                        T.C. Memo. 1996-153



                      UNITED STATES TAX COURT



  GENERAL DYNAMICS CORPORATION AND SUBSIDIARIES, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 19202-94.                     Filed March 26, 1996.



     David C. Bohan, James M. Lynch, Richard T. Franch, and

Philip A. Stoffregen, for petitioner.

     William H. Quealy, Jr., and Alice M. Harbutte, for

respondent.



                        MEMORANDUM OPINION

     GERBER, Judge:   Petitioner moved, in limine, to preclude

respondent from questioning further or litigating the amount of
                               - 2 -

research credits claimed under section 411 in connection with

fixed-price Government contracts.    For the reasons expressed

hereinafter, petitioner’s motion will be denied.

Background

     This case was specially assigned to this division of the

Court by an April 4, 1995, order.    The parties were placed under

a pretrial schedule, and trial was set to begin April 29, 1996.

One of the issues involved whether petitioner was entitled to

research credits in connection with fixed-price Government

contracts.   Although petitioner had claimed other research

credits on its original returns for the years in controversy, no

research credits had originally been claimed with respect to

fixed-price Government contracts.

     The credits claimed on petitioner’s original returns were

examined by respondent’s engineer.     During 1991, the engineer

issued a report concerning the credits claimed on the original

returns.   Respondent mailed a notice of deficiency during 1994




     1
       Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the periods under
consideration. The taxable years in this case are 1985 and 1986.
Sec. 41 was added in the Tax Reform Act of 1986, Pub. L. 99-514,
sec. 231(d)(2), 100 Stat. 2085, 2178, as a successor to sec. 30.
Sec. 30 was added by the Tax Reform Act of 1984, Pub. L.98-369,
secs. 471(c), 471(i)(1), 98 Stat. 494, 826, 831, as a successor
to sec. 44F. The research tax credit was established as sec. 44F
in the Economic Recovery Tax Act of 1981, Pub. L. 97-34, sec.
221(a), 95 Stat. 172, 241. Rule references are to this Court’s
Rules of Practice and Procedure.
                                - 3 -

that, in part, made adjustments to the originally claimed credits

and was based on the engineer’s 1991 report.

     During 1992, petitioner filed administrative claims on Forms

1120X seeking overpayments attributable to research credits in

connection with fixed-price Government contracts (increased

credits).   Because petitioner had not originally accounted for or

claimed the increased credits, an accounting firm (accountant)

was engaged to identify and quantify the amount of the increased

credits.    It was necessary to determine from among the costs in

fixed-price Government contracts those expenditures which

qualified for the research credit.      The accountant was not able

to develop the amount of the research credits based on references

to particular contract line items or based on some method that

was specifically related to the contract terms.

     Petitioner has explained that its costs were collected and

accounted for by work orders that were grouped by reference to an

aspect of various products under development or production.     By

analyzing work orders and interviewing petitioner’s employees,

the accountant developed an amount that petitioner claimed

qualified for the credit.   Respondent assigned the engineer who

had examined the credit claimed on petitioner’s original returns

to examine petitioner’s claim for increased credits.     The

engineer, after examining the accountant’s materials and

recommending adjustments, issued a report in 1994 prior to the

issuance of the notice of deficiency, recommending that the
                               - 4 -

increased credits be disallowed.   In addition, the engineer’s

1994 report reflected an amount that the engineer believed was

allowable if respondent was incorrect regarding the legal theory

for disallowance of the research credits attributable to fixed-

price Government contracts.   The 1994 notice of deficiency made

no reference to the increased credits claimed by petitioner.

     At the time of the engineer’s 1994 report, the Government

was engaged in litigation with another taxpayer involving a

substantially similar theory for disallowing research credits

attributable to fixed-price Government contracts.   At the time of

the issuance of the notice of deficiency and the filing of the

petition in this case, respondent’s legal approach had been

approved by the Court of Federal Claims.   See Fairchild Indus.,

Inc. v. United States, 30 Fed. Cl. 839 (1994).   The decision in

Fairchild was on appeal during the pendency of this Court’s

pretrial order.

     In its petition, petitioner claimed entitlement to the

increased credits, and, in her answer, respondent denied that

petitioner was entitled to such credits.   In an October 1995

status report to the Court, respondent stated, concerning the

issue of whether petitioner was entitled to the increased

credits, that “the parties expect to enter into stipulations

which establish the amounts of increase in petitioner’s R&E

[research] Expenses for each period.   The issue will be whether

these R&E [research] Expenses were ‘funded’ by the contracts.”
                                 - 5 -

In other words, respondent reported that it was expected that the

parties would be able to agree on the amount of the expenses and,

hence, the substantiation of the credits, leaving the legal issue

for the Court’s consideration.

     The focus of the legal issue was whether petitioner’s

research, which was performed pursuant to fixed-price Government

contracts, was “funded” within the meaning of section

41(d)(4)(H). The question of whether the research was funded is

dependent on whether the amounts petitioner received under the

fixed-price Government contracts were “contingent on the success

of the [petitioner’s] research and thus considered to be paid for

the product or result of the research”.   Sec. 1.41-5(d)(1),

Income Tax Regs.

     During November 1995, the Court of Appeals for the Federal

Circuit reversed the decision, Fairchild Indus., Inc. v. United

States, 71 F.3d 868 (Fed. Cir. 1995).    Following this reversal of

fortune for the parties in this case, respondent advised that she

would concede the legal issue that had been decided by the Court

of Appeals.   Respondent’s counsel also advised that they were not

prepared to stipulate to the amount of research credits based on

the engineer’s 1994 report, but that petitioner must quantify the

amount of expenses underlying any credit with respect to fixed-

cost Government contracts by reference to the contract line items
                                 - 6 -

or other contract provisions.2    The accountant’s methodology,

which had been examined by respondent’s engineer, would not

satisfy the approach that respondent now contends is appropriate.

Respondent does not contend that her method will result in a

larger or smaller credit than the amount reflected in the

engineer’s report.    She only argues that it is necessary to

compute the amount of the credit based on the terms of the

contract.

     Petitioner objected to respondent’s refusal to stipulate to

the amount of the increased credit contained in respondent’s

engineer’s report, on the following grounds:    (1) Respondent

should be held to the amount agreed to by the engineer, and,

further, respondent should be precluded from reauditing3 and

     2
       Respondent contends that petitioner is required to
identify research expenditures in terms of each contract line
item in the fixed-price Government contracts. Respondent bases
her contention on language in the opinion of the Court of
Appeals, as follows:
     The Court of Federal Claims correctly held that the
     availability of the credit does not depend on whether the
     researcher is in fact paid; it depends, as stated in
     Treasury Regulation § 1.41-5(d)(1), on whether, by the terms
     of the research agreement, payment is contingent upon
     development of a specified "product or result," to be paid
     "contingent on the success of the research." [Fairchild
     Indus., Inc. v. United States, 71 F.3d 868, 872 (Fed. Cir.
     1995), revg. 30 Fed. Cl. 839 (1994).]
     We do not intend to decide in this opinion whether
petitioner’s accountant’s approach or the approach that
respondent contends should be followed is the correct approach.
Our focus is solely on the procedural questions raised and relief
sought in petitioner’s motion.
     3
         Petitioner has couched the language of its motion in terms
                                                     (continued...)
                               - 7 -

litigating the amount of the increased credit, and alternatively,

(2) if respondent is not precluded from reauditing and/or

litigating the amount of the increased credit, the Court should

exercise its discretion under Rule 142 to shift the burden of

proving any decrease in the amount of the credit to respondent

because respondent’s engineer had agreed to a number in her 1994

report.


Discussion

     (1) Is respondent bound by the findings in the engineer’s

report?

     Initially, we agree with respondent that no binding

agreement regarding the amount of the increased claims exists

between the parties in this case.   The reversal in Fairchild was

the catalyst for the parties’ current disagreement.   Respondent’s

engineer likely considered the Government’s pending litigation in

the Court of Federal Claims in the Fairchild case when writing

the report concerning the amount of the research expenses and,

hence, the credit.   Respondent’s counsel was aware of the

favorable legal precedent when they advised the Court that the



     3
      (...continued)
of reauditing the amount of the credit in this Court. The
question is more correctly centered on the issue of whether
respondent is bound or estopped from questioning the amount of
the credit petitioner claimed in its petition. This matter does
not involve a question of whether a second examination was or
should be conducted within the meaning of sec. 7605(b).
                               - 8 -

parties were attempting to stipulate to the amount of the credit

and only the legal question would be presented to the Court.

     After the Court of Appeals’ reversal of the lower court in

Fairchild, respondent decided to concede the legal issue

(regarding funding).   Respondent, for the first time, contended

that, based on the appellate court’s rationale, petitioner was

required to show the amount of research expenses in connection

with a particular line item in the fixed-price Government

contracts.   In that regard, petitioner, under respondent’s

approach, would be more specifically required to show that the

contract language for that item supports the conclusion that

payment is contingent on development of a specified product or

result, so as to have been paid contingent on the success of the

research.

     We note that petitioner’s grievance is not without

substance.   After all, respondent’s engineer had reflected an

adjusted (reduced but apparently agreeable to the engineer)

amount of research credit in her report.   Those circumstances had

provided petitioner with comfort concerning the resolution of the

quantitative aspects of the research credit controversy.

Ultimately, however, we view the question here as one of timing

and prejudice.   This is so because no enforceable agreement had

been entered into by the parties.   Accordingly, we must consider

whether respondent timely raised the requirement and whether
                               - 9 -

petitioner has been prejudiced in terms of its opportunity to

have a fair trial on the merits of the items in controversy.

     We find that respondent’s action was timely in the setting

of this case.   The parties were preparing for a trial to begin

April 29, 1996.   The litigation had proceeded only a few months

into the pretrial schedule and was about 6 months from trial date

when the Court of Appeals’ holding changed the slant of the legal

playing field concerning the funding issue.   This Court

informally agreed with the parties that they would be given time

to consider the effect of the Court of Appeals’ holding.    In

addition, we were disposed to continue the funding issue from the

scheduled April 29, 1996, starting date.   Approximately 1 month

after the Fairchild reversal, respondent announced her concession

of the legal issue and that it would be necessary for petitioner

to tie the amount of the credit to the contract language.    At

that point, the parties agreed to proceed to trial on the other

unresolved issue(s) beginning April 29, 1996, and that any trial

concerning the funding issue should be delayed.   The Court agreed

to continue the funding issue for a reasonable time to give the

parties an opportunity to evaluate the effects of the concession

and respondent’s position on quantification of the research

credit.

     Petitioner refers us to Durkin v. Commissioner, 87 T.C.

1329, 1402-1403 (1986), affd. 872 F.2d 1271 (7th Cir. 1989), for

its contention that this Court’s Rules and Procedures are not to
                               - 10 -

be used by respondent to conduct an audit.   In that case, the

Commissioner had issued notices of deficiency with “little, if

any, prior investigation”, and respondent’s attorney had

attempted, through discovery and subpoenas, to conduct the

investigation ordinarily carried on by respondent’s agents.      Id.

at 1402.   Reflecting upon that situation, we stated that “The

processes of this Court are simply not designed to be used to

conduct a thorough investigation of a complex tax case.”     Id. at

1403.

     Respondent counters that Durkin v. Commissioner, supra, is

not applicable here because the increased credits were not

addressed in the notice of deficiency but, instead, were placed

in controversy by petitioner’s allegations in its initial

pleading (petition).    Respondent points out that, in her answer,

she denied petitioner’s claim for the increased credits, and that

it remains petitioner’s obligation and burden to show entitlement

to research credits in connection with the fixed-price Government

contracts.   We agree with respondent.   Based on the foregoing, we

hold that respondent is not bound by the agreement in her

engineer’s report.

     (2) Should the burden of proof be shifted to respondent with

respect to the amount of the research credit on fixed-price

Government contracts?

     Because we have held that respondent may question the amount

of the credit, we must address petitioner’s alternative request
                              - 11 -

that the Court shift the burden of proof to respondent with

respect to the amount of the credit.    In this regard, petitioner

refers us to Rule 142(a) and suggests that we use our discretion

to shift the burden to respondent.     Petitioner does not provide a

specific reason for our shifting the burden to respondent;

petitioner only argues that it would be appropriate.

     Rule 142(a) generally places the burden of proof on

petitioner except as provided by statute or determined by the

Court.   In that regard, under Rule 142(a), the burden is shifted

to respondent “in respect of any new matter, increases in

deficiency, and affirmative defenses”.    In addition, this Court

has authority to sanction a party in appropriate circumstances,

including shifting of the burden of proof.    See Rule 104.

Shifting the burden of proof, in particular, has been described

as a relatively harsh sanction.   See, e.g., Estate of Spear v.

Commissioner, 41 F.3d 103 (3d Cir. 1994), vacating and remanding

T.C. Memo. 1993-213.

     “The assertion of a new theory which merely clarifies or

develops the original determination without being inconsistent or

increasing the amount of the deficiency is not a new matter

requiring shifting of the burden of proof.”     Achiro v.

Commissioner, 77 T.C. 881, 890 (1981) (and cases cited therein);

see also Seagate Tech., Inc., & Consol. Subs. v. Commissioner,

102 T.C. 149, 169 (1994).
                              - 12 -

     Respondent argues that her contention that the amount of the

credits must be substantiated as described above is a new theory

and not “new matter” within the meaning of Rule 142(a).

Respondent goes on to point out that her new theory “merely

clarifies or develops respondent’s original determination without

requiring the presentation of different evidence, is not

inconsistent with respondent’s original determination, or does

not increase the amount of the deficiency.”

     We do not agree with respondent’s statement that the “new

theory” will not require the presentation of different evidence,

because, if respondent is correct about the method of determining

the amount of the credit, petitioner may be required to develop

and employ a different methodology from that used by its

accountants to calculate the credits.

     We do agree, however, that respondent’s approach is a

different theory rather than new matter.   It represents a new

theory for respondent’s denial of the claim for increased

credits.   We note that respondent’s position in this case is not

derived from the notice of deficiency, but from respondent’s

answer in response to petitioner’s allegation in its petition.

     In this case, respondent did not make a determination in her

notice of deficiency concerning the increased credits.    Instead,

petitioner made allegations in its petition seeking the benefit

of such.   The examination of petitioner’s returns that led to the

issuance of the notice of deficiency and this controversy did not
                                - 13 -

address the increased credits.    The increased credits were part

of a collateral matter in which petitioner had made claim for

overpayments based on its claim for increased credits

attributable to fixed-price Government contracts.   That claim has

not been formally acted on by respondent.

     Petitioner’s claim for overpayment, involving a series of

years, including the ones at issue here, had proceeded along a

parallel path and was not formally incorporated into this

proceeding until petitioner made its allegations in its petition.

Respondent’s engineer had reviewed the claim and recommended that

it be denied.   The engineer, acknowledging that petitioner would

be entitled to some increased credits if successful on the legal

issue, merely made proposed adjustments which reduced the total

amount of the credit petitioner had claimed.   That total amount

was reflected in the engineer’s report.   Petitioner agrees with

and relies on the amount proposed by the engineer for purposes of

this litigation.   However, respondent’s counsel does not agree to

the amount and, instead, contends that petitioner must show a

relation to the contract language to be entitled to the credit.

The key fact here is that the parties did not enter into a

binding agreement with respect to the amount of the increased

credit.   Accordingly, petitioner continues to bear the burden of

proving the amount of the credit, and respondent, in the context

of this litigation, has not bound herself to the adjustment that

was proposed by her engineer.
                              - 14 -

     That scenario leaves respondent free to argue positions or

theories that she believes set the standard that petitioner must

meet to satisfy its burden of proof.   As discussed above, the

advancing of theories in that setting is subject to timeliness

and fairness.   Accordingly, respondent is not precluded from

contending that petitioner must show the relationship between the

expenditure and the contract provisions is nothing more than

respondent’s theory. Petitioner’s burden of proof on this issue

will not be shifted to respondent.

     Finally, respondent has not shown bad faith or any willful

act for which a sanction should be considered.   The parties

ideally should develop and adhere to their theories at the

earliest possible time in the controversy process.   In practice,

that level of foresight and consistency is not always achieved.

Indeed, petitioner’s claim for the increased research credits was

not part of its original return.   Instead, it surfaced near the

end of the administrative process preceding this litigation.

That is a different setting from one where an issue is raised in

a taxpayer’s return and developed in the normal course of an

audit.   The circumstances of this case fit within the reasonable

limits of controversy development, and no remedial action to

shift the burden is needed.   Petitioner continues to bear the

burden of proving the amount of the increased credit.   In that

regard, the Court is prepared to allow an adequate pretrial

period within which the parties may develop their approaches and
                                - 15 -

attempt to resolve any differences they may have concerning the

amount of petitioner’s claim.

     To reflect the foregoing,

                                      An appropriate order will be

                                 issued.
