Court Opinion

ID: 4331808
Source: CourtListenerOpinion
Date Created: 2018-11-14 00:21:15.397775+00
Date Added: 2024-06-11T14:47:41.024118
License: Public Domain

110 T.C. No. 34

                       UNITED STATES TAX COURT

         NORWEST CORPORATION AND SUBSIDIARIES, Petitioner v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent

     Docket Nos. 13908-92, 20567-93,         Filed June 29, 1998.
                 26213-93.1

         Between 1986 and 1991, N, a bank holding company
    whose affiliates provide banking and other financial
    services, developed or modified previously developed
    software for the internal management and administration
    of its businesses (internal use software). N seeks tax
    credits for increasing research activities pursuant to
    sec. 41, I.R.C., with respect to expenditures associated
    with the development of its internal use software. The
    parties selected 8 of 67 internal use software activities
    to serve as representative or sample activities to
    determine whether all or part of the 67 activities
    constituted qualified research for purposes of the tax
    credit.

     1
          These cases are consolidated for trial, briefing, and
opinion solely with respect to the issue of whether petitioner's
activities constitute qualified research pursuant to sec. 41,
I.R.C. (the research and experimentation credit, or R&E credit).
                         - 2 -

     Sec. 41(d)(1), I.R.C., sets forth four tests for
qualified research: (1) The expenditures must qualify as
expenses under sec. 174, I.R.C.; (2) the taxpayer must
discover information which is technological in nature;
(3)   the  taxpayer    must  discover   information   the
application of which is intended to be useful in the
development of a new or improved business component; and
(4) substantially all of the research activities must
constitute elements of a process of experimentation.
     In the conference report accompanying the Tax Reform
Act of 1986 (TRA 1986), Pub. L. 99-514, 100 Stat. 2085,
H. Conf. Rept. 99-841 (Vol. II), at II-73 through II-74
(1986), 1986-3 C.B. (Vol. 4) 1, 73-74, Congress set forth
three additional tests for qualified research under sec.
41, I.R.C., for the development of internal use software:
(1) The software must be innovative; (2) the software
development must involve significant economic risk; and
(3) the software must not be commercially available.
     The   parties   agree   that   in  order   for   the
representative internal use software activities to
constitute qualified research for purposes of the tax
credit, all seven tests must be satisfied.

     1.   Held: The three additional tests for qualified
research in the development of internal use software
enunciated in the conference report accompanying the TRA
1986 require a higher threshold of technological
advancement and functional improvement than is necessary
in other fields of research.

     2.   Held, further: One of the eight representative
internal use software activities, the development of the
Strategic Banking System's (SBS) customer module,
satisfies all seven tests and constitutes qualified
research pursuant to sec. 41, I.R.C. SBS was a concerted
effort at advancing the state of technology in the field
of computer science and pushed existing technology to new
heights.

     3.   Held, further: N failed to establish that the
remaining seven representative internal use software
activities constitute qualified research.
                              - 3 -

     Mark A. Hager, Albert G. Lauber, Julie W. Davis, Carl S.

Kravitz, James Sottile IV, John R. Kalligher, and Matthew W. Frank,

for petitioner.

     Barry J. Laterman, Paul Colleran, Michael Goldbas, Tyrone J.

Montague, and Bruce G. Warner, for respondent.

                             CONTENTS

                                                             Page

FINDINGS OF FACT ............................................    7

1.   Background .............................................    7
2.   Software Development Methodology .......................    8
     A. Phase 1: Request ..................................      9
     B. Phase 2: Project Initiation .......................      9
     C. Phase 3: Definition ...............................     10
     D. Phase 4: Logical Design ...........................     10
     E. Phase 5: Physical Design ..........................     11
     F. Phase 6: Development ..............................     11
     G. Phase 7: Testing ..................................     11
     H. Phase 8: Implementation ...........................     12
     I. Phase 9: Postimplementation .......................     12
     J. Application of the Software Development Methodology.    13

3.   The Eight Sample Internal Use Software Development
     Activities .............................................   14
     A. Strategic Banking System ...........................    15
     B. Trust TU ...........................................    23
     C. Success ............................................    28
     D. General Ledger .....................................    33
     E. Money Transfer .....................................    36
     F. Cyborg Payroll .....................................    42
     G. Trust Payment ......................................    44
     H. Debit Card .........................................    46

OPINION ..................................................... 50

1.   Section 41 ............................................. 51

2.   Internal Use Software .................................. 56
                                   - 4 -

3.   The   Seven Tests ........................................       59
     A.    The Section 174 Test ...............................       60
     B.    The Discovery Test .................................       64
     C.    The Business Component Test ........................       69
     D.    The Process of Experimentation Test ................       70
     E.    The Innovativeness Test ............................       74
     F.    The Significant Economic Risk Test .................       76
     G.    The Commercial Availability Test ...................       77

4.   Summary of Internal Use Software Requirements Under the
     Seven Tests ............................................ 78

5.   United Stationers, Inc. v. United States ............... 79

6.   The Experts ............................................         82
     A. Petitioner's Expert--Dr. Drew McDermott ............          83
     B. Respondent's Experts ...............................          87
          i.   Dr. Randall Davis ............................         87
          ii. The Tower Group ..............................          92

7.   Analysis of the Eight Sample Activities ................         97
     A. Strategic Banking System ...........................          98
     B. Trust TU ...........................................          112
     C. Success ............................................          115
     D. General Ledger .....................................          117
     E. Money Transfer .....................................          118
     F. Cyborg Payroll .....................................          119
     G. Trust Payment ......................................          121
     H. Debit Card .........................................          123

Conclusion .................................................. 125

     JACOBS, Judge:     By separate notices of deficiency, respondent

determined    the   following   deficiencies   in   petitioner's   Federal

income taxes:

           Docket No.           Year           Deficiency

             13908-92           1983           $2,605,571
                                1984            2,442,134
                                1985               29,187
                                1986           19,301,530

             20567-93           1987               93,413
                                1988            3,999,398
                                         - 5 -

              26213-93                1989           10,532,064

Respondent      also       determined   additional    interest    under   section

6621(c)2 for 1983, 1984, 1986, 1988, and 1989.

       Following the filing of petitions contesting respondent's

determinations, petitioner engaged Coopers & Lybrand, LLP (Coopers

& Lybrand), to ascertain whether it was entitled to credits for

increasing research activities pursuant to section 41 (the research

and experimentation credit, or R&E credit) between 1986 and 1993

with       respect    to    certain     internal   use   software   development

activities.3         Coopers & Lybrand concluded that 67 of 118 internal

use    software       development       activities    petitioner    engaged   in

qualified for the R&E credit.                On the basis of the Coopers &

Lybrand study, petitioner sought and was permitted to amend its

petitions to claim the R&E credit for 1986 through 1989.

       Subsequently, petitioner again sought and was permitted to

amend its petitions in order to carry back the R&E credit from 1990

       2
          Unless otherwise indicated, all section references are
to the Internal Revenue Code as in effect for the years in issue,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
       3
          Petitioner did not claim the R&E credit on any of its
U.S. Corporation Income Tax Returns for 1986 through 1991. The
engagement of Coopers & Lybrand in August 1994 followed the
Department of the Treasury's issuance of proposed regulations
that further defined research and experimental expenditures under
sec. 174. See sec. 1.174-2, Proposed Income Tax Regs., 58 Fed.
Reg. 15821 (Mar. 24, 1993).
                                   - 6 -

and 1991 to 1989 and to increase the R&E credit for 1986 through

1991.

     For purposes of trial, briefing, and opinion, the parties have

selected 8 of the 67 internal use software development activities

to serve as representative or sample activities to determine the

outcome of the other 59.     The parties agree that $20,552,274 of the

$22,658,829 in expenditures claimed by petitioner as associated

with the eight internal use software development activities have

been substantiated.        In addition, the parties agree that the

remaining 59 activities are deemed substantiated in the same ratio

(90.7 percent) as the 8 sample activities.             The parties further

agree that if we determine that any of the 8 sample activities

qualify for the R&E credit, the remaining 59 activities will be

deemed   qualified   for   the   credit    according   to   an   agreed-upon

formula.

     The sole issue we must decide herein is whether Norwest

Corporation & Subsidiaries (petitioner or Norwest) is entitled to

the R&E credit with respect to any or all of the eight sample

internal use software development activities conducted between 1986

and 1991.   Resolution of this issue requires us to interpret and

apply the four statutory requirements for the credit provided in

section 41, and the three additional requirements provided by

Congress in the conference report accompanying the Tax Reform Act

of 1986 (TRA 1986), Pub. L. 99-514, 100 Stat. 2085, specifically
                                - 7 -

relating to internal use software development activities. H. Conf.

Rept. 99-841 (Vol. II), at II-73 through II-74 (1986), 1986-3 C.B.

(Vol. 4) 1, 73-74 (and as adopted by the Department of the Treasury

in its proposed regulations, section 1.41-4(e)(5), Proposed Income

Tax Regs., 62 Fed. Reg. 83 (Jan. 2, 1997)).

                           FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.   The

stipulation of facts and the attached exhibits are incorporated

herein by this reference.

     Norwest Corporation, a Delaware corporation, is the common

parent of an affiliated group of corporations that timely filed

consolidated U.S. Corporation Income Tax Returns (Forms 1120) for

the years in issue.   It is a bank holding company whose affiliates

provide banking and other financial services.

     At the time the petitions were filed, Norwest Corporation had

its principal place of business in Minneapolis, Minnesota.

1.   Background

     During the years in issue, petitioner engaged in numerous

projects involving the development of internal use software--that

is, software developed solely for petitioner's internal business

and management purposes.    Most of these projects were managed and

executed by Norwest Technical Services, Inc. (NTS or Norwest
                                           - 8 -

Technical         Services),4      a    wholly    owned    subsidiary        of    Norwest

Corporation,         which   employed       between       600    and   800        technical

personnel, such as computer programmers.                   NTS occasionally sought

the assistance of outside consultants and contractors to provide

technical support for its projects.

       All of the eight sample activities at issue in this case

involve software applications.                   Software enables a computer to

perform         specific   functions       by    providing      instructions        to   the

computer in the form of source code.                   The source code is written

in a programming language, often according to an architectural

design, which commands the computer to perform the specific tasks.

(A compilation of programs or tasks necessary to operate the

software often is referred to as a system.)                       The source code is

then converted, through the use of a compiler, into executable code

that is readable by the computer.

2.   Software Development Methodology

       To maintain discipline, structure, and standardization in the

software development process, Norwest Technical Services created a

formalized approach known as the Software Development Methodology

(sometimes referred to as SDM).                  SDM was developed to prevent the

need       to   "reinvent    the       wheel"    by   providing    managers         with   a

documented process in developing software. The result was that SDM

       4
          Norwest Technical Services, Inc., was formerly known as
Norwest Information Services, Inc.
                                        - 9 -

improved controls and managed risks. SDM was applied in developing

new   software     by    Norwest    personnel      and    in    modifying    software

purchased from vendors.            The SDM procedures were applied to each

project activity, with the exception of small maintenance projects

that were grouped together for purposes of SDM.

      SDM involved the following nine phases, which permitted an

incremental approach to funding and development:

      A.    Phase 1:     Request

      In   the    request    phase,     those   seeking        the     development    or

modification        of    the      software     evaluate         the     feasibility,

cost/benefits, and risks associated with the project.                     During this

phase,     the    business   problem     to   be   solved       is   described,      and

potential business and technical solutions are discussed.

      B.    Phase 2:     Project Initiation

      In    the    project   initiation       phase,     expectations       regarding

project scope, deliverables, approach, costs, and schedules are

agreed upon, documented, and approved.                   Determinations are made

with respect to the skills required to complete the project, and a

project team is assembled.          Additionally, resource commitments are

made for future phases.

      During      this   phase,     a   Project     Risk       Assessment    Form     is

completed. This form "is used to evaluate the risk associated with

completing a project [and] * * * is intended to help the Project

Manager determine the kinds of structure and controls that are
                                   - 10 -

necessary to ensure project success."          The form does not measure

the project's technical risk.           Rather, the form is focused on

process risk; that is, whether the experience and skills of the

project team will allow completion of the project within the

project's parameters, as they have been determined, including time

and cost.

      C.   Phase 3:   Definition

      In the definition phase, the business requirements and needs

are analyzed and prioritized.         Additionally, the project's impact

on business and technical functions is reviewed.

      D.   Phase 4:   Logical Design

      In the logical design phase, the design (how it will be done)

of   the   business   solution   is    completed    on   the   basis    of   the

requirements (what needs to be done) set forth in the definition

phase. The logical design phase performs a so-called external view

of the project (that is, examining the project from a business

person's perspective to determine whether the needs of the business

can be met) before the development of the technical solution,

because the design of the business solution will often constrain

the technical solution. Also in this phase, consideration is given

to whether the necessary software can be purchased.              Finally, an

investment    decision   is   made,     and   the   cost/benefit       analysis

(previously performed in the request phase) is verified.
                                       - 11 -

     E.    Phase 5:    Physical Design

     In the physical design phase, which is sometimes referred to

as the technical design phase, the technical solution to the

business    problem        described   in    the   logical    design     phase   is

determined. The technical approach to building the system requires

consideration of the interfaces; that is, how the software operates

in conjunction with other applications or systems.                     During this

phase, the tools for building the system are described, as well as

the nature      of   the    interfaces      between   the   software    and   other

systems, the estimates of volume that requires processing, and the

timeframe for processing.

     F.    Phase 6:     Development

     In the development phase, physical system components are

constructed, documented, and verified.                During this phase, the

programmers write the source code that will allow the computer to

perform the required tasks, and initial plans are made for testing

the software.

     G.    Phase 7:    Testing

     In the testing phase, the technical development portion of the

project is completed.           During this phase: (i) Unit testing is

performed to determine whether the individual components of a

system    are   technically      ready   for    production,    (ii)     integrated

systems testing is performed to determine whether all components of
                                       - 12 -

a system can operate together, and (iii) acceptance testing is

performed to determine whether the business user's requirements

have been satisfied.         Further, during this phase, the programmers

correct errors in the coding process (known as debugging) as well

as in the design process.

     Typically,       the    testing     known      as   regression      testing      is

performed on prerecorded data.                The use of prerecorded data is

important because the testers have known solutions and outcomes

against    which   the      software    can    be   tested,   and     new       methods,

capabilities, and functions can be tested without risk to real

(production) data.

     H.    Phase 8:      Implementation

     In the implementation phase, the software is placed into

production    (also    known    as     going   live),     usually   in      a    gradual

process.     During this phase, the software application is used on

actual data by the end users (those who will be using the software

product).     It is also during this phase that the end users are

trained in the use of the software.

     I.    Phase 9:      Postimplementation

     In the postimplementation phase, the software is maintained

through continuous debugging, updating, and enhancing to meet new

business needs.
                               - 13 -

     J.   Application of the Software Development Methodology

     The development of software applications does not end with any

particular phase of the Software Development Methodology.       The

process is often iterative in that unanticipated problems are

discovered in one phase that require the developers to return to a

prior phase. For example, during the testing phase, the developers

may learn that the software is not sufficiently scalable; that is,

that it cannot handle variances in the volume of data to be

processed.     In such a case, the project may be returned to the

physical design or development phase to reconsider the technical

approach or the source code used and, after modifications, resume

the testing phase.    This iterative process continues until either

the software is operational to the satisfaction of those involved

or the project is abandoned because of either technical or business

constraints.

     Throughout the SDM process, some form of technical risk (the

risk that the project will not succeed for technical reasons) is

present, even after the software is placed into production.     (The

risk of failure exists throughout a project because problems that

arise because of volume or scale cannot be resolved until the
                                 - 14 -

implementation   phase.5)    Norwest   did   not   maintain   any   formal,

documented method of reporting this technical risk.

3.   The Eight Sample Internal Use Software Development Activities

     During the mid-1980's, Norwest made a concerted effort to

expand its banking and financial services business.           Between 1986

and 1991, Norwest's assets grew from approximately $20 billion to

more than $38 billion (and by 1995, Norwest's assets further grew

to over $75 billion).       Given the anticipated growth of Norwest's

business that was forecast in 1986,6 Norwest Technical Services was

assigned the task of determining the necessary data processing

support structure and technology to handle this expansion.

     The eight sample activities, and the substantiated expenses

incurred by Norwest with respect to each activity for the years in

issue, are as follows:

     5
          The testing of software for volume or scalability
cannot be completed before the implementation phase because of
the cost required to replicate a full production environment.
     6
          In 1986, petitioner expected that most States would
liberalize their branch banking restrictions and permit more
interstate banking services.
                                                    - 15 -

 Activity           1986         1987        1988         1989          1990         1991         Total1

                2
 Strategic      $451,386      $1,367,679   $2,441,576   $2,696,099    $2,260,394   $3,073,334   $12,290,468
 Banking
 System

 Trust TU           373,469     623,538      551,729      742,462       649,270      650,161     3,590,629

 Success             ---          ---        129,320      138,196       410,030      303,452       980,998

 General            173,596     136,735       94,744      384,237       175,020      183,468     1,147,800
  Ledger

 Money              85,179      173,925      193,493      224,109       125,610      180,462       982,778
  Transfer

 Cyborg             73,881       90,923      100,683         74,991      82,056      130,714       553,248
  Payroll

 Trust              93,265      171,334      182,047      101,704         ---          ---         548,350
  Payment

 Debit Card          ---          ---         22,687      435,318         ---          ---         458,005

1       The total expenses for the eight activities equals $20,552,276. The $2 discrepancy for the
total amount the parties agreed in their stipulation was substantiated is unexplained.
2       The expenses incurred on the Strategic Banking System project for 1986 were contract expenses
paid to Electronic Data Systems Corp.

           A.   Strategic Banking System

           Strategic Banking System (SBS) was a large7 joint effort by

three entities to develop an integrated banking system in which a

number of software applications would operate together. Electronic

Data Systems Corp. (EDS) of Dallas, Texas, and Bank One, Columbus,

N.A.8 (Bank One), of Columbus, Ohio, began the SBS project on

August 18, 1986.               The purpose of the SBS project was to develop a

software system in which all information regarding the bank's

financial products centered around the customer (the customer

           7
          By 1993, the three entities involved in developing SBS
had incurred approximately $125 million in expenses and written
10 million lines of code.
           8
                    Bank One, Columbus, N.A., is an affiliate of Banc One
Corp.
                                         - 16 -

module) rather than a particular account.                 Before the development

of SBS, information relating to individual bank accounts or other

financial products was not linked but rather was maintained in

separate systems.       Thus, when information about one account was

retrieved on a computer, the user would have no way of obtaining

information    about    other      accounts       owned   or   maintained      by    the

customer or a related customer.                The SBS project sought to change

that situation by integrating all account software systems around

the customer.     The customer module, which would contain basic

information    about    the       customer      (e.g.,    name,     address,   Social

Security   number,     and    demographics),        would      be   integrated      with

deposit and loan (or credit) modules so that information relating

to customer deposit and loan accounts could be readily accessed and

retrieved.

      Because of concerns that SBS was becoming specific solely to

Bank One's needs, in late 1986 Norwest was asked and agreed to join

in   the   development       of    SBS    to    provide    more     of   an   industry

perspective.    In exchange for sharing in the development costs of

SBS, Norwest received a perpetual license to use the system.9

      9
          Norwest paid a base development charge of approximately
$6.5 million to Bank One (although the Participant Agreement
between Norwest and Bank One required a $7 million payment) in
exchange for a percentage of the royalties to be paid to Bank One
by Electronic Data Systems Corp. (EDS). Further, Norwest paid
$1,750,000 to EDS in exchange for a perpetual license to use SBS.
                                                   (continued...)
                                  - 17 -

     Before joining the SBS development project, Norwest considered

other alternatives.    In this regard, Norwest examined commercially

available   software   in   the   market,   considering   the   products'

functionality, economic benefit, scalability, and applicability to

interstate banking activities.      In particular, Norwest focused on

a software product offered by Hogan Systems, Inc. (Hogan). Norwest

ultimately rejected the Hogan product because it did not meet

Norwest's volume and economic benefit criteria.

     Norwest also considered building its own system. It abandoned

this idea, however, believing that the opportunity to enter into a

development project with EDS and Bank One would enable it to

achieve its goal and limit its risk.        Accordingly, on December 16,

1986, Norwest entered into a Participant Agreement10 with Bank One,

and a separate Participant License Agreement with EDS.

     Section 3.2 of the Participant Agreement between Bank One and

Norwest provided for Norwest's role in the development of SBS:

     In connection with the development of the Financial
     System by EDS as contemplated under the [EDS-Bank One]
     Participation Agreement, Norwest will, on a timely basis

     9
      (...continued)
As part of a separate license agreement, Norwest paid EDS $1.2
million to use the software in connection with services provided
to nonaffiliated financial institutions.
     Under the participant and license agreements, EDS maintained
all ownership rights to the SBS system.
     10
          The Participant Agreement was amended on Sept. 8, 1988,
Feb. 8, 1992, and again in July 1992.
                                    - 18 -

     as requested by * * * [Bank One] so long as this
     Agreement shall be in effect:

           (a) Perform its tasks in connection with the
           Development Plan including providing banking
           expertise required from time to time by * * *
           [Bank One] and provide management decisions
           and support as reasonably required by * * *
           [Bank One] to develop the Development Plan.

           (b) Develop     with   the   cooperation   and
           assistance of * * * [Bank One], test data and
           test conditions which * * * [Bank One] will
           use in connection with its obligations with
           EDS in order to perform system testing
           designed to establish that each component of
           the Financial System functions in accordance
           with the applicable Functional Specifications.

           (c) Cooperate with * * * [Bank One], and, if
           requested, with EDS, by, among other things,
           making available as reasonably requested by *
           * * [Bank One], office space and services at
           Norwest's premises, personnel, information,
           approvals, and acceptances in order that the
           work required of EDS or of * * * [Bank One]
           may be accomplished in accordance with the
           Development Plan.

     EDS' primary tasks in the development of SBS were to define

the technical environment for SBS, to provide the necessary tools

for its development and production, and to ultimately construct the

system (including the writing of the source code).            Bank One's and

Norwest's primary tasks were to provide the business requirements

for the software (the logical design phase, which was the greatest

expense   for   the   participant    banks   in   the   SBS   project).   In

addition, Bank One and Norwest provided the technical expertise as

to how such systems should operate in a banking environment.
                                  - 19 -

Ultimately, though, only EDS actually developed the technology and

the source code.

     Bank One and Norwest employees worked with EDS employees to

determine   the    appropriate   technical        environment,   tools,   and

products for SBS.       (At any given time, approximately 100 people

from each entity worked on the SBS project.)              Employees of the

three entities met approximately every 6 weeks to review and

critique the work done to date and to recommend changes to the

technical   design.11     As   part   of   this    process,   NTS   personnel

conducted research and proposed solutions to design problems.

     As part of the logical design phase, EDS technical personnel

met with Bank One and Norwest employees to learn about the banking

     11
          For example, Bank One and Norwest employees raised
concerns about whether DB2, a relational database system EDS
proposed using for SBS, could handle the volume of data the
parties projected would be run on the system. Ultimately, Bank
One and Norwest employees conceded that DB2 was appropriate when
EDS demonstrated its success in other high-volume environments.
     Another concern raised by Bank One and Norwest employees
related to the use of so-called dummy terminals. EDS proposed
maintaining all data in a mainframe computer (which would perform
all data processing and run all applications) and placing
nonintelligent dummy computers at user stations (e.g., bank
teller windows and desks). The dummy computers could access the
mainframe's data and software applications through a special menu
screen but could not perform any processing functions on their
own. Bank One objected to this proposal primarily because it was
already using personal computers (PC's), which enabled its users
to access data from a host computer, to input new information
through software applications processed locally on the PC's, and
to ship the new data back to the host computer for updating.
(This is known as a client-server architecture.)
                                - 20 -

business requirements and needs for the system (a process known as

data modeling).      The bank employees (e.g., bank tellers) would

explain to the EDS personnel the types of functionality (i.e.,

information) that they needed to access in using the SBS system.

Additionally, business analysts at Norwest examined the various

functionality requirements of the bank employees and drafted design

documents indicating the recommended design approaches or changes.

     After EDS completed the initial design and development phases,

Norwest was used as the test bed for SBS.         A large database of

sample test data was created, and as early design releases arrived

from EDS, Norwest ran SBS in its computer environment to test the

software.    These    tests   were   conducted   on   multiple   days   of

transactions to observe the performance of the system over a

specific time span.    After a test run, the results were analyzed,

EDS employees were debriefed, and suggested changes to the design

were made.   These testing and redesigning phases continued for

approximately 3 years in the case of the customer module and for

approximately 4-1/2 years in the case of the deposit module.

     Norwest discovered hundreds of problems in the modules it

received from EDS.     One problem that arose in the development of

the customer module was its interface link to the deposit and loan

application systems already in place at Norwest during that time,

which was necessary until the new SBS deposit and credit modules
                              - 21 -

were developed.   Another problem that arose was the development of

a so-called pointer system which allowed the end user to access

information about a customer through one of various identification

sources (e.g., name, account number, Social Security number, etc.).

The pointer system was one of the more critical functions of the

SBS software.

     Many of the problems were reviewed and corrected during the

testing phase by Norwest technical staff, who would inform EDS

personnel of the problems and recommend corrective changes to the

software.   (A small group of programming experts was assembled

specifically to handle the SBS problems through the use of a

specialized case tool called PACBASE, which was selected by EDS.)

Norwest employed a repeatable testing process to isolate problems

and find solutions.12   A running list of these technical problems

was maintained in a system provided by EDS.   Not all problems were

resolved in this process, and often new problems arose from the

correction of old ones.    Some of the problems that arose in the

development of SBS were attributable to poor programming and the

     12
          This was a particularly difficult process because three
different entities were working on the development of SBS.
Norwest had to reconcile all of the changes and discover the
source of the problems. This process required the isolation of
each change made by each entity for testing purposes. Often the
attempts to correct one set of problems created new ones.
                                 - 22 -

delivery of faulty code by EDS; others were attributable to poor

technical design.

     Ultimately,    the   customer   module   of   SBS    was   successfully

developed (although it contained many bugs). During 1989 and 1990,

it was placed into production (the implementation phase) by Norwest

in its banks and used for a number of years.13           The deposit module

was a technical failure. The failure was attributed to the deposit

module's inability to produce the results sought by the users in

     13
          A test pilot program for the customer module began in
Norwest's Duluth, Minnesota, bank in November 1989 and continued
through early 1990. After the pilot proved successful, it was
implemented throughout 1990 in Norwest's other banks around the
country in what was known as release 1.2. During 1991, EDS
issued a new upgraded release of SBS which required Norwest to
"retrofit" the core functionality and design changes with the
customization performed by Norwest in the interim period since
the prior release. The upgraded release required a new round of
testing and modifications by Norwest technical staff in
conjunction with EDS. Many of these changes related to technical
problems (such as the source code for the pointer system), and
others related to nontechnical cosmetic problems (such as
changing the name of a database field or the way a screen looks
to the end user, or modifying reports produced by the software).
A statement of work dated Oct. 10, 1992, reported:

          The migration of the Customer system from EDS
          Release 1.2 to Release 1.3.2 was completed
          for all Norwest banks using Customer in June
          of 1992. Installing Release 1.3.2 involved a
          massive effort of customization, testing and
          converting the existing data bases to the new
          release. Since the banks have been using
          Customer 1.3.2, problems have been
          identified.
                                   - 23 -

terms of stability and reliability, as well as its inability to

timely process or handle the volume of data required.

     Because of the failure to adequately develop the deposit

module, which was supposed to work in conjunction with the customer

module, Norwest abandoned SBS in 1993 and turned to an alternative

system created by Hogan.         Following a 5-year joint venture with

IBM, Hogan developed a customer module system which performed

approximately 90 percent of the functions needed by Norwest and met

Norwest's critical volume requirement.

     After the period in issue, both the customer and deposit

modules were eventually successfully implemented at Bank One.            The

record does not indicate the ultimate success or failure of the

credit module and its implementation at Norwest or Bank One.

     B.    Trust TU

     The   Trust   TU   system    consisted   of   a   group   of   software

applications designed to maintain trust accounts, including the

tracking of assets, purchase and sale of securities, and collection

and disbursement of income.         The software for this system was

purchased from a vendor in 1979 and installed in 1981.              Norwest

made numerous changes to the system in subsequent years.
                                - 24 -

     Between   1986   and   1991,   Norwest   instituted   hundreds   of

projects14 to improve the Trust TU system's functionality (including

compliance and regulatory changes) and to reduce processing costs.

These projects involved all stages of the Software Development

Methodology.

     Between two and five senior programmers were assigned to

accomplish the goal of reducing the monthly cost per trust account

that was being maintained.    Before 1987, the average monthly cost

per account was approximately $9.      By 1990, the monthly cost per

account was reduced to approximately $4 or $5.

     The programmers were also assigned the goal of increasing the

volume of trust accounts maintained in the Trust TU system.           In

1986, there were approximately 25,000 trust accounts running on the

system, and the number of trust accounts was increasing by 10 to 12

percent per year.     It was assumed that the existing system could

not handle more than 30,000 trust accounts.

     To accomplish both goals (reduction in cost and increased

volume), NTS had to increase the speed of the so-called batch

process15 that occurred each night.      (During the day, the Trust TU

     14
          Some of the smaller projects included building reports,
updating software to reflect regulatory changes, converting
acquired bank trusts customers, and changing screens.
     15
          The batch process consists of editing information,
posting information, extracting information, and producing
                                                   (continued...)
                                  - 25 -

system was on-line and transactions were stored.           Beginning at 6

p.m., the on-line system was shut down, and the trust accounts were

updated on the basis of the transactions that had occurred during

the day.)    There was a maximum 12-hour window to accomplish the

batch process.

     Before the start of the project to increase the speed of the

batch process, approximately 10 of the 12 hours of available time

for batch processing were being used.        To reduce this time and to

more efficiently use the mainframe computer's disk space (where the

trust account data was stored), NTS needed to determine how to

increase    the   number   of   processing   jobs   that   could   be   run

concurrently rather than serially.         To accomplish this goal, NTS

developed a module of as many as 20 processes to determine which

batch processing jobs had to be run concurrently and which had to

be run serially. This required a determination of those processing

jobs that were independent and those that were interdependent.           In

this respect, the jobs had to be organized in a manner so that no

two jobs were updating the same account at the same time.

     After the module was designed and built, unit testing was

performed on a subset of accounts on the mainframe computer.            The

test outcomes produced varied results. Some of the concurrent jobs

     15
      (...continued)
transactions for the following day.
                                 - 26 -

ran more slowly than they did as serial jobs, and others ran

faster. To determine why some concurrent jobs ran more slowly, the

programs that constituted the module had to be reexamined and

reorganized using a different approach to the module's design.          At

times, different modules were considered and used to increase

efficiency.   Hundreds of test batch processes were performed over

a 3-year period to accomplish NTS' goals.     Eventually, NTS was able

to reduce the total batch processing time to approximately 6 hours.

     The Trust TU system was abandoned when the number of trust

accounts reached 40,000.   In 1993, NTS switched to another system

(known as Compass) which used newer technology.

     One of the numerous projects relating to the Trust TU system

during the years in issue involved the development of an interface

between Norwest's trust system and a vendor-supplied fiduciary tax

reporting system called Fasttax.      The interface was necessary to

transfer trust account information to the tax system in order to

calculate the appropriate tax and thereafter send that information

back to the trust system in order that checks could be issued and

remitted to the various taxing authorities.       The primary concerns

involved in   this   interface   project   were   the   accuracy   of   the

information coming from Fasttax to the trust system and the ability

to process that information in a timely manner for filing tax
                                         - 27 -

returns.        The    development      of   this    project      followed    the   SDM,

including extensive testing on a separate test bed.

        Yet another project, the Micro IS system, which was vendor

supplied,      was     designed    to    automate       purchases     and    sales    of

investment securities.          This portfolio management system permitted

a "what-if" analysis whereby the user could examine the impact of

hypothetical purchases and sales.                When Micro IS was purchased, it

was written in Lotus (a spreadsheet program). The processing time,

as much as 5 minutes, was unacceptable to NTS.                     Consequently, NTS

suggested to the vendor that the application be written in a

"higher" language, such as C, to increase the efficiency of the

system.        The    vendor    accepted     the    suggestion     and   rewrote     the

application for Norwest.           The result, after an iterative testing

process by Norwest taking approximately 6 to 9 months, was the

reduction in response time to less than 5 seconds.

     The Micro IS system required two other notable changes.                         One

was to increase the speed by which data could be extracted from the

mainframe computer (which updated the data the night before) and

sent to the Micro IS system.              The trust portfolio data had to be

extracted and loaded on to the Micro IS system from the mainframe

each morning by 7 a.m., at which time portfolio managers arrived at

work.     As a result of this time constraint, the vendor had to

rewrite    a    portion    of    the    system     in   the   C   language.    Norwest
                                  - 28 -

conducted iterative testing on its accounts following the vendor's

rewriting of the software.

     The second notable change was to increase the speed by which

the purchases and sales of securities by portfolio managers could

be sent from the Micro IS system to the Trust TU system.            This

change required the writing of polling software that essentially

checked the Micro IS system every 8 to 10 seconds in order to

determine the occurrence of any trades that needed to be sent to

the Trust TU system.       The increased speed was achieved by writing

the program in a language called Clipper, after the rejection of

two other languages.

     Each of these changes resulted in increased efficiency in the

use of the Micro IS system both in terms of cost per account and

speed of nightly batch processing.

     C.     Success

     The Success system was designed in-house by Norwest to improve

the speed and efficiency of the data processing for Norwest's

equipment leasing business.       It supported all aspects of leasing

activity, including origination of contracts, tracking assets,

invoicing     customers,    tracking   collection,    accounting,   cash

management, and off-line reporting.        Success was developed between

1988 and 1991 by a group of 15 to 20 people within the Norwest

Financial Information Services Group (NFISG), the data processing
                                       - 29 -

department for Norwest Financial, Inc. (Norwest Financial), a

Norwest Corporation subsidiary.                 Norwest Financial is in the

consumer finance business and provides various types of lending

products, sales finance, and revolving charge products, as well as

data processing services to other unaffiliated consumer finance

companies in the industry.

       Before the development of Success, Norwest Financial Leasing

(the   subsidiary    of    Norwest      Financial     for   which     Success    was

developed) used a system known as Infolease for its equipment

leasing business which was not meeting its needs.                    The Infolease

system was causing delays for the users with respect to month-end

data processing which in turn required the system to be off-line

for approximately 3 days. During the time the system was off-line,

users had to maintain records manually, and the data could be

entered only after the system was on-line and running again.                      If

problems arose in the month-end processing, the system could be

down for 7 to 10 days.

       NFISG   lacked     the    expertise      to   maintain   or    enhance     the

Infolease      system.    As     a   result,     NFISG   was    unable     to    make

improvements to that system.

       The   development        of   Success    required    NFISG     to   use    the

networking of various operating system platforms.                    In Norwest's

leasing offices, where the end users were situated, minicomputers
                                   - 30 -

were in place.       Data would be input into the minicomputers, which

would then send the information to a mainframe computer, known as

a Tandem system.        (The Tandem system was a highly reliable and

scalable data processor which stored static data; that is, data

which would not change on a regular basis.)                The Tandem system

would then send a message back to the minicomputers indicating the

receipt and update of the new data.           If the entered information

required    number    crunching,   the    Tandem   system    would    send   the

information to the transaction processing facility (TPF) known as

SWIFT.16    These three systems--the minicomputers, Tandem, and the

TPF--were      all   on-line   systems,   which    meant    that     they    were

continuously updated and processed in real time, so that the

results could be verified immediately.

      After a transaction or data input was completed, a real-time

activity (RTA) record would be created which provided a snapshot of

what had occurred.       The RTA records would then be written onto a

tape which was used to create off-line reporting or month-end batch

processing on an IBM MVS system.

      During the first 6 to 9 months in the development of the

Success system, NFISG personnel met with the intended end users of

the   system    to   determine   their    needs.   These    meetings,       which

      16
          Examples of the processing performed by SWIFT included
billing, aging of accounts, earnings calculations, and
depreciation.
                                     - 31 -

continued throughout the design, coding, and testing phases, were

designed to ensure a minimum level of functionality in the new

system, as well as appropriate improvements from Infolease.                   As

part of this development process, NFISG needed to learn many

aspects of Norwest Financial Leasing's business. Additionally, in

the early development phases, NFISG studied the Infolease system to

determine what data records needed to be maintained.

     The primary17 technical concern at this point was the TPF

system.    The     existing    system   was     designed    to    handle   "short

records"--referring to the size of the transactions--between the

mainframe computer and the minicomputers. To obtain the efficiency

needed,   NFISG    sought     to   create   a   system     that   could    handle

transactions with longer and varying sizes.                As a result, NFISG

examined the development of a message system that could pass

information       efficiently.18     Further,      NFISG     considered       the

accessibility     of   the    data   through    direct-access      indexing    to

minimize disk space and increase response time.                   Additionally,

     17
          Other issues included human interfacing--the user's
ability to navigate through the system according to the screens
set up on the system. Additionally, NFISG addressed off-line
reporting capabilities of the system.
     18
          To increase efficiency in the TPF system, NFISG
programmed the system using an "assembler-based" language, which
is a lower level (i.e., each assembler instruction can be
directly interpreted to machine language) and less descriptive
language than most other programming languages.
                                     - 32 -

there was concern over "error recovery" to maintain data integrity

--the   need   to   return    the    system    to    its   state   prior    to   the

transaction in the event the transaction process failed.                   In order

to address the problem of error recovery, the technical support

staff developed a design through macros (code that is frequently

used throughout the system and which, through standardization,

ensures data integrity and reliability).               All of these technical

concerns were addressed and ultimately led to an initial design and

conceptualization of the TPF system for Success.

     Following the development of a basic design of the TPF system,

the project was divided into smaller projects and assigned to

different analysts.      Code development then began, including the

development of macros.        (Following the coding process, the divided

projects were reintegrated for the testing phase.)                  Additionally,

some redesigning occurred upon the discovery of concepts which did

not operate as anticipated.           Throughout this development phase,

unit testing occurred on two separate test beds (one for the TPF

system and the other for the IBM MVS reporting system) followed by

systems   testing    (e.g.,    the    TPF     with   the   Tandem    system)     and

acceptance testing for the users.             This coding and testing phase

lasted 1-1/2 to 2 years.

     Success was implemented and placed into production following

the coding and testing phases, although there was some delay.                     As
                              - 33 -

part of the implementation phase, NFISG was required to convert the

data from the Infolease system to the Success system.         This

required parallel operations of both systems to ensure that the

data had been properly converted and that all aspects of the new

system were working in accordance with the users' needs.     After

production began, NFISG sought to improve the response time of the

minicomputers in retrieving information.

     Ultimately, the Success system improved speed and efficiency

in the month-end processing, reducing the processing time from 3 or

more days to overnight.

     The Success system was leased out to other leasing companies

affiliated with Norwest Corporation.

     D.   General Ledger

     The General Ledger (G/L) system was an integrated collection

of software applications designed to support and maintain Norwest's

general ledger accounts and to produce balance sheets, income

statements, and other similar reports for Norwest.   Approximately

five NTS persons were assigned to work on the G/L system.

     During the years in issue, the corporate controllers who used

the G/L system annually met with NTS personnel to discuss their

business goals. The primary purpose of these meetings was to

discuss ways to improve the source code in order to expedite the

month-end closing of the corporate books.
                               - 34 -

     The G/L system was based on a widely used vendor-supplied

package known as Financial Control System (FCS).          After purchasing

the FCS G/L system, Norwest customized approximately 25 percent of

the vendor code.

     Throughout the relevant time period, NTS needed to upgrade the

system and install new vendor releases.            This posed problems

because of the customization work already conducted by NTS on the

vendor code. The upgrading required NTS to study how to "retrofit"

the new vendor code with both the old code and the customized code

without sacrificing the functionality and efficiency needed.             The

retrofitting process involved the use of Norwest's SDM and included

reiterative unit, integrated, and acceptance testing.          The testing

usually sought to isolate problems in the code that required

debugging or rebuilding.

     During the retrofitting process, NTS found that the vendor

code was inefficient with respect to the corporate consolidation

component   (consolidating   and   eliminating    transactions      of   the

various   corporate   divisions)   of   the   software.      This   problem

required a redesigning of the software by NTS.       To accomplish this

redesign, NTS examined various structures (containers for holding

the data) and tools for providing similar functionality as provided

in the vendor code but with greater efficiency.
                                    - 35 -

       Another corporate consolidation project involved automating

the    corporate   consolidation     process.    Before      NTS'   work,    the

corporate consolidation process was manual, requiring corporate

personnel    to    examine   cost   center   reports   and    determine      the

appropriate location of transactions to appropriate accounts.                The

automating of the corporate consolidation process through SDM

involved four or five technicians conducting extensive testing over

a 2-year period.

       Another project with respect to the G/L involved the on-line

component of the system.        Every evening, the mainframe computer

went off-line and updated the G/L system with transactions that had

occurred during the day.            However, often during the day the

corporate controller's office or other Norwest personnel needed

access to the G/L system to obtain on-line updates for ad hoc

reporting.    This presented a problem because the updating occurred

at night--whereas users often needed real-time updates during the

day.    To accommodate the users' needs, NTS developed a "shadow

file" system, which was a secondary set of files, copied from the

primary files, that could be used for off-line reporting.                   As a

result of the shadow file system, the users had access to shadow

files with real-time updates.

       The shadow file system presented technical issues for NTS.

The shadow file system worked on a DB2 database system which, at
                                   - 36 -

the time, was new to both the vendor (IBM) and to Norwest.                    The

Norwest users found DB2 to have a slow response time; consequently,

as users queried the database files for access to data, the queries

became backed up--each query waiting for the query ahead of it to

be   completed.      Although    the   resolution     of   this     problem   was

important, it involved no more than basic troubleshooting by IBM

and NTS personnel.

      Another problem, which was similar to the one resolved by the

shadow file     system,   involved     the   great   number    of    batch    jobs

processed each evening.      Because of the large number of users who

wanted     reports   processed   following    the    evening   updating,      the

mainframe often became locked out (known as getting IO bound) so

that jobs requiring access to the same data at the same time could

not be completed.      As a result, NTS both developed a system that

provided multiple data files for the jobs to run against and

created a mainframe scheduling system that allowed an organized

processing of the batch jobs.

      There were several other, albeit smaller, projects that were

addressed by NTS personnel during the years in issue, ranging from

report writer customization to new releases to interface tasks.

      E.    Money Transfer

      The money transfer, or wire transfer, system was a software

package that enabled Norwest to move funds electronically in real
                                  - 37 -

time from its accounts, through the Federal Reserve System (the

Federal Reserve), to the destination financial institutions.19 (The

software    also   permitted   transfers   from   other   institutions   to

Norwest.)    During the years in issue, NTS was engaged in many

projects20 designed to address Federal Reserve regulatory changes

and Norwest's business needs. (Norwest was experiencing a large

growth in the wire transfer business--20 percent or more per

year.21)

     19
          To effectuate a wire transfer of funds, Norwest set up
a contra account (also known as a due-to/due-from account) with
the Federal Reserve. When a Norwest customer wanted to make a
transfer, Norwest would debit the customer's account and credit
its own account at the Federal Reserve. The Federal Reserve
would then debit Norwest's account and credit the destination
institution's account. This procedure was used for all domestic
wire transfers; international wire transfers did not go through
the Federal Reserve.
     Initially, the wire transfer system used by Norwest did not
provide for international wire transferring of funds.
International transfers occurred through other, antiquated,
systems which were manual and paper based. Norwest converted the
international wire transferring to the MoneyNet system, which
provided on-line, real-time transfers and validation. This was a
large project that took several months of work.
     20
          Some of the smaller projects included additions and
changes to the screen and reporting functions of the system.
     21
          Norwest was processing approximately $5 to $7 billion
in wire transfers per day. The expansion of this business raised
critical security issues that had to be addressed any time new
technology was instituted. (In fact, Norwest was the victim, on
at least one occasion, of a fraudulent wire transfer ring that
infiltrated the system.) Thus, any software development was
constrained by security concerns.
                                 - 38 -

     The   money   transfer   system    was   based   on   vendor-supplied

software, known as MoneyNet, purchased by Norwest during the early

1980's.    Although the MoneyNet system did not provide all of the

functionality Norwest needed, following an assessment of all other

software on the market, NTS determined that MoneyNet was the most

viable for its long-term needs.        In anticipation that changes to

MoneyNet would be necessary, Norwest acquired the system's source

code from the vendor.

     The first major regulatory change to affect Norwest was the

Federal Reserve's so-called 5 p.m. rule.          In general, this rule

stated that all wire transfers were to be completed by 5 p.m. each

business day.   For years prior to 1986, the Federal Reserve did not

enforce the rule, staying open as late as necessary to accommodate

businesses whose systems failed or which otherwise could not

complete their transfers before 5 p.m.        But by the late 1980's, the

Federal Reserve began strictly to enforce its rule, which required

institutions    such   as   Norwest    to   develop   systems   that   were

sufficiently reliable to ensure the timely transfer of the funds.

The failure to complete transfers by 5 p.m. could result in severe

consequences to Norwest: (1) It would be liable for interest

payouts on the funds it was unable to transfer (an estimated $1

million per day); and (2) it would be potentially liable for any
                                - 39 -

business deals of its customers that were not completed because it

was unable to transfer funds.

     In response to the Federal Reserve's enforcement of the 5 p.m.

rule, NTS examined the timeliness of the MoneyNet system in terms

of logging and processing the wire transfers. To protect itself in

the event the system crashed, NTS developed a contingency site22

(also known as a disaster site or hot site) in which all logs of

wire transfers were copied or mirrored from the production site to

a second site in real time.   Thus, if the production system failed,

the users could simply move over to the contingency site and

complete the transfers on that system.      At the same time, NTS

needed to quickly recover the production system from the point at

which it crashed so that the users could continue logging transfers

for its customers.

     The second major Federal Reserve regulatory change affecting

Norwest was the so-called daylight overdraft rule.   Often, because

of the large number of transfers to and from wire institutions,

many of which were not settled until the end of each business day,

some institutions maintained negative balances in their Federal

Reserve accounts during some part of the day, which placed a risk

     22
          The wire transfer system's lack of a contingency site
resulted in Norwest's being cited by the Office of the
Comptroller of the Currency and Norwest's internal auditors
because of the potential for large losses.
                                - 40 -

on the Federal Reserve if the wire transfers were not settled.         In

general, the daylight overdraft rule stated that the Federal

Reserve would not permit wire transfer institutions to maintain

balances in their Federal Reserve accounts below a specified

minimum   level.   The   same   prohibition   applied   to   the   bank's

customers with respect to their bank accounts from which the wire

transfers were coming and going.

     In response to this rule, Norwest developed (over a 9-month

period) two programs (one each for the Federal Reserve accounts and

for customer accounts) that monitored the wire transfers and

essentially froze all transfers from an account once the minimum

credit level was reached.

     Another project, referred to as the distributed wire project,

involved Norwest's attempt to consolidate all wire transfers among

its branch locations to one bank location in Minneapolis.          Norwest

was concerned with the manual, paper-based systems used in its

branch banks, particularly in the Des Moines and Omaha branches,

which had a history of crashing (which meant the systems were down

until repaired) because of too much volume.

     NTS sought to run all wire transfers on the MoneyNet system.

The bank branches were provided with a fault-tolerant system which

provided protection against system crashes similar to that used in

the 5 p.m. rule project's contingency site system.       One technical
                                              - 41 -

problem      with    the        MoneyNet      system    addressed      by    NTS   was   the

software's inability to take into consideration the multibanking

environment of Norwest. In this regard, the software did not fully

recognize all of the accounting relationships among the different

Norwest banks, and thus the accounting records were often incorrect

following a wire transfer.

      NTS allocated five or six technicians to remedy the problem.

The technicians mapped out the appropriate accounting entries in

order to determine which entries were not properly made following

a wire transfer.                They then filled in the gaps in the code.

Following each change to the code, the changed code was tested and

retested. The distributed wire project improved efficiency through

the elimination of much of the paper process.                          It also improved

reliability through the fault-tolerant system.

      During the years in issue, the vendor released upgrades of the

MoneyNet software.              The installation of these new releases posed

compatibility problems for Norwest as a result of prior changes to

the   code    made        by    NTS.    The    retrofitting       process      required    a

comparison      of    the        new    and    old     vendor   codes       with   the   NTS

modifications        to        ensure   that    the     required      functionality      was

maintained.

      For    all     of    the     MoneyNet     projects,       NTS   employed     the   SDM

process, continually testing the modifications to the system to
                               - 42 -

ensure that the code worked properly and that functionality was not

compromised.

     F.     Cyborg Payroll

     The Cyborg payroll software was a payroll management system

designed to automate the calculation and payment of wages to

employees and taxes to Federal, State, and local authorities.    It

also maintained and processed audit reports of those payments. The

Cyborg software was vendor acquired in the late 1970's, although it

was originally designed in the mid-1960's.    Given the age of the

system, much of NTS' effort was focused on "trying to keep it

running".    Eventually, after the period at issue here, Cyborg was

replaced by a payroll system known as Peoplesoft.

     Cyborg was customized by Norwest to meet its needs, including

the need to make nonstandard payments to certain employees and to

maintain different types of reports. NTS developed its own "method

code" which permitted the users to customize payments or deductions

for employees--a function not fully available on the original

version of Cyborg.23

     During the years in issue, there were as many as 50 discrete

service projects with respect to Cyborg.   They included:   Payroll

     23
          For example, customization of the various payments and
deductions was necessary to reflect different tax withholding
rates in different States and to reflect the imposition of local
or county taxes in some jurisdictions.
                                    - 43 -

method code JL--calculating the amount of paycheck deductions for

savings and investments plans; Cyborg release 34--implementation of

a new vendor release of the system; payroll work facility--a mail

station identifier for the users; payroll general ledger reports--

changes to the reports made from the interface with the general

ledger; and payroll Cyborg yearend--customizations with respect to

the yearend production of documents.

        Upgrades and new releases were common, particularly with

respect to changes in the tax laws that required changes to the

payroll system.       The many customization projects involved changes

to each of the three programs (the edit program, the calculation

program, and the print program) that constituted the heart of

Cyborg.

        In using the Software Development Methodology to customize the

Cyborg    software,     NTS   reviewed   the   old    and   new    source   codes

(obtained from the vendor) to determine where the customized code

could    be   written   without    sacrificing       required     functionality.

Following the design and development phases, NTS conducted test

payroll and reporting runs in order to ensure that the users' needs

were met.     As part of this process, in order to verify that the

results were consistent, NTS tested the system both before and

after the changes were made.
                                         - 44 -

       One area that created a problem in customizing Cyborg for

Norwest's needs was the programming language for the reporting

function.         The three main programs of Cyborg were written in an

older COBOL language (a common mainframe programming language), but

the reporting program was in a language specific to Cyborg which

had severe limitations.            Moreover, the Cyborg language was not

designed for the mainframe systems used at Norwest, but rather for

personal computers.

       Besides customization, NTS was responsible for converting the

payroll systems of the banks acquired by Norwest to the Cyborg

system.       The Cyborg software was not developed specifically to

handle      conversions    of   this     nature.    Consequently,    NTS   had   to

determine a means of converting the payroll data, or perform the

conversions manually (in the case of small banks).

       G.     Trust Payment

       The Trust Payment system was created in-house by Norwest in

1987 as       a   means   for   making    disbursements    from   pension   trust

accounts to beneficiaries, maintaining trust account records, and

reporting tax-related information.                Norwest chose to build this

system itself after a determination was made that commercially

available trust systems were unable to meet its needs.

       The Trust Payment system automated many manual processes as

well     as       providing     integrated        check-cutting     capabilities.
                               - 45 -

Initially, NTS developed the system using DB2 technology, as

indicated supra, a relatively new relational database24 offered and

heavily promoted by IBM.     Even though NTS had little experience

with the technology, NTS used DB2 because it possessed many of the

characteristics Norwest needed for its pension system.

     NTS experienced various problems in building the Trust Payment

system.    First, the system ran slowly, taking several days rather

than only a couple of hours to process data and produce a batch of

checks.     Second, occasionally, pension checks were issued in

negative dollars; that is, pensioners received checks in negative

amounts.     Third, the system crashed when too many users were

seeking to access the same data.    Ultimately, these problems were

solved by the NTS personnel assigned to this area.

     After the Trust Payment system was implemented, NTS conducted

(over a 2-year period) a thorough review of the system to determine

its ability to handle timely the anticipated increase in the number

of trust account checks that would need to be issued in the future.

This review focused on the use of the DB2 technology and whether

there was a means of making the system run faster.   (The DB2 system

had a reputation for being sluggish.)       NTS considered several

possible reasons for the slowness of the Trust Payment system but

     24
          In general, a relational database allows the user to
store data in one table which relates to (and can be used with)
other tables for reporting and updating purposes.
                                     - 46 -

was sure of neither the reasons nor the solutions.             The process of

improving the Trust Payment system required code review, the

rewriting of several Trust Payment system functions, and then

testing     the   system    to   observe   the   processing    time.     If   the

improvements       were    not   satisfactory,    NTS   went   on   to    other

approaches.       Throughout this process, NTS received assistance from

IBM.

       Although developed for in-house use by Norwest, the Trust

Payment system was examined by two other companies interested in

purchasing the system.

       H.   Debit Card

       The Debit Card software system was built to support the

issuance of Norwest's debit card product.               A debit card is a

financial product that permits payment of point-of-sale purchases

directly from the card holder's checking (or other) account.25                 To

accomplish payment, a number of transactions occur, as follows:

Upon presentation of the debit card to a merchant, the transaction

is sent to a card association network processor (in this case

Visa);26 Visa then seeks to identify the transaction as being made

       25
          This is as opposed to a credit card system in which the
card holder makes purchases against a preestablished line of
credit.
       26
          The card processor, in addition to routing transaction
requests to the issuing bank, also performs card holder and
                                                   (continued...)
                                       - 47 -

with a particular financial institution's (here Norwest's) product;

following recognition of Norwest as the appropriate financial

institution,      Visa   sends    a    communication       to   Norwest    seeking

authorization of the transaction; Norwest then verifies that the

card holder has sufficient funds in his or her account to make the

purchase,   authorizes      the   transaction,       and   finally   debits      the

holder's account.

       Once Norwest decided to enter the debit card market in 1989,27

NTS was under pressure to complete the project by yearend so that

Norwest could market the product before its competitors.                    At the

time    Norwest   entered   the       debit   card   market,    there     were   two

approaches to issuing the card.           The first approach was through a

credit card processing system by which a third party handled all of

the transactions in a credit-card-like fashion and then sent the

transactions to the card issuer (Norwest) for payment and debit.28

       26
      (...continued)
account authentication and transaction authorization.
       27
          Typically, projects were identified in the year prior
to the time Norwest's business units wanted the projects
completed. However, in the case of the debit card software
project, the decision to enter the debit card market was not made
until early 1989, and the goal was to complete the project by the
end of that same year.
       28
          Under this approach, two messages are sent from the
merchant: One seeking authorization and one seeking settlement.
However, settlement is performed by the credit card processing
company in an off-line batch job (which is usually done at
                                                   (continued...)
                                  - 48 -

The second approach, the one used by Norwest, involved direct

access to the checking (or other) account for debiting, skipping

the processing middleman.        This latter approach gave Norwest

greater control over the product and its use.        Although by the late

1980's the credit card processing version of the debit card product

had been used throughout the United States, it was not available in

the nine States in which Norwest competed--and thus, Norwest chose

to use the direct access approach.29

     To build the debit card system and links to Visa,30 NTS, which

applied Norwest's Software Development Methodology, relied on the

Base 24 operating system that ran Norwest's automatic teller

machines   (ATM's)   and   the   Visanet   module,   which   was   jointly

developed by Visa and ACI, the vendor of Base 24.            The Visanet

module was necessary to connect the Base 24 operating system to the

Visa debit card system.      Norwest was the first bank to acquire,

     28
      (...continued)
night). This requires extension of short-term credit by the
issuing bank to the customer, a risk banks generally consider
appropriate for 60 to 80 percent of their customers.
     29
          First Data Resources (FDR), the credit card processor
used by Norwest for its credit cards, lacked experience with the
debit card product at the time Norwest entered the market.
Further, Norwest was not comfortable with FDR's having direct
access to its checking accounts.
     30
          As part of their partnership in developing the debit
card system, Visa provided Norwest with technical manuals,
transaction simulators, and an access point communications
device.
                                 - 49 -

install, and test the connection of the Visanet module to the Base

24 system for the debit card product.

      NTS and Visa experienced problems with communications between

the two systems.      (Two types of communications are necessary for

the debit card to operate properly:       (1) A communication from Visa

to Norwest seeking authorization for a purchase (this is referred

to as an on-line transaction); and (2) a communication from Visa to

Norwest   posting   the   transaction    to    the   checking    account      and

Norwest's   general    ledger   (known    as   settlement).)          The     most

significant   communication     problem       was    with   respect      to   the

transaction posting communication, which often failed entirely--

potentially resulting in customers' purchasing goods and services

without having their Norwest accounts correspondingly debited.

      Because the settlement information was not being received from

Visa, NTS had to create its own set of transactions and run them

through a test system to ensure that other systems (including the

checking account and general ledger systems) that were dependent on

the    settlement     communications       operated         correctly.        This

communication problem required a Norwest team of four or five

technicians working for 4 or 5 months to redesign the code and

retest the system until communications were correctly established.

      The introduction of the debit card product required several

changes to other systems that operated in conjunction with the
                                     - 50 -

debit card system. Although these changes were relatively minor in

comparison to the process of connecting the Visanet module to the

Base 24 system, they still required a pattern of trial and error

through testing and retesting.           Further, because the debit card

operated on the same system that operated the ATM card, it was

important for the various Norwest systems to recognize that the

debit card was a distinct product.

     Ultimately,     the     debit     card     went   into    production    and

implementation in January 1990, as scheduled.            Norwest entered the

market with the debit card approximately 3 months ahead of its

nearest competitor, First Bank.

                                     OPINION

     Our task herein is to determine whether any or all of the

eight    sample   internal   use     software    development    activities    of

Norwest constitute qualified research for purposes of the tax

credit provided by section 41.          The parties agree that section 41

and its legislative history, combined, set forth seven tests to

determine whether internal use software development activities

constitute qualified research.

        This is a case of first impression in this Court.          However, we

are mindful of the recent decision of the District Court for the

Northern District of Illinois in United Stationers, Inc. v. United

States, 982 F. Supp. 1279 (N.D. Ill. 1997), on appeal (7th Cir.,
                                    - 51 -

Dec. 23, 1997), which addressed the application of section 41 to

qualified research in the development of internal use software. We

discuss that case infra.

1. Section 41

     Section    41,31   captioned    "Credit     For   Increasing     Research

Activities", provides a nonrefundable credit against a taxpayer's

U.S. income tax liability as provided in section 38 (general

business credits).      Any excess credit may be carried forward or

carried back as provided in section 39.          The credit is computed as

an amount equal to the sum of 20 percent of the excess of the

taxpayer's qualified research expenses over a "base amount", and 20

percent of the taxpayer's basic research expenses. Sec. 41(a)-(c).

Qualified   expenses    include   those      amounts   paid   for   "in-house"

research services (i.e., wages) or supplies, or "contract" research

by nonemployees.    Sec. 41(b).

     Section 41(d) defines qualified research and provides in part:

          SEC. 41(d). Qualified Research Defined.--For purposes of
     this section--

          (1) In general.--The         term     "qualified    research"
     means research--

                 (A) with respect to which expenditures
            may be treated as expenses under section 174,

     31
          The R&E credit under sec. 41 expires on June 30, 1998,
with a limited exception. Taxpayer Relief Act of 1997, Pub. L.
105-34, sec. 601(a)(1), 111 Stat. 788, 861.
                           - 52 -

          (B) which is undertaken for the purpose of
discovering information--

                (i)    which       is    technological in
      nature, and

                (ii) the application of which is
      intended to be useful in the development of a
      new or improved business component      of the
      taxpayer, and

           (C) substantially all of the activities
      of which constitute elements of a process of
      experimentation for a purpose described in
      paragraph (3).

  *        *       *           *         *        *         *

     (2) Tests to be applied separately to each business
component.--For purposes of this subsection--

           (A) In general.--Paragraph (1) shall be
      applied separately with respect to each
      business component of the taxpayer.

           (B) Business    component   defined.--The
      term "business component" means any product,
      process,   computer    software,    technique,
      formula, or invention which is to be--

                (i) held       for      sale,   lease,   or
           license, or

                (ii) used by the taxpayer in a trade
           or business of the taxpayer.

  *        *       *           *         *        *         *

     (3) Purposes for which research may qualify for
credit.--For purposes of paragraph (1)(C)--

           (A) In    general.--Research  shall  be
      treated as conducted for a purpose described
      in this paragraph if it relates to--

                (i)     a new or improved function,
                                 - 53 -

                    (ii)       performance, or

                    (iii)      reliability or quality.

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

Section 41 excludes certain activities from qualifying for the

credit, including the development of internal use software--except

to the extent provided by regulations or to the extent the software

is developed for use in an activity or process that otherwise

qualifies for the credit.      Sec. 41(d)(4)(E).

     The R&E credit under section 4132 was first created by Congress

as part of the Economic Recovery Tax Act of 1981 (ERTA), Pub. L.

97-34, sec. 221(a), 95 Stat. 172, 227, which provided for a

nonrefundable   income   tax    credit    for    certain   research   and

experimental expenditures paid or incurred by a taxpayer during the

taxable year in carrying on a trade or business.           The purpose of

the credit was to "stimulate a higher rate of capital formation and

to increase productivity", S. Rept. 97-144, at 76-77 (1981), 1981-2

C.B. 412, 438-439; H. Rept. 97-201, at 111 (1981), 1981-2 C.B. 352,

     32
          The tax credit was first designated sec. 44F by the
Economic Recovery Tax Act of 1981 (ERTA), Pub. L. 97-34, sec.
221(a), 95 Stat. 172, 227, and was then redesignated sec. 30 by
the Deficit Reduction Act of 1984, Pub. L. 98-369, sec. 471(c),
98 Stat. 494, 826, and then sec. 41 by the Tax Reform Act of 1986
(TRA 1986), Pub. L. 99-514, sec. 231(d)(2), 100 Stat. 2085, 2178.
                                 - 54 -

358, and to "encourage business firms to perform the research

necessary to increase the innovative qualities and efficiency of

the U.S. economy", S. Rept. 99-313, at 694 (1986), 1986-3 C.B.

(Vol. 3) 1, 694; H. Rept. 99-426, at 177 (1985), 1986-3 C.B. (Vol.

2) 1, 177.

     ERTA     adopted    the     definitions      of    "research"      and

"experimentation"   as   those   terms    are   generally   defined   under

section 174.     ERTA sec. 221(a).33       ERTA failed to address how

     33
            ERTA sec. 221(a) defined qualified research as follows:

     For purposes of this section the term "qualified
     research" has the same meaning as the term research or
     experimental has under section 174, except that such
     term shall not include--

          (1) qualified research conducted outside of the
     United States,

          (2) qualified research in the social sciences or
     humanities, and

          (3) qualified research to the extent funded by any
     grant, contract, or otherwise by another person (or any
     governmental entity).

     In TSR, Inc. & Sub. v. Commissioner, 96 T.C. 903 (1991), we
considered a taxpayer's claim to the R&E credit under then sec.
44F for 1981. The taxpayer, a manufacturer of historical and
fantasy games, sought the credit for its historical research into
the development of the games. In considering the taxpayer's
claim, we applied the plain meaning to the terms "experimental"
("relating to, or based on [experiment]") and "laboratory" ("a
place devoted to experimental study in any branch of natural
science or to the application of scientific principles in testing
and analysis"). We ultimately rejected the taxpayer's claim
because we found that the R&E credit was originally intended by
                                                   (continued...)
                              - 55 -

research expenditures in developing software operated within the

credit, but the House report accompanying ERTA indicated that the

credit applied only where the costs were "incurred in developing

new or significantly improved programs or routines that cause

computers to perform desired tasks (as distinguished from other

software costs where the operational feasibility of the program or

routine is not seriously in doubt)".      H. Rept. 97-201, supra at

114, 1981-2 C.B. at 360.    This language was not adopted by the

conference report which accompanied ERTA.     H. Conf. Rept. 97-215,

at 223 (1981), 1981-2 C.B. 481, 495.

     In 1986, Congress became concerned with the lack of an express

statutory definition of qualified research in the R&E credit and of

taxpayers' abuse of the credit.        The Senate Finance Committee

report accompanying the Tax Reform Act of 1986 stated:

     After reviewing available information and testimony on
     the actual use of the credit to date, the committee
     believes that the statutory credit provision should set
     forth an express definition of qualified research

     33
      (...continued)
Congress to apply only to technological discoveries and not
historical or other nontechnological research.

     In Yellow Freight Sys., Inc. & Subs. v. United States, 24
Cl. Ct. 804 (1991), the Court of Federal Claims considered (on a
motion for partial summary judgment) whether the taxpayer's
development of software programs constituted qualified research
under then sec. 44F for 1983 and 1984. That court found that
material facts were in dispute, and thus it did not address
whether the taxpayer's activities fell within the court's
understanding of research and experimentation under sec. 174.
                              - 56 -

     expenses for purposes of the credit.       The committee
     believes that the definition has been applied too broadly
     in practice, and some taxpayers have claimed the credit
     for   virtually   any  expenses   relating   to   product
     development. According to early data on the credit, the
     Treasury has reported, many of these taxpayers do not
     engage in high technology activities.

S. Rept. 99-313, supra at 694-695, 1986-3 C.B. (Vol. 3) at 694-695;

see also TSR, Inc. & Sub. v. Commissioner, 96 T.C. 903, 919 (1991);

H. Rept. 99-426, supra at 178, 1986-3 C.B. (Vol. 2) at 178.

     Congress amended the R&E credit by TRA 1986 sec. 231(b), 100

Stat. 2173, to provide the definition of qualified research that

now is codified in section 41(d).

2. Internal Use Software

     As part of the 1986 amendment to the R&E credit, Congress

addressed the application of the credit to the expenditures paid or

incurred in the development of internal use software. Congress did

not define what it meant by internal use software, other than to

indicate that the phrase refers to software that supports general

and administrative functions (such as payroll, bookkeeping, or

personnel management) or provides noncomputer services (such as

accounting, consulting, or banking services).   H. Conf. Rept. 99-

841 (Vol. II), at II-73 (1986), 1986-3 C.B. (Vol. 4) 1, 73.      (The

parties herein agree that each of the eight sample activities

constitutes internal use software.)
                                   - 57 -

       In the conference report accompanying the TRA 1986, the

conferees gave the Department of the Treasury responsibility for

promulgating regulations relating to the application of section 41

to    research   with   respect   to   the    development   of   internal     use

software.     In this regard, the conferees stated:

            The conferees intend that these regulations will
       make the costs of new or improved internal-use software
       eligible for the credit only if the taxpayer can
       establish, in addition to satisfying the general
       requirements for credit eligibility, (1) that the
       software is innovative (as where the software results in
       a reduction in cost, or improvement in speed, that is
       substantial and economically significant); (2) that the
       software development involves significant economic risk
       (as where the taxpayer commits substantial resources to
       the   development   and   also   there   is    substantial
       uncertainty, because of technical risk, that such
       resources would be recovered within a reasonable period);
       and (3) that the software is not commercially available
       for use by the taxpayer (as where the software cannot be
       purchased, leased, or licensed and used for the intended
       purpose without modifications that would satisfy the
       first two requirements just stated).        The conferees
       intend that these regulations are to apply as of the
       effective date of the new specific rule relating to
       internal-use software; i.e., internal-use computer
       software costs that qualify under the three-part test set
       forth in this paragraph are eligible for the research
       credit even if incurred prior to issuance of such final
       regulations.

Id.    at   II-73   through   II-74,   1986-3    C.B.   (Vol.    4)   at   73-74.

Congress provided that these rules would be effective to guide

taxpayers until the Department of the Treasury issues regulations

pursuant to the quoted language.             The Department of the Treasury

issued proposed regulations with respect to the R&E credit for
                                     - 58 -

internal use software in January 1997. The regulatory language was

nearly identical to that provided in the conference report.                Sec.

1.41-4(e)(5), Proposed Income Tax Regs., 62 Fed. Reg. 83 (Jan. 2,

1997).

     Ordinarily, proposed regulations carry no more weight than a

position advanced on brief by the Commissioner. F.W. Woolworth Co.

v. Commissioner, 54 T.C. 1233, 1265-1266 (1970).                However, with

regard   to   the     R&E   credit    under    section    41,   Congress   has

specifically expressed its position with respect to the three

internal use software tests.          Thus, we look to the tests as an

expression of legislative intent rather than a position of the

Commissioner.

     The proposed regulations add two features worthy of note that

are not expressly provided in the conference report accompanying

the TRA 1986.       First, the regulations provide that all facts and

circumstances shall be considered in determining whether a taxpayer

satisfies     the    requirements     for     qualified   research   in    the

development of internal use software.              Second, the regulations

require that the software meet a "high threshold of innovation" to

obtain the credit under section 41.            Sec. 1.41-4(e)(6), Proposed

Income Tax Regs., 62 Fed. Reg. 83 (Jan. 2, 1997).
                              - 59 -

3.   The Seven Tests

     The parties agree that the combination of section 41 and the

conference report accompanying the TRA 1986 results in a total of

seven tests that taxpayers must satisfy to obtain the R&E credit

with respect to qualified research in the development of internal

use software:34

     (1) The section 174 test (the research expenditures must
qualify as expenses under section 174);35

     (2) the discovery test (the research must be undertaken for
the purpose of discovering information which is technological in
nature);

     (3) the business component test (the research must be
undertaken for the purpose of discovering information the
application of which is intended to be useful in the development of
a new or improved business component of the taxpayer);

     (4) the process of experimentation test (substantially all of
the activities which constitute elements of a process of
experimentation must relate to a new or improved function,
performance, reliability, or quality);

     (5) the innovativeness test (the software must be innovative
(as where the software results in a reduction in cost, or
improvement in speed, that is substantial and economically
significant));

     34
          Tax credits are a matter of legislative grace, and the
taxpayer bears the burden of proving entitlement to the credits.
Rule 142(a); Interstate Transit Lines v. Commissioner, 319 U.S.
590, 593 (1943); Segel v. Commissioner, 89 T.C. 816, 842 (1987).
      35
           Sec. 41(d)(1)(A) provides that "qualified research"
means research "with respect to which expenditures may be treated
as expenses under section 174". We believe that the statutory
phrase "may be treated as expenses under section 174" means that
the expenditures must "qualify" for the deduction under sec. 174.
See infra.
                                         - 60 -

     (6) the significant economic risk test (the software
development must involve significant economic risk (as where the
taxpayer commits substantial resources to the development and also
there is substantial uncertainty, because of technical risk, that
such resources would be recovered within a reasonable period)); and

     (7) the commercial availability test (the software must                       not
be commercially available for use by the taxpayer (as where                        the
software cannot be purchased, leased, or licensed and used for                     the
intended purpose without modifications that would satisfy tests                    (5)
and (6))).

     These      seven    tests,     however,      must    be    applied    with     an

understanding of some of the terminology used by Congress which is

not defined.        To understand these tests, we will rely on the

ordinary    meaning     of   the    language      used    in    the    statute,    see

Commissioner v. Soliman, 506 U.S. 168, 174 (1993); United States v.

American Trucking Associations, Inc., 310 U.S. 534, 543-544 (1940),

as well as the legislative history surrounding the promulgation of

the TRA 1986, see Landgraf v. USI Film Prods., 511 U.S. 244 (1994);

Trans City Life Ins. Co. v. Commissioner, 106 T.C. 274, 299 (1996).

     A.    The Section 174 Test

     The section 174 test requires that the research expenditures

qualify as expenses under section 174.                    Section 174 generally

allows     as   a   current        deduction      research      and    experimental

expenditures     which    are     paid    or   incurred    by    the    taxpayer    in

connection with the operation of a trade or business.                    Section 174

does not define the phrase "research and experimental", but the

applicable regulations require that the expenditures represent
                               - 61 -

research and development costs "in the experimental or laboratory

sense".     Sec. 1.174-2(a)(1), Income Tax Regs.    The regulations

further provide:

     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.
     Whether expenditures qualify as research or experimental
     expenditures depends on the nature of the activity to
     which the expenditures relate, not the nature of the
     product or improvement being developed or the level of
     technological advancement the product or improvement
     represents.

T.D. 8562, 1994-2 C.B. 30, 31.36    "Product" refers to any pilot,

model, process, formula, invention, technique, patent, or similar

property.    Sec. 1.174-2(a)(2), Income Tax Regs.

     On brief, respondent concedes that the expenditures associated

with all eight of the sample internal use software activities "may

be treated as expenses under I.R.C. § 174" (emphasis added), the

language used in section 41(d)(1)(A).    Respondent asserts that it

is the Commissioner's policy not to disturb a taxpayer's method of

accounting with regard to computer software expenditures if the

     36
          The 1994 regulations under sec. 174 are effective for
all taxable years after Oct. 3, 1994. Because the amendments
provided in the 1994 regulations only clarify the definition of
research or experimental expenditures, retroactivity was
unnecessary. 59 Fed. Reg. 50159, 50160 (Oct. 3, 1994).
                               - 62 -

requirements of Rev. Proc. 69-21 are satisfied.   Rev. Proc. 69-21,

1969-2 C.B. at 303,   states that "The costs of developing software

* * * in many respects so closely resemble the kind of research and

experimental expenditures that fall within the purview of section

174 * * * as to warrant accounting treatment similar to that

accorded such costs under that section."37   Respondent notes that

his concession of the section 174 test "does not mean, however,

     37
          The 1983 proposed regulations under sec. 174 provided
extensive language and examples relating to the treatment of the
development of computer software. The proposed regulations
provided that the term "research or experimental expenditures"
included the costs for developing "new or significantly improved
computer software. The term does not include costs paid or
incurred for the development of software the operational
feasibility of which is not seriously in doubt." Sec. 1.174-
2(a)(3), Proposed Income Tax Regs., 48 Fed. Reg. 2799 (Jan. 21,
1983). This language appears to have been derived from the House
report accompanying ERTA, which discussed the treatment of
computer software development under the R&E credit (under then
sec. 44F). H. Rept. 97-201, at 114 (1981), 1981-2 C.B. 352, 360.
     The treatment of computer software in the 1983 proposed
regulations was criticized by commentators because the proposed
regulations treated computer software differently than other
products, imposing a more difficult test. 54 Fed. Reg. 21225
(May 17, 1989). The 1989 proposed regulations removed the
controversial language and stated that computer software was to
be treated the same as other products. Id. at 21227.
     Although Notice 87-12, 1987-1 C.B. 432, indicated that the
IRS intended to issue regulations further explaining the
treatment of computer software under sec. 174, no regulations
were forthcoming. The 1993 proposed regulations only indicated
that no additional conditions were to be imposed on computer
software development activities, and that taxpayers could
continue to rely upon Rev. Proc. 69-21, 1969-2 C.B. 303. The
1994 final regulations are silent altogether. Sec. 1.174-2,
Proposed Income Tax Regs., 58 Fed. Reg. 15821 (Mar. 24, 1993).
                                   - 63 -

that respondent concedes that petitioner has met the requirements

of I.R.C. § 174, which is simply not an issue in this case."

       Petitioner objects to respondent's claim that its expenditures

"may be treated" as expenses under section 174 without in fact

meeting the section's requirements for a deduction.               Petitioner

hazards a guess that respondent wants to have it both ways; that

is, respondent wants to avoid an adverse ruling on the issue (and

its potential impact on other tests under section 41) without

conceding that the section 174 requirements are actually satisfied.

       We believe that the phrase "the research expenditures may be

treated as expenses under section 174" is meant to require the

taxpayer to satisfy all the elements for a deduction under section

174.    The    legislative   history    of    section   41   supports   this

requirement.      See H. Conf. Rept. 99-841 (Vol. II), supra at II-71,

1986-3 C.B. (Vol. 4) at 71 ("the conference agreement limits

research      expenditures   eligible   for   the   incremental   credit   to

'research or experimental expenditures' eligible for expensing

under section 174. * * * Under the conference agreement, research

satisfying the section 174 expensing definition is eligible for the

credit").

       Thus, on the basis of respondent's concessions, each of

petitioner's eight sample activities satisfies the elements for a

deduction under section 174.
                               - 64 -

     B.   The Discovery Test

     The discovery test requires that the research be undertaken

for the purpose of discovering information which is technological

in nature.   In the conference report accompanying the TRA 1986,

Congress explained the discovery test as follows:

          The determination of whether the research is
     undertaken for the purpose of discovering information
     that is technological in nature depends on whether the
     process of experimentation utilized in the research
     fundamentally relies on principles of the physical or
     biological sciences, engineering, or computer science3--
     in which case the information is deemed technological in
     nature--or on other principles, such as those of
     economics--in which case the information is not to be
     treated as technological in nature.        For example,
     information relating to financial services or similar
     products (such as new types of variable annuities or
     legal forms) or advertising does not qualify as
     technological in nature.

          3
              Research does not rely on the principles of
     computer science merely because a computer is employed.
     Research may be treated as undertaken to discover
     information that is technological in nature, however, if
     the research is intended to expand or refine existing
     principles of computer science.

H. Conf. Rept. 99-841 (Vol. II), supra at II-71 through II-72 &

n.3, 1986-3 C.B. (Vol. 4) at 71-72 & n.3.

     The purpose of the discovery test is to limit the type of

information discovered to that which is technological in nature, as

opposed to nonscientific information, such as in the fields of the

social sciences, arts, or humanities, that is specifically excluded

by section 41(d)(4)(G). See TSR, Inc. & Sub. v. Commissioner, 96
                                  - 65 -

T.C. 903 (1991).   Additionally, the test is intended to limit the

form of discovery to the "process of experimentation", which is

defined elsewhere by the conference report accompanying the TRA

1986 and which is discussed infra.

     Congress did not statutorily define the word "discovery".

Petitioner asserts on brief that "discovery" has the same meaning

as in the regulations under section 174, see sec. 1.174-2(a)(1),

Income Tax Regs., directing the Court to the structure of section

41(d)(1)(B).    Consequently,     petitioner     contends,   if   Norwest's

activities satisfy the section 174 test, there is no need to

address whether Norwest performed discovery in the context of the

second test.

     Respondent contends that the discovery tests under sections

174 and 41 are different.    For several reasons, we agree.          First,

the discovery test under the section 174 regulations was not

adopted until 1994, 8 years after the discovery test in section 41

was created in the TRA 1986--thus, we find it difficult to conclude

that Congress intended the tests to have the same meaning.          Second,

the discovery test under the section 174 regulations relates to

"uncertainty   concerning   the    development    or   improvement    of   a

product".   The discovery test under section 41, on the other hand,

relates to information which is "technological in nature" and which

"fundamentally relies on principles of the [hard sciences]". Thus,
                                   - 66 -

the   tests   relate   to   the   discovery   of   different   information.

Finally, we note that the legislative history of section 41 reveals

that in 1986, Congress sought to tighten the requirements for

obtaining the R&E credit because taxpayers were not using the

credit for high technology purposes.           H. Rept. 99-426, at 178

(1985), 1986-3 C.B. (Vol. 2) 1, 178; S. Rept. 99-313, at 694

(1986), 1986-3 C.B. (Vol. 3) 1, 694-695. Congress effectuated this

goal by adding three tests to section 41, including the discovery

test, but did not change the meaning of section 174 (and presumably

the discovery test subsequently created under the section 174

regulations).    H. Conf. Rept. 99-841 (Vol. II), supra at II-76,

1986-3 C.B. (Vol. 4) at 71, 76; see also S. Rept. 97-144, at 81

(1981), 1981-2 C.B. 412, 441.       We therefore conclude that Congress

intended to treat the discovery test under section 41 more narrowly

than the discovery test created under section 174.

      The dictionary definition of "discover" is "to make known or

visible" or "to obtain sight or knowledge of for the first time".

Webster's Ninth New Collegiate Dictionary (1985).         The legislative

history of section 41 dictates that the knowledge gained from the

research and experimentation must be that which exceeds what is

known in the field in which the taxpayer is performing the research

and experimentation--in this case, the computer science field. The

fact that the information is new to the taxpayer, but not new to
                                     - 67 -

others, is not sufficient for such information to come within the

meaning of discovery for purposes of this test.            The purpose of the

R&E credit was to stimulate capital formation and improve the U.S.

economy--not merely the taxpayer's business.             See H. Rept. 97-201,

at 111 (1981), 1981-2 C.B. 352, 358; H. Rept. 99-426, supra at 177,

1986-3 C.B. (Vol. 2) at 177.

     The legislative purpose of the discovery test in section 41

was to narrow the scope of the research and experimentation under

section    174   to   that   which   is    technological   in   nature.       The

technological-in-nature requirement is consistent with Congress'

concern that the R&E credit was not being used for high technology

research before the 1986 amendments.             S. Rept. 99-313, supra at

694-695, 1986-3 C.B. (Vol. 3) at 694-695; H. Rept. 99-426, supra at

178, 1986-3 C.B. (Vol. 2) at 178.              Thus, Congress specifically

stated that the discovery process must fundamentally rely on

principles of the hard sciences--namely, physical or biological

sciences, engineering, or computer science.

     The    parties    dispute   the      significance   of   note   3   of   the

conference report, H. Conf. Rept. 99-841 (Vol. II), supra at II-71

n.3, 1986-3 C.B. (Vol. 4) at 71 n.3, accompanying the TRA 1986.

That footnote states that the research must "expand or refine" the

principles of the hard sciences.              Respondent contends that the

phrase "expand or refine" is meant to explain the nature of the
                                     - 68 -

discovery required by the taxpayer, noting the legislative history

of section 41. On the other hand, petitioner contends that "expand

or refine" is only illustrative and is intended to contrast the

mere use of a computer which in and of itself does not necessarily

involve fundamental reliance on the principles of computer science.

         We believe the purpose of the first sentence of note 3

("Research does not rely on the principles of computer science

merely because a computer is employed.") is to emphasize that

Congress intended the R&E credit not for the use of the hard

sciences per se, but for the use of the principles of the hard

sciences in conducting research.              "Principle" is defined as "a

comprehensive        and   fundamental   law,    doctrine,   or   assumption".

Webster's Ninth New Collegiate Dictionary (1985). Clearly, the use

of   a    computer    does   not   necessarily    require    reliance   on   any

fundamental laws, doctrines, or assumptions.

         The purpose of the second sentence of note 3 ("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.") is to indicate that the

taxpayer must discover information with respect to the principles

of the hard sciences on which it fundamentally relies.             Note 3 sets

forth two means of discovering information about the principles of

the hard sciences--either by "expanding", or by "refining"--either
                              - 69 -

or both of which allows the taxpayer "to make known or visible" or

"to obtain sight or knowledge for the first time", the definition

of discovery discussed above.    Congress' goals of stimulating a

higher rate of capital formation and improving the U.S. economy

cannot be achieved unless the taxpayer goes beyond the preexisting

knowledge of the principles of the hard sciences.     Expanding or

refining those principles are two, but not the exclusive, ways of

satisfying these goals.38

     C.   The Business Component Test

     The business component test (which is actually part of the

discovery test) requires that the research be undertaken for the

purpose of discovering information the application of which is

intended to be useful in the development of a new or improved

business component of the taxpayer.     This test was addressed by

Congress as follows:

          Under the conference agreement, research is treated
     as conducted for a functional purpose only if it relates
     to a new or improved function, performance, reliability,
     or quality. (Activities undertaken to assure achievement
     of the intended function, performance, etc. of the
     business component after the beginning of commercial
     production of the component do not constitute qualified

     38
          Respondent relies on the language in TSR, Inc. & Sub.
v. Commissioner, 96 T.C. 903 (1991), in which we stated that the
technological-in-nature requirement amounted to a requirement of
a "technological breakthrough". Id. at 920. Inasmuch as TSR,
Inc. did not involve the R&E credit as it exists under sec. 41,
we do not consider that language an element of the discovery
test.
                                 - 70 -

     experimentation.) The conference agreement also provides
     that research relating to style, taste, cosmetic, or
     seasonal design factors is not treated as conducted for
     a functional purpose and hence is not eligible for the
     credit.

H. Conf. Rept. 99-841 (Vol. II), supra at II-72, 1986-3 C.B. (Vol.

4) at 72.

     The parties do not seriously dispute the meaning of the

business component test or the legislative history.          Indeed, it is

evident that Congress intended only that the taxpayer's activities

provide some level of functional improvement, at a minimum.

     D.     The Process of Experimentation Test

     The     process   of   experimentation      test      requires    that

substantially all of the activities which constitute elements of a

process of experimentation relate to a new or improved function,

performance,      reliability,   or       quality.   The     process     of

experimentation test, which is referenced in the discovery test, is

explained by Congress as follows:

          The term process of experimentation means a process
     involving the evaluation of more than one alternative
     designed to achieve a result where the means of achieving
     that result is uncertain at the outset. This may involve
     developing one or more hypotheses, testing and analyzing
     those hypotheses (through, for example, modeling or
     simulation), and refining or discarding the hypotheses as
     part of a sequential design process to develop the
     overall component.

          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
                              - 71 -

     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 the viable
     alternatives. On the other hand, costs of experiments
     undertaken by chemists or physicians in developing and
     testing a new drug are eligible for the credit because
     the    researchers    are    engaged     in    scientific
     experimentation. Similarly, engineers 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.

H. Conf. Rept. 99-841 (Vol. II), supra at II-72, 1986-3 C.B. (Vol.

4) at 72.

     Unlike the regulations under section 174, which are silent

about the means of discovering information, the conference report

accompanying the TRA 1986 made it clear that a more structured

method of discovery is required with respect to section 41.      By

requiring that at the outset uncertainty exist about the ability to

develop the product in the scientific or laboratory sense, the

process of experimentation test is aimed at eliminating uncertainty

about the technical ability to develop the product--as opposed to

uncertainty as to whether the product can be developed within

certain business or economic constraints, even though the taxpayer

knew that it was technically possible to develop it.

     As evidence of the required uncertainty, Congress mandated the

evaluation of more than one alternative, which in turn may require
                               - 72 -

the use of a structured process of experimentation through the

continuous development of hypotheses that require testing and

analysis until the method for reaching the objective is discovered.

Congress did not specify that any particular number of hypotheses

be developed by the taxpayer, but the more hypotheses that are

developed, tested, and analyzed, the more likely the project will

satisfy the process of experimentation test.

     This test also requires that "substantially all" of the

activities constitute elements of a process of experimentation.

This requirement raises two questions: (1) What does the term

"substantially all" mean? and (2) what activities come within the

elements of a process of experimentation?

     Respondent contends that "substantially all" means at least 80

percent, referring to section 1.41-2(d)(2), Income Tax Regs., which

defines the term "substantially all" with respect to qualified

wages under section 41 as meaning at least 80 percent of the wages

paid or incurred by the taxpayer for the employee. Petitioner does

not dispute respondent's proposed 80-percent test.

     We agree with respondent and hold that in the context of

section 41, the term "substantially all" refers to at least 80

percent of the activities that constitute elements of a process of

experimentation.   This   interpretation   is   consistent   with   the
                                    - 73 -

existing definition of "substantially all" in the regulations under

section 41 with respect to qualified wages.

      Congress indicated in the conference report accompanying the

TRA   1986     those    elements     which     constitute        a    process   of

experimentation.       They   include    the    developing,          testing,   and

analyzing of hypotheses.       They do not include activities performed

after commercial production or implementation or otherwise set

forth in section 41(d)(4).         See H. Conf. Rept. 99-841 (Vol. II),

supra at II-72, 1986-3 C.B. (Vol. 4) at 72.           However, in the case

of internal use software, exceptions are made for the modifications

of commercially available software.            See infra.

      Thus, at least 80 percent of the activities engaged in by a

taxpayer     with   respect   to   the   preproduction      or   implementation

development of a product must involve the development, testing, and

analysis of hypotheses that are designed to eliminate technical

uncertainty as to the development of that product.                      This then

raises the issue of which activities in a project are to be

examined together and which are to be examined separately for

purposes of section 41.            Congress has provided us with some

guidance in a so-called shrinking back test:

           The term business component means a product,
      process, computer software, technique, formula, or
      invention that is to be held for sale, lease, or license,
      or is to be used by the taxpayer in a trade or business
      of a taxpayer. If the requirements described * * * [in
      the first four tests under section 41] are not met with
                                 - 74 -

     respect to a product, etc. but are met with respect to
     one or more elements thereof, the term business component
     means the most significant set of elements of such
     product, etc. with respect to which all requirements are
     met.

          Thus, the requirements are applied first at the
     level of the entire product, etc. to be offered for sale,
     etc. by the taxpayer.         If all aspects of such
     requirements are not met at that level, the test applies
     at the most significant subset of elements of the
     product, etc. This "shrinking back" of the product is to
     continue until either a subset of elements of the product
     that satisfies the requirements is reached, or the most
     basic element of the product is reached and such element
     fails to satisfy the test.      Treasury regulations may
     prescribe rules for applying these rules where a research
     activity relates to more than one business component.

H. Conf. Rept. 99-841 (Vol. II), supra at II-72 through II-73,

1986-3 C.B. (Vol. 4) at 72-73.     We conclude that the shrinking back

test must be examined on a case-by-case basis to determine which

activities are part of the same product or process, and which are

so discrete as to warrant a separate evaluation.

     E.    The Innovativeness Test

     The   innovativeness   test     requires   that   the   software   be

innovative "as where the software results in a reduction in cost,

or improvement in speed, that is substantial and economically

significant".    Id. at II-73, 1986-3 C.B. (Vol. 4) at 73.              The

parties disagree over the meaning of the innovativeness test.

Respondent contends that the legislative history of section 41

mandates that we require a "high threshold of innovation", the

phrase that appears in the House and Senate reports accompanying

the TRA 1986, S. Rept. 99-313, at 694-695 (1986), 1986-3 C.B. (Vol.
                                   - 75 -

3) 1, 694-695; H. Rept. 99-426, at 178 (1986), 1986-3 C.B. (Vol. 2)

1, 178, and as used by the Department of the Treasury in its

proposed regulations, section 1.41-4(e)(6), Proposed Income Tax

Regs., 62 Fed. Reg. 83 (Jan. 2, 1997).      Further, respondent asserts

that we should read this and the other internal use software tests

narrowly inasmuch as they are exceptions to the general rule that

internal use software activities are not eligible for the R&E

credit.   Sec. 41(d)(4)(E).

      Petitioner argues that the language in the innovativeness test

is straightforward and that we should focus on its plain meaning.

Petitioner analyzes the meaning of "substantial" and "significant"

to reach the conclusion that these words connote a range of 5- to

20-percent improvement in the product or process.          In support of

this conclusion, petitioner cites several statutes, regulations,

and Nabisco Brands, Inc. & Consol. Subs. v. Commissioner, T.C.

Memo. 1995-127 (applying 25 percent in the context of section

1253(b)(2) and discussing the various statutes and regulations

which define the term "substantial").

      We do not believe that quantifying by way of a percentage that

which is "substantial" and "significant" will materially assist us

in   determining   whether   the   innovativeness   test   is   satisfied.

Suffice it to say, the extent of the improvements required by

Congress with respect to internal use software is much greater than

that required in other fields.        The business component test (the

third of the seven tests, which applies to all research and
                                               - 76 -

experimentation under section 41) requires only a "new or improved"

function, whereas the innovativeness test (which applies only to

internal       use     software         development)      requires    change    "that     is

substantial and economically significant".                     H. Conf. Rept. 99-841

(Vol. II), supra at II-73, 1986-3 C.B. (Vol. 4) at 73 (emphasis

added). We therefore agree with respondent that only a "high

threshold of innovativeness" will satisfy this requirement.

        F.    The Significant Economic Risk Test

      The significant economic risk test requires that the software

development       involve         significant       economic    risk    "as    where     the

taxpayer commits substantial resources to the development and also

there is substantial uncertainty, because of technical risk, that

such resources would not be recovered within a reasonable period".

Id.     Petitioner contends that the significant economic risk test

requires that             only   a   20-percent     risk    need     exist,    because    of

technical uncertainty, to prevent the taxpayer from recovering its

investment within a reasonable period of time.                       Petitioner reaches

this conclusion on the basis of the same analysis it used with

respect to the innovativeness test. Respondent, on the other hand,

emphasizes the magnitude of the technical risk as a key factor in

analyzing the internal use activities under this test.

        Again,       we    find      significant        Congress'    requirement    of     a

substantial uncertainty.                 In both the contexts of the regulations

under        section      174     and    the     explanation    of     the    process     of

experimentation test provided in the conference report accompanying
                                    - 77 -

the TRA 1986, only uncertainty is required.            The use of the word

substantial here requires a further step in the context of the

development of internal use software. As in the case of the

innovativeness test, we believe the significant economic risk test

requires a higher threshold of technological advancement in the

development of internal use software than in other fields.

      G.    The Commercial Availability Test

      The commercial availability test requires that the software

not be commercially available for use by the taxpayer "as where the

software cannot be purchased, leased, or licensed and used for the

intended purpose without modifications that would satisfy [tests

(5)   and   (6)]".    Id.    Although   this   language   is   fairly   self-

explanatory, respondent argues that a taxpayer's expenses incurred

in the implementation of vendor releases of commercially available

software can never satisfy this final test because the releases are

commercially available.

      We refuse to adopt such a bright-line rule.         Congress clearly

anticipated    that   some    modifications    to   commercially   available

software can satisfy the fifth and sixth tests of our seven-test

analysis.      We must examine those modifications, including any

modifications resulting from the implementation of commercially

available software, on a case-by-case basis.
                                   - 78 -

4. Summary of Internal Use Software Requirements Under the Seven
Tests

     The     higher   threshold    of     technological   advancement    and

functional improvement in the development of internal use software

vis-a-vis other fields of research is consistent with the general

rule that qualified research under section 41 excludes internal use

software development.     Sec. 41(d)(4)(E).       Although the reasons for

such discrimination are not readily apparent, they nonetheless do

exist.     The   conclusion   we   draw    from   these   higher   threshold

requirements is that Congress sought to limit the development of

internal use software under section 41 only to those endeavors that

ventured into uncharted territory.39        We are mindful, however, that

     39
          We recognize that commentators to the 1983 and 1989
proposed regulations under sec. 174 were concerned with language
that could discourage the "evolutionary" nature of research. The
Explanation of Provisions in the 1989 proposed regulations to
sec. 174 states in pertinent part:

     A number of commentators suggested that the [1983]
     proposed regulations could be read to require a
     significant improvement for an activity to qualify
     under section 174. They suggested that such a reading
     would be overly restrictive because research and
     development activities may in many instances be part of
     an evolutionary process involving a series of minor
     improvements that, when taken together over a period of
     time, lead to a significantly improved product. The
     regulations proposed by this document do not include
     the reference to "routine" or "periodic" improvements.
     * * *

54 Fed. Reg. 21225 (May 17, 1989).

     The Explanation of Provisions in the 1993 proposed
regulations to sec. 174 states in part:
                                                   (continued...)
                                   - 79 -

we should apply these higher threshold requirements reasonably and

practically and assume that Congress set standards that are not

impossible     to   meet.   See   United    States    v.   American      Trucking

Associations, Inc., 310 U.S. 534, 543 (1940); Venture Funding, Ltd.

v. Commissioner, 110 T.C. 236, 264 (1998) (Ruwe, J., dissenting).

In applying each of the seven tests under section 41 to the facts

herein,   we    shall   consider    the     facts    and   circumstances      in

determining whether the taxpayer performed qualified research.

5.   United Stationers, Inc. v. United States

     Both parties rely on the District Court's decision in United

Stationers, Inc. v. United States, 982 F. Supp. 1279 (N.D. Ill.

1997), in advancing their differing positions as to whether Norwest

engaged   in    qualified    research      under    section   41.   In    United

Stationers, the taxpayer, a large office supply wholesaler, sought

the R&E credit with respect to eight software projects.                       To

automate its business operations, the taxpayer acquired from a

vendor a software package which it then customized to meet its

particular needs. The court principally relied upon the report and

recommendation of a magistrate judge to find the facts in the case,

see United Stationers, Inc. v. United States, 79 AFTR 2d 97-1761,

     39
      (...continued)
     Commentators argued that the "time-line" approach of
     the 1989 proposed regulation was unrealistic because
     progress in research and development is often achieved
     only in small, incremental steps. * * *

58 Fed. Reg. 15819 (Mar. 24, 1993).
                                    - 80 -

97-1 USTC par. 50,457 (N.D. Ill. 1997) (report and recommendation

of magistrate judge), although the court did not accept all of the

magistrate judge's findings.           The Government therein, as in this

case, conceded that the taxpayer satisfied the section 174 test.

     In analyzing section 41, the District Court disallowed the

credit on several grounds.         First, the court concluded that the

taxpayer did not discover information that was technological in

nature.    Applying     a     dictionary      definition    for     technological

("resulting from improvement in technical processes that increases

the productivity of machines and eliminates manual operations or

the operations done by older machines") and discovery ("to make

known" or "to obtain for the first time sight or knowledge of"),

the court found that the taxpayer did no more than use the software

package   as   a   building    block    and   that   it    failed    to   discover

information that was technological in nature.              In that regard, the

court found that the taxpayer did not expand or refine existing

principles of computer science, stating:                   "Rather, Stationers

merely applied, modified, and at most, built upon, pre-existing,

technological information already supplied to it.                 This is a far-

cry from what Congress contemplated when it spoke of research

directed at the `principles of computer science'." 982 F. Supp. at

1284.

     The court next considered the process-of-experimentation test.

The court defined experimentation as "the act, process, or practice

of making experiments" and defined an experiment as "a test or
                                      - 81 -

trial" or "a tentative procedure or policy; [especially] one

adopted in uncertainty as to whether it will answer the desired

purpose or bring about the desired result".           The court then cited

the legislative history of the test and found that it was necessary

to   determine    the   extent   of    uncertainty   that   existed   in   the

taxpayer's projects.      The court concluded that "while the aspired

benefits of the projects were in doubt, the development of the

means that would allow Stationers to potentially achieve those

benefits was not."      Id. at 1285.

      Despite the court's finding that the taxpayer failed to

satisfy both the discovery and process-of-experimentation tests, it

considered whether the taxpayer could have satisfied any of the

internal use software tests.          In doing so, the court rejected the

magistrate judge's findings that the taxpayer did not satisfy the

innovativeness test. Instead, the court noted that the "Magistrate

Judge was correct in reasoning that Stationers' projects `simply

increased efficiency and revenues for Plaintiff'," but nonetheless

concluded that "[the projects] all fall under the plain meaning of

the definition included in the legislative history" and were thus

innovative.      Id. at 1287-1288.

      The court did, however, agree with the magistrate judge and

find that the taxpayer failed to satisfy the significant economic

risk test because "`the ability to implement [the projects] was

clear from the outset.       The only risk or uncertainty was whether
                                 - 82 -

the [projects] would produce the desired efficiency, not whether

they could, in fact, be developed.'"         Id. at 1288.

      The District Court's opinion is, unfortunately, of little

benefit to us because of the lack of a detailed record from which

we can compare the facts therein to the facts before us.         Moreover,

we are not bound by the District Court's analysis.          See A.E. Staley

Manufacturing Co. & Subs. v. Commissioner, 105 T.C. 166, 208

(1995), revd. on other grounds and remanded 119 F.3d 482 (7th Cir.

1997); Estate of Schwartz v. Commissioner, 83 T.C. 943, 952 (1984).

Consequently, we will not rely on or otherwise refer to United

Stationers in evaluating the present case.

6.    The Experts

      Both parties rely upon the opinions of experts in support of

their respective positions. Both parties' experts prepared initial

and rebuttal reports and testified in support of those reports.

The    experts   reviewed   thousands   of    pages   of    documents   and

interviewed many Norwest employees in the process of preparing

their reports and testimony.

      We look to the parties' experts to aid us in applying the

facts relating to Norwest's eight internal use software development

activities to the seven tests for internal use software under

section 41.

      We evaluate the opinions of an expert in light of the expert's

qualifications and all other evidence in the record.             Estate of

Christ v. Commissioner, 480 F.2d 171, 174 (9th Cir. 1973), affg. 54
                                - 83 -

T.C. 493 (1970); Parker v. Commissioner, 86 T.C. 547, 561 (1986).

We are not bound by the opinions of an expert, especially when they

are contrary to our own judgment.     Orth v. Commissioner, 813 F.2d
837, 842 (7th Cir. 1987), affg. Lio v. Commissioner, 85 T.C. 56

(1985); Silverman v. Commissioner, 538 F.2d 927, 933 (2d Cir.

1976), affg. T.C. Memo. 1974-285. Instead, we may reach a decision

based on our own analysis of all the evidence in the record.

Silverman v. Commissioner, supra at 933. We may accept the opinion

of an expert in its entirety, Buffalo Tool & Die Manufacturing Co.

v. Commissioner, 74 T.C. 441, 452 (1980), or we may be selective in

the use of any portion of such an opinion, Parker v. Commissioner,

supra at 562.      We may also reject the expert's opinion in its

entirety.     Palmer v. Commissioner, 523 F.2d 1308, 1310 (8th Cir.

1975), affg. 62 T.C. 684 (1974).

     A.     Petitioner's Expert--Dr. Drew McDermott

     Petitioner offered the opinion of Drew McDermott, Ph.D., a

professor of computer science at Yale University.     Dr. McDermott's

area of expertise is artificial intelligence, and he has widely

published on that topic.     He also has an extensive knowledge of

programming language design and implementation, formal learning

theory, and philosophy of mind.      However, Dr. McDermott readily

admitted that he does not maintain much familiarity with the

banking industry or banking software in particular.

     Dr. McDermott opined that all eight of the sample internal use

software activities he examined qualify for the R&E credit based on
                              - 84 -

his understanding of the seven tax law tests.       However, in his

rebuttal report and at trial, he expressed reservations as to

whether the Cyborg Payroll project so qualified.      When asked to

rank the eight activities from most to least characteristic of

research, Dr. McDermott provided the following list:    Success and

SBS; Trust TU; MoneyNet, Trust Payment, and General Ledger; Debit

Card; and finally Cyborg Payroll.

     Dr. McDermott summarized his general findings as follows:

     There is usually little room for debate about whether a
     project passes tests T4 and T7, having to do with
     "improved    business    component"     and   commercial
     availability. The main goal of most projects was a piece
     of software that automated a process that was previously
     done by hand, or that did essentially the same job as an
     earlier piece of software, but had more features and
     better performance. Even when the project failed, a goal
     of this kind was usually clearly present and explicitly
     stated. As far as commercial availability is concerned,
     I was impressed by how thoroughly Norwest searched for
     commercial products, proceeding to develop software
     internally only when it had to, and usually by beginning
     with a commercial product and adding functions to it that
     were crucial to the banking business. * * *

     Another criterion that is usually met fairly easily is
     T3, the use of a process of experimentation, involving
     the development and testing of hypotheses. There was
     always some process of experimentation involved in the
     eight sample projects. The process was generally not as
     systematic as one would find in a physics or chemistry
     lab.   I think that reflects the state of practice in
     computer science, where effects are usually less subtle
     than in physics, and require less rigorous experimental
     methodology.

       *       *       *       *        *       *        *

     For these eight projects, it is clear that there was a
     process of experimentation to reduce significant
     computer-science uncertainties in every case. There are
     some areas of uncertainty that were not involved in any
                                  - 85 -

       of these projects, although I saw evidence that they were
       addressed in other Norwest projects.

       Dr. McDermott defined computer science as "the study of what

can be accomplished by various classes of algorithm on various

classes of computer architecture in a certain amount of time, or

using memory in a certain way."40     He stated that these limitations

make computer science a "science". Dr. McDermott testified that in

software development the issue is rarely whether something can be

done at all,41 but rather, whether something can be done given

constraints, particularly in the computer environment, e.g., the

type    of   hardware,   the   programming   language,   the   degree   of

reliability, or the level of security.

       In each of the Norwest activities (other than the Debit Card

project), Dr. McDermott found that the programmers were attempting

to "push a little bit beyond the current state of the art in order

to produce their next product", and the question was "whether

[fairly familiar elements] * * * could be put together in a

       40
          By "algorithm" Dr. McDermott referred to the steps a
computer is supposed to execute; and by "architecture" he
referred to the types of elementary steps that are available.
The "time" referred to both the time necessary to develop a
program and the time necessary for a program to process the
selected task.
       41
          Dr. McDermott agreed that none of the Norwest projects
confronted the question of whether they could be done at all. He
stated that Norwest was more concerned with whether it was
"technically possible to do this with the resources available,
that is, with controllable development costs, manageable schedule
delays, and acceptable performance when completed".
                                    - 86 -

slightly    new   combination".42       These    types     of   activities,   Dr.

McDermott claimed, are distinguishable from what he identified as

"cookbook" results--"where past practice has codified a way of

solving problems of a certain kind, and it requires no creativity

or experimentation to apply that method to a new problem of that

kind."

      Dr. McDermott claimed that a computer science project is

considered research if it has "a significant chance of failure due

to uncertainty regarding questions of computer science".                      He

further identified eight types of uncertainty that when present can

result in a project's characterization as research:                      (1) Ill

definedness--the inability to formally define a problem to be

solved; (2) time and space complexity--lack of sufficient computing

power due to growth in data that requires an exponential growth in

computing power; (3) intractability--the inability of a program to

work with many different data sets; (4) software engineering--the

management   of   complex     programming      projects;      (5)   architectural

constraints--the process by which the computer completes its tasks;

(6)   asynchronousness--the       organization        of    several    computers

operating in widely separated places; (7) security--the proper

authority    to   enter   a   system;    and    (8)    user     engineering--the

friendliness of a computer to the user.               Dr. McDermott estimated

      42
          Dr. McDermott conceded that the work performed by
Norwest on the eight sample activities would not produce
publishable results for a textbook on algorithms.
                                  - 87 -

that, to the extent that it is possible to quantify, a 20-percent

level of    uncertainty   (in   the   ability   to   predict   a   program's

behavior) in a project constitutes "technical risk"43--which, in

turn, would result in a significant chance of failure.44 Dr.

McDermott was of the belief that Norwest would not have engaged in

any project in which there was a greater than 50-percent chance of

failure in the first place.

     Finally, Dr. McDermott noted that the field of computer

science does not engage in research in the same manner as other

fields--i.e.,   the   "white    lab   coat"   experiments.     Rather,   he

asserted that computer science research is less formal.

     B.    Respondent's Experts

           i.   Dr. Randall Davis

     One of respondent's experts was Randall Davis, Ph.D., a

professor of management in the electrical engineering and computer

science department at Massachusetts Institute of Technology (MIT).

He previously served as an associate director at the Artificial

Intelligence Laboratory at MIT.        Dr. Davis has been a consultant

     43
          In his rebuttal report, Dr. McDermott defined the type
of technical risk that arises in most cases as "the risk that a
given computing configuration, or `architecture,' might not be
programmable to perform a task within realistic time and space
bounds, assuming that there are compelling reasons to use that
architecture."
     44
          Dr. McDermott noted, however, that software projects
fail for many reasons that have nothing to do with research or
technical risk, but rather with a vendor's failure to deliver a
product on time, changing conditions, or the incompetency of the
programmers.
                                  - 88 -

for numerous corporations and has served as a court-appointed

expert.

     Dr. Davis concluded that all eight of the sample internal use

software activities failed to satisfy one or more of the seven

tests for the R&E credit.45      He summarized his findings as follows:

     It is my opinion based on the sources [provided] * * *
     that the work performed by Norwest involved normal and
     routine software development. The software produced, in
     terms of the products and services provided, and the
     technology used to support it, was all within the then
     current state of the art in the industrial work of
     management information systems. None of the documents
     provided suggest that any of the software developed by
     Norwest was, among other things, innovative or involved
     a significant degree of technical risk.

     Dr. Davis described five types of projects associated with

software development:     (1) Design and implementation (the de novo

creation of a body of software); (2) installation and testing (the

purchase    and   installation    of    software   from    a    vendor);   (3)

maintenance (ongoing adjustments to the code); (4) enhancement

(adding    of   functionality    to    the   program);    and   (5)   research

(attempting to do something for the first time).            Dr. Davis found

that each of Norwest's activities involved at least one of the

first four types of projects, and generally characterized Norwest's

work as installation, interfacing, and testing. When asked to rank

the eight activities in order from most to least characteristic of

research, Dr. Davis provided the following list:           SBS; Success and

     45
          However, Dr. Davis opined that one of the activities
not included in the eight sample activities, known as Expert
Systems, qualified as research and experimentation under sec. 41.
                              - 89 -

Trust TU; Debit Card, Trust Payment, and Money Transfer; and

General Ledger and Cyborg Payroll.

     Dr. Davis stated that routine software development must be

distinguished from software research efforts.    He contended that

software research is characterized by the search for information

(as opposed to the production of code),46 the use of test data (as

opposed to production data), and the presence of technical risk.

By "technical risk", Dr. Davis referred to the development of novel

tasks, the use of familiar technology in a new manner,47 or the size

or complexity48 of the project.   However, according to Dr. Davis,

whether a software project is research cannot be cast in terms of

black and white:   the fact that the task has been done before is

     46
          Dr. Davis dismissed Norwest's activities as not
qualified research because Norwest produced operational software
and not information about principles.
     47
           As an example of this research, Dr. Davis referred to
the development of spreadsheets in C language as opposed to the
lower level assembly-based language. At the time this was first
done, both the C language and spreadsheets were commonly known
and understood, but C had never been used to develop a
spreadsheet. The use of C reduced the amount of memory spent by
the computer in running the spreadsheet program, but it was
unclear until the project was completed that C would also be fast
enough to operate on the then-current generation of personal
computers.
     48
          As an example of a large project that constitutes
research, Dr. Davis noted the attempted development of a single,
comprehensive reservation system among an airline, a hotel, and a
car rental company which spanned three different businesses,
their operating divisions, and thousands of sites. As an example
of a complex project that might constitute research, Dr. Davis
referred to the efforts of running multiple programs on multiple
machines over a network.
                                 - 90 -

not controlling as to whether it is necessarily research because of

the different environments in which the tasks are attempted.

Further, Dr. Davis contended that technical risk49 cannot entirely

be eliminated from any project, even up to and through the time of

production.

      Dr. Davis explained that routine software development is

characterized by the use of commercially available tools or known

methodologies, both applied within their expected limits, and

skilled practice.50   He stated that routine tasks often include the

moving of an existing application to a new operating system or to

a new machine, translating code from one programming language to

another, or putting a new interface on an existing code.           Dr. Davis

asserted that these projects, although difficult and challenging

and   requiring   considerable   time,    effort,   and   skill,    are   not

research but merely the typical part of any development effort.

      Further, Dr. Davis maintained that although routine software

development   often   involves   uncertainty,   trial     and   error,    and

experimentation, such factors do not convert the projects into

      49
          Dr. Davis defined technical risk in his initial report
as arising "when we don't know whether it's possible to
accomplish the task in the current state of the art." However,
at trial, Dr. Davis amended his definition by stating that
technical risk can arise due to constraints in, for example, the
type of hardware used or the resources available. In this
regard, once again Dr. Davis suggested that technical risk, like
his definition of research, was a matter of degree.
      50
          As an analogy, Dr. Davis referred to the building of a
skyscraper which, although a large and difficult task, involves
the application of known methodologies and skilled practice.
                                  - 91 -

research efforts.    He stated that within the computer science

community there is general agreement as to the basic elements of

the routine software development process:       Problem definition and

specification,   design,    implementation,    integration      and   system

testing, installation and field testing, and maintenance.               The

development involves a constant, cyclical process of designing,

testing, and modifying.51

     Finally, Dr. Davis claimed that failure in the software

development process is usually not attributable to technical risk,

but is more often due to people and project management concerns.52

Additionally, he insisted that Norwest's use of the SDM was meant

to minimize risk because Norwest was developing "mission-critical"

software where it could ill afford to redesign a system late in the

development   process.     Dr.   Davis   conceded,   however,    that   the

activities generally appeared to provide a new or improved business

function.

     51
           Dr. Davis testified that in the early stages of
development, the modification efforts are generally characterized
as redesigning, while in the later stages, as the development
approaches production, the efforts are generally characterized as
debugging.
     52
          Dr. Davis stated that as much as 30 percent of all
software projects fail or are canceled before completion.
                                    - 92 -

             ii.   The Tower Group53

     Respondent's other expert was Diogo Teixeira, president of the

Tower     Group,   a   research   and   consulting   firm   specializing    in

information technology in the financial services industry.                 Mr.

Teixeira     is    widely   published    on   issues   involving   software

applications in the banking industry. He lacks formal education or

training in computer science or software development, or research

in either of those fields.

     The Tower Group report, although not specifically concluding

that the eight sample internal use software activities failed to

qualify for the R&E credit, found that Norwest did not develop any

technology that was not within the then-current state of the art of

the banking industry.       The Tower Group summarized its findings as

follows:

     It is our opinion, based on the documentation submitted
     by the petitioner and on our knowledge of the US banking
     industry, that the work performed by Norwest was the
     normal and routine data processing activities of a bank.
     The software produced by Norwest, in terms of the
     products and services provided and the technology used to
     support them, were all well within the then current state
     of the industry. We find no characteristics which would
     distinguish the overall work performed by Norwest within
     the claim from the nearly $17.5 billion spent by US

     53
          Before trial, petitioner sought to disqualify Diogo
Teixeira and the Tower Group from serving as an expert witness at
trial because of a prior relationship between the Tower Group and
Norwest. After hearing arguments at trial and, upon due
consideration, we denied petitioner's motion for reasons
expressed on the record.
     Mr. Teixeira was assisted in the preparation of the Tower
Group report by George T. Kivel, the group director of Wholesale
Banking and General Technologies.
                                     - 93 -

     commercial banking industry between 1986 and 1991 on
     routine data processing implementation. Norwest, as a
     result of the work performed within the claim, developed
     no approaches or components that were conceptually or
     fundamentally different from those already in use within
     the banking industry.

     In its report, the Tower Group stated that nothing Norwest

developed   could   be     considered     unique    because     Norwest   already

possessed the necessary information.54         The Tower Group report also

stated that three factors determine whether a banking software

application is unique:         Product (e.g., checking account, credit

card), channel (e.g., bank branch, ATM), and volume.               Mr. Teixeira

asserted that Norwest did not offer any products or services that

were unavailable      in    the   banking   industry,     and    the   volume   of

transactions    was        typical   of     banks    of    Norwest's      size.55

Consequently, Mr. Teixeira insisted that Norwest had numerous

sources from which it could learn about software applications, and

that any uncertainties Norwest faced were unique to it but not to

the banking industry.56

     54
          According to Mr. Teixeira, the sources of this
information are vendors, consultants, conferences, and
newsletters.
     55
          Mr. Teixeira stated that Norwest was never a top 15
bank (in terms of asset value) but fluctuated between 17th and
33d. Banks such as Citibank, Chase Manhattan, Wells Fargo, and
Security Pacific were all two to three times larger than Norwest.
Citibank had total assets of approximately $220 billion in 1991,
while Norwest's total assets reached approximately $40 billion in
1991. In this regard, Norwest's transactional volumes never
reached the levels of the larger banks'.
     56
            Mr. Teixeira opined that, on the basis of the channels,
                                                     (continued...)
                                       - 94 -

       Mr. Teixeira characterized the nature of Norwest's work as the

automation of processes that previously were performed manually.

In    this regard,     he    claimed   that     Norwest's    work    was   oriented

primarily toward routine maintenance (correcting problems with

existing    applications),       enhancement       (adding    new    features    to

existing applications), and the implementation (deploying) of those

projects, but it was not research and experimentation.57                   Further,

Mr.    Teixeira    emphasized    that    Norwest's     use    of     the   Software

Development Methodology was designed to limit risk and prevent the

undertaking       of   any   implementation       projects    with    significant

uncertainty.58

       56
      (...continued)
products, and volumes supported within the banking industry at
the time, no significant technical risk existed in the eight
sample activities. He found that after Norwest investigated its
needs and the information available to it, the only risk that
remained related to business and ability to execute; but no
technical risk existed. He also indicated that generally even
where technical risk exists in a bank technology project and
causes its failure, the failure is usually attributable to the
cost of correcting the problem--not the ability to correct it.
Thus, the solution is often the purchase of more expensive
technology.
     Further, Mr. Teixeira described Norwest as a conservative
user of technology that generally spent its time attempting to
catch up to the technology already deployed by other U.S. banks.
       57
          Mr. Teixeira believed that Norwest's expenditures on
maintenance and enhancement projects generally reflected industry
trends.
       58
          Mr. Teixeira contended that he "[found] no evidence
that technical risk was factored into the [return on investment]
calculation of the projects claimed indicating that the
expectation that it would impact delivery of the project was
minimal."
                                                   (continued...)
                                       - 95 -

     Mr.   Teixeira   maintained        that    Norwest   did   not    engage   in

research and experimentation because "At all times after the design

phase, Norwest was working with just one option--not a set of

alternatives."    Mr. Teixeira identified two main attributes of

technology   research       in   the    banking   industry:59    The    "primary

deliverable"   and    the    "project     approach".       According     to     Mr.

Teixeira, the primary deliverable in technology research in the

banking industry is information which helps make decisions about

other information technology projects rather than a production

system. He further stated that the project approach60 in technology

     58
      (...continued)
     Further, through his understanding of the Software
Development Methodology, Mr. Teixeira claimed that most risk
would be resolved before the logical design phase (the business
requirements phase), which is where only 20 to 30 percent of all
expenditures in information technology projects occur in average
U.S. banks. Mr. Teixeira asserted that very little of the work
prior to the logical design phase involved research or
experimentation.
     59
          Mr. Teixeira noted that many top U.S. banks fund a
technology research entity within their information technology
organization for the purpose of "understanding when a technology
is sufficiently mature for use within the bank and working with
the lines of business to determine where the technology may be
deployed effectively". These research groups account for less
than one-half of 1 percent of the total information technology
organization's budget, and even less at a bank of Norwest's size.
Given these percentages, Mr. Teixeira projected that Norwest's
expenditures for research and advanced development were over 50
times greater than he would have expected from an entity of its
size.
     60
          The technology research project approach has a pattern
of: (1) Posing a question (stating what information the project
is trying to determine); (2) performing targeted work (e.g.,
model, prototype, or literature review aimed at resolving the
                                                   (continued...)
                                     - 96 -

research in the banking industry involves identifying the critical

elements and capabilities of the technology under study and then

modeling them in context.        In the case of Norwest, Mr. Teixeira

found that the work was intended to deploy a production system, not

to provide information or identify the elements of technology.

      Mr. Teixeira distinguished experimentation from the testing

performed by Norwest.      He asserted that experimentation addresses

the issue of how to achieve a goal, whereas testing shows whether

the goal has been reached.           In this regard, he stated that most

banks perform feasibility experiments which ask the question "can

it be done at all?".       However, at trial, Mr. Teixeira testified

that these experiments also involved questions of whether the goal

can   be   achieved   given    certain      constraints    in   the    business

environment.

      Finally, Mr. Teixeira attributed much of the inability of

Norwest to complete its projects on time and within budget to

management issues, not technical difficulties or risk.                He defined

technical risk as the probability that the chosen technological

architecture    combined      with    the     user's   determined     features,

functions, and volumes would not go into production.             He believed,

that on a percentage basis a 10- to 20-percent chance of failure

would constitute technical risk.            And with respect to Norwest's

      60
      (...continued)
question); and (3) applying the resulting information to other
projects (e.g., to implement or not).
                                  - 97 -

projects, he found the technical risk very low; however, he did not

determine any specific percentage in his analysis.             Mr. Teixeira

conceded that all of the activities at issue provided a new or

improved business function to Norwest, although not to the banking

industry.

7.    Analysis of the Eight Sample Activities

      The parties' experts aided the Court in understanding research

in the context of the computer science field and the banking

industry.   We did not find any one of the experts more helpful than

another.     Mr.   Teixeira   assisted   the   Court    by   explaining   the

existing state of technology in the computer science field as

related to the banking industry.      Drs. McDermott and Davis offered

particular insight into software development issues, although they

were often abstract or vague.       Unfortunately, with respect to all

of the experts, much of their reports and testimony was of limited

use   because   they   applied   definitions   and     standards   that   are

inconsistent with our interpretation of the seven tests that must

be satisfied to obtain the R&E credit.61             See Alumax, Inc. v.

      61
          There were several problems with the definitions
provided by each of the experts. For example, Dr. McDermott
appears to apply a 20-percent test to the definition of
substantial uncertainty--which we have rejected for the reasons
expressed. Additionally, his example of a hypothesis, as in the
case of the SBS project, is overly simple and not workable: "This
collection of algorithms, run on such-and-such a hardware
configuration, can perform such-and-such an account-management
task with no errors, in such-and-such a period of time." This
hypothesis cannot be used to develop true alternatives which can
be examined and considered by the taxpayer.
                                                   (continued...)
                                    - 98 -

Commissioner,   109 T.C. 133,    171-172   (1997);   Phi   Delta   Theta

Fraternity v. Commissioner, 90 T.C. 1033, 1041 (1988), affd. 887
F.2d 1302 (6th Cir. 1989).           Thus, while we will rely on the

experts' technical findings, we will generally discount their

conclusions with respect to the seven tests.

     A.   Strategic Banking System

     Petitioner's expert, Dr. McDermott, contended that at the time

SBS, the integrated banking system, was developed, no existing

product could have accomplished the increase in data processing

capability Norwest required.        He insisted that SBS was subject to

several uncertainties, particularly those relating to time and

space complexity, software engineering, and user-friendliness.           He

concluded that "The painful complexities and ultimate failure of

SBS ought to be evidence that there was significant risk due to

     61
      (...continued)
     Dr. Davis' definitions were too academic and did not conform
to the language used by Congress. For example, he stated that
"discovery" is the result of an experimental or laboratory
effort, which he defined as "the creation of an isolated
situation intended to mimic the real world in some respects, but
tightly controlled in all other respects." We recognize that Dr.
Davis was attempting to explain his understanding of research and
experimentation as understood in the computer science community--
but in reaching judicial decisions the definitions used by
Congress are controlling.
     Mr. Teixeira and the Tower Group, as well as Dr. Davis, also
assumed that the ultimate goal in research is information rather
than a product. This is inconsistent with the language of sec.
41, which clearly permits the ultimate goal to be a product.
Also, both of respondent's experts used definitions of
innovativeness that, although more familiar to us, are not
consistent with the language used by Congress in the conference
report accompanying the TRA 1986 on the innovativeness test.
                                - 99 -

technological   uncertainty."     This   conclusion,   Dr.   McDermott

claimed, is bolstered by a statement of Brian Phillips, former

president of NTS, that SBS had a 50-percent chance of failure at

the outset of the project.

     Dr. Davis stated that the SBS project was within the then-

current state of the art and asserted that any uncertainties could

be eliminated through information that was reasonably available to

Norwest.    Further, he claimed that any risks that existed during

the project were attributable to business risk, not technical risk,

despite the large-scale nature of the project.

     Mr. Teixeira, in the Tower Group report, contended that the

SBS customer module was first implemented by GMAC, a division of

General Motors, in 1990, and involved nearly five times as many

accounts.   He further explained that the failure of SBS was due to

continual changes in the banking industry and the growth of banks

such as Norwest and Bank One and was not due to technical risks.

Mr. Teixeira attributed innovative qualities in the SBS project to

the building of the customer module as the centerpiece of an

integrated banking system and the use of the PACBASE development

environment.    A July 1993 Tower Group report was more generous in

describing the SBS project, noting it as a "monumental effort * *

* based on providing a bank with state of the art technology".     The

July 1993 report also stated that the customer module had the

ability to contain up to 12,000 pieces of data, or six times more

than any other system available.
                                     - 100 -

      In both the Davis and Teixeira reports, it appears that

respondent's      experts    found       that   Norwest    was    not   engaged    in

qualified research in the SBS project because the majority of the

work was performed by EDS.         This is only relevant, however, if EDS

was   not   performing      contract      research    on   behalf       of   Norwest.

Respondent contends that EDS did not perform contract research.

      We find that together Norwest and EDS engaged in qualified

research in the SBS project with respect to the customer module.

See sec. 1.41-2(e)(5), Examples (5) and (6), Income Tax Regs.

(allowing R&E credit where in-house and contract research are

performed together).62       In making this finding, we are influenced

by the writings of respondent's expert, the Tower Group, which were

prepared before its involvement in this case and are a part of the

record.

      The   SBS   project    was     a    massive    effort      at   developing   an

integrated banking system that could interact with several other

systems and handle a tremendous volume of data.                       Although some

integrated systems existed in 1986 (about 25 percent of the top 100

U.S. banks had such systems according to Mr. Teixeira), none of

them could handle the volume of data in the SBS system, nor were

they customer based (rather, they were product or account based).

      62
          Although petitioner claimed that it was a "development
partner" with EDS in the development of the SBS system, neither
petitioner nor respondent suggests that Norwest and EDS were
engaged in a partnership that would implicate the rules under
sec. 1.41-2(a)(4), Income Tax Regs.
                                - 101 -

The Tower Group expected that the customer-centric module of SBS

would become the "core foundation around which a bank can integrate

all of its customer information".

     The development of the deposit and credit modules, however,

does not constitute qualified research.      The record is void of any

testimony or evidence (other than reports dated after 1991, after

the timeframe in issue) from which we can evaluate the nature of

the work performed on the deposit and credit modules.             We note

however Mr. Teixeira's indication that the deposit and credit

modules provided "no significant functional innovations to the

industry".

     The SBS customer module project involved the discovery of

information    which   was   technological   in    nature   and   expanded

principles of computer science--namely, the ability to create a

customer-based system that could integrate with other banking

systems and handle large volumes of data.         In this regard, we note

that qualified research for purposes of section 41 is not limited

to the development of new technology but also encompasses the use

of existing technology in new and dynamic ways.

     There is no doubt that SBS provided a new or improved business

component of Norwest in terms of customer service and growth

opportunities.    The Tower Group described the GMAC customer module

system as providing "quicker, more efficient underwriting, and a

faster, accurate understanding of changes in automobile purchase

behavior".    The sheer volume capacity of SBS, as compared with the
                                    - 102 -

preexisting banking systems, resulted in a new or improved business

component at Norwest.

      The SBS project went through a process of experimentation.

EDS, Bank One, and Norwest personnel met regularly to review and

critique the EDS technical development of SBS and recommend changes

to   the   system's    design.     Specific    concerns   were    raised,   for

example, with respect to the volume capacity of the database

system, DB2, which was one of the critical elements of SBS.                  In

addition, concerns were expressed as to the user architecture and

the use     of   the   PACBASE    tool.   Alternatives    were   proposed   and

discussed for each of these concerns (although apparently not

adopted by EDS).       These alternative suggestions, together with Mr.

Phillips' claim (to Dr. McDermott) of a 50-percent chance of

failure of the SBS project, buttress a finding that there was

uncertainty at the outset of the SBS project.                    Other issues

concerning       functionality,     through    data   modeling,    were     also

discussed.       These issues and others were tested extensively at

Norwest with respect to the customer module over a 3-year period,

resulting in the discovery of hundreds of problems, some of which

were attributable to poor technical design and others to poor

programming of the source code.               This process of developing,

reviewing, testing, and analyzing the various approaches proposed

by EDS constituted at least 80 percent of the development of the

SBS system and satisfies the formal standards of experimentation

sought by Congress.
                                      - 103 -

       In concluding that the process of experimentation test is

satisfied, we believe the activities in the development of the SBS

system should be examined in toto, rather than separately.                       The

activities     were      interdependent      and    built      on   each     other.

Separately, the activities were of no utility.

       The SBS system was an innovative effort that had the potential

to   result   in   substantial      efficiency     and   significant       economic

benefit to Norwest.        McKinsey & Co., Inc. (McKinsey), which was

hired by EDS to conduct a valuation of the SBS system for Norwest

in September 1987, found that SBS would provide better cross-

selling of products to customers, improved relationship pricing,

and the completion of backlogged development projects.                     McKinsey

concluded that these improvements would result in an increase in

pretax profits for Norwest of approximately $24 million for its

retail banking business.            Further, it was believed that Norwest

would save approximately $6 million in data processing expenses as

a    result   of   the   use   of    fourth-generation      technology      tools,

integration, and business model design.                  Finally, another $1

million in pretax savings would result from better collection

procedures and personnel productivity.             The McKinsey report stated

that "the system's major value will be allowing banks to develop

innovative products and target their customers more effectively.

Maximizing these capabilities gives a participating bank a clear

advantage over its bank and `near bank' competitors."                 McKinsey's

findings were      unchallenged       by   respondent    and   lead   us    to   the
                              - 104 -

inescapable conclusion that Norwest would have obtained substantial

competitive and fiscal benefits from the SBS customer module had it

and the other modules been successfully implemented.

     The SBS system also involved significant economic risk to the

three entities that participated in the development of the project.

The Tower Group reported in 1993 that an estimated $125 million had

been spent at that time by the three participants.         Further,

substantial uncertainty existed because of technical risk that

those resources would not be recovered within a reasonable period

of time.   In 1993, the Tower Group characterized EDS' efforts as

"venturing into new territory for both itself * * * and its

prospects".   In 1994, the Tower Group, in looking back on the

prospect of failure of the SBS system, stated: "The world of

banking is moving faster than EDS and its two development banks

could move SBS into production.   This fact is a commentary on the

time and resources required to implement a complex new system in a

large bank environment."   A January 1989 internal audit at Norwest

also revealed strong concern about the ability to complete the SBS

project: "In a project of this complexity and magnitude, involving

major new concepts, original database designs and state-of-the-art

technological application, by its very nature will result in

unforeseen problems."

     Dr. Davis stated in his initial report that size or complexity

of a project can create technical risk.   We agree and find that SBS

falls within that category.   The development of the customer-based
                                    - 105 -

system,   the   creation   of   a    large    volume   capacity,   and   the

implementation and integration of new systems into a large banking

environment each separately may not be technically difficult.            But

together these activities pose serious technical challenges.             We

believe SBS was a technically risky venture for the participants,

as the ability to accomplish all three goals and recover the costs

within a reasonable period of time was substantially uncertain.

This is confirmed, in hindsight, by the Tower Group in an American

Banker article in which respondent's expert discussed the reason

why systems such as SBS have failed:

          As the size of core application systems has grown,
     it has become impossible for teams of mere mortals to
     understand and control the almost infinite number of
     details. The world won't hold still while every detail
     is isolated, structured, and efficiently related to every
     other detail.    The number of relationships goes up
     exponentially with the number of details - and so does
     the number of points where an error can occur. The net
     result: a high likelihood of failure.

Teixeira, "Why Big Bank Core-Processing Systems Will No Longer Be

Built", Am. Banker (hereinafter Am. Banker article) 7A (Apr. 11,

1994).

     Finally, the SBS customer module built for GMAC could not have

entirely helped in the development of the modules for Norwest and

Bank One because the module for GMAC was not operational until

1990--whereas the rollout for Norwest began in 1989.               Further,

systems such as Anacomp, which was acquired by EDS, and others

developed by EDS' competitors, did not offer the functionality or

volume capacity that was critical to SBS' potential success. Thus,
                                   - 106 -

no commercially available products were available at the time

Norwest entered into the SBS project with EDS and Bank One.

     In sum, the SBS customer module project satisfies all seven

tests   for    qualified   research.         The   project,   at   the    time,

represented a concerted effort at advancing the state of technology

in the field of computer science, pushing existing technology to

new heights.     Its ultimate failure, at least at Norwest, does not

diminish its contribution to the field but only demonstrates the

rapid pace of technological advancement in the industry.

     Respondent contends that even assuming arguendo that the SBS

customer module project satisfied the definition of qualified

research in section 41(d), the work performed by EDS did not

satisfy the requirements of contract research on behalf of Norwest,

and thus Norwest is not entitled to the R&E credit.            Specifically,

respondent claims that Norwest did not retain a right to the

research results, and further, that the payments made to EDS were

contingent on the success of the research.           We disagree.

     Section 41(b)(3) allows the R&E credit for 65 percent of any

expenses paid or incurred by the taxpayer to any person (other than

an employee of the taxpayer) for qualified research. Section 1.41-

2(e)(2), Income Tax Regs., requires that the contractor of the

qualified     research   perform   such   research     "on    behalf     of   the

taxpayer" and that the payments not be contingent on the success of

the research.      Section 1.41-2(e)(3), Income Tax Regs., further

states: "Qualified research is performed on behalf of the taxpayer
                              - 107 -

if the taxpayer has a right to the research results.         Qualified

research can be performed on behalf of the taxpayer notwithstanding

the fact that the taxpayer does not have exclusive rights to the

results."

     Under the Participant License Agreement between Norwest and

EDS executed on December 16, 1986, the SBS system and each release

of that system were the property of EDS, except that Norwest was

entitled to a "perpetual, nontransferable, nonexclusive, and * * *

royalty-free license to use the [SBS system]".     The license to use

the SBS system was subject to several conditions, and the failure

of Norwest to adhere to those conditions gave EDS the right to

revoke the license if the noncompliance was not cured within 10

days.   The license was later extended to permit Norwest to use SBS

in   providing   banking   services     to   nonaffiliated   financial

institutions.

     Respondent contends that this limited license to use the

software is not sufficient as a "right to the research results" to

warrant the treatment of EDS as a contractor of qualified research.

Respondent differentiates between research results and the final

product and argues that had EDS failed to deliver a product,

Norwest would have been entitled to nothing.       Respondent asserts

that if research results and the final product are synonymous, then

the term "research results" would be rendered meaningless and

every time a person purchased a product, the purchaser might be

entitled to a qualifying research credit under section 41.
                                   - 108 -

     Petitioner    argues   that    Norwest,     Bank    One,      and   EDS   were

"development partners" in the SBS project, noting that this was how

Mr. Teixeira characterized the relationship of the three entities

in the Am. Banker article.       Further, petitioner contends that the

language of the regulations anticipates no more than this type of

relationship where each entity shares in responsibilities and the

rights to use the software upon completion of development.                        We

agree with petitioner that Norwest had a right to the research

results within the meaning of section 1.41-2(e)(2)(ii) and (3),

Income Tax Regs.

     The regulations provide that a contractor may obtain the R&E

credit if it retains "substantial rights" in the research.                      Sec.

1.41-2(a)(3)(ii), Income Tax Regs.             A taxpayer does not retain

substantial rights in the research if the taxpayer must pay for the

right to use the results of the research.           Sec. 1.41-5(d)(3)(i),

Income Tax Regs. (applying to the pre-1986 version of the R&E

credit but cross-referenced by section 1.41-2(a)(3), Income Tax

Regs.).    We believe that the right to use the results of the

research without paying for that right is at least a right to the

research   results   as   that     term   is   applied       in    section     1.41-

2(e)(2)(ii),   Income     Tax    Regs.--although        it   may    or   may     not

constitute "substantial rights in the research" within the purview

of the regulations.

     Norwest retained a right to the research results in this case

through its perpetual license from EDS, the contractor, to use the
                                  - 109 -

SBS system without paying any royalties.           This is sufficient to

satisfy the requirements of section 1.41-2(e)(2)(ii), Income Tax

Regs.

       Respondent contends that Norwest's payments to EDS after May

25, 1987, were contingent on the success of the SBS system.          Under

the Participant Agreement between Norwest and Bank One, Norwest was

required to pay $7 million to Bank One for its participation in the

SBS project.     The payments were made in installments, beginning

with    an   initial   payment   of   $694,440   upon   execution   of   the

agreement, followed by monthly payments of $138,890 until February

25, 1988, and followed by monthly payments of $250,000 until July

25, 1989.      (The last two payments were deferred pursuant to an

amended agreement between the parties because of delays by EDS in

releasing SBS.) However, under the terms of the agreement, Norwest

could stop making payments and terminate the agreement at selected

times during the interim periods in which development milestones of

the SBS project were being completed.             The first development

milestone was completed on May 25, 1987.

        Petitioner argues that although Norwest was not obligated to

make payments to Bank One (and EDS) after each interim development

milestone period, there was never an agreement that any amounts

that it chose to pay were recoverable if the research was not

successful.     We agree with petitioner.

        As to respondent's argument that the payments made to EDS were

contingent on the success of the research, we note that the
                                   - 110 -

participant agreements between Norwest and Bank One, and Norwest

and EDS, are void of any reference to such a contingency.                     Had

Norwest been dissatisfied with a development milestone, it could

have terminated the agreements at that point and taken the SBS

release as it then existed--but Norwest could not have recovered

the payments it had already made.                Thus, the requirements of

section 1.41-2(e)(2)(iii), Income Tax Regs., are satisfied.

       We hold that the expenses paid or incurred by Norwest in the

development    of   the   SBS    customer      module   constitute     qualified

research under section 41.        The only remaining issue then is which

expenses of EDS and Norwest in the SBS customer module project

constitute qualified research. In this regard, respondent contends

that Norwest's installation and customization activities, and the

subsequent testing after it received the releases of SBS from EDS,

do not constitute qualified research.               Respondent specifically

relies on section 41(d)(4)(D)(v), which excludes from qualified

research any routine or ordinary testing or inspection for quality

control.    Respondent asserts that installation and customization,

and the testing activities related to those processes, are routine

or ordinary testing procedures in the software field and thus must

be excluded from qualified research.

       While respondent's characterizations may be accurate in some

contexts, they are not accurate in the context of the SBS project.

The customer module's unique feature was its ability to interact

with   other   modules    to    permit   the    easy    sharing   of   data   and
                                      - 111 -

information.         Thus,     the   installation   process,     including   the

interfacing of SBS with Norwest's existing deposit and credit

modules and other systems, and the subsequent testing, was critical

to the success of SBS.          This was all part of the research process.

It was far from routine.             Mr. Teixeira, in a book published in

1990,      indicated    that    installation    and     conversion   of     large

integrated software systems like SBS "can be risky".

      We     agree     with    respondent,   however,     that    customization

activities relating to SBS by Norwest after delivery by EDS that

were unrelated to the installation and interfacing activities are

not qualified research as those activities relate only to style,

taste, cosmetic, or seasonal design factors. See sec. 41(d)(3)(B).

We also agree with respondent that any activities performed by

Norwest after the first SBS release was installed at each bank is

not     qualified    research.        Section   41(d)(4)(A)      excludes    from

qualified research any research conducted after the beginning of

commercial production of the business component. Although Congress

anticipated that some postproduction activities, including internal

use software activities after the installation of commercially

available software, could be treated as qualified research, H.

Conf. Rept. 99-841 (Vol. II), at II-73, II-74 n.4 (1986), 1986-3

C.B. (Vol. 4) 1, 73, 74 n.4, Norwest has not shown that the

subsequent releases of SBS by EDS involved qualified research by

EDS or Norwest, Rule 142(a).
                                 - 112 -

     To summarize, we conclude that all expenses paid or incurred

by Norwest in the development of the SBS customer module constitute

qualified research through the first deployment of the customer

module to each of Norwest's banks, and that expenses relating to

customization activities by Norwest after receipt of the first SBS

release do not.

     B.    Trust TU

     Dr. McDermott found that the NTS staff used "considerable

ingenuity" in keeping the Trust TU system running as long as

possible.     He stated that even though the project was eventually

abandoned,    had   Norwest's   Trust   TU   system   failed    before   new

technology (the Compass system) was available, Norwest would have

incurred     significantly   greater    costs   in    running   its   trust

department.     Thus, he concluded that the project was a "mixed

success".

     Dr. Davis characterized this project generally as maintenance

and enhancement of the source code and claimed that the efforts to

increase volume and efficiency were "one of the most common,

routine tasks in information processing".             He found that the

volumes sought by NTS were well within the then state of the art.

     Mr. Teixeira also characterized the Trust TU project as

generally maintenance and enhancement efforts.          He found that the

changes did not add any new functionality that was not already

available at any other trust department.        In this regard, he noted

that the volume sought by NTS was well below the volume already
                                      - 113 -

processed by the larger trust departments such as at State Street

Bank and Bank of New York.

       We agree with respondent that the Trust TU activities do not

constitute qualified research.           None of the activities engaged in

by NTS in this project involved anything more than "cookbook"

approaches to software development and the basic "skilled practice"

of computer programmers.            Indeed, Dr. McDermott admitted as much

when    he   stated   that    the    changes    to    Trust     TU   "required   the

application     of    basic   principles       of    software    engineering     and

testing" and that "This is not cutting-edge science, but it falls

exactly within the bounds of computer science as it is taught in

textbooks."

       Routine software development is characterized by the use of

cookbook approaches, as described by Dr. McDermott, in which at the

outset the ability to accomplish a task is known because of the

presence of skilled practice and known methodologies,63 even though

       63
          We accept petitioner's assertion that standard
methodologies (such as Norwest's SDM) are employed because
researchers find that they are the best way to discover new
information. These are not the types of methodologies we are
concerned with in qualified research; the key is whether the
practices and methodologies provide the researchers with the
known capabilities (e.g., formulas) for accomplishing the task--
and in routine software development, that is often the case.
     We think Dr. Davis' testimony on this subject is
instructive:

             A    One of the things that I think is worth
             distinguishing is the notion of research
             activity from what I'll call the skilled
             practice.
                                                      (continued...)
                                   - 114 -

the exact benefits to be derived are in doubt.       Cookbook approaches

to software development preclude any finding of a discovery of

information that is technological in nature, or a process of

experimentation.      Cookbook approaches to software development do

not result in new knowledge about the principles of computer

science or technical uncertainty that requires the consideration of

alternative hypotheses.         In our opinion, Congress did not intend

cookbook approaches to software development to come within the

bounds of section 41 when it excluded from the R&E credit the

duplication     of   existing   business   components,   or   routine   data

collection or testing.      See sec. 41(d)(4)(B), (D)(iv) and (v); H.

Rept. 99-426, at 182 (1985), 1986-3 C.B. (Vol. 2) 1, 182; cf.

     63
          (...continued)
                   Anybody engaged in, well, almost any
              profession -- but let me make it in the
              engineering profession for the moment --
              accumulates a body of skilled practice over
              time. These are things that you know how to
              do because you're in the business.

                  Some of those things are difficult to
             do. Some of them require a substantial
             amount of skilled practice to do them. So to
             say something is not research, or even to
             call it routine software construction is no
             way to denigrate it or to say it doesn't take
             a substantial body of skill to do.

                  What it says is that, in the community
             of people who do this kind of thing, the
             knowledge of how to do it is out there, as
             opposed to it has to be discovered or
             revealed in some fashion. Okay? It's what
             you would expect a competent professional in
             the field to know and be to [sic] able to do.
                                      - 115 -

Mayrath v. Commissioner, 41 T.C. 582, 590-591 (1964), affd. 357
F.2d 209 (5th Cir. 1966) (rejecting section 174 deduction for

development     of     experimental    house    which   involved   the   use   of

standard construction principles).

      The Trust TU project was not one that expanded or refined the

principles of computer science. Nothing new was accomplished.                  The

capacity to develop the project was already a part of the skilled

practice of NTS and had been achieved elsewhere.                To the extent

risks were present in this project, they related solely to business

risk, not to technical risk that involved substantial uncertainty.

        C.   Success

      Dr. McDermott described the technical efforts of developing

the   Success      equipment     leasing   system    as   "getting   TPF   [the

processor] to do things slightly beyond what it was designed to do"

(although later in the same report he indicated that the Success

project pushed the TPF system "well beyond its known limits").                 He

found    serious     questions    regarding     whether   the   "complex   data

structures" required by Success could be handled within the TPF

framework, and the solutions developed by NFISG "made a definite

contribution to computer science".             He further found that Success

provided a substantial improvement over its predecessor, Infolease,

in terms of speed, functionality, and data integrity.

        Dr. Davis found that the development of the Success system

involved nothing more than routine practice, and that none of the

activities required the use of a process of experimentation.                   He
                                  - 116 -

also found that no significant degree of technical risk was present

in any of the various activities.

     Mr. Teixeira reported that the Success system offered no new

or unique features to the banking industry, and that although

Success was an improvement from its predecessor, it did not provide

industry-leading capabilities.         Mr. Teixeira noted that although

some functions, such as the use of e-mail and the ENFORM program to

generate reports, improved efficiency, NTS did not discover any new

or unique ways to exploit those functions.              He concluded that

although no commercially available software could provide exactly

the functionality needed by Norwest, there was no doubt about the

ability to develop viable equipment leasing software in Norwest's

environment.

     We agree with respondent that the development of the Success

system does not constitute qualified research.          All three experts

noted the lack of documentary evidence for the Success project, and

we note that the record is specifically lacking with respect to the

technical   risks    involved.    It   appears   that   the    only    project

activity which may have involved technical risk was with respect to

the ability to develop Success on the TPF platform.             However, Dr.

McDermott was vague about the nature of the technical risk in this

regard, and Mr. Teixeira reported that this was a small part of the

overall project.       We also note the testimony of Dan Franker,

manager of     the   Success   project,   who   indicated     that    he   never

encountered insurmountable issues with the project and that he
                                 - 117 -

anticipated    that   the   project    could    be   accomplished   with   the

available resources.        Further, the major risks to the project

appear to have related to the ability to develop the software

within tight time constraints--a business risk, not a technical

risk.    In sum, the project simply falls short of one that could be

characterized as venturing into uncharted territory.

     D.    General Ledger

        Dr. McDermott identified the "shadow files" system as the

major technical challenge of the general ledger project, allowing

virtual access to real-time data while continuing to run batch

processing only once per day.         He stated that the logical problems

that had to be solved for this system were "complex and hard to get

right".

        Dr. Davis described the changes to the general ledger system

as "remarkably small-scale, routine modifications". He stated that

the issues raised by the performance problems were routine, and

that the solutions were well known and could be accomplished

through good coding practices and established methodologies.

        Mr. Teixeira stated that the general ledger system from FCS,

which Norwest purchased, was used at over 30 of the top 100 U.S.

banks during the relevant period.          Moreover, he stated that the

work performed by NTS did not provide any significant technical

innovations    beyond   those   which     the   vendor   had   designed    and

delivered.
                                       - 118 -

      We agree with respondent that the general ledger project

activities do not constitute qualified research. The only activity

that could have involved technical risk was the shadow files

system.    However, we accept Mr. Teixeira's assertion that the

development of a shadow files system was common at large U.S. banks

and   required    only     the    following      of    known    methodologies        and

approaches--routine software development that does not expand or

refine the principles of computer science and does not involve the

engagement of technical risk.

      E.   Money Transfer

      Dr. McDermott opined that the money transfer system project

involved qualified research due to the financial and security risks

involved in complying with the regulatory changes imposed by the

Federal Reserve and the expected growth in the industry.                      He wrote

of NTS' efforts of extensive testing to assure the elimination of

software bugs.         Finally, he noted that NTS rewrote as much as 50

percent    of    the    source    code    to     the   system    to       provide    the

functionality needed by Norwest.

      Dr. Davis admitted lack of knowledge of wire transfer systems;

he deferred to Mr. Teixeira for elaboration. He commented that the

development of systems through the use of COBOL language and the

Tandem computer (which were apparently used in the money transfer

system) do not constitute the discovery of information that is

technological     in     nature   or   which     could   involve      a    process    of

experimentation.
                                 - 119 -

     Mr. Teixeira reported that by late 1986, the money transfer

system used by Norwest, MoneyNet, was being used by 46 of the top

100 U.S. banks.      He stated that Norwest's modifications to the

system    to   satisfy   regulatory   and   business   requirements   were

consistent with the changes made by other users of the same system.

He found that although the technology may have been new to Norwest,

it was not new to the industry.

     Although a taxpayer's making changes that are being made

concurrently by other users of a system does not mean that the

taxpayer cannot be engaged in qualified research, Norwest has not

demonstrated that any of its work on its money transfer system

involved technical risks or a process of experimentation--and thus

the activities do not constitute qualified research.          There were

obvious business risks involved with this project, e.g., failing to

implement critical security measures that ensured the safe and sure

transfer of funds, but there was no evidence of uncertainty about

the ability to complete the project.        The project did not involve

alternative designs or hypotheses but merely required conducting

good coding and eliminating bugs through testing--issues resolved

through cookbook approaches and skilled practice, not research and

experimentation.

     F.    Cyborg Payroll

     Dr. McDermott strained to conclude in his rebuttal report that

the Cyborg payroll system constituted qualified research.               He

insisted "it is possible that the process was one of mechanical
                                    - 120 -

trial and error rather than true research." However, he refused to

concede   that   this   project     did   not   qualify.     Elsewhere,      Dr.

McDermott appeared to regard as significant the use of the arcane

report writer language of the Cyborg payroll system, as well as the

"heroic efforts" of NTS to sustain this "increasingly inadequate"

system.

     Dr. Davis classified the task of maintaining and enhancing the

payroll   system   as   "one   of   the   oldest   and     most   familiar    in

information technology". He found that everything performed by NTS

was routine and well within industry practice.

     Mr. Teixeira also found NTS' efforts entirely routine and

noted that the functionality added to Cyborg already existed at

every other major U.S. bank.

     The Cyborg payroll system activities clearly do not fall

within the realm of qualified research.          Dr. McDermott stated that

the key issue "was how long the system could be made to survive".

Cyborg was an outdated system.        It is evident that the goal of NTS

was not to advance the principles of computer science, but rather

was to maintain a 1970's system running into the early 1990's.                It

was this type of activity that Congress had in mind when it sought

to narrow the definition of qualified research and expressed its

concern that taxpayers were claiming the R&E credit even though

they were not engaged in high technology activities.              See S. Rept.

99-313, at 694-695 (1986), 1986-3 C.B. (Vol. 3) 1, 694-695; H.

Rept. 99-426, at 178 (1985), 1986-3 C.B. (Vol. 2) 1, 178.              Heroic
                                      - 121 -

as the efforts of NTS       may have been, such efforts involved nothing

more    than   the   skilled   practice      of    those    in   the     information

technology industry.

       G.   Trust Payment

       Dr. McDermott identified two complex issues in developing the

Trust Payment system which related to performance and reliability.

These involved "optimizing" the programs to make them run faster

and more efficiently and attempting to avoid "locking" of the

system when too many users were accessing data.                  He found that the

changes to this system were "more difficult than usual" because

small changes could disrupt the logical structure of a larger

system.

       Dr. Davis stated that the task of developing the Trust Payment

system, and the technology used, were familiar and well established

in the industry. He found nothing uncommon about interfacing a new

system to other older systems. Dr. Davis conceded that uncertainty

over    NTS'   ability    to   develop       a     system   to    meet     Norwest's

requirements     may   have    existed,      but    he   denied    that     any   new

principles of computer science were discovered through the routine

use    of   standard   tools   that    had   been     around     for   many   years.

Finally, he found that the problems and solutions encountered by

Norwest in the development of this system were routine.

       Mr. Teixeira, as in the case of the Trust TU system, made

reference to the fact that Norwest was a mid-tier trust service

provider, and that other trust service providers processed as many
                               - 122 -

accounts as Norwest.    Indeed, some providers processed as many as

five times more.   Mr. Teixeira found that Norwest's development of

the Trust Payment system did not result in any new or unique

functions or technology to the industry, and that commercially

available software offered comparable functionality.   He concluded

that the technologies used in developing the system were well

established in the banking industry and were familiar to Norwest

personnel.

     We agree with respondent that the development of the Trust

Payment system does not constitute qualified research.    Although

technical risks arose in the development process, those risks were

limited and did not involve substantial uncertainty that Norwest's

investment could be recovered within a reasonable period of time.

The technical risks were clearly solvable: the only issue to

Norwest was whether they could be solved in time so as to maintain

or advance Norwest's competitive standing in the trust service

provider industry.     Indeed, Dr. McDermott admitted this when he

reported:

     The key point to repeat here is that the risk to Norwest
     was that a project would be delayed because of technical
     uncertainties. Even if a project could clearly be done
     eventually, the results might be useless if they came too
     late. The cost to Norwest would be wasted development
     effort, inefficiency in using old solutions, and
     backwardness with respect to their competitors. It seems
     clear that in the case of * * * [the Trust Payment
     system] these risks were real, and actually materialized,
     although not to the extent that the project failed
     altogether.
                                  - 123 -

A "reasonable period of time" for the development of a software

system does not relate to self-imposed business time constraints,

but rather to the reasonable time of those in the field of computer

science.

     H.    Debit Card

     Dr.   McDermott    found   that    the    Debit   Card    project    had   a

"significant chance of failure" due to software engineering, one

which the project team placed as high as 50 percent.             However, Dr.

McDermott admitted that "With all resource constraints removed,

there is little doubt the project would have eventually succeeded."

He indicated that the software engineering question was whether it

was "possible to make hundreds of modifications to several existing

systems in the time allotted".         In the end, the entire success of

the project, i.e., becoming the first bank in Norwest's market to

deliver a debit card product, was dependent upon Visa's ability to

develop the appropriate interface with Norwest's existing ATM

system on time.    "This was out of Norwest's control, and was a risk

the Norwest programmers could do nothing about."                Dr. McDermott

concluded in his rebuttal report that there was no high degree of

uncertainty about the particular algorithms used in the project,

and that the only uncertainty was the ability to complete the

project in the short time provided.

     Dr. Davis concurred that the only risks in this project

related    to   business   or   economic      risks,   not    technical   ones.

Further, he found that the processes engaged in by Norwest were
                                  - 124 -

routine and consistent with standard practice in the computer

science field.

       Mr. Teixeira reported that debit cards were common by 1989,

and several banks had transaction volumes significantly larger than

Norwest's.       Further, by 1990, 673 banks were issuing Visa logo

debit cards.      He also found that Norwest's experience with ATM's,

which Norwest used to operate the debit card system, provided a

solid understanding of the technical issues involved, including

interfacing, card issuance, and capacity planning.         Additionally,

Mr. Teixeira stated that Norwest's activities in interfacing the

new debit card system with its other systems were consistent with

the deployment of the products by other institutions. Finally, Mr.

Teixeira rejected any claim by Norwest that technical alternatives

were considered in the process of developing the debit card system

and insisted that the alternatives related only to business issues.

       We agree with respondent that the development of the Debit

Card    system    does   not   constitute   qualified   research.    Dr.

McDermott's own findings that the project's only risk was its

ability to be completed and deployed before those of Norwest's

competitors undermines any claim to the R&E credit.          None of the

experts reveal any technical risks, and it is apparent that the

debit card was a fairly common product (nearly 40 percent of the

top 75 banks had the debit card by late 1989) by the time Norwest

entered the market.       No new principles of computer science were

discovered by this project, and although alternative approaches
                               - 125 -

existed   (e.g.,   credit   card   processor   versus   direct   access

approach), they related entirely to business concerns and not

technical risks.

Conclusion

     In summary, we hold that the development of the SBS customer

module constituted qualified research under section 41, to the

extent indicated supra, and that the remaining seven internal use

software projects failed to satisfy the seven tests required to

obtain the R&E credit.

     To reflect the foregoing,

                                           Appropriate orders

                                      will be issued.