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:: Credit for Increasing Research Activites - Qualified Research
Activities
5.
QUALIFIED RESEARCH ACTIVITIES
a. In
General
In order for an
activity to qualify for the
research credit, the taxpayer
must show that it meets all the
requirements as described in
section 41(d). Under section
41(d), the term "qualified
research" means research:
-
With
respect to which
expenditures may be
treated as expenses
under section 174, (also
known as the section 174
test);
-
Which
is undertaken for the
purpose of discovering
information which is
technological in nature,
(also known as the
discovering
technological
information test);
-
The
application of which is
intended to be useful in
the development of a new
or improved business
component of the
taxpayer (also known as
the business component
test); and
-
Substantially all of the
activities of which
constitutes elements of
a process of
experimentation for a
qualified purpose (also
known as the process of
experimentation test).
To be
considered “qualified research”,
the taxpayer must be able to
establish that the research
activity being performed meets
ALL four of the above tests.11
These tests must be applied
separately to each business
component of the taxpayer.
Activities listed in section
41(d)(4) are not qualified
research. Infra.
(1).
The Section 174 Test
In order to
meet the section 174 test, the
expenditure must (1) be incurred
in connection with the
taxpayer’s trade or business,
and (2) represent a research and
development cost in the
experimental or laboratory
sense.
Expenditures
represent research and
development costs in the
experimental or laboratory sense
if they are for activities
intended to discover information
that would eliminate uncertainty
concerning the development or
improvement of a product.
Uncertainty exists if the
information available to the
taxpayer does not establish the
capability or method for
developing or improving the
product or the appropriate
design of the product.
Whether
expenditures qualify as research
or experimental expenditures
depends on the nature of the
activity to which the
expenditures relate, not the
nature of the product or
improvement being developed or
the level of technological
advancement the product or
improvement represents.
Section 174
treatment is allowed only to the
extent that the amount is
reasonable under the
circumstances. Expenditures for
land and depreciable property
are not allowed under section
174, although in certain cases,
depreciation may be treated as a
section 174 expense.
(Depreciation is not a QRE under
section 41). Exploration
expenditures do not qualify as
section 174 expenses.
Furthermore, the provisions of
section 174 are not applicable
to any expenditure paid or
incurred for the purpose of
ascertaining the existence,
location, extent, or quality of
any deposit of ore, oil, gas, or
other mineral. Refer to the
regulations under section 174
for further explanation on
specific expense disallowances.
Treasury
Regulation section 1.174-2(a)(3)
disallows section 174 treatment
for certain activities,
including:
i. The
ordinary testing or
inspection of materials or
products for quality
control;
ii. Efficiency surveys;
iii. Management studies;
iv. Consumer surveys;
v. Advertising or
promotions;
vi. The acquisition of
another’s patent, model,
production or process; or
vii. Research in connection
with literary, historical,
or similar projects.
Since section
41 is more restrictive than
section 174, expenses allowable
under section 174 will still
have to meet the other
requirements of section 41(b)
and (d) to be a QRE. For
example, patent procurement
expenses generally qualify under
section 174 but would not
qualify under section 41.
(2).
The Discovering Technological
Information Test
Final
regulations, issued in January
2004 (TD 9104), 12
mirror the 2001 proposed
regulations with respect to the
discovering technological
information test. There is no
“discovery” requirement under
section 41 separate and apart
from that already required under
Treasury Regulation section
1.174-2(a)(1) (i.e., was the
research undertaken to eliminate
uncertainty concerning the
development or improvement of a
business component). The final
regulations, like the proposed
regulations, abandon the
requirement that the research
activities be undertaken to
obtain knowledge that exceeds,
expands or refines the common
knowledge of skilled
professionals in a particular
field of science or engineering.
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.
In order to
satisfy the technological in
nature requirement for qualified
research, the process of
experimentation used to discover
information must fundamentally
rely 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.
The final
regulations state that the
issuance of a patent by the
Patent and Trademark Office
under 35 USC sections 51 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. This is
known as the “patent
safe-harbor”. Be aware that the
issuance of a patent is not
conclusive evidence of qualified
research, as the taxpayer still
has to meet all the other
activity requirements of section
41(d). Examiners should note
that the securing of a patent
usually occurs some time after
the actual research year(s).
(3).
The Business Component Test
The taxpayer
must intend to apply the
information being discovered to
develop a new or improved
business component of the
taxpayer. A business component
is any product, process,
computer software, technique,
formula, or invention, which is
to be held for sale, lease,
license, or used in a trade or
business of the taxpayer. Often
times, taxpayers group all
research in one broad category
and do not identify the specific
business component to which the
business relates. A taxpayer
must be able to tie the research
it is claiming for the credit to
the relevant business
component. The ‘substantially
all’ test is applied at the
business component level.
(4).
The Process of Experimentation
Test
The final
research credit regulations
provide rules on the “process of
experimentation test”, which
requires that qualified research
be research “substantially all
of the activities of which
constitute elements of a process
of experimentation”.
The final
regulations clarify the
requirement 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. Examiners
are encouraged to read the
preamble to these regulations to
get a better understanding of
the changes made. 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 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.
The final
regulations articulate the core
elements of a process of
experimentation. In addition to
requiring that the research be
undertaken for the purpose of
discovering information that is
technological in nature, the
taxpayer must:
-
Identify the
uncertainty
regarding the
development or
improvement of a
business component that
is the object of the
taxpayer’s research
activities;
-
Identify one or
more alternatives
intended to eliminate
that uncertainty; and
-
Identify and
conduct a process of
evaluating the
alternatives.
The key
difference regarding
“uncertainty” in sections 41 and
174 is that, under section 41,
uncertainly must relate to a
qualified purpose, and must be
resolved through a 3-element
process of experimentation,
fundamentally relying on the
principles of the hard sciences,
engineering, or computer
science. The regulations
clarify that merely
demonstrating that uncertainty
has been eliminated is
insufficient to satisfy the
process of experimentation
test. Focus upon developing
facts necessary to determine
whether the taxpayer’s
activities meet these
requirements and the core
elements.
The preamble to
the final regulations states
that because of the
clarifications made, the readily
discernible and applicable
provision in the 2001 proposed
regulations is no longer
necessary, because those
activities do not constitute a
process of experimentation under
the final regulations.
Accordingly, examiners who
properly applied the “readily
discernible and applicable” rule
as a basis for disallowing the
research credit have made proper
adjustments. In pending and
future examinations, however,
the readily discernible and
applicable standard should not
be applied to a taxpayer’s
activities.
In order for
activities to constitute
qualified research under section
41(d)(1), 80 percent or more of
taxpayer’s research activities,
measured on a cost or other
consistently applied reasonable
basis (and without regard to
Treasury Regulation section
1.41-2(d)(2)), must constitute
elements of a process of
experimentation for a qualified
purpose. The regulations
provide that, if this
substantially all requirement is
met, then the balance of the
research activities may qualify,
if the remaining balance meets
the requirements of section
41(d)(1)(A) (with respect to
which expenditures may be
treated as expenses under
section 174), and if they are
not excluded activities under
section 41(d)(4) (such as
research after commercial
production, adaptation or
duplication of an existing
business component, etc.).
Although the
final regulations are effective
for taxable years ending after
December 31, 2003, the Service
will not challenge return
positions that are consistent
with the final regulations. As
these final regulations merely
clarify the proposed regulations
upon which taxpayers are already
relying, the Service’s
administrative approach will
follow these final rules for all
open years.
The process of
experimentation must be
conducted for a “qualified
purpose”, i.e., it must relate
to a new or improved function,
performance, reliability, or
quality of the business
component. The process of
experimentation is not for a
qualified purpose if it relates
to style, taste, cosmetic, or
seasonal design factors. I.R.C.
§ 41(d)(3)(B). Accordingly, be
alert to claimed QREs for
research related to
non-functional aspects of the
business component.
b.
Shrink Back
The
requirements of section 41(d)
are to be applied first at the
level of the discrete business
component, i.e., the product,
process, computer software,
technique, formula, or invention
to be held for sale, lease, or
license, or used by the taxpayer
in its trade or business.
If the
requirements for credit
eligibility are met at that
first level, then some, or all,
of the taxpayer's research
activities are eligible for the
credit. If all aspects of such
requirements are not met at that
level, the test applies 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”
is to continue until either a
subset of elements of the
business component that
satisfies the requirements is
reached, or the most basic
element of the business
component is reached and such
element fails to satisfy the
test.
The burden is
on the taxpayer to establish
that all of the section 41(d)(1)
requirements have been met. The
examiner should issue an IDR
requesting a list of each
qualifying project or activity,
along with a complete
description of that activity or
project as a starting point in
the evaluation, including the
business component to which each
research activity relates. As
with the evaluation of wages,
interviews should be considered
to supplement and corroborate
information obtained from the
review of existing records.
c.
Exclusions
There are
certain research activities that
are specifically excluded from
qualified research under section
41(d)(4). It is critical to
look at the underlying facts to
see if the exclusions apply.
Taxpayer labels are not
controlling. The following
activities are not qualified
research:
1.
Exclusion for Research after
Commercial Production
Section 41(d)
(4) states that qualified
research does not include any
research conducted after the
beginning of commercial
production. A business
component is considered ready
for commercial production when
it is developed to the point
where it is ready for use or
meets the basic functional and
economic requirements of the
taxpayer. In some cases, there
may be “product release”
documents where all responsible
managers sign off that the new
product and or new production
method is now released for
production, which may be helpful
in the application of this
exclusion.
The following
activities are deemed to occur
after the commencement of
commercial production:
a) Preproduction planning
for a finished business
component,
b) Tooling
up for production,
c) Trial
production runs,
d) Troubleshooting involving
detecting faults in
production equipment or
processes,
e) Accumulating data
relating to production
processes, and
f) Debugging flaws in a
business component.
This per se
list includes “debugging”
activities, but not “correction
of flaws”. Treasury Regulation
section 1.41 4(c)(10), Examples
1 and 2, illustrate the
application of the exclusion for
research after commercial
production.
2.
Exclusion for Adaptation
This exclusion
applies if the taxpayer's
activities relate to adapting an
existing business component to a
particular customer's
requirement or need. This
exclusion does not apply merely
because a business component is
intended for a specific
customer. A contractor’s
adaptation of an existing
business component to a
taxpayer’s particular
requirement or need is not
qualified research.
Treasury
Regulation section 1.41
4(c)(10), Examples 3 7,
illustrates the application of
the adaptation exclusion.
3.
Exclusion for Duplication
This exclusion
applies if the taxpayer
reproduced an existing business
component, in whole or in part,
from a physical examination of
the business component, plans,
blueprints, detailed
specifications, or publicly
available information with
respect to such component. This
exclusion does not apply merely
because the taxpayer evaluates
another's business component in
the course of developing its own
business component.
Treasury
Regulation section 1.41
4(c)(10), Example 8, illustrates
the application of the
duplication exclusion.
4.
Exclusion for Surveys, Studies,
Research Relating to Management
Functions
The following
activities are excluded under
this provision:
(a)
Efficiency surveys;
(b)
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);
(c)
Market research, testing, or
development (including
advertising or promotions);
(d)
Routine data collections; or
(e)
Routine or ordinary testing
or inspections for quality
control.
Treasury
Regulation section 41 4(c)(10),
Example 9, illustrates the
application of this exclusion.
Note that it is
the activity which governs, not
the intended end result. For
example, the development of a
new production process, which
met all the tests for qualified
research, would not be excluded
simply because the activity was
preceded by a management
efficiency survey.
5.
Exclusion for Internal-Use
Software
This exclusion
is beyond the scope of this
ATG.
6.
Exclusion for Foreign Research
Qualified
research does not include any
research conducted outside the
United States, Puerto Rico, or
any possession of the United
States.
13
This exclusion applies to
in-house, as well as contract
research. The foreign research
disallowance applies even if the
research is done by American
researchers, or performed for an
American taxpayer.
7.
Exclusion for 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).
Treasury
Regulation section 1.41
4(c)(10), Example 10,
illustrates the application of
this exclusion. Note that the
process, not the end result,
governs. The development of new
formulation of artists’ paint
would not be excluded simply
because it benefited the arts,
while research into Van Gogh’s
life would be excluded under
this rule.
8.
Exclusion for Funded Research
The exclusion
for "funded research" under
section 41(d)(4)(H) provides
that the credit shall not be
available for qualified research
to the extent funded by a
contract, grant, or otherwise by
another person (or governmental
entity).
All agreements
(not only research contracts)
entered into between the
taxpayer performing the research
and other persons are to be
considered in determining the
extent to which the research is
funded. As a result, the
examiner should request a
complete copy of all contracts
(including modifications),
agreements, letters of
understanding or similar
documents where funding is an
issue. These contracts and
similar documents will need to
be reviewed to determine
whether, and to what, extent the
research is to be considered
funded. A “fixed-price”
contract, where the customer
agrees to pay a set price for a
deliverable, and a “cost-plus”
contract, where the customer
agrees to pay the actual costs
incurred by the contractor in
acquiring/constructing the
deliverable plus an additional
amount for profit, are examples
of the different contracts you
may encounter. Counsel can be
helpful in securing and
interpreting these agreements.
In the case of documents that
are “classified” by a government
agency, contact the Classified
Contract Technical Advisor or a
Research Credit Technical
Advisor for further assistance.
In order to
determine if the contractor’s
research expenditures are
“funded”, you must resolve the
following issues:
-
Is
payment for the
contractor’s research
activities “contingent
upon the success of the
research” under Treasury
Regulation section
1.41-4A(d)(1)?
-
Does
the contractor retain
“substantial rights” in
the results of the
research activities
within the meaning of
Treasury Regulation
section 1.41-4A(d)(2)?
If the answer
to either question is no, then
the research is treated as
funded. Amounts payable under
any agreements that are
contingent on the success of the
research (thus considered to be
paid for the product or result
of the research) are treated as
funded research. If a
contractor retains substantial
rights in the results of the
research, and if payment to him
is contingent on the success of
the research, then the contract
is not funded and the contractor
is eligible to claim the credit.
Note that, if
the contractor performing
research for another person does
not retain substantial rights in
the research, and if the
research payments are contingent
on the contractor’s success,
neither the contractor nor the
person paying for the research
is eligible to claim the credit.
If a taxpayer
performing qualified research
for another person retains
substantial rights in the
research under the agreement
providing for the research, the
research is funded to the extent
of the payments (and fair market
value of any property) to which
the taxpayer becomes entitled by
performing the research. A
taxpayer does not retain
substantial rights in the
research if the taxpayer must
pay for the right to use the
results of the research.
Frequently,
taxpayers make some sort of
funding allocation between
“qualified research” and
“non-qualified research”
expenditures incurred in certain
types of contracts, e.g.,
cost-share or cost overrun
situations. In so doing,
taxpayers often overlook the
“pro rata allocation”
requirements of Treasury
Regulation section
1.41-4A(d)(3)(ii).
The general
rule is that funding is to be
allocated 100 percent to
otherwise qualified research
expenses (as provided by
Treasury Regulation section
1.41-4A(d)(3)(i)) unless the
taxpayer can meet the pro rata
allocation requirements of
Treasury Regulation section
1.41-4A(d)(3)(ii).
Pursuant to
Treasury Regulation section
1.41-4A(d)(3)(ii), the taxpayer
may allocate funding pro rata to
nonqualified, and otherwise
qualified research expenses,
rather than allocating it 100
percent to otherwise qualified
research expenses, if the
taxpayer can establish to the
satisfaction of the Service:
A) the
total amount of research
expenses,
B) that the
total amount of research
expenses exceed the funding,
and
C) that the
otherwise qualified research
expenses (that is, the
expenses that would be
qualified research expenses
if there were no funding)
exceed 65 percent of the
funding.
In no event,
however, shall less than 65
percent of the funding be
applied against the otherwise
qualified research expenses.
Material adjustments may be
warranted if the specific
requirements of Treasury
Regulation section
1.41-4A(d)(3)(ii) have not been
met.
Funding is
determinable only in the
subsequent taxable year.
Treasury Regulation section
1.41-4A(d)(5) states that if, at
the time the taxpayer files its
return for a taxable year, it is
impossible to determine to what
extent particular research
performed by the taxpayer during
the year may be funded, then the
taxpayer shall treat the
research as completely funded
for purposes of completing that
return. When the amount of
funding is finally determined,
the taxpayer should amend the
return and any interim returns
to reflect the proper amount of
funding.
11
In the case of certain software
developed for internal use,
taxpayers must meet the
requirements of an additional
three-part “high threshold of
innovation” test. See Prop.
Treas. Reg. § 1.41-4(c)(6)(vi).
See also the ANPRM relating to
the section 41(d)(4)(E) internal
use software exclusion.
12
Final Regulations for the
Definition of Qualified Research
under section 41(d) (doc, 90kb),
also in HTML (htm, 137kb) and
Adobe (pdf, 65kb), T.D. 9104.
13
Section 41(d)(4)(F) was modified
by P.L. 106-170 section
502(c)(1) which added the
Commonwealth of Puerto Rico and
any possession of the United
States for amounts paid or
incurred after June 30, 1999.
Prior to amendment, section
41(d)(4)(F) applied only to the
United States.
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