On March 31, 2022, the NAM filed an amicus brief urging the Seventh Circuit to reverse the Tax Court’s misapplication of tax code regulations which rendered a taxpayer’s valid research expenditures ineligible for the R&D tax credit. This case is of critical importance to manufacturers as the manufacturing sector leads all others in performing private sector R&D. Here, after finding that the taxpayer (a manufacturer of oil tankers and dry docks) undertook the type of research that the credit was intended to incentive, the Tax Court nonetheless denied the claimed credit after concluding that the taxpayer failed to prove that “substantially all” (80%) of its development activities “constitute[d] elements of a process of experimentation.” To reach this erroneous conclusion, that Tax Court distinguished costs incurred for employees engaging in qualified research from costs incurred for those directly supporting or supervising qualified research—a distinction not supported by the tax code or the relevant Treasury regulations.
The NAM’s brief explains that the Tax Court’s approach is inconsistent with the text, structure, history, and purpose of the Tax Code and with the relevant implementing regulations. Fabrication of prototypes or pilot models used in testing can be essential to the development of new products, particularly in the manufacturing sector. And, as was true in this case, the labor costs for such fabrication can be substantial. The Tax Court’s reasoning inexplicably penalizes manufacturers who, in performing legitimate and potentially important R&D, incur substantial costs to test new designs or concepts. If affirmed, that reasoning will undermine Congress’ efforts to encourage increased investments in domestic R&D, including increased spending on employees who directly support R&D efforts—results completely at odds with the purpose of the law.
On March 7, 2023, although the Seventh Circuit affirmed the Tax Court's decision, it clarified that both support time and supervision time as well as the costs of building and testing a prototype can be elements of a process of experimentation for purposes of the R&D tax credit.