T.D. 8930 (January 2001 Final Regulations)

[Federal Register: January 3, 2001 (Volume 66, Number 2)]

[Rules and Regulations]

[Page 280-296]

From the Federal Register Online via GPO Access [wais.access.gpo.gov]

[DOCID:fr03ja01-15]

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8930]

RINs 1545-AV14 and 1545-A051

Credit for Increasing Research Activities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the

computation of the credit under section 41(c) and the definition of

qualified research under section 41(d). These regulations are intended

to provide guidance concerning the requirements necessary to qualify

for the credit for increasing research activities, guidance in

computing the credit for increasing research activities, and rules for

electing and revoking the election of the alternative incremental

credit. These regulations reflect changes to section 41 made by the Tax

Reform Act of 1986 (the 1986 Act), 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 (the

1998 Act), and the Tax Relief Extension Act of 1999 (the 1999 Act).

These regulations also provide certain technical amendments to the

existing regulations.

DATES: Effective Dates: These regulations are effective January 3,

2001.

Applicability Dates: For dates of applicability of these

regulations, see Effective Dates under SUPPLEMENTARY INFORMATION.

FOR FURTHER INFORMATION CONTACT: Lisa J. Shuman or Leslie H. Finlow at

(202) 622-3120 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in Sec. 1.41-8(b) of this

final rule have been reviewed and approved by the Office of Management

and Budget in accordance with the Paperwork Reduction Act of 1995 (44

U.S.C. 3507) under the number 1545-1625. Responses to these collections

of information are mandatory.

The reporting burden contained in Sec. 1.41-8(b)(2) (relating to

the election of the alternative incremental credit) is reflected in the

burden of Form 6765.

Estimated average annual burden hours per respondent under

Sec. 1.41-8(b)(3) (relating to the revocation of the election to use

the alternative incremental credit) is 250 hours.

Comments concerning the accuracy of this burden estimate and

suggestions for reducing this burden should be sent to the Internal

Revenue Service, Attn: IRS Reports Clearance Officer, W:CAR:MP:FP:S:O,

Washington, DC 20224, and 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.

The collections of information contained in Sec. 1.41-4(d) of this

final rule have been reviewed and, pending receipt and evaluation of

public comments, approved by the Office of Management and Budget (OMB)

under 44 U.S.C. 3507 and assigned control number 1545-1625. This

information is required to assist in the examination of the research

credit and to ensure that the research credit is properly targeted to

serve as an incentive to engage in qualified research. This information

will be used to verify that the amounts treated as qualified research

expenses were paid or incurred for activities intended to discover

information that exceeds, expands, or refines the common knowledge of

skilled professionals in the relevant field of science or engineering.

This collection of information is required to obtain a benefit. The

likely recordkeepers are businesses or other for-profit institutions.

Estimated total annual recordkeeping burden for Sec. 1.41-4(d) is

18,000 hours. The annual estimated burden per respondent varies from .5

hours to 2.5 hours, depending on the circumstances, with an estimated

average of 1.5 hours.

The estimated number of recordkeepers is 12,000.

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, W:CAR:MP:FP:S:O,

[[Page 281]]

Washington, DC 20224. Comments on the collection of information should

be received by March 5, 2001. Comments are specifically requested

concerning:

Whether the collection of information is necessary for the proper

performance of the functions of the Internal Revenue Service, including

whether the information will have practical utility;

The accuracy of the estimated burden associated with the collection

of information (see below);

How the quality, utility, and clarity of the information to be

collected may be enhanced;

How the burden of complying with the collection of information may

be minimized, including through the application of automated collection

techniques or other forms of information technology; and

Estimates of capital or start-up costs and costs of operation,

maintenance, and purchase of services to provide information.

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.

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 2, 1997, the IRS and Treasury published in the Federal

1997-1 C.B. 723) 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). Comments

responding to the 1997 proposed regulations were received and a public

hearing was held on May 13, 1997.

On December 2, 1998, the IRS and Treasury published in the Federal

1998-50 I.R.B. 10) under section 41 relating to the credit for

increasing research activities (the 1998 proposed regulations). The

1998 proposed regulations propose rules and examples relating to (1)

the definition of gross receipts for purposes of computing the base

amount under section 41(c), (2) the application of the consistency rule

in computing the base amount, (3) the definition of qualified research

under section 41(d), (4) the application of the exclusions from the

definition of qualified research, (5) the application of the shrinking-

back rule, and (6) the election of the alternative incremental credit.

The 1998 proposed regulations also propose certain technical amendments

to the existing regulations. Comments responding to the 1998 proposed

regulations were received and a public hearing was held on April 29,

1999.

In the 1999 Act, Congress extended the credit for a five-year

period. The Conference Report accompanying the 1999 Act included the

following language addressing the proposed regulations:

In extending the research credit, the conferees are concerned

that the definition of qualified research be administered in a

manner that is consistent with the intent Congress has expressed in

enacting and extending the research credit. The conferees urge the

Secretary to consider carefully the comments he has and may receive

regarding the proposed regulations relating to the computation of

the credit under section 41(c) and the definition of qualified

research under section 41(d), particularly regarding the ``common

knowledge'' standard. The conferees further note the rapid pace of

technological advance, especially in service-related industries, and

urge the Secretary to consider carefully the comments he has and may

receive in promulgating regulations in connection with what

constitutes ``internal use'' with regard to software expenditures.

The conferees also wish to observe that software research, that

otherwise satisfies the requirements of section 41, which is

undertaken to support the provision of a service, should not be

deemed ``internal use'' solely because the business component

involves the provision of a service.

The conferees wish to reaffirm that qualified research is

research undertaken for the purpose of discovering new information

which is technological in nature. For purposes of applying this

definition, new information is information that is new to the

taxpayer, is not freely available to the general public, and

otherwise satisfies the requirements of section 41. Employing

existing technologies in a particular field or relying on existing

principles of engineering or science is qualified research, if such

activities are otherwise undertaken for purposes of discovering

information and satisfy the other requirements of section 41.

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

record keeping requirements.

H.R. Conf. Rep. No. 106-478, at 132 (1999).

After considering the comments received, the statements made at the

public hearings, and the legislative history for the research credit,

the proposed regulations are adopted as revised by this Treasury

decision.

Explanation of Provisions

This document amends 26 CFR part 1 to provide additional rules

under section 41. Section 41 contains the rules for the credit for

increasing research activities.

I. Basic Principles

A number of commentators objected to the inclusion of the basic

principles statement in Sec. 1.41-1(a) of the proposed regulations.

They stated that the inclusion of a basic principles section was

unusual, and that the basic principles section could be read to impose

additional and unwarranted conditions for credit eligibility. In

response to these comments, and because IRS and Treasury have concluded

that the requisite principles are adequately reflected in the

provisions of the regulations, the final regulations omit a separate

statement of basic principles. The clarifications that the credit may

be available where the technological advance sought is evolutionary,

where the taxpayer is not the first to achieve the advance, and where

the taxpayer fails to achieve the intended advance have been

incorporated elsewhere in the regulations.

II. 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).

The proposed regulations generally defined gross receipts as the

total amount derived by a taxpayer from all activities and sources.

However, in recognition of the fact that certain extraordinary gross

receipts might not be taken into account when a business determines its

research budget, the proposed regulations provided that certain

extraordinary items (such as receipts from the sale or exchange of

capital assets) would be excluded from the computation of gross

receipts.

Several commentators objected to the definition of gross receipts

in the proposed regulations. Referring to the inclusion in a House

Budget Report of the term sales growth as an apparent

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short-hand reference to an increase in gross receipts, some

commentators argued that gross receipts should be limited to income

from sales. See H.R. Rep. No. 101-247, at 1200 (1989). In determining

its research budget, however, a business may take into account any

expected income stream, regardless of whether or not the income is

derived from sales or from other active business activities. Moreover,

many businesses do not generate any income in the form of sales.

Accordingly, the final regulations do not adopt this suggestion.

The final regulations also do not adopt suggestions that the

definition of gross receipts be narrowed to exclude those items not

directly related to the conduct of the taxpayer's trade or business. As

noted above, any expected income stream may be taken into account in

determining a business' research budget, regardless of the source of

the income. Moreover, IRS and Treasury believe that a subjective

narrowing of the term gross receipts, as suggested by these

commentators, could leave the definition of the term, and thus the

computation of the base amount, vulnerable to manipulation.

For example, a narrower definition allowing taxpayers to exclude

items not derived in the ordinary course of business might prompt a

taxpayer to assert that certain royalties received in the 1980s were

derived in the ordinary course of business and are includable as gross

receipts (thus decreasing the taxpayer's fixed-base percentage), but

that certain interest income received in the years preceding the credit

year was not derived in the ordinary course of business and was not

includable in gross receipts (thus decreasing the base amount). Nor

would a rule of consistency be effective in preventing such

manipulation. While the taxpayer described above would be

characterizing the nature of its income items as derived or not derived

in the ordinary course of a trade or business so as to maximize the

amount of the credit, the taxpayer would not be taking inconsistent

positions with respect to the same items of income.

Several commentators objected to the definition of gross receipts

in the proposed regulations as it applies to start-up firms with pre-

operating interest income. If pre-operating interest income is treated

as a gross receipt, many start-up firms would be precluded from using

the start-up rules to compute their fixed-base percentages, because the

application of the start-up rules is conditioned on a taxpayer not

having both gross receipts and qualified research expenses in certain

taxable years during the 1980s. Moreover, because a start-up firm whose

only gross receipt is pre-operating interest income likely would have

significant qualified research expenses relative to gross receipts (and

thus a high fixed-base percentage), such a firm likely would derive

less benefit from the credit.

IRS and Treasury recognize that the start-up rules appear to

contemplate that there will be years in which a taxpayer has qualified

research expenses but no gross receipts. However, it would be difficult

to conceive of such a year if gross receipts are defined to include

pre-operating investment income. To address these concerns and pursuant

to the regulatory authority of section 41(c)(3)(B)(iii), the final

regulations exclude from the definition of gross receipts any income

received 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. For this purpose, investment

income is defined as interest or distributions with respect to stock

(other than the stock of a 20-percent owned corporation as defined in

section 243(c)(2) of the Code).

Some commentators suggested that the definition of gross receipts

should be clarified to exclude certain payments made by pharmaceutical

manufacturers to various insurers, managed care organizations and state

governments. The final regulations do not adopt any provision

specifically addressing such payments.

III. The Discovery Requirement

To qualify for the research credit, section 41(d) requires that a

taxpayer undertake research for the purpose of discovering information

which 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. Section 1.41-4(a)(3) of the proposed

regulations defines the phrase discovering information as obtaining

knowledge that exceeds, expands, or refines the common knowledge of

skilled professionals in a particular field of science or engineering.

Commentators criticized this definition of discovering information,

arguing that the definition imposes a discovery requirement that was

not mandated by the statute. Commentators suggested that the phrase

discovering information, as used in the statute, was not intended as an

additional requirement, but was simply used as a phrase to link the

term research with the types of information required as the subject of

the research. Commentators argued that a taxpayer who seeks to resolve

its own subjective uncertainty as to the information at issue is

undertaking sufficient discovery for purposes of section 41(d).

Consistent with the legislative history and case law as described

below, however, IRS and Treasury continue to believe that section 41

conditions credit eligibility on an attempt to discover information

that goes beyond the common knowledge of skilled professionals in the

particular field of science or engineering.

The legislative history to the 1986 Act, which narrowed the

definition of the term qualified research, explained that Congress had

originally 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 177-78; S.

Rep. No. 99-313, at 694-95. Congress was concerned that taxpayers had

applied the original definition of qualified research ``too broadly,''

that some taxpayers had claimed the credit for ``virtually any expenses

relating to product development'' and that many of these taxpayers were

``in industries that do not involve high technology or its application

in developing technologically new and improved products or methods of

production.'' Id. In an illustration of the changes enacted, the

legislative history explained that, under the new definition:

``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)

(emphasis added).

Following the 1986 Act changes to the credit, a discovery

requirement has been applied in several recent cases. See, e.g., United

Stationers, Inc. v. United States, 163 F.3d 440 (7th Cir. 1998),

Norwest v. Commissioner, 110 T.C. 454 (1998), and WICOR, Inc. v. United

States, 116 F. Supp. 2d 1028 (E.D. Wis. 2000).

In reaffirming the scope of the term qualified research, the

Conference Report to the 1998 Act noted that:

evolutionary research activities intended to improve functionality,

performance, reliability, or quality are eligible for the credit, as

are research activities intended to achieve a result that has

already been achieved by other persons but is not yet within the

common knowledge (e.g., freely available to the general public) of

the field (provided that the research otherwise meets

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the requirements of section 41, including not being excluded by

subsection (d)(4)).

H.R. Conf. Rep. No. 105-825, at 1548 (1998) (emphasis added). In

particular, it is noteworthy that the conferees clarified that the

credit is available for research intended to achieve a result that has

been achieved by others but is not yet within the common knowledge. The

negative inference is that the credit is not available for research

intended to achieve a result that has been achieved by others and is

within the common knowledge of the field.

The discovery requirement as set forth in the final regulations

also is consistent with the legislative history to the 1999 Act (the

text of which is set forth above under Background). In that legislative

history, for example, the conferees stated that:

[e]mploying existing technologies in a particular field or relying

on existing principles of engineering or science is qualified

research, if such activities are otherwise undertaken for purposes

of discovering information and satisfy the other requirements under

section 41.

H.R. Conf. Rep. No. 106-478, at 132 (emphasis added). By referring

separately to a requirement that the research be undertaken for

purposes of discovering information, this legislative history again

confirmed that the phrase ``discovering information'' is a separate

substantive requirement and not merely a phrase used to link the term

research with the types of information required as the subject of the

research.

In light of the case law and the legislative history, the final

regulations retain the requirement that a taxpayer seek to discover

information that exceeds, expands, or refines the common knowledge of

skilled professionals in the particular field of science or

engineering. However, consistent with the legislative history to the

1999 Act, IRS and Treasury have carefully considered comments relating

to the ``common knowledge'' standard, and made a number of changes to

address specific taxpayer concerns about the discovery requirement.

In response to comments regarding the application of the discovery

requirement, the final regulations clarify that the phrase ``common

knowledge of skilled professionals in a particular field of science or

engineering'' means information that should be known to skilled

professionals had they performed, before the research in question was

undertaken, a reasonable investigation of the existing level of

information in the particular field of science or engineering. Thus, in

order to satisfy the discovery requirement, research must be undertaken

for the purpose of discovering information that is beyond the knowledge

that should be known to skilled professionals had they performed a

reasonable investigation of the existing level of knowledge in the

particular field of science or engineering. There is no requirement,

however, that a taxpayer actually conduct such an investigation in

order to claim the credit. To further clarify the application of the

discovery requirement, the final regulations also state, as an example,

that trade secrets generally are not within the common knowledge of

skilled professionals because they are not reasonably available to

skilled professionals not employed, hired, or licensed by the owner of

such trade secrets.

Also, in response to comments, the discovery requirement in the

final regulations has been reworded to refer to the common knowledge of

skilled professionals in a particular field of science or engineering

(rather than a particular field of technology or science, as in the

proposed regulations). As in the proposed regulations, the common

knowledge of skilled professionals is intended to serve as an objective

standard for the baseline knowledge that a credit-eligible taxpayer

must seek to exceed, expand, or refine. The reference to the common

knowledge of skilled professionals is not intended to impose

qualification requirements on the personnel that the taxpayer uses to

conduct qualified research.

Several commentators raised concerns that the discovery requirement

in the proposed regulations required that taxpayers must ``prove a

negative;'' in response to these concerns about the potential burden

imposed on taxpayers to demonstrate that they satisfy the discovery

requirement, IRS and Treasury have added to the final regulations a

rebuttable presumption. The final regulations provide that, 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 this 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. This rebuttable presumption would arise,

however, only if the taxpayer cooperates with reasonable requests by

the IRS for witnesses, information, documents, meetings, and

interviews.

In a case where the rebuttable presumption arises, the final

regulations provide that the Commissioner may overcome this 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. That is, the

Commissioner would have to demonstrate that the information would have

been known to such skilled professionals had they performed (before the

research was undertaken) a reasonable investigation of the existing

level of information in the particular field of science or engineering.

By way of further clarification, a provision has been added and

several examples have been changed or eliminated to remove any

implication that the underlying principles of science or engineering

used in the research must themselves be novel. IRS and Treasury

recognize that virtually all research utilizes existing scientific

principles and technology. 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 themselves be beyond the common

knowledge.

Also, in response to commentators' suggestions, the final

regulations provide 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 for the business

component. Section 101 of title 35 of the United States Code provides

that ``[w]hoever invents or discovers any new and useful process,

machine, manufacture, or composition of matter, or any new and useful

improvement thereof, may obtain a patent therefor, subject to the

conditions and requirements of [title 35].'' Such an invention or

discovery may be patentable if it was not previously known, used,

patented, or described, as set forth in 35 U.S.C. 102, and the

differences between the invention and the prior art are such that the

invention would not have been obvious to a person having ordinary skill

in the relevant art. See 35 U.S.C. 102.

The final regulations contain a patent safe harbor because IRS and

Treasury believe that information leading to a patentable invention

constitutes information that exceeds, expands, or refines the common

knowledge of skilled professionals in the relevant

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field. Of course, qualification under the patent safe harbor does not

necessarily establish that the discovery requirement is satisfied with

respect to all of the research associated with the patentable invention

(for example, some of the research might relate to style).

The final regulations emphasize that a patent is not a precondition

for credit eligibility. Because not all research succeeds in achieving

its objective and for other reasons, it is obvious that not all

research intended to discover information that goes beyond the common

knowledge results in a patent. Thus, the absence of a patent should

have no bearing on credit eligibility. The factors underlying the

denial of a patent application, on the other hand, may be relevant to

the determination of whether the discovery requirement is satisfied.

Because section 41(d)(3)(B) provides that the credit is not

available for research related to style, taste, cosmetic, or seasonal

design factors, the patent safe harbor does not include patents for

design, as defined by 35 U.S.C. 171.

In light of these changes, modifications have been made to several

examples in the proposed regulations, including an example in the

proposed regulations relating to research undertaken to develop a new

tire. This example has been moved to the section of the final

regulations that illustrates the exclusion for research conducted after

the beginning of commercial production (discussed in VII. Research

After Commercial Production of this Preamble).

To address concerns expressed by a number of commentators that the

common knowledge standard may be difficult for taxpayers and examiners

to apply, and may give rise in practice to inconsistent treatment of

similarly situated taxpayers (especially where examiners have limited

expertise in a particular scientific field) IRS and Treasury have

initiated measures to promote fair and consistent application of the

discovery requirement and the other conditions for credit eligibility.

Consistent with the suggestion of one commentator, IRS has met with

Revenue Canada to discuss Canada's joint industry/government initiative

to improve administration of the Canadian research credit. IRS also has

met with various industry associations to form joint initiatives to

devise guidelines for the administration and examination of the credit

in particular industries. Similar efforts with respect to other

industry groups are anticipated.

IV. Process of Experimentation

Commentators objected to Sec. 1.41-4(a)(5) of the proposed

regulations, which defines a process of experimentation to include a

prescribed four-step process. Commentators argued that while the four-

step process may accurately have described the pure scientific method

of conducting experiments, commercial and industrial practice does not

always conform precisely to such requirements. Commentators also argued

that the four-step process required by the proposed regulations was

adapted from a description in the legislative history of the 1986 Act

that was included for illustrative purposes and not as a comprehensive

definition of the term process of experimentation.

In light of these comments, the final regulations provide that

taxpayers conducting a process of experimentation may, but are not

required to, engage in the four-step process.

Consistent with the legislative history, the final regulations

provide further clarification on the manner in which a process of

experimentation differs from research and development in the

experimental or laboratory sense, as required by Sec. 1.174-2(a). 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 (in contrast

to expenditures that qualify under section 174) 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. See H.R. Conf. Rep.

No. 99-841, at II-72 (``The term process of experimentation means a

process involving the evaluation of more than one alternative designed

to achieve a result where the means of achieving that result is

uncertain at the outset.''); United Stationers, 163 F.3d at 446;

Norwest, 110 T.C. at 496.

V. Recordkeeping Requirement

Part of the four-step process of experimentation test prescribed in

Sec. 1.41-4(a)(5) of the proposed regulations was a requirement that

taxpayers record the results of their experiments. Maintaining that

this requirement was particularly burdensome, commentators argued that,

in the industrial or commercial setting, the recording of results is

not necessarily inherent in a bona fide process of experimentation.

For these reasons, the final regulations do not contain a

requirement that taxpayers record the results of their experiments.

Moreover, reference to the recording of results has been eliminated

from the illustrative (non-mandatory) description of a four-step

process of experimentation.

To assist in the examination of claims for the credit and to ensure

that the credit is properly targeted to serve as an incentive to engage

in qualified research, the final regulations do include a less

burdensome contemporaneous documentation requirement. Under the final

regulations, taxpayers 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

the taxpayer seeks to obtain that exceeds, expands, or refines the

common knowledge of skilled professionals in the relevant field of

science or engineering. Taxpayers also must comply with the general

recordkeeping requirements of section 6001.

As noted above, taxpayers may also avail themselves of a rebuttable

presumption that they satisfy the discovery requirement if their

contemporaneous documentation also sets forth the basis for the

taxpayer's belief that obtaining this information would exceed, expand,

or refine the common knowledge of skilled professionals in the

particular field of science or engineering.

VI. The Shrinking-Back Rule

Under Sec. 1.41-4(b) of the proposed regulations, and consistent

with the legislative history to the 1986 Act, if the requirements of

section 41(d) are not met for an entire product, then the credit may be

available with respect to the next most significant subset of elements

of that product. This shrinking back continues 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.

The final regulations clarify that this shrinking-back rule applies

only if the taxpayer incurs some research expenses with respect to the

overall business component that would constitute qualified research

expenses with respect to that business component but for the fact that

less than substantially all of the research activities with respect to

that component constitute elements of a process of experimentation that

relates to a new or improved function, performance, reliability or

quality. In cases where the substantially-all test is

[[Page 285]]

satisfied with respect to the overall business component, those

research expenses with respect to the overall business component that

are qualified research expenses are credit eligible, and there is no

need for a taxpayer to shrink back to apply the tests with respect to

subsets of elements of the business component. Of course, the mere fact

that taxpayers are not required to shrink back to a smaller business

component does not mean that all of the research expenses with respect

to the overall credit are credit eligible. Research expenses that are

not qualified research expenses, for example because they relate to

style, taste, cosmetic, or seasonal design factors, remain ineligible

for the credit.

In response to commentators' suggestions, the final regulations

also clarify that, if the original product is not eligible for the

credit, the 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

may not itself be applied as a reason to exclude research activities

from credit eligibility. Finally, an example has been added to

illustrate these concepts.

VII. Research After Commercial Production

Several commentators addressed the section of the proposed

regulations providing that activities conducted after the beginning of

commercial production of a business component are not qualified

research. Under the proposed regulations, 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. Moreover, certain specified activities (like

preproduction planning for a finished business component and trial

production runs) are deemed to occur after the beginning of commercial

production.

Because the provisions set forth above closely reflect the

legislative history of the post-production exclusion, these tests have

been retained in the final regulations. See H.R. Conf. Rep. No. 841, at

II-74-75. However, several changes have been made in response to

commentators' concerns.

First, a change has been made to the list of activities that are

per se deemed to occur after the beginning of commercial production. In

the proposed regulations, one of the items on that list was ``debugging

or correcting flaws in a business component.'' Consistent with the

legislative history, IRS and Treasury continue to believe that

debugging should be conclusively presumed to occur after the beginning

of commercial production. However, many activities conducted before the

beginning of commercial production could be construed as the correction

of flaws. Thus, the per se list contained in the final regulations has

been changed to refer to debugging activities but not to the correction

of flaws.

Second, an example has been added to clarify that a new research

project to improve a business component is not disqualified merely

because the new research project commences after the commercial

production of the unimproved business component. Other examples have

been changed to eliminate references to and factual assertions about

specific industries.

Third, the final regulations incorporate provisions from the

legislative history to the 1986 Act that 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, and that 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 are not treated as occurring after the beginning of

commercial production if such clinical tests are undertaken to

establish new functional uses, characteristics, indications,

combinations, dosages, or delivery forms for the product.

VIII. Adaptation

Several commentators suggested alternate formulations of the

adaptation exclusion. Because such formulations effectively would

render the adaptation exclusion inapplicable to activities that satisfy

the other requirements for qualified research, thereby reading the

exclusion out of the Internal Revenue Code, the final regulations do

not adopt the suggestions.

Two new examples clarify that the adaptation exclusion may also

apply to contract research expenses paid by the customer to the vendor

or to in-house research expenses incurred by the customer itself to

adapt an existing business component to that customer's requirement or

need.

IX. Internal-Use Software

As noted above, the 1997 proposed regulations describe when

software that is developed by (or for the benefit of) a taxpayer

primarily for the taxpayer's internal use can qualify for the credit.

The final regulations incorporate these special provisions for

internal-use software. A number of changes have been made to the 1997

proposed regulations to address commentator concerns, and to coordinate

the internal-use provisions with the other provisions of the final

regulations.

Under the proposed regulations, research with respect to software

developed primarily for a taxpayer's internal use is qualified research

only if it satisfies both the general requirements for credit

eligibility under section 41 and an additional condition for

eligibility. Except for certain software developed for use in

conducting qualified research or for use in a production process, and

for certain software created as part of a package of hardware and

software developed concurrently, the additional condition for

eligibility is a requirement that the taxpayer satisfy a three-part

test (requiring that the internal-use software be innovative, that its

development involve significant economic risk, and that it not be

commercially available).

Most of the comments received focused on two issues--(1) the

determination of when software is developed primarily for internal use,

and (2) the application of the three-part test to internal-use

software. On the first issue, several commentators urged that internal-

use software be defined to exclude any software used to deliver a

service to customers or any software that includes an interface with

customers or the public. After careful analysis of the legislative

history to the 1986 Act and the 1999 Act, however, IRS and Treasury

concluded that such a broad exclusion would be inconsistent with the

statutory mandate, because the exclusion would extend to some software

that Congress clearly intended to treat as internal-use software. At

the same time, IRS and Treasury share the commentators' belief that the

goals of the research credit may be advanced by removing additional

conditions for credit-eligibility in the case of certain internal-use

software used to provide new features to services offered to customers

that are not otherwise available to them. Accordingly, as described in

more detail below, the final regulations retain the definition of

internal-use software contained in the proposed regulations, but

provide a new exception (pursuant to the regulatory

[[Page 286]]

authority under section 41(d)(4)(E)) under which the development of

certain internal-use software used to deliver noncomputer services to

customers with features that are not yet offered by a taxpayer's

competitors is not subject to the three-part test.

Consistent with a statement in the Conference Report to the 1999

Act that software research undertaken to support the provision of a

service should not be deemed internal-use software ``solely because the

business component involves the provision of a service,'' the final

regulations 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. 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. 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.

The conclusion that software used to provide noncomputer services

is internal-use software is consistent with the legislative history to

the 1986 Act, which defined internal-use software as software used in

general administrative functions and software used in providing

noncomputer services (such as accounting, consulting, or banking

services). See H.R. Conf. Rep. No. 841, at II-73 (emphasis added).

As noted above, the final regulations contain a new exception under

which a taxpayer is not required to establish that internal-use

software used to provide noncomputer services containing features or

improvements that are not yet offered by a taxpayer's competitors

satisfies the three-part test. Software that is intended to be used to

provide noncomputer services is described within the exception if the

software is designed to provide customers a new feature with respect to

a noncomputer service; the taxpayer reasonably anticipated that

customers would choose to obtain the noncomputer service from the

taxpayer (rather than from the taxpayer's competitors) because of those

features of the service that will be provided by the software; and

those features are not available (at the time the research is

undertaken) from any of the taxpayer's competitors.

No inference should be drawn that software described within the

foregoing exception is not internal-use software or that internal-use

software not described within the exception would fail the three-part

test. Rather, the exception reflects a determination by IRS and

Treasury that it is appropriate to exercise the regulatory authority in

section 41(d)(4)(E) to exempt certain internal-use software from having

to fulfil additional conditions for credit eligibility. This exercise

of regulatory authority is based on a determination that the

development of software containing features or improvements that are

not available from a taxpayer's competitors and that provide a

demonstrable competitive advantage is more likely to increase the

innovative qualities and efficiency of the U.S. economy (by generating

knowledge that can be used by other service providers) than is the

development of software used to provide noncomputer services containing

features or improvements that are already offered by others. IRS and

Treasury believe that drawing such a line is an appropriate way to

administer the credit with a view to identifying and facilitating the

credit availability for software with the greatest potential for

benefitting the U.S. economy, an important rationale for the research

credit.

The final regulations also make a number of changes with respect to

the three-part high threshold of innovation test, which continues to

apply to certain software not described within the new exception. For

example, commentators had questioned whether the 1997 proposed

regulations impose a separate high threshold of innovation requirement

that serves as an additional condition for credit eligibility, even

where taxpayers otherwise satisfy the three-part test. The final

regulations clarify that the three-part test is the high threshold of

innovation test, and not a separate requirement. Similarly,

commentators had objected to a sentence in the 1997 proposed

regulations that could be read to suggest that certain internal-use

software could never qualify for the credit. The final regulations

clarify that research with respect to internal-use software that

satisfies both the general conditions for credit eligibility and the

three-part test is eligible for the credit.

Consistent with the application of the discovery requirement, the

final regulations adopt the suggestion of several commentators that the

three-part test should be applied without regard to whether the

taxpayer succeeds in achieving the results described in that test.

Commentators questioned whether the ``as where'' clauses used to

elaborate on the three requirements of the high threshold of innovation

test in the 1997 proposed regulations were intended as mandatory

requirements or merely as illustrations of ways in which taxpayers

could satisfy the tests. By replacing the ``as where'' clauses with

``in that'' clauses, the final regulations confirm that a taxpayer must

satisfy the provisions, as elaborated. Consistent with this

clarification, the final regulations provide that the innovative prong

of the three-part test may be satisfied with respect to any intended

improvement, not just reductions in cost or improvements in speed.

Under the final regulations, all qualified research, including

research with respect to internal-use software, must satisfy the

discovery requirement (that is, must be intended to exceed, expand, or

refine the common knowledge of skilled professionals in the particular

field of science or engineering). The final regulations clarify how the

three-part high threshold of innovation test supplements the discovery

requirement. Specifically, the final regulations provide that several

aspects of the three-part test (the determination of whether the

software is intended to result in an improvement that is substantial

and economically significant and the extent of uncertainty and

technical risk) also must be applied with respect to the common

knowledge of skilled professionals. In essence, the common knowledge of

skilled professionals rather than the knowledge base of the taxpayer's

employees is treated as the baseline with respect to which the intended

software must satisfy the innovative prong and other prongs of the

three-part test. Stated differently, research with respect to internal-

use software is credit eligible only if it is intended to exceed,

expand, or refine the common knowledge of skilled professionals (as

defined in Sec. 1.41-4(a)(3)(ii)) to a degree that is substantial and

economically significant. See Norwest 110 T.C. at 499-500 (stating that

``* * * the extent of the improvements required by Congress with

respect to internal use software is much greater than that required in

other fields'' and that ``* * * the significant economic risk test

requires a higher threshold of technological advancement in the

development of internal use software than in other fields'').

Reference to the common knowledge of skilled professionals as the

baseline is necessary to give proper meaning to

[[Page 287]]

the statutory three-part test. For example, if the innovative

requirement was applied simply with respect to the prior state of the

taxpayer's own business, then ordinary inventory software installed by

a taxpayer who previously tracked its inventory manually could be

deemed to satisfy the innovative requirement merely because the

taxpayer had achieved a substantial and economically significant

improvement in speed over its prior non-automated operations.

Although the final regulations related to internal use software

generally are effective for taxable years beginning after December 31,

1985, the provisions relating to software developed for use in

providing computer and noncomputer services to customers and the

provisions clarifying the interaction of the three-part test with the

discovery requirement, like other provisions concerning the discovery

requirement, are effective only prospectively; however, taxpayers may

rely on these rules for expenditures paid or incurred prior to January

3, 2001.

X. Alternative Incremental Credit

Certain commentators suggested that taxpayers be permitted to elect

the alternative incremental credit on an amended return. However, IRS

and Treasury believe that the intended incentive effects of the credit

would not be advanced by permitting taxpayers to make retroactive

elections to alter the computation of (and presumably increase) the

credit for prior years. Similarly, the availability of a retroactive

election would undermine the application of section 41(c)(4)(B). Thus,

the final regulations retain the requirement contained in the proposed

regulations that the election to apply the provisions of the

alternative incremental credit must be made on the taxpayer's timely

filed original return.

Effective Dates

In general, the regulations are applicable for expenditures paid or

incurred on or after January 3, 2001. However, the regulations

addressing the base amount are applicable for taxable years beginning

on or after January 3, 2001. The regulations addressing internal-use

software are applicable for taxable years beginning after December 31,

1985. However, Sec. 1.41-4(c)(6)(ii)(C)(4), Sec. 1.41-4(c)(6)(iv)(A)

and (B), Sec. 1.41-4(c)(6)(v), the second and third sentences of

Sec. 1.41-4(c)(6)(vii), and Sec. 1.41-4(c)(6)(viii) Example 2 are

applicable for expenditures paid or incurred on or after January 3,

2001. The special documentation requirements of Sec. 1.41-4(d) are

applicable with respect to research projects that begin on or after

March 5, 2001. The regulations providing for the election and

revocation of the alternative incremental credit are applicable for

taxable years ending on or after January 3, 2001. No inference should

be drawn from the applicability date concerning the application of

section 41 to expenditures paid or incurred or the computation of the

base amount before the applicability date.

Special Analyses

It has been determined that these regulations are not a significant

regulatory action as defined in Executive Order 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. This certification is based on

the fact that the rules of this section impact only taxpayers who

engage in qualified research. Moreover, in those instances where the

rules of this section impact small entities, the economic impact is not

likely to be significant because it merely requires taxpayers to (1)

prepare (before or during the early stages of a research project) and

retain written documentation describing the principal questions to be

answered and the information the taxpayer seeks to obtain that

satisfies the requirements of Sec. 1.41-4(a)(3) of these regulations;

(2) elect on Form 6765, ``Credit for Increasing Research Activities,''

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. Further, 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. Accordingly, a regulatory flexibility analysis under the

Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required.

Pursuant to section 7805(f), the notice of proposed rulemaking

preceding these regulations was submitted to the Chief Counsel for

Advocacy of the Small Business Administration for comment on its impact

on small business.

Drafting Information

The principal authors of these regulations are Lisa J. Shuman and

Leslie H. Finlow of the Office of the Associate Chief Counsel

(Passthroughs and Special Industries), IRS. However, personnel from

other offices of the IRS and the Treasury Department participated in

their development.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are 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 * * *

Sec. 1.30-- [Amended]

Par. 2. Revise the undesignated centerheading immediately before

Sec. 1.30-1 to read as follows:

Credits Allowable Under Sections 30 Through 44B

Par. 3. Remove the undesignated centerheading immediately before

Sec. 1.41-0.

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

Sec. 1.41-0 Table of contents.

This section lists the paragraphs contained in Secs. 1.41-1 through

1.41-8 as follows:

Sec. 1.41-1 Credit for increasing research activities.

(a) Amount of credit.

(b) Introduction to regulations under section 41.

Sec. 1.41-2 Qualified research expenses.

(a) Trade or business requirement.

(1) In general.

(2) New business.

(3) Research performed for others.

(i) Taxpayer not entitled to results.

(ii) Taxpayer entitled to results.

(4) Partnerships.

(i) In general.

(ii) Special rule for certain partnerships and joint ventures.

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

qualified research.

(1) In general.

(2) Certain utility charges.

(i) In general.

(ii) Extraordinary expenditures.

(3) Right to use personal property.

(4) Use of personal property in taxable years beginning after

December 31, 1985.

(1) Engaging in qualified research.

(2) Direct supervision.

(3) Direct support.

(d) Wages paid for qualified services.

(1) In general.

(2) ``Substantially all.''

(e) Contract research expenses.

[[Page 288]]

(1) In general.

(2) Performance of qualified research.

(3) ``On behalf of.''

(4) Prepaid amounts.

(5) Examples.

Sec. 1.41-3 Base amount for taxable years beginning on or after

January 3, 2001.

(a) New taxpayers.

(b) Special rules for short taxable years.

(1) Short credit year.

(2) Short taxable year preceding credit year.

(3) Short taxable year in determining fixed-base percentage.

(1) In general.

(2) Amounts excluded.

(3) Foreign corporations.

(d) Consistency requirement.

(1) In general.

(2) Illustrations.

(e) Effective date.

Sec. 1.41-4 Qualified research for expenditures paid or incurred on

or after January 3, 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) Common knowledge.

(iii) Means of discovery.

(iv) Patent safe harbor.

(v) Rebuttable presumption.

(4) Technological in nature.

(5) Process of experimentation.

(6) Substantially all requirement.

(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.

(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 computer software.

(i) General rule.

(ii) Requirements.

(iii) Primarily for internal use.

(iv) Software used in the provision of services.

(A) Computer services.

(B) Noncomputer services.

(v) Exception for certain software used in providing noncomputer

services.

(vi) High threshold of innovation test.

(vii) Application of high threshold of innovation test.

(viii) Illustrations.

(ix) Effective dates.

(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) Documentation.

(e) Effective dates.

Sec. 1.41-5 Basic research for taxable years beginning after

December 31, 1986. [Reserved]

Sec. 1.41-6 Aggregation of expenditures.

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

common control.

(1) In general.

(2) Definition of trade or business.

(3) Determination of common control.

(4) Examples.

(b) Minimum base period research expenses.

(1) In general.

(2) Special rule where timing of research is manipulated.

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

(e) Intra-group transactions.

(1) In general.

(2) In-house research expenses.

(3) Contract research expenses.

(4) Lease payments.

(5) Payment for supplies.

Sec. 1.41-7 Special rules.

(a) Allocations.

(1) Corporation making an election under subchapter S.

(i) Pass-through, for taxable years beginning after December 31,

1982, in the case of an S corporation.

(ii) Pass-through, for taxable years beginning before January 1,

1983, in the case of a subchapter S corporation.

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

(3) Pass-through in the case of a partnership.

(i) In general.

(ii) Certain expenditures by joint ventures.

(4) Year in which taken into account.

(5) Credit allowed subject to limitation.

(b) Adjustments for certain acquisitions and dispositions--

Meaning of terms.

(d) Carryback and carryover of unused credits.

Sec. 1.41-8 Special rules for taxable years ending on or after

January 3, 2001.

(a) Alternative incremental credit.

(b) Election.

(1) In general.

(2) Time and manner of election.

(3) Revocation.

(4) Effective date.

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

Sec. 1.41-1 Credit for increasing research activities.

(a) 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).

(b) 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 Internal

Section of the regulation Revenue Code

------------------------------------------------------------------------

Sec. 1.41-2.............................. 41(b).

Sec. 1.41-3.............................. 41(c).

Sec. 1.41-4.............................. 41(d).

Sec. 1.41-5.............................. 41(e).

Sec. 1.41-6.............................. 41(f).

Sec. 1.41-7.............................. 41(f).

41(g).

Sec. 1.41-8.............................. 41(c).

Sec. 1.41-3A............................. 41(c) (taxable years

beginning before January 1,

1990).

Sec. 1.41-4A............................. 41(d) (taxable years

beginning before January 1,

1986).

Sec. 1.41-5A............................. 41(e) (taxable years

beginning before January 1,

1987).

------------------------------------------------------------------------

(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 as 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.

Sec. 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 ``Sec. 1.41-5(d)(2)'' and adding ``Sec. 1.41-4A(d)(2)'' in

its place.

2. The last sentence of paragraph (a)(3)(ii) is amended by removing

the language ``Sec. 1.41-5(d)(3)'' and adding ``Sec. 1.41-4A(d)(3)'' in

its place.

3. The last sentence of paragraph (a)(4)(ii)(F) is amended by

removing the language ``Sec. 1.41-9(a)(3)(ii)'' and adding ``Sec. 1.41-

7(a)(3)(ii)'' in its place.

4. Paragraph (e)(1)(i) is amended by removing the language

``Sec. 1.41-5'' and

[[Page 289]]

adding ``Sec. 1.41-4 or 1.41-4A, whichever is applicable'' in its

place.

Secs. 1.41-0A through 1.41-8A [Removed]

Par. 6A. Sections 1.41-0A through 1.41-8A and the undesignated

centerheading preceding these sections are removed.

Par. 7. An undesignated centerheading is added immediately

following Sec. 1.44B-1 to read as follows:

Research Credit--For Taxable Years Beginning Before January 1, 1990

Sec. 1.41-3 [Redesignated as Sec. 1.41-3A]

Par. 8. Section 1.41-3 is redesignated as Sec. 1.41-3A and added

under the new undesignated centerheading ``RESEARCH CREDIT--FOR TAXABLE

YEARS BEGINNING BEFORE JANUARY 1, 1990.''

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

Sec. 1.41-3 Base amount for taxable years beginning on or after

January 3, 2001.

(a) New taxpayers. If, with respect to any credit year, the

taxpayer has not been in existence for any previous taxable year, the

average annual gross receipts of the taxpayer for the four taxable

years preceding the credit year shall be zero. If, with respect to any

credit year, the taxpayer has been in existence for at least one

previous taxable year, but has not been in existence for four taxable

years preceding the taxable year, then the average annual gross

receipts of the taxpayer for the four taxable years preceding the

credit year shall be the average annual gross receipts for the number

of taxable years preceding the credit year for which the taxpayer has

been in existence.

(b) Special rules for short taxable years--(1) Short credit year.

If a credit year is a short taxable year, then the base amount

determined under section 41(c)(1) (but not section 41(c)(2)) shall be

modified by multiplying that amount by the number of months in the

short taxable year and dividing the result by 12.

(2) Short taxable year preceding credit year. If one or more of the

four taxable years preceding the credit year is a short taxable year,

then the gross receipts for such year are deemed to be equal to the

gross receipts actually derived in that year multiplied by 12 and

divided by the number of months in that year.

(3) Short taxable year in determining fixed-base percentage. No

adjustment shall be made on account of a short taxable year to the

computation of a taxpayer's fixed-base percentage.

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);

(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;

and

(vi) Amounts received 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. For purposes of this

paragraph (c)(2)(vi), investment income is interest or distributions

with respect to stock (other than the stock of a 20-percent owned

corporation as defined in section 243(c)(2).

(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, the Commonwealth of Puerto Rico, or other

possessions of 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 calendar

year as its taxable year, incurs qualified research expenses in

2001. X wants to compute its research credit under section 41 for

the tax year ending December 31, 2001. As part of the computation, X

must determine its fixed-base percentage, which depends in part on

X's qualified research expenses incurred during the fixed-base

period, the taxable years beginning after December 31, 1983, and

before January 1, 1989.

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

amounts as qualified research expenses on its Form 6765:

1984........................................................... $100x

1985........................................................... 120x

1986........................................................... 150x

1987........................................................... 180x

1988........................................................... 170x

--------

Total...................................................... 720x

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

December 31, 1985, X based the amounts reported as qualified

research expenses on the definition of qualified research in effect

for those taxable years. The definition of qualified research

changed for taxable years beginning after December 31, 1985. If X

used the definition of qualified research applicable to its taxable

year ending December 31, 2001, the credit year, its qualified

research expenses for the taxable years ending December 31, 1984,

and December 31, 1985, would be reduced to $ 80x and $ 100x,

respectively. Under the consistency rule in section 41(c)(5) and

paragraph (d)(1) of this section, to compute the research credit for

the tax year ending December 31, 2001, X must reduce its qualified

research expenses for 1984 and 1985 to reflect the change in the

definition of qualified research for taxable years beginning after

December 31, 1985. Thus, X's total qualified research expenses for

the fixed-base period (1984-1988) to be used in computing the fixed-

base percentage is $80 + 100 + 150 + 180 + 170 = $680x.

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, 2001, X claimed that a certain type of

expenditure incurred in 2001 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.

[[Page 290]]

(e) Effective date. The rules in paragraphs (c) and (d) of this

section are applicable for taxable years beginning on or after the date

final regulations are published in the Federal Register.

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

Sec. 1.41-4 Qualified research for expenditures paid or incurred on or

after January 3, 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.

For certain recordkeeping requirements, see paragraph (d) of this

section.

(3) Undertaken for the purpose of discovering information--(i) In

general. For purposes of section 41(d) and this section, 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 professionals in a particular field of

science or engineering. A determination that research is undertaken for

the purpose of discovering information does not require that the

taxpayer succeed in obtaining the knowledge that exceeds, expands, or

refines the common knowledge of skilled professionals in a particular

field of science or engineering, nor does it require that the advance

sought be more than evolutionary. However, research is not undertaken

for the purpose of discovering information merely because an

expenditure may be treated as an expense under section 174.

(ii) Common knowledge. Common knowledge of skilled professionals in

a particular field of science or engineering means information that

should be known to skilled professionals had they performed, before the

research in question is undertaken, a reasonable investigation of the

existing level of information in the particular field of science or

engineering. Thus, knowledge may, in certain circumstances, exceed,

expand, or refine the common knowledge of skilled professionals in a

particular field of science or engineering even though such knowledge

has previously been obtained by other persons. For example, trade

secrets generally are not within the common knowledge of skilled

professionals in a particular field of science or engineering because

they are not reasonably available to skilled professionals not

employed, hired, or licensed by the owner of such trade secrets.

(iii) Means of discovery. In seeking to obtain knowledge that

exceeds, expands, or refines the common knowledge of skilled

professionals in a particular field of science or engineering, a

taxpayer may employ existing technologies in a particular field and may

rely on existing principles of science or engineering.

(iv) 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 section 151 of

title 35, United States Code (other than a patent for design issued

under the provisions of section 171 of title 35, United States Code) is

conclusive evidence that a taxpayer has obtained knowledge that

exceeds, expands, or refines the common knowledge of skilled

professionals. However, the issuance of such a patent is not a

precondition for credit availability.

(v) Rebuttable presumption. If a taxpayer demonstrates with

credible evidence that research activities were undertaken to obtain

the information described in the taxpayer's contemporaneous

documentation required under paragraph (d)(1) of this section, and if

that documentation also sets forth the basis for the taxpayer's belief

that obtaining this information would exceed, expand, or refine the

common knowledge of skilled professionals in the particular field of

science or engineering, the research activities are presumed to satisfy

the requirements of this paragraph (a)(3). However, the presumption

applies only if the taxpayer cooperates with reasonable requests by the

Commissioner for witnesses, information, documents, meetings, and

interviews. Furthermore, the Commissioner may overcome the presumption

in this paragraph if the Commissioner demonstrates that the information

described in the taxpayer's documentation was within the common

knowledge of skilled professionals (as described in paragraph

(a)(3)(ii) of this section), or that the research activities were not

undertaken to obtain the information described in the taxpayer's

documentation.

(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.

(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

capability or method of achieving that result is uncertain at the

outset. A process of experimentation does not include the evaluation of

alternatives to establish the appropriate design of a business

component, if the capability and method for developing or improving the

business component are not uncertain. A process of experimentation in

the physical or biological sciences, engineering, or computer science

may involve--

(i) Developing one or more hypotheses designed to achieve the

intended result;

(ii) Designing an 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) Conducting the experiment; and

(iv) Refining or discarding 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 (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.

(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

[[Page 291]]

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 this paragraph (a):

Example 1. (i) Facts. X and other manufacturing companies have

previously designed and manufactured a particular kind of machine

using Material S. Material T is less expensive than Material S. X

wishes to design a new machine that appears and functions exactly

the same as its existing machines, but that is made of Material T

instead of Material S. The capability and method necessary to

achieve this objective should not have been known to skilled

professionals had they conducted a reasonable investigation of the

existing information in the relevant field of science or engineering

at the time the research was undertaken.

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

Material T may be qualified research within the meaning of section

41(d)(1) and this paragraph (a). In seeking to design the machine, X

undertook to obtain knowledge that exceeds, expands, or refines the

common knowledge of skilled professionals in the relevant field of

science or engineering.

Example 2. (i) Facts. X is engaged in the business of developing

and manufacturing widgets. X wants to manufacture an improved widget

made out of a material that X has not previously used. Although X is

uncertain how to use the material to manufacture an improved widget,

the capability and method of using the material to manufacture such

widgets should have been known to skilled professionals had they

conducted a reasonable investigation of the existing level of

information in the particular field of science or engineering at the

time the research was undertaken.

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

to resolve the uncertainty in manufacturing the improved widget may

be treated as expenses for research activities under section 174 and

Sec. 1.174-2, X's activities to resolve the uncertainty in

manufacturing the improved widget are not qualified research within

the meaning of section 41(d) and this paragraph (a). Although X's

activities were intended to eliminate uncertainty, the activities

were not undertaken to obtain knowledge that exceeds, expands, or

refines the common knowledge of skilled professionals in the

relevant field of science or engineering.

Example 3. (i) Facts. X desires to build a bridge that can

sustain greater traffic flow without deterioration than can existing

bridges. The capability and method used to build such a bridge

should not have been known to skilled professionals had they

conducted a reasonable investigation of the existing level of

information in the particular field of science or engineering at the

time the research was undertaken. X eventually abandons the project

after attempts to develop the technology prove unsuccessful.

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

build the bridge may be qualified research within the meaning of

section 41(d)(1) and this paragraph (a), regardless of the fact that

X did not actually succeed in developing that technology. In seeking

to develop the technology, X undertook to obtain knowledge that

exceeds, expands, or refines the common knowledge of skilled

professionals in the relevant field of science or engineering.

Example 4. (i) Facts. The facts are the same as in Example 3,

except that Y successfully builds a bridge that can sustain the

greater traffic flow. Thereafter, Z seeks to build a bridge that can

also sustain such greater traffic flow. The method Y used to build

its bridge is a closely guarded trade secret that is not known to Z

and should not have been known to skilled professionals had they

conducted a reasonable investigation of the existing level of

information in the particular field of science or engineering at the

time the research was undertaken.

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

build the bridge may be qualified research within the meaning of

section 41(d)(1) and this paragraph (a), even if it so happens that

the technology Z used to build its bridge is similar or identical to

the technology Y used. In developing the technology, Z undertook to

obtain knowledge that exceeds, expands, or refines the common

knowledge of skilled professionals in the relevant field of science

or engineering.

Example 5. (i) Facts. X, a widget manufacturer, seeks to develop

a new widget and initiates Project A. Before or during the early

stages of Project A, X's employees prepare contemporaneous

documentation that describes the principal questions to be answered

by Project A and the information that X seeks to obtain to exceed,

expand, or refine the common knowledge of skilled professionals in

the relevant field of science or engineering. The documentation

includes a statement from one of X's skilled professionals setting

forth the basis for that professional's belief that the information

is beyond the common knowledge of skilled professionals in the

relevant field. Upon examination by the Commissioner, X presents

credible evidence that the research activities were undertaken to

obtain the information described in the contemporaneous

documentation. X cooperates with all requests by the IRS for

witnesses, information, documents, meetings, and interviews.

(ii) Conclusion. X's research activities with respect to Project

A are presumed to be undertaken for the purpose of obtaining

knowledge that exceeds, expands, or refines the common knowledge of

skilled professionals in the relevant field of science or

engineering. The Commissioner may overcome this presumption by

demonstrating that the information X sought to obtain was within the

common knowledge of skilled professionals in the relevant field of

science or engineering (i.e., by demonstrating that, at the time

Project A began, the information should have been known to skilled

professionals had they performed a reasonable investigation of the

existing level of knowledge in the relevant field).

(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, 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 research expenses

are eligible for the credit. A special shrinking-back rule applies in

the case where a taxpayer incurs some research expenses with respect to

that discrete business component that would constitute qualified

research expenses with respect to that business component but for the

fact that less than substantially all of the research activities with

respect to that component constitute elements of a process of

experimentation that relates to a new or improved function,

performance, reliability or quality. In such a case, the requirements

for the credit 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 or series of

subsets of elements of the business component satisfies substantially

all requirements of section 41(d)(1)(C) and paragraph (a)(2)(iii) of

this section (treating that subset of elements as a business component)

[[Page 292]]

the most basic element fails to satisfy the requirements. This

shrinking-back rule is applied only if a taxpayer does not satisfy the

requirements of section 41(d)(1)(C) and paragraph (a)(2)(iii) 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):

(i) Facts. X, a widget manufacturer, develops a widget that is

improved in several respects. Among the various improvements to the

widget is an improvement to the widget's cooling mechanism. Although

the capability and method of making the other improvements to the

widget would have been known to skilled professionals had they

conducted a reasonable investigation of the existing level of

information in the particular field of science or engineering, the

method of developing the improved cooling mechanism and of

incorporating the improved mechanism into the widget would not have

been known to skilled professionals had they conducted a reasonable

investigation of the existing level of information in the particular

field of science or engineering. Substantially all of X's research

activities in improving the widget constitute elements of a process

of experimentation for purposes of improving the performance of the

widget. None of X's research activities in improving the widget are

described in section 41(d)(4) or paragraph (c) of this section.

(ii) Conclusion. Some, but not all, of X's research activities

in developing the improved widget are qualified research within the

meaning of section 41(d)(1) and paragraph (a) of this section. In

seeking to improve the widget, some of X's activities (related to

improving the cooling mechanism and incorporating the improved

cooling mechanism into the widget) were undertaken to obtain

knowledge that exceeds, expands, or refines the common knowledge of

skilled professionals in the relevant field of science or

engineering. However, other activities (related to the other

improvements) were not undertaken to obtain knowledge that exceeds,

expands, or refines the common knowledge of skilled professionals in

the relevant field of science or engineering, and thus are not

qualified research and are not eligible for the credit. Not all of

X's research activities relating to the widget are eligible for the

credit because some of the activities are not qualified research as

defined in section 41(d) and paragraph (a) of this section, even

though the widget qualifies as a business component with respect to

which qualified research that satisfies the requirements of section

41(d) and paragraph (a) of this section is undertaken.

not include any activity described in section 41(d)(4) and paragraph

(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;

(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 are not

treated as occurring after the beginning of commercial production if

such clinical tests are 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 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 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--(i) General rule. Research with

respect to computer 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 research satisfies the requirements of section 41(d)(1);

(B) The research 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--

[[Page 293]]

(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 meets the requirements of section 41(d)(1);

(3) The taxpayer develops a new or improved package of computer

software and hardware together as a single product, of which the

software is an integral part, that is used directly by the taxpayer in

providing technological services in its trade or business to customers.

In these cases, eligibility for the research credit is to be determined

by examining the combined hardware-software product as a single

product;

(4) The taxpayer develops the software for use in providing

computer services to customers; or

(5) The software satisfies the high threshold of innovation test of

paragraph (c)(6)(vi) of this section.

(iii) Primarily for internal use. Software is developed primarily

for the taxpayer's internal use if the software is to be used

internally, for example, in general administrative functions of the

taxpayer (such as payroll, bookkeeping, or personnel management) or in

providing noncomputer services (such as accounting, consulting or

banking services). If computer software is developed primarily for the

taxpayer's internal use, the requirements of paragraph (c)(6) apply

even though the taxpayer intends to, or subsequently does, sell, lease,

or license the computer software.

(iv) 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.

(v) Exception for certain software used in providing noncomputer

services. The requirements of paragraph (c)(6)(ii)(C) of this section

are deemed satisfied for research with respect to computer software if,

at the time the research was undertaken--

(A) The software is designed to provide customers a new feature

with respect to a noncomputer service;

(B) The taxpayer reasonably anticipated that customers would choose

to obtain the noncomputer service from the taxpayer (rather than from

the taxpayer's competitors) because of those new features provided by

the software; and (C) Those new features were not available from any of

the taxpayer's competitors.

(vi) High threshold of innovation test. Computer software satisfies

the high threshold of innovation test of this paragraph (c)(6)(vi) only

if the taxpayer can establish that--

(A) The software is innovative in that the software is intended to

result in a reduction in cost, improvement in speed, or other

improvement, that is substantial and economically significant;

(B) The software development involves significant economic risk in

that the taxpayer commits substantial resources to the development and

there is a substantial uncertainty, because of technical risk, that

such resources would be recovered within a reasonable period; and

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)(vi)(A) and (B) of this

section.

(vii) Application of high threshold of innovation test. In

determining if the high threshold of innovation test of paragraph

(c)(6)(vi) of this section is satisfied, all of the facts and

circumstances are considered. The determination of whether the software

is intended to result in an improvement or cost reduction that is

substantial and economically significant is based on a comparison of

the intended result with software that is within the common knowledge

of skilled professionals in the relevant field of science or

engineering, see Sec. 1.41-4(a)(3)(ii). Similarly, the extent of

uncertainty and technical risk is determined with respect to the common

knowledge of skilled professionals in the relevant field of science or

engineering. Further, in determining if the high threshold of

innovation test of paragraph (c)(6)(vi) of this section is satisfied,

the activities to develop the new or improved software are considered

independent of the effect of any modifications to related hardware or

other software.

(viii) Illustrations. The following examples illustrate the

application of this paragraph (c)(6):

Example 1. (i) Facts. X is engaged in the business of

manufacturing and selling widgets to wholesalers. X has experienced

strong growth and at the same time has expanded its product

offerings. X also has increased significantly the size of its

business by expanding into new territories. The increase in the size

and scope of its business has strained X's existing financial

management systems such that management can no longer obtain timely

comprehensive financial data. Accordingly, X undertakes the

development of a financial management computer software system that

is more appropriate to its newly expanded operations.

(ii) Conclusion. X's new computer software system is developed

by X primarily for X's internal use. X's activities to develop the

new computer software system may be eligible for the research credit

only if the computer software development activities satisfy the

requirements of paragraph (c)(6)(ii) of this section.

Example 2. (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. In keeping with X's

corporate commitment to provide customers with top quality service,

X undertakes a project to develop for X's internal use a computer

software system to facilitate the tracking of the manufacturing and

delivery of widgets which will enable X's customers to monitor the

progress of their orders and know precisely when their widgets will

be delivered. X's computer software activities include research

activities that satisfy the discovery requirement in section

41(d)(1) and paragraph (a)(3) of this section. At the time the

research is undertaken, X reasonably anticipates that if it is

successful, X will increase its market share as compared to X's

competitors, none of which has such a tracking feature for its

delivery system.

(ii) Conclusion. Although X's computer software system is

developed primarily for X's internal use, X's activities are

excepted from 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 improved tracking

features, X reasonably anticipates that customers will purchase

widgets from X because these improved tracking features, and because

comparable tracking features are not available from any of X's

competitors.

(ix) Effective dates. This paragraph (c)(6) is applicable for

taxable years beginning after December 31, 1985, except paragraphs

(c)(6)(ii)(C)(4), (c)(6)(iv)(A) and (B), (c)(6)(v), the second and

third sentences of paragraph (c)(6)(vii), and paragraph (c)(6)(viii)

Example 2 of this section apply to expenditures paid or incurred on or

after January 3, 2001.

(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

[[Page 294]]

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 (A) in

the United States, the Commonwealth of Puerto Rico and other

possessions of the United States and (B) 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) 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, seeks to build a

tire that will not deteriorate as rapidly under certain conditions

of high speed and temperature as do existing tires. X commences

laboratory research on January 1. On April 1, X determines in the

laboratory that a certain combination of materials and additives can

withstand higher rotational speeds and temperatures than the

combination of materials and additives used in existing tires. On

the basis of this determination, X undertakes further research

activities to determine how to design a tire using those materials

and additives, and to determine whether such a tire functions

outside the laboratory as intended under various actual road

conditions. By September 1, X's research has progressed to the point

where the new tire meets X's basic functional and economic

requirements.

(ii) Conclusion. Any research activities conducted by X after

September 1 with respect to the design of the tire are not qualified

research within the meaning of section 41(d)(1) and paragraph (a) of

this section because they are undertaken after the beginning of

commercial production of the tire. Whether any activities X engaged

in to develop a process for manufacturing the new tire constitute

qualified research depends on if the development of the process

itself separately satisfies the requirements of section 41(d) and

paragraph (c)(2) of this section, and also depends on if the

activities occur before the point in time when the process meets the

taxpayer's basic functional and economic requirements or is ready

for commercial use.

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 an improved widget.

(ii) Conclusion. X's activities to develop an improved widget

are not excluded from the definition of qualified research under

section 41(d)(4)(A) and paragraph (c)(2) of this section until the

beginning of commercial production of the improved widget. The fact

that X's activities relating to the improved widget are undertaken

after the beginning of commercial production of the unimproved

widget does not bar the activities from credit eligibility because

those activities constitute a new research project to develop a new

business component, an improved widget.

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, 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 do not

constitute 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 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. 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 discover potential alternative formulations of

the additive (i.e., the development and use of various ingredients

other than C to use with A and B).

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

ingredients A and B involve duplication of existing business

components and are excluded from qualified research under section

41(d)(4)(C) and paragraph (c)(4) of this section. X's

experimentation activities to discover potential alternative

formulations of the additive do not involve duplication of an

existing business component and are not excluded from qualified

research under section 41(d)(4)(C) and paragraph (c)(4) of this

section.

Example 7. (i) 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, and are thus excluded

from qualified research under section 41(d)(4)(G) and paragraph

(c)(8) of this section.

(d) Documentation. No credit shall be allowed under section 41 with

regard to an expenditure relating to a research project unless the

taxpayer--

(1) Prepares documentation before or during the early stages of the

research

[[Page 295]]

project, that describes the principal questions to be answered and the

information the taxpayer seeks to obtain to satisfy the requirements of

paragraph (a)(3) of this section, and retains that documentation on

paper or electronically in the manner prescribed in applicable

regulations, revenue rulings, revenue procedures, or other appropriate

guidance until such time as taxes may no longer be assessed (except

under section 6501(c)(1), (2), or (3)) for any year in which the

taxpayer claims to have qualified research expenditures in connection

with the research project; and

(2) Satisfies section 6001 and the regulations thereunder.

(e) Effective dates. In general, the rules of this section are

applicable for expenditures paid or incurred on or after January 3,

2001. The rules of paragraph (d), however, apply to research projects

that begin on or after March 5, 2001.

Sec. 1.41-5 [Redesignated as Sec. 1.41-4A, and Amended]

Par. 11. Section 1.41-5 is redesignated as Sec. 1.41-4A, and the

last sentence of paragraph (d)(1) is amended by removing the language

``Sec. 1.41-8(e)'' and adding ``Sec. 1.41-6(e)'' in its place.

Sec. 1.41-6 [Redesignated as Sec. 1.41-5, and Amended]

Par. 12. Section 1.41-6 is redesignated as Sec. 1.41-5 and the

section heading is amended by removing the language ``December 31,

1985'' and adding ``December 31, 1986'' in its place.

Sec. 1.41-7 [Redesignated as Sec. 1.41-5A, and Amended]

Par. 13. Section 1.41-7 is redesignated as Sec. 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

``Sec. 1.41-5(c)'' and adding ``1.41-4A(c)'' in its place.

Sec. 1.41-8 [Redesignated as Sec. 1.41-6, and Amended]

Par. 14. Section 1.41-8 is redesignated as Sec. 1.41-6, and the

last sentence of paragraph (c) is amended by removing the language

``Sec. 1.41-3, except that Sec. 1.41-3(c)(2)'' and adding ``Sec. 1.41-

3A, except that Sec. 1.41-3A(c)(2)'' in its place.

Sec. 1.41-9 [Redesignated as Sec. 1.41-7]

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

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

Sec. 1.41-8 Special rules for taxable years ending on or after January

3, 2001.

(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.

(4) Effective date. Paragraphs (b)(2) and (3) of this section are

applicable for taxable years ending on or after January 3, 2001.

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:

Sec. 1.41-0A Table of contents.

This section lists the paragraphs contained in Secs. 1.41-0A, 1.41-

3A, 1.41-4A and 1.41-5A.

Sec. 1.41-0A Table of contents.

Sec. 1.41-3A Base period research expense.

(a) Number of years in base period.

(b) New taxpayers.

(d) Special rules for short taxable years.

(1) Short determination year.

(2) Short base period year.

(3) Years overlapping the effective dates of section 41 (section

44F).

(i) Determination years.

(ii) Base period years.

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

(e) Examples.

Sec. 1.41-4A Qualified research for taxable years beginning before

January 1, 1986.

(a) General rule.

(b) Activities outside the United States.

(1) In-house research.

(2) Contract research.

(d) Research funded by any grant, contract, or otherwise.

(1) In general.

(2) Research in which taxpayer retains no rights.

(3) Research in which the taxpayer retains substantial rights.

(i) In general.

(ii) Pro rata allocation.

(iii) Project-by-project determination.

(4) Independent research and development under the Federal

Acquisition Regulations System and similar provisions.

(5) Funding determinable only in subsequent taxable year.

(6) Examples.

Sec. 1.41-5A Basic research for taxable years beginning before

January 1, 1987.

(a) In general.

(b) Trade or business requirement.

(1) In general.

(2) Transfers of property.

(d) Written research agreement.

(1) In general.

(2) Agreement between a corporation and a qualified organization

after June 30, 1983.

(i) In general.

(ii) Transfers of property.

(3) Agreement between a qualified fund and a qualified

educational organization after June 30, 1983.

(e) Exclusions.

(1) Research conducted outside the United States.

(2) Research in the social sciences or humanities.

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

qualified fund.

Sec. 1.218-0 [Removed]

Par. 18. Section 1.218-0 is removed.

Sec. 1.482-7 [Amended]

Par. 19. In Sec. 1.482-7, the sixth sentence of paragraph (h)(1) is

amended by removing the language ``Sec. 1.41-8(e)'' and adding

``Sec. 1.41-6(e)'' in its place.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 20. The authority citation for part 602 continues to read as

follows:

Authority: 26 U.S.C. 7805.

Par. 21. In Sec. 602.101, paragraph (b) is amended by adding an

entry to the table in numerical order to read as follows:

Sec. 602.101 OMB Control numbers.

* * * * *

(b) * * *

[[Page 296]]

------------------------------------------------------------------------

Current OMB

CFR part or section where identified and described control No.

------------------------------------------------------------------------

* * * * *

1.41-4(d)............................................... 1545-1625

* * * * *

1.41-8(b)............................................... 1545-1625

* * * * *

------------------------------------------------------------------------

Robert E. Wenzel,.

Deputy Commissioner of Internal Revenue.

Approved: December 22, 2000.

Jonathan Talisman,

Acting Assistant Secretary of the Treasury.

[FR Doc. 00-33170 Filed 12-27-00; 12:33 pm]

BILLING CODE 4830-01-P