Dow Chemical is challenging the U.S. Internal Revenue Service in a rare court case over expanding the research and development tax credit to cover the costs of supplies used to improve the ways existing products are made.

Oral arguments are set for Thursday at the 2nd U.S. Circuit Court of Appeals in New York in a case that pits Union Carbide, a wholly owned subsidiary of Dow, against the IRS.

A win for Dow would widen the scope of the R&D credit - a mainstay of the corporate tax code that costs U.S. taxpayers roughly $7 billion a year - at a time when corporate tax breaks, in general, are under scrutiny in Washington.

As lawmakers grapple with the enormous U.S. budget deficit and a tax code riddled with loopholes, the R&D credit continues to enjoy broad political support, but it has critics.

Far from being just about lab coats and microscopes, the credit today is part of the economic mainstream. It can be claimed by all sorts of companies, from chicken farmers and fast-food packagers to brewers and wineries, according to the many tax consulting shops that promote it to the private sector.

Since its creation in 1981, the credit has helped support basic research. But detractors say it has become a costly corporate hand-out, too broadly claimed, that does little to further the goal of driving more U.S. R&D hiring and investment.

Dow is arguing that traditional manufacturers with older but popular products - it produces ethylene, a basic chemical used to make plastics - deserve the credit just as much as high-tech companies creating the next big cellphone or cancer drug.

The IRS is arguing, according to court documents, that to allow the R&D credit to be claimed as Dow wants "would transform the research credit into a manufacturing subsidy."

Dow disputes this, arguing that availability of the R&D credit "should not hinge on whether a product or process improvement is the desired outcome," Dow spokesman Greg Baldwin said. "This distinction is not supported by the Internal Revenue Code, applicable Treasury regulations or legislative history."

Stretching the credit

Under current law, the R&D credit is typically claimed to cover research labor costs. Widening it to manufacturing process improvements would lift profits, but raise taxpayers' costs.

The IRS, which won an earlier round in the case at the Tax Court level, argues that Dow should not get the credit simply for streamlining the way it makes an existing product.

The case involves process improvements that were researched in 1994 and 1995. Dow wants to apply the credit retroactively to the cost of the work. 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.

With less than $8 million in R&D claims in dispute, Dow's lawsuit is about setting a precedent, tax professionals said, adding Dow has a strong argument as the R&D law is so broad.

"The government ought to lose because they've got a real problem with the statutory language," said Roseann Cutrone, a counsel with law firm Skadden Arps Slate Meagher & Flom.

Dow, like many manufacturers, says the government needs to offer stronger tax incentives to businesses to keep research centers and manufacturing plants from moving offshore.

Dow is "looking for some of these process improvements in an effort to save money," said Jeffrey Stafford, a chemical industry analyst with Morningstar. "To be getting a tax credit on top of that would seem to me like gravy."

The U.S. Chamber of Commerce, the country's largest lobbying group for businesses and other industry groups, backs Dow.

The IRS has tagged the R&D tax credit a high risk audit concern due to frequent abuses.

"The credit is a big waste of money," said Calvin Johnson, a law professor at the University of Texas, who favors dumping the present credit for one that defines research more specifically.

Permanently temporary?

In some ways, the Dow case illustrates the controversy around the R&D credit, which has become maddeningly complex.

Never enacted as a permanent provision of the tax code, the credit has always been "temporary," requiring Congress to extend it 14 times in its 31-year lifespan.

This is frustrating to businesses that need to plan for the future. The credit expired again at the end of 2011, but Congress is expected to renew it again retroactively after the November elections for the presidency and Congress.

Dow Chief Executive Andrew Liveris has said the United States s hould mimic countries with higher R&D credits, including his native Australia, which reimburses R&D costs at 125%.

Michigan-based Dow recently opened a research center for light-emitting diode display technologies in South Korea, where the government reimburses 100% of R&D costs.

Many companies - Dow included - favor putting manufacturing plants near research centers and actively shop the globe for countries willing to subsidize operations.

In a theme echoed in Dow's lawsuit against the IRS, Liveris has argued that R&D is integrally linked to production.

"Engineers on the factory floor are more likely to notice potential areas where a product can be improved," he wrote.

Edging toward tax reform

Tax breaks of all sorts are being questioned in Washington as Congress - despite its present paralysis - edges closer to overhauling the tax code for the first time in 25 years.

The R&D credit enjoys bipartisan support and President Barack Obama has repeatedly called for making it stronger.

Senator Orrin Hatch, the top Republican on the Senate Finance Committee, told Reuters he had no doubts the credit is "beneficial for innovative companies."

At the same time, Hatch said: "We need to work on the language of the research and development tax credit."

The R&D credit is a big-ticket lobbying cause on Capitol Hill. Mentions of a U.S. House of Representatives bill to expand and make permanent the R&D credit showed up in more lobbying reports than any other legislation, according to public records.

Microsoft is the top U.S. research spender, with a $9 billion R&D budget in fiscal 2011. The software company spent $7.3 million on congressional lobbying in 2011. Its top goal, unrealized, was making the R&D credit permanent.

Congress waited until the last days of 2010 to extend the credit last time and likely will do the same this year.

About two-thirds of the manufacturing sector's R&D credit claims are made to cover wage expenses. Dow's case involves the supplies portion of the credit, or 20% of claims. Computer and contracting costs make up the rest.

"It was abusive on the part of Union Carbide to take the credit on everything that they delivered to customers," said Michael Solomon, a tax lawyer at Fenwick & West, who has argued R&D claims on behalf of General Electric and General Motors "A supply is something that is consumed in research, not delivered to a customer."

The cost to taxpayers of the R&D credit will likely continue to rise if Dow wins its suit against the IRS, said Annette Nellen, a tax professor at San Jose State University.

"Maybe more people will go back and file amended returns to see if there are supplies they overlooked," she added.