January 30, 2010

Trinity Industries, Inc. v. United States: Ship Designs Qualify for the Research Tax Credit

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In Trinity Industries, Inc. v. United States, 691 F. Supp. 2d 688, the U.S. District Court for the Northern District of Texas concluded that the designs for experimental first in class ships qualified for the research tax credit even though the taxpayer could not demonstrate which subset of expenses for each project were qualified.

The facts and procedural history are as follows:

  1. Trinity Industries, Inc. (“Trinity”) is in the shipbuilding business. This included designing and constructing new types or classes of ships (i.e., “first in class” ships) for clients.
  2. Trinity filed refund claims for tax years 1994 and 1995 to take research tax credits. The credits were for six shipbuilding projects.
  3. The IRS disallowed Trinity’s refund claims and Trinity sued to obtain the refunds.

The court considered the facts for each of these projects and in light of the four-part test for qualified research, which requires that:

  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 IRS only contested the section 174 and 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 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. Instead, 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.

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