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CIP addresses "qualified research" definition.

The IRS recently issued a Coordinated Issue Paper (CIP) addressing the definition of "qualified research" under Sec. 41(d)(1). In the CIP, the Service applies Sec. 41(d)(1)(A), (B) and (C) to a classic research and development example, the redesign or improvement of a product for sale. Specifically, the taxpayer redesigned a toaster in its kitchen appliance product line to include a newly designed rapid-heating-and-cooling element. It also redesigned the toaster's outward appearance, to give it a "high-tech" look in an attempt to enhance its marketability.

In applying Sec. 41(d)(1) to the facts, the IRS also applies the "shrinking-back" rule, under which the qualified research tests are to be applied first at the level of the discrete business component to be held for sale and then to the next most significant subset of elements (if all aspects of the requirements are not met at the first level). In the CIP, "substantially all" of the toaster's redesign activities fail to satisfy the qualified research definition. Thus, the Service analyzes the construction of the new heating element as the next most significant element constituting a "business component"

Analysis of the Qualified Research Requirements

"Sec. 174" Test. Sec. 41(d)(1)(A) provides that an activity may constitute qualified research if the expenditures associated with it can be treated as expenses under Sec. 174. In general, this means that the activity must be intended to discover information that would eliminate uncertainty in the development or improvement of a product or process. The uncertainty may relate to if or how a product or component can be developed, or to its appropriate design (Regs. Sec. 1.174-2 (a)(1)). The CIP suggests that the IRS views this test as relatively straightforward and, in fact, spends little time discussing the requirement. The Service states, "[s]ection 174, as distinguished from [sections] 41, does not require technical uncertainty as a basis for qualification" and finds that uncertainty as to the toaster's appropriate design, and (under the shrinking-back rule), the uncertainty as to the appropriate design and method for developing the heating element, will satisfy this requirement.

"Discovery" Test. The second qualified research requirement is the discovery test, which has two elements. First, Sec. 41(d)(1)(B)(i) requires that an activity be undertaken to discover information that is technological. Citing the legislative history but using language from recently issued Prop. Kegs. Sec. 1.41-4(a) (3), the IRS states, "the term `discovering information' means obtaining knowledge that expands or refines the common knowledge of skilled professionals in a particular field of technology or science" Citing United Stationers, 163 F3d 440 (7th Cir. 1998), the Service also states,"[i]n the context of [sections] 41(d)(1)(B)(i) , discovery demands something more than mere superficial newness; it connotes innovation in underlying principle"

The IRS determines that in improving the toaster as a whole, the taxpayer merely integrates the new heating element into the new toaster and upgrades its appearance. (According to the CIP's facts, the new heating element was fully self-contained and resembled the existing heating element from a design standpoint and, thus, posed no significant integration challenges.) The Service concludes that neither of these actions expands or refines the common knowledge of skilled professionals in the relevant field of technology or science. Therefore, the improved toaster, as a whole, failed the discovery test's discovery element.

However, on the other hand, in applying the shrinking-back rule to the next most significant level of the business component, the IRS finds that in developing the new heating element (rather than integrating it), the taxpayer develops and uses a material in a new way. Thus, the development of the new heating element meets the requirements of the discovery test's discovery element.

The rules governing the second element of the discovery test are found in Sec. 41(d)(1)(B)(ii). The business component element requires that the application of the discovered information must be useful in developing a new or improved business component for the taxpayer. In improving the toaster as a whole and in developing the new heating element, the taxpayer clearly intended to develop a new or improved business component. However, the discovery test contains two elements; only in developing the new heating element have both been met, thus satisfying the discovery test.

"Process of Experimentation" Test.

The third qualified research requirement is found in Sec. 41(d)(1)(C) . The process of experimentation test requires that substantially all of the activities that constitute elements of a process of experimentation relate to a new or improved function, performance, reliability or quality, and not to style, cosmetic or seasonal design factors (Sec. 41(d)(3)(A) and (B)).

In examining whether this test has been met, the Service finds as a principal requirement that research must address the technical uncertainty of the means and method of achieving a result. It focuses on the method of discovery. "The `process of experimentation test' generally presupposes a scientific methodology that may entail the evaluation of more than one alternative to achieve a result where the means of achieving that result is uncertain at the outset." Citing Norwest Corp., 110 TC 454 (1998), the IRS concludes, "the more hypotheses that are developed, tested, analyzed, the more likely the project will satisfy the `process of experimentation test'"

Because the taxpayer clearly possessed the technical ability to design a toaster incorporating a heating element prior to engaging in redesigning the toaster, the Service finds that the taxpayer faced no technical uncertainty in. incorporating the new heating element into the improved toaster. It also finds that the research related to creating a "high-tech" appearance for the toaster is excluded, because it relates to style, taste or cosmetic design factors. Thus, the improved toaster taken as a whole fails the third qualified research requirement. However, in applying the shrinking-back rule, the IRS finds that, because the taxpayer developed the new heating element-through a process of experimentation that entailed the evaluation of more than one alternative to achieve a result and the means of achieving that result were uncertain at the outset, the development of the new heating element satisfies this qualified research requirement.


The Service concludes that the taxpayer's activities related to the toaster's overall improvement, including the incorporation of the new heating element and the enhancement of the toaster's appearance, will not qualify for the research credit; only one of the three qualified research tests is met. However, the research related to the development of the new heating element, a subset of the improved toaster, satisfies all three qualified research requirements under Sec. 41(d)(1) and, thus, will be eligible for the research credit.

With the issuance of a CIP addressing the definition of qualified research, taxpayers undergoing an examination should expect to see issues raised about their research credits. However, while CIPs do indicate the Service's views on a particular issue, they are not official pronouncements and do not carry the authoritative weight of revenue rulings or regulations. Further, the fact pattern in the CIP is very specific and, therefore, easily distinguishable from most taxpayers' situations.

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Title Annotation:IRS Coordinated Issue Paper
Author:Hudson, David
Publication:The Tax Adviser
Geographic Code:1USA
Date:Jan 1, 2000
Previous Article:Acquisition price establishes base-year cost of bargain inventory.
Next Article:CIP addresses three-part exception for internal-use software development.

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