The Fifth Circuit Court of Appeals ruled July 2 that a taxpayer claiming the R&D credit is allowed to adjust base period expenses if projects or costs for the credit year are determined to not be qualified.

In Trinity Industries Inc. v. United States, No. 12-11012 (5th Cir. 2014), the court further clarified the application of the "consistency rule" from Section 41(c)(6).

Trinity Industries Inc. (Trinity) is a shipbuilder that claimed an R&D credit for certain vessels designed and built during its tax years ending in 1994 and 1995. A district court had previously ruled on whether certain projects met the R&D tax credit qualification requirements (Trinity Industries Inc. v. United States, No. 3:06-CV-0726-N (N.D. Tex. 2010)). In its ruling, the district court relied on an "all or nothing" approach because records did not exist to allow the court to "shrink back" to only qualified portions of the project if it determined the entire project was not qualified. After ruling that certain projects were not qualified, the district court failed to address Trinity's argument that similar projects from the base years should also be removed to lower the base amount.

The calculation of the R&D credit requires that current year expenses be compared to a base amount, and only expenses that exceed that base amount are eligible for the credit. If Trinity could not adjust its base amount to remove similar nonqualified projects that the district court removed for the credit years, the base amount hurdle would be artificially high and result in a lower credit for Trinity. The appeals court agreed with Trinity's argument that the base amount should be adjusted, and it remanded the issue to the district court to determine if the base period projects in question were similar in nature to the disallowed projects in the credit year.

While the appeals court applied a fairly plain reading of the statute and regulations to allow for adjustments to the base years, the ruling is still important to taxpayers. Many taxpayers run into situations where IRS exam teams make adjustments to the credit years but do not want to allow corresponding adjustments to base years. This ruling helps clarify that these types of base-year adjustments are appropriate.

This ruling also reinforces the importance of retaining adequate records to be able to shrink back in cases where the entire business component or project is not qualified. Like the district court, the appeals court indicated that certain projects that were ultimately disallowed involved elements of qualified research; however, the lack of detailed records did not allow the taxpayer or the court to shrink back to the qualified portions of the project.

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