Maximizing opportunities under the new research and experimentation regulations.

• Author: Seltzer, Bradley M.

1. Introduction

   For more than 40 years, Congress has provided incentives for research and development activities in an effort to "increase the innovative qualities and efficiency of the U.S. economy."(1)(*) These incentives are currently embodied in section 174 of the Internal Revenue Code, which allows taxpayers to deduct research or experimental expenditures in the year they are paid or incurred(2) or to amortize such expenditures over a period of at least 60 months,(3) and in section 41,(4) which currently allows a tax credit of 20 percent of the increase in research expenditures for the current taxable year over a base amount calculated in part by reference to the level of such expenditures in previous years.(5) The primary and most fundamental requirement for eligibility under section 174 and section 41(6) is that a taxpayer's efforts must constitute "research or experimental" (R&E) activities.(7) Nearly 13 years after Congress expressed a need for additional guidance on the definition of R&E expenditures,(8) and following the issuance of a series of restrictive proposed regulations, the Internal Revenue Service on October 3, 1994, promulgated final regulations governing the types of expenses that qualify as R&E expenditures.(9)

   This article discusses the opportunities presented by the new regulations and provides practical suggestions for taxpayers seeking to maximize the available tax benefits. The article first reviews the general categories of expenditures that qualify as "research or experimental" for purposes of both section 174 and section 41. It then summarizes the IRS's various attempts to provide guidance and explores how the final regulations have liberalized the definition of qualifying expenditures. The additional statutory limitations on the types of expenditures qualifying for the section 41 credit are then discussed, including the special rules for computer software and contract research expenses. Finally, the article outlines the practical steps that taxpayers can take to derive the maximum benefit from the final regulations for prior, current, and future taxable years.

11. Research or Experimental Expenditures

    under Section 174

    Satisfying the definition of R&E expenditures is critical not only for purposes of the section 174 deduction, but also for claiming the section 41 credit. It is thus important to recognize that the Code and the regulations employ a definition of "research and experimental" that is frequently inconsistent with the understanding of that term as it is used by the personnel engaged in research. Establishing a common understanding of this and other relevant terms between researchers and the company's tax department is critical to maximizing the available tax benefits.

    The section 174 regulations defining "research or experimental expenditures" were originally issued in 1957. The 1957 regulations defined R&E expenditures as "research and development costs in the experimental or laboratory sense." The regulations provided only that the term included all costs incident to the development of an experimental or pilot model, a plant process, a product, a formula, an invention, or similar property, and the improvement of already existing similar property.(10) Proposed regulations issued in 1983 and 1989 provided further, albeit somewhat taxpayer-unfavorable, guidance on the meaning of the term, largely by attempting to specify the types of expenditures that did not qualify. The new final regulations, which generally parallel the proposed regulations issued in 1993,(11) provide substantially more guidance than the 1957 regulations, and represent a significant liberalization of the definition of "research or experimental expenditures" found in the now-withdrawn 1983 and 1989 proposed regulations.

    In light of these changes, taxpayers who initially determined that particular expenditures did not qualify under the 1983 or 1989 proposed regulations should reexamine whether they qualify under the less-restrictive standards of the final regulations. Part IV provides practical suggestions for conducting such a reexamination.

    1. 1983 and 1989 Proposed Regulations

       The 1983 proposed regulations(12) focused on the results the research activities were designed to achieve and limited qualifying research under section 174 to activities "aimed at the discovery of new knowledge" or "searching for new applications of either research findings or other knowledge."(13) The proposed regulations identified the following 11 specific nonqualifying activities:

       * Routine, periodic, or cosmetic improvements to existing products;

       * Efficiency or management surveys;

       * Consumer surveys or market testing;

       * Quality control testing;

       * Routine design of tools, jigs, molds, and dies;

       * Construction of copies of prototypes;

       * Planning for commercial production and trial production runs;

       * Engineering follow-through or troubleshooting during commercial production;

       * Adaptation of an existing capability to a particular requirement or customer's need;

       * Routine data collection; and

       * The cost of acquiring another person's patent, model, or production process.(14)

       The IRS interpreted the basic exclusion for "routine, periodic, or cosmetic improvements" as requiring a significant improvement to an existing product in order for research on that product to qualify.(15) In addition, the 1983 proposed regulations limited deductions and credits for computer software development expenditures to activities where the software's operational feasibility was seriously in doubt.(16)

       The 1989 proposed regulations"(17) retained the requirement of the 1983 proposed regulations that R&E costs be "aimed at the discovery of new knowledge" or result from "searching for new applications of either research and experimentation findings or other knowledge."(18) In addition, the 1989 proposed regulations slightly modified the 1983 regulations' list of 11 nonqualifying activities:

       * Activities not directed at the functional aspects of a product including expenses relating to style, taste, cosmetic, or seasonal design factors;

       * Efficiency surveys or management studies;

       * Consumer surveys, market development, or market testing;

       * Quality control testing;

       * Activities relating to management functions or techniques developed primarily for internal use of the taxpayer in its trade or business and not generally intended for sale to customers;

       * Activities relating to the implementation of commercial production;

       * Construction of duplicate prototypes;

       * Adaptation of an existing capability to a particular requirement or customer's need;

       * Routine data collection;

       * The acquisition of another person's patent, model, or production process; and

       * Literary, historical, or similar projects.(19)

       The most significant aspect of the 1989 regulations was the adoption of a timeline approach, under which all expenditures incurred "after the point that the product or property . . . meets its basic design specifications related to function and performance level" would not qualify as R&E expenditures under section 174 unless they were made to cure a significant design defect, obtain significant cost reductions, or achieve significantly enhanced function or performance levels.(20) This approach was widely assailed as reflecting an unrealistic view of most manufacturing processes.(21) Although computer software development costs were generally subject to the same test as other research Costs,(22) the timeline approach was viewed as particularly unworkable for those costs because changes in basic design specifications often occur throughout the software development process as a result of almost continuous testing.

    2. 1994 Final Regulations

       The 1994 final regulations alter the entire focus of the inquiry concerning research or experimental expenditures. No longer must the qualifying research be aimed at the development of new knowledge or significant improvements, or be limited to the attainment of basic design specifications. Under the final regulations, if expenditures are designed to eliminate uncertainty concerning the development or improvement of a product, the expenditures will be considered "research and development costs in the experimental or laboratory sense." The regulations set forth the following three types of "uncertainty," any one of which will satisfy the test:

       * the capability for improving the product,

       * the method for improving the product, or

       * the appropriate design for the product.

       The requisite uncertainty is based on the information actually (not theoretically) available to the taxpayer."(23)

       The regulations make clear that the proper focus of the uncertainty test is on the nature of the research activities themselves and not on the product or improvement being developed or the level of technological advancement that the product or improvement represents.(24) The final regulations are thus consistent with recent decisions sustaining section 174 deductions for research not appearing to involve significant technological advancement. For example, the Tax Court recently held that the expenditures of a taxpayer who unsuccessfully attempted to develop through trial and error a new rifle bullet suited for hunting large game qualified as R&E expenditures for purposes of section 174.(25) Similarly, the Tax Court has also held that expenditures to develop software designed to recognize license plates are eligible for the section 174 deduction even though comparable, but slower, software was already commercially available."(26)

1. Formerly Excluded

   Activities

   The final regulations now list only seven activities that are specifically excluded from the definition of research or experimental expenditures:

   * Quality control testing;(27)

   * Efficiency surveys;

   * Management studies;

   * Consumer surveys;

   * Advertising or promotions;

   * The acquisition of another's patent, model, or production process; and

   * Research in connection with literary...