Opinion ID: 760150
Heading Depth: 2
Heading Rank: 1

Heading: The Qualified Research Tax Credit

Text: 9 Section 41, the Credit for Increasing Research Activities, allows taxpayers a credit for certain expenses incurred conducting qualified research. Subsection 41(d) defines qualified research in pertinent part as follows: 10 (d) Qualified research defined.--For purposes of this section-- 11 (1) In general.--The term qualified research means research-- 12 (A) with respect to which expenditures may be treated as expenses under section 174, 13 (B) which is undertaken for the purpose of discovering information-- 14 (i) which is technological in nature, and-- 15 (ii) the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, and 16 (C) substantially all of the activities of which constitute elements of a process of experimentation for a purpose described in paragraph (3). 17 Such term does not include any activity described in paragraph (4). 18 26 U.S.C. § 41(d)(1). This provision sets out a four-pronged test for qualified research. First, the research must have qualified as a business deduction under § 174. See id. § 41(d)(1)(A). Second, the research must be undertaken to discover information which is technological in nature. Id. § 41(d)(1)(B)(i). Third, the taxpayer must intend to use the information to develop a new or improved business component. Id. § 41(d)(1)(B)(ii). Finally, the taxpayer must pursue a process of experimentation during substantially all of the research. Id. § 41(d)(1)(C). 19 Only two of these requirements are at issue here. A § 174 deduction has been allowed, satisfying the first requirement, and the government concedes the third requirement, involving usefulness for a new or improved business component. We will address the two other requirements in turn. 20
21 Section 41(d)(1)(B)(i) requires research to be undertaken for the purpose of discovering information which is technological in nature. The district court held that, although the programs were technological in nature, USI did not develop the programs to discover information. United Stationers II, 982 F.Supp. at 1284. Citing dictionary definitions and the legislative history of § 41, the district court instead found that Stationers [had] merely applied, modified, and at most, built upon, pre-existing, technological information already supplied to it. Id. USI now claims that the district court's interpretation of this prong comports with neither the Code's plain language nor its legislative history. While we do not necessarily adopt the district court's view that the issue turns on the breadth of the definition of the word discover, we believe that the terms of the requirement in question have not been met. 22 USI cites a dictionary which defines discover as to make known (something secret, hidden, unknown, or previously unnoticed) or to obtain for the first time sight or knowledge of. Appellant's Br. at 15 (citing W EBSTER'S T HIRD N EW I NTERNATIONAL D ICTIONARY, U NABRIDGED 647 (1993)). USI invites us to end our definitional inquiry here, content with an interpretation which equates discovery with mere newness. We decline this invitation. Congress attempted to give further meaning to § 41(d)(1)(B)(i) and we can look to legislative history for guidance. See, e.g., Sundstrand Corp. v. Commissioner of Internal Revenue, 17 F.3d 965, 967-68 (7th Cir.1994). 23 The Conference Report accompanying the 1986 amendments states that research that discovers information which is technological in nature must rely on principles of the physical or biological sciences, engineering, or computer science. H.R. C ONF. R EP. N O. 99-841, at II-71 (1986). Specifically, [r]esearch 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. Id. n. 3. Thus Congress set a demanding standard. Not just any computer programming would qualify for a § 41 credit; qualifying research must go beyond the current state of knowledge in that field--expand or refine its principles. See Norwest Corp. v. Commissioner, Tax Ct. Rep. (CCH), p 52,758, at 4653-54, 1998 WL 341634 (U.S. Tax Ct. June 29, 1998). Therefore, in the context of § 41(d)(1)(B)(i) discovery demands something more than mere superficial newness; it connotes innovation in underlying principle. See id. 24 This understanding of discovery also brings the requirements for the credit in line with the purposes of both the original statute in 1981 and the amendments in 1986. Congress first created a research and experimentation tax credit in 1981 as part of the Economic Recovery Tax Act of 1981 (ERTA). ERTA adopted § 174's definitions of research and experimentation but failed to specifically indicate how the credit applied to computer software development. 1 Congress hoped that ERTA would energize the overall economy and specifically would stimulate business investment in technological research. See S.REP. NO. 97-144, at 76-77 (1981), U.S.Code Cong. & Admin.News 1981, pp. 105, 181-182; H. R EP. N O. 97-201, at 111 (1981). In 1986, in response to taxpayer abuse, Congress amended the research tax credit provision to include an express statutory definition of qualified research. The 1986 amendments restricted the definition of qualified research to that which discover[s] information which is technological in nature in an attempt to limit the deduction to only high technology research. 2 Congress clearly intended, then, that qualifying research pass a high threshold of innovation and be of broad effect. See Norwest, p 52,758, at 4653-54, 1998 WL 341634; see also TSR, Inc. v. Commissioner, 96 T.C. 903, 916-20, 1991 WL  445 110430 (1991). 3 25 We believe that our interpretation--as well as that of the district court--comfortably fits the Code's language and its legislative history and compels the conclusion that USI's programs did not discover information which is technological in nature. USI's projects did not refine or expand the principles of computer science. Instead, they modified an existing software program in an attempt specifically to improve USI's inventory control system. Further, although these applications were new to USI and helped it eliminate various operational inefficiencies, they were not of broad economic effect. USI accuses the district court of imposing a revolutionary standard where Congress intended no more than evolutionary research to qualify. USI's amicus similarly cautions against raising the bar of the research tax credit too high. We are respectful of these warnings but are no less convinced of our conclusion. Wherever the line is drawn, these projects fall short. The more or less routine modification of a commercially-available software package to apply to USI's inventory control computers simply does not measure up to the demanding requirements of § 41(d)(1)(B)(i). See H. R EP. N O. 99-426, at 180 (1985); compare Norwest, p 52,758, at 4663-65, 1998 WL 341634 (examples of computer programs that meet the high standard) with id. at 4667, 4668, 1998 WL 341634 (examples of computer programs that do not meet the high standard).
26 Section 41(d)(1)(C) provides that qualified research involve substantially all of the activities which constitute elements of a process of experimentation. 26 U.S.C. § 41(d)(1)(C). The district court, again looking to dictionary definitions and legislative history for guidance, held that this test requires qualifying research to have significant design uncertainty from its outset. See United Stationers II, 982 F.Supp. at 1285. The court then found USI's claim of uncertainty not persuasive: while the aspired benefits of the projects were in doubt, the development of the means that would allow [USI] to potentially achieve those benefits was not. Id. (citation omitted). USI now challenges both the district court's legal interpretation of this process of experimentation test and its factual findings regarding design uncertainty in the eight projects. We reject both challenges. 27 USI again begins with its plain reading of the subsection. According to USI's dictionary, an experiment is ... a test, trial, or tentative procedure, an act or operation for the purpose of discovering something unknown or of testing a principle, supposition, etc. Appellant's Br. at 23 (citing R ANDOM H OUSE C OLLEGE D ICTIONARY 465 (rev. ed.1984)). The projects fit squarely within this definition, USI claims, because software development involves debugging, a process of testing and correcting computer programs. We find this argument unpersuasive. Debugging programs amounts simply to fine-tuning computer operating instructions. Although we are reluctant to establish bright-line rules--s 41 cases will always be highly fact-intensive--we think that a process of experimentation involves something more than simply debugging a computer program. See Norwest, p 52,758, at 4669, 1998 WL 341634 (computer programming project did not qualify because it merely required conducting good coding and eliminating bugs through testing). 28 The legislative history of § 41(d)(1)(C) bolsters this conclusion. The Conference Report explains the meaning of the process of experimentation test: 29 The term process of experimentation means a process involving the evaluation of more than one alternative designed to achieve a result where the means of achieving that result is uncertain at the outset. This may involve developing one or more hypotheses, testing and analyzing those hypotheses (through, for example, modeling or simulation), and refining and discarding the hypotheses as part of a sequential design process to develop the overall component. 30 Thus, for example, costs of developing a new or improved business component are not eligible for the credit if the method of reaching the desired objective (the new or improved product characteristics) is readily discernible and applicable as of the beginning of the research activities, so that true experimentation in the scientific or laboratory sense would not have to be undertaken to develop, test, and choose among viable alternatives .... [E]ngineers who design a new computer system, or who design improved or new integrated circuits for use in computer or other electronic products, are engaged in qualified research because the design of those items is uncertain at the outset and can only be determined through a process of experimentation relating to specific design hypotheses and decisions as described above. 31 H.R. C ONF. R EP. N O. 99-841, at II-72 (1986). USI would have us hold that this Report dictates a per se credit for software development. This suggestion, however, ignores the Report's mention of only systems design (not software design) as well as its focus on overcoming design uncertainty through a systematic--almost scientific--methodology. The Report suggests that qualifying research must from its outset involve some technical uncertainty about the possibility of developing the product. See Norwest, p 52,758, at 4655, 1998 WL 341634 (discussing the required uncertainty); cf. TSR, 96 T.C. at 920-21, 1991 WL 110430. 32 USI and amicus again caution that this articulation of the relevant standard is too narrow. We are not persuaded, however, and conclude that USI's projects did not involve a process of experimentation as envisaged by Congress. The eight projects involved the modification of a commercially-available software package to fit USI's particular operational needs. Most of the project summaries include general statements about the uncertainty of actually realizing the anticipated operational efficiencies and resultant economic benefits. None of the summaries, however, describes any technical uncertainty about actually developing the programs. Compare Norwest, p 52,758, at 4670, 1998 WL 341634 (programming project did not constitute qualified research because, in part, it did not involve technical risk). Nor were there any doubts about the ability of computers to perform the invoicing, billing and marketing tasks. That is, there was simply no technical uncertainty from the outset. We therefore conclude that USI's development of the eight programs did not involve a process of experimentation and that the district court did not clearly err in concluding that the projects did not involve the level of uncertainty necessary to clear this hurdle.