Change the IRS’s “Private Use in Bonded Facilities” Regulation

IRS_iStock_000017797441SmallEditor’s note: The following is an excerpt of Laura A. Schoppe’s submission in response to a request from the Office of Science and Technology Policy (OSTP) and the National Economic Council (NEC) for input into an upcoming update of the “Strategy for American Innovation.

I wish to offer an answer to the request for information’s (RFI’s) third Overarching Question: What specific actions can the Federal Government take to build and sustain U.S. strengths including its entrepreneurial culture, flexible labor markets, world-class research universities, strong regional innovation ecosystems, and large share of global venture capital investment?

My answer: Change Section 6.02 of Revenue Procedure 2007-47 (from IRB 2007-29 issued on July 16, 2007) regarding corporate-sponsored research so as to better ensure that such innovative R&D occurs in U.S. universities rather than overseas. This change can serve as a no-cost solution that can have a positive impact on local/regional economies without creating a financial burden on the federal government or on U.S. taxpayers.

This RFI response provides an overview of the current regulations and the deleterious effect they are having on innovation.

The Current Regulation

The regulation—which is referred to as “private use in bonded facilities”—reads as follows:

Internal Revenue Bulletin: 2007-29 | Revenue Procedure 2007-47

Section 6.02 Corporate-sponsored research. A research agreement relating to property used for basic research supported or sponsored by a sponsor is described in this section 6.02 if any license or other use of resulting technology by the sponsor is permitted only on the same terms as the recipient would permit that use by any unrelated, non-sponsoring party (that is, the sponsor must pay a competitive price for its use), and the price paid for that use must be determined at the time the license or other resulting technology is available for use. Although the recipient need not permit persons other than the sponsor to use any license or other resulting technology, the price paid by the sponsor must be no less than the price that would be paid by any non-sponsoring party for those same rights. [emphasis mine]

In other words, public universities cannot accept funding contracts that have pre-negotiated royalty rates. A company that pays a public university to conduct R&D cannot know in advance the price they will need to pay to license the outcomes of that R&D. Despite the fact that it risked its own resources to have the university conduct cutting-edge R&D that ultimately may yield nothing patentable or commercializable, the company must pay the same rate that would be paid by any party, including one that did not pay for the research.

This is problematic for companies that understandably want some assurances on ownership of the intellectual property (IP) that might emerge from the research they are funding. The sponsored research agreement (SRA) can include a “first right of refusal” provision, whereby the company can pay to acquire the IP if they want it (and if they do not, the university can license it to anyone). However, the company will want to minimize the risk associated with the IP-ownership acquisition. If the company were hiring another business to do the R&D, the parties would pre-negotiate the license fees or enter a work-for-hire arrangement where IP ownership automatically goes to the funder. But in the case of a public university, research sponsors cannot pre-negotiate the license fees because to do so would jeopardize the university’s tax-exempt status, according to Rev. Proc. 2007-47§6.02.

A Regulation Out of Synch with Reality

The intention of the “private use in bonded facilities” regulation was to prevent companies from receiving what essentially amounted to a subsidy by having their R&D conducted in a building funded through publicly issued bonds. This avoidance of “corporate welfare” may have made some sense in an era when public universities were flush with government funding that was not tied to any specific research, when full-cost accounting was not the norm, and when academic researchers had the time and money to do what they wanted in their labs.

Ask any researcher in a public university and he or she will tell you that things have changed:

  • Public universities are not receiving as much support from the state as they used to. Therefore, researchers are fighting for every dollar, whether it comes from dwindling federal funds or from private companies.
  • Corporate research is funded by companies, and companies pay fair market value for that research. (If they didn’t, the researcher would pursue R&D funding from another source.)
  • Universities are performing full-cost accounting, including overhead fees associated with the facilities in which the sponsored R&D is conducted. Therefore, the company is paying for the use of any publicly funded facilities used in conducting the R&D.
  • Research projects are not untargeted, and universities cannot do R&D without money being provided from some source. This research leads to future innovations for this country.

In short, the “private use in bonded facilities” regulation is outdated and no longer aligned with the reality of R&D in public universities. Not only is it mitigating a non-existent risk, the regulation is being recognized more and more as a problem, as noted by Dr. Elizabeth Hart-Wells during the July 24, 2013, hearing of the U.S. House Subcommittee on Research and Technology on “Improving Technology Transfer at Universities, Research Institutes and National Laboratories.” Dr. Hart-Wells was Assistant Vice President for Research as well as Associate Director of the Burton D. Morgan Center for Entrepreneurship at Purdue University. She said the following in response to a question from Rep. Ami Bera about the tax code issues associated with university partnerships with entrepreneurs/industry:

We run into this and we have this conversation—actually more vigorous conversations more recently.… There is a prohibition on basically for-profit activities in those spaces [i.e., private use in bonded facilities]. So that is actually an input in the analysis that is often not considered… in the dialogue on the outside but is a critical go/no-go of whether a university can even undertake a partnership, whether it wishes to or not. It would be very appropriate in the context of all of the conversations about realizing the value of federally funded research through products and services, where appropriate, to consider and take up the question of “private use” and its impact—positive and negative—on this whole ecosystem.

The Damages from the Current Regulation

The negative impact of the “private use in bonded facilities” regulation is real, measurable, and far-reaching:

  • A Tracking Burden for Universities: Because of this regulation, public universities have to track which buildings—or portions thereof—were funded by public bonds and how much of the research in those buildings is corporate sponsored versus federally funded. This not only is difficult but also leads to the inefficient use of resources. For example, one U.S. public university uses different colored carpeting in buildings to virtually “tape off” areas that can and cannot be used for corporate sponsored research. As this example demonstrates, the IRS rule creates a logistical burden that universities would not have to suffer if the regulation were changed.
  • Sharing Across Campuses Is Impossible: Section 2.01 of Rev. Proc. 2007-47 specifies that up to 10 percent of a public bond can be used for any private business use. However, this attempt to be generous becomes an administrative nightmare for multi-campus universities, such as the 17-campus system of the University of North Carolina. The rule allows the 10 percent to be shared across the system, which in theory would be useful if some campuses do not need their full 10 percent. In reality, private business use is so difficult to track that most universities do not even bother to try for fear of running afoul of the IRS and therefore hold back on fully reaping the benefits of the 10 percent exception.
  • Companies Perceive Universities as Hard to Work with: Most corporations do not know about this IRS rule and therefore do not understand why universities are not willing to pre-negotiate a license for research they are paying for (and when it is explained to them, they surely don’t like it). With federal research dollars being reduced, universities are forced to obtain more funding from corporations. However, this IRS rule makes it more difficult for them to secure the corporate funding needed to continue valuable research that has benefits beyond just the company’s interests (e.g., progressing science, funding graduate students, discovering an enabling capability). This is in direct conflict with the Administration’s growing emphasis on cooperation and collaboration between universities and industry.
  • Companies Perceive Universities as Greedy and Adversarial: Under the current IRS regulation, companies can pay to have research done at a public university, but they essentially have to do it as a grant. If any IP results from the R&D, they cannot lay claim to it any more than anyone else can, even though they funded it. Without a guarantee, companies understandably become suspicious that the university will later hold the IP hostage. This is by no means the reality, but it is what companies fear. And their concern is understandable.
  • Companies Are Taking Their R&D Dollars Overseas: If a company has $500,000 to invest in R&D and can choose between a university that will guarantee a specific licensing fee and one that will not, it stands to reason that they will choose the former. And they are doing so, directing their R&D dollars to non-U.S. universities. (Note: I have been told point-blank by representatives of at least three companies that, rather than deal with the limitations that the IRS rule placed on their SRAs with U.S. universities, they are now having the R&D performed overseas.) Furthermore, universities in Europe understand this problem and are starting to take advantage of it, emphasizing the IRS issue when they market their R&D labs to U.S. companies.

If the OSTP and NEC want to ensure that cutting-edge research will be conducted in the U.S., that our nation’s universities continue to be deemed world-class by all, that our historical investments in science and engineering reap economic benefits for our citizens, then I urge you to change IRS Revenue Procedure 2007-47§6.02 so that companies funding research at public universities can pre-negotiate their license rates.

Thank you for your consideration. If you would like to discuss this topic further, feel free to contact me.

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Posted by Laura Schoppe

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