The future of the R&D credit.

• Author: Packard, Pamela

For most companies, the current environment is turbulent for determining whether they satisfy the requirements for a Sec. 41 research and development (R&D) credit. Taxpayers are unsure as to whether to rely on the rules set forth in proposed regulations or to follow the case law in determining whether they meet the Sec. 41 (d) "discovery test."

Background

Nonvest Corp., 110TC 454 (1998), and United Stationers, Inc., 163 F3d 440 (7th Cir. 1998), set the standard for the discovery test. Those cases held that software development will satisfy Sec. 41's technological/information requirement only if the research intends to expand or refine existing principles of computer science and has a broad effect.

As to experimentation, the courts held that mere trial and error was inadequate to qualify for the test; they required a more rigorous standard of forming and testing hypotheses. The discovery test, later codified in the 2000 final regulations (TD 8930) as Regs. Sec. 1.41-4(a)(3)(i), allowed a credit only if the taxpayer undertook a research activity "to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering." (Emphasis added.) This tends to bias the availability of the R&D credit toward research that is revolutionary instead of evolutionary, and to limit companies' ability to take a credit.

Prop. Regs.

In December 2001, many taxpayers proclaimed victory when new Sec. 41 proposed regulations (REG-11299101) omitted the controversial discovery test, including its "common knowledge" standard. Those regulations also included a definition of what constitutes "qualified research." They were supposed to replace final regulations published in early 2001, which Treasury unofficially withdrew for review shortly thereafter. Reflecting the review and input of the current Administration, the proposed regulations significantly changed some parts of the withdrawn regulations. Unfortunately, Treasury has yet to finalize them, more than a year later.

In support of the proposed regulations, former Treasury Secretary O'Neill said, "We need to use every tool available to encourage growth, investment and job creation in our economy ... The elimination of the discovery test will make it easier for businesses to qualify for the credit in the course of developing new products."

To taxpayers' dismay, the regulations have no legal effect in their "proposed" state. This was highlighted...