Research tax credit regulations: It's time to jettison the discovery test and start over.

• Author: Shanahan, James R., Jr.

INTRODUCTION

"[R]esearch is the life-blood of our economic progress and ... effective tax incentives for research and development must be a fundamental element of America's competitive strategy."(2)

Since its enactment in 1981, the research tax credit contained in section 41 of the Internal Revenue Code has provided an incentive for U.S. companies to conduct U.S.-based research to develop new and improved products resulting in safer, more efficient, and less expensive products that have new or improved functions, performance reliability, and quality. The efficacy of the credit, however, is threatened by the final section 41 regulations, which were promulgated by the outgoing Clinton Administration as Treasury Decision 8930 (66 Fed. Reg. 280) on January 3, 2001. The final regulations are fundamentally flawed and, if not substantially revised, may prompt U.S. firms to consider conducting their research outside of the United States, thereby frustrating the very purpose of the credit. An essential component of an efficient credit is an understandable and administrable definition of "qualified research" that appropriately encompasses the types of research and development activities envisioned by Congress. Regrettably, the definition of qualified research in the January 2001 is deeply flawed.

Most significantly, by retaining the misconceived "discovery" test and its underlying "common knowledge" standard (both of which are discussed below), the Treasury Department missed an opportunity to rein in IRS agents who, during the past four years, have sought to limit the reach of the credit. The continued presence of the discovery test, without clear guidance, will likely be misinterpreted by IRS agents, prompting them to challenge a wide range of product development activities that are clearly within the scope of the credit. In addition, an "uncertainty test" has been added to the process-of-experimentation test that impairs the meaningful operation of the credit. Moreover, the internal-use software rules in the January 2001 regulations arbitrarily distinguish between software that provides or facilitates computer services and that which provides or facilitates noncomputer services. Finally, the regulations contain surprise recordkeeping burdens that directly conflict with the legislative history of the Tax Relief Extension Act of 1999 (the 1999 Act). In their current form, the regulations will cause R&D departments to spend the bulk of their time complying with unnecessary red tape.

One of the most frustrating and perplexing aspects of the January 2001 regulations is their issuance in final form. History teaches that defining the term "research" is a most difficult process. For example, the regulations under section 174 relating to the definition of "research and experimental expenditures" were originally proposed in 1983, re-proposed in both 1989 and 1993, and then issued in final form in 1994. The Treasury Department should have learned from and been guided by the history of the section 174 regulations when considering whether to re-propose the section 41 regulations or to issue them in final form. In going final, Treasury minimized if not ignored the strong testimony of taxpayers and practitioners at a May 13, 1999, public hearing on the proposed section 41 regulations. It thus gave short shrift to Congress's mandate that the Secretary of the Treasury "consider carefully the comments he has and may receive regarding the proposed regulations relating to the computation of the credit under section 41(c) and the definition of `qualified research' under section 41(d), particularly regarding the `common knowledge' standard."(3)

Because the regulations are inconsistent with congressional intent, highly subjective, and not workable, many commentators urged that they be promptly withdrawn and re-proposed. Fortunately, on January 31, 2001, the new Bush Administration responded to those calls by issuing Notice 2001-19, which indefinitely postpones the effective date of the January 2001 regulations. The Notice also announced that the IRS and Treasury will undertake a complete review of the regulations and reconsider all comments previously submitted; it also solicited additional comments on all aspects of the regulations and announced that any changes to the regulations will be announced in the form of proposed regulations. Finally, the Notice states that Treasury Decision 8930 will be revised so that the provisions of the regulations will be effective "no earlier than the date when the completion of this review is announced, except that the provisions related to internal-use computer software (including any revisions) generally will be applicable for taxable years beginning after December 31, 1985." The Treasury Department has requested that comments on the January 2001 regulations be submitted by April 2. All taxpayers and practitioners affected by the regulations are urged to submit comments by this deadline.

This article discusses the background of the 20-year-old definition of "qualified research" and delves into three key areas: (1) the four-part test for "qualifying research," including the discovery test and the process-of-experimentation test; (2) internal-use software rules, and (3) a new regulatory "exclusion" for lack of recordkeeping.(4) It argues that the Treasury Department should jettison the discovery test and make other changes in the January 2001 regulations.

LEGISLATIVE BACKGROUND TO THE DEFINITION OF "QUALIFIED RESEARCH"

1. Economic Recovery Tax Act of 1981

   Congress enacted the research tax credit in the Economic Recovery Tax Act of 1981 (ERTA) as a key component of a multifaceted tax-reduction package intended to ensure future economic growth of the U.S. economy.(5) The tax incentives adopted by Congress in ERTA were intended to stimulate investment both in plant and equipment and in research and development, thereby increasing the efficiency, productivity, and competitiveness of U.S. firms in the global marketplace.

   Concerned about the decline in research spending by industry, Congress decided to enact a "substantial tax credit" to encourage greater private research by operating businesses.(6) Without "major new tax incentives," Congress concluded, many businesses would be reluctant to allocate sufficient funds to research and development.(7) This reluctance results from the inability of the firm performing research to capture the full profit potential of the research results. In other words, normal market forces and self-interest may not produce the optimal amount of research.

   In defining "qualified research" eligible for the new credit, Congress in 1981 adopted the definition of "research or experimental expenditures" used for purposes of section 174,(8) subject to three specified credit exclusions.(9) Thus, ERTA rejected narrower definitions of credit-eligible expenditures in earlier versions of the bill.(10)

   Moreover, in adopting the section 174 definition for purposes of the new credit, Congress expressly cited the 1957 regulations under section 174,(11) which defined "research or experimental" expenditures as "research and development costs in the experimental or laboratory sense" and therefore swept broadly to apply to industrial and commercial research and development costs.(12) The regulations in effect in 1981 further stated:

   [The term "research or experimental expenditures"] includes generally all such 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 property of the type mentioned.(13) Thus, under the section 174 regulations, "research or experimental expenditures" includes generally all such costs incident to the development or improvement of a pilot model, plant process, product, invention, formula, technique, patent, or similar property.

   IRS rulings similarly have illustrated the application of section 174 to usual and customary industrial and commercial research and development costs. The range of activities specifically recognized in these rulings includes designing, developing, fabricating, testing, and improving, and more generally has included research and development of an "investigative nature."(14) The objects of these multifold activities have included manufacturing processes, methods, and products. The historical application of section 174 in these rulings is consistent with the purposes of enacting section 174 and the broad interpretation of research or experimental expenditures in the 1957 regulations.(15)

2. Tax Reform Act of 1986

   To afford Congress the opportunity to evaluate the effectiveness of the new credit in encouraging increased U.S.-based research and development expenditures by companies, ERTA provided that the credit would terminate after 1985. In anticipation of this sunset date, the House Ways and Means Subcommittee on Oversight held extensive hearings on the credit in August 1984.(16)

   The 1984 hearings reflected concerns of congressional leaders and Treasury officials that the research tax credit had been claimed by taxpayers in industries other than industrial and commercial industries, such as fast food restaurants, fashion designers, and hair stylists.(17) More specifically, there was concern that the credit might be claimed for developing a "Chicken McNugget" or a "banana that tastes like an orange."(18) Treasury urged that the credit should be targeted to "truly innovative research," and suggested amending the statute to limit credit eligibility to research designed to produce "a significant technological improvement" in a business component.(19) Treasury also supported exclusions from the credit for activities such as the development of financial products, routine product development costs, costs of reverse engineering, adaptation costs, and costs incurred after the beginning of commercial production.(20)

   In the...