© Annette Nellen 2003, 2005, 2008

Tax Treatment of Research Expenditures

By Annette Nellen

October 2008

Distinguishing Between §§195, 162, 174, and 41 Expenditures

The distinction between §195 start-up expenditures and §162 operating expenses is generally similar for high technology businesses as for other types of businesses. Because high technology companies will also have §174 R&E expenditures, which are specifically excluded from the definition of §195 start-up expenditures, the tax adviser must be able to distinguish between §174 and §195 expenditures. The need to properly determine what expenditures qualify as R&E expenditures under §174 is also pertinent after the start-up phase because under the uniform

capitalization rules of §263A, §174 expenditures are excepted from capitalization.1

The tax adviser must be familiar with how the §41 research credit rules operate for a start-up company and which types of expenditures will not qualify for the credit during this stage of existence.

A. §195

"Start-up expenditure" means amounts paid or incurred in connection with i) investigating the creation or acquisition of an active trade or business, ii) creating an active trade or business, or iii) any activity engaged in for profit and the production of income prior to when an active trade or business begins, in anticipation of the activity becoming an active trade or business. The expenditure must be one that would be allowable as a current deduction if incurred in connection with the operation of an existing active trade or business. Start-up expenditures do not include deductions allowed under Sections 163(a) (interest), 164 (taxes) or 174 (R&E).

For start-up expenditures paid or incurred after October 22, 2004, a taxpayer may elect to deduct such expenditures of up to $5,000. If the start-up expenditures exceed $50,000, the $5,000 deduction is reduced by the amount of expenditures in excess of $50,000 (so no current deduction if the expenditures for start-up are $55,000 or more). The amount not currently deductible is to be amortized over 15 years. This is the rule provided by the American Jobs Creation Act of 2004. Prior to this change, an election under §195 enabled a taxpayer to amortize the expenditures over no less than 60 months. If no election is made, the amounts must be capitalized without amortization or deduction.

1. §195 versus §162

Section 195(c)(2)(A) provides that the determination of when an active trade or business begins is to be made in accordance with the regulations. However, such regulations have never been issued. Section 195(c)(2)(B) provides a more specific guideline with respect to an acquired business by stating that an acquired active trade or business is treated as beginning when the taxpayer acquires it; thus, such a taxpayer clearly knows when to make a §195 election. However, a taxpayer that is starting a new business from scratch, needs to know when business begins for §195 purposes so that it will know when to make the §195 election and what expenditures fall under §195. As noted earlier, the high technology start-up company must not only distinguish between Sections 195 and 162, but must also consider what expenditures fall under §174.

The legislative history to §195 states:

Generally, it is anticipated that the definition of when a business begins is to be made in reference to the existing provisions for the amortization of organizational expenditures (Code Secs. 248 and 709). Generally, if the activities of the corporation have advanced to the extent necessary to establish the nature of its business operations, it will be deemed to have begun business. For example, the acquisition of operating assets which are necessary to the type of business contemplated may

constitute the beginning of business.2

1 § 263A(c)(2). 2 S. Rpt. No. 96-1036, 96th Cong., 2d Sess. (1980), reprinted in 1980 U.S.C.C.A.N. 7293, 7304. I.R.C. § 195 was added by the

Miscellaneous Revenue Act of 1980, Pub. L. No. 96-605, § 102, 94 Stat. 3521..

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Regulations under §248 provide that generally a corporation begins business "when it starts the business

operations for which it was organized."3 The corporation begins business when it has advanced to the point where the nature of its business operations is established such as by acquiring its operating assets. The §248 definition of when business begins may produce an unfavorable result for some taxpayers because the point that a corporation begins business for §248 purposes might be before it meets the definition of "carrying on" a trade or business for §162 purposes. The result of such an interpretation would be that expenditures incurred between the business starting date for §248 purposes and the carrying on date for §162 purposes would not fall under either §162 or §195 and would instead be permanently capitalized. The Service has recognized this problem in private letter rulings

under §195 and has used §162 as the definition of when a business begins.4

In a 1990 ruling,5 the Service relied on the rule set out in the Richmond Television case6 for when a business begins. This case predates §195, but is the seminal case to address when a new business may begin to treat expenditures as deductible under §162. This standard is referred to as the "going concern" standard. To have begun business for §162 purposes, the taxpayer must not only have acquired its operating assets, but must also be using them to conduct actual business operations. Generally, a business is considered to have begun when it is ready to receive revenue. In the Richmond Television case, the court held that training employees did not constitute start of a business. Instead, business did not start until the taxpayer received its broadcasting license and began to broadcast. In the 1990 ruling, the Service stated that it was not enough to have acquired the necessary operating assets, but that they must also be put to productive use in the business; "actual business operations must commence."

In another 1990 ruling,7 the Service stated that an active business did not begin for §195 purposes until it started to market the works for which it went into business to market. It did not matter that the taxpayer had made a firm decision to enter the particular business and had spent a large amount of money preparing to enter the business.

2. §195 Election Procedure

Final regulations were issued in December 1998 (T.D. 8797) to address the election procedure under §195. The election statement is to be filed no later than the date for filing the return (including extensions) for the tax year in which the active trade or business begins. "The statement may be filed with a return for any taxable year prior to the year in which the taxpayer's active trade or business begins, but no later than the date prescribed in the preceding sentence." [§1.195-1(b)] The election statement is to describe the trade or business and a description of each start-up expenditure and the month the active trade or business began or was acquired. A revised statement may be filed to include start-up expenditures that were not included in the original election, "but the revised statement may not include any expenditures for which the taxpayer had previously taken a position on a return inconsistent with their treatment as start-up expenditures."

B. §174

Section 174 provides a general rule that a taxpayer may treat R&E expenditures paid or incurred during the tax year in connection with his trade or business as expenses which are not chargeable to a capital account. Thus, expenditures meeting the definition of R&E expenditures may be currently deducted even though they may create a long-lived asset. If a taxpayer does not want to currently expense R&E expenditures, it must make a timely election to capitalize such expenditures under §174(b). Under the election method, the taxpayer would begin to amortize the capitalized expenditures ratably over no fewer than 60 months beginning in the month that he first realizes benefits from the R&E expenditures. The accounting method aspects of §174 are discussed later under "Selecting an accounting method for R&E expenditures."

3 Treas. Reg. § 1.248-1(a)(3). Beginning business is to be distinguished from being in existence. A corporation is in existence

on its date of incorporation. 4 Additional support for the Service's use of the I.R.C. § 162 standard for when a business begins, rather than the Section 248

standard perhaps also exists from the addition of the word "active" to I.R.C. §195(b) by the Deficit Reduction Act of 1984, Pub. L. No. 98-369, § 94(a), 98 Stat. 494. The Service confirmed this interpretation in PLR 9047032 (Aug. 27, 1990).

5 PLR 9047032, supra. 6 Richmond Television Corp. v. Commissioner, 354 F.2d 410 (4th Cir. 1965). 7 TAM 9027002 (May 16, 1990).

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1. Rationale

An expensing rule encourages R&D activities. In addition, an expensing rule eliminates the uncertainty and the conflict that can arise between taxpayers and the Service regarding the proper tax treatment (current expensing

versus capitalizing) of R&D expenditures.8

2. "In Connection With"

The wording at §174(a) allowing a current deduction for R&E is not identical to the wording at §162 allowing a current deduction for most business expenses. §162 only allows a deduction for ordinary and necessary expenses incurred in carrying on a trade or business. Thus, expenses of getting ready for a business are not deductible under §162 (such expenses might be capitalizable and amortizable under Sections 195, 248 and/or 709). The language at §174 allows a deduction for R&E incurred in connection with a trade or business. The landmark case that explains the significance of the differing terminology at Sections 162 and 174 is the Supreme Court case,

Snow v. Commissioner.9

Mr. Snow was a partner in a partnership formed in 1964 to develop a special purpose incinerator. There were no sales in 1964, but Snow deducted expenditures under §174 which the Service disallowed. Snow was devoting about one-third of his time to the project and sales began soon after 1964. The Supreme Court reviewed the legislative history to §174 and found that Congress intended to provide an economic incentive, particularly for small and growing businesses to engage in the search for new products. Thus, Mr. Snow was allowed to deduct R&E expenditures prior to carrying on a trade or business. In this case, §183 (dealing with activities not engaged in for profit) was ignored because there was a clear profit motive from the venture.

While the "in connection with" language of §174 is a lesser standard than the "carrying on" language of §162, §174 does not eliminate the trade or business requirement. The taxpayer "must still be engaged in a trade or business at some time." Also, the facts must be examined to determine whether the taxpayer's activities are

"sufficiently substantial and regular to constitute a trade or business."10 "Although a reasonable expectation of profit is not required, the taxpayer must have entered into the activity with the actual and honest objective of making

a profit."11

"Inventive activities" have been held to constitute a trade or business for §174 purposes where the

taxpayer's inventive activities were of "sufficiently sustained character."12 Exploiting inventions through the collection of royalties or sales of patents may constitute a business; a taxpayer need not put them to commercial use

himself.13 Also, because developmental activity may not yield any income in the early years, lack of income from a

project is not determinative of whether or not the trade or business requirement is satisfied.14 However, as noted earlier under "Financing vehicles and §174," the facts and circumstances of the planned activities must be reviewed to determine if the taxpayer is entitled to §174 deductions. The "mere presence of a profit motive ... is not

8 Rev. Rul. 85-186, 1985-2 C.B. 85. 9 Snow v. Commissioner, 416 U.S. 500 (1974). 10 Green v. Commissioner, 83 T.C. 667, 686-687 (1984); similarly, see McManus v. Commissioner, 54 T.C.M. (CCH) 475

(1987). 11 Brown v. Commissioner, 58 T.C.M. (CCH) 850 (1989). Also, Agro Science Co. v. Commissioner, 927 F.2d 213 (5th Cir.

1991). 12 Louw v. Commissioner, 30 T.C.M. (CCH) 1421, 1422 (1971). Taxpayer had designed inventions over his lifetime and had

pursued marketing some of them as well as patenting them. The court noted that he had pursued his activities in a business-like manner (at 1423). Similarly, in Kilroy v. Commissioner, 41 T.C.M. (CCH) 292, 295 (1980), the taxpayer was found to be engaged in the business of inventing "at least to the extent required by section 174." In Magee v. Commissioner, 32 T.C.M. (CCH) 1277, 1279 (1973), the court stated: "First, we note that the lack of economic return to the petitioner does not alone rule out the intention and expectation of making a profit. Such experimental activity often shows little, if any, return during developmental stages. It was to encourage this kind of activity that Congress authorized the current deduction of research and experimental expenditures. S. Rpt. No. 1622, 83d Cong., 2d Sess., p. 33. Significantly, the petitioner obtained a patent on his scaffold" (footnote omitted). Also see Maximoff v. Commissioner, 53 T.C.M. (CCH) 423 (1987) where the taxpayer's inventive activities that were engaged in with continuity and regularity were held to constitute a trade or business for I.R.C. § 162 purposes. However, the court does not specify why its conclusion involved I.R.C. § 162 rather than I.R.C. § 174.

13 Louw v. Commissioner, supra. 14 Maximoff v. Commissioner, supra.

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determinative of whether the §174 deduction will be allowed."15 In order to meet the trade or business requirement of §174, a profit motive is not enough. The entity incurring the R&E expenditures must actually manage and control

the "use or marketing of the research results."16

3. Business Requirement (part of “in connection with”)

Lewin v. Comm’r., 91 AFTR 2d 2003-1435 (4th Cir.) involved a partnership (I-Tech) formed to fund research to be performed by 5 Israeli companies. I-Tech did not set aside any of the funds for manufacture or marketing of the technology to be produced by the research companies. Funding agreements between I-Tech and the research companies granted the companies a limited nonexclusive license to commercially exploit the technology with I-Tech receiving royalties. The tax court and circuit court both found that I-Tech did not qualify for deductions under §174 because the payments to the research companies was not “in connection” with a trade or business. “There must be a ‘realistic prospect” at the time of the expenditure that the partnership will enter a trade or business involving the technology being developed.” Partner inspections of the R&D companies and conversations with personnel did not show active involvement with the companies. Also, without contractual control over the research and no prospect of entering into a trade or business with the technology to be created, §174 was not applicable. “To demonstrate a ‘realistic prospect’ of entering its own business in connection with the fruits of the research and development, the taxpayer must ‘manifest both the objective intent to enter such a business and the capability of doing so.” (Kantor, 998 F.2d at 1518).

Saykally v. Comm’r., T.C. Memo 2003-152, is a reminder, that even where the taxpayer is the knowledgeable software developer doing the development work, §174 will not apply if he is merely an investor and has not objective intent to engage in his own trade or business using the technology.

In 2007, the 9th Circuit (Saykally v. Comm’r., 100 AFTR 2d 2007-XXXX (CA9) (unpublished)) affirmed the tax court decision denying a §174 deduction to Mr. Saykally. Per the court:

“We have held that R&D expenses are not deductible under I.R.C. § 174 unless a taxpayer demonstrates a ““realistic prospect” of subsequently enteringits own business in connection with the fruits of the research” by manifesting (1) the “objective intent” to enter such a business, and (2) the “capability of doing so.” Kantor, 998 F.2d at 1518 (citations omitted) (emphasis added). Saykally failed to demonstrate that he possessed the requisite objective intent at the time he incurred the R&D expenses. The record before us plainly indicates that Saykally engaged in the R&D efforts to create technology which could be licensed to another entity for use in that entity's existing business, not his own. Id. at 1519 (“In order to qualify for the section 174 deduction, a taxpayer's existing or prospective business must be its own and not that of another entity.”).”

S developed software for his wholly-owned corporation C. S deducted his costs on his tax return. The deduction was denied by the IRS as it was not incurred in connection with S’s own trade or business and S did not “have the objective intent to prospectively enter into his own trade or business with the developed technology.”

A December 2005 Chief Counsel memo provides helpful guidance on how to structure a joint venture so that that taxpayer (the joint venture) is entitled to §174 deductions. It provides a nice review of the case law dealing with the “in connection with a trade or business” requirement of §174.

In Chief Counsel Advice 20055203F, the IRS National Office addressed a question from the field on whether a joint venture with no employees or office space, that contracted with its two shareholders to conduct research was allowed to deduct the costs under §174. The concern of the field agents was that the joint venture did not incur the expenditures in connection with a trade or business. After reviewing the facts and extensive case law, the Chief Counsel Office (CC) found that the joint venture was entitled to the §174 deduction, but cautioned that the ruling should not be viewed as providing a blanket interpretation applicable to all joint ventures. Instead, “each case must be examined based on its own facts and circumstances to determine the true substance of the activity. That is, the economic realities of each particular case must be evaluated to determine whether the activity is undertaken with the requisite profit motive and carried on in a manner to endow it with trade or business status, or whether the activity is merely an investment purporting to be a business and the taxpayer has no realistic prospect of entering into a business of its own in the future with the R&E results.”

15 Harris v. Commissioner, 16 F.3d 75, 80 (5th Cir. 1994). 16 Id.

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Details: Joint venture (T) is a U.S. taxpayer owned 50% by foreign shareholder (F) and 50% by U.S. shareholder (U). Both shareholders are in the same industry. U and F contributed in-process R&D, other intangibles and capital to form T. The purpose of T was to enable U and F to engage in R&D and commercialize a product. When T was formed, U was already working on invention C which both shareholders were interested in. In Year 1, T started engaging in R&D. T is managed by a 6-person board of directors with three each provided by U and F. U and F have service agreements with T under which these shareholders provide R&D and support services. Under the agreements, the shareholders are reimbursed based on an hourly rate and actual R&D expenditures.

T has ownership of the R&D and licenses successful inventions to U and F. The licenses are granted prior to knowing if the R&D will result in anything useful. In geographical areas where U and F don’t have license to use specified inventions of T, T has licenses with third parties. In Years 1 to 6, expenditures exceeded royalty income for T, but in Year 7 to 15, net income was produced.

IRS examiners questioned T’s §174 deductions because it was engaged in passive activities (collecting royalties) and had no employees. Examiners did not question T’s §162 deductions thereby indicating that T was engaged in a trade or business. CC noted that there is no requirement under §174 that a taxpayer be engaged in an active business (rather than a passive one). Also, if a taxpayer meets the §162 trade or business requirements, it will also meet the §174 business connection requirement (Christensen, 56 TCM (CCH) 425 (1988)). CC noted that the only difference in §174 and §162 is when deductions may be made. Under §174, deductions may be claimed before the start of a trade or business (as long as it has a “realistic prospect” of entering into a trade or business) (Snow, 416 US 500 (1974) and Scoggins, 46 F.3d 950 (9th Cir. 1995)).

In addition, there is no requirements under §174 that a taxpayer manufacture what it creates from the R&D. The §174 trade or business requirement is met by a showing of a requisite profit motive and conducting activities with regularity and continuity (Louw, 30 TCM (CCH) 1421 (1971) and Kilroy, 41 TCM 292 (1980)). The CC noted though that there is a distinction explained in case law between investing in and carrying out your own R&D and merely being an investor in someone else’s R&D without ownership of the inventions and control over their development, production and marketing (Green, 83 TC 667 (1984)). The CC found that T was conducting a business with a profit motive, it owned the developments and was involved in their exploitation. T also conducts its operations in a substantial, continuous and regular manner.

CC also found that using contract workers rather than employees did not change the §174 result because the form of operations is not important to receiving the tax benefit.

CC also addressed the long line of cases, such as Green, supra, that denied a §174 to a taxpayer because they were an investor in R&D rather than operating a business engaged with the R&D. CC summarized such cases as involving ones where the taxpayer lacked technical expertise, oversight of the R&D and management and control over the R&D. Basically, in Green and similar cases, the taxpayer was not operating its own business to use the R&D. In looking at the substance of the situation and the economic realities, CC found that T was engaged in a trade or business of exploiting its own R&D. Through its officers and directors, T has significant expertise in the business of developing and exploiting its research and did so. Also, unlike Green and similar cases where the person conducting the R&D was independent from the party generating royalties from it, T, U and F are well connected. T also had rights to the R&D beyond what U and F had and T had actually licensed the R&D to some third parties.

“There is a fundamental difference between a person that invests in the R&E conducted by an unrelated enterprise and two existing businesses which form a joint venture in the same field as their existing businesses and conduct R&E on behalf of that joint venture, with the intention of making a profit from the assets to be developed by the joint venture. In the latter situation, these businesses are conducting a new business through the joint venture, not making an investment through it. We believe these types of pioneering joint ventures are among the class of taxpayers Congress intended to benefit when it enacted section 174.”

CC noted that for a joint venture, it is expected that T would be managed by those creating the joint venture and that did not pose any problem in and of itself under §174. CC also did not find any abuse that part of the R&D was performed outside of the US because there is no requirement under §174 that the R&D only be performed in the US. Also, there was no problem that T did not manufacture the inventions itself which may have yielded greater profit because there is no such requirements under §174.

LMSB Directive on Biotech: In May 2007, the LMSB Division issued Industry Director Directive on the “Proper Treatment of Upfront Fees, Milestone Payments, Royalties and Deferred Income.” This directive describes a “Tier 2” issue warranting coordination in the field. The directive addresses tax issues related to collaboration agreements where a small biotech firm with research or a product not yet ready for market seeks funds from a larger

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biotech or pharmaceutical company to enable it to continue its work. The benefit to the larger company is obtaining some right to the final product. The IRS has found that some large funders have treated the non-refundable upfront payment as deductible under §174 and possibly qualified for the research credit. Some recipients of the upfront fees have tried to defer the revenue over the life of the agreement. Revenue Agents are to look for these fact patterns to determine if the proper tax treatment was applied. For further details, see the complete text at http://www.irs.gov/businesses/article/0,,id=170719,00.html.

4. Definition of R&E

R&E expenditures are those which represent R&D costs in the experimental or laboratory sense. The regulations provide that expenditures represent R&D costs in the "experimental or laboratory sense if they are for

activities intended to discover information that would eliminate uncertainty concerning the development or17

improvement of a product. Uncertainty exists if the information available to the taxpayer18 does not establish the capability or method for developing or improving the product or the appropriate design of the product" (footnotes

added).19 In applying the definition, one is to look at the nature of the activity producing the expenditures, not to the nature of the product or improvement being developed "or the level of technological advancement the product or

improvement represents."20

Example: In TAM 9538008, redesign of existing home appliances or components was held to qualify as R&E. Projects were undertaken to, 1) produce better and more competitive product, 2) to increase reliability, 3) to

increase general product safety, or 4) to respond to new federal restrictions.21

A "product" includes "any pilot model, process, formula, invention, technique, patent, or similar property, and includes products to be used by the taxpayer in its trade or business as well as products to be held for sale, lease,

or license."22 Research for new products and processes is not required to be related to the taxpayer's current product

lines in order to be considered R&E under §174.23

It is important in applying §174 to distinguish R&E from actual production.24 Production costs would be subject to the inventory accounting rules of Sections 471 and 263A, rather than §174. To qualify as a §174 expenditure, the expenditure must be of an "investigative nature in developing the concept of a model or product"

rather than incurred in the actual construction of the product.25

R&E expenditures include costs of obtaining a patent, including attorney fees in making and perfecting the

application.26 Quality control testing does not constitute R&E. However, the regulations clarify that "quality control testing does not include testing to determine if the design of the product is appropriate" (validation

testing).27

17 Note the use of "or" rather than "and." 18 The March 1993 proposed regulations (PS-2-89, 1993-1 C.B. 904) used the term "information reasonably available to the

taxpayer." 19 Treas. Reg. § 1.174-2(a)(1) (as amended in 1994). 20 Id. 21 Also see FSA 200125019 included in the course reading materials. 22 Treas. Reg. § 1.174-2(a)(2) (as amended in 1994). 23 Rev. Rul. 71-162, 1971-1 C.B. 97. Also see Best Universal Lock Co., Inc. v. Commissioner, 45 T.C. 1 (1965), acq. 1966-2

C.B. 4. 24 See Rev. Rul. 73-275, 1973-1 C.B. 134, citing Martin Mayrath, 41 T.C. 582 (1964), aff'd, 357 F.2d 209 (5th Cir. 1966). 25 Mayrath v. Commissioner, 41 T.C. 582, 590 (1964), aff'd, 357 F.2d 209 (5th Cir. 1966). In TAM 8211004 (Nov. 27, 1981),

the Service ruled that the R&E phase of developing a drug extended until the completion of all testing because prior to that point, there was no marketable product.

26 This definition is contrary to Financial Accounting Statement No. 2, Accounting for Research and Development Costs, which specifically states that costs to obtain a patent do not constitute R&D expenditures.

27 Treas. Reg. § 1.174-2(a)(4) (as amended in 1994).

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Section 174 only applies to R&E expenditures if they are reasonable in amount under the circumstances. Generally, expenditures are reasonable in amount if the amount "would ordinarily be paid for like activities by like

enterprises under like circumstances."28

Historical Notes

Although language from the 1983 and 1989 proposed regulations defining R&E were never effective and was not made part of the final regulations, it is relevant to an understanding of the history of the definitional problem.

The May 1989 proposed regulations basically defined R & E using a time-line approach. Thus, whether an expenditure fell under §174 depended on when in the development process the expenditure was incurred. If the expenditure was incurred after the basic design specification was met, generally, it did not fall under §174. The May 1989 proposed regulations defined R & E as follows:

[N]ot all of the expenditures incident to developing or improving a product or property will qualify as research or experimental expenditures within the meaning of §174. Expenditures incurred after the point that the product or property (or component of the product or property) meets its basic design specifications related to function and performance level generally will not qualify as research or experimental expenditures under §174 unless the expenditures related to modifications to the basic design specifications for the purpose of curing significant defects in design, obtaining significant cost reductions or achieving significantly enhanced function or

performance level.29

Obvious problems with the above definition of R & E include the subjectiveness of the terms "basic" and "significant". Taxpayers and practitioners also raised objections that the time-line approach to defining R & E did not follow Congressional intent. They argued that Congress intended that R & E be defined based on what was done, rather than when it was done. The final regulations eliminated the time line approach.

The May 1989 proposed regulations also contained specific rules and examples on the application of §174 to the costs of developing computer software, again taking a time-line approach. These rules were not included in the final regulations.

5. Software Development As R&E

Per Revenue Procedure 2000-50,30 software development costs may be treated similarly to §174 expenditures thereby allowing the taxpayer to currently expense the costs or to elect to amortize them over 60 months. If instead of developing the software, a taxpayer purchases software designed by someone else, the taxpayer must capitalize the software. The definition of software used in Rev. Proc. 2000-50 ties to the definition in §197. Computer software is defined as “any program or routine (that is, any sequence of machine-readable code) that is designed to cause a computer to perform a desired function or set of functions, and the documentation required to describe and maintain that program or routine. It includes all forms and media in which the software is contained, whether written, magnetic, or otherwise. Computer programs of all classes, for example, operating systems, executive systems, monitors, compilers and translators, assembly routines, and utility programs as well as application programs, are included. Computer software also includes any incidental and ancillary rights that are necessary to effect the acquisition of the title to, the ownership of, or the right to use the computer software, and that are used only in connection with that specific computer software.” The term does not include any data or information base unless it is in the public domain and is incidental to the program. The term also does not include any costs of procedures external to the computer’s operations.

Rev. Proc. 2000-50 provides that software development costs may be accounted for similarly to §174 expenditures thereby allowing the taxpayer (1) to currently expense the costs, or (2) to elect to amortize them over 60 months from the date the development is completed in accordance with rules similar to §174(b), or under the 167(f) depreciation rule (36 months) starting with the date the software is placed in service.

28 Treas. Reg. § 1.174-2(a)(6) (as amended in 1994); based on I.R.C. § 174(e) added by Omnibus Budget Reconciliation Act of

1989, Pub. L. No. 101-239, § 7110, 103 Stat. 2106. 29 Treas. Reg. § 1.174-2(a)(1) of the May 1989 proposed §174 regulations. 30 Rev. Proc. 2000-50, 2000-52 I.R.B. 601 which replaces Rev. Proc. 69-21, 1969-2 C.B. 303.

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Observations: The IRS appears to be giving taxpayers a choice of deducting capitalized costs of developing software as either 60 months or longer under 174(b) or 36 months under 167(f). This may indicate that the IRS is referring to two different types of software - one type that falls under §174(b) and the other under §167(f). Perhaps the IRS is getting at the issue of when software developed by the taxpayer is inventory, which would not be depreciable under 167(f). But, this begs the question as to whether the developed software is a depreciable asset, like a mold, that is used to produce inventory (that is, copies of software)

and would be depreciable under 167(f).31

Like its predecessor, Rev. Proc. 2000-50 does not state that software development expenditures are per se R&E expenditures. Instead, it states that software development costs "in many respects so closely resemble the kind of research and experimental expenditures that fall within the purview of §174 as to warrant similar accounting treatment." This is particularly important for purposes of §41 because for software development activities to constitute “qualified research,” such activities must meet the definition of R&E under §174 and Reg. §1.174-2 (a standard not required to be able to currently deduct software development costs).

In FSA 20006023 involving a taxpayer’s research credit claim for internal use software, the IRS stated: “The United States Claims Court has provided some guidance for determining when expenditures associated with computer software come within the definition of “research or experimental expenditures.” Specifically, the expenditures satisfy the definition only if new or significantly improved programs have been produced. Yellow

Freight, Inc. v. United States, 24 Cl. Ct. 804, 809 (1992).”

In PLR 200236028 Taxpayer incurred costs to acquire and install enterprise resource planning (ERP) software. Installation costs included consultants who engaged in implementation and creation of additional software code, and trained employees. Consulting costs were identified as “functional” and “technical” with the former involving maintenance and training and the latter involving modeling and designing of additional software, writing code, and option selection and implementation of existing imbedded ERP software templates. The consulting contracts made the taxpayer responsible for the task – that is, taxpayer paid until the work was completed. The IRS ruled that the technical consulting costs for writing code fell under Rev. Proc. 2000-50. In addition, an allocable portion of the modeling and design costs fell under Rev. Proc. 2000-50. In contrast, the technical consulting costs for option selection and implementation of imbedded templates along with the allocable portion of modeling and design work for this were part of the installation of the ERP software. Basically, the ERP software doesn’t function without this work and such costs don’t fall under Rev. Proc. 2000-50 (they are not software development). Such costs are capitalized as part of the ERP software and amortized over 36 months. Employee training and related costs are currently deductible under §162 (see Rev. Rul. 96-62).

Relevance to the §41 research credit: In Norwest v. Commissioner, 110 T.C. 454 (1998), the court stated that for purposes of software development expenditures qualifying for the credit, they must meet the definition of R&E under §174. "We believe that the phrase 'the research expenditures may be treated as expenses under section 174' is meant to require the taxpayer to satisfy all the elements for a deduction under section 174."

In PLR 9709041 (12/3/96), the Service granted a taxpayer permission to change its accounting method for software development costs. This ruling includes the following statement: "it should be understood that the responsibility for making determinations as to whether the expenditures for the development of computer software paid or incurred by the taxpayer in connection with the taxpayer's trade or business are costs similar to research and experimental expenditures is a matter to be considered by the district director upon examination of the taxpayer's return." This "similar to" language is slightly different from that of Revenue Procedure 69-21 which states that software development costs so closely resemble R&E expenditures to warrant accounting treatment similar to that accorded such costs under §174. In the PLR, the Service is stating that the software development costs be similar to R&E expenditures (and thus, apparently allowed §174 accounting treatment).

Under Rev. Proc. 2000-50, taxpayers acquiring software would be able to amortize the cost ratably over 36 months per §167(f)(1), unless the software was acquired as part of the hardware without the cost being separately stated (in which case it is depreciated along with the hardware).

31 Section 174(b) provides that if R&E (research and experimental) expenditures result in development of depreciable property,

deductions for the unrecovered expenditures shall be determined under §167, rather than a minimum 60-month period under §174(b). See Reg. §1.174-4(a)(2) and (4), and Reg. §1.167(a)-14(b)(1).

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Where software is leased or licensed by a taxpayer, the rental expensing rule of Reg. §1.162-11 should be

followed unless the amount is properly chargeable to a capital account.32

6. Depreciable Property

Expenditures to acquire or improve land or depreciable property to be used in connection with R&E activities do not qualify for §174 treatment. However, depreciation allowances can be expenditures under §174 to

the extent that the related property is used in connection with R&E.33 If R&E expenditures are incurred in the construction or manufacture of depreciable property by another person, they are only deductible under §174 if

"made upon the taxpayer's order and at his risk."34

Example 1: X Corporation orders a specially-built automatic milling machine with the guarantee that it is capable of producing a set number of units per hour. X may not treat this expenditure as a deduction under §174

because the machine was not made at X's risk.35

Example 2:36 Software Developer (SD) created the design, elements and designations of computer games and then contracted out certain graphics software development for them. SD also gave the contract developers proprietary software information necessary to the development of the games. The development agreement between the parties included detailed specifications and listed deliverable items and milestones. The contract developer had to meet the specifications before SD was required to pay. The contract developer was to test each deliverable prior to delivery. SD was required to notify the contract developer of any errors within a specified time and the developer was given a specified time to fix the problems. The software became the exclusive property of SD, but the contract developer retained ownership of any and all separately developed and acquired programming technology, subroutines, programming utilities and programming tools embodied in or used in the preparation of the software. The contract developers were paid royalties based on sales with a specified advance royalty also paid. SD had the right to terminate the agreement at any time for any reason and the contract developer could keep any payments received to date. Sometimes, design and deliverables were modified during the course of the agreement.

The Service ruled that SD was not at risk for the development of the software. The contract developers were not paid until SD verified that the programs were bug-free and were required to make any corrections for later discovered errors, at no additional cost to SD. The Service stated that the contract developers were responsible for the operability of the software per SD's specifications and the developer kept no ownership interest in the software. Thus, the developer bore the risk of developing the software.

Thus, the Service concluded that the advance royalty payments made to the independent software developers by SD constituted expenditures for purchased software, capitalizable per Revenue Procedure 69-21, rather than R&E expenditures. This example is a good illustration of the difficulty that can arise in determining which party bears the risk of development and the importance of contract terms.

If R&E expenditures result in an end product that constitutes depreciable property to be used in the taxpayer's trade or business, the costs of the component materials, labor and other costs involved in the construction

or acquisition of the property do not constitute R&E expenditures.37 For example, taxpayer D incurs $30,000 of costs to develop a new machine to be used in D's business. The cost of material, labor and other costs is $10,000 and additional costs, representing research costs total $20,000. Under §174(a), D may deduct the $20,000, but the

$10,000 must be capitalized to an asset account.38

Example 3: In TAM 199927001, the Service held that costs of constructing molds and other tooling for the manufacture of plastic injection molded products were not §174 R&E expenditures because the costs represented the component parts to create depreciable property. T would only be paid if it successfully designed and built the molds and the customer accepted them. T used the molds after title transferred to customers. Once accepted by the customer, title to the mold shifted to the customer. The Service applied §1.174-2(a) which provides that §174 does

32 See Reg. §1.197-2(a)(3). 33 Treas. Reg. § 1.174-2(b)(1). 34 Treas. Reg. § 1.174-2(b)(3). 35 Id. 36 Example is based on TAM 94-49-003(Aug. 25, 1994). 37 Treas. Reg. § 1.174-2(b)(2) and (4). 38 Example is from Treas. Reg. § 1.174-2(b)(4).

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not apply to expenditures for the acquisition or improvements of land or depreciable property used in connection with R&E. The Service also applied §1.174-2(b)(4) which provides that §174 does not apply to the costs of component materials or depreciable property or labor and other costs involved in construction, installation acquisition or improvement of property.

"Under the present facts, the expenditures in question are those attributable to the construction of the molds and other tooling. The parties in this case agree that the molds and other tooling are property of a character subject to the allowance for depreciation. It is the Taxpayer's position, however, that such property is not subject to the limitations of section 1.174-2(b)(2) and (4) because the property is not depreciable property "in the hands of Taxpayer. In fact, the plain meaning of the term "property of a character subject to the allowance for depreciation" refers to the character of the property, and not to whether it is depreciable in the hands of a particular taxpayer."

Observations: (1) Costs of R&E (rather than the cost of the component parts) should qualify as §174 R&E. (2) Is the Service's interpretation of "property of a character subject to the allowance for depreciation" correct? Does this term refer to the nature of the business property in anybody's hands, or just the taxpayer's hands? How does one distinguish inventory from depreciable property under this interpretation?

When does depreciation begin? Ekman v. Comm'r., T.C. Memo 1997-318, offers some guidance on when depreciation begins for property used in an R&E activity. "The engine was acquired by [taxpayer] in March 1991, and the record supports a finding that the research and experimentation was a trade or business of [taxpayer] and was conducted during 1991. The engine, therefore, was placed in service during 1991. [Taxpayers,] therefore, are entitled to a depreciation deduction for the cost of the engine for 1991."

C. §41

The credit for increasing research activities was enacted in 1981 effective for qualified research expenditures paid or incurred after June 30, 1981 and before January 1, 1986. The credit was set to expire in 1985 so that Congress could

evaluate its efficiency.39 Since 1985, a pattern of expiration and reinstatement has existed for this credit. On June 30, 1998, the credit expired for the ninth time since it first expired in 1985. Public Law 105-277 (October 21, 1998) extended the credit to June 30, 1999. In December 1999, the credit was extended through June 30, 2004. The credit was retroactively extended by P.L. 108-311 on October 4, 2004. The credit now expires after 12/31/05 (that is, it was extended for qualified research expenses paid or incurred before 1/1/06). [P.L. 108-311, §301; Working Families Tax Relief Act of 2004] The temporary reinstatements of this credit have often been retroactive, but once, the credit was allowed to lapse for a one-year period (July 1, 1995 to June 30, 1996).

Various changes have been made to the credit subsequent to its first expiration date. The key to maximizing the tax benefits from the research credit is a good understanding of what constitutes "qualified research expenditures," how the formula works, the carryforward provisions and what documentation is appropriate. In fully understanding the research credit, legislative histories to the tax acts that created it and modified it must often be consulted because the regulations under §41 are not complete and parts are in proposed form. The research credit is calculated and reported on Form 6765, Credit for Increasing Research Activities.

1. Purpose

The credit for increasing research activities was added by the Economic Recovery Tax Act of 1981. The reasons given for enacting this provision included the following:

(1) To overcome the resistance of some businesses to incur the significant costs involved in research projects;

(2) To encourage companies to engage in research activities which might otherwise not be undertaken because of the reluctance to allocate scarce funds for "uncertain rewards";

(3) That incentives to stimulate productivity would lead to greater private activity in research; and

39 General Explanation of the Economic Recovery Tax Act of 1981, prepared by the staff of the Joint Committee on Taxation,

pages 119 to 120.

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(4) The decline in R&D activities in the U.S. adversely affected economic growth and

competitiveness in world markets and needed to be addressed.40

2. Brief Legislative History

a. Economic Recovery Tax Act of 1981 – added IRC §44F, Credit for Increasing Research

Activities (currently IRC §41). ERTA also brought us the rapid depreciation rules of ACRS. ERTA was a “tax reduction program [to] help upgrade the nation's industrial base, stimulate productivity and innovation throughout the economy…” Congress was concerned that the economy was not operating at its full potential and that companies were not spending enough on R&D and the U.S. non-military R&D spending was a smaller percentage of GNP relative to Germany and Japan. So, they desired a substantial incentive to encourage more R&D activity.

• Credit = 25% x (qualified research expenses - base period research expenses).

• Qualified Research Expenses (QRE): In-house research expenses (wages, supplies, amount paid or incurred for right to use personal property in conduct of qualified research) + Contract expenses (65% of amount paid or incurred to any person for qualified research, including certain basic research by colleges, universities and certain research organizations if pursuant to a written research agreement).

• Base period research expenses: Average of QRE for each year in the base period which consisted of the 3 tax years immediately preceding the tax year for which the credit was being calculated; thus, the credit was calculated based on a rolling average of prior year research expenditures.

• Minimum base period research expense - could not be less than 50% of QRE for the credit year.

• “Qualified research” meant research or experimental expenditures under §174. However, the following research was excluded: 1) research conducted outside the U.S., 2) research in the social sciences or humanities, and 3) funded research.

• In reviewing the legislative history of §44F, be aware that the language in the Blue Book to ERTA does not refer to the actual bill that was passed on the House floor. The version of §44F passed in the House was very short and only referred to §174 in defining “qualified research.”

The formula was changed in 1989 and the definition of “qualified research” was tightened up in 1986.

b. Tax Reform Act of 1986—First Extension + Tightening of the Definition of Qualified Research

• Substantial changes were made to the research credit because Congress believed that the definition of research that qualifies for the credit had been applied too broadly. To tighten up the definition of "qualified research," additional requirements were created and new terminology added to §41 (see next section). In addition, limitations were placed on the availability of the credit for costs of developing internal-use software.

c. The Revenue Reconciliation Act of 1989 (RRA’89) (P.L. 101-239)—Change to the Formula

• The 3-year rolling average was replaced with a base amount that considers the taxpayer’s “research intensity” (aggregate QRE/aggregate gross receipts for 1984 – 1988). The problem with the rolling base was that it presented an odd incentive because it could actually encourage companies to decrease R&D in the second and third years in order to get a larger credit in the fourth year.

▪ Gross receipts were factored into the formula “because businesses often determine their research budgets as a fixed percentage of gross receipts” – therefore, Congress found it

40 S. Rpt. No. 97-144, 97th Cong., 1st Sess (1981), reprinted in 1981 U.S.C.C.A.N. 105, 181 to 182.

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appropriate to index each taxpayer’s base amount to the average growth in its gross receipts.

d. The Small Business Job Protection Act of 1996 (SBJPA) (P.L. 104-188)—New Elective Alternative Formula

▪ The credit was extended, but, for the first time, it was not retroactively extended and thus, July 1, 1995 through June 30, 1996 is a gap period in which no federal research tax credit was available.

▪ The Act created an elective alternative incremental research credit (AIRC) designed to provide an incentive to certain firms that despite increasing QRE, were denied a credit because of rapidly increasing gross receipts, or a very high research intensity for the base period. The AIRC uses a 3-tiered fixed-base percentage that is lower than the standard fixed-base percentage (see later example).

e. The Tax and Trade Relief Extension Act of 1998 (P.L. 105-277)—Clarification + 1 Year Extension

▪ Congress provided further clarification as to the meaning of “qualified research” in response to some recent court decisions.

f. The Tax Relief Extension Act of 1999 (P.L. 106-170)—Further Clarification of “Qualified Research” + 5 Year Extension

� The three percentages used to compute the alternative incremental research credit (AIRC) were also increased by one percentage point (to 2.65, 3.2, and 3.75) (effective for tax years beginning after June 30, 1999).

g. The Energy Tax Incentives Act of 2005 (P.L. 109-58; 8/8/2005) —Energy Research Consortium

� Modified the research tax credit to allow a credit of 20% of the amount paid or incurred in carrying on any trade or business to an “energy research consortium.” The amount paid includes contributions. The definition is provided at §41(f)(6) and is generally a non-profit organization that primarily conducts energy research.

In addition, the Act modifies at §41(b)(3) to provide that for amounts paid to eligible small businesses, universities and federal labs for qualified research that is energy research, 100% (rather than 65%) of the payment is considered contract research expenses.

h. Tax Relief and Health Care Act of 2006 (P.L. 109-432; 12/20/06) —Various changes

� The credit was extended to 12/31/07.

� The percentages used in the alternative incremental credit of §41(c)(4) were increased to 3%, 4% and 5% (from 2.65%, 3.2% and 3.75%). This change is generally effective for tax years ending after 12/31/06. Transition rules are provided at Act §104(b)(3) and are relevant to taxpayers on a fiscal year.

� An elective “alternative simplified credit” was added at §41(c)(5).

i. Tax Extenders and Alternative Minimum Tax Relief of 2008 (P.L. 110-343) – Various changes

• The credit was extended to 12/31/09.

• The AIRC was terminated for tax years beginning after December 31, 2008.

• The percentage for the ASC was increased from 12% to 14%. For tax years ending before January 1, 2009, 12% applies.

• §41(h)(3) on how to compute the credit for a tax year in which the credit terminates was modified, effective for tax years beginning after 12/31/07.

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3. Operation of the Credit

• Standard Formula: The credit is computed on Form 6765. The calculation itself is relatively straightforward. The problems in dealing with the credit are with the numerous definitions, lack of guidance, and recordkeeping. The formula per §41(a)(1):

20% x [QRE less base amount]

Computed on Form 6765.

• AIRC: The Small Business Jobs Protection Act of 1996 added an alternative incremental research credit (AIRC) that a taxpayer could irrevocably elect to use in place of the regular credit. This credit benefits taxpayers who do not have adequate records to compute a base year (perhaps due to an acquisition), or who obtain a regular credit of zero due to the special features of that credit, such as how it factors in a taxpayer’s “research intensity” for prior years (percentage of QRE to gross receipts). The AIRC was terminated for tax years beginning after December 31, 2008.

• ASC: An elective “alternative simplified credit” was added at §41(c)(5). The simplified credit is calculated as:

14% x [QRE – 50%(total QRE for 3 preceding tax years ÷ 3)]

Thus, the credit is generated if current year QRE exceeds a rolling average base using QRE for the past 3 years. This will eliminate the need to know or track QRE and gross receipts for the 1984 – 1988 base used in the regular research tax credit. New taxpayers or those in their first year of having QRE may also use this credit under a special rule that allows the credit to equal 6% of QRE. For tax years ending before January 1, 2009, the rate was 12% rather than 14%.

An election to use this simplified method is binding in the year made and all succeeding tax years unless revoked with the consent of the IRS. The simplified credit is effective for tax years ending after 12/31/06. Special transition rules are provided at Act §104(c)(2) & (4) for fiscal year taxpayers. An election may not be made if the taxpayer has already elected to use the alternative incremental credit. However, a transition rule provides that for an alternative incremental credit election that applies to a tax year that includes 1/1/07, that election is treated as revoked with IRS consent if the taxpayer makes an election to use the simplified credit for that year. See Act §104(c) for specifics.

• Additional calculation for standard, AIRC and ASC: §41(a) also allows any taxpayer to get a credit for:

(2) 20 percent of the basic research payments determined under subsection (e)(1)(A) , and

(3) 20 percent of the amounts paid or incurred by the taxpayer in carrying on any trade or business of the taxpayer during the taxable year (including as contributions) to an energy research consortium for energy research.

Basic research payments: A basic research payment is a cash payment by a corporation to a qualified organization for basic research to be performed by the organization. The payment

must be made pursuant to a written agreement between the corporation and the organization.41

• Definitions:

a) QRE = Qualified Research Expenses = total of,

In-house research expenses (wages per §3401(a) + supplies)42

41 I.R.C. § 41(e). There are several special rules and definitions for the research credit generated from basic research payments. 42 See §1.41-2(b), (c), and (d). Wages can include the spread from the exercise of non-qualified stock options. Apple Computer,

98 TC 232 (1992); acq. 1992-31 I.R.B. 4. Wages can also include the spread resulting from disqualifying dispositions of incentive stock options (ISO). Sun Microsystems Inc. v. Comm'r., T.C. Memo 1995-69, acq, 1997-2 C.B. 1.

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+ 65% of contract research expenses43

[The above must be incurred for "qualified research."]

Wages: Per §41(b)(2)(A)(i), the wages must be paid for “qualified services” performed by the employee. In addition, for wages to be considered an in-house research expense, they must meet the definition at §3401(a). Court cases have also held that wage income resulting from non-qualified stock options and disqualifying dispositions of both ISOs and stock obtained from an employee stock purchase plan constitute wages for purposes

of the credit.44 The House Report to the Economic Recovery Tax Act of 1981 notes that compensation "not subject to withholding, such as certain fringe benefits" is not eligible

for the credit.45

Qualified services: Services are qualified if they consist of engaging in qualified research or engaging in directly supervising or directly supporting research activities that constitute qualified research. If at least 80% of an employee's wages are for qualified

services, all of his services are treated as qualified services for the tax year.46 Per §1.41-2(c)(2), “direct supervision” means the "immediate supervision (first-line management) of qualified research." It does not include supervision by higher-level managers even if that manager is a "qualified research scientist." Per §1.41-2(c)(3), "direct support" refers either to people engaging in the actual conduct of qualified research, or those directly supervising those engaging in the actual conduct of qualified research. It would include a secretary who types reports that describe lab results derived from qualified research and a lab worker who cleans equipment used in qualified research. However, it would not include general administrative services or other services that only indirectly benefit research activities. Thus, the costs of an accountant analyzing research expenses or a janitor for "general cleaning of a research laboratory" would not constitute direct support.

FSA 2184 (9/97): “An employee on paid holiday, vacation or sick leave is not time spent in the performance of services for the employer. Therefore, during hours attributable to paid leave, neither nonqualified nor qualified services are being performed by the employee. Paid leave time is not included in computing the hours allocated between qualified and nonqualified services. However, amounts paid for leave are included as wages for purposes of determining the amount of house research expenses.”

“For purposes of illustration, we use the following hypothetical: Assume a work year of 2080 hours for which the employer pays $10 per hour, so the employee receives total wages of $20,800 for the year. There are 10 paid holidays, accounting for 80 hours. The employee also takes 4 weeks of vacation, using 160 hours of leave and she uses 104 hours of sick leave. Hence, the employee has actually worked or performed services for her employer for 1736 hours: 2080 Total hours - 80 holiday hrs - 160 vacation hrs -104 sick leave = 1736 hours worked

“The employee spends 1145 hours of the 1736 hours in qualified services and the remaining 591 hours in nonqualifying activities.

“In accordance with Treas. Regs.§§1.41-(d)(1) and 1.41-(d)(2), the ratio of time spent on performing qualifying services is 1145/1736 or .6595. Hence 66 percent of the employee's time is spent on qualified services. To determine the amount of in-house research expenses with respect to this employee, multiply .6595 by $20,800, the total

43 See §1.41-2(e). 44 Apple Computer, Inc. and Consolidated Subsidiaries v. Commissioner, 98 T.C. 232 (1992); acq. 1992-2 C.B. 1 and Sun

Microsystems v. Commissioner, 69 T.C.M. (CCH) 1884 (1995). Note that in the Sun case, the Service conceded to the treatment of the wages resulting from the disqualifying disposition of the stock obtained from the employee stock purchase plan as QRE.

45 Apple Computer, supra. 46 I.R.C. § 41(b)(2)(B) and Treas. Reg. § 1.41-2(d)(2).

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wages paid to the employee. Thus, $13,718.89 of these wages are in-house research expenses.”

Supplies: Supplies include tangible property other than land, improvements to land, and depreciable property. Generally, supplies are considered items with a useful life of one year of less. Supplies do not include general and administrative expenses or indirect

research expenditures, such as utility charges.47 Supplies do not include depreciation or

lease or rental payments for personal property.48

In certain situations, extraordinary utilities may be treated as supplies. Per the IRS

Coordinated Issue Paper on Extraordinary Utilities:49 “Treas. Reg. § 1.41-2(b)(2)(ii) further provides for extraordinary expenditures a limited exception to the general rule. To qualify for this limited exception, a taxpayer must establish the following:

(1) that the qualified research is of a "special character," (2) that the special character of the qualified research "required" the utilities

expenses, and (3) that the required utilities expenses are both "additional" and "extraordinary."”

IRS Coordinated Issue Paper on §41 and Self-Constructed Supplies: The IRS has raised the question as to what a taxpayer who had self-created supplies could claim as part of in-house expenses. A Coordinated Issue Paper released in June 2004 provides the Service’s answer – at least for audit and litigation purposes. The paper uses an example where a taxpayer used a plant to produce chemicals for use in qualified research. The taxpayer treated its direct and indirect manufacturing costs as supplies for purposes of calculating its in-house research expenses. These costs included depreciation, G&A, employee benefits, T&E, overhead and other indirect expenses.

The IRS held that the costs of producing the chemical supplies for research were not in-house research expenditures. The paper points out that in-house research expenses include wages incurred to employees performing qualified research. Also, the types of expenditures are not ones that qualify under §41, even though they might qualify under §174. Also see FSA 200219001.

The IRS has also questioned whether certain prototypes are supplies. Generally, if they are subject to depreciation, they are not supplies. Also at issue is whether a third party creating the prototype is providing services or a finished product. If the third party is designing a product, such as a wafer, per the taxpayer’s design specs, it may not be QRE because it would not involve discovering information that is technological in nature. The IRS also takes the position that if the prototype is property of a type subject to depreciation in someone’s hands, it is not a supply.

In FSA 200013017, the Service ruled that a manufacturer of integrated circuits could not include manufacturing expenses as eligible for the research credit. The Service also ruled that research under §41 ends when the research no longer qualifies as ‘qualified research.’” The first set of silicon wafers produced for a new chip design is examined by engineers to determine if the process was successful. This examination may lead to design changes. T included the cost of wafers from the first production set to the time that production is at the proper volume and a stable yield is derived. T’s production and design inspection was handled by a third party. The Service ruled that the chips are property of a character subject to depreciation and therefore, are not a supply under §41.

47 Treas. Reg. § 1.41-2(b)(1). Under Reg. § 1.41-2(b)(2), extraordinary expenditures for utilities might be considered as supplies

used in the conduct of qualified research. 48 Staff of the Joint Committee on Taxation, 99th Cong., 2d Sess., General Explanation of the Tax Reform Act of 1986 131

(Comm. Print 1987) [hereinafter TRA 1986 Bluebook]. 49 Coordinated Issue Paper of 5/9/06; http://www.irs.gov/businesses/article/0,,id=182084,00.html.

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Excerpt from the IRS Audit Technique Guide for the Aerospace Industry (1/05), http://www.irs.gov/businesses/corporations/article/0,,id=137957,00.html#14:

“5. Multiple Prototypes In the Aerospace Industry it is not unusual for the taxpayer to claim multiple prototypes as qualifying items for purposes of both sections 41 and 174. A prototype is an original model constructed to include all the technical characteristics and performances of a potential new product. For example, if a state of the art military jet aircraft is being designed for a customer, several prototypes may be needed to perform specific tests, each prototype being used to perform its own unique tests. The design and testing of the prototypes may be considered qualified research, while the construction of the prototypes may be considered the acquisition of depreciable property. A question also arises whether the mere duplication of the original prototype is considered qualified research pursuant to IRC § 41(d). In many cases one or more of the prototypes are pre-sold while the item undergoes further testing. Thus, the obvious question the examiner is confronted with is whether one or more of the so called prototypes actually qualifies as either an expense item pursuant to IRC § 174 or as QRE for the credit under section 41. In general, items pre-sold represent property of a character which is subject to depreciation. The nature of the property and not the particular usage by the taxpayer is determinative under IRC § 174. Accordingly, property of a character which is subject to the allowance for depreciation is not eligible for a current deduction. IRC § 174(c); Treas. Reg. § 1.174-2(b)(1). Cost which cannot be deducted pursuant to IRC § 174 are not QRE. IRC § 41(d)(1)(A).

6. Mock-ups and Models The terms prototype, mock-ups and models are often used interchangeably to mean any full scale pre-production representation of a design, whether operational or not. The terms mock-up or models are sometimes used to describe a non-operational representation and the term prototype to describe an operational item. The same depreciable property limitations for allowance of the research credit that apply to prototypes also apply to mock-ups and models.”

Contract research expenses: Contract research expenses represent 65% of amounts paid or incurred for any non-employee for qualified research. If a taxpayer prepays contract research expenses, the amount is treated as paid or incurred during the tax year in which the qualified research is conducted. The researcher cannot claim a credit for its

expenditures in performing the contract.50

TAM 200811020 – A US and foreign corporation formed a C corporation in the US with each owning 50% of the stock. The purpose of the joint venture was to develop and bring to market inventions. Each shareholder contributed capital, in-process R&D and other intangibles. JV began research in its first year. JV has ownership of all the production and marketing rights to inventions developed. Before it knows if its R&D will be successful, JV grants exclusive licenses to its shareholders to use the inventions for manufacturing and sales of products in their countries. The shareholders pay royalties to JV for their exclusive manufacturing and distribution rights. JV also generates royalties from licenses granted to third parties in geographic areas not covered by other licenses. JV maintains right to further develop inventions that have been licensed.

Within a few years, JV generated royalty income greater than its expenditures and started funding its own R&D. JV does not pay dividends.

The IRS held that JV’s contract research expenses incurred in carrying on a trade or business that involves licensing of research results are qualified research expenditures per §41(b)(1) and §1.41-2(a)(1). The National Office also noted that §41(b)(1) does not impose any limit as to the types of businesses a taxpayer can be carrying on to claim the

50 General Explanation of the Economic Recovery Tax Act of 1981 (Blue Book), prepared by the staff of the Joint Committee on

Taxation, pg. 128.

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credit. Thus, a business of licensing research results can benefit from §41. The National Office also noted that JV uses its research results for future R&D activities

The National Office also referred to legislative intent as carried out in the regulations:

“Consistent with the legislative history underlying §41, 1.41-2(a)(1) provides that a contract research expense is not a QRE if the ' product or result of the research is intended to be transferred to another in return for license or royalty payments and the taxpayer does not use the product of the research in the taxpayer's trade or business. This provision was intended to prevent the abusive use of QREs by individuals or tax shelter partnerships. However, this language was not directed toward situations in which there is no tax avoidance motive, and in which the research results are used by the taxpayer in carrying on the taxpayer's trade or business.” (emphasis added)

“Neither the statute, nor the legislative history or regulations underlying §41(b)(1) define the term “use” for purposes of §41(b)(1) and 1.41-2(a)(1). We, ' however, believe that a reasonable interpretation of this term involves the type of uses that Taxpayer undertakes by continuing to use and develop Inventions even after it has licensed them.”

Lockheed Martin Corp. v. U.S., 87 AFTR2d 2001-1799 (Fed. Cls. 2001)—LM sought a refund of over $64 million for 1984 – 1988. LM sought summary judgment on the position that about $200 million of payments to subcontractors constituted a supply expense (in-house research expenditure) rather than a contract research expense. The court denied summary judgment due to an incomplete factual record. The court was unable to determine if expenditures were for supplies (noting that LM’s argument that the expenditures were not contract research expenses did not make them supply expenditures) and whether they were for non-depreciable, tangible property. Helpful observations by the court: ▪ To claim QRE for supplies, the taxpayer must show that it acquired non-depreciable,

tangible property.

▪ The payments were not contract research payments because payment was contingent upon the success of the research.

▪ “[T]he central question in determining whether a taxpayer may claim Supply QRE is not simply whether the supplies are tangible, but also, more generally, whether the taxpayer has used supplies ‘in the conduct of qualified research.’”

b) Qualified Research per §41(d) means research—(also see final regulations summarized later in this outline)-

• that falls under §174;

• which is undertaken to discover information (i) which is technological in nature, and (ii) the application of which is intended to be useful in the development of a new or improved business component of the taxpayer; and

• substantially all of the activities of which constitute elements of a process of experimentation for a purpose that relates to a new or improved function, performance, or reliability or quality. [Note: certain purposes do not qualify—those that relate to style, taste, cosmetic, or seasonal design factors.]

• The tests to determine if research is "qualified research" are to be applied separately for each of the taxpayer's business components. A business component is any product, process, software, technique, formula or invention that will be, i) held for sale, lease, or license, or ii) used by the taxpayer in its trade or business. Any plant process, machinery, or technique for commercial production of a business component is to be treated as a separate business component, rather than as part of the business component being produced. "Thus, research relating to the development of a new or improved production process is not eligible for the credit unless the definition of qualified research is met

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separately with respect to such production process research, without taking into account

research relating to the development of the product."51

The test of whether research is "qualified research" is to be applied separately to each business component is sometimes referred to as the "shrinking back" concept. As

described in the legislative history to the Tax Reform Act of 1986:52

[T]he requirements are applied first at the level of the entire product, etc. to be offered for sale, etc. by the taxpayer. 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, etc. This "shrinking back" of the product is to continue 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. Treasury regulations may prescribe rules for applying these rules where a research activity relates to more than on business component.

As further clarified by the Service:53

We believe the shrinking back concept is applied only to determine if research related to a business component or to a subset of elements of a business component satisfies the requirements for qualified research under §41(d)(1) of the Code. If any duplication exists, however, no shrinking back is permitted to qualify various components or subsets of elements for the research credit. Application of the shrinking back concept was not intended to circumvent the exclusions in §41(d)(4). Therefore, the shrinking back concept is not applicable in the case of a generic drug product or for any other business component excluded from the definition of "qualified research" because of the duplication that exists in the development of the generic drug.

• Technological in nature: Per the legislative history to the TRA'8654 -

The determination of whether the 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 science3 - in which case the information is deemed technological in nature - or on other principles, such as those of economics - in which case the information is not to be treated as technological in nature. For example, information relating to financial services or similar products (such as new types of variable annuities or legal forms) or advertising does not qualify as technological in nature.

3 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.

• Process of experimentation: Per the legislative history to the TRA'8655 -

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. This 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.

Purpose:

51 TRA'86 Conference Report, 1986-3 C.B. Vol. 4 pg. 73. 52 TRA'86 Conference Report, 1986-3 C.B. Vol. 4 pg. 72-73. 53 TAM 93-46-006 (Aug. 13, 1993). 54 Conference Report No. 99-841, 1986-3 C.B. Vol 4, 71. 55 Conference Report No. 99-841, 1986-3 C.B. Vol 4, 72.

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• Per §41(d)(1) & (3) – “(A) In general. Research shall be treated as conducted for a purpose described in [paragraph (1)(C) on process of experimentation”] if it relates to—

(i) a new or improved function,

(ii) performance, or

(iii) reliability or quality.

(B) Certain purposes not qualified. Research shall in no event be treated as conducted for a purpose described in this paragraph if it relates to style, taste, cosmetic, or seasonal design factors.”

• “Although Taxpayer is in the business of developing and manufacturing food products, all of Taxpayer's research activities are not excluded from the definition of the term “qualified research” because section 41(d)(3)(B) of the Internal Revenue Code excludes research that relates to taste. We believe that the word “taste” as used in section 41(d)(3)(B) means individual or consumer preference. Therefore, Taxpayer's activities related to the development and improvement of the functional aspects of a target product may constitute qualified research. In addition, research in developing or improving manufacturing techniques and equipment may constitute qualified research.” TAM 9522001

• Certain activities are specifically excluded from qualifying for the credit (§41(d)(4) & §1.41-4(c)):

• Research after commercial production;

• Adaptation of existing business components;

• Duplication of existing business component from examination of the business component

or from plans or publicly available information;56

• Survey, studies, and data collections;

• Software developed primarily for internal use by the taxpayer other than for use in an activity constituting qualified research or a production process, or as specified in

regulations;57

• Research conducted outside the United States, Puerto Rico or a U.S. possession;

• Research in the social sciences, arts, or humanities;58 or

• Research to the extent it is funded by any grant, contract or by some other person,

including a governmental entity.59

c) Base Amount—see examples below.

56 In TAM 9346006 (8/13/93), the IRS held that research with respect to the development of generic drugs was not qualified

research because of the exclusion for duplication procedures. Also see FSA 1999-1023. 57 See United Stationers, Inc. v. U.S., 99-1 USTC ¶50,136, 82 AFTR2d 98-7488 (7th Cir.), cert. denied S.Ct. Dkt. No. 98-1870

(6/21/99); Norwest Corp., et al. v. Comm'r., 110 T.C. 454 (1998); §1.41-4(c)(6); and Notice 87-12, 1987-1 C.B. 432. 58 See TSR, Inc. and Subs. v. Commissioner, 96 T.C. 903 (1991). 59 Guidance on the meaning of "funded research" can be found at TAM 9410007 (Nov. 30, 1993), Fairchild Industries v.

Comm'r., 95-2 USTC ¶50,633, 76 AFTR2d ¶95-5683 (Fed. Cir. 1995), rev'g 94-1 USTC ¶50,164 (Ct. Cls.) and Lockheed

Martin Corp., et al v. U.S., 82 AFTR2d 98-7141, 98-2 USTC ¶50,887 (Fed Cls). Fairchild case: "inquiry turns on who bears the research costs upon failure, not on whether the researcher is likely to succeed in performing the project." See PLR 8945029 and PLR 8914026 on treatment of research among members of a controlled group not being treated as funded research. Per PLR 8914026: “r and b are connected through 100 percent stock ownership, with r being the common parent. Therefore, r and b are members of the same controlled group of corporations within the meaning of section 41(f)(5), and under section 41(f), for purposes of determining the research credit for the group, all the corporations in that group are to be treated as a single taxpayer. Because r and b are to be treated as a single taxpayer, the fact that r will reimburse b for the research performed does not make the research funded research as described in section 41(d)(4)(H).”

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• Special rules for start-up companies: QRE must be paid or incurred in carrying on a trade or business. A special rule at §41(b)(4) allows certain startup ventures to disregard this "carrying on" requirement for in-house research expenses (wages and supplies). Thus, a start-up may not include contract research expenses in calculating the research credit. Special rules also apply to start-up companies in computing their base amount. [§41(c)(3)(B)]

• Rules of controlled groups of corporations: IRC §41(f)(1) provides for aggregation of expenditures for a controlled group of corporations. Specifically:

(A) In determining the amount of the credit under this section —

(i) all members of the same controlled group of corporations shall be treated as a single taxpayer, and

(ii) the credit (if any) allowable by this section to each such member shall be its proportionate shares of the qualified research expenses and basic research payments giving rise to the credit.

See the regulations under 1.41-6 for the details of how to calculate the group credit and get it allocated to the members. The calculation also requires each member to compute their stand-alone credit based on which of the three formulas would give them the highest credit amount (thus, it is a lot of work).

• Prevention of double benefit: To help pay for renewal of the credit and to prevent a double benefit for R&E expenditures (deduction and credit), §280C(c) requires taxpayers to reduce their §174 amount by the amount of the research credit, or to instead elect to take a reduced credit.

Example: Corporation with has a marginal tax rate of 34%, QRE of $16,000 and a credit of $1,600. It must reduce its R&E deduction by $1,600. If instead, the corporation elects to take a reduced credit:

1st - compute §41 credit [$1,600]

2nd - multiply credit by 35% [$560]

3rd - reduce credit by amount from step 2 [$1,040]

4. Credit Calculation Examples

a. Standard Credit Calculation: Disk Drive, Inc. (DD) - a publicly-traded corporation that designs and manufactures disk drives for personal computers.

Research credit data:

Year Gross Receipts (GR) Qualified Research Exp. (QRE)

1984 $28,000,000 $3,000,000

1985 $32,000,000 $4,200,000

1986 $31,000,000 $5,000,000

1987 $34,000,000 $6,200,000

1988 $43,000,000 $6,800,000

[1989 – 1995 – information omitted]

1996 $48,000,000 $8,400,000

1997 $60,000,000 $10,200,000

1998 $68,000,000 $11,000,000

1999 $76,000,000 $12,000,000

2000 $80,000,000 $10,000,000

Research Credit Calculation for DD: Step 1 - determine the fixed base percentage:

Fixed base percentage = total qualified research expenses 1984 - 1988

total gross receipts 1984 - 1988

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= $3,000,000 + 4,200,000 + 5,000,000 + $6,200,000 + 6,800,000

$28,000,000 + 32,000,000 + 31,000,000 + 34,000,000 + 43,000,000

= $25,200,000

$168,000,000 = 15.00%

Because 15.00% is below the maximum fixed base percentage of 16%, 15.00% is used. Step 2 - determine base amount:

Base amount = fixed base % X average annual gross receipts of DD for the four preceding tax years

Average annual gross receipts from 1996 to 1999 =

[$48,000,000 + 60,000,000 + 68,000,000 + 76,000,000] ÷ 4 = $63,000,000

Base amount = 15.00% x $63,000,000 = $9,450,000

Minimum allowable base amount is 50% of the current year QRE:

50% x $10,000,000 = $5,000,000

Because $9,450,000 is greater than the minimum base amount, $9,450,000 must be used.

Step 3 - determine credit:

20% x [qualified research expense - base amount] + 20% of basic research payments

20% x [$10,000,000 - $9,450,000] + 20% x $0 = $110,000

Thus, the $10,000,000 of 2000 QRE generated a $110,000 credit (1.10% of QRE).

Per IRC §280C(c), DD must reduce its R & E expense deduction on its 2000 return by $110,000 (the amount of the credit), or, it may chose instead to take a reduced credit and not change its R & E deduction. Note that DD would have had a higher credit if its 2000 research expenses were greater, its base years' research expenses were less, its base years' gross receipts were more, and/or its gross receipts in the prior four years was less.

b. Start-up company: ABC Corporation was formed in 1999 and had the following revenue and expenses:

1999 2000

Sales revenue $20,000 $45,000

Interest income $1,000 $1,000

Section 174 expenses

$35,000 $55,000

QRE $22,000 $39,000

2000 research credit calculation:

Step 1: Fixed base percentage = 3% Step 2: Base amount = 3% x ($20,000 + $45,000) 2 = $975 Minimum base amount = 50% of 2000 QRE = $19,500 Step 3: Credit =

20% x [$39,000 - $19,500] = $3,900

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or, ABC may elect to take a reduced research credit:

$3,900 x 35% = $1,365

Credit = $3,900 - $1,365 = $2,535

Thus, ABC obtained a credit equal to 6.5% of its QRE ($2,535 ÷ $39,000). This is the maximum credit amount available.

If ABC does not elect to take a reduced research credit, it must reduce its §174 amount by $3,900.

c. Alternative Incremental Credit: Example: Research credit data for T Corporation:

Year Gross Receipts (GR) Qualified Research Exp. (QRE)

1984 $ 28,000,000 $ 4,400,000

1985 $ 30,000,000 $ 6,300,000

1986 $ 31,000,000 $ 6,400,000

1987 $ 31,000,000 $ 7,200,000

1988 $ 32,000,000 $ 7,600,000

1989 $ 42,000,000 $ 8,800,000

1990 $ 56,000,000 $ 8,900,000

1991 $ 68,000,000 $ 9,000,000

1992 $ 81,000,000 $10,000,000

1993 $ 99,000,000 $11,000,000

1994 $117,000,000 $12,000,000

1995 $122,000,000 $13,000,000

1996 $134,000,000 $14,000,000

1997 $156,000,000 $16,000,000

1) Determine fixed base percentage:

= total QRE 1984 - 1988 = $31,900,000

total gross receipts 1984 – 1988 $152,000,000 = 20.99%

Because 20.99% is above the maximum fixed base percentage of 16%, 16.00% is used.

2) Determine the base amount:

= fixed base percentage x average annual GR for the 4 preceding tax years

= 16.00% x $118,000,000 = $18,880,000

Minimum allowable base amount is 50% of the current year QRE:

$16,000,000 x 50% = $8,000,000

Because $18,880,000 > the minimum base amount, $18,880,000 must be used.

3) Determine the credit amount:

20% x [$16,000,000 - $18,880,000] + 20% x $0 = $0

Thus, the $16,000,000 of QRE generates no research tax credit for 1997.

Alternative incremental credit calculation: Preliminary amounts needed:

1% x $118,000,000 = $1,180,000

1.5% x $118,000,000 = $1,770,000

2% x $118,000,000 = $2,360,000 Calculation - credit equals the sum of the following amounts:*

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(a) QRE in excess of $1,180,000, but not in excess of

$1,770,000

$ 590,000

x 1.65%

$ 9,735

(b) QRE in excess of $1,770,000, but not in excess of

$2,360,000

$ 590,000

x 2.2%

$ 12,980

(c) QRE in excess of $ 2,360,000

$16,000,000

$13,640,000

x 2.75%

$ 375,000

Total = $397,815

* The Tax Relief Extension Act of 1999 (P.L. 106-170) increased each of the three percentages used to compute the AIRC by one percentage point (to 2.65, 3.2, and 3.75) effective for tax years beginning after June 30, 1999. The Tax Relief and Health Care Act of 2006 (P.L. 109-432; 12/20/06) further increased the percentages used at §41(c)(4) to 3%, 4% and 5% (from 2.65%, 3.2% and 3.75%). This change was generally effective for tax years ending after 12/31/06. Transition rules were provided at Act §104(b)(3) and were relevant to taxpayers on a fiscal year.

5. Special Rules For Start-up Companies

Start-up companies receive certain benefits under §41. As noted above for the definition of QRE, such expenses must be incurred in carrying on a trade or business. However, an exception exists at §41(b)(4) such that the trade or business requirement is relaxed if at the time the in-house research expenses are paid or incurred, the taxpayer's principal purpose in incurring the expenses is to use the research results in the active conduct of a future trade or business. However, this exception only applies to in-house research expenses, not to contract research expenses. Thus, if a start-up company hires a contractor to perform research prior to the point at which the company is carrying on a trade or business, the expenses will not constitute QRE.

Generally, the calculation of the fixed base percentage involves amounts from tax years beginning after December 31, 1983 and before January 1, 1989. A company that comes into existence during or after that time period will not have the appropriate data. To address this situation, a special rule for start-up companies is provided at §41(c)(3)(B). Under this rule, a taxpayer's fixed base percentage for its first five tax years is 3% (for its sixth and

subsequent tax years, special determinations are provided for).60 This 3% rule applies to taxpayers if

i) the first tax year in which it has both gross receipts and qualified research expenses begins after December 31, 1983, or

ii) there are fewer than 3 tax years beginning after December 31, 1983 and before January 1, 1989, in which the taxpayer had both gross receipts and qualified research expenses.

60 See §41(c)(3)(B)(ii).

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6. Gross Receipts

Reg. §1.41-3(c) defines gross receipts as receipts from all activities and sources before reduction for cost of sales. The following items are specifically excluded from gross receipts:

“i) Returns or allowances;

(ii) Receipts from the sale or exchange of capital assets, as defined in section 1221;

(iii) Repayments of loans or similar instruments (e.g., a repayment of the principal amount of a loan held by a commercial lender);

(iv) Receipts from a sale or exchange not in the ordinary course of business, such as the sale of an entire trade or business or the sale of property used in a trade or business as defined under section 1221(2);

(v) Amounts received with respect to sales tax or other similar state and local taxes if, under the applicable state or local law, the tax is legally imposed on the purchaser of the good or service, and the taxpayer merely collects and remits the tax to the taxing authority; and

(vi) Amounts 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 purposes of this paragraph (c)(2)(vi), investment income is interest or distributions with respect to stock (other than the stock of a 20-percent owned corporation as defined in section 243(c)(2).”

Thus, investment income is included in gross receipts.

It is unclear how revenues from foreign entities factor into gross receipts as illustrated by the following rulings and regulations. In CCA 200620023, the IRS concluded that a corporation must include revenues from foreign subsidiaries in gross receipts for research credit purposes. This Chief Counsel Advice notes that there are several field examinations with similar fact patterns involving calculation of the research credit. A domestic corporation (T) owns more than 50% of certain foreign subsidiaries per §1563(a)(1). T receives royalty income from the subs for licensing of intangibles. T’s originally filed return included T’s receipts from the foreign subs in gross receipts for §41(c) purposes. T then filed amended returns removing the foreign receipts and consequently increasing its research credit.

The IRS ruling relies on the “aggregation rule” of §41(f) and the incremental nature of the credit (to reward increases in research) to reach its conclusion. IRC §41(f) provides that members of a controlled group are treated as a single taxpayer in calculating the credit. The credit is then allocated to the members per each member’s proportionate share of the increase in qualified research expenditures that gave rise to the credit. The IRS notes that per the 1981 legislative history, this aggregation rule was provided to be sure that the credit was only allowed for actual increases in research expenditures and to “prevent artificial increases in research expenditures by shifting expenditures among commonly controlled or otherwise related persons. H.R. Rep. No. 97-201, 1981-3 C.B. (Vol. 2) 364; S. Rep. No. 97-144, 1981-3 C.B. (Vol. 2) 442.”

The IRS notes: “Temp. Treas. Reg. §1.41-6T and former Treas. Reg. §1.41-6(e) continue to require that a controlled group of corporations or trades or businesses under common control only disregard generally intra-group transfers with respect to research expenditures, not gross receipts.” The CCA notes that “treatment of gross receipts attributable to intra-group transactions is on the 2005-06 Priority Guidance Plan.” This item is also on the 2008-2009 Priority Guidance Plan (http://taxprof.typepad.com/taxprof_blog/files/guidance_plan_2008_2009.pdf).

Also see CCA 200233011 where an opposite result was reached, although the IRS notes it is based on the particular facts of the situation. Per this CCA: “Given the particular facts and circumstances of this case, Taxpayer should exclude the sales to its majority-owned foreign subsidiaries when computing gross receipts for purposes of determining its base amount under section 41(c). For the years at issue, Taxpayer should consistently exclude such sales from gross receipts for purposes of both the fixed-base percentage and the average annual gross receipts for the four taxable years preceding the credit year.”

7. §41 versus §174

Section 174 covers a broader range of research expenses than does §41. For example, utilities and overhead related to research in the experimental or laboratory sense, are §174 expenditures, but are not QRE. While

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some types of activities and expenses are specifically excluded from the definition of QRE under §41, such as foreign research and research related to taste or style, Congress has cautioned taxpayers not to assume that such

exclusions constitute §174 items by default.61

8. §280C(c)

Section 280C(c) denies a taxpayer a deduction for the portion of its QRE or basic research expenses equal to the amount of its research credit, unless it instead elects to take a reduced credit determined for the tax year. If the taxpayer has elected under §174(b) to capitalize R&E expenditures, the capitalized amount is reduced by the

amount of the research credit. The election to claim a reduced credit must be made on a timely filed return including extension and is irrevocable.

The calculation of the reduced credit (when elected in lieu of reducing §174 expenditures by the amount of the credit) involves the following three steps:

1st - compute the §41 credit

2nd - multiply the credit by 35 percent (maximum corporate tax rate)

3rd - reduce the §41 credit by the amount from step 262

Example: Assume X Corporation is in the 34% corporate tax bracket and calculated a research credit of $1,600 for 1994 based on QRE of $16,000. X may either reduce its §174 deduction for 1994 by $1,600, or elect to take a reduced research credit of $1,040 calculated as follows:

$1,600 credit x 35% = $560

Actual credit = $1,600 - $560 = $1,040

A company might elect to take a reduced research credit rather than reduce its §174 amount by the amount of the credit if it is in an AMT position in that it owes AMT in addition to regular tax (the research credit is not usable against AMT). The election for a reduced research credit may also be desired if the company has other types of credits it is using and does not need a large research credit. Some states that start with federal taxable income in computing state taxable income may not allow for the §280C(c) amount to be subtracted in deriving state taxable income. In such cases, the reduced credit would be preferable to a reduced R&D deduction.

A company might reduce its §174 amount by the amount of the credit rather than elect to take a reduced research credit if it is in a net operating loss (NOL) position and does not want to make it larger, thus it prefers a

smaller §174 amount.63 A full credit may also be the desired choice if a company is in a net operating loss (NOL) position for state tax purposes and the state does not allow the entire NOL to be carried back or carried forward. In addition, a taxpayer subject to the R&E allocation rules of §864(f) and Treas. Reg. Sec. 1.861-8(e) may desire a reduced R&E deduction amount so that a smaller R&E expenditure amount exists to be allocated to foreign source

income (thus, possibly increasing the amount of usable foreign tax credit).64 Finally, a taxpayer in a tax bracket less than 35 percent may wish not to take a reduced credit because the credit must be reduced using a 35 percent tax rate.

AM 2008-002 (http://www.irs.gov/pub/irs-utl/am2008002.pdf) – For corporations in AMT or that file in states that do not allow for the §280C(c) amount to be subtracted in computing state taxable income, they will generally prefer a reduced credit. A reduced credit must be elected on a timely filed return including extension. The IRS has found that some taxpayers are electing a reduced credit even though they have not claimed a research tax credit or claimed a nominal credit. For example, a taxpayer might include a Form 6765 on its return that is blank other inserting “section 280C” next to the line that would otherwise show the amount of the reduced credit. Or, a

61 "No inference is intended from the rules ... defining research for purposes of the incremental credit as to the scope of the term

"research or experimental" for purposes of the section 174 expensing deduction." TRA 1986 Bluebook at 137. 62 These three steps are the equivalent of the 0.13 multiplier on line 26 of Form 6765, Credit for Increasing Research Activities. 63 This company should consider switching from the §174(a) method to the §174(b) method or utilizing §59(e) to spread out the

deductions for current R&E expenditures (discussed later). 64 The R&E expenditure allocation rules exist to determine U.S. and foreign source taxable income. These rules have been

modified several times in the past few years and their discussion is beyond the scope of this outline. See Raby, Allocating

R&D When Determining Foreign Tax Credit, Tax Notes Today, 94 TNT 201-47 (Oct. 13, 1994) and final regulations under § 1.861-8(e) (T.D. 8646, Dec. 1995).

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taxpayer has made the notation and claimed a $1 credit.65 It has also found that some taxpayers attempt to make the reduced credit election by indicating on a statement attached to their timely filed return that they are reserving or deferring the decision to elect the reduced credit. The likely rationale for such treatment is that the taxpayer has not been able to accurately compute its research credit by the due date of the return or is keeping its options open should analysis likely already underway to see if it qualifies for the research credit is completed.

In AM 2008-002, the IRS National Office is advising field agents that if the taxpayer clearly indicates on the timely filed return its intent to make an election to claim a reduced credit, it should be treated as having made a valid election. However, a taxpayer is not treated as having made a timely election for a reduced research credit if has only noted on the return that it reserves or defers the making of the election.

The position in AM 2008-002 regarding making the election on a blank or nominal credit Form 6765 is contrary to the IRS’ audit guide issued in 2005 which stated that such treatments did not constitute a valid election for a reduced credit meaning that the taxpayer would not be able to claim a reduced credit on an amended return that claimed a research credit. [http://www.irs.gov/businesses/article/0,,id=156864,00.html]

9. AMT and IRC §280C(c)

Does §280C(c) also apply in computing AMTI?

In TAM 9722005 the IRS analyzed the legislative history behind AMT and the likely meaning of the commonly stated theory that the AMT system is separate from, but parallel to the regular tax system. At issue was whether taxpayer should be allowed a full wage deduction for AMT, or only the reduced one claimed for regular tax purposes that had been reduced for the targeted jobs credit under §280C(a) (the TAM also discusses the similar R&E expense reduction under §280C(c)). Taxpayer argued that separate but parallel means that to compute AMTI, one should assume that the regular tax did not exist. Since the jobs credit cannot be applied against AMT, it would not exist, and there would be no wage expense reduction.

IRS disagreed and ruled that taxpayer's interpretation had no support in the legislative history behind AMT or the theory of AMT. The IRS stated that the "separate from but parallel to" phrase only appears in the TRA'86 legislative history in reference to the NOL and FTC AMT carryover amounts. The IRS also noted that if Congress had intended that §280C(a) not apply for AMT purposes, they should have created a specific adjustment for this item, as they specifically had done for other types of differences. Thus, there is a presumption that Congress intended for the same treatment to apply for regular and AMT tax purposes. In addition, the IRS pointed to the fact that Congress specifically allows an AMT adjustment for the alcohol fuel credit at §56(a)(8). Also supporting its position, IRS referred to Hightower, T.C. Memo 1982-559 which held that in computing SE tax, the taxpayer had to reduce its wage deduction by the jobs credit (even though the credit was not applicable against SE tax).

Thus, based on the legislative histories, the principle that deductions are a matter of legislative grace, and the fact that the taxpayer could elect not to take the credit, the IRS ruled that §280C(a) must also be applied in computing AMTI. The IRS stated that any other interpretation would be a policy decision for Congress to make.

10. Limitation and Carryover Provisions

The research credit is one of several credits included in the general business credit. Special rules exist at §§38 and 39 on how much general business credit a taxpayer may use to reduce its tax liability, and what happens to any unusable credit. Generally, a taxpayer may not use general business credits to reduce its regular tax liability to below its tentative minimum tax (as computed for AMT purposes). Excess general business credits may be carried back three years and then forward 15 years until used. The mechanics of the yearly credit limitations and carryforward calculations can be somewhat complex and require good recordkeeping so that a credit carryover is not forgotten. If a taxpayer is unable to utilize the credit during the carryforward period it may deduct the unused

amount per §196.66

65 AM 2008-002 must be referring to pre-2006 Forms 6765 because since 2006, the form includes a yes/no question

with boxes to check to indicate if the taxpayer is electing to take a reduced credit. 66 See I.R.C. § 196(c)(4) for a caution in how I.R.C. § 196 interacts with I.R.C. § 280C(c)(3).

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11. Research Credit Issues

a. The credit has expired 13 times since it was first enacted in 1981 – should it be made permanent?

There have been numerous proposals to make the credit permanent and to make improvements to it. President Bush’s FY2009 Budget Proposal – called for making the research credit

permanent. Reasons cited to support this proposal included:67

o Economists tend to agree that government intervention can improve overall economic efficiency when it comes to research.

o The current level of research spending in the US and worldwide is “too little to maximize society’s well-being.”

o U.S. R&D expenditures represent 2.6% of GDP for 2005 and 2006. While that is greater than in the EU and the average of all countries in the OECD, it is less than that of Japan.

o While an incremental credit can be complex relative to a flat credit, it is less likely to reward research that would have been undertaken even without a credit.

o There is evidence that the credit has led to increased research activity in the U.S.

b. Should the base period (1984 – 1988 ) be updated? Should the 50% minimum base rule be repealed? Should the regular credit be repealed?

• Basically, a credit is generated if current QRE exceeds research intensity (QRE/GR) for base period (capped at 16%) applied to average gross receipts for the prior 4 years.

• However, the base amount cannot be less than 50% of current year QRE. This serves as a cap on the credit (basically limits it to 10% of QRE – which is then further reduced to 6.5% by §280C(c)). This 50% base rule serves to limit the credit for companies with a large increase in QRE over the base amount.

Example: Base amount = $10

Current QRE = $20

Credit = 20% x $10 = $2

Modification: Base amount = $10

Current QRE = $30

Credit = 20% x $15 = $3 (so additional $10 of current QRE only generated $1 of credit --- 10%, not 20%)

• A 1995 GAO study found that almost 60% of corporations were subject to the 50% minimum base rule. Query: Is the incremental nature of the credit being carried out if almost 60% of firms, in effect, calculate the research tax credit at 10% of current year QRE?

• Additional issues with the current base: (1) provides little incentive for companies, such as defense firms, with QRE in the base period that is unrealistically high for them today; (2) doesn’t reward companies that have become more efficient in their R&D activities; and (3) incentive is diminished if company has changed its business focus such that it doesn’t make sense to devote the same percentage of GR to R&D as in the base period (such as a company that has added new lines of business in the finance area).

c. Is a maximum of 6.5% credit on a subset of §174 expenditures the appropriate incentive? Because a company may not receive all of the return from its research investment, but will

67 Joint Committee on Taxation, Description of Revenue Provisions Contained in the President’s Fiscal Year 2009

Budget Proposal, page 245 – 263; available at http://www.house.gov/jct/s-1-08.pdf.

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instead share some of it with society, there is justification for public support of such research. Query: How much? Also, since many countries are seeking U.S. R&D activities and offer a variety of incentives, what is the appropriate incentive to keep the R&D in the U.S.?

d. The credit cannot be used to reduce AMT and is not a refundable credit.

e. Claims: The significant number of amended returns and claims for refund that have been filed in the past several years. The IRS treats these claims as “Tier I” issues that must be examined and coordinated through one IRS office. In May 2008, the IRS issued a special audit techniques guide on research claims. Concerns of the IRS include the size of the claims, the lack of contemporaneous records, and the use of estimates. http://www.irs.gov/businesses/article/0,,id=183208,00.html

A 2008 district court case illustrates concerns the IRS has with some credit claims. U.S. v.

McFerrin, 102 AFTR 2d 2008-6269 (DC TX) – The IRS brought suit against a married couple, shareholders in four S corporations, for a refund claim for 1999 that IRS says was paid erroneously. The claim was for research credit of $472,092 plus interest of $129,136 related to an 1120S where no credit was originally claimed. The IRS notes that the refund was issued due to a clerical error. The S corps are involved in manufacturing chemicals. In 2003, one of the S corps contracted with a consultant for a research credit study for 199 through 2002. The court described the work as follows:

“The Government proved convincingly that alliantgroup's work and resulting report were fundamentally flawed and unreliable. The report is entitled to no weight. Performance of this engagement consisted largely of alliantgroup staff conducting superficial on-site meetings with personnel from KMCO, KMTEX, and SC Terminals and reviewing various records of the companies. There is no evidence that alliantgroup had engineers, chemists, or anyone with meaningful scientific experience or training on staff, or that skilled or knowledgeable individuals conducted the study, did any investigation, or rendered conclusions for the client, KMCO. In its interviews with employees of KMCO and its affiliates, alliantgroup did not give the employees a definition of “research” for purposes of the research tax credit. As a result, each employee was forced to answer the questions based on that employee's own personal interpretation of what qualified as “research.””

The research credit calculation included a bonus paid to McFerrin of $6.4 million. M conceded at trial that this bonus was based on profits rather than research. In addition, per the court supplies was apparently determined “simply by subtracting the entities' costs of labor from the entity's costs of good sold, then multiplying the result by an arbitrary fixed percentage.”

The court found that the records were not sufficient to indicate that research and that amounts claimed were valid. It did acknowledge that some qualified research may have occurred, but the records could not prove it.

Penalty for Erroneous Refund Claims - §6676, added by the U.S. Troop Readiness, Veterans’ Care, Katrina Recovery, and Iraq Accountability Appropriations Act, 2007 (P.L. 110-28; 5/25/07), created a new penalty for erroneous refund claims effective for claims filed or submitted after 5/25/07. Under this rule, a person filing an erroneous refund claim without any reasonable basis is subject to a penalty equal to 20% of the “excessive amount.” 6676(b) defines “excessive amount” as “the amount by which the amount of the claim for refund or credit for any taxable year exceeds the amount of such claim allowable under this title for such taxable year.” This penalty does not apply to any EITC claim or to any part of the excessive amount which is subject to a penalty under §6662 – §6664 (substantial understatement of tax and fraud penalties).

Per the IRS audit guidelines for research credit claims, examiners are to determine if the 20% penalty of §6676 applies to the research credit claim under audit.

12. Has the Research Tax Credit Accomplished its Policy Goals?

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Both government and private studies have shown that the research tax credit has had an impact on the amount of research conducted. A 1989 General Accounting Office (GAO) report, "The Research Tax Credit Has Stimulated Some Additional Research Spending," stated that the research credit "raised corporate spending on

R&E above the level that otherwise would have been achieved."68 This study, based on a sample of 800 corporations and economic models, concluded that the credit "stimulated between $1 billion and $2.5 billion of additional spending for the 5 years 1981 through 1985." Such an increase represented an increase of 15 cents to 36

cents for every dollar of foregone tax revenue due to the credit.69

A 1994 private study concluded that the GAO study underestimated the benefits of the research tax credit. This study estimated that the credit stimulated additional spending of about $2 billion per year with

foregone tax revenues of about $1 billion per year.70

As noted in two government reports, studies of the research credit may not have captured its complete benefits because of the sometimes long lead times for research projects and changes made to the credit

since 1981, particularly in 1989.71 A 1993 report noted that the 1989 changes likely increased the credit's incentive

effect "substantially" and may have increased the credit's impact "beyond what is shown by the existing data."72

In April 2004, Washington Council Ernst & Young released a report it prepared for the R&D

Credit Coalition, a group of high tech companies.73 Some of findings:

� Between 14,000 and 16,000 companies of all sizes claim the credit, with manufacturing (68.6%), information (16.2%) and service (9.7%) sectors claiming most of the research credit dollars.

� Companies with $250 million or more of assets claimed about 80% of the research credit in 2000.

� Looking at the credit as a percentage of average firm assets, the “value” of the credit is greatest for small firms. For example, companies with $1000 - $99,000 in assets claimed a research credit equal to 9.4% of average assets. The equivalent measure for firms with $250 million or more of assets was 1%.

� California companies claimed the largest share of research activity with 6,634 firms in 2000, followed by New York with 2,331 firms and Texas with 2,062.

13. The California Research Tax Credit

� R&T §17052.12 and §23609.

� California Form 3523.

� Permanent provision in California law.

68 "The Research Tax Credit Has Stimulated Some Additional Research Spending," by GAO, GAO/GGD-89-114, Sept. 1989,

pg. 22. 69 1989 GAO report, supra, pg. 22. 70 "R&D Tax Policy During the 1980s: Success or Failure," by Bronwyn H. Hall, National Bureau of Economic Research,

Reprint No. 1872, April 1994, pg. 29. The author also noted that the investment incentives of the research tax credit should also consider the interaction of the foreign tax credit and the AMT. Pgs. 28 - 30.

71 Prior to the 1989 changes to the research tax credit, the amount of the credit was based on a rolling base period of research expenditures. There was some disincentive built into such a system because more dollars spent on research today would result in a smaller credit in future years. "The R&D Tax Credit: An Evaluation of Evidence On Its Effectiveness," A Staff Study prepared for the use of the Joint Economic Committee, 8/23/85, page 4., also noted that the temporary nature of the credit "has detracted from its effectiveness" (pg. 1).

72 "The R&D Tax Credit: An Evaluation of Evidence On Its Effectiveness," A Staff Study prepared for the use of the Joint Economic Committee, 8/23/85, page 1 and Congressional Research Service Issue Brief "The Research and Experimentation Tax Credit," by D. Brumbaugh, November 17, 1993.

73 Cathy Koch, Supporting Innovation and Economic Growth: The Broad Impact of the R&D Credit, available at http://www.nam.org/s_nam/bin.asp?CID=155&DID=230921&DOC=FILE.PDF.

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� Similar to the federal credit at IRC §41 except that a 15% rate is used instead of a 20% rate, IRC §41(a)(2) regarding payments to qualified organizations for basic research is a 24% rate for corporations (rather than the 20% rate allowed for the federal research credit).

� California conforms to the federal definition of QRE.

� Qualified research includes only research performed in California

� Gross receipts used for the credit calculation only includes receipts from sales that are delivered or shipped to a purchaser in California ("throwback" sales are not included). The definition of gross receipts is not as broad as for federal. Per R&T §23609(h)(3): “

“Section 41(c)(6) of the Internal Revenue Code, relating to gross receipts, is modified to take into account only those gross receipts from the sale of property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business that is delivered or shipped to a purchaser within this state, regardless of f.o.b. point or any other condition of the sale.”

Per FTB Publication 1082:74

“How are “gross receipts” defined for California purposes?

California gross receipts include receipts minus returns and allowances from the sale of real, tangible, or intangible property held for sale to customers in the ordinary course of the taxpayer’s trade or business delivered or shipped to a purchaser within California, regardless of free on board shipping point or other condition of sale. This includes sales to the U.S. government, which could be identified as delivered in California. Excluded receipts are items such as California “throwback” sales for apportionment purposes, as well as, receipts from services, rents, operating leases and interest. In addition, royalties and license payments are generally excluded from the definition of gross receipts for research credit purposes.

Qualified California gross receipts include any property sale defined above (delivered to a California customer) that has been excluded for apportionment purposes because of the application of Public Law 86-272 or any other provision.

This California definition of gross receipts applies to both the average annual gross receipts for the prior four years and the base years (1984-1988). For aggregation purposes, the “gross receipts” figures used in the base amount calculations (the “average annual gross receipts” and the “aggregate gross receipts” of the fixed-base percentage) should reflect those from the entire “controlled group” (even when only one corporation has research expenses). Using the “gross receipts” of the entire controlled group reflects an accurate comparison of the research expenditures to the business as a whole.”

Thus, despite the statutory reference to IRC §41(c)(6) which ties to Reg. §1.41-3(c), the FTB implies that gross receipts do not include investment income or royalty payments.

� In General Motors Corp. v. Franchise Tax Board, Cal. No. S127086 (CA Supreme Ct, 8/17/06), the court agreed with the FTB that a research credit may only be used by the entity that generated it rather than shared by other members of the unitary group based on their apportioned share of the research expenses. R&T §23609 does not address this issue, so the court referred to IRC §41(f)(1)(A) on the use of the credit by controlled groups of corporations. The court noted that reliance on this provision of the federal statute was appropriate given the silence of the CA statute including that it did not say that subsection (f) should not be followed.

LAO's Report - An Overview of California's Research and Development Credit

In November 2003, the CA Legislative Analyst’s Office issued a report for the Assembly Committee on Revenue & Taxation. The report notes that while there is evidence to support a subsidy at the federal level,

74 Franchise Tax Board, Research & Development Credit: Frequently Asked Questions, Pub. 1082;

http://www.ftb.ca.gov/forms/misc/1082.pdf.

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the LAO is not aware of any economic evidence to justify a state credit in addition to the federal credit. The cost of the state credit is likely to be high relative to any additional research activity generated. The LAO also points out that direct research spending by the state, such as grants to the UC, may be more effective in achieving the objective of more research activity.

Given all of that, the LAO recommends that the Legislature not expand the research credit any further “unless convincing evidence if sound indicating that this is warranted.” In addition, the LAO recommends that the Legislature consider reducing the credit or even phasing it out over time.

The report notes the following commonly cited arguments in favor of a California research credit:

- Social benefits exceed private benefits – research in the state provides spillover benefits to the state.

- Tax credits promote particular economic activity.

- The credit improves the business climate and reduces business costs. This better enables California to compete with other states for research activity.

Arguments against the credit:

- Direct subsidies may be better because credits may be rewarding activity that would have occurred even without the credit.

- Spillover effects do not all occur in California.

- California’s research credit is too high.

- On top of the federal credit, the state credit yield relatively small benefits.

The “cost” of the credit in 03/04 is projected to be 5.3% of corporate revenues, compared to about 4% prior to 00/01.

Today, 31 states (including California) offer a research tax credit. Except for Hawaii, the formulas are similar to CA. In Hawaii, all qualified research expenses generate a 20% credit (rather than only qualified research expenses that exceed a base amount).

D. AMT Considerations

A taxpayer's §174 treatment for R&E expenditures may also be used for AMT purposes. However, if an individual does not materially participate (as defined at §469(h)), R&E expenditures must be amortized ratably over ten years

for AMT purposes (unless the §174(b) method is used).75 Alternatively, an individual subject to the AMT adjustment, may make an election under §59(e) to also ratably amortize all or a portion of their R&E expenditures for regular tax purposes as well (thus avoiding an AMT adjustment). There is no AMT adjustment for corporations for R&E expenditures.

For a taxpayer subject to the AMT adjustment for R&E expenditures, it is important to properly distinguish between §162 and §174 expenditures because only the §174(a) expenditures would be subject to the AMT adjustment.

E. Depreciation

Depreciation deductions are not §195 expenditures.76 Depreciation may not be claimed until an asset is placed in

service.77 An asset is considered placed in service when it is in a "state of readiness and availability for a

75 I.R.C. § 56(b)(2). 76 TAM 92-34-004 (May 20, 1992). Start-up expenditures do not include items that would not be treated as I.R.C. § 162

deductions if incurred after the start-up phase (depreciation deductions are allowed under I.R.C. § 167). Also, property is not depreciable until the asset is placed in service which would be after the trade or business has begun.

77 Treas. Reg. § 1.167(a)-10(b). Also see McManus v. Commissioner, 54 T.C.M. (CCH) 475 (1987).

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specifically assigned function" in a trade or business.78 Depreciation may not be claimed on assets acquired for a

business which has not yet begun.79

F. Example of Issues

During the current year, Bill started work in his spare time to develop a software program for teachers. He works full-time as a software engineer for an electronics company, but devotes about 5 to 15 hours per week on his own software project. He hopes to have a working prototype by early next year. During the current year, Bill incurred $3,800 to acquire a computer, $600 for miscellaneous supplies, $450 for a business development seminar, and $1,300 for assistance from a programming expert with respect to his initial work. This is the first year that Bill incurred any expenditures for this project. How should Bill treat these expenditures in the current year? Considerations:

(1) Does Bill have a profit motive? It would appear from Bill's expertise in software development and his activities to date, including attending a business development seminar, that Bill can establish a profit motive. Bill and his tax advisor should review the case law under §§174, 162 and 183, as well as the factors at §1.183-2(b) to determine whether Bill is engaged in an activity for profit.

(2) Are Bill's activities substantial and regular such that they constitute a trade or business? Based on the case law discussed earlier under "In connection with," Bill arguably has a trade or business per §174. It is also important that Bill controls and owns his research, similar to Mr. Snow, rather than being a passive investor for someone else conducting research.

(3) Bill must classify his expenditures between §174 and §195 prior to the point in which he begins carrying on a trade or business for §162 purposes, at which time he will no longer have any §195

expenditures (unless he begins a new trade or business). Although the law is not entirely clear,80 it would appear that §195 and §162 apply to a start-up business with R&E expenditures just as they would for a business without R&E expenditures. The only difference is that §174 expenditures incurred during the start-up period are treated under §174, rather than as capitalizable start-up expenditures under §195. Once the start-up operation reaches the point of carrying on a business for §162 purposes, and per the Richmond Television standard (see earlier discussion under §195), the taxpayer will stop capitalizing its non-R&E expenditures (except for expenditures capitalizable even by an operating trade or business). Part of the confusion for an R&E start-up business lies in the case law that has called inventive activities a trade or business, without clearly

distinguishing whether it was solely in the §174 context, or also in the §162 context.81 Bill must

78 Treas. Reg. § 1.167(a)-11(e)(1). 79 See Piggly Wiggly Southern, Inc. v. Commissioner, 84 T.C. 739, 748 (1985), aff'd 803 F.2d 1572 (11th Cir. 1986), where the

court stated: "Equipment located in retail stores, which is to be used in connection with the trade or business conducted in those stores, is placed in service upon the opening of the stores."

80 Case law dealing with individual inventors has not clearly distinguished between having a trade or business for Section 174 purposes versus Section 162 purposes. For example, in Maximoff, supra, the court held that the inventor had a trade or business under Section 162 prior to having any sales; there was no discussion of Sections 174 or 195.

81 See Marvin Petry, Taxation of Intellectual Property (1995) § 3.05 where the author notes that case law has not clearly distinguished between having a trade or business for I.R.C. § 174 purposes versus for I.R.C. § 162 purposes. Petry suggests that if a trade or business exists for I.R.C. § 174 purposes, all expenses incurred in the start-up phase are currently deductible. However, he also notes that it may be that Section 195 still applies in the start-up phase.

It is important to note that several of the older I.R.C. § 174 cases predate I.R.C. § 195 which limits the available authority on I.R.C. § 162 versus I.R.C. § 195 in an R&E start-up situation.

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identify which of his expenditures are not §174 expenditures to determine if they are start-up

expenditures under §195.82

(4) The cost of the computer may not be treated as a §174 expenditure per §174(c) because it is depreciable property.

(5) Bill may not begin to depreciate the computer (or take a §179 expensing deduction) until it is placed in service and business has begun.

(6) Bill must decide whether to treat any §174 expenditures as current deductions or to capitalize them under §174(b).

(7) Bill must determine whether any of his §174 expenditures are for research that meets the definition of QRE (for example, were they incurred to discover information which is technological in nature?). If Bill is not yet carrying on a trade or business, his contract research expenses ($1,300 paid to the non-employee programmer), will not qualify as QRE.

(8) Bill should be considering choice of business entity and recordkeeping procedures.

G. Orphan Drug Credit

Section 45C provides a tax credit for clinical testing expenses for certain drugs for rare diseases or conditions (referred to as the orphan drug credit). Biotechnology companies should review this credit if they are

engaged in research related to rare disease or conditions as defined at §45C(d).83 Unlike the research credit, the orphan drug credit was made permanent in 1997.

Additional §41 Reading

The Tax Relief Extension Act of 1999 (P.L. 106-170; December 17, 1999)

Clarification of TRA'86 legislative language: Just as Congress did when it extended the credit in October 1998, it included language in the conference committee report to help define key terms in defining "qualified research." The

full text of this language follows:84

"In extending the research credit, the conferees are concerned that the definition of qualified research be administered in a manner that is consistent with the intent Congress has expressed in enacting and extending the research credit. The conferees urge the Secretary to consider carefully the comments he has and may receive

82 Office and travel expenses related to R&E activities are deductible under Section 174. Kilroy v. Commissioner, supra, Magee

v. Commissioner, supra. 83 The orphan drug credit is expired with respect to amounts paid or incurred after December 31, 1994. At December 1995, the

House-Senate tax bill (H.R. 2491, 104th Cong., 1st Sess.) included a provision to renew this credit through December 31, 1996.

84 Cong. Rec. November 17, 1999, page H12207.

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regarding the proposed regulations relating to the computation of the credit under section 41(c) and the definition of qualified research under section 41(d), particularly regarding the "common knowledge" standard. The conferees further note the rapid pace of technological advance, especially in service-related industries, and urge the Secretary to consider carefully the comments he has and may receive in promulgating regulations in connection with what constitutes "internal use" with regard to software expenditures. The conferees also observe that software research, that otherwise satisfies the requirements of section 41, which is undertaken to support the provision of a service, should not be deemed "internal use" solely because the business component involves the provision of a service.

The conferees wish to reaffirm that qualified research is research undertaken for the purpose of discovering new information which is technological in nature. For purposes of applying this definition, new information is information that is new to the taxpayer, is not freely available to the general public, and otherwise satisfies the requirements of section 41. Employing 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 of section 41.

The conferees also are concerned about unnecessary and costly taxpayer record keeping burdens and reaffirm that eligibility for the credit is not intended to be contingent on meeting unreasonable record keeping requirements."

Tax and Trade Relief Extension Act of 1998

In response to recent cases involving the meaning of some of the terms used to define "qualified research" under §41(d), when Congress extended the research tax credit to June 30, 1999, it also included a clarification of "qualified research" in the legislative history.

From: Congressional Record: October 19, 1998 (House), Pages H11503-H11545 (thomas.loc.gov).

CONFERENCE REPORT ON H.R. 4328, MAKING OMNIBUS CONSOLIDATED AND EMERGENCY SUPPLEMENTAL APPROPRIATIONS FOR FISCAL YEAR 1999

TITLE I. EXTENSION AND MODIFICATION OF CERTAIN EXPIRING PROVISIONS Subtitle A--Tax Provisions

A. Extension of Research Tax Credit (sec. 101 of the House bill, sec. 101 of S. 2622, and sec. 41 of the Code)

Conference Agreement excerpt [Also see 1998 Blue Book pages 236-237]

"In extending the credit, the conferees wish to reaffirm the scope of the term ``qualified research.'' Section 41 targets the credit to research which is undertaken 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. However, eligibility for the credit does not require that the research be successful--i.e., the research need not achieve its desired result. Moreover, 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)).

Activities constitute a process of experimentation, as required for credit eligibility, if they involve evaluation of more than one alternative to achieve a result where the means of achieving the result are uncertain at the outset, even if the taxpayer knows at the outset that it may be technically possible to achieve the result. Thus, even though a researcher may know of a particular method of achieving an outcome, the use of the process of experimentation to effect a new or better method of achieving that outcome may be eligible for the credit (provided that the research otherwise meets the requirements of section 41, including not being excluded by subsection (d)(4)).

Lastly, the conferees observe the lack of clarity in the interpretation of the distinction between internal-use software, the costs of which may be eligible for the credit if additional tests are met, and other software. The conferees emphasize that application of the definition of internal-use software should fully reflect congressional intent."

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Final Research Credit Regulations (TD 9104; 1/2/04)

Proposed regulations were issued in 1998 (for 1986 legislative changes!); final regulations were issued in January 2001 in the last days of the Clinton administration. These regulations were pulled in January 2001 (in the first few days of the Bush administration), proposed regulations were issued in December 2001 with final regulations issued in January 2004 (TD 9104). The final regulations address “qualified research,” the exclusions from the definition of qualified research and the shrinking back concept. However, one exclusion –for certain internal-use software, is addressed in proposed regulations (discussed in the next section of the outline).

Highlights of the final regulations (including the preamble to the regulations):

� “Discovering information”

o Research satisfies this requirement 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.”

How does this compare to the uncertainty rule of §174? Per §1.174-2: Expenditures represent R&D 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.”

Query: Given §41(d)(1)(A), why would Congress have repeated that requirement with the “discovering information” phrase at §41(d)(1)(B)?

o Taxpayers do not have to be “seeking to obtain information that exceeds, expands or refines the common knowledge of skilled professionals in the particular field of science or engineering in which the taxpayer is performing the research.” Also, there is no need to succeed.

o Issuance of a patent is conclusive evidence that the discovering information requirement was met.

� Technological in nature is met if the process of experimentation used to discover information fundamentally relies on the principles of the physical or biological sciences, engineering or computer science.

� Process of experimentation “implies that research activities must contain certain core elements in order to constitute a process of experimentation.”

� The process must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science.

� The “core elements” of a process of experimentation – 3 things that the taxpayer must identify:

o The uncertainty that exists regarding the development or improvement of a business component that is the object of the taxpayer’s research activities

o 1 or more alternatives intended to eliminate the uncertainty

o a process of evaluating the alternatives (and the taxpayer must conduct that process too)

� “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.”

� Substantially all – 80% or more of the research activities, as measured by cost or other “consistently applied reasonable basis,” must be elements of a process of experimentation. Thus, as long as the other

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20% satisfy the other requirements of §41(d)(1)(A) and are not excluded under §41(d)(4), the substantially all requirement is met.

� Shrinking back rule – the definition of qualified research is to be “applied first at the level of the discrete business component, that is, the produce, process, computer software, technique, formula, or invention to be held for sale, lease, or license, or used by the taxpayer in a trade or business of the taxpayer.” If not met at that level, keep shrinking back to find if there is a subset of the larger item to which the definition of qualified research is met. This rule is not intended to serve to exclude activities from being qualified research.

� Additional guidance is provided for some of the exclusions from qualified research, such as for clinical testing and apportionment of in-house research expenses performed both in the U.S, Puerto Rico and other US possessions and outside of these areas.

� Recordkeeping – The general recordkeeping rules of §1.6001-1 apply. The IRS and taxpayers may agree to guidelines on how to keep specific records to substantiate the credit.

� Effective date – tax years ending after 12/31/03. However, for earlier tax years, the IRS will not challenge positions taken that are consistent with the final regulations.

Notice of Proposed Rulemaking – Internal-use software and §41 (REG-153656-03 and Ann. 2004-9, 2004-6 IRB 441)

§41 Review: An excluded activity provided for at §41(d)(E) is – “Computer software. Except to the extent provided in regulations, any research with respect to computer software which is developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer, other than for use in—

(i) an activity which constitutes qualified research (determined with regard to this subparagraph), or

(ii) a production process with respect to which the requirements of paragraph (1) are met.”

Per the legislative history to the Tax Reform Act of 1986 which tightened up the research credit rules, the

costs of new or improved internal use software will only be eligible for the credit if the software is

innovative, its development involves significant economic risk, and the software is not commercially

available to the taxpayer; see General Explanation to the Tax Reform Act of 1986 (Blue Book), prepared

by the staff of the Joint Committee on Taxation, page 135, and Notice 87-12 (1987-1 CB 432).

Announcement 2004-9 reviews the legislative and regulatory history of attempts to define internal-use software. Treasury and IRS are requesting comments on the definition of internal-use software “that appropriately reflects the statute and legislative history, can be readily applied by taxpayers and readily administered by the IRS, and is flexible enough to provide continuing application into the future.” Commentary on earlier proposed definitions is also welcome as are comments on mixed use software. Finally, comments on whether the new regulations should have retroactive effect are requested.

Meanwhile, taxpayers may rely on all of the provisions related to internal-use software contained in the 2001 proposed regulations (66 FR 66362) or upon all of the provisions in TD 8930 (66 FR 280). “For example, taxpayers relying upon the internal-use software rules of TD8930 must also apply the ‘discovery test’ as set forth in TD 8930.” Those regulations provided “research is undertaken for the purpose of discovering information only if it is undertaken to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering.”

Comments were requested by 3/2/04.

§41 Recordkeeping Pilot Program – Notice 2004-11, 2004-6 IRB 434

Notice 2004-11 explains a pilot program where the IRS and large and mid-size businesses may enter into “research credit recordkeeping agreements” (RCRAs). An RCRA will enable the IRS and an LMSB taxpayer under exam to specify the type and amount of documents that must be kept by the taxpayer in order for the taxpayer to satisfy the §6001 recordkeeping requirements for claiming the research credit. The LMSB Division expects to select 5 – 10 taxpayers for the pilot.

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LMSB Briefing Paper on Taxpayer Approaches to Capturing Costs for the Research Credit

This briefing paper, issued in June 2004, is designed to point out to agents that the “hybrid” approach of capturing costs for computing the research credit is “unauditable.” The 2 commonly used approaches to capturing costs, as noted in the IRS 1995 audit plan for the credit are:

(1) The project or job cost approach – “directly matches costs with the activities that gave rise to them.

(2) The cost center or departmental approach - . “tracks costs based on where within the company structure the cost was incurred.” Taxpayers using this approach may also have to segregate out from the cost centers, costs that are not for qualified research.

Many agents have discovered that some taxpayers who say they are using the cost center approach are really using a hybrid approach. “The costs captured under the hybrid approach are generally based on the opinions of company managers delivered years after the fact.” The LMSB Division reports that typically when it sees the hybrid method, it does not find contemporaneous records. In addition, they often find that there is no connection between the “purportedly qualified activities and the allegedly associated costs.” For example, the taxpayer may have captured all wages of employees in a particular department identified on an organizational chart and determined a percentage of the wages that are not for qualified research and the cost center may not match centers used in the taxpayer’s cost accounting system.

The briefing paper reminds agents not to focus just on the cost capturing method, but instead need to be “examining the research credit that was claimed.” The cost capturing technique is important to planning an audit strategy for the credit.

The paper is available at http://www.irs.gov/pub/irs-utl/cost_capturing_approaches_2004-05-24.pdf.

Qualified Research and Special Rules for Internal Use Software

In United Stationers, Inc. v. U.S., 99-1 USTC ¶50,136, 82 AFTR2d 98-7488 (7th Cir.), cert. denied S.Ct. Dkt. No. 98-1870 (6/21/99), the district court denial of a research tax credit for eight internal use software programs was affirmed. USI had purchased a software package to be modified to meet its needs for various internal purposes, such as tracking inventory. To qualify for the credit, USI not only had to meet the four requirements of "qualified research" under §41(d) (explained in the following chart), but also had to show that the research met the additional requirements for internal-use software.

Test Analysis

1. The research must qualify as R&E under §174.

Not contested by the Service.

2. The research must be undertaken to discover information that is technological in nature.

Not met. The lower court had focused on the dictionary definition of "discover." The 7th Circuit stated that they did not adopt this view that this test turns on the breadth of the definition of "discover." The court, with reference to Norwest, 110 T.C. 454 (1998), stated that "qualifying research must go beyond the current state of knowledge in that field - expand or refine its principles. ... discovery demands something more than mere superficial newness; it connotes innovation in underlying principle. ... Congress clearly intended, ..., that qualifying research pass a high threshold of innovation and be of broad effect." The court also noted that this interpretation was in line with the original 1981 and modified 1986 purpose of the research credit. NOTE – since this case, regulations have changed this test.

3. The taxpayer must intend to use the information to develop a new or improved business component.

The Service conceded that this test was met.

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4. The taxpayer must pursue a "process of experimentation" during substantially all of the research.

Not met. The court stated that the legislative history to §41 was to be interpreted to indicate that a process of experimentation involved more than just debugging a computer program. "USI would have us hold that [H.R. Conf. Rep. No. 99-841] dictates a per se credit for software development. This suggestion, however, ignores the Report's mention of only SYSTEMS design (not SOFTWARE design) as well as its focus on overcoming design uncertainty through a systematic - almost scientific - methodology. The Report suggests that qualifying research must from its outset involve some technical uncertainty about the possibility of developing the product." The court also noted that USI's summary description of each program only noted the uncertainty of realizing the expected operational efficiencies; they did not describe any technical uncertainty of creating the programs—"there was no technical uncertainty from the outset."

Internal-use software: USI argued that the §41 exclusion for internal use software (which imposes additional tests that must be met for the qualified research expenditures to qualify for the credit), only applies to software that is intended exclusively for internal use. Per USI, the legislative history refers to software for general and administrative functions or in providing noncomputer services, while USI's software related to its core business activities. USI posited that its programs, such as for inventory control, are integral to its core revenue activities as a wholesale distributor. The court disagreed with this analysis—even programs to which USI customers had access served the purpose of streamlining USI's operations. The programs did not fall within the congressional purpose for creating the credit.

The lower court concluded that USI met both the innovative and not commercially available tests for internal use software, but not the significant economic risk test. The 7th Circuit agreed holding that the programs did not involve the "requisite technical risk." "[W]e can be confident that because USI's projects did not meet the less demanding general requirements of section 41's qualified research definition, they necessarily do not pass the higher threshold of risk required by the exception to the internal use exclusion."

Comments: (1) Qualified research: The 12/24/98 7th Circuit decision made no reference to the TTREA'98 legislative history which clarified the terms "technological in nature" and "process of experimentation." Arguably, USI was engaged in making evolutionary improvements to the functionality and performance of the canned software it began with. Perhaps the emphasis on the "discovery test" is better explained as to whether or not USI was engaged in research activities, or mere programming/writing of code. Both the statute (§41(d)(3)(E)) and legislative history use the term "research with respect to computer software which is developed ...," rather than just using the term software development. What is the difference, if any, between "research with respect to software" and software

development?85 Unfortunately, the USI opinions to not delve into the nature of the work performed by the software developers and the terms "research" and "development."

Note that for Test #4, the Court states that the original legislative history suggests that qualifying research must involve some technical uncertainty about the possibility of developing the product. In contrast, the October 1998 legislative clarification provides that a process of experimentation requires that the means of achieving a result are uncertain, "even if the taxpayer knows at the outset that it may be technically possible to achieve the result."

(2) What is internal-use software? Is a better definition of "internal use software" needed? Prop. §1.41-4(e)(1) states: "Research with respect to computer software that is developed by (or for the benefit of) the taxpayer primarily for the taxpayer's internal use is eligible for the research credit only if the software satisfies the requirements of paragraph (e)(2) of this section. Generally, research with respect to computer software is not eligible for the research credit where software is used internally, for example, in general and administrative functions (such as payroll, bookkeeping, or personnel management) or in providing noncomputer services (such as accounting, consulting, or banking services)." This language echoes that in the 1986 Blue Book (pages 134-135).

Statement of Position (SOP) 98-1, Accounting for the Costs of Computer Software Developed or Obtained for

Internal Use (3/4/98), defines internal-use software as "acquired, internally developed, or modified solely to meet the entity's internal needs" and "during the software's development or modification, no substantive plan exists or is being developed to market the software externally" [¶12]. The SOP lists four types of software: 1) software to be

85 One of the Service's experts in Norwest, supra, noted the difference between software development and research. Software

research involves a search for information, use of test data, and the presence of technical risk. Software development involves the production of code, use of production data, and failure is more likely to be due to people and project management risks, rather than technical risk.

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sold, leased, or otherwise marketed as a separate product or as part of a product or process (costs to be treated per FAS #86), 2) software for use in R&D (costs to be treated per FAS #2 and FAS Interpretation #6), 3) software developed for others under a contract (costs to be treated per contract accounting rules), and 4) internal-use software (costs to be treated per SOP 98-1) [§6]. The appendix to SOP 98-1 contains 13 examples of internal-use software, as well as 8 examples of software that is not for internal use. The focus of the SOP definition of internal-use software is on whether the software is to be marketed to customers, rather than whether customers might use it in some manner. Example 10 in the SOP Appendix provides that a software database developed by a broker-dealer entity which then charges for financial information distributed through the database is internal-use software.

While the SOP definition of internal-use software, which basically looks at whether there was a primary intent to market the software or just use it internally, is fairly clear, would such a definition satisfy the congressional intent in creating the research credit and the carve-out for certain internal use software under §41? Certainly, Congress could have carved out all internal-use software development costs from the credit and provided a definition as used in the SOP, but it did not. Instead, it provided certain tests that, if met, would allow the research costs to

potentially qualify for the credit.86 Congress used the phrase, "research with respect to computer software that is developed by (or for the benefit of) the taxpayer primarily for the taxpayer's own internal use" (emphasis added; 1986 Blue Book page 134). Perhaps this language was used with the intent of §41 in mind because certain software, even though not marketed by a taxpayer, might "increase the innovative qualities and efficiency of the U.S. economy" [1986 Blue Book page 130].

(3) Should limitation of the credit under the TRA'86 requirements be through market forces or IRS scrutiny of what

is a new discovery? Did Congress intend for the research credit to only be available where the taxpayer can show that it discovered something that was new to everyone? Did Congress intend that software development would have to expand or refine the field of computer science, or somehow go beyond the preexisting knowledge of the principles of computer science? Who is to make this determination—does the Service have the ability to make this level of scientific/engineering determination? Isn't the "deemed" language of the legislative history intended to prevent a need for the Service to make such a determination?—

"The determination of whether the 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

science23—in which case the information is deemed technological in nature—or on other principles, such as those of economics—in which case the information is not to be treated as technological in nature." [TRA'86 Blue Book page 133]

23 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.

Does the "deemed" language imply a separate discovery test, or does it just provide that if the research is in an appropriate field, it is deemed technological in nature (which along with the other requirements and limitations of §41, ensures that the credit is allowed only for the appropriate expenses and research activities)?

Given that many software processes are protected by trade secret, how can a taxpayer know if they have expanded the field of computer science?

Did Congress use a tax credit rather than direct research grants to allow for market forces and industry knowledge to operate to ensure that government funds not go to the "wrong" projects?

Note that the final regulations (TD 9104 summarized earlier) clarify the “discovery and technological in nature requirements of §41.

86 Meeting the "three tests" (innovative, significant economic risk, and not commercially available) are not the only ways that

research with respect to internal-use software might qualify for the credit. Also potentially eligible are "(1) qualified research (other than the development of the internal-use software itself) undertaken by the taxpayer, or (2) a production process that meets the requirements for the credit (e.g., where the taxpayer is developing both robotics and software for the robotics to be used in a manufacturing process, and the taxpayer's research costs of developing the robotics are eligible for the credit).

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Tax and Accounting Software Corporation87 presents a different interpretation of the phrase “discovering information which is technological in nature” (an important term used in defining “qualified research”) than was applied in earlier cases. Earlier decisions focused on the “discover” part of this phrase, while the District Court in TAASC looked at the context of the entire Code section and the purpose behind the addition of this language in 1986. The TAASC decision also considered clarifications made by Congress in the committee reports accompanying extensions of the credit in 1998 and 1999.

TAASC, a subchapter S corporation, developed and distributed four commercial software programs for accounting and office applications. The programs combined the functionality of various separate programs, but were operable within existing computer memory constraints. Some programs included features that were not available in other programs and some operated at higher speeds than competitor programs. TAASC treated the software development costs as deductions under §174 and claimed a research credit for the eligible costs. The Service disallowed the credit.

In reviewing case law precedent under §41 dealing with software development, the court noted that the only two

cases – United Stationers and Norwest,88 involved internal use software where §41 is “construed much more strictly.” The court did not believe that the Norwest and United Stationers cases fully comply with the Congressional intent behind §41 and are not applicable to cases involving software developed for the commercial market.

Applying the requirements of “qualified research” set forth in §41(d),89 the court first noted that the Service was not challenging TAASC’s assertion or evidence that the expenditures fell under §174. TAASC also submitted evidence that its activities related to a new or improved function, performance, reliability or quality of a product.

The court also found that the “discovering information that is technological in nature” test was satisfied. Per the court, the courts in United Stationers and Norwest “erroneously tried to divide this requirement into two tests with the first being whether the taxpayer’s actions can be considered a ‘discovery’ in the scientific sense.” Per the court, the “emphasis should be on whether the information qualifies as being ‘technological in nature’ (the Technology Test), not whether the work could be considered a revolutionary discovery in the scientific sense.” Based on its reading of the TRA’86 legislative history, the court did not see a reason to put a “scientific” spin on the word “discovery” when the intent of the requirement was to distinguish between technologically-based information and non-technologically-based information. The term “discovery” could also mean “detect,” unearth” and “learn.”

The court also looked to the 1998 committee report where Congress stated that evolutionary research activities could qualify for the credit. Per the court, evolutionary research is not ‘revolutionary research.” “[Evolutionary research] suggests to the Court a pattern of research that is unfolding in a series of events rather than something that is a radical change from the norm.” In short, per the court, the “purpose of the ‘technology’ requirement of section 41 is to eliminate the ‘soft sciences’ from contention for the credit, not to focus on the word ‘discovery.’”

Finally, while noting that comments from Congress subsequent to enactment of a rule do not have the weight of a contemporaneous history, the court noted that it cannot be ignored. The court also noted that in its 1999 report, Congress “made it clear that the IRS’s regulations do not follow the intent of Congress.” Thus, the court found that TAASC satisfied the technology/discovery test because its final product was a “new and more efficient combination of software that was not available to the public and that the competition was stiff to develop and bring such a product to the market,” and information new to TAASC was obtained that was not generally available to the public. In addition, because the process of experimentation relied on the principles of computer science, it was technological in nature.

The court also found that the “process of experimentation” test was satisfied. It pointed out that the IRS regulations seemed to be referring to academic research, rather than what Congress intended – commercial research. “TAASC has proven that it followed a ‘process of experimentation’ where it evaluated more than one alternative to achieve its intended result, where the process of achieving that result was uncertain at the outset.”

87 Tax and Accounting Software Corporation v. U.S., 86 AFTR2d 2000-5752, 2000-2 USTC ¶50,672 (ND OK 2000). 88 United Stationers, Inc., 82 AFTR2d 98-7488, 99-1 USTC ¶50,136 (7th Cir.), cert. denied S.Ct. Dkt. No. 98-1870 (6/21/99),

and Norwest v. Commissioner, 110 T.C. 454 (1998) (Appeal docketed sub nom Wells Fargo & Co. v. Commissioner, Nos. 99-3878 and 99-3883 *8th Cir. Sept. 29, 1999).

89 Section 41(d) defines “qualified research” as research (A) for which expenditures may be treated as §174 expenses, (B) which is undertaken for the purpose of discovering information (i) which is technological in nature, and (ii) the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, and (C) substantially all of the activities of which constitute elements of a process of experimentation.

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Based on its interpretation of §41 and its legislative history and TAASC’s facts, the court granted summary judgment to TAASC. In February 2001, the government filed an appeal in the Tenth Circuit Court (discussed later).

Observation: The TAASC case was viewed by taxpayers as a welcome contribution to the guidance interpreting “qualified research” under §41. The proposed regulations issued by the Service in December 1998 did not really clarify the statute or tie to all of the legislative history. Also, use of the dictionary definitions in the United

Stationers and Norwest cases, rather than considering why Congress added the words technological in nature and discovery, led to strained legal interpretations, which the IRS followed in its proposed regulations. Also missing from the interpretations in the United Stationers and Norwest cases was the reality that Congress was unlikely to have enacted a standard that could not be audited by the IRS.

The legislative history to TRA’86 provides (Blue Book page 133): “Under the Act, research satisfying the section 174 expensing definition is eligible for the credit only if the research is undertaken for the purpose of discovering information (a) that is technological in nature, and also (b) the application of which is intended to be useful in the development of a new or improved business component of the taxpayer.” …

“The determination of whether the 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 science3 – in which case the information is deemed technological in nature – or on other principles, such as those of economics – in which case the information is not to be treated as technological in nature.”

3 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.

The District Court in TAASC acknowledged the key importance of use of the word “deemed” in the above legislative explanation. If the process of experimentation involves a proper technology field, the “technology test” should be satisfied. The court seems to be saying that a combination of the proper technology field, a process of experimentation, and achieving an application “intended to be useful in the development of a new or improved business component of the taxpayer” (§41(d)(1)(B)(ii)), are the necessary elements to show that the research credit is available for the activity in question (assuming all other requirements of §41 are satisfied).

Government Appeals TAASC—On February 12, 2001, the Justice Department filed an appeal in the TAASC case in the 10th Circuit. Highlights of the brief are noted below, along with commentary from Professor Nellen.

▪ The Government states that “qualified research” is “research (1) that is intended to discover information that is technological in nature, and (2) which involves a process of experimentation.” “The legislative history indicates that, in order to satisfy the first test, qualified research must rely upon, and expand or refine, principles of the physical or biological sciences, engineering, or computer science. The courts in [United

Stationers and Norwest] held that this test requires the discovery of technological information, not merely the use of technological information.” [p. 13]

Comments: The “expand or refine” language only appears in footnote 3 to the TRA’86 legislative history, with reference to computer science. The legislative history states: “The determination of whether the 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 – in which case the information is deemed technological in nature – or on other principles, such as those of economics – in which case the information is not to be treated as technological in nature.”

Thus, “technological in nature” depends on the type of activity used in the process of experimentation. If it is the hard sciences or computer science or engineering, the activity is deemed to be technological in nature. The Government is overlooking the “deemed” language, as well as the relationship of the test to the process of experimentation requirement.

▪ “The Seventh Circuit and the Tax Court, however, properly gave effect to the statutory language and the underlying legislative intent. The district court’s statutory analysis, on the other hand, if fatally flawed, because it essentially emasculates the discovery of information requirement that Congress imposed in enacting Section 41.” [pages 14 – 15]

Comments: It is questionable whether the earlier courts gave “proper effect” to the statutory language. For some reason, they looked very closely at the use of the word “discover,” even using the dictionary to

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interpret it, rather than looking at the context of how the term “discovering information” was used in the legislative history (see text above). The court overlooked use of the word “deemed” in the legislative history.

The Government’s argument is flawed in that it assumes that there is a separate discovery test, when that is the issue at hand in the case.

▪ The “development of new software does not ordinarily involve the discovery of any information which is technological in nature. On the contrary, it does no involve any discovery process at all. Rather, it simply entails the application of known principles of computer science to modify existing software.” [p. 31]

Comments: Again, this argument assumes there is a “discovery test.” Also, the legislative history mandates that the research “fundamentally” rely on the principles of computer science. It is not clear that Congress was requiring some new principle of computer science to be discovered. If the same interpretation were applied to require discovery of a new principle of chemistry, there would probably be little need for a credit for commercial ventures (much of the research discovering new scientific principles is probably occurring in non-profit organizations).

▪ The lower court erred by relying on “post enactment pronouncements of a later Congress as to what an earlier Congress intended.” The Government notes that such statements are an “unreliable indicator of legislative intent. … Those Conference Reports thus have no bearing on the correct interpretation of Section 41.”

Comments: What’s a Congress to do? The 1998 and 1999 statements were provided by Congress in response to the United Stationer’s and Norwest opinions. Congress desired to clarify the provision – something it felt it had to do due to the misinterpretation of the earlier courts. Perhaps this has become an issue for the U.S. Supreme Court to have to resolve.

▪ “Contrary to the district court’s holding, computer programming does not involve a ‘process of experimentation.’ … Computer programming is the skilled practice of creating or modifying computer software through programming techniques, which are well established in the field of computer science. Computer science principles are available to the general public through textbooks, treatises, journals and similar publications. That computer programming can be difficult and laborious does not mean that it is experimental. Regardless of how challenging the project may be, the capability and methods for creating software are found in well established principles of computer science.” [pages 38 – 39]

Comments: The TRA’86 legislative history states 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. This 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.” The facts of the TAASC case indicates that new features were created for the programs. It would seem that if this involved evaluation of more than one alternative, a process of experimentation was involved.

The government won upon appeal to the 10th Circuit (90 AFTR2d 2002-6107, 2002-2 USTC ¶50623, 301 F3d 1254 (10th Cir.). The 10th Circuit Court ruled that the phrase “discovering information” used in the statute is a separate requirement to be met to qualify for the research tax credit. “Under [this] requirement, the taxpayer must show that he discovered new information and that information must be separate from the product that is actually developed. The court did not find it necessary to look at the legislative history to the research tax credit because the statute was not ambiguous. The court did not find that TAASC had discovered anything. The court did look to the legislative history to get better guidance on process of experimentation. The court stated, however, that subsequent legislative histories could not be considered. The court questioned whether either the discovering information or process of experimentation requirements were met and reversed the lower court’s decision and remanded to that court.

With clarification of the definition of “qualified research” in the final regulations (TD 9104), it is important to look at the regulations rather than only case law.

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Another recent case, Wicor, Inc.,90 involved eligibility of expenses incurred in developing an “integrated customer information system” for internal use The project involved about 35,000 labor days including work by an outside consulting firm. The project involved in-house custom development and integration of some software provided by outside vendors. Integrated software packages required development of an interface system. The project cost $30 million and resulted in a “multiple-function integrated system that improved customer service and resulted in labor and cash flow savings by contributing to a reduction in staff, including reducing information technology positions and meter readers.” Wicor claimed a research tax credit for the project and the Service disallowed it.

To be able to claim a research credit for internal use software, three additional requirements must be satisfied beyond those that indicate that the project was “qualified research.” The court’s analysis of the factors to be satisfied to claim a research credit for internal-use software follows (the first four pertain to “qualified research” and the last three to internal use software).

Test Analysis

1. The research must qualify as R&E under §174.

Wicor’s satisfaction of this requirement was not in dispute by the Service.

2. The research must be undertaken to discover information that is technological in nature.

The Service did not dispute that the information gained was technological in nature, but argued that the research was not conducted for the purpose of discovering information that was technological in nature.

The court applied the “discovery” test that was laid out by the court in United

Stationers, Inc. v. U.S., supra. Per the court: “The discovery test is intended to limit the form of discovery to the ‘process of experimentation.’ … The fact that the information is new to the taxpayer, but not new to others, is not sufficient for such information to come within the meaning of discovery for purposes of this test. … Discovery demands something more than mere superficial newness; it connotes innovation in underlying principle.”

Wicor had an expert who testified that the project “expanded the application of computer science principles within the gas utility customer information system application.” Other experts noted that the project discovered information that was technological in nature and the concepts explored were beyond what was known in the utility field. An expert for the Service noted that Wicor’s project was fairly standard and it did not appear that any new algorithms were created.

The court sided with the Service, referring to the Norwest case, supra, to support its conclusion that the credit was not intended to apply to projects that only expanded knowledge in a particular industry.

3. The taxpayer must intend to use the information to develop a new or improved business component.

Wicor’s satisfaction of this requirement was not in dispute by the Service.

4. The taxpayer must pursue a "process of experimentation" during substantially all of the research.

The Court ruled that this test was not met because Wicor was unable to prove that the means for achieving the result of its project were uncertain at the start.

5. Innovativeness Test: The software is innovative ("results in a reduction in

The court found that this requirement was not met because the work focused only on the utility industry, rather than the computer science field as a whole. The court also noted that the fact that Wicor did not apply for a patent raised a “reasonable inference” that Wicor did not view the project as highly innovative in the computer

90 Wicor, Inc. & Subs. v. U.S., 86 AFTR 2d 2000-6567, 2000-2 USTC ¶50,833 (ED Wisc).

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cost, or improvement in speed, that is substantial and economically significant").

science field.

6. Significant Economic Risk Test: The development involved a significant economic risk ("the taxpayer commits substantial resources to the development and also there is substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period").

The court did not find that this requirement was satisfied because the outside consultants had experience in designing the type of software Wicor required. Also, the Service’s experts testified that the key risk involved were ones related to management of the project. The court stated that if an outside consultant had not been used, technological risk may have been present in the project.

7. Commercial Availability Test: The software is not commercially available.

Wicor’s satisfaction of this requirement was not in dispute by the Service.

The court mentioned the TAASC case (discussed above), but stated that it was distinguishable in that §41 should be construed more strictly for internal use software than programs developed for sale.

Following the filing of the Government’s appeal in TAASC, the Tax Court ruled in favor of the Service in a case involving development of computer software for commercial purposes. In Eustace v. Comm’r., 90 AFTR2d 2002-7661, 312 F.3d 905 (7th Cir.), the court affirmed the tax court’s disallowance of the company’s research tax credit for software. An S corporation, Applied Systems (AS), developed computer programs for independent agencies. AS had not claimed a research credit, but a new tax director determined that some of the salary expense was “qualified research” and filed amended returns for three years to claim the credit (over $600,000 of credit over three years). The Service disallowed the credit and the tax court upheld the IRS on the basis that AS did not satisfy either the “discovery test” or the process of experimentation test. The tax court described AS’s basis for claiming the credit as requiring only significant programming changes to software since all programming relies on computer science principles. AS also argued that the process of experimentation requirement was satisfied because employees considered alternatives when increasing the functionality of the programs.

The tax court noted that most of the development occurred in years prior to the years covered by the amended returns and that much of the work in the claim period was merely updates or addition of functionality that was just basic programming. Per the tax court: AS “fell woefully short of presenting sufficient evidence to establish” that AS was entitled to a credit. AS “did not undertake research to discover information beyond the current state of knowledge in the computer science field. Nor did [AS] conduct a process of experimentation aimed at eliminating uncertainty about the technical ability to develop the software.”

Additional comments from the 7th Circuit (the same court that ruled against the taxpayer in the United Stationers case): As engaged in “normal software development.” “None of [the work] was pioneering; all of it entailed variations on themes long used by other developers.” “Process of experimentation” refers to the “scientific sense of forming and testing hypotheses rather than the lay (or even engineering) sense of trial and error. Galileo engaged in

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experiments about acceleration when he rolled balls down an inclined plane. An auto manufacturer trying different nozzles from those on hand to find the one that applies the smoothest coat of paint is not engaged in ‘experimentation’ under this view, nor is a software developer trying different methods to implement a feature accompanied by maximum execution speed and minimum demand on system resources such as RAM. Tinkering differs from experimentation in the vocabulary of research-and §41 is about research, and thus about use of the scientific method. Authors and movie makers playing with sentences and scenes to find what most impresses the public are not doing scientific research using ‘experimentation’. Just so with software. Developers are authors too; that they write lines of code readable by machines rather than lines of words readable by people does not fundamentally change the nature of the task and make one form of writing ‘experimentation’ when the other is not. Experimentation is a subset of all steps taken to resolve uncertainty; otherwise searching for a place to park a car would be a ‘process of experimentation.’” …. Whether it is internal use software or commercial software, “simple industrious software development does not qualify for the §41 tax credit.”

Observations: One problem for AS was that the credit was claimed after the fact and, as indicated by the Court, the records were not complete. The perspective of the IRS and Tax Court seems to be that there must be revolutionary research in the computer science field for a company to claim the credit for software work. However, the TRA’86 legislative history says merely that research must be undertaken to discover information that is technological in nature and the process of experimentation used in the research must fundamentally rely on the principles of computer science – in which case the information is deemed to be technological in nature. Since AS was using the principles of computer science and used some trial and error to create new or modified programs, the only way to deny the credit would be to say that no “research” occurred. Since it appears that the IRS believed that AS’s work fell under §174, research was involved.

Generic Drugs - IRS 2001 Internal Directive

In TAM 9346006, FSA 1999-1023 and the MSSP paper for the Manufacturing Industry (page 9-14), the Service held that the expenditures of developing a generic drug do not qualify for the research tax credit due to the exclusion for duplication of an existing business component. In the 2001 Internal Directive (2001 TNT 44-38), the Service notes that instead of taking a per se rule that all generic drug development costs are not QRE, a case by case approach should be used.

An abbreviated procedure is used by the FDA to approve a generic drug. The applicant must show that the generic drug is the bioequivalent of the listed drug and that there is no patent violation. No clinical studies are needed. Research is still needed on the formulation of the drug and its inactive ingredients. The Service acknowledges that it may be possible for a developer of generic drugs to satisfy the “discovery test” and avoid the duplication exclusion.

In-house Patent Counsel Wages

In FSA 200131007, the Service ruled that wages of in-house patent counsel did not constitute qualified research expenditures for the research credit. Taxpayer provides telecommunications products and services. In-house patent counsel gets involved from the point at which an engineer creates a written disclosure of an idea. Taxpayer’s Patent Department includes attorneys, agents, engineers, illustrators and coordinators (clerical support). All, but the coordinators have technical degrees.

To qualify for the credit, the wages paid to Patent Department personnel must meet the definition of “qualified services” under §41(b)(2)(B) and §1.41-2(c). Such services must provided for engaging in qualified research or engaging in direct supervision or support of research activities that constitute qualified research. Determination of qualified services is to consider the activities performed, rather than job titles.

The Service stated that the work of patent personnel was not for direct engagement in qualified research because the work did not involve discovery of technological information or a process of experimentation. The fact that the patent personnel may have interacted with researchers to determine whether something is patentable or how distinct the research outcome must be for it to be patentable did not rise to the level of direct research. In addition, the patent personnel’s work was not direct supervision of qualified research because it did not involve day-to-day supervision or first-line management of qualified research.

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Finally, the Service did not find that patent personnel work was in direct support of qualified research. While clerical work to prepare research reports and compile data may be direct support, the work of the patent personnel was not seen as crucial to the research.

The Service took an interesting interpretation of the meaning of qualified support by implying that work is in direct support of research if failure to the do the work would impede the research.

“Taxpayer correctly notes that activities in direct support of research include typing reports, cleaning equipment, compiling data, and machining parts so that without such activities, the research could not be completed. See Treas. Reg. section 1.41-2(c)(3)(ii). Thus, the failure of a secretary to type a report describing laboratory results derived from qualified research may impede the research, particularly to the extent such report would document the requisite process of experimentation. Similarly, the failure of a clerk to compile research data may delay if not suspend the research.

Conversely, the failure of a Patent Coordinator to prepare a monthly report on Patent Department activities, or to ensure that patent docketing procedures are followed, may impede the operations of the Patent Department but not the progress of Taxpayer's researchers. Similarly, the failure of a Patent Attorney to determine if the product under development may potentially infringe upon an existing patent will only temporarily curtail product development in the same way the failure of a payroll employee to cut a salary check only may delay the research phase to the extent Taxpayer's overall business activities are affected. In short, the activities of the Patent Department are intended to facilitate, streamline and validate the research efforts and end products of Taxpayer's inventors and engineers. The Patent Department will perform all necessary tasks to achieve this end but such activities alone do not contribute to the efforts underlying the research or support the research.”

Similarly, the IRS concluded in FSA 2365 (6/98): “Legal and patent expenses incurred by Taxpayer are not qualified research expenses because such amounts are neither “in-house research expenses” nor “contract research expenses” for the performance of qualified research or the direct support of qualified research.”

Comments: The issue presented in these FSA is a longstanding one. It would seem arguable that where the patent personnel work very closely with researchers to guide documentation and perhaps even the direction of the research, it would be in direct support of that research. After all, if the research yields something already patentable, it won’t be useful to the taxpayer. Also, some research needs to be patented in order to be useful to the taxpayer. One might also argue that because the §1.174-2 regulations so clearly state that costs to obtain patents on research qualify as R&E expenditures under §174, that Congress would have specifically excluded such activities under §41(e) if they did not want them to qualify for the research tax credit. On the other hand, arguments can also certainly be made that the attorneys aren’t conducting research or enabling it to occur and thus, are not performing qualified services. This remains an unclear area under §41 since FSAs are not binding authority.

Funded Research

The determination as to whether or not research is funded, particularly in situations where government contracts are involved, is not simple, as evidenced by the reversal of a lower court decision that had denied research credits claimed on amended returns.

The Lockheed Martin case91 involved credits of about $64 million claimed on amended returns for 1984 to 1988. The research related to work on approximately 300 contracts with both government and business entities although about 80% of the costs were incurred on 13 of the largest contracts. The Service had previously issued TAM 9410007 denying the research credit on the basis that the research was funded: 1) payment by the government for LM's research was not contingent on the success of the research, and 2) LM did not retain "substantial rights" in the research. The Service subsequently issued an RAR to LM disallowing research credits for three types of expenditures: 1) those related to projects where LM did not retain substantial rights in the research, 2) those were subcontractors may have also claimed the credit, and 3) those associated with certain service contracts which did not require that research be incorporated into the deliverable. The case at hand only dealt with the credits disallowed due to the substantial rights issue. The parties agreed to resolve this issue by looking only to the rights involved in LM's four major programs (an apparent use of judgmental sampling, rather than statistical sampling).

91 Lockheed Martin Corp., et al v. U.S., 82 AFTR2d 98-7141, 98-2 USTC ¶50,887 (Fed Cls).

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The contracts include standard regulatory clauses regarding the treatment of patent rights and the government's rights in certain technical data and software. The patent clauses gave LM certain rights, but generally subject to some control by the government, such as requiring LM to grant the government a non-exclusive license. LM did not apply for any patents with respect to the major programs. The other clauses generally gave the government unlimited rights in the technical data and software generated from work required by the contracts. Some contract provisions either allowed the government to disclose or required LM to disclosure information to other potential suppliers to the government. The programs were subject to security classification guidelines that required LM to obtain State Dept. approval before entering into licensing agreements or technology transfers. The contracts also included recoupment clauses allowing the government to recovery certain nonrecurring costs related to commercial sales by LM.

LM questioned the validity of §1.41-5(d) defining funded research because the "substantial rights" part of the definition is not mentioned in the statute. However, the trial court found that this was a reasonable interpretation because of the "clear connection between payment for research and the allocation of rights to research results." The court summarized the regulation as requiring that the taxpayer retain some right to use the research as a "minimum prerequisite for satisfying the substantial rights requirement." Yet, neither the researcher nor the funding party had to retain exclusive rights to the research in order to meet the substantial rights requirements. However, the rights had to be more than incidental benefits such as increased experience from performing the research.

The Service posited that to interpret "substantial rights," guidance could be obtained from §1235 on whether a patent had been sold or exchanged. In looking at the circumstances and the commercial or practical value of LM's retained rights. Here, the government's unlimited right to use and disclose the technical data greatly diminished the commercial value of LM's right to use the research results. The contractual language placed "considerable restrictions" on LM's ability to use the research results. LM's "actual use of its research results is immaterial, since the parties' contracts and applicable regulations gave the government the power to completely prevent any use of such research." Thus, the trial court held that LM did not retain substantial rights in the research.

In 2000, the Federal Court of Appeals reversed the trial court decision to find that LM was entitled to a credit.92 The court found that taxpayers could be found to have retained substantial rights in research results even if they don’t have the exclusive rights to the research. The court also found that the Service’s analogy to §1235 was unsound because the law does not require that the taxpayer retain all substantial rights.

The decision includes a succinct definition of the types of research projects that are considered “funded” and thus not eligible for the credit:

“These regulations [§1.41-5(d)] imply two scenarios in which the taxpayer’s research will be considered ‘funded’ by another person. The first is when the parties agree that payment shall not be contingent on the success of the research. If the taxpayer’s research will be paid for by another person whether or not the research succeeds, the research is funded and the expenditures are not entitled to the tax credit. In contrast, if the taxpayer will be paid only if it succeeds in its research for the other party, the taxpayer’s research will not be considered funded. ….

The second scenario in which a taxpayer’s research can be considered ‘funded’ or ‘paid for’ is when the taxpayer agrees to perform research for another person without retaining “substantial rights” to its research – when the person for whom the research is performed has ‘the exclusive right to exploit the results of the research’ and the taxpayer “must pay for the right to use the results of the research.” … If the taxpayer does not have the right to use or exploit the results of the research, its expenditures are not entitled to the tax credit regardless whether there is an agreement that the research will be paid for only if successful, and regardless whether the taxpayer receives some ‘incidental benefit’ such as increased experience. On the other hand, it follows that as long as exclusive rights are not vested in “another person,” the taxpayer may retain substantial rights. Treasury Reg. Section 1.41-5(d) thus implements the statute’s purpose of giving a tax credit only to those taxpayers who themselves take on the financial burden of research and experimentation to develop new techniques, equipment, and products that they can use in their businesses.”

In FSA 200018026, a heavily redacted ruling, the Service explains funded research as follows: “The customer may claim the credit only if the agreement requires the customer to pay for the research even if the research is

92 Lockheed Martin Corp., et al v. U.S., 85 AFTR2d 2000-1495, 2000-1 USTC ¶50,401 (Fed. Cir. 2000).

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unsuccessful. If, however, the customer need not pay unless the research is successful, the customer has paid for the product or result rather than the performance of the research and cannot claim the tax credit because the customer has assumed no risk.” This FSA applies the lower court’s decision in Lockheed Martin (see above) which was overruled on appeal.