Conclusion and Implications for Prototypes

Tax Research

I. IRC Section 41 Excerpts of the Internal Revenue Code:

(1) Qualified research expenses

     The term "qualified research expenses" means the sum of the following amounts which are paid or incurred by the taxpayer during the taxable year in carrying on any trade or business of the taxpayer--

(A) in-house research expenses, and
(B) contract research expenses.

(2) In-house research expenses

(A) In general

     The term "in-house research expenses" means--

(i) any wages paid or incurred to an employee for qualified services performed by such employee,

(ii) any amount paid or incurred for supplies used in the conduct of qualified research . . . .

            At issue is to what extent are supplies deemed to have been used in the conduct of qualified research.  IRC Section 41(b)(2)(C) defines the term supply to mean any tangible property other than land or land improvements, and property subject to depreciation. Supply expense must be directly linked to qualified research activities using the taxpayer's accounting system. Qualified supplies include prototypes and testing materials. However travel, shipping and royalty expenses cannot be included as supplies.

            There have been several recent Court cases relating to "supplies" in the context of the R & E credit.  The cases that follow are of interest in that they represent a trend of court decisions that are generally favorable to the taxpayer claiming the R & E credit. The Union Carbide case essentially says that employee recollections and extrapolated data can be used to determine qualifying expenses. And while it did not allow a deduction for supplies that were already in commercial production it did provide that an R & E credit can be claimed for improving processes. The Missouri Industries case provided that only depreciable property that is such in the hands of the claimant taxpayer is excluded from qualifying for the credit. (The IRS has long asserted that property that can be depreciated regardless of who owns it cannot give rise to the credit.) From the perspective of THE PROTOTYPE, the Trinity Industries case has profound implications.

II. Trinity Industries, Inc. v United States, 691 F. Supp. 2d 688 (N.D. Tex. 2010)

(Case available on taxanalysts)

The following is a quote from the Court's decision,

            "TRINITY in the Tax Years was in the business of shipbuilding. Halter Marine began building work boats that serviced offshore drilling rigs and wells. By the Tax Years, Trinity had expanded into many other market segments for shipbuilding. TRINITY used a design methodology, it called the design spiral, consisting of six phases: conceptual, contract design, functional design, detail design, construction, and testing. When TRINITY designs a new type, or class, of ship, the first one is called "first in class." A first in class ship is essentially a prototype. Trinity's hope is that many more will be built that are substantially duplicates of the first in class, but there is no guarantee of that. The claimed Ares here were primarily related to design and construction of first in class ships designed and built under contracts for various customers.

At issue are six projects:

1. Mark V

2. Extra-Fast Patrol Boat ("FOB")

3. Oceanographic Survey Ship T-AGS 60

4. Dirty Oil Barge

5. Hurley Dredge

6. Crew Rescue Boat"

The discussion continues with a definition of qualified research under IRC Section 41(d). Of particular importance to this case was the definition of "business component." Section 41(d)(B)  and 41(d)(C) states:

            (B) Business component defined. -- The term "business component" means any product, process, computer software, technique, formula, or invention which is to be --

                        (i) held for sale, lease, or license, or

                        (ii) used by the taxpayer in a trade or business of the taxpayer.

            (C) Special rule for production processes. -- Any plant process, machinery, or technique for commercial production of a business component shall be treated as a separate business component (and not as part of the business component being produced).

            The IRS argued that the prototype ships (the so called "first in class") ships did not qualify as business components in that the ships in question were special order rather than sold out of inventory. (The statute defines business components as including a product which is to be held for sale.) The Court rejected the IRS position and noted that the "government cites no authority for that proposition. . . The Court holds that after the ships were completed and before Trinity conveyed them to customers, Trinity held the ships for sale within the meaning of IRC Section 41(d)(2)(B)(i). The Court thus finds that each first in class ship was a business component." Having resolved the business component issue, the Court turned to whether or not there was qualified research. It noted;

            "Much of the design work at issue involved integrating extant subassemblies into a ship design. The government suggests that this is nothing more than ordering off a menu: pick a hull from column A, a propulsion system from column B, an HVAC from column C, etc. The Court finds this greatly oversimplifies the process. . . . .

            The first in class ships at issue here ranged from all new hull up designs to cafeteria-style mix and match combinations of existing elements to slight modifications of existing designs. Trinity did not attempt to segregate those expenses related to new aspects of the designs from tried and true elements. Rather, Trinity took an all or nothing approach to the litigation. Either the design or construction of the first in class was sufficiently experimental that the whole project constitutes QRE, or it is not. Trinity did not offer any evidence from which the Court could estimate what portion of the costs were QREs if it finds that the entire vessel does not qualify as QRE.

            The government, on the other hand, insists that Trinity must break out every expense and determine whether it is a QRE; for example, the government criticized Trinity for claiming the cost of painting a first in class, pointing out that painting a ship was not experimental.

            The Court conceptually agrees with Trinity. If a first in class ship is sufficiently experimental, the risk of failure attaches to the entire project. The potential loss includes not just the experimental aspects, but also the paint. The regulations support this view. . . "

            As a result, the Court concluded that if Trinity can show that 80% of a first in class ship was part of a process of experimentation, it can claim the entire cost of the first in class.

            In terms of the six projects the Court addressed the projects, "from most novel to least novel." It found that the Mark V and The Dirty Oil Barge qualified for the credit. The remaining four projects did not. The Extra Fast Patrol Boat was found to be "fairly routine." The Oceanographic Survey Ship T-AGS 60 contained some innovations but the Court found that Trinity did not meet the burden of showing 80% of the costs incurred were R & E qualified as it had previously built similar albeit smaller ships. Likewise the Crew Rescue Boat "integrated known capabilities into a single vessel" and the Hurley Dredge "involved qualified research costs". However the Court held that those costs were small in comparison to the overall project.

            The Court then turned to how much credit should be allowed. There was a discussion concerning subcontracting costs and materials:

            "The government objects to Trinity's calculation of the QRE credit, pointing out various items in Trinity's claim that are not properly considered QRE, such as insurance. The implication is that the Court should scour the records and determine which line items are for matters not properly considered QRE. The Court believes this is an issue the 80% rule of Treas. Reg. 1.41-4(a)(6) is intended to address. The Court finds that the additional expenses the government cites are properly considered research expenditures in that the    business component -- the ship -- could not have been developed without them. Under the 80% rule, the Court finds that those costs are properly included in QRE for the Mark V and the Dirty Oil Barge.

            The government also points to certain inconsistencies between the testimony of James Bennett and the exhibits. The Court finds that Bennett's testimony reasonably estimates the QRE and that the documentation upon which he bases his report and testimony are  sufficiently reliable to support the claimed credit, with one exception. The testimony showed that TRINITY''s accounting system categorized certain subcontracting expenses as material, which should therefore be included at 65% rather than 100%.

III. Union Carbide Corp. v. Commissioner (T.C. Memo 2009-50) - March 10, 2009

(Case available on Tax Notes)

This is an interesting case in that a number of commentators describe it as providing judicial guidance, significant potential benefits and several favorable elements that may offer opportunities to taxpayers albeit that Union Carbide was only able to deduct a total of $1,045 of additional qualified research expenditures out of a total of more than $20 million claimed.

The noted advantages to the taxpayer were that the Tax Court generally accepted the validity of employee recollections and data extrapolation to estimate qualified research expenditures. This has been opposed by the IRS despite the Legislative history that eligibility for the credit should not be contingent on meeting unreasonable record keeping requirements. And the case generally supports the idea that qualified research can occur as part of a process of producing goods for sale to customers.

            In the case the Tax Court examined five large projects for which the R & E credit had been claimed. All five projects involved process experimentation after products (and processes) were placed in commercial operation. As noted in the decision,

            "Petitioner's basic chemicals and plastics (C&P) operations involved the processing of raw hydrocarbon feedstocks -principally ethane, propane, and naphtha -- into basic building- block chemicals known as olefins. Ethylene and propylene were the major olefins UCC produced and were key raw materials for petitioner's olefins-chain C&P businesses.

            Petitioner used process technologies to convert manufactured and purchased ethylene and  polypropylene into first-line derivatives such as: (1) Polyethylene, which is used for high-  volume applications such as food containers, milk and water bottles, grocery and trash  bags, pipes, and tubing; (2) polypropylene, which is used for similar high-volume applications; and (3) ethylene oxide/glycol and derivatives, which are used for products such as automobile antifreeze, polyester resin, and film and as raw materials for petitioner's specialty and intermediates chemicals business.

            Petitioner's specialty and intermediates chemicals operations involved the production of a wide variety of specialty chemical and polymer product lines, as well as solvents and chemical intermediates. During the credit years petitioner also licensed its key olefins- based process technologies, such as the UNIPOL process for manufacturing polyethylene, to third parties in the oil and gas petrochemical industries."

The Court ultimately found that two of the five projects constituted qualified research activities but disallowed all of the additional supply costs because they were included in the production of goods for sale, not in the conduct of qualified research. Specifically it determined that the costs of materials incurred to produce the commercial product necessary for UCC to conduct the process research were not eligible for the credit. This outcome is not wholly unexpected as Section 41(d)(4)(A), Qualified Research Defined specifically states:

(4) Activities for which credit not allowed

    The term "qualified research" shall not include any of the following:

            (A) Research after commercial production

            (B) Any research conducted after the beginning of commercial production of the business component.

            It should be noted that the Court did make a clear distinction between product research and process research. Even if a certain product has been developed to a point where it "meets the basic functional and economic requirements of the taxpayer," the Court maintained that the research credit qualification tests should be applied separately to the development or improvement of a production process for that product.  It stated, "Even after a product is ready for commercial sale, activities relating to the development of the manufacturing process may constitute qualified research.

            However, there is no R & E credit for supplies that would otherwise have been used in the process or product absent any research to improve the process.

            It should be noted that the Court's opinion was somewhat nuanced. For example, one of the projects was deemed not to involve a process of experimentation because Union Carbide did not conduct additional post-test analysis after it determined the test was successful.

IV. Union Carbide v. Commissioner, Second Circuit (See Tax Notes)

Tax Notes' Summary follows:

            The Second Circuit affirmed a Tax Court decision that allowed a chemical manufacturing company to claim section 41 research credits for the amount spent for supplies used to perform research as long as those supplies wouldn't otherwise have been used in the production of finished goods.

            The company, Union Carbide Corp., tried to claim additional research credits related to research to improve several of its chemical production processes. The Tax Court determined that the company wasn't entitled to credits it claimed for expenses spent on supplies that were related to ordinary production.

            The Second Circuit agreed with the Tax Court that the cost of supplies used in the manufacturing process that would have been used regardless of research were not creditable expenses. Those amounts failed to qualify as "any amount paid or incurred for supplies used in the conduct of qualified research" under section 41. The circuit court also agreed with the Tax Court's denial of research credits for a project that it found didn't fulfill "the process of experimentation test" to show that it was qualified research.

V. TG Missouri Corporation v. Commissioner (T.C. Memo Filed November 12, 2009)

            Under Section 41(b)(2)(C), the cost of property that is of a character subject to depreciation cannot be claimed as a qualified research expense. The IRS has long contended that depreciable property is not allocable to the R & E credit regardless of who owns it. Missouri Corp. contended that the section only applies if the property is depreciable in the hands of the taxpayer claiming the credit.

Tax Notes' Summary Follows:

            The Tax Court, in a case of first impression, has held that production molds an automobile parts manufacturer purchased from third parties and later sold to customers were not assets subject to depreciation under sections 41 and 174 and that the manufacturer properly included costs of the molds as costs of supplies in determining its research credit.

            TG Missouri Corp. manufactures molds for automobile parts for its customers. In some instances TG contracts with third-party toolmakers to make production molds that it then alters to meet its customers' needs. The molds may or may not be purchased by the customer, with TG retaining possession of them.

            For molds sold to customers, the company included the costs to produce the molds as research expenses for purposes of calculating its section 41 research credit on its 1998 and 1999 returns. The IRS issued TG a notice of deficiency in which it determined that the costs associated with the molds sold to customers didn't qualify as research expenses and reduced TG's claimed research credit for the years at issue.

            In its opinion, the Tax Court first addressed an evidentiary issue and sustained the IRS's objection to TG's attempt to admit an engineering report and a revenue agent report as evidence, finding it unnecessary to look beyond the notice of deficiency for the IRS's reasoning for the disallowance.

            The court considered the question whether the molds were "property of a character subject to the allowance for depreciation." To constitute a qualified research expense for purposes of the section 41 research credit, an expenditure must qualify as a research expense under section 174. That section does not apply to expenditures for "the acquisition or improvement of property to be used in connection with the research or experimentation and of a character which is subject to the allowance" for depreciation.

            The IRS maintained that the molds were subject to expensing under section 174 and not supplies because they are property subject to a depreciation allowance. The IRS suggested that since the molds are subject to wear and tear, exhaustion, or obsolescence, they are subject to an allowance for depreciation under section 167 and therefore do not qualify for research expense treatment regardless of whether they are depreciable in the hands of the taxpayer.

            The court, however, disagreed with the IRS and was persuaded by TG and an amicus brief filed by Northrop Grumman Corp. arguing that the phrase "property of a character subject to the allowance for depreciation" in section 41 refers to property depreciable in the hands of the taxpayer.

            The Tax Court rejected the IRS's argument that since the company depreciated the molds over which it maintained ownership, the ones for which ownership was transferred should be treated similarly. The court found that the molds sold to customers should be treated differently because TG didn't have an economic interest in them and could not depreciate them. The court also found that other sections of the code that use the phrase "property of a character subject to the allowance for depreciation" supported its conclusion.

            The court concluded that the IRS erred in its deficiency determination because the molds sold to TG's customers were not of a depreciable nature. Therefore, TG properly included the associated costs in the calculation of its research credit.