     Case: 12-11012    Document: 00512685765     Page: 1   Date Filed: 07/02/2014




        IN THE UNITED STATES COURT OF APPEALS
                 FOR THE FIFTH CIRCUIT   United States Court of Appeals
                                                  Fifth Circuit

                                                                      FILED
                                                                     July 2, 2014
                                  No. 12-11012
                                                                    Lyle W. Cayce
                                                                         Clerk
TRINITY INDUSTRIES, INC., for Itself and on Behalf of Certain Subsidiaries,

                                            Plaintiff–Appellant,
v.

UNITED STATES OF AMERICA,

                                            Defendant–Appellee.



                 Appeal from the United States District Court
                      for the Northern District of Texas


Before OWEN, SOUTHWICK, and GRAVES, Circuit Judges.
PRISCILLA R. OWEN, Circuit Judge:
      Trinity Industries, Inc. (Trinity) designed and built vessels during the
taxable years ending March 1994 and March 1995 (the claim years). On its
amended tax returns, Trinity claimed research tax credits under Internal
Revenue Code (I.R.C.) § 41 based on several of these vessel projects. The I.R.S.
denied these claims. Trinity then filed this tax refund action in federal court,
seeking research tax credits based on the projects. After a two-phase bench
trial, the district court held that the tax credit due Trinity was $135,787.60 for
1994 and $0 for 1995. Trinity now appeals, asserting that it is entitled to a tax
credit of $1,808,832.53 for 1994 and $2,712,977.00 for 1995. We affirm in part
and vacate and remand in part.
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                                                  I
      Trinity’s amended tax returns for 1994 and 1995 claimed that it was
entitled to a research tax credit because its claim year expenses in developing
certain vessels constituted qualified research expenses (QREs). As discussed
more fully below, I.R.C. § 41 generally provides a 20% credit for claim year
QREs that exceed what the taxpayer spent on research in an earlier
comparison period (the base amount). 1 The base amount, in turn, is a “fixed
base percentage” multiplied by the company’s average annual gross receipts
for the four years preceding the claim year. 2 In calculating its research tax
credit, Trinity’s amended tax returns reported a fixed base percentage (the
ratio of base period QREs over base period gross receipts 3) of 1.3152% for the
taxable year ending March 1994 and 1.3125% for the year ending March 1995.
The tax returns themselves do not report the base period QREs or the base
period gross receipts used to calculate the fixed base percentage. The I.R.S.
denied these claims in a 2001 claim disallowance letter.
      Trinity subsequently filed this tax refund action in federal court. Before
trial began, Trinity retained James Bennett as an expert. Bennett submitted
a report finding that the “consistency rule” under I.R.C. § 41(c)(6)—which
requires that claim year QREs and base period QREs be computed on a
consistent basis 4—was satisfied on Trinity’s amended tax returns. Bennett
noted only one caveat to this conclusion: the records available for the claim
years were more complete than those available for the base period years, so he



      1   I.R.C. § 41(a)(1) (codified at 26 U.S.C. § 41(a)(1)).
      2   Id. § 41(c)(1).
      3   Id. § 41(c)(3)(A).
      4  Id. § 41(c)(6)(A) (“[T]he [QREs] taken into account in computing [the fixed base]
percentage shall be determined on a basis consistent with the determination of [QREs] for
the credit year.”).
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                                            No. 12-11012
estimated certain costs for the base period. Based on documentation provided
by Trinity, Bennett also provided specific calculations of the base period QREs,
the base period gross receipts, and the fixed base percentage.                           Bennett
calculated the overall base period QREs as $49,483,136. Dividing this base
period QRE figure by the base period gross receipts ($3,851,683,536) yielded a
fixed base percentage of 1.2847%, which was slightly lower than the fixed base
percentages reported in the amended tax returns. Although Bennett based his
calculations on the same records used to complete the amended tax returns, it
is not clear why his fixed base percentage figure was slightly lower.
      The district court conducted a two-phase bench trial. In Phase I, the
court considered claimed tax credits for six vessel development projects. In its
order following Phase I, the court decided that Trinity was wrongly denied
credits for only two of the six projects it considered because these two projects
(the Mark V and the Dirty Oil Barge) met all four requirements for constituting
QREs. 5 According to the court, the other four vessels (the XFPB, the T-AGS
60, the Crew Rescue Boat, and the Hurley Dredge) did not meet the fourth
QRE requirement: that substantially all of the research activities in developing
the project (i.e., 80% or more) were part of a process of experimentation. 6
      In reaching these conclusions, the court explained that the “shrinking-
back rule” in the Treasury regulations ordinarily allows taxpayers to show that
smaller      subcomponents          of   a    given     project     satisfy    the    process-of-
experimentation test even if the entire project does not. 7 For instance, if a


      5   See id. § 41(d)(1) (providing that to constitute QREs, (1) the expenses must be
deductible under I.R.C. § 174; (2) the research must be for the purpose of discovering
technological information; (3) the application of that information must be intended to be
useful in the development of a new or improved business component; and (4) substantially
all of the research must constitute elements of a process of experimentation).
      6   Id. § 41(d)(1)(C); Treas. Reg. § 1.41-4(a)(6) (codified at 26 C.F.R. § 1.41-4(a)(6)).
      7   See Treas. Reg. § 1.41-4(b)(2).
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                                 No. 12-11012
whole vessel project does not satisfy the test, perhaps the development of the
vessel’s engine is sufficiently experimental. In this case, however, the court
noted that “Trinity took an all or nothing approach” because it did not offer
proof of its claim year expenses at the subcomponent level. Trinity was unable
to offer evidence of its expenses at a more specific level partly because
Hurricane Katrina destroyed many of its records. The court thus made its
determination on the fourth QRE requirement based on whether, considering
each of the six claim year projects as a whole, 80% of the costs incurred in the
development of each project were part of a process of experimentation. It did
not apply the shrinking-back rule in analyzing the claim year QREs.
      In Phase II of the trial, two other vessel projects (the Queen of New
Orleans and the Penn Tugs), as well as the method of calculating Trinity’s base
period QREs were at issue. With regard to its base period QRE calculation,
Trinity called as a witness Phil Nuss, Trinity’s former Vice President of
Engineering. Nuss first confirmed that the ten vessels identified by Bennett
in his report were the vessels used in computing the base period QREs on the
amended tax returns. Trinity’s counsel then asked Nuss whether he believed
expenses related to those ten vessels should still be counted as QREs given the
district court’s Phase I order holding that certain claim year vessel expenses
were not QREs. Nuss answered that expenses relating to four of the ten base
period vessels should no longer be counted. According to Nuss, two of the base
period vessels—the LSV and the North Carolina Auto Ferry—were similar to
the Hurley Dredge, one of the claim year vessels held not to be qualified
research in Phase I, since they all involved Trinity constructing a vessel based
on a design provided to Trinity by a third party. In addition, Nuss believed
that another base period vessel—the Cajun Queen—was like the Crew Rescue
Boat, a claim year vessel held not to be qualified research in Phase I, since the
Cajun Queen was also not a complicated technological boat to build. Finally,
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                                 No. 12-11012
Nuss testified that a fourth base period vessel—the Ecuador—was like the
XFPB, which the district court held was not qualified research in Phase I, since
the Ecuador similarly had some experimental features but not enough to
satisfy the QRE test. Nuss thus concluded that these four base period vessels
should no longer be included in the base period QRE figure, though the other
six base period vessels still should be. There was also similar testimony from
Sam Charters, Trinity’s former Chief Project Engineer, that the LSV was
similar, in terms of the amount of experimentation involved, to the Hurley
Dredge held not to constitute qualified research.
      After Phase II of the trial concluded, the parties submitted briefing
addressing whether the two vessel projects at issue constituted QREs, as well
as the proper base period QRE figure under the consistency rule. Trinity made
two distinct arguments about the consistency rule. Its first was that it had
followed the consistency rule on its amended tax returns by calculating both
its claim year QREs and its base period QREs using an all-or-nothing
approach. In making this argument, Trinity acknowledged that it did not use
the shrinking-back rule in computing its base period QREs on its returns:
      On the Amended Returns, Trinity sought a tax credit for only
      certain vessels that could be considered prototypes. In presenting
      its claim, Trinity took an “all or nothing” approach—i.e., it did not
      seek shrink-back credit for any subcomponents of any vessels
      constructed in the Claim Years. To be consistent with this
      determination of Claim Year expenditures, Trinity included in the
      Base Period only expenditures for those vessels that it believed were
      sufficiently experimental such that the entire vessel constituted
      qualified research. Consistent with the manner in which it
      determined QREs for the Claim Years, Trinity did not shrink-back
      to subcomponents of any vessels in the Base Period.




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                                 No. 12-11012
In taking this position, Trinity was not asking the court to allow it to
recalculate its base year QREs; it was simply defending how it originally
calculated its base period QREs on its amended tax returns.
      Trinity then made a second, distinct argument regarding the consistency
rule. Relying primarily on the testimony of Nuss but also citing Charters’s
testimony, Trinity asserted it should be able to remove four vessels from its
base period QREs as calculated on its amended tax returns, since those vessels
were similar, in terms of how much experimentation was involved, to the four
vessels held not to be claim year QREs in Phase I:
      In Trinity I the Court articulated a different standard for
      “prototype” than Trinity applied on the Amended Return. The
      Court’s holding defined the universe of QREs allowable in the
      Claim Years. . . . With respect to four of the projects claimed by
      Trinity, the Court found that the integration of subsystems did not
      rise to the level required for the cost of developing and constructing
      the entire vessel to qualify.
             Given this standard, pursuant to [the consistency rule]
      Trinity’s Base Period QREs must be reevaluated in light of the
      uncontroverted evidence to ensure they are determined consistent
      with the QREs in the Claim Years. Mr. Nuss . . . considered
      whether any of the vessels originally included in the Base Period
      would no longer be considered prototypes under the standard
      articulated in Trinity I. . . . Mr. Nuss testified that expenditures
      on four vessel projects in the Base Period should not be treated as
      QRE[s] . . . . For each of these vessels, Mr. Nuss testified that the
      identification, configuration and integration of the components of
      the vessels were not sufficiently complex for the vessels to
      constitute prototypes under the Court’s standard.


Trinity contended that, after removing the four base period vessels from the
base period QRE figure of $49,483,136 provided by Bennett’s report, the base
period QRE figure would total $26,706,987. Trinity’s second consistency rule
argument thus asked the district court to allow it to reduce its base period QRE



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                                 No. 12-11012
figure by over $20 million, which in turn would reduce its fixed base percentage
and increase its overall research tax credit.
      In its Phase II order, the district court concluded that Trinity was
wrongly denied tax credit for the Queen of New Orleans but was correctly
denied credit for the Penn Tugs. According to the court, the Penn Tugs did not
meet the fourth QRE requirement. With respect to the consistency rule, the
court only addressed the merits of Trinity’s first consistency rule argument—
Trinity’s defense of its use of an all-or-nothing, “entire project” approach in
both the base period years and the claim years:
      Trinity now argues that, in view of the consistency rule, its base
      period QREs should include only projects that were overall 80% or
      more research. The Court disagrees. . . . Here the Court applied
      the 80% rule only to entire projects due to a lack of evidence to
      permit application of the “shrinkback rule.” This . . . simply
      reflects the absence of evidence of costs incurred on a subset of an
      entire vessel . . . . Accordingly, the Court will not exclude from the
      base period QREs any QREs incurred that were less than 80% of
      an entire project.

The court accordingly rejected the merits of Trinity’s first argument but failed
to address the merits of Trinity’s second argument based on Nuss’s testimony.
The court also failed to acknowledge that Trinity did not use the shrinking-
back rule in calculating the base period QREs in its amended tax returns, and
therefore the base period QREs already excluded any QREs incurred that were
less than 80% of an entire project. The same order provided that “[o]ther than
Trinity’s consistency argument, the Court credits the testimony of Trinity’s
witnesses and finds Trinity’s calculation to be a reasonable estimate of the base
amount.”
      After additional briefing, the district court issued its final judgment
holding that Trinity was entitled to $135,787.60 in tax credit for 1994 and $0
for 1995. Trinity now appeals.

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                                         No. 12-11012
                                                II
      “The standard of review for a bench trial is well established: findings of
fact are reviewed for clear error and legal issues are reviewed de novo.” 8 A fact
finding “is clearly erroneous if it is without substantial evidence to support it,
the court misinterpreted the effect of the evidence, or this court is convinced
that the findings are against the preponderance of credible testimony.” 9 Mixed
questions of law and fact are also reviewed de novo. 10
                                               III
      Trinity first contends that the district court erred in applying the
consistency rule in calculating its base period QREs.                    We begin with an
overview of the research tax credit calculation and the consistency rule, and
then consider Trinity’s position regarding the consistency rule.
                                                A
      Under I.R.C. § 41, companies can claim a 20% credit for QREs that
exceed what they spent in an earlier comparison period. 11                          Using the
terminology of the I.R.C., the research tax credit is calculated as follows:

• Research credit = the lesser of: 20% x (claim year QREs – base amount),
  and 20% x (50% x claim year QREs); 12
• Base amount = fixed base percentage x average annual gross receipts for
  the four years preceding claim year; 13




      8 Coe v. Chesapeake Exploration, L.L.C., 695 F.3d 311, 316 (5th Cir. 2012) (quoting
Preston Exploration Co. v. GSF, L.L.C., 669 F.3d 518, 522 (5th Cir. 2012)).
      9 Petrohawk Props., L.P. v. Chesapeake La., L.P., 689 F.3d 380, 388 (5th Cir. 2012)
(quoting French v. Allstate Indem. Co., 637 F.3d 571, 577 (5th Cir. 2011)).
      10   Id. (citing Dickerson v. Lexington Ins. Co., 556 F.3d 290, 294 (5th Cir. 2009)).
      11   I.R.C. § 41(a)(1).
      12   Id. § 41(a)(1), (c)(2).
      13   Id. § 41(c)(1).
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                                          No. 12-11012
• Fixed base percentage = aggregate base period QREs / aggregate base
  period gross receipts, where base period here = taxable year ending
  3/31/1985 through taxable year ending 3/31/1989. 14
The research tax credit can be summarized in the following formula:




To constitute QREs, four requirements must be met:
             (1) the expenses must be of the type deductible under I.R.C.
             § 174; (2) the research must be undertaken “for the purpose of
             discovering information . . . which is technological in nature;”
             (3) the application of that information must be “intended to be
             useful in the development of a new or improved business
             component of the taxpayer;” and (4) substantially all of the
             research activities must “constitute elements of a process of
             experimentation.” 15

Under Treasury regulations, the fourth requirement is met if 80% or more of
the research activities constitute elements of a process of experimentation. 16
       This four-part QRE test is to be applied separately to each business
component of the taxpayer, which is defined to include any product held for
sale, lease, or license, or used by the taxpayer in its trade or business. 17 If,



       14   See id. § 41(c)(3)(A).
       15United States v. McFerrin, 570 F.3d 672, 676 (5th Cir. 2009) (alteration in original)
(quoting I.R.C. § 41(d)(1)).
       16   Treas. Reg. § 1.41-4(a)(6).
       17   I.R.C. § 41(d)(2).
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                                          No. 12-11012
however, each of the four requirements is not met with respect to an entire
business component, the shrinking-back rule under Treasury Regulation
§ 1.41-4(b)(2) is implicated.             Under the shrinking-back rule, these four
requirements “are to be applied first at the level of the discrete business
component,” but “[i]f these requirements are not met at that level, then they
apply at the most significant subset of elements of the product.” 18                 “This
shrinking back of the product is to continue until either a subset of elements
of the product that satisfies the requirements is reached, or the most basic
element of the product is reached and such element fails to satisfy the test.” 19
Accordingly, the rule “is applied only if a taxpayer does not satisfy the [four
requirements] with respect to the overall business component.” 20
       The consistency rule also plays a role in computing QREs. The rule
ensures that the research tax credit due is not overstated or understated
because the taxpayer inconsistently compares QREs in the base period years
and the claim year. The rule provides that “the [QREs] taken into account in
computing [the fixed base] percentage shall be determined on a basis
consistent with the determination of [QREs] for the credit year.” 21                   The
corresponding Treasury regulation uses similar language. 22




       18   Treas. Reg. § 1.41-4(b)(2).
       19   Id.
       20   Id.
       21   I.R.C. § 41(c)(6)(A).
       22 Treas. Reg. § 1.41-3(d)(1) (“[QREs] and gross receipts taken into account in
computing a taxpayer’s fixed-base percentage and a taxpayer’s base amount must be
determined on a basis consistent with the definition of [QREs] and gross receipts for the
credit year, without regard to the law in effect for the taxable years taken into account in
computing the fixed-base percentage or the base amount.”).
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                                        B
      On appeal, Trinity challenges the district court’s application of the
consistency rule in calculating its base period QREs, and it presents two
distinct arguments as to why the rule was violated. The first argument is that
the district court violated the consistency rule by applying the shrinking-back
rule in the base period years but not applying it in the claim years. This
argument hinges on the assumption that the district court used a shrink-back
analysis for the base period QREs, so that if expenses related to the entire
vessel did not constitute qualified research, expenses related to subcomponents
of the vessel were still counted as qualified research. The Government has not
contested Trinity’s understanding of the facts, so the parties argue over
whether, as a legal matter, when the shrinking-back rule could not be applied
in calculating the claim year QREs because of a lack of evidence, the base
period QREs also had to be calculated on an all-or-nothing, “whole ship” basis.
      There is a significant issue, however, regarding the facts assumed in
much of the briefing in our court: the briefs assumed that the shrinking-back
rule was applied by the district court, while the record reflects that it was not
applied in the district court’s calculation of the base period QREs. In fact,
neither Trinity’s amended tax returns, nor Bennett’s report, nor the district
court judgment based on Bennett’s report used the shrinking-back rule in
computing Trinity’s base period QREs. Trinity’s briefing before the district
court acknowledged that it did not use the shrinking-back rule in its amended
tax returns.    Moreover, Bennett’s report confirms that neither Trinity’s
amended tax returns nor his report could have used the shrinking-back rule in
computing Trinity’s base period QREs. For one, Bennett’s report stated that
he calculated the base period QREs “based on 100% of the wages, supplies and
contract labor costs, less overhead costs” for the ten vessel projects in the base
period. Including all of the projects’ expenses shows that entire projects were
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                                  No. 12-11012
considered qualified research, not just “subcomponents” of the projects like the
vessels’ engines. Second, Bennett noted that Trinity’s records for the base
period years were even less detailed than the records for the claim years, in
which Trinity was unable to avail itself of the shrinking-back rule because
records were lacking. This further establishes that neither Bennett’s report
nor Trinity’s amended returns applied the shrinking-back rule in the base
period.
      The district court’s order also did not employ the shrinking-back rule in
computing the base period QREs. In its final judgment, the district court held
Trinity was entitled to $135,787.60 for 1994 and $0 for 1995. These figures are
the same as those in Trinity’s post-trial briefing, which asked the court to adopt
the base amount figures from Bennett’s report. This means that the base
amounts used in the final judgment were calculated using the fixed base
percentage, including the base period QREs, used in Bennett’s report, and
Bennett’s report did not employ the shrinking-back rule in calculating the base
period QREs. As a result, the district court’s judgment incorporated a base
period QRE figure calculated using an all-or-nothing approach, thereby
excluding any QREs incurred that were less than 80% of an entire project, even
though it held that it would “not exclude from the base period QREs any QREs
incurred that were less than 80% of an entire project.” Trinity’s attorney at
oral argument acknowledged that the district court did not apply a shrink-back
analysis in calculating the base period QREs.
      In short, the district court did not use the shrinking-back rule in
calculating Trinity’s base period QREs. Trinity argues that the district court
should have applied a “whole ship” methodology in calculating its base period
QREs, but this is exactly what the district court did by calculating the base
amount based on Bennett’s report. Moreover, any argument—from either
party—about whether the shrinking-back rule should have been applied in the
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                                  No. 12-11012
base period years need not be addressed as the lack of records from the base
period years apparently would have precluded the shrinking-back rule from
being applied in the base period. Trinity’s first consistency rule argument
therefore entitles it to nothing more than what the district court awarded it.
                                         C
      Trinity presents a second argument as to why the consistency rule was
violated and why it is therefore entitled to a lower base period QRE figure of
$26,706,987. The $26,706,987 amount is the base period QRE used in the
Bennett report less the QREs attributable to the four base period vessels Nuss
testified would not constitute qualified research under the standard
articulated by the district court in Phase I of trial.
       Nuss testified that he did not believe that four base period vessels—the
LSV, the North Carolina Auto Ferry, the Cajun Queen, and the Ecuador—
involved the level of experimentation necessary to constitute QREs since they
were similar, in terms of how much experimentation was involved, to the claim
year vessels the district court held not to be QREs after Phase I. In other
words, if the district court found that certain claim year vessels—including the
XFPB, the T-AGS 60, the Crew Rescue Boat, and the Hurley Dredge—did not
satisfy the QRE test, then four of the base period vessels should not have
satisfied the QRE test, either. As discussed above, Nuss testified that two of
the base period vessels—the LSV and the North Carolina Auto Ferry—were
similar to the Hurley Dredge, since they all involved Trinity constructing a
vessel based on a design provided to Trinity by a third party. There was also
testimony from Charters that the LSV was comparable to the Hurley Dredge
since both were based in part on an existing design. Nuss believed that another
base period vessel—the Cajun Queen—was like the Crew Rescue Boat, another
claim year vessel held not to be qualified research, since the Cajun Queen was
also not a complicated technological boat to build. Finally, Nuss testified that
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                                 No. 12-11012
a fourth base period vessel—the Ecuador—was like the XFPB, which the
district court held was not qualified research, since the Ecuador similarly had
some experimental features but not enough to satisfy the QRE test. Nuss
testified that to calculate the QREs on a consistent basis, the four base period
vessels should be removed from the base period QRE calculation.
      Though much of Trinity’s briefing on appeal focused on its first
consistency rule argument concerning the shrinking-back rule, Trinity has
adequately raised its second argument based on Nuss’s testimony. In its
opening brief, Trinity argued that, under a proper application of the
consistency rule, this court should calculate its base period QREs as
$26,706,987: the base period QRE amount used in the Bennett report less the
QREs attributable to the four vessels Nuss said would not satisfy the district
court’s Phase I QRE standard. Trinity’s reply brief again referenced Nuss’s
testimony, noting that “[b]ased on the District Court’s ruling in Phase I, [Nuss
and Charters] identified four comparable vessels, out of the [ten] submitted by
Trinity in the base years, that similarly would not qualify for research credit
as whole ships under the Court’s analysis.” Trinity also contended that the
panel could reverse and render judgment in its favor based on “Nuss’s
testimony of why four ships from the base years . . . should be removed under
the consistency rule” and referred to “Nuss’s and Charters’s testimony on
removing four partial ships from the base years.” At oral argument, Trinity’s
counsel again urged that if the district court disqualified certain claim year
vessels, it should have also disqualified the four base period vessels, which
involved a similar level of experimentation, as not satisfying the process-of-
experimentation test. Trinity therefore sufficiently raised this argument on
appeal.
      Assuming the district court would credit Nuss’s and Charters’s
testimony, we agree with Trinity that if certain base period vessels are just as
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                                         No. 12-11012
experimental as claim-year vessels held not to be qualified research, those base
period vessels should not be counted as qualified research for purposes of the
base period QRE calculation. I.R.C. § 41 allows a taxpayer to claim a tax credit
for claim year research expenses that exceed the research expenses spent in
an earlier comparison period, the base period years. 23 To equitably measure
the increase in qualified research spending between the two periods, the same
standard should be applied in determining whether certain projects pursued
in the two periods are sufficiently experimental to be qualified research.
      The consistency rule addresses this very issue: it aims to ensure that the
research tax credit due is not overstated or understated because the taxpayer
inconsistently compares QREs in the base period years and the claim year.
The rule provides that the QREs “taken into account in computing [the fixed-
base] percentage shall be determined on a basis consistent with the
determination of [QREs] for the credit year.” 24 The corresponding Treasury
regulation uses language very similar to the consistency rule itself but adds
the word “definition”:
      [QREs] . . . taken into account in computing a taxpayer’s fixed-base
      percentage and a taxpayer’s base amount must be determined on
      a basis consistent with the definition of [QREs] . . . for the credit
      year, without regard to the law in effect for the taxable years taken
      into account in computing the fixed-base percentage or the base
      amount. 25

The regulation then provides two illustrations. In the first, for a hypothetical
taxpayer, the statutory definition of QRE for its first two base period years
(1984 and 1985) is different than a revised QRE definition applicable in its last



      23   I.R.C. § 41(a)(1).
      24   Id. § 41(c)(6)(A).
      25   Treas. Reg. § 1.41-3(d)(1).
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                                           No. 12-11012
three base period years (1986, 1987, and 1988) and in its claim year (2001). 26
To compute the credit for 2001, the taxpayer must apply the new QRE
definition to its 1984 and 1985 base period years “to reflect the change in the
definition of qualified research” beginning in 1986. 27 The second illustration
following the regulation shows another slightly different application of the
consistency rule.         It states that if the taxpayer counts “a certain type of
expenditure”—such as the wages of its research assistants—as QREs in the
claim year, it must also count “similar expenditures” as QREs in its base period
years. 28 In sum, the consistency rule calls for consistent application of the QRE
definition across the base period years and the claim year, including the types
of expenditures the taxpayer treats as QREs.
       The consistency rule is equally applicable to a case like this one. Here,
the district court decided that certain claim year projects were not sufficiently
experimental to pass the fourth QRE requirement—that 80% or more of the
research activities involved in the project constitute elements of a process of
experimentation 29—and Trinity simply asked the court to consider whether
four of its base period projects were also not sufficiently experimental to pass
that same test. If, for instance, the Ecuador and the XFPB projects involved
exactly the same level of experimentation, then it would violate the consistency
rule (and understate Trinity’s tax credit) not to count the XFPB as qualified
research in the claim year but to count the Ecuador as qualified research in


       26   Id. § 1.41-3(d)(2) (Example 1).
       27   Id.
       28Id. (Example 2); see also Union Carbide Corp. v. Comm’r, 97 T.C.M. (CCH) 1207,
T.C. Memo 2009-50, at *75 (2009) (“[T]he taxpayer must include the same types of activities
from the credit year and the base period when identifying qualified research activities and
include the same types of costs as QREs for the credit year and the base period.”), aff’d, 697
F.3d 104 (2d Cir. 2012).
       29   See I.R.C. § 41(d)(1); Treas. Reg. § 1.41-4(a)(6).
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                                 No. 12-11012
the base period years. Trinity is entitled to have a consistent QRE test applied
to projects in the base period years and the claim years.
      The only matter still unsettled is whether the district court would credit
Nuss’s and Charters’s testimony that the four base period vessels were similar
to the four claim year vessels held not be qualified research, in terms of how
much experimentation was involved. In its order after Phase II of the trial,
the district court stated that, “[o]ther than Trinity’s consistency argument, the
Court credits the testimony of Trinity’s witnesses and finds Trinity’s
calculation to be a reasonable estimate of the base amount.” But again, though
Trinity raised in the district court the second consistency rule argument based
on Nuss’s and Charters’s testimony, the district court did not address this
issue, so it is unclear whether the district court credited those witnesses’
testimony on the four base period vessels.
      We therefore remand to the district court for a limited purpose: making
a factual finding as to whether to credit the testimony of Nuss and Charters
that the four base period vessels were as experimental as (or less experimental
than) the four claim year vessels held not to satisfy the fourth QRE
requirement. If the district court credits this testimony against any possible
conflicting testimony or evidence, then those four base period vessels should
be removed from the base period QRE calculation, and the resulting base
period QRE figure would be $26,706,987. If the district court finds that the
four base period vessels (or some of them) were more experimental than the
four claim year vessels and were sufficiently experimental to qualify as QREs,
then the base period QRE figure should include the expenses associated with
those vessel projects. We thus vacate the district court’s holding as to the
consistency rule and remand for findings as to whether, in light of the district
court’s Phase I order, the four base period vessels at issue are sufficiently
experimental to constitute qualified research.
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                                         No. 12-11012
                                              IV
       Trinity also challenges the district court’s conclusion that its research
expenses in developing the Penn Tugs did not satisfy the fourth QRE
requirement and therefore did not constitute claim year QREs. Trinity first
argues that because the I.R.S. already determined that the Penn Tugs met the
fourth QRE requirement, the Government was either conclusively or
presumptively bound by that decision in this litigation. When the I.R.S. issued
its claim disallowance letter, it incorporated a revenue agent report stating
that, with respect to the Penn Tugs, the fourth requirement—the process-of-
experimentation test—was satisfied, even though two other QRE requirements
were not. Even if the Government is not conclusively bound by the conclusion
in Trinity’s favor on the fourth QRE requirement, Trinity argues it is entitled
to a presumption of correctness, so the Government bore the burden of
rebutting it by affirmative evidence.
       We disagree.          The district court correctly held that the report’s
conclusion, though admissible evidence, 30 was neither binding nor entitled to
a presumption of correctness. In tax refund actions, the district court reviews
de novo the Commissioner’s decision regarding a taxpayer’s tax liability. 31 The
taxpayer has the burden of proving by a preponderance of the evidence that
the Commissioner’s assessment—its final determination of the taxpayer’s
liability—was erroneous, since the assessment is presumed to be correct. 32


       30   See FED. R. EVID. 801(d)(2)(D).
       31 See Clapp v. Comm’r, 875 F.2d 1396, 1403 (9th Cir. 1989) (“In tax cases . . . [the]
United States District Court review[s] the Commissioner’s decision on the merits de novo.”);
Int’l Paper Co. v. United States, 36 Fed. Cl. 313, 320 (1996) (recognizing the “de novo nature
of tax refund proceedings in the Court of Federal Claims (as well as in the district courts)”).
       32Carson v. United States, 560 F.2d 693, 695-96 (5th Cir. 1977) (“The burden and the
presumption, which are for the most part but the opposite sides of a single coin, combine to
require the taxpayer always to prove by a preponderance of the evidence that the
Commissioner’s determination was erroneous.”) (citing United States v. Janis, 428 U.S. 433,
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                                           No. 12-11012
While the assessment itself is entitled to a presumption of correctness, the
“reasons for the Commissioner’s determination are not relevant for the Court
does not review those reasons.” 33 Accordingly, here, while the I.R.S.’s ultimate
determination of Trinity’s tax liability is presumptively correct, the revenue
agent report’s subsidiary conclusion that the Penn Tugs met the process-of-
experimentation test is neither binding on the Government nor presumptively
correct.
       Trinity’s second contention is that, even if the conclusions in the revenue
agent report are not binding or presumptively correct in this litigation, the
district court erred in deciding that the Penn Tugs did not satisfy the process-
of-experimentation test under the fourth QRE requirement.                           Under this
requirement, substantially all (i.e., 80%) of the taxpayer’s research activities,
“measured on a cost or other consistently applied reasonable basis,” must
constitute elements of a process of experimentation. 34                       As the Treasury
regulations elaborate, a “process of experimentation”
       involves three steps: (1) “the identification of uncertainty
       concerning the development or improvement of a business
       component,” (2) “the identification of one or more alternatives
       intended to eliminate that uncertainty,” and (3) “the identification
       and the conduct of a process of evaluating the alternatives




440 (1976)); see also Cook v. United States, 46 Fed. Cl. 110, 113-14 (2000) (discussing the
presumption of correctness and the taxpayer’s burden in tax refund suits).
       33Int’l Paper Co., 36 Fed. Cl. at 320 (quoting Pierson v. United States, 428 F. Supp.
384, 390 (D. Del. 1977)); see also MICHAEL I. SALTZMAN & LESLIE BOOK, IRS PRACTICE AND
PROCEDURE ¶ 1.05[2][a] (explaining that in a tax refund suit in federal court, “any ‘record’
made in the Service, including the reasons for its assessment, is irrelevant” and that the
“action involves a de novo determination of the correct tax and is not a review of the
administrative processing of the case”).
       34   I.R.C. § 41(d)(1)(C); Treas. Reg. § 1.41-4(a)(6).
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                                             No. 12-11012
       (through, for example, modeling, simulation, or a systematic trial
       and error methodology).” 35

       Case law applying the Treasury regulations explains that the process-of-
experimentation test is not satisfied when the taxpayer uses “a method of
simple trial and error to validate that a process or product change meets the
taxpayer’s needs.” 36         Instead, at a minimum, the research activities must
involve a “systematic trial and error methodology” 37—“a methodical plan
involving a series of trials to test a hypothesis, analyze the data, refine the
hypothesis, and retest the hypothesis so that it constitutes experimentation in
the scientific sense.” 38
       The Penn Tugs were each designed to connect to a barge by an
articulating arm (the “Intercon coupler”) so that the tugboat and the barge
could function as a single ship with high horsepower. In this tug-coupler-barge
combination, or articulated tug barge (ATB), “the tug functioned as the
propeller for the barge, rather than as a traditional tug that pulls another
vessel.”       Trinity designed the Penn Tugs to avoid the Coast Guard’s
requirement that large cargo ships have a 20-person crew with advanced
licenses. Instead of treating the ATB as a cargo ship, the Coast Guard would
certify the vessel as a tug and a barge, so it could be manned by a smaller crew
with simpler licenses, resulting in cost savings for the operator.




       35 United States v. McFerrin, 570 F.3d 672, 677 (5th Cir. 2009) (quoting Treas. Reg.
§ 1.41-4(a)(5)(i)).
       36 Union Carbide Corp. v. Comm’r, 97 T.C.M. (CCH) 1207, T.C. Memo 2009-50, at *81
(2009), aff’d, 697 F.3d 104 (2d Cir. 2012); see United States v. Davenport, 897 F. Supp. 2d 496,
506 (N.D. Tex. 2012) (same).
       37   Treas. Reg. § 1.41-4(a)(5)(i).
        Union Carbide Corp., T.C. Memo 2009-50, at *81; see Davenport, 897 F. Supp. 2d at
       38

506 (same).
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                                       No. 12-11012
        In addressing the Penn Tugs, the district court first noted that the
Intercon coupler part of the ATB was invented, developed, and built by other
companies. The court then considered the first Penn Tug and noted that, in
designing it, Trinity modified an existing hull design. The court acknowledged
this modification involved assessing “the structural integrity of the tug-coupler
combination” since “portions of the tug can be ‘hanging’ from the Intercon
coupler, depending on wave action on the barge.”                   The court nonetheless
concluded that less than 80% of the costs were incurred in a process of
experimentation “because third parties designed and manufactured the
coupler system itself and the first Penn Tug was only a modification of an
existing design.”
        The district court then separately addressed the second Penn Tug.
Trinity made the elevated pilot house on the first Penn Tug out of aluminum
to save weight, but due to changes in Coast Guard fire regulations, Trinity was
required to make the pilot house on the second Penn Tug out of steel. Although
the heavier steel pilot house required other design changes, the district decided
that “the only process of experimentation between the first and second Penn
Tugs was the change to the composition of the pilot house.” The district court
concluded that the second Penn Tug also failed the process-of-experimentation
test.
        This determination on the Penn Tugs is best characterized as a mixed
question of law and fact, since the underlying facts and applicable legal
standard are basically undisputed, and the question is whether those facts
satisfy the legal standard. 39 We therefore review any underlying fact findings


        39See Ornelas v. United States, 517 U.S. 690, 696-97 (1996) (explaining that for mixed
questions of law and fact, “historical facts are admitted or established, the rule of law is
undisputed, and the issue is whether the facts satisfy the [relevant statutory standard]”)
(internal quotation marks and citation omitted).
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                                          No. 12-11012
for clear error, but we review the legal conclusion that the Penn Tugs failed
the process-of-experimentation test de novo. 40 In addition, Trinity had the
burden of proof, including the burden of going forward with evidence and the
burden of persuasion, that 80% of its Penn Tugs research activities constituted
a process of experimentation. 41
       Trinity has not established that 80% of the research activities for the
Penn Tugs constituted elements of a process of experimentation.                          Trinity
argues that modifying the existing hull design involved some systematic trial
and error—“[f]inding a working hull design required testing and retesting,
including computer modeling and at least four design revisions”—and has cited
testimony to support this assertion. However, Trinity has failed to establish
which other aspects of its research involved the sort of systematic trial and
error required under the process-of-experimentation test. For instance, in
arguing that changing the composition of the pilot house involved a process of
experimentation, Trinity says it “experimented” with an aluminum tower and
pilothouse but does not allege that designing the tower involved the sort of
systematic trial and error that the hull design involved. While designing the
hull involved some systematic experimentation, Trinity has not shown that
substantially all of its Penn Tugs research activities involved the type of
systematic experimentation courts have required. 42


       40 See Dunn v. Comm’r, 301 F.3d 339, 348 (5th Cir. 2002) (holding that the
“determination of fair market value” of common stock under Treasury regulations is a mixed
question of fact and law, and that the factual premises of mixed questions are reviewed for
clear error and the legal conclusions are reviewed de novo).
       41   Int’l Paper Co. v. United States, 36 Fed. Cl. 313, 322 (1996).
       42 See Union Carbide Corp., T.C. Memo 2009-50, at *7, *85-86 (holding that
substantially all of the research activities in connection with an “anticoking project” (a project
aimed at reducing the build-up of carbon in the taxpayer’s furnaces) constituted elements of
a process of experimentation because the project involved collecting and analyzing data to
compare existing technologies with alternatives and ultimately refining the process to
improve it overall); see also Davenport, 897 F. Supp. 2d at 514-15 (holding that the taxpayer’s
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                                          No. 12-11012
       Moreover, since the coupler was not designed by Trinity, the district
court correctly focused on research activities with respect to the tugs only.
Trinity does not dispute that it did not invent, design, or build the coupler; it
only claims it “had to work alongside the company manufacturing the coupler
to design the support structure required for it to work within this prototype.”
While Trinity had to consider how the tugs would support the coupler, it did
not design the coupler itself.
        The district court also did not err in finding that, even if aspects of
designing the hull involved a process of experimentation, the hull’s design was
still based on an existing hull design to some extent. Although there was
testimony that Trinity had “to start over from scratch with a different hull,”
the testimony also established that designing the new hull involved
“modifications” of old hulls, and that the ultimate hull design had similarities
to existing hulls. Additionally, it was not error to consider the two Penn Tugs
“separately and sequentially,” as Trinity argues. Trinity cites no authority
requiring the court to treat the tugs together, and even if Trinity had, Trinity
has not shown how the 80% threshold would be surpassed by doing so.
Accordingly, the district court did not err in its analysis of the Penn Tugs.
                                      *        *         *
       For the foregoing reasons, the judgment of the district court is
AFFIRMED in part, and VACATED and REMANDED in part for proceedings
consistent with this opinion.




project “did not involve a process of experimentation or the type of systematic plan involving
a series of trials to test a hypothesis, analyze the data, refine the hypothesis, and retest the
hypothesis; nor did it involve a series of experiments with one or more alternatives to develop
the [project]”) (internal quotation marks and citation omitted).
                                              23
