NORWEST v. COMMISSIONER
Download the complete brief here: 110 T.C. No. 34
110 T.C. No. 34 (also cited as 110 T.C. 454, 489)
UNITED STATES TAX COURT
NORWEST CORPORATION AND SUBSIDIARIES, Petitioner
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 13908-92, 20567-93, 26213-93.[1]
Filed June 29, 1998.
Between 1986 and 1991, N, a bank holding company whose affiliates provide banking and other financial services, developed or modified previously developed software for the internal management and administration of its businesses (internal use software). N seeks tax credits for increasing research activities pursuant to sec. 41, I.R.C., with respect to expenditures associated with the development of its internal use software. The parties selected 8 of 67 internal use software activities to serve as representative or sample activities to determine whether all or part of the 67 activities constituted qualified research for purposes of the tax credit.
Sec. 41(d)(1), I.R.C., sets forth four tests for qualified research:
(1) The expenditures must qualify as expenses under sec. 174, I.R.C.;
(2) the taxpayer must discover information which is technological in nature;
(3) the taxpayer must discover information the application of which is intended to be useful in the development of a new or improved business component; and
(4) substantially all of the research activities must constitute elements of a process of experimentation.
In the conference report accompanying the Tax Reform Act of 1986 (TRA 1986), Pub. L. 99-514, 100 Stat. 2085, H. Conf. Rept. 99-841 (Vol. II), at II-73 through II-74 (1986), 1986-3 C.B. (Vol. 4) 1, 73-74, Congress set forth three additional tests for qualified research under sec. 41, I.R.C., for the development of internal use software:
(1) The software must be innovative;
(2) the software development must involve significant economic risk; and
(3) the software must not be commercially available.
The parties agree that in order for the representative internal use software activities to constitute qualified research for purposes of the tax credit, all seven tests must be satisfied.
1. Held: The three additional tests for qualified research in the development of internal use software enunciated in the conference report accompanying the TRA 1986 require a higher threshold of technological advancement and functional improvement than is necessary in other fields of research.
2. Held, further: One of the eight representative internal use software activities, the development of the Strategic Banking System’s (SBS) customer module, satisfies all seven tests and constitutes qualified research pursuant to sec. 41, I.R.C. SBS was a concerted effort at advancing the state of technology in the field of computer science and pushed existing technology to new heights.
3. Held, further: N failed to establish that the remaining seven representative internal use software activities constitute qualified research.
Mark A. Hager, Albert G. Lauber, Julie W. Davis, Carl S. Kravitz, James Sottile IV, John R. Kalligher, and Matthew W. Frank, for petitioner.
Barry J. Laterman, Paul Colleran, Michael Goldbas, Tyrone J. Montague, and Bruce G. Warner, for respondent.
CONTENTS
FINDINGS OF FACT
1. Background
2. Software Development Methodology
A. Phase 1: Request
B. Phase 2: Project Initiation
C. Phase 3: Definition
D. Phase 4: Logical Design
E. Phase 5: Physical Design
F. Phase 6: Development
G. Phase 7: Testing
H. Phase 8: Implementation
I. Phase 9: Postimplementation
J. Application of the Software Development Methodology
3. The Eight Sample Internal Use Software Development Activities
A. Strategic Banking System
B. Trust TU
C. Success
D. General Ledger
E. Money Transfer
F. Cyborg Payroll
G. Trust Payment
H. Debit Card
OPINION
1. Section 41
2. Internal Use Software
3. The Seven Tests
A. The Section 174 Test
B. The Discovery Test
C. The Business Component Test
D. The Process of Experimentation Test
E. The Innovativeness Test
F. The Significant Economic Risk Test
G. The Commercial Availability Test
4. Summary of Internal Use Software Requirements Under the Seven Tests
5. United Stationers, Inc. v. United States
6. The Experts
A. Petitioner’s Expert–Dr. Drew McDermott
B. Respondent’s Experts
i. Dr. Randall Davis
ii. The Tower Group
7. Analysis of the Eight Sample Activities
A. Strategic Banking System
B. Trust TU
C. Success
D. General Ledger
E. Money Transfer
F. Cyborg Payroll
G. Trust Payment
H. Debit Card
CONCLUSION
JACOBS, Judge:
By separate notices of deficiency, respondent determined the following deficiencies in petitioner’s Federal income taxes:
Docket No. Year Deficiency
13908-92 1983 $2,605,571
1984 2,442,134
1985 29,187
1986 19,301,530
20567-93 1987 93,413
1988 3,999,398
26213-93 1989 10,532,064
Respondent also determined additional interest under section 6621(c)[2] for 1983, 1984, 1986, 1988, and 1989.
Following the filing of petitions contesting respondent’s determinations, petitioner engaged Coopers & Lybrand, LLP (Coopers & Lybrand), to ascertain whether it was entitled to credits for increasing research activities pursuant to section 41 (the research and experimentation credit, or R&E credit) between 1986 and 1993 with respect to certain internal use software development activities.[3] Coopers & Lybrand concluded that 67 of 118 internal use software development activities petitioner engaged in qualified for the R&E credit. On the basis of the Coopers & Lybrand study, petitioner sought and was permitted to amend its petitions to claim the R&E credit for 1986 through 1989. Subsequently, petitioner again sought and was permitted to amend its petitions in order to carry back the R&E credit from 1990 and 1991 to 1989 and to increase the R&E credit for 1986 through 1991.
For purposes of trial, briefing, and opinion, the parties have selected 8 of the 67 internal use software development activities to serve as representative or sample activities to determine the outcome of the other 59. The parties agree that $20,552,274 of the $22,658,829 in expenditures claimed by petitioner as associated with the eight internal use software development activities have been substantiated. In addition, the parties agree that the remaining 59 activities are deemed substantiated in the same ratio (90.7 percent) as the 8 sample activities. The parties further agree that if we determine that any of the 8 sample activities qualify for the R&E credit, the remaining 59 activities will be deemed qualified for the credit according to an agreed-upon formula.
The sole issue we must decide herein is whether Norwest Corporation & Subsidiaries (petitioner or Norwest) is entitled to the R&E credit with respect to any or all of the eight sample internal use software development activities conducted between 1986 and 1991. Resolution of this issue requires us to interpret and apply the four statutory requirements for the credit provided in section 41, and the three additional requirements provided by Congress in the conference report accompanying the Tax Reform Act of 1986 (TRA 1986), Pub. L. 99-514, 100 Stat. 2085, specifically relating to internal use software development activities. H. Conf. Rept. 99-841 (Vol. II), at II-73 through II-74 (1986), 1986-3 C.B. (Vol. 4) 1, 73-74 (and as adopted by the Department of the Treasury in its proposed regulations, section 1.41-4(e)(5), Proposed Income Tax Regs., 62 Fed. Reg. 83 (Jan. 2, 1997)).
—footnotes—
[1] These cases are consolidated for trial, briefing, and opinion solely with respect to the issue of whether petitioner’s activities constitute qualified research pursuant to sec. 41, I.R.C. (the research and experimentation credit, or R&E credit).
[2] Unless otherwise indicated, all section references are to the Internal Revenue Code as in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
[3] Petitioner did not claim the R&E credit on any of its U.S. Corporation Income Tax Returns for 1986 through 1991. The engagement of Coopers & Lybrand in August 1994 followed the Department of the Treasury’s issuance of proposed regulations that further defined research and experimental expenditures under sec. 174. See sec. 1.174-2, Proposed Income Tax Regs., 58 Fed. Reg. 15821 (Mar. 24, 1993).
