R&D tax credits are hard to claim because the IRS defines research narrowly, but a federal court decision involving a ship builder sheds light that may help companies in the energy sector.
Trinity Industries built six “first in class” boats for various customers that had to be specially designed for the particular uses to which the customers planned to put the boats. The company hoped it might eventually have orders for more, but there was no guarantee.

For example, one of the boats was a “Mark V” high-speed craft that the company designed for use by special forces units. The craft had to fit in a C-5 cargo plane for rapid deployment. It had to move at unusually high speeds, have a low surface area and throw off little engine exhaust to avoid detection by radar and infrared sensors. It also had to be able to carry a variety of weapons.

Another boat was a double-hulled oil barge that was a response to the Exxon-Valdez oil spill.

The IRS defines “research” as a process of experimentation undertaken to discover information that is technological in nature and that will be used to develop new or improved components for the taxpayer’s products.

The IRS argued that Trinity did little more than allow customers to order off a menu: “pick a hull design from column A, a propulsion system from column B.”

The court disagreed. It said the process used by Trinity varied from all-new hull designs to cafeteria-style mix and match combinations of existing elements to slight modifications of existing designs. It said it would allow R&D tax credits to be claimed on the entire cost of a boat if 80% or more of the effort that went into building the boat involved a process of experimentation, measured on a cost or other consistently-applied reasonable basis. If Trinity could not reach the 80% threshold for the entire boat, then it should identify the largest subset of components that satisfies the test. The court said this “shrinking back” rule only comes into play if the company cannot reach 80% on the entire boat.

The US tax code allows companies to claim a 20% tax credit for their spending on research. The credit is claimed only on incremental research during the year, meaning the amount a company increases its research spending above a base. However, companies have the option of using a sliding formula instead and taking a smaller credit based on research spending as a percentage of average gross receipts over the last four years. For example, the credit would be 3% of research spending above 1% of gross receipts, 4% of such spending above 1.5% of gross receipts and 5% of research spending above 2% of gross receipts.

The tax credit expired at the end of 2009. Both the House and Senate voted to extend it through 2010 as part of a tax extenders bill that is expected to clear Congress by late May.

Keith Martin