Though championed by politicians on both sides of the aisle and by businesses both large and small, the R&D tax credit, has long been a contested issue between taxpayers, the accounting industry and the IRS. One of the more contentious legal issues regarding the R&D credit has been that of supply costs. However, the Tax Court’s opinion in TG Missouri Corp. v. Comm’r, 133 TC No. 13 (2009), has clarified the law surrounding supply costs in taxpayers’ favor.
In order to put the decision from the TG Missouri lawsuit into context, let’s start withsome background on the R&D Credit. Enacted in 1981, the R&D credit provides a 20% credit for all qualified research expenses (QREs) in excess of a taxpayer’s base amount. A taxpayer’s QREs include wage, supply, and contractor costs incurred in the performance of qualified research.
In order to qualify for the credit, a taxpayer’s research must meet the following requirements:
• The research must be intended to develop a new or improved business component (i.e., a product, process, computer software, technique, formula, or invention.
• The taxpayer must be uncertain regarding the capability, method, or design of the business component.
• Substantially all of the taxpayer’s research activities must be a process of experimentation designed to reduce or eliminate the aforementioned uncertainty.
• Finally, the taxpayer must attempt to discover information that fundamentally relies on the principles of the physical or biological sciences, engineering, or computer science.
Under the law of the Internal Revenue Code and Treasury Regulations, supplies are defined as any tangible property other than property of a character subject to depreciation. It is not clear, based on the code and regulations alone, whether depreciable property must actually be depreciable in the hands of the taxpayer claiming the credit in order to be disqualified under the law.
Fortunately, this is the precise issue addressed by the TG Missouri lawsuit. In TG Missouri, the taxpayer manufactured plastic molded products for customers in the automotive industry. In order to manufacture the products, the taxpayer designed and developed molds.
Often, TG Missouri would hire a third-party contractor to fabricate a prototype mold, which the taxpayer would then improve until it was capable of producing products that met customer requirements. The third-party contractor then produced a production mold that TG Missouri modified until the mold was capable of producing satisfactory products. In some instances, the taxpayer retained ownership of the molds and depreciated them for accounting purposes. In others, TG Missouri sold the molds to its customers and retained possession of them to use in further research and to produce replacement parts. When the company sold the molds to its customer, and removed them from its accounting books, it claimed the costs that it incurred for the molds as supply costs in calculating its research credit.
The IRS sought to disallow the claimed research costs on the grounds that the molds in question were property of a character subject to an allowance for depreciation even though the taxpayer, itself, was not eligible to claim depreciation deductions under the law with respect to the molds. The IRS reasoned that the character of the property itself was at issue, not the identity of the taxpayer to whom the deduction was allowed and that, since TG Missouri depreciated the molds to which it retained title, the molds that it sold were depreciable property for the purpose of the credit.
The Tax Court disagreed with the IRS’s interpretation on the grounds that everywhere else the phrase was used in the code, “property of character subject to the allowance for depreciation” meant property subject to the allowance for deprecation in the hands of the taxpayer. In the limited instances that the phrase referred to other taxpayers, those taxpayers were specifically mentioned in the statute.
Based on the Tax Court’s ruling in the TG Missouri lawsuit, the law regarding the types of supplies allocable to the R&D tax credit has become a little clearer – the exclusion for supplies that are “depreciable in nature” is applicable only if those supplies are depreciable in the hands of the taxpayer claiming the credit.
This is great news for taxpayers as well as their trusted advisors providing accounting and legal services.
alliantgroup is the nation’s premier provider of specialty tax services. The company, headquartered in Houston, TX, works with alliantgroup accounting and legal services providers and their clients to ensure that they receive the full benefits of all available federal and state government sponsored tax credit and incentive programs, such as the research and development tax credit, export tax incentives, manufacturing tax incentives, federal and state hiring credits, sales and use tax refund reviews, and a dedicated tax controversy services team that assists in various legal matters, including IRS and State Tax Matters and various lawsuits. For additional information please visit www.alliantgroup.com.