TAX NEWS - DECEMber 2009
US Tax: Tax Court rules on research credit-eligible expenses under section 41
TG Missouri Corp (TGM) manufactured injection-molded products, such as steering wheels, air bags, and body side molding, for customers - referred to as original equipment manufacturers (OEMs) - in the automotive industry. TGM typically contracts with third-party toolmakers to make "production molds" that it then alters to meet its customers' needs.
The process of designing, modifying, and testing the production mold so that it produces the desired automotive part generally takes two to three years. If successful, the completed production molds are purchased by the customer in many cases or, in certain situations, TGM retains ownership of the mold. In either event, TGM generally retains possession of the molds in order to mass produce the injection-molded parts for the customer.
TGM's manufacturing process ordinarily begins when it receives a request for quotation from an OEM. The request for quotation includes general product specifications and requires TGM to develop a basic technical design for the injectionmolded product. After receiving the request, TGM contracts with the OEM to develop a production mold that will enable TGM to manufacture the desired product. Under the terms of the contract, TGM is entitled to payment only if it successfully designs and builds a mold capable of producing sample products that are acceptable to the OEM. Depending on the particular injection-molded product, TGM will either construct the production mold in-house or contract with a third-party toolmaker. Typically, TGM works with the toolmaker to build a "prototype mold" to permit a limited number of test runs of the component part to isolate design flaws. Then, based on test results, the toolmaker constructs the so-called "production mold." Because the production mold is not necessarily capable of producing products that meet all of the OEM's specifications, TGM incurs additional engineering costs (primarily wages) so that the completed production mold can be used to mass produce component parts for the OEM. For tax accounting purposes, TGM treated the cost of developing and constructing molds that it sold to OEMs as inventory, whereas it capitalized (and depreciated) the costs incurred with respect to the molds when it retained ownership.
In calculating its section 41 research credit for 1997, 1998, and 1999, TGM claimed "costs of supplies" exceeding $50 million. Approximately 80 percent of the costs of supplies claimed for these three taxable years were attributable to amounts paid by TGM to third-party toolmakers for production molds that were sold to the OEMs. (The remaining 20 percent of supply expenses were allowed by the IRS examiner.) The IRS made a nominal adjustment to the $11.5 million of engineers' wages that TGM treated as qualified research expenses for the three years at issue. (TGM conceded the 3 percent adjustment.) As a result, the IRS issued a notice of deficiency reducing TGM's claimed research credit by about $3 million for the three years at issue.
Qualified research expenses eligible for the section 41 research credit must (as a threshold matter) qualify as research expenses under section 174. That section does not apply to expenditures for "the acquisition or improvement of property to be used in connection with the research or experimentation and of a character which is subject to the allowance" for depreciation. The section 41 definition of qualifying supplies includes a similar rule, excluding costs incurred for property of a character subject to the allowance for depreciation. Consequently, the narrow issue the Tax Court addressed was whether costs incurred to purchase plastic-injection molds constructed by third-party toolmakers to TGM's specifications, and subsequently modified and tested by TGM, constituted section 41 and 174 expenses for supplies, considering that the completed molds were sold to OEMs and not depreciated by TGM.
The Tax Court concluded that the production molds that TGM sold to its customers (i.e., the OEMs) are not assets of a character subject to the allowance for deprecation from TGM's perspective, and that amounts paid to third-party toolmakers to purchase these molds were properly treated as costs of research "supplies" in calculating TGM's section 41 credit.
The court rejected the IRS's argument that, because TGM depreciated the molds over which it maintained ownership, the molds for which ownership was transferred (although possession was maintained) should be treated as having the same "character." Instead, the Tax Court concluded that the molds sold to customers should be treated differently for purposes of sections 174 and 41, because TGM would not suffer an economic loss from deterioration and exhaustion of the molds and, thus, could not depreciate them for that reason. The court also found that other sections of the code (e.g., sections 1239 and 453) containing the phrase "property of a character subject to the allowance for depreciation" supported its conclusion that Congress intended that a taxpayer-specific inquiry should be undertaken, rather than attempting to determine the inherent character of the property in any taxpayer's hands.