Chief Counsel Advice 201111006
In Chief Counsel Advice (CCA), IRS has concluded that a taxpayer's design and development costs—including research and experimental costs described in Code Sec. 174 (R&E)—had to be capitalized as “pre-contracting year costs” under the percentage-of-completion method (PCM). The costs in question became deductible only when the taxpayer became obligated to manufacture and deliver items under one or more purchase orders.
Background. Code Sec. 460(c)(1) sets out the general rule for allocating costs to a long-term contract that are accounted for under the PCM. In the case of a long-term contract, all costs (including R&E costs) which directly benefit, or are incurred by reason of, the long-term contract activities of the taxpayer are allocated to the contract in the same manner as costs are allocated to extended period long-term contracts under Code Sec. 451 and its regs.
Under Reg. §1.460-4(b)(5)(iv), if a taxpayer reasonably expects to enter into a long-term contract in a future tax year, it must capitalize all costs incurred before entering into the contract that will be allocable to that contract (e.g., bidding and proposal costs).
However, under Code Sec. 460(c)(5), independent research and development (IR&D) expenses aren't allocated. IR&D expenses include any expense incurred in the performance of research or development, except (1) any expenses which are directly attributable to a long-term contract in existence when the expenses are incurred, or (2) any expenses under an agreement to perform research or development.
Reg. §1.460-1(d) provides that if the performance of a non-long-term contract activity is incident to or necessary for the manufacture, building, installation, or construction of the subject matter of one or more of the taxpayer's long-term contracts, the gross receipts and costs attributable to that activity must be allocated to the long-term contracts benefitted.
Under the PCM, the taxpayer does not include any amount in estimated contract revenue in a year ending before a contract is entered into. Similarly, if a taxpayer incurs costs allocable to a contract in a tax year ending before the date the contract is entered into, these costs are not taken into account in determining the completion percentage. (Notice 89-15, 1989-1 CB 634, Q&A 29)
Applying the pre-contracting year cost rule to uncompensated costs, Notice 89-15, Q&A 36, provides that costs that are allocable to a long-term contract, but are incurred before the date that the contract is entered into, are treated as allocated to the contract and are deductible in the tax year in which the contract is entered into. Such costs include bidding and proposal costs allocable to the contract, raw land purchased before a construction contract was entered into, and labor costs incurred in anticipation that a contract will be awarded.
Facts. Taxpayer and its customer entered into “terms agreements” that required Taxpayer to design and develop certain items. The agreements also set out terms for sale of the components when the customer had submitted a purchase order. Before the customer has submitted a purchase order, Taxpayer wasn't obligated to provide the customer with any manufactured item.
As the CCA notes, Taxpayer apparently didn't dispute that when it incurred the design and development costs, it reasonably expected to enter into a long-term contract. The CCA surmised that, in all likelihood, Taxpayer expected that its customer would issue one or more purchase orders that would obligate Taxpayer to manufacture and deliver the items that were the subject of the design and development costs.
Taxpayer's position. Taxpayer argued that the design and development costs arose from a non-long-term contract activity and couldn't be allocable contract costs because the costs of a non-long-term contract activity are allocable contract costs only when they benefit an existing long-term contract. Taxpayer relied on Reg. §1.460-1(d) and Reg. §1.460-1(j), Examples 6 and 7 (which illustrate the treatment of non-long-term contract activities).
Taxpayer reasoned that Congress intended for R&E costs described in Code Sec. 174 to be currently deductible under all circumstances, and that the Code Sec. 460 regs should be interpreted so as to allow a current deduction. Taxpayer argued that any other interpretation would make the regs invalid.
Treatment of R&E costs. The CCA concluded that taxpayer's design and development costs, including R&E costs, had to be capitalized as pre-contracting year costs that became deductible only when Taxpayer became obligated to manufacture and deliver items under one or more purchase orders.
While Reg. §1.460-1(d) could be read to imply that non-long-term contract activity costs (such as the Taxpayer's) were allocable contract costs only if incurred to benefit an existing long-term contract, such an interpretation was inconsistent with the statutory definition of IR&D expenses. Code Sec. 460(c)(1) generally makes R&E costs allocable to benefitted long-term contracts.
The CCA explained that Code Sec. 460(c) sets out two categories of research and development expenses that are not IR&D expenses and that are allocable to benefitted long-term contracts: (1) Code Sec. 460(c)(5)(A) includes only those costs incurred to benefit existing long-term contracts; (2) Code Sec. 460(c)(5)(B) includes costs performed under an agreement without requiring the contemporaneous existence of a benefitted long-term contract. The CCA reasoned that Taxpayer's argument that non-long-term contract activity costs, such as research and development costs, must benefit existing long-term contracts in order to be allocable contract costs, would nullify Code Sec. 460(c)(5)(B).
The CCA also found Taxpayer's argument that non-long-term contract activity costs need not be capitalized as pre-contracting year costs inconsistent with Reg. §1.460-4(b)(5)(iv)’s treatment of bidding costs as costs required to be capitalized. Similarly, Notice 89-15, 1989-1 CB 634’s treatment of “labor costs incurred in anticipation that a contract will be awarded” suggested that the pre-contract rule was broad enough to apply to Taxpayer's costs.
Further, the CCA stated that, even assuming that Reg. §1.460-1(d) contains an implicit requirement that non-long-term contract activity costs benefit an existing long-term contract, by its terms, the reg requires that both the revenue and costs associated with a non-long-term contract activity be allocated to a benefitted long-term contract. Here, Taxpayer wasn't separately compensated for designing and developing the item. Rather, Taxpayer was looking to one or more future long-term contracts to recover the costs of design and development.
The CCA conceded that it might be proper to separately account for income and costs rather than allocate those items to a future long-term contract if a contract for design and development provides for separate compensation. But in Taxpayer's case, capitalizing design and development costs and deducting them when future long-term contract income was recognized resulted in a matching of income and associated costs.
As to Congress' intent, the CCA looked at the historical treatment of Code Sec. 174 and concluded that, at least in certain circumstances, Congress not only permitted but directed the capitalization of Code Sec. 174 costs associated with long-term contracts.
References: For pre-contract costs under the PCM, see FTC 2d/FIN ¶G-3131; United States Tax Reporter ¶4604.001; TaxDesk ¶445,015.