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The US Tax Court recently held that a taxpayer was not entitled to Section 41 research credits for activities conducted by its shipbuilding subsidiary regarding development of a tanker and dry dock (Little Sandy Coal Co. Inc. v. Commissioner, T.C. Memo. 2021-15). In a 61-page opinion, the court found that the subsidiary did not perform ‘qualified research’ as defined in Section 41(d) and that ‘the includible amount of QREs for each of the Apex tanker and the dry dock pursuant to section 41(a) and (b) [therefore] was zero.’

More specifically, the Tax Court held that:

  • The requirement that at least 80% of a taxpayer's research must constitute elements of a process of experimentation (the ‘substantially all’ test) applies to activities and not to physical components of the product being developed or improved. Therefore, said the court, the test is not met simply because at least 80% of the product's elements differ from those of products the taxpayer previously had developed.
  • A person who provides services in direct supervision or support of research is not ‘engaged in’ research, so the activities of such a person cannot ‘constitute elements of a process of experimentation’ (POE) for purposes of the substantially all test.
  • Because supplies are not activities, when the fraction described in the regulations explaining the substantially all test is computed using costs as a measure of activities, the costs of supplies used in the development of the product are not taken into account.