Research Credit Regs Would Eliminate Controversial Test
The following article is provided courtesy of CCH, Inc.
Newly proposed regulations relating to the computation of the research credit under IRS Code Sec. 41(c) and the definition of qualified research under IRS Code Sec. 41(d) are designed to lay to rest many of the disputes regarding whether research and experimentation (R&E) expenses qualify for the credit. The proposals would eliminate the "discovery test," which was included in T.D. 8930. Pursuant to that test, R&E expenses do not qualify for the credit unless the taxpayer's research advances the state of knowledge in a particular field. According to the Treasury Department, the discovery test is the single greatest source of controversy between taxpayers and the IRS.
In addition, the proposals describe when computer software that is developed by, or for the benefit of, a taxpayer primarily for internal use would be excepted from the internal-use software exclusion of Code Sec. 41(d)(4)(E). Further, the regulations cover the documentation necessary to substantiate the research credit.
Elimination of "Discovery Test"
The proposed regulations do not retain the requirement from T.D. 8930 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, they state 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. For purposes of this requirement, uncertainty exists if the information 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.
The definition in T.D. 8930 of "technological in nature" would be expanded. Information would be technological in nature if the process of experimentation used to discover the information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science. The proposals clarify the definition by providing that a taxpayer could employ existing technologies and could rely on existing principles of the physical or biological sciences, engineering, or computer science to satisfy the requirement.
A taxpayer would be 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 the taxpayer were awarded a patent for the business component. This patent safe harbor rule would conform to the underlying requirement for credit eligibility in Code Sec. 41(d)(1)(B)(i) that research must be undertaken for the purpose of discovering information that is technological in nature.
Process of Experimentation
The proposals 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 would have to be determined based on the facts and circumstances. The regulations set forth nonexclusive factors that are indicative of a process of experimentation.
The IRS has requested comments on the provision in T.D. 8930 that the "substantially all" requirement of Code Sec. 41(d)(1)(C) is satisfied only if 80% 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 Code Sec. 41(d)(3). The proposals retain that rule, and input is being sought on its application. In particular, the IRS is seeking comments on whether research expenses incurred for nonqualified purposes are includible in the credit computation provided that substantially all of the research expenses constitute elements of a process of experimentation.
Software developed by, or for the benefit of, a taxpayer primarily to be commercially sold, leased, licensed, or otherwise marketed for separately stated consideration to unrelated third parties would not be treated as internal-use software. All other software would be presumed to be developed by, or for the benefit of, the taxpayer primarily for its internal use.
The rule in T.D. 8930 that internal-use software does not include computer software and hardware developed as a single product has been modified by the proposed regulations. Internal-use software would not include a new or improved package of computer software and hardware developed together by the taxpayer as a single product 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.
The proposals would retain the general rule that internal-use software must satisfy the requirements for credit eligibility and the three-part high threshold of innovation test. Also, they would provide that software is not required to satisfy that test if it was developed for use in an activity that constitutes qualified research, a production process that satisfies Code Sec. 41(d)(1), or in providing computer services to customers. However, the special rule in T.D. 8930 for software used to deliver noncomputer services to customers with features that are not yet offered by a taxpayer's competitors would be eliminated.
The revisions to the internal-use software rules are proposed to be effective for tax years beginning after 1985. Nevertheless, taxpayers may continue to rely on T.D. 8930 until the new regulations are finalized.
A public hearing on the proposed regulations will begin at 10:00 a.m. on March 22, 2002, in the IRS Auditorium (seventh floor), Internal Revenue Building, 1111 Constitution Ave., NW., Washington, DC. Interested parties have until March 6, 2002, to submit comments, requests to speak, and outlines of topics to be discussed at the hearing to the IRS, P.O. Box 7604, Ben Franklin Station, Room 5226, Attn: CC:IT&A:RU (REG-112991-01), Washington, D.C. 20044. Comments may also be submitted electronically by selecting the "Tax Regs" option on the IRS's homepage.