Publish Date

Jul 11, 2019

Will the Court Wrench Another Taxpayer “Tooling” Victory in Shiloh Industries?

A&M Tax Advisor Weekly

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) I 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.”