Comments on proposed regulations relating to the credit for increasing research activities: March 6, 2002.

On March 6, 2002, Tax Executives Institute filed comments with the U.S. Treasury Department and the Internal Revenue Service on proposed regulations under section 41 of the Internal Revenue Code, relating to the credit for increasing research activities. The comments were prepared jointly by TEI' s Federal Tax and IRS Administrative Affairs Committees, whose chairs are Mitchell S. Trager of Georgia-Pacific Corporation and David L. Bernard of Kimberly-Clark Corporation, respectively. Contributing substantially to the development of TEI's comments were Eileen D. Frack of Kimberly-Clark Corporation and Loren M. Opper of Ford Motor Company. *

On December 14, 2001, the Treasury Department and the Internal Revenue Service released proposed regulations (REG-112991-01) on the definition of qualified research activities and other matters affecting the computation of the research tax credit under section 41 of the Internal Revenue Code. (1) The proposed regulations follow through on the Treasury Department's announcement (2) in Notice 2001-19 that, in response to concerns expressed by taxpayers about the rules set forth in T.D. 8930, (3) it would review those rules and issue re-proposed regulations. When final, the proposed regulations will modify the regulations under section 41 in T.D. 8930 that were issued on January 3, 2001, and subsequently suspended. The proposed regulations in REG-112991-01 were published in the Federal Register (66 Fed. Reg. 66362) and in the Internal Revenue Bulletin (2002-4 I.R.B. 404). (4) A public hearing on the proposed regulations is scheduled for March 27, 2002.

Background

Tax Executives Institute is the preeminent association of business tax executives in North America with more than 5,200 members representing 2,800 of the leading corporations in the United States, Canada, and Europe. 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 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), including pre-regulation comments (which were filed on June 9, 1997), comments on the December 1998 proposed regulations (which were filed on March 31, 1999), and comments in response to Notice 2001-19 (which were filed on May 7, 2001). We are pleased to submit the comments that follow.

Executive Summary

TEI commends the Treasury Department and IRS for issuing Notice 2001-19 and for undertaking a review of the statute, legislative history, court decisions, T.D. 8930, comments submitted in connection with the previously proposed regulations (REG-105170-97), and comments submitted in response to Notice 2001-19. The new proposed regulations represent a laudable and bold change in course. By eliminating the discovery test (or the "common knowledge" test) set forth in T.D. 8930 and aligning the requirements for qualified research more closely with section 174, the IRS and Treasury have taken significant steps to ensure that the regulations conform more closely with congressional intent to provide a salutary incentive for research activities and to ease the process for claiming the credit.

The proposed regulations have also beneficially clarified the process-of-experimentation tests set forth in T.D. 8930 so that a process of experimentation may include a process designed to evaluate one or more alternatives where capability or the method of achieving the result, or the appropriate design of that result is uncertain. Finally, the proposed regulations abandon the requirement in T.D 8930 that taxpayers create credit-specific documentation at the inception of a research project. Eliminating onerous recordkeeping requirements will significantly ease the administrative burden of claiming the credit. (5) TEI applauds these changes and believes that they address many of the concerns expressed by TEI and other commentators as well as those expressed by Congress in the Conference Report to the Tax Relief Extension Act of 1999. (6)

As a result, the new rules -- properly administered -- hold great promise for diminishing the scope, number, and degree of audit controversies about qualified research activities. Notwithstanding our enthusiasm for the many improvements in the proposed regulations, TEI has concerns and questions about some new provisions in the proposed rules as well as some provisions that are unchanged from T.D. 8930. Specific comments and requests for clarification are detailed below. A summary of the principal revisions that TEI recommends includes:

* Modifying the overbroad definition of "gross receipts" to adopt a consistent and easily administrable definition of gross receipts based on sales from a U.S. trade or business, which for most taxpayers is line 1(c) of Form 1120.

* Expanding the patent safe harbor in order to make it more effective.

* Clarifying the scope of excluded activities, especially research undertaken after commercial production to permit modifications to functional capabilities or design specifications to qualify for the research credit and to avoid creating per se exclusion rules for nebulous terms such as "debugging" and "trial production runs" that may involve a process of experimentation.

* Modifying and clarifying the rules relating to internal-use software, especially where the software is used in connection with the taxpayer's business of providing services to customers.

* Adopting a new procedure to permit taxpayers to obtain automatic consent for revocation of the alternative incremental credit computation under section 41(c)(4).

Gross Receipts

1. Definition. T.D. 8930 adopted a broad definition of the term gross receipts for purposes of computing the research credit. Gross receipts means the total amount derived by the taxpayer from all its activities and for all sources, reduced by certain enumerated items. (7) Regrettably, the proposed regulations retain the broad definition of gross receipts set forth in T.D. 8930. Many commentators, including TEI, said that the overbroad definition of gross receipts would impose a substantial administrative burden on taxpayers to recompute their base periods, especially where the data may not be available. The Preamble avers that the administrative burden is attributable to the incremental nature of the credit and the statutorily determined base period. (8) In TEI's view, the lack of guidance on the definition of gross receipts for more than 11 years contributed to the administrative burden. Indeed, in the absence of guidance, most taxpayers adopted a definition of gross receipts based on line 1(c) of Form 1120 (sales less returns and allowances) and excluded gross investment income and other receipts that have no direct relationship to the products or services for which research activities are conducted. (9)

   TEI believes that taxpayers and the IRS would be better served by a definition of gross receipts directly related to the business activities that taxpayers' research activities are intended to support. Thus, where a taxpayer has consistently included in the computation of gross receipts subcategories of receipts under Prop. Reg. [section] 1.41-3(c)(2) for purposes of computing its research credit and where the continued use of such subcategories will not materially distort the computation of the credit, the taxpayer should be permitted to continue using that method notwithstanding Prop. Reg. [section] 1.41-3(c)(2). For example, where a taxpayer consistently used sales receipts less returns and allowances in its computation (even though it had receipts for other subcategories such as dividends, rents, royalties, and interest), then the continuing use of sales less returns should be permissible so long as it does not materially distort the taxpayer's credit computation. Evidence indicating that the use of such subcategories of gross receipts does not produce a material distortion should include the IRS's accepting the approach in prior examinations or a showing that the method has been used on prior returns.

   In addition, the definition of gross receipts should be narrowed to enable U.S.-based multinational companies to be more competitive with foreign-based companies operating in the United States. The proposed regulations provide that foreign-based companies need only consider gross receipts that are connected with the conduct of a U.S. trade or business, whereas U.S.-based companies must include all gross receipts, including receipts from income from foreign subsidiaries or branches that are not connected with the conduct of the U.S. trade or business. This seems counterproductive to the purposes of the credit in encouraging U.S.-based research and ensuring that products made in the United States are competitive in the global marketplace. To ameliorate this effect, the regulations should permit a domestic corporation to compute gross receipts as though it were a foreign corporation with taxable income arising from income effectively connected with the conduct of a U.S. trade or...