United States

Application of consistency rule results in favorable R&D credit adjustment

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In a recent Fifth Circuit Court of Appeals decision, Trinity Industries, Inc. v. Unites States,1 the court ruled that disallowed qualified expenditures should be treated consistently in both credit years and base-period years. Considered a taxpayer victory, the court's ruling clarifies the consistency rule under section 41(c)(6) and provides for fair treatment of qualified expenditures in all tax years.

Background

The research tax credit equals 20 percent of the lesser of: 1) 50 percent of current-year qualified research expenses (QREs), or 2) current-year QREs less a base amount.2> Hence, the credit is considered incremental as it favors increased qualified spending in current years over a historical base amount.

The IRS typically subjects research tax credits claimed on amended returns to a fairly rigorous examination. When the IRS believes insufficient documentation exists to support the claimed qualified research activities and related expenses, it will disallow the portion of the credit relating to those activities and expenses. However, the IRS often fails to make a corresponding adjustment to reduce base period QREs that have no better documentation than those QREs disallowed in the credit exam years. This creates a mathematical disadvantage to taxpayers because their base period expenses remain higher than they would be if computed like the adjusted current-year expenses, making the incremental threshold greater to surpass.

Trinity case

Trinity Industries, Inc., a vessel designer and manufacturer, claimed research tax credits for several vessel projects on an amended return. The research credit claims were denied under IRS exam, and Trinity sought refund action in district court, which awarded a reduced credit to Trinity. Appealing the district court's opinion, Trinity moved its case to the Fifth Circuit Court of Appeals.

While the case involved numerous issues, the primary issue surrounded the consistency rules of section 41(c)(6) and Reg. section 1.41-3(d)(1) in relation to disallowed projects. The consistency rules state that QREs taken into account in computing the base amount should be determined on a consistent basis with the QREs for the credit year. This prevents overstatement or understatement of the research credit by removing a potential avenue to manipulate base-year QREs compared to current-year QREs.

In district court arguments, Trinity admitted that some projects in the claim years were not truly qualified projects (i.e., were projects that failed to meet the process of experimentation requirement), and as such, these projects and related expenses were disallowed. In making such determination, the taxpayer also raised the fact that certain projects included in base period QREs were substantially similar in nature to the disallowed projects, were thus nonqualified, and should be removed from the base period. The court agreed, ruled in the taxpayer's favor that consistent treatment of QREs should apply in both base years and claim years, and remanded the case to the district court for fact-finding regarding the disqualification of such base period projects.

The court's opinion also discussed the "shrinking-back rule"3 that allows subcomponents of a nonqualified project to qualify if the subcomponents meet the definition of qualified research. Trinity admittedly had poor documentation in both the base years and credit years and took an "all or nothing" approach applied to the entire vessel to qualify or disqualify projects, which the court agreed with given the lack of detailed documentation. It should be noted that detailed contemporaneous documentation could have allowed application of the shrinking-back rule to qualify certain sub-projects or components of an overall project.

Takeaway

In Trinity, the court clarified the consistency rule for calculating qualified research expenditures. Taking a literal interpretation of the statute and regulations, the court stated that adjustments in a credit year must be consistently reflected in base years as well, so as to prevent the overstatement or understatement of the credit. In essence, this ruling levels the playing field for taxpayers under exam that were subject to credit-year adjustments without corresponding adjustments to base-period QREs. Taxpayers should be mindful of the consistency rule when calculating original research credits and also during exams where IRS adjustments are proposed. Furthermore, Trinity reaffirmed the need to maintain accurate, detailed contemporaneous documentation of the qualified activities undertaken in any credit claim tax year.

1 See Trinity Industries, Inc. v. United States, 5th Cir., No. 12-11012, 2014 BL 184763, 7/2/14.
2 To compute the base amount, a taxpayer compares its current-year QREs to an average of QREs as a percentage of gross receipts from the 1984-1988 base period, or a later "start-up" base period (if QREs and gross receipts did not exist in at least three of the 1984-1988 base years), and multiplies the resulting "fixed-base percentage" by the average of the prior four years gross receipts.
3
See Reg. section 1.41-4(b)(2).

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