These three cases, Union Carbide Corp. v. Comm’r, TG Missouri Corp. v. Comm’r, and Trinity Indus, Inc. v. U.S., will have a substantial impact on an issue that has rarely been discussed at length in the courts: the qualification of supply costs for the R&D credit.
In the Union Carbide lawsuit, the taxpayer (UCC), a manufacturer of plastics and chemicals, claimed R&D credits based on the development of new and improved production processes. The overwhelming majority of qualified research expenses (QREs) that the taxpayer claimed in the lawsuit were supply costs attributable to raw materials used in their improved production processes. These materials were ultimately manufactured into products and sold to UCCs customers and would have typically been considered costs of goods sold for accounting purposes. Because it was necessary for UCC to operate its manufacturing processes for extended periods of time in order to test the improvements to the processes, UCC claimed the cost of all raw materials that went through the process – whether or not they were ultimately sold as a finished good.
In reviewing UCCs allocated supply costs, the court held that the company’s claimed supply costs did not qualify under the law. UCC argued that because the law did not define the phrase “used in the conduct of qualified research” the words should be given their plain meaning and that UCCs use of the supplies was sufficient to qualify for the credit. The court disagreed, finding that the development of a new production process should be distinguished from the company’s product manufacturing and that UCC would have purchased the supplies used to manufacture products regardless of whether or not the company conducted the research.
Several months later, another Tax Court lawsuit, TG Missouri Corp., provided further guidance on supply costs. In the TG Missouri lawsuit, the taxpayer manufactured plastic molded products for customers in the automotive industry. In order to manufacture the products, the taxpayer designed and developed molds. In some instances, the taxpayer retained ownership of the molds and depreciated them. In others, TG Missouri sold the molds to its customers, thus removing them from the company’s accounting books, and retained possession of them to use in further research and to produce replacement parts. When the company sold the molds to its customer, it claimed the costs that it incurred for the molds as supply costs in calculating its research credit.
Although the court in UCC lawsuit disallowed costs for products sold to customers during process development, the Tax Court now seems to clarify in the TG Missouri decision that supply costs used during process development for processes that are sold to customers are allocable to the credit.
Most recently, the District Court for the Northern District of Texas issued its opinion in Trinity Industries, Inc. In the Trinity lawsuit, the taxpayer sought credits for the development of special order ships. For each project, the taxpayer claimed all of the supply costs related to the development and construction of the entire first article or prototype ship. Throughout the opinion, the court rejected numerous IRS arguments, including the attempts to exclude allocated supply costs under the law.
Trinity sold its prototype ships when its designs proved to be successful. Thus, Trinity, was similar to TG Missouri, in that the taxpayers in each case claimed supply costs for business components that they sold to outside parties. The district court in Trinity allowed the taxpayer to claim these costs as did the Tax Court in the TG Missouri lawsuit. The primary difference between the costs in the two lawsuits is that the costs in Trinity related to product development, whereas the costs in TG Missouri related to process development. When combined with Union Carbide, the three cases start to show a consistent pattern for the way in which taxpayers should treat their supply costs.
In Union Carbide, the court disallowed product costs incurred during process development because the costs were not tied closely enough to the business component in question. In TG Missouri and Trinity, however, the supply costs in question were incurred as a direct result of the taxpayers’ respective process and product development. Thus, supply costs are includable when they are a part of the business component that the taxpayer seeks to develop, regardless of whether that business component is a product or a process.
Before these recent cases, there was great uncertainty regarding the allocation of supply costs under the law. Experienced accounting and legal services practitioners recognize that there is probably never going to be perfect knowledge and guidance for taxpayers to rely on in this area of the law. These lawsuits, however, provide taxpayers with some illumination in what has previously been an area of darkness.
With these new guideposts in mind, knowledgeable accounting and legal services practitioners can better navigate the issues of supply costs and ultimately provide clients a more accurate and possibly greater R&D tax credit. More tax savings for clients in this tough economy is a welcome development indeed.
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