Supplies

Overview:

IRC Section 41(b)(2)(C) defines supplies as “any tangible property, other than land or improvements to land, and property of a character not subject to the allowance for depreciation”. Qualifying supplies expenditures are used in the conduct of qualifying research if they are used or consumed in the performance of “qualified services” by an employee of the taxpayer (or person acting in the capacity of an employee).  Certain industries, such as software development, will generally have little or no qualifying supply expenses.

Some examples of qualified supply expenses (non-exhaustive) include:

1. Internal prototype costs
2. External prototype costs, such as coating, heat treating and machining
3. Lab supplies used during testing
4. Prototype equipment sold to customers
5. Costs of prototype molds made for short-term use to test a product or process design
6. Production molds, tooling or patterns used in research and sold to customers
7. Material scrapped from experimental production runs

An in-depth description of associated prototypical costs and expenditures is included in this manual.

Some examples of ineligible (but commonly requested) supply costs include:

1. Expenses used in general and administrative services
2. Travel, meals and entertainment
3. Relocation
4. Rental or lease payments
5. Professional dues
6. Royalty or license expenses
7. Server costs
8. Subscription services
9. Building materials cost
10. Depreciable equipment, even if used in R&D

Supplies Case Law: 

Trinity Industries: In a U.S. district court case, Trinity Industries Inc., No. 3:06-CV-0726-N (N.D. Tex. 1/29/10), the court held that the taxpayer (Trinity) is, in certain situations, entitled to the Sec. 41 research credit for qualified research expenditures (QREs) for activities relating to the design, development, and construction of new types/classes of ships. Trinity considered these first-in-class ships to be prototypes because the specific designs had never been previously attempted and, once validated and proven to meet their objectives, would be duplicated and commercially produced.

Because Trinity was not able to offer sufficient evidence for the court to determine QREs for a business component smaller than the entire vessel (Hurricane Katrina destroyed many of the records), Trinity adopted an all-or-nothing approach for each ship and applied the 80% threshold in Regs. Sec. 1.41-4(a)(6). Thus, Trinity would qualify for the research credit only if substantially all (80%) of the costs to build a first-in-class ship were QREs. 

Because the first-in-class ships are essentially developed as prototypes, the court appears to conclude that the costs of materials used in developing and constructing prototypes may be qualified. The court did not seem to condition its conclusions about the qualification of costs in the development/construction of a prototype on whether the prototype is successful and eventually turned into a salable product.

Similarly, if the risk of failure is applicable to a prototype on a project basis, when activities are substantially all qualified (80% or more) under Sec. 41, nonexperimental costs, such as paint, could be included in the total qualified cost of the prototype.

Union Carbide Corp. v. Comm’r: the taxpayer (UCC), a manufacturer of plastics and chemicals, claimed R&D credits based on the development of new and improved production processes. The majority of QREs that the taxpayer claimed in the lawsuit were supply costs attributable to raw materials used in their improved production processes. These materials were ultimately manufactured into products and sold to UCCs customers and would have typically been considered costs of goods sold for accounting purposes. Essentially the taxpayer claimed all materials for all processes regardless of whether they were old or new products.

In reviewing UCCs allocated supply costs, the court held that the company’s claimed supply costs did not qualify under the law. UCC argued that because the law did not define the phrase “used in the conduct of qualified research” the words should be given their plain meaning and that UCCs use of the supplies was sufficient to qualify for the credit. The court disagreed, finding that the development of a new production process should be distinguished from the company’s product manufacturing and that UCC would have purchased the supplies used to manufacture products regardless of whether or not the company conducted the research.

TG Missouri: the taxpayer manufactured plastic molded products for customers in the automotive industry. In order to manufacture the products, the taxpayer designed and developed molds. In some instances, the taxpayer retained ownership of the molds and depreciated them. In others, TG Missouri sold the molds to its customers, thus removing them from the company’s accounting books, and retained possession of them to use in further research and to produce replacement parts. When the company sold the molds to its customer, it claimed the costs that it incurred for the molds as supply costs in calculating its research credit.

In November 2009, the U.S. Tax Court (TG Missouri Corp v. Commissioner, 133 T.C. No. 13) ruled that the definition of qualified supplies may include the purchase cost of production molds sold to a taxpayer’s customer. Depending on the facts and circumstances of the taxpayer, production molds that are not subject to depreciation by the taxpayer and no interest is retained by the taxpayer, may qualify as a qualifying supply expense by the taxpayer.