prototype memo and attachment

1

DRAFT FOR DISCUSSION PURPOSES

Inclusion of Prototype Cost as Qualified Research Expenditures

In general, when a prototype is placed in inventory for sale to customers, the wages, contract

research (for which the taxpayer bears the risk), and supply costs incurred to develop the

prototype are qualified research expenditures (QREs), but the wages and contract research

related to construction and the supply costs for component parts are not. The same is true

when a prototype is used for rotable spare parts or is used as depreciable property by the

taxpayer.

However, when a prototype is scrapped by the taxpayer, all of the wages, contract research (for

which the taxpayer bears the risk), and supply costs incurred to develop and construct the

prototype are QREs. Similarly, when the taxpayer pays a third party to develop a prototype and

does not obtain an ownership interest in the prototype all of the costs incurred by the taxpayer

to develop the prototype are QREs.

Finally, when the taxpayer develops the prototype for a customer and does not obtain an

ownership interest in a prototype, all of the costs incurred by the taxpayer to develop the

prototype are QREs as long as the taxpayer’s compensation for services is contractually subject

to performance guarantees relating to the prototype.

Under section 174(a), “a taxpayer may treat research or experimental expenditures which are

paid or incurred by him during the taxable year in connection with his trade or business as

expenses which are not chargeable to capital account. The expenditures so treated shall be

allowed as a deduction.” However, under section 174(c) no deduction is allowed for “any

expenditure … for the acquisition or improvement of property … of a character which is subject

to the allowance under section 167.”

The regulations clarify that expenditures for depreciable property are not subject to an

allowance for depreciation even if the property that is acquired or improved is used for

research and development; however, expenditures that result in depreciable property to be

used in the taxpayer's trade or business may be allowable as a current expense deduction. QREs

for the acquisition or production of depreciable property do not include the cost of component

materials, construction labor, or other costs attributable to acquisition/ improvement.

Additionally, the regulations provide that expenditures paid to third parties for the construction

of depreciable property that is acquired by the taxpayer are deductible if such construction is

done at the taxpayer’s specification and risk.

Any amount paid or incurred for supplies used in the conduct of qualified research is a

qualifying in-house research expense. However, property of a character subject to the

allowance for depreciation is excluded from qualifying as supplies. The legislative history of the

section 41 credit suggests that the costs of component parts could be included in the credit

2

calculations as qualifying supply expenditures; however, neither the IRS nor the courts have

taken this approach.

Revenue Rulings

In general, Revenue Rulings have been favorable regarding the deductibility of costs incurred to

develop prototypes, but somewhat limited in their reasoning and discussion of the law.

Rev. Rul. 69-484 held that payments made by a taxpayer airline, in concert with other airlines

and the Federal Aviation Administration, to an aircraft manufacturer to design, develop, and

test a supersonic transport aircraft were deductible under section 174. These payments did not

entitle the taxpayer to any rights in the prototype and were made because the development of

the aircraft would benefit the taxpayer in general.

Rev. Rul. 73-20, which cited Rev. Rul. 69-484 as precedent, similarly held that payments made

by a taxpayer utility to a non-profit research and development organization formed to develop

a model that would benefit the utility field were deductible under section 174. Notably, the

Ruling held that even the portion of the payments that were administrative and operating

expenses were deductible. Like the payments in Rev. Rul. 69-484, the payments in Rev. Rul. 73-

20 did not entitle the taxpayer to any rights in the prototype and no mention was made about

the eventual use or disposition of the prototype.

Similarly, Rev. Rul. 73-324 determined that payments made by a taxpayer in concert with other

industry members and a government agency for the development of a product, were

deductible under section 174.

Rev. Rul. 73-275 considered whether a taxpayer was entitled to a section 174 deduction for

costs incurred in constructing special order manufacturing systems for its customers. The Ruling

held that the product engineering expenses qualified under section 174, but the production

costs did not. The Ruling emphasized that “section 174 covers costs incurred in developing the

concept of a product as opposed to the product itself.

Rev. Rul. 75-122 considered whether the taxpayer mining company’s costs to access a

previously unexploited mineral deposit, develop equipment to mine that deposit, and develop

equipment and processes to extract the mineral from the ore were deductible under section

174. The Ruling held that the costs to locate and access the ore were explicitly disallowed by

section 174(d). However, the costs for developing new mining equipment, developing new

refining processes and equipment, and shipping ore samples to the lab were deductible under

section 174.

3

Private Letter Rulings

A number of private letter rulings (PLRs) have also been favorable to the taxpayer.

In PLR 7921037, the Service ruled a taxpayer utility company that participated in a coal

gasification plant project funded by several utility companies was entitled to a deduction under

section 174.

PLR 7948031 was issued to a taxpayer chicken farmer that engaged an engineer to develop an

advanced system to extract uric acid from chicken manure so that the manure could be used

for animal feed. The Letter Ruling held that the engineering and plant costs incurred that

related to removing the uric acid from the manure were not deductible because that process

had already been tested and developed, but the plant and development costs attributable to

conversion of uric acid into fertilizer were deductible under section 174 except to the extent

that those costs were for the acquisition or improvement of land or property that were subject

to the allowance for depreciation under section 167.

PLR 8138145 was issued to a taxpayer partnership that was in the process of developing a pilot

residential energy efficiency program that would pay the taxpayer if it could provide energy

cost savings to customers that were greater than the cost to the utility of providing energy. The

Letter Ruling held “… the partnership may deduct all amounts which qualify as research and

experimental expenditures … in connection with the pilot test….”

In a slightly different situation, PLR 8835002 was issued to a taxpayer that developed a

prototype that used a new construction method in a laboratory. The Letter Ruling held that the

following constituted QRE under section 41: 1) wages and supplies used for research and

development in taxpayer's research and development department both prior to and after the

installation of the first prototype; 2) wages for on-site monitoring of the prototype installations;

3) supplies for modifying the prototype installations; and, 4) 65 percent of the amounts relating

to the testing of the prototypes paid to subcontractors to replace the original prototypes due to

method modifications and damage to the extent that these expenses were incurred during the

period the taxpayer was developing its new method.

Similarly, in TAM 199927001, a taxpayer that constructed molds and other tools for the

manufacture of plastic products was allowed to deduct the costs incurred in designing the

tools, but the costs incurred in constructing the tools were not deductible even though they

would not be depreciated by the taxpayer.

4

Court Cases

In Honeywell Inc. & Subsidiaries,1 the Court held that rotable spare parts were depreciable

assets rather than inventory. Honeywell used such parts to service computers owned by its

customers as part of its computer maintenance and service business. Honeywell consistently

capitalized cost of rotable parts and depreciated them over the same life span assigned to the

related computers. The parts were provided by Honeywell to its customers under computer

lease or maintenance agreements and were repaired after removal from customer's machines

to be used again. There was no direct relationship between the fixed fee charged to maintain

the computers and the price or cost of parts in taxpayer's replacement parts pool; thus, parts

were not considered an income-producing factor that would require treatment as inventory.

The pool of parts was necessary for Honeywell’s maintenance business and the fixed asset

method of accounting used by Honeywell properly matched the cost of establishing the pool

with revenue earned from maintenance agreements.

In Trinity Industries, Inc. v. US2, the Court held that under the substantially all rule, if 80 percent

of the activities to develop a prototype constituted a process of experimentation, then all of the

costs associated with the prototype project were eligible for inclusion in calculating the section

41 credit. Trinity operated several businesses as divisions, one of which built work boats for

offshore drilling rigs along with other special purpose boats. This division engaged in research

and development to design and build “first in class” ships or prototypes for specific customers.

Trinity claimed a credit for work done to design and build these prototypes. The IRS denied the

claim and argued that the ships developed by Trinity were not a “business component” because

the prototype ships being developed were for special orders and not to be sold out of general

inventory. The Court disagreed, finding that after Trinity completed the ships they were held for

sale and thus satisfied the business component requirement. The Court went on to hold that

under section 41(d), if 80 percent of the cost of developing a prototype was incurred as part of

the process of experimentation, the entire cost of the prototype qualified as a research

expense. Thus, Trinity was entitled to its claim for a credit.

In TG Missouri Corp. v. Commissioner, 3 the taxpayer manufacturer claimed research tax credits

for expenditures it incurred to develop prototypes of production molds used to make plastic

auto parts for customers. These parts were built to customers’ specifications and the prototype

molds became the customer’s property upon completion. The taxpayer manufacturer,

however, retained physical possession after it sold the molds to customers so the taxpayer

could produce auto parts for its customers. Importantly, the taxpayer guaranteed that the

molds would perform in the manner desired by its customers. The taxpayer claimed these

expenditures on its 1998 and 1999 tax returns. In 2006, the IRS audited the returns and denied

the credits on the basis that the molds were “property of a character subject to the allowance

for depreciation” and were not qualified research expenditures. The taxpayer argued the

expenditures did, in fact, qualify because they were depreciable in the hands of someone other

than the taxpayer. The Court agreed with the taxpayer and allowed the expenditures to be used

5

to calculate the research tax credit. The Court noted that the statute linked the proper financial

accounting treatment of the molds to the treatment of the expenditures incurred to develop

those molds for purposes of calculating the research tax credit.

Analysis

An overarching theme in the relevant authorities that consider whether the costs incurred by a

taxpayer in developing and producing prototypes are qualified expenditures for the purpose of

sections 41 and 174 is these sections allow a taxpayer benefits for developing the concept of a

product, but not for producing the product itself. When the prototype is placed in inventory for

sale to customers, the wages, contract research (for which the taxpayer bears the risk), and

supply costs incurred to develop the prototype are qualified expenditures, but the wages and

contract research costs related to the construction of the prototype and the supply costs for

component parts of the prototype are not. In Rev. Rul. 73-275, the IRS held that a taxpayer was

entitled to a section 174 deduction for the engineering costs incurred in constructing special

order manufacturing systems for its customers, but was not entitled to deduct the cost to

manufacture those systems. Therefore, in the case where prototypes are placed into inventory,

the costs to develop the prototype are qualified expenditures, but the costs to construct the

prototype are not.

The outcome is the same when the prototype is used for rotable spare parts; the wages,

contract research (for which the taxpayer bears the risk), supply costs to develop the prototype

are qualified expenditures, but the wages and contract research related to the construction of

the prototype and the supply costs for component parts of the prototype are not. Under

Honeywell rotable spare parts are depreciable assets rather than inventory. Generally, under

section 174, no deduction is allowed for any expenditure for the acquisition or improvement of

depreciable property. However, under the section 174 regulations, expenditures for research or

experimentation that result in depreciable property to be used in a taxpayer's trade or business

are deductible. Importantly, the regulations state that expenditures for component materials,

construction labor, or other costs attributable to acquisition and improvement do not qualify.

Like in the inventory situation, the distinction in the rotable spare parts situation is that the cost

of developing the property is deductible while the cost of producing the property is not;

therefore, the costs to develop the prototypes that become rotable spare parts are qualified

expenditure, but the costs to construct the prototypes are not. For the same reasons, when the

prototype is kept and used as depreciable property by the taxpayer, the wages, contract

research (for which the taxpayer bears the risk), supply costs to develop the prototype are

qualified expenditures, but the wages and contract research related to the construction of the

prototype and the supply costs for component parts of the prototype are not.

When the prototype is scrapped by the taxpayer, all of the wages, contract research (for which

the taxpayer bears the risk), and supply costs incurred to develop and construct the prototype

are qualified expenditures. Generally, a taxpayer can take a deduction for research or

6

experimental expenditures that are paid or incurred in connection with the taxpayer’s trade or

business. A deduction is not allowed, however, for any expenditure made for the acquisition or

improvement of depreciable property. When a taxpayer develops a prototype that is later

scrapped, he or she is not creating depreciable property; therefore, the costs paid or incurred

by the taxpayer to create the scrapped prototype are deductible. When the taxpayer develops

the prototype for a customer and does not obtain an ownership interest in a prototype, all of

the costs incurred by the taxpayer to develop the prototype are qualified expenditures as long

as the taxpayer provides its customer with performance guarantees relating to the prototype.

TG Missouri showed that the depreciable property exceptions found in sections 174 and 41

only apply if the property is depreciable in the hands of the taxpayer.

When the taxpayer does not obtain an ownership interest in the prototype as a result of the

costs that it incurs, all of the costs are qualified expenditures. In Rev. Rul. 69-484, Rev. Rul. 73-

202, and Rev. Rul. 73-324, taxpayers that made payments to a third party in concert with other

industry members and a government agency for the development of a product prototype were

deductible under section 174. In these cases, the taxpayer and other industry members did not

obtain an ownership interest in the prototypes that were created as a result of their payments.

Lockheed Martin

In LOCKHEED MARTIN CORPORATION, No. 8:12-cv-03725 (AW), filed 5-14-13, Lockheed

amended its complaint against the IRS to take R&D credits as described by a few examples

below for the following (See Exhibit A copy of amended complaint):

(The disputed QREs include the costs of wages, supplies, and contract research incurred in

connection with the design, development, testing, integration, and fabrication of innovative

and unproven prototypes, including four different first-configuration Atlas V launch vehicles

and an advanced electronic surveillance and security system).

1. Atlas V launch vehicle consists of a complex array of integrated systems, including the

propulsion systems, vehicle and payload structures, and avionics systems. To meet a

particular customer’s mission specifications, these systems and their respective

components and subsystems must work together flawlessly under extreme conditions.

Each new configuration of Atlas V components presents new and different engineering

and scientific challenges.

Lockheed Martin (previously on its own and now as part of the ULA joint venture)

undertakes extensive preproduction design and development efforts with respect to

each new configuration of the Atlas V. To the extent feasible, each part, component,

and system is subjected to extensive laboratory testing and analysis. Throughout the

production process and up to launch, the launch vehicle and its various systems are

subjected to rigorous preflight testing.

7

A new launch-vehicle-configuration design cannot be proven or validated until it is

actually assembled and successfully launched.

For each launch, an array of sensors gathers information about the status of all critical

components and systems. This information is carefully analyzed as part of a formal post

flight review. Anomalies identified through this process are analyzed in order to

understand their causes and to develop engineering solutions for future missions.

At the time of their respective launches, the four Atlas V launch vehicles described

below represented new and unproven configurations for which Lockheed Martin

claimed QREs.

The costs Lockheed Martin incurred to design, develop, test, integrate, and fabricate the

launch vehicle that would be used to launch Inmarsat’s 4-F1 satellite included wages

paid to employees for qualified services (as that term is defined in section 41(b)(2)(B)),

amounts paid for supplies (as that term is defined in section 41(b)(2)(C)) that were used

in the conduct of qualified research, and contract research expenses (as that term is

defined in section 41(b)(3)).

2. To improve launch availability for the New Horizons mission, Lockheed Martin increased

the maximum gimbal angle for the common core booster engine. The increased angle

was needed to control the launch vehicle because of the additional thrust supplied by

the five solid rocket boosters.

Due to the configuration of the New Horizons spacecraft, Lockheed Martin had to design

a new umbilical system that mounted to the payload fairing. The new umbilical system

allowed for proper separation from the spacecraft.


launch vehicle that would be used to launch NASA’s New Horizons spacecraft included

wages paid to employees for qualified services (as that term is defined in section

41(b)(2)(B)), amounts paid for supplies (as that term is defined in section 41(b)(2)(C))

that were used in the conduct of qualified research, and contract research expenses (as

that term is defined in section 41(b)(3)).

The launch services agreement with SES ASTRA S.A. was a firm fixed-price contract

under which Lockheed Martin was to receive a total purchase price of $62,500,000 for

Atlas launch services.

During the years at issue, Lockheed Martin incurred costs, including those to design,

develop, test, integrate, and fabricate a new configuration of the Atlas V launch vehicle

that would satisfy the customer’s specifications for the ASTRA 1KR mission.

8

The launch vehicle for the ASTRA 1KR mission was the first Atlas V rocket to incorporate

a lone solid rocket booster.

The launch vehicle was the first Atlas V flight with an X-Stringer, or reduced part count,

extended payload fairing. This extended payload fairing allowed the ASTRA 1KR

spacecraft to properly fit within the fairing of the launch vehicle.


launch vehicle that would be used to launch the ASTRA 1KR satellite included wages

paid to employees for qualified services (as that term is defined in section 41(b)(2)(B)),

amounts paid for supplies (as that term is defined in section 41(b)(2)(C)) that were used

in the conduct of qualified research, and contract research expenses (as that term is

defined in section 41(b)(3)).

Conclusion

It seems clear that expenditures incurred for prototypes qualify as R&D to the extent the

taxpayer does not retain ownership in the prototype or if the prototype is not included as

inventory.

Further, the legislative history of the section 41 credit suggests that the costs of component

parts could be included in the credit though the IRS and courts appear reluctant to endorse this

approach to date.

1

-IN THE UNITED STATES DISTRICT COURTFOR THE DISTRICT OF MARYLAND

SOUTHERN DIVISION

LOCKHEED MARTIN CORPORATION,

Plaintiff,

v.

UNITED STATES OF AMERICA,

Defendant.

))))))))))

No. 8:12-cv-03725 (AW)

FIRST AMENDED COMPLAINT

Plaintiff Lockheed Martin Corporation (Lockheed Martin), by and through counsel,

alleges as follows:

THE PARTIES

1. Lockheed Martin is a domestic corporation incorporated in the State of Maryland,

with its corporate headquarters at 6801 Rockledge Drive, Bethesda, Maryland 20817. Lockheed

Martin's employer identification number (EIN) is 52-1893632.

2. Defendant is the United States of America.

JURISDICTION

3. Lockheed Martin brings this complaint in accordance with the requirements of

section 7422 of the United States Internal Revenue Code (the Code), 26 U.S.C. § 7422, for

recovery of federal income taxes erroneously collected from Lockheed Martin for the tax years

Case 8:12-cv-03725-AW Document 16 Filed 05/14/13 Page 1 of 25

david

Typewritten Text

david

Typewritten Text

EXHIBIT A

2

ending December 31, 2004, December 31, 2005, December 31, 2006, December 31, 2007, and

December 31, 2008 (the years at issue).1

4. Lockheed Martin is the common parent of an affiliated group of corporations that

have elected to file consolidated federal income tax returns for the years at issue and is therefore

the sole agent that is authorized to act in its own name with respect to all matters relating to the

tax liability for those consolidated return years under 26 C.F.R. § 1.1502-77(a)(1).

5. This Court has jurisdiction over this action under 28 U.S.C. § 1346(a)(1).

6. Venue for this action properly lies in the United States District Court for the

District of Maryland under 28 U.S.C. § 1391.

7. Lockheed Martin is timely filing this complaint as required in section 6532(a)(1)

(the relevant notices of disallowance were dated May 24, 2012).

GENERAL ALLEGATIONS

8. Lockheed Martin seeks to recover the sum of at least $16,157,226, plus statutory

interest as the law provides, which sum represents an overpayment by Lockheed Martin of

federal income taxes for the years at issue.

9. Lockheed Martin timely filed federal income tax returns for its 2004 through 2007

tax years with the Internal Revenue Service Center in Ogden, Utah. Lockheed Martin timely

filed its 2008 federal income tax return electronically.

10. Lockheed Martin paid the full amount of income taxes shown on its federal

income tax returns or subsequently assessed for each of the years at issue.

1 Unless otherwise indicated, all “section” references are to the Internal Revenue Code of1986 (26 U.S.C.), as amended and as in effect during the relevant year.


3

11. This action arises out of administrative claims for refund that Lockheed Martin

submitted for the years at issue. In those administrative claims, Lockheed Martin claimed

(among other things) refunds attributable to (1) additional research credits under section 41 with

respect to four projects (which projects are described below), (2) increased deductions under

section 199, and (3) an increased amount of extraterritorial income (ETI) exclusion under former

section 114. These claims are described in more detail below.

Lockheed Martin’s Business Operations During the Years at Issue

12. Lockheed Martin is a global security and aerospace company principally engaged

in the research, design, development, manufacture, integration, and sustainment of advanced

technology systems and products. A substantial portion of Lockheed Martin’s sales during the

years at issue were to agencies of the U.S. Government.

13. During the years at issue, Lockheed Martin’s Space Systems business segment

provided launch services to both government and commercial customers. Under this line of

business, Lockheed Martin designed, developed, manufactured, and integrated expendable and

reusable space launch systems for the Department of Defense, NASA, and commercial

customers.

14. In 2005, Lockheed Martin entered into an agreement with The Boeing Company

to create a joint venture that would combine the production, engineering, test, and launch

operations associated with U.S. Government launches of Lockheed Martin’s Atlas launch

vehicles and Boeing’s Delta launch vehicles. The joint venture, named United Launch Alliance,

LLC (ULA), commenced operations on December 1, 2006.


4

Section 41 Research Credit Claims

15. Congress enacted the research credit under section 41 “to encourage business

firms to perform the research necessary to increase the innovative qualities and efficiency of the

U.S. economy.” S. Rep. No 99-313, at 694 (1986). Congress has recognized that “research is

the lifeblood of our economic progress” and that “effective tax incentives for research and

development must be a fundamental element of America’s competitiveness strategy.” H.R. Rep.

No. 100-1104, Vol. II, at 88 (1988) (Conf. Rep.).

16. As in effect during the years at issue, section 41 generally provided for a tax

credit equal to 20% of incremental “qualified research expenditures” (QREs) over a base

amount. Section 41(c)(4) provided for an alternative incremental credit and section 41(c)(5)

provided for an alternative simplified credit. Under each version of the credit, the allowable

credit was a function of the taxpayer’s QREs for the tax year. Section 41(b)(1) defines

“qualified research expenditures.”

17. For its 2004 to 2006 tax years, Lockheed Martin elected to compute its allowable

research credit using the alternative incremental credit computation under section 41(c)(4).

18. For its 2007 and 2008 tax years, Lockheed Martin elected to compute its

allowable research credit using the alternative simplified credit computation under section

41(c)(5). In those tax years, the alternative simplified credit rate was 12%.

19. During the years at issue, Lockheed Martin incurred QREs, including wages,

supplies, and contract research costs, with respect to a variety of research projects.


5

20. The Internal Revenue Service denied a portion of the research credits that

Lockheed Martin has claimed for the years at issue on the basis that some costs were allegedly

not QREs.

21. The disputed QREs include the costs of wages, supplies, and contract research

incurred in connection with the design, development, testing, integration, and fabrication of

innovative and unproven prototypes, including four different first-configuration Atlas V launch

vehicles.

Atlas V Launch Vehicles

22. Lockheed Martin developed the Atlas V launch vehicle pursuant to the U.S.

Department of Defense’s (DOD) Evolved Expendable Launch Vehicle (EELV) Program.

23. DOD initiated the EELV Program in 1995 to develop a new generation of

launch vehicles. The Atlas V is one of two families of launch vehicles developed under the

EELV Program to provide assured and affordable access to space for government satellites via

commercially owned and operated launch vehicles.

24. Atlas V launch vehicles are designed and marketed for commercial and

government launches.

25. The Atlas V launch vehicle family was designed as a multi-stage, medium- to

heavy-lift rocket with various potential configurations depending on mission specifications.

26. The Atlas V incorporates a common core booster. The Atlas V can be

configured to add up to five strap-on solid rocket boosters, an upper stage configured with one or

two engines, and various sizes of payload fairings.


6

27. Each Atlas V launch vehicle consists of a complex array of integrated systems,

including the propulsion systems, vehicle and payload structures, and avionics systems. To meet

a particular customer’s mission specifications, these systems and their respective components

and subsystems must work together flawlessly under extreme conditions.

28. Each new configuration of Atlas V components presents new and different

engineering and scientific challenges.

29. Lockheed Martin (previously on its own and now as part of the ULA joint

venture) undertakes extensive preproduction design and development efforts with respect to each

new configuration of the Atlas V. To the extent feasible, each part, component, and system is

subjected to extensive laboratory testing and analysis. Throughout the production process and up

to launch, the launch vehicle and its various systems are subjected to rigorous preflight testing.

30. A new launch-vehicle-configuration design cannot be proven or validated until it

is actually assembled and successfully launched.

31. For each launch, an array of sensors gathers information about the status of all

critical components and systems. This information is carefully analyzed as part of a formal post-

flight review. Anomalies identified through this process are analyzed in order to understand

their causes and to develop engineering solutions for future missions.

32. The first Atlas V launch vehicle was launched on August 21, 2002.

33. By the end of the years at issue, fourteen Atlas V launch vehicles had been

launched.


7

34. At the time of their respective launches, the four Atlas V launch vehicles

described below represented new and unproven configurations for which Lockheed Martin

claimed QREs.

Atlas V, Type 431 (INMARSAT)

35. On May 10, 2005, Lockheed Martin entered into an amended and restated

contract with Inmarsat Launch Company Limited under which Lockheed Martin agreed to

launch Inmarsat’s 4-F1 satellite.

36. The contract with Inmarsat was a firm fixed-price contract under which Lockheed

Martin was to receive a total purchase price of $84,000,000 for launch services.

37. During the years at issue, Lockheed Martin incurred costs, including those to

design, develop, test, integrate, and fabricate a new configuration of the Atlas V launch vehicle

that would satisfy the customer’s specifications for the Inmarsat 4-F1 mission.

38. Inmarsat's 4-F1 satellite was at the time of launch the heaviest spacecraft to be

carried into orbit by an Atlas V launch vehicle.

39. The launch vehicle for the Inmarsat 4-F1 satellite was the first Atlas V rocket to

incorporate a four-meter payload fairing and three solid rocket boosters.

40. The launch vehicle was the first Atlas V flight with an extra extended payload

fairing (XEPF). It incorporated an additional 0.9-m (36-in.) high cylindrical plug to increase the

available payload volume. The XEPF was necessary to accommodate the satellite payload.

41. The launch vehicle was the first Atlas V launch vehicle to use pre-launch

pressurization of the upper stage to accommodate the heavy payload and to improve the launch

availability of the vehicle.


8

42. The costs Lockheed Martin incurred to design, develop, test, integrate, and

fabricate the launch vehicle that would be used to launch Inmarsat’s 4-F1 satellite included

wages paid to employees for qualified services (as that term is defined in section 41(b)(2)(B)),

amounts paid for supplies (as that term is defined in section 41(b)(2)(C)) that were used in the

conduct of qualified research, and contract research expenses (as that term is defined in section

41(b)(3)).

43. For the years at issue, Lockheed Martin claimed these costs as QREs in the

computation of its allowable research credit on its original or amended corporate income tax

returns.

44. The IRS disallowed some of the claimed QREs associated with the design,

development, testing, integration, and fabrication of the launch vehicle for the Inmarsat 4-F1

mission.

45. For the years at issue, the IRS disallowed the following amount of QREs incurred

by Lockheed Martin with respect to the Inmarsat 4-F1 mission:

46. On March 11, 2005, Inmarsat’s 4-F1 satellite was successfully launched into orbit

from Cape Canaveral, Florida, atop an Atlas V launch vehicle, serial number AV-004.

Atlas V, Type 551 (New Horizons)

47. On June 16, 2000, Lockheed Martin entered into a contract with NASA to provide

launch services (the NLS contract).

YEAR DISALLOWED QREs

2004 $ 20,792,923


9

48. The NLS contract is an indefinite delivery/indefinite quantity (IDIQ) minimum

order contract providing for the delivery of an unspecified number of launches and other services

over a period of time.

49. Under the NLS contract, Lockheed Martin was to receive a firm fixed total

purchase price of $130,725,294 for launch services for the New Horizons mission.

50. The New Horizons mission was intended to send the first spacecraft to fly by and

study Pluto and its moons.



that would satisfy NASA’s specifications for the New Horizons mission.

52. The launch vehicle was the first Atlas V rocket to incorporate a five-meter

payload fairing and five solid rocket boosters.

53. Due to the extended mission duration and distance from the sun, electric power

for the New Horizons spacecraft was supplied by a radioisotope thermoelectric generator (RTG)

fueled by radioactive plutonium. The RTG imposed additional design requirements for the New

Horizons launch vehicle.

54. The launch vehicle for the New Horizons mission incorporated an upgraded flight

termination system (FTS). This upgraded system allowed for termination of the vehicle at

various stages during the launch both autonomously and by radio signals from ground

controllers.

55. The launch vehicle was the first that contained four composite overwrapped

pressure vessels (COPVs). These four vessels were used to pressurize and expel the propellants


10

to the engine in order to maintain the proper pressures in the tank. The new design reduced the

weight of the common core booster.

56. To improve launch availability for the New Horizons mission, Lockheed Martin

increased the maximum gimbal angle for the common core booster engine. The increased angle

was needed to control the launch vehicle because of the additional thrust supplied by the five

solid rocket boosters.

57. Due to the configuration of the New Horizons spacecraft, Lockheed Martin had to

design a new umbilical system that mounted to the payload fairing. The new umbilical system

allowed for proper separation from the spacecraft.


fabricate the launch vehicle that would be used to launch NASA’s New Horizons spacecraft

included wages paid to employees for qualified services (as that term is defined in section

41(b)(2)(B)), amounts paid for supplies (as that term is defined in section 41(b)(2)(C)) that were

used in the conduct of qualified research, and contract research expenses (as that term is defined

in section 41(b)(3)).

59. For the years at issue, Lockheed Martin has claimed these costs as QREs in the


returns.


development, testing, integration, and fabrication of the launch vehicle for the New Horizons

mission.


11

61. For the years at issue, the IRS disallowed the following amounts of QREs

incurred by Lockheed Martin with respect to the New Horizons mission:

62. On January 19, 2006, NASA’s New Horizons spacecraft was successfully

launched from Cape Canaveral, Florida, atop an Atlas V launch vehicle, serial number AV-010.

63. The New Horizons spacecraft is expected to fly by Pluto and its moons in July

2015.

Atlas V, Type 411 (ASTRA 1KR)

64. On October 14, 2005, Lockheed Martin entered into an amended and restated

launch services agreement with SES ASTRA S.A. under which Lockheed Martin agreed to

launch the ASTRA 1KR satellite.

65. The ASTRA 1KR was a new telecommunications satellite intended to provide

distribution of direct-to-home broadcast services across Europe.

66. The launch services agreement with SES ASTRA S.A. was a firm fixed-price

contract under which Lockheed Martin was to receive a total purchase price of $62,500,000 for

Atlas launch services.



that would satisfy the customer’s specifications for the ASTRA 1KR mission.


2004 $ 46,393,602

2005 17,921,246

Total $ 64,314,848


12

68. The launch vehicle for the ASTRA 1KR mission was the first Atlas V rocket to

incorporate a lone solid rocket booster.

69. The launch vehicle was the first Atlas V flight with an X-Stringer, or reduced part

count, extended payload fairing. This extended payload fairing allowed the ASTRA 1KR

spacecraft to properly fit within the fairing of the launch vehicle.


fabricate the launch vehicle that would be used to launch the ASTRA 1KR satellite included




41(b)(3)).



returns.


development, testing, integration, and fabrication of the launch vehicle for the ASTRA 1KR

mission.


incurred by Lockheed Martin with respect to the ASTRA 1KR mission:


2004 $ 19,048,985

2005 23,826,283

2006 4,282,342

Total $ 47,157,610


13

74. On April 20, 2006, the ASTRA 1KR satellite was successfully launched into orbit

from Cape Canaveral, Florida, atop an Atlas V launch vehicle, serial number AV-008.

Atlas V, Type 421 (WGS SV-1)

75. On October 16, 1998, Lockheed Martin entered into a contract with the United

States Air Force to provide launch services (the ILS contract).

76. The ILS contract is a requirements contract providing for the delivery of a

specified number of launches and other services when and as ordered by the customer.

77. The Wideband Global SATCOM (WGS) system is a military communications

satellite network.

78. The WGS Space Vehicle 1 (SV-1) was the first satellite of the WGS system.

79. Under the ILS contract, Lockheed Martin was to receive a firm fixed total

purchase price of $117,893,019 for launch services for the WGS SV-1 launch.



that would satisfy the customer’s specifications for the WGS SV-1 mission.

81. The launch vehicle for the WGS SV-1 mission was the first Atlas V rocket that

incorporated a four-meter payload fairing and two solid rocket boosters.

82. The WGS SV-1 launch vehicle was the first Atlas V to use the newly designed

solid rocket booster staging thruster cartridge.

83. The WGS SV-1 launch vehicle was the first Atlas V that used minimum residual

shutdown software. This software was used to shut down the upper stage after the vehicle

launched.


14

84. The WGS SV-1 launch vehicle was the first Atlas V to use an S/L band

reradiating antenna. This was a mission-unique modification that allowed payload radio

frequency telemetry transmission and command receipt communications after the payload was

enclosed in the spacecraft until launch.


fabricate the launch vehicle that would be used to launch the WGS SV-1 spacecraft included




41(b)(3)).



returns.


development, testing, integration, and fabrication of the WGS SV-1 mission.


incurred by Lockheed Martin with respect to the WGS SV-1 mission:

89. On October 11, 2007, the WGS SV-1 satellite was successfully launched into

orbit from Cape Canaveral, Florida, atop an Atlas V launch vehicle, serial number AV-011.


2004 $ 7,480,436

2005 18,999,587

2006 22,313,175

Total $ 48,793,198


15

Additional Atlas V Design and Development Costs

90. In addition to the QREs disallowed with respect to the four new launch vehicle

configurations described above, the IRS disallowed additional Atlas V engineering design and

development costs claimed as QREs in the amounts of $2,403,639 for tax year 2004, $2,274,204

for tax year 2005, and $1,239,298 for tax year 2006.

91. The Atlas V engineering design and development costs Lockheed Martin incurred

included wages paid to employees for qualified services (as that term is defined in section

41(b)(2)(B)).

Section 199 Refund Claims

92. Enacted in 2004, section 199 allows a deduction based on a percentage of

qualifying production activities income (QPAI) subject to various caps and limits. QPAI is a

measure of, among other things, income from the sale or lease of property manufactured,

produced, grown, or extracted in whole or in significant part in the United States as well as

income from certain services performed in the United States.

93. Lockheed Martin generated QPAI during the years at issue and claimed

deductions under section 199. In computing its section 199 deductions for its 2005 through 2008

tax years, Lockheed Martin incorrectly reduced QPAI by the amount of its extraterritorial

income (ETI) exclusion for those tax years.

94. Under section 199, Lockheed Martin is entitled to additional deductions in its

2005 through 2008 tax years because Lockheed Martin is not required to reduce QPAI by the

amount of its ETI exclusion for those tax years.


16

ETI Refund Claims

95. Enacted in 2000 and repealed (except for certain transition rules discussed below)

in 2004, former section 114 provided an exclusion from taxable income for qualified

extraterritorial income.

96. Under former section 114(a), “[g]ross income does not include extraterritorial

income.” Former section 114(b) provides that the exclusion under section 114(a) applies only to

“qualifying foreign trade income.” Former section 941(a)(1), in turn, provides that in general,

“qualifying foreign trade income” with respect to any transaction is “the amount of gross income

which, if excluded, will result in a reduction of the taxable income of the taxpayer from such

transaction” equal to the greatest of: (i) 30% of “foreign sale and leasing income”; (ii) 1.2% of

“foreign trading gross receipts” (FTGR); or (iii) 15% of “foreign trade income.”

97. Congress repealed section 114 effective for transactions after 2004 and provided

transition rules that (i) decreased the amount of ETI excludable from income to 80% (for 2005)

and then 60% (for 2006) and (ii) permitted the continued exclusion of ETI from certain “binding

contracts.” Pub. L. No. 108-357, § 101(d) and (f), 118 Stat. 1418, 1423, 1424. In 2006,

Congress struck the binding-contract transition rule applicable to tax years beginning after May

17, 2006. See Pub. L. No. 109-222, § 513(b), 120 Stat. 345, 366.

98. Lockheed Martin had transactions that generated ETI during the years at issue and

was eligible for ETI exclusions for the years at issue.

99. In computing its income exclusion under former section 114 for its 2005 through

2008 tax years, Lockheed Martin did not reduce gross income attributable to FTGR by the

amount of its section 199 deductions for those tax years.


17

100. The IRS disallowed a portion of Lockheed Martin’s income exclusions under

section 114 for Lockheed Martin’s 2005 through 2008 tax years on the ground that in computing

its income exclusions under former section 114 for those tax years, Lockheed Martin should

have reduced gross income attributable to FTGR by the amount of its section 199 deductions.

101. Under former section 114 and the relevant transition rules, Lockheed Martin is

entitled to additional income exclusions in its 2005 through 2008 tax years because Lockheed

Martin is not required to reduce gross income attributable to FTGR by the amount of its section

199 deductions for those tax years.

COUNT ONE(2004 TAX YEAR)

102. Lockheed Martin incorporates herein by reference and realleges all allegations in

paragraphs 1 through 91 of this Complaint.

103. On or before September 15, 2005, Lockheed Martin timely filed a Form 1120

federal income tax return for its 2004 tax year with the IRS at Ogden, Utah. The name, address,

and identification number appearing on that return were as follows:

Lockheed Martin Corporation & Affiliated Corps6801 Rockledge DriveBethesda, MD 20817EIN: 52-1893632

104. During 2004, Lockheed Martin made estimated tax payments in excess of the tax

shown on its Form 1120 for its 2004 tax year. Lockheed Martin received a refund of some

portion of that overpayment and had some of the overpayment credited to its 2005 tax year.

Following its examination of Lockheed Martin’s 2004 tax year, the IRS assessed additional tax,

which Lockheed Martin satisfied in part by way of a payment and a capital loss carryback.


18

Following administrative review at IRS Appeals, the IRS assessed a small additional amount of

tax for Lockheed Martin’s 2004 tax year. As of the date of this complaint, Lockheed Martin has

paid in full all assessments for its 2004 tax year.

105. On February 21, 2012, Lockheed Martin timely filed an amended return on Form

1120X with the IRS, seeking a refund of tax for Lockheed Martin’s 2004 tax year on the basis

that Lockheed Martin is entitled to refunds attributable to additional research credits under

section 41 with respect to its Atlas V Launch Vehicle projects. In addition, the computations

contained in the Form 1120X assumed that all of the additional QREs claimed for the 2004

through 2007 tax years were qualified research expenses. Lockheed Martin claimed that if any

of these expenses did not qualify as qualified research expenses for the relevant year, the amount

of the research credit and any resulting refund may be larger or smaller.

106. The IRS disallowed that claim in full on May 24, 2012.

107. For the reasons described above, Lockheed Martin overpaid its federal income tax

for the 2004 tax year and Lockheed Martin is entitled to a refund of at least $2,135,139, plus

statutory interest as the law provides.

COUNT TWO(2005 TAX YEAR)


paragraphs 1 through 34 and 47 through 101 of this Complaint.


19





110. During 2005, Lockheed Martin made estimated tax payments for its 2005 tax

year. Following the IRS examination and subsequent IRS Appeals review of Lockheed Martin’s

2005 tax year, the IRS determined that Lockheed Martin had tax overpayments for its 2005 tax

year. As of the date of this complaint, Lockheed Martin paid in full all assessments for its 2005

tax year.



that Lockheed Martin is entitled to refunds attributable to (i) additional research credits under

section 41 with respect to its Atlas V Launch Vehicle projects, (ii) increased deductions under

section 199, and (iii) an increased amount of ETI exclusion under former section 114. In

addition, the computations contained in the Form 1120X assumed that all of the additional QREs

claimed for the 2004 through 2007 tax years were qualified research expenses. Lockheed Martin

claimed that if any of these expenses did not qualify as qualified research expenses for the

relevant year, the amount of the research credit and any resulting refund may be larger or

smaller.



20




COUNT THREE(2006 TAX YEAR)











tax year.




section 41 with respect to its Atlas V Launch Vehicle projects, (ii) increased deductions under

section 199, and (iii) an increased amount of ETI exclusion under former section 114. In


21

addition, the computations contained in the Form 1120X assumed that all of the additional QREs

claimed for the 2004 through 2007 tax years were qualified research expenses. Lockheed Martin

claimed that if any of these expenses did not qualify as qualified research expenses for the

relevant year, the amount of the research credit and any resulting refund may be larger or

smaller.





COUNT FOUR(2007 TAX YEAR)











22


tax year.




section 41, (ii) increased deductions under section 199, and (iii) an increased amount of ETI

exclusion under former section 114. In addition, the computations contained in the Form 1120X

assumed that all of the additional QREs claimed for the 2004 through 2007 tax years were

qualified research expenses. Lockheed Martin claimed that if any of these expenses did not

qualify as qualified research expenses for the relevant year, the amount of the research credit and

any resulting refund may be larger or smaller.





COUNT FIVE(2008 TAX YEAR)




23


federal income tax return for its 2008 tax year with the IRS electronically. The name, address,




year. Following the IRS Appeals review of Lockheed Martin’s 2008 tax year, the IRS

determined that Lockheed Martin had tax overpayments for its 2008 tax year. As of the date of

this complaint, Lockheed Martin paid in full all assessments for its 2008 tax year.



that Lockheed Martin is entitled to refunds attributable to (i) increased deductions under section

199, and (ii) an increased amount of ETI exclusion under former section 114. In addition, the

computations contained in the Form 1120X assumed that all of the additional QREs claimed for

the 2004 through 2007 tax years were qualified research expenses. Lockheed Martin claimed

that if any of these expenses did not qualify as qualified research expenses for the relevant year,

the amount of the research credit and any resulting refund may be larger or smaller.






24

RELIEF REQUESTED

WHEREFORE, Plaintiffs pray for judgment against the United States of at least the sum

of $16,157,226 representing overpayments in tax by Lockheed Martin, plus statutory interest as

the law provides, and such costs and attorneys’ fees as are available, and such other and further

relief that this Court deems equitable and proper.

DATED: May 2, 2013.

/s/ Kevin L. KenworthyKevin L. Kenworthy

[email protected] No. 18420

Patricia J. [email protected] No. 18427

Steven R. [email protected] No. 18415

MILLER & CHEVALIER CHARTERED655 Fifteenth St. N.W., Suite 900Washington, DC 20005-5701Tel. (202) 626-5800Fax: (202) 626-5801Attorneys for Plaintiff Lockheed Martin

OF COUNSELDavid A. HeywoodUrvi D. SoodJason M. RudinskyLOCKHEED MARTIN CORPORATION6801 Rockledge DriveBethesda, MD 20817


mailto:[email protected]



25

CERTIFICATE OF SERVICE

I hereby certify that on May 2, 2013, I electronically filed the foregoing with the Clerk of

Court using the CM/ECF System, which will send notice of such filing to the following

registered CM/ECF users:

Katherine M. ReinhartU.S. Dep’t of Justice, Tax Div.P.O. Box 227, Ben Franklin StationWashington, D.C. 20044Email: [email protected]

Lindsay L. ClaytonU.S. Dep’t of Justice, Tax Div.P.O. Box 683Washington, DC 20044Email:[email protected]

Robert J. KovacevU.S. Dep’t of Justice, Tax Div.555 4th St NW, Room 7110Washington, DC 20001Email: [email protected]

/s/ Kevin L. Kenworthy
