Proposed Regs on Research Credit Issued

The IRS has issued proposed regulations (REG-105170-97) on the definition of qualified research under section 41(d) and the computation of the research credit under section 41(c). The proposed regs reflect changes made to section 41 by the Tax Reform Act of 1986 (1986 Act), the Revenue Reconciliation Act of 1989, the Small Business Job Protection Act of 1996, and the Taxpayer Relief Act of 1997.

In determining eligibility for the research credit under section 41(d), "qualified research" activities must satisfy a multipart eligibility test. The proposed regs clarify the definition of "qualified research" by providing additional guidance on the multipart test.

Under the multipart test, expenditures must relate to research undertaken for the purpose of discovering information that is technological in nature. The proposed regs provide that research is undertaken for this purpose only if (1) it is undertaken to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in the particular field of technology or science; and (2) the process of experimentation fundamentally relies on principles of physical or biological sciences, engineering, or computer science.

The multipart test also requires that substantially all of the research activities are elements of a process of experimentation that relates to a new or improved function, performance, reliability, or quality. The proposed regs explain that a process of experimentation is a process that involves the evaluation of more than one alternative designed to achieve an intended result, when the means of achieving the intended result are uncertain at the outset. Under the proposed regs, the process of experimentation requires that the taxpayer (1) develop one or more hypotheses designed to achieve an intended result; (2) design a scientific experiment to test and analyze the hypotheses; (3) conduct the experiment and record the results; and (4) refine or discard the hypotheses as part of a sequential design process to develop or improve the business component.

The proposed regs also explain that the "shrinking back" method should be used when applying the section 41(d) tests to a business component. Under the shrinking back method, if the requirements of section 41(d) are not met for an entire product, the term "business component" means the most significant set of elements of the product for which all of the requirements of section 41(d) are met.

Also, the proposed regs provide documentation requirements for scientific experiments. Taxpayers must record results in a manner appropriate for the particular field of science and comply with the recordkeeping requirements of section 6001.

Finally, the proposed regs provide rules for electing the alternative incremental credit under section 41(c)(4). Taxpayers must make the election on Form 6765, "Credit for Increasing Research Activities," attached to the taxpayer's timely filed original return for the tax year in which the election applies.

The IRS will schedule a public hearing on the proposed regs and asks that persons interested in speaking via teleconference submit requests for teleconference sites by January 18, 1999. Written comments are due by March 2, 1999. Send submissions to Internal Revenue Service, CC:DOM:CORP:R (REG-105170-97), Room 5228, PO Box 7604, Ben Franklin Station, Washington, DC 20044.

This document appeared in TNT as 98 TNT 231-3 and in the AccServ & Microfiche as Doc 98-34925 (42 pages).

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[4830-01-u]

DEPARTMENT OF THE TREASURY

26 CFR Part 1

[REG-105170-97]

RIN 1545-AV14

[1] AGENCY: Internal Revenue Service (IRS), Treasury.

[2] ACTION: Notice of proposed rulemaking.

[3] SUMMARY: This document contains proposed regulations relating to the computation of the credit under section 41(c) and the definition of qualified research under section 41(d). The 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, and the Taxpayer Relief Act of 1997. The proposed regulations also provide certain technical amendments to the regulations.

[4] DATES: Written comments must be received no later than March 2, 1999.

[5] ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-105170- 97), room 5228, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-105170-97), 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.ustreas.gov/prod/tax_regs/comments.html.

[6] FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Lisa J. Shuman or Leslie H. Finlow at (202)622-3120 (not a toll-free number); concerning submission of comments, the hearing, and/or to be placed on the building access list to attend the hearing, La Nita Van Dyke at (202)622-7190 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

[7] The collection of information contained in this notice of proposed rulemaking has been submitted to the Office of Management and Budget for review in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). Comments on the collection of information should be sent to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503, with copies to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC 20224. Comments on the collection of information should be received by March 2, 1999. Comments are specifically requested concerning:

[8] Whether the proposed collection of information is necessary for the proper performance of the functions of the IRS, including whether the information will have practical utility;

[9] The accuracy of the estimated burden associated with the proposed collection of information (see below);

[10] How the quality, utility, and clarity of the information to be collected may be enhanced;

[11] How the burden of complying with the proposed collection of information may be minimized, including through the application of automated collection techniques or other forms of information technology; and

[12] Estimates of capital or start-up costs and costs of operation, maintenance, and purchase of services to provide information.

[13] The collection of information in this proposed regulation is in sections 1.41-4(a) and 1.41-8(b). The information is required by the IRS to ensure that taxpayers have engaged in qualified research and to ensure the proper computation of the credit for increasing research activities under section 41. Section 1.41-4(a) defines a process of experimentation, as required for credit eligibility, to include the recording of the results of the experiments. This requirement imposes no additional recordkeeping burden, because taxpayers engaging in a bona fide process of experimentation already record the results in any event (see discussion under Explanation of Provisions, 3. Documentation, in this preamble). The information required by section 1.41-8 will be used to determine if the taxpayer has elected or revoked the election to use the alternative incremental credit allowed under section 41(c)(4). The collection of information is mandatory. The likely respondents are businesses or other for-profit institutions and organizations. Responses to this collection of information are required to elect to use and to revoke the election to use the alternative incremental credit computation allowed under section 41(c)(4).

[14] The reporting burden contained in section 1.41-8(b)(2) (relating to the election of the alternative incremental credit) is reflected in the burden of Form 6765.

[15] Estimated total annual reporting burden under section 1.41-8(b)(3) (relating to the revocation of the election to use the alternative incremental credit): 250 hours.

[16] Estimated average annual burden hours per respondent: 50 hours.

[17] Estimated number of respondents: 5.

[18] Estimated frequency of responses: On occasion.

[19] 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 the Office of Management and Budget.

[20] 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

[21] The research credit provisions originally appeared in section 44F of the Internal Revenue Code of 1954 (the 1954 Code), as added to the 1954 Code by section 221 of the Economic Recovery Tax Act of 1981. Section 471(c) of the Tax Reform Act of 1984 redesignated section 44F as section 30. Section 231 of the Tax Reform Act of 1986 (the 1986 Act) redesignated section 30 as section 41 and substantially modified the research credit provisions. The amendments made to section 41 by the 1986 Act primarily relate to the definition of qualified research in section 41(d) and the computation of BASIC RESEARCH payments under section 41(e). The Revenue Reconciliation Act of 1989 (the 1989 Act), the Revenue Reconciliation Act of 1993 (the 1993 Act), the Small Business Job Protection Act of 1996 (the 1996 Act), and the Taxpayer Relief Act of 1997 (the 1997 Act) also amended the research credit provisions. These amendments primarily relate to the trade or business requirement in section 41(b) and the computation of the credit under sections 41(c) and 41(f).

[22] On May 17, 1989, the IRS published in the Federal Register (54 FR 21203) final regulations under section 41. The 1989 final regulations generally do not reflect the amendments to section 41 made by the 1986 Act, the 1989 Act, the 1993 Act, the 1996 Act, and the 1997 Act. The amendments proposed by this document contain rules relating primarily to the amendments to section 41(d) made by the 1986 Act. The amendments proposed by this document also contain some rules relating to amendments to section 41 made by the 1989 Act, the 1996 Act, and the 1997 Act.

[23] On January 2, 1997, the IRS published in the Federal Register (62 FR 81) proposed regulations (the 1997 proposed regulations) under section 41 describing when computer software that is developed by (or for the benefit of) a taxpayer primarily for the taxpayer's internal use can qualify for the credit for increasing research activities. The 1997 proposed regulations reflect a change to section 41 made by the 1986 Act. The proposed regulations set forth in this notice of proposed rulemaking complement but otherwise do not affect the 1997 proposed regulations.

[24] The Tax and Trade Relief Extension Act of 1998 extended the research credit from June 30, 1998 through June 30, 1999. In the Conference Report, H.R. Rep. No. 105-825, at 1547-49 (1998), the conferees address the scope of the term qualified research, comment on an aspect of the process of experimentation requirement, and note a lack of clarity in the interpretation of the distinction between internal-use software and other software. These proposed regulations reflect the views expressed by the conferees, as well as prior legislative history, regarding the term qualified research and the process of experimentation. The IRS and Treasury request comments on the distinction between internal-use software and other software.

Explanation of Provisions

1. Qualified Research

[25] Congress enacted the research credit to encourage business firms to perform the research necessary to increase the innovative qualities and efficiency of the U.S. economy. H.R. Rep. No. 99-426, at 177 (1985); S. Rep. No. 99-313, at 694 (1986). In extending the research credit in the 1986 Act, Congress expressed concern that, in practice, taxpayers had applied the existing definition of qualified research too broadly and some taxpayers had claimed the credit for virtually any expense relating to product development. H.R. Rep. No. 99-426, at 178; S. Rep. No. 99-313, at 694-95. Many taxpayers claiming the credit were not in industries that involved high technology or its application in developing technologically new and improved products or methods of production. H.R. Rep. No. 99-426, at 178; S. Rep. No. 99-313, at 695.

[26] To address these concerns, Congress narrowed the scope of the research credit by providing in the Internal Revenue Code (Code) an express definition of the term qualified research. In determining eligibility for the research credit, section 41(d) requires that qualified research activities satisfy a multi-part test. First, the taxpayer's expenditures must be eligible to be treated as expenses under section 174. See section 1.174-2(a)(1) (defining research and experimental expenditures).

[27] Second, the expenditures must relate to research undertaken for the purpose of discovering information that is both technological in nature and the application of which is intended to be useful in developing a new or improved business component of the taxpayer. The proposed regulations provide that research is undertaken for the purpose of discovering information that is technological in nature only if the research activities are undertaken to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in the particular field of technology or science and the process of experimentation utilized fundamentally relies on principles of physical or biological sciences, engineering, or computer science. Consistent with the requirement that the research activities be undertaken to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in the particular field of technology or science, the credit may be available where the technological advance sought by the taxpayer is evolutionary, and, in certain circumstances, where the taxpayer is not the first to achieve the same advance. Moreover, the credit is available regardless of whether the taxpayer succeeds or fails in achieving the desired advance.

[28] Third, section 41(d) requires that substantially all of the activities of the research constitute elements of a process of experimentation that relates to a new or improved function, performance, reliability or quality. As noted in the previous paragraph, the process of experimentation utilized must fundamentally rely on principles of physical or biological sciences, engineering, or computer science.

[29] In developing a process of experimentation rule applicable to all scientific disciplines, IRS personnel met with personnel from the National Science Foundation and the National Institute of Standards and Technology. The proposed regulation explains that a process of experimentation is a process involving the evaluation of more than one alternative designed to achieve a result where the means of achieving that result are uncertain at the outset. This requires that the taxpayer (i) develop one or more hypotheses designed to achieve the intended result; (ii) design a scientific experiment (that, where appropriate to the particular field of research, is intended to be replicable with an established experimental control) to test and analyze those hypotheses (through, for example, modeling, simulation, or a systematic trial and error methodology); (iii) conduct the experiment and record the results; and (iv) refine or discard the hypotheses as part of a sequential design process to develop or improve the business component.

[30] The proposed regulation does not require that the results of the experiments be recorded in any specific manner. The results of the experiments should be recorded in a manner that is appropriate for the particular field of science in which the experiment is conducted and for the type of experimentation involved. In some fields, for example, experiments are recorded in lab books. When developing computer software, by contrast, the experiments might be recorded in comment lines contained in the source code.

[31] In the 1986 Act, Congress also specified that expenditures incurred in certain research, research-related, or non-research activities are not eligible for the credit. The excluded activities are: post-production activities, adaptation, duplication, surveys and studies, research outside the United States, research in the social sciences, funded research, and research related to certain internal- use computer software.

[32] Section 1.41-4 of this proposed regulation contains rules that clarify the definition of the term qualified research and other terms used in section 41(d). The proposed regulation also provides rules relating to activities for which the research credit is not allowed.

2. Application of Tests

[33] In the legislative history to the 1986 Act, Congress stated that if the requirements of section 41(d) are not met for an entire product, the term business component means the most significant set of elements of that product for which all the requirements of section 41(d) are met. The legislative history provides that this "shrinking back" 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.

[34] Consistent with the legislative history, section 1.41-4(b) of the proposed regulation explains that the "shrinking-back" concept is the method for applying the tests in section 41(d) to a business component.

3. Documentation

[35] Taxpayers must (a) record the results of their scientific experiments (in a manner that is appropriate for the particular field of science in which the experiment is conducted and for the type of experiment involved) and (b) comply with the recordkeeping requirements of section 6001 and the regulations thereunder. The requirement that taxpayers record the results of their scientific experiments is not intended to cause taxpayers to create records that otherwise would not be created. Rather, the recording of results is inherent in a process of experimentation to discover information that is technological in nature. Limiting the availability of the credit to taxpayers who record the results of their scientific experiments is not intended to change taxpayer behavior, but to identify taxpayers who engage in a bona fide process of experimentation and thus may be eligible for the credit.

4. Election of the Alternative Incremental Credit

[36] The notice of proposed rulemaking provides rules for electing the alternative incremental credit, which may be elected under section 41(c)(4). Section 1.41-8 of the proposed regulation provides that the election is made on Form 6765, "Credit for Increasing Research Activities," and that the completed form must be attached to the taxpayer's timely filed original return (including extensions) for the taxable year to which the election applies.

Proposed Effective Date

[37] In general, the regulations are proposed to be effective for expenditures paid or incurred on or after the date final regulations are published in the Federal Register. The regulations addressing the base amount are proposed to be effective for taxable years beginning on or after the date final regulations are published in the Federal Register. The regulations providing for the election and revocation of the alternative incremental credit are proposed to be effective for taxable years ending on or after the date final regulations are published in the Federal Register. No inference should be drawn from the proposed effective date concerning the application of section 41 to expenditures paid or incurred or the computation of the base amount before the proposed effective date.

Special Analyses

[38] It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. It is hereby certified that the collection of information contained in these regulations will not have a significant economic impact on a substantial number of small entities. Accordingly, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. This certification is based on the information that follows. The economic impact of the collection of information contained in these regulations on any small entity would result from the entity being required to (1) record the results of experiments related to its qualified research activities, (2) elect on Form 6765 to use the alternative incremental credit if the entity desires to use that method, and (3) obtain permission to revoke the alternative incremental credit election, if so desired. Because taxpayers record results in conducting their research activities in any event (see discussion under Explanation of Provisions, 3. Documentation, in this preamble), the economic impact of the recordkeeping requirement in the regulation would not be significant. The economic impact of electing the alternative incremental credit on Form 6765 also would not be significant because the election is made on the same form and is based on the same information that is used to claim the research credit. Pursuant to section 7805(f), 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

[39] Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (preferably a signed original and eight (8) copies) that are submitted timely (in the manner described in the ADDRESSES portion of this preamble) to the IRS. Submissions might include comments on the definition of gross receipts, comments regarding the exclusion for post-production activities, comments on whether and how the definition of a process of experimentation should be refined to ensure that it is appropriate for all scientific fields, and comments on the interaction of the discovery requirement and the duplication exclusion and the effect of such interaction on specific industries. Also, submissions might include comments on clarifying the distinction between internal- use software (i.e., software described in section 41(d)(4)(E)) and other software. All comments will be available for public inspection and copying.

[40] A public hearing will be scheduled in the Internal Revenue Building, 1111 Constitution Avenue, NW., Washington, DC. The IRS recognizes that persons outside the Washington, DC area also may wish to testify at the public hearing through teleconferencing. Requests to include teleconferencing sites must be received by January 18, 1999. If the IRS receives sufficient indications of interest to warrant teleconferencing to a particular city, and if the IRS has teleconferencing facilities available in that city on the date the public hearing is to be scheduled, the IRS will try to accommodate the requests.

[41] The IRS will publish the time and date of the public hearing and the locations of any teleconferencing sites in an announcement in the Federal Register. The announcement will include the date by which persons that wish to present oral comments at the hearing must submit requests to speak, outlines of the topics to be discussed, and the time to be devoted to each topic.

[42] 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.

Drafting Information

[43] The principal authors of these proposed regulations are Lisa J. Shuman and Leslie H. Finlow of the Office of the Assistant Chief Counsel (Passthroughs and Special Industries). However, personnel from other offices of the IRS and the Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

[44] Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

[45] Accordingly, 26 CFR part 1 is proposed to be amended as follows. (Note: The proposed amendments complement the proposed amendments published at 62 FR 83, January 2, 1997.)

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. Revise the undesignated centerheading immediately before section 1.30-1 to read as follows:

CREDITS ALLOWABLE UNDER SECTION 30 THROUGH 44B

Par. 3. Remove the undesignated centerheading immediately before section 1.41-0.

Par. 4. Section 1.41-0 is revised to read as follows:

SECTION 1.41-0 TABLE OF CONTENTS.

This section lists the paragraphs contained in

SECTIONS 1.41-0 THROUGH 1.41-8.

SECTION 1.41-0 TABLE OF CONTENTS.

SECTION 1.41-1 CREDIT FOR INCREASING RESEARCH ACTIVITIES.

(a) Basic principles.

SECTION 1.41-2 QUALIFIED RESEARCH EXPENSES.

(a) Trade or business requirements.

(1) In general.

(i) Taxpayer not entitled to results.

(4) Partnerships.

(i) In general.

(b) Supplies and personal property used in the conduct of

(1) In general.

(i) In general.

(3) Right to use personal property.

(c) Qualified services.

(1) Engaging in qualified research.

(d) Wages paid for qualified services.

(1) In general.

(e) Contract research expenses.

(1) In general.

SECTION 1.41-3 BASE AMOUNT FOR TAXABLE YEARS BEGINNING ON OR AFTER

(a) and (b) [Reserved]

(1) In general.

(d) Consistency requirement.

(1) In general.

SECTION 1.41-4 QUALIFIED RESEARCH FOR EXPENDITURES PAID OR INCURRED

(a) Qualified research.

(1) General rule.

(b) Application of requirements for qualified research.

(1) In general.

(c) Excluded activities.

(1) In general.

(i) In general.

(3) Adaptation of existing business components.

(i) In general.

(8) Research in the social sciences, etc.

(d) Documentation.

SECTION 1.41-5 BASIC RESEARCH FOR TAXABLE YEARS BEGINNING AFTER

SECTION 1.41-6 AGGREGATION OF EXPENDITURES.

(a) Controlled group of corporations; trades or businesses under

(1) In general.

(b) Minimum base period research expenses.

(1) In general.

(d) Membership during taxable year in more than one group.

(1) In general.

SECTION 1.41-7 SPECIAL RULES.

(a) Allocations.

(1) Corporation making an election under subchapter S.

(i) Pass-through for taxable years beginning after

(2) Pass-through in the case of an estate or trust.

(i) In general.

(4) Year in which taken into account.

(b) Adjustments for certain acquisitions and dispositions --

SECTION 1.41-8 SPECIAL RULES FOR TAXABLE YEARS ENDING ON OR AFTER

(a) Alternative incremental credit.

(1) In general.

Par. 5. Section 1.41-1 is revised to read as follows:

SECTION 1.41-1 CREDIT FOR INCREASING RESEARCH ACTIVITIES.

(a) Basic principles. Section 41 provides a credit for increasing research activities. The credit is intended to encourage business firms to perform the technological research necessary to increase the innovative qualities and efficiency of the U.S. economy. The credit provides an incentive for business firms to increase their expenditures for research to obtain new knowledge through a scientific process of experimentation. Consequently, the credit is not to be applied too broadly or in a manner such that virtually any expense relating to the development of a product is eligible for the credit, even if some portion of the expense of developing the product does qualify for the credit. Similarly, the credit is not available for an expenditure merely because the expenditure may be treated as an expense under section 174. On the other hand, the credit may be available even though the technological advance sought by the taxpayer is evolutionary, and, in certain circumstances, even if another taxpayer has previously achieved the same advance. Moreover, the credit is available regardless of whether the taxpayer succeeds or fails in achieving the desired advance. The credit is limited to eligible expenditures paid or incurred for qualified research, as defined in section 41(d) and section 1.41-4.

(b) Amount of credit. The amount of a taxpayer's credit is determined under section 41(a). For taxable years beginning after June 30, 1996, and at the election of the taxpayer, the portion of the credit determined under section 41(a)(1) may be calculated using the alternative incremental credit set forth in section 41(c)(4).

(c) Introduction to regulations under section 41. (1) Sections 1.41-2 through 1.41-8 and 1.41-3A through 1.41-5A address only certain provisions of section 41. The following table identifies the provisions of section 41 that are addressed, and lists each provision with the section of the regulations in which it is covered.

Section of the           Section of the

section 1.41-2                41(b)

(2) Section 1.41-3A also addresses the special rule in section 221(d)(2) of the Economic Recovery Tax Act of 1981 relating to taxable years overlapping the effective dates of section 41. Section 41 was formerly designated sections 30 and 44F. Sections 1.41-0 through 1.41-8 and 1.41-0A through 1.41-5A refer to these sections as section 41 for conformity purposes. Whether section 41, former section 30, or former section 44F applies to a particular expenditure depends upon when the expenditure was paid or incurred.

SECTION 1.41-2 [AMENDED]

Par. 6. Section 1.41-2 is amended as follows:

1. The last sentence of paragraph (a)(3)(i) is amended by removing the language "section 1.41-5(d)(2)" and adding "section 1.41-4A(d)(2)" in its place.

2. The last sentence of paragraph (a)(3)(ii) is amended by removing the language "section 1.41-5(d)(3)" and adding "section 1.41-4A(d)(3)" in its place.

3. The last sentence of paragraph (a)(4)(ii)(F) is amended by removing the language "section 1.41-9(a)(3)(ii)" and adding "section 1.41- 7(a)(3)(ii)" in its place.

4. Paragraph (e)(1)(i) is amended by removing the language "section 1.41-5" and adding "section 1.41-4 or 1.41-4A, whichever is applicable" in its place.

Par. 7. An undesignated centerheading is added immediately following section 1.44B-1 to read as follows:

RESEARCH CREDIT -- FOR TAXABLE YEARS BEGINNING BEFORE

SECTION 1.41-3 [REDESIGNATED AS SECTION 1.41-3A]

Par. 8. Section 1.41-3 is redesignated as section 1.41-3A and added under the new undesignated centerheading "RESEARCH CREDIT -- FOR TAXABLE YEARS BEGINNING BEFORE JANUARY 1, 1990."

Par. 9. New section 1.41-3 is added to read as follows:

SECTION 1.41-3 BASE AMOUNT FOR TAXABLE YEARS BEGINNING ON OR AFTER

(a) and (b) [Reserved]

(c) Definition of gross receipts -- (1) In general. For purposes of section 41, gross receipts means the total amount, as determined under the taxpayer's method of accounting, derived by the taxpayer from all its activities and from all sources (e.g., revenues derived from the sale of inventory before reduction for cost of goods sold).

(2) Amounts excluded. For purposes of this paragraph (c), gross receipts do not include amounts representing --

(i) Returns or allowances;

(ii) Receipts from the sale or exchange of capital assets, as defined in section 1221;

(iii) Repayments of loans or similar instruments (e.g., a repayment of the principal amount of a loan held by a commercial lender);

(iv) Receipts from a sale or exchange not in the ordinary course of business, such as the sale of an entire trade or business or the sale of property used in a trade or business as defined under section 1221(2); and

(v) Amounts received with respect to sales tax or other similar state and local taxes if, under the applicable state or local law, the tax is legally imposed on the purchaser of the good or service, and the taxpayer merely collects and remits the tax to the taxing authority.

(3) Foreign corporations. For purposes of section 41, in the case of a foreign corporation, gross receipts include only gross receipts that are effectively connected with the conduct of a trade or business within the United States. See section 864(c) and applicable regulations thereunder for the definition of effectively connected income.

(d) Consistency requirement -- (1) In general. In computing the credit for increasing research activities for taxable years beginning after December 31, 1989, qualified research expenses and gross receipts taken into account in computing a taxpayer's fixed-base percentage and a taxpayer's base amount must be determined on a basis consistent with the definition of qualified research expenses and gross receipts for the credit year, without regard to the law in effect for the taxable years taken into account in computing the fixed-base percentage or the base amount. This consistency requirement applies even if the period for filing a claim for credit or refund has expired for any taxable year taken into account in computing the fixed-base percentage or the base amount.

(2) Illustrations. The following examples illustrate the application of the consistency rule of paragraph (d)(1) of this section:

          Example 1. (i) X, an accrual method taxpayer using the

          (ii) During the fixed-base period, X reported the following

                  1984              $  100x

          (iii) For the taxable years ending December 31, 1984, and

Example 2. The facts are the same as in Example 1, except that, in computing its qualified research expenses for the taxable year ending December 31, 1999, X claimed that a certain type of expenditure incurred in 1999 was a qualified research expense. X's claim reflected a change in X's position, because X had not previously claimed that similar expenditures were qualified research expenses. The consistency rule requires X to adjust its qualified research expenses in computing the fixed- base percentage to include any similar expenditures not treated as qualified research expenses during the fixed-base period, regardless of whether the period for filing a claim for credit or refund has expired for any year taken into account in computing the fixed-base percentage.

Par. 10. Section 1.41-4 is revised to read as follows:

SECTION 1.41-4 QUALIFIED RESEARCH FOR EXPENDITURES PAID OR INCURRED

(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 (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 section 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) Discovering information. For purposes of section 41(d) and this section, the term discovering information means obtaining knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of technology or science.

(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 physical or biological sciences, engineering, or computer science.

(5) Process of experimentation. For purposes of section 41(d) and this section, a process of experimentation is a process to evaluate more than one alternative designed to achieve a result where the means of achieving that result are uncertain at the outset. A process of experimentation in the physical or biological sciences, engineering, or computer science requires that the taxpayer--

(i) Develop one or more hypotheses designed to achieve the intended result;

(ii) Design a scientific experiment (that, where appropriate to the particular field of research, is intended to be replicable with an established experimental control) to test and analyze those hypotheses (through, for example, modeling, simulation, or a systematic trial and error methodology);

(iii) Conduct the experiment and record the results; and

(iv) Refine or discard the hypotheses as part of a sequential design process to develop or improve the business component.

(6) Substantially all requirement. 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, 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.

(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) of this section:

Example 1. (i) Facts. X undertakes to develop for sale a

(ii) Conclusion. X's activities to develop the technology

Example 2. (i) Facts. X acquired a new software

(ii) Conclusion. X's activities to redeploy its data

Example 3. (i) Facts. X operates a computer system that

(ii) Conclusion. Because the activities of X's employees

Example 4. (i) Facts. X is engaged in the business of

(ii) Conclusion. Even though X's expenditures for the

Example 5. (i) Facts. X desires to build a bridge that can

(ii) Conclusion. X's activities to develop the technology

Example 6. (i) Facts. The facts are the same as in Example

(ii) Conclusion. Z's activities to develop the technology

Example 7. (i) Facts. X and other manufacturing companies

(ii) Conclusion. X's activities to design the new machine

Example 8. (i) Facts. X, a tire manufacturer, seeks to

(ii) Conclusion. Some or all of X's research activities

(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 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 to be held for sale, lease or license, or used by the taxpayer in a trade or business of the taxpayer. If all aspects of the requirements are not met at the first level, the requirements are to be applied at the next most significant subset of elements of the business component. The shrinking-back of the applicable business component continues until a subset of elements of the business component satisfies the requirements of section 41(d) and paragraph (a) of this section (treating that subset of elements as a business component) or the most basic element fails to satisfy the requirements.

(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. For purposes of this example, it is assumed that the new carburetor is the next most significant subset of elements of the business component. 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 sections 41(d)(3)(B) and (4), this paragraph (c), and paragraph (e) 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 or correcting 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.

(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 inspects 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 (except for the direct supervision of qualified research as defined in section 1.41-2(c)(2)) 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 computer software. [Reserved]. /1/

(7) Activities outside the United States -- (i) In general. Research conducted outside the United States, as defined in section 7701(a)(9), 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 and outside the United States must be apportioned between the services performed in the United States and the services performed outside the United States. Only those in-house research expenses apportioned to the services performed within 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 section 1.41- 2(d)(2) applies.

(iii) Apportionment of contract research expenses. If contract research is performed partly in the United States and partly outside 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 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).

(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, section 1.41-4A(d) applies.

(10) Illustrations. The following examples illustrate provisions contained in paragraphs (c)(1) through (9) 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:

Example 1. (i) Facts. X, a pharmaceutical company, performs

(ii) Conclusion. Because the additional tests are performed

Example 2. (i) Facts. The facts are the same as in Example

(ii) Conclusion. Because the new clinical studies are

Example 3. (i) Facts. X, a domestic corporation that

(ii) Conclusion. X's activities of preproduction planning,

Example 4. (i) Facts. X, a computer software development

(ii) Conclusion. Because X's activities represent

Example 5. (i) Facts. An existing gasoline additive is

(ii) Conclusion. X's activities in analyzing and

Example 6. (i) Facts. X, an appliance manufacturer,

(ii) Conclusion. X's activities associated with rearranging

Example 7. (i) Facts. X, an insurance company, develops a

(ii) Conclusion. X's activities related to the new product

(d) Documentation. See section 6001 and the regulations thereunder for the recordkeeping requirements that must be satisfied.

SECTION 1.41-5 [REDESIGNATED AS SECTION 1.41-4A, AND AMENDED]

Par. 11. Section 1.41-5 is redesignated as section 1.41-4A, and the last sentence of paragraph (d)(1) is amended by removing the language "section 1.41-8(e)" and adding "section 1.41-6(e)" in its place.

SECTION 1.41-6 [REDESIGNATED AS SECTION 1.41-5 AND AMENDED]

Par. 12. Section 1.41-6 is redesignated as section 1.41-5 and the section heading is amended by removing the language "December 31, 1985" and adding "December 31, 1986" in its place.

SECTION 1.41-7 [REDESIGNATED AS SECTION 1.41-5A, AND AMENDED]

Par. 13. Section 1.41-7 is redesignated as section 1.41-5A, and amended as follows:

1. The section heading is amended by removing the language "January 1, 1986" and adding "January 1, 1987" in its place.

2. Paragraph (e)(2) is amended by removing the language "section 1.41-5(c)" and adding "1.41-4A(c)" in its place.

SECTION 1.41-8 [REDESIGNATED AS SECTION 1.41-6, AND AMENDED]

Par. 14. Section 1.41-8 is redesignated as section 1.41-6, and the last sentence of paragraph (c) is amended by removing the language "section 1.41-3, except that section 1.41-3(c)(2)" and adding "section 1.41- 3A, except that section 1.41-3A(c)(2)" in its place.

SECTION 1.41-9 [REDESIGNATED AS SECTION 1.41-7]

Par. 15. Section 1.41-9 is redesignated as section 1.41-7.

Par. 16. New section 1.41-8 is added to read as follows:

SECTION 1.41-8 SPECIAL RULES FOR TAXABLE YEARS ENDING ON OR AFTER

(a) Alternative incremental credit. At the election of the taxpayer, the credit determined under section 41(a)(1) equals the amount determined under section 41(c)(4).

(b) Election -- (1) In general. A taxpayer may elect to apply the provisions of the alternative incremental credit in section 41(c)(4) for any taxable year of the taxpayer beginning after June 30, 1996. If a taxpayer makes an election under section 41(c)(4), the election applies to the taxable year for which made and all subsequent taxable years.

(2) Time and manner of election. An election under section 41(c)(4) is made by completing the portion of Form 6765, "Credit for Increasing Research Activities," relating to the election of the alternative incremental credit, and attaching the completed form to the taxpayer's timely filed original return (including extensions) for the taxable year to which the election applies.

(3) Revocation. An election under this section may not be revoked except with the consent of the Commissioner. A taxpayer must attach the Commissioner's consent to revoke an election under section 41(c)(4) to the taxpayer's timely filed original return (including extensions) for the taxable year of the revocation.

Par. 17. Section 1.41-0A is added under the new undesignated centerheading "RESEARCH CREDIT--FOR TAXABLE YEARS BEGINNING BEFORE JANUARY 1, 1990" to read as follows:

SECTION 1.41-0A TABLE OF CONTENTS.

This section lists the paragraphs contained in sections 1.41-0A, 1.41-3A, 1.41-4A and 1.41-5A.

SECTION 1.41-0A TABLE OF CONTENTS.

SECTION 1.41-3A BASE PERIOD RESEARCH EXPENSES.

(a) Number of years in base period.

(1) Short determination year.

(i) Determination years.

(4) Number of months in a short taxable year.

(e) Examples.

SECTION 1.41-4A QUALIFIED RESEARCH FOR TAXABLE YEARS BEGINNING

(a) General rule.

(1) In-house research.

(c) Social sciences or humanities.

(1) In general.

(i) In general.

(4) Independent research and development under the Federal

SECTION 1.41-5A BASIC RESEARCH FOR TAXABLE YEARS BEGINNING BEFORE

(a) In general.

(1) In general.

(d) Written research agreement.

(1) In general.

(i) In general.

(3) Agreement between a qualified fund and a qualified

(e) Exclusions.

(1) Research conducted outside the United States.

(f) Procedure for making an election to be treated as a

SECTION 1.218-0 [REMOVED]

Par. 18. Section 1.218-0 is removed.

SECTION 1.482-7 [AMENDED]

Par. 19. In section 1.482-7, the sixth sentence of paragraph (h)(1) is amended by removing the language "section 1.41-8(e)" and adding "section 1.41-6(e)" in its place.

Michael P. Dolan

FOOTNOTE

/1/ Section 1.41-4(e), proposed on January 2, 1997 (62 FR 83), including any revisions to that proposed rule will be incorporated as this paragraph (c)(6) in the final rule.

END OF FOOTNOTE