                       133 T.C. No. 13



                 UNITED STATES TAX COURT



TG MISSOURI CORPORATION f.k.a. TG (U.S.A.) CORPORATION, A
            MISSOURI CORPORATION, Petitioner v.
       COMMISSIONER OF INTERNAL REVENUE, Respondent



 Docket No. 8333-06.                Filed November 12, 2009.



      P develops and uses production molds to
 manufacture automotive parts for its customers. P
 contracts with third-party toolmakers to build the
 production molds that P does not construct. After a
 third-party toolmaker finishes constructing a
 production mold, P purchases the mold and incurs
 additional design and engineering costs to modify the
 mold so that it can be used to produce the desired
 component part. P then either sells the completed
 production molds to its customers or retains ownership
 of the molds, but in either case P keeps the molds for
 production of automotive parts. On its 1998 and 1999
 tax returns, in calculating its research credit under
 sec. 41, I.R.C., P included the amounts it paid the
 third-party toolmakers for the production molds it
 purchased and sold to P’s customers, as the cost of
 supplies. R determined P improperly included the
 amounts it paid for such molds as the cost of supplies
 in computing its sec. 41, I.R.C., research credit
                                 - 2 -

     because the production molds sold to P’s customers are
     assets of a character subject to depreciation.

          Held: The production molds P sold to its
     customers are not assets of a character subject to the
     allowance for depreciation for purposes of secs.
     41(b)(2)(C), I.R.C., and 174(c), I.R.C. P properly
     included the costs of the production molds it purchased
     from third-party toolmakers and sold to its customers
     as the cost of supplies for calculating its sec. 41,
     I.R.C., research credit.



     William E. Elwood, Andrew W. MacLeod, and Peter J. Kulick,

for petitioner.*

     Meso T. Hammoud, Elizabeth R. Proctor, and Eric R. Skinner,

for respondent.



                                OPINION


     MARVEL, Judge:   Respondent determined deficiencies in

petitioner’s Federal income tax of $3,815,746 and $1,544,033 for

1998 and 1999,1 respectively.    After concessions,2 the sole issue

for consideration is whether production molds petitioner sold to

its customers are assets subject to depreciation for purposes of




     *
      Brief amicus curiae was filed by Leslie J. Schneider and
Patrick J. Smith as attorneys for Northrop Grumman Corp.
     1
      Petitioner’s 1999 tax year began on Jan. 1, 1999, and ended
on Mar. 31, 1999.
     2
      With the exception of the adjustments addressed in this
Opinion, petitioner concedes all adjustments made by respondent
with respect to 1998 and 1999.
                                    - 3 -

sections 41 and 174.3       The resolution of that issue determines

whether the amounts petitioner paid to third-party toolmakers for

the molds4 should have been included as “cost of supplies” in

petitioner’s qualified research expenses for purposes of

computing its tentative research credits for 1997,5 1998, and

1999.

                                 Background

        The parties submitted this case fully stipulated under Rule

122.        We incorporate the stipulated facts into our findings by

this reference.        Petitioner’s principal place of business was in

Missouri when its petition was filed.

        Petitioner is in the trade or business of manufacturing

injection-molded products, such as steering wheels, air bags, and

body side molding, for customers in the automotive industry.

Petitioner’s manufacturing process ordinarily begins when it

receives a request for quotation from a customer.        The request

for quotation includes general product specifications and

requirements and requires petitioner to develop a basic technical



        3
      Unless otherwise indicated, all section references are to
the Internal Revenue Code (Code) in effect for the years in
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
        4
      The amounts for 1997, 1998, and 1999 were $25,909,801,
$12,363,599, and $4,602,854, respectively.
        5
      Petitioner’s 1997 tax year is only relevant as a
carry-forward year, as respondent did not determine a deficiency
for that year.
                                - 4 -

design for the injection-molded product.   After receiving the

request, petitioner contracts with the customer to develop a

production mold that will enable petitioner to manufacture the

desired product.   Under the terms of the contract, petitioner is

entitled to payment only if it successfully designs and builds a

mold capable of producing a sample product and the customer

accepts the products produced using the mold.

     Depending on the particular injection-molded product,

petitioner will either construct the production mold in-house or

contract with a third-party toolmaker.   When petitioner contracts

with a third-party toolmaker, the toolmaker will construct the

production mold according to petitioner’s design specifications.

The toolmaker does not guarantee that the mold will perform to

petitioner’s customer’s specifications or produce the desired

part in accordance with design specifications of petitioner’s

customers.   Once petitioner and the third-party toolmaker develop

a design, petitioner works with the toolmaker to build a

prototype mold.    The purpose of the prototype mold is to permit a

limited number of test runs of the component part to isolate

design flaws.   Partly on the basis of input from testing the

component parts of the prototype mold, petitioner then engages

the third-party toolmaker to build the production mold.    While

the third-party toolmaker constructs the production mold,
                                - 5 -

petitioner accumulates all costs relating to the production

mold’s construction in a tooling inventory account.

     After the third-party toolmaker finishes constructing the

production mold, petitioner purchases the mold.   However, the

production mold petitioner purchases from the third-party

toolmaker is not capable of producing sample products in

accordance with the specifications of petitioner’s customers.

Consequently, petitioner incurs additional design and engineering

costs to modify the production mold so that the mold produces the

desired component part.    These costs are primarily wages paid to

petitioner’s engineers.6   The completed production mold is then

used in the mass production of the single component part desired

by the customer.   From the request for quotation until the time

the customer accepts the production mold, it generally takes 24

to 36 months to develop, design, construct, and test it.

     Depending on the terms of the agreement between petitioner

and the customer, the customer may either purchase the completed

production mold from petitioner or, in certain cases, it may have

petitioner retain ownership of the mold.   The process for

developing a production mold and the use of the mold in

petitioner’s business to produce the parts for the customer is

the same regardless of whether petitioner retains ownership of


     6
      Petitioner claimed the wages paid to its engineers as
research expenditures under sec. 41. Respondent does not
challenge these amounts.
                                 - 6 -

the mold or the customer purchases the mold.    If petitioner

retains ownership of the production mold, it depreciates the cost

of the mold, and the customer effectively pays for the production

mold by paying a higher per-unit price for the part produced

using the mold.   Petitioner does not claim any research expenses

or credit for the production molds it owns and depreciates.

     If the customer purchases a completed production mold, title

to the mold shifts to the customer once construction of the mold

is completed and the customer pays for the mold.    However,

petitioner retains possession of the mold for production of the

component part, and the customer retains the risk of loss for the

mold.7   Petitioner also reduces its tooling inventory account by

the cost of the mold when it sells the mold to the customer.

     Petitioner timely filed its 1997-99 Forms 1120, U.S.

Corporation Income Tax Return.    On its 1998 and 1999 returns,

petitioner capitalized and depreciated the costs paid to third-

party toolmakers for the production molds for which it retained

ownership.   However, with respect to the production molds sold to

customers, petitioner included the costs paid to the third-party

toolmakers as qualified research expenses for purposes of

computing its section 41 research credit.    On its 1997, 1998, and

1999 returns, petitioner included in its qualified research



     7
      Regardless of who retains ownership of the production mold,
the customer may require petitioner to retain the mold for
several years after production for the production of any spare
parts.
                                    - 7 -

expenses, for purposes of computing its research credit for each

year, “cost of supplies” of $32,055,348, $15,192,035, and

$5,347,217, respectively.8       Of those amounts, $25,909,801,

$12,192,783, and $4,602,854 were attributable to the costs

petitioner paid to third-party toolmakers for the production

molds in 1997, 1998, and 1999, respectively.

     On its 1997 tax return petitioner claimed a $2,316,601

research credit; petitioner used $48,675 of this amount in 1997

and carried forward $2,267,926 to 1998.          On its 1998 tax return,

petitioner claimed a $1,225,235 research credit; petitioner used

$306,636 of this amount in 1998 and carried forward $918,599 to

1999.        On its 1999 tax return, petitioner claimed a $399,4729

research credit; petitioner used $231,558 of this amount in 1999

and carried forward $167,914.

        On February 6, 2006, respondent mailed petitioner a notice

of deficiency for 1998 and 1999.10          Respondent determined that

the $25,909,801, $12,192,783, and $4,602,854 petitioner claimed

in 1997, 1998, and 1999, respectively, for costs incurred in

purchasing the production molds from third-party toolmakers did



        8
      On its 1997, 1998, and 1999 returns, petitioner also
included in its claimed qualified research expenses “wages” of
$5,224,973, $5,151,557, and $1,230,404, respectively.
        9
      The parties’ stipulation 33 reflects an incorrect amount
for petitioner’s research credit.
        10
      The notice of deficiency is dated Feb. 1, 2006, but the
parties stipulated that respondent mailed it to petitioner on
Feb. 6, 2006.
                                - 8 -

not qualify as research expenses for purposes of computing

petitioner’s tentative research credit for each year.     As a

result of this and other adjustments,11 respondent reduced

petitioner’s claimed research credit for 1997, 1998, and 1999 by

$1,695,028, $876,992, and $301,610, respectively, and adjusted

the amounts available for petitioner to carry over from these

years.    Respondent’s adjustments resulted in total allowable

research credits to petitioner of $921,141 and $97,862 for 1998

and 1999, respectively, and total reductions to petitioner’s

allowable section 38 general business credit, as set forth in the

notice of deficiency, of $216,357 and $623,684, respectively, for

these years.

     Petitioner timely filed a petition with this Court

challenging respondent’s adjustments.    Petitioner alleges in the

petition that the costs it incurred in 1997, 1998, and 1999 in

producing the production molds sold to its customers qualify as

research expenditures for purposes of the section 41 research

credit.    Petitioner asserts that it is entitled to the research

and development tax credits it claimed for 1998 and 1999 and is

entitled to carry over to those years all excess tax credits

arising from 1997-99.



     11
      Respondent also determined that $167,548, $170,816, and
$37,290 of “wages” petitioner claimed as qualified research
expenses for 1997, 1998, and 1999, respectively, did not qualify
as research expenses for purposes of computing petitioner’s sec.
41 research credit. Petitioner concedes this adjustment.
                                - 9 -

     When this case was called from the trial calendar of this

Court, the parties moved pursuant to Rule 122 to submit this case

fully stipulated.   We granted the motion and set a briefing

schedule.   Both parties filed timely posttrial briefs in

accordance with the briefing schedule.

     Subsequently, Northrop Grumman Corp. filed a motion for

leave to file a brief as amicus curiae.   We granted Northrop

Grumman Corporation’s motion, and Northrop Grumman Corp.’s brief

amicus curiae was filed.   Respondent and petitioner each filed a

response to Northrop Grumman Corp.’s brief amicus curiae.

                             Discussion

I.   Admissibility of Exhibits 8-P and 9-P

     Respondent objects on relevancy grounds to the admissibility

of Exhibit 8-P, Engineering and Valuation Report (engineering

report), and Exhibit 9–P, Form 886-A, Explanations of Items,

(revenue agent report).    Although this case was submitted fully

stipulated, respondent reserved an objection to the admissibility

of these reports.

     As a general rule, the Court will examine the positions of

the parties de novo in a deficiency proceeding and will “not look

behind a deficiency notice to examine the evidence used or the

propriety of respondent’s motives or of the administrative policy

or procedure involved in making his determinations.”    Greenberg’s

Express, Inc. v. Commissioner, 62 T.C. 324, 327 (1974).     The
                              - 10 -

rationale for this rule “is the fact that a trial before the Tax

Court is a proceeding de novo; * * * [the Court’s] determination

as to a petitioner’s tax liability must be based on the merits of

the case and not any previous record developed at the

administrative level.”   Id. at 328.   On occasion, this Court has

recognized an exception to this rule where there is substantial

evidence of arbitrary or unconstitutional behavior by the

Commissioner and the integrity of our judicial process would be

compromised by permitting the Commissioner to benefit from such

conduct.   Jackson v. Commissioner, 73 T.C. 394, 401 (1979);

Suarez v. Commissioner, 58 T.C. 792, 813-814 (1972).

     Petitioner states that it offers the revenue agent report

and the engineering report in an effort to fill the void created

by respondent’s failure to describe the basis for his

determination in the notice of deficiency.   Petitioner argues

that the two reports will assist the Court in understanding

respondent’s basis for the proposed disallowance.   In support of

its argument petitioner cites Clark v. Commissioner, 266 F.2d

698, 707 (9th Cir. 1959), affg. in part, revg. in part and

remanding T.C. Memo. 1957-129, for the proposition that a revenue

agent’s report is admissible when it is introduced only to show

the basis used by the Commissioner in arriving at his

determinations.
                               - 11 -

      We are not persuaded by petitioner’s argument.   Petitioner

has not demonstrated that an exception applies to justify looking

behind the notice of deficiency.   Although petitioner cites Clark

in support of admitting the engineering report and the revenue

agent report to explain respondent’s determination, the Court of

Appeals for the Ninth Circuit, which decided the appeal in Clark,

never addressed the admissibility of the revenue agent’s report.

The parties had stipulated that the report would be received in

evidence for that purpose.   Clark v. Commissioner, T.C. Memo.

1957-129.    Therefore, we cannot and do not read Clark as

requiring us to admit the engineering report and the revenue

agent report to explain the basis of respondent’s determination.

      Moreover, the position of respondent’s agent in his or her

report is immaterial because the trial de novo examines only

respondent’s determination as set forth in the notice of

deficiency.   Under these circumstances, we conclude there is no

reason to consider the pre-deficiency-notice reports in reaching

our decision.   We sustain respondent’s objection with respect to

Exhibits 8-P and 9-P.

II.   Burden of Proof

      Ordinarily, the Commissioner’s determination in the notice

of deficiency is presumed to be correct, and the taxpayer bears

the burden of proving that the Commissioner’s determination is

erroneous.    Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
                              - 12 -

(1933).   The fact that a case is fully stipulated does not change

or lessen the taxpayer’s burden.   Borchers v. Commissioner, 95

T.C. 82, 91 (1990), affd. 943 F.2d 22 (8th Cir. 1991).     However,

the presumption of correctness does not apply and the burden of

proof shifts to the Commissioner when he fails to make a

determination and issues a “‘naked’ assessment without any

foundation whatsoever”.   United States v. Janis, 428 U.S. 433,

441 (1976).

     Petitioner makes several arguments for shifting the burden

of proof to respondent.   Petitioner argues that in the notice of

deficiency respondent states only that petitioner’s expenses do

not qualify for the section 41 research credit and that the

notice does not adequately explain respondent’s disallowance of

petitioner’s general business tax credits.    Petitioner asserts

that respondent unfairly forces petitioner to bear the burden of

supporting essentially every dollar of the claimed research

credits because it cannot identify which qualified research

expenses respondent challenges, or the basis for those

challenges.   Petitioner also contends that, because respondent

has failed to make an evidentiary showing to support his

deficiency determination, respondent’s determination is not

entitled to the presumption of correctness.

     We do not address petitioner’s arguments regarding the

proper allocation of the burden of proof and the presumption of
                                 - 13 -

correctness.     The assignment of the burden of proof does not

affect the result, and our holding regarding petitioner’s

research credits eliminates the need to decide any issue raised

by petitioner with respect to the burden of proof.

III. Research Credit Under Section 41

     A.      Sections 174(c) and 41(b)(2)(C)

     The research credit was introduced with the enactment of the

Economic Recovery Tax Act of 1981, Pub. L. 97-34, sec. 221(a), 95

Stat. 241.12     Congress enacted the research credit to “encourage

business firms to perform the research necessary to increase the

innovative qualities and efficiency of the U.S. economy.”      S.

Rept. 99-313, at 694 (1986), 1986-3 C.B. (Vol. 3) 1, 694; H.

Rept. 99-426, at 177 (1985), 1986-3 C.B. (Vol. 2) 1, 177.

     Section 41(a)(1) allows a taxpayer to claim a credit, as

part of the taxpayer’s general business credit under section

38(b), against income taxes in an amount equal to 20 percent of

the excess (if any) of the taxpayer’s qualified research expenses

for the year over the base amount.13      Section 41(b)(1) defines


     12
      Originally, the research credit was included in sec. 44F.
See Economic Recovery Tax Act of 1981, Pub. L. 97-34, sec.
221(a), 95 Stat. 241.
     13
          Sec. 41 provides, in pertinent part:

          SEC. 41(a). General Rule.--For purposes of
     section 38, the research credit determined under this
     section for the taxable year shall be an amount equal
     to the sum of--
                                                   (continued...)
                                  - 14 -

“qualified research expenses” as the sum of “in-house research

expenses” and “contract research expenses” paid or incurred by

the taxpayer during the taxable year in carrying on any of its

trade or business.     Under section 41(b)(2)(A), “in-house research

expenses” include any amount paid or incurred for “supplies” used

in the conduct of “qualified research”.       Section 41(b)(2)(C)

defines “supplies” as any tangible property, but excludes from

this definition (1) land or improvements to land and (2)

“property of a character subject to the allowance for

depreciation.”

     Section 41(d)(1) defines “qualified research” as research

that meets the requirements of subparagraphs (A), (B), and (C).

One of those requirements is that expenditures with respect to

qualified research may be treated as expenses under section

174.14     Sec. 41(d)(1)(A).   Consequently, an expenditure must be a


     13
          (...continued)

             (1) 20 percent of the excess (if any) of–-

                  (A) the qualified research expenses for the
             taxable year, over

                  (B) the base amount * * *
     14
      Generally, sec. 174(a) allows a taxpayer to currently
deduct research or experimental expenditures paid or incurred
during the taxable year in connection with the taxpayer’s trade
or business. Under sec. 174(a), the taxpayer may treat such
research or experimental expenditures as expenses which are not
chargeable to capital account. Sec. 280C(c) provides that no
deduction is allowed for the portion of the qualified research
expenses otherwise allowable as a deduction which is equal to the
                                                   (continued...)
                              - 15 -

section 174 expense to constitute “qualified research” under

section 41.   See Norwest Corp. & Subs. v. Commissioner, 110 T.C.

454, 489-490 (1998).   Section 174 does not define the phrase

“research and experimental expenditures”, but, similar to the

definition of “supplies” in section 41(b)(2)(C), section 174(c)

provides that section 174 does not apply to expenditures for “the

acquisition or improvement of property to be used in connection

with the research or experimentation and of a character which is

subject to the allowance” for depreciation.15

     Section 1.174-2(b)(2), Income Tax Regs., addresses a

scenario in which research or experimentation expenditures

result, as an end product of the research or experimentation, in

depreciable property to be used in the taxpayer’s trade or

business.   Section 1.174-2(b)(2), Income Tax Regs., provides that

subject to limitations of subparagraph (4), such expenditures may

be allowable as a current expense deduction under section 174(a).

Section 1.174-2(b)(4), Income Tax Regs., in turn provides:

     The deductions referred to in [subparagraph] (2) * * *
     for expenditures in connection with the acquisition or
     production of depreciable property to be used in the
     taxpayer’s trade or business are limited to amounts


     14
      (...continued)
amount of the credit claimed under sec. 41(a).
     15
      Although sec. 174(c) excludes property of a depreciable
character from being expensed under sec. 174, allowances for
depreciation are considered research or experimental expenditures
under sec. 174 to the extent that the property to which the
allowances relate is used for research or experimentation. Sec.
174(c); sec. 1.174-2(b)(1), Income Tax Regs.
                              - 16 -

     expended for research or experimentation. For the
     purpose of the preceding sentence, amounts expended for
     research or experimentation do not include the costs of
     the component materials of the depreciable property,
     the costs of labor or other elements involved in its
     construction and installation, or costs attributable to
     the acquisition or improvement of the property.[16]

    B.    The Parties’ Positions

     Respondent argues that petitioner’s costs in obtaining

production molds from the third-party toolmakers are not eligible

for expensing under section 174 and, consequently, the production

molds do not qualify as “supplies” under section 41(b)(2)(C),

because the costs at issue are for the acquisition and

improvement of property of a character subject to the allowance

for depreciation.   Respondent contends that the phrase “property

of a character subject to the allowance for depreciation” in

sections 41(b)(2)(C) and 174(c) refers to the character of the

property itself and not to whether the property is depreciable in

the hands of a particular taxpayer.    Respondent argues that an

interpretation that focuses on the taxpayer’s ability to

depreciate the property renders the phrase “of a character”

superfluous.   In respondent’s view, property is of a depreciable


     16
      An example in sec. 1.174-2(b)(4), Income Tax Regs., is
that of a taxpayer who undertakes to develop a new machine for
use in his business. The taxpayer expends a total of $30,000 on
the project, of which $10,000 represents the actual costs of
material, labor, etc., to construct the machine, and $20,000
represents research costs that are not attributable to the
machine itself. Id. In this example, the $20,000 research costs
are deductible under sec. 174(a), but the $10,000 is not
deductible and must be charged to the asset account (the
machine). Id.
                                - 17 -

character if it is subject to wear and tear, exhaustion, or

obsolescence, has a useful life exceeding 1 year, and is used in

the taxpayer’s trade or business.    In support of his argument,

respondent cites section 167(a), which allows a depreciation

deduction for the exhaustion, wear and tear, or obsolescence of

property used in a taxpayer’s trade or business.    Respondent also

relies on Simon v. Commissioner, 103 T.C. 247, 260 (1994), affd.

68 F.3d 41 (2d Cir. 1995), suggesting that in Simon the Court

interpreted the phrase property “of a character subject to the

allowance for depreciation” (in the context of section 168) to

mean property of a type which is subject to wear and tear,

exhaustion, or obsolescence.    Because petitioner used the

production molds it sold to its customers to manufacture the

customers’ desired automotive parts, respondent asserts that the

molds were subject to wear and tear, exhaustion, or obsolescence,

in petitioner’s business.17    Respondent points out that

petitioner depreciated the production molds in which it retained

ownership and that petitioner used those molds in its business in

the same manner as it used the production molds it sold to its

customers.   Respondent concludes that petitioner’s costs in

acquiring the production molds from third-party toolmakers are

not qualified research expenses under section 41.




     17
      The parties stipulated that the production molds had an
expected useful life exceeding 1 year.
                              - 18 -

     Petitioner and the amicus take a contrary view.    They argue

that the reference to “property * * * of a character which is

subject to the allowance under section 167 (relating to allowance

for depreciation, etc.)” in section 174(c) and the reference to

“property of a character subject to the allowance for

depreciation” in section 41(b)(2)(C) mean property that is

depreciable in the hands of the taxpayer.    Petitioner and the

amicus draw support from statutes and regulations, the

legislative history of section 174, and caselaw interpreting the

depreciation provisions of section 167.

     C.    Analysis of the Language of Sections 174(c) and
           41(b)(2)(C)

     We begin with the language of the relevant statutory

provisions.   See Landreth Timber Co. v. Landreth, 471 U.S. 681,

685 (1985).   If a statute is clear and unambiguous and the

statutory scheme is coherent and consistent, the Court’s function

is to apply the statute as written and according to its terms.

Robinson v. Shell Oil Co., 519 U.S. 337, 340 (1997); Fernandez v.

Commissioner, 114 T.C. 324, 329 (2000).     The statute must be read

as a whole, and the meaning of a particular portion of a

statutory provision must be determined with reference to its

context.   See FDA v. Brown & Williamson Tobacco Corp., 529 U.S.

120, 133 (2000).   Ordinarily, we examine a statute’s legislative

history to ascertain congressional intent only if we determine
                              - 19 -

that the statute is ambiguous.   Fernandez v. Commissioner, supra

at 329-330.

     Section 41(b)(2)(A)(ii) and (C)(ii) excludes from section 41

qualified research expenses any amount paid for “property of a

character subject to the allowance for depreciation” that is

“used in the conduct of qualified research”.    Section 174(c)

similarly excludes from section 174 the costs of acquiring or

improving property “of a character which is subject to the

allowance * * * [for depreciation]” that is “to be used in

connection with the research or experimentation”.    The Code

provides for the allowance for depreciation referred to in

sections 41(b)(2)(C) and 174(c) in section 167, which authorizes

a taxpayer who has a depreciable interest in property used in the

taxpayer’s trade or business to deduct a reasonable allowance in

the form of depreciation for the wear and tear, exhaustion, and

obsolescence of property so used.18

     We begin our analysis with an examination of the language in

sections 174 and 41 that Congress used to describe the property

costs that are excluded in calculating the section 174(a)

deduction and the section 41 research credit.    Section 174 sets

forth the rules governing the proper tax treatment of research



     18
      Sec. 167(a) allows as a depreciation deduction a
reasonable allowance for the wear and tear, exhaustion, and
obsolescence of: (1) Property used in the trade or business or
(2) property held for the production of income.
                                - 20 -

and experimental expenditures.    Section 174(a)(1) provides that a

taxpayer may treat research or experimental expenditures that he

pays or incurs during the taxable year in connection with his

trade or business “as expenses which are not chargeable to

capital account.”    Section 174(a)(1) further provides that “The

expenditures so treated shall be allowed as a deduction.”

Alternatively, section 174(b)(1) authorizes a taxpayer to elect

to amortize research or experimental expenditures that are paid

or incurred by the taxpayer in connection with his trade or

business, are not treated as expenses under section 174(a), and

are “chargeable to capital account but not chargeable to property

of a character which is subject to the allowance under section

167 (relating to allowance for depreciation, etc.) or section 611

(relating to allowance for depletion)”.     Sec. 174(b)(1) (emphasis

added).   Specifically, section 174(b) allows a taxpayer to elect

to treat research or experimental expenditures that are

chargeable to a capital account but are not chargeable to

property of a character subject to the depreciation allowance or

the section 611 depletion allowance as amortizable deferred

expenses that may be deducted ratably over a period of not less

than 60 months.     Research and experimental expenditures that are

neither currently expensed nor amortized must be charged to

capital account.    Sec. 1.174-1, Income Tax Regs.
                                - 21 -

     Section 174(c) describes expenditures that do not qualify

for deduction under section 174(a) or for amortization under

section 174(b).   Section 174(c) provides as follows:

          SEC. 174(c). Land and Other Property.--This
     section shall not apply to any expenditure for the
     acquisition or improvement of land, or for the
     acquisition or improvement of property to be used in
     connection with the research or experimentation and of
     a character which is subject to the allowance under
     section 167 (relating to allowance for depreciation,
     etc.) or section 611 (relating to allowance for
     depletion); but for purposes of this section allowances
     under section 167, and allowances under section 611,
     shall be considered as expenditures. [Emphasis added.]

     Both section 174(b) and (c) use the same language to

describe property “of a character which is subject to the

allowance” under section 167.    In the case of section 174(b), one

of the express requirements that research or experimental

expenditures must satisfy in order for the taxpayer who paid or

incurred those expenditures to be able to elect to amortize them

under section 174(b) is that the expenses must be chargeable to

capital account but must not be chargeable to a depreciable asset

account.   In other words, section 174(b) examines the proper

accounting treatment in the hands of the taxpayer of research or

experimental expenditures made by the taxpayer.   If the

expenditures are capital but are not chargeable to a depreciable

asset account, then the taxpayer may elect to amortize those

expenses under section 174(b).    If, however, the expenditures are

chargeable to a depreciable asset account and therefore are
                              - 22 -

expenditures “of a character which is subject to the allowance

under section 167”, then section 174(c) ensures that the

expenditures cannot qualify for expensing under section 174(a) or

for amortization under section 174(b).

     It is a well-established principle of statutory construction

that a statute must be interpreted as a symmetrical and coherent

regulatory scheme, Gustafson v. Alloyd Co., 513 U.S. 561 (1995);

2A Singer & Singer, Sutherland Statutory Construction, sec. 46:5,

at 189-190 (7th ed. 2007), and courts consider the entire

legislative scheme of which the particular provision is a part,

2A Singer & Singer, supra at 202-205.    “‘[T]he Code must be given

“as great an internal symmetry and consistency as its words

permit.”’”   Commissioner v. Keystone Consol. Indus., Inc., 508

U.S. 152, 159 (1993) (quoting Commissioner v. Lester, 366 U.S.

299, 304 (1961)).   Both subsections (b) and (c) of section 174

use the same language to describe expenditures that will not

qualify under section 174 for deduction or amortization.    Section

174(b)(1)(C) makes clear that its reference to research or

experimental expenditures that are chargeable to capital account

but are not chargeable to property of a character subject to

depreciation is a reference to the proper accounting treatment of

the expenditures on the taxpayer’s books and records and reflects

Congress’ intention that a taxpayer’s expenditures that are

properly charged to a depreciable asset account do not qualify
                              - 23 -

for section 174 expensing or amortization because they will be

depreciated by the taxpayer under section 167.    Section 174(c),

read in context, reinforces this conclusion because it clearly

states that section 174 does not apply to such expenditures but

that the depreciation allowance under section 167 with respect to

those expenditures is itself a research or experimental

expenditure for purposes of section 174.    In each case, section

174(c) clearly requires an examination of the proper tax

treatment of the expenditure in the hands of the taxpayer.

     An examination of the pertinent language of section 41

reveals a similar definitional approach in identifying those

expenditures that constitute “qualified research expenses” under

section 41(b).   Section 41(b)(1) defines the phrase “qualified

research expenses” to include amounts paid or incurred by the

taxpayer for in-house research expenses and contract research

expenses.   Section 41(b)(2)(A)(ii) defines “in-house research

expenses” to include amounts paid or incurred for supplies used

in the conduct of qualified research.    Section 41(b)(2)(C)

defines the term “supplies” to mean any tangible property other

than land or improvements to land, sec. 41(b)(2)(C)(i), and

“property of a character subject to the allowance for

depreciation”, sec. 41(b)(2)(C)(ii).    It is reasonable to

interpret the language of section 41(b)(2)(C)(ii), like the

comparable language in section 174(b) and (c), as a reference to
                              - 24 -

property that is not properly classified as depreciable property

on the books and records of the taxpayer.   Like section 174,

section 41 reflects Congress’ intent that a taxpayer not be

allowed to expense the costs of purchasing or improving property

that are properly chargeable to a depreciable asset account on

the taxpayer’s books and records and also include those costs in

calculating the taxpayer’s research credit under section 41.19

Cf. S. Rept. 97-144, at 76 (1981), 1981-2 C.B. 412, 438; H. Rept.

97-201, at 110 (1981), 1981-2 C.B. 352, 357.

     Our reading of sections 41(b)(2)(C) and 174(c) and our

conclusion that the reference in both sections to property of a

character subject to the depreciation allowance means property

that is depreciable in the hands of the taxpayer are supported by

the function of these provisions in the overall statutory scheme.

By their terms, sections 41(b)(2)(C) and 174(c) prevent a

taxpayer from receiving a credit for or expensing property used



     19
      While the legislative history surrounding the enactment of
sec. 174 offers little insight in interpreting sec. 174(c), the
House and Senate committee reports accompanying the enactment of
sec. 41 provide some guidance. After noting that sec. 174(c)
expressly excluded the cost of depreciable property, both reports
stated, as an example, that the “cost of a research building or
of equipment used for research cannot be deducted in one year.”
S. Rept. 97-144, at 76 (1981), 1981-2 C.B. 412, 438; H. Rept. 97-
201, at 110 (1981), 1981-2 C.B. 352, 357. Equipment used for
research is excluded because it is of a character subject to the
allowance for depreciation as used by the taxpayer in its
research activities–-i.e., the equipment is subject to wear and
tear, exhaustion, and obsolescence in the taxpayer’s research.
See sec. 174(c); see also sec. 167(a).
                              - 25 -

in the taxpayer’s research or experimentation activities where

the cost is more appropriately recovered over time through

depreciation deductions.   Without these sections, a taxpayer

could circumvent the gradual cost recovery mandated by the

depreciation rules of sections 167 and 168 by recovering the full

cost of such property in 1 year.

     D.   The Phrase “of a Character Subject to the Allowance”
          for Depreciation in the Context of Other Code
          Provisions

          1.   Depreciation Provisions of the Code and
               Regulations and Relevant Caselaw

     Respondent states that under section 167(a) a depreciation

deduction is allowed for tangible property which is subject to

wear and tear and obsolescence, is used in a taxpayer’s business,

and has a useful life exceeding 1 year.   Respondent correctly

notes that in Simon v. Commissioner, 103 T.C. at 260, we

interpreted the phrase “of a character subject to the allowance

for depreciation” to mean that property must suffer exhaustion,

wear and tear, or obsolescence to be depreciated.

     However, respondent’s analysis bypasses the inquiry as to

whether a depreciation allowance under section 167 is appropriate

with respect to particular tangible property in the first place.

As discussed above, section 167(a) allows as a depreciation

deduction a reasonable allowance for the exhaustion and wear and

tear (including a reasonable allowance for obsolescence) of

property used in a trade or business or property held for the
                              - 26 -

production of income.   Section 1.167(a)-2, Income Tax Regs.,

recognizes that the depreciation allowance applies to tangible

property, but it specifically excludes inventories or stock in

trade as ineligible for depreciation allowances.   Accordingly, as

section 1.167(a)-2, Income Tax Regs., suggests, a taxpayer may

hold tangible property for use in a trade or business, for the

production of income, or as inventory or stock in trade.

     With respect to inventories, for example, we have held that

whether property is used in a trade or business or is held

primarily for sale to customers in the ordinary course of the

taxpayer’s trade or business, so as to preclude the depreciation

allowance, is a question of fact.   See Luhring Motor Co. v.

Commissioner, 42 T.C. 732, 751 (1964); see also Valmont Indus.,

Inc. v. Commissioner, 73 T.C. 1059, 1080-1081 (1980).    In Luhring

Motor Co. v. Commissioner, supra at 747-750, the taxpayer, an

automobile dealer, purchased from a manufacturer a supply of new

automobiles; most of the automobiles were held for immediate

sale, but the taxpayer assigned some of them to its employees and

claimed a depreciation deduction with respect to those

automobiles.   We recognized that the taxpayer could take some of

its new cars out of stock in trade and use them in its business

as depreciable assets, id. at 754, but found that the taxpayer

did so only temporarily without altering the essential purpose

for which the taxpayer acquired the vehicles, id. at 753.
                               - 27 -

Accordingly, we held that the taxpayer could not claim

depreciation deductions with respect to the automobiles.      Id. at

755.    Because the issue of whether a taxpayer may claim a

depreciation deduction with respect to an asset is a question of

fact, in the context of sections 174(c) and 41(b)(2)(C) the

phrase “of a character subject to the allowance for depreciation”

cannot mean there is a generic character of property that exists

without any reference to a particular taxpayer and such

taxpayer’s use of the property.20

       We also disagree with respondent’s position that the

character of the production molds did not change as a result of a

sale to customers.    It is true that although petitioner

transferred title to the production molds to its customers,

petitioner retained possession of the molds and used them in its

business to produce component parts.    However, generally, only

taxpayers with an economic interest in an asset can deduct

depreciation with respect to that asset; “‘The statutory

allowance [for depreciation] is available to him whose interest

in the wasting asset is such that he would suffer an economic

loss resulting from the deterioration and physical exhaustion as


       20
      An approach incorporating sec. 1.167(a)-2, Income Tax
Regs., and caselaw interpreting depreciation provisions of the
Code is consistent with current sec. 1.168(a)-1, Income Tax
Regs., which provides that “The determination of whether tangible
property is property of a character subject to the allowance for
depreciation is made under section 167 and the regulations under
section 167.”
                                - 28 -

it takes place.’”   Hutchinson v. Commissioner, 116 T.C. 172, 185

(2001) (quoting Commissioner v. Moore, 207 F.2d 265, 268 (9th

Cir. 1953), revg. and remanding 15 T.C. 906 (1950)); see also

Helvering v. F. & R. Lazarus & Co., 308 U.S. 252, 254 (1939);

Weiss v. Wiener, 279 U.S. 333, 335-336 (1929).    Both the

production molds that petitioner sold to customers and the ones

it continued to own had useful lives over 1 year and were subject

to wear and tear, and petitioner used them to make parts for the

customers.   However, the record does not allow us to conclude

that with respect to the production molds sold to customers, it

was petitioner who suffered an economic loss resulting from their

deterioration and exhaustion.    See Hutchinson v. Commissioner,

supra at 185.   Although petitioner retained physical possession

of the molds after sale, its customers bore the risk of loss with

respect to the production molds.    The parties also stipulated

that petitioner adjusted its pricing for the parts produced from

the molds depending on whether it retained ownership of the

production molds, and customers effectively paid a higher per-

unit price for the parts produced using the molds if petitioner

did not sell the molds.   Accordingly, we disagree with respondent

that the production molds that petitioner sold to its customers

were no different from those petitioner continued to own.

Because petitioner does not have an economic interest in

production molds it has sold and cannot depreciate them for that
                              - 29 -

reason, the sold production molds are not property of a character

subject to depreciation allowances under section 167.

          2.   Other Provisions of the Code

     Besides sections 174(c) and 41(b)(2)(C), several other Code

sections use the phrase “of a character subject to the allowance

for depreciation” or its slight variation.21    Although none of

these sections defines the phrase, we find the language of some

other Code sections, in particular section 1239, instructive as

to the meaning of the phrase in sections 174(c) and 41(b)(2)(C).

     Section 1239 addresses gain from sale of depreciable

property between certain related taxpayers and denies capital

gain treatment on the sale of assets in certain circumstances.

Section 1239(a) provides that the transferor’s gain shall be

treated as ordinary income “if such property is, in the hands of

the transferee, of a character which is subject to the allowance

for depreciation provided in section 167.”     (Emphasis added.)

Section 1239 was introduced in 1951, see Revenue Act of 1951, ch.

521, sec. 328(a), 65 Stat. 504, and by that time Congress had

already used the term “of a character which is subject to the



     21
      Such other sections in the current Code are secs.
30(c)(1), 30B(g)(1) and (h)(6), 30C(b)(1), (d)(1), and (e)(2),
42(d)(4)(B), (C)(i), and (e)(2)(A), 144(a)(1)(A) and (11)(B),
147(c)(2)(F)(i), 168(l)(2), 169(d)(4)(A), 172(d)(4)(A)(i),
175(c)(1)(A), 179A(d)(1) and (e)(6)(B), 179B(c)(2), 197(f)(7),
198(b)(2), 419(c)(3)(C)(ii)(I), 453(f)(7), 514(a)(3), 616(a),
617(a)(1), 818(b)(1)(A), 1017(b)(3)(B), 1221(a)(2), 1231(b)(1),
1239(a) and (e), 1245(a)(3), 1250(c), 7871(c)(3)(B)(i).
                              - 30 -

allowance” for depreciation in revenue legislation, see, e.g.,

Revenue Act of 1938, ch. 289, sec. 117(a), 52 Stat. 500 (enacting

the predecessor of the current section 1221).   When drafting

section 1239, however, Congress did not merely reuse the already

familiar phrase but clarified in the hands of which taxpayer the

determination of the character of the property should be made.

Because section 1239 discussed the transferor’s gain but Congress

deemed it necessary to determine the character of property by

looking at the transferee, such clarification was necessary.    If

Congress believed that an asset were inherently depreciable as

long as it were subject to wear and tear and obsolescence,

clarifying in whose hands the property would be depreciable would

be unnecessary, and the phrase “in the hands of the transferee”

in section 1239(a) would be superfluous.

     When section 1239 became part of the 1954 Code, Congress

used the phrase “of a character which is subject to the

allowance” for depreciation in the newly enacted section 174 as

well as in nine other sections.22   Generally, “‘identical words

used in different parts of the same act are intended to have the

same meaning’”.   Commissioner v. Keystone Consol. Indus., Inc.,



     22
      Such sections of the 1954 Code were sec. 169(d) (flush
language) (repealed 1969), sec. 172(d)(4)(A)(i), sec.
174(b)(1)(C) and (c), sec. 175(c)(1)(A), sec. 615(a) (repealed
1976), sec. 616(a), sec. 1071(a) (repealed 1995), sec.
1082(a)(2)(A) (repealed 2005), sec. 1221(2), sec. 1231(b)(1),
sec. 1239(b).
                              - 31 -

508 U.S. at 159 (quoting Atl. Cleaners & Dyers, Inc. v. United

States, 286 U.S. 427, 433 (1932)).     We believe Congress could not

have intended that property could be of a general character

without reference to a specific taxpayer for purposes of section

174 and at the same time spell out in section 1239 in whose hands

the relevant determination of the character should be made.

     The current section 453 titled “Installment Method” takes an

approach similar to that of section 1239.    Generally, section

453(a) provides that income from an installment sale shall be

taken into account under the installment method.    Section 453(g)

contains rules for an installment sale of depreciable property

between related persons.   Section 453(f)(7) defines depreciable

property as “property of a character which (in the hands of the

transferee) is subject to the allowance for depreciation provided

in section 167.”   (Emphasis added.)   If we were to adopt

respondent’s reading of the phrase, the words “in the hands of

the transferee” in section 453(f)(7) would also be superfluous.

     E.   Section 1.174-2(b)(2) and (4), Income Tax Regs.

     Respondent maintains that section 1.174-2(b)(4), Income Tax

Regs., precludes application of section 174 to the costs of

component materials for research and experimentation when

research and experimentation result, as an end product, in

depreciable property.   Because we hold that the production molds

petitioner sold to customers are not of a character subject to an
                              - 32 -

allowance under section 167, the limitation applicable to costs

of component materials found in section 1.174-2(b)(4), Income Tax

Regs., does not apply.

IV.   Conclusion

      We hold that the production molds that petitioner sold to

its customers are not assets of a character subject to the

allowance for depreciation under sections 41(b)(2)(C) and 174(c)

and that petitioner properly included the costs of the production

molds it purchased from third-party toolmakers as the cost of

supplies in calculating its section 41 research credit.     We

conclude, therefore, that respondent’s adjustments to

petitioner’s 1998 and 1999 returns are erroneous and are not

sustained.

      We have considered the remaining arguments made by the

parties, and to the extent not discussed above, we conclude those

arguments are irrelevant, moot, or without merit.

      To reflect the foregoing,


                                       Decision will be entered

                                  under Rule 155.
