In-Depth Look: Research Tax Credit Case Brings Consistency Rule into Focus.
(Parker Tax Publishing July 21, 2014)

In calculating the research tax credit, the consistency rule is an important concept, but not one that is often the center of a court case. In order to equitably measure the increase in qualified research spending between the two periods measured to calculate the credit, the consistency rule holds that the same standard must be applied in both periods. That concept was the focus of a recent decision by the Fifth Circuit in Trinity Industries, Inc. v. U.S., 2014 PTC 326 (5th Cir. 7/2/14).

OBSERVATION: While the research tax credit does not apply to amounts paid or incurred after 2013, it has typically been part of the "tax extenders" package that Congress periodically passes. However, due to gridlock in Congress, the bill extending the research tax credit, as well as other credits, is currently stalled in the Senate (the bill that passed the House in May would permanently extend and make changes to the calculation of credit). While many believe the bill will become law and be made retroactive, there is some uncertainty as to which credits will survive. Because the research tax credit is a favorite on both sides of the aisle, it is generally assumed that this credit will continue.

In the Trinity case, a shipbuilder argued that, under the consistency rule, it should be able to remove four vessels from its base period qualified research expenses (QREs) since those vessels were similar, in terms of how much experimentation was involved, to four vessels a lower court removed from the shipbuilders claim year QREs. By reducing the base period QREs, the shipbuilder would receive a higher research tax credit on its 1994 and 1995 tax returns. The Fifth Circuit agreed with the shipbuilder's premise and remanded the case back to the lower court to consider if the criteria that was applied to remove ships from the claim year QREs was similar enough to remove the four ships cited by the shipbuilder from its base year QREs.

Calculating the Research Tax Credit

Taxpayers are allowed a credit for certain research expenses paid or incurred in a trade or business. Generally, the research credit is allowed for increasing research activities. Under Code Sec. 41, the credit is equal to the lesser of:

(1) 20% x (claim year QREs a base amount), and 20% x (50% x claim year QREs); or

(2) the base amount, which is equal to a fixed base percentage times the average annual gross receipts for the four years preceding the claim year (i.e., the base years).

In (2), above, the fixed base percentage is equal to the aggregate base period QREs / aggregate base period gross receipts.

The claim year is the year in which the research credit is claimed. As discussed below, for the taxpayer in Trinity, the base years were tax years ending 3/31/1985 through 3/31/1989.

OBSERVATION: In 2005, the Energy Policy Act of 2005 expanded the research credit to apply to certain energy research consortiums for tax years ending after August 8, 2005.

Under Code Sec. 41(d), to constitute QREs, the following four requirements be met: (1) the expenses must be of the type deductible under Code Sec. 174; (2) the research must be undertaken for the purpose of discovering information which is technological in nature; (3) the application of that information must be intended to be useful in the development of a new or improved business component of the taxpayer; and (4) substantially all of the research activities must constitute elements of a process of experimentation for a qualified purpose. Reg. Sec. 1.41-4(a)(6) provides that the fourth requirement is met if 80 percent or more of the research activities constitute elements of a process of experimentation.

The four-part QRE test is applied separately to each business component of the taxpayer, which is defined to include any product held for sale, lease, or license, or used by the taxpayer in its trade or business. However, if each of the four requirements is not met with respect to an entire business component, the shrinking-back rule in Reg. Sec. 1.41-4(b)(2) may be applied to bring some expenses into the QRE calculation. Under the shrinking-back rule, the four requirements are applied first at the level of the discrete business component, but if these requirements are not met at that level, then they apply at the most significant subset of elements of the product.

This shrinking back of the product continues until either a subset of elements of the product that satisfies the requirements is reached, or the most basic element of the product is reached and such element fails to satisfy the test. Accordingly, the rule is applied only if a taxpayer does not satisfy the four requirements with respect to the overall business component.

There is also a consistency rule which plays a role in computing QREs by ensuring that the research tax credit due is not overstated or understated because the taxpayer inconsistently compares QREs in the base period years and the claim year. Code Sec. 41(c)(6)(A) and Reg. Sec. 1.41-3(d)(1) provide that the QREs taken into account in computing the fixed base percentage must be determined on a basis consistent with the determination of QREs for the credit year.

Background

Trinity Industries, Inc. designs and builds ships. On amended tax returns for its tax years ending March 1994 and March 1995, Trinity took a research tax credit because its claim year expenses in developing certain vessels constituted QREs. In calculating its research tax credit, Trinity reported a fixed base percentage (i.e., the ratio of base period QREs over base period gross receipts) of 1.3152 percent and 1.1325 percent 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 IRS denied the research tax credit in full.

Trinity filed a tax refund suit in district court and hired James Bennett to testify as an expert on the amount of research tax credits that should be allowed for Trinity's 1994 and 1995 tax returns. Based on documentation provided by Trinity, Bennett provided specific 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 percent, 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 Code Sec. 41(c)(6) was satisfied on Trinity'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 Hurricane Katrina. Thus, he estimated certain costs for the base period.

The District Court Case

The district court conducted a two-phase trial. In Phase I, the court decided that Trinity was wrongly denied credits for two of the six projects it considered in calculating the research tax credit 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 fourth QRE requirement: that substantially all of the research activities in developing the project (i.e., 80 percent or more) were part of a process of experimentation. In reaching its conclusion, the court did not apply the shrinking-back rule in analyzing the claim year QREs because Trinity was unable to offer evidence of its expenses at a more specific level partly because of Hurricane Katrina destroying many of its records.

In Phase II of the trial, two other vessel projects (the Queen of New Orleans and the Penn Tugs), as well as the method of calculating Trinity's base period QREs were at issue. With regard to its base period QRE calculation, a Trinity Vice President of Engineering, Phil 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 Trinity constructing a vessel based on a design provided to Trinity 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 QRE test. Nuss thus 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.

After Phase II concluded, the IRS and Trinity 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. Trinity 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, Trinity 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 Trinity applied on its returns. With respect to four of the projects claimed by Trinity, 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, Trinity 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. Trinity 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.

Trinity 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 Trinity's fixed base percentage and increase its overall research tax credit.

In its Phase II order, the district court concluded that Trinity 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 Trinity was entitled to a credit of approximately $136,000 for 1994 and $0 for 1995.

With respect to Trinity's second argument, the court rejected Trinity's request to reduce its base period QRE by over $20 million. Trinity appealed to the Fifth Circuit.

Appeal to Fifth Circuit

While presenting two arguments to the court, only one gained traction the same argument that Trinity 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, Trinity 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 Trinity 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.

Code Sec. 41 allows a taxpayer to claim a tax credit 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 consistency rule, the court s stated, applies to cases like Trinity'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 Trinity 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 Trinity 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, then the base period QRE figure should include the expenses associated with those vessel projects, the Fifth Circuit said. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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