Maximizing opportunities under the new research and experimentation regulations.
For more than 40 years, Congress has provided incentives for research and development activities in an effort to "increase the innovative qualities and efficiency of the U.S. economy."(1)(*) These incentives are currently embodied in section 174 of the Internal Revenue Code, which allows taxpayers to deduct research or experimental expenditures in the year they are paid or incurred(2) or to amortize such expenditures over a period of at least 60 months,(3) and in section 41,(4) which currently allows a tax credit of 20 percent of the increase in research expenditures for the current taxable year over a base amount calculated in part by reference to the level of such expenditures in previous years.(5) The primary and most fundamental requirement for eligibility under section 174 and section 41(6) is that a taxpayer's efforts must constitute "research or experimental" (R&E) activities.(7) Nearly 13 years after Congress expressed a need for additional guidance on the definition of R&E expenditures,(8) and following the issuance of a series of restrictive proposed regulations, the Internal Revenue Service on October 3, 1994, promulgated final regulations governing the types of expenses that qualify as R&E expenditures.(9)
This article discusses the opportunities presented by the new regulations and provides practical suggestions for taxpayers seeking to maximize the available tax benefits. The article first reviews the general categories of expenditures that qualify as "research or experimental" for purposes of both section 174 and section 41. It then summarizes the IRS's various attempts to provide guidance and explores how the final regulations have liberalized the definition of qualifying expenditures. The additional statutory limitations on the types of expenditures qualifying for the section 41 credit are then discussed, including the special rules for computer software and contract research expenses. Finally, the article outlines the practical steps that taxpayers can take to derive the maximum benefit from the final regulations for prior, current, and future taxable years.
11. Research or Experimental Expenditures
under Section 174
Satisfying the definition of R&E expenditures is critical not only for purposes of the section 174 deduction, but also for claiming the section 41 credit. It is thus important to recognize that the Code and the regulations employ a definition of "research and experimental" that is frequently inconsistent with the understanding of that term as it is used by the personnel engaged in research. Establishing a common understanding of this and other relevant terms between researchers and the company's tax department is critical to maximizing the available tax benefits.
The section 174 regulations defining "research or experimental expenditures" were originally issued in 1957. The 1957 regulations defined R&E expenditures as "research and development costs in the experimental or laboratory sense." The regulations provided only that the term included all costs incident to the development of an experimental or pilot model, a plant process, a product, a formula, an invention, or similar property, and the improvement of already existing similar property.(10) Proposed regulations issued in 1983 and 1989 provided further, albeit somewhat taxpayer-unfavorable, guidance on the meaning of the term, largely by attempting to specify the types of expenditures that did not qualify. The new final regulations, which generally parallel the proposed regulations issued in 1993,(11) provide substantially more guidance than the 1957 regulations, and represent a significant liberalization of the definition of "research or experimental expenditures" found in the now-withdrawn 1983 and 1989 proposed regulations.
In light of these changes, taxpayers who initially determined that particular expenditures did not qualify under the 1983 or 1989 proposed regulations should reexamine whether they qualify under the less-restrictive standards of the final regulations. Part IV provides practical suggestions for conducting such a reexamination.
A. 1983 and 1989 Proposed Regulations
The 1983 proposed regulations(12) focused on the results the research activities were designed to achieve and limited qualifying research under section 174 to activities "aimed at the discovery of new knowledge" or "searching for new applications of either research findings or other knowledge."(13) The proposed regulations identified the following 11 specific nonqualifying activities:
* Routine, periodic, or cosmetic improvements to existing products;
* Efficiency or management surveys;
* Consumer surveys or market testing;
* Quality control testing;
* Routine design of tools, jigs, molds, and dies;
* Construction of copies of prototypes;
* Planning for commercial production and trial production runs;
* Engineering follow-through or troubleshooting during commercial production;
* Adaptation of an existing capability to a particular requirement or customer's need;
* Routine data collection; and
* The cost of acquiring another person's patent, model, or production process.(14)
The IRS interpreted the basic exclusion for "routine, periodic, or cosmetic improvements" as requiring a significant improvement to an existing product in order for research on that product to qualify.(15) In addition, the 1983 proposed regulations limited deductions and credits for computer software development expenditures to activities where the software's operational feasibility was seriously in doubt.(16)
The 1989 proposed regulations"(17) retained the requirement of the 1983 proposed regulations that R&E costs be "aimed at the discovery of new knowledge" or result from "searching for new applications of either research and experimentation findings or other knowledge."(18) In addition, the 1989 proposed regulations slightly modified the 1983 regulations' list of 11 nonqualifying activities:
* Activities not directed at the functional aspects of a product including expenses relating to style, taste, cosmetic, or seasonal design factors;
* Efficiency surveys or management studies;
* Consumer surveys, market development, or market testing;
* Quality control testing;
* Activities relating to management functions or techniques developed primarily for internal use of the taxpayer in its trade or business and not generally intended for sale to customers;
* Activities relating to the implementation of commercial production;
* Construction of duplicate prototypes;
* Adaptation of an existing capability to a particular requirement or customer's need;
* Routine data collection;
* The acquisition of another person's patent, model, or production process; and
* Literary, historical, or similar projects.(19)
The most significant aspect of the 1989 regulations was the adoption of a timeline approach, under which all expenditures incurred "after the point that the product or property . . . meets its basic design specifications related to function and performance level" would not qualify as R&E expenditures under section 174 unless they were made to cure a significant design defect, obtain significant cost reductions, or achieve significantly enhanced function or performance levels.(20) This approach was widely assailed as reflecting an unrealistic view of most manufacturing processes.(21) Although computer software development costs were generally subject to the same test as other research Costs,(22) the timeline approach was viewed as particularly unworkable for those costs because changes in basic design specifications often occur throughout the software development process as a result of almost continuous testing.
B. 1994 Final Regulations
The 1994 final regulations alter the entire focus of the inquiry concerning research or experimental expenditures. No longer must the qualifying research be aimed at the development of new knowledge or significant improvements, or be limited to the attainment of basic design specifications. Under the final regulations, if expenditures are designed to eliminate uncertainty concerning the development or improvement of a product, the expenditures will be considered "research and development costs in the experimental or laboratory sense." The regulations set forth the following three types of "uncertainty," any one of which will satisfy the test:
* the capability for improving the product,
* the method for improving the product, or
* the appropriate design for the product.
The requisite uncertainty is based on the information actually (not theoretically) available to the taxpayer."(23)
The regulations make clear that the proper focus of the uncertainty test is on the nature of the research activities themselves and not on the product or improvement being developed or the level of technological advancement that the product or improvement represents.(24) The final regulations are thus consistent with recent decisions sustaining section 174 deductions for research not appearing to involve significant technological advancement. For example, the Tax Court recently held that the expenditures of a taxpayer who unsuccessfully attempted to develop through trial and error a new rifle bullet suited for hunting large game qualified as R&E expenditures for purposes of section 174.(25) Similarly, the Tax Court has also held that expenditures to develop software designed to recognize license plates are eligible for the section 174 deduction even though comparable, but slower, software was already commercially available."(26)
1. Formerly Excluded
The final regulations now list only seven activities that are specifically excluded from the definition of research or experimental expenditures:
* Quality control testing;(27)
* Efficiency surveys;
* Management studies;
* Consumer surveys;
* Advertising or promotions;
* The acquisition of another's patent, model, or production process; and
* Research in connection with literary, historical, or similar projects.(28)
Thus, the following six exclusions found in the 1983 and 1989 regulations are absent from the final regulations:
* Activities related to management functions or techniques developed primarily for use of the taxpayer;
* Activities not directed at the functional aspects of a product;
* Activities related to the implementation of commercial production;
* Construction of duplicate prototypes;
* Adaptation of an existing capability to a particular requirement or customer's need; and
* Routine data collection.(29)
Such expenditures are now qualified under section 174 if they meet the uncertainty test.(30)
Taxpayers that followed the 1983 or 1989 proposed regulations and excluded the costs of performing these activities from their qualifying R&E expenditures, or that accepted disallowances based on the proposed regulations in tax years still open for claims for refund, should reevaluate the eligibility of those activities under the uncertainty standard of the final regulations.
2. Computer Software
The elimination of both the "new knowledge" test and the timeline approach of the 1983 and 1989 proposed regulations is particularly significant in qualifying the costs of computer software development activities as R&E expenditures. Perhaps equally important, unlike the 1983 regulations, the new final regulations do not provide more restrictive requirements for software development than for other activities. In the preamble to the 1993 proposed regulations, which are virtually identical to the final regulations, the IRS states both that software development activities are subject to the same liberalized general rules applicable to all other research activities, and that it will still follow the position expressed in Notice 87-12,(31) Rev. Proc. 69-21,(32) and the legislative history of the Tax Reform Act of 1986(33) that the costs of developing computer software qualify under the same standards applicable to the costs of developing other products.(34)
Even prior to the issuance of the 1993 proposed regulations, the Claims Court declined to follow the IRS'S previous restrictive approach to computer software development costs. In Yellow Freight Systems, Inc. v. Commissioner,(35) the Claims Court adamantly rejected the views expressed in the report of an IRS-retained expert who insisted that the taxpayer's software development activities must meet an academic or scientific definition of "research" (i.e., that such activities be "innovative, risky, or challenging" in light of current progress in the field of computer science). The court denied the government's motion for summary judgment, finding that "research or experimentation' was to be given its plain and ordinary meaning rather than the academic meaning urged by the expert's report.(36)
Taxpayers that initially applied either the timeline approach of the 1989 regulations or the "operational feasibility" standard of the 1983 regulations to computer software development expenditures should now find that more of these costs qualify as R&E expenditures under the uncertainty standard of the final regulations.(37) Thus, even though computer programmers may have been certain of their ability to develop software to meet performance specifications, their activities should qualify as long as the programmers were uncertain about either the proper method to follow or the most efficient design that would satisfy the performance specifications.
3. Effective Date
The final regulations apply only to taxable years beginning after October 3, 1994. The preamble states that some commentators requested a retroactive effective date, but "[b]ecause the amendments merely clarify the existing definition of research or experimental expenditures, retroactive application of the amendments is unnecessary. Return positions consistent with the amendments will be consistent with the existing regulations and will be recognized as such by the IRS."(38) IRS officials have informally elaborated that since the standard established in the final regulations is a clarification of prior law, it should be applied retroactively to all open tax years.(39)
Such an approach is particularly proper in light of Congress's 1981 mandate that the IRS provide additional guidance "not inconsistent with existing regulations" defining R&E for purposes of both section 174 and the research credit.(40)
III. Qualified Research Under Section 41
In addition to satisfying the definition of "research or experimental expenditures" under section 174, expenditures must meet several additional requirements to satisfy the definition of "qualified research" under section 41.
A. Additional Section 41 Requirements
An activity that qualifies as R&E under the section 174 regulations must meet the following three additional general requirements to be eligible for the section 41 credit:
* it must be technological in nature,
* substantially all of the activity must constitute a process of experimentation, and
* the process of experimentation must be carried on for a permitted purpose.
These tests are applied separately with respect to each "business component" of the taxpayer.(41)
Research will satisfy the technological-in-nature test(42) if it relies on principles of the physical or biological sciences, engineering, or computer science.(43) Research will not satisfy the technological-in-nature requirement if it is based on economic principles, information related to financial services, development of legal forms, or advertising.(44) For example, research to develop new computer software generally should be treated as technological in nature,(45) whereas research primarily based on economic principles to develop information on a new financial product, such as a new type of variable annuity, would not be treated as technological in nature.(46)
2. Process of Experimentation
The second requirement is that substantially all of the research activities must constitute elements of a "process of experimentation."(47) This test merely requires that the taxpayer engage in an evaluation of more than one alternative designed to achieve a result where the means of achieving that result are uncertain at the outset.(48) Although experimentation includes the traditional scientific process of developing, testing, analyzing, and refining or discarding hypotheses, it certainly is not limited to such formal scientific processes.(49) A methodical trial-and-error process need not meet any particular scientific requirements to be treated as a process of experimentation. If the design of any product is uncertain at the outset and can only be determined through trial and error, the trial-and-error regimen is treated as a process of experimentation.(50)
3. Permitted Purpose
A process of experimentation will be deemed to be conducted for a permitted purpose if the research relates to new or improved function, performance, reliability, or quality.(51) Research is not conducted for a permitted purpose if it relates to style, taste, cosmetic, or seasonal design factors.(52)
Although a specified degree of new or improved function is not expressly required, to the extent that such improvements can be quantified, a showing of degree of improvement will facilitate the satisfaction of this requirement. For example, researchers should be encouraged to specify that the new product is not merely faster" but "25 percent faster."
4. Application of Tests to Business Components
For purposes of determining whether an activity meets the definition of "qualified research," the three section 41 requirements are applied separately to each "business component" of the taxpayer. A business component is any product, process, computer software, technique, formula, or invention that is to be held for sale, lease, or license, or used by the taxpayer in its trade or business.(53) Production processes are treated as separate business components from the product being produced.(54)
If all the tests cannot be satisfied with respect to an entire product, a taxpayer may treat the most significant set of elements of that product with respect to which all the tests are met as its business component.(55) Under this "shrinking back" concept, a taxpayer may define the functional elements of a product with both functional and style improvements as the business component," which then can qualify for the credit. For example, if the product is a refrigerator that has both functional elements (a new cooling mechanism) and style elements (a redesign of the appearance of the shelves and doors), the taxpayer can define the business component" as the functional elements of the product.
B. Specifically Excluded Activities
Notwithstanding the qualification of certain activities as R&E under section 174 and their satisfaction of the three additional section 41 requirements, certain activities are specifically excluded from the definition of "qualified research" eligible for the credit.
1. Research After Commercial Production
Except for separate product improvements that independently qualify for the credit, once a business component meets its basic functional and economic requirements or is ready for commercial sale or use, additional research conducted on the product is considered to have been conducted after commercial production and therefore is not eligible for the credit.(56) Examples of research after commercial production are reproduction planning for a finished business component, "tooling-up" for production, trial production runs, "trouble-shooting," and debugging."(57)
2. Adaptation to a Particular Customer
The credit is not available for the costs of adapting an existing business component to the needs of a particular customer.(58) Otherwise qualified research expenses are not disqualified, however, by the fact that a new product is intended for a particular customer.(59)
3. Reverse Engineering
Costs related to the reproduction of an existing business component (in whole or in part) from a physical examination of the business component or from plans, blueprints, detailed specifications, or publicly available information do not qualify for the credit.(60) Applying the reverse engineering exclusion, the IRS has ruled that the costs of developing a generic drug for approval by the Food and Drug Administration under a procedure that does not require a demonstration of safety or effectiveness are not eligible for the credit.(61) The reverse engineering exclusion does not apply if the taxpayer examines a competitor's product as part of an experimentation process that is otherwise qualified (i.e., if a taxpayer tests a competitor's product for the purpose of discovering technological information that will enable it to improve its own product).(62)
4. Management Activities, Efficiency Surveys,
and Market Research
Activities relating to management functions and techniques and efficiency surveys are ineligible for the credit.(63) Management functions and techniques include the preparation of financial data and analysis, development of employee training programs and management organization plans, and management-based changes in production processes.(64)
5. Routine Data Collection and Quality Control
Expenditures for routine data collection and quality control testing do not qualify for the credit.(65)
6. Research Conducted Outside the United States
Since the credit is designed to encourage U.S. industries to invest in research and development, the credit is not available for research conducted outside the United States.(66) The focal point is the location of the research activities for which the credit is claimed, not the location of the taxpayer's business.(67) Costs of in-house research conducted partly within and partly without the United States must be apportioned based on the activities performed in each location, though the wages of an in-house scientist need not be apportioned if substantially all (i.e., 80 percent) of such wages are attributable to qualified research conducted in the United States.(68) Contract research activities conducted both within and without the United States must be similarly apportioned, but are not eligible for the 80-percent rule.(69)
7. Social Sciences, Arts, or Humanities Research
The exclusion of research in the social sciences, arts, or humanities reinforces the requirement that eligible research be conducted in the field of science, engineering, or technology.(70)
8. Funded Research
To the extent a taxpayer's research is funded by another person, the taxpayer is not eligible for the credit with respect to such research.(71) Research is considered fully funded if the taxpayer retains no substantial rights in the research.(72) If a taxpayer retains substantial rights, the research is considered funded to the extent of the payments to which the taxpayer becomes entitled by performing the research.(73) Payments contingent on the success of the research are considered to be paid for the results of the research and therefore are not treated as funding.(74) If a taxpayer can demonstrate that otherwise qualified research expenses for a particular project exceed 65 percent of the funding provided, the taxpayer may allocate the funding pro rata between qualified and nonqualified activities.(75) If the taxpayer cannot demonstrate that qualified activities exceed 65 percent of the funding, however, all funding for a project is allocated to funded qualified research for which the funding source - not the taxpayer - is eligible for the credit.(76)
The recent decision of the Court of Federal Claims in Fairchild Industries, Inc. v. United States,(77) has complicated the issue of when research is considered to be "funded" for purposes of the section 41 credit. In Fairchild, the contract between the taxpayer and the Air Force provided both that progress payments would be made, and that the research results were required to meet specifications before the full target payment would be made.(78) In determining whether payment was "contingent on the success of the research," the court held that the research was funded to the extent of the payments received because, in hindsight, those payments were unrelated to the success of the research.(79) The court's consideration of subsequent events in determining which party actually bore the risk for the research has generated some uncertainty about when contract research is considered to be "funded."
9. Internal Use Computer Software
Except to the extent provided in regulations yet to be issued, internal use computer software (i.e., software developed by or for the benefit of the taxpayer primarily for its internal use) must meet three additional requirements in order to be eligible for the section 41 credit for taxable years beginning after December 31, 1985.(80) Specifically, the software must be developed for use:
* in an activity which is qualified research,
* in a production process that qualifies for the credit, or
* in an integrated hardware-software product.(81)
The legislative history of the 1986 amendments to the credit provision states that the regulations should provide that, for such software to qualify for the credit, the taxpayer must establish that the software is
* involves significant economic risk, and
* was not commercially available for use by the taxpayer.(82)
Software is "innovative" if it results in a quantifiable reduction in cost or improvement in speed that is substantial and economically significant.(83) "Significant economic risk" exists where the taxpayer commits substantial resources to the development of the software and there is substantial uncertainty, because of technical risks, that those resources would not be recovered within a reasonable period.(84) Finally, software is "not commercially available" for use by the taxpayer if the software cannot be purchased, leased, or licensed and used for the taxpayer's intended purpose without modifications that would be innovative and involve significant economic risk.(85) In other words, as a practical matter, if the taxpayer can satisfy the first two tests (innovation and significant economic risk), the third test will likely be deemed satisfied.
C. Types of Expenditures Eligible for the Credit
Once an activity is determined to constitute "qualified research," the activity's costs must be allocated between two categories: (1) in-house research expenses, and (2) contract research expenses.(86) The sum of a taxpayer's in-house and contract research expenses equals its "qualified research expenses" for purposes of computing the section 41 credit. There are certain additional rules relevant to each category.
1. In-House Research Expenses
In-house research expenses include wages for employees performing qualified services, amounts paid or incurred for supplies used in the conduct of qualified research, and any amount paid or incurred for computer timesharing in the conduct of qualified research.(87) Except for computer timesharing, qualified research expenses do not include amounts paid or incurred for the use of personal property.(88)
a. Wages Paid for Qualified Services. Wages paid to an employee for the performance of qualified services are qualified research expenses for purposes of section 41.(89) Qualified services include the actual conduct of qualified research, direct supervision of qualified research and direct support of qualified research. For example, a scientist conducting laboratory experiments engages in the actual conduct of qualified research.(90) A research scientist who directly supervises laboratory experiments, but does not perform the experiments, engages in direct supervision. Supervision by managers other than first-line managers does not qualify as direct supervision, even if those managers are qualified research scientists themselves.(91)
Employees performing services that directly support other employees who are engaged in the performance of qualified research or in direct supervision engages in direct support. Examples of such direct support include a secretary's typing reports detailing qualified research, a laboratory worker's cleaning equipment used directly in qualified research, a clerk's compiling data produced from qualified research, and a machinist's fabricating a part for an experimental model used in qualified research. Direct support does not include general administrative services such as payroll, financial, personnel, or general laboratory cleaning services, nor does it include supervision not qualifying as direct supervision.(92)
* Technical Writers. Technical writers (employed primarily in the computer software industry) are employees responsible for incorporating technical information into the manuals and other documentation necessary for customers using the product. In the view of the IRS, none of the activities performed by technical writers constitutes qualified services.(93)
In reaching this conclusion, the IRS may have misunderstood certain activities typically performed by technical writers. In addition to drafting manuals, technical writers are likely to be involved in recording and documenting the work of the technical personnel who are engaged in a process of experimentation to develop a software product. Inasmuch as the regulations treat a secretary's typing results of qualified research as qualifying direct support,(94) it is very difficult understand why the opposite conclusion is reached concerning activities performed by a technical writer.
* Wage Allocation. In general, if an employee performs both qualified services and nonqualified services, the employee's wages must be allocated between qualified and nonqualified services. The regulations prescribe an allocation based upon the time spent on qualified and nonqualified activities, but also authorize the use of other methods if the taxpayer can demonstrate them to be more appropriate.(95) For example, if an employee is engaged solely to perform two discrete projects, one requiring more skill and expertise than the other, a taxpayer may be justified in allocating a greater proportion of the employee's wages to the more-demanding project. If at least 80 percent of an employee's time is spent performing qualified services, the taxpayer need not allocate the wages of such an employee between qualified and nonqualified services. Rather, under such circumstances, the employee's qualified services are deemed to constitute "substantially all" of the services performed, thus permitting the taxpayer to treat all wages paid to such employee as wages paid for qualified services.(96)
b. Supplies Used in Qualified Research.
Amounts paid or incurred for supplies used by employees performing qualified services are the second component of in-house research expenses. Supplies include any tangible property other than land, improvements to land, or depreciable property.(97) Supplies may be used by employees performing any of the three categories of qualified services (qualified research, direct supervision, and direct support). Supplies that are used for indirect supervision or support or for general and administrative functions do not qualify.(98) Although utility expenses generally are treated as general and administrative expenditures, if a taxpayer can establish that the character of the qualified research required additional, extraordinary expenditures for utilities, the additional expenditures may qualify.(99) For example, the extraordinary cost of utilities for a specialized air purification or cooling system might qualify under this rule.
c. Computer Timesharing
For taxable years beginning after December 31, 1985, payments for the use of personal property are not qualified research expenditures, except for certain amounts paid to other persons for the use of computers in the conduct of qualified research. To qualify, the computer must be owned and operated by someone other than the taxpayer, it must be located off the taxpayer's premises, and the taxpayer must not be its primary user.
2. Contract Research
The second category of qualified research expenses for purposes of the credit is contract research expenses. Contract research expenses are defined as 65 percent of any amount paid or incurred by the taxpayer to any person other than an employee for (1) qualified research or (2) qualified services.(101) Qualifying contract research payments are eligible for the credit only in the taxable year in which the research is actually conducted - taxpayers may not claim the credit for prepaid contract research expenses until the research is performed.(102)
a. Qualified Research
An expense is paid or incurred for the performance of qualified research only to the extent it is paid or incurred pursuant to a prior agreement giving the taxpayer a right to the research results and requiring the taxpayer to bear the risk that the research will not be successful.(103) To the extent that payment is contingent on the success of the research, the taxpayer is considered to be paying for the results of the research rather than for the performance of the research, and the payment is not a contract research expense.(104) For example, if the taxpayer requires its contractors to produce a computer program satisfying detailed design specifications before it is obligated to pay for their research activities and requires the contractors to correct errors it discovers at no additional charge, the taxpayer is essentially buying the successful research results and therefore may not claim the credit.(105)
Because only 65 percent of contract research expenses is treated as qualified research expenses, taxpayers should not be required to allocate the contractor's charges between those related to its qualified research activities and those related to its general or administrative costs. The regulations state that under a cost-plus research contract, the allocable general and administrative expenses of the contract researcher charged in connection with the contract research performed for the taxpayer constitute qualified research expenditures.(106) Nevertheless, at least one IRS Industry Specialist has expressed the view that a contract research organization's general and administrative costs are not properly includible in contract research expenses.(107)
b. Qualified Services
An expense is paid or incurred for qualified services if it is paid to a person other than the taxpayer's employee for services that would constitute qualified services if performed by the taxpayer's employees (i.e., qualified research, direct supervision, or direct support).(108) Amounts paid to a contractor for qualified services are also subject to the 35 percent reduction.(109)
IV. Maximizing the Available Opportunities
Taxpayers that relied on the more-restrictive standards of the 1983 or 1989 proposed regulations in preparing their returns or in negotiating nonbinding settlements for tax years that remain open for claims for refund should reexamine their expenditures in light of the more liberal "uncertainty" standard reflected in the new final regulations. Computer software development expenditures may particularly benefit from the application of the new regulations. Taxpayers planning to claim additional qualified expenditures for prior taxable years (or for current or future years) must carefully develop and document the nature of such expenditures. Moreover, if similar expenditures were incurred in taxable years taken into account in determining the taxpayer's fixed-base percentage, taxpayers must also consider the effect of the section 41 consistency rules.
A. Development of Support
Taxpayers seeking to take advantage of the liberalized final regulations for past, current, and future years' returns should establish a comprehensive program to identify, document, and sustain qualified expenditures. Prospectively, this program should encompass the creation and retention of appropriate documentation for the preparation of tax returns. Taxpayers that wish to apply the more liberal standards of the final regulations to past years' returns, and taxpayers under audit for deductions and credits already claimed, should also implement a retrospective program to identify and retain support for their activities.
A well-considered and -structured documentation program will develop, capture, and retain information supporting qualification for research tax benefits. Perhaps equally important, such a program will minimize the costs of developing information, avoid imposing unduly burdensome administrative responsibilities on researchers and eliminate (or at least reduce) the development of unnecessary information. It is essential that documents be collected or created as a matter of course to describe the goals of the research, the activities that were or will be undertaken to achieve those goals, the uncertainties and risks associated with the research, the individuals involved in the project and their roles, the difficulties and failures encountered during the course of the research, and an explanation of why existing products are inadequate for the desired purpose.
Not surprisingly, most researchers are reluctant to admit, let alone document, their failures. Nevertheless, they should be strongly encouraged to do so because documented failures are persuasive evidence of the "uncertainty" required for qualifying research or experimental expenditures. Similarly, research funding requests are usually viewed as selling tools and therefore emphasize the limited risks involved in an effort to maximize the chances of obtaining funding authorization. Accordingly, they should be scrutinized in writing and supplemented with requests for details regarding the true risks involved in the research, with particular focus on the uncertainties that satisfy the requirements of the final regulations.
1. Potential Sources of Documentation
Obviously, contemporaneous documentation is ideal and will be the most persuasive substantiation to present to an examining agent. Where contemporaneous records are available, taxpayers should capture and preserve such records. Where contemporaneous records are not available or are insufficient, taxpayers should investigate alternative methods of substantiating the nature and cost of the activities performed.
a. Contemporaneous Documentation
Whenever possible, the taxpayer should obtain written, contemporaneous evidence of the activities performed by its employees and contractors, the cost of such activities, and how such activities were designed to eliminate uncertainty. New reports specifically designed to capture the critical information may need to be created. Potential sources of helpful documentation include: time sheets, time cards, job cost analysis sheets, billing details, job descriptions, project descriptions, budget spreadsheets, external project cost data, flowcharts, letters from customers, meeting minutes, news articles, patents and patent applications, release documents, design improvement reports, schedules of releases, staff/budget estimates, technical reports or memos, trial and test reports, and work program cost analyses. Linking accounting records to the records of technical personnel will enable the tax department to document both the nature of the activities and their cost.
b. Alternative Documentation
If contemporaneous records do not fully document the nature of the activities performed, the tax department should gather additional information from the technical employees and contractors who performed the work and from the budgetary or accounting records that substantiate the amount of any claimed deductions or credits. Questionnaires may be used to identify technical personnel with knowledge of potentially qualifying activities. These questionnaires can be used to match particular technical personnel with the projects of which they have knowledge.
Interviews with technical personnel who have been fully educated about the tax requirements regarding activities that qualify as research or experimentation should be performed as soon as the need for the information is discovered, and should routinely be performed when any such personnel leave the taxpayer's employment. These interviews should focus on discovering the nature of the activities performed by the technical personnel and the uncertainties inherent in such activities. Well-documented activities involving uncertainty may qualify even though they do not represent a significant advance in technology. Summaries of the interviews prepared by the tax department or outside counsel should be reviewed and revised for accuracy by the interviews and the final documents should be retained in the tax department's files.
Interviews are also valuable in discovering which of the technical employees with knowledge of a particular project (either researchers or direct supervisors) can articulate the nature of the project in a nontechnical way in terms of the three types of uncertainty under the regulations. These employees will become a valuable resource if an IRS examiner decides to request face-to-face interviews with technical personnel. It is often difficult for an IRS examiner to successfully challenge an articulate technical employee with full knowledge of the research activities undertaken and their relationship to the standards in the final regulations.
c. Record Retention
Copies of records documenting the nature and amount of qualified activities should be segregated and maintained in the tax department. If a separate copy cannot be made for the tax department, an index of such records should be created and maintained by the tax department. In any event, all relevant records should be subject to a clear nondestruction policy until notification from the tax department that a particular tax year is closed.
2. Sustaining Expenditures on Audit
In auditing a taxpayer's R&E expenditures, the IRS will seek documentation of the expenditures and may also seek to conduct its own interviews with the taxpayer's technical employees. If the IRS requests interviews, the taxpayer should attempt to participate in the formulation of the IRS questions and should prepare the interviews. (selected both for knowledge of the relevant project and for the ability to articulate the project in nontechnical, tax-related terms) in advance of the actual interviews. Written responses to IRS questions, which can be reviewed by counsel, are preferable to oral interviews.
In cases where a taxpayer claims qualifying expenditures that arise from a large number of research projects, the IRS frequently will seek to reach an agreement with the taxpayer to audit a statistical sample of the projects. Since the results of this audit will be extrapolated to all of the taxpayer's potentially qualifying activities, it is critical to work closely with the examiners to formulate an acceptable sampling methodology, including a representative sampling population.
3. Additional Potential Litigation Considerations
Taxpayers undertaking a reexamination of their research activities under the more liberal standard found in the final regulations should be mindful of the potential necessity of litigation to establish their entitlement to additional deductions or credits, particularly when claiming a refund of significant magnitude. Accordingly, taxpayers should take steps to ensure that documentation of their research activities is sufficiently detailed to substantiate such expenditures and is potentially admissible in evidence. To the extent possible, taxpayers should also seek to preserve the confidentiality of communications between the taxpayer's employees or consultants and in-house or outside counsel.(110)
B. Applicability of the Consistency Rules
Finally, taxpayers that incur expenditures for similar activities in the same projects over multiple taxable years should consider the application of the section 41 consistency rules to any claimed increase in qualified expenditures. For taxable years after 1989, expenditures must be treated consistently for purposes of the current year's research expenditures and for purposes of calculating the fixed-base percentage.(111) Even if the prior years are closed, the taxpayer must recalculate the fixed-base percentage by treating expenditures consistently.(112) Neither regulations nor the legislative history(113) define the types of expenditures to which a taxpayer is required to give consistent treatment or the precise manner in which such consistency will be determined.
The new final R&E regulations represent a significant liberalization of the standards found in the 1983 and 1989 proposed regulations. Taxpayers may gain a significant benefit from the application of the new regulations' uncertainty standard to current and past expenditures.
In addition, the adoption of the final regulations should minimize many of the disputes that arose from the commonly stringent application of the restrictive 1983 and 1989 proposed regulations by examiners. Nevertheless, because retroactive application of the 1994 final regulations may produce significant refund claims and increased deductions and credits claimed in future years, taxpayers must prepare and develop a comprehensive program for the collection, retention, and presentation of the data and documentation necessary to support such claims.
(1) Staff of the Joint Committee on Taxation, 99th Cong., 2d Sess., General Explanation of the Tax Reform Act of 1986, at 130 (Comm. Print 1987). (2) I.R.C. [sections] 174(a); Treas. Reg. [sections] 1.174-3(a). (3) I.R.C. [sections] 174(b); Treas. Reg. [sections] 1.174-4(a). (4) For taxable years beginning before January 1, 1986, the research tax credit was found in section 30. For taxable years beginning before January 1, 1984, the research tax credit was found in section 44F. Although slightly different rules apply for calculation of the credit for past years, the definition of "research or experimental expenditures," which is the primary focus of this article, has not changed by reason of the statutory changes. For convenience, this article refers to section 41 and its predecessors as "section 41." (5) I.R.C. [sections] 41(a). For taxable years beginning after December 31, 1990, the base amount is calculated by multiplying the ratio of the taxpayer's total qualified expenditures to total gross receipts for its 1984 through 1988 tax years by the taxpayer's average gross receipts for the four years preceding the current taxable year. I.R.C. [sections] 41(c). The base amount may not be less than 50 percent of the taxpayer's qualified research expenditures for the current year. I.R.C. [sections] 41(c)(2). The base amount must be calculated on a controlled group basis, and must be adjusted for acquisitions and dispositions of businesses. I.R.C. [sections] 41(f). There are also special rules for start-up companies. I.R.C. sections] 41(c)(3)(B). In addition, to ensure that the credit is computed with reference to an incremental increase of qualified expenditures over the base period, certain consistency rules apply. I.R.C. sections] 41(c)(4).
The section 41 credit is scheduled to terminate as of June 30, 1995. I.R.C. [sections] 41(h). In the past, however, the credit has always been extended, often retroactively. The latest extension occurred in 1993 and retroactively extended the credit from July 1, 1992, through June 30, 1995. Omnibus Budget Reconciliation Act of 1993, Pub. L. No. 103-66, [sections] 13111, 107 Stat. 312, 420. Two bills to permanently extend the credit are currently pending. H.R. 803, 104th Cong., 1st Sess.; S. 351, 104th Cong. 1st. Sess. (6) Under current law, the deduction under section 174 for qualified research expenses is reduced by the amount of the section 41 credit for the year. I.R.C. [sections] 28OC(c)(1). For taxable years beginning before January 1, 1990, the section 174 deduction was only reduced by 50 percent of the credit for the year. (7) I.R.C. [subsections] 174(a) & (b), 41(d)(1)(A). (8) In enacting the predecessor to section 41 in 1981, the Senate Finance Committee said Treasury was expected to provide additional guidance "not inconsistent with existing regulations," defining R&E expenditures. S. Rep. No. 144, 97th Cong., 1st Sess. 81 (1981) (hereinafter cited as "1981 Senate Report"). (9) T.D. 8562, 59 Fed. Reg. 50159 (Oct. 3, 1994). (10) T.D. 6255, 22 Fed. Reg. 7901 (Oct. 4, 1957). This language has been restated in the new final regulations. Treas. Reg. [sections] 1.174-2(a)(1). (11) 58 Fed. Reg. 15819 (Mar. 24, 1993). (12) The 1983 proposed regulations were proposed to be effective for taxable years after 1953 and were published at 48 Fed. Reg. 2790 (Jan. 21, 1983). They were withdrawn upon the issuance of the 1989 proposed regulations. 54 Fed. Reg. 21224 (May 17, 1989). (13) Prop. Reg. [sections] 1.174-2(a)(1) (1983). The 1983 proposed regulations were influenced by the legislative history of section 41 and by the financial accounting rules for research and development expenditures. See David S. Hudson, The Tax Concept of Research or Experimentation, 45 Tax Law. 85, 97-106 (1990). (14) Prop. Reg. [subsections] 1.174-2(a)(1)(i)-(xi) (1983). (15) See 54 Fed. Reg. 21225 (May 17, 1989) (preamble to the 1989 proposed regulations). (16) Prop. Reg. [subsections] 1.174-2(a)(3) & (4) (1983). (17) The 1989 proposed regulations were published at 54 Fed. Reg. 21224 (May 17, 1989) and were withdrawn in 1993. 58 Fed. Reg. 15819 (Mar. 24, 1993). (18) Prop. Reg. [sections] 1.174-2(a)(1) (1989). (19) Prop. Reg. [subsections] 1.174-2(a)(3)(i)-(xi) (1989). (20) Prop. Reg. [sections] 1.174-2(a)(1) (1989). (21) See 58 Fed. Reg. 15819 (Mar. 24, 1993) (preamble to 1993 proposed regulations). (22) In the preamble to the 1989 proposed regulations, the IRS announced that it was studying whether to apply a different test to software. 54 Fed. Reg. at 21224. (23) Treas. Reg. [sections] 1.174-2(a)(1). See also 59 Fed. Reg. 50168 (Oct. 3, 1994). (24) Treas. Reg. [sections] 1.174-2(a)(1). The final regulations clarify that the reasonableness requirement of section 174(e) applies only to the reasonableness of the amount spent for research. The regulations confirm that there is no objective reasonableness requirement applicable to the type or nature of the activities for which the expenditure was incurred. Treas. Reg. [sections] 1.174-2(a)(6). (25) Bush v. Commissioner, 68 T.C.M. (CCH) 974, 977-78 (1994). (26) Universal Research & Dev. Partnership No. 1 v. Commissioner, 62 T.C.M. (CCH) 661 (1991). (27) The final regulations define "quality control testing" as "testing or inspection to determine whether particular units of materials or products conform to specified parameters." The regulations make clear that testing to determine whether the design of a product is appropriate is not quality control testing and thus remains eligible. Treas. Reg. [sections] 1.174-2(a)(4). (28) Treas. Reg. [subsections] 1.174-2(a)(3)(i)-(vii). (29) See Treas. Reg. [sections] 1.174-2(a)(3). (30) 58 Fed. Reg. 15820 (Mar. 23, 1993) (preamble to 1993 proposed regulations). None of those activities, however, is eligible for the section 41 credit. See I.R.C. [sections] 41(d)(4) and part III.B., infra. (31) 1987-1 C.B. 432. (32) 1969-2 C.B. 303. The preamble to the 1989 proposed regulations cautioned that the IRS was considering revoking Rev. Proc. 69-21. 54 Fed. Reg. 21224. (33) H.R. Rep. No. 841, 99th Cong., 2d Sess. II-74 (1986) (Conference Report on Tax Report Act of 1986) (hereinafter cited as "1986 Conference Report"). (34) The preamble to the 1993 proposed regulations stated that the IRS has "no present intention of changing its administrative position contained in Rev. Proc. 69-21, but continues to study its viability." 58 Fed. Reg. 15820 (Mar. 24, 1993). (35) 24 Cl. Ct. 804 (1991). (36) Id. at 806. (37) The availability of the section 41 credit for internal use computer software, however, continues to be significantly restricted. See I.R.C. [sections] 41(d)(4)(E) and part III.B.9., infra. (38) 59 Fed. Reg. 50160 (Oct. 3, 1994). (39) Of course, such representations are not binding. Field agents have generally applied first the 1993 proposed regulations and now the final regulations retroactively. The retroactive application of the 1994 regulations, however, is a less than uniform practice, particularly among some agents who had aggressively applied the more restrictive requirements of the 1983 and 1989 proposed regulations.
(40) 1981 Senate Report 81. (41) I.R.C. [subsections] 41(d)(1)-(3). (42) I.R.C. [sections] 41(d)(1)(B). (43) 1986 Conference Report II-71. The mere use of a computer does not mean that an activity relies on the principles of computer science; research must be intended to expand or refine existing principles of computer science. Id. at II-71 n.3. (44) Id. at II-71 to -72. Cf. TSR, Inc. v. Commissioner, 96 T.C. 903, 912-21 (1991) (finding, under section 44F prior to amendment in 1986, that the taxpayer's development and play-testing of adventure games and its evaluation of metals, paints, and glues for use in such games did not qualify for the credit because the activities were not scientific or technological). (45) 1986 Conference Report II-71 n.3. (46) Id. at II-72. (47) I.R.C. [sections] 41(d)(1)(C). (48) 1986 Conference Report II-72. (49) Id. (50) Id. (51) I.R.C. [sections] 41(d)(3). (52) Id. (53) I.R.C. [sections] 41(d)(2)(B). (54) I.R.C. [sections] 41(d)(2)(C). (55) 1986 Conference Report II-72 to -73. (56) I.R.C. [sections] 41(d)(4)(A); 1986 Conference Report II-74 to -75. The credit is intended to encourage taxpayers to initiate or expand research programs where the relationship between the investment and the subsequent earnings of a product is not assured. H.R. Rep. No. 201, 97th Cong., 1st Sess. 112 (1981) (hereinafter cited as "1981 House Report"); 1981 Senate Report 77. The exclusion for research after commercial production may reflect a recognition that such research is more closely tied to earnings from the production of the product. (57) 1986 Conference Report II-74 to -75. (58) I.R.C. [sections] 41(d)(4)(B). (59) 1986 Conference Report II-75. (60) I.R.C. [sections] 41(d)(4)(C). (61) Letter Ruling No. 9346006 Aug. 13, 1993). (62) 1986 Conference Report II-75. (63) I.R.C. [subsections] 41(d)(4)(D)(i) & (ii). (64) 1986 Conference Report II-75. (65) I.R.C. [subsections] 41(d)(4)(D)(iv) & (v). (66) I.R.C. [sections] 41(d)(4)(F). (67) 1981 House Report 116. (68) Treas. Reg. [sections] 1.41-5(b)(1). (69) Treas. Reg. [sections] 1.41-5(b)(2). The same limitation does not apply for purposes of the section 174 deduction. In addition, R&E expenditures must be allocated and apportioned between U.S. source and foreign source income. See Treas. Reg. [sections] 1.861-8(e)(3). But see St. Jude Medical Inc. v. Commissioner, 34 F.3d 1394 (8th Cir. 1994) (Treas. Reg. [sections] 1.861-8(e)(3) held invalid as applied to DISC combined taxable income computations), nonacq. 1995-1 I.R.B. 4. (70) I.R.C. [sections] 41(d)(4)(G); Treas. Reg. [sections] 1.41-5(c). (71) I.R.C. [sections] 41(d)(4)(H). (72) Treas. Reg. [sections] 1.41-5(d)(2). (73) Treas. Reg. [sections] 1.41-5(d)(3)(i). (74) Treas. Reg. [sections] 1.41-5(d)(1). (75) Treas. Reg. [sections] 1.41-5(d)(3)(ii). (76) Treas. Reg. [sections] 1.41-5(d)(3)(i). (77) 30 Fed. Cl. 839 (1994), appeal pending. (78) Id. at 849. (79) Id. at 850. (80) The regulations, when issued, will reflect the legislative history. Notice 87-12, 1987-1 C.B. 432. (81) I.R.C. [sections] 41(d)(4)(E); 1986 Conference Report II-73 to -74. (82) 1986 Conference Report II-73. (83) Id. (84) Id. (85) Id. (86) I.R.C. [sections] 41(b)(1). (87) I.R.C. [sections] 41(b)(2)(A). (88) Treas. Reg. [sections] 1.41-2(b)(4). (89) I.R.C. [sections] 41(b)(2)(D)(i). Compensation subject to withholding under section 3401(a), such as the income generated on the exercise of nonqualified stock options or the amount of incentive bonuses, constitutes "wages" for purposes of section 41. Apple Computer, Inc. v. Commissioner, 98 T.C. 232 (1992), acq. 1992-2 C.B. 1; Letter Ruling No. 9018003 (Jan. 23, 1990). Compensation not subject to withholding under section 3401(a), such as certain fringe benefits, does not constitute "wages." 1981 House Report 116; 1981 Senate Report 78.
The Tax Court recently held that compensation from the disqualifying disposition of qualified stock options constitutes "wages" for purposes of section 41 even though it is not subject to withholding under Notice 87-49, 1987-2 C.B. 355, and Rev. Rul. 71-52, 1971-1 C.B. 278. Sun Microsystems Inc. v. Commissioner, T.C. Memo 1995-69 (Feb. 13, 1995). (90) Treas. Reg. [sections] 1.41-2(c)(1). (91) Treas. Reg. [sections] 1.41-2(c)(2). (92) Treas. Reg. [sections] 1.41-2(c)(3)(ii). (93) Data Processing Industry Coordinated Issue Paper, Wages of Technical Writers and the R&E Credit (1992). (94) Treas. Reg. [sections] 1.41-2(c)(3)(ii). (95) Treas. Reg. [sections] 1.41-2(d)(1). (96) Treas. Reg. [sections] 1.41-2(d)(2). (97) I.R.C. [sections] 41(b)(2)(c). Neither the cost of acquisition of depreciable property nor depreciation allowances for such property are eligible for the credit, whether or not amounts of depreciation are deductible during the year and whether or not the cost of such property can be "expensed." 1981 House Report 118. (98) Treas. Reg. [sections] 1.41-2(b). (99) Treas. Reg. [sections] 1.41-2(b)(2). (100) Treas. Reg. [sections] 1.41-2(b)(4). (101) I.R.C. [sections] 41(b)(3); Treas. Reg. [sections] 1.41-2(e). (102) I.R.C. [sections] 41(b)(3)(B); Treas. Reg. [sections] 1.41-2(e)(4). (103) Treas. Reg. [subsections] 1.41-2(e)(2) & (3). (104) Treas. Reg. [sections] 1.41-2(e)(2). (105) Letter Ruling No. 9449003 (Aug. 25, 1994). (106) Treas. Reg. [sections] 1.41-2(e)(5) (Example 3). (107) Utilities Industry Coordinated Issue Paper, Membership Payments Made to Industry-Created Research Organizations (1993). (108) Treas. Reg. [sections] 1.41-2(e)(1)(ii). (109) Treas. Reg. [sections] 1.41-2(e)(1). (110) Two recent decisions illustrate the application of the attorney-client privilege to tax planning communications with outside consultants. The U.S. District Court for the Southern District of New York held that a taxpayer was not entitled to the attorney-client privilege for communications between in-house tax counsel and an outside accounting firm. United States v. Adlman, 94-2 U.S.T.C. (CCH) [paragraph] 50,389 (S.D.N.Y 1994). The Adlman case currently is on appeal to the Second Circuit. See Brief Amicus Curiae of the Tax Executives Institute, 46 Tax Executive 400 (1994). The U.S. District Court for the Northern District of California, on the other hand, held after an in-camera review that a taxpayer's outside counsel's communications with an outside accounting firm were covered by both the attorney-client privilege and the work product doctrine. United States v. Bell, 95-1 U.S.T.C. (CCH) [paragraph] 50,006 (N.D. Cal. 1994).
These decisions highlight the importance of a clear expression of purpose to protect communications with outside consultants. To increase the likelihood that the attorney-client privilege will apply to such communications, the agreement engaging the consultant should clearly state that the consultant is retained to assist the taxpayer's counsel (whether in-house or outside) in rendering legal advice and the consultant's reports should be used only for that purpose. (111) I.R.C. [sections] 41(c)(4). (112) Id. (113) See H.R. Rep. No. 247, 101st Cong., 1st Sess. 1202 (1989).
BRADLEY M. SELTZER is a partner in the Washington, D.C. office of Sutherland, Asbill & Brennan. He received a B.A. degree from the State University of New York in Albany and a J.D. degree with honors from the George Washington University National Law Center. Mr. Seltzer is Chair of the ABA Section of Taxation's Committee on Regulated Public Utilities, and is a Barrister member of the J. Edgar Murdock Inn of Court (which is dedicated to tax litigation). He has previously written for the Tax Executive.
DAVID A. GOLDEN is a partner in the Washington, D.C. office of Sutherland, Asbill & Brennan. He received a B.B.A. degree from Georgia State University and a J.D. degree, magna cum laude, from the University of Georgia School of Law, where he served as an editor of the Georgia Law Review.
MARY E. MONAHAN is associated with the Washington, D.C. office of Sutherland, Asbill & Brennan. She received an A.B. degree from Geogetown University and a J.D. degree with high honors from the George Washington University National Law Center, where she served as an editor of The George Washington Law Review.
|Printer friendly Cite/link Email Feedback|
|Author:||Monahan, Mary E.|
|Date:||Mar 1, 1995|
|Previous Article:||Venturing into a paperless office.|
|Next Article:||Responding to the new subsidiary investment and earnings and profits consolidated return regulations.|