[Federal Register Volume 66, Number 247 (Wednesday, December 26, 2001)]
[Proposed Rules]
[Pages 66362-66375]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-31007]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-112991-01]
RIN 1545-AY82
Credit for Increasing Research Activities
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
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SUMMARY: This document contains proposed regulations relating to the
computation of the research credit under section 41(c) and the
definition of qualified research under section 41(d). In addition, this
document contains proposed regulations describing when computer
software that is developed by (or for the benefit of) a taxpayer
primarily for the taxpayer's internal use is excepted from the
internal-use software exclusion contained in section 41(d)(4)(E). These
proposed regulations reflect changes to section 41 made by the Tax
Reform Act of 1986, the Revenue Reconciliation Act of 1989, the Small
Business Job Protection Act of 1996, the Taxpayer Relief Act of 1997,
the Tax and Trade Relief Extension Act of 1998, and the Tax Relief
Extension Act of 1999. This document also provides notice of a public
hearing on these proposed regulations.
DATES: Written and electronic comments and requests to speak (with
outlines of oral comments) at the public hearing scheduled for March
27, 2002 must be received no later than March 6, 2002.
ADDRESSES: Send submissions to: CC:IT&A:RU (REG-112991-01), room 5226,
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,
DC 20044. Submissions may also be hand delivered Monday through Friday
between the hours of 8 a.m. and 5 p.m. to: CC:IT&A:RU (REG-112991-01),
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW.,
Washington, DC. Alternatively, taxpayers may submit comments
electronically via the Internet by selecting the ``Tax Regs'' option of
the IRS Home Page, or by submitting comments directly to the IRS
Internet site at: http://www.irs.gov/tax_regs/reglist.html. The public
hearing will be held in the IRS Auditorium (7th Floor), Internal
Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Lisa J.
Shuman, 202-622-3120; concerning submissions of comments and the
hearing, LaNita VanDyke, 202-622-7180 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in this proposed
regulation have been previously reviewed and approved by the Office of
Management and Budget (OMB) in accordance with the Paperwork Reduction
Act of 1995 (44 U.S.C. 3507(d)) and assigned OMB Control Number 1545-
1625. An agency may not conduct or sponsor, and a person is not
required to respond to, a collection of information unless it displays
a valid control number assigned by OMB.
Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.
Background
On January 3, 2001, Treasury and the IRS published in the Federal
Register (66 FR 280) final regulations (TD 8930) relating to the
computation of the credit for increasing research activities (the
research credit) under section 41(c) and the definition of qualified
research under section 41(d). In response to taxpayer concerns
regarding TD 8930, on January 31, 2001, Treasury and the IRS published
Notice 2001-19 (2001-10 I.R.B. 784), announcing that Treasury and the
IRS would review TD 8930 and reconsider comments previously submitted
in connection with the finalization of TD 8930. Comments were requested
on all aspects of TD 8930 with specific comments requested on whether
modifications should be made to the documentation requirement contained
in Sec. 1.41-4(d).
Notice 2001-19 also provided that, upon the completion of this
review, Treasury and the IRS would announce changes to the regulations,
if any, in the form of proposed regulations. Notice 2001-19 stated that
TD 8930 would be revised so that the provisions of the regulations,
including any changes to TD 8930, would be effective no earlier than
the date when the completion of this review was announced, except that
the provisions relating to internal-use computer software (including
any revisions) generally would be applicable for taxable years
beginning after December 31, 1985.
Explanation of Provisions
This document amends 26 CFR part 1 to provide additional rules
under section 41. Section 41 contains the rules for the research
credit. After consideration of the statute and legislative history, the
court decisions, TD 8930 and the comments previously submitted in
connection with the finalization of TD 8930, and the comments submitted
in response to Notice 2001-19, Treasury and the IRS have revised TD
8930 to provide rules regarding:
(i) The requirement in section 41(d)(1)(B)(i) that qualified
research be ``undertaken for the purpose of discovering information
which is technological in nature'';
(ii) The requirement in section 41(d)(1)(C) that qualified research
be research ``substantially all of the activities of which constitute
elements of a process of experimentation'';
(iii) The type of computer software constituting software ``which
is developed by (or for the benefit of) the taxpayer primarily for
internal use by the taxpayer'' for purposes of section 41(d)(4)(E); and
(iv) the documentation required to substantiate the research
credit. These and other changes to TD 8930 are discussed below.
I. Research That Is Undertaken for the Purpose of Discovering
Information Which Is Technological in Nature
Section 41(d)(1)(B)(i) requires that qualified research must be
``undertaken for the purpose of discovering information which is
technological in nature.'' TD 8930 provided that ``research is
undertaken for the purpose of discovering information only if it is
undertaken to obtain knowledge that exceeds, expands, or refines the
common knowledge of skilled
[[Page 66363]]
professionals in a particular field of science or engineering'' and
that ``information is technological in nature if the process of
experimentation used to discover such information fundamentally relies
on principles of the physical or biological sciences, engineering, or
computer science.''
With respect to the phrase ``undertaken for the purpose of
discovering information,'' commentators noted that Sec. 1.174-2(a)(1)
imposes a requirement that a taxpayer's activities must be ``intended
to discover information'' in order to give rise to research and
experimental expenditures under section 174, and that section
41(d)(1)(A) incorporates this requirement because an expenditure must
qualify under section 174 in order to give rise to the research credit.
Commentators argued that the enactment of the section 41(d)(1)(B)
``undertaken for the purpose of discovering information'' language
should not necessarily be viewed as imposing a different standard than
that imposed under section 174 because the section 174 ``intended to
discover information'' language was promulgated in regulations after
section 41(d)(1)(B) was enacted.
Commentators also stated that the requirement that qualified
research be ``undertaken for the purpose of discovering information
which is technological in nature'' reflects Congress' concern that the
research credit had been claimed for non-technological research. These
commentators note that in 1984 hearings to evaluate the operation of
the research credit prior to the changes of the Tax Reform Act of 1986,
Public Law 99-514, 100 Stat. 2085, 2186 (the 1986 Act), members of the
Subcommittee on Oversight of the House Committee on Ways and Means and
Treasury officials cited research credit claims by fast food
restaurants, fashion designers and hair stylists as examples of
activities that should not be credit eligible. These commentators argue
that the 1986 Act modifications to the research credit were intended to
target research that relies upon principles of the physical or
biological sciences, engineering, or computer science.
Based upon their review of these comments, the statute and
legislative history, Treasury and the IRS have determined that the
definition of qualified research set out in TD 8930 does not fully
address Congress' concerns regarding the importance of research
activities to the U.S. economy. Accordingly, Treasury and the IRS have
eliminated in these proposed regulations the requirement that qualified
research must be undertaken to obtain knowledge that exceeds, expands,
or refines the common knowledge of skilled professionals in a
particular field of science or engineering. Rather, Treasury and the
IRS believe that the requirement that qualified research be
``undertaken for the purpose of discovering information which is
technological in nature'' is intended to distinguish technological
research, which may qualify for the research credit, from non-
technological research, which does not.
When the research credit rules were amended by the 1986 Act,
Congress explained the requirement in section 41(d)(1)(B)(i) as
follows:
[t]he determination of whether the research is undertaken for
the purpose of discovering information that is technological in
nature depends on whether the process of experimentation utilized in
the research fundamentally relies on principles of the physical or
biological sciences, engineering, or computer science/3/--in which
case the information is deemed technological in nature--or on other
principles, such as those of economics--in which case the
information is not to be treated as technological in nature. For
example, information relating to financial services or similar
products (such as new types of variable annuities or legal forms) or
advertising does not qualify as technological in nature.
H.R. Conf. Rep. No. 99-841, at II-71 (1986) (footnote omitted). This
explanation of section 41(d)(1)(B)(i) focuses on the distinction
between information derived from a process of experimentation that
fundamentally relies on principles of physical or biological sciences,
engineering or computer science, and information derived by other
means. This and other changes to the research credit by the 1986 Act
were driven by Congressional concerns that the research credit had been
applied ``too broadly'' and that ``[m]any taxpayers claiming the credit
were not in industries that involved high technology or its application
in developing new and improved products or methods of production.''
H.R. Rep. No. 99-426, at 177-78; S. Rep. No. 99-313, at 694-95. The
examples provided by Congress illustrate this point. Information
relating to financial services, variable annuities, legal forms and
advertising all involve information derived from non-technological
research. This distinction between technological and non-technological
research is further emphasized by other changes made to the definition
of qualified research by the 1986 Act. For example, section 41(d)(4)(D)
specifically excludes from the definition of qualified research certain
non-technical activities including efficiency surveys, activities
relating to management function or technique, market research testing,
routine data collection and quality control testing. Similarly, section
41(d)(3)(B) generally provides that if the purpose of research relates
to style, taste, cosmetic or seasonal design factors, then that
research cannot constitute qualified research. The 1986 Act also
expanded the list of social science exclusions contained in section
41(d)(4)(G).
In contrast, the 1986 legislative history does not indicate that
section 41(d)(1)(B)(i) was enacted to impose a scientific discovery
requirement. The legislative history does not contain a definition of
the term discovery. The footnote 3 referenced in the above quoted
legislative history does state:
Research does not rely on the principles of computer science
merely because a computer is employed. Research may be treated as
undertaken to discover information that is technological in nature,
however, if the research is intended to expand or refine existing
principles of computer science.
H.R. Conf. Rep. No. 99-841, at II-71, n.3 (1986). This footnote,
however, does not set forth a rule of general application, but instead
merely illustrates a clear example of research satisfying the
requirement that qualified research be technological in nature.
For all of these reasons, Treasury and the IRS have concluded that
there should be no ``discovery'' requirement in the research credit
regulations separate and apart from that already required under
Sec. 1.174-2(a)(1), which states, in part:
Expenditures represent research and development costs in the
experimental or laboratory sense if they are for activities intended
to discover information that would eliminate uncertainty concerning
the development or improvement of a product. Uncertainty exists if
the information available to the taxpayer does not establish the
capability or method for developing or improving the product or the
appropriate design of the product.
Accordingly, these proposed regulations do not retain from TD 8930 the
requirement that qualified research must be undertaken to obtain
knowledge that exceeds, expands, or refines the common knowledge of
skilled professionals in a particular field of science or engineering.
Instead, the proposed regulations repeat the requirement from
Sec. 1.174-2(a)(1) by stating that research is undertaken for the
purpose of discovering information if it is intended to eliminate
uncertainty concerning the development or improvement of a business
component. Uncertainty, for purposes of this requirement, exists if the
information
[[Page 66364]]
available to the taxpayer does not establish the capability or method
of developing or improving the business component, or the appropriate
design of the business component.
These proposed regulations expand on the definition of
technological in nature set out in TD 8930. As under TD 8930,
information is technological in nature if the process of
experimentation used to discover such information fundamentally relies
on principles of the physical or biological sciences, engineering, or
computer science. As in TD 8930, these proposed regulations clarify the
definition of technological in nature by stating that a taxpayer may
employ existing technologies and may rely on existing principles of the
physical or biological sciences, engineering, or computer science to
satisfy this requirement.
TD 8930 contained a patent safe harbor providing that a taxpayer is
conclusively presumed to have obtained knowledge that exceeds, expands,
or refines the common knowledge of skilled professionals in the
relevant field of science or engineering, if that taxpayer was awarded
a patent (other than a patent for design issued under the provisions of
35 U.S.C. 171) for the business component. These proposed regulations
contain a similar rule that conforms to the underlying requirement for
credit eligibility in section 41(d)(1)(B)(i) that research must be
undertaken for the purpose of discovering information that is
technological in nature. Accordingly, these proposed regulations
provide that a taxpayer is conclusively presumed to have discovered
information that is technological in nature that is intended to
eliminate uncertainty concerning the development or improvement of a
business component if that taxpayer was awarded a patent (other than a
patent for design issued under the provisions of 35 U.S.C. 171) for the
business component.
II. Process of Experimentation
Together with the requirements of section 41(d)(1)(A) and (B),
section 41(d)(1)(C) provides that qualified research means research
substantially all of the activities of which constitute elements of a
process of experimentation related to a new or improved function,
performance, or reliability or quality. In TD 8930, Treasury and the
IRS clarified how the process of experimentation required by section
41(d)(1)(C) differs from research and development in the experimental
or laboratory sense required by Sec. 1.174-2(a). Specifically, TD 8930
provided that a process of experimentation is a process to evaluate
more than one alternative designed to achieve a result where the
capability or method of achieving that result is uncertain at the
outset, but does not include the evaluation of alternatives to
establish the appropriate design of a business component when the
capability and method for developing or improving the business
component are not uncertain. Several commentators objected to any
distinction regarding the design of a business component and cited
examples from the legislative history which these commentators contend
show that the determination of the appropriate design of a business
component involved a process of experimentation.
Treasury and the IRS continue to believe that the requirements for
a process of experimentation under section 41 are more stringent than
the requirements for research and development in the experimental or
laboratory sense under Sec. 1.174-2(a)(1). However, Treasury and the
IRS have determined that a process of experimentation may exist if a
taxpayer performs research to establish the appropriate design of a
business component when the capability and method for developing or
improving the business component are not uncertain. As is discussed in
more detail below, not all research to arrive at the appropriate design
of a business component will be credit eligible.
These proposed regulations provide that a process of
experimentation is a process designed to evaluate one or more
alternatives to achieve a result where the capability or the method of
achieving that result, or the appropriate design of that result, is
uncertain as of the beginning of the taxpayer's research activities.
Whether a taxpayer has undertaken a process of experimentation is a
facts and circumstances determination. The proposed regulations provide
factors that are indicative of a process of experimentation. The
factors listed are not exclusive, and no one factor is dispositive.
A taxpayer's activities do not constitute elements of a process of
experimentation where the capability and method of achieving the
desired new or improved business component, and the appropriate design
of the desired new or improved business component, are readily
discernible and applicable as of the beginning of the taxpayer's
research activities so that true experimentation in the scientific or
laboratory sense would not have to be undertaken to test, analyze, and
choose among viable alternatives. Similarly, a process of
experimentation does not include merely selecting among several
alternatives that are readily discernible and applicable. The fact that
a taxpayer conducts only rudimentary or non-technological testing in
order to develop or improve a business component tends to indicate that
the appropriate design of the business component was readily
discernible and applicable at the outset within the meaning of these
rules.
TD 8930 provided that the substantially all requirement of section
41(d)(1)(C) is satisfied only if 80 percent or more of the research
activities, measured on a cost or other consistently applied reasonable
basis (and without regard to Sec. 1.41-2(d)(2)), constitute elements of
a process of experimentation for a purpose described in section
41(d)(3). The substantially all requirement is applied separately to
each business component. These proposed regulations retain the same
rule. Treasury and the IRS, however, request comments on the
application of the substantially all rule. Treasury and the IRS are
specifically interested in comments on whether research expenses
incurred for non-qualified purposes are includible in the credit
computation provided that substantially all of the research expenses
constitute elements of a process of experimentation.
III. Internal Use Software
Section 41(d)(4)(E) provides that, except to the extent provided by
regulations, research with respect to ``computer software which is
developed by (or for the benefit of) the taxpayer primarily for
internal use by the taxpayer'' (i.e., internal-use software) is
excluded from the definition of qualified research. TD 8930 provided
that the development of internal-use software constitutes qualified
research only if the research satisfies both the general requirements
for credit eligibility under section 41 (including that the research
not be otherwise excluded) and an additional, three-part high threshold
of innovation test. TD 8930 defined internal-use software as software
that is to be used internally, such as software used in general and
administrative functions of the taxpayer, or in providing noncomputer
services. Noncomputer services are services offered by a taxpayer to
customers who do business with the taxpayer primarily to obtain a
service other than a computer service, even if such other service is
enabled, supported, or facilitated by computer or software technology.
TD 8930, however, contained an exception to this rule that provides
that internal-use software does not include software that is designed
to
[[Page 66365]]
provide customers with a new feature, not available from the taxpayer's
competitors, with respect to a noncomputer service and that the
taxpayer reasonably anticipates will give rise to increased customer
demand for the noncomputer service.
The high threshold of innovation test in TD 8930 generally required
that (i) the internal-use software be innovative; (ii) the development
of the internal-use software involve significant economic risk; and
(iii) the internal-use software not be commercially available. The high
threshold of innovation test, however, does not apply with respect to
the development of software (i) for use in conducting qualified
research; (ii) for use in a production process; (iii) for use as part
of a package of hardware and software developed concurrently; and (iv)
for use in providing computer services to customers. Computer services
are services offered by a taxpayer to customers who do business with
the taxpayer primarily for the use of the taxpayer's computer or
software technology.
In response to Notice 2001-19, several commentators objected to the
internal-use software provisions of TD 8930. After reviewing the
legislative history to the 1986 Act, the Tax and Trade Relief Extension
Act of 1998, Public Law 105-277, 112 Stat. 2681, 2681-888 (the 1998
Act), and the Tax Relief Extension Act of 1999, Public Law 106-170, 113
Stat. 1860, 1919, together with the comment letters, Treasury and the
IRS made several changes to the internal-use software rules. These
proposed regulations clarify the definition of internal-use software
contained in TD 8930 as well as the exceptions to this definition and
the types of software that are not required to satisfy the high
threshold of innovation test. These changes are discussed below.
Internal-Use Software Defined
Under these proposed regulations, software that is developed by (or
for the benefit of) the taxpayer primarily to be commercially sold,
leased, licensed, or otherwise marketed, for separately stated
consideration to unrelated third parties is not treated as internal use
software. All other software is presumed to be developed by (or for the
benefit of) the taxpayer primarily for the taxpayer's internal use.
This distinction reflects the view that software that is sold, leased,
licensed, or otherwise marketed, for separately stated consideration to
unrelated third parties is software that is intended to be used
primarily by the customers of the taxpayer, whereas software that does
not satisfy this requirement is software that is intended to be used
primarily by the taxpayer for its internal use or in connection with a
noncomputer service provided by the taxpayer.
These proposed regulations retain the provision in TD 8930 that
excluded from the definition of internal-use software computer software
and hardware developed as a single product. This rule, however, has
been modified in response to a commentator's suggestion that some
purchasers of combined software and hardware packages may develop their
own computer software to operate the package or modify the imbedded
computer software. Because the computer software is an integral part of
the hardware, these commentators urged that the computer software/
hardware rule should be extended to these development costs. Treasury
and the IRS agree that, provided the computer software is developed to
be used with hardware as a single product and the activities are
otherwise credit-eligible and not excluded under another provision
(e.g., section 41(d)(4)(B)), the computer software/hardware rule should
extend to these development costs. Thus, under these proposed
regulations, internal-use software does not include a new or improved
package of computer software and hardware developed together by the
taxpayer as a single product (or to the costs to modify an acquired
computer software and hardware package), of which the software is an
integral part, that is used directly by the taxpayer in providing
services in its trade or business to customers.
High Threshold of Innovation Test
These proposed regulations retain the general rule contained in TD
8930 that internal-use software must satisfy the general requirements
for credit eligibility (and not be excluded from the definition of
qualified research under any other exclusion) and the three-part high
threshold of innovation test. These proposed regulations clarify the
first prong of the three-part test by providing that internal-use
software is innovative if the software is intended to be unique or
novel and is intended to differ in a significant and inventive way from
prior software implementations or methods. This change is being
proposed pursuant to the authority provided in section 41(d)(4)(E) and
the legislative history thereunder in order to update the definition of
innovative contained in TD 8930. The TD 8930 definition was derived
from the legislative history to the 1986 Act and required that the
software be intended to result in a reduction in cost, improvement in
speed, or other improvement, that is substantial and economically
significant. Treasury and the IRS became concerned that the elements of
the TD 8930 definition, while perhaps reflecting innovations in
computer software in the mid-1980s, did not adequately reflect the
factors that indicate that software is innovative today. The proposed
change, therefore, is an attempt both to update the definition of
innovative, and to provide a more flexible definition with continuing
application. Several examples were added to these proposed regulations
to illustrate the application of this proposed rule. The second and
third prongs of the high threshold of innovation test (i.e.,
significant economic risk and commercial availability) remain unchanged
from TD 8930.
Software Not Required To Satisfy the High Threshold of Innovation Test
Like TD 8930, these proposed regulations provide that software is
not required to satisfy the high threshold of innovation test if the
software was developed by the taxpayer for use in an activity that
constitutes qualified research (other than the development of the
internal-use software itself), a production process that meets the
requirements of section 41(d)(1), or in providing computer services to
customers. These proposed regulations, however, eliminate the special
rule contained in TD 8930 for software used to deliver noncomputer
services to customers with features that are not yet offered by a
taxpayer's competitors. Several commentators stated that this rule is
too limited and subjective in its application to have significant value
to taxpayers. Due to other revisions contained in these proposed
regulations, Treasury and the IRS believe that the computer software
targeted by this rule generally would be credit eligible without this
rule.
Several commentators objected to the distinction between computer
services and noncomputer services and urged that the definition of
internal-use software exclude any software used to deliver a service to
customers or any software that includes an interface with customers or
the public. An exclusion for software that includes an interface with
customers or the public would entail substantial administrative
difficulties and may inappropriately permit certain categories of costs
(e.g., certain web site development costs) to constitute qualified
research expenses without having to satisfy the high threshold of
innovation test.
[[Page 66366]]
With respect to software developed by a taxpayer for use in a
production process satisfying the requirements of section 41(d)(1),
comments from service providers urged Treasury and the IRS to give
service providers the same benefits as manufacturing companies.
Congress provided an explicit exclusion for software developed for use
in a production process; however, it did not provide a similar
exclusion for software used in the provision of noncomputer services.
Therefore, Treasury and the IRS conclude that software used in the
provision of noncomputer services generally should be subject to the
internal-use software requirements.
Effective Date
Treasury and the IRS propose the revisions to the internal-use
software rules to be effective for taxable years beginning after
December 31, 1985. Treasury and the IRS believe that the proposed rule
is consistent with the legislative history and the legislative mandate
for retroactive application of the rule. Taxpayers, however, may
continue to rely on TD 8930 until regulations are finalized.
IV. Shrinking-Back Rule
TD 8930 contained a special shrinking-back rule. These proposed
regulations revise the shrinking-back rule to conform it to the rule in
the legislative history to the 1986 Act. These proposed regulations
also reiterate that the shrinking-back rule may not itself be applied
as a reason to exclude research activities from credit eligibility.
V. Other Exclusions
Several commentators raised issues concerning activities excluded
from the definition of qualified research. In particular, the
commentators were concerned about the research after commercial
production exclusion. Because the rules contained in Sec. 1.41-4(c) of
TD 8930 closely reflected the legislative history regarding post-
research activities, these proposed regulations retain the rules
contained in TD 8930. See H.R. Conf. Rep. No. 99-841, at II-74-75.
However, new examples are included to illustrate the application of the
exclusions. Treasury and the IRS request comments concerning the
application of the exclusions and the extent to which additional
guidance concerning the exclusions may be helpful.
VI. Gross Receipts
When Congress revised the computation of the research credit to
incorporate a taxpayer's gross receipts, neither the statute nor the
legislative history defined the term gross receipts, other than to
provide that gross receipts for any taxable year are reduced by returns
and allowances made during the tax year, and, in the case of a foreign
corporation, that only gross receipts effectively connected with the
conduct of a trade or business within the United States are taken into
account. See section 41(c)(6).
TD 8930 adopted a broad definition of the term gross receipts for
purposes of computing the research credit. TD 8930 generally defined
gross receipts as the total amount derived by a taxpayer from all
activities and sources. In addition, because certain extraordinary
gross receipts might not be taken into account when a business
determines its research budget, TD 8930 provided that certain items
(e.g., receipts from the sale or exchange of capital assets, or
repayments of loans or similar instruments) would be excluded from the
computation of gross receipts. Further, TD 8930 excluded from the
definition of gross receipts any income derived by a taxpayer in a
taxable year that precedes the first taxable year in which the taxpayer
derives more than $25,000 in gross receipts other than investment
income.
In response to Notice 2001-19, some commentators suggested that the
definition of gross receipts created an administrative burden to the
extent that taxpayers would be obligated to apply the definition of the
term for the four years preceding the determination years as well as to
the 1984 through 1988 base years.
These proposed regulations retain the definition of gross receipts
contained in TD 8930. Treasury and the IRS continue to believe that the
definition of gross receipts should be construed broadly and that the
definition of gross receipts in TD 8930 is appropriate for purposes of
computing the research credit. Further, Treasury and the IRS believe
that the administrative burden referred to by commentators is due to
the incremental nature of the credit and the statutorily determined
base years, and not to the definition of gross receipts.
VII. Recordkeeping for the Research Credit
Under TD 8930, taxpayers were required to prepare and retain
written documentation before or during the early stages of the research
project that describes the principal questions to be answered and the
information the taxpayer seeks to obtain that exceeds, expands, or
refines the common knowledge of skilled professionals in the relevant
field of science or engineering. These proposed regulations eliminate
this recordkeeping requirement.
Treasury and the IRS recognize that the research credit presents a
particular burden for taxpayers because tracking eligible expenditures
may necessitate taxpayers preparing and keeping records unlikely to be
prepared or kept for other business purposes. The fact that the records
are not prepared or kept for other business purposes has made
administration of the research credit burdensome for the IRS. Moreover,
section 41 often requires an allocation between qualifying and non-
qualifying costs that is difficult for taxpayers to make and for the
IRS to administer.
Nevertheless, when the research credit was extended in 1999,
Congress made clear that the credit should not impose unreasonable
recordkeeping requirements:
The conferees also are concerned about unnecessary and costly
taxpayer record keeping burdens and reaffirm that eligibility for
the credit is not intended to be contingent on meeting unreasonable
recordkeeping requirements.
H.R. Conf. Rep. No. 106-478, at 132 (1999). Treasury and the IRS have
re-evaluated whether a research credit-specific documentation
requirement is warranted and have concluded that the high degree of
variability in the objectives and conduct of research activities in the
United States compels a conclusion that taxpayers must be provided
reasonable flexibility in the manner in which they substantiate their
research credits. Accordingly, Treasury and the IRS have concluded that
the failure to keep records in a particular manner (so long as such
records are in sufficiently usable form and detail to substantiate that
the expenditures claimed are eligible for the credit) cannot serve as a
basis for denying the credit. Treasury and the IRS have decided that
the rules generally applicable under section 6001 provide sufficient
detail about required documentary substantiation for purposes of the
research credit. Consequently, no separate research credit-specific
documentation requirement is included in these proposed regulations.
Section 1.6001-1 requires the keeping of records ``sufficient to
establish the amount of * * * credits, * * * required to be shown * *
*.'' The consequence of failing to keep sufficient records
substantiating a claimed credit may be denial of the credit. To address
any ongoing recordkeeping concerns regarding the research credit,
Treasury and the IRS propose to use pre-filing
[[Page 66367]]
processes, including industry issue resolution, pre-filing agreements,
determination letters, and record retention agreements, to provide
certainty to taxpayers about the records that must be kept and to
ensure the availability to the IRS of the records necessary to examine
taxpayers' returns expeditiously. Treasury and the IRS solicit comments
from taxpayers on establishing recordkeeping rules that will facilitate
compliance and administration, including whether pre-filing agreements
should extend to the qualification of particular cost centers or to the
procedures established by the taxpayer for determining the expenditures
qualifying for the credit. Treasury and the IRS also solicit comments
from taxpayers on the extent to which guidelines may be developed on an
industry-by-industry basis.
Proposed Effective Dates
Except as specifically provided in Sec. 1.41-4(c)(6)(ix), the
proposed amendments to Sec. 1.41-4 are proposed to apply to taxable
years ending on or after December 26, 2001. Notwithstanding this
prospective effective date, Treasury and the IRS believe that these
rules prescribe the proper treatment of the expenditures they address,
and the IRS generally will not challenge return positions consistent
with the proposed regulations. Therefore, taxpayers may rely on these
proposed regulations until the date final regulations under Sec. 1.41-4
are published in the Federal Register.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. It also has been determined that section 533(b) of the
Administrative Procedures Act (5 U.S.C. chapter 5) does not apply to
these regulations, and because these regulations do not impose a
collection of information on small entities, the Regulatory Flexibility
Act (5 U.S.C. chapter 6) does not apply. Therefore, a Regulatory
Flexibility Analysis is not required. Pursuant to section 7805(f) of
the Internal Revenue Code, this notice of proposed rulemaking will be
submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its impact on small business.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any electronic and written comments (a
signed original and eight (8) copies) that are submitted timely to the
IRS. The IRS and the Treasury Department specifically request comments
on the clarity of the proposed regulations and how they may be made
easier to understand. All comments will be available for public
inspection and copying. All comments will be available for public
inspection and copying.
A public hearing has been scheduled for March 27, 2002, at 10 a.m.
in the IRS Auditorium (7th Floor), Internal Revenue Building, 1111
Constitution Avenue, NW., Washington, DC. Because of access
restrictions, visitors will not be admitted beyond the building lobby
more than 15 minutes before the hearing starts.
The rules of 26 CFR 601.601(a)(3) apply to the hearing.
Persons that wish to present oral comments at the hearing must
submit (in the manner described in the ADDRESSES portion of this
preamble) comments and an outline of the topics to be discussed and the
time to be devoted to each topic by March 6, 2002.
A period of 10 minutes will be allotted to each person for making
comments.
An agenda showing the scheduling of the speakers will be prepared
after the deadline for receiving outlines has passed. Copies of the
agenda will be available free of charge at the hearing.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.41-0 is amended as follows:
1. Revising the section heading for 1.41-3.
2. Revising the entries for 1.41-4.
3. Revising the section heading for 1.41-8.
Sec. 1.41-0 Table of contents.
* * * * *
Sec. 1.41-3 Base amount for taxable years ending on or after December
26, 2001.
* * * * *
Sec. 1.41-4 Qualified research for expenditures paid or incurred in
taxable years ending on or after December 26, 2001.
(a) Qualified research.
(1) General rule.
(2) Requirements of section 41(d)(1).
(3) Undertaken for the purpose of discovering information.
(i) In general.
(ii) Application of the discovering information requirement.
(iii) Patent safe harbor.
(4) Technological in nature.
(5) Process of experimentation.
(i) In general.
(ii) Readily discernible capability, method and appropriate
design.
(iii) Qualified purpose.
(iv) Factors tending to indicate that the taxpayer has engaged
in a process of experimentation.
(6) Substantially all requirement.
(i) General rule.
(ii) Illustrations. [Reserved]
(7) Use of computers and information technology.
(8) Illustrations.
(b) Application of requirements for qualified research.
(1) In general.
(2) Shrinking-back rule.
(3) Illustration.
(c) Excluded activities.
(1) In general.
(2) Research after commercial production.
(i) In general.
(ii) Certain additional activities related to the business
component.
(iii) Activities related to production process or technique.
(iv) Clinical testing.
(3) Adaptation of existing business components.
(4) Duplication of existing business component.
(5) Surveys, studies, research relating to management functions,
etc.
(6) Internal use software for taxable years beginning on or
after December 31, 1985.
(i) General rule.
(ii) Requirements.
(iii) Computer software and hardware developed as a single
product.
(iv) Primarily for internal use.
(v) Software used in the provision of services.
(A) Computer services.
(B) Noncomputer services.
(vi) High threshold of innovation test.
(vii) Application of high threshold of innovation test.
(viii) Illustrations.
(ix) Effective date.
(7) Activities outside the United States, Puerto Rico, and other
possessions.
(i) In general.
(ii) Apportionment of in-house research expenses.
(iii) Apportionment of contract research expenses.
(8) Research in the social sciences, etc.
(9) Research funded by any grant, contract, or otherwise.
(10) Illustrations.
(d) Recordkeeping for the research credit.
(e) Effective dates.
* * * * *
Sec. 1.41-8 Special rules for taxable years ending on or after
December 26, 2001.
Par. 3. Section 1.41-3 is amended by:
[[Page 66368]]
1. Revising the section heading.
2. Revising paragraph (e).
The revisions read as follows:
Sec. 1.41-3 Base amount for taxable years ending on or after December
26, 2001.
* * * * *
(e) Effective date. The rules of this section are applicable for
taxable years ending on or after the date December 21, 2001.
Par. 4. Section 1.41-4 is revised to read as follows:
Sec. 1.41-4 Qualified research for expenditures paid or incurred in
taxable years ending on or after December 26, 2001.
(a) Qualified research--(1) General rule. Research activities
related to the development or improvement of a business component
constitute qualified research only if the research activities meet all
of the requirements of section 41(d)(1) and this section, and are not
otherwise excluded under section 41(d)(3)(B) or (d)(4), or this
section.
(2) Requirements of section 41(d)(1). Research constitutes
qualified research only if it is research--
(i) With respect to which expenditures may be treated as expenses
under section 174, see Sec. 1.174-2;
(ii) That is undertaken for the purpose of discovering information
that is technological in nature, and the application of which is
intended to be useful in the development of a new or improved business
component of the taxpayer; and
(iii) Substantially all of the activities of which constitute
elements of a process of experimentation that relates to a new or
improved function, performance, reliability or quality.
(3) Undertaken for the purpose of discovering information--(i) In
general. For purposes of section 41(d) and this section, research must
be undertaken for the purpose of discovering information that is
technological in nature. Research is undertaken for the purpose of
discovering information if it is intended to eliminate uncertainty
concerning the development or improvement of a business component.
Uncertainty exists if the information available to the taxpayer does
not establish the capability or method for developing or improving the
business component, or the appropriate design of the business
component.
(ii) Application of the discovering information requirement. A
determination that research is undertaken for the purpose of
discovering information that is technological in nature does not
require the taxpayer be seeking to obtain information that exceeds,
expands or refines the common knowledge of skilled professionals in the
particular field of science or engineering in which the taxpayer is
performing the research. In addition, a determination that research is
undertaken for the purpose of discovering information that is
technological in nature does not require that the taxpayer succeed in
developing a new or improved business component.
(iii) Patent safe harbor. For purposes of section 41(d) and
paragraph (a)(3)(i) of this section, the issuance of a patent by the
Patent and Trademark Office under the provisions of 35 U.S.C. 151
(other than a patent for design issued under the provisions of 35
U.S.C. 171) is conclusive evidence that a taxpayer has discovered
information that is technological in nature that is intended to
eliminate uncertainty concerning the development or improvement of a
business component. However, the issuance of such a patent is not a
precondition for credit availability.
(4) Technological in nature. For purposes of section 41(d) and this
section, information is technological in nature if the process of
experimentation used to discover such information fundamentally relies
on principles of the physical or biological sciences, engineering, or
computer science. A taxpayer may employ existing technologies and may
rely on existing principles of the physical or biological sciences,
engineering, or computer science to satisfy this requirement.
(5) Process of experimentation--(i) In general. For purposes of
section 41(d) and this section, a process of experimentation is a
process designed to evaluate one or more alternatives to achieve a
result where the capability or the method of achieving that result, or
the appropriate design of that result, is uncertain as of the beginning
of the taxpayer's research activities. Thus, a taxpayer may undertake a
process of experimentation if there is no uncertainty concerning the
taxpayer's capability or method of achieving the desired result so long
as the appropriate design of the desired result is uncertain as of the
beginning of the taxpayer's research activities. However, a process of
experimentation does not include the evaluation of alternatives to
achieve the desired result if the capability and method of achieving
the desired result, and the appropriate design of the desired result,
are readily discernible and applicable as of the beginning of the
taxpayer's research activities. A process of experimentation may
include developing one or more hypotheses designed to achieve the
desired result, designing and conducting an experiment to test and
analyze those hypotheses, and refining or discarding the hypotheses as
part of a design process to develop or improve the business component.
For purposes of this paragraph (a)(5), factors that tend to indicate
that the taxpayer has engaged in a process of experimentation are
listed in paragraph (a)(5)(iv) of this section.
(ii) Readily discernible capability, method and appropriate design.
A taxpayer's activities do not constitute elements of a process of
experimentation where the capability and method of achieving the
desired new or improved business component, and the appropriate design
of the desired new or improved business component, are readily
discernible and applicable as of the beginning of the taxpayer's
research activities, so that true experimentation in the scientific or
laboratory sense would not have to be undertaken to test, analyze, and
choose among viable alternatives. A process of experimentation does not
include any activities to select among several alternatives that are
readily discernible and applicable.
(iii) Qualified purpose. For purposes of section 41(d) and this
section, a process of experimentation is undertaken for a qualified
purpose if it relates to a new or improved function, performance,
reliability or quality of the business component. Research will not be
treated as conducted for a qualified purpose if it relates to style,
taste, cosmetic, or seasonal design factors.
(iv) Factors tending to indicate that the taxpayer has engaged in a
process of experimentation. For purposes of section 41(d) and this
section, in determining whether a taxpayer has undertaken a process of
experimentation, all facts and circumstances with respect to a
taxpayer's research activities are taken into account. No one factor is
dispositive in making this determination. Further, it is not intended
that only the factors described in this paragraph are to be taken into
account in making the determination. Thus, no inference should be drawn
from the taxpayer's failure to satisfy any or all of the factors. Among
the factors that tend to indicate that the taxpayer has engaged in a
process of experimentation are--
(A) The taxpayer tests and analyzes numerous alternative hypotheses
to develop a new or improved business component;
(B) The taxpayer engages in extensive, comprehensive, intricate or
complex scientific or laboratory testing; or
(C) The taxpayer evaluates numerous or complex specifications
related to the
[[Page 66369]]
function, performance, reliability or quality of a new or improved
business component.
(6) Substantially all requirement--(i) General rule. The
substantially all requirement of section 41(d)(1)(C) and paragraph
(a)(2)(iii) of this section is satisfied only if 80 percent or more of
the research activities, measured on a cost or other consistently
applied reasonable basis (and without regard to Sec. 1.41-2(d)(2)),
constitute elements of a process of experimentation for a purpose
described in section 41(d)(3). The substantially all requirement is
applied separately to each business component.
(ii) Illustrations. [Reserved]
(7) Use of computers and information technology. The employment of
computers or information technology, or the reliance on principles of
computer science or information technology to store, collect,
manipulate, translate, disseminate, produce, distribute, or process
data or information, and similar uses of computers and information
technology does not itself establish that qualified research has been
undertaken.
(8) Illustrations. The following examples illustrate the
application of paragraph (a)(5) of this section:
Example 1. (i) Facts. X is engaged in the business of developing
and manufacturing widgets. X wants to change the color of its blue
widget to green. X obtains from various suppliers several different
shades of green paint. X paints several sample widgets, and surveys
X's customers to determine which shade of green X's customers
prefer.
(ii) Conclusion. X's activities to change the color of its blue
widget to green are not qualified research under section 41(d)(1)
and paragraph (a)(5) of this section because substantially all of
X's activities are not undertaken for a qualified purpose. All of
X's research activities are related to style, taste, cosmetic, or
seasonal design factors.
Example 2. (i) Facts. X is engaged in the business of
manufacturing widgets and wants to change the color of its blue
widget to green. X obtains samples of green paint from a supplier
and determines that X must modify its painting process to
accommodate the green paint because the green paint has different
characteristics from other paints X has used. X obtains detailed
data on the green paint from X's paint supplier. X also consults
with the manufacturer of X's paint spraying machines and determines
that X must acquire new nozzles that are designed to operate with
paints similar to the green paint X wants to use. X installs the new
nozzles on its paint spraying machines and tests the nozzles to
ensure that to ensure that they work as specified by the
manufacturer of the paint spraying machines.
(ii) Conclusion. X's activities to modify its painting process
is a separate business component under section 41(d)(2)(A). X's
activities to modify its painting process by installing new nozzles
on its paint spraying machines to change the color of its blue
widget to green are not qualified research under section 41(d)(1)
and paragraph (a)(5) of this section. The capability, method and
appropriate design of the changes to X's painting process are
readily discernible and applicable to X as of the beginning of X's
activities. X's activities to test the nozzles to determine if the
nozzles work as specified by the manufacturer of the paint spraying
machines are not the type of testing activities that tend to
indicate that a process of experimentation was undertaken.
Example 3. (i) Facts. X is engaged in the business of
manufacturing food products and currently manufactures a large-shred
version of a product. Because X's competitors manufacture both a
large-shred and fine-shred version of comparable food products, X
seeks to modify its current production line to permit it to
manufacture both a large-shred version and fine-shred version of one
of its own food products. A shredding blade capable of producing a
fine-shred version of the food product is not commercially
available. Thus, X must develop a new shredding blade that can be
fitted onto X's current production line. X must test and analyze
numerous alternative hypotheses to determine whether a new shredding
blade must be constructed of a different material from that of its
existing shredding blade. In addition, X must engage in
comprehensive and complex scientific or laboratory testing to ensure
that its modified production process, with the newly-developed
shredding blade, can accommodate the manufacture of both the large-
shred and fine-shred versions of X's food products.
(ii) Conclusion. X's activities to modify its current production
line meet the requirements of qualified research as set forth in
paragraph (a)(2) of this section. Substantially all of X's
activities constitute elements of a process of experimentation
because X must evaluate more than one alternative to achieve a
result where the method and appropriate design are uncertain as of
the beginning of the taxpayer's research activities. X must test and
analyze numerous alternative hypotheses and engage in comprehensive
and complex scientific or laboratory testing to ensure that its
modified production process, with a newly-developed shredding blade,
can accommodate the manufacture of both the large-shred and fine-
shred versions of X's food products.
Example 4. (i) Facts. X operates wireless networks in several
U.S. cities. X discovers in City a service problem and collects data
on the nature of the problem. X analyzes the data and knows, based
on its previous experience with wireless networks in other cities,
that the installation of a new type of gateway will eliminate the
problem. X installs the new gateway in its City network.
(ii) Conclusion. X's activities to determine a solution to its
service problem are not qualified research under section 41(d)(1)
and paragraph (a)(5) of this section. Substantially all of X's
research activities do not constitute elements of a process of
experimentation because the solution to the service problem is
readily discernible and applicable by X as of the beginning of X's
research activities.
Example 5. (i) Facts. X is engaged in the business of
manufacturing and selling automobiles. X incorporated into one of
its new vehicles a new exhaust system that it designed. After X
offered the vehicle for sale, X received complaints of a rattling
noise that could be heard in the passenger compartment. X's
engineers determined that the cause of the noise was the exhaust
system coming into contact with the undercarriage of the vehicle.
Based on previous experience with similar noise problems, X's
engineers knew of two safe, effective, reliable solutions that would
eliminate the noise. X's engineers selected one of the solutions
based on cost studies that indicated it would be the less expensive
alternative.
(ii) Conclusion. X's activities to eliminate the rattling noise
are not qualified research under section 41(d)(1) and paragraph
(a)(5) of this section. Substantially all of X's research activities
do not constitute elements of a process of experimentation because
the solution is readily discernible and applicable to X as of the
beginning of X's activities.
Example 6. (i) Facts. X is in the business of designing,
developing and manufacturing automobiles and decides to update one
of its current model vehicles. In response to government-mandated
fuel economy requirements, X undertakes to improve aerodynamics by
lowering the hood of the current model vehicle. X determines that
lowering the hood changes the air flow under the hood, which changes
the rate at which air enters the engine through the air intake
system, and which reduces the functionality of the cooling system. X
designs, models, tests, refines, and re-tests proposed modifications
to both the air intake system and cooling system until modifications
are developed that meet X's requirements. X then integrates the
modified air intake and cooling systems into a current model vehicle
with a lower hood, modifying in the process the new air intake and
cooling systems as well as the underhood wiring, brake lines and
fuel line. X conducts extensive and complex scientific or laboratory
testing to determine if the current model vehicle meets X's
requirements. X conducts extensive and complex scientific or
laboratory testing (including simulations and crash tests) to
determine if the current model vehicle meets X's requirements.
(ii) Conclusion. X's activities to update its vehicle meet the
requirements of qualified research as set forth in paragraph (a)(2)
of this section. X must test and analyze numerous alternative
hypotheses, engage in extensive testing and analysis, and evaluate
complex specifications related to the functionality of several of
the vehicle's underhood systems and to the vehicle's overall
performance. These activities indicate that X undertook a process of
experimentation to achieve the appropriate design of the updated
vehicle.
(b) Application of requirements for qualified research--(1) In
general. The requirements for qualified research in section 41(d)(1)
and paragraph (a) of this section, must be applied separately to each
business component, as defined in section 41(d)(2)(B). In cases
involving development of both a product and a manufacturing or other
commercial
[[Page 66370]]
production process for the product, research activities relating to
development of the process are not qualified research unless the
requirements of section 41(d) and this section are met for the research
activities relating to the process without taking into account the
research activities relating to development of the product. Similarly,
research activities relating to development of the product are not
qualified research unless the requirements of section 41(d) and this
section are met for the research activities relating to the product
without taking into account the research activities relating to
development of the manufacturing or other commercial production
process.
(2) Shrinking-back rule. The requirements of section 41(d) and
paragraph (a) of this section are to be applied first at the level of
the discrete business component, that is, the product, process,
computer software, technique, formula, or invention to be held for
sale, lease, or license, or used by the taxpayer in a trade or business
of the taxpayer. If the requirements for credit eligibility are met at
that first level, then some or all of the taxpayer's qualified research
expenses are eligible for the credit. If all aspects of such
requirements are not met at that level, the test applies at the most
significant subset of elements of the product, process, computer
software, technique, formula, or invention to be held for sale, lease,
or license. This shrinking back of the product is to continue until
either a subset of elements of the product that satisfies the
requirements is reached, or the most basic element of the product is
reached and such element fails to satisfy the test. This shrinking-back
rule is applied only if a taxpayer does not satisfy the requirements of
section 41(d)(1) and paragraph (a)(2) of this section with respect to
the overall business component. The shrinking-back rule is not itself
applied as a reason to exclude research activities from credit
eligibility.
(3) Illustration. The following example illustrates the application
of this paragraph (b):
Example. X, a motorcycle engine builder, develops a new
carburetor for use in a motorcycle engine. X also modifies an
existing engine design for use with the new carburetor. Under the
shrinking-back rule, the requirements of section 41(d)(1) and
paragraph (a) of this section are applied first to the engine. If
the modifications to the engine when viewed as a whole, including
the development of the new carburetor, do not satisfy the
requirements of section 41(d)(1) and paragraph (a) of this section,
those requirements are applied to the next most significant subset
of elements of the business component. Assuming that the next most
significant subset of elements of the engine is the carburetor, the
research activities in developing the new carburetor may constitute
qualified research within the meaning of section 41(d)(1) and
paragraph (a) of this section.
(c) Excluded activities--(1) In general. Qualified research does
not include any activity described in section 41(d)(4) and paragraph
(c) of this section.
(2) Research after commercial production--(i) In general.
Activities conducted after the beginning of commercial production of a
business component are not qualified research. Activities are conducted
after the beginning of commercial production of a business component if
such activities are conducted after the component is developed to the
point where it is ready for commercial sale or use, or meets the basic
functional and economic requirements of the taxpayer for the
component's sale or use.
(ii) Certain additional activities related to the business
component. The following activities are deemed to occur after the
beginning of commercial production of a business component--
(A) Preproduction planning for a finished business component;
(B) Tooling-up for production;
(C) Trial production runs;
(D) Trouble shooting involving detecting faults in production
equipment or processes;
(E) Accumulating data relating to production processes; and
(F) Debugging flaws in a business component.
(iii) Activities related to production process or technique. In
cases involving development of both a product and a manufacturing or
other commercial production process for the product, the exclusion
described in section 41(d)(4)(A) and paragraphs (c)(2)(i) and (ii) of
this section applies separately for the activities relating to the
development of the product and the activities relating to the
development of the process. For example, even after a product meets the
taxpayer's basic functional and economic requirements, activities
relating to the development of the manufacturing process still may
constitute qualified research, provided that the development of the
process itself separately satisfies the requirements of section 41(d)
and this section, and the activities are conducted before the process
meets the taxpayer's basic functional and economic requirements or is
ready for commercial use.
(iv) Clinical testing. Clinical testing of a pharmaceutical product
prior to its commercial production in the United States is not treated
as occurring after the beginning of commercial production even if the
product is commercially available in other countries. Additional
clinical testing of a pharmaceutical product after a product has been
approved for a specific therapeutic use by the Food and Drug
Administration and is ready for commercial production and sale is not
treated as occurring after the beginning of commercial production if
such clinical testing is undertaken to establish new functional uses,
characteristics, indications, combinations, dosages, or delivery forms
for the product. A functional use, characteristic, indication,
combination, dosage, or delivery form shall be considered new only if
such functional use, characteristic, indication, combination, dosage,
or delivery form must be approved by the Food and Drug Administration.
(3) Adaptation of existing business components. Activities relating
to adapting an existing business component to a particular customer's
requirement or need are not qualified research. This exclusion does not
apply merely because a business component is intended for a specific
customer.
(4) Duplication of existing business component. Activities relating
to reproducing an existing business component (in whole or in part)
from a physical examination of the business component itself or from
plans, blueprints, detailed specifications, or publicly available
information about the business component are not qualified research.
This exclusion does not apply merely because the taxpayer examines an
existing business component in the course of developing its own
business component.
(5) Surveys, studies, research relating to management functions,
etc. Qualified research does not include activities relating to--
(i) Efficiency surveys;
(ii) Management functions or techniques, including such items as
preparation of financial data and analysis, development of employee
training programs and management organization plans, and management-
based changes in production processes (such as rearranging work
stations on an assembly line);
(iii) Market research, testing, or development (including
advertising or promotions);
(iv) Routine data collections; or
(v) Routine or ordinary testing or inspections for quality control.
(6) Internal use software for taxable years beginning on or after
the December 31, 1985--(i) General rule. Research with respect to
computer
[[Page 66371]]
software that is developed by (or for the benefit of) the taxpayer
primarily for the taxpayer's internal use is eligible for the research
credit only if the software satisfies the requirements of paragraph
(c)(6)(ii) of this section.
(ii) Requirements. The requirements of this paragraph (c)(6)(ii)
are--
(A) The software satisfies the requirements of section 41(d)(1);
(B) The software is not otherwise excluded under section 41(d)(4)
(other than section 41(d)(4)(E)); and
(C) One of the following conditions is met--
(1) The taxpayer develops the software for use in an activity that
constitutes qualified research (other than the development of the
internal-use software itself);
(2) The taxpayer develops the software for use in a production
process that satisfies the requirements of section 41(d)(1);
(3) The taxpayer develops the software for use in providing
computer services to customers; or
(4) The software satisfies the high threshold of innovation test of
paragraph (c)(6)(vi) of this section.
(iii) Computer software and hardware developed as a single product.
This paragraph (c)(6) does not apply to the development costs of a new
or improved package of computer software and hardware developed
together by the taxpayer as a single product (or to the costs to modify
an acquired computer software and hardware package), of which the
software is an integral part, that is used directly by the taxpayer in
providing services in its trade or business to customers. In these
cases, eligibility for the research credit is to be determined by
examining the combined software-hardware product as a single product.
(iv) Primarily for internal use. Unless computer software is
developed to be commercially sold, leased, licensed, or otherwise
marketed, for separately stated consideration to unrelated third
parties, computer software is presumed developed by (or for the benefit
of) the taxpayer primarily for the taxpayer's internal use. For
example, the computer software may serve general and administrative
functions of the taxpayer, or may be used in providing a noncomputer
service. General and administrative functions include, but are not
limited to, functions such as payroll, bookkeeping, financial
management, financial reporting, personnel management, sales and
marketing, fixed asset accounting, inventory management and cost
accounting. Computer software that is developed to be commercially
sold, leased, licensed or otherwise marketed, for separately stated
consideration to unrelated third parties is not developed primarily for
the taxpayer's internal use. The requirements of this paragraph (c)(6)
apply to computer software that is developed primarily for the
taxpayer's internal use even though the taxpayer subsequently sells,
leases, licenses, or otherwise markets the computer software for
separately stated consideration to unrelated third parties.
(v) Software used in the provision of services--(A) Computer
services. For purposes of this section, a computer service is a service
offered by a taxpayer to customers who conduct business with the
taxpayer primarily for the use of the taxpayer's computer or software
technology. A taxpayer does not provide a computer service merely
because customers interact with the taxpayer's software.
(B) Noncomputer services. For purposes of this section, a
noncomputer service is a service offered by a taxpayer to customers who
conduct business with the taxpayer primarily to obtain a service other
than a computer service, even if such other service is enabled,
supported, or facilitated by computer or software technology.
(vi) High threshold of innovation test. Computer software satisfies
this paragraph (c)(6)(vi) only if the taxpayer can establish that--
(A) The software is innovative in that the software is intended to
be unique or novel and is intended to differ in a significant and
inventive way from prior software implementations or methods;
(B) The software development involves significant economic risk in
that the taxpayer commits substantial resources to the development and
there is substantial uncertainty, because of technical risk, that such
resources would be recovered within a reasonable period; and
(C) The software is not commercially available for use by the
taxpayer in that the software cannot be purchased, leased, or licensed
and used for the intended purpose without modifications that would
satisfy the requirements of paragraphs (c)(6)(v)(A) and (B) of this
section.
(vii) Application of high threshold of innovation test. The costs
of developing internal use software are eligible for the research
credit only if the software satisfies the high threshold of innovation
test of paragraph (c)(6)(vi) of this section. This test takes into
account only the results attributable to the development of the new or
improved software independent of the effect of any modifications to
related hardware or other software.
(viii) Illustrations. The following examples illustrate provisions
contained in this paragraph (c)(6) of this section. No inference should
be drawn from these examples concerning the application of section
41(d)(1) and paragraph (a) of this section to these facts. The examples
are as follows:
Example 1. (i) Facts. X, an insurance company, has increased its
number of insurance policies in force. In recent years, regulatory
and financial accounting rules for computing actuarial reserves on
these insurance policies have changed several times. In order to
compute actuarial reserves in a more timely and cost-effective
manner, X undertakes to create an improved reserve valuation
software that will generate data for regulatory and financial
accounting purposes.
(ii) Conclusion. The improved reserve valuation software created
by X is internal use software because the software is not developed
to be commercially sold, leased, licensed, or otherwise marketed,
for separately stated consideration to unrelated third parties. The
improved reserve valuation software was developed by X to serve X's
general and administrative functions. X's costs of developing the
reserve valuation software are eligible for the research credit only
if the software satisfies the high threshold of innovation test of
paragraph (c)(6)(vi) of this section.
Example 2. (i) Facts. Assume the same facts as in Example 1.
Also assume that in order to create an improved reserve valuation
software, X purchases updated hardware with a new operating system
to build the new software system. Several other insurance companies
using the same updated hardware and new operating system have in
place software systems that can handle the volume of transactions
that X seeks to handle, provide reserve computations within a
similar time frame, and accommodate the most current regulatory and
financial accounting requirements.
(ii) Conclusion. X's reserve valuation software system is
internal use software that does not satisfy the high threshold of
innovation test of paragraph (c)(6)(vi) of this section. The
software is not intended to be unique or novel in that it is
intended to be merely comparable to software developed by other
insurance companies. The software does not differ in a significant
or inventive way from prior software implementations because X's
reserve valuation software system was developed using the same
technologies and methods that were employed by other insurance
companies. Further, X's reserve valuation software is not excluded
from the application of paragraph (c)(6) of this section by the rule
of paragraph (c)(6)(iii) of this section.
Example 3. (i) Facts. In 1986, X, a large regional bank with
hundreds of branch offices, maintained separate software systems for
each of its customer's accounts, including checking, deposit, loan,
lease, and trust. X determined that improved customer service could
be achieved by redesigning its disparate systems into one customer-
centric system. X also determined that commercially
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available database management systems did not meet all of the
critical requirements of the proposed system. Specifically,
available relational database management systems were well suited
for the proposed system's data modeling requirements but not the
data integrity and transaction throughput (transactions-per-second)
requirements. Rather than waiting several years for vendor offerings
to mature and become viable for its purpose, X decided to embark
upon the project utilizing older technology that satisfied the data
integrity and transaction throughput requirements but that was
severely challenged with respect to the data modeling capabilities.
X commits substantial resources to this project and, because of
technical risk, X cannot determine if it will recover its resources
in a reasonable period. Early in the course of the project, industry
analysts observed that the project appeared highly ambitious and
risky. The limitations of the technology X was attempting to utilize
required that X develop a new database architecture that could
accommodate transaction volumes unheard-of in the industry. X was
unable to successfully develop the system and X abandoned the
project.
(ii) Conclusion. X intended to develop a computer software
system primarily for X's internal use because X did not intend to
commercially sell, lease, license, or otherwise market the software,
for separately stated consideration to unrelated third parties, and
X intended to use the software in providing noncomputer services to
its customers. X's software development activities satisfy the high
threshold of innovation test of paragraph (c)(6)(vi) of this section
because the system was intended to be innovative in that it was
intended to be novel and it was intended to differ in a significant
and inventive way from prior software implementations. In addition,
X's development activities involved significant economic risk in
that X committed substantial resources to the development and there
was substantial uncertainty, because of technical risk, that such
resources would be recovered within a reasonable period. Finally, at
the time X undertook the development of the system, software meeting
X's requirements was not commercially available for use by X.
Example 4. (i) Facts. X wishes to improve upon its capabilities
in the area of insurance fraud prevention, detection and control. X
believes that it can exceed the capabilities of current commercial
offerings in this area by developing and applying pattern matching
algorithms that are not implemented in current vendor offerings. X
has determined that many insurance fraud perpetrators can evade
detection because its current system relies too heavily on exact
matches and scrubbed data. Because a computer software system that
will accomplish these objectives is not commercially available, X
undertakes to develop and implement advanced pattern matching
algorithms that would significantly improve upon the capabilities
currently available from vendors. X commits substantial resources to
the development of the software system and cannot determine, because
of technical risk, if it will recover its investment within a
reasonable period.
(ii) Conclusion. X's computer software system is developed
primarily for X's internal use because X did not intend to sell,
lease, license or otherwise market the software, for separately
stated consideration to unrelated third parties. X's software
development activities satisfy the high threshold of innovation test
of paragraph (c)(6)(vi) of this section because the software system
is innovative in that it was intended to be novel and it was
intended to differ in a significant and inventive way from prior
software implementations. In addition, X's development activities
involved significant economic risk in that X committed substantial
resources to the development and there was substantial uncertainty,
because of technical risk, that such resources would be recovered
within a reasonable period. Finally, at the time X undertook the
development of the software, software satisfying X's requirements
was not commercially available for use by X.
Example 5. (i) Facts. X is engaged in the business of designing,
manufacturing, and selling widgets. X delivers its widgets in the
same manner and time as its competitors. To improve customer
service, X undertakes to develop computer software that will monitor
the progress of the manufacture and delivery of X's widgets to
enable X's customers to track their widget orders from origination
to delivery, whether by air, land or ship. In addition, at the
request of a customer, X will be able to intercept and return or
reroute packages prior to delivery. At the time X undertakes its
software development activities, X is uncertain whether it can
develop the real-time communication software necessary to achieve
its objective. None of X's competitors have a comparable tracking
system. X commits substantial resources to the development of the
system and, because of technical risk, X cannot determine if it will
recover its investment within a reasonable period.
(ii) Conclusion. X's computer software is developed primarily
for X's internal use because the software is not developed to be
commercially sold, leased, licensed, or otherwise marketed, for
separately stated consideration to unrelated third parties. X's
computer software was developed to be used by X in providing
noncomputer services to its customers. X's software satisfies the
high threshold of innovation test of paragraph (c)(6)(vi) of this
section because, at the time the research is undertaken, X's
software is designed to provide a new tracking capability that is
novel in that none of X's competitors have such a capability.
Further, the new capability differs in a significant and inventive
way from prior software implementations. In addition, X's
development activities involved significant economic risk in that X
committed substantial resources to the development and there was
substantial uncertainty, because of technical risk, that such
resources would be recovered within a reasonable period. Finally, at
the time X undertook the development of the software, software
satisfying X's requirements was not commercially available for use
by X.
Example 6. (i) Facts. X, a multinational chemical manufacturer
with different business and financial systems in each of its
divisions, undertakes a software development project aimed at
integrating the majority of the functional areas of its major
software systems into a single enterprise resource management system
supporting centralized financial systems, inventory, and management
reporting. This project involves the detailed analysis of X's (as
well as each of X's divisions) legacy systems to understand the
actual current business processes and data requirements. X also has
to develop programs to fill in the gaps between the software
features and X's system requirements. X hires Y, a systems
consulting firm to assist with this development effort. Y has
experience in developing similar systems. X, working jointly with Y,
evaluates its needs, establishes goals for the new system, re-
engineers the business processes that will be made concurrently with
the implementation of the new system, and chooses and purchases a
software system upon which to base its enterprise-wide system.
(ii) Conclusion. X's enterprise-wide computer software is
developed primarily for internal use because the software is not
developed to be commercially sold, leased, licensed, or otherwise
marketed, for separately stated consideration to unrelated third
parties. X's computer software was developed to be used by X to
serve X's general and administrative functions. However, the
development of X's enterprise management system does not satisfy the
high threshold of innovation test of paragraph (c)(6)(vi) of this
section because the system that X is seeking to develop is not
intended to be unique or novel. Further, the software does not
differ in a significant or inventive way from software implemented
by other manufacturers.
Example 7. (i) Facts. X, a financial services company
specializing in commercial mortgages, decides to support its ongoing
expansion by upgrading its information technology infrastructure. In
order to accommodate its expanding efforts to acquire and maintain
corporate borrowers and draw securitized loan investors, X builds a
scalable and modular enterprise network to run its latest business
applications, including web-based portfolio access for investors and
staff, document imaging for customer service personnel, desktop
access to information services for in-house securities traders and
multimedia on-line training and corporate information delivery for
all company personnel. As a result, X is able to access market
information faster and function more efficiently and effectively
than before. The new network is based on a faster local area network
technology which is better able to meet the higher bandwidth
requirements of X's current multimedia applications.
(ii) Conclusion. X's software is software developed primarily
for X's internal use because the software is not developed to be
commercially sold, leased, licensed, or otherwise marketed, for
separately stated consideration to unrelated third parties. X's
software development activities do not meet the high threshold of
innovation test of paragraph (c)(6)(vi) of this section because the
system is not intended to be unique or
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novel. Further, the software does not differ in a significant or
inventive way from other existing software implementations.
Example 8. (i) Facts. X, a corporation, undertook a software
project to rewrite a legacy mainframe application using an object-
oriented programming language, and to move the new application off
the mainframe to a client/server environment. Both the object-
oriented language and client/server technologies were new to X. This
project was undertaken to develop a more maintainable application,
and to be able to implement new features more quickly. X had to
perform a detailed analysis of the old legacy application in order
to determine the requirements of the rewritten application. To
accomplish this task, X had to train the legacy mainframe
programmers in the new object-oriented and client/server
technologies that they would have to utilize. Several of X's
competitors had successfully implemented similar systems using
object-oriented programming language and client/server technologies.
(ii) Conclusion. X's software is developed primarily for
internal use because the software is not developed to be
commercially sold, leased, licensed, or otherwise marketed, for
separately stated consideration to unrelated third parties. X's
activities to rewrite a legacy mainframe application using an
object-oriented programming language, and to move the application
from X's mainframe to a client/server environment do not satisfy the
high threshold of innovation test of paragraph (c)(6)(vi) of this
section. The software developed is not intended to be either unique
or novel and is not intended to differ in a significant and
inventive way from prior software implementations or methods.
Example 9. (i) Facts. X, a retail and distribution company,
wants to upgrade its warehouse management software. Therefore, X
performs an analysis of the warehouse management products and
vendors in the marketplace. X selects vendor V's software and, in
turn, develops the software interfaces between X's legacy systems
and V's warehouse management software in order to integrate the new
warehouse management system with X's financial and inventory
systems. The development of these interfaces requires a detailed
understanding of all the input and output fields and their data
formats, and how they map from the old system to the new system and
vice-versa. Once X develops the interfaces, X has to perform
extensive testing and validation work to ensure that the interfaces
work correctly and accurately.
(ii) Conclusion. X's software is developed primarily for
internal use because the software is not developed to be
commercially sold, leased, licensed, or otherwise marketed, for
separately stated consideration to unrelated third parties. X's
software development activities do not satisfy the high threshold of
innovation test of paragraph (c)(6)(vi) of this section because the
software development does not involve significant economic risk in
that there is no substantial uncertainty, because of technical risk,
that such resources will be recovered within a reasonable period.
Example 10. (i) Facts. X, a credit card company, knows that its
customers are not comfortable with purchasing products over the
Internet because they feel the Web is not secure. X decides to build
a payment system that provides customers with a single use,
automatically generated, short-term time-based, transaction number.
This single-use transaction number has a short expiration period
that is just long enough to allow a merchant to process and fill the
customer's order. Thus, when a customer wishes to make a purchase
over the Internet, the customer requests X to generate automatically
a single-use transaction number that merchant systems will accept as
a legitimate card number. All purchases using single-use transaction
numbers are automatically linked back to the customer's credit card
account. X commits substantial resources to the development of the
system and X cannot determine, because of technical risk, if it will
recover its investment within a reasonable period. At the time of
this project, nothing exists in the market that has these
capabilities.
(ii) Conclusion. X's software is developed primarily for
internal use because the software is not developed to be
commercially sold, leased, licensed, or otherwise marketed, for
separately stated consideration to unrelated third parties. X's
computer software is developed primarily for X's internal use
because it was intended to be used by X in providing noncomputer
services to its customers. X's software satisfies the high threshold
of innovation test of paragraph (c)(6)(vi) of this section because
the system is a novel way to solve the security issue of making
purchases over the Internet. Further, because of the secure payment
capability, the software differs in a significant and inventive way
from prior software implementations. In addition, X's development
activities involved significant economic risk in that X committed
substantial resources to the development and there was substantial
uncertainty, because of technical risk, that such resources would be
recovered within a reasonable period. Finally, at the time X
undertook the development of the software, software satisfying X's
requirements was not commercially available for use by X.
Example 11. (i) Facts. X, a corporation, wants to expand its
internal computing power, and is aware that its PCs and workstations
are idle at night, on the weekends, and for a significant part of
any business day. Because the corporate computations that X needs to
make could be done on workstations as well as PCs, X develops a
screen-saver like application that runs on employee computers. When
employees' computers have been idle for an amount of time set by
each employee, the ``screen-saver'' starts to execute. However,
instead of displaying moving lines, like the typical screen-saver,
X's application goes back to a central server to get a new job to
execute. This job will execute on the idle employee's computer until
it has either finished, or the employee resumes working on his
computer. X wants to ensure that it can manage all of the
computation jobs distributed across its thousands of PCs and
workstations. In addition, X wants to ensure that the additional
load on its network caused by downloading the jobs and uploading the
results, as well as in monitoring and managing the jobs, does not
adversely impact the corporate computing infrastructure. At the time
X undertook this software development project, X was uncertain,
because of technical risk, it could develop a server application
that could schedule and distribute the jobs across thousands of PCs
and workstations, as well as handle all the error conditions that
occur on a user's machine. Also, at the time X undertook this
project, there was no commercial application available with such a
capability.
(ii) Conclusion. X's computer software is developed primarily
for internal use because the software is not developed to be
commercially sold, leased, licensed, or otherwise marketed, for
separately stated consideration to unrelated third parties. X's
computer software was developed to be used by X to serve X's general
and administrative functions. X's software satisfies the high
threshold of innovation test of paragraph (c)(6)(vi) of this section
because making use of idle corporate computing resources through
what is ostensibly a screen-saver, was a novel approach to solving
X's need for more computer intensive processing time. In addition,
X's software development involves significant economic risk in that
there was substantial uncertainty, because of technical risk, that
the server application that schedules and distributes the jobs
across thousands of PCs and workstations, as well as handles all the
error conditions that can occur on a user's machine, amounts to
developing a new operating system with new capabilities. Finally, at
the time X undertook the development of the software, software
satisfying X's requirements was not commercially available for use
by X.
Example 12. (i) Facts. (A) X, a corporation, wants to protect
its internal documents without building a large public key
infrastructure. In addition, X needs to implement a new highly
secure encryption algorithm that has a ``back-door'' such that X can
decrypt and read any document, even when the employee is on vacation
or leaves the company. X wants to develop a new encryption algorithm
that is both secure, easy to use, and difficult to break. Current
commercial encryption/decryption products are too slow for high-
level secure encryption processing. Furthermore, no commercial
product exists that provides the capability of having a secure back-
door key to decrypt files when the owner is unavailable.
(B) The development of the encryption/decryption software
requires specialized knowledge of cryptography and computational
methods. Due to the secret nature of X's work, the encryption
algorithm has to be unbreakable, yet recoverable should the employee
forget his key. X commits substantial resources to the development
of the system and, because of technical risk, cannot estimate
whether it will recover its investment within a reasonable period.
(ii) Conclusion. X's back-door file encryption software is
developed primarily for internal use because the software is not
developed to be commercially sold, leased, licensed, or otherwise
marketed, for
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separately stated consideration to unrelated third parties. X's
back-door file encryption software was developed to be used by X to
serve X's general and administrative functions. X's encryption
software satisfies the high threshold of innovation test of
paragraph (c)(6)(vi) of this section because, at the time the
research is undertaken, X's software is designed to provide
encryption and back-door decryption capabilities that are unique in
that no other product has these capabilities, which indicates the
software encryption system differs in a significant way from prior
software implementations. Further, the encryption and back-door
decryption capabilities indicate that the software differs in a
significant and inventive way from prior software implementations.
In addition, X's development activities involved significant
economic risk in that X committed substantial resources to the
development and there was substantial uncertainty, because of
technical risk, that such resources would be recovered within a
reasonable period. Finally, at the time X undertook the development
of the software, software satisfying X's requirements was not
commercially available for use by X.
Example 13. (i) Facts. X, a large regional telephone company, is
experiencing rapidly increasing customer demand. X would like to
determine whether evolutionary algorithms such as genetic algorithms
may improve its ability to design cost-effective networks and extend
existing networks. X would also like to determine whether such
adaptive algorithms may be used to optimize the routing of call
traffic across existing networks in order to use efficiently the
resources available without causing congestion. X first explores the
use of evolutionary algorithms for the call routing task, because X
determines that this type of complex, unpredictable problem is most
appropriate for an adaptive algorithm solution. X develops and tests
genetic algorithms until it determines that it has developed a
software system it can test on a pilot basis on its existing
networks. X commits substantial resources to the project, and cannot
predict, because of technical risk, whether it will recover its
resources within a reasonable period. Finally, at the time X
undertook the development of the software, software satisfying X's
requirements was not commercially available for use by X.
(ii) Conclusion. X's software is developed primarily for
internal use because the software is not developed to be
commercially sold, leased, licensed, or otherwise marketed, for
separately stated consideration to unrelated third parties. X's
computer software is intended to be used by X in providing
noncomputer services to its customers. X's software satisfies the
high threshold of innovation test of paragraph (c)(6)(vi) of this
section because the software is intended to be novel and is intended
to differ in a significant and inventive way from other existing
software implementations. In addition, X's development activities
involved significant economic risk in that X committed substantial
resources to the development and there was substantial uncertainty,
because of technical risk, that such resources would be recovered
within a reasonable period. Finally, at the time X undertook the
development of the software, software satisfying X's requirements
was not commercially available.
(ix) Effective date. This paragraph (c)(6) is applicable for
taxable years beginning after December 31, 1985.
(7) Activities outside the United States, Puerto Rico, and other
possessions--(i) In general. Research conducted outside the United
States, as defined in section 7701(a)(9), the Commonwealth of Puerto
Rico and other possessions of the United States does not constitute
qualified research.
(ii) Apportionment of in-house research expenses. In-house research
expenses paid or incurred for qualified services performed both in the
United States, the Commonwealth of Puerto Rico and other possessions of
the United States and outside the United States, the Commonwealth of
Puerto Rico and other possessions of the United States must be
apportioned between the services performed in the United States, the
Commonwealth of Puerto Rico and other possessions of the United States
and the services performed outside the United States, the Commonwealth
of Puerto Rico and other possessions of the United States. Only those
in-house research expenses apportioned to the services performed within
the United States, the Commonwealth of Puerto Rico and other
possessions of the United States are eligible to be treated as
qualified research expenses, unless the in-house research expenses are
wages and the 80 percent rule of Sec. 1.41-2(d)(2) applies.
(iii) Apportionment of contract research expenses. If contract
research is performed partly in the United States, the Commonwealth of
Puerto Rico and other possessions of the United States and partly
outside the United States, the Commonwealth of Puerto Rico and other
possessions of the United States, only 65 percent (or 75 percent in the
case of amounts paid to qualified research consortia) of the portion of
the contract amount that is attributable to the research activity
performed in the United States, the Commonwealth of Puerto Rico and
other possessions of the United States may qualify as a contract
research expense (even if 80 percent or more of the contract amount is
for research performed in the United States, the Commonwealth of Puerto
Rico and other possessions of the United States).
(8) Research in the social sciences, etc. Qualified research does
not include research in the social sciences (including economics,
business management, and behavioral sciences), arts, or humanities.
(9) Research funded by any grant, contract, or otherwise. Qualified
research does not include any research to the extent funded by any
grant, contract, or otherwise by another person (or governmental
entity). To determine the extent to which research is so funded,
Sec. 1.41-4A(d) applies.
(10) Illustrations. The following examples illustrate provisions
contained in paragraphs (c)(1) through (9) (excepting (c)(6)) of this
section. No inference should be drawn from these examples concerning
the application of section 41(d)(1) and paragraph (a) of this section
to these facts. The examples are as follows:
Example 1. (i) Facts. X, a tire manufacturer, develops a new
material to use in its tires. X conducts research to determine the
changes that will be necessary for X to modify its existing
manufacturing processes to manufacture the new tire. X determines
that the new material retains heat for a longer period of time than
the materials X currently uses and, as a result, adheres to the
manufacturing equipment during tread cooling. X evaluates numerous
options for processing the treads at cooler temperatures. X designs,
develops, and conducts sophisticated tests on the numerous options
for a new type of belt to be used in tread cooling. X then
manufactures a set of belts for its production equipment, installs
the belts, and tests the belts to make sure they were manufactured
correctly.
(ii) Conclusion. X's research with respect to the design of the
new belts to be used in its manufacturing of the new tire may be
qualified research under section 41(d)(1) and paragraph (a) of this
section. However, X's expenses to implement the design, including
the costs to manufacture, install, and test the belts were incurred
after the belts met the taxpayer's functional and economic
requirements and are excluded as research after commercial
production under section 41(d)(4)(A) and paragraph (c)(2) of this
section. In addition, amounts expended on component materials of the
production belts and the costs of labor or other elements involved
in the manufacture and installation of the production belts are not
qualified research expenses. These expenses are not for expenditures
that may be treated as expenses under section 174 and thus are not
qualified research under section 41(d)(1)(A) and paragraph (a)(2)(i)
of this section. See section 174(c) and Sec. 1.174-2(b). Further,
testing or inspection to determine whether the production belts were
manufactured correctly is quality control testing under Sec. 1.174-
2(a)(4) and thus is not qualified research under section 41(d)(1)(A)
and paragraph (a)(2)(i) of this section.
Example 2. (i) Facts. For several years, X has manufactured and
sold a particular kind of widget. X initiates a new research project
to develop a new or improved widget.
(ii) Conclusion. X's activities to develop a new or improved
widget are not excluded from the definition of qualified research
under section 41(d)(4)(A) and paragraph (c)(2) of this section. X's
activities relating to
[[Page 66375]]
the development of a new or improved widget constitute a new
research project to develop a new business component. X's research
activities relating to the development of the new or improved
widget, a new business component, are not considered to be
activities conducted after the beginning of commercial production
under section 41(d)(4)(A) and paragraph (c)(2) of this section.
Example 3. (i) Facts. X, a computer software development firm,
owns all substantial rights in a general ledger accounting software
core program that X markets and licenses to customers. X incurs
expenditures in adapting the core software program to the
requirements of C, one of X's customers.
(ii) Conclusion. Because X's activities represent activities to
adapt an existing software program to a particular customer's
requirement or need, X's activities are excluded from the definition
of qualified research under section 41(d)(4)(B) and paragraph (c)(3)
of this section.
Example 4. (i) Facts. The facts are the same as in example 3,
except that C pays X to adapt the core software program to C's
requirements.
(ii) Conclusion. Because X's activities are excluded from the
definition of qualified research under section 41(d)(4)(B) and
paragraph (c)(3) of this section, C's payments to X are not for
qualified research and are not considered to be contract research
expenses under section 41(b)(3)(A).
Example 5. (i) Facts. The facts are the same as in example 3,
except that C's own employees adapt the core software program to C's
requirements.
(ii) Conclusion. Because C's employees' activities to adapt the
core software program to C's requirements are excluded from the
definition of qualified research under section 41(d)(4)(B) and
paragraph (c)(3) of this section, the wages C paid to its employees
do not constitute in-house research expenses under section
41(b)(2)(A).
Example 6. (i) Facts. X manufacturer and sells rail cars.
Because rail cars have numerous specifications related to
performance, reliability and quality, rail car designs are subject
to extensive, complex testing in the scientific or laboratory sense.
B orders passenger rail cars from X. B's rail car requirements
differ from those of X's other customers in that B wants fewer seats
in its passenger cars and a higher quality seating material and
carpet. X manufactures rail cars meeting B's requirements. X does
not conduct complex testing in the scientific or laboratory sense on
the rail cars manufactured for B.
(ii) Conclusion. X's activities to manufacture rail cars for B
are excluded from the definition of qualified research. The rail
cars designed for B were not subject to the type of complex testing
that is indicative of a process of experimentation. Further, the
rail car sold to B was not a new business component, but merely an
adaptation of an existing business component. Thus, X's activities
to manufacture rail cars for B are excluded from the definition of
qualified research under section 41(d)(4)(B) and paragraph (c)(3) of
this section because X's activities represent activities to adapt an
existing business component to a particular customer's requirement
or need.
Example 7. (1) Facts. X, a manufacturer, undertakes to create a
manufacturing process for a new valve design. X determines that it
requires a specialized type of robotic equipment to use in the
manufacturing process for its new valves. X is unable to locate
robotic equipment that meets X's precise specifications, and,
therefore, purchases the existing robotic equipment for the purpose
of modifying it to meet its needs. X's engineers conduct experiments
using modeling and simulation in modifying the robotic equipment and
conduct extensive scientific and laboratory testing of design
alternatives. As a result of this process, X's engineers develop a
design for the robotic equipment that meets X's specifications. X
constructs and installs the modified robotic equipment on its
manufacturing process.
(ii) Conclusion. X's research activities to determine how to
modify X's robotic equipment for its manufacturing process are not
excluded from the definition of qualified research under section
41(d)(4)(B) and paragraph (c)(3) of this section.
Example 8. (1) Facts. An existing gasoline additive is
manufactured by Y using three ingredients, A, B, and C. X seeks to
develop and manufacture its own gasoline additive that appears and
functions in a manner similar to Y's additive. To develop its own
additive, X first inspects the composition of Y's additive, and uses
knowledge gained from the inspection to reproduce A and B in the
laboratory. Any differences between ingredients A and B that are
used in Y's additive and those reproduced by X are insignificant and
are not material to the viability, effectiveness, or cost of A and
B. X desires to use with A and B an ingredient that has a materially
lower cost than ingredient C. Accordingly, X engages in a process of
experimentation to develop, analyze and test potential alternative
formulations of the additive.
(ii) Conclusion. X's activities in analyzing and reproducing
ingredients A and B involve duplication of existing business
components and are excluded from the definition of qualified
research under section 41(d)(4)(C) and paragraph (c)(4) of this
section. X's experimentation activities to develop potential
alternative formulations of the additive do not involve duplication
of an existing business component and are not excluded from the
definition of qualified research under section 41(d)(4)(C) and
paragraph (c)(4) of this section.
Example 9. (1) Facts. X, a manufacturing corporation, undertakes
to restructure its manufacturing organization. X organizes a team to
design an organizational structure that will improve X's business
operations. The team includes X's employees as well as outside
management consultants. The team studies current operations,
interviews X's employees, and studies the structure of other
manufacturing facilities to determine appropriate modifications to
X's current business operations. The team develops a recommendation
of proposed modifications which it presents to X's management. X's
management approves the team's recommendation and begins to
implement the proposed modifications.
(ii) Conclusion. X's activities in developing and implementing
the new management structure are excluded from the definition of
qualified research under section 41(d)(4)(D) and paragraph (c)(5) of
this section. Qualified research does not include activities
relating to management functions or techniques including management
organization plans and management-based changes in production
processes.
Example 10. (1) Facts. X, an insurance company, develops a new
life insurance product. In the course of developing the product, X
engages in research with respect to the effect of pricing and tax
consequences on demand for the product, the expected volatility of
interest rates, and the expected mortality rates (based on published
data and prior insurance claims).
(ii) Conclusion. X's activities related to the new product
represent research in the social sciences (including economics and
business management) and are thus excluded from the definition of
qualified research under section 41(d)(4)(G) and paragraph (c)(8) of
this section.
(d) Recordkeeping for the research credit. A taxpayer claiming a
credit under section 41 must retain records in sufficiently usable form
and detail to substantiate that the expenditures claimed are eligible
for the credit. For the rules governing record retention, see
Sec. 1.6001-1. To facilitate compliance and administration, the IRS and
taxpayers may agree to guidelines for the keeping of specific records
for purposes of substantiating research credits.
(e) Effective dates. In general, the rules of this section are
applicable for taxable years ending on or after December 26, 2002.
Par. 5. Section 1.41-8 is amended by:
1. Revising the section heading.
2. Revising paragraph (b)(4).
The revisions read as follows:
Sec. 1.41-8 Special rules for taxable years ending on or after
December 26, 2001.
* * * * *
(b) * * *
(4) Effective date. Paragraphs (b)(2) and (3) of this section are
applicable for taxable years ending on or after December 26, 2002.
Charles O. Rossotti,
Commissioner of Internal Revenue.
[FR Doc. 01-31007 Filed 12-21-01; 8:45 am]
BILLING CODE 4830-01-P