company was not entitled to the credit because its contracts—while fixed-price—did not sufficiently demonstrate that payments were contingent on the success of the research as opposed to merely the delivery of a product. This case serves as a warning for Texas contractors: if the uncertainty being resolved is not explicitly tied to the payment terms, the Comptroller may classify the project as funded research.

Application of Guidance: The “Clear and Convincing” Standard in Practice

The “clear and convincing” standard adopted in TAC § 3.599(e) changes the strategy for audit defense in Texas. Unlike federal audits, where a taxpayer might prevail by showing a project was “more likely than not” qualified research, a Texas auditor or Administrative Law Judge (ALJ) requires evidence that leaves “no serious or substantial doubt” about the nature of the activities and the retention of rights.

The Role of Contemporaneous Documentation

To meet this evidentiary bar, the Comptroller requires contemporaneous business records. For the substantial rights analysis, this documentation should include:

1. Fully Executed Master Service Agreements (MSAs): Specifically identifying intellectual property (IP) clauses.
2. Specific Statements of Work (SOWs): Ensuring that no project-specific language overrides the MSA’s IP protections.
3. Patent Filings and Registrations: Demonstrating that the taxpayer actively protected the research results in their own name.
4. Usage Records: Logbooks or commercialization plans showing that the “substantial rights” were actually exercised by the taxpayer to improve other business components.

The Comptroller’s STAR system (State Tax Automated Research) contains numerous examples of hearings where credits were denied because the taxpayer could not produce the underlying contracts, or because the contracts they did produce were too vague to satisfy the clear and convincing standard.

Industry-Specific Implications

The substantial rights doctrine manifests differently across Texas’s major economic sectors.

Aerospace and Defense

Texas is a hub for aerospace, with companies frequently contracting with the Department of Defense (DoD) or NASA. Federal Acquisition Regulation (FAR) clauses often govern these contracts. If a contract grants the government “unlimited rights” but leaves the contractor with “non-exclusive, royalty-free rights” to use the technical data for commercial purposes, the contractor typically satisfies the substantial rights test. However, if the contract is classified or restricted by Export Administration Regulations (EAR) or International Traffic in Arms Regulations (ITAR) to the point that the contractor cannot practically use the results in their commercial business, the Comptroller may argue those rights are not “substantial.”

Software Development and SaaS

For the thousands of software companies in Austin, Dallas, and Houston, substantial rights often hinge on the definition of “deliverables” vs. “background IP.” If a software developer uses their own proprietary framework to build a custom application for a client, they must ensure the contract explicitly states that they retain the rights to the framework and any improvements made to it during the project. Under the 2011 IRC (Subchapter M), internal-use software (IUS) was subject to a more stringent three-part “high threshold of innovation” test. The 2026 transition to Subchapter T and rolling conformity may relax some of these software-specific hurdles, but the retention of rights will remain a prerequisite for any client-funded development.

Construction and Engineering

The Cajun and Perficient cases have highlighted the risks for the construction industry. Many construction projects involve engineering research to solve site-specific problems. If the contract states that the client owns “all work product,” the engineering firm may lose the R&D credit, even if they developed a groundbreaking new foundation method. To preserve the credit, firms must negotiate “license-back” provisions that allow them to use the engineering methods in future projects.

Calculating the Credit: Formulas and the Role of Rights

The retention of substantial rights directly impacts the calculation of the credit. Only those expenses incurred in “unfunded” research may be entered into the calculation.

For Texas franchise tax purposes, the credit amount is generally determined by one of two methods: the Regular Research Credit (RRC) or the Alternative Simplified Credit (ASC).

The Alternative Simplified Credit (ASC) Formula

Most modern taxpayers utilize the ASC because it does not require historical data dating back to the 1980s. Under Subchapter T (Post-2026), the formula is:

Credit = 8.722% * (Current Year QREs – 50% * Average QREs of Prior 3 Years)

If a taxpayer has no QREs in any of the prior three years, the rate is 4.361% of the current year’s QREs.

The “Current Year QREs” variable in this formula is strictly limited to research conducted in Texas that satisfies the four-part test and is not funded. If a major project is disqualified during an audit due to a lack of substantial rights, it can reduce the current year’s QREs, potentially eliminating the credit entirely if the remaining QREs fall below the 50% threshold of the prior years.

Example Case Study: “Deep-Oil Tech” and the Substantial Rights Test

To provide a comprehensive example of how this guidance applies, consider the fictional entity “Deep-Oil Tech,” a Houston-based engineering firm specializing in subsea drilling equipment. Deep-Oil Tech engages in two distinct projects in 2024.

Project 1: The Sole-Source Development

Deep-Oil Tech is contracted by a major energy conglomerate to develop a new type of blowout preventer (BOP). The contract is a “Time and Materials” (T&M) agreement where the conglomerate pays Deep-Oil Tech $500 per hour for its engineering team. The contract contains the following IP clause: “All intellectual property, including designs, formulas, and technical data developed during the performance of this agreement, shall be the sole and exclusive property of the Conglomerate. Deep-Oil Tech shall have no right to use, disclose, or reproduce the results for any purpose other than fulfilling this contract.”

Analysis of Project 1:

• Funding Status: This project is considered fully funded.
• Substantial Rights: Deep-Oil Tech has retained no substantial rights. They are explicitly prohibited from using the results.
• Economic Risk: Deep-Oil Tech bears no risk because they are paid on an hourly basis regardless of whether the BOP works.
• Texas R&D Credit: None of the wages or supplies associated with Project 1 can be claimed as QREs by Deep-Oil Tech.

Project 2: The Shared-Risk Innovation

Deep-Oil Tech collaborates with a different client to develop an autonomous underwater vehicle (AUV) for pipe inspection. This contract is a “Milestone-Based Fixed-Price” agreement for $2,000,000. Deep-Oil Tech only receives payment if the AUV successfully completes a test dive at a depth of 5,000 feet. The IP clause states: “The Client shall own the specific AUV unit delivered under this contract. However, Deep-Oil Tech retains all rights to the underlying navigation software and sensor integration algorithms. Deep-Oil Tech grants the Client a non-exclusive license to use the software solely for the operation of the AUV unit.” Deep-Oil Tech spends $2,500,000 in Texas on this project.

Analysis of Project 2:

• Funding Status: This project is considered unfunded for the researcher to the extent of the risk and the rights.
• Substantial Rights: Deep-Oil Tech has retained substantial rights. They own the underlying software and can use it in other products or for other clients.
• Economic Risk: Deep-Oil Tech bears the risk. They only get paid if the milestones are met, and they have already spent $500,000 more than the contract value.
• Texas R&D Credit: Deep-Oil Tech can claim the full $2,500,000 in QREs for the Texas R&D credit.

The University Partnership: An Enhanced Opportunity

Texas offers a unique incentive for businesses to collaborate with universities. Under the new Subchapter T, the credit rate for such research is 10.903%, a significant premium over the standard rate.

However, university contracts are notorious for complex intellectual property provisions. Most Texas universities have a mandate to protect and license technology for the public good. To claim the R&D credit at the higher rate, a Texas business must ensure that its contract with the university grants it substantial rights. If the university retains the patent and only gives the business a “right of first refusal” to license it at a later date, the business has not retained substantial rights at the time the research was conducted.

To comply with TAC § 3.599, the business must have an “agreement entered into prior to the performance of the research” that grants them the right to use the results without paying for them. A common strategy is to negotiate a “joint development agreement” (JDA) where the business and university share the rights to the IP.

Administrative Procedures and the SOAH Process

When the Comptroller denies a credit based on the “funded research” exclusion, the taxpayer has the right to a redetermination. This process often leads to the State Office of Administrative Hearings (SOAH), where an independent Administrative Law Judge (ALJ) hears the case.

The SOAH process is governed by the Texas Administrative Procedure Act (APA). In these hearings, the “clear and convincing” burden of proof is applied to the taxpayer. The ALJ’s Proposal for Decision (PFD) is then sent to the Comptroller for final adoption.

Recent changes in Texas law (SB 14, effective September 1, 2025) have limited the level of deference that Texas courts must give to state agency legal interpretations. This may provide a more favorable environment for taxpayers to challenge the Comptroller’s restrictive definitions of substantial rights in court, as judges will now be required to review the law de novo rather than defaulting to the agency’s expertise.

Statistical Sampling and Audit Efficiency

Recognizing the complexity of reviewing thousands of research projects, the Texas Tax Code and the Comptroller’s rules allow for the use of statistical sampling.

Under Subchapter T, the law permits sampling procedures in accordance with IRS Revenue Procedure 2011-42. This allows an auditor to examine a representative subset of a taxpayer’s contracts to determine the overall percentage of “funded” vs. “unfunded” research. If a taxpayer fails the substantial rights test in several sample projects, the auditor will extrapolate that failure rate across the entire credit claim. This makes it imperative that even smaller, less expensive projects follow the same rigorous IP drafting standards as major initiatives.

Future Outlook: The 2026 Shift

The repeal of the R&D sales tax exemption in 2026 is intended to consolidate Texas’s innovation incentives into a single, high-value franchise tax credit. For many years, companies had to choose between the exemption and the credit on a yearly basis. By eliminating the sales tax option, the state is pushing all R&D activity toward the franchise tax credit, where the “substantial rights” analysis is mandatory.

This consolidation will likely lead to an increase in R&D audits as the fiscal impact of the credit grows. Taxpayers should use the time leading up to 2026 to review their existing contract portfolios and ensure they meet the modern “rolling” standards that will soon be in effect.

Period	Governance	Conformity	Key Limitation
2014 – 2025	Subchapter M	2011 IRC	“Frozen” IUS & Cloud Rules
2026 – Beyond	Subchapter T	Rolling IRC	Line 48 Federal Sync

The introduction of refundability for small businesses and veteran-owned entities in 2026 is another landmark change. Previously, many startups in the development phase could only carry forward their credits for up to 20 years because they had no tax liability to offset. The new refundable credit provides immediate cash flow, but only if the startup can prove they own the rights to the innovation they are being paid to develop.

Summary of Best Practices for Texas Taxpayers

To satisfy the substantial rights requirement and withstand Comptroller scrutiny, professional practitioners should adhere to the following narrative strategies:

1. Draft for Rights: Contracts must explicitly state that the researcher retains the right to use the results of the research for their own business purposes without additional payment.
2. Verify Risk: Ensure that payment is contingent on the success of the research (e.g., meeting technical milestones or performance specs) rather than merely hours worked.
3. Contemporaneous Bridge: Create a factual nexus between each dollar spent, the technical uncertainty resolved, and the specific rights retained.
4. Identify All Parties: Be prepared to identify every person or entity with rights to the research to satisfy the reporting requirements of TAC § 3.599(b)(5)(E).
5. Audit Defense through “Clear and Convincing” Proof: Maintain a “permanent file” of executed contracts and IP registrations to meet the high evidentiary burden in Texas.

The substantial rights doctrine remains a powerful tool for the Texas Comptroller to limit the state’s exposure to tax credit claims. However, for companies that understand the interaction between contract language, economic risk, and state revenue office guidance, it provides a clear roadmap for securing one of the most significant tax incentives in the United States. The 2026 transition to Subchapter T further underscores the importance of this doctrine, as the state moves toward a more generous but highly standardized R&D regime.