Opinion
2408-19
07-12-2022
J.G. BOSWELL COMPANY AND SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
ORDER
Travis A. Greaves Judge
Respondent moved for summary judgment under Rule 121, asking us to disallow most of the section 41(b) qualified research expenses (QREs) petitioner claimed on its return. Section 41(d)(2)(C) distinguishes between research designed to improve a taxpayer's commercial product, on the one hand, and research that seeks a better process for producing the taxpayer's existing product, on the other. Respondent argues that petitioner engaged in only the latter kind of research, testing new ways of growing the same crops. Based on this Court's holding in Union Carbide Corp. & Subs. v. Commissioner, T.C. Memo. 2009-50, aff'd, 697 F.3d 104 (2d Cir. 2012), respondent says this means QREs exclude any costs of the experiments petitioner would have incurred to grow the crops using its nonexperimental methods.
Unless otherwise indicated, all Rule references are to the Tax Court Rules of Practice and Procedure, all statutory references are to the Internal Revenue Code (Code), Title 26 U.S.C., in effect at all relevant times, and all regulation references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all relevant times. All monetary amounts are rounded to the nearest dollar.
Petitioner cross-moved for partial summary judgment, asking us to sustain its QREs on the grounds that its research sought to improve its products as well as its production processes, that respondent's method of calculating QREs incurred to improve processes alone is incorrect, and that respondent misapplied his own method.
Although we agree with respondent that the reasoning of Union Carbide applies to petitioner's research on its processes, the record does not establish whether any of petitioner's research trials sought to improve one or more of its products. We will deny both Motions so we can distinguish petitioner's product research from its process research and determine the amount of QREs in each instance.
Background
The Court derives the following facts from the pleadings and the parties' motion papers and attached exhibits. We recite these facts to provide context for our analysis of the parties' motions, not as findings of fact. See Rule 1(b); Fed.R.Civ.P. 52(a)(3).
Petitioner is a consolidated group of corporations that filed a single federal income tax return based on the taxable year of J.G. Boswell Company, its common parent corporation. See §§ 1501, 1504; Treas. Reg. §§ 1.1502-1(h), -76(a). The principal place of business of J.G. Boswell Company was in California when the petition was filed.
Petitioner operates a large farming business in the central California valley. In its taxable year ended June 30, 2014, see § 441 (pertaining to non-calendar taxable years), petitioner grew cotton, tomatoes, alfalfa hay, and safflower, among other crops, from which it produced and sold products including cotton lint and tomato paste.
As part of an ongoing effort to improve its business through agronomic research, petitioner conducted 33 research trials in 2013 and 22 research trials in 2014 on about 7% of its farmland (research acres), in general by growing crops on a test plot and a control plot. Petitioner's researchers grew one of petitioner's standard crops on the control plot, using the standard, nonexperimental method petitioner used on the other 93% of its farmland (production acres). On the test plot the researchers tried an experimental method, which they evaluated by comparing the output of the test plot to the output of the control plot. Petitioner claims the researchers hoped each experimental method would improve the quality or yield of the crop or reduce economic or environmental costs of production relative to the standard method. Petitioner generally sold the output of both plots, in some cases at a premium or discount based on quality relative to production acre crops.
In one research trial, for example, petitioner says it found that new cotton seed varieties planted on a test plot produced more and higher quality cotton that could be sold at a higher price per unit than the standard variety grown on the control plot, and thereafter began planting the new varieties on the production acres. Petitioner claims to have determined in another research trial that it could save money by forgoing its standard application of nitrogen to its safflower crop, which had no effect on yield.
Petitioner's 2014 federal income tax return claimed $17,062,147 of QREs incurred in its research activities, and a corresponding section 41(a) credit of $1,735,424. Petitioner generally included in QREs all costs of cultivating and evaluating the research acre crops, adjusted per section 41(b). See, e.g., § 41(b)(3)(A) (QREs include only 65% of any amount paid or incurred by the taxpayer to a non-employee for qualified research). Respondent's examination allowed petitioner a section 41(a) credit of only $117,722 based on QREs of $885,132, which respondent contends is all petitioner can prove it incurred on the research acres beyond what it would have incurred to cultivate the same land as production acres. This adjustment produced a $1,617,702 decrease in taxable income under section 280C(c)(1), a $145,593 increase in taxable income arising from a reduced section 199 deduction, and a $1,102,464 deficiency.
As in effect for the taxable year in issue, section 280C(c)(1) denies a deduction of QREs to the extent of the section 41(a) credit. By reducing petitioner's section 41(a) credit by $1,617,702, respondent reduced the deduction disallowed under section 280C(c)(1) by the same amount.
As in effect for the taxable year in issue, section 199(a)(1) allows a deduction of 9% of the lesser of the subparagraph (A) amount, the qualified production activities income (QPAI) of the taxpayer for the taxable year, or the subparagraph (B) amount, the taxable income determined without regard to section 199 for the taxable year. Petitioner reported a lower subparagraph (B) amount than QPAI, and the section 280C(c)(1) adjustment explained in the preceding note reduced the former by $1,617,702. Petitioner thereby lost a section 199 deduction of 9% of this amount, or $145,593.
Petitioner sought redetermination of the entire deficiency in this Court on February 1, 2019. Respondent moved for summary judgment on December 20, 2019, and petitioner cross-moved for partial summary judgment on February 28, 2020.
Discussion
I. Summary Judgment
The purpose of summary judgment is to expedite litigation and avoid costly and unnecessary trials. FPL Grp., Inc. & Subs. v. Commissioner, 116 T.C. 73, 74 (2001). We may grant a motion for summary judgment, or partial summary judgment regarding an issue, when there is no genuine dispute of material fact, and a decision may be rendered as a matter of law. Rule 121(b); Elec. Arts, Inc. & Subs. v. Commissioner, 118 T.C. 226, 238 (2002); see also Take v. Commissioner, 82 T.C. 630, 633 (1984), aff'd, 804 F.2d 553 (9th Cir. 1986) (explaining that this rule applies to each motion where both parties move for summary judgment or partial summary judgment). We construe the facts and draw all inferences in the light most favorable to the nonmoving party to decide whether summary judgment is appropriate. Sundstrand Corp. & Consol. Subs. v. Commissioner, 98 T.C. 518, 520 (1992), aff'd, 17 F.3d 965 (7th Cir. 1994). The nonmoving party may not rest upon the mere allegations or denials in its pleadings but must set forth specific facts showing that there is a genuine dispute for trial. Rule 121(d); Sundstrand, 98 T.C. at 520.
II. Statutory and Regulatory Framework
Sections 38 and 41(a) provide an incentive for certain research activities through a credit against federal income tax. A taxpayer may claim a credit of 20% of the excess of its section 41(b) QREs for the taxable year over the section 41(c) base amount, a function of the taxpayer's QREs in prior years. QREs arise from "qualified research," which is research on a "business component of the taxpayer" that satisfies a series of criteria listed in section 41(d)(1). See § 41(d)(2)(A).
As relevant to this case, a business component is "any product, process, . . . technique, formula, or invention" which is to be held for sale or used by the taxpayer in its trade or business. See § 41(d)(2)(B). Section 41(d)(2)(C) directs us to treat the product a taxpayer produces as a separate business component from its production process. If a taxpayer produces a product as part of its trade or business, the taxpayer's search for a way to produce the same product in greater quantity or at lower cost may be qualified research on the production process, but not on the product itself. See Union Carbide, T.C. Memo. 2009-50, at *275-78; Treas. Reg. § 1.41-4(b)(1) (last sentence).
To illustrate, imagine that a taxpayer tests two experimental production processes designed to improve on its standard process for producing Product X. In Test A, the taxpayer evaluates an experimental process designed to produce an improved product, Product X+. Test B, on the other hand, should yield the same Product X in greater quantity or at lower cost than the standard process. Section 41(d)(2)(C), Union Carbide, and Treasury Regulation § 1.41-4(b)(1) tell us that if Test B involves qualified research at all, the taxpayer conducts such research on the production process alone. The Court must allocate the taxpayer's expenditures on Test B between product and process, and exclude the former from QREs.
III. The Process Business Component
Respondent argues that all petitioner's research trials, like Test B in the above hypothetical, pertain to a production process rather than a product. Citing Union Carbide, respondent thereby limits petitioner's QREs to the excess of the expenditures petitioner incurred on its research acres over the expenditures petitioner would have incurred by cultivating the same land as production acres.
Union Carbide involved a revised method for producing ethylene, a substance created by heating fossil fuels and used to manufacture plastics. Union Carbide, T.C. Memo. 2009-50, at *10, *15-16, *22. The taxpayer regularly suspended operation of its ethylene manufacturing furnaces to rid them of coke, a brittle carbon byproduct that impeded production. Id. at *20-21. Looking for a way to mitigate this problem, the taxpayer treated one of its furnaces with chemicals designed to obstruct coke formation. Id. at *22-32. Its tax return claimed as QREs the costs of running the treated furnace, including raw material costs and employee wages the taxpayer would have incurred by using its ordinary production method. Id. at *110-14, *275.
We rejected this approach based on the section 41(d)(2)(C) distinction between the process a taxpayer uses to produce a product, and the product itself, as separate business components. If a taxpayer tests an experimental production process designed to boost yield or cut costs without altering the product itself, the Court reasoned, QREs do not include costs of the experiment the taxpayer would have incurred to manufacture the same product by the standard method. See id. at *275- 78. The Union Carbide taxpayer sought to improve its ethylene production process, not the ethylene it produced. Costs the taxpayer would have incurred to run its furnace without conducting the chemical treatment experiment were not QREs, therefore, even though the taxpayer could not have conducted the experiment without incurring these costs. See id.; see also Union Carbide, 697 F.3d at 108 (agreeing with the Tax Court's reasoning).
Petitioner points out that Union Carbide is a memorandum opinion, which means it is not controlling authority. See Huffman v. Commissioner, 126 T.C. 322, 350 (2006), aff'd, 518 F.3d 357 (6th Cir. 2008). However, this Court may rely on persuasive reasoning in memorandum opinions and the opinions of other courts. See, e.g., Kellett v. Commissioner, T.C. Memo. 2022-62, at *11-12 (looking to a memorandum opinion and a Texas district court opinion in determining whether a taxpayer's activities satisfy one of the elements of section 41(d)(1) qualified research). Petitioner argues that the Treasury overturned Union Carbide by amending Treasury Regulation § 1.174-2(a). See T.D. 9680, 2014-32 I.R.B. 254, 257. This regulation defines section 174 research or experimental expenditures, which were deductible expenses in the taxable year in issue, not section 41(b) QREs. Although section 41(d)(1)(A) limits qualified research for the taxable year in issue to research "with respect to which expenditures may be treated as expenses under section 174," a change in the regulatory definition of section 174 research or experimental expenditures does not affect the section 41(d)(2)(C) dichotomy or the broader section 41 definition of qualified research.
Like the taxpayer in Union Carbide, petitioner objects that section 41(b) defines QREs in relevant part as "any wages paid or incurred to an employee" for engaging in qualified research or "the direct supervision or direct support" of qualified research, "any amount paid or incurred for supplies used in the conduct of qualified research," and "65 percent of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research" (emphasis added). Neither section 41 nor the regulations, petitioner continues, exclude from QREs production costs a taxpayer would have incurred by using its standard production process. Petitioner further contends that section 41(d)(2)(C) "does nothing more than establish a rule for distinguishing process from product improvements" and "does not alter the law defining QREs."
We reject these arguments based on our mandate to avoid reading the Code in a way that makes any of its language superfluous. See Reiter v. Sonotone Corp., 442 U.S. 330, 339 (1979) ("In construing a statute we are obliged to give effect, if possible, to every word Congress used."). Section 41(d) exists to define "qualified research" as used in section 41(b), which defines QREs. Petitioner does not explain why section 41(d) distinguishes process from product if not to restrict the scope of QREs where a taxpayer conducts qualified research on one but not the other. Where a taxpayer sets out to improve its production process alone, section 41(d)(2)(C) distinguishes the act of testing an experimental process, which may be qualified research, from the act of making the product, which is not research at all. Much less is it qualified research, from which section 41(d)(4)(A) and Treasury Regulation § 1.41-4(c)(2)(i) exclude activities that occur after the beginning of commercial production of the business component. Treating costs of making the standard product as QREs would violate section 41(b), which provides that QREs arise from qualified research, and would make section 41(d)(2)(C) a dead letter.
Petitioner points out that even where its research sought only to cut production costs, researchers had to verify that its experimental method would not have "a negative effect on the resulting plant and derived product." To the extent petitioner thereby implies that all 55 research trials pertained to the product business component, this argument proves too much. Any viable production process must turn out a sound product, so a taxpayer must verify that any adjustments to its production process do not undermine product quality. Here again, allowing petitioner to treat as QREs the usual costs of cultivating the research acres just because any change to petitioner's production processes could affect its crops would give no effect to section 41(d)(2)(C). See Union Carbide, T.C. Memo. 2009-50, at *280 (addressing a similar argument).
Section 41(d)(2)(C) applies to any of petitioner's research trials that, like Test B, focused on the production process rather than the product. One such trial based on its description in the motion papers may be the safflower experiment discussed supra. Like the Union Carbide anticoking project, the safflower experiment tested a way to reduce production costs, in this case by withholding nitrogen from petitioner's safflower crop, apparently without altering the product itself. The Court requires further factual development to determine whether the safflower experiment or any of the other 54 research trials fit the paradigm of Test B and Union Carbide, and which of the disallowed QREs associated with these trials petitioner would not have incurred had it employed its standard processes. Petitioner bears the burden of establishing any disallowed QREs associated with these research trials. See Rule 142(a); Norwest Corp. & Subs. v. Commissioner, 110 T.C. 454, 488 n.34 and accompanying text (1998).
IV. The Product Business Component
Section 41(d)(2)(C) does not apply to any research trials that sought to improve one of petitioner's products. Test A in the above hypothetical illustrates that such trials inherently pertain to both the product itself and the production process. One such research trial based on its description in the motion papers may be the cotton seed experiment discussed supra. Petitioner tried planting new seed varieties, a revised production process that produced not only more cotton than the standard process, but higher quality cotton that could be sold at a higher price per unit. To the extent petitioner set out to improve cotton quality instead of or in addition to increasing cotton yield or reducing cotton production costs, petitioner's cultivation of the cotton on the research acres is a new research project to develop improved cotton, a new business component, and the research is not conducted after the beginning of commercial production of the cotton under section 41(d)(4)(A). See Treas. Reg. § 1.41-4(c)(10), ex. 2. Per the last sentence of the preceding paragraph, petitioner must establish which of its research trials fit the Test A paradigm, that any such trials otherwise constitute section 41(d) qualified research, and that any disallowed QREs associated with these trials satisfy section 41(b).
Respondent makes much of the Court's statement in Union Carbide, T.C. Memo. 2009-50, at *276, that expenditures the taxpayer would have incurred to run its test furnace had it not conducted the anticoking project were "at best" indirect research expenditures. Treasury Regulation § 1.41-2(b)(1) excludes from QREs expenditures "for supplies or for the use of personal property that are indirect research expenditures," but does not define the term. Paragraph (c)(3)(ii) of the same regulation provides examples of "direct support" of qualified research, for which section 41(b)(2)(B) includes expenditures in QREs. Such examples are "the services of a secretary for typing reports describing laboratory results derived from qualified research, of a laboratory worker for cleaning equipment used in qualified research, of a clerk for compiling research data, and of a machinist for machining a part of an experimental model used in qualified research." Direct support does not include "services of payroll personnel in preparing salary checks of laboratory scientists, of an accountant for accounting for research expenses, of a janitor for general cleaning of a research laboratory, or of officers engaged in supervising financial or personnel matters." Based on the regulation's concept of direct support, expenditures for supplies or for the use of personal property that are indirect research expenditures might include expenditures on accounting software for the employee who tracks research expenses, or cleaning supplies for the janitor who cleans the laboratory. See Guardian Indus. Corp. v. Commissioner, 143 T.C. 1, 15 (2014) (explaining that the meaning of an unclear phrase should be determined by the words immediately surrounding it).
To the extent respondent invites us to interpret Treasury Regulation § 1.41-2 to exclude from QREs all expenditures a taxpayer would have incurred had it used its standard production process, even if the research seeks to improve the product rather than the process alone, we decline the invitation. Although a taxpayer would not engage in any of the foregoing examples of direct support without conducting research, the regulation does not mandate the Union Carbide holding, and the examples of activities that are not direct support are too narrow for us to infer the rule respondent advocates. Petitioner pays for irrigation and weed control on both the research acres and the production acres, for example, but these activities are much closer to the research process than the activities of administrative personnel who account for these costs, which the regulation excludes from direct support.
Moreover, petitioner's cultivation of experimental products is analogous to the regulation's example of a machinist's fabrication of part of an "experimental model," which is direct support if the model is used in qualified research. The regulation does not define "experimental model," but the term connotes the definition of "pilot model" in Treasury Regulation § 1.174-2(a)(4): "any representation or model of a product that is produced to evaluate and resolve uncertainty concerning the product during the development or improvement of the product." See Little Sandy Coal Co., Inc. v. Commissioner, T.C. Memo. 2021-15, at *30-31. The same regulation confirms that a trial production to "evaluate and resolve uncertainty during the . . . improvement of the product" is a pilot model even if the taxpayer sells it. See Treas. Reg. § 1.174-2(a)(11), ex. 7. If petitioner demonstrates that its tests of the viability of improved crops are section 41(d) qualified research, therefore, the trial crops it produced were experimental models, and the associated costs are QREs to the extent permitted by section 41(b). Respondent cannot defeat any such argument simply by demonstrating that petitioner would have incurred the expenditures had it used its standard production processes on the research acres.
The text accompanying this note reflects amendments adopted in 2014 to Treasury Regulation § 1.174-2, which "apply to taxable years ending on or after July 21, 2014." Treas. Reg. § 1.174-2(d). However, petitioner points out that the same paragraph of the regulation allows taxpayers to apply the amended provisions "to taxable years for which the limitations [period] for assessment of tax has not expired."
Conclusion
We deny both Motions so we may determine (1) which of petitioner's 55 research trials sought to improve petitioner's production process alone, as opposed to one of its products, (2) which disallowed QREs associated with these research trials petitioner would not have incurred had it cultivated the research acres as production acres, and (3) the amount of QREs incurred in the remaining research trials.
Upon due consideration, it is therefore
ORDERED that respondent's Motion for Summary Judgment, petitioner's Cross-Motion for Partial Summary Judgment, and petitioner's Request for Oral Argument are denied.