The right direction: treasury proposes new research tax credit regulations.

• Author: Goldbas, Michael

Introduction

The Treasury Department has proposed regulations that represent a bold move toward a more rational and practical tax policy relating to the research credit. According to Treasury Secretary Paul H. O'Neill, the proposed regulations eliminate the controversial discovery test in order to "make it easier for businesses to qualify for the credit in the course of developing new products." (2) This surprising policy reversal is commendable because the IRS applied the discovery test in litigation and Treasury defended it in prior versions of the regulations. Another significant development in the proposed regulations is the position that a process of experimentation may address not only issues related to capability and method, but also design issues. The proposed regulations also eliminate all credit-specific documentation requirements. By squarely addressing these issues, Treasury has moved significantly closer to its goal of expanding the scope of qualifying activities to make the research credit a more effective "tool available to encourage growth, investment and job creation in our economy." (3) While the proposed regulations overall represent a significant advance toward this goal, the new rules relating to internal-use software will be difficult to apply and appear inconsistent with stated tax policy.

The proposed regulations are subject to the public notice and comment period as well as a hearing. The significant changes made in the proposed regulations demonstrate that the Treasury and IRS carefully considered comments they received previously. Accordingly, taxpayers are encouraged to submit comments, as well as consider testifying at the public hearing on the proposed regulations. Requests to participate in the public hearing and comment letters are due no later than March 6, 2002. (4) A public hearing on the regulations is set for March 27, 2002.

This article reviews the new discovery test, the changes in the process of experimentation test, the new rules relating to internal-use software, the exclusions for research after commercial production and for adaptation, the new documentation provisions, the definition of gross receipts, the new effective date rules, and other changes. In addition, the article explores the implications of some of these new rules.

Background (5)

The proposed regulations constitute the third attempt by the Treasury to develop effective interpretative guidance covering myriad, vague definitional and computational provisions in section 41 of the Internal Revenue Code. (6) The prior version of the regulations was issued in final form on January 3, 2001, by the outgoing Clinton administration. (7) Many taxpayers felt ambushed by a provision, which appeared there for the first time, that required taxpayers to maintain certain research-credit specific documentation. (8) In response to substantial taxpayer criticism, the Treasury placed those regulations under review, and announced that the regulations would be reissued in proposed form after a comprehensive review of all provisions. (9) Because Treasury was willing to reconsider the more controversial provisions, taxpayers anxiously awaited the issuance of these proposed regulations. (10)

The most controversial position adopted by Treasury in the prior versions of the regulations related to the discovery test. Since the definition of qualified research derived from the anti-abuse legislation, Treasury sought to establish a definition that would restrict qualified research to research that would produce scientific or engineering discoveries. Hence, taxpayers were required to prove that their research was undertaken for the purpose of obtaining knowledge "that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering. (11) This so-called common knowledge standard, whether justified by the legislative history or not, was difficult to apply and led to excessively burdensome audits. (12) Treasury has finally concluded the discovery test is inconsistent with legislative intent and "does not fully address Congress's concerns regarding the importance of research activities to the U.S. economy." (13)

The Demise of the Discovery Test

Most examiners applied the discovery test to significantly narrow the scope of qualifying research activities. The IRS considered the discovery test well-settled law, and examiners were trained to apply this test despite the objections of taxpayers and practitioners. (14) Indeed, the discovery test grew so much in importance during the last four years that it became the definitive hurdle for establishing the qualified nature of research. While initially relating to only one aspect of the definition of qualified research, the common knowledge standard eventually became the basis for defining highly innovative software, (15) as well as the basis for applying the shrink-back rule. (16) In light of this background, there is concern that examiners will interpret the proposed regulations consistently with the familiar discovery test, particularly with respect to the application of the new "uncertainty" test.

Disguised Discovery Test? The "Readily Discernible and Applicable" Standard

A process of experimentation is defined in the new proposed regulations as a "process designed to evaluate one or more alternatives where the [capability, method, or design] is uncertain as of the beginning of the taxpayer's research activities." (17) There is sufficient uncertainty if the method, capability, or appropriate design of the new or improved business component is not readily discernible and applicable as of the beginning of the taxpayer's research activities. (18) Relying on the readily discernible language, Treasury notes, "not all research to arrive at the appropriate design of a business component will be credit eligible." (19) According to Treasury, research undertaken to determine the appropriate design of a component may simply involve choosing an alternative that is readily discernible and applicable as of the beginning of the research effort. (20) Thus, the regulations continue to view design-related activities with more skepticism than efforts to establish the capability or method for developing a business component. This is consistent with Treasury's view that the requirements for a process of experimentation under section 41 are more stringent than the requirements for research and development under section 174. (21) Examiners will therefore apply the readily discernible standard as the basis for distinguishing section 174 research from the more narrowly defined section 41 research. The now-defunct discovery test was intended to serve the same purpose.

Some examiners may evaluate whether there is "uncertainty" by applying criteria with which they are familiar, were trained on, and have applied frequently, i.e., a common knowledge standard. Examiners can justify this approach by reasoning that if a design can be developed by applying what is commonly known in the relevant fields of science or engineering, then the design is readily discernible and applicable. (22) From this reasoning emerges a disguised discovery test, thereby undermining Treasury's intent to eliminate this test to "make it easier for businesses to qualify for the credit in the course of developing new products." (23) The regulations should not be interpreted so that they simply shift the restrictive concepts previously found in the discovery test to the process of experimentation test.

While the proposed regulations do not define readily discernible and applicable, several new examples illustrate the application of this standard. (24) The examples suggest that readily discernible generally equates to easily achievable, straightforward, etc. In addition, the Preamble to the proposed regulations provides that, if a "taxpayer conducts only rudimentary or non-technological testing" to develop the new or improved business component, this tends to indicate that the appropriate design of the business component was readily discernible and applicable at the outset. (25) One concern is that examiners will equate "rudimentary and non-technological testing" with routine engineering. This would clearly be inappropriate, however, because the taxpayer can employ readily discernible methods (routine engineering) as long as the design is not readily discernible at the outset of the activity. While the meaning of "rudimentary and non-technological testing" (26) is unclear, there is no doubt that the more complex, intricate, and comprehensive the testing, the more likely the activity will be viewed as qualified.

Two examples in the proposed regulations could be construed to deny credits for research activities merely because a readily discernible solution emerges after studying and evaluating a technical problem to formulate hypotheses and develop viable solutions. (27) In many instances, however, the most significant and difficult aspect of the research relates to collecting and analyzing the data on a problem. During this phase of the research effort, a simple, straightforward solution to the technical issue may emerge, but that does not mean that the solution was readily discernible as of the beginning of a taxpayer's research activities.

A Revised Discovery Test

The proposed regulations retain a two-part test to determine whether (1) an activity is undertaken for the purpose of discovering information and (2) such information is technological in nature. (28) With respect to the first part of this test, Treasury replaced the common knowledge standard with the section 174 definition of discovery, stating, "[r]esearch is undertaken for the purpose of discovering information if it is intended to eliminate uncertainty concerning the development or improvement of a business component. Uncertainty exists if the information available to the taxpayer does not establish the capability or...