Final Regulations for Research Credit


The following article is provided courtesy of CCH, Inc.


Newly finalized Treasury regulations relate to the computation of the Code Sec. 41 credit for increasing research activities and to the definition of "qualified research" for purposes of the credit. The regulations provide guidance regarding:

  • The requirements necessary to qualify for the credit;

  • Computation of the credit; and

  • Electing and revoking the election of the alternative incremental credit.
  • In order for expenditures to give rise to the research credit:

  • They must qualify as research and experimental expenditures under Code Sec. 174;

  • They must relate to research undertaken for the purpose of discovering information that is technological in nature, and the application of which is intended to be useful in developing a new or improved business component of the taxpayer; and

  • Substantially all of the activities of the research must constitute elements of a process of experimentation that relates to a new or improved function, performance, reliability or quality.
  • The 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 science or engineering; and

  • The process of experimentation utilized fundamentally relies on principles of the physical or biological sciences, engineering or computer science.
  • A rebuttable presumption is included in the regulations regarding satisfaction of the discovery requirement. If a taxpayer demonstrates with credible evidence that research activities were undertaken to obtain the information described in documentation prepared before or during the early stages of the research and if that documentation also sets forth the basis for the taxpayer's belief that obtaining the information would exceed, expand, or refine the common knowledge of skilled professionals in the particular field of science or engineering, then the research activities are presumed to satisfy the discovery requirement.

    However, this rebuttable presumption would arise only if the taxpayer cooperates with reasonable requests by the IRS for witnesses, information, documents, meetings and interviews. In circumstances where the rebuttable presumption arises, the regulations provide that the IRS may overcome the presumption by demonstrating that the information described in the taxpayer's documentation was within the common knowledge of skilled professionals in the particular field of science or engineering.

    The requirement that a taxpayer seek to exceed, expand or refine the common knowledge of skilled professionals does not mean that the tools and principles used in the attempt to achieve the technological advance must be beyond the common knowledge. Moreover, a regulatory patent safe harbor provides that a taxpayer who was awarded a patent for a business component will be 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. Qualification under the patent safe harbor, however, will not necessarily establish that the discovery requirement is satisfied with respect to all of the research associated with the patentable invention.

    Under the regulations, a taxpayer conducting a process of experimentation may, but is not required to, engage in the four-step process that consists of

  • The development of one or more hypotheses designed to achieve the intended result;

  • The design of a scientific experiment to test and analyze those hypotheses;

  • The conduct of the experiment; and

  • The refining or discarding of the hypotheses as part of a sequential design process to develop or improve the business component.
  • 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. Taxpayers are not required by the regulations to record the results of their experiments. However, they must 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 sought. Also, the general recordkeeping requirements of Code Sec. 6001 must be satisfied.

    The regulations also incorporate a "shrinking-back rule" under which, if the requirements of Code Sec. 41(d) are not met for an entire product, the credit may be available with respect to the next most significant subset of elements of that product. This shrinking back continues either until a subset of elements of the product that satisfies the requirements is reached, or until the most basic element of the product is reached and such element fails to satisfy the test.

    The shrinking-back rule applies only if the taxpayer incurs some research expenses in connection with the overall business component that would constitute qualified research expenses with respect to that component but for the fact that less than substantially all of the research activities regarding that component constitute elements of a process of experimentation that relates to a new or improved function, performance, reliability or quality. If the original product is ineligible for the credit, application of the shrinking-back rule may result in credit eligibility for multiple business components that are subsets of the original product. The regulations clarify that the shrinking-back rule cannot itself be applied as a reason to exclude research activities from credit eligibility.

    The regulations also describe 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 rules clarify that the determination of whether software is internal-use software depends on the nature of the service provided by the taxpayer. Software that is intended to be used to provide noncomputer services to customers is internal-use software, while software that is to be used to provide computer services is not developed primarily for internal use.


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