On January 29th, the U.S. District Court for the Northern District of Texas (Dallas Division) issued its ruling in the Trinity Industries, Inc. v. U.S. The Court’s ruling is another in a long line of recent major court cases regarding R&D Tax Credits cases.
Trinity is a large corporation engaged in a variety of businesses. The expenditures at issue here were incurred by a division of Trinity sometimes called Trinity Marine Group (“TMG”). Trinity dealt with research in the development of special purpose boats by Halter Marine of New Orleans.
When TMG designs a new type, or class, of ship, the first one is called “first in class.” A first in class ship is essentially a prototype. TMG’s hope is that many more will be built that are substantially duplicates of the first in class, but there is no guarantee of that. The claimed QREs here were primarily related to design and construction of first in class ships designed and built under contracts for various customers. TMG took the position that the entire cost of the “first in class” ships represented QRE credits based upon the significantly all (80%) rule.
There were three issues addressed by the Court:
Business Component:
The IRS contended that the ships did not qualify as “business components” because they were special order rather than being sold out of inventory. The court quickly dismissed that position by noting that the IRS cited no authority for its position; Taxpayer victory.
Integrating Existing Components:
Much of the design work at issue involved integrating extant subassemblies into a ship design. The government suggested that this is 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 found this greatly oversimplifies the process, for the following reasons:
First, many of the systems, at issue, are not monolithic entities, but rather families of products with considerable flexibility in their configuration. Determining which configuration out of the universe available can in particular cases itself involve a significant research effort.
Second, the systems do not exist in a vacuum. They interact with each other, sometimes in complex and non-intuitive ways. A change in electronics may require a change in power generation and distribution, which may require a change in the engine plant, any one of which may affect the weight distribution and performance of the vessel as a whole.
Taxpayer victory. This is an important victory point for electric utilities, in that a significant proportion of the R&D performed in generation power plants involves research to determine the overall impact one design change may have on other plant systems and the plant as a whole.
All Or Nothing
There were six ship projects involved in this case and Trinity took the position that the entire cost of each project qualified under Sec. 41 under the rule whereby if 80% or more is research, the whole thing is research. Trinity did not attempt to segregate those expenses related to new aspects of the designs from tried and true elements. Rather, Trinity took an all or nothing approach to the litigation.
The Court conceptually agreed with TMG, that if a first in class ship is sufficiently experimental, the risk of failure attaches to the entire project.
The Court held that the entire costs of two projects did qualify, and held that less than 80% of the other ones qualified, thereby disallowing the other four. The Court provided that they would have applied the Shrink-back rule if Trinity had supplied any evidence to allow them to apply the Cohan Rule. The Court also noted the case law requiring the Court to apply the Cohan rule as required by the Fifth Circuit in the recent McFerrin case.
Taxpayer Victory. Although only two of the six projects were approved, the Court’s logic reinforces the use of estimates to allow the Shrink-back rule to be employed. This is important in that R&D tax claims should always contain a scaled-back position to enable shrink-back estimates.
This is the fifth major victory for taxpayers in R&D cases within the last 12 months. The results of this case should be strongly considered in taxpayer R&D claims. The most significant finding in this case is the opinion that, “the risk of the failure attaches to the entire project. The potential loss includes not just the experimental aspects, but also the paint.” This ruling enables the opportunity to claim cost not historically included in research projects.
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