TG Missouri R&D Tax Credit Prototype Expenditures

Supply Costs clarified by courts for Research & Development Tax Credits

By Randy Eickhoff, President, Acena Consulting, LLC

Recently, an important court case was decided that helped to clarify the definition of supply costs incurred by a taxpayer taking a research and development tax credit. In summary, the Tax Court in TG Missouri v. Commissioner (TG Missouri v. Commissioner, 133 T.C. 13) concluded that supply costs associated with the purchase of production molds that were ultimately sold to their customers were not depreciable assets and could be included as supply costs in the calculation of the R&D tax credit under IRC Section 41.

This result has dramatic effects for taxpayers that spend substantial amounts of money on the development of prototypes that are ultimately sold to customers.

Background

The R&D credit has been a part of the US Tax Code since 1981. Under Internal Revenue Code Section 41, taxpayers that engage in activities to discover information related to the development or improvement of a product, process, technique, formula or software may generate a tax credit to offset regular income tax. While these development activities must pass a number of additional tests, costs for employee wages, supplies and outside research are generally allowed to be used in the calculation of this credit.

The R&D Tax Credit regulations and congressional intent has long held that costs includible as Qualified Research Expenditures (“QREs”) must not be “assets of a character subject to the allowance for depreciation.” As such, the IRS has routinely disallowed supply costs attributable to prototypes that are sold to customers, taking the position that these costs can be depreciated by the customer and, as such, are assets and may not be included in the calculation of the R&D Tax Credit under Section 41.

TG Missouri is in the business of producing injection-molded products for the automotive industry such as steering wheels, air bags and body side molding. TG Missouri develops and uses production molds to manufacture these automotive parts for its customers. The company contracts with third-party toolmakers to build the production molds that it does not construct itself. Upon receipt of the finished production mold from the toolmaker, TG Missouri engineers incur additional design and engineering costs to modify the mold to be used to produce the desired product. Some production molds are sold to customers and retained on-site for production while other production molds are owned by TG Missouri and the unit cost charged to the customer is increased slightly to amortize the cost of the production mold over time. TG Missouri included in their R&D costs both the amounts paid to the toolmakers and additional engineering time incurred for production molds sold to their customers. The IRS challenged the inclusion of amounts paid to toolmakers taking the position that these costs did not meet the definition of supplies because they were of a character subject to depreciation.

Defining Depreciable Property in taxpayer’s hands is the key

The definition of supply costs at issue for taxpayers and the IRS are those that are includible in the R&D credit calculation. The key question has been whether or not certain expenditures are assets and, as a result, depreciable and should be disallowed. In TG Missouri, the Tax Court looked to the definition of depreciation found in Section 167 and definitions under Section 174 & 41of the Internal Revenue Code (“IRC”) in making their ruling.

IRC Section 167 holds that depreciation is applicable to

“…property used in a trade or business or held for the production of income.”

IRC Section 174(b) (1) (C) makes clear that its reference to R&D expenditures chargeable to capital accounts but not to property of a character subject to depreciation is a reference to the proper accounting treatment of expenditures on the taxpayer’s books and records. This clarified for the Tax Court that congressional intent was to disallow expenditures from inclusion in the R&D tax credit calculation that related to assets where costs would be depreciated under Section 167. It also clarified that congressional intent was to address the treatment of such expenditures at the taxpayer level based upon how they were used rather than one generic definition.

The Tax Court also noted that under IRC Section 1239(a), the sale of depreciable property between certain related taxpayers denies capital gain treatment on the sale of assets in certain circumstances. Section 1239(a) provides that the transferor’s gain shall be treated as ordinary income

“if such property is, in the hands of the transferee, of a character which is subject to the allowance for depreciation provided in Section 167.”

If Congress intended an inherent definition of an asset without regard to whose hands the property would be depreciable, the phrase “in the hands of the transferee” would have been unnecessary.

The impact to companies taking R&D tax credits

Companies today are spending millions of dollars developing new and improved products and technologies. In many cases, the material and design costs to secure a new customer or contract can be immense due to the cost of expensive materials and highly engineered products such as semiconductors and computer integrated capital equipment. In the past, the IRS has uniformly disallowed expenditures for prototypes that were ultimately sold to customers.

With the Tax Court’s decision in TG Missouri, these expenditures can now be included in the R&D tax credit calculation increasing the amount of the credit for the taxpayer.

For more information, or to discuss how this case can impact your company or organization, please contact Randy Eickhoff at 805-426-9669 or via email at randy.eickhoff@acenaconsulting.com.

Any U.S. tax advice contained in this communication is not intended or written by the practitioner to be used, and that it cannot be used by any taxpayer, for the purpose of (i) avoiding penalties that may be imposed on the taxpayer, or (ii) supporting the promotion or marketing of any transactions or matters addressed herein.