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TEI testimony at IRS public hearing on proposed definition of R & E expenditures.

TEI Testimony at IRS Public Hearing on Proposed Definition of R&E Expenditures

December 5, 1989

Good morning. My name is Bill Burk, and I am Director, Domestic Taxes and audits for CPC International Inc. in Englewood Cliffs, New Jersey. I am her today in my capacity as President of Tax Executives Institute. I am accompanied by Mike Bernard of Mobil Corporation, the Institute's Senior Vice President, and by Timothy McCormally, our Tax Counsel. Together, we will endeavor to respond to any questions you may have about our written comments on the R&E regulations.

Historical Perspective

In our written comments, TEL spends a good deal of time placing the R&E regulations into historical perspective. We do that because we believe it is important to remember that administrability and compliance concerns were key factors prompting Congress to enact section 174 in the first place. From an administrative standpoint, allowing current deductions for research and experimental costs makes sense. In the absence of a statutory rule, the problems of allocating costs, establishing useful lives, and justifying abandonment losses would pose serious administrative challenges -- for both taxpayers and the IRS.

Follwing years of contrvoersy, section 174 was enacted in 1954 "[t]o eliminate uncertainty and to encourage taxpayers to carry on research and experimentation." If section 174 were unduly narrowed through the regulatory process -- which we believe the proposed regulations threaten to do -- these administrative problems would again come to the fore.

The Flawed Nature of the IRS's Time-Line


On their face, of course, section 174 and the regulations are not limited in scope to so-called "hight tech" companies. To be sure, such companies may proportionally spend more n research and development than companies in other industries, but it would be unreasonable to confine the research credit and the R&E deduction to particular industries or particular types of research. Regrettably, some of the examples set forth in the regulations could have the effect of doing that.

TEI also believes it is wrong to provide that R&E expenditures are deductible only if they are incurred at or before a certain time -- that is to say, only if they fall in the right place on the IRS's "time line." Other witnesses will no doubt discuss in detail the flaws of the time-line approach. We join the chorus in supporting a funcitonal approach -- one that focuses on whether activities relate to development, improvement, or testing of the functional design or specifications of the product or process without regard to whether such activities occur before or after the point at which one could consider the "basic design specifications" to be met.

Given the definitional problems inherent in the IRS's time-line approach and the false clarity offered by the term "basic specifications" there can be little doubt that the proposed regulations would invite debate, audit disputes, and (ultimately) litigation over the definition of R&E. The adoption of a functional approach would reduce administrative disputes. Such an approach, moreover, is entirely consistent with the legislative history for section 174, and also conforms to the manner in whcih taxpayers account for R&E for financial accounting purposes.

Administrative Problems with the "Significance"


The proposed regulations state that in certain situations research activities undertaken after basic design specifications are met will qualify as R&E. This exception is so circumscribed by the use of the word "significant," however, that it is stripped of most of its value.

We believe the "significance" standard is inconsistent with congressional intent, ignores the realities of the research environment, and -- like the "basic specifications" standard itself -- invites audit disputes. The "significance" standard would reduce R&E audits to a line-drawing exercise that not only undermines the administrability of sections 174 and 41, but also frustrates the overriding incentive purposes of the statutory provisions.

Exclusions to R&E: Needed Clarifications

In our written comments, TEI discusses several needed clarifications to the exclusions from qualified research. Specifically, with respect to the exclusion for activities relating to implementation of commercial production, we recommend both modifications to the existing regulations and the inclusion of an additional example to clarify that the testing of a design or process, as contrasted with quality control or ordinary testing, constitutes research. (1)

Our comments also discuss the need for the regulations to clarify that an activity directed toward adapting a process or product constitutes research if it involved the process of experimentations. Thus, an activity should not be considered "out of the box" simply because it involves an adaptation. An example in our comments clarifies that the critical consideration should be whether the activity relates to the development, improvement, or testing of the functional design or specifications of a product or process. (2)

Finally, we propose several clarifications of the exclusion for activities not related to a product's functional aspects. The regulations distinguish between those activities that are merely related to the superficial aspects of appearance, individual preference, or fashion, and those related to the functional aspects of a product. For some types of products, however, the style, taste, and cosmetic aspects may be inseparable from, inherently related to, or inconsequential or incidental in comparison to functional aspects of the product.

TEI suggests that the following are among the activities that should not be covered by this exclusion:

* Laboratory tests performed by a food processor in order to extend the shelf life of certain food products.

* Clinical tests by a pharmaceutical manufacturer in an effort to establish new delivery forms.

* Research by manufacturer of packaging containers to develop a new film coating to inhibit moisture contamination and increase the strength and durability of the containers.

Our written comments explain why these activities, though not undertaken by "high-tech" companies, nevertheless constitute qualified research.

Software: Continued Efficacy of Rev. Proc. 69-21

The preamble to the regulations states that the IRS is studying "the continuing validity" of Rev. Proc. 69-21. TEI believes the revenue procedure should be retained. The revenue procedure is consistent with the proposed regulations and serves to confirm the general applicability of section 174 to software. It would also minimize disputes between taxpayers and the IRS examinign agents.

"Substantially All" Test

Finally, the research credit regulations contain in "substantially all" test, under which all the services of an employee will be deemed to be "qualified services" if at least 80 percent of such services satisfy the statutory requirements. TEI believes that the extension of such a "substantially all" test to all R&E would greatly reduce the administrative burden of keeping detailed time and costs records for purposes of the R&E deduction. Application of such a rule under section 174 would go a long way not only to reducing the taxpayer's recordkeeping burden, but also to simplifying the IRS's task in auditing compliance with the statute. (3)

Concluding Remarks

Tax Executive Institute appreciates the opportunity to present our views on these regulations. I would not be pleased to respond to any questions you may have.

(1) The following example is set forth on page 19 of the Institute's written statement:

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

(2) The following example is set forth on page 21 of TEI's written comments:

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

(3) On pages 38-39 of the Institutehs written comments, the following language is proposed:

"Where substantially all (at least 80 percent) of the services performed by an individual for or on behalf of the taxpayer during the taxable year * * * are services performed in activities the expenditures for which qualify as research and experimental expenditures within the meaning of section 174, then all the services performed by that individual or that facility during the taxable year are treated as research and experimental expenditures."
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Author:Burk, William M.
Publication:Tax Executive
Date:Jan 1, 1990
Previous Article:Testimony on development of electronic funds transfer programs for the payment of state taxes before the Federation of Tax Administrators.
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