In a Tax Court petition filed October 22, 2018, Shiloh (“Shiloh”) Industries Inc., a global supplier of automotive parts and a designer and engineer of precision tools, dies, welding, and assembly equipment, is disputing the Internal Revenue Service’s (IRS) assertion that the company’s claimed tooling expenses in 2012 and 2013 can be treated as qualified research expenses (“QREs”).[1] Will the Tax Court follow its decision in TG Missouri v. Commissioner [2] and allow tooling costs to be treated as supplies used in the conduct of qualified research under Internal Revenue Code (“IRC”) Section 41(b)? Alternatively, will the IRS concede the qualifying nature of tooling costs similar to its recent acquiescence in TSK v. Commissioner [3]? These cases pertain to tooling expenditures in the automotive industry. However, this research credit opportunity is relevant to any taxpayers with tooling expenditures.

Property of a Character Subject to Depreciation — A Brief History under Sections 41 and 174

Generally, three categories of expenses qualify for the research credit under IRC Section 41:

• Wages paid to an employee for qualified services;
• Amounts paid for supplies used in the conduct of qualified research; and
• 65 percent of any contract research expenses, which are amounts paid to any person other than an employee for qualified research.

The term "supplies" means any tangible property used in the conduct of qualified research other than:

• Land or improvements to land; and
• Property of a character subject to the allowance for depreciation.

Section 174 permits a deduction for supplies used in research. However, Section 174(c) provides that expenditures to acquire or improve land or to acquire property of a character subject to an allowance for depreciation may not be expensed or amortized under Section 174. Thus, the term "property of a character subject to an allowance for depreciation" is important in determining whether certain research or development expenditures qualify for deduction under Section 174 and whether they qualify for the research credit under Section 41.

Prior to the TG Missouri decision, the IRS commonly cited Ekman v. Commissioner [4], a decision pertaining to depreciable property used in research. Here, the taxpayer purchased an automobile engine to use in experiments to determine if he could increase the engine's horsepower through design modifications. The enhanced engine was not intended to become a finished product and was only used as a test engine. The IRS disallowed the taxpayer's Section 174 deduction, and the Sixth Circuit upheld the tax court's finding that the engine represented a depreciable asset. The taxpayer argued on appeal that Section 174 only excludes property used in producing final goods to be sold. The court disagreed, holding that "the character of the property, not the use of the property, is critical to the determination of whether an expense is deductible or only depreciable."

The IRS has also closely scrutinized prototypes to determine if they can be classified as property that is subject to an allowance for depreciation and, therefore, not qualify as supply expenses. Letter rulings have held that taxpayers' prototypes are property of a character subject to an allowance for depreciation and do not qualify for the research credit.[5] These rulings tended to ignore an example found in the regulations that indicate expenditures for building models can qualify as R&D expenses under Section 174.[6]

In short, the IRS' position prior to TG Missouri was to treat almost any property that is tangible in nature as being of a character subject to an allowance for depreciation. In other words, the IRS argues there is a "generic" character of property that exists without reference to a taxpayer's use of such property and that generic character controls whether costs related to the property in question qualify for the credit. However, given the lack of support in the IRC or regulations for this position, the IRS' guidance has created confusion and controversy for taxpayers attempting to properly quantify and document their research credit supply expenses.

TG Missouri: The Tax Court Appears to Provide Clarity

In TG Missouri (“TG”), the Tax Court rejected the IRS' decade-long stance on whether depreciable property can qualify as a supply expense under Section 41. The court held that production molds of an automobile parts manufacturer purchased from third parties, and later sold to customers, were not assets subject to depreciation under Sections 174 and 41. The taxpayer properly included costs of the molds as supply expenses in determining its research credit.

TG manufactured injection molded products, such as steering wheels, for automotive industry customers. TG contracted with customers to develop injection molded products and production molds that enabled TG to manufacture the desired product. TG was entitled to payment only if it successfully designed and built a mold capable of producing a sample product and the customer accepted the products produced using the mold.

TG either constructed the production mold in-house or contracted with a third-party toolmaker. The third-party toolmaker constructed the production mold according to TG's design specifications. The toolmaker did not guarantee that the mold would perform to TG's customer's specifications or produce the desired part. After the third-party toolmaker finished constructing the production mold, TG purchased the mold. Usually, TG incurred additional design and engineering costs to modify the production mold so that it produced the desired component. These costs were primarily TG engineer wages. The completed production mold was then used in the mass production of a single component part. It generally took 24 to 36 months to develop, design, construct and test a construction mold.

Either TG's customer purchased the completed production mold from TG or TG retained ownership. The process for developing a production mold and its use in TG's business to produce parts for a customer was the same regardless of whether TG retained ownership.

TG did not claim any research expenses for the production molds it owned and depreciated. If the customer purchased a production mold, title to the mold shifted to the customer. On its tax return, TG capitalized and depreciated the costs paid to third-party toolmakers for the production molds for which it retained ownership. For the production molds sold to customers, TG included the costs paid to the third-party toolmakers as qualified research expenses.[7]

The Tax Court focused on the molds as they were held by TG. Although TG retained possession of the molds it sold to its customers and used them to produce component parts, the court stated that "generally, only taxpayers with an economic interest in an asset can deduct depreciation with respect to that asset." Both the production molds that TG sold to its customers and the ones it continued to own had useful lives over one year and were subject to wear and tear. For the molds sold to customers it was not TG who "suffered from economic loss resulting from their deterioration and exhaustion." The court decided that even though TG retained physical possession of the molds after their sale, its customers "bore the risk of loss with respect to the production molds."

The Tax Court held that production molds of an automobile parts manufacturer purchased from third parties, and later sold to customers, were not assets subject to depreciation under Sections 174 and 41, and that TG properly included costs of the molds as supply expenses in determining its research credit.

Final Section 174 Regulations

The final Section 174 regulations (Treas. Regs. Section 1.174-2, dated July 22, 2014) clarify the definition of qualifying research and development expenditures. To counter an interpretation that Section 174 eligibility can be reversed by a subsequent event, the regulations provide that the ultimate success, failure, sale, or other use of the research or property resulting from research or experimentation is not relevant to a determination of eligibility under Section 174. This supports the conclusion of TG Missouri. Additionally, a number of examples in the final Section 174 regulations have fact patterns similar to TG Missouri and reinforce the Tax Court’s holding in that case.

TSK

In TSK of America Inc. (“TSK”), a Michigan automotive parts supplier, included tooling costs for metal stamping and plastic injection molding in its 2013 research tax credit.[8] TSK purchased the tools from a third party with the intention of using the tools in its production process. Typically, TSK’s customers required TSK to sell any unique tools produced to the customers, while TSK retained possession of the tool to produce the part.

Tooling purchased from a third-party supplier was not guaranteed to meet TSK specifications and production requirements. TSK argued that it undertook a thorough trial-and-error process to ensure the tools performed as designed and could meet its needs for efficiency, accuracy and economic productivity.

The IRS disallowed tooling QREs on the grounds that (1) there was not significant uncertainty surrounding the development of the tooling and (2) the tooling was for production purposes, not research purposes. TSK filed a petition with the U.S. Tax Court to dispute the IRS ruling. After discovery was conducted, the IRS notified TSK in August 2018, that it would not dispute TSK’s credit claim. As the TSK case did not result in a decision, it cannot be cited as precedent.

Shiloh

In Shiloh Industries Inc. (“Shiloh”) disputes the IRS's assertion that none of the $24.5 million the company claimed as tooling expenses in 2012 and 2013 can be treated as QREs under section 41(b).

According to the petition, Shiloh designs and sells precision tools and dyes to auto parts manufacturers. The precision tools and dies are used in Shiloh’s own manufacturing operations and are also sold to original equipment manufacturers (OEMs) automotive part manufacturers. Thus, in addition to manufacturing and selling parts used in the automotive industry, Shiloh also designs and sells tooling products that can be used to manufacture parts.

Typically, Shiloh’s tooling customer's engineers design and develop a part the customer wants to manufacture. The customer communicates to Shiloh its general specifications and requirements for the part. These specifications relate to the part the customer wants to produce. Shiloh then must design a tool that can produce the part.

To design the tool, Shiloh’s engineers create a conceptual or virtual model of the tool using computer design simulations and repeatedly tests the design with further computer simulations and analyses. The engineers eventually reach a point at which further computer simulation cannot eliminate the remaining uncertainties. At this point. Shiloh either (1) engages a third-party tooling manufacturer to build a prototype or "pilot model" of the tool or (2 builds the prototype or "pilot model" tool itself.

Although the toolmaker utilizes its general knowledge and know-how in manufacturing a tool, the toolmaker is not engaged to perform research, but instead is a vendor engaged to manufacture a tool that meets the design specifications provided by Shiloh. Once the toolmaker produces the tool to Shiloh’s specifications, Shiloh’s engineers and tooling experts conduct multiple tests on the prototype tool to resolve remaining uncertainties.

Shiloh is bound by the purchase order terms to pay the vendor for any finished work or work in process and raw material regardless of cancellation or termination and irrespective of ultimate delivery and acceptance of the tool by the customer. As such, tools are built in accordance with Shiloh’s agreement with the vendors and such vendors do not warrant that the tools will meet the performance requirements of Shiloh’s customers.

Shiloh’s design, testing, research, experimentation, and development activities are all undertaken to discover information and to be useful in the development of new tools for sale to customers. Shiloh’s development activities are undertaken to satisfy the customer's requirements. Under Shiloh’s production parts approval process (PPAP), Shiloh must prove, through engineering trial runs, that the tool in question meets the customer's requirements. If those requirements are not met and approved by the customer. Shiloh must make further modifications to the tool or its design. The tools in question will not be accepted by a customer, cannot be sold to a customer and are not available for use in commercial production by the customer, until the testing and modification process described above is completed.

As in TG Missouri and TSK, Shiloh sold all of the tools at issue to customers and did not retain ownership of such tools, nor did it claim depreciation with respect to such tools. While Shiloh has not been decided, it appears factually parallel to TG Missouri (decided) and TSK (acquiesced).

Alvarez & Marsal Taxand Says:

The Shiloh, TSK, and TG Missouri cases all involve tooling design expenditures by the taxpayer for its customers. The tool development required the performance of a battery testing to ensure that the tool met the end customers' requirements. In each case, the taxpayer bore the economic risk if the tools failed to meet customer requirements.

The similarities among the facts of these cases suggest that the Tax Court will follow its decision in TG Missouri and hold that Shiloh’s tools purchased from third parties and later sold to customers, were not assets subject to depreciation. Shiloh properly included costs of the tools as supply expenses. It will also be interesting to see how the IRS responds to Shiloh’s petition, given its earlier decision to acquiesce in TSK.

Like many of the other favorable judicial decisions regarding the research credit (e.g., FedEx, Union Carbide and McFerrin, which we discussed in Tax Advisor Weekly Issue 44, 2009 — "Wins of Change"), the TG Missouri result provides taxpayers with helpful guidance as they quantify and document qualifying supply expenses.

The TG Missouri decision provides a strong basis for including additional supply costs, such as certain tools and prototypes. Note that if you begin claiming additional supplies prospectively, remember that the consistency rule may require you to include such amounts in the base years, whether or not you amend those years.

Importantly, the logic of the tax court's reasoning in TG Missouri can be expanded far beyond molds and tooling. The most significant expenditures that may be affected are prototype expenses. The IRS often classifies prototypes as property of a character subject to the allowance for depreciation. Thus, the expenditures are not qualified for the research credit. Often taxpayers significantly undercount their qualifying supply expenditures. In industries such as manufacturing, aerospace, defense and communications, large tangible prototypes are often sold to third-party customers. Based upon the TG Missouri reasoning, there is significant support to include these amounts as qualifying supply expenditures.

Footnotes

[1] Petition of Shiloh Industries Inc., Shiloh Industries Inc. et al. v. Commissioner, No. 20802-18 (United States Tax Court, OCTOBER 22, 2018)

[2] TG Missouri v. Comm'r, 133 T.C. No. 13 (2009).

[3] TSK v. Commissioner (Docket No. 2018-35060)

[4] 184 F.3d 522 (6th Cir. 1999).

[5] See FSA 200125019, for example.

[6] Regs. Section 1.174-4(c) — models, like prototypes, are generally built during a product development's design or testing phases in order to verify that proposed designs function properly

[7] The IRS accepted that any wages paid to TG engineers for additional design work related to the molds after they were purchased from the third-party toolmakers were qualifying wage expenses

[8] TSK v. Commissioner (Docket No. 2018-35060); 2018 TNT 169-6