California OTA Confirms Need for Documentation in R&D Tax Claims

The California Office of Tax Appeals (OTA) has recently issued two opinions regarding the burden of proof taxpayers must meet to substantiate entitlement to California’s research and development (R&D) tax credit for qualified expenditures under California Revenue and Taxation Code section 23609. In both opinions, the OTA ruled in favor of the California Franchise Tax Board, holding each taxpayer failed to meet its respective burden to substantiate the R&D tax credit claimed.

It has long been stated that the burden of proof falls on taxpayers, but as a result of the complexity of the R&D tax credit, many taxpayers fail to meet this requirement. California’s R&D tax credit follows much of the same legislation as the federal and requires that taxpayers retain sufficiently detailed records to substantiate the four part test as outlined in IRC Sec 41:

  1. the expenditures must be eligible to be treated as research expenses under Internal Revenue Code section 174;
  2. the research must be undertaken for the purpose of discovering information that is technological in nature;
  3. the application of the research must be intended to be useful in the development of a new or improved business component of the taxpayer; and
  4. substantially all of the research activities must constitute elements of a process of experimentation for a qualified purpose. 

Opinion 1Appeal of First Solar, Inc., 2023-OTA-532P (Sept. 19, 2023)

The OTA held that the taxpayer failed to meet its burden of proof. The precedential opinion noted that the taxpayer had a single, total line item for R&D expenses but did not include the audit working papers or any document itemizing the expenses that made up the total amount. The taxpayer also provided (a) a list of 15 patent applications, (b) documents relating to an IRS audit of the taxpayer for a previous tax year (the documents did not indicate the IRS examined the R&D tax credit); and (c) testimony by the taxpayer’s co-founder and Chief Technology Officer.

Opinion 2Appeal of Electronic Data Systems Corporation & Subsidiaries, 2023-OTA-540 (Sept. 20, 2023)

In this case, the OTA held in a non-precedential opinion that the taxpayer failed to meet its burden of proof for substantiating its claimed R&D tax credit by relying primarily on insufficient employee surveys developed after the conclusion of the research activities. The OTA stated that the provided employee surveys submitted by the taxpayer were insufficient for numerous reasons including: the employees who completed the surveys lacked relevant legal experience, there was no evidence the employees completed the surveys impartially, the employees did not provide signed statements under penalty of perjury, and the surveys did not contain contemporaneous supporting documentation from when the taxpayer conducted the research activities.

Opinions like this reinforce the need for sufficient and detailed documentation. This means both financial documentation and that which describes and substantiates development efforts. One approach is the use of a narrative which describes a project and its technical uncertainties and experimentation processes in detail. This narrative is often not enough alone. For these reasons, it is often recommended, even by the OTA, that taxpayers should work closely with their internal and external advisors on establishing and enforcing proper document retention procedures to comply with applicable R&D tax credit substantiation requirements.

Are you developing new technology for an existing application? Did you know your development work could be eligible for the R&D Tax Credit and you can receive up to 14% back on your expenses? Even if your development isn’t successful your work may still qualify for R&D credits (i.e. you don’t need to have a patent to qualify). To find out more, please contact a Swanson Reed R&D Specialist today or check out our free online eligibility test.

Who We Are:

Swanson Reed is one of the U.S.’ largest Specialist R&D tax advisory firms. We manage all facets of the R&D tax credit program, from claim preparation and audit compliance to claim disputes.

Swanson Reed regularly hosts free webinars and provides free IRS CE and CPE credits for CPAs. For more information please visit us at or contact your usual Swanson Reed representative.

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