Software ATG – Law
CONTENTS:
1. Process of Experimentation
I.R.C. § 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 explains 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.” H.R. Conf. Rep. No. 99-841, at II-71, 72 (1986). 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 design process to develop the overall business component. Id.
Final regulations issued in January 2004 address the application of the process of experimentation test. The rule is as follows:
A process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science and involves the identification of uncertainty concerning the development or improvement of a business component, the identification of one or more alternatives intended to eliminate that uncertainty, and the identification and the conduct of a process of evaluating the alternatives (through, for example, modeling, simulation, or a systematic trial and error methodology). A process of experimentation must be an evaluative process and generally should be capable of evaluating more than one alternative. A taxpayer may undertake a process of experimentation if there is no uncertainty concerning the taxpayer’s capability or method of achieving the desired result so long as the appropriate design of the desired result is uncertain as of the beginning of the taxpayer’s research activities. Uncertainty concerning the development or improvement of the business component (e.g. its appropriate design) does not establish that all activities undertaken to achieve that new or improved business component constitute a process of experimentation.
Treas. Reg. § 1.41-4(a)(5). Notably, there is no statement either in the regulatory rule (or in the examples applying the rule) that any activity, including software development, per se constitutes a process of experimentation. To the contrary, the preamble to these final regulations states as follows:
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 clrification 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.
T.D. 9104 (January 2, 2004) (emphasis added).
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2. Selected Exclusions from Qualified Research
There are certain research activities that are specifically excluded from qualified research under I.R.C. § 41(d)(4). The following activities are not qualified research:
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I. Exclusion for Research after Commercial Production
I.R.C. § 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.
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) Trouble shooting involving detecting faults in production equipment or processes;
e) Accumulating data relating to production processes; and
f) Debugging flaws in a business component.
Treas. Reg. § 1.41-4(c)(10), Examples 1 and 2, illustrate the application of the exclusion for research after commercial production.
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II. 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.
Treas. Reg. § 1.41-4(c)(10), Examples 3 and 7, illustrate the application of the adaptation exclusion.
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III. 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.
Treas. Reg. § 1.41-4(c)(10), Example 8, illustrates the application of the duplication exclusion.
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IV. 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.
Treas. Reg. § 1.41-4(c)(10), Example 9, illustrates the application of this exclusion.
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V. 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).
Treas. Reg. §1.41-4(c)(10), Example 10, illustrates the application of this exclusion.
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