Research funded by any grant, contract or otherwise by another person or governmental entity is excluded from qualified research. The purpose is to credit the party that takes the risk of the research, once. The regulations turn that purpose into two tests, and a great deal of customer-funded engineering, government-contract work and sponsored research turns on them.
What it is
Research is treated as funded, and so excluded, to the extent that either of two conditions holds:
| Test | Question | Funded (excluded) when | Not funded when |
|---|---|---|---|
| Contingent payment | Does the taxpayer get paid whether or not the research succeeds? | Payment is for the work itself, regardless of outcome: time and materials, cost-plus, fixed milestone fees for effort | Payment depends on delivering a working result; the taxpayer bears the cost of failure |
| Substantial rights | Can the taxpayer use the results in its own business without paying for them? | The customer owns the results exclusively and the taxpayer must pay to use them | The taxpayer keeps a right to use the results, even non-exclusively |
The two tests are independent. A fixed-price contract where the taxpayer bears the risk of failure but assigns all rights to the customer is funded. A contract that leaves the taxpayer the rights but pays cost-plus is funded. Only work that passes both tests stays in the claim.
Who it applies to
Two parties face the exclusion from opposite sides. The contractor performing the research asks whether its work for the customer is funded. The customer paying for the research asks whether its payment is a contract research expense, which requires the same two conditions in mirror image: the customer bears the expense even if the research fails and retains substantial rights. If the contractor's work is funded, the customer may claim 65% of the payment; if it is not funded, the contractor claims its own costs. In some arrangements neither party qualifies, and in none do both qualify for the same work.
Grants follow the same logic. A grant that reimburses costs regardless of outcome funds the research to the extent of the grant; the grantee can claim only costs in excess of the funding.
How it works
Read the contract. The analysis is contract by contract, and clause by clause. Payment terms decide the first test. The intellectual property, licence and confidentiality clauses decide the second. Where a contract is silent on rights, the regulations treat the taxpayer as retaining them only if that is the legal result; courts have read the clauses closely, and an advisor should too.
Apportion where needed. Where a project is partly funded, the funded portion is excluded and the rest can qualify. Where payment is contingent for some deliverables and not others, each deliverable is analysed on its own.
Substantial rights do not mean exclusive rights. A non-exclusive right to use the research results in the taxpayer's business, without paying the funder, is enough. A right that is incidental, such as the right to use the results only in performing the same contract, is not.
Government contracts. Federal contracts are analysed the same way. Many are cost-reimbursement, which fails the contingent payment test, and many allocate rights to the government with a licence back; the licence back can be a substantial right. Cost-plus-fixed-fee development contracts are the usual example of funded research from the contractor's side.
| Arrangement | Contingent on success? | Taxpayer keeps substantial rights? | Result for the taxpayer |
|---|---|---|---|
| Fixed price for a working prototype; taxpayer keeps a licence to reuse the design | Yes | Yes | Not funded: claim |
| Time and materials engineering services; customer owns everything | No | No | Funded: excluded |
| Fixed price for a working result; customer owns everything, no licence back | Yes | No | Funded: excluded |
| Cost-plus development; taxpayer retains background IP and a licence to the results | No | Yes | Funded: excluded |
| Grant reimbursing 50% of project cost regardless of outcome | No, for the funded half | Yes | Funded as to 50%: claim the other half |
Worked example
Illustrative example. Ashby Engineering, a hypothetical firm, develops a new filtration module for a customer, Varley Water, under a fixed-price contract of US$800,000. Ashby bears the cost if the module fails its specification; the contract gives Varley ownership of the module design but grants Ashby a perpetual licence to use the filtration method in other products. Ashby's costs are US$650,000, of which US$500,000 are QREs.
Contingent payment: yes, Ashby is paid only for a module that meets specification. Substantial rights: yes, the licence to reuse the method is a right to use the results in Ashby's business. The work is not funded, and Ashby claims the US$500,000 of QREs. Varley, which paid US$800,000, cannot claim contract research for the same work because it did not bear the expense of failure. Had the contract paid Ashby monthly for hours worked, the work would have been funded, Ashby would claim nothing, and Varley might claim 65% of its payments if it retained substantial rights.
Common questions
Our customer pays in milestones. Is that contingent? It depends whether a milestone is paid for reaching a result or for completing a period of effort. Read the acceptance clauses.
We keep the know-how but the customer owns the product. Which is it? If the retained know-how can be used in your business without paying, that is usually a substantial right; if it is limited to the same contract, it is not.
Does a government grant exclude the whole project? Only to the extent of the funding, and only if the grant pays regardless of outcome.
Related pages
- Contract research from the customer's side
- The statutory exclusions
- How examiners test funded research
- Guide: how grants affect your claim
- Guide: contractors and subcontracted R&D
Official sources
Educational content only, not tax advice. See the disclaimer.