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DRAFT FOR DISCUSSION PURPOSES

Inclusion of Prototype Cost as Qualified Research Expenditures

In general, when a prototype is placed in inventory for sale to customers, the wages, contract

research (for which the taxpayer bears the risk), and supply costs incurred to develop the

prototype are qualified research expenditures (QREs), but the wages and contract research

related to construction and the supply costs for component parts are not. The same is true

when a prototype is used for rotable spare parts or is used as depreciable property by the

taxpayer.

However, when a prototype is scrapped by the taxpayer, all of the wages, contract research (for

which the taxpayer bears the risk), and supply costs incurred to develop and construct the

prototype are QREs. Similarly, when the taxpayer pays a third party to develop a prototype and

does not obtain an ownership interest in the prototype all of the costs incurred by the taxpayer

to develop the prototype are QREs.

Finally, when the taxpayer develops the prototype for a customer and does not obtain an

ownership interest in a prototype, all of the costs incurred by the taxpayer to develop the

prototype are QREs as long as the taxpayer’s compensation for services is contractually subject

to performance guarantees relating to the prototype.

Under section 174(a), “a taxpayer may treat research or experimental expenditures which are

paid or incurred by him during the taxable year in connection with his trade or business as

expenses which are not chargeable to capital account. The expenditures so treated shall be

allowed as a deduction.” However, under section 174(c) no deduction is allowed for “any

expenditure … for the acquisition or improvement of property … of a character which is subject

to the allowance under section 167.”

The regulations clarify that expenditures for depreciable property are not subject to an

allowance for depreciation even if the property that is acquired or improved is used for

research and development; however, expenditures that result in depreciable property to be

used in the taxpayer's trade or business may be allowable as a current expense deduction. QREs

for the acquisition or production of depreciable property do not include the cost of component

materials, construction labor, or other costs attributable to acquisition/ improvement.

Additionally, the regulations provide that expenditures paid to third parties for the construction

of depreciable property that is acquired by the taxpayer are deductible if such construction is

done at the taxpayer’s specification and risk.

Any amount paid or incurred for supplies used in the conduct of qualified research is a

qualifying in-house research expense. However, property of a character subject to the

allowance for depreciation is excluded from qualifying as supplies. The legislative history of the

section 41 credit suggests that the costs of component parts could be included in the credit

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calculations as qualifying supply expenditures; however, neither the IRS nor the courts have

taken this approach.

Revenue Rulings

In general, Revenue Rulings have been favorable regarding the deductibility of costs incurred to

develop prototypes, but somewhat limited in their reasoning and discussion of the law.

Rev. Rul. 69-484 held that payments made by a taxpayer airline, in concert with other airlines

and the Federal Aviation Administration, to an aircraft manufacturer to design, develop, and

test a supersonic transport aircraft were deductible under section 174. These payments did not

entitle the taxpayer to any rights in the prototype and were made because the development of

the aircraft would benefit the taxpayer in general.

Rev. Rul. 73-20, which cited Rev. Rul. 69-484 as precedent, similarly held that payments made

by a taxpayer utility to a non-profit research and development organization formed to develop

a model that would benefit the utility field were deductible under section 174. Notably, the

Ruling held that even the portion of the payments that were administrative and operating

expenses were deductible. Like the payments in Rev. Rul. 69-484, the payments in Rev. Rul. 73-

20 did not entitle the taxpayer to any rights in the prototype and no mention was made about

the eventual use or disposition of the prototype.

Similarly, Rev. Rul. 73-324 determined that payments made by a taxpayer in concert with other

industry members and a government agency for the development of a product, were

deductible under section 174.

Rev. Rul. 73-275 considered whether a taxpayer was entitled to a section 174 deduction for

costs incurred in constructing special order manufacturing systems for its customers. The Ruling

held that the product engineering expenses qualified under section 174, but the production

costs did not. The Ruling emphasized that “section 174 covers costs incurred in developing the

concept of a product as opposed to the product itself.

Rev. Rul. 75-122 considered whether the taxpayer mining company’s costs to access a

previously unexploited mineral deposit, develop equipment to mine that deposit, and develop

equipment and processes to extract the mineral from the ore were deductible under section

174. The Ruling held that the costs to locate and access the ore were explicitly disallowed by

section 174(d). However, the costs for developing new mining equipment, developing new

refining processes and equipment, and shipping ore samples to the lab were deductible under

section 174.

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Private Letter Rulings

A number of private letter rulings (PLRs) have also been favorable to the taxpayer.

In PLR 7921037, the Service ruled a taxpayer utility company that participated in a coal

gasification plant project funded by several utility companies was entitled to a deduction under

section 174.

PLR 7948031 was issued to a taxpayer chicken farmer that engaged an engineer to develop an

advanced system to extract uric acid from chicken manure so that the manure could be used

for animal feed. The Letter Ruling held that the engineering and plant costs incurred that

related to removing the uric acid from the manure were not deductible because that process

had already been tested and developed, but the plant and development costs attributable to

conversion of uric acid into fertilizer were deductible under section 174 except to the extent

that those costs were for the acquisition or improvement of land or property that were subject

to the allowance for depreciation under section 167.

PLR 8138145 was issued to a taxpayer partnership that was in the process of developing a pilot

residential energy efficiency program that would pay the taxpayer if it could provide energy

cost savings to customers that were greater than the cost to the utility of providing energy. The

Letter Ruling held “… the partnership may deduct all amounts which qualify as research and

experimental expenditures … in connection with the pilot test….”

In a slightly different situation, PLR 8835002 was issued to a taxpayer that developed a

prototype that used a new construction method in a laboratory. The Letter Ruling held that the

following constituted QRE under section 41: 1) wages and supplies used for research and

development in taxpayer's research and development department both prior to and after the

installation of the first prototype; 2) wages for on-site monitoring of the prototype installations;

3) supplies for modifying the prototype installations; and, 4) 65 percent of the amounts relating

to the testing of the prototypes paid to subcontractors to replace the original prototypes due to

method modifications and damage to the extent that these expenses were incurred during the

period the taxpayer was developing its new method.

Similarly, in TAM 199927001, a taxpayer that constructed molds and other tools for the

manufacture of plastic products was allowed to deduct the costs incurred in designing the

tools, but the costs incurred in constructing the tools were not deductible even though they

would not be depreciated by the taxpayer.

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Court Cases

In Honeywell Inc. & Subsidiaries,1 the Court held that rotable spare parts were depreciable

assets rather than inventory. Honeywell used such parts to service computers owned by its

customers as part of its computer maintenance and service business. Honeywell consistently

capitalized cost of rotable parts and depreciated them over the same life span assigned to the

related computers. The parts were provided by Honeywell to its customers under computer

lease or maintenance agreements and were repaired after removal from customer's machines

to be used again. There was no direct relationship between the fixed fee charged to maintain

the computers and the price or cost of parts in taxpayer's replacement parts pool; thus, parts

were not considered an income-producing factor that would require treatment as inventory.

The pool of parts was necessary for Honeywell’s maintenance business and the fixed asset

method of accounting used by Honeywell properly matched the cost of establishing the pool

with revenue earned from maintenance agreements.

In Trinity Industries, Inc. v. US2, the Court held that under the substantially all rule, if 80 percent

of the activities to develop a prototype constituted a process of experimentation, then all of the

costs associated with the prototype project were eligible for inclusion in calculating the section

41 credit. Trinity operated several businesses as divisions, one of which built work boats for

offshore drilling rigs along with other special purpose boats. This division engaged in research

and development to design and build “first in class” ships or prototypes for specific customers.

Trinity claimed a credit for work done to design and build these prototypes. The IRS denied the

claim and argued that the ships developed by Trinity were not a “business component” because

the prototype ships being developed were for special orders and not to be sold out of general

inventory. The Court disagreed, finding that after Trinity completed the ships they were held for

sale and thus satisfied the business component requirement. The Court went on to hold that

under section 41(d), if 80 percent of the cost of developing a prototype was incurred as part of

the process of experimentation, the entire cost of the prototype qualified as a research

expense. Thus, Trinity was entitled to its claim for a credit.

In TG Missouri Corp. v. Commissioner, 3 the taxpayer manufacturer claimed research tax credits

for expenditures it incurred to develop prototypes of production molds used to make plastic

auto parts for customers. These parts were built to customers’ specifications and the prototype

molds became the customer’s property upon completion. The taxpayer manufacturer,

however, retained physical possession after it sold the molds to customers so the taxpayer

could produce auto parts for its customers. Importantly, the taxpayer guaranteed that the

molds would perform in the manner desired by its customers. The taxpayer claimed these

expenditures on its 1998 and 1999 tax returns. In 2006, the IRS audited the returns and denied

the credits on the basis that the molds were “property of a character subject to the allowance

for depreciation” and were not qualified research expenditures. The taxpayer argued the

expenditures did, in fact, qualify because they were depreciable in the hands of someone other

than the taxpayer. The Court agreed with the taxpayer and allowed the expenditures to be used

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to calculate the research tax credit. The Court noted that the statute linked the proper financial

accounting treatment of the molds to the treatment of the expenditures incurred to develop

those molds for purposes of calculating the research tax credit.

Analysis

An overarching theme in the relevant authorities that consider whether the costs incurred by a

taxpayer in developing and producing prototypes are qualified expenditures for the purpose of

sections 41 and 174 is these sections allow a taxpayer benefits for developing the concept of a

product, but not for producing the product itself. When the prototype is placed in inventory for

sale to customers, the wages, contract research (for which the taxpayer bears the risk), and

supply costs incurred to develop the prototype are qualified expenditures, but the wages and

contract research costs related to the construction of the prototype and the supply costs for

component parts of the prototype are not. In Rev. Rul. 73-275, the IRS held that a taxpayer was

entitled to a section 174 deduction for the engineering costs incurred in constructing special

order manufacturing systems for its customers, but was not entitled to deduct the cost to

manufacture those systems. Therefore, in the case where prototypes are placed into inventory,

the costs to develop the prototype are qualified expenditures, but the costs to construct the

prototype are not.

The outcome is the same when the prototype is used for rotable spare parts; the wages,

contract research (for which the taxpayer bears the risk), supply costs to develop the prototype

are qualified expenditures, but the wages and contract research related to the construction of

the prototype and the supply costs for component parts of the prototype are not. Under

Honeywell rotable spare parts are depreciable assets rather than inventory. Generally, under

section 174, no deduction is allowed for any expenditure for the acquisition or improvement of

depreciable property. However, under the section 174 regulations, expenditures for research or

experimentation that result in depreciable property to be used in a taxpayer's trade or business

are deductible. Importantly, the regulations state that expenditures for component materials,

construction labor, or other costs attributable to acquisition and improvement do not qualify.

Like in the inventory situation, the distinction in the rotable spare parts situation is that the cost

of developing the property is deductible while the cost of producing the property is not;

therefore, the costs to develop the prototypes that become rotable spare parts are qualified

expenditure, but the costs to construct the prototypes are not. For the same reasons, when the

prototype is kept and used as depreciable property by the taxpayer, the wages, contract

research (for which the taxpayer bears the risk), supply costs to develop the prototype are

qualified expenditures, but the wages and contract research related to the construction of the

prototype and the supply costs for component parts of the prototype are not.

When the prototype is scrapped by the taxpayer, all of the wages, contract research (for which

the taxpayer bears the risk), and supply costs incurred to develop and construct the prototype

are qualified expenditures. Generally, a taxpayer can take a deduction for research or

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experimental expenditures that are paid or incurred in connection with the taxpayer’s trade or

business. A deduction is not allowed, however, for any expenditure made for the acquisition or

improvement of depreciable property. When a taxpayer develops a prototype that is later

scrapped, he or she is not creating depreciable property; therefore, the costs paid or incurred

by the taxpayer to create the scrapped prototype are deductible. When the taxpayer develops

the prototype for a customer and does not obtain an ownership interest in a prototype, all of

the costs incurred by the taxpayer to develop the prototype are qualified expenditures as long

as the taxpayer provides its customer with performance guarantees relating to the prototype.

TG Missouri showed that the depreciable property exceptions found in sections 174 and 41

only apply if the property is depreciable in the hands of the taxpayer.

When the taxpayer does not obtain an ownership interest in the prototype as a result of the

costs that it incurs, all of the costs are qualified expenditures. In Rev. Rul. 69-484, Rev. Rul. 73-

202, and Rev. Rul. 73-324, taxpayers that made payments to a third party in concert with other

industry members and a government agency for the development of a product prototype were

deductible under section 174. In these cases, the taxpayer and other industry members did not

obtain an ownership interest in the prototypes that were created as a result of their payments.

Lockheed Martin

In LOCKHEED MARTIN CORPORATION, No. 8:12-cv-03725 (AW), filed 5-14-13, Lockheed

amended its complaint against the IRS to take R&D credits as described by a few examples

below for the following (See Exhibit A copy of amended complaint):

(The disputed QREs include the costs of wages, supplies, and contract research incurred in

connection with the design, development, testing, integration, and fabrication of innovative

and unproven prototypes, including four different first-configuration Atlas V launch vehicles

and an advanced electronic surveillance and security system).

1. Atlas V launch vehicle consists of a complex array of integrated systems, including the

propulsion systems, vehicle and payload structures, and avionics systems. To meet a

particular customer’s mission specifications, these systems and their respective

components and subsystems must work together flawlessly under extreme conditions.

Each new configuration of Atlas V components presents new and different engineering

and scientific challenges.

Lockheed Martin (previously on its own and now as part of the ULA joint venture)

undertakes extensive preproduction design and development efforts with respect to

each new configuration of the Atlas V. To the extent feasible, each part, component,

and system is subjected to extensive laboratory testing and analysis. Throughout the

production process and up to launch, the launch vehicle and its various systems are

subjected to rigorous preflight testing.

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A new launch-vehicle-configuration design cannot be proven or validated until it is

actually assembled and successfully launched.

For each launch, an array of sensors gathers information about the status of all critical

components and systems. This information is carefully analyzed as part of a formal post

flight review. Anomalies identified through this process are analyzed in order to

understand their causes and to develop engineering solutions for future missions.

At the time of their respective launches, the four Atlas V launch vehicles described

below represented new and unproven configurations for which Lockheed Martin

claimed QREs.

The costs Lockheed Martin incurred to design, develop, test, integrate, and fabricate the

launch vehicle that would be used to launch Inmarsat’s 4-F1 satellite included wages

paid to employees for qualified services (as that term is defined in section 41(b)(2)(B)),

amounts paid for supplies (as that term is defined in section 41(b)(2)(C)) that were used

in the conduct of qualified research, and contract research expenses (as that term is

defined in section 41(b)(3)).

2. To improve launch availability for the New Horizons mission, Lockheed Martin increased

the maximum gimbal angle for the common core booster engine. The increased angle

was needed to control the launch vehicle because of the additional thrust supplied by

the five solid rocket boosters.

Due to the configuration of the New Horizons spacecraft, Lockheed Martin had to design

a new umbilical system that mounted to the payload fairing. The new umbilical system

allowed for proper separation from the spacecraft.

The costs Lockheed Martin incurred to design, develop, test, integrate, and fabricate the

launch vehicle that would be used to launch NASA’s New Horizons spacecraft included

wages paid to employees for qualified services (as that term is defined in section

41(b)(2)(B)), amounts paid for supplies (as that term is defined in section 41(b)(2)(C))

that were used in the conduct of qualified research, and contract research expenses (as

that term is defined in section 41(b)(3)).

The launch services agreement with SES ASTRA S.A. was a firm fixed-price contract

under which Lockheed Martin was to receive a total purchase price of $62,500,000 for

Atlas launch services.

During the years at issue, Lockheed Martin incurred costs, including those to design,

develop, test, integrate, and fabricate a new configuration of the Atlas V launch vehicle

that would satisfy the customer’s specifications for the ASTRA 1KR mission.

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The launch vehicle for the ASTRA 1KR mission was the first Atlas V rocket to incorporate

a lone solid rocket booster.

The launch vehicle was the first Atlas V flight with an X-Stringer, or reduced part count,

extended payload fairing. This extended payload fairing allowed the ASTRA 1KR

spacecraft to properly fit within the fairing of the launch vehicle.

The costs Lockheed Martin incurred to design, develop, test, integrate, and fabricate the

launch vehicle that would be used to launch the ASTRA 1KR satellite included wages

paid to employees for qualified services (as that term is defined in section 41(b)(2)(B)),

amounts paid for supplies (as that term is defined in section 41(b)(2)(C)) that were used

in the conduct of qualified research, and contract research expenses (as that term is

defined in section 41(b)(3)).

Conclusion

It seems clear that expenditures incurred for prototypes qualify as R&D to the extent the

taxpayer does not retain ownership in the prototype or if the prototype is not included as

inventory.

Further, the legislative history of the section 41 credit suggests that the costs of component

parts could be included in the credit though the IRS and courts appear reluctant to endorse this

approach to date.