How the Assembly Line Can Help Gaming

The automotive industry is not typically a source the gaming industry would consider a model to structure research activities in an effort to maximize federal research tax credits. However, the automotive industry and the gaming industry—particularly equipment manufacturers—do share some similarities with respect to product development. Both industries incur substantial expenditures to develop new products and sufficiently modify prototypes to ultimately produce the equipment each industry craves. While the automotive industry may need tier-one suppliers to design and develop air bags, steering wheels or other components of an automobile, the gaming industry relies on equipment suppliers to develop electronic gaming devices, which often incorporate innovative features such as interactive screens, sophisticated computer chips and programs.

An opinion recently released by the U.S. Tax Court, TG Missouri Corporation v. Commissioner, 133 T.C. 12 (Nov. 12, 2009)—a case that I litigated with my tax partners William Elwood and Andrew MacLeod—provides an excellent framework for research and development intense industries, including the gaming industry, to structure research activities to maximize federal research tax credits. In TG Missouri, the tax court resolved a long-simmering debate between the IRS and businesses engaged in research and development activities concerning the eligibility of certain properties to qualify for the research and development credits under Sections 41 and 174 of the Internal Revenue Code of 1986, as amended (IRC or Code). In TG Missouri, my colleagues and I secured a significant victory for business taxpayers when the U.S. Tax Court issued its opinion favorable to business taxpayers. The decision and its implications have been widely reported to several other industries involved in research and development activities. The benefits secured by TG Missouri may similarly be available to gaming businesses with research and development activities.

The research credit available under the code operates through a complex web of regulations issued under two code sections, both which use similar language. The research credit allows taxpayers to claim a credit under the IRC Section 38 general business credit for “qualified research expenses.” Courts have identified five elements for activities to constitute “qualified research” under the code.1 Essentially, qualifying expenses must be incurred for a purpose to discover technological information, the application of which is intended to be useful in developing a new or improved business activity of the taxpayer. In TG Missouri, it was not disputed that TG Missouri Corp.’s activities satisfied four of the five elements. The crux of the issue was the interpretation of a clause in IRC Section 41 under which the business is denied a research credit for expenditures incurred for property that is “of a character subject to the allowance for depreciation.” Thus, the focus of the tax litigation was the meaning of that phrase.

The research and development activities undertaken by TG Missouri Corp. are similar to many automotive and non-automotive businesses involved in manufacturing and supplying products for customers. The activities involved related to the development of molds that ultimately were used in production. Often a third-party toolmaker will construct a production mold, which a manufacturer such as TG Missouri then purchases. The production mold as purchased from the third-party toolmaker is usually incapable of being used in production. As a result, a manufacturer will incur substantial costs to modify the mold so that it is capable of producing products in accordance with customer specifications.

After making these refinements to the molds, a mold is either (1) purchased by a manufacturer such as TG Missouri’s customer, or (2) ownership is retained by the manufacturer. In the latter circumstance—when a manufacturer such as TG Missouri retains ownership—it will depreciate the third-party toolmaker costs associated with the production mold and the IRC § 41 research credit will be unavailable. However, in the former circumstance, when a customer purchases a production mold, manufacturers such as TG Missouri had traditionally been claiming IRC § 41 research credits for the costs incurred in connection with the construction of the molds.

The Crux of the Issue
The sole issue before the tax court in TG Missouri was the meaning of the phrase “property of a character subject to the allowance for depreciation.” To disallow research credits, the IRS had conjured the novel argument that the expenditures attributable to any property that might, in some circumstance, be subject to depreciation were ineligible for research credits even if the owner could not claim such depreciation. The IRS’ position was premised on an analysis of the character of the property itself and did not involve an examination with respect to whether the property would be depreciable in the hands of the particular taxpayer. TG Missouri, on the other hand, argued that the statutory phrase necessarily refers to property that is depreciable in the hands of the taxpayer—or TG Missouri in the case—and not the abstract nature of the property.

Tax Court Adopts Statutory Interpretation
In the first case to ever decide that issue, the tax court held that the statutory language of both IRC § 41 and IRC § 174, each of which refers to “property of a character subject to the allowance for depreciation,” requires an examination of whether the property is depreciable in the hands of the taxpayer claiming the credit. TG Missouri was able to successfully focus the tax court’s analysis on the legislative history of the research credit as well as the plain language of the statute and the well-defined function of depreciation under federal tax law. Applying principles of consistency of statutory construction of related code provisions, the court concluded that “section 174(c) clearly requires an examination of the proper tax treatment of the expenditure in the hands of the taxpayer,” and that the same interpretation was required with respect to the meaning of the similar phrase that is used in IRC § 41.

Opportunities from the Decision
The TG Missouri decision has implications beyond just the automotive industry. The decision offers businesses, particularly businesses with extensive research and development activities, the ability to structure their activities in order to maximize the availability of the research credit. Specifically, TG Missouri further clarifies that third-party toolmaker costs relating to production molds can qualify for the research credit. As a result, those businesses that were reluctant, following the IRS’ assault with respect to this issue, to claim research credits on their property because it may have been theoretically depreciable in the hands of another person, now have clear guidance that the proper analysis focuses solely on whether the property is depreciable in that business’ hands.

For the gaming industry—particularly for gaming equipment manufacturers involved in the development of new products—TG Missouri is a significant decision. Take the following example:

Suppose an equipment manufacturer, when designing new electronic gaming devices, develops and designs new integrated circuits to be used in electronic gaming devices.2 The equipment manufacturer contracts with a third-party to manufacturer the integrated circuits. Upon delivery of prototypes to the equipment manufacturer, further testing and revisions to the design of the integrated circuits are required.

The process of developing the prototype integrated chips that will be used in the new electronic gaming devices is analogous to TG Missouri’s use of third-party toolmakers and the development of production molds. Prior to the tax court’s decision in TG Missouri, the IRS likely would have disallowed research credit claims for those expenses incurred relating to the further development of the integrated chips after delivery of prototypes. As in TG Missouri, and audits of other taxpayers on the same issue, the IRS argument would follow that because, theoretically, the integrated circuits may conceivably be depreciable in some person’s hands, the expenditures are not qualified research expenses and, thus, the research credit is unavailable.

The court’s opinion, however, provides a basis for the equipment manufacturer to argue that the expenditures incurred to modify the prototypes are eligible expenditures to support a claim for research credits. TG Missouri directs that the proper inquiry is whether the integrated chips are depreciable in the hands of the equipment manufacturer. To the extent that integrated chips are not depreciable in the hands of the equipment manufacturer, then the expenditures may constitute qualified research expenditures for purposes of the research credit.

As the example illustrates, TG Missouri provides guidance to gaming businesses involved in research and development activities with respect to what expenditures are eligible to constitute qualified research expenditures for code purposes. The opinion offers a framework to structure research and development activities, as well as presents an opportune time for gaming businesses with research and development activities to re-examine the administration of their research activities. Gaming businesses may wish to re-examine the basis on which their research credits are currently being claimed and/or to consider filing protective refund claims against the IRS.

Future Planning and Concluding Comments
Under current law, the research credit is available under IRC Section 41 for qualified research expenditures paid or incurred prior to Jan. 1, 2010. Congress has extended the research credit on several occasions and an extension was included in the tax extender legislation passed by the House of Representatives in late 2009. Whether the Senate will adopt the House tax extender legislation, with an extension of the research credit for expenditures incurred after Dec. 31, 2009, remains to be seen.

Regardless if Congress extends the IRC Section 41 research credit, TG Missouri still remains a highly relevant decision for taxpayers involved in research and development activities. The decision is relevant because it affords business taxpayers the opportunity to reexamine past use of research credits to determine whether there is a basis to file a refund claim against the IRS.3

1 The five elements of “qualified research” identified by courts are: (1) the research expenses must qualify as expenses under IRC § 174; (2) the research expenses must be incurred for the purpose of discovery information; (3) the information discovered must be technological in nature; (4) the information discovered must be intended to be useful in the development of a new or improved business component of the taxpayer; and (5) substantially all of the research must constitute elements of a process of experimentation for a valid purpose under the code.
2 The facts in the example are based on FSA 20013017 (Dec. 23, 1999), where the IRS concluded that costs associated with integrated chips were not qualified research expenditures and, therefore, the research credit was unavailable. TG Missouri may call into question the continuing viability of FSA 20013017.
3 At the time this article goes to press, it is not known whether the IRS will appeal the tax court’s decision. Under the unique procedures of the court, the opinion is released prior to becoming final. The court’s opinion does not become final for purposes of triggering the time to file an appeal until the computations of taxes and refunds are entered by the court.

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