Appeals court affirms Tax Court’s research credit decision

The U.S. Court of Appeals for the Seventh Circuit recently affirmed the Tax Court’s decision in Little Sandy Coal Company, Inc. v. Commissioner, (T.C. Memo. 2021-15), holding that a taxpayer failed to adequately document that “substantially all” of the research activities constituted elements of a process of experimentation.

The taxpayer in the case claimed a research credit under Section 41 based on activities performed by a shipbuilding subsidiary. The research credit was computed based on qualified research expenses relating to the design and construction of 11 “first-in-class” vessels.

Treas. Reg. Sec. 1.41-4(a)(6) generally requires taxpayers to establish that “substantially all” (i.e., 80% or more) of their research activities constitute the process of experimentation in order to claim a research credit. The taxpayer in Little Sandy Coal Company argued that its development activities met this test because the majority of each of the two vessels that were evaluated consisted of new components.

The Tax Court ruled in favor of the IRS, holding that the taxpayer did not meet the burden of proof that the “substantially all” requirement needed because the requirement must be analyzed at the activity level rather than physical elements of the business components.

The Seventh Circuit agreed with the Tax Court’s analysis on several key elements, including: 

• The “substantially all” fraction: The appeals court found that the fraction for evaluating the “substantially all” requirement is computed by dividing research activities which constitute elements of a process of experimentation by research activities not excluded under Section 41(d)(4) and whose expenses are deductible under Section 174.
• The taxpayer’s “novelty” argument: Citing language in Treas. Reg. Sec. 1.41-4(a)(6), which specifically references activities, the Seventh Circuit denied the taxpayer’s argument that its development of the two vessels met the process of experimentation “substantially all” requirement because they were “first-in-class,” had never been built before, and substantially all of the components were new.
• The taxpayer’s “all or nothing” approach: Section 174 and process of experimentation tests could not be performed at the component level (i.e., applying the “shrink-back” rule in Treas. Reg. Sec. 1.41-4(b)(2) to sub-components of each vessel) because the taxpayer applied an “all or nothing” strategy in claiming the development of the entire vessels as qualified research.

Although the Seventh Circuit ultimately agreed with the Tax Court’s conclusions, its findings departed from that of the Tax Court on aspects related to pilot model production expenses and their inclusion in the “substantially all” fraction.

The Tax Court found that pilot model production activities are direct support activities under Section 41(b)(2)(B)(ii), rather than qualified research or elements of a process of experimentation, and thus are includible in the denominator of the fraction and not the numerator. In contrast, the appeals court concluded that pilot model expenses should be included in the numerator and denominator of the “substantially all” fraction.

The Seventh Circuit referred to several examples in Treas. Reg. Sec. 1.41-4(a)(8) that describe a process of experimentation as including activities such as “designing,” “modeling,” and “simulating” and reasoned that the Tax Court erroneously imported a distinction in Section 41(b) into Section 41(d), in part because Section 41(b) addresses qualified research expenses whereas Section 41(d) addresses qualified research activities. However, the Seventh Circuit aligned its analysis with the Tax Court by performing the “substantially all” analysis under alternative assumptions that the vessels were and were not pilot models and concluded that in either instance, the taxpayer failed to provide enough evidence to calculate the “substantially all” fraction and document the activities that constituted elements of a process of experimentation.

The ruling in this case emphasizes the importance of adequate documentation to establish that “substantially all” of a taxpayer’s development activities constitute elements of a process of experimentation. It is important for taxpayers to understand that generalized descriptions of uncertainty, assertions of novelty, and arbitrary estimates of time performing experimentation are not sufficient for documenting qualified research activities. Rather than taking an “all or nothing” approach to documenting the “substantially all” requirement, taxpayers can consider alternative approaches such as shrinking back the analysis to sub-components of business components.