The regulation further provides that if at least 80% of the research activities constitute elements of a process of experimentation for a purpose described in IRC Section 41(d)(3), the substantially all requirement is satisfied even if the remaining 20% or less don’t constitute elements of a process of experimentation for a purpose described in IRC Section 41(d)(3), so long as these remaining research activities satisfy the requirements of IRC Section 41(d)(1)(A)—relating to IRC Section 174—and aren’t otherwise excluded under IRC Section 41(d)(4).
The Substantially All Fraction
Importantly, the appeals court emphasized the word elements in the numerator of the substantially all computation and stated “the numerator is broad enough to encompass research activities that are not per se experimentation or testing.”
The appeals court provides that the correct approach in determining substantially all is such that “direct support and supervision activities should be considered in both the numerator and denominator of the fraction,” thereby rejecting the tax court’s categorical exclusion of direct support and supervision from the numerator.
The appeals court points to examples in the regulations to illustrate that the production of prototypes or pilot models, and the associated expenses, can be included in the substantially all numerator.
While demonstrating nexus for the activities performed on a given project is still a critical component that should be documented, as was illustrated throughout the case, taxpayers can include direct supervision and support as elements of a process of experimentation in the numerator when determining if a particular business component meets the substantially all requirement for qualified research.
Use of Pilot Models in a Process of Experimentation
The appeals court underscored the requirement that pilot models be used in the process of experimentation. The court explained merely making a pilot model isn’t enough to pass the process of experimentation test; such model must be used to evaluate one or more alternatives using a scientific method.
In its analysis for the tanker project, the appeals courts commented the deadweight survey to determine the vessel’s water displacement was more akin to quality control testing, an excluded activity under IRC Section 174, than the methodical plan involving a series of trials to test a hypothesis described in Union Carbide and Siemer Milling.
In relation to the tanker project, the appeals court reasoned “no hypothesis was postulated, and no alternatives were evaluated.” Similarly, for the dry dock project, the appeals court found the raise-and-lower test “less experimentation than it is a quality control test that establishes whether a customer's specifications have been met.”
These holdings reinforce the need for taxpayers to clearly document how pilot models were used in the process of experimentation.
For both projects, the appeals court recognized the taxpayer encountered uncertainties during the builds for tanker and dry dock and that research activities would have occurred.
However, the taxpayer failed to document what, if any, of those activities involved a process of experimentation and didn’t provide any means to apply the shrink-back rule to subcomponents.
The appeals court stated, “by choosing an ‘all or nothing’ strategy, Taxpayer swung for the fences and missed.” The appeals court cautioned that “other taxpayers seeking to avail themselves of the research tax credit would be well advised to document research activities for subcomponents if they cannot demonstrate a process of experimentation at the business component level.”
Novelty Isn’t an Acceptable Method to Establish Substantially All
The appeals court agreed with the tax court’s evaluation of the Trinity Industries case and rejected the novelty approach for the substantially all determination. The substantially all test must be applied in reference to activities, not the physical elements of the project. The appeals court notes, “the novelty of a business component is not a proper heuristic for the substantially all test.”
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