TD 9104 – Explanation of Provisions
CONTENTS:
Process of Experimentation—In General
Process of Experimentation— Requirements
Process of Experimentation—Substantially all Requirement
Other Issues
Patent Safe Harbor
Shrinking-Back Rule
Research After Commercial Production
Gross Receipts
Examples
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 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 nondispositive 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.
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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 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.
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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 § 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 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 § 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.
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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 § 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 § 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 § 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.
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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 § 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 § 1.41–4(a)(8) in the final regulations (Example 6 of § 1.41–4(a)(8) of the 2001 proposed regulations) were made to illustrate more clearly the application of the substantially all requirement of § 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 § 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 § 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.
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