Appeal of First Solar, Inc.

First Solar, Inc. claimed $2,208,925 in California research and development credit carryforwards on its 2013 franchise tax return, generated between 2006 and 2009 by OptiSolar Inc., a solar technology and project-development company First Solar had acquired. OptiSolar's audited financial statements reported a total research and development expense line item and disclosed roughly $2.2 million and $2.4 million in federal and state R&D credit carryforwards as of the end of 2008, but contained no working papers or itemization of the underlying expenses. The Franchise Tax Board audited First Solar's 2013 return and disallowed the entire OptiSolar credit, finding First Solar had not retained records sufficient to substantiate that the claimed expenditures were eligible.

The Evidentiary Record

At the hearing, First Solar relied on four categories of evidence: OptiSolar's audited financial statements; a list of fifteen patent applications OptiSolar filed between 2007 and 2009 (eight of which the FTB conceded issued as patents); documents from an unrelated IRS audit of First Solar's 2011 tax year that did not adjust the federal research credit; and testimony from Dr. Marvin Keshner, OptiSolar's co-founder and former Chief Technology Officer, describing OptiSolar's research activities in general terms.

Audited Financial Statements Do Not Establish the Four Qualified Research Tests

First Solar argued that the audited financial statements, prepared consistent with the methodology underlying the IRS's ASC 730 Directive (an administrative program letting large-business taxpayers use audited financial-statement R&D figures to streamline federal audits), either satisfied or excused it from proving the four qualified research tests under IRC section 41(d). The Office of Tax Appeals rejected this, explaining that the IRS Directive itself disclaims determining whether financial-statement R&D expenses constitute qualified research, requires specific adjustments and supporting books and records the record here did not contain, and — even under the Cohan estimation doctrine — audited financial statements can support estimating the amount of a credit only after a taxpayer has first proven, as a threshold matter, that its activities satisfy the four qualified research tests.

Patents and Testimony Did Not Close the Gap

The Office of Tax Appeals acknowledged that OptiSolar's issued patents triggered the patent safe harbor of Treasury Regulation section 1.41-4(a)(3)(iii), conclusively establishing the technological-in-nature and business-component tests for the patented components. But it held the safe harbor does not reach the section 174 test or the process-of-experimentation test, and that a patent covering one business component does not make all of a taxpayer's research qualified. Dr. Keshner's testimony, while credible, was found too general to establish that 'substantially all' of OptiSolar's research activities constituted a genuine process of experimentation, and it never tied specific research activities to the financial statements' aggregate R&D figure or distinguished research performed in California from research performed in Canada, where OptiSolar also operated.

The Office of Tax Appeals sustained the Franchise Tax Board's disallowance of the entire OptiSolar research credit for the 2013 tax year.

Significance: Designated precedential, this decision is a controlling California authority on two recurring substantiation questions — that an IRS ASC 730 Directive letter does not itself prove qualified research under the four-part test, and that even the patent safe harbor only carries a taxpayer through two of the four required tests, leaving section 174 and process-of-experimentation proof squarely on the taxpayer regardless of how many patents its research produced.