TRINITY INDUSTRIES v. UNITED STATES OF AMERICA
CASE FACTS
Trinity Industries (taxpayer) is a large corporation engaged
in a variety of businesses. The taxpayer claimed research
credits on its 1994 and 1995 tax returns; however, the credits
were disallowed. During the years in question, Trinity Marine
Group, a division of Trinity, was in the business of shipbuilding.
According to the court, the claimed qualified research expenditures (QREs) in question primarily were related to the design
and construction of first-in-class ships designed and built under
contracts for various customers. For the taxpayer’s purposes,
a first-in-class ship is a prototype. Trinity had hoped it would
be able to build and sell many more ships that would be
duplicates of the prototypes. The court looked at six different
projects to determine if the taxpayer was eligible for a credit.
ISSUES
The primary issues were determining if the projects in question
qualified as business components and whether or not a
process of experimentation was used to design and build the
prototypes in each project.
ANALYSIS
The IRS argued that because the ships were special order
pursuant to customer contracts they were not held for sale
and did not meet the definition of a business component.
However, the court found that each first-in-class ship was
indeed a business component because they were held for sale
during the period between completion and when they were
sent to customers.
The IRS then argued that “much of the design work at issue
involved integrating extant subassemblies into a ship design,”
thus arguing there were no uncertainties and no process of
experimentation. However, the court said this oversimplified
the efforts undertaken by Trinity, stating that “determining
which configuration out of the universe available can in partic-
ular cases itself involve a significant research effort.” While
the government suggested that the design activity involved
nothing more than ordering off a menu, the court concluded
that because of the considerable flexibility in ship configurations and complex interactions among various components,
there can be integration risk in the design of a vessel as a
whole.
The court examined six projects from the years in question.
The taxpayer was not able to provide sufficient evidence
for the court to determine QREs for a business component
smaller than the entire ship, so an “all or nothing” approach
was employed. In doing this, the court determined that the
“shrinking back” rule did not apply to the taxpayer. The
shrinking back rule states that if less than 80 percent of the
taxpayer’s activities with a business component constitute
qualified research, the taxpayer must provide sufficient
evidence to shrink back the business component to the
subcomponents for which the qualified research requirements
are met. Since the court determined the “shrinking back” rule
did not apply, Trinity applied the “substantially all” rule for each
ship and would qualify for the research credit only if 80 percent
or more of the costs to build a first-in-class ship were qualified
research expenditures. Further it was determined that nonexperimental costs incidental to the development, e.g., painting,
were qualified expenses under Internal Revenue Code (IRC)
Section 174; because they were not otherwise excluded under
IRC §41(d)(4), they could be included as qualified research
expenses by virtue of the “substantially all process of experimentation rule” of Reg. §1.41-4(a)(6). With this approach, the
court found that only two of the six ships originally claimed by
Trinity met the “substantially all” rule.
According to the court, “the first-in-class ships in question
ranged from all new hull-up designs to cafeteria-style
mix-and-match combinations of existing elements to slight
modifications of existing design.” The two ships that met the
“substantially all” rule differed from the rest in that, at the time
of the contract, nothing existed like them. Since these required
substantial amounts of research compared to the other four,
they were considered QREs.
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TRINITY INDUSTRIES v. UNITED STATES OF AMERICA
The court did recognize that research was undertaken with
respect to the other four first in class ships; however, Trinity
failed to prove that substantially all of the costs were related to
a process of experimentation. Since documentation did not
exist to apply the “shrinking back” rule, the court was forced
to disallow 100 percent of these expenses.
IMPLICATIONS
This case offers substantial insight regarding the nature of
qualified research activities. As previously mentioned, the
court states “determining which configuration out of the
universe available can in particular cases itself involve a significant research effort.” This reinforces the notion that qualified
research activities include development efforts designed to
use existing technologies in new and innovative ways. It also
highlights that uncertainty related to the overall design of
a business component is enough to satisfy the uncertainty
requirement.
This case also offers an actual example of how the “shrink
back” rule applies to qualified research activities. The rule
is applied to projects where some of the expenses qualify as
research, but not 80 percent or more. As the court explains,
“the regulations call for a progressively granular approach,
until the 80 percent threshold is met for some subunit of the
vessel. If the whole ship doesn’t qualify, perhaps the new
engines do; if the engines don’t qualify, perhaps the new
pistons do, etc.” With appropriate documentation, Trinity
could have applied the shrink back rule to estimate QREs
and possibly claim a percentage of qualified research on the
four projects that did not meet the “substantially all” rule.
Taxpayers should be prepared to apply the shrink back rule for
qualified work on projects that fail to meet the substantially all
threshold.
Finally, the Trinity case provides another example of the importance of documentation to support seemingly “old claims”
and for application of different methods to develop claims
with differing scopes of qualified research, e.g., whole ships vs.
engines.
This information was written by qualified, experienced BKD professionals, but applying specific information to your situation requires
careful consideration of facts and circumstances. Consult your BKD
advisor before acting on any matter covered in this update.
FOR MORE INFORMATION // Visit bkd.com or contact Ashley Thompson // Director // 317.383.4000 // athompson@bkd.com
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