[Federal Register Volume 59, Number 190 (Monday, October 3, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-24153]


[[Page Unknown]]

[Federal Register: October 3, 1994]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8562]
RIN 1545-AM92

 

Research or Experimental Expenditures

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains amendments to the Income Tax 
Regulations clarifying the definition of research or experimental 
expenditures and providing guidance regarding the reasonableness 
requirement of section 174(e), added to the Internal Revenue Code by 
the Revenue Reconciliation Act of 1989. These amendments affect 
taxpayers conducting research or experimentation in connection with a 
trade or business.

EFFECTIVE DATE: October 3, 1994.

FOR FURTHER INFORMATION CONTACT: Lisa J. Shuman, (202) 622-3120 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    Section 174 of the Internal Revenue Code (Code) provides two 
alternative methods that taxpayers may use to account for research or 
experimental expenditures. A taxpayer may either deduct the 
expenditures in the year in which they are paid or incurred, or treat 
the expenditures as deferred expenses, amortizable over a period of at 
least 60 months. In 1957, the IRS adopted Sec. 1.174-2(a)(1), which 
defines the term research or experimental expenditures as expenditures 
which represent research and development costs in the experimental or 
laboratory sense (22 FR 7901 (October 4, 1957)).
    In 1993, the IRS proposed amendments to Sec. 1.174-2(a)(1) to 
clarify the definition of research or experimental expenditures (58 FR 
15819 (March 24, 1993)). The amendments also provide guidance regarding 
section 174(e), which was added to the Code by the Revenue 
Reconciliation Act of 1989. Section 174(e) provides that the accounting 
rules of section 174 apply to a research or experimental expenditure 
only to the extent that the amount of the expenditure is reasonable 
under the circumstances.
    The IRS received comments on the proposed amendments both in 
writing and at a public hearing on June 18, 1993. This Treasury 
decision adopts the proposed amendments with several revisions in 
response to public comments.

Explanation of Provisions

A. Clarification of Uncertainty Test

    As noted above, the 1957 regulations define research or 
experimental expenditures as expenditures which represent research and 
development costs in the experimental or laboratory sense. The proposed 
amendments provide 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 proposed amendments, the requisite uncertainty exists if the 
information reasonably available to the taxpayer does not establish the 
capability or method for developing or improving the product.
    Several commentators expressed concern that the uncertainty test 
provided in the proposed amendments could be construed to limit unduly 
the definition of research or experimental expenditures. In particular, 
the commentators argued that the test could exclude expenditures 
incurred to determine the appropriate design of a product if the 
taxpayer knows at the outset that the procedure will be successful. In 
such a case, the taxpayer is not uncertain as to either its capability 
to develop the product or the method by which it will develop the 
product.
    The Treasury Department and the IRS agree that a taxpayer's 
knowledge that a product development project will be successful does 
not preclude the process of determining the appropriate design of the 
product from qualifying as research. The Treasury Department and the 
IRS also agree that the language of the uncertainty test provided in 
the proposed amendments could be construed to reach a result contrary 
to that intended. The final amendments thus clarify the uncertainty 
test. Under the final amendments, the requisite uncertainty exists if 
the information available to the taxpayer does not establish either (i) 
The capability or method for developing or improving the product, or 
(ii) the appropriate design of the product.
    The uncertainty test, as clarified in the final amendments, 
reflects the dual purposes of section 174. Congress enacted section 174 
not only to encourage research, but also to avoid the difficult tax 
accounting questions that would arise regarding research expenditures 
in the absence of special tax accounting rules. See H. Rep. 1337, 83d 
Cong., 2d Sess. (1954), reprinted in 1954 U.S.C.C.A.N. 4017, 4053. 
These difficult tax accounting questions would not be limited to cases 
in which the success of a product development project is in doubt. If a 
given line of inquiry proves to be unfruitful, questions could arise 
regarding whether the costs involved could be deducted, or whether the 
knowledge gained from the inquiry might contribute sufficiently to the 
ultimate design of the product that the costs must be capitalized. In 
short, the tax accounting questions that section 174 was meant to 
resolve can arise whenever the taxpayer is uncertain as to the 
capability or method for developing or improving the product, or the 
appropriate design of the product.
    The proposed amendments apply the uncertainty test with reference 
to ``the information reasonably available to the taxpayer.'' The 
Treasury Department and the IRS agree with the commentators that the 
meaning of the phrase reasonably available is unclear. Further, the 
phrase could be read to impose an unintended restriction on the 
definition of research or experimental expenditures. Information could 
be considered to be reasonably available to a taxpayer if the taxpayer 
can obtain the information through procedures that, while not 
particularly involved, are nonetheless in the nature of research 
activities. To avoid the ambiguities resulting from the term 
reasonably, the final amendments provide for the application of the 
uncertainty test with reference to the information actually available 
to the taxpayer. The removal of the term reasonably is not intended to 
expand the information considered to be available to the taxpayer.

B. Validation Testing

    The 1957 regulations exclude from the definition of research the 
ordinary testing or inspection of materials or products for quality 
control. Several commentators on the proposed amendments asked for 
clarification that research includes validation testing to ensure that 
a product design meets its intended objectives. In response to these 
comments, the final amendments clarify that the existing exclusion for 
quality control testing does not apply to testing to determine if the 
design of a product is appropriate.

C. Effective Date

    The final amendments retain the effective date of the proposed 
amendments, and thus apply to taxable years beginning after October 3, 
1994. Some commentators requested that the proposed amendments apply to 
all open taxable years. Because the amendments merely clarify the 
existing definition of research or experimental expenditures, 
retroactive application of the amendments is unnecessary. Return 
positions consistent with the amendments will be consistent with the 
existing regulations and will be recognized as such by the IRS.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in EO 12866. Therefore, a 
regulatory assessment is not required. It has also been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) 
and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to 
these regulations, and, therefore, a Regulatory Flexibility Analysis is 
not required. Pursuant to section 7805(f) of the Internal Revenue Code, 
the notice of proposed rulemaking preceding these regulations was 
submitted to the Small Business Administration for comment on their 
impact on small business.

Drafting Information

    The principal author of these regulations is Lisa J. Shuman of the 
Office of Assistant Chief Counsel (Passthroughs and Special 
Industries), IRS. However, other personnel from the IRS and Treasury 
Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.174-2 is amended as follows:
    1. Paragraph (a)(1) is revised.
    2. Paragraphs (a) (2) and (3) are redesignated as paragraphs (a) 
(8) and (9), respectively.
    3. New paragraphs (a) (2) through (7) are added.
    4. Paragraph (c) is amended by removing the reference ``sections 
615'' and adding ``sections 617'' in its place.
    5. The additions and revisions read as follows:


Sec. 1.174-2  Definition of research and experimental expenditures.

    (a) In general. (1) The term research or experimental expenditures, 
as used in section 174, means expenditures incurred in connection with 
the taxpayer's trade or business which represent research and 
development costs in the experimental or laboratory sense. The term 
generally includes all such costs incident to the development or 
improvement of a product. The term includes the costs of obtaining a 
patent, such as attorneys' fees expended in making and perfecting a 
patent application. 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. 
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. Whether expenditures 
qualify as research or experimental expenditures depends on the nature 
of the activity to which the expenditures relate, not the nature of the 
product or improvement being developed or the level of technological 
advancement the product or improvement represents.
    (2) For purposes of this section, the term product includes any 
pilot model, process, formula, invention, technique, patent, or similar 
property, and includes products to be used by the taxpayer in its trade 
or business as well as products to be held for sale, lease, or license.
    (3) The term research or experimental expenditures does not include 
expenditures for--
    (i) The ordinary testing or inspection of materials or products for 
quality control (quality control testing);
    (ii) Efficiency surveys;
    (iii) Management studies;
    (iv) Consumer surveys;
    (v) Advertising or promotions;
    (vi) The acquisition of another's patent, model, production or 
process; or
    (vii) Research in connection with literary, historical, or similar 
projects.
    (4) For purposes of paragraph (a)(3)(i) of this section, testing or 
inspection to determine whether particular units of materials or 
products conform to specified parameters is quality control testing. 
However, quality control testing does not include testing to determine 
if the design of the product is appropriate.
    (5) See section 263A and the regulations thereunder for cost 
capitalization rules which apply to expenditures paid or incurred for 
research in connection with literary, historical, or similar projects 
involving the production of property, including the production of 
films, sound recordings, video tapes, books, or similar properties.
    (6) Section 174 applies to a research or experimental expenditure 
only to the extent that the amount of the expenditure is reasonable 
under the circumstances. In general, the amount of an expenditure for 
research or experimental activities is reasonable if the amount would 
ordinarily be paid for like activities by like enterprises under like 
circumstances. Amounts supposedly paid for research that are not 
reasonable under the circumstances may be characterized as disguised 
dividends, gifts, loans, or similar payments. The reasonableness 
requirement of this paragraph (a)(6) does not apply to the 
reasonableness of the type or nature of the activities themselves.
    (7) This paragraph (a) applies to taxable years beginning after 
October 3, 1994.
* * * * *
    Dated: September 9, 1994.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
    Approved: September 9, 1994.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 94-24153 Filed 9-30-94; 8:45 am]
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