In a tax decision with broad impact for manufacturing companies, a U.S. appeals court ruled on Friday that Dow Chemical could not retroactively claim research and development tax credits for improving how it made an existing product.

The case pitted the largest U.S. chemicals maker against the Internal Revenue Service, which often fights with companies over the R&D credit. The IRS had argued that a unit of Dow improperly claimed the credit for normal manufacturing operations.

A three-judge panel at the 2nd Circuit Court of Appeals unanimously upheld an earlier U.S. Tax Court ruling that said Union Carbide Corp, the Dow unit, could not claim the R&D credit for manufacturing process improvements more than a decade old.

The IRS commissioner's "interpretation is entirely consistent with the purpose of the research tax credit," Judge Edward Korman wrote in the court's opinion.

Manufacturing and chemical companies were watching the case and backing Dow. Only $8 million of R&D claims were at issue, but the case was seen as a key test of how broadly companies can claim the R&D credit, tax professionals said.

"All manufacturers have a vested interest in this case, not just chemical, but really anyone who incurs R&D that's related at all with production process," said Jeff Malo, a director with tax advisory firm WTP Advisors.

Dow said it was "disappointed" by the ruling and is considering its options.

"Plant-related process research and development plays a central role in helping manufacturers achieve cost and efficiency savings," said Dow spokeswoman Nancy Lamb.

She added that "the availability of the tax credit is important to encourage and enable manufacturers to make these substantial R&D investments."

Critics question credit

Opponents of the R&D credit, created by Congress in 1981, say it has become a costly corporate handout that does little to further the goal of driving more R&D hiring and investment.

The U.S. Chamber of Commerce, the country's largest lobbying group for businesses, backed Dow.

Automotive and defense companies "have a huge interest in this," said Michael Solomon, a tax lawyer at Fenwick & West.

The case involves research conducted in 1994 and 1995 to improve the way existing products were made. Dow wanted to apply the credit retroactively to cover costs for supplies, even though it ended up selling the finished goods.

One improvement was an experimental, cost-cutting method to make polyethylene resin for dry cleaning bags with fewer materials. Using the new process, Dow sold enough resin to customers to make 125 million dry cleaning bags.

Giving Dow the credit to cover supply costs it would have incurred anyway in the normal course of doing business "simply creates an unintended windfall," Korman wrote.

In a concurring opinion, Judge Rosemary Pooler wrote that Congress may have intended the tax law to include supplies as qualifying for the research tax credit, but lawmakers did not write the law specifically enough.

The IRS did not respond to a request for comment.

The case could go next to the Supreme Court, but tax lawyers said that was unlikely.

The case is: Union Carbide Corp & Subsidiaries v Commissioner of Internal Revenue in the 2nd Circuit U.S. Court of Appeals No. 11-2552.