Direct supervision / Support NOT Qualified Research
The United States Tax Court has upheld the IRS’s 100% disallowance of the Little Sandy Coal Company’s research credit claim on the basis that the taxpayer had not demonstrated that at least 80% of its research as to any business component constituted elements of a process of experimentation (POE). This decision may also signal stricter scrutiny of section 174 pilot model claims.
Facts, issues and analysis
The court upheld the disallowance of Little Sandy Coal Company’s research credit claim for the taxable year ended June 30, 2014. The credit claimed related to the activities performed by the taxpayer’s shipbuilding subsidiary (Corn Island Shipyard, or CIS) involving a tanker and a dry dock.
The process of experimentation test
To satisfy the fourth, and probably most stringent, part of the section 41 qualified research four-part test, substantially all of the research activities must constitute elements of a process of experimentation for a purpose related to a new or improved function, performance, reliability or quality.2 If 80% or more of a taxpayer’s research activities with respect to a business component constitute elements of a process of experimentation (POE), the substantially all rule is satisfied even when the remaining 20% or less of a taxpayer’s research activities do not constitute elements of a process of experimentation. The court explained that the substantially all test requires analysis of the ratio of (i) research activities conducted in regard to a business component that constitute elements of a POE to (ii) all research activities in regard to the business component that satisfy section 41(d)(1)(A) that are not covered by one of the 41(d)(4) exclusions from qualified research.
POE test looks to activities
CIS listed various elements of the vessel, including every major system, which were ‘redesigned and re-engineered’ during the development process, noting that “the tanker’s hull ‘alone makes up 90% of the vessel,’” in support of its claim to have satisfied the POE test. However, the court ruled that the substantially all test must “be applied in reference to activities -- not physical elements of the business component being developed or improved.” The court continued by stating that “the design of some, or even all, of the elements whose design was uncertain at the outset could have been determined by means other than a process of experimentation.” Further, “uncertainty concerning the development or improvement of the business component does not establish that all activities undertaken to achieve that new or improved business component constituted a process of experimentation.”
Contrast this decision with the ruling in Trinity Industries, Inc. v. United States,3 which found that 80% of the costs a taxpayer incurred in developing two of six vessels constituted a process of experimentation. Little Sandy Coal noted that it does not understand how the district court in Trinity could have concluded that the 80% test was met, unless the court performed a line-by-line detailed determination, which Trinity did not do.
Under the shrinking-back rule, if a business component as a whole fails to satisfy the POE test, then the test may be met as to a subcomponent.4 In this case, however, the court did not have sufficient data to be able to apply the shrinking-back test. That is, the taxpayer forced the court to apply an “all or nothing” test. Since the court had decided the taxpayer had not satisfied the POE test as to “all” (i.e, the entire business components of the tanker and of the dry dock), and since the court lacked sufficient data as to various subcomponents, the court had no choice other than to hold that the taxpayer did not satisfy the POE test as to any subcomponent and thus had no qualified research at all.
Direct supervision / Support NOT qualified research
Turning to the taxpayer’s alternative argument as to how it satisfied the POE substantially all test, the court considered whether CIS’s direct supervision and direct support activities constituted elements of a process of experimentation. The court stated that “while a person who directly supervises research may perform qualified services, he is not himself engaged in qualified research and cannot be treated as conducting any experimentation that research involves.” As to direct support, the court said:
[I]t does not follow that, if the testing of that component of the tanker involved a process of experimentation, the work of the production employees in fabricating the physical component was part of that process of experimentation. In fact, section 1.41-2(c)(3)(ii) … tells us that the work of the production employees would not be considered part of that process of experimentation … A production worker who directly supports qualified research is not himself engaged in qualified research and thus cannot be engaged in any process of experimentation the research might involve.
The court concluded that none of the direct supervision and direct support activities CIS performed constituted elements of a process of experimentation, and therefore none of it could be included in the numerator of the POE substantially all test.
The court ruled that to qualify as a section 174-eligible pilot model, the taxpayer’s purpose in building the model must be to “evaluate and resolve uncertainty during development or improvement of the product and test the appropriate design.” The court then held that taxpayer had made no such showing, but rather, in contrast with the section 174 2(a) regulations, “the taxpayer built the machine itself to fulfill its contractual obligations to its customer.” Perhaps of special significance was the government’s expert witness who testified that “almost all of these uncertainties have to be resolved well before the structural steel is assembled and welded to form the hull” – the court thought this was consistent with the taxpayer’s expert witness who had said: “We have to feel pretty comfortable with a design before we start cutting steel.”
Taxpayers should retain records in sufficiently usable form and detail to substantiate that the expenditures claimed are eligible for the credit, and to allow the fact-finder to use the shrinking-back rule, if necessary. Taxpayers will want to pay special attention to the POE test and its substantially all ratio, as the Tax Court gave this heightened scrutiny. As to pilot models – RSM has seen an increase in taxpayers claiming supplies as section 41 QREs over the years – but Little Sandy Coal’s strict scrutiny of pilot models suggests the IRS may challenge that section 174 pilot model claims satisfy the criteria of the Regulations.