Expert Report: The Meaning and Application of the Funded Research Exclusion in the Context of the Connecticut R&D Tax Credit (CGS § 12-217n)

I. Executive Summary: The Connecticut Funded Research Exclusion (FRE)

A. Simple Definition of Funded Research Exclusion

The Funded Research Exclusion (FRE) dictates that expenditures paid or incurred for research and development (R&D) conducted in Connecticut are not eligible for the state R&D tax credit if those activities are financially supported by a grant, contract, or other entity.1 Eligibility relies on meeting complex federal standards, specifically Internal Revenue Code (IRC) § 41(d)(4)(H), which govern the retention of intellectual property rights and the assumption of economic risk, subject to a critical Connecticut-specific exception for related parties filing a combined return.3

B. Key Findings and Recommendations for CT Taxpayers

Compliance with the Connecticut R&D tax credit provisions under Chapter 208, particularly those concerning the FRE, necessitates rigorous adherence to federal tax precedent. For Connecticut corporate taxpayers, the determination of qualified research expenditures (QREs) involves three core compliance pillars: the geographic specificity requiring work to be performed in-state 1, conformity to the federal definition of funded research (the risk and rights tests) 4, and the correct application of the state-level combined return override.3 Companies must proactively structure external contracts to ensure the assumption of financial risk and the retention of substantial intellectual property rights to qualify costs, while internal unitary funding mechanisms offer a valuable statutory bypass of these complex federal tests.

II. Statutory Framework: Connecticut’s R&D Tax Credit Landscape

A. Overview of Eligible Credits Under Chapter 208

The Connecticut R&D tax credits serve as mechanisms to reduce the tax imposed under Chapter 208 of the Connecticut General Statutes (CGS), known as the Corporation Business Tax.2 Connecticut offers two primary R&D credit structures, both of which utilize a common underlying definition of qualified expenditures that is strictly subject to the Funded Research Exclusion.

The first structure is the Research and Experimental (Incremental) Expenditures Tax Credit (RC). This credit is equal to 20% of the incremental increase in R&D expenses conducted in Connecticut, calculated as the excess of current year expenditures over the amount spent in the preceding income year.6

The second structure is the Research and Development (Non-Incremental) Expenses Tax Credit (RDC). This credit applies to a percentage of the current year’s R&D expenses and is structured based on a sliding scale dependent on a company’s gross receipts.8 Qualified Small Businesses (QSBs), generally defined as companies with gross income not exceeding $100 million in the previous income year, benefit most from this credit structure.2 Non-QSBs receive a lower rate, starting at 1% of expense up to $50 million, while the maximum rate of 6% is reserved for expenditures exceeding $200 million.8

It is essential that taxpayers select one credit for a specific set of QREs, as Connecticut law prohibits claiming both the RC and RDC on identical qualified expenses; an annual election must be made.9 Both credit types are generally subject to a limitation that they, along with other tax credits, cannot reduce the corporation income tax liability by more than 50.01%.6 Furthermore, credits earned in income years beginning on or after January 1, 2021, have a 15-year carryforward limit.7

B. Defining Qualified Expenses (QREs) under CGS § 12-217n

Connecticut’s definition of QREs is fundamentally linked to the federal Internal Revenue Code (IRC). CGS § 12-217n defines “Research and development expenses” by reference to two specific federal components: first, research or experimental expenditures deductible under IRC § 174 (as in effect on May 28, 1993), and second, basic research payments as defined under IRC § 41, to the extent not deducted under § 174.2

IRC § 174 expenses generally cover costs incident to the development or improvement of a product, formula, process, or invention, encompassing costs incurred in the experimental or laboratory sense.2 Examples of non-qualifying expenses explicitly excluded are general and administrative overhead, management studies, consumer surveys, advertising, and ordinary quality control testing.2

In addition to federal conformity, Connecticut imposes a strict geographic restriction: QREs must be paid or incurred for R&D and basic research that is conducted in this state.1 Expenditures conducted outside of Connecticut, even if otherwise federally qualified, are entirely excluded from the state credit base.11

C. Connecticut’s Mandate: Exclusion of Funded Research Expenditures

The most complex layer of qualification is the exclusion of funded research. The Connecticut statute unequivocally conditions eligibility on the requirement that the expenditures and payments are not funded, within the meaning of Section 41(d)(4)(H) of said Internal Revenue Code, by any grant, contract, or otherwise by a person or governmental entity other than the taxpayer.2

This statutory language signifies that Connecticut has formally adopted the federal standards for determining funded research. Consequently, the state R&D credit statute becomes inseparable from the technical regulations, Treasury rulings, and voluminous case law governing IRC § 41(d)(4)(H). By incorporating this specific federal code section, Connecticut adopts the technical definitions and interpretative regulations, such as Treasury Regulations § 1.41-4A(d).4 This legal adoption means state auditors from the Department of Revenue Services (DRS) are empowered to apply the same rigorous economic risk and intellectual property (IP) retention standards utilized by the IRS.

The requirement for uniform strict compliance regardless of the company’s size or structure forces all corporate taxpayers to master the federal tax law precedent concerning funded research. For a QSB electing to exchange a credit for a cash refund (available to those with gross income not exceeding $70 million and no tax liability 7), the financial consequence of failing to properly apply the FRE is magnified, as an adjustment could result in the clawback of a cash refund previously issued.

III. The Fundamental Legal Principle: Incorporation of IRC § 41(d)(4)(H)

The federal rule, adopted by Connecticut, mandates that all agreements entered into between the taxpayer performing the research and other persons must be considered in determining the extent to which the research is funded, not merely those formally designated as research contracts.4 The analysis hinges on two primary tests established in federal regulations: the economic risk standard and the substantial rights standard.5

A. Detailed Analysis of the Economic Risk Standard (The Risk of Loss Test)

The economic risk standard focuses on who bears the financial burden if the research is unsuccessful. If the performing taxpayer is reimbursed for costs regardless of the research outcome, the taxpayer has not assumed the risk and the activity is deemed funded and ineligible.

Amounts payable under an agreement are only treated as non-funding if they are contingent on the success of the research, meaning the payment is for the successful product or result of the research.4 This contingency mandates that the performing taxpayer must absorb the cost of failed experiments.12

The application of this standard is differentiated by contract type:

1. Cost-Reimbursable Contracts: These structures guarantee reimbursement of all allowable costs, regardless of the research outcome. Since the funding entity bears the financial risk, the contractor is ineligible for the R&D credit on related expenses. This structure is typically excluded under the FRE.12
2. Fixed-Price Contracts: When a contractor commits to delivering research for a set amount, they inherently assume the risk of cost overruns or failure. If the taxpayer performing the research absorbs the costs of failed experiments, they may pass the risk standard.12

To defend the credit effectively, it is insufficient merely to present a fixed-price contract. The performing taxpayer must be prepared to demonstrate through granular project-level tracking and accounting records that they bore the economic risk. This usually involves showing cost overruns or losses incurred on the contract. If a DRS auditor determines that the contractual profit margin was so large that the risk of actual financial loss was statistically improbable, they may still challenge the qualification under this standard.

B. Detailed Analysis of the Substantial Rights Standard (The IP Ownership Test)

The research is considered funded if the taxpayer performing the research retains no substantial rights in the results of the research activities.4

Substantial rights typically imply the right of the researcher to use the resulting intellectual property (IP)—including patents, formulae, and processes—in their own business, or the right to license them to others, even if the funder also receives rights.12 If the agreement requires the exclusive assignment of all resultant IP to the funding party (such as a governmental entity or an unrelated client), the researcher retains no substantial rights, and the research is excluded as funded.12

If either the Economic Risk test or the Substantial Rights test is failed, the related expenditure is excluded from the Connecticut QRE base.

IV. Connecticut Department of Revenue Services (DRS) Guidance and Compliance

A. DRS Technical Guidance on Definitions

DRS publications consistently reiterate the necessity of statutory conformity, confirming that R&D expenses must meet IRC § 174 standards, be conducted in Connecticut, and specifically exclude expenses funded “as provided in IRC § 41(d)(4)(H)”.2 The guidance clarifies that eligible expenses include costs incident to the development or improvement of a product, formula, or patent.2 Non-qualifying costs explicitly listed include general and administrative overhead, management studies, consumer surveys, and quality control testing.2

B. Documentation and Record-Keeping Mandates

Taxpayers are mandated to submit Form CT-1120RC, providing detailed project descriptions, expense methods, and employee roles.9 Records must be retained for audit support for at least four years.9

For DRS audit purposes, the burden of proof is high concerning compliance with the FRE. Documentation must substantiate not only that the research occurred in Connecticut 2 but also, for contracts with unrelated parties, that the taxpayer met both the risk of loss and substantial rights standards.4

Furthermore, for projects involving mixed funding—where only a portion is considered non-funded and thus qualified—DRS expects clear cost separation to be maintained between the qualified and non-qualified expenditures.12 If a $1 million project is 50% government-funded and 50% self-funded, the taxpayer must provide precise accounting data (timecards, ledger accounts) that separates the self-funded component. Failure to achieve this granular cost separation, even if a portion of the work was genuinely self-funded, can lead an auditor to disqualify the entire expense, citing the inability to substantiate the qualified allocation.12

V. The Critical CT Modification: The Combined Return Exception

A. Statutory Operation and Purpose

CGS § 12-217n(1)(B) provides a crucial statutory modification to the federal FRE rules. It grants an absolute waiver of the funding exclusion test when the person or governmental entity providing the funding is included in a combined return with the person paying or incurring the expenses.3 The term “Combined return” refers specifically to a combined unitary tax return under CGS § 12-222.3

This exception significantly alters the compliance landscape for multistate or multinational corporations subject to Connecticut’s mandatory unitary reporting. Within a unitary group that files a combined return, the funding is treated as internal to the consolidated taxpayer.

B. Implications for Unitary Groups and Intercompany Transactions

This exception allows Connecticut unitary groups to structure R&D funding across related entities without subjecting the intercompany payments to the rigorous IRC § 41(d)(4)(H) risk and rights assessments. This mechanism bypasses the complexity required for external, unrelated commercial contracts.

For the exception to apply, the funding entity must be included in the CT combined return. However, it is paramount to note that the FRE waiver does not override the geographic restriction. The research activities themselves must still be conducted in Connecticut to qualify.3 Intercompany funding of R&D performed outside of the state remains ineligible due to the geographic nexus test.

The statutory construction offers a superior planning environment compared to federal controlled group rules. Federally, taxpayers often still need to prove economic risk within the controlled group. In Connecticut, being part of the combined return under CGS § 12-222 is sufficient to qualify the expenditure, provided the actual work is performed in-state. This simplifies compliance for internal transactions within large corporate taxpayers, provided the parameters of the combined return filing are strictly met.

VI. Detailed Application Case Study: Determining Qualified Expenditures

A. Hypothetical Entity Setup and Project Descriptions

Entity Profile: AeroTech CT Solutions, Inc. (AeroTech) is a Connecticut-based R&D company. AeroTech is a Qualified Small Business (QSB) and files a combined unitary return with its Parent, Aero Holdings Corp. (AHC).

B. Analysis of Funding Agreements

1. Project Sigma: Government Fixed-Price Contract with IP Assignment

The funding source, NASA, is a governmental entity and is not included in AeroTech’s combined return. Therefore, the IRC § 41(d)(4)(H) tests must be applied. Although the fixed-price structure suggests AeroTech bore the economic risk (Risk Standard passed), the contract mandates that NASA retains exclusive rights to the resulting sensor technology IP. By failing the Substantial Rights Standard 4, the research is considered funded.

Conclusion: The entire $1,500,000 is Excluded from Connecticut QREs.

2. Project Tau: Unrelated Customer Cost-Reimbursable Contract

Client X is an unrelated entity not included in the combined return, requiring the application of the FRE tests. The contract is cost-reimbursable, meaning Client X guarantees payment for all allowable costs, regardless of the research outcome.13

Since AeroTech is guaranteed reimbursement, it does not bear the economic risk of failure, causing the activity to fail the Economic Risk Standard.12

Conclusion: The entire $500,000 is Excluded from Connecticut QREs.

3. Project Delta: Related-Party Funding (AHC)

The funding was provided by AHC, which is included in the Connecticut combined unitary return with AeroTech.3

The Connecticut Combined Return Exception applies, bypassing the requirement to perform the IRC § 41(d)(4)(H) tests.3 The expense is treated as self-funded by the unitary group.

Conclusion: The entire $200,000 is Qualified for the Connecticut R&D tax credit.

C. Calculation of Excluded vs. Qualified Research Expenses (QREs)

The analysis confirms that the total potential QRE base of $2.2 million is sharply reduced due to the rigorous application of the Funded Research Exclusion.

Table 3: Comprehensive Working Example: Calculation of Qualified Expenses (AeroTech CT Solutions, Inc.)

VII. Conclusions and Expert Recommendations for Compliance

The Connecticut R&D tax credit regime demands high technical proficiency, effectively requiring taxpayers to integrate complex federal funding analysis directly into state tax compliance. The Funded Research Exclusion serves as a powerful statutory constraint, eliminating large portions of R&D investment from the credit base if contractual structures are not optimized for tax purposes.

Taxpayers must recognize that the decision regarding credit eligibility is often determined at the contract drafting stage. For external, unrelated contracts, the immediate priority must be ensuring that the agreement avoids language that guarantees payment regardless of success (thereby failing the economic risk test) and that avoids exclusive assignment of resulting IP (thereby failing the substantial rights test).

For internal transactions, the strategic value of the Combined Return Exception cannot be overstated. By leveraging the combined unitary filing under CGS § 12-222, corporate groups can bypass the challenging federal funded research tests, effectively treating intercompany-funded R&D performed in Connecticut as automatically qualified, provided stringent record-keeping is maintained to document the geographic location of the research activity. Adherence to these strictures is essential for maximizing R&D tax benefits and successfully navigating DRS audits.

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