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Proposed regulations relating to the computation of the research credit and the definition of qualified research.

March 31, 1999

On March 31, 1999, Tax Executives Institute submitted the following comments to the Internal Revenue Service concerning proposed regulations relating to issues related to the research tax credit. The Institute's comments were prepared under the aegis of TEI's Federal Tax Committee, whose chair is Philip G. Cohen of Unilever United States Inc. Contributing substantially to the development of TEI's comments were Andrew J. Ford and James A. Ramsey of General Motors Corporation, Paul Cherecwich, Jr. of Cordant Technologies Inc., and Eileen D. Frack of Kimberly-Clark Corp. Also contributing were Jim Aden of Willamette Industries, Kathy Berning of Sequent Computer Corporation, H.J. Cockrell of Longview Fibre Company, and Raymond G. Rossi and David L. Klausman of Intel Corporation.

On December 2, 1998, the Internal Revenue Service issued proposed regulations (REG-105170-97) relating to the computation of the research credit for increasing research activities under section 41(c) of the Internal Revenue Code and the definition of qualified research under section 41(d). The proposed regulations set forth rules relating primarily to the amendments to section 41(d) made by the Tax Reform Act of 1986 (the 1986 Tax Act), but they also address amendments to section 41 made by the Revenue Reconciliation Act of 1989 (the 1989 Tax Act), the Small Business Job Protection Act of 1996 (the 1996 Tax Act), and the Taxpayer Relief Act of 1997 (the 1997 Act). The proposed rules were published in the FEDERAL REGISTER (63 Fed. Reg. 66503) and in the INTERNAL REVENUE BULLETIN (1998-50 I.R.B. 10). A hearing on the proposed regulations is scheduled for April 29, 1999. Tax Executives Institute is pleased to provide the following comments on the proposed rules.

Background

Tax Executives Institute is the preeminent association of business tax executives in North America. Our more than 5,000 members represent 2,800 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the proposed regulations on the research credit. Indeed, TEI has a vital interest in ensuring that the salutary incentive effect of the research credit is properly implemented. Over the years, the Institute has submitted a plethora of comments on various aspects of the research credit as well as on the need for guidance under section 41(d). Most recently, on June 9, 1997, TEI submitted comments to the Internal Revenue Service on proposed regulations relating to the eligibility of internal-use software for the research credit.(1) Included in those comments is a draft of proposed regulations defining qualified research under section 41. Specifically, the Institute undertook to develop for the government's consideration both the operative rules and illustrative examples that we believe comport with the 1986 Tax Act changes. Included as Appendix 2 to these comments is an excerpt from that submission related to qualified research activities, which we again commend for your consideration.

Summary of TEI's Recommendations

The proposed regulations on qualified research activities are concise, but evoke a host of issues that TEI believes will expand the scope and degree of disputes about taxpayers' qualified research activities. Our concerns are set forth in the detailed comments and recommendations that follow. In summary, TEI recommends that the government:

* Modify the statement of basic principles in Prop. Reg. [sections] 1.41-4(a) to minimize confusion and eliminate the perception that it erects an independent test for qualified research unsupported by section 41(d);

* Abandon the "common knowledge" test in Prop. Reg. [sections] 1.414(a)(3) because it (1) distends the statute and undermines the congressional intent expressed in the legislative history and (2) is wholly unadministrable;

* Clarify the process-of-experimentation rule by ameliorating the requirement that taxpayers "record the results" of their experiments because the proposed rule (1) likely conflicts with taxpayers' current recordkeeping practices, which revenue agents have examined and accepted, and (2) will require taxpayers to augment their current recordkeeping practices if not create entirely new "books and records";

* Adopt a simpler, consistent definition of gross receipts based generally on line 1(c) of Form 1120;

* Modify the rules regarding non-qualified activities and adaptation; and

* Consider revising the currently proposed rules by including the examples set forth in Appendix 1 or consider substituting for the proposed rules all or parts of TEI's draft of proposed regulations for qualified research that are set forth in Appendix 2. [Note: Appendix 2 does not appear in this issue of The Tax Executive. The information contained in Appendix 2 is identical to a TEI submission made June 9, 1997, that was reprinted on pages 332-36 of the July-August 1997 issue of The Tax Executive.]

Overview

The research credit was enacted by Congress in 1981 in order to provide an incentive to taxpayers for increasing their research activities within the United States. Now contained in section 41 of the Internal Revenue Code, the research credit is equal to the sum of (i) 20 percent of the excess of the taxpayer's qualified research expenses for the taxable year over a base amount and (ii) 20 percent of the taxpayer's basic research payments. "Qualified research expenses" include in-house expenses for wages paid and supplies used in the conduct of qualified research, and 65 percent of any contract expenses for qualified research.(2)

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

Given the menagerie of amorphous concepts and terms in the research credit -- for example, "process of experimentation," "technological in nature," "innovative," "significant economic risk," and "commercially available" -- it is unsurprising that disputes have arisen between taxpayers and the IRS concerning the meaning and application of section 41. These disputes have been underscored by what TEI and its members perceive as a historical aversion of the IRS National Office and field personnel to implement the research credit in a manner fully consistent with the congressional intent to provide an incentive for increasing research activities. Significantly, we believe that the scope and degree of disputes have been exacerbated by the lack of formal guidance from the IRS. Without meaningful guidance in the nearly two decades since the credit was enacted, IRS agents have adopted differing (and generally restrictive) views of what constitutes qualified research activities and expenditures.(3) Consequently, although TEI has serious reservations about some aspects of the proposed regulations, we commend the IRS for seeking to fill the guidance void by promulgating proposed regulations relating to the eligibility of various research activities for the credit.(4)

While many aspects of the proposed regulations comport with the legislative history and clarify the statutory language, there are significant areas where the regulations depart from the legislative history, adding new concepts, terminology, and requirements that were not contemplated by Congress. The statutory language and committee explanations of the fundamental definitions and threshold tests adopted in the 1986 Tax Act were developed with great care over a three-year period. Congressional tax staff, Treasury and IRS staffs, and knowledgeable tax professionals discussed at length the purposes and precise wording of nearly every sentence, refining the statute and the explanation at each stage of the legislative process. From those discussions, which are reflected in the legislative history to the 1986 Tax Act, a careful balance emerged between providing an incentive for research activities directed at producing innovative products and processes and erecting curbs against claims for activities that did not warrant incentives. In TEI's view, the regulations should track as closely as possible with the legislative history and the IRS should avoid devising new approaches, introducing vague new definitions, or adopting tests that were not contemplated in connection with the 1986 Act. Exceeding the final legislation by introducing new restrictions and complexities would be inconsistent with congressional intent. Consequently, we urge the IRS and Treasury to revise the regulations along the lines set forth below.

Basic Principles

Prop. Reg. [sections] 1.41-1(a), which adds a statement of basic principles pertaining to the entire body of research credit regulations, states in part:
 The credit [for increasing research activities] is intended to encourage
 business firms to perform the technological research necessary to increase
 the innovative qualities and efficiency of the U.S. economy. The credit
 provides an incentive for business firms to increase their expenditures for
 research to obtain new knowledge through a scientific process of
 experimentation. Consequently, the credit is not to be applied too broadly
 or in a manner such that virtually any expense relating to the development
 of a product is eligible for the credit, even if some portion of the
 expense of developing the product does qualify for the credit. (Emphasis
 supplied.)


The statement of "basic principles" is comparable to a preamble that the IRS generally provides in connection with proposed or final regulations. Such principles generally explain the operative rules in the regulations or justify underlying policy decisions. Propounding the vague statement quoted above as a preface to the regulations governing the research credit intimates that it should be viewed as an independent test that research expenditures must satisfy to qualify for the credit. Since the statement can easily be misinterpreted, it will likely engender confusion and uncertainty both for taxpayers and IRS examiners.

For example, assume that an examiner carefully reviews a taxpayer's claim that $10 million in expenditures to develop a new product qualify for the credit. After examining the facts and applying the four-part test of section 41(d), the agent tentatively concludes that 90 percent of the expenditures qualify. Nonetheless, if Prop. Reg. [sections] 1.41-1(a) is viewed as setting forth a separate test, an examiner might conclude that he or she is applying the credit "too broadly" or "in a manner such that virtually any expense" (here, 90 percent) relating to the product is eligible. Hence, even though the $9 million in expenditures meets all the statutory requirements, an agent might improperly reduce the qualifying expenditures to permit a lesser amount.

Promulgating a statement of vague "basic principles" with implicit instructions not to allow too much credit will undermine the salutary incentive effect of the credit. When Congress adopted the current tests for qualifying activities in the 1986 Tax Act, it concededly intended to limit the scope of the research credit for some types of product development expenditures. That said, the importance of the credit in spurring the U.S. economy by promoting globally competitive products and processes has been consistently reaffirmed by Congress and the White House. Consequently, if a taxpayer satisfies the four-part statutory tests of section 41(d), the taxpayer is entitled to the credit for the full amount of its expenditures. In TEI's view, the statement of basic principles will spawn unnecessary controversy between taxpayers and revenue agents and undermine the credit's incentive effect. Consequently, we recommend that the excerpt of Prop. Reg. [sections] 1.41-1(a) quoted above be deleted. Indeed, the only unarguable statements are the first and last sentences of Prop. Reg. [sections] 1.41-1(a) (which are not reproduced).

At a minimum, the italicized words and sentence in Prop. Reg. [sections] 1.41-1(a) noted above should be deleted. The last quoted sentence should be deleted for the reasons explained above. In addition, the word necessary in the first sentence implies that taxpayers' conduct unnecessary research and intimates that revenue agents can disqualify research activities that are not "necessary to increase the innovative qualities and efficiency of the U.S. economy." In other words, an agent might be emboldened to make judgments about whether a taxpayer's research is "good," "bad," "necessary," or "unnecessary" for the economy. The question whether research is necessary should be entirely within the exercise of the taxpayer's business judgment.(5) We do not believe that revenue agents should second guess that business judgment with a subjective standard that is unsupported by the statute. Finally, the word scientific in the second sentence should be deleted. Section 41(d) requires only that a taxpayer employ a "process of experimentation;" there is no requirement that the experimental process employed be "scientific." Taxpayers often conduct engineering and manufacturing process experimentation in a fashion that may not qualify in the laboratory or textbook definition of a "scientific" process of experimentation. Hence, the inclusion of the adjective "scientific" can only lead to additional controversy over the process of experimentation that must be undertaken in order to satisfy section 41. Additional comments on the process of experimentation are set forth below.

Qualified Research

Section 41(d)(1) provides that the term "qualified research" means research:
 (A) with respect to which expenditures may be treated as research and
 experimental expenditures under section 174;

 (B) that is undertaken for the purpose of discovering information

 (i) that is technological in nature, and

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

 (C) substantially all of the activities of which constitute elements of a
 process of experimentation for certain enumerated purposes.


Prop. Reg. [sections] 1.41-4 provides guidance on the generally applicable four-part statutory test of sections 41(d)(1) to (4) for determining the eligibility of "qualified research" activities. In many cases, the proposed rules are helpful in explaining the statutory provisions and, as important, conform with congressional intent in enacting the credit. In several instances, however, the proposed rules introduce vague concepts to a statute already plagued by nebulous terms. In other places, the proposed rules adopt strained interpretations or engraft new -- and in some cases redundant -- tests for qualified research. As a result, the proposed rules undermine the incentive effect of the credit.

1. The Common Knowledge Test is Significantly Flawed. Prop. Reg. [sections] 1.41-4(a)(2)(i) states that "research constitutes qualified research only if it is research (i) with respect to which expenditures may be treated as expenses under section 174, see [sections] 1.174-2." Consequently, Prop. Reg. [sections] 1.41-4(a)(2)(i) is a restatement of subparagraph 41(d)(1)(A). Likewise, Prop. Reg. [subsections] 1.41-4(a)(2)(ii) and (iii) restate subparagraphs 41(d)(1)(B) and (C).

Under Treas. Reg. [sections] 1.174-2(a), "[e]xpenditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product." Hence, an expenditure "intended to discover information that eliminates uncertainty concerning the development or improvement of a product" should seemingly satisfy section 41(d), especially given the direct cross reference to section 174 in subparagraph 41(d)(1)(A). That is to say, if an expenditure meets the section 174 definition of research undertaken to discover information, it should also satisfy section 41(d) if it is undertaken to discover information that is technological in nature and intended to improve a business component. Nonetheless, Prop. Reg. [sections] 1.41-4(a)(3) states that "for purposes of section 41(d) ... the term discovering information means obtaining knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of technology or science." The definition of discovering information in Prop. Reg. [sections] 1.41-4(a)(3) applies to both Prop. Reg. [subsections] 1.41-4(a)(i) and (ii) and, by extension, to both subparagraphs 41(d)(1)(A) and (B) of the statute. But, if an expenditure satisfies subparagraph 41(d)(1)(A) of the statute -- i.e., it is an expenditure that may be treated as an expense under section 174 -- then subparagraph 41(d)(1)(B) of the statute should not require a separate or independent "discovery" test. In other words, by isolating the words "discovering information" from the context of section 41(d)(1), the regulations articulate a new and overreaching test: that research activities are eligible for the credit only where the activities obtain "knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of technology or science." The common knowledge test should be deleted because (1) it is unsupported by a proper reading of the statute and legislative history and (2) it is unadministrable.

A. The "Common Knowledge" Threshold is Inconsistent with Congressional Intent.

Section 41(d) provides that, to be eligible for the research credit, an activity must do more than satisfy the definition of research and experimental expenditures for purposes of section 174. It must also be undertaken for the purpose of discovering information that is technological in nature, the application of which is intended to be useful in development of a new or improved business component of the taxpayer. Nonetheless, there is no statutory requirement that credit-eligible research involves "discovering information that exceeds, expands, or refines common knowledge." Moreover, the legislative history of the 1986 Act does not support or even intimate such a test. Although the "discovery" test incorporated in Prop. Reg. [sections] 1.41-4(a)(3) seems to restate tests developed by courts in the absence of broadly applicable guidance from the IRS,(6) this approach was marginalized by Congress just last year. Hence, the legislative history of the Tax and Trade Relief Extension Act of 1998 (hereinafter the 1998 Act) -- which extended the research credit from July 1, 1998, through June 30, 1999(7) -- rejected the "discovery" test as articulated in those decisions. Specifically, the conference report to the 1998 Act states that otherwise qualifying "research activities intended to achieve a result that already has been achieved by other persons but is not yet within the common knowledge (e.g., freely available to the general public) of the field ..." will qualify for the credit.(8) That legislative history is specifically intended to address situations where the goal of a taxpayer's research activity has already has been achieved by one taxpayer, and states that the latter taxpayer's research still qualities unless the information is freely available to the general public. In other words, Congress was well aware of the court decisions articulating an expansive "discovery" test and rejected the notion that qualified research must "exceed, expand, or refine the common knowledge of skilled professionals in a particular field...." As a result, TEI believes that if a taxpayer's activities qualify as "research" under the section 174 definition, then the activities have, ipso facto, been undertaken to discover information in the sense required under section 41, and should, if intended to produce information that is "technological in nature" and useful in the development of a new or improved business component, qualify for the credit unless a separate statutory exclusion under section 41(d)(4) applies. Put another way, it strains congressional intent to have one definition of "discovering information" for purposes of subparagraph 41(d)(1)(A) and another for purposes of subparagraphs 41(d)(1)(B) and (C) of the same statute.

B. Common Knowledge Test Is Unadministrable.

TEI firmly believes that guidance on the definition of qualified research activities should narrow rather than broaden the scope and degree of controversy over qualified research activities. Regrettably, the common knowledge test of Prop. Reg. [sections] 1.41-4(a)(3) introduces a number of vague, undefined terms that can be construed as constituting independent tests for qualified research activities. In TEI's view, the nebulous terms pose a substantial risk of exacerbating audit controversies. In particular, determining whether information is within the "common knowledge" of skilled professionals, determining whether "new" information "exceeds, expands, or refines" that common knowledge, identifying who the relevant "skilled professionals" are, identifying the relevant "particular field" of knowledge being expanded, and determining the relevant "technology or science" being refined may prove problematic. Hence, we question whether taxpayers will be able to comply with these standards and, as important, whether revenue agents will be able to properly evaluate taxpayers' determinations. Assuming that agents are not qualified to assess the judgments that a taxpayer's engineers and scientists provide, the issues will likely be decided through protracted litigation and a battle of expert opinions. Such a scenario is analogous to the disputes that plague transfer-pricing issues under section 482. As a result, we urge the IRS to withdraw the "common knowledge" test as unadministrable.

i. What is Common Knowledge? To illustrate our concern whether anyone -- taxpayers, agents, or the courts -- can discern whether information is within "common knowledge," suppose that a new technological process for manufacturing a product is described in a scientific paper posted on the Internet by a Japanese university, but the paper is not translated to English. Will a U.S. taxpayer seeking to develop what turns out to be an identical or highly similar process lose the anticipated credit for research activities conducted to discover similar information? In other words, is this process within the common knowledge of skilled professionals employed by U.S. taxpayers? What due diligence obligation does the standard impose on taxpayers to ascertain what is common knowledge? As important from the government's perspective, how will revenue agents discover whether information is available at the time that a taxpayer is engaged in its research activities?(9) That issue, in turn, leads to a related question.

ii. When Does "New" Information Become Common Knowledge? Regardless of who is to discern new information from common knowledge, when does a process or information become a matter of "common knowledge" to skilled professionals? Suppose that a new technological process is discussed at an international conference of university physicists in Finland, but a paper describing the process is not published until the following year and then in an obscure Finnish technical journal. On these facts, does information become common knowledge at the time of the conference where the broad outline of the process is first broached, when more details are first published (in Japanese), or later when the information is published in an English-language journal? TEI is greatly concerned that revenue agents will employ hindsight to disallow a taxpayer's research credit merely by asserting that information that is new to the taxpayer is, in fact, common knowledge.(10) Research activities directed toward evolutionary product or process improvements, successful innovations that are rapidly adopted by industry competitors, and similar products introduced at about the same time (regardless of whether they rely on the same research information or depend on similar techniques or processes) will be especially prone to disputes. For example, assume two drug companies announce within six months of one another that they have independently developed a breakthrough treatment for a form of cancer. The second (or even a third or fourth, etc.) company's research activities should not be disqualified unless the information was "freely available to the general public."

iii. Proof of Common Knowledge. As difficult as it will be for IRS examiners who likely are not "skilled professionals" in the relevant "field" and therefore do not possess the knowledge, expertise, or judgment to determine what the state of "common knowledge" among skilled professionals is, it will be equally challenging, if not impossible, for taxpayers to rebut an agent's assertion that the information or process under investigation is not a matter of common knowledge. Moreover, the notion of discovering "knowledge that exceeds, expands, or refines the common knowledge of skilled professionals" implies that the same standard applies to small businesses operating out of basements and garages and to large corporations with a highly educated research staff in locations around the world. This flies in the face of common sense as well as congressional intent. Taxpayers conduct research in order to advance the state of their own knowledge rather than the state of "common knowledge." Hence, Example [sections] of Prop. Reg. 1.41 - 4(a)(8) is problematic from several perspectives. It is especially troubling because it suggests that a taxpayer's proprietary and confidential research activities become known to skilled professionals (i.e., become a part of the base of "common knowledge") even though the product or process has not resulted in a commercial sale of the product. Prior to the commercial production of the tire in Example 8, it is difficult to comprehend how a competitor could even "reverse engineer" the product -- an activity that section 41(d)(4)(C) precludes from qualifying for the credit -- let alone be considered to have reached the stage where the taxpayer's "research" activities no longer qualify. Hence, apart from the conclusory statement in Example 8, it is difficult to determine when or how research activities cross the line from discovering information "intended to exceed, expand, or refine common knowledge" (i.e., constitutes qualified research) to merely discovering information "that would eliminate uncertainty concerning the development or improvement of a product" (i.e., constitutes research activity in the sense of Treas. Reg. [sections] 1.174-2(a), but not section 41(d)).

iv. Who Are the Relevant "Skilled Professionals" and What Are the Requisite Qualifications? The facts presented in Example 1 of Prop. Reg. [sections] 1.41-4(a)(8) are useful in exploring the issue of who are the relevant "skilled professionals" whose common knowledge must be exceeded. Are the relevant professionals only the developers of versatile database access middleware that is the business component being improved? Alternatively, does the relevant group of skilled professionals consist of broader groups of all database developers, all software developers, or all computer engineers and technicians? Based on the regulations, we cannot determine who the relevant class of skilled professionals is whose knowledge must be exceeded.

In addition to determining how broad the group of skilled professionals is, the issue of credentials or qualifications of the skilled professional arises. In some cases, the relevant professional may be a factory floor worker who discovers that a theoretical process is not working properly and undertakes through a trial-and-error process of experimentation to discover a key technological improvement that makes a process feasible. Such activity by a factory worker could be considered a qualified research activity. Moreover, we do not believe that Congress intended to impose a requirement that there be any particular level of formal education or credentials necessary for a person to be considered to be engaged in a research activity. For example, a high school student might develop the key software code instructions leading to the development of a commercially available computer program that becomes a standard computer operating system. We do not believe that the individual's contributions to a particular research activity is any less valuable -- or less than a "qualified research" activity -- simply because the individual lacks a formal degree in computer science, software development, or electrical engineering.

v. What Field of Technology or Science ? Similarly, the meaning of the "particular field of technology or science" may be a source of disputes between taxpayers and field agents. Example 3 of Prop. Reg. [sections] 1.41-4(a)(8), which relates to a company's efforts to identify and manually repair all date fields in its computer software to ensure Y2K compliance and is seemingly the simplest of the examples, fails to identify what the relevant technological field is. At a minimum, if the standard is retained more explanation is required.

2. The Common Knowledge Test Should be Abandoned. We urge the IRS to reconsider whether the term "discovering information" in section 41 requires elaboration apart from that in Treas. Reg. [sections] 1.174-2. As long as research activity is directed at discovering information that is technological in nature and its application will be useful in the development of a new or improved business component of the company, section 41(d)(1)(B) should be satisfied. In TEI's view, the notion of "common knowledge" in the proposed regulations constitutes an unnecessary gloss on the statutory language that does not comport with congressional intent. Hence, we recommend that the "common knowledge" test be rejected.

3. The Regulations Should Create a Safe Harbor or Presumption for Research Leading to a Process or Product that Is Patented or for which Copyrights Are Obtained. Taxpayers generally engage in research activities in order to advance the state of their knowledge, especially in respect of proprietary business components. Occasionally, a taxpayer's research activities will lead to the discovery of information for a product, process, or invention for which a patent may be issued. TEI believes that, if the United States Patent Office is satisfied that a process or invention that is technological in nature qualifies for patent protection, the research activities undertaken to develop that product or process should qualify for the credit. Similarly, software products afforded copyright protection should qualify for the credit. Hence, we recommend that the IRS consider creating a safe harbor for research activities that result in the discovery of information qualifying for patent or copyright protection.(11) At a minimum, the IRS should create a presumption that such research activities qualify. Since most research projects do not culminate in a patentable process or product (or the development of a software product that qualifies for copyright protection), however, the safe harbor should include a statement that no inference should be drawn regarding research activities that do not culminate in the issuance of a patent or produce a copyrighted software product.(12) Finally, once issued, taxpayers frequently continue to improve the patented (or copyrighted software) product or process. Research activities conducted to improve a business component -- even one covered in whole or in part by a patent or copyright -- still qualify for the credit under section 41(d).

4. The Examples Should Clarify the Application of the Common Knowledge Test. If, contrary to TEI's recommendation, the common knowledge test is retained, the examples in the regulations should clarify the application of the "common knowledge" test. Moreover, the regulations should clarify that common knowledge is information that is freely available to the general public in accord with the legislative history of the 1998 Tax Act.

For example, in Example 4 of Prop. Reg. [sections] 1.41-4(a)(8), the availability and means of using a particular material to manufacture certain widgets are deemed to be within "common knowledge." The example concludes, without explanation, that the taxpayer's activities may be treated as expenses for research activities under section 174 (because they are activities to resolve uncertainty in manufacturing the improved widget), but the activities do not qualify for the credit. Without more explanation, it is unclear why the taxpayer in Example 4 is incurring expenditures to duplicate knowledge that is freely available.

Moreover, it is unclear how to distinguish and apply the test as it is illustrated in Example 4 from, say, Example 6, where the taxpayer is seeking to replicate knowledge that is a "closely guarded secret," or from Example 7, where the taxpayer is attempting to manufacture a new machine with a new material. The implication of Example 4 is that the particular taxpayer may lose the credit because, perhaps, its research staff is small or unsophisticated and failed to identify a key article published in an obscure journal. We do not believe Congress intended such a result.

In several examples in Prop. Reg. [sections] 1.41-4(a)(8) where the activity fails to qualify for the credit, the same result would obtain even without the notion of "common knowledge." The taxpayer in Example 3, for example, seemingly fails to meet the process-of-experimentation test. Moreover, the taxpayer in Example 8 may have engaged in activities after the point where the improved tire met its basic functional and economic requirements. In addition, it is unclear from the facts stated in Examples 3 and 4 whether the taxpayer is actually engaged in any research activity. Again, the meaning and role of the "common knowledge" notion are uncertain, and can only lead to frequent and unnecessary disputes.

Finally, if the "common knowledge" test is retained, we recommend that the IRS consider including a more comprehensive example in order to better illustrate the application of that test. Example A in Appendix I restates the "common knowledge" test to comport with the legislative history of the 1998 Tax Act and illustrates its application. Example A also addresses other issues including the proper application of the process-of-experimentation test.

Process of Experimentation

Section 41(d)(1)(C) states that in order for research activities to qualify for the credit "substantially all the activities [must] ... constitute elements of a process of experimentation for a purpose described in [section 41(d)(3)]." Prop. Reg. [sections] 1.414(a)(5) states that a "process of experimentation is a process to evaluate more than one alternative designed to achieve a result where the means of achieving that result are uncertain at the outset." Hence, the proposed rule continues:
 a process of experimentation in the physical or biological sciences,
 engineering, or computer sciences requires that the taxpayer--

 (i) Develop one or more hypotheses designed to achieve the desired result;

 (ii) Design a scientific experiment (that, where appropriate to the
 particular field of research, is intended to be replicable with an
 established experimental control) to test and analyze those hypotheses
 (through, for example, modeling, simulation, or a systematic trial and
 error methodology);

 (iii) Conduct the experiment and record the results; and

 (iv) Refine or discard the hypotheses as part of a sequential design
 process to achieve the end result.


The requirement that a "process of experimentation" satisfy all of the foregoing criteria is troubling. Specifically, the second and third criteria requiring that taxpayers "design a scientific experiment" and "record the results" of their experimentation are over stringent and vary significantly from actual taxpayer practices in respect of commercial or applied research and development.

1. Definition of Process of Experimentation Is too Stringent for Applied Research. The preamble states that, in developing the process-of-experimentation rule, the IRS met with personnel from the National Science Foundation and the National Institute of Standards and Technology.(13) The resulting definition for a process of experimentation reflects the view of scientists engaged in pure or basic research (or contract research funded by a third party) rather than companies under competitive pressure to produce viable products or processes. Significantly, the second step of Prop. Reg. [sections] 1.41-4(a)(5) is too restrictive to reflect the full range of research methods through which hypotheses are tested and analyzed. Alternative methods of experimentation should not be disregarded simply because they do not conform with a clinical or laboratory notion of a scientific experiment. Indeed, depending on the scope of the problem under investigation in the research, there will be significant variation in the sophistication or types of experiments conducted to test hypotheses. As a result, we recommend that the regulations be revised to make the scientific experiment model merely illustrative of one manner in which the statutory requirement of a "process of experimentation" can be satisfied. In other words, the proposed definition should not constitute the exclusive method of experimentation permitted. Specifically, TEI recommends that Prop. Reg. [sections] 1.41-4(a)(5)(ii) be revised to state:
 Design an experiment or test to analyze those hypotheses through, for
 example, modeling, simulation, or a systematic trial and error methodology;


Similarly, Prop. Reg [sections] 1.41-4(a)(5)(iii) should be revised to state: "Conduct the experiment or test.... "

2. Record the Results. The third step of a process of experimentation as defined in Prop. Reg. [sections] 1.414(a)(5) states that taxpayers must record the results of their scientific experiments in a manner that is appropriate for the particular field of science in which the experiments are conducted. Prop. Reg. [sections] 1.41-4(d) adds that the recordkeeping requirements of section 6001 of the Code apply. The preamble explains that "the recording of results is inherent in a process of experimentation to discover information that is technological in nature."(14) As a result, "the requirement to record the results ... is not intended to cause taxpayers to create records that otherwise would not be created."(15)

TEI disagrees with the assumptions stated in the preamble and, moreover, with the requirement that a process of experimentation necessarily requires the taxpayer to record the results in any particular fashion. Together with the general requirement that taxpayers maintain books and records of research in accordance with the standard of section 6001 ("keep all records necessary to support the taxpayer's tax liability"), we believe there is substantial likelihood that the requirement to "record the results" will be applied so stringently that taxpayers' legitimate research credits will be disallowed in a fashion contrary to congressional intent.

Many companies likely do not record, in a systematic, uniform, or rigorous fashion, the many design or process possibilities that are evaluated in connection with developing new or improved business products or processes. Failed experiments in particular are less likely to be extensively or permanently documented in formal memoranda or reports. Rather, an iterative trial-and-error process is designed to identify quickly those processes that have a successful outcome. Hence, although most taxpayers will document successful results in some fashion, only rarely will taxpayers document a formal process of experimentation as extensively or rigorously as that contemplated in the proposed rules.

As important, most businesses likely do not (or did not prior to the announcement of the proposed regulations) have a formal record-retention policy in respect of their experiments since such records do not constitute traditional tax records. For most taxpayers, formal documentation of the research activities takes place in respect of the successful steps in the path to the destination of a viable product or process. Indeed, in some types of research the results of a process of experimentation may be retained solely on a whiteboard in an engineering conference room (or supervisor's office) where the latest experimental goal, hypothesis, problem, or failure is documented by dry-erase marker. Moreover, even where research leads to a successful new business component, documentation may be minimized in order to safeguard the confidentiality of trade secrets and other proprietary information.

The recordkeeping practices for research activities imposed by the proposed regulations (and assumed in the preamble) seemingly reflects, again, the style and practices of structured laboratory research or basic research rather than private-sector product or process research. The aim of the basic scientific research scientist at, say, the National Institute of Standards or the National Science Foundation is to employ a rigorous process of experimentation "that is intended to be replicable with an established experimental control." In other words, the documentation process set forth in the proposed rules reflects the view of those for whom publication or replication of the scientific experiment and results is the principal aim.(16) Contrariwise, in the private sector the goal of research is not to publish but to gain a competitive advantage by bringing superior, higher quality, or lower-cost products to market or improving the process for producing the product. As important, the manner of keeping detailed records of successful experiments are as diverse as the number of products or processes they represent. Hence, the personnel keeping records can be front-line supervisors, engineering task-team members, or hourly production workers. The method of recordkeeping for research activities can be as formal as designated project controls with full descriptions of the project and process to be employed coupled with job-cost accounting, or as loose as simple "run" sheets, productivity reports, maintenance work orders, or even monthly progress reports. TEI believes that the lack of lab books or notes should not create an inference that a taxpayer's bona fide research activities do not qualify.

Finally, the IRS should refrain from imposing additional compliance burdens by creating new recordkeeping requirements. Regrettably, the requirement to "record the results" of a process of experimentation set forth in Prop. Reg. [sections] 1.41-4(a)(5)(iii) combined with the cross-reference in Prop. Reg. [sections] 1.41-4(d) to section 6001's requirement to maintain books and records will likely engender substantial confusion that, notwithstanding the preamble's demurrer, will lead to additional recordkeeping burdens. Section 6001 does not specify the form of books and records that taxpayers must retain; it merely requires a taxpayer to maintain the books and records that it does create and to support the amount of its reported tax liability. Hence, even in the absence of regulations or a formal requirement to "record the results" of a process of experimentation, revenue agents have been able to examine taxpayers' books and records and confirm that taxpayers' research activities qualify for the credit. As a result, we see no reason to adopt a new, and ill-defined, requirement to "record the results" of a process of experimentation. Consequently, TEI recommends that the requirement that a taxpayer "record the results" in Prop. Reg. [sections] 1.41-4(a)(5)(iii) be deleted from the required elements of a "process of experimentation." At a minimum, the regulations should confirm that a taxpayer's current recordkeeping practices and procedures will be considered satisfactory where they have been scrutinized in prior IRS examinations.

Gross Receipts

Prop. Reg. [sections] 1.41-3(c) states that "[f]or purposes of section 41, gross receipts means the total amount, as determined under the taxpayer's method of accounting, derived by the taxpayer from all its activities and from all sources (e.g., revenues derived from the sale of inventory before reduction for cost of goods sold)." Prop. Reg. [sections] 1.41-3(c)(2) specifically excludes from gross receipts, the following items:
 (i) Returns and allowances;

 (ii) Receipts from the sale or exchange of capital assets, as defined in
 section 1221;

 (iii) Repayments of loans or similar instruments (e.g., a repayment of the
 principal amount of a loan held by a commercial lender);

 (iv) Receipts from a sale or exchange not in the ordinary course of
 business, such as the sale of an entire trade or business or the sale of
 property used in a trade or business as defined under section 1221(2); and

 (v) Amounts received with respect to sales tax or other similar state and
 local taxes if, under the applicable state or local law, the tax is legally
 imposed on the purchaser of the good or service, and the taxpayer merely
 collects and remits the tax to the taxing authority.


By including receipts from all the taxpayer's activities and from all sources (such as interest and dividend income), the proposed regulations significantly expand the scope of gross receipts that are considered in determining the credit. This definition is critical since gross receipts are used to develop both the "fixed-base percentage" and "average gross receipts" components for computing the credit.(17) Generally, an expansive definition of gross receipts will reduce the fixed base percentage for most taxpayers and increase the average gross receipts component.

Unless a taxpayer coincidentally used the proposed definition of gross receipts, the net effect will be to require a recomputation of all base period amounts because all the components of the base period are affected by the revised definition. We have two concerns about requiring a recomputation of the base period components.

The first is the administrative burden imposed on all taxpayers to make the recomputation, especially where the statute of limitations is closed for the base period years and for which the affected taxpayers may not have the data available to make the recomputation.

The second, more substantive concern is that revised definition of gross receipts will either increase or diminish the amount of credit otherwise available to particular taxpayers. Chief among the losers will be start-up companies. Under the proposed definition of gross receipts, a start-up company that receives venture capital funds that are held in an interest-bearing account until expended in the business will be considered to have begun operations in the year it first reports interest income. This will likely reduce -- or eliminate -- the amount of eligible credit for start-up companies. By accelerating the date the start-up company is deemed to be an operating company, the start-up company's fixed-base percentage will be significantly overstated in the start-up years when research expenditures are substantial and operating revenues nil.

Taxpayers and revenue agents would be better served by adopting a definition of gross receipts that reflects gross receipts directly related to the conduct of the taxpayer's trade or business. For example, manufacturers should likely use line 1(c) on Form 1120 (sales less returns and allowances) as gross receipts used in the taxpayer's trade or business. (Financial services industries would likely require a different definition.) The regulations under section 263A, on which Prop. Reg. [sections] 1.41-3(c) is generally modeled,(18) provide a workable definition of gross receipts. Hence, TEI recommends that the following modification of Treas. Reg. [sections] 1.263A-3(b)(2) be considered as the definition of gross receipts for purposes of the research credit:
 In general. Gross receipts are the total amount, as determined under the
 taxpayer's method of accounting from all of the taxpayer's U.S. trades or
 businesses (e.g., revenues derived from the sale of inventory before
 reduction for the cost of goods sold).

 Amounts excluded. For purposes of determining the credit under section 41,
 gross receipts do not include amounts representing --

 (i) Returns or allowances;

 (ii) Interest, dividends, rents, royalties, or annuities, not derived in
 the ordinary course of a U.S. trade or business;

 (iii) Receipts from the sale or exchange of capital assets, as defined
 under section 1221(2);

 (iv) Repayments of loans or similar instruments (e.g., a repayment of the
 principal amount of a loan held by a commercial lender);

 (v) Receipts from a sale or exchange not in the ordinary course of
 business, such as the sale of an entire trade or business or the sale of
 property used in a trade or business as defined under section 1221(2); and

 (vi) Receipts from any activity other than a trade or business or an
 activity engaged in for profit.


Under TEI's recommended version of Prop. Reg. [sections] 1.41-4(c), the start-up company issue will be adequately addressed (since the taxpayers would have no gross receipts from ordinary trade or business operations) and few taxpayers, if any, will be required to recompute the components of their base period.

Finally, in the absence of clear guidance from the IRS about the definition of the term "gross receipts" for purposes of section 41, taxpayers have likely adopted (and revenue agents accepted) different interpretations of the term that reasonably reflect the facts and circumstances of taxpayers' trades or businesses. In order to avoid imposing a burden on taxpayers to amend their tax returns for years ending before the date the regulations are effective, TEI recommends that the final regulations permit each taxpayer to employ on a consistent basis any reasonable interpretation of the term "gross receipts" that reflects the facts and circumstances of the taxpayer's trade or business.

Non-Qualified Activities

Section 41(d)(4) lists eight activities for which the credit is not available, including research conducted after the beginning of commercial production, adaptation of existing business components, and duplication of existing business components. Prop. Reg. [sections] 1.41-4(c) elaborates on the exclusion of post-commercial production activities from credit-eligible activities but adds little guidance in respect of the other statutorily excluded activities.

1. Research after Commercial Production. Under Prop. Reg. [sections] 1.41-4(c)(2), the credit is not available for activities conducted after a new business component is ready for commercial sale or the product or process meets its basic functional and economic design requirements. Prop. Reg. [sections] 1.41-4(c)(2)(ii) lists six activities "deemed to occur after the beginning of commercial production." By definition, then, these activities seemingly never qualify as research activities regardless of when they occur. If so, the statement is overbroad and conflicts with the helpful statement in Prop. Reg. [sections] 1.41-4(c)(2)(i) that "activities are conducted after the beginning of commercial production ... if such activities are conducted after the component is developed to the point where it is ready for commercial sale or use, or meets the basic functional and economic requirements of the taxpayer.... "As important, the meaning and interpretation of the terms or activities listed in Prop. Reg. [subsections] 1.41-4(c)(2)(ii)(A) to (F) deemed to occur after production can vary from industry to industry. The proposed rules erroneously assume that the six listed activities have a common definition or uniform interpretation to determine when research is completed and the business component is no longer a subject of qualified research. For example, one of the six listed activities is the accumulation of data relating to a production process. Accumulation of data relating to current production processes, however, can be a preliminary step in developing a hypothesis to be tested and, hence, can form a part of the process of experimentation under Prop. Reg. [sections] 1.41-4(a)(5)(i). TEI recommends that the proposed rules be clarified to permit taxpayers to demonstrate that their activities are part of the process of experimentation or otherwise constitute qualified research activities. The listed activities should not automatically be deemed disqualified.

In addition, Prop. Reg. [sections] 1.41-4(c)(2)(ii)(F) includes "debugging or correcting flaws in a business component" as an activity deemed to commence after commercial production. Whereas the concept of "debugging" a product generally implies correcting simple or routine malfunctions in an otherwise useful product, "correcting a flaw" can require a significant change in the design or development of a product that must be addressed through additional research. Hence, product development may not be complete even after commercial sales have begun, especially where a design flaw is detected that requires additional research and development to correct. In other words, the regulations do not contemplate that commercial production may commence prematurely for "flawed" products that must be altered. TEI believes that the phrase "correcting flaws in a business component" in Prop. Reg. [sections] 1.41-4(c)(2)(ii)(F) may easily be misinterpreted, resulting in the disallowance of otherwise eligible research activities for evolutionary technological developments. As a result, TEI recommends that the phrase "correcting flaws in" be deleted.

2. Examples of Excluded Activities Prop. Reg. [sections] 1.41-4(c)(10). Regrettably, some of the examples in Prop. Reg. [sections] 1.41-4(c)(10) are so conclusory that they do precious little to illustrate the application of the proposed rules. Indeed, the statements of "facts" in many examples include bare legal conclusions. Moreover, some examples seem targeted at specific industry practices. For example, it is unclear in Example 3 why the paper company does not qualify for the credit. Example 3 might be interpreted as saying that all "trial" runs in developing new types of paper are not qualified activities, especially since Prop. Reg. [sections] 1.41(c)(2)(ii) states that certain activities, e.g., trial production runs, are deemed to occur after the beginning of commercial production. In the paper industry a "mill trial" has a commonly accepted meaning that should qualify as part of a process of experimentation since it involves a determination of whether commercial production of a new process is feasible.(19)

TEI recommends that the regulations provide a better balance of examples between qualified and excluded activities. One approach to remedy the perceived imbalance in the examples is to make all the examples generic as in Example 4 (widgets) and Example 7 (a particular kind of machine) rather than industry specific. Another approach would be to provide an example illustrating qualified and excluded activities for the paper industry (as in the other industry examples). To avoid perpetuating a perception among revenue agents that all paper industry manufacturing consists of excluded activities (caused perhaps by a misunderstanding of industry terms and practices), we recommend that Example 3 of Prop. Reg. [sections] 1.41-4(c)(10) either be eliminated or that Example D of Appendix 1 be substituted for Example 3.

In addition, in Appendix 1 we have developed Examples A and B that we believe are better balanced and illustrate a number of issues including "common knowledge," "process of experimentation," and "postproduction research activities." Example C provides an illustration to distinguish "adaptation" from "qualified research."

Adaptation

The research credit was enacted as an incentive to encourage companies to engage in activities that promote technological improvements -- whether evolutionary or revolutionary -- in a taxpayer's business components. Congress saw no reason, however, to extend the credit to activities that duplicate, adapt, or re-create existing technology. Hence, section 41(d)(4)(B) denies the research credit for costs related "to the adaptation of an existing business component to a particular customer's requirement or need." Similarly, section 41(d)(4)(C) denies the credit for any research related to the reproduction of an existing business component (in whole or in part) from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information with respect to such business component.

In other words, reverse engineering an existing technology or business component or adapting an existing business component for a particular customer's need will not qualify for the credit.

Distinguishing between an "adaptation" of an existing business component for which no credit is allowed and an "improved" business component for which section 41(d)(1)(B)(ii) permits a credit likely requires an examination of all the facts and circumstances of individual cases. The legislative history to the Economic Recovery Tax Act of 1981, in which the research credit was first enacted, provides some distinctions between the two activities. Specifically, the General Explanation of the Act notes that "adaptation of an existing capability to a particular requirement or customer's need as part of a continuing commercial activity" does not qualify for the credit.(20) Accordingly, an adaptation might be defined as occurring where an existing capability of a business component is used for another purpose. An improved business component, on the other hand, requires a change in the capability of a business component. In other words, once known design limitations of a business component are exceeded, a qualified research project (rather than an adaptation) is underway.(21) Hence, an improvement or change in a function will qualify for the credit, whereas adaptation of the same functionality to a different use usually will not qualify.(22) In addition, an adaptation occurs in the conduct of continuing commercial activity, rather than being a separate business project for improvement of the component. The fundamental distinction between an adaptation and an improvement is that a qualifying "improvement" to a business component must satisfy all the prongs of section 41(d)(1). An improvement must involve discovering information to resolve uncertainty (in the sense required under section 174), be technological in nature, and involve a process of experimentation. Under Treas. Reg. [sections] 1.174-2(a)(1), "[u]ncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product." Since the section 174 test is incorporated in sections 41(d)(1)(A) and (B), an improvement necessarily involves resolving an uncertainty that is technological in nature that can alter the capability of a product or the process of producing it. Where a customer requests a change to a product that does not involve a new capability or function, the change should be deemed an adaptation. A change that requires a new capability or function but that can be achieved without resolving any technological uncertainty would also be an adaptation. A change in capability or function that requires the resolution of a technological uncertainty, however, should qualify as a credit-eligible improvement rather than an adaptation.

Finally, we provide Example C in Appendix i to illustrate the distinction between an adaptation and an improvement in a business component.

Conclusion

Tax Executives Institute appreciates this opportunity to present our views on the proposed regulations relating to the computation of the research credit and the definition of qualified research activities. If you have any questions, please do not hesitate to call Philip G. Cohen, chair of TEI's Federal Tax Committee, at (201) 871-5504, or Jeffery P. Rasmussen of the Institute's professional staff at (202) 638-5601.

Notes

(1) On December 31, 1996, the Internal Revenue Service issued proposed regulations under section 41 of the Internal Revenue Code describing when computer soilware that is developed primarily by (or for the benefit of) a taxpayer primarily for the taxpayer's internal use can qualify for the credit for increasing research activities. See 1996,2 C.B. 511.

(2) In 1996, Congress enacted an alternative incremental credit, which is codified in section 41(c)(4) of the Code.

(3) The absence of guidance in the form of regulations contributed to the issuance of two so-called research tax audit plans by the IRS's industry specialist in 1995. While the plans were clearly well intentioned, TEI regrets that they perpetuate the IRS's constricted interpretation of the research credit. The Institute recognizes that the IRS must ensure that the myriad requirements of the Code are satisfied. We submit, however, that the IRS (through its audit plans, regulations, or otherwise) should not adopt strained interpretations of section 41's numerous requirements, erect artificial barriers to taxpayer's claiming the credit, or betray a philosophical disagreement with Congress's decision to provide taxpayers with an incentive for increasing research activities. Unfortunately, the audit plans do all of these things. (TEI filed detailed comments on the audit plans in March 1996, and will provide additional copies upon request.)

(4) We recognize that the sheer volume of tax legislation over the intervening years, coupled with uncertainty about the duration of a provision "temporarily" -- but inevitably -- extended, inhibited the development and re]ease of contemporaneous guidance. In the absence of definitive guidance on fundamental definitions, however, taxpayers and revenue agents have faced significant uncertainty about the scope and application of section 41.

(5) The tax benefits accorded to research activities offset only a marginal portion of taxpayers' costs. Hence, taxpayers have an incentive to maintain strict controls over their research expenditures and will not engage in unnecessary research activities any more than they engage in unnecessary repair or maintenance costs.

(6) See Norwest Corp. v. Commissioner, 110 T.C. No. 34 (1998) (qualified research "must be that which exceeds what is known in the field"); United Stationers, Inc. v. United States, No. 97-4201 (7th Cir. Dec. 24, 1998) (research must expand or refine the common state of knowledge).

(7) The 1998 Tax Act is part J of the Omnibus Consolidated and Emergency Supplemental Appropriations Act for Fiscal Year 1999, Pub. L. No. 105-277 (Oct. 21, 1998).

(8) H.R. Rep. No. 105-825, 105th Cong., 2d Sess. (1998).

(9) By asserting that the information that the taxpayer is searching for is within the "common knowledge of skilled professionals," a revenue agent can compel a taxpayer to prove a negative -- that the information is not within common knowledge at the time of the research activity. This creates an unreasonable burden on taxpayers.

(10) During a February 9, 1999, liaison meeting with TEI, Treasury Department representatives expressed a desire to inhibit taxpayers from adopting the kitchen-sink approach to identifying expenditures that qualify for the research credit. Regrettably, the test formulated in the proposed regulations suggests a different metaphor. Indeed, the highly subjective nature of the common knowledge test invites revenue agents to "throw the baby out with the bath water" -- disallowing all of a taxpayer's expenditures outside of pure or basic laboratory research.

(11) In many IRS districts, revenue agents have adopted such an informal rule-of-thumb approach for determining whether research activities qualify.

(12) Indeed, taxpayers frequently refrain from seeking patent protection in order to protect the confidentiality of their research activities and trade secrets.

(13) 1998-50 I.R.B. at 11.

(14) 1998-50 I.R.B. at 12.

(15) Id.

(16) Broadly speaking, "publication" is also the goal of contract research efforts.

(17) The fixed-base percentage is applied to average gross receipts to determine the "base amount." A taxpayer's costs for qualified research must exceed the base amount in order to claim a research credit.

(18) Indeed, the only difference between the two is that the proposed rules under section 41 do not include the exception for interest, etc.

(19) In the paper industry, a "mill trial" frequently involves testing multiple hypotheses for developing or improving paper in which the means of achievement is fraught with uncertainty. A "production run," on the other hand, involves manufacturing a paper product for commercial sale. As a result, combining the terms "trial" and "production" in a single phrase may skew the application of the research credit for paper industry research activities.

(20) Staff of the Joint Committee on Taxation, General Explanation of the Economic Recovery Act of 1981, 97th Cong. 1st Sess. 125 (Dec. 29, 1981).

(21) See page Appendix 2 for a more complete discussion [not reprinted].

(22) Under TEI's formulation of the distinction between adaptation and qualified research activity (exceeding known design parameters), a company's research effort in conducting, say, clinical drug trials to qualify an existing drug formula for a new therapeutic use, will still qualify for the credit notwithstanding that the formula is unchanged.

Appendix 1: Proposed Examples for Research Credit Regulations

Example A. (i) Facts. X has been requested to manufacture a new part (e.g., turbine fan blades) for Y, an original equipment manufacturer, that is designing and developing a new jet engine. Although X has manufactured similar parts for Y and other customers, X is uncertain whether it can manufacture the new part because of unique dimensional (i.e., shape or design features), mechanical, or metallurgical specifications that X has not previously encountered. X's production and metallurgical engineers design a unique batch process for the production of this new part and through trial-and-error experimentation on the factory floor determine how to manufacture the part to meet the specifications. Several such parts are manufactured and sold to Y for incorporation into the jet engine. The batch production process developed by X's engineers, however, is not viable because the number of acceptable parts per batch is too low. In other words, X will either suffer a loss on the sale of its parts to Y or will be compelled to charge a price that Y refuses to pay (or inflates the cost of the jet engines such that Y's customers will refuse to purchase the engines.) Through further trial-and-error experimentation, X modifies the production process and increases the yield of acceptable parts to a viable level. X's engineers prepare detailed factory instructions explaining how to manufacture the part in a fashion that ensures the quality and yield per production run are acceptable.

(ii) Conclusion. The batch production process is a business component. Even though X is in the trade or business of manufacturing the parts, X's determination that it was uncertain whether it could produce the new part is evidence that the appropriate production process design was not within the common knowledge of production and metallurgical engineers because the information was not freely available to the general public. As a result, the activities of X in designing and developing a batch process to manufacture the part are qualified research activities. In addition, since the process originally developed was not viable, X's additional efforts to modify the process to make it viable also constitute qualified research activities. Finally, by preparing detailed factory instructions, X has recorded the results of its experimentation in a manner that satisfies the "process of experimentation."

Comments. Example A illustrates a number of important issues. First, it illustrates that a "process of experimentation" can take place on a factory floor rather than in a laboratory. Second, it illustrates, in the initial development of the part, how the discovery test might be applied to the business component rather than to the process of developing the business component. Third, it illustrates that even research activities conducted after commercial production commences can be qualified research where the objective is to develop a commercially viable business component (or refine the production process). Next, it illustrates that the "adaptation" of a business component (a fan blade) to meet new specifications frequently requires evolutionary research activity that results in the development of a new business component. Finally, it illustrates that laboratory notebooks are not the only means of "recording" the results of experimentation.

Example B. (i) Facts. X has two design projects: Project A is to design a heating, ventilating, and air conditioning system for a manufacturing area; Project B is to design a water treatment and reclamation process for wastewater generated during X's manufacturing activity. X hires two engineers, one for each project. The engineer assigned to Project A consults standard reference materials and designs the heating, ventilating, and air conditioning system. X constructs the system, and, though minor modifications are required, the system works as intended. The engineer assigned to Project B also consults standard reference materials, but can find little information that would enable him to design a treatment and reclamation process that removes the impurities from the waste water generated by X's manufacturing process. The second engineer designs a process, builds it, tests it, modifies the process based upon test results, and finally develops a process that meets the requisite specifications.

(ii) Conclusion. The activities of the engineer on Project A are within the common knowledge of persons who work on such projects because the information is freely available, and, hence, are not qualified research activities. The information necessary to design and construct the specific waste water treatment process in Project B, however, is not within the common knowledge of persons who work on such projects because the information is not freely available to the public; consequently, the activities of the engineer on Project B constitute qualified research activities.

Comments. To the extent the common knowledge test is retained, Example B is intended to illustrate that, in accord with the legislative history of the Tax and Trade Relief Extension Act of 1998, common knowledge refers to information that is freely available to the public. Where common knowledge that is freely available to the general public is used, the activity does not constitute qualified research.

Example C. (i) Facts. X, a developer of widgets, currently manufactures a widget that it markets to customers. Customer Y requests that X decrease the weight and extend the useful life of the widget while maintaining its same size, appearance, and functions. The technology required to achieve this goal is not within the common knowledge of skilled professionals in the relevant field because the information is not freely available to the general public. X uses a process of experimentation to discover technological information that enables it to improve the widget to meet Customer Y's specifications.

(ii) Conclusion. In seeking to develop an improved widget for Customer Y, X undertakes to discover information that exceeds, expands, or refines the common knowledge of skilled professionals in the relevant engineering fields. Because X must discover information that eliminates technological uncertainty concerning the development of widgets with less weight and a longer life for Customer Y, the research activity of X goes beyond mere adaptation of an existing business component and constitutes the development of an improved business component under section 41(d)(1)(B)(ii). Therefore, the research conducted by X to develop the widget is not excluded from the definition of qualified research under section 41(d)(4)(B) and Prop. Reg. [sections] 1.414(c)(3).

(iii) Subsequent Adaptation. After X successfully develops and produces the widget with less weight and an extended life for Customer Y, Customer Z requests that X modify the weight of the widget again. This modification, however, falls within the design parameters of the widget achieved in connection with developing the widget for Customer Y and, hence, can be produced without affecting functionality, performance, reliability, or quality. As a result, X's activities are adaptive in nature and excluded from the definition of qualified research under section 41(d)(4)(B) and paragraph (c)(3) of Prop. Reg. [sections] 1.41-4.

Comments. The foregoing example illustrates the distinction between an adaptation that does not qualify under section 41(d)(4) and an improvement in the functionality of a business component that does qualify under section 41(d)(1)(B)(ii). Since the weight modification requested by Z can be achieved within the known design parameters for the widgets developed for Y, the modification is an adaptation.

Example D. (i) Facts. X, a domestic corporation that manufactures paper, expends significant resources developing a new type of paper containing a different chemical composition. The different chemical composition will permit X to manufacture paper of similar quality to currently manufactured paper but at a reduced cost. The paper formulation is unknown, but the capability of manufacturing the paper once the proper formulation is established is known to X. (In other words, for purposes of the Example, the business component is the paper formulation.) In the development process, X develops several hypotheses about the chemicals that can be used in lieu of existing formulations. X tests these formulations and the methodologies in delivering the new formulations to the process both in the laboratory and in the paper mill. X collects the results of these tests and evaluates their effectiveness in producing paper. These activities are undertaken for the purpose of discovering information that is technological in nature, are intended to improve the taxpayer's business component by reducing its costs, and constitute elements of a process of experimentation. These activities and the associated costs therefore satisfy the requirements of section 41 of the Code. After the company determines the new paper meets the basic functional and economic requirements necessary for its sale, the company prepares to manufacture the paper and market it. The company conducts preproduction planning and tools up for production. The company conducts several test runs of the new paper for the purpose of detecting and trouble-shooting problems in production equipment, accumulating production process data, and debugging the product.

(ii) Conclusion. X's activities to the point where it determines that the new paper meets the basic functional and economic requirements constitute qualified research activities. After determining the product meets its functional and economic requirements, X's activity in pre-production planning, tooling up for production, detecting and trouble shooting problems in production equipment, accumulating production process data, and debugging the product do not constitute qualified research with respect to development of the new paper product because the activities occur after the product is ready for sale.

Comments. This example provides balance to the current Example 3 at Prop. Reg. [sections] 1.41- 4(c)(10). In addition, in this example the paper manufacturing process is generally known, but the correct formulation for the paper is not. Hence, the example also illustrates the application of section 41(d)(2)(C), which requires that the tests for qualified research activities apply separately to the product and the manufacturing process. As required under section 41(d)(2)(C), the research activity ends when X determines the proper formulation for the paper because the manufacturing process, which is a business component separate from the product, is known in the industry.
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