[Federal Register: January 2, 2004 (Volume 69, Number 1)]

[Rules and Regulations]

[Page 22-29]

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

[DOCID:fr02ja04-6]

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9104]

RIN 1545-AY82

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

definition of qualified research under section 41(d) for the credit for

increasing research activities. These final regulations reflect changes

to section 41(d) made by the Tax Reform Act of 1986.

DATES: Effective Dates: These regulations are effective January 2,

2004.

Applicability Dates: For dates of applicability of these

regulations, see Sec. 1.41-4(e) and Effective Dates under

SUPPLEMENTARY INFORMATION.

FOR FURTHER INFORMATION CONTACT: Nicole R. Cimino at (202) 622-3120

(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On December 2, 1998, the Treasury Department and the IRS published

in the Federal Register (63 FR 66503) a notice of proposed rulemaking

(REG-10570-97, 1998-2 C.B. 729) under section 41 (1998 proposed

regulations) relating to the credit for increasing research activities

(research credit). The 1998 proposed regulations addressed, in relevant

part, (1) the definition of qualified research under section 41(d), (2)

the application of the exclusions from the definition of qualified

research, and (3) the application of the shrinking-back rule. Comments

responding to the 1998 proposed regulations were received and a public

hearing was held on April 29, 1999.

On January 3, 2001, the Treasury Department and the IRS published

in the Federal Register (66 FR 280) final regulations relating, in

relevant part, to the definition of qualified research under section

41(d) (TD 8930). In response to taxpayer concerns regarding TD 8930, on

January 31, 2001, the Treasury Department and the IRS published Notice

2001-19 (2001-10 I.R.B. 784), announcing that the Treasury Department

and the IRS would review TD 8930 and reconsider comments previously

submitted in connection with the finalization of TD 8930. Notice 2001-

19 also provided that, upon the completion of the review, the Treasury

Department and the IRS would announce changes to the regulations, if

any, in the form of proposed regulations.

On December 26, 2001, the Treasury Department and the IRS published

in the Federal Register (66 FR 66362) a notice of proposed rulemaking

(REG-112991-01) reflecting the Treasury Department and the IRS' review

of TD 8930 (2001 proposed regulations). Comments responding to the 2001

proposed regulations were received and a public hearing was held on

March 27, 2002. After considering the comments received and the

statements made at the public hearing, portions of the 2001 proposed

regulations are adopted as revised by this Treasury Decision.

Explanation of Provisions

This document amends 26 CFR part 1 to provide revised rules for the

research credit under section 41. These final regulations generally

retain the provisions of the 2001 proposed regulations but clarify the

provisions relating to the requirement in section 41(d)(1)(C) that

qualified research be research ``substantially all of the activities of

which constitute elements of a process of experimentation.'' These

final regulations, however, do not contain final rules for research

with respect to computer software ``which is developed by (or for the

benefit of) the taxpayer primarily for internal use by the taxpayer''

for purposes of section 41(d)(4)(E).

Process of Experimentation--In General

The Tax Reform Act of 1986, Public Law 99-514 (100 Stat. 2085) (the

1986 Act), which narrowed the definition of the term qualified

research, amended the definition of qualified research by adding a

process of experimentation requirement. Section 41(d)(1) provides

[[Page 23]]

that in order to constitute qualified research, substantially all of

the activities of the research must constitute elements of a process of

experimentation related to a new or improved function, performance, or

reliability or quality. The legislative history to the 1986 Act

explained that ``[t]he determination of whether research is undertaken

for the purpose of discovering information that is technological in

nature depends on whether the process of experimentation utilized in

the research fundamentally relies on principles of the physical or

biological sciences, engineering, or computer science.'' H.R. Conf.

Rep. No. 99-841, at II-71 (1986). The legislative history further

explained that 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.'' Id., at II-72. In addition, a process of

experimentation may involve developing one or more hypotheses, testing

and analyzing those hypotheses (through, for example, modeling or

simulation), and refining or discarding the hypotheses as part of a

sequential design process to develop the overall component. Id.

The 1998 proposed regulations defined a process of experimentation

as ``a process to evaluate more than one alternative designed to

achieve a result where the means of achieving that result are uncertain

at the outset.'' Further, the 1998 proposed regulations specified that

a process of experimentation is a four-step process requiring that the

taxpayer: (i) Develop one or more hypotheses designed to achieve the

intended result; (ii) design a scientific experiment (that, where

appropriate to the particular field of research, is intended to be

replicable with an established experimental control) to test and

analyze those hypotheses (through, for example, modeling, simulation,

or a systematic trial and error methodology); (iii) conduct the

experiment and record the results; and (iv) refine or discard the

hypotheses as part of a sequential design process to develop or improve

the business component. Commentators generally objected to this

prescribed four-step test arguing that it would not be appropriate for

evaluating the qualification of certain commercial and industrial

research activities.

In response to these comments, the Treasury Department and the IRS

in TD 8930 provided that taxpayers conducting a process of

experimentation may, but were not required to, engage in the four-step

process described in the 1998 proposed regulations, but eliminated, for

this purpose, the specific recordation requirement. (As an addition to

the general recordkeeping requirement under section 6001, TD 8930

instead included a contemporaneous documentation requirement that was

intended to be less burdensome than the specific recordation

requirement. The contemporaneous documentation requirement in TD 8930

was eliminated in the 2001 proposed regulations.) Consistent with the

legislative history, however, TD 8930 retained the underlying process

of experimentation requirement in the 1998 proposed regulations by

providing that a process of experimentation ``is a process to evaluate

more than one alternative designed to achieve a result where the

capability or method of achieving that result is uncertain at the

outset.''

The 2001 proposed regulations further clarified the definition of a

process of experimentation and provided, in relevant part, that ``a

process of experimentation is a process designed to evaluate one or

more alternatives to achieve a result where the capability or the

method of achieving that result, or the appropriate design of that

result, is uncertain as of the beginning of the taxpayer's research

activities.'' More specifically, however, the general requirement was

modified in the 2001 proposed regulations to provide, first, that ``a

process of experimentation is a process designed to evaluate one or

more alternatives to achieve a result.'' (Emphasis added). The 2001

proposed regulations also provided that a process of experimentation

may exist if a taxpayer performs research to establish the appropriate

design of a business component even when the capability and method for

developing or improving the business component are not uncertain. The

2001 proposed regulations further stated that a taxpayer's activities

do not constitute elements of a process of experimentation where the

capability and method of achieving the desired new or improved business

component, and the appropriate design of the desired new or improved

business component, are readily discernible and applicable as of the

beginning of the taxpayer's research activities so that true

experimentation in the scientific or laboratory sense would not have to

be undertaken to test, analyze, and choose among viable alternatives.

Finally, the 2001 proposed regulations emphasized that the

determination of whether a taxpayer has engaged in a process of

experimentation was dependent on the facts and circumstances of the

taxpayer's research activities and, for this purpose, contained three

non-dispositive and non-exclusive factors that tend to indicate that a

taxpayer has engaged in a process of experimentation.

In response to the 2001 proposed regulations, a number of

commentators expressed concern with the rules for the process of

experimentation requirement, and, in particular, stated that the rules

and terms used (including uncertainty, appropriate design, and readily

discernible and applicable) did not provide clear guidance for the

requirement. More specifically, commentators stated that the term

readily discernible and applicable was highly subjective in nature, and

thus arguably could be construed as a variant of the discovery test of

TD 8930. In addition, one commentator expressed concern regarding the

meaning and scope of the term uncertain and suggested adding examples

illustrating the factors that tend to indicate that a taxpayer has

engaged in a process of experimentation. Another commentator also noted

that the 2001 proposed regulations appeared to allow the inclusion of

all design costs as qualified research expenditures to the extent that

the appropriate design of the desired result is never certain at the

outset of the typical design process.

The Treasury Department and the IRS continue to believe that the

process of experimentation test requires an evaluation of the facts and

circumstances of a taxpayer's research activities. As reflected by the

changes made in the 2001 proposed regulations, this requirement is not

intended to be inflexible or overly narrow. Nevertheless, the Treasury

Department and the IRS continue to believe that the requirement in the

2001 proposed regulations that a process of experimentation is ``a

process designed to evaluate one or more alternatives to achieve a

result'' (emphasis added) implies that research activities must contain

certain core elements in order to constitute a process of

experimentation within the meaning of section 41(d)(1)(C). These final

regulations, therefore, make the following clarifications relating to

the process of experimentation requirement in the 2001 proposed

regulations.

Process of Experimentation--Requirements

The final regulations retain, but further clarify, the requirement

in the 2001 proposed regulations that ``a process of experimentation is

a process designed to evaluate one or more alternatives to achieve a

result where

[[Page 24]]

the capability or the method of achieving that result, or the

appropriate design of that result, is uncertain as of the beginning of

the taxpayer's research activities.'' Further, the final regulations

emphasize that the taxpayer's activities must be directed at resolving

uncertainty regarding the taxpayer's development or improvement of a

business component, and that the process of experimentation must

fundamentally rely on the principles of the physical or biological

sciences, engineering, or computer science in attempting to resolve the

uncertainty. Although these concepts are stated explicitly in the 1986

legislative history and are implicit in the statute, they may not have

been given appropriate or necessary weight in prior proposed or final

guidance on the process of experimentation requirement.

The final regulations, therefore, set out what the Treasury

Department and the IRS have concluded to be the core elements of a

process of experimentation for purposes of the research credit. As

noted above and consistent with the statute's wording which requires

purposeful activity (i.e., ``undertaken for the purpose of discovering

information''), a taxpayer is required to identify the uncertainty

regarding the development or improvement of a business component that

is the object of the taxpayer's research activities. A taxpayer is also

required to identify one or more alternatives intended to eliminate

that uncertainty. Additionally, a taxpayer is required to identify and

to conduct a process of evaluating the alternatives. The final

regulations provide that such a process may involve, for example,

modeling, simulation, or a systematic trial and error methodology.

The final regulations further provide that a process of

experimentation ``must be an evaluative process and generally should be

capable of evaluating more than one alternative.'' (Emphasis added).

Although the identification and evaluation of more than a single

alternative is not required to satisfy the process of experimentation

requirement, the Treasury Department and the IRS believe that a

taxpayer's activities, in order to qualify for the research credit,

generally should be capable of evaluating more than one alternative

and, in any event, must be designed to evaluate the alternative, or

alternatives, being considered.

The final regulations state that the mere existence of uncertainty

regarding the development or improvement of a business component does

not indicate that all of a taxpayer's activities undertaken to achieve

that new or improved business component constitute a process of

experimentation, even if the taxpayer, in fact, does achieve the new or

improved business component. The Treasury Department and the IRS

believe that the inclusion of a separate process of experimentation

requirement in the statute makes this proposition clear. However, the

Treasury Department and the IRS have included this clarification in the

final regulations out of concern that taxpayers have not been giving

sufficient weight to the requirement that a taxpayer engage in a

process designed to evaluate one or more alternatives to achieve a

result where the capability or the method of achieving that result, or

the appropriate design of that result, is uncertain as of the beginning

of the taxpayer's research activities. In particular, this

clarification is intended to indicate that merely demonstrating that

uncertainty has been eliminated (e.g., the achievement of the

appropriate design of a business component when such design was

uncertain as of the beginning of a taxpayer's activities) is

insufficient to satisfy the process of experimentation requirement. A

taxpayer bears the burden of demonstrating that its research activities

additionally satisfy the process of experimentation requirement.

As noted above, all of the facts and circumstances of a taxpayer's

research activities are taken into account to determine whether the

taxpayer identified uncertainty concerning the development or

improvement of a business component, identified one or more

alternatives intended to eliminate that uncertainty, and identified and

conducted a process of evaluating the alternatives. Although the final

regulations set out the core elements of a process of experimentation,

how a taxpayer's qualified research activities will reflect these core

elements will depend on the facts and circumstances. These core

elements will not necessarily occur in a strict, sequential order. A

process of experimentation is an evaluative process, and as such, often

involves refining throughout much of the process the taxpayer's

understanding of the uncertainty the taxpayer is trying to address,

modifying the alternatives being evaluated to eliminate that

uncertainty, or modifying the process used to evaluate those

alternatives.

Accordingly, the final regulations do not provide detailed guidance

as to how the regulatory provisions are to be applied to a given

factual situation. Rather, the Treasury Department and the IRS have

concluded that the application of these provisions will depend on the

specific activities being claimed by a taxpayer as qualified research,

the nature of the taxpayer's business and industry, and the

uncertainties being addressed by the taxpayer's research activities.

The Treasury Department and the IRS believe that additional, industry-

specific guidance may be appropriate and request comments on the form

of such guidance.

The final regulations do not include the rule contained in the 2001

proposed regulations that a taxpayer's activities do not constitute a

process of experimentation where the capability and method of achieving

the desired new or improved business component, and the appropriate

design of the desired new or improved business component, are readily

discernible and applicable as of the beginning of the taxpayer's

research activities. A number of commentators expressed concern that

this rule was too vague and susceptible to conflicting interpretations.

In light of the clarifications made in these final regulations, the

Treasury Department and the IRS have concluded that this rule is no

longer necessary because such activities do not constitute a process of

experimentation under the final regulations.

As noted above, the 2001 proposed regulations do not contain a

specific recordkeeping requirement beyond the requirements set out in

section 6001 and the regulations thereunder. No change regarding

recordkeeping is being made in these final regulations. The

clarifications being made to the process of experimentation requirement

do not impose any recordkeeping requirement on taxpayers beyond the

requirements set out in section 6001 and the regulations thereunder.

Process of Experimentation--Substantially all Requirement

The 2001 proposed regulations retained the rule in TD 8930 that the

``substantially all'' requirement of section 41(d)(1)(C) is satisfied

only if 80 percent or more of the research activities, measured on a

cost or other consistently applied reasonable basis (and without regard

to Sec. 1.41-2(d)(2)), constitute elements of a process of

experimentation for a purpose described in section 41(d)(3). This

requirement is applied separately to each business component.

The Treasury Department and the IRS requested comments on the

application of the substantially all rule and, in particular, whether

research expenses incurred for non-qualified purposes (i.e., relating

to style, taste, cosmetic, or seasonal design factors) are includible

[[Page 25]]

in the credit computation provided that substantially all of the

research activities constitute elements of a process of experimentation

for a qualified purpose. After consideration of the comments received,

the Treasury Department and the IRS have concluded that the

substantially all requirement can be satisfied even if some portion of

a taxpayer's activities are not for a qualified purpose.

Accordingly, these final regulations clarify the substantially all

rule and provide that the substantially all requirement is satisfied if

20 percent or less of a taxpayer's research activities do not

constitute elements of a process of experimentation for a purpose

described in section 41(d)(3), so long as these remaining activities

satisfy the requirements of section 41(d)(1)(A) and are not otherwise

excluded under section 41(d)(4). Example (6) of Sec. 1.41-4(a)(8) of

the 2001 proposed regulations has been modified to illustrate the

application of this rule, and appears as example (4) in these final

regulations.

Other Issues

Patent Safe Harbor

Section 1.41-4(a)(3)(iii) of the 2001 proposed regulations

generally provided that the issuance of certain patents is conclusive

evidence that a taxpayer has discovered information that is

technological in nature that is intended to eliminate uncertainty

concerning the development or improvement of a business component. Some

commentators requested that this patent safe harbor be expanded to

cover all requirements contained in sections 41(d)(1) and (3). After

consideration of these comments, and in light of the clarifications

being made in these final regulations to the provisions relating to the

process of experimentation requirement, the Treasury Department and the

IRS continue to believe that the patent safe harbor is appropriately

limited and, therefore, have not changed the patent safe harbor

provision.

Shrinking-Back Rule

Some commentators expressed concern that the language of the

shrinking-back rule in Sec. 1.41-4(b)(2) of the 2001 proposed

regulations implied that not all of a taxpayer's qualified research

expenses would be eligible for the research credit as a result of the

application of the rule. This provision has been revised in these final

regulations to clarify that the rule is not intended to exclude

qualified research expenses from the credit, but rather is intended to

ensure that expenses attributable to qualified research activities are

eligible for the research credit for purposes of section 41(d)(1).

Research After Commercial Production

Some commentators requested additional clarification regarding the

scope of the research after commercial production, adaptation, and

duplication exclusions set out in section 41(d)(4)(A), (B) and (C), and

Sec. 1.41-4(c)(2), (3) and (4) of the 2001 proposed regulations. After

consideration of these comments, the Treasury Department and the IRS

believe that the multitude of factual situations to which these

exclusions might apply make it impractical to provide additional

clarification that is both meaningful and of broad application. The

Treasury Department and the IRS believe these three specific exclusions

do not cover research activities that otherwise satisfy the

requirements for qualified research. Taxpayers, however, should

carefully review (including, as appropriate, the application of the

shrinking-back rule) research activities that might otherwise fall

within these exclusions to ensure that only eligible activities are

being included in their credit computations.

One commentator expressed concern that the language of Sec. 1.41-

4(c)(2)(iv), relating to the clinical testing of pharmaceutical

products, could exclude from credit eligibility clinical trials

performed under an arrangement where the Food and Drug Administration

has granted conditional approval for a pharmaceutical product

contingent upon the results of additional clinical trials. Another

commentator expressed concern that the language would exclude otherwise

qualifying activities because the research was not required to be

approved by the Food and Drug Administration. Section 1.41-4(c)(2)(iv)

is not a rule of exclusion. As stated above, the Treasury Department

and the IRS believe that the research after commercial production

exclusion (as well as the adaptation and duplication exclusions) do not

cover research activities, including these additional clinical trials,

so long as such trials satisfy the requirements for qualified research.

Gross Receipts

These final regulations retain the broad definition of gross

receipts contained in TD 8930. In response to Notice 2001-19, a number

of commentators reiterated earlier comments that this definition was

overly broad. As stated in the preamble to the 2001 proposed

regulations, the Treasury Department and the IRS continue to believe

that the definition of gross receipts should be construed broadly, and,

accordingly, no change has been made in these final regulations to the

definition contained in TD 8930.

Examples

The examples in the regulations have been changed to remove

references to ``readily discernible and applicable.'' While the

Treasury Department and the IRS continue to believe that the activities

in Examples 4 and 5 of Sec. 1.41-4(a)(8) of the 2001 proposed

regulations would not qualify under the final regulations, these

examples were removed as the only purpose of these examples was to

illustrate the ``readily discernable and applicable'' standard. Minor

changes to the facts in Example 4 of Sec. 1.41-4(a)(8) in the final

regulations (Example 6 of Sec. 1.41-4(a)(8) of the 2001 proposed

regulations) were made to illustrate more clearly the application of

the substantially all requirement of Sec. 1.41-4(a)(6). These changes

do not indicate that the Treasury Department and the IRS believe that

the integration activities removed from the example, as contained in

the 2001 proposed regulations, are or are not qualified activities

standing alone. The determination of whether activities are qualified

research is based on the specific facts and circumstances of those

activities.

Additionally, minor changes were made to the examples in Sec.

1.41-4(c)(10) to remove references to ``readily discernable and

applicable'' and to make some clarifications based on comments

received. Example 1 of Sec. 1.41-4(c)(10) was modified to remove the

conclusion regarding qualification of expenses under section 174.

Although the Treasury Department and the IRS continue to believe that

the conclusion in the 2001 proposed regulations is correct, the

Treasury Department and the IRS believe that the point illustrated in

the removed portion of the example would be more appropriately

addressed in guidance issued under section 174, rather than in guidance

under section 41.

Effective Date

Notice 2001-19 stated, in relevant part, that the provisions of TD

8930, including any changes to TD 8930, would be effective no earlier

than the date when the completion of the Treasury Department and the

IRS' review of TD 8930 was announced. The 2001 proposed regulations

provided, in relevant part, that final regulations would apply to

taxable years ending on or after December 26, 2001, the date the

proposed regulations were published in the Federal Register.

[[Page 26]]

Because these final regulations only clarify the provisions of the

2001 proposed regulations, these final regulations apply to taxable

years ending on or after December 31, 2003. For taxable years ending

before December 31, 2003, the IRS will not challenge return positions

that are consistent with these final regulations.

Special Analyses

It has been determined that these regulations are not a significant

regulatory action as defined in Executive Order 12866. 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, and because

these regulations do not impose a collection of information on small

entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not

apply. Therefore, a Regulatory Flexibility Act Analysis 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 author of these regulations is Nicole R. Cimino of

the Office of Associate Chief Counsel (Passthroughs and Special

Industries), IRS. However, personnel from other offices of the IRS and

the Treasury Department participated in their development.

List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

0

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART I--INCOME TAXES

0

Paragraph 1. The authority for part 1 continues to read in part as

follows:

Authority: 26 U.S.C. 7805 * * *.

0

Par. 2. Section 1.41-0 is amended by revising the entry for Sec. 1.41-

4 to read as follows:

The revision reads as follows:

Sec. 1.41-0 Table of contents.

* * * * *

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

taxable years ending on or after December 31, 2003.

(a) Qualified research.

(1) General rule.

(2) Requirements of section 41(d)(1).

(3) Undertaken for the purpose of discovering information.

(i) In general.

(ii) Application of the discovering information requirement.

(iii) Patent safe harbor.

(4) Technological in nature.

(5) Process of experimentation.

(i) In general.

(ii) Qualified purpose.

(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.

(c) Excluded activities.

(1) In general.

(2) Research after commercial production.

(i) In general.

(ii) Certain additional activities related to the business

component.

(iii) Activities related to production process or technique.

(iv) Clinical testing.

(3) Adaptation of existing business components.

(4) Duplication of existing business component.

(5) Surveys, studies, research relating to management functions,

etc.

(6) Internal use software for taxable years beginning on or

after December 31, 1985. [Reserved].

(7) Activities outside the United States, Puerto Rico, and other

possessions.

(i) In general.

(ii) Apportionment of in-house research expenses.

(iii) Apportionment of contract research expenses.

(8) Research in the social sciences, etc.

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

(10) Illustrations.

(d) Recordkeeping for the research credit.

(e) Effective dates.

* * * * *

0

Par. 3. Section 1.41-4 is amended as follows:

0

1. The section heading and paragraphs (a)(2)(iii), (a)(3), (a)(4),

(a)(5), (a)(6), (a)(8), (b)(2), (b)(3), (c)(2)(iv), (c)(4), (c)(7)(ii),

(c)(10), (d), and (e) are revised.

0

2. The heading of paragraph (c)(6) is revised and the text is removed

and reserved.

The revisions read as follows:

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

taxable years ending on or after December 31, 2003.

(a) * * *

(2) * * *

(iii) Substantially all of the activities of which constitute

elements of a process of experimentation that relates to a qualified

purpose.

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

general. For purposes of section 41(d) and this section, research must

be undertaken for the purpose of discovering information that is

technological in nature. Research is undertaken for the purpose of

discovering information if it is intended to eliminate uncertainty

concerning the development or improvement of a business component.

Uncertainty exists if the information available to the taxpayer does

not establish the capability or method for developing or improving the

business component, or the appropriate design of the business

component.

(ii) Application of the discovering information requirement. A

determination that research is undertaken for the purpose of

discovering information that is technological in nature does not

require the taxpayer be seeking to obtain information that exceeds,

expands or refines the common knowledge of skilled professionals in the

particular field of science or engineering in which the taxpayer is

performing the research. In addition, a determination that research is

undertaken for the purpose of discovering information that is

technological in nature does not require that the taxpayer succeed in

developing a new or improved business component.

(iii) Patent safe harbor. For purposes of section 41(d) and

paragraph (a)(3)(i) of this section, the issuance of a patent by the

Patent and Trademark Office under the provisions of 35 U.S.C. 151

(other than a patent for design issued under the provisions of 35

U.S.C. 171) is conclusive evidence that a taxpayer has discovered

information that is technological in nature that is intended to

eliminate uncertainty concerning the development or improvement of a

business component. However, the issuance of such a patent is not a

precondition for credit availability.

(4) Technological in nature. For purposes of section 41(d) and this

section, information is technological in nature if the process of

experimentation used to discover such information fundamentally relies

on principles of the physical or biological sciences, engineering, or

computer science. A taxpayer may employ existing technologies and may

rely on existing principles of the physical or biological sciences,

engineering, or computer science to satisfy this requirement.

(5) Process of experimentation--(i) In general. For purposes of

section 41(d) and this section, a process of experimentation is a

process designed to evaluate one or more alternatives to achieve a

result where the capability or

[[Page 27]]

the method of achieving that result, or the appropriate design of that

result, is uncertain as of the beginning of the taxpayer's research

activities. A process of experimentation must fundamentally rely on the

principles of the physical or biological sciences, engineering, or

computer science and involves the identification of uncertainty

concerning the development or improvement of a business component, the

identification of one or more alternatives intended to eliminate that

uncertainty, and the identification and the conduct of a process of

evaluating the alternatives (through, for example, modeling,

simulation, or a systematic trial and error methodology). A process of

experimentation must be an evaluative process and generally should be

capable of evaluating more than one alternative. A taxpayer may

undertake a process of experimentation if there is no uncertainty

concerning the taxpayer's capability or method of achieving the desired

result so long as the appropriate design of the desired result is

uncertain as of the beginning of the taxpayer's research activities.

Uncertainty concerning the development or improvement of the business

component (e.g., its appropriate design) does not establish that all

activities undertaken to achieve that new or improved business

component constitute a process of experimentation.

(ii) Qualified purpose. For purposes of section 41(d) and this

section, a process of experimentation is undertaken for a qualified

purpose if it relates to a new or improved function, performance,

reliability or quality of the business component. Research will not be

treated as conducted for a qualified purpose if it relates to style,

taste, cosmetic, or seasonal design factors.

(6) Substantially all requirement. In order for activities to

constitute qualified research under section 41(d)(1), substantially all

of the activities must constitute elements of a process of

experimentation that relates to a qualified purpose. 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 a taxpayer's

research activities, measured on a cost or other consistently applied

reasonable basis (and without regard to section 1.41-2(d)(2)),

constitute elements of a process of experimentation for a purpose

described in section 41(d)(3). Accordingly, if 80 percent (or more) of

a taxpayer's research activities with respect to a business component

constitute elements of a process of experimentation for a purpose

described in section 41(d)(3), the substantially all requirement is

satisfied even if the remaining 20 percent (or less) of a taxpayer's

research activities with respect to the business component do not

constitute elements of a process of experimentation for a purpose

described in section 41(d)(3), so long as these remaining research

activities satisfy the requirements of section 41(d)(1)(A) and are not

otherwise excluded under section 41(d)(4). The substantially all

requirement is applied separately to each business component.

* * * * *

(8) Illustrations. The following examples illustrate the

application of paragraph (a)(5) of this section:

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

and manufacturing widgets. X wants to change the color of its blue

widget to green. X obtains from various suppliers several different

shades of green paint. X paints several sample widgets, and surveys

X's customers to determine which shade of green X's customers

prefer.

(ii) Conclusion. X's activities to change the color of its blue

widget to green are not qualified research under section 41(d)(1)

and paragraph (a)(5) of this section because substantially all of

X's activities are not undertaken for a qualified purpose. All of

X's research activities are related to style, taste, cosmetic, or

seasonal design factors.

Example 2. (i) Facts. The facts are the same as in Example 1,

except that X chooses one of the green paints. X obtains samples of

the green paint from a supplier and determines that X must modify

its painting process to accommodate the green paint because the

green paint has different characteristics from other paints X has

used. X obtains detailed data on the green paint from X's paint

supplier. X also consults with the manufacturer of X's paint

spraying machines. The manufacturer informs X that X must acquire a

new nozzle that operates with the green paint X wants to use. X

tests the nozzles to ensure that they work as specified by the

manufacturer of the paint spraying machines.

(ii) Conclusion. X's activities to modify its painting process

are a separate business component under section 41(d)(2)(A). X's

activities to modify its painting process to change the color of its

blue widget to green are not qualified research under section

41(d)(1) and paragraph (a)(5) of this section. X did not conduct a

process of evaluating alternatives in order to eliminate uncertainty

regarding the modification of its painting process. Rather, the

manufacturer of the paint machines eliminated X's uncertainty

regarding the modification of its painting process. X's activities

to test the nozzles to determine if the nozzles work as specified by

the manufacturer of the paint spraying machines are in the nature of

routine or ordinary testing or inspection for quality control.

Example 3. (i) Facts. X is engaged in the business of

manufacturing food products and currently manufactures a large-shred

version of a product. X seeks to modify its current production line

to permit it to manufacture both a large-shred version and a fine-

shred version of one of its food products. A smaller, thinner

shredding blade capable of producing a fine-shred version of the

food product, however, is not commercially available. Thus, X must

develop a new shredding blade that can be fitted onto its current

production line. X is uncertain concerning the design of the new

shredding blade, because the material used in its existing blade

breaks when machined into smaller, thinner blades. X engages in a

systematic trial and error process of analyzing various blade

designs and materials to determine whether the new shredding blade

must be constructed of a different material from that of its

existing shredding blade and, if so, what material will best meet

X's functional requirements.

(ii) Conclusion. X's activities to modify its current production

line by developing the new shredding blade meet the requirements of

qualified research as set forth in paragraph (a)(2) of this section.

Substantially all of X's activities constitute elements of a process

of experimentation because X evaluated alternatives to achieve a

result where the method of achieving that result, and the

appropriate design of that result, were uncertain as of the

beginning of the taxpayer's research activities. X identified

uncertainties related to the development of a business component,

and identified alternatives intended to eliminate these

uncertainties. Furthermore, X's process of evaluating identified

alternatives was technological in nature, and was undertaken to

eliminate the uncertainties.

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

developing and manufacturing automobiles. In response to government-

mandated fuel economy requirements, X seeks to update its current

model vehicle and undertakes to improve aerodynamics by lowering the

hood of its current model vehicle. X determines, however, that

lowering the hood changes the air flow under the hood, which changes

the rate at which air enters the engine through the air intake

system, and which reduces the functionality of the cooling system.

X's engineers are uncertain how to design a lower hood to obtain the

increased fuel economy, while maintaining the necessary air flow

under the hood. X designs, models, simulates, tests, refines, and

re-tests several alternative designs for the hood and associated

proposed modifications to both the air intake system and cooling

system. This process enables X to eliminate the uncertainties

related to the integrated design of the hood, air intake system, and

cooling system, and such activities constitute eighty-five percent

of X's total activities to update its current model vehicle. X then

engages in additional activities that do not involve a process of

evaluating alternatives in order to eliminate uncertainties. The

additional activities constitute only fifteen percent of X's total

activities to update its current model vehicle.

(ii) Conclusion. In general, if eighty percent or more of a

taxpayer's research activities measured on a cost or other

consistently applied reasonable basis constitute elements of a

process of experimentation for a qualified purpose under section

41(d)(3)(A) and paragraph (a)(5)(ii) of this section, then

[[Page 28]]

the substantially all requirement of section 41(d)(1)(C) and

paragraph (a)(2)(iii) of this section is satisfied. Substantially

all of X's activities constitute elements of a process of

experimentation because X evaluated alternatives to achieve a result

where the method of achieving that result, and the appropriate

design of that result, were uncertain as of the beginning of X's

research activities. X identified uncertainties related to the

improvement of a business component and identified alternatives

intended to eliminate these uncertainties. Furthermore, X's process

of evaluating the identified alternatives was technological in

nature and was undertaken to eliminate the uncertainties. Because

substantially all (in this example, eighty-five percent) of X's

activities to update its current model vehicle constitute elements

of a process of experimentation for a qualified purpose described in

section 41(d)(3)(A), all of X's activities to update its current

model vehicle meet the requirements of qualified research as set

forth in paragraph (a)(2) of this section, provided that X's

remaining activities (in this example, fifteen percent of X's total

activities) satisfy the requirements of section 41(d)(1)(A) and are

not otherwise excluded under section 41(d)(4).

(b) * * *

(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 these requirements are not met at that level, then

they apply at the most significant subset of elements of the product,

process, computer software, technique, formula, or invention to be held

for sale, lease, or license. This shrinking back of the product is to

continue until either a subset of elements of the product that

satisfies the requirements is reached, or the most basic element of the

product is reached and such element fails to satisfy the test. This

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

requirements of section 41(d)(1) and paragraph (a)(2) of this section

with respect to the overall business component. The shrinking-back rule

is not itself applied as a reason to exclude research activities from

credit eligibility.

(3) Illustration. The following example illustrates the application

of this paragraph (b):

Example. X, a motorcycle engine builder, develops a new

carburetor for use in a motorcycle engine. X also modifies an

existing engine design for use with the new carburetor. Under the

shrinking-back rule, the requirements of section 41(d)(1) and

paragraph (a) of this section are applied first to the engine. If

the modifications to the engine when viewed as a whole, including

the development of the new carburetor, do not satisfy the

requirements of section 41(d)(1) and paragraph (a) of this section,

those requirements are applied to the next most significant subset

of elements of the business component. Assuming that the next most

significant subset of elements of the engine is the carburetor, the

research activities in developing the new carburetor may constitute

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

paragraph (a) of this section.

(c) * * *

(2) * * *

(iv) Clinical testing. Clinical testing of a pharmaceutical

product prior to its commercial production in the United States is

not treated as occurring after the beginning of commercial

production even if the product is commercially available in other

countries. Additional clinical testing of a pharmaceutical product

after a product has been approved for a specific therapeutic use by

the Food and Drug Administration and is ready for commercial

production and sale is not treated as occurring after the beginning

of commercial production if such clinical testing is undertaken to

establish new functional uses, characteristics, indications,

combinations, dosages, or delivery forms for the product. A

functional use, characteristic, indication, combination, dosage, or

delivery form shall be considered new only if such functional use,

characteristic, indication, combination, dosage, or delivery form

must be approved by the Food and Drug Administration.

* * * * *

(4) Duplication of existing business component. Activities

relating to reproducing an existing business component (in whole or

in part) from a physical examination of the business component

itself or from plans, blueprints, detailed specifications, or

publicly available information about the business component are not

qualified research. This exclusion does not apply merely because the

taxpayer examines an existing business component in the course of

developing its own business component.

* * * * *

(6) Internal use software for taxable years beginning on or

after December 31, 1985. [Reserved].

(7) * * *

(ii) Apportionment of in-house research expenses. In-house

research expenses paid or incurred for qualified services performed

both in the United States, the Commonwealth of Puerto Rico and other

possessions of the United States and outside the United States, the

Commonwealth of Puerto Rico and other possessions of the United

States must be apportioned between the services performed in the

United States, the Commonwealth of Puerto Rico and other possessions

of the United States and the services performed outside the United

States, the Commonwealth of Puerto Rico and other possessions of the

United States. Only those in-house research expenses apportioned to

the services performed within the United States, the Commonwealth of

Puerto Rico and other possessions of the United States are eligible

to be treated as qualified research expenses, unless the in-house

research expenses are wages and the 80 percent rule of Sec. 1.41-

2(d)(2) applies.

* * * * *

(10) Illustrations. The following examples illustrate provisions

contained in paragraphs (c)(1) through (9) (excepting paragraphs (c)(6)

of this section) of this section. No inference should be drawn from

these examples concerning the application of section 41(d)(1) and

paragraph (a) of this section to these facts. The examples are as

follows:

Example 1. (i) Facts. X, a tire manufacturer, develops a new

material to use in its tires. X conducts research to determine the

changes that will be necessary for X to modify its existing

manufacturing processes to manufacture the new tire. X determines

that the new tire material retains heat for a longer period of time

than the materials X currently uses for tires, and, as a result, the

new tire material adheres to the manufacturing equipment during

tread cooling. X evaluates several alternatives for processing the

treads at cooler temperatures to address this problem, including a

new type of belt for its manufacturing equipment to be used in tread

cooling. Such a belt is not commercially available. Because X is

uncertain of the belt design, X develops and conducts sophisticated

engineering tests on several alternative designs for a new type of

belt to be used in tread cooling until X successfully achieves a

design that meets X's requirements. X then manufactures a set of

belts for its production equipment, installs the belts, and tests

the belts to make sure they were manufactured correctly.

(ii) Conclusion. X's research with respect to the design of the

new belts to be used in its manufacturing of the new tire may be

qualified research under section 41(d)(1) and paragraph (a) of this

section. However, X's expenses to implement the new belts, including

the costs to manufacture, install, and test the belts were incurred

after the belts met the taxpayer's functional and economic

requirements and are excluded as research after commercial

production under section 41(d)(4)(A) and paragraph (c)(2) of this

section.

Example 2. (i) Facts. For several years, X has manufactured and

sold a particular kind of widget. X initiates a new research project

to develop a new or improved widget.

(ii) Conclusion. X's activities to develop a new or improved

widget are not excluded from the definition of qualified research

under section 41(d)(4)(A) and paragraph (c)(2) of this section. X's

activities relating to the development of a new or improved widget

constitute a new research project to develop a new business

component. X's research activities relating to the development of

the new or improved widget, a new business component, are not

considered to be activities conducted after the beginning of

commercial production under section 41(d)(4)(A) and paragraph (c)(2)

of this section.

Example 3. (i) Facts. X, a computer software development firm,

owns all substantial rights in a general ledger accounting software

core program that X markets and licenses to customers. X incurs

[[Page 29]]

expenditures in adapting the core software program to the

requirements of C, one of X's customers.

(ii) Conclusion. Because X's activities represent activities to

adapt an existing software program to a particular customer's

requirement or need, X's activities are excluded from the definition

of qualified research under section 41(d)(4)(B) and paragraph (c)(3)

of this section.

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

except that C pays X to adapt the core software program to C's

requirements.

(ii) Conclusion. Because X's activities are excluded from the

definition of qualified research under section 41(d)(4)(B) and

paragraph (c)(3) of this section, C's payments to X are not for

qualified research and are not considered to be contract research

expenses under section 41(b)(3)(A).

Example 5. (i) Facts. The facts are the same as in Example 3,

except that C's own employees adapt the core software program to C's

requirements.

(ii) Conclusion. Because C's employees' activities to adapt the

core software program to C's requirements are excluded from the

definition of qualified research under section 41(d)(4)(B) and

paragraph (c)(3) of this section, the wages C paid to its employees

do not constitute in-house research expenses under section

41(b)(2)(A).

Example 6. (i) Facts. X manufacturers and sells rail cars.

Because rail cars have numerous specifications related to

performance, reliability and quality, rail car designs are subject

to extensive, complex testing in the scientific or laboratory sense.

B orders passenger rail cars from X. B's rail car requirements

differ from those of X's other existing customers only in that B

wants fewer seats in its passenger cars and a higher quality seating

material and carpet that are commercially available. X manufactures

rail cars meeting B's requirements.

(ii) Conclusion. X's activities to manufacture rail cars for B

are excluded from the definition of qualified research. The rail car

sold to B was not a new business component, but merely an adaptation

of an existing business component that did not require a process of

experimentation. Thus, X's activities to manufacture rail cars for B

are excluded from the definition of qualified research under section

41(d)(4)(B) and paragraph (c)(3) of this section because X's

activities represent activities to adapt an existing business

component to a particular customer's requirement or need.

Example 7. (i) Facts. X, a manufacturer, undertakes to create a

manufacturing process for a new valve design. X determines that it

requires a specialized type of robotic equipment to use in the

manufacturing process for its new valves. Such robotic equipment is

not commercially available, and X, therefore, purchases the existing

robotic equipment for the purpose of modifying it to meet its needs.

X's engineers identify uncertainty that is technological in nature

concerning how to modify the existing robotic equipment to meet its

needs. X's engineers develop several alternative designs, and

conduct experiments using modeling and simulation in modifying the

robotic equipment and conduct extensive scientific and laboratory

testing of design alternatives. As a result of this process, X's

engineers develop a design for the robotic equipment that meets X's

needs. X constructs and installs the modified robotic equipment on

its manufacturing process.

(ii) Conclusion. X's research activities to determine how to

modify X's robotic equipment for its manufacturing process are not

excluded from the definition of qualified research under section

41(d)(4)(B) and paragraph (c)(3) of this section, provided that X's

research activities satisfy the requirements of section 41(d)(1).

Example 8. (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 develop, analyze and test potential alternative

formulations of the additive.

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

ingredients A and B involve duplication of existing business

components and are excluded from the definition of qualified

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

section. X's experimentation activities to develop potential

alternative formulations of the additive do not involve duplication

of an existing business component and are not excluded from the

definition of qualified research under section 41(d)(4)(C) and

paragraph (c)(4) of this section.

Example 9. (i) Facts. X, a manufacturing corporation, undertakes

to restructure its manufacturing organization. X organizes a team to

design an organizational structure that will improve X's business

operations. The team includes X's employees as well as outside

management consultants. The team studies current operations,

interviews X's employees, and studies the structure of other

manufacturing facilities to determine appropriate modifications to

X's current business operations. The team develops a recommendation

of proposed modifications which it presents to X's management. X's

management approves the team's recommendation and begins to

implement the proposed modifications.

(ii) Conclusion. X's activities in developing and implementing

the new management structure are excluded from the definition of

qualified research under section 41(d)(4)(D) and paragraph (c)(5) of

this section. Qualified research does not include activities

relating to management functions or techniques including management

organization plans and management-based changes in production

processes.

Example 10. (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 (including economics and

business management) and are thus excluded from the definition of

qualified research under section 41(d)(4)(G) and paragraph (c)(8) of

this section.

(d) Recordkeeping for the research credit. A taxpayer claiming a

credit under section 41 must retain records in sufficiently usable form

and detail to substantiate that the expenditures claimed are eligible

for the credit. For the rules governing record retention, see Sec.

1.6001-1. To facilitate compliance and administration, the IRS and

taxpayers may agree to guidelines for the keeping of specific records

for purposes of substantiating research credits.

(e) Effective dates. This section is applicable for taxable years

ending on or after December 31, 2003.

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

0

Par. 4. The authority citation for part 602 continues to read in part

as follows:

Authority: 26 U.S.C. 7805 * * *.

0

Par. 5. In Sec. 602.101, paragraph (b) is amended by removing the

entry from the table for Sec. 1.41-4(d).

Mark E. Matthews,

Deputy Commissioner for Services and Enforcement.

Pamela Olson,

Assistant Secretary of the Treasury.

[FR Doc. 03-31818 Filed 12-31-03; 8:45 am]

BILLING CODE 4830-01-P