Research tax credit audit plan and audit plan for internal-use software.

On March 29, 1996, Tax Executives Institute submitted the following comments to the Internal Revenue Service on two audit plans developed by the IRS's Research Credit Issue Specialist. The two plans are entitled "Research Tax Credit: Audit Plan for Examination of the Research Tax Credit" and "Research Tax Credit: Internal Use Software Audit Plan." TEI's written comments, which elaborate on issues discussed during a March 15 meeting between representatives of TEI's IRS Administrative Affairs Committee and the Internal Revenue Service, were submitted to David G. Harris, Director, Coordinated Examination Programs, and Ray Presley, Director, Industry Specialization Branch.

TEI's submission on the research tax credit audit plans were prepared under the aegis of TEI's IRS Administrative Affairs Committee, whose chair is Robert L. Ashby of Northern Telecom Inc. In addition to Mr. Ashby, the following individuals contributed to the preparation of the Institute's comments: Marc C. Filut of MCI Communications Corporation, Sheldon A. Kimel of Brunswick Corp., Kelly A. Nall and Karyn Ward of Electronic Data Systems Corp., Thomas B. Rogers of Apple Computer, Inc., Richard C. Sammut of Whirlpool Corporation, Paul J. Schaffhausen of McDonald's Corporation, and John P. Shepherd of PacifiCorp.

Background

Tax Executives Institute is a volunteer, professional association of approximately 5,000 accountants, lawyers, and other professionals who are responsible for managing the tax affairs of their companies. TEI members must contend daily with the recordkeeping and other compliance challenges associated with the business tax laws. TEI represents a cross-section of the business community, including companies that engage in all levels of research activities. We are dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and the government alike.

The Institute is firmly committed to maintaining a tax system that works -- both for taxpayers and tax administrators. We believe the diversity and training of our members enable us to bring a unique, balanced, and practical perspective to your attention.

General Comments

1. Overview of the Research Tax Credit: The research tax credit was enacted by Congress in 1981 in order to provide an incentive to taxpayers for increasing their research activities. Now contained in section 41 of the Internal Revenue Code, the research tax credit is equal to the sum of (i) 20 percent of the excess of the taxpayer's qualified research expenses for the taxable year over a base amount and (ii) 20 percent of the taxpayer's basic research payments. "Qualified research expenses" include in-house expenses for wages paid and supplies used in the conduct of qualified research, and 65 percent of any contract expenses for qualified research.

The definition of "qualified research" was amended by Congress in 1986. Section 41 provides that, to be eligible for the research tax credit, an activity must do more than satisfy the definition of research and experimental expenditures for purposes of section 174; it must also be undertaken for the purpose of discovering information that is technological in nature, the application of which is intended to be useful in development of a new or improved business component of the taxpayer. In addition, an activity is eligible for the research tax credit only if substantially all of the activities of the research constitute elements of a process of experimentation for a new or improved function, performance, reliability, or quality.

Given the menagerie of complicated concepts and terms in the research tax credit, it is not surprising that many disputes arise between taxpayers and the Internal Revenue Service concerning the meaning and application of section 41. The number and extent of disputes has no doubt been exacerbated by the lack of formal guidance from the IRS. Hence, although the IRS issued final regulations under section 41 in 1989, those regulations do not address themselves to the 1986 changes in the definition of qualified research and basic research, nor to the amended rules for computing the credit in respect of basic research payments. (The regulations similarly do not reflect changes made to section 41 in 1989 and 1993.) Without formal guidance, IRS agents have adopted differing views of what constitute qualified research activities and expenditures. TEI sincerely believes that the promulgation of regulations on the definition of credit-eligible activities and expenses would bring salutary clarity to the area, enhance the ability of taxpayers to voluntarily comply with the Internal Revenue Code's complicated requirements in respect of the research tax credit, and materially reduce the number and magnitude of disputes between taxpayers and the IRS in respect of the credit.

2. Issuance of Research Tax Audit Plans: Into the void created by the lack of current regulations, the IRS's research credit issue specialist in 1995 propounded two audit plans for use by examining agents. One of the two plans released by the issue specialist is addressed to general research tax credit issues, and is captioned "Research Tax Credit: Audit Plan for Examination of the Research Tax Credit" (10/12/95). The second plan addresses itself to software developed for the taxpayer's internal use, and is captioned "Research Tax Credit: Internal Use Software Audit Plan" (10/23/95).

TEI believes that the two audit plans provide much useful information, and although we believe the plans can be improved, we commend the IRS's research credit issue specialist for his efforts to bring a greater measure of certainty and uniformity to this area. Notwithstanding our support for the issuance of audit plans, we believe it necessary to say that they are no substitute for formal guidance upon which taxpayers may rely. Indeed, we believe that many of the problems in administering the research tax credit --for taxpayers and examining agents -- could be ameliorated by the issuance of formal guidance. Accordingly, we continue to believe that tax administration would be well served by the promulgation of revised regulations that fully take into account Congress's intent in enacting and modifying the research tax credit and, obviously, reflect and comport with the most recent statutory amendments to section 41. In this regard, we are pleased to note that a project to provide additional guidance under section 41 (presumably through the issuance of regulations) is included on the Treasury Department and IRS's 1996 priorities list.

3. A Question about Process: We understand that the two audit plans were developed with the assistance of major accounting firms whose clients include many companies with experience under section 41. To our knowledge, however, comments were not solicited from other qualified and interested stakeholders, including affected taxpayers themselves, taxpayer groups such as TEI, industry associations, and law firms whose client bases may well duplicate or complement those of the accounting firms. We recommend that the views of these other stakeholders be sought in revising the research tax credit audit plans (or, for that matter, in developing any other such plans).(1)

4. A Comment on Tone: TEI regrets to report that many TEI members have interpreted the audit plans as hostile to the allowance of additional research tax credits. Our members' perceptions have undeniably been influenced by their experiences with section 41 since the research tax credit was enacted in 1981. The Institute itself has long perceived a historical reluctance by the IRS to implement the research tax credit in a manner consistent with Congress's intent to provide an incentive for increasing research activities. We are concerned that, unless tempered, the restrictive language and tone of the plans will unfairly communicate that reluctance to examining agents. For example, the plans state that examining agents should "challenge" expenses, instead of using the more neutral term "review"; they similarly instruct agents to develop a "strategy" for their audits rather than a "plan." There is nothing wrong with these terms in the abstract, but we suggest that they convey a more adversarial than cooperative tone.

We recognize that the IRS must ensure that the varying requirements of the Code are satisfied; in applying the research tax credit, however, the IRS should not adopt strained interpretations of section 41's varied requirements, erect artificial barriers to a taxpayer's claiming the credit, or betray a philosophical disagreement with Congress's policy decision to provide taxpayers with an incentive for increasing research activities. Unfortunately, it does all of these, especially in respect of internal-use software. The suggested approach -- to challenge the taxpayer's characterization of software development activities and require the taxpayer to prove why each such activity meets the definition of research -- seems at odds with the underlying intent of section 41 because it leaves taxpayers in doubt whether the tax credit will in fact be available and that doubt may well vitiate section 41's incentive effect. It also seems potentially at odds with the IRS's own mission -- to determine the taxpayer's correct amount of tax liability.

In this regard, we believe that the plans unnecessarily remind examining agents that taxpayers have the burden of proof. Although such reminders are accurate (inasmuch as taxpayers have the burden with respect to all matters reported on their returns), the pointed language (combined with the rather exhaustive list of documents that examining agents should seek) sends a strong signal that taxpayers may well be unable to sustain their burden. We do not believe a hard-line approach to the research tax credit is justified.

5. The Shortcomings of the Bottom-Up Approach: The audit plans state that examining agents should adopt a two-part audit strategy: First, they should examine the underlying expenditures in respect of which the credit is claimed, and then they should examine the activity in respect of which those expenditures were incurred. With due respect, TEI submits that the proposed sequence of events is precisely and absolutely wrong. If an activity does not qualify as a research activity, why should the agents expend the time and effort (and require the taxpayer to expend the time and effort) auditing the precise numbers? We submit that they should not.

Instead of adopting a "bottom-up approach," pursuant to which the agent scrutinizes the expenses claimed before determining whether the activity to which those expenses relate constitute qualified research, the audit team should employ a top-down approach. The first determination should be whether an activity is prrly characterized as qualified research. If it is not so characterized, the agents need go no further; if it is, then the audit team can undertake to determine which expenses are properly taken into account in calculating the research tax credit. We recognize that a company's ability to document its qualified expenditures is an indispensable part of substantiating its entitlement to the credit. At the same time, the fundamental question whether a particular project is a research activity for purposes of section 41 does not turn -- and should not turn -- on the quality of the taxpayer's bookkeeping. In other words, although the taxpayer's ability to sustain a particular deduction may turn in part on the quality and sufficiency of its records, the basic issue whether an activity qualifies as research should not depend on this matter.

6. The Need for Flexibility and Taxpayer Involvement: TEI is concerned that many agents may interpret the plans as prescribing a "one-size-fits-all" approach. The plans seemingly instruct examining agents to always do this or always do that, and they strongly intimate that a taxpayer's inability to provide particular information (or to provide it in a particular format) should always lead to a disallowance of a credit claim. For example, the plans are replete with phrases like "all employees," "each account," "all entities," "all activities," "each qualifying project," "each project or activity," "in almost all software development activity," and "must" (or "MUST").

Given the wide variety of research activities undertaken by taxpayers, the seeming rigidity of the audit plans is unfortunate. Clearly, there is no single approach that will work in all cases, but we question whether the plans adequately communicate the flexibility that agents should have in auditing the research tax credit. Accordingly, we suggest that the plans be restructured as a menu of ideas or guidelines from which examining agents can choose -- using them (or not using them) depending on their judgment and the particular facts and circumstances of each case.

In this regard, we recommend that the plans be revised to include a preamble that encourages the audit team to invite the taxpayer to actively participate in planning the audit of research tax credit issues. Hence, although the plans instruct agents to request a great deal of information from the taxpayer, they neglect to suggest that the audit team may be able to streamline the whole examination process by including the taxpayer in the audit planning process. In many cases, the company's tax department can facilitate the audit team's understanding the sometimes incomprehensibly complex activities in respect of which the research tax credit has been claimed. For example, the tax department may productively provide an overview of the company's research activities and assist the agents in identifying areas that may or may not be the proper target of enhanced audit scrutiny. We also suggest that the plans should clearly signal that agents should explore the use of sampling, estimates, and ratios as reasonable -- indeed, preferred -- alternatives to auditing each and every expense of each and every research project.

We also note that, compared with general accounting data, information concerning research activities tends to vary more from company to company. By working with the taxpayer from the outset, the audit team can more fully comprehend the overall nature of the company's research activities and the types of information the taxpayer has assembled to support the claimed research tax credit. Such an approach will enable the audit team to tailor the examination to fit the particular taxpayer and to make a more informed decision regarding the overall scope of the research tax credit examination.

7. Unanswered Questions: Some important questions are left unaddressed by the audit plans. Indeed, in many respects the plans resemble technical position papers on the IRS's interpretation of section 41, rather than plans for how to audit research tax credit claims. The technical information contained in the plans likely will prove helpful (especially in the absence of more definitive guidance), but in a very real sense the plans do not deal adequately with the difficult process issues inherent in auditing the research tax credit.

For example, the plans do not address how a taxpayer can prove that a certain employee performed research activities several years after the fact. True, the plans suggest looking at performance reviews. But these are typically highly summarized -- and sensitive -- documents covering delimited periods of time and, more to the point, in many companies they address not what was done but how it was done. Detailed diaries or daily work logs would be ideal, but in the real world, they often do not exist. In the real world, what is the taxpayer -- and the agent -- to do? That the level of detail and sophistication of taxpayers has evolved in the 15 years since section 41 was enacted is something that agents should keep in mind as they develop their approaches to particular examinations. They should also keep in mind that neither the statute nor the legislative history provides (or even suggests) that contemporaneous documentation is a prerequisite to claiming the research tax credit, and that alternative means (such as interviews, questionnaires, and surveys) exist to substantiate the taxpayer's claim.

Consider another example: How can a taxpayer establish that a certain supply item was used in qualified research activities? The company's accounting records will prove that the supplies were purchased and for what amount, but rarely are there tracking systems in place that detail the exact usage of specific supplies purchases. We believe that the activities of the department (indeed, the entire company) that purchased the item could prove probative (perhaps even determinative), but the audit plans intimate that the absence of "perfect records" should put the taxpayer's claim beyond the pale. To redress this concern, we believe the plans should note that many companies' recordkeeping systems have evolved over the years, and that the audit team could productively look at the records for subsequent years (possibly including years outside the current audit cycle) in making an informed judgment about the companies' eligibility for the research tax credit in earlier periods where the records may not be as detailed or sophisticated.

In some respects, the audit plans can be characterized as glossing over the difficulties inherent in administering and auditing the research tax credit. Literal compliance with all aspects of the statute, regulations, and audit plans would again be ideal, but it requires additional layers of burdensome recordkeeping systems that, quite candidly, are wholly out of sync with the way businesses conduct their affairs and keep their records. In our view, there are no easy answers for these difficult problems, and we believe it would be both realistic and therapeutic for the plans to at least acknowledge their existence and to encourage examining agents to use reasonable, practical, and imaginative approaches in dealing with them. In the absence of such acknowledgment and encouragement, the plans may be misconstrued as encouraging agents to adopt an unbending approach that will ultimately frustrate if not vitiate entirely the underlying intent of the research tax credit. To guard against this, we suggest consideration be given to including a broad array of examples in the plans, which would illustrate both how the research tax credit rules work in real-world situations and the extent to which agents should be flexible in auditing compliance with those rules. We would be pleased to work with the IRS in this endeavor.

General Research Tax Credit Audit Plan

8. Request All Workpapers Used to Compute the Research Credit (page 4, [paragraph] I.2): The plan provides that --

The taxpayer's workpapers in which it computed the research credit should include all entities. The expenditures should be broken down into wages, supplies, and contract research expenses. The workpapers should identify whether the taxpayer is computing the credit using a cost center/departmental approach, project approach, or just listing the specific expenses that qualify. If computed under a cost center approach, the workpapers should identify each cost center and department, by its appropriate cost center or department number, that is included in the credit. Also, the workpapers should contain each qualifying wage, supply, and contract research account by its appropriate number.

Although TEI appreciate that the information listed above may be helpful, we are concerned by the plan's establishing an expectation that such records will exist in the desired format in each and every instance. Hence, we worry that agents may interpret the plan too rigidly, where what is needed is flexibility. More to the point, since companies generally prepare their tax returns based on summary information submitted by their business units, the tax workpapers may well not have the level of detail anticipated by the plan, and we recommend that the plan so inform the agents.

9. Plan Your Audit Strategy (page 4, [paragraph] I.3): The plan states that "[i]n auditing the research tax credit, the examiners should employ a `two-prong' approach. First examine the underlying expenses and then examine the underlying technology." Thus, the plan implies that the two-prong approach for testing compliance with sections 41(b) and 41(d) is sequential -- first do one, then the other. In practice, however, the audit is often an integrated procedure conducted as a single process for the sake of efficiency. This efficiency should not be sacrificed, especially (as explained above) since the bottom-up approach evinced by the plan could have the effect of creating unnecessary work.

In addition, we suggest that the caption of this part of the plan be changed from "Plan Your Audit Strategy" to "Plan the Audit." Some of our members have interpreted the word "strategy" negatively, as intimating that examining agents should develop an approach to "trip up the taxpayer" rather than to "collect the proper amount of tax" (as prescribed in the IRS's Mission Statement).

10. Request a Written Description of Each Account (page 6, [paragraph] II.2): The plan states that --

Regardless of the methodology the taxpayer used to compute the credit, request a written description of each account included in the calculation of the credit. These descriptions should identify the function of each account. By reviewing the description or profile of each account, the examiner may find non-qualified accounts such as fringe benefits, travel, capital assets, etc., included in the computation of the credit.

The detailed chart of accounts -- which the agent will typically request at the commencement of the audit -- invariably contains this information. Requesting a written description of each account would be redundant.

In addition, we believe the audit plan's reference to fringe benefits as constituting a "non-qualified account" needs to be clarified. Many components of a company's "fringe benefits" account qualify for purpose of the research tax credit. For example, in some companies, taxable vacation pay, the taxable portion of group-term life insurance, and sick pay are included in the fringe benefits account (along with some nontaxable benefits). The key is whether the amount is includible in wages. Hence, if a benefit (such as a company-provided automobile) is taxable to the employee and reported on the Form W-2, it may well be properly taken into account in computing the research tax credit.

11. Examine the Wage Component of the Research Credit (page 6, [paragraph] II.3): The plan states that the examiners should --

[b]reak down the wage component of the credit into individual employees. Identify each employee by name, job title, total wage, and wage included in the credit. At a minimum, employees with questionable job titles and duties such as administrative, manufacturing, managerial, etc., should be reviewed. Review the employees written job descriptions and evaluations.

As previously stated, TEI questions the propriety and utility of the agents' obtaining access to employee performance reviews. Performance evaluations are extraordinarily sensitive documents, and in our view should never be sought as a matter of course. In addition, we question the utility of evaluations since their primary purpose is to evaluate how a person did their job (which is irrelevant for research tax credit purposes), not necessarily to detail what they did. Given the different policies and philosophies that different companies adopt in respect of performance evaluations, the adoption of a hard-and-fast rule by the IRS would be improper. Obviously, if an agent has questions about a particular employee's duties, the questions should be asked, but digging into personnel files is both unwarranted and unprofessional, and it should be eschewed by the IRS. Instead, the agent should pursue alternative means of documenting the taxpayer's claim (such as interviews and surveys).

We also are concerned that reliance on written job descriptions may exalt form over substance. The audit plan itself suggests that the agent should not rely on job title alone in evaluating a company's eligibility for the credit; similarly, the stated probity of job descriptions should be tempered. (After all, as currently drafted the plan might well prompt companies to modify their job descriptions and evaluation practices to include "the magic words" -- a practice that, by itself, we assume the IRS would not find persuasive.) Hence, we believe agents should be advised that taxpayers should not be penalized for failing to load up (or update) job descriptions to describe in detail the specific duties of particular employees. The key is the type of activities the employees actually engage in, and job descriptions and similar documents will provide no assistance to the agent in segregating the employees' time between qualifying and non-qualifying activities.

In addition, we question the efficacy of the suggestion that the taxpayer be required to segregate the wage component of the credit on an employee-by-employee basis. The time and effort required to prepare such a detailed breakdown would be tremendous, and the utility of employee "snapshots" is suspect. Hence, looking at individual employees in isolation -- especially through their performance reviews -- would not give a complete, or accurate, picture; research activities are routinely conducted by employees working in teams, and team members should be reviewed in the context of their department or project activities.

12. Review the Accounts Claimed as Qualifying Supplies (page 7, [paragraph] II.4): The plan states "[t]o be considered a qualifying supply, the item must be tangible property and totally used or consumed in the qualifying research activity."

The articulation of a hard-and-fast rule that the supplies be totally consumed is improper. Many qualifying supplies are not totally consumed in the research activity. For example, the paper used to produce laboratory reports clearly constitutes a qualifying supply, and yet it is not consumed. What is more, an absolute rule is impractical. For the sake of administrative convenience, the IRS has routinely allowed small-dollar supplies items to be expensed for section 162 purposes, and we believe that such an administrative practice should also be utilized in respect of research-related supplies. We recommend that the plan be revised to permit such a practice, which would spare taxpayers the burden of having to take a year-end physical inventory of supplies in order to determine which were consumed and which remained on hand.

We also believe that the plan is overdrawn in stating that "[g]enerally, supplies should only represent the costs to build prototypes." Indeed, the plan itself provides that supplies are often consumed in the experimental processes inherent in research activities and, accordingly, do not necessarily end up in a final prototype. For example, liquid nitrogen used as a coolant evaporates during experimentation, and gasoline is used to power engines to determine whether they run properly after development. Similarly, some companies (such as those in the semi-conductor industry) use considerable amounts of water to "wash" or cool the subject of the research, and that supply clearly falls within the definition of qualifying supply.

We also recommend that the plan acknowledge that in some industries and with respect to some research activities, supplies may constitute a large percent of qualifying expenditures (i.e., the cost to build a prototype). For example, an aerospace company's testing of ten-story rocket motors is an experiment that wholly consumes the test product; the not in-substantial cost of such an activity qualifies for the research tax credit. Again, the plan should instruct the audit team to remain flexible and to adapt it examination to the taxpayer's particular facts.

Moreover, not all research leads to the development of prototypes, and research frequently continues after the prototype is developed. The plan should be revised to reflect this.

Finally, we disagree with the plan's implication that utility costs never qualify for the credit. The IRS's own regulations provide that incremental utility costs can qualify for the research tax credit. Treas. Reg. [sections] 1.41-2(b)(2) (ii) ("To the extent the taxpayer can establish that the special character of the qualified research required additional extraordinary expenditures for utilities, the additional expenditures shall be treated as amounts paid or incurred for supplies used in the conduct of qualified research.").

Taking into account the foregoing comments (as well as our general concerns about the plan's overall tone, the need for flexibility, and the desirability of injecting a materiality concept into research tax credit audits), we propose that the second paragraph on page 7 be revised, as follows:

Supplies generally represent a small percentage of the amount eligible for the credit (for example, between -- and -- percent). The range of eligible supplies varies by industry and even within each industry, and the amount of time and effort devoted to examining this area should be carefully considered in light of the overall potential adjustment. For example, a taxpayer who is engaged in heavy manufacturing may be incurring qualifying supply expenses that are at the higher end of the range, and a taxpayer who is engaged in light manufacturing may incur qualifying supply expenses that are at the lower end of the range. In addition, since the eligible supply amount frequently represents a relatively small portion of total eligible research expenses (at least in some industries), you may want to estimate the overall tax effect of potential adjustments in establishing the audit scope and the amount of time to be devoted to this area. (The difference between the amount of eligible supplies claimed by the taxpayer and the aforementioned range provides some measure of the amount of unqualified supply expenses, which in turn may guide you in determining how much attention to devote to this area.)

In some cases, of course, the relative amount of qualified supplies may substantially exceed the norm (even for the industry), owing to the requirements of particular research projects. In other words, although the use of ranges may be helpful, it is not possible to prescribe a one-size-fits-all rule.

13. Review the Contract Research Portion of Contract (page 7, [paragraph] 5) (also page 6 of the internal-use software plan): Paragraph c of the plan states:

The specific activities performed by the contract researcher must be reviewed to determine if all activities constituted qualified research. It is possible that an allocation may be required to eliminate the non-qualified activities from the credit calculation.

Although not entirely clear, this language can be read as requiring the disallowance of overhead expenses incurred by contract researchers. Under the regulations, however, allocable overhead expenses of contract researchers are clearly eligible for the research tax credit. Treas. Reg. [sections] 1.412(e)(5) (Example 3).

On the administrative level, we are concerned about the rigidity of the plan's language. In many cases (especially those involving CEP taxpayers), it will simply not be necessary for the IRS to burden the taxpayer with a request for a list of all contract research vendors. For example, inasmuch as 65 percent of all contract research is allowable in computing the credit, we question the utility of agents' devoting significant time to contract research where the amount of the company's overall contract research is small in relation to the amount of its total qualified expenses. Moreover, we seriously question whether normal IRS audit procedures would ever require a review of all contract research, even where research is a large portion of qualified expenses.

14. The Activity or Project Must Meet the Tests of IRS Section 41(d) (page 8, [paragraph] III.1): The plan states that the examiner should request a "list of each qualifying project or activity along with a complete description of that activity or project." (Emphasis added.) The plan also instructs the agent to "[i]ssue an IDR for each project or activity requesting documentation and/or other information establishing that each project or activity satisfies the above requirements [of section 41(d)]."

As a practical matter, the taxpayer may be unable to provide the list. Equally important, the list may be of limited assistance to the IRS in conducting its examination. As the plan itself recognizes, some taxpayers use a department approach whereas others use a project approach to computing the credit. The former group of taxpayers may understandably not have discrete project lists or project tracking systems since their research activities are organized by departments. This is an example of the seemingly inflexible approach of the audit plan, which would impose significant burdens on taxpayers without taking into account the differing facts and circumstances of particular cases. Finally, we reiterate our belief (stated in Comment No. 13) that normal IRS audit procedures would likely not require a review of each and every qualifying project or activity.

15. Undertaken for the Purpose of Discovering Information that Is Technological in Nature (page 9, [paragraph] III.1.B): The plan states:

A key point appearing as a footnote in the Committee Reports states that research does not rely on the principles of computer science merely because a computer is employed. Research may be treated as technological in nature, however, if the research is intended to expand or refine existing principles of computer science. (Emphasis added.)

Although the plan merely quotes the footnote, in our view it makes too much of it. First, taxpayers may legitimately question how "key" a point is if Congress consigns it to footnote status. More fundamentally, the plan fails to recognize that the purpose of the footnote is merely to illustrate the distinction set forth in the text of the committee reports -- that research fundamentally relying on principles of certain specified sciences, including computer science, is qualified research whereas research relying on certain social science principles, such as economics, does not qualify. In other words, the footnote does not provide that computer-based research must invariably represent a higher level of technological sophistication than other research. Regrettably, in our experience some agents have invoked this footnote to disallow computer-based research on the ground that it is not sufficiently technologically sophisticated. That misapprehension should not be perpetuated in the audit plan.

16. Constitutes Elements of a Process of Experimentation (pages 9-10, [paragraph] III.1.C): The plan states:

It seems that the activities of scientists and engineers in researching, designing, and testing new products will generally meet the process of experimentation requirement as long as the specific design of the products is uncertain at the outset. It is important that the examiner review the experimentation process being performed by the individual scientist or engineer and not look to the end product. (Emphasis in original.)

TEI believes that the focus of this comment on any uncertainty relating to the "specific design" of the product is somewhat misleading, in that the regulations permit any of three types of uncertainty: uncertainty relating to the capability for improving the product, the method for improving the product, or the appropriate design for the product. Treas. Reg. [sections] 1.1743(a)(1). In applying the process-of-experimentation requirement, however, we agree that the instruction not to focus on the end product is proper.

17. For a Permitted Purpose (page 10, [paragraph] III.1.D): The plan states that --

[t]he research is not qualified research if its purpose relates to style, taste, cosmetic, or seasonal design factors.... The examiner should question the eligibility of qualified research on consumer product development activities where style and taste factors are a significant part of the product. (Emphasis added.)

Although the plan accurately paraphrases the regulations, it fails to distinguish properly between aesthetic taste and sensory taste. We recommend that the plan be revised to provide that sensory taste research does qualify for the credit. Letter Ruling No. 9522001 (December 21, 1994.)

18. Application of Above Tests (page 10, [paragraph] III.2): The plan states that "[t]he term business component means the most significant set of elements of such product with respect to which all the requirements [of the Code] are met."

This definition of business component generally is taxpayer-favorable in allowing a significant set of elements of a product to qualify for the credit, even though all of the research activities for the entire product may not qualify. We are concerned, however, that the definition could be invoked to fragment research projects into individual elements that -- when examined exclusive of their integration into, as well as the overall context provided by, the larger project -- may not appear to qualify for the credit. Such a result would not be proper.

Our concern about the definition is heightened by the plan's next two sentences, which read, as follows:

The burden of proof is on the taxpayer to show that the research being performed represents qualified research. The taxpayer should identify each qualified business component and provide documentation supporting the four [statutory] tests.

Although taxpayers undeniably have the burden of proof (as they do with respect to all matters reported on their returns), we are concerned by the implication that taxpayers will have difficulty sustaining their burden, even though it is clear that contemporaneous records are not required by the statute and taxpayers have multiple means of documenting their claims. We recommend that the first quoted sentence be deleted as unnecessary.

19. Other Information to Request that May Be Helpful in the Audit of the Research Tax Credit (page 11, [paragraph] IV.1): The plan suggests that agents request copies of organizational charts and similar documents describing the organization of the taxpayer, explaining:

Organization charts should identify the research activity and where it is in relation to the overall structure of the taxpayer. Management and other administrative activities may be identified by reviewing the organization charts.

Contrary to the IRS's assumption, organizational charts may not identify an organization's research activity. Hence, we are concerned that the organizational chart may well be cited by the agent as refuting the taxpayer's claim that a particular managerial employee is engaged in qualifying research or in direct supervision or support of qualified research. For example, the head of a taxpayer's research department may well engage in qualifying research. In summary, we question whether organizational charts (or even job titles) will provide the agent with meaningful evidence of whether the individual is -- or is not -- conducting or supervising research. A much better approach is for the plan to recommend that examining agents talk with the taxpayer's representatives to discuss which employees the credit is claimed in respect of and also to satisfy themselves that particular projects qualify for the credit.

The plan also states that the agent should request accounting, financial, and other manuals that describe research activity and the research tax credit, explaining:

These [manuals] would give the examiner a written description as to what the taxpayer included in the calculation of the research tax credit. This may not be needed if the taxpayer can explain the methodology used to compile the accounts and numbers during the interview with the taxpayer.

We are pleased that the plan recognizes that requests for various manuals may prove unnecessary if the taxpayer provides any necessary information from other sources. Even acknowledging that manuals could have some bearing on an activity's eligibility for the credit, we suggest the plan advise agents that before asking for the manuals, they should satisfy themselves that the information requested will be useful. In addition, we believe agents should be reminded that statements in non-tax materials -- prepared for non-tax purposes -- may or may not have relevance to the proper tax treatment of any item. For example, differences between the tax and financial accounting treatment of items could render statements in non-tax manuals irrelevant for tax purposes. In fact, research and development expenditures from the accounting perspective may differ materially from research and experimental expenditures that qualify for deduction under section 174 or the research tax credit under section 41 of the Code. For example, process improvement activity rarely is classified for research and development for financial accounting purposes.

Internal-Use Software Audit Plan

20. General Comment: TEI recommends that the internal-use software audit plan be expanded to explain why research expenditures on such software merit special scrutiny from the examining agent. In addition to setting forth the statutory requirements (and pertinent legislative history) in respect of internal-use software audit plan, the preamble to the internal use software audit plan should define precisely what is meant by internal-use software (through the use of examples).

For example, we believe the plan should note that some computer software is developed for both internal and external uses and confirm that expenditures in respect of such software should not necessarily be subjected to the more stringent rules that apply to software developed for strictly internal purposes; at the same time, the plan should explicitly acknowledge that research expenditures in respect of strictly internal software may in fact qualify for the credit. We also recommend the audit plan identify the particular types of problems the IRS is encountering its examination of internal-use software expenditures (which, again, should reinforce why a special audit plan is required in respect of such expenditures).

21. Review Form 6765 and/or Form 1139 (page 3, [paragraph] 1): The plan states that "[i]f supplies are a significant portion of the qualified costs, you should consider reviewing those costs. In almost all software development activity, supplies represent only a nominal amount."

Although TEI agrees that agents may be properly instructed to scrutinize expenses that seem out of line with "industry norms," we think care should be taken not to bias agents against certain projects simply because the relative cost of supplies is at variance with the norm. Indeed, given the pliable nature of the terms used in the quoted language ("significant" and "nominal"), we believe agents should be informed that the relative cost of supplies will in fact vary depending on the type of research that is being conducted. What is more, agents should be reminded that research activities at a particular company may be expanding (or contracting) at a rate faster (or slower) than the overall rate for the industry, depending on (among other things) the company's status as a start-up or mature enterprise and its products' life cycle. Consideration should be given to including examples of what is meant by the words "significant" and "nominal," as well as examples of how the use of industry norms, while helpful, will often not be dispositive. By including such examples in the plan, the IRS could inject greater flexibility into the application of the plan.

22. Plan Your Audit Strategy (page 3, [paragraph] 3): As noted in respect of the general audit plan (see Comment No. 9), the plan states that agents should adopt a two-prong approach:

1. The examiner MUST determine the expenses the taxpayer is claiming for the credit are qualified research expenses.

2. Then the examiner must look at the activity being conducted by the taxpayer to determine if it is a qualifying research activity as defined in section 41(d).

TEI believes that the approach set forth in the plan should be inverted. If an activity does not qualify as research, why should the agent expend the time and effort (and require the taxpayer to expend the time and effort) auditing the precise numbers? In our view, the agent should not. (We recognize, however, that if the taxpayer intends to protest the agent's determination of whether an activity constitutes qualifying research, an audit of the expenses will be necessary in the event the agent's determination is overturned by Appeals.)

In addition, we repeat our suggestion (see Comment No. 9) that the caption of this part of the plan be changed from "Plan Your Audit Strategy" to "Plan the Audit."

23. Request a Meeting with Taxpayer to Explain the Workpapers and Discuss the Overall Research Activity (page 4, [paragraph] 4): The plan states:

At a minimum, [the agent should] ask the who, what, where, when, and how questions regarding the taxpayer's research activities during the years under examination. (For example, what research activities were engaged in, when did the research activity start and stop, where were they undertaken, who was involved, and how did the activity end up? Successful? Failure?)

Interestingly, the quoted language is not included in the general audit plan, though it would seem equally relevant there. More fundamentally, we believe that the references to a research activity's success or failure are potentially misleading, for they could be interpreted as saying that successful research will not give rise to the credit. Although this discredited notion was included in previous regulations under section 174, it was subsequently dropped from the regulations and should not be resurrected in the audit plan. Stated simply, "how did the activity end up" has no bearing on the taxpayer's eligibility for the research credit. We do acknowledge, however, that a research activity's failure is persuasive evidence of the uncertainty that is required to qualify for the credit. If it is that notion that the plan intends to address, we suggest that it explicitly so state.

With respect to the level of documentation required to substantiate the credit, the plan also states (at page 4):

I have found that many taxpayers who are filing claims for refund for internal-use software have little or no contemporaneous records... If there are no contemporaneous records, the examiner must determine if the taxpayer has adequately supported the claim.

Many taxpayers have interpreted this language as insinuating that taxpayers who substantiate their research tax credit claims with surveys or interviews conducted after the fact are acting improperly. (Indeed, we believe it suggests that taxpayers who file claims for refund -- in respect of the research tax credit or otherwise -- should be viewed with suspicion.) It also evidences the shortcomings of the two-prong approach advocated by the plan. Hence, it seems that even if a taxpayer's research clearly meets the substantive requirements of the regulations, the IRS intends to demand extensive (and, preferably, contemporaneous) substantiation of the amount and nature of the expenditures.

This approach is presumably a reaction to the burgeoning use of accounting firm studies to retroactively document expenditures that qualify for the credit under section 41. The Code, however, does not impose a contemporaneous documentation requirement in respect of the research tax credit. Accordingly, to the extent the necessary documentation can be created even years after the research activity is concluded, the credit should be allowed. We recommend that the final paragraph on page 4 be revised along the following lines:

Many taxpayers have filed claims for refunds in respect of internal-use software on the basis of surveys or interviews with project managers or other officials indicating that certain employees worked a percentage of time on a qualified research project. Although contemporaneous records may ultimately be more probative, the use of surveys may prove helpful in assessing the taxpayer's claim. The examiner should determine what the project managers and officials relied on when completing the surveys and generally be satisfied that the taxpayer has adequately supported the claim.

24. Request Job Descriptions and Employee Evaluations (page 6, [paragraph] 5.D): As is the case in respect of the general plan (see Comment No. 11), the audit plan for internal-use software states:

At a minimum, all employees who have job titles that appear to have little or nothing to do with software development should be reviewed. Documentation such as written job descriptions and employee evaluations should be requested and reviewed by the examiner.

As stated in respect of the similar statement in the general audit plan, TEI believes that the audit plans should be revised to show greater deference to the confidential nature and sensitivity of performance evaluations. We do not dispute the IRS's authority to request evaluations, but we do question the prudence of doing so on other than an extraordinary basis. If an agent has questions about a particular employee's duties, certainly the questions should be asked, but we believe that digging into personnel files should be considered only as a last resort.

25. Request the Contracts for Outside Consultants Who Are Performing Qualifying Research -- Software Core (page 6, [paragraph] 5.E.3.a): The plan states:

Often, software developers have a software core they will use as their starting point. They will then attempt to configure/adapt the software to program or customize the client's needs. This software core has previously been developed and its cost should not be included in the calculation of the credit.

The IRS often asks to examine the software code for particular internal-use computer software projects. If a certain mechanical percentage of the code originates in a software core, the IRS has disallowed that same percentage of research costs. This approach, however, is erroneous because it assumes that each line of software code costs the same to develop. In fact, modifications to the software core may be the most difficult and expensive part of a software development project because such modification may require reconfiguration of portions of the core itself. More fundamentally, there is absolutely no support for the notion that the level of qualifying expenses bears any relation to the number of lines of software code that are created or modified; the taxpayer may expend considerable resources only to discover -- at the end of the research -- that the desired result can be achieved by adding or modifying a relatively few lines of software code. The plan should be modified to reflect this.

In addition, we believe the statement that "[t]his software core has previously been developed and should not be included in the calculation of the credit" is too unequivocal. If core software costs are "passed along" to the taxpayer/customer, then we believe that the taxpayer should be able to claim the research tax credit in respect of those costs.

Finally, the plan states that "[t]he costs to install the software into the taxpayer's system does not qualify for the research tax credit." We believe the foregoing statement is too absolute. To be sure, the costs of a simple installation will not qualify for the credit, but if "installation" involves significant adaptation to ensure that the prototype that works in the laboratory will actually work in the field, the costs of such "installation" may well constitute a qualified research activity.

26. It Is Undertaken for the Purpose of Discovering Information that is Technological in Nature, the Application of Which Is Intended to Be Useful in the Development of a New or Improved Business Component (page 8, [paragraph] 6.B.2): The plan states:

A key point appearing as a footnote in the Committee Reports states that research does not rely on the principles of computer science merely because a computer is employed. Research may be treated as technological in nature, however, if the research is intended to expand or refine existing principles of computer science.

As noted in respect of the general audit plan (see Comment No. 15), we believe the IRS makes too much of the footnote from the legislative history concerning the distinction between using a computer and relying on the principles of computer science. The plan suggests that computer-based research must invariably involve a higher level of technological sophistication than other research in order to qualify, but that clearly is not the case.

28. Substantially All the Activities of Which Constitute Elements of a Process of Experimentation (page 9, [paragraph] 6.B.3): The plan's discussion of the process-of-experimentation requirement varies slightly from the discussion in the general audit plan, and the difference is significant -- and misleading. Specifically, the internal-use software plan states:

Process of experimentation means a process of scientific experimentation or engineering activities to design a business item where the design of the item as a whole is uncertain at the outset, but instead must be determined by developing one or more hypotheses for specific design decisions, testing, and analyzing those hypotheses and refining or discarding the hypotheses as part of a sequential design process to develop the overall item.

The general audit plan correctly notes that the legislative history confirms that no formal scientific hypothesis is necessary for a method to qualify as a process of experimentation. H.R. Rep. No. 841, 99th Cong., 2d Sess. II-72 (1986). We are disappointed, but not surprised, at the statement in the plan because in our experience the IRS has only reluctantly acknowledged that a systematic, trial-and-error methodology satisfies the process of experimentation test. We recommend, however, that the plan be revised to comport more fully with the legislative history and explicitly state that the mere expectation of success does not preclude qualification so long as there is uncertainty about how such success can be best achieved.

28. Internal-Use Software Must Also Meet All the Requirements Contained in I.R.C. Sec. 41(d)(4)(E) (page 9, [paragraph] 6.C): The plan acknowledges that software developed internally for use in a "production process" can qualify for the research tax credit, but continues that --

Congress intended that the development of software used internally for general and administrative functions or in providing noncomputer services should be excluded from the definition of qualified research except to the extent provided by Treasury regulations....

Although the plan explains that Congress intended for the Treasury to issue regulations providing that internal-use software will be considered qualified research where it is innovative, involves significant economic risk, and is not commercially available (see H.R. Rep. No. 841, 99th Cong., 2d Sess. II-73 (1986), we interpret the plan as intimating that the taxpayer bears a very heavy burden in respect of such a determination. To address this concern, we recommend that the plan be revised to illustrate the type of internal-use software that will qualify for the credit. More fundamentally, we believe the plan should address what is meant by the terms "innovative," significant economic risk," and "commercially available." For example, the plan should quote the statement in the legislative history that software will be considered innovative where it "results in a reduction in cost, or improvement in speed, that is substantial and economically significant." See H.R. Rep. No. 841, 99th Cong., 2d Sess. II-73 (1986). (The legislative history also contains descriptions of where software development will be considered to involve significant economic risk or the software will be considered to be not commercially available.)

In addition, we believe the plan can productively clarify the definition of the term "general and administrative function," thereby signaling that not all internal-use software is subject to the more stringent rules. Hence, the plan should provide that activities related to the development of software enabling the taxpayer to provide services more efficiently do not fall within the scope of the special rules. For example, if a worldwide courier service develops software to permit it to track the location of packages on an ongoing basis, the activity associated with the development of that software should be regarded as relating to a production process and hence be eligible for the research tax credit without satisfying the special rules. In addition, software developed by a company both to use internally in its service business and to market externally to other companies should fall within the ambit of section 41.

Conclusion

TEI appreciates the opportunity to submit these comments on its two research tax credit audit plans. The Institute believes that the two audit plans provide much useful information. In addition, we believe that, if refined as suggested in these comments, the plans can serve to better focus and hence improve the examination of research tax credit claims -- to the mutual benefit of taxpayers and the IRS. Again, we commend the IRS's research credit issue specialist for his efforts in developing the plans.

If you should have any questions about the Institute's position, or if we can be of further assistance, please do not hesitate to call either Robert L. Ashby, chair of TEI's IRS Administrative Affairs Committee, at [phone] or Timothy J. McCormally of the Institute's legal staff at [phone].

(1) On March 15, 1996, representatives of TEI met with officials of the IRS's Office of Corporate Examination to discuss the Institute's general concerns about the two audit plans. We welcome the opportunity for another meeting to discuss the specific comments set forth in this position paper.