Significant changes have occurred over the past few years in the treatment of research and development tax expenditures under section 174 and research tax credits under section 41. Improved examination procedures and practical regulations covering such topics as prototypes and internal-use software have generally benefited taxpayers. Recently, on Feb. 2, 2017, the IRS Office of Chief Counsel released Memorandum 20170501F (memo), addressing the deductibility of costs to develop a pilot model plant under regulations that were finalized in 2014.
The taxpayer addressed in the memo was an electric power utility company that provided power generation, transmission, and retail and wholesale power distribution to its customers. According to the taxpayer, they had to evaluate and resolve overall design uncertainty in building a power plant (Plant). The taxpayer asserted that the Plant’s three sub-systems have first-of-a-kind (FOAK) equipment. These subsystems had previously been developed, tested and validated at the Plant’s prototype. The taxpayer claims to have gained overall knowledge associated with providing its services, as well as engineering, design, and construction expertise and capabilities.
The following three questions were addressed by the IRS:
- Can the taxpayer amend its tax returns for open years to claim costs as section 174 expenditures that were not so treated on the original return;
- Does the Plant qualify as a pilot model, which entitles the taxpayer to a deduction of all Plant expenditures under section 174 and section 1.174-2(a)(1); and
- Do the Plant subcomponents qualify as pilot models, which entitles the taxpayer to a deduction of all Plant subcomponent expenditures under section 174 and section 1.174-2(a)(1)?
Section 174 generally permits a taxpayer to deduct research and experimental (R&E) expenditures that are paid or incurred during the taxable year in connection with his trade or business. Pursuant to section 1.174-2(a), research and experimental expenditures are costs that are incurred in connection with the taxpayer’s trade or business, which represent research and development costs in the experimental or laboratory sense, including all such costs incident to the development or improvement of a product. Expenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product. A product, in relevant part, includes pilot models. According to section 1.174-2(a), a pilot model is a representation or model of a product that is produced to evaluate and resolve uncertainty.
The first issue addressed by the IRS was whether the taxpayer could amend its returns for open years to claim costs as section 174 expenditures that were not so treated on the original return. In making its determination, the IRS focused on Rev. Rul. 58-74, 1958-1, which concluded that a taxpayer, which had adopted the section 174(a) expense method, but had failed to include certain research expenses in prior years, should file amended returns for those years, if those years are still open, to claim the omitted research expenses. Consistent with Rev. Rul. 58-74, the IRS determined that the taxpayer could amend its returns for open years to claim costs as section 174(a) expenditures that had been on the originally filed return for those years.
In determining that neither the Plant nor the Plant subcomponents qualified as pilot models, the IRS focused on the issue of evaluating and resolving technical uncertainty. According to the facts, the purpose of the Plant was to specifically display a functioning system, which employs a technology that the industry had successfully used for many years. Accordingly, the IRS argued that all technical uncertainties had already been resolved prior to demonstration by the Plant. Since the Plant contained proven and commercially available equipment and technology, it could not have been produced to evaluate and resolve uncertainty during its development and, as such, was not a pilot model.
Along that same line of reasoning, the IRS determined that since the Plant contained proven and commercially available equipment and technology, so too did the Plant subcomponents, and, as such, the subcomponents were not pilot models. This position was supported by the fact that “no,” “low,” or “moderate” technology risks were assigned to the subcomponents, which is comparable to any other power plant project. Therefore, each subcomponent in its entirety could not have been designed or created to resolve uncertainty.
Evaluating and resolving technical uncertainty is a critical element in determining whether or not a cost is a deductible research and development expenditure, both in general and with respect to pilot models. Taxpayer’s who wish to deduct the pilot model costs and claim the research tax credit should become familiar with the uncertainty test of section 1.174 in order to increase their odds of sustaining the deduction and the credit.