November 13, 2009

TG Missouri Corp. v. Commissioner: Revisiting Supply Expenses for the Research Tax Credit

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In TG Missouri Corporation v. Commissioner, 133 T.C. No. 13, the U.S. Tax Court held that expenses for property used by the taxpayer in its research that is owned by another party is allowable as a supply expense in computing the research tax credit.

The facts and procedural history are as follows:

  • TG Misouri is in the trade or business of manufacturing injection-molded products, such as steering wheels, air bags, and body side molding, for customers in the automotive industry.
  • TG Missouri engages a third-party toolmaker to design and construct the production mold and then it purchases the mold.
  • The production mold petitioner purchases from the third-party toolmaker is not capable of producing sample products in accordance with the specifications of petitioner’s customers, so TG Missouri incurs additional design and engineering costs to modify the production mold so that the mold produces the desired component part. These costs are primarily wages paid to petitioner’s engineers.
  • The completed production mold is then used in the mass production of the single component part desired by the customer.
  • Depending on the terms of the agreement between petitioner and the customer, the customer may either purchase the completed production mold from petitioner or, in certain cases, it may have petitioner retain ownership of the mold.
  • TG Missouri does not claim any research expenses or credit for the production molds it owns and depreciates.
  • If the customer purchases a completed production mold, title to the mold shifts to the customer once construction of the mold is completed and the customer pays for the mold.
  • TG Missouri included the costs paid to the third-party toolmakers as qualified research expenses or QREs for the production molds sold to customers.
  • The IRS determined that these QREs did not qualify for the research tax credit.

The issue for the court was whether production molds petitioner sold to its customers are assets subject to depreciation for purposes of the research tax credit.

The Section 41 research tax credit incorporates Section 174. Section 174 does not define the phrase “research and experimental expenditures”, but, similar to the definition of “supplies” in Section 41(b)(2)(C), Section 174(c) provides that Section 174 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 IRS argued that TG Missouri’s costs in obtaining production molds from the third-party toolmakers are not eligible for expensing under Section 174 and, consequently, the production molds do not qualify as “supplies” under Section 41(b)(2)(C), because the costs at issue are for the acquisition and improvement of property of a character subject to the allowance for depreciation. More specifically, the IRS argued that the phrase “property of a character subject to the allowance for depreciation” in Sections 41(b)(2)(C) and 174(c) refers to the character of the property itself and not to whether the property is depreciable in the hands of a particular taxpayer.

TG Missouri cited the statutes and regulations, the legislative history of section 174, and caselaw interpreting the depreciation provisions of section 167 in arguing that the reference to “property of a character which is subject to the allowance under Section 167 (relating to allowance for depreciation, etc.)” in Section 174(c) and the reference to “property of a character subject to the allowance for depreciation” in Section 41(b)(2)(C) mean property that is depreciable in the hands of the taxpayer.

The court agreed with TG Missouri, saying that:

[T]he reference in both sections to property of a character subject to the depreciation allowance means property that is depreciable in the hands of the taxpayer are supported by the function of these provisions in the overall statutory scheme. By their terms, Sections 41(b)(2)(C) and 174(c) prevent a taxpayer from receiving a credit for or expensing property used in the taxpayer’s research or experimentation activities where the cost is more appropriately recovered over time through depreciation deductions. Without these sections, a taxpayer could circumvent the gradual cost recovery mandated by the depreciation rules of Sections 167 and 168 by recovering the full cost of such property in 1 year.

Thus, this case stands for the proposition that expenses for property used by the taxpayer in its research that is owned by another party is allowable as a supply expense in computing the research tax credit.

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