C. Explanation of Provisions

TD 8930 – Explanation of Provisions

CONTENTS:
I. Basic Principles
II. Gross Receipts
III. The Discovery Requirement
IV. Process of Experimentation
V. Recordkeeping Requirement
VI. The Shrinking-back Rule
VII. Research After Commercial Production
VIII. Adaptation
IX. Internal-use Software
X. Alternative Incremental Credit

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 §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.
[back to top]

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) [currently section 41(c)(7)] .

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 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 includible 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 includible 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.
[back to top]

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 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 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.
[back to top]

IV. Process of Experimentation
Commentators objected to §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 §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.
[back to top]

V. Recordkeeping Requirement
Part of the four-step process of experimentation test prescribed in §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.
[back to top]

VI. The Shrinking-back Rule
Under §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 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.
[back to top]

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.
[back to top]

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.
[back to top]

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 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 §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 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.
[back to top]

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.
[back to top]