66362 Federal Register / Vol. 66, No. 247 / Wednesday, December 26, 2001 / Proposed Rules

Note 4: Information concerning the

existence of approved alternative methods of

compliance with this AD, if any, may be

obtained from the Seattle ACO.

Special Flight Permits

(e) Special flight permits may be issued in

accordance with sections 21.197 and 21.199

of the Federal Aviation Regulations (14 CFR

21.197 and 21.199) to operate the airplane to

a location where the requirements of this AD

can be accomplished.

Issued in Renton, Washington, on

December 17, 2001.

Kalene C. Yanamura,

Acting Manager, Transport Airplane

Directorate, Aircraft Certification Service.

[FR Doc. 01–31558 Filed 12–21–01; 8:45 am]

BILLING CODE 4910–13–U

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG–112991–01]

RIN 1545–AY82

Credit for Increasing Research

Activities

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Notice of proposed rulemaking

and notice of public hearing.

SUMMARY: This document contains

proposed regulations relating to the

computation of the research credit

under section 41(c) and the definition of

qualified research under section 41(d).

In addition, this document contains

proposed regulations describing when

computer software that is developed by

(or for the benefit of) a taxpayer

primarily for the taxpayer’s internal use

is excepted from the internal-use

software exclusion contained in section

41(d)(4)(E). These proposed regulations

reflect changes to section 41 made by

the Tax Reform Act of 1986, the

Revenue Reconciliation Act of 1989, the

Small Business Job Protection Act of

1996, the Taxpayer Relief Act of 1997,

the Tax and Trade Relief Extension Act

of 1998, and the Tax Relief Extension

Act of 1999. This document also

provides notice of a public hearing on

these proposed regulations.

DATES: Written and electronic comments

and requests to speak (with outlines of

oral comments) at the public hearing

scheduled for March 27, 2002 must be

received no later than March 6, 2002.

ADDRESSES: Send submissions to:

CC:IT&A:RU (REG–112991–01), room

5226, Internal Revenue Service, POB

7604, Ben Franklin Station, Washington,

DC 20044. Submissions may also be

hand delivered Monday through Friday

between the hours of 8 a.m. and 5 p.m.

to: CC:IT&A:RU (REG–112991–01),

Courier’s Desk, Internal Revenue

Service, 1111 Constitution Avenue NW.,

Washington, DC. Alternatively,

taxpayers may submit comments

electronically via the Internet by

selecting the ‘‘Tax Regs’’ option of the

IRS Home Page, or by submitting

comments directly to the IRS Internet

site at: http://www.irs.gov/tax_regs/

reglist.html. The public hearing will be

held in the IRS Auditorium (7th Floor),

Internal Revenue Building, 1111

Constitution Avenue, NW., Washington,

DC.

FOR FURTHER INFORMATION CONTACT:

Concerning the regulations, Lisa J.

Shuman, 202–622–3120; concerning

submissions of comments and the

hearing, LaNita VanDyke, 202–622–

7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information

contained in this proposed regulation

have been previously reviewed and

approved by the Office of Management

and Budget (OMB) in accordance with

the Paperwork Reduction Act of 1995

(44 U.S.C. 3507(d)) and assigned OMB

Control Number 1545–1625. An agency

may not conduct or sponsor, and a

person is not required to respond to, a

collection of information unless it

displays a valid control number

assigned by OMB.

Books or records relating to a

collection of information must be

retained as long as their contents may

become material in the administration

of any internal revenue law. Generally,

tax returns and tax return information

are confidential, as required by 26

U.S.C. 6103.

Background

On January 3, 2001, Treasury and the

IRS published in the Federal Register

(66 FR 280) final regulations (TD 8930)

relating to the computation of the credit

for increasing research activities (the

research credit) under section 41(c) and

the definition of qualified research

under section 41(d). In response to

taxpayer concerns regarding TD 8930,

on January 31, 2001, Treasury and the

IRS published Notice 2001–19 (2001–10

I.R.B. 784), announcing that Treasury

and the IRS would review TD 8930 and

reconsider comments previously

submitted in connection with the

finalization of TD 8930. Comments were

requested on all aspects of TD 8930 with

specific comments requested on

whether modifications should be made

to the documentation requirement

contained in § 1.41–4(d).

Notice 2001–19 also provided that,

upon the completion of this review,

Treasury and the IRS would announce

changes to the regulations, if any, in the

form of proposed regulations. Notice

2001–19 stated that TD 8930 would be

revised so that the provisions of the

regulations, including any changes to

TD 8930, would be effective no earlier

than the date when the completion of

this review was announced, except that

the provisions relating to internal-use

computer software (including any

revisions) generally would be applicable

for taxable years beginning after

December 31, 1985.

Explanation of Provisions

This document amends 26 CFR part 1

to provide additional rules under

section 41. Section 41 contains the rules

for the research credit. After

consideration of the statute and

legislative history, the court decisions,

TD 8930 and the comments previously

submitted in connection with the

finalization of TD 8930, and the

comments submitted in response to

Notice 2001–19, Treasury and the IRS

have revised TD 8930 to provide rules

regarding:

(i) The requirement in section

41(d)(1)(B)(i) that qualified research be

‘‘undertaken for the purpose of

discovering information which is

technological in nature’’;

(ii) The requirement in section

41(d)(1)(C) that qualified research be

research ‘‘substantially all of the

activities of which constitute elements

of a process of experimentation’’;

(iii) The type of computer software

constituting software ‘‘which is

developed by (or for the benefit of) the

taxpayer primarily for internal use by

the taxpayer’’ for purposes of section

41(d)(4)(E); and

(iv) the documentation required to

substantiate the research credit. These

and other changes to TD 8930 are

discussed below.

I. Research That Is Undertaken for the

Purpose of Discovering Information

Which Is Technological in Nature

Section 41(d)(1)(B)(i) requires that

qualified research must be ‘‘undertaken

for the purpose of discovering

information which is technological in

nature.’’ TD 8930 provided that

‘‘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

Federal Register / Vol. 66, No. 247 / Wednesday, December 26, 2001 / Proposed Rules 66363

professionals in a particular field of

science or engineering’’ and that

‘‘information is technological in nature

if the process of experimentation used

to discover such information

fundamentally relies on principles of

the physical or biological sciences,

engineering, or computer science.’’

With respect to the phrase

‘‘undertaken for the purpose of

discovering information,’’ commentators

noted that § 1.174–2(a)(1) imposes a

requirement that a taxpayer’s activities

must be ‘‘intended to discover

information’’ in order to give rise to

research and experimental expenditures

under section 174, and that section

41(d)(1)(A) incorporates this

requirement because an expenditure

must qualify under section 174 in order

to give rise to the research credit.

Commentators argued that the

enactment of the section 41(d)(1)(B)

‘‘undertaken for the purpose of

discovering information’’ language

should not necessarily be viewed as

imposing a different standard than that

imposed under section 174 because the

section 174 ‘‘intended to discover

information’’ language was promulgated

in regulations after section 41(d)(1)(B)

was enacted.

Commentators also stated that the

requirement that qualified research be

‘‘undertaken for the purpose of

discovering information which is

technological in nature’’ reflects

Congress’ concern that the research

credit had been claimed for nontechnological research. These

commentators note that in 1984

hearings to evaluate the operation of the

research credit prior to the changes of

the Tax Reform Act of 1986, Public Law

99–514, 100 Stat. 2085, 2186 (the 1986

Act), members of the Subcommittee on

Oversight of the House Committee on

Ways and Means and Treasury officials

cited research credit claims by fast food

restaurants, fashion designers and hair

stylists as examples of activities that

should not be credit eligible. These

commentators argue that the 1986 Act

modifications to the research credit

were intended to target research that

relies upon principles of the physical or

biological sciences, engineering, or

computer science.

Based upon their review of these

comments, the statute and legislative

history, Treasury and the IRS have

determined that the definition of

qualified research set out in TD 8930

does not fully address Congress’

concerns regarding the importance of

research activities to the U.S. economy.

Accordingly, Treasury and the IRS have

eliminated in these proposed

regulations the requirement that

qualified research must be undertaken

to obtain knowledge that exceeds,

expands, or refines the common

knowledge of skilled professionals in a

particular field of science or

engineering. Rather, Treasury and the

IRS believe that the requirement that

qualified research be ‘‘undertaken for

the purpose of discovering information

which is technological in nature’’ is

intended to distinguish technological

research, which may qualify for the

research credit, from non-technological

research, which does not.

When the research credit rules were

amended by the 1986 Act, Congress

explained the requirement in section

41(d)(1)(B)(i) as follows:

[t]he 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/3/—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.

H.R. Conf. Rep. No. 99–841, at II–71

(1986) (footnote omitted). This

explanation of section 41(d)(1)(B)(i)

focuses on the distinction between

information derived from a process of

experimentation that fundamentally

relies on principles of physical or

biological sciences, engineering or

computer science, and information

derived by other means. This and other

changes to the research credit by the

1986 Act were driven by Congressional

concerns that the research credit had

been applied ‘‘too broadly’’ and that

‘‘[m]any taxpayers claiming the credit

were not in industries that involved

high technology or its application in

developing new and improved products

or methods of production.’’ H.R. Rep.

No. 99–426, at 177–78; S. Rep. No. 99–

313, at 694–95. The examples provided

by Congress illustrate this point.

Information relating to financial

services, variable annuities, legal forms

and advertising all involve information

derived from non-technological

research. This distinction between

technological and non-technological

research is further emphasized by other

changes made to the definition of

qualified research by the 1986 Act. For

example, section 41(d)(4)(D) specifically

excludes from the definition of qualified

research certain non-technical activities

including efficiency surveys, activities

relating to management function or

technique, market research testing,

routine data collection and quality

control testing. Similarly, section

41(d)(3)(B) generally provides that if the

purpose of research relates to style,

taste, cosmetic or seasonal design

factors, then that research cannot

constitute qualified research. The 1986

Act also expanded the list of social

science exclusions contained in section

41(d)(4)(G).

In contrast, the 1986 legislative

history does not indicate that section

41(d)(1)(B)(i) was enacted to impose a

scientific discovery requirement. The

legislative history does not contain a

definition of the term discovery. The

footnote 3 referenced in the above

quoted legislative history does state:

Research does not rely on the principles of

computer science merely because a computer

is employed. Research may be treated as

undertaken to discover information that is

technological in nature, however, if the

research is intended to expand or refine

existing principles of computer science.

H.R. Conf. Rep. No. 99–841, at II–71, n.3

(1986). This footnote, however, does not

set forth a rule of general application,

but instead merely illustrates a clear

example of research satisfying the

requirement that qualified research be

technological in nature.

For all of these reasons, Treasury and

the IRS have concluded that there

should be no ‘‘discovery’’ requirement

in the research credit regulations

separate and apart from that already

required under § 1.174–2(a)(1), which

states, in part:

Expenditures represent research and

development 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.

Accordingly, these proposed regulations

do not retain from TD 8930 the

requirement that qualified research

must be undertaken to obtain

knowledge that exceeds, expands, or

refines the common knowledge of

skilled professionals in a particular field

of science or engineering. Instead, the

proposed regulations repeat the

requirement from § 1.174–2(a)(1) by

stating that research is undertaken for

the purpose of discovering information

if it is intended to eliminate uncertainty

concerning the development or

improvement of a business component.

Uncertainty, for purposes of this

requirement, exists if the information

66364 Federal Register / Vol. 66, No. 247 / Wednesday, December 26, 2001 / Proposed Rules

available to the taxpayer does not

establish the capability or method of

developing or improving the business

component, or the appropriate design of

the business component.

These proposed regulations expand

on the definition of technological in

nature set out in TD 8930. As under TD

8930, information is technological in

nature if the process of experimentation

used to discover such information

fundamentally relies on principles of

the physical or biological sciences,

engineering, or computer science. As in

TD 8930, these proposed regulations

clarify the definition of technological in

nature by stating that a taxpayer may

employ existing technologies and may

rely on existing principles of the

physical or biological sciences,

engineering, or computer science to

satisfy this requirement.

TD 8930 contained a patent safe

harbor providing that a taxpayer is

conclusively presumed to have obtained

knowledge that exceeds, expands, or

refines the common knowledge of

skilled professionals in the relevant

field of science or engineering, if that

taxpayer was awarded a patent (other

than a patent for design issued under

the provisions of 35 U.S.C. 171) for the

business component. These proposed

regulations contain a similar rule that

conforms to the underlying requirement

for credit eligibility in section

41(d)(1)(B)(i) that research must be

undertaken for the purpose of

discovering information that is

technological in nature. Accordingly,

these proposed regulations provide that

a taxpayer is conclusively presumed to

have discovered information that is

technological in nature that is intended

to eliminate uncertainty concerning the

development or improvement of a

business component if that taxpayer was

awarded a patent (other than a patent

for design issued under the provisions

of 35 U.S.C. 171) for the business

component.

II. Process of Experimentation

Together with the requirements of

section 41(d)(1)(A) and (B), section

41(d)(1)(C) provides that qualified

research means research substantially

all of the activities of which constitute

elements of a process of

experimentation related to a new or

improved function, performance, or

reliability or quality. In TD 8930,

Treasury and the IRS clarified how the

process of experimentation required by

section 41(d)(1)(C) differs from research

and development in the experimental or

laboratory sense required by § 1.174–

2(a). Specifically, TD 8930 provided that

a process of experimentation is a

process to evaluate more than one

alternative designed to achieve a result

where the capability or method of

achieving that result is uncertain at the

outset, but does not include the

evaluation of alternatives to establish

the appropriate design of a business

component when the capability and

method for developing or improving the

business component are not uncertain.

Several commentators objected to any

distinction regarding the design of a

business component and cited examples

from the legislative history which these

commentators contend show that the

determination of the appropriate design

of a business component involved a

process of experimentation.

Treasury and the IRS continue to

believe that the requirements for a

process of experimentation under

section 41 are more stringent than the

requirements for research and

development in the experimental or

laboratory sense under § 1.174–2(a)(1).

However, Treasury and the IRS have

determined that a process of

experimentation may exist if a taxpayer

performs research to establish the

appropriate design of a business

component when the capability and

method for developing or improving the

business component are not uncertain.

As is discussed in more detail below,

not all research to arrive at the

appropriate design of a business

component will be credit eligible.

These proposed regulations provide

that a process of experimentation is a

process designed to evaluate one or

more alternatives to achieve a result

where the capability or the method of

achieving that result, or the appropriate

design of that result, is uncertain as of

the beginning of the taxpayer’s research

activities. Whether a taxpayer has

undertaken a process of

experimentation is a facts and

circumstances determination. The

proposed regulations provide factors

that are indicative of a process of

experimentation. The factors listed are

not exclusive, and no one factor is

dispositive.

A taxpayer’s activities do not

constitute elements of a process of

experimentation where the capability

and method of achieving the desired

new or improved business component,

and the appropriate design of the

desired new or improved business

component, are readily discernible and

applicable as of the beginning of the

taxpayer’s research activities so that true

experimentation in the scientific or

laboratory sense would not have to be

undertaken to test, analyze, and choose

among viable alternatives. Similarly, a

process of experimentation does not

include merely selecting among several

alternatives that are readily discernible

and applicable. The fact that a taxpayer

conducts only rudimentary or nontechnological testing in order to develop

or improve a business component tends

to indicate that the appropriate design

of the business component was readily

discernible and applicable at the outset

within the meaning of these rules.

TD 8930 provided that the

substantially all requirement of section

41(d)(1)(C) is satisfied only if 80 percent

or more of the research activities,

measured on a cost or other consistently

applied reasonable basis (and without

regard to § 1.41–2(d)(2)), constitute

elements of a process of

experimentation for a purpose described

in section 41(d)(3). The substantially all

requirement is applied separately to

each business component. These

proposed regulations retain the same

rule. Treasury and the IRS, however,

request comments on the application of

the substantially all rule. Treasury and

the IRS are specifically interested in

comments on whether research

expenses incurred for non-qualified

purposes are includible in the credit

computation provided that substantially

all of the research expenses constitute

elements of a process of

experimentation.

III. Internal Use Software

Section 41(d)(4)(E) provides that,

except to the extent provided by

regulations, research with respect to

‘‘computer software which is developed

by (or for the benefit of) the taxpayer

primarily for internal use by the

taxpayer’’ (i.e., internal-use software) is

excluded from the definition of

qualified research. TD 8930 provided

that the development of internal-use

software constitutes qualified research

only if the research satisfies both the

general requirements for credit

eligibility under section 41 (including

that the research not be otherwise

excluded) and an additional, three-part

high threshold of innovation test. TD

8930 defined internal-use software as

software that is to be used internally,

such as software used in general and

administrative functions of the taxpayer,

or in providing noncomputer services.

Noncomputer services are services

offered by a taxpayer to customers who

do business with the taxpayer primarily

to obtain a service other than a

computer service, even if such other

service is enabled, supported, or

facilitated by computer or software

technology. TD 8930, however,

contained an exception to this rule that

provides that internal-use software does

not include software that is designed to

Federal Register / Vol. 66, No. 247 / Wednesday, December 26, 2001 / Proposed Rules 66365

provide customers with a new feature,

not available from the taxpayer’s

competitors, with respect to a

noncomputer service and that the

taxpayer reasonably anticipates will

give rise to increased customer demand

for the noncomputer service.

The high threshold of innovation test

in TD 8930 generally required that (i)

the internal-use software be innovative;

(ii) the development of the internal-use

software involve significant economic

risk; and (iii) the internal-use software

not be commercially available. The high

threshold of innovation test, however,

does not apply with respect to the

development of software (i) for use in

conducting qualified research; (ii) for

use in a production process; (iii) for use

as part of a package of hardware and

software developed concurrently; and

(iv) for use in providing computer

services to customers. Computer

services are services offered by a

taxpayer to customers who do business

with the taxpayer primarily for the use

of the taxpayer’s computer or software

technology.

In response to Notice 2001–19, several

commentators objected to the internaluse software provisions of TD 8930.

After reviewing the legislative history to

the 1986 Act, the Tax and Trade Relief

Extension Act of 1998, Public Law 105–

277, 112 Stat. 2681, 2681–888 (the 1998

Act), and the Tax Relief Extension Act

of 1999, Public Law 106–170, 113 Stat.

1860, 1919, together with the comment

letters, Treasury and the IRS made

several changes to the internal-use

software rules. These proposed

regulations clarify the definition of

internal-use software contained in TD

8930 as well as the exceptions to this

definition and the types of software that

are not required to satisfy the high

threshold of innovation test. These

changes are discussed below.

Internal-Use Software Defined

Under these proposed regulations,

software that is developed by (or for the

benefit of) the taxpayer primarily to be

commercially sold, leased, licensed, or

otherwise marketed, for separately

stated consideration to unrelated third

parties is not treated as internal use

software. All other software is presumed

to be developed by (or for the benefit of)

the taxpayer primarily for the taxpayer’s

internal use. This distinction reflects the

view that software that is sold, leased,

licensed, or otherwise marketed, for

separately stated consideration to

unrelated third parties is software that

is intended to be used primarily by the

customers of the taxpayer, whereas

software that does not satisfy this

requirement is software that is intended

to be used primarily by the taxpayer for

its internal use or in connection with a

noncomputer service provided by the

taxpayer.

These proposed regulations retain the

provision in TD 8930 that excluded

from the definition of internal-use

software computer software and

hardware developed as a single product.

This rule, however, has been modified

in response to a commentator’s

suggestion that some purchasers of

combined software and hardware

packages may develop their own

computer software to operate the

package or modify the imbedded

computer software. Because the

computer software is an integral part of

the hardware, these commentators urged

that the computer software/hardware

rule should be extended to these

development costs. Treasury and the

IRS agree that, provided the computer

software is developed to be used with

hardware as a single product and the

activities are otherwise credit-eligible

and not excluded under another

provision (e.g., section 41(d)(4)(B)), the

computer software/hardware rule

should extend to these development

costs. Thus, under these proposed

regulations, internal-use software does

not include a new or improved package

of computer software and hardware

developed together by the taxpayer as a

single product (or to the costs to modify

an acquired computer software and

hardware package), of which the

software is an integral part, that is used

directly by the taxpayer in providing

services in its trade or business to

customers.

High Threshold of Innovation Test

These proposed regulations retain the

general rule contained in TD 8930 that

internal-use software must satisfy the

general requirements for credit

eligibility (and not be excluded from the

definition of qualified research under

any other exclusion) and the three-part

high threshold of innovation test. These

proposed regulations clarify the first

prong of the three-part test by providing

that internal-use software is innovative

if the software is intended to be unique

or novel and is intended to differ in a

significant and inventive way from prior

software implementations or methods.

This change is being proposed pursuant

to the authority provided in section

41(d)(4)(E) and the legislative history

thereunder in order to update the

definition of innovative contained in TD

8930. The TD 8930 definition was

derived from the legislative history to

the 1986 Act and required that the

software be intended to result in a

reduction in cost, improvement in

speed, or other improvement, that is

substantial and economically

significant. Treasury and the IRS

became concerned that the elements of

the TD 8930 definition, while perhaps

reflecting innovations in computer

software in the mid-1980s, did not

adequately reflect the factors that

indicate that software is innovative

today. The proposed change, therefore,

is an attempt both to update the

definition of innovative, and to provide

a more flexible definition with

continuing application. Several

examples were added to these proposed

regulations to illustrate the application

of this proposed rule. The second and

third prongs of the high threshold of

innovation test (i.e., significant

economic risk and commercial

availability) remain unchanged from TD

8930.

Software Not Required To Satisfy the

High Threshold of Innovation Test

Like TD 8930, these proposed

regulations provide that software is not

required to satisfy the high threshold of

innovation test if the software was

developed by the taxpayer for use in an

activity that constitutes qualified

research (other than the development of

the internal-use software itself), a

production process that meets the

requirements of section 41(d)(1), or in

providing computer services to

customers. These proposed regulations,

however, eliminate the special rule

contained in TD 8930 for software used

to deliver noncomputer services to

customers with features that are not yet

offered by a taxpayer’s competitors.

Several commentators stated that this

rule is too limited and subjective in its

application to have significant value to

taxpayers. Due to other revisions

contained in these proposed regulations,

Treasury and the IRS believe that the

computer software targeted by this rule

generally would be credit eligible

without this rule.

Several commentators objected to the

distinction between computer services

and noncomputer services and urged

that the definition of internal-use

software exclude any software used to

deliver a service to customers or any

software that includes an interface with

customers or the public. An exclusion

for software that includes an interface

with customers or the public would

entail substantial administrative

difficulties and may inappropriately

permit certain categories of costs (e.g.,

certain web site development costs) to

constitute qualified research expenses

without having to satisfy the high

threshold of innovation test.

66366 Federal Register / Vol. 66, No. 247 / Wednesday, December 26, 2001 / Proposed Rules

With respect to software developed by

a taxpayer for use in a production

process satisfying the requirements of

section 41(d)(1), comments from service

providers urged Treasury and the IRS to

give service providers the same benefits

as manufacturing companies. Congress

provided an explicit exclusion for

software developed for use in a

production process; however, it did not

provide a similar exclusion for software

used in the provision of noncomputer

services. Therefore, Treasury and the

IRS conclude that software used in the

provision of noncomputer services

generally should be subject to the

internal-use software requirements.

Effective Date

Treasury and the IRS propose the

revisions to the internal-use software

rules to be effective for taxable years

beginning after December 31, 1985.

Treasury and the IRS believe that the

proposed rule is consistent with the

legislative history and the legislative

mandate for retroactive application of

the rule. Taxpayers, however, may

continue to rely on TD 8930 until

regulations are finalized.

IV. Shrinking-Back Rule

TD 8930 contained a special

shrinking-back rule. These proposed

regulations revise the shrinking-back

rule to conform it to the rule in the

legislative history to the 1986 Act.

These proposed regulations also

reiterate that the shrinking-back rule

may not itself be applied as a reason to

exclude research activities from credit

eligibility.

V. Other Exclusions

Several commentators raised issues

concerning activities excluded from the

definition of qualified research. In

particular, the commentators were

concerned about the research after

commercial production exclusion.

Because the rules contained in § 1.41–

4(c) of TD 8930 closely reflected the

legislative history regarding postresearch activities, these proposed

regulations retain the rules contained in

TD 8930. See H.R. Conf. Rep. No. 99–

841, at II–74–75. However, new

examples are included to illustrate the

application of the exclusions. Treasury

and the IRS request comments

concerning the application of the

exclusions and the extent to which

additional guidance concerning the

exclusions may be helpful.

VI. Gross Receipts

When Congress revised the

computation of the research credit to

incorporate a taxpayer’s gross receipts,

neither the statute nor the legislative

history defined the term gross receipts,

other than to provide that gross receipts

for any taxable year are reduced by

returns and allowances made during the

tax year, and, in the case of a foreign

corporation, that only gross receipts

effectively connected with the conduct

of a trade or business within the United

States are taken into account. See

section 41(c)(6).

TD 8930 adopted a broad definition of

the term gross receipts for purposes of

computing the research credit. TD 8930

generally defined gross receipts as the

total amount derived by a taxpayer from

all activities and sources. In addition,

because certain extraordinary gross

receipts might not be taken into account

when a business determines its research

budget, TD 8930 provided that certain

items (e.g., receipts from the sale or

exchange of capital assets, or

repayments of loans or similar

instruments) would be excluded from

the computation of gross receipts.

Further, TD 8930 excluded from the

definition of gross receipts any income

derived 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.

In response to Notice 2001–19, some

commentators suggested that the

definition of gross receipts created an

administrative burden to the extent that

taxpayers would be obligated to apply

the definition of the term for the four

years preceding the determination years

as well as to the 1984 through 1988 base

years.

These proposed regulations retain the

definition of gross receipts contained in

TD 8930. Treasury and the IRS continue

to believe that the definition of gross

receipts should be construed broadly

and that the definition of gross receipts

in TD 8930 is appropriate for purposes

of computing the research credit.

Further, Treasury and the IRS believe

that the administrative burden referred

to by commentators is due to the

incremental nature of the credit and the

statutorily determined base years, and

not to the definition of gross receipts.

VII. Recordkeeping for the Research

Credit

Under TD 8930, taxpayers were

required to prepare and retain written

documentation before or during the

early stages of the research project that

describes the principal questions to be

answered and the information the

taxpayer seeks to obtain that exceeds,

expands, or refines the common

knowledge of skilled professionals in

the relevant field of science or

engineering. These proposed regulations

eliminate this recordkeeping

requirement.

Treasury and the IRS recognize that

the research credit presents a particular

burden for taxpayers because tracking

eligible expenditures may necessitate

taxpayers preparing and keeping records

unlikely to be prepared or kept for other

business purposes. The fact that the

records are not prepared or kept for

other business purposes has made

administration of the research credit

burdensome for the IRS. Moreover,

section 41 often requires an allocation

between qualifying and non-qualifying

costs that is difficult for taxpayers to

make and for the IRS to administer.

Nevertheless, when the research

credit was extended in 1999, Congress

made clear that the credit should not

impose unreasonable recordkeeping

requirements:

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 recordkeeping

requirements.

H.R. Conf. Rep. No. 106–478, at 132

(1999). Treasury and the IRS have reevaluated whether a research creditspecific documentation requirement is

warranted and have concluded that the

high degree of variability in the

objectives and conduct of research

activities in the United States compels

a conclusion that taxpayers must be

provided reasonable flexibility in the

manner in which they substantiate their

research credits. Accordingly, Treasury

and the IRS have concluded that the

failure to keep records in a particular

manner (so long as such records are in

sufficiently usable form and detail to

substantiate that the expenditures

claimed are eligible for the credit)

cannot serve as a basis for denying the

credit. Treasury and the IRS have

decided that the rules generally

applicable under section 6001 provide

sufficient detail about required

documentary substantiation for

purposes of the research credit.

Consequently, no separate research

credit-specific documentation

requirement is included in these

proposed regulations.

Section 1.6001–1 requires the keeping

of records ‘‘sufficient to establish the

amount of * * * credits, * * * required

to be shown * * *.’’ The consequence

of failing to keep sufficient records

substantiating a claimed credit may be

denial of the credit. To address any

ongoing recordkeeping concerns

regarding the research credit, Treasury

and the IRS propose to use pre-filing

Federal Register / Vol. 66, No. 247 / Wednesday, December 26, 2001 / Proposed Rules 66367

processes, including industry issue

resolution, pre-filing agreements,

determination letters, and record

retention agreements, to provide

certainty to taxpayers about the records

that must be kept and to ensure the

availability to the IRS of the records

necessary to examine taxpayers’ returns

expeditiously. Treasury and the IRS

solicit comments from taxpayers on

establishing recordkeeping rules that

will facilitate compliance and

administration, including whether prefiling agreements should extend to the

qualification of particular cost centers or

to the procedures established by the

taxpayer for determining the

expenditures qualifying for the credit.

Treasury and the IRS also solicit

comments from taxpayers on the extent

to which guidelines may be developed

on an industry-by-industry basis.

Proposed Effective Dates

Except as specifically provided in

§ 1.41–4(c)(6)(ix), the proposed

amendments to § 1.41–4 are proposed to

apply to taxable years ending on or after

December 26, 2001. Notwithstanding

this prospective effective date, Treasury

and the IRS believe that these rules

prescribe the proper treatment of the

expenditures they address, and the IRS

generally will not challenge return

positions consistent with the proposed

regulations. Therefore, taxpayers may

rely on these proposed regulations until

the date final regulations under § 1.41–

4 are published in the Federal Register.

Special Analyses

It has been determined that this notice

of proposed rulemaking is not a

significant regulatory action as defined

in Executive Order 12866. It also has

been determined that section 533(b) of

the Administrative Procedures Act (5

U.S.C. chapter 5) does not apply to these

regulations, and because these

regulations do not impose a collection

of information on small entities, the

Regulatory Flexibility Act (5 U.S.C.

chapter 6) does not apply. Therefore, a

Regulatory Flexibility Analysis is not

required. Pursuant to section 7805(f) of

the Internal Revenue Code, this notice

of proposed rulemaking will be

submitted to the Chief Counsel for

Advocacy of the Small Business

Administration for comment on its

impact on small business.

Comments and Public Hearing

Before these proposed regulations are

adopted as final regulations,

consideration will be given to any

electronic and written comments (a

signed original and eight (8) copies) that

are submitted timely to the IRS. The IRS

and the Treasury Department

specifically request comments on the

clarity of the proposed regulations and

how they may be made easier to

understand. All comments will be

available for public inspection and

copying. All comments will be available

for public inspection and copying.

A public hearing has been scheduled

for March 27, 2002, at 10 a.m. in the IRS

Auditorium (7th Floor), Internal

Revenue Building, 1111 Constitution

Avenue, NW., Washington, DC. Because

of access restrictions, visitors will not be

admitted beyond the building lobby

more than 15 minutes before the hearing

starts.

The rules of 26 CFR 601.601(a)(3)

apply to the hearing.

Persons that wish to present oral

comments at the hearing must submit

(in the manner described in the

ADDRESSES portion of this preamble)

comments and an outline of the topics

to be discussed and the time to be

devoted to each topic by March 6, 2002.

A period of 10 minutes will be

allotted to each person for making

comments.

An agenda showing the scheduling of

the speakers will be prepared after the

deadline for receiving outlines has

passed. Copies of the agenda will be

available free of charge at the hearing.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and

recordkeeping requirements.

Proposed Amendments to the

Regulations

Accordingly, 26 CFR part 1 is

proposed to be amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation

for part 1 continues to read in part as

follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.41–0 is amended as

follows:

1. Revising the section heading for

1.41–3.

2. Revising the entries for 1.41–4.

3. Revising the section heading for

1.41–8.

§ 1.41–0 Table of contents.

* * * * *

§ 1.41–3 Base amount for taxable years

ending on or after December 26, 2001.

* * * * *

§ 1.41–4 Qualified research for

expenditures paid or incurred in taxable

years ending on or after December 26, 2001.

(a) Qualified research.

(1) General rule.

(2) Requirements of section 41(d)(1).

(3) Undertaken for the purpose of

discovering information.

(i) In general.

(ii) Application of the discovering

information requirement.

(iii) Patent safe harbor.

(4) Technological in nature.

(5) Process of experimentation.

(i) In general.

(ii) Readily discernible capability, method

and appropriate design.

(iii) Qualified purpose.

(iv) Factors tending to indicate that the

taxpayer has engaged in a process of

experimentation.

(6) Substantially all requirement.

(i) General rule.

(ii) Illustrations. [Reserved]

(7) Use of computers and information

technology.

(8) Illustrations.

(b) Application of requirements for

qualified research.

(1) In general.

(2) Shrinking-back rule.

(3) Illustration.

(c) Excluded activities.

(1) In general.

(2) Research after commercial production.

(i) In general.

(ii) Certain additional activities related to

the business component.

(iii) Activities related to production

process or technique.

(iv) Clinical testing.

(3) Adaptation of existing business

components.

(4) Duplication of existing business

component.

(5) Surveys, studies, research relating to

management functions, etc.

(6) Internal use software for taxable years

beginning on or after December 31, 1985.

(i) General rule.

(ii) Requirements.

(iii) Computer software and hardware

developed as a single product.

(iv) Primarily for internal use.

(v) Software used in the provision of

services.

(A) Computer services.

(B) Noncomputer services.

(vi) High threshold of innovation test.

(vii) Application of high threshold of

innovation test.

(viii) Illustrations.

(ix) Effective date.

(7) Activities outside the United States,

Puerto Rico, and other possessions.

(i) In general.

(ii) Apportionment of in-house research

expenses.

(iii) Apportionment of contract research

expenses.

(8) Research in the social sciences, etc.

(9) Research funded by any grant, contract,

or otherwise.

(10) Illustrations.

(d) Recordkeeping for the research credit.

(e) Effective dates.

* * * * *

§ 1.41–8 Special rules for taxable years

ending on or after December 26, 2001.

Par. 3. Section 1.41–3 is amended by:

66368 Federal Register / Vol. 66, No. 247 / Wednesday, December 26, 2001 / Proposed Rules

1. Revising the section heading.

2. Revising paragraph (e).

The revisions read as follows:

§ 1.41–3 Base amount for taxable years

ending on or after December 26, 2001.

* * * * *

(e) Effective date. The rules of this

section are applicable for taxable years

ending on or after the date December 21,

2001.

Par. 4. Section 1.41–4 is revised to

read as follows:

§ 1.41–4 Qualified research for

expenditures paid or incurred in taxable

years ending on or after December 26, 2001.

(a) Qualified research—(1) General

rule. Research activities related to the

development or improvement of a

business component constitute qualified

research only if the research activities

meet all of the requirements of section

41(d)(1) and this section, and are not

otherwise excluded under section

41(d)(3)(B) or (d)(4), or this section.

(2) Requirements of section 41(d)(1).

Research constitutes qualified research

only if it is research—

(i) With respect to which

expenditures may be treated as expenses

under section 174, see § 1.174–2;

(ii) That is undertaken for the purpose

of discovering information that 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; and

(iii) Substantially all of the activities

of which constitute elements of a

process of experimentation that relates

to a new or improved function,

performance, reliability or quality.

(3) Undertaken for the purpose of

discovering information—(i) In general.

For purposes of section 41(d) and this

section, research must be undertaken for

the purpose of discovering information

that is technological in nature. Research

is undertaken for the purpose of

discovering information 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.

(ii) Application of the discovering

information requirement. A

determination that research is

undertaken for the purpose of

discovering information that is

technological in nature does not require

the taxpayer 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.

In addition, a determination that

research is undertaken for the purpose

of discovering information that is

technological in nature does not require

that the taxpayer succeed in developing

a new or improved business component.

(iii) Patent safe harbor. For purposes

of section 41(d) and paragraph (a)(3)(i)

of this section, the issuance of a patent

by the Patent and Trademark Office

under the provisions of 35 U.S.C. 151

(other than a patent for design issued

under the provisions of 35 U.S.C. 171)

is conclusive evidence that a taxpayer

has discovered information that is

technological in nature that is intended

to eliminate uncertainty concerning the

development or improvement of a

business component. However, the

issuance of such a patent is not a

precondition for credit availability.

(4) Technological in nature. For

purposes of section 41(d) and this

section, information is technological in

nature if the process of experimentation

used to discover such information

fundamentally relies on principles of

the physical or biological sciences,

engineering, or computer science. A

taxpayer may employ existing

technologies and may rely on existing

principles of the physical or biological

sciences, engineering, or computer

science to satisfy this requirement.

(5) Process of experimentation—(i) In

general. For purposes of section 41(d)

and this section, a process of

experimentation is a process designed to

evaluate one or more alternatives to

achieve a result where the capability or

the method of achieving that result, or

the appropriate design of that result, is

uncertain as of the beginning of the

taxpayer’s research activities. Thus, 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. However, a process

of experimentation does not include the

evaluation of alternatives to achieve the

desired result if the capability and

method of achieving the desired result,

and the appropriate design of the

desired result, are readily discernible

and applicable as of the beginning of the

taxpayer’s research activities. A process

of experimentation may include

developing one or more hypotheses

designed to achieve the desired result,

designing and conducting an

experiment to test and analyze those

hypotheses, and refining or discarding

the hypotheses as part of a design

process to develop or improve the

business component. For purposes of

this paragraph (a)(5), factors that tend to

indicate that the taxpayer has engaged

in a process of experimentation are

listed in paragraph (a)(5)(iv) of this

section.

(ii) Readily discernible capability,

method and appropriate design. A

taxpayer’s activities do not constitute

elements of a process of

experimentation where the capability

and method of achieving the desired

new or improved business component,

and the appropriate design of the

desired new or improved business

component, are readily discernible and

applicable as of the beginning of the

taxpayer’s research activities, so that

true experimentation in the scientific or

laboratory sense would not have to be

undertaken to test, analyze, and choose

among viable alternatives. A process of

experimentation does not include any

activities to select among several

alternatives that are readily discernible

and applicable.

(iii) Qualified purpose. For purposes

of section 41(d) and this section, a

process of experimentation is

undertaken for a qualified purpose if it

relates to a new or improved function,

performance, reliability or quality of the

business component. Research will not

be treated as conducted for a qualified

purpose if it relates to style, taste,

cosmetic, or seasonal design factors.

(iv) Factors tending to indicate that

the taxpayer has engaged in a process

of experimentation. For purposes of

section 41(d) and this section, in

determining whether a taxpayer has

undertaken a process of

experimentation, all facts and

circumstances with respect to a

taxpayer’s research activities are taken

into account. No one factor is

dispositive in making this

determination. Further, it is not

intended that only the factors described

in this paragraph are to be taken into

account in making the determination.

Thus, no inference should be drawn

from the taxpayer’s failure to satisfy any

or all of the factors. Among the factors

that tend to indicate that the taxpayer

has engaged in a process of

experimentation are—

(A) The taxpayer tests and analyzes

numerous alternative hypotheses to

develop a new or improved business

component;

(B) The taxpayer engages in extensive,

comprehensive, intricate or complex

scientific or laboratory testing; or

(C) The taxpayer evaluates numerous

or complex specifications related to the

Federal Register / Vol. 66, No. 247 / Wednesday, December 26, 2001 / Proposed Rules 66369

function, performance, reliability or

quality of a new or improved business

component.

(6) Substantially all requirement—(i)

General rule. The substantially all

requirement of section 41(d)(1)(C) and

paragraph (a)(2)(iii) of this section is

satisfied only if 80 percent or more of

the research activities, measured on a

cost or other consistently applied

reasonable basis (and without regard to

§ 1.41–2(d)(2)), constitute elements of a

process of experimentation for a

purpose described in section 41(d)(3).

The substantially all requirement is

applied separately to each business

component.

(ii) Illustrations. [Reserved]

(7) Use of computers and information

technology. The employment of

computers or information technology, or

the reliance on principles of computer

science or information technology to

store, collect, manipulate, translate,

disseminate, produce, distribute, or

process data or information, and similar

uses of computers and information

technology does not itself establish that

qualified research has been undertaken.

(8) Illustrations. The following

examples illustrate the application of

paragraph (a)(5) of this section:

Example 1. (i) Facts. X is engaged in the

business of developing and manufacturing

widgets. X wants to change the color of its

blue widget to green. X obtains from various

suppliers several different shades of green

paint. X paints several sample widgets, and

surveys X’s customers to determine which

shade of green X’s customers prefer.

(ii) Conclusion. X’s activities to change the

color of its blue widget to green are not

qualified research under section 41(d)(1) and

paragraph (a)(5) of this section because

substantially all of X’s activities are not

undertaken for a qualified purpose. All of X’s

research activities are related to style, taste,

cosmetic, or seasonal design factors.

Example 2. (i) Facts. X is engaged in the

business of manufacturing widgets and wants

to change the color of its blue widget to

green. X obtains samples of green paint from

a supplier and determines that X must

modify its painting process to accommodate

the green paint because the green paint has

different characteristics from other paints X

has used. X obtains detailed data on the

green paint from X’s paint supplier. X also

consults with the manufacturer of X’s paint

spraying machines and determines that X

must acquire new nozzles that are designed

to operate with paints similar to the green

paint X wants to use. X installs the new

nozzles on its paint spraying machines and

tests the nozzles to ensure that to ensure that

they work as specified by the manufacturer

of the paint spraying machines.

(ii) Conclusion. X’s activities to modify its

painting process is a separate business

component under section 41(d)(2)(A). X’s

activities to modify its painting process by

installing new nozzles on its paint spraying

machines to change the color of its blue

widget to green are not qualified research

under section 41(d)(1) and paragraph (a)(5) of

this section. The capability, method and

appropriate design of the changes to X’s

painting process are readily discernible and

applicable to X as of the beginning of X’s

activities. X’s activities to test the nozzles to

determine if the nozzles work as specified by

the manufacturer of the paint spraying

machines are not the type of testing activities

that tend to indicate that a process of

experimentation was undertaken.

Example 3. (i) Facts. X is engaged in the

business of manufacturing food products and

currently manufactures a large-shred version

of a product. Because X’s competitors

manufacture both a large-shred and fineshred version of comparable food products,

X seeks to modify its current production line

to permit it to manufacture both a large-shred

version and fine-shred version of one of its

own food products. A shredding blade

capable of producing a fine-shred version of

the food product is not commercially

available. Thus, X must develop a new

shredding blade that can be fitted onto X’s

current production line. X must test and

analyze numerous alternative hypotheses to

determine whether a new shredding blade

must be constructed of a different material

from that of its existing shredding blade. In

addition, X must engage in comprehensive

and complex scientific or laboratory testing

to ensure that its modified production

process, with the newly-developed shredding

blade, can accommodate the manufacture of

both the large-shred and fine-shred versions

of X’s food products.

(ii) Conclusion. X’s activities to modify its

current production line meet the

requirements of qualified research as set forth

in paragraph (a)(2) of this section.

Substantially all of X’s activities constitute

elements of a process of experimentation

because X must evaluate more than one

alternative to achieve a result where the

method and appropriate design are uncertain

as of the beginning of the taxpayer’s research

activities. X must test and analyze numerous

alternative hypotheses and engage in

comprehensive and complex scientific or

laboratory testing to ensure that its modified

production process, with a newly-developed

shredding blade, can accommodate the

manufacture of both the large-shred and fineshred versions of X’s food products.

Example 4. (i) Facts. X operates wireless

networks in several U.S. cities. X discovers

in City a service problem and collects data

on the nature of the problem. X analyzes the

data and knows, based on its previous

experience with wireless networks in other

cities, that the installation of a new type of

gateway will eliminate the problem. X

installs the new gateway in its City network.

(ii) Conclusion. X’s activities to determine

a solution to its service problem are not

qualified research under section 41(d)(1) and

paragraph (a)(5) of this section. Substantially

all of X’s research activities do not constitute

elements of a process of experimentation

because the solution to the service problem

is readily discernible and applicable by X as

of the beginning of X’s research activities.

Example 5. (i) Facts. X is engaged in the

business of manufacturing and selling

automobiles. X incorporated into one of its

new vehicles a new exhaust system that it

designed. After X offered the vehicle for sale,

X received complaints of a rattling noise that

could be heard in the passenger

compartment. X’s engineers determined that

the cause of the noise was the exhaust system

coming into contact with the undercarriage of

the vehicle. Based on previous experience

with similar noise problems, X’s engineers

knew of two safe, effective, reliable solutions

that would eliminate the noise. X’s engineers

selected one of the solutions based on cost

studies that indicated it would be the less

expensive alternative.

(ii) Conclusion. X’s activities to eliminate

the rattling noise are not qualified research

under section 41(d)(1) and paragraph (a)(5) of

this section. Substantially all of X’s research

activities do not constitute elements of a

process of experimentation because the

solution is readily discernible and applicable

to X as of the beginning of X’s activities.

Example 6. (i) Facts. X is in the business

of designing, developing and manufacturing

automobiles and decides to update one of its

current model vehicles. In response to

government-mandated fuel economy

requirements, X undertakes to improve

aerodynamics by lowering the hood of the

current model vehicle. X determines that

lowering the hood changes the air flow under

the hood, which changes the rate at which air

enters the engine through the air intake

system, and which reduces the functionality

of the cooling system. X designs, models,

tests, refines, and re-tests proposed

modifications to both the air intake system

and cooling system until modifications are

developed that meet X’s requirements. X then

integrates the modified air intake and cooling

systems into a current model vehicle with a

lower hood, modifying in the process the

new air intake and cooling systems as well

as the underhood wiring, brake lines and fuel

line. X conducts extensive and complex

scientific or laboratory testing to determine if

the current model vehicle meets X’s

requirements. X conducts extensive and

complex scientific or laboratory testing

(including simulations and crash tests) to

determine if the current model vehicle meets

X’s requirements.

(ii) Conclusion. X’s activities to update its

vehicle meet the requirements of qualified

research as set forth in paragraph (a)(2) of

this section. X must test and analyze

numerous alternative hypotheses, engage in

extensive testing and analysis, and evaluate

complex specifications related to the

functionality of several of the vehicle’s

underhood systems and to the vehicle’s

overall performance. These activities indicate

that X undertook a process of

experimentation to achieve the appropriate

design of the updated vehicle.

(b) Application of requirements for

qualified research—(1) In general. The

requirements for qualified research in

section 41(d)(1) and paragraph (a) of this

section, must be applied separately to

each business component, as defined in

section 41(d)(2)(B). In cases involving

development of both a product and a

manufacturing or other commercial

66370 Federal Register / Vol. 66, No. 247 / Wednesday, December 26, 2001 / Proposed Rules

production process for the product,

research activities relating to

development of the process are not

qualified research unless the

requirements of section 41(d) and this

section are met for the research

activities relating to the process without

taking into account the research

activities relating to development of the

product. Similarly, research activities

relating to development of the product

are not qualified research unless the

requirements of section 41(d) and this

section are met for the research

activities relating to the product without

taking into account the research

activities relating to development of the

manufacturing or other commercial

production process.

(2) Shrinking-back rule. The

requirements of section 41(d) and

paragraph (a) of this section are to be

applied first at the level of the discrete

business component, that is, the

product, 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 the requirements for

credit eligibility are met at that first

level, then some or all of the taxpayer’s

qualified research expenses are eligible

for the credit. 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,

process, computer software, technique,

formula, or invention to be held for sale,

lease, or license. 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. This shrinking-back rule is

applied only if a taxpayer does not

satisfy the requirements of section

41(d)(1) and paragraph (a)(2) of this

section with respect to the overall

business component. The shrinkingback rule is not itself applied as a reason

to exclude research activities from

credit eligibility.

(3) Illustration. The following

example illustrates the application of

this paragraph (b):

Example. X, a motorcycle engine builder,

develops a new carburetor for use in a

motorcycle engine. X also modifies an

existing engine design for use with the new

carburetor. Under the shrinking-back rule,

the requirements of section 41(d)(1) and

paragraph (a) of this section are applied first

to the engine. If the modifications to the

engine when viewed as a whole, including

the development of the new carburetor, do

not satisfy the requirements of section

41(d)(1) and paragraph (a) of this section,

those requirements are applied to the next

most significant subset of elements of the

business component. Assuming that the next

most significant subset of elements of the

engine is the carburetor, the research

activities in developing the new carburetor

may constitute qualified research within the

meaning of section 41(d)(1) and paragraph (a)

of this section.

(c) Excluded activities—(1) In general.

Qualified research does not include any

activity described in section 41(d)(4)

and paragraph (c) of this section.

(2) Research after commercial

production—(i) In general. Activities

conducted after the beginning of

commercial production of a business

component are not qualified research.

Activities are conducted after the

beginning of commercial production of

a business component if such activities

are conducted after the component is

developed to the point where it is ready

for commercial sale or use, or meets the

basic functional and economic

requirements of the taxpayer for the

component’s sale or use.

(ii) Certain additional activities

related to the business component. The

following activities are deemed to occur

after the beginning of commercial

production of a business component—

(A) Preproduction planning for a

finished business component;

(B) Tooling-up for production;

(C) Trial production runs;

(D) Trouble shooting involving

detecting faults in production

equipment or processes;

(E) Accumulating data relating to

production processes; and

(F) Debugging flaws in a business

component.

(iii) Activities related to production

process or technique. In cases involving

development of both a product and a

manufacturing or other commercial

production process for the product, the

exclusion described in section

41(d)(4)(A) and paragraphs (c)(2)(i) and

(ii) of this section applies separately for

the activities relating to the

development of the product and the

activities relating to the development of

the process. For example, even after a

product meets the taxpayer’s basic

functional and economic requirements,

activities relating to the development of

the manufacturing process still may

constitute qualified research, provided

that the development of the process

itself separately satisfies the

requirements of section 41(d) and this

section, and the activities are conducted

before the process meets the taxpayer’s

basic functional and economic

requirements or is ready for commercial

use.

(iv) Clinical testing. Clinical testing of

a pharmaceutical product prior to its

commercial production in the United

States is not treated as occurring after

the beginning of commercial production

even if the product is commercially

available in other countries. Additional

clinical testing of a pharmaceutical

product after a product has been

approved for a specific therapeutic use

by the Food and Drug Administration

and is ready for commercial production

and sale is not treated as occurring after

the beginning of commercial production

if such clinical testing is undertaken to

establish new functional uses,

characteristics, indications,

combinations, dosages, or delivery

forms for the product. A functional use,

characteristic, indication, combination,

dosage, or delivery form shall be

considered new only if such functional

use, characteristic, indication,

combination, dosage, or delivery form

must be approved by the Food and Drug

Administration.

(3) Adaptation of existing business

components. Activities relating to

adapting an existing business

component to a particular customer’s

requirement or need are not qualified

research. This exclusion does not apply

merely because a business component is

intended for a specific customer.

(4) Duplication of existing business

component. Activities relating to

reproducing an existing business

component (in whole or in part) from a

physical examination of the business

component itself or from plans,

blueprints, detailed specifications, or

publicly available information about the

business component are not qualified

research. This exclusion does not apply

merely because the taxpayer examines

an existing business component in the

course of developing its own business

component.

(5) Surveys, studies, research relating

to management functions, etc. Qualified

research does not include activities

relating to—

(i) Efficiency surveys;

(ii) Management functions or

techniques, including such items as

preparation of financial data and

analysis, development of employee

training programs and management

organization plans, and managementbased changes in production processes

(such as rearranging work stations on an

assembly line);

(iii) Market research, testing, or

development (including advertising or

promotions);

(iv) Routine data collections; or

(v) Routine or ordinary testing or

inspections for quality control.

(6) Internal use software for taxable

years beginning on or after the

December 31, 1985—(i) General rule.

Research with respect to computer

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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

(c)(6)(ii) of this section.

(ii) Requirements. The requirements

of this paragraph (c)(6)(ii) are—

(A) The software satisfies the

requirements of section 41(d)(1);

(B) The software is not otherwise

excluded under section 41(d)(4) (other

than section 41(d)(4)(E)); and

(C) One of the following conditions is

met—

(1) The taxpayer develops the

software for use in an activity that

constitutes qualified research (other

than the development of the internaluse software itself);

(2) The taxpayer develops the

software for use in a production process

that satisfies the requirements of section

41(d)(1);

(3) The taxpayer develops the

software for use in providing computer

services to customers; or

(4) The software satisfies the high

threshold of innovation test of

paragraph (c)(6)(vi) of this section.

(iii) Computer software and hardware

developed as a single product. This

paragraph (c)(6) does not apply to the

development costs of a new or improved

package of computer software and

hardware developed together by the

taxpayer as a single product (or to the

costs to modify an acquired computer

software and hardware package), of

which the software is an integral part,

that is used directly by the taxpayer in

providing services in its trade or

business to customers. In these cases,

eligibility for the research credit is to be

determined by examining the combined

software-hardware product as a single

product.

(iv) Primarily for internal use. Unless

computer software is developed to be

commercially sold, leased, licensed, or

otherwise marketed, for separately

stated consideration to unrelated third

parties, computer software is presumed

developed by (or for the benefit of) the

taxpayer primarily for the taxpayer’s

internal use. For example, the computer

software may serve general and

administrative functions of the taxpayer,

or may be used in providing a

noncomputer service. General and

administrative functions include, but

are not limited to, functions such as

payroll, bookkeeping, financial

management, financial reporting,

personnel management, sales and

marketing, fixed asset accounting,

inventory management and cost

accounting. Computer software that is

developed to be commercially sold,

leased, licensed or otherwise marketed,

for separately stated consideration to

unrelated third parties is not developed

primarily for the taxpayer’s internal use.

The requirements of this paragraph

(c)(6) apply to computer software that is

developed primarily for the taxpayer’s

internal use even though the taxpayer

subsequently sells, leases, licenses, or

otherwise markets the computer

software for separately stated

consideration to unrelated third parties.

(v) Software used in the provision of

services—(A) Computer services. For

purposes of this section, a computer

service is a service offered by a taxpayer

to customers who conduct business

with the taxpayer primarily for the use

of the taxpayer’s computer or software

technology. A taxpayer does not provide

a computer service merely because

customers interact with the taxpayer’s

software.

(B) Noncomputer services. For

purposes of this section, a noncomputer

service is a service offered by a taxpayer

to customers who conduct business

with the taxpayer primarily to obtain a

service other than a computer service,

even if such other service is enabled,

supported, or facilitated by computer or

software technology.

(vi) High threshold of innovation test.

Computer software satisfies this

paragraph (c)(6)(vi) only if the taxpayer

can establish that—

(A) The software is innovative in that

the software is intended to be unique or

novel and is intended to differ in a

significant and inventive way from prior

software implementations or methods;

(B) The software development

involves significant economic risk in

that the taxpayer commits substantial

resources to the development and there

is substantial uncertainty, because of

technical risk, that such resources

would be recovered within a reasonable

period; and

(C) The software is not commercially

available for use by the taxpayer in that

the software cannot be purchased,

leased, or licensed and used for the

intended purpose without modifications

that would satisfy the requirements of

paragraphs (c)(6)(v)(A) and (B) of this

section.

(vii) Application of high threshold of

innovation test. The costs of developing

internal use software are eligible for the

research credit only if the software

satisfies the high threshold of

innovation test of paragraph (c)(6)(vi) of

this section. This test takes into account

only the results attributable to the

development of the new or improved

software independent of the effect of

any modifications to related hardware

or other software.

(viii) Illustrations. The following

examples illustrate provisions contained

in this paragraph (c)(6) of this section.

No inference should be drawn from

these examples concerning the

application of section 41(d)(1) and

paragraph (a) of this section to these

facts. The examples are as follows:

Example 1. (i) Facts. X, an insurance

company, has increased its number of

insurance policies in force. In recent years,

regulatory and financial accounting rules for

computing actuarial reserves on these

insurance policies have changed several

times. In order to compute actuarial reserves

in a more timely and cost-effective manner,

X undertakes to create an improved reserve

valuation software that will generate data for

regulatory and financial accounting

purposes.

(ii) Conclusion. The improved reserve

valuation software created by X is internal

use software because the software is not

developed to be commercially sold, leased,

licensed, or otherwise marketed, for

separately stated consideration to unrelated

third parties. The improved reserve valuation

software was developed by X to serve X’s

general and administrative functions. X’s

costs of developing the reserve valuation

software are eligible for the research credit

only if the software satisfies the high

threshold of innovation test of paragraph

(c)(6)(vi) of this section.

Example 2. (i) Facts. Assume the same

facts as in Example 1. Also assume that in

order to create an improved reserve valuation

software, X purchases updated hardware

with a new operating system to build the new

software system. Several other insurance

companies using the same updated hardware

and new operating system have in place

software systems that can handle the volume

of transactions that X seeks to handle,

provide reserve computations within a

similar time frame, and accommodate the

most current regulatory and financial

accounting requirements.

(ii) Conclusion. X’s reserve valuation

software system is internal use software that

does not satisfy the high threshold of

innovation test of paragraph (c)(6)(vi) of this

section. The software is not intended to be

unique or novel in that it is intended to be

merely comparable to software developed by

other insurance companies. The software

does not differ in a significant or inventive

way from prior software implementations

because X’s reserve valuation software

system was developed using the same

technologies and methods that were

employed by other insurance companies.

Further, X’s reserve valuation software is not

excluded from the application of paragraph

(c)(6) of this section by the rule of paragraph

(c)(6)(iii) of this section.

Example 3. (i) Facts. In 1986, X, a large

regional bank with hundreds of branch

offices, maintained separate software systems

for each of its customer’s accounts, including

checking, deposit, loan, lease, and trust. X

determined that improved customer service

could be achieved by redesigning its

disparate systems into one customer-centric

system. X also determined that commercially

66372 Federal Register / Vol. 66, No. 247 / Wednesday, December 26, 2001 / Proposed Rules

available database management systems did

not meet all of the critical requirements of

the proposed system. Specifically, available

relational database management systems

were well suited for the proposed system’s

data modeling requirements but not the data

integrity and transaction throughput

(transactions-per-second) requirements.

Rather than waiting several years for vendor

offerings to mature and become viable for its

purpose, X decided to embark upon the

project utilizing older technology that

satisfied the data integrity and transaction

throughput requirements but that was

severely challenged with respect to the data

modeling capabilities. X commits substantial

resources to this project and, because of

technical risk, X cannot determine if it will

recover its resources in a reasonable period.

Early in the course of the project, industry

analysts observed that the project appeared

highly ambitious and risky. The limitations

of the technology X was attempting to utilize

required that X develop a new database

architecture that could accommodate

transaction volumes unheard-of in the

industry. X was unable to successfully

develop the system and X abandoned the

project.

(ii) Conclusion. X intended to develop a

computer software system primarily for X’s

internal use because X did not intend to

commercially sell, lease, license, or

otherwise market the software, for separately

stated consideration to unrelated third

parties, and X intended to use the software

in providing noncomputer services to its

customers. X’s software development

activities satisfy the high threshold of

innovation test of paragraph (c)(6)(vi) of this

section because the system was intended to

be innovative in that it was intended to be

novel and it was intended to differ in a

significant and inventive way from prior

software implementations. In addition, X’s

development activities involved significant

economic risk in that X committed

substantial resources to the development and

there was substantial uncertainty, because of

technical risk, that such resources would be

recovered within a reasonable period.

Finally, at the time X undertook the

development of the system, software meeting

X’s requirements was not commercially

available for use by X.

Example 4. (i) Facts. X wishes to improve

upon its capabilities in the area of insurance

fraud prevention, detection and control. X

believes that it can exceed the capabilities of

current commercial offerings in this area by

developing and applying pattern matching

algorithms that are not implemented in

current vendor offerings. X has determined

that many insurance fraud perpetrators can

evade detection because its current system

relies too heavily on exact matches and

scrubbed data. Because a computer software

system that will accomplish these objectives

is not commercially available, X undertakes

to develop and implement advanced pattern

matching algorithms that would significantly

improve upon the capabilities currently

available from vendors. X commits

substantial resources to the development of

the software system and cannot determine,

because of technical risk, if it will recover its

investment within a reasonable period.

(ii) Conclusion. X’s computer software

system is developed primarily for X’s

internal use because X did not intend to sell,

lease, license or otherwise market the

software, for separately stated consideration

to unrelated third parties. X’s software

development activities satisfy the high

threshold of innovation test of paragraph

(c)(6)(vi) of this section because the software

system is innovative in that it was intended

to be novel and it was intended to differ in

a significant and inventive way from prior

software implementations. In addition, X’s

development activities involved significant

economic risk in that X committed

substantial resources to the development and

there was substantial uncertainty, because of

technical risk, that such resources would be

recovered within a reasonable period.

Finally, at the time X undertook the

development of the software, software

satisfying X’s requirements was not

commercially available for use by X.

Example 5. (i) Facts. X is engaged in the

business of designing, manufacturing, and

selling widgets. X delivers its widgets in the

same manner and time as its competitors. To

improve customer service, X undertakes to

develop computer software that will monitor

the progress of the manufacture and delivery

of X’s widgets to enable X’s customers to

track their widget orders from origination to

delivery, whether by air, land or ship. In

addition, at the request of a customer, X will

be able to intercept and return or reroute

packages prior to delivery. At the time X

undertakes its software development

activities, X is uncertain whether it can

develop the real-time communication

software necessary to achieve its objective.

None of X’s competitors have a comparable

tracking system. X commits substantial

resources to the development of the system

and, because of technical risk, X cannot

determine if it will recover its investment

within a reasonable period.

(ii) Conclusion. X’s computer software is

developed primarily for X’s internal use

because the software is not developed to be

commercially sold, leased, licensed, or

otherwise marketed, for separately stated

consideration to unrelated third parties. X’s

computer software was developed to be used

by X in providing noncomputer services to

its customers. X’s software satisfies the high

threshold of innovation test of paragraph

(c)(6)(vi) of this section because, at the time

the research is undertaken, X’s software is

designed to provide a new tracking capability

that is novel in that none of X’s competitors

have such a capability. Further, the new

capability differs in a significant and

inventive way from prior software

implementations. In addition, X’s

development activities involved significant

economic risk in that X committed

substantial resources to the development and

there was substantial uncertainty, because of

technical risk, that such resources would be

recovered within a reasonable period.

Finally, at the time X undertook the

development of the software, software

satisfying X’s requirements was not

commercially available for use by X.

Example 6. (i) Facts. X, a multinational

chemical manufacturer with different

business and financial systems in each of its

divisions, undertakes a software

development project aimed at integrating the

majority of the functional areas of its major

software systems into a single enterprise

resource management system supporting

centralized financial systems, inventory, and

management reporting. This project involves

the detailed analysis of X’s (as well as each

of X’s divisions) legacy systems to

understand the actual current business

processes and data requirements. X also has

to develop programs to fill in the gaps

between the software features and X’s system

requirements. X hires Y, a systems consulting

firm to assist with this development effort. Y

has experience in developing similar

systems. X, working jointly with Y, evaluates

its needs, establishes goals for the new

system, re-engineers the business processes

that will be made concurrently with the

implementation of the new system, and

chooses and purchases a software system

upon which to base its enterprise-wide

system.

(ii) Conclusion. X’s enterprise-wide

computer software is developed primarily for

internal use because the software is not

developed to be commercially sold, leased,

licensed, or otherwise marketed, for

separately stated consideration to unrelated

third parties. X’s computer software was

developed to be used by X to serve X’s

general and administrative functions.

However, the development of X’s enterprise

management system does not satisfy the high

threshold of innovation test of paragraph

(c)(6)(vi) of this section because the system

that X is seeking to develop is not intended

to be unique or novel. Further, the software

does not differ in a significant or inventive

way from software implemented by other

manufacturers.

Example 7. (i) Facts. X, a financial services

company specializing in commercial

mortgages, decides to support its ongoing

expansion by upgrading its information

technology infrastructure. In order to

accommodate its expanding efforts to acquire

and maintain corporate borrowers and draw

securitized loan investors, X builds a scalable

and modular enterprise network to run its

latest business applications, including webbased portfolio access for investors and staff,

document imaging for customer service

personnel, desktop access to information

services for in-house securities traders and

multimedia on-line training and corporate

information delivery for all company

personnel. As a result, X is able to access

market information faster and function more

efficiently and effectively than before. The

new network is based on a faster local area

network technology which is better able to

meet the higher bandwidth requirements of

X’s current multimedia applications.

(ii) Conclusion. X’s software is software

developed primarily for X’s internal use

because the software is not developed to be

commercially sold, leased, licensed, or

otherwise marketed, for separately stated

consideration to unrelated third parties. X’s

software development activities do not meet

the high threshold of innovation test of

paragraph (c)(6)(vi) of this section because

the system is not intended to be unique or

Federal Register / Vol. 66, No. 247 / Wednesday, December 26, 2001 / Proposed Rules 66373

novel. Further, the software does not differ in

a significant or inventive way from other

existing software implementations.

Example 8. (i) Facts. X, a corporation,

undertook a software project to rewrite a

legacy mainframe application using an

object-oriented programming language, and

to move the new application off the

mainframe to a client/server environment.

Both the object-oriented language and client/

server technologies were new to X. This

project was undertaken to develop a more

maintainable application, and to be able to

implement new features more quickly. X had

to perform a detailed analysis of the old

legacy application in order to determine the

requirements of the rewritten application. To

accomplish this task, X had to train the

legacy mainframe programmers in the new

object-oriented and client/server technologies

that they would have to utilize. Several of X’s

competitors had successfully implemented

similar systems using object-oriented

programming language and client/server

technologies.

(ii) Conclusion. X’s software is developed

primarily for internal use because the

software is not developed to be commercially

sold, leased, licensed, or otherwise marketed,

for separately stated consideration to

unrelated third parties. X’s activities to

rewrite a legacy mainframe application using

an object-oriented programming language,

and to move the application from X’s

mainframe to a client/server environment do

not satisfy the high threshold of innovation

test of paragraph (c)(6)(vi) of this section. The

software developed is not intended to be

either unique or novel and is not intended to

differ in a significant and inventive way from

prior software implementations or methods.

Example 9. (i) Facts. X, a retail and

distribution company, wants to upgrade its

warehouse management software. Therefore,

X performs an analysis of the warehouse

management products and vendors in the

marketplace. X selects vendor V’s software

and, in turn, develops the software interfaces

between X’s legacy systems and V’s

warehouse management software in order to

integrate the new warehouse management

system with X’s financial and inventory

systems. The development of these interfaces

requires a detailed understanding of all the

input and output fields and their data

formats, and how they map from the old

system to the new system and vice-versa.

Once X develops the interfaces, X has to

perform extensive testing and validation

work to ensure that the interfaces work

correctly and accurately.

(ii) Conclusion. X’s software is developed

primarily for internal use because the

software is not developed to be commercially

sold, leased, licensed, or otherwise marketed,

for separately stated consideration to

unrelated third parties. X’s software

development activities do not satisfy the high

threshold of innovation test of paragraph

(c)(6)(vi) of this section because the software

development does not involve significant

economic risk in that there is no substantial

uncertainty, because of technical risk, that

such resources will be recovered within a

reasonable period.

Example 10. (i) Facts. X, a credit card

company, knows that its customers are not

comfortable with purchasing products over

the Internet because they feel the Web is not

secure. X decides to build a payment system

that provides customers with a single use,

automatically generated, short-term timebased, transaction number. This single-use

transaction number has a short expiration

period that is just long enough to allow a

merchant to process and fill the customer’s

order. Thus, when a customer wishes to

make a purchase over the Internet, the

customer requests X to generate

automatically a single-use transaction

number that merchant systems will accept as

a legitimate card number. All purchases

using single-use transaction numbers are

automatically linked back to the customer’s

credit card account. X commits substantial

resources to the development of the system

and X cannot determine, because of technical

risk, if it will recover its investment within

a reasonable period. At the time of this

project, nothing exists in the market that has

these capabilities.

(ii) Conclusion. X’s software is developed

primarily for internal use because the

software is not developed to be commercially

sold, leased, licensed, or otherwise marketed,

for separately stated consideration to

unrelated third parties. X’s computer

software is developed primarily for X’s

internal use because it was intended to be

used by X in providing noncomputer services

to its customers. X’s software satisfies the

high threshold of innovation test of

paragraph (c)(6)(vi) of this section because

the system is a novel way to solve the

security issue of making purchases over the

Internet. Further, because of the secure

payment capability, the software differs in a

significant and inventive way from prior

software implementations. In addition, X’s

development activities involved significant

economic risk in that X committed

substantial resources to the development and

there was substantial uncertainty, because of

technical risk, that such resources would be

recovered within a reasonable period.

Finally, at the time X undertook the

development of the software, software

satisfying X’s requirements was not

commercially available for use by X.

Example 11. (i) Facts. X, a corporation,

wants to expand its internal computing

power, and is aware that its PCs and

workstations are idle at night, on the

weekends, and for a significant part of any

business day. Because the corporate

computations that X needs to make could be

done on workstations as well as PCs, X

develops a screen-saver like application that

runs on employee computers. When

employees’ computers have been idle for an

amount of time set by each employee, the

‘‘screen-saver’’ starts to execute. However,

instead of displaying moving lines, like the

typical screen-saver, X’s application goes

back to a central server to get a new job to

execute. This job will execute on the idle

employee’s computer until it has either

finished, or the employee resumes working

on his computer. X wants to ensure that it

can manage all of the computation jobs

distributed across its thousands of PCs and

workstations. In addition, X wants to ensure

that the additional load on its network

caused by downloading the jobs and

uploading the results, as well as in

monitoring and managing the jobs, does not

adversely impact the corporate computing

infrastructure. At the time X undertook this

software development project, X was

uncertain, because of technical risk, it could

develop a server application that could

schedule and distribute the jobs across

thousands of PCs and workstations, as well

as handle all the error conditions that occur

on a user’s machine. Also, at the time X

undertook this project, there was no

commercial application available with such a

capability.

(ii) Conclusion. X’s computer software is

developed primarily for internal use because

the software is not developed to be

commercially sold, leased, licensed, or

otherwise marketed, for separately stated

consideration to unrelated third parties. X’s

computer software was developed to be used

by X to serve X’s general and administrative

functions. X’s software satisfies the high

threshold of innovation test of paragraph

(c)(6)(vi) of this section because making use

of idle corporate computing resources

through what is ostensibly a screen-saver,

was a novel approach to solving X’s need for

more computer intensive processing time. In

addition, X’s software development involves

significant economic risk in that there was

substantial uncertainty, because of technical

risk, that the server application that

schedules and distributes the jobs across

thousands of PCs and workstations, as well

as handles all the error conditions that can

occur on a user’s machine, amounts to

developing a new operating system with new

capabilities. Finally, at the time X undertook

the development of the software, software

satisfying X’s requirements was not

commercially available for use by X.

Example 12. (i) Facts. (A) X, a corporation,

wants to protect its internal documents

without building a large public key

infrastructure. In addition, X needs to

implement a new highly secure encryption

algorithm that has a ‘‘back-door’’ such that X

can decrypt and read any document, even

when the employee is on vacation or leaves

the company. X wants to develop a new

encryption algorithm that is both secure, easy

to use, and difficult to break. Current

commercial encryption/decryption products

are too slow for high-level secure encryption

processing. Furthermore, no commercial

product exists that provides the capability of

having a secure back-door key to decrypt files

when the owner is unavailable.

(B) The development of the encryption/

decryption software requires specialized

knowledge of cryptography and

computational methods. Due to the secret

nature of X’s work, the encryption algorithm

has to be unbreakable, yet recoverable should

the employee forget his key. X commits

substantial resources to the development of

the system and, because of technical risk,

cannot estimate whether it will recover its

investment within a reasonable period.

(ii) Conclusion. X’s back-door file

encryption software is developed primarily

for internal use because the software is not

developed to be commercially sold, leased,

licensed, or otherwise marketed, for

66374 Federal Register / Vol. 66, No. 247 / Wednesday, December 26, 2001 / Proposed Rules

separately stated consideration to unrelated

third parties. X’s back-door file encryption

software was developed to be used by X to

serve X’s general and administrative

functions. X’s encryption software satisfies

the high threshold of innovation test of

paragraph (c)(6)(vi) of this section because, at

the time the research is undertaken, X’s

software is designed to provide encryption

and back-door decryption capabilities that

are unique in that no other product has these

capabilities, which indicates the software

encryption system differs in a significant way

from prior software implementations.

Further, the encryption and back-door

decryption capabilities indicate that the

software differs in a significant and inventive

way from prior software implementations. In

addition, X’s development activities involved

significant economic risk in that X

committed substantial resources to the

development and there was substantial

uncertainty, because of technical risk, that

such resources would be recovered within a

reasonable period. Finally, at the time X

undertook the development of the software,

software satisfying X’s requirements was not

commercially available for use by X.

Example 13. (i) Facts. X, a large regional

telephone company, is experiencing rapidly

increasing customer demand. X would like to

determine whether evolutionary algorithms

such as genetic algorithms may improve its

ability to design cost-effective networks and

extend existing networks. X would also like

to determine whether such adaptive

algorithms may be used to optimize the

routing of call traffic across existing networks

in order to use efficiently the resources

available without causing congestion. X first

explores the use of evolutionary algorithms

for the call routing task, because X

determines that this type of complex,

unpredictable problem is most appropriate

for an adaptive algorithm solution. X

develops and tests genetic algorithms until it

determines that it has developed a software

system it can test on a pilot basis on its

existing networks. X commits substantial

resources to the project, and cannot predict,

because of technical risk, whether it will

recover its resources within a reasonable

period. Finally, at the time X undertook the

development of the software, software

satisfying X’s requirements was not

commercially available for use by X.

(ii) Conclusion. X’s software is developed

primarily for internal use because the

software is not developed to be commercially

sold, leased, licensed, or otherwise marketed,

for separately stated consideration to

unrelated third parties. X’s computer

software is intended to be used by X in

providing noncomputer services to its

customers. X’s software satisfies the high

threshold of innovation test of paragraph

(c)(6)(vi) of this section because the software

is intended to be novel and is intended to

differ in a significant and inventive way from

other existing software implementations. In

addition, X’s development activities involved

significant economic risk in that X

committed substantial resources to the

development and there was substantial

uncertainty, because of technical risk, that

such resources would be recovered within a

reasonable period. Finally, at the time X

undertook the development of the software,

software satisfying X’s requirements was not

commercially available.

(ix) Effective date. This paragraph

(c)(6) is applicable for taxable years

beginning after December 31, 1985.

(7) Activities outside the United

States, Puerto Rico, and other

possessions—(i) In general. Research

conducted outside the United States, as

defined in section 7701(a)(9), the

Commonwealth of Puerto Rico and

other possessions of the United States

does not constitute qualified research.

(ii) Apportionment of in-house

research expenses. In-house research

expenses paid or incurred for qualified

services performed both in the United

States, the Commonwealth of Puerto

Rico and other possessions of the

United States and outside the United

States, the Commonwealth of Puerto

Rico and other possessions of the

United States must be apportioned

between the services performed in the

United States, the Commonwealth of

Puerto Rico and other possessions of the

United States and the services

performed outside the United States, the

Commonwealth of Puerto Rico and

other possessions of the United States.

Only those in-house research expenses

apportioned to the services performed

within the United States, the

Commonwealth of Puerto Rico and

other possessions of the United States

are eligible to be treated as qualified

research expenses, unless the in-house

research expenses are wages and the 80

percent rule of § 1.41–2(d)(2) applies.

(iii) Apportionment of contract

research expenses. If contract research

is performed partly in the United States,

the Commonwealth of Puerto Rico and

other possessions of the United States

and partly outside the United States, the

Commonwealth of Puerto Rico and

other possessions of the United States,

only 65 percent (or 75 percent in the

case of amounts paid to qualified

research consortia) of the portion of the

contract amount that is attributable to

the research activity performed in the

United States, the Commonwealth of

Puerto Rico and other possessions of the

United States may qualify as a contract

research expense (even if 80 percent or

more of the contract amount is for

research performed in the United States,

the Commonwealth of Puerto Rico and

other possessions of the United States).

(8) Research in the social sciences,

etc. Qualified research does not include

research in the social sciences

(including economics, business

management, and behavioral sciences),

arts, or humanities.

(9) Research funded by any grant,

contract, or otherwise. Qualified

research does not include any research

to the extent funded by any grant,

contract, or otherwise by another person

(or governmental entity). To determine

the extent to which research is so

funded, § 1.41–4A(d) applies.

(10) Illustrations. The following

examples illustrate provisions contained

in paragraphs (c)(1) through (9)

(excepting (c)(6)) of this section. No

inference should be drawn from these

examples concerning the application of

section 41(d)(1) and paragraph (a) of this

section to these facts. The examples are

as follows:

Example 1. (i) Facts. X, a tire manufacturer,

develops a new material to use in its tires.

X conducts research to determine the

changes that will be necessary for X to

modify its existing manufacturing processes

to manufacture the new tire. X determines

that the new material retains heat for a longer

period of time than the materials X currently

uses and, as a result, adheres to the

manufacturing equipment during tread

cooling. X evaluates numerous options for

processing the treads at cooler temperatures.

X designs, develops, and conducts

sophisticated tests on the numerous options

for a new type of belt to be used in tread

cooling. X then manufactures a set of belts for

its production equipment, installs the belts,

and tests the belts to make sure they were

manufactured correctly.

(ii) Conclusion. X’s research with respect to

the design of the new belts to be used in its

manufacturing of the new tire may be

qualified research under section 41(d)(1) and

paragraph (a) of this section. However, X’s

expenses to implement the design, including

the costs to manufacture, install, and test the

belts were incurred after the belts met the

taxpayer’s functional and economic

requirements and are excluded as research

after commercial production under section

41(d)(4)(A) and paragraph (c)(2) of this

section. In addition, amounts expended on

component materials of the production belts

and the costs of labor or other elements

involved in the manufacture and installation

of the production belts are not qualified

research expenses. These expenses are not for

expenditures that may be treated as expenses

under section 174 and thus are not qualified

research under section 41(d)(1)(A) and

paragraph (a)(2)(i) of this section. See section

174(c) and § 1.174–2(b). Further, testing or

inspection to determine whether the

production belts were manufactured

correctly is quality control testing under

§ 1.174–2(a)(4) and thus is not qualified

research under section 41(d)(1)(A) and

paragraph (a)(2)(i) of this section.

Example 2. (i) Facts. For several years, X

has manufactured and sold a particular kind

of widget. X initiates a new research project

to develop a new or improved widget.

(ii) Conclusion. X’s activities to develop a

new or improved widget are not excluded

from the definition of qualified research

under section 41(d)(4)(A) and paragraph

(c)(2) of this section. X’s activities relating to

Federal Register / Vol. 66, No. 247 / Wednesday, December 26, 2001 / Proposed Rules 66375

the development of a new or improved

widget constitute a new research project to

develop a new business component. X’s

research activities relating to the

development of the new or improved widget,

a new business component, are not

considered to be activities conducted after

the beginning of commercial production

under section 41(d)(4)(A) and paragraph

(c)(2) of this section.

Example 3. (i) Facts. X, a computer

software development firm, owns all

substantial rights in a general ledger

accounting software core program that X

markets and licenses to customers. X incurs

expenditures in adapting the core software

program to the requirements of C, one of X’s

customers.

(ii) Conclusion. Because X’s activities

represent activities to adapt an existing

software program to a particular customer’s

requirement or need, X’s activities are

excluded from the definition of qualified

research under section 41(d)(4)(B) and

paragraph (c)(3) of this section.

Example 4. (i) Facts. The facts are the same

as in example 3, except that C pays X to

adapt the core software program to C’s

requirements.

(ii) Conclusion. Because X’s activities are

excluded from the definition of qualified

research under section 41(d)(4)(B) and

paragraph (c)(3) of this section, C’s payments

to X are not for qualified research and are not

considered to be contract research expenses

under section 41(b)(3)(A).

Example 5. (i) Facts. The facts are the same

as in example 3, except that C’s own

employees adapt the core software program

to C’s requirements.

(ii) Conclusion. Because C’s employees’

activities to adapt the core software program

to C’s requirements are excluded from the

definition of qualified research under section

41(d)(4)(B) and paragraph (c)(3) of this

section, the wages C paid to its employees do

not constitute in-house research expenses

under section 41(b)(2)(A).

Example 6. (i) Facts. X manufacturer and

sells rail cars. Because rail cars have

numerous specifications related to

performance, reliability and quality, rail car

designs are subject to extensive, complex

testing in the scientific or laboratory sense.

B orders passenger rail cars from X. B’s rail

car requirements differ from those of X’s

other customers in that B wants fewer seats

in its passenger cars and a higher quality

seating material and carpet. X manufactures

rail cars meeting B’s requirements. X does

not conduct complex testing in the scientific

or laboratory sense on the rail cars

manufactured for B.

(ii) Conclusion. X’s activities to

manufacture rail cars for B are excluded from

the definition of qualified research. The rail

cars designed for B were not subject to the

type of complex testing that is indicative of

a process of experimentation. Further, the

rail car sold to B was not a new business

component, but merely an adaptation of an

existing business component. Thus, X’s

activities to manufacture rail cars for B are

excluded from the definition of qualified

research under section 41(d)(4)(B) and

paragraph (c)(3) of this section because X’s

activities represent activities to adapt an

existing business component to a particular

customer’s requirement or need.

Example 7. (1) Facts. X, a manufacturer,

undertakes to create a manufacturing process

for a new valve design. X determines that it

requires a specialized type of robotic

equipment to use in the manufacturing

process for its new valves. X is unable to

locate robotic equipment that meets X’s

precise specifications, and, therefore,

purchases the existing robotic equipment for

the purpose of modifying it to meet its needs.

X’s engineers conduct experiments using

modeling and simulation in modifying the

robotic equipment and conduct extensive

scientific and laboratory testing of design

alternatives. As a result of this process, X’s

engineers develop a design for the robotic

equipment that meets X’s specifications. X

constructs and installs the modified robotic

equipment on its manufacturing process.

(ii) Conclusion. X’s research activities to

determine how to modify X’s robotic

equipment for its manufacturing process are

not excluded from the definition of qualified

research under section 41(d)(4)(B) and

paragraph (c)(3) of this section.

Example 8. (1) Facts. An existing gasoline

additive is manufactured by Y using three

ingredients, A, B, and C. X seeks to develop

and manufacture its own gasoline additive

that appears and functions in a manner

similar to Y’s additive. To develop its own

additive, X first inspects the composition of

Y’s additive, and uses knowledge gained

from the inspection to reproduce A and B in

the laboratory. Any differences between

ingredients A and B that are used in Y’s

additive and those reproduced by X are

insignificant and are not material to the

viability, effectiveness, or cost of A and B. X

desires to use with A and B an ingredient

that has a materially lower cost than

ingredient C. Accordingly, X engages in a

process of experimentation to develop,

analyze and test potential alternative

formulations of the additive.

(ii) Conclusion. X’s activities in analyzing

and reproducing ingredients A and B involve

duplication of existing business components

and are excluded from the definition of

qualified research under section 41(d)(4)(C)

and paragraph (c)(4) of this section. X’s

experimentation activities to develop

potential alternative formulations of the

additive do not involve duplication of an

existing business component and are not

excluded from the definition of qualified

research under section 41(d)(4)(C) and

paragraph (c)(4) of this section.

Example 9. (1) Facts. X, a manufacturing

corporation, undertakes to restructure its

manufacturing organization. X organizes a

team to design an organizational structure

that will improve X’s business operations.

The team includes X’s employees as well as

outside management consultants. The team

studies current operations, interviews X’s

employees, and studies the structure of other

manufacturing facilities to determine

appropriate modifications to X’s current

business operations. The team develops a

recommendation of proposed modifications

which it presents to X’s management. X’s

management approves the team’s

recommendation and begins to implement

the proposed modifications.

(ii) Conclusion. X’s activities in developing

and implementing the new management

structure are excluded from the definition of

qualified research under section 41(d)(4)(D)

and paragraph (c)(5) of this section. Qualified

research does not include activities relating

to management functions or techniques

including management organization plans

and management-based changes in

production processes.

Example 10. (1) Facts. X, an insurance

company, develops a new life insurance

product. In the course of developing the

product, X engages in research with respect

to the effect of pricing and tax consequences

on demand for the product, the expected

volatility of interest rates, and the expected

mortality rates (based on published data and

prior insurance claims).

(ii) Conclusion. X’s activities related to the

new product represent research in the social

sciences (including economics and business

management) and are thus excluded from the

definition of qualified research under section

41(d)(4)(G) and paragraph (c)(8) of this

section.

(d) Recordkeeping for the research

credit. A taxpayer claiming a credit

under section 41 must retain records in

sufficiently usable form and detail to

substantiate that the expenditures

claimed are eligible for the credit. For

the rules governing record retention, see

§ 1.6001–1. To facilitate compliance and

administration, the IRS and taxpayers

may agree to guidelines for the keeping

of specific records for purposes of

substantiating research credits.

(e) Effective dates. In general, the

rules of this section are applicable for

taxable years ending on or after

December 26, 2002.

Par. 5. Section 1.41–8 is amended by:

1. Revising the section heading.

2. Revising paragraph (b)(4).

The revisions read as follows:

§ 1.41–8 Special rules for taxable years

ending on or after December 26, 2001.

* * * * *

(b) * * *

(4) Effective date. Paragraphs (b)(2)

and (3) of this section are applicable for

taxable years ending on or after

December 26, 2002.

Charles O. Rossotti,

Commissioner of Internal Revenue.

[FR Doc. 01–31007 Filed 12–21–01; 8:45 am]

BILLING CODE 4830–01–P