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Comments on proposed regulations on the definition of research and experimental expenditures.

Comments on Proposed Regulations on the Definition of Research and Experimental Expenditures

I. Introduction

On May 16, 1989, the Internal Revenue Service issued proposed regulations under section 174 of the Internal Revenue Code, relating to the definition of the term "research and experimental expenditures" and the application of section 174 to computer software development costs. The regulations are intended to provide interpretative guidance not only for purposes of section 174 (which accords taxpayers a deduction for research and experimental expenditures) but also for purposes of section 41 (which provides a credit for increasing research activities).

The proposed regulations (PS-002-89) were published in the Federal Register on May 17, 1989 (54 Fed. Reg. 21224), and in the June 26, 1989, issue of the Internal Revenue Bulletin, 1989-26 I.R.B. 30. (1*) They represent a revision of proposed regulations which were promulgated by the IRS on January 21, 1983 (48 Fed. Reg. 2790, 1983-1 C.B. 1003). In these comments, the proposed rules that were published earlier this year are referred to as "the proposed regulations," and the initial proposed regulations are referred to as "the initial 1983 regulattions." (2)

II. Placing the Proposed

Regulations in Historical

Perspective

In considering the issues raised by the proposed regulations' definition of research and experimental (R&E) expenditures, the Internal Revenue Service and Department of the Treasury should bear in mind section 174's legislative history. Enacted as part of the Internal Revenue Code of 1954, the current provision generally permits a taxpayer to deduct research and experimental costs as incurred. Costs relating to depreciable assets, however, may not be currently deducted, but rather are subject to the normal depreciation rules.

A. Pre-1954 Code Developments

In contrast, the Internal Revenue Code of 1939 did not authorize any specific treatment for R&E expenditures. Thus, under generally prevailing principles, R&E costs were deductible to the extent they were ordinary and necessary business expenses, whereas expenses that were capital in nature were only recoverable through deductions for amortization, depreciation, depletion, and loss. Capitalized costs that could not be attributed to a specific product or process that had a determinable useful life were deductible only as losses upon proof of either total failure or abandonment of an experimental project. Where projects were not abandoned and a useful life could not be determined, taxpayers were unable to claim any type of deduction in respect of the R&E expenses. (3)

Under the 1939 Code, the difficulty of differentiating capital expenditures from ordinary and necessary business expenses led to conflicts over the proper tax treatment of R&E expenditures. In practice, the Bureau of Internal Revenue generally allowed taxpayers to take current deductions for expenses incurred under a continuing research program, but was more likely to require capitalization in other circumstances. (4) Because the Bureau did not permit current deduction in all cases, the issue was the subject of considerable litigation, with the courts almost invariably holding that the costs should be capitalized. (5)

Congress was aware of the uncertainty created by the inconsistent positions taken by the Bureau, taxpayers, and the courts. In 1952, then-Commissioner Dunlap appeared before the Joint Committee on Internal Revenue Taxation and formally announced that the Bureau's policy was to allow deduction of "research and development costs in the experimental or laboratory sense" by taxpayers who currently deducted those costs under an established method of accounting. The Commissioner cited several justifications in support of this position:

* apportioning research and development costs in advance of specific projects is very difficult;

* such costs "usually are a necessary part of most businesses";

* most taxpayers consistently charge these costs to expense; and

* over time, allowing expense deductions does not create a materially different tax result from requiring capitalization with later deductions for depreciation or abandonment losses. (6)

Although heartened by this testimony, taxpayers pressed for legislation to resolve the inconsistency between administrative practice and court decisions. Specifically, Congress was urged to enact definitive rules that could be consistently and broadly applied to R&E expenditures, thereby obviating the need for a case-by-case evaluation of R&E costs. (7)

B. Legislative History of 1954 Code

For these reasons, section 174 was enacted as part of the Internal Revenue Code of 1954. The House and Senate reports on the 1954 Code recognized the confusion in the existing law and stated that the purpose of section 174 was "[to] eliminate uncertainty and to encourage taxpayers to carry on research and experimentation." (8) Thus, the impetus for section 174 was a desire -- of both taxpayers and the government -- for a statutory resolution of the uncertainty over the proper treatment of research and experimental expenses.

From an administrative standpoint, allowing current deductions for research and experimental costs makes consummate sense. The speculative nature of future benefits from R&E expenditures, as well as the frequent "cross-fertilization" of research results, makes a meaningful allocation of costs to specific assets virtually impossible. The problems of allocating costs, establishing useful lives, and justifying abandonment losses would pose serious administrative challenges -- for both taxpayers and the IRS -- in the absence of a statutory rule. If section 174 were narrowed through the regulatory process, these problems would again come to the fore. (9)

III. Specific Comments

A. Time-Line Approach

The proposed regulations adopt a "time-line" basis for distinguishing R&E activities from manufacturing, marketing, and other activities. Specifically, Prop. Reg. 1.174-2(a)(1) states:

Expenditures incurred after the point that the product or property (or component of the product or property) meets its basic design spedifications related to function and performance level generally will not qualify as research and experimental expenditures under section 174 unless the expenditures relate to modifications to the basic design specifications for the purpose of curing significant defects in design, obtaining significant cost reductions or achieving significantly enhanced function or performance level.

Thus, under this approach the character of a particular cost as a qualified R&E expenditure would seemingly depend on when the activity giving rise to the cost is undertaken. This "time line" differs from the functional approach taken in the current regulations to distinguish research from other activities. The functional approach looks to the nature of the activity conducted to determine whether that activity is research as opposed to something else.

The preamble to the proposed regulations repeats, but does not elaborate on, the time line approach. 1989-26 I.R.B. at 31. The preamble notes, however, that the initial 1983 regulations would have excluded "the routine or periodic alteration or improvement of existing products, commercial existing products, commercial production lines, or other ongoing operations." The preamble explains that the reference to "routine" and "periodic" improvements had been deleted in response to comments filed on the initial 1983 regulations. Those comments -- including a submission filed by TEI -- argued that the initial 1983 regulations would have unreasonably restricted the definition of R&E expenditures by failing to recognize that R&E activities may in many instances be part of an evolutionary process involving a series of minor improvements. 1989-26 I.R.B. at 31.

TEI submits that the time-line approach to R&E is flawed. Section 174 does not specify that R&E expenditures are deductible only if incurred at a certain time. To truly determine whether an expenditure is for R&E, the particular activity to which the expenditure relates must be examined -- not the time it is undertaken. Under the time-line approach, R&E costs incurred after the prescribed point will be excluded from section 174. This is inconsistent with the legislative history of section 174. The regulations should explicitly recognize that research is research, without regard to when it occurs.

Thus, TEI recommends a return to the functional approach to distinguish R&E from other activities. Activities related to development, improvement, or testing of the functional design or specifications of the product or process are R&E. Such activities may occur before or after the point at which one could consider the basic design specifications to be met. In fact, they may occur, and often do occur, after the taxpayer is manufacturing the product or is otherwise utilizing the process. The functional approach is not only entirely consistent with the legislative history for section 174, but conforms to the manner in which taxpayers account for R&E for financial accounting purposes.

B. Basic Design Specifications

In general, the proposed regulations look to the point at which the "basic [functional or performance] design specifications" have been met as a guide for determining when the research effort has ended. The presence of the nebulous term "basic" in the proposed regulations is of great concern to TEI, for it has the ring of false clarity and invites debate, audit disputes, and (ultimately) litigation over the definition of R&E.

TEI believes that all research activities up until the time the product is ready for commercial sale should qualify as R&E for purposes of section 174. Thus, assuming the time-line approach is retained in the final regulations, a product's "basic design specifications" should not be deemed to be met until that point. In the case of a process, "basic design specifications" should be considered met when the process is actually utilized for its intended purpose and performs at the quantity, rate, and quality intended.

Unless the regulations are clarified to minimize the potential for capricious line-drawing, the "basic" design specifications standard will be completely unadministrable. Thus, we can envision an examining agent concluding that a taxpayer's activities did not qualify as R&E under section 174 because they occurred right after the basic design specifications were met. Such a bathetic exercise would not only threaten to clog the audit process but, more fundamentally, would frustrate congressional intent.

At a minimum, we believe the word "basic" should be eliminated. Its usage suggests that a new product or process can (or should) be bifurcated into certain "core" elements -- the development of which constitutes R&E -- and "other" elements -- the development of which does not constitute R&E. Neither the Code nor the process through which new products or processes are developed supports such an approach to R&E activities.

Regrettably, the examples set forth in the proposed regulations fail to shed much light on the meaning of the term "basic design specification." For example, Prop. Reg. 1.174-2(a)(2), Example (1) merely assumes the point at which the basic design is met without giving any guidance on the type of design specifications that will be deemed to be "basic." (10) In fact, we believe the examples demonstrate exactly what is wrong with the time-line approach: it leads to inequitable results because it relies on arbitrary determinations of whether basic design specifications have been met rather than on a reasoned analysis of the taxpayer's particular activities. Thus, Prop. Reg. 1.174-2(a)(6), Example (1) excludes field testing from R&E because, under the conjured facts of the example, such testing is deemed to have taken place after the basic design specifications of the product were met. Field testing, however, is undertaken to ensure that the product functions in accordance with its basic design specfiications; consequently, it is intimately connected to the satisfaction of those specifications.

TEI submits that a proper analysis of field testing is set forth in Letter Ruling No. 8835002 (April 22, 1988). In that case, the IRS conducted a factual analysis to determine whether field testing activities constituted qualified research, rather than basing its denial of a section 174 deduction on the application of a rather crude, certainly strict time-line approach. Although the ruling makes a reference to whether the taxpayer had a method that met its basic design specifications at a particular point, this point is not particularly relevant to the ruling's conclusion. Indeed, the IRS held that qualified R&E did not end when products were transferred to customers and isntalled in order for those products to be field tested. In order words, a section 174 deduction (and section 41 credit) was allowed in respect of some field testing.

TEI recommends that the regulations confirm that testing, whether conducted in-house or in the field, undertaken to determine whether the design specfiications of a product or process have been met, will constitute R&E. In addition, we believe the facts of Letter Ruling No. 8835002 form the basis of an example to be included in the regulations.

C. Exceptions to the

Time-Line Approach

Prop. Reg. 1.174-2(a)(1) provides that in certain situations research activities undertaken after basic design specifications are met will quality as R&E for section 174 purposes. Specifically, the regulations state that activities related to the modifications to the basic design specifications for the purpose of (i) "curing significant defects in design," (ii) "obtaining significant cost reductions," or (iii) "achieving significantly enhanced function or performance level" will constitute R&E even though occurring after those basic design specifications are met. (Emphasis added). TEI objects to the use of the term "significant" or "significantly" in setting forth exceptions to the basic time-line rule.

1. The "Significance" Standard

Is Inconsistent with

Congressional Intent

We believe the imposition of a "significance" test is inconsistent with the legislative history of section 174 and section 41. The research tax credit was added to the Code as part of the Economic Recovery Tax Act of 1981, and the House version of that bill would have imposed a "significance" requirement in defining "qualified research." See 241, H.R. 4242 (House Version 1981). (11) This narrow definition of research, however, was rejected by the House-Senate conferees, who chose to define research for credit purposes by cross-referencing section 174. Similarly, in modifying the credit as part of the Tax Reform Act of 1986, Congress again chose not to require that improvements be "significant." See I.R.C. 41(d)(3d)(A). Since no activity can quality for the research tax credit without first qualifying for deduction under section 174 (by virtue of section 41's cross-reference to section 174's definition of research), it follows that the section 174 definition of research similarly does not include a "significance" test.

The preamble to the proposed regulations acknowledges, at least implicitly, that the imposition of a "significance" standard in respect of improvements is incorrect. Specifically, the preamable notes that a number of commentators had criticized the initial 1983 regulations on the ground that they "could be read to require a significant improvement for an activity to qualify under section 174." 1989-26 I.R.B. at 31. The regulations were revised to exclude the reference to "routinec or "periodic" improvements the preamable implies, so that qualified research would include activities that --

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.

1989-26 I.R.B. at 31. Amazingly, the exceptions to the time-line approach go ahead and reimpose such a standard.

Thus, by limiting the exception to activities for the purpose of curing significant defects in design, obtaining significant cost reductions, or achieving significantly enhanced function or performance level, the proposed regulations adopt the same "overly restrictive" interpretation of research that exposed the initial 1983 regulations to substantial criticism. (12)

2. The "Significance" Standard

Ignores Reality

In addition to being contrary to congressional intent,the imposition of a "significance" standard is at odds with the realities of the research environment. R&E is often an incremental, iterative process whereby small improvements are made in products in order to stay ahead of the competition. Over time, these small improvements accumulate and lead to major changes in products or processes and, potentially, to breakthroughs in related or even unrelated fields.

Prop. Reg. 1.174-2(a)(6), Example (4) illustrates the problems with both the time-line approach and the "significance" standard in the exceptions. The example presumptuously concludes that the improvement of a software program by adding "some additional commands" is not a change to the basic design specifications and therefore not R&E. The facts of the example, however, assume that the changes result in an improvement. We submit that a taxpayer's development of an updated version of a software program would be "part of an evolutionary process involving a series of minor improvements" that, the preamble clearly suggests, constitutes research.

6. The "Significance" Standard

Invites Audit Disputes

"Significance" is in the eye of the beholder. What a particular taxpayer may view as a significant improvement, a customer, a competitor, or perhaps even the Commissioner of Internal Revenue could judge unimportant or insignificant. Thus, by premising the exceptions from the time-line approach on a finding of "significance," the proposed regulations will spawn disptues between taxpayers and the IRS over whether the cost reductions achieved or the defects cured as a result of particular activities were "significant" or whether particular activities give rise to a "significantly" enhanced function or performance level.

The proposed regulations provide no guidance on what is, or is not, "significant." Only Prop. Reg. 1.174(a)(6), Example (2) explicitly addresses the point, and it simply states that errors in the original design of a database management system that "caused the system to shut down after extensive use" constitute "significant defects." In the absence of meaningful guidance, taxpayers (especially those who read and take to heart the preamble's reference to research as an "evolutionary process") can be expected to conclude that the "significance" standard has been satisfied. Conversely, on audit an examining agent can be expected to analyze the same activities to cure the same defects or achieve the same cost reductions and enhanced function or performance level and pronounce them "insignificant." Such line drawing, especially in the absence of legislative authority, does more than undermine the administrability of sections 174 and41; it frustrates the incentive purpose underlying those provisions.

D. The Exclusions to R&E

1. Activities Relating to the

Implementation of

Commercial Production

Prop. Reg. 1.174-2(a)(3)(vi) excludes from the definition of R&E activities "relating to the implementation of commercial production." Prop. Reg. 1.174-2(a)(4), Example (1) is intended to illustrate this rule. The example provides that expenses incurred after initial marketing of a new synthetic fiber to modify the production process in order to eliminate flaws that existed in a significant percentage of the marketed fabric did not constitute qualified R&E. The example reasons that expenses related not to modifications of the basic design specifications of the product (the fabric) but rather to implementing commercial production specifications. To avoid misunderstanding, we recommend that the example be revised to state expressly that the adjustments (or modifications) to the process did not change the basic design specifications of the process; consequently, they did not separately qualify as R&E.

This basic fact pattern should be elaborated on in a related example involving a modification to the production process. Specifically, the example should address the situation where the taxpayer conducts tests on, or otherwise experiments with, variations to the production process in order to increase the amount of fabric that is produced each shift. Because such activities would qualify as R&E without regard to whether they change the basic design specifications of the product, the example should conclude that the activities qualify as R&E for section 174 purposes.

We also recommend that the following example be added to the regulations to confirm that the testing of the functional design or specification of a product or process (as contrasted with quality control and ordinary testing) should constitute qualified research:

Example: B, a manufacturer of electronic instruments, undertakes to develop a radio frequency analyzer to be sold to telecommunications companies for use in measuring the accuracy and reliability of portable car telephones. During the design phase, B's test engineers incurred $250X in developing test systems (composed of hardware and software) that are used by B's design engineers in determining whether the analyzer meets its basic design specifications. The $250X incurred qualifies as research or experimental expenditures within the meaning of section 174.

2. Adaptation

Under Prop. Reg. 1.174-2(a)(3)(viii), costs related to "the adaptation of an existing capability to a particular requirement or customer's need" would be excluded from the definition of qualified R&E expenditures. TEI recommends that the final regulations clarify that a taxpayer's directing an activity at an "adaptation" will not be determinative of that activity's qualification as R&E. Rather, the critical consideration is whether such activity relates to the development, improvement, or testing of the functional design or specifications of a product or process.

Thus, the regulations should recognize that an "adaptation" may require a substantial redesign of the product, which then must be tested and refined through the process of experimentation. In such situations, the activities undertaken clearly qualify as research within the meaning of section 174. For example, in Rev.Rul. 73-275, 1973-1 C.B. 134, a taxpayer was engaged in the business of developing and manufacturing specially-built automated manufacturing systems that were used to perform certain operations on a customer-designed metal part in accordance with the customer's specifications concerning the rate of production, tolerance, and efficiency. The ruling holds that the taxpayer could deduct its design and development costs for each manufacturing system under section 174, even though each system was designed for a single customer and was merely "the integration into one continuous operation of known machines, precision machine tools, transfer mechanisms, and related equipment."

Consistent with this ruling, the regulations should provide that an activity directed toward a particular adaptation will qualify as a research activity under section 174, if that activity involves the process of experimentation and, if successful, will result in a new or improved product or process. (13)

TEI suggests the inclusion in the final regulations of the following example to illustrate this point:

Example: P is in the business of developing and manufacturing computers. Customer G wants to purchase 10 of P's current model for use in its manufacturing process. P's engineers modify the computer to withstand and operate within the temperature, motion, and sound environment of G's plant. In addition, the computer is modified so that it can hang from and move along a track in accordance with the production flow of the plant. Even though the costs of the activities of P's engineers relate to the adaptation of a particular customer's need, those activities constitute R&E expenditures for purposes of section 174 because they relate to the development, improvement, or testing of the functional design or specifications of a product.

3. Quality Assurance and Testing

Prop. Reg. 1.174-2(a)(3)(iii) excludes from the definition of research "[t[he routine or ordinary testing or inspection of materials or products for quality control." Section 41(d)(4) (D)(v) of the Code similarly includes "routine or ordinary testing or inspection for quality control" in the list of activities for which R&E tax credit is not allowed.

Although quality control activities relating to, for example, materials or production standards after the beginning of commercial production do not qualify for the credit, section 41(d) specifically provides that "qualified research" includes research --

the application of which is intended to be useful in the development of a new or improved business component of the taxpayer ... [if] ... substantially all of the activities of which constitute elements of a process of experimentation ....

I.R.C. 41(d)(1)(B)(ii) and 41(d)(1)(C) (emphasis added). The issue, then, is what is a "process of experimentation"? Addressing a related issue, the Conference Report on the Tax Reform Act of 1986 states that the "process of experimentation" includes the development of --

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 item.

H.R. Rep. No. 99-841, 99th Cong, 2d Sess. II-72 (1986).

Thus, the testing of different materials or manufacturing processes during the design phase should clearly be deemed to constitute qualifying activities. (14) Consider, for example, a manufacturer whose quality department's engineers perform a "failure analysis" of products during the design process. A failure analysis may consist, among other things, of --

i. the calculation and setting of reliability standards during the product design phase;

ii. stress testing of the business items in environmental chambers using accelerated aging techniques; and

iii. compiling and reporting the test results to the design engineers who use the test results in determining whether redesign of the product is necessary.

The failure analysis is performed during the prototype stage or pre-inventory pilot run and before the production of salable units.

The regulations should confirm that failure analysis activities constitute qualified R&E because they involve the testing of the functional design or specifications of a part, product, or process for reliability and quality. Moreover, a failure analysis may still constitute research, even if similar analyses are performed on the product after the beginning of commercial production as part of ongoing quality control.

Prop. Reg. 1.174-2(a)(4), Example (3) should be modified to demonstrate this point. That example posits a case in which testing is conducted on a perfume product to determine if each batch is allergenic. The example should distinguish this testing (apparently, quality control testing) from testing to determine whether the perfume retains its allergenic properties several months after manufacture or after storage in different types of containers.

Similarly, because governmental or other compliance testing (for example, under the aegis of Underwriters Laboratories) often leads to design changes, such testing should be deemed to constitute qualified R&E. (15)

4. Activities Not Related to a

Product's Functional Aspects

Prop. Reg. 1.174-2(a)(3)(v) excludes from the definition of research "[a]ctivities not directed to the functional aspects of a product including expenses relating to style, taste, cosmetic, or seasonal design factors." This language is certainly an improvement over that contained in the initial 1983 regulations.

The common meaning of the terms "style," "taste," cosmetic," and "seasonal" suggests that the purpose of the exclusion is to distinguish between (i) those activities that are merely related to the superficial aspects of appearance, individual preference, or fashion, and (ii) those activities related to the functional aspects of a product. For some types of products, however, style, taste, and cosmetic aspects may be inseparable from functional aspects of the product. Consequently, the regulations should provide that the exclusion does not apply where style, taste, or cosmetic factors are inherently related to functional aspects of the product. Similarly, the exclusion should not apply where otherwise qualified research has incidental or consequential effect on "style, taste, cosmetic, or seasonal design factors."

Examples of research that should not be excluded by virtue of this exclusion include:

* A food processor conducts laboratory testing with various processes and preservative agents in order to extend the shelf lives of certain food products.

Shelf life is a functional aspect of the product, since it is directly related to product reliability and quality. Because the product involved is food, any change in process or material may affect "taste." Again, where the purpose of the research is to develop a new or improved function, the activities should not be disqualified merely because they also affect product taste. Indeed, we suggest the regulations expressly distinguish between "oral" taste (whether a product is sweet, salty, sour, or bitter) and aesthetic taste. Costs relating to the former that would otherwise constitute research should not be covered by the "taste" exclusion.

* A pharmaceutical manufacturer conducts clinical testing seeking to establish new delivery forms as an improvement to an existing product.

The delivery form -- say, tablet, capsule, or liquid -- is a functional aspect of the product, yet it also is inherently related to the "cosmetic" aspect of the product, in that each delivery form has a distinct superficial appearance, and to "taste" either in the meaning of one's individual preference (for one form over another), or in the meaning of flavor by mouth. Nevertheless, if the clinical testing activities separately qualify under section 174, they should not be excluded merely because of the effect on cosmetic and taste factors of the product.

* A manufacturer of packaging containers conducts research to develop a new film coating to improve the functional aspects of the product by inhibiting moisture contamination and increasing the strength and durability of the container.

The film has a shiny appearance. If the activities separately qualify under section 174, they should not be disqualified merely because the new film also changes the cosmetic appearance of the product.

* An automobile manufacturer conducts research to increase the aerodynamic efficiency of an automobile.

The research results conclude that maximum efficiency gains may be achieved if the external shape of the automobile body is changed. Although thos change affects the "style" of the automobile, the purpose of the research is to improve the function of aerodynamic efficiency. Thus, the research should not be disqualified. (16)

* A computer manufacturer conducts laboratory experimentation on the functional aspects of the casing of a new computer in which the monitor, disk drive, and logic boards of the computer are housed.

The casing serves certain functional ends -- for example, radiation shielding, electromagnetic interference shielding, and heat ventilation -- but is also intended to be aesthetically pleasing. The design of the computer casing should not be disqualified merely because the design also affects the external appearance of the computer.

5. Duplicate Prototypes

Prop. Reg. 1.174-2(a)(3)(vii) excludes from the definition of research "[t]he construction of duplicate prototypes types used for market testing purposes or held for sale." This language represents an improvement over that contained in the initial 1983 regulations and generally addresses the concerns we discussed in our November 1987 comments. We recommend, however, that the final regulations include an affirmative statement (or example) confirming that R&E includes both --

i. expenditures for the production of duplicate (or multiple) prototypes where each prototype is subjected to a different test during the development process (which testing may destroy each prototype or eliminate its utility for any subsequent sale), and

ii. expenditures for "sequential" prototypes each of which reflect a progressively sophisticated design of the product than its predecessor, which design is derived through the testing and experimentation process itself. (17)

See, e.g., Reve. Rul. 69-484, 1969-2 C.B. 38, in which the IRS held that the costs of producing multiple prototypes for use in the research and development process are R&E expenditures under section 174.

6. Tools, Jigs, Molds, and Dies

The initial 1983 regulations contain an exclusion from R&E for "the routine design of tools, jigs, molds, and dies." Prop. Reg. 1.174-2(a)(3) does not contain such an exclusion, but neither the proposed regulations nor the preamble address the reason for the change. We believe the significance of this change should be explained in the final regulations.

We also believe the final regulations should contain an example relating to tooling. Specifically, the example should clarify that tooling required to produce units of the product for testing, or to test a new process, should qualify as R&E even though the tooling could, on occasion, be utilized for actual commercial production of the units. TEI suggests the following example to illustrate this point in the case of both "hard" and "soft" tooling: (18)

Example: E, a manufacturer of portable computers, undertakes to develop and manufacture a new laptop computer. E purchases two types of tooling from a third party for use in fabricating parts for prototypes. E purchases "soft" tooling for $50X. (The soft tooling can be used to fabricate a limited number of parts before it wears out or otherwise becomes unusable.) E purchases "hard" tooling for $100X. (The hard tooling can be used over a longer period of time and for different parts than the soft tooling. On occasion, the hard tooling will be used for commercial production, provided the tooling is still operable, and if the same parts are needed in production as were needed in the design of the prototype.) The costs of both the soft and the hard tooling are research and experimental expenditures within the meaning of section 174.

E. Software

TEI applauds the inclusion in the proposed regulations of the statement in Prop. Reg. 1.174-2(a)(5) that "[t]he costs of developing computer software qualify as research or experimental expenditures within the meaning of section 174 under the same rules that apply to other products or properties." We are concerned, however, that the software examples contained in the regulations provide precious little meaningfdul guidance on what constitutes R&E in respect of software.

The examples set forth in Prop. Reg. 1.174-2(a)(6) endeavor to apply the basic rules that are applied elsewhere in the regulations to fact patterns involving software. The examples need to be modified, however, to ensure that the treatment of software costs under the regulations will conform with the treatment of non-software costs. REgrettably, that is not clear from the way the examples are currently framed. Indeed, rather than confirming that the development of software nwhether for internal or external use) can constitute research and providing taxpayers with clear guidance on where a section 174 deduction will be available, the examples deal with the research issue in an almost tautological fashion. Stated differently, although the examples provide that certain activities are or are not research, their utility in "real world" situations is extremely limited.

Before turning to our recommendations concerning specific examples, we present our comments on the continuing validity of REv. Proc. 69-21, 1969-2 C.B. 303.

1. Rev. Proc. 69-21

The preamble to the proposed regulations states that the IRs is studying "the continuing validity of Rev. Proc. 69-21 (1969-2 C.B. 303) in light of the enactment of section 263A of the Code" and invites comments on "the proper treatment of computer software that does not qualify for section 174 treatment." 1989-26 I.R.B. at 31.

In section 3.01 of Rev. Proc. 69-21, the IRS held that the costs of developing software --

in many respects so closely resembles the kind of research and experimental expenditures that fall within the purview of section 174 of the Internal Revenue Code of 1954 as to warrant accounting treatment similar to that accorded such costs under that section.

Consequently, the IRS stated it would not disturb a taxpayer's treatment of software as current expenses "in accordance with rules similar to those applicable under section 174(a) of the Code."

Inasmuch as Rev. Proc. 69-21 is consistent with the statement in Prop. Reg. 1.174-2(a)(5) that "[t]he costs of developing computer software qualify as research or experimental expenditures within the meaning of section 174 under the same rules that apply to other products or properties," there is no independent need for the revenue procedure in order to achieve the proper tax result with respect to computer software. We suggest, however, that there would be a benefit in retaining Rev. Proc. 69-21. Specifically, by clarifying the general applicability of section 174 to software, the revenue procedure serves to minimize disputes between taxpayers and the IRS examining agents. Moreover, we fear that examining agents might misinterpret the revocation of Rev. Proc. 69-21 -- without regard to the rule set forth in Prop. Reg. 1.174-2(a)(5) -- as a signal to generally disallow section 174 deductions in respect of computer software. This is especially the case in view of the absence of clear guidance to the contrary in the examples under Prop. Reg. 1.174-2(a)(6). Thus, we recommend that the revenue procedure be retained. (19)

2. Example (1)

Example (1) under Prop. Reg. 1.174-2(a)(6) provides that the costs of "further testing" do not qualify as an R&E expenditure. The example should claify what is meant by "further testing." Specifically, the example should provide that the referenced testing is "market testing" (or "quality control") and not the testing necessary to determine if the software meets its design specifications. This latter type of testing is, of course, an activity that constitutes R&E.

Example (1) also provides that activities related to "writing the documentation for users" are excluded from the definition of research. Apparently, this language is supposed to parallel the exclusion for activities related to "writing and printing an owner's manual" found in Prop. Reg. 1.174-2(a)(2), Example (1). TEI believes that this reference to documentation could be improperly construed as excluding all documentation activities from the definition of qualified research.

Documenting the results of research is an integral part of the research process. Thus, the product of technical writers and engineers engaged in documentation activities -- for both hardware and software products -- is used throughout the R&E process to validate the efforts of the engineers and to assist in and facilitate the ultimate "manufacturability" of the product. To be consistent with the rules governing non-software costs, the activity in the example should be clearly identified as documentation not performed to support the engineering function or as merely printing activities.

In addition, in order to make clear that the documentation of research results constitutes research where done as an integral part of other R&E activities, TEI suggests the following example.

Example: C, a manufacturer of personal computers, develops a new computer with a faster and more technologically sophisticated operating system than any computer it had previously developed and marketed. Contemporaneously with the research on the new computer, C incurs $100X in developing documentation which explains in detail the functions and specifications of the new computer. This documentation is prepared so that C's testing, repair, and maintenance personnel can understand the technical aspects of the computer in performing their jobs. The $100X incurred to develop documentation that supports the research function qualifies as research or experimental expenditures within the meaning of section 174. The result is not changed by the fact that the documentation may utlimately also be used in preparing a user's manual in respect of the computer.

Finally, Example (1) excludes from the definition of research "debugging." We submit, however, that a software product that has not been "debugged" does not -- by definition -- meet its basic design specifications. To be consistent with the general rule, the reference to "debugging" should be dropped.

3. Example (4)

Example (4) under Prop. Reg. 1.174-2(a)(6), which relates to the development of an updated version of a software program, is discussed in Part III.C.2. in the context of evolutionary changes and the flawed nature of the time-line approach. The example betrays a misunderstanding of the software development process. The example implies that "adding some additional commands" to a software program that may already have many commands is somehow minor or insignificant. The efforts giving rise to those changes in the program, however, involve substantial experimentation. For example, adding a footnoting, spell-checking, or thesaurus facility to a word-processing software program may be just "adding some additional commands" to the writers of the proposed regulations, but for the software company undertaking the changes, the task of integrating these functions with numerous others is a monumental one of experimentation.

4. Example (5)

Example (5) under Prop. Reg. 1.174-2(a)(6) reflects a similar failure to appreciate the significance of improvements that can actually be major advancements. The example involves the expansion of the number of data fields in an inventory control system, as well as the design of a custom data input screen. These changes are deemed not to alter the system's basic design specifications, but in reality the addition of data fields is usually a task requiring a great deal of experimentation because of the interrelationships between the new and the old fields and the commands that operate upon these fields.

5. Example (6)

Example (6) under Prop. Reg. 1.174-2(a)(6) addresses the proper treatment of internally developed software relating to management function or techniques. The example states that because the software relates to internal management functions or techniques, the development costs do not constitute qualified R&E expenditures. The example begs the question, however, because it states that its conclusion is also based on the expenses' "not separately qualify[ing] as research and experimental expenditures within the meaning of section 174." Thus, Example (6) stands as an excellent example of the tautological and, therefore, not particularly helpful approach to providing regulatory guidance.

What is more, the guidance it does provide is wrong. There is only one factor that should govern the eligibility of costs relating to software: the effort required to develop the software. In other words, neither the subject matter of the software nor the fact that it was internally developed is relevant to the determination. If the effort giving rise to a software program involves scientific experimentation, the costs associated with that effort should qualify as R&E expenditures within the meaning of section 174 without regard to whether the software relates to a management function or technique.

We note that, in amending the research tax credit as part of the Tax Reform Act of 1986, Congress chose to exclude certain internal use software from the reach of the credit. I.R.C. 41(d)(4)(E). That exclusion, however, has no application in respect of deductions under section 174 and, in fact, would not have been necessary if such internal use software were not otherwise eligible for the credit (by virtue of section 174's definition of R&E). (20)

For the foregoing reasons, we recommend that Example (6) be revised to provide that the costs of developing internal use software will be qualified R&E expenditures where the activity undertaken to develop the software (without regard to whether it relates to management functions or techniques) is research.

IV. Other Comments

A. "Substantially All" Test

TEI reiterates the comments made in our November 1987 submission that a "substantially all" test be applied to all R&E. Such a rule would greatly reduce the administrative burden of keeping detailed time and costs records for purposes of the R&E deduction. An 80-percent test, such as that contained in Treas. Reg. 1.41-2(d)(2) for purposes of the research tax credit, would go a long way to not only ameliorating the taxpayer's recordkeeping burden, but also to simplifying the IRS's task in auditing compliance with the statute.

In addition, a "substantially all" rule could efficaciously be broadened to permit the deduction under section 174 of all costs of a stand-alone research facility for a taxable year if substantially all (i.e., 80 percent) of the activities performed in that laboratory facility constituted R&E. Such a rule would greatly simplify administrative burdens to both taxpayers and the IRS.

To implement this suggestion, the following subparagraph could be added to the section 174 regulations:

Where substantially all (at least 80 percent) of the services performed by an individual for or on behalf of the taxpayer during the taxable year, or the services performed in a laboratory facility for or on behalf of the taxpayer during the taxable year, are services performed in activities the expenditures for which qualify as research and experimental expenditures within the meaning of section 174, then all the services performed by that individual or that facility during the taxable year are treated as research and experimental expenditures.

B. What to Do with Costs

Excluded from Section 174

The proposed regulations contain numerous exclusions to costs that can be deducted under section 174. An issue arises concerning the proper treatment of costs that relate to maintaining the design of a product and not to improving the product, but which do not constitute qualified R&E expenditures.

The treatment of expenses that do not qualify as R&E expenditures (whether they are computer software expenses or other expenses that relate to maintaining the design of a product and not to improving the product) involves a distinction that is analogous to that which arises between capital improvements and repairs to a capital asset. Generally, repairs that keep property running as it was designed to are deductible. Treas. Reg. 1.263(a)-1(b). Recognition of this analogy in the section 174 area would help to resolve the issue of what to do with costs no longer considered research. Specifically, we recommend that the final regulations clarify that all costs relating to the product that are not R&E expenditures will either be section 162 expenses (if the costs relate to maintaining, rather than improving, the product design) or inventoriable costs under section 263A(a)(1)(A) (if the cost related to individual units of the product). Such a rule would further the legislative purposes underlying section 174.

For example, quality control costs associated with routine or ordinary testing are not R&E expenditures. The quality control function is a testing function that ensures that the manufacturing process continues to work as it was designed. (21) As such, the costs increase the value of the units produced and not the design of the product or process. Hence, these costs should be inventoried.

Similarly, the printing of user's manuals does not constitute qualified R&E. (See the discussion in Part III.E.) Such activities, however, should be viewed as related to the sales, training, and service functions of the taxpayer. As such, their costs should be treated as marketing costs deductible under section 162.

V. Conclusion

Tax Executives Institute appreciates this opportunity to present our views on the proposed regulations relating to the definition of research and experimental expenditures for purposes of section 174. If you have any questions, please do not hesitate to call Lester D. Ezrati, chair of TEI's Federal Tax Committee, at (415) 857-2089 or the Institute's professional staff (Timothy J. McCormally or Mary L. Fahey) at (202) 638-5601.

Footnotes -- Definition of Research and Experimental Expenditures

(1) Final regulations under section 41 (T.D. 8251), relating to the credit for increasing research activities, were also published in the Federal Register on May 16, 1989 (54 Fed. Reg. 21203), and in the June 26, 1989, issue of the Internal Revenue Bulletin, 1989-26 I.R.B. 5.

(2) TEI filed comments on the initial 1983 regulations on March 29, 1983, and testified at the IRS's April 19, 1983, public hearing on the regulations. In addition, on November 6, 1987, the Institute filed supplemental comments on the proper definition of research for purposes of section 174, as well as on other issues raised by the research tax credit.

(3) See H.R. Rep. No. 1337, 83d Cong., 2d Sess. 28 (1954); S. Rep. No. 1622, 83d Cong., 2d Sess. 33 (1954), reprinted in 3 U.S. Code Cong. & Admin. News 4053, 4663-64 (1954).

(4) Blake, Research and Experimental Costs, N.Y.U. Sixteenth Annual Institute on Federal Taxation 831, 831-32 (1958).

(5) See the cases cited in Swanson, Tax Treatment of Research and Experimentation Expenditures, 34 Taxes 541 (1956), and Miller, Research and Development Costs, N.Y.U. Seventh Annual Institute on Federal Taxation 134 (1949). See also Lee, Pre-Operating Expenses and Section 174: Will Snow Fall?, 27 Tax Law. 381 (1974); Stream, Pioneering Activities, 26 Taxes 64 (1948); Alexander, Research and Experimental Expenditures Under the 1954 Code, 10 Tax L. Rev. 549 (1955).

(6) The quoted language is taken from Swanson, supra note 4, at 541-42.

(7) See Rice, Research and Development Costs, 25 Taxes 41 (1947), as well as the articles cited in notes 4, 5, and 6.

(8) See H.R. Rep. No. 1337, 83d Cong., 2d Sess. 28 (1954); S. Rep. No. 1622, 83d Cong., 2d Sess. 33 (1954), reprinted in 3 U.S. Code Cong. & Admin. News 4053, 4663-64 (1954).

(9) A finding that certain R&E expenses do not qualify under section 174 would not necessarily preclude their current deduction. This is because such expenses could well qualify as ordinary and necessary expenses under section 162 of the Code. Thus, a narrow definition of "research and experimental expenditures" would not necessarily lead to the capitalization of product or process development costs. Indeed, allowing such costs to be currently deducted under section 162 would be consistent with congressional intent.

(10) A similar conclusion is reached in Prop. Reg. 1.174-2(a)(6), Example (1).

(11) Specifically, to qualify for the credit under the House bill, the amount would have to have been related to the development of a new business item or in bringing about a significant improvement in an existing business item. See H.R. Rep. No. 97-201, 97th Cong., 1st Sess. 113 (1981).

(12) The preamble does not clearly state that activities related to "routine" or "periodic" improvements constitute qualified research for purposes of section 174. Nor does the preamble openly embrace the notion of research as an "evolutionary process." By citing the criticism of the initial 1983 regulations and then stating that the "routine" and "periodic" improvements language had been deleted from the regulations, however, the preamble gives the clear impression that the revised definition of research would encompass at least some activities giving rise to such improvements. We submit that the IRS should clarify whether this interpretation of the preamble is correct.

(13) In addition, the regulations should clarify that otherwise qualifying R&E activities that are germane to the development of a special product or products for which there may be only one single customer (e.g., the U.S. government) will not fall outside the definition of R&E simply because of the operation of the adaptation exclusion in Prop. Reg. 1.174-2(a)(viii).

(14) This is true even where the testing is performed by personnel in a quality control or other "quality" department, or where the testing is similar in nature to that which may also be performed for quality control purposes.

(15) In this regard, Prop. Reg. 1.174-2(a)(4), Example (9) provides that costs incurred to test and secure government approval of a blood pressure drug (following the drug's development) constitute qualified R&E expenditures for purposes of section 174. We believe that the result reached in Example (9) is clearly appropriate and suggest that it underscores the "line-drawing" problems that will arise with the IRS's time-line approach.

(16) This example relates to Prop. Reg. 1.174-2(a)(4), Example (4). As currently drafted, Example (4) intimates that automotive designs generally relate almost exclusively to style and taste. Such an assumption, however, is erroneous. In fact, most automotive design activity is functionally related.

(17) The successive modifications to the prototype could be viewed as conceptually equivalent to modifications to the basic design specifications.

(18) Generally, "soft" tooling can be used to fabricate a limited number of parts before it becomes unusable, whereas "hard" tooling can be used over a longer period of time and for different parts than the "soft" tooling. In addition, on occasion "hard" tooling may be used for commercial production, provided the tooling is still operable and the same parts are needed in production as were needed in the design of the prototype.

(19) As to the proper treatment of costs related to computer software and other expenses that may not qualify as R&E expenses, see Part IV.B.

(20) Furthermore, the Conference Report on the 1986 Act expresses Congress's intent that Treasury regulations make costs related to internal use software eligible for the research tax credit where the software is "innovative," involves "significant economic risks," and is "not commercially available for use by the taxpayer." H.R. Rep. No. 99-841, 99th Cong., 2d Sess. II-73 (1986).

(21) The testing function as part of the design of a new or improved manufacturing process, however, does constitute qualified R&E.
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Title Annotation:filed with IRS by Tax Executives Institute on September 21, 1989
Author:Ezrati, Lester D.
Publication:Tax Executive
Date:Sep 1, 1989
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