United States: Phoenix Tax Workshop - Research and Development Expenditures

I. INTRODUCTION

Federal income tax deductions and credits for research and development expenditures are outlined in Section 174 and Section 41, respectively, of the Internal Revenue Code.¹ To be eligible for the deduction under § 174, an expenditure must be incurred in connection with the taxpayer's trade or business and must represent a research and development cost in the "experimental or laboratory sense." Research must meet three additional criteria before an expenditure is eligible for a tax credit under § 41: the research must be undertaken for the purpose of discovering information which is technological in nature; substantially all of the activities must constitute elements of a process of experimentation; and the experimentation must relate to a permitted purpose (set forth in the Code and Regulations). In addition to the federal research credit, the state of Arizona provides an income tax credit for increased research activities. The state credit, which previously applied only to corporations, was recently extended to individuals as well, and thus to pass-through entities such as partnerships and limited liability companies.

II. FEDERAL DEDUCTIONS AND TAX CREDITS

Under §174, a taxpayer can elect to deduct research or experimental expenditures that are paid or incurred during the taxable year in connection with his or her trade or business. A taxpayer can also elect to amortize these research expenses ratably over a period of not less than 60 months, beginning with the month in which he or she first realizes benefits from such expenditures. § 174(a), (b)(1). The term "research and development expenditures," within the meaning of § 174, generally includes expenditures which represent research and development costs in the experimental or laboratory sense. See Regs. § 1.174-2(a)(1). Code § 174 applies to costs paid or incurred directly by the taxpayer for research or experimentation as well as for payments for research or experimentation conducted by another person on behalf of the taxpayer. 1994 Regs. § 1.174-2(a)(8). Research or experimental expenditures may be deducted only to the extent that the amount of such expenditures is reasonable under the circumstances. Code § 174(e).

B. Tax Credit For Qualified Research Expenses

In addition to the deduction allowed under § 174, Congress also added a tax credit for certain qualified research expenses paid or incurred in carrying on an active trade or business of the taxpayer. To be eligible for the credit, the current year research expenditures must exceed the average annual amount of such expenditures in the specified base period (generally, the four taxable years immediately preceding the current tax year). The credit, which has been extended ten times and significantly modified about a half-dozen times, is currently set to expire on June 30, 2004. See § 41(h).

The permissible credit under § 41 is equal to 20% of the amount by which a taxpayer's qualified research and experimentation expenditures exceed a base amount. A taxpayer's base amount is determined by multiplying a taxpayer's "fixed-base percentage" by its average gross income in the preceding four tax years. § 41(c)(1). This amount must equal 50% or more of a taxpayer's qualified research expenditures in a given tax year. § 41(c)(2). The fixed-base percentage depends on when a firm first performed qualified research and earned gross income in the same tax year. If it did both during three of the years from 1984 to 1988, then its fixedbase percentage is the ratio of its combined qualified research expenditures to its combined gross income in that period, up to a maximum ratio of 16%. § 41(c)(3). All other firms are considered start-up firms and assigned a fixed-base percentage of 3% for the first five tax years after 1993 in which they have qualified research expenses. During the sixth through tenth tax years after 1993, the fixed-base percentages are gradually adjusted to reflect their actual research intensities. See Code § 41(c)(3)(B)(ii).

Under amendments made by the Small Business Job Protection Act of 1996, P.L. 104- 188), a business can choose an alternative three-tiered credit. § 41(h)(1).² The alternative credit is also incremental in design and comprises three fixed rates (for tax years beginning after June 30, 1999): 2.65%, 3.2%, and 3.75%. Under this regime, a business can claim a credit equal to the sum of 2.65% of its qualified research expenses above 1.0% to 1.5% of its average gross receipts during the previous four years; 3.2% of its qualified research expenses above 1.5% to 2.0% of its average gross receipts in the previous four years; and 3.75% of its qualified research expenses above 2.0% of its average gross receipts in the previous four years. Because these base amounts are independent of a firm's research intensity, most firms with qualified research expenditures that are unable to use the regular credit should be able to claim the alternative credit.

C. Eligible Research or Experimental Expenditures

The definition of research or experimental expenditures for purposes of §174 determines what costs can be deducted as such under §174. The §174 definition of research or experimental expenditures is also used to determine research expenses eligible for the § 41 tax credit. Thus, the two sections present many common issues and involve many of the same considerations.

Section 174 does not define the term "research or experimental expenditures." Instead, the meaning of this term has been established by regulations, including the most recent regulations which took effect in 1994.³ Despite the absence of a statutory definition, the term "research or experimental expenditures" has not been the subject of extensive interpretation by the courts or the IRS (other than the treatment of this term in the regulations). Prior to the enactment of the R&D credit, there was little incentive for either the IRS or taxpayers to press for a definition of research or experimental expenditures since, in most cases, expenditures that are not deductible as research expenditures under § 174 may be deductible as ordinary and necessary business expenses under § 162.

In October 1994, the IRS issued final regulations under §1.174-2(a) clarifying the definition of the term "research or experimental expenditures" and providing guidance regarding the reasonableness requirement of §174(e).⁴

The 1994 regulations define the term research or experimental expenditures for purposes of §174 as "expenditures incurred in connection with the taxpayer's trade or business which represent research and development costs in the experimental or laboratory sense." Regs. § 1.174-2(a)(1).⁵ The term generally includes the costs of obtaining a patent, such as attorney's fees incident to the making and perfecting a patent application. Id. The 1994 regulations clarify that expenditures represent "research and development costs in the experimental or laboratory sense" if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Under the regulations, uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product. Id.

In determining whether uncertainty exists, the regulations focus on the information available to the taxpayer. Regs. § 1.174-2(a)(1) states that uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product. The nature of the product or improvement being developed and the level of technological advancement the research product or improvement represents are not considered in determining if the costs incurred by a taxpayer constitute research or experimental expenditures. Rather, the determinative factor is the nature of the activity to which the expenditures relate. Id.

The 1994 regulations specifically exclude the following activities from the definition of research and experimental expenditures:

• Ordinary testing or inspection of materials or products for quality control (quality control testing);
• Efficiency surveys;
• Management studies;
• Consumer surveys;
• Advertising or promotions;
• The acquisition of another's patent, model, production, or process; or
• Research in connection with literary, historical or similar projects.

Regs. § 1.174-2(a)(3).

The exclusion for quality control testing does not apply to testing to determine whether the design of the product is appropriate. Regs. § 1.174-2(a)(4). However, testing or inspection to determine whether particular units of materials or products conform to specified parameters does constitute quality control testing. Id.

Section 41(d) defines "qualified research" for purposes of the § 41 research credit. The starting point for determining what constitutes "qualified research" under § 41 is to determine whether the expenditure may be treated as an expense under §174. If research may be expensed under § 174, then the research may also be eligible for the § 41 credit, provided that the additional requirements of § 41(d) are met. Code § 41(d) imposes three additional requirements for research to constitute qualified research:

(1) the research must be undertaken for the purpose of discovering information which is technological in nature;

(2) substantially all of the activities must constitute elements of a process of experimentation; and

(3) the experimentation must relate to a permitted purpose.

Code § 41(d)(1)(B), (C).

With respect to the first of these requirements (undertaken for the purposes of discovering technological information), § 41(d) specifies that the application of the research activities must be intended to be useful in the development of a new or improved business component of the taxpayer. Code § 41(d)(1)(B)(ii).

Final Regulations. In January, 2001, the IRS issued final regulations (T.D. 8930) relating to the computation of the research credit under § 41 and the definition of qualified research under § 41(d). These regulations reflect legislative changes to § 41 made by Congress from 1986 through 1999. Originally, T.D. 8930 was generally applicable for expenditures paid or incurred on or after Jan. 3, 2001. However, in an about face, the IRS issued Notice 2001-19, 2001-10 I.R.B. 784 (3/5/2001), which delayed the effective date of T.D. 8930 indefinitely pending review of the final regulations. Notice 2001-19 does provide, though, that taxpayers may continue to rely on T.D. 8930 while this review is pending. Thus, although the rules contained in the 2001 regulations may be revised, they are still instructive and taxpayer may rely on them until such time that the IRS issues new regulations.

(a) General Rule

Under Reg. § 1.41-4(a)(1), the three additional tests set forth in § 41(d) are applied separately to each business component. A "business component" is any product, process, computer software, technique, formula, or invention held for sale, lease, or license or used by a taxpayer in a trade or business. Code § 41(d)(2)(B).

(b) The Discovery Requirement

To qualify for the research credit, section 41(d) requires that a taxpayer undertake research for the purpose of discovering information which is technological in nature, and the application of which is intended to be useful in the development of a new or improved business component of the taxpayer. Regs. § 1.41-4(a)(3) defines the phrase "discovering information" as obtaining knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering.

The definition of the term "qualified research" was narrowed by the 1986 amendments to § 41, based on concerns that taxpayers had applied the original definition of qualified research "too broadly," that some taxpayers had claimed the credit for "virtually any expenses relating to product development" and that many of these taxpayers were "in industries that do not involve high technology or its application in developing technologically new and improved products or methods of production." H.R. Rep. No. 99-426, at 177-78; S. Rep. No. 99- 313, at 694-95. Following the 1986 changes to the § 41 credit, a discovery requirement has been applied in several recent cases. See, e.g., United Stationers, Inc. v. United States, 163 F.3d 440 (7th Cir. 1998), Norwest v. Commissioner, 110 T.C. 454 (1998); WICOR, Inc. v. United States, 116 F. Supp. 2d 1028 (E.D. Wis. 2000) (affirmed by WICOR, Inc. v. U.S., 2001-2 U.S. Tax Cas. (CCH) ¶50,576 (7th Cir., August 14, 2001)).

Seventh Circuit Sets a High "Discovery Innovation" Requirement to Qualify for R & D Credit. In the WICOR case, the Seventh Circuit upheld the district court noting that discovery is a complex concept and the fact that information gleaned from research is "new" to a taxpayer does not automatically qualify the discovery for the research and development credit. The Court reasoned that intertwined with newness is innovation and that the qualifying research must pass a high threshold of innovation and be a broad effect. The lower court concluded that the taxpayer’s research project cannot jump the high threshold of innovation without "discovering" some principle of computer science. The taxpayer put on no evidence at trial to show that its research activities added to the current body of knowledge. In other words, while it may have been new to the taxpayer, it wasn’t new to the industry. The taxpayer’s research activities which merely adapted existing technologies to meet its own needs failed the innovation test.

The 2001 regulations retain the requirement that a taxpayer seek to discover information that exceeds, expands, or refines the common knowledge of skilled professionals in the particular field of science or engineering. The regulations clarify that the phrase "common knowledge of skilled professionals in a particular field of science or engineering" means information that should be known to skilled professionals had they performed, before the research in question was undertaken, a reasonable investigation of the existing level of information in the particular field of science or engineering. Regs. § 1.41-4(a)(3)(ii). Thus, in order to satisfy the discovery requirement, research must be undertaken for the purpose of discovering information that is beyond the knowledge that should be known to skilled professionals had they performed a reasonable investiga tion of the existing level of knowledge in the particular field of science or engineering. There is no requirement, however, that a taxpayer actually conduct such an investigation in order to claim the credit. To further clarify the application of the discovery requirement, the final regulations also state, as an example, that trade secrets generally are not within the common knowledge of skilled professionals because they are not reasonably available to skilled professionals not employed, hired, or licensed by the owner of such trade secrets. Id.

The regulations provide that, if a taxpayer demonstrates with credible evidence that research activities were undertaken to obtain the information described in documentation prepared before or during the early stages of the research and if that documentation also sets forth the basis for the taxpayer’s belief that obtaining this information would exceed, expand, or refine the common knowledge of skilled professionals in the particular field of science or engineering, then the research activities are presumed to satisfy the discovery requirement. Regs. § 1.41-4(a)(3)(v). In a case where the rebuttable presumption arises, the regulations provide that the Commissioner may overcome this presumption by demonstrating that the information described in the taxpayer’s documentation was within the common knowledge of skilled professionals in the particular field of science or engineering. That is, the Commissioner would have to demonstrate that the information would have been known to such skilled professionals had they performed (before the research was undertaken) a reasonable investigation of the existing level of information in the particular field of science or engineering. Id. The regulations also provide that a taxpayer is conclusively presumed to have obtained knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in the relevant field of science or engineering, if that taxpayer was awarded a patent for the business component (the regulations emphasize, however, that a patent is not a precondition for credit eligibility). Regs. § 1.41-4(a)(3)(iv).

(c) Technological In Nature

In order to be "technological in nature," a process or experimentation used to discover information must fundamentally rely on principles of physical or biological sciences, engineering, or computer science. Regs. § 1.41-4(a)(4).

(d) Process of Experimentation

Regs. §1.41-4(a)(5) of the proposed regulations had defined a process of experimentation to include a prescribed four-step process. The 2001 regulations, however, provide that taxpayers conducting a process of experimentation may, but are not required to, engage in this four-step process. The regulations now state that a process of experimentation in the physical or biological sciences, engineering, or computer science may involve –

1. Developing one or more hypotheses designed to achieve the intended result;
2. Designing an experiment (that, where appropriate to the particular field of research, is intended to be replicable with an established experimental control) to test and analyze those hypotheses (through, for example, modeling, simulation, or a systematic trial and error methodology);
3. Conducting the experiment; and
4. Refining or discarding the hypotheses as part of a sequential design process to develop or improve the business component.

The 2001 regulations provide further clarification on the manner in which a process of experimentation differs from research and development in the experimental or laboratory sense, as required by §1.174-2(a). A process of experimentation is a process to evaluate more than one alternative designed to achieve a result where the capability or method of achieving that result is uncertain at the outset, but (in contrast to expenditures that qualify under section 174) does not include the evaluation of alternatives to establish the appropriate design of a business component when the capability and method for developing or improving the business component are not uncertain. Regs. 1.41-4(a)(5); see also H.R. Conf. Rep. No. 99-841, at II-72 ("[t]he term process of experimentation means a process involving the evaluation of more than one alternative designed to achieve a result where the means of achieving that result is uncertain at the outset"); United Stationers, 163 F.3d at 446; Norwest, 110 T.C. at 496.

Part of the four-step process under the proposed regulations was a requirement that taxpayers record the results of their experiments. This requirement was removed in the T.D. 8930, however, and the reference to recordkeeping has been eliminated from the illustrative (non- mandatory) description of a four-step process of experimentation.

(e) Substantially All Requirement

Code § 41(d)(1)(C) requires that "substantially all" of the research activities constitute elements of a process of experimentation for a qualifying purpose. Regs. § 1.41-4(a)(6) states that the "substantially all" requirement is satisfied only if 80 percent or more of the research activities, measured on a cost or other consistently applied reasonable basis, constitute elements of a process of experimentation described in Code § 41(d)(3). The substantially all requirement is applied separately to each business component. Pursuant to Code § 41(d)(3), research will be treated as conducted for a qualifying purpose if it relates to (i) a new or improved function, (ii) performance, or (iii) reliability or quality. The regulations clarify that the use of computers or information technology does not by itself establish that qualified research has been undertaken. Regs. § 1.41-4(a)(7).

(f) The Shrinking-Back Rule

Under the regulations, if the requirements of Code § 41(d) are not met for an entire product, the credit may be available with respect to the next most significant subset of elements of that product. Regs. § 1.41-4(b)(2). This "shrinking back" continues until either a subset of elements of the product that satisfies the requirements is reached, or the most basic element of the product is reached and such element fails to satisfy the test. However, this shrinking-back rule applies only if the taxpayer incurs some research expenses with respect to the overall business component that would constitute qualified research expenses with respect to that business component but for the fact that less than substantially all of the research activities with respect to that component constitute elements of a process of experimentation that relates to a new or improved function, performance, reliability or quality. Id. In cases where the "substantially all" test is satisfied with respect to the overall business component, those research expenses with respect to the overall business component that are qualified research expenses are credit eligible, and there is no need for a taxpayer to shrink back to apply the tests with respect to subsets of elements of the business component.

The regulations list a number of activities that are specifically excluded from the research credit. These include the following:

(a) Research After Commercial Product

The regulations specify that activities conducted after the beginning of commercial production of a business component do not constitute qualified research. Regs. § 1.41-4(c)(2). This includes all activities conducted after a component is developed to the point where it is ready for commercial sale or use, or meets the basic function and use for which it was designed. Id.

The following activities are deemed to occur after the beginning of commercial production of a business component—

1. Preproduction planning for a finished business component;
2. Tooling- up for production;
3. Trial production runs;
4. Trouble shooting involving detecting faults in production equipment or processes;
5. Accumulating data relating to production processes; and
6. Debugging flaws in a business component.

Regs. § 1.41-4(c)(2)(ii).

Notwithstanding the above, in cases involving the development of both a product and a manufacturing or other commercial production process for the product, the "after commercial production" exclusion applies separately for the activities relating to the development of the product and the activities relating to the developme nt of the process. Thus, for example, even after a product meets a taxpayer's basic functional and economic requirements, activities relating to the development of the manufacturing process still may constitute qualified research, provided that the development of the process itself separately satisfies the requirements of Code § 41(d) and the regulations, and further provided that the activities are conducted before the process meets the taxpayer's basic functional and economic requirements or is ready for commercial use. Regs. § 1.41-4(c)(2)(iii).

(b) Adaptation of Existing Business Components

Activities relating to adapting an existing business component to a particular customer's requirement or need do not constitute qualified research. However, this exclusion does not apply merely because a business component is designed for a specific customer. Regs. § 1.41-4(c)(3).

(c) Duplication of Existing Business Component

Activities relating to the reproduction of an existing business component, in whole or in part, from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information about the business component do not constitute qualified research. However, research activity that otherwise qualifies for the credit will not be excluded merely because a taxpayer inspects an existing business component in the course of developing its own business component.

(d) Surveys, Studies, Research Relating to Management Functions

Qualified research does not include activities relating to efficiency surveys; management functions or techniques (including such items as preparation of financial data and analysis, development of employee training programs and management organization plans, and management- based changes in production processes); market research, testing, or development (including advertising or promotions); routine data collections; or routine or ordinary testing or inspections for quality control.

(e) Internal Use Computer Software