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January 30, 2010

What is a Project for the Research Tax Credit?

Federal Income Tax

Houston Tax Attorney

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It can be difficult to separate qualified and nonqualified research in computing the research tax credit.  The research tax credit rules are generally applied to the “project,” but the term “project” is not even mentioned in the Code.  The Trinity Industries, Inc. v. United States, 691 F. Supp. 2d 688, (N.D. Tex. 2010), case provides guidance on what can count as a project for purposes of the research tax credit.  

Facts & Procedural History

Trinity Industries, Inc. (“Trinity”) is in the shipbuilding business. This work includes designing and constructing new types or classes of ships (i.e., “first in class” ships) for clients.

Trinity filed refund claims for tax years 1994 and 1995 to take research tax credits. The credits were for six shipbuilding projects.

The IRS disallowed Trinity’s refund claims and Trinity sued to obtain the refunds.

About the Research Tax Credit

The research tax credit rewards taxpayers for performing research in the United States.  The term “research” is not defined in the Code.  Rather, the Code sets out a four-part test that provides guidelines as to what research is qualified.  These tests ask whether:

  1. The expenditures connected with the research must be eligible for treatment as expenses under section 174 (the section 174 test). Sec. 41(d)(1)(A).
  2. The research must be undertaken for the purpose of discovering technological information (the technological information test). Sec. 41(d)(1)(B)(i).
  3. The taxpayer must intend that the information to be discovered be useful in the development of a new or improved business component of the taxpayer (the business component test). Sec. 41(d)(1)(B)(ii).
  4. Substantially all of the research activities must constitute elements of a process of experimentation for a purpose relating to a new or improved function, performance, reliability, or quality (the process of experimentation test). Sec. 41(d)(1)(C), (3).

The Trinity case focused on the 1st and 4th tests.  

The Research Activity

For the Section 174 test and the process of experimentation tests, the IRS argued that the research was nothing more than ordering off a menu: pick a hull from column A, a propulsion system from column B, an HVAC from column C, etc.

The court did not agree. It noted that the components consisted of families of products with considerable flexibility in their configuration and they interact with each other, sometimes in complex and nonintuitive ways.

The Focus on Projects

The IRS then focused on the projects to which the tests applied.  The IRS took the position that Trinity had to break out every expense and determine whether it was qualified. Trinity was not able to do this as it was not able to access the records for this as they were maintained in computer systems that were no longer in use and/or destroyed by Hurricane Katrina.

Trinity argued that if the ship as a whole was sufficiently experimental, then the whole project was qualified.

The court followed this approach and evaluated the facts for each project. This led the court to conclude that some of the projects were qualified in full as the ships were sufficiently experimental and others were not qualified at all.

The Takeaway

This case is important as it provides guidance on how to apply the four-part test.  Specifically, the case clarifies that it may be possible to apply the tests to the project, rather than a more narrow subset of components when records are not available.  

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