In calculating the Research and Experimentation Tax Credit (hereinafter “RTC”) under I.R.C. § 41 and its corresponding treasury regulations, the consistency rules are a critical concept to understand in order to properly measure and compute the RTC and achieve a sustainable tax return filing position per Circular 230. In order to properly measure and compute the increase in qualified research and experimentation expenditures between the two periods measured to calculate the RTC, the consistency rule holds that the same standard must be applied in both periods. This critical concept was the focal point of a recent pivotal judicial interpretation handed down back in July of 2014 by the Fifth Circuit Court in Trinity Industries, Inc. v. United States.
Trinity Industries, Inc. (hereinafter “TII”) designs and builds ships. On amended tax returns for its tax years ending March 1994 and March 1995, TII took a RTC because its claim year expenses in developing certain vessels constituted Qualified Research Expenditures (hereinafter “QREs”). In calculating its RTC, TII reported a Fixed Base Percentage (i.e., the ratio of base period QREs over base period gross receipts) of 1.3152% and 1.1325% for the 1994 and 1995 tax years, respectively. The tax returns did not report the base period QREs or the base period gross receipts used to calculate the Fixed Base Percentage. The Internal Revenue Service (hereinafter the “Service”) denied the RTC in full.
TII filed a tax refund suit in district court and hired James Bennett (hereinafter “Bennett”) to testify as a subject matter expert on the amount of RTCs that should be allowed for TII’s 1994 and 1995 tax returns. Based upon available documentation furnished by TII, Bennett prepared detailed calculations of the base period QREs, the base period gross receipts, and the Fixed Base Percentage. Bennett calculated the overall base period QREs as $49,483,136. Dividing this base period QRE amount by the base period gross receipts of $3,851,683,536 yielded a Fixed Base Percentage of 1.2847%, which was slightly lower than the Fixed Base Percentages reported in the amended tax returns. Bennett submitted a report finding that the consistency rule under I.R.C. § 41(c)(6) was satisfied on TII’s amended tax returns. Bennett noted only one caveat to this conclusion: the records available for the claim years were more complete than those available for the base period years due to records being destroyed as a result of the aftermath of Hurricane Katrina. Consequently, Bennett approximated certain costs for the base period.
The District Court Case
The district court case conducted a two-phased trial. In Phase I, the court decided that TII was wrongly denied RTCs for two of the six projects it considered in calculating the RTC because those two projects met all four requirements for constituting QREs. According to the court, the other four vessels: the XFPB; the T-AGS 60; the Crew Rescue Boat; and the Hurley Dredge did not meet the process of experimentation test under I.R.C. § 41(d). In reaching its conclusion, the court did not apply the shrink-back provision in analyzing the claim year QREs because TII was unable to offer evidence of its expenses at a more specific level partly because of the aftermath of Hurricane Katrina destroying many of its records.
In Phase II of the trial, two other vessel projects (e.g., the Queen of New Orleans and the Penn Tugs), as well as the method of calculating TII’s base period QREs were at issue. With regard to its base period QRE calculation, a TII Vice President of Engineering, Phil Nuss (hereinafter “Nuss”), testified that the 10 vessels identified by Bennett in his report were the vessels used in computing the base period QREs on the amended tax returns. When asked if he believed expenses related to those 10 vessels should still be counted as QREs given the district court’s Phase I order holding that certain claim year vessel expenses were not QREs, Nuss replied that expenses relating to four of the ten base period vessels should no longer be counted. According to Nuss, two of the base period vessels were similar to the Hurley Dredge, one of the claim year vessels held not to be qualified research in Phase I, since they all involved TII constructing a vessel based on a design provided to TII by a third party. In addition, Nuss believed that another base period vessel was like the Crew Rescue Boat, another claim year vessel held not to be qualified research in Phase I, since it was also not a complicated technological boat to build. Finally, Nuss testified that a fourth base period vessel was like the XFPB, which the district court held was not qualified research in Phase I, since it similarly had some experimental features but not enough to satisfy the four part test. To that end, Nuss concluded that these four base period vessels should no longer be included in the base period QRE figure, though the other six base period vessels still should be included.
After Phase II concluded, the Service and TII addressed whether the other two vessel projects at issue (i.e., the Queen of New Orleans and the Penn Tugs) constituted QREs, as well as the proper base period QRE figure under the consistency rule. TII made two distinct arguments about the consistency rule. First, it argued that it had followed the consistency rule on its amended tax returns by calculating both its claim year QREs and its base period QREs using an all-or-nothing approach i.e., meaning it did not shrink-back to subcomponents of any vessels in the base period or the claim years. Thus, it should be allowed the credit it originally took on the amended return.
Second, TII argued that it should be able to remove four vessels from its base period QREs as calculated on its amended tax returns, since those vessels were similar, in terms of how much experimentation was involved, to the four vessels held not to be claim year QREs in Phase I. In Phase I, the district court articulated a different standard for “prototype” than TII applied on its returns. With respect to four of the projects claimed by TII, the court found that the integration of subsystems did not rise to the level required for the cost of developing and constructing the entire vessel to qualify. Given this standard, pursuant to the consistency rule, TII argued that its base period QREs had to be reevaluated to ensure they were determined in a manner consistent with the QREs in the claim years. TII noted that under the standard articulated in Phase I, four vessel projects in the base period should not be treated as QREs because, for each of these vessels, the identification, configuration and integration of the components of the vessels were not sufficiently complex for the vessels to constitute prototypes under the court’s standard.
TII contended that, after removing the four base period vessels from the base period QRE figure of $49,483,136, the base period QRE amount would equal $26,706,987. The reduction of the base period QRE amount by over $20 million would reduce TII’s fixed base percentage and increase its overall research tax credit.
In its Phase II order, the district court concluded that TII was wrongly denied a tax credit for one of the two vessels at issue (the Queen of New Orleans) but was correctly denied a tax credit for the other (the Penn Tugs) because it did not meet the fourth QRE requirement. The court held that TII was entitled to a credit of approximately $136,000 for 1994 and $0 for 1995.
With respect to TII’s second argument, the court rejected TII’s request to reduce its base period QRE by over $20 million. TII appealed to the Fifth Circuit.
Appeal to the Fifth Circuit Court
While presenting two arguments to the court, only one argument gained traction with the same argument that TII made before the district court where it contended that it should be allowed to remove the four base period vessels from the base period QRE figure of $49,483,136. Before the Fifth Circuit, TII argued that, under a proper application of the consistency rule, the court should calculate its base period QREs as $26,706,987: the base period QRE amount used in the Bennett report less the QREs attributable to the four vessels Nuss said would not satisfy the district court’s Phase I QRE standard.
The Fifth Circuit agreed with TII that if certain base period vessels are just as experimental as claim-year vessels held not to be qualified research, those base period vessels should not be counted as qualified research for purposes of the base period QRE calculation. Pursuant to I.R.C. § 41, a taxpayer is allowed to claim a RTC for claim year research expenses that exceed the research expenses spent in an earlier comparison period, the base period years. To equitably measure the increase in qualified research spending between the two periods, the Fifth Circuit said, the same standard should be applied in determining whether certain projects pursued in the two periods are sufficiently experimental to be qualified research.
The court indicated that the consistency rule applies to cases like TII’s where the district court decided that certain claim year projects were not sufficiently experimental to pass the fourth QRE requirement that 80 percent or more of the research activities involved in the project constitute elements of a process of experimentation and TII simply asked the court to consider whether four of its base period projects were also not sufficiently experimental to pass that same test.
The court concluded that TII was entitled to have a consistent QRE test applied to projects in the base period years and the claim years and remanded the case to the district court for the limited purpose of making a factual determination as to whether to credit the testimony given that the four base period vessels were as experimental as (or less experimental than) the four claim year vessels held not to satisfy the fourth QRE requirement.
If the district court credits this testimony against any possible conflicting testimony or evidence, then those four base period vessels should be removed from the base period QRE calculation, and the resulting base period QRE figure would be $26,706,987. If the district court finds that the four base period vessels (or some of them) were more experimental than the four claim year vessels and were sufficiently experimental to qualify as QREs, and then the base period QRE figure should include the expenses associated with those vessel projects, the Fifth Circuit indicated.
In calculating the RTC under I.R.C. § 41 and its corresponding treasury regulations, be sure to properly design and implement a sustainable methodology for your RTC claim by, in part, correctly adhering to the consistency rules requiring both in-depth procedural qualitative and quantitative analysis.
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