[Federal Register Volume 62, Number 1 (Thursday, January 2, 1997)]
[Proposed Rules]
[Pages 81-83]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-32671]


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DEPARTMENT OF THE TREASURY
26 CFR Parts 1 and 602

[REG-209494-90]
RIN 1545-A051


Credit for Increasing Research Activities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations under section 41 
of the Internal Revenue Code of 1986 describing when computer software 
which is developed by (or for the benefit of) a taxpayer primarily for 
the taxpayer's internal use can qualify for the credit for increasing 
research activities. The proposed regulations reflect a change to 
section 41 made by the Tax Reform Act of 1986. This document also 
provides notice of a public hearing on these proposed regulations.

DATES: Comments and outlines of topics to be discussed at the public 
hearing scheduled for May 13, 1997 must be received by April 22, 1997.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-209494-90), room 
5228, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered between the 
hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-209494-90), Courier's 
Desk, Internal Revenue Service, 1111 Constitution Avenue NW., 
Washington, DC. Alternatively, taxpayers may submit comments 
electronically via the Internet by selecting the ``Tax Regs'' option of 
the IRS Home Page, or by submitting comments directly to the IRS 
Internet site at: http://www.irs.ustreas.gov/prod/tax__regs/
comments.html. The public hearing will be held in the auditorium, 
Internal Revenue Building, 1111 Constitution Avenue, NW., Washington, 
DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Lisa J. 
Shuman or Robert B. Hanson, 202-622-3120; concerning submissions and 
the hearing, Christina Vasquez, 202-622-7180 (not toll-free numbers).

[[Page 82]]

SUPPLEMENTARY INFORMATION:

Background

    Section 41 of the Internal Revenue Code provides a credit against 
tax for increasing research activities. Eligibility for the credit is 
determined in part on the definition of qualified research under 
section 41(d)(1). Section 231 of the Tax Reform Act of 1986 (the 1986 
Act), 1986-3 C.B. 1, 87, established a new definition of qualified 
research for purposes of the research credit. Qualified research was 
narrowed to require that research be undertaken for the purpose of 
discovering information that is technological in nature and the 
application of which is intended to be useful in developing a new or 
improved business component of the taxpayer. In addition, research is 
eligible for the credit only if substantially all of the activities of 
the research constitute elements of a process of experimentation for a 
new or improved function, performance, or reliability or quality. 
Treasury and the IRS request comments on the appropriate explanation of 
the terms used in the definition of qualified research under the 1986 
Act, in particular, the term process of experimentation.
    Section 231 of the 1986 Act also specified that expenditures 
incurred in certain research, research-related, and non-research 
activities are to be excluded from eligibility for the credit without 
reference to the general requirements for credit eligibility. Under 
section 41(d)(4)(E) of the Code, except to the extent provided in 
regulations, qualified research does not include research with respect 
to computer software developed by (or for the benefit of) the taxpayer 
primarily for the taxpayer's own use (internal-use software), other 
than for use in (1) an activity which constitutes qualified research, 
or (2) a production process whose development meets the requirements in 
section 41(d)(1) for qualified research (as where the taxpayer is 
developing robotics and software for the robotics for use in operating 
a manufacturing process, and the taxpayer's research costs of 
developing the robotics are eligible for the credit).
    The legislative history indicates that Congress intended to limit 
the credit for the costs of developing internal-use software to 
software meeting a high threshold of innovation. In particular, 
Congress intended that regulations would permit internal-use software 
to qualify for the credit only if, in addition to satisfying the 
general requirements for credit eligibility, the taxpayer can establish 
that the following three-part test is satisfied: the software is 
innovative (as where the software results in a reduction in cost, or 
improvement in speed, that is substantial and economically 
significant); the software development involves significant risk (as 
where the taxpayer commits substantial resources to the development of 
the software and there is substantial uncertainty, because of technical 
risk, that such resources would not be recovered in a reasonable period 
of time); and the software is not commercially available for use by the 
taxpayer (as where the software cannot be purchased, leased, or 
licensed and used for the intended purpose without modifications that 
would satisfy the first two requirements). See H.R. Rep. No. 841, 99th 
Cong., 2d Sess. II-73. Thus, Congress did not intend that the three-
part test in the legislative history would apply in lieu of the general 
requirements for credit eligibility but, rather, intended that the 
general requirements for credit eligibility of section 41(d) also would 
have to be satisfied. See H.R. Rep. No. 841 at II-73.
    The legislative history indicates, however, that Congress did not 
intend the internal-use software exclusion in section 41(d)(4)(E) to 
apply to research related to the development of a new or improved 
package of software and hardware developed as a single product of which 
the software is an integral part, and that is used directly by the 
taxpayer in providing technological services to customers in its trade 
or business (as where a taxpayer develops together a new or improved 
high technology medical or industrial instrument containing software 
that processes and displays data received by the instrument, or where a 
telecommunications company develops a package of new or improved 
switching equipment plus software to operate the switches). See H.R. 
Rep. No. 841 at II-74.
    Congress intended that regulations incorporating the three-part 
test in the legislative history as an exception to the exclusion from 
the definition of qualified research under section 41(d)(4)(E) would be 
effective on the same date section 41(d)(4)(E) became effective. In 
Notice 87-12 (1987-1 C.B. 432), the IRS stated that regulations to be 
issued under section 41(d)(4)(E) would be effective for taxable years 
beginning after December 31, 1985.

Explanation of Provisions

    The proposed regulations follow the legislative history and provide 
that internal-use software that meets the general requirements of 
section 41(d), is innovative, involves significant economic risk, and 
is not commercially available for use by the taxpayer is not excluded 
from eligibility for the research credit under section 41(d)(4)(E). 
Under the proposed regulations, this is a facts and circumstances test. 
Treasury and the IRS request comments on facts and circumstances, other 
than those factors enumerated in the legislative history, to be 
considered in determining whether internal-use software satisfies the 
three-part test.

Proposed Effective Dates

    The amendments are proposed to be effective for taxable years 
beginning after December 31, 1985.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in EO 12866. Therefore, 
a regulatory assessment is not required. It also has been determined 
that section 553(b) of the Administrative Procedure Act (5 U.S.C. 
chapter 5) does not apply to these regulations, and because these 
regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Therefore, a Regulatory Flexibility Analysis is not required. 
Pursuant to section 7805(f) of the Internal Revenue Code, this notice 
of proposed rulemaking will be submitted to the Chief Counsel for 
Advocacy of the Small Business Administration for comment on its impact 
on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any comments that are submitted timely 
(in the manner described in the ADDRESSES portion of this preamble) to 
the IRS. All comments will be available for public inspection and 
copying.
    A public hearing has been scheduled for May 13, 1997, at 10 a.m. in 
the auditorium, Internal Revenue Building, 1111 Constitution Avenue, 
NW., Washington, DC. Because of access restrictions, visitors will not 
be admitted beyond the building lobby more than 15 minutes before the 
hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons that wish to present oral comments at the hearing must 
submit (in the manner described in the ADDRESSES portion of this 
preamble) comments and an outline of the topics to be discussed and the 
time to be devoted to each topic by April 22, 1997.

[[Page 83]]

    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are proposed to be amended as 
follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
an entry in numerical order to read as follows:

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

    Section 1.41-4 also issued under 26 U.S.C. 41(d)(4)(E). * * *
    Par. 2. Section 1.41-0 is amended by revising the entry for 
Sec. 1.41-4 to read as follows:


Sec. 1.41-0  Table of contents.

* * * * *

Sec. 1.41-4  Qualified research for taxable years beginning after 
December 31, 1985.

    (a) through (d) [Reserved].
    (e) Internal-use computer software.
    (1) General rule.
    (2) Requirements.
    (3) Computer software and hardware developed as a single 
product.
    (4) Primarily for internal use.
    (5) Special rule.
    (6) Application of special rule.
    (7) Effective date.
* * * * *
    Par. 3. Section 1.41-4 is revised to read as follows:


Sec. 1.41-4  Qualified research for taxable years beginning after 
December 31, 1985.

    (a) through (d) [Reserved].
    (e) Internal-use computer software--(1) General rule. Research with 
respect to computer software that is developed by (or for the benefit 
of) the taxpayer primarily for the taxpayer's internal use is eligible 
for the research credit only if the software satisfies the requirements 
of paragraph (e)(2) of this section. Generally, research with respect 
to computer software is not eligible for the research credit where 
software is used internally, for example, in general and administrative 
functions (such as payroll, bookkeeping, or personnel management) or in 
providing noncomputer services (such as accounting, consulting, or 
banking services).
    (2) Requirements. The requirements of this paragraph (e)(2) are--
    (i) The software satisfies the requirements of section 41(d)(1);
    (ii) The software is not otherwise excluded under section 41(d)(4) 
(other than section 41(d)(4)(E)); and
    (iii) One of the following conditions is met--
    (A) The taxpayer uses the software in an activity that constitutes 
qualified research (other than the development of the internal-use 
software itself);
    (B) The taxpayer uses the software in a production process that 
meets the requirements of section 41(d)(1); or
    (C) The software satisfies the special rule of paragraph (e)(5) of 
this section.
    (3) Computer software and hardware developed as a single product. 
This paragraph (e) does not apply to the development costs of a new or 
improved package of computer software and hardware developed together 
by the taxpayer as a single product, of which the software is an 
integral part, that is used directly by the taxpayer in providing 
technological services in its trade or business to customers. In these 
cases, eligibility for the research credit is to be determined by 
examining the combined hardware-software product as a single product.
    (4) Primarily for internal use. All relevant facts and 
circumstances are to be considered in determining if computer software 
is developed primarily for the taxpayer's internal use. If computer 
software is developed primarily for the taxpayer's internal use, the 
requirements of this paragraph (e) apply even though the taxpayer 
intends to, or subsequently does, sell, lease, or license the computer 
software.
    (5) Special rule. Computer software satisfies the special rule of 
this paragraph (e)(5) only if the taxpayer can establish that--
    (i) The software is innovative (as where the software results in a 
reduction in cost, or improvement in speed, that is substantial and 
economically significant);
    (ii) The software development involves significant economic risk 
(as where the taxpayer commits substantial resources to the development 
and there is a substantial uncertainty, because of technical risk, that 
such resources would be recovered within a reasonable period); and
    (iii) The software is not commercially available for use by the 
taxpayer (as where the software cannot be purchased, leased, or 
licensed and used for the intended purpose without modifications that 
would satisfy the requirements of paragraphs (e)(5) (i) and (ii) of 
this section).
    (6) Application of special rule. In determining if the special rule 
of paragraph (e)(5) of this section is satisfied all of the facts and 
circumstances are considered. The special rule allows the costs of 
developing internal-use software to be eligible for the research credit 
only if the software meets a high threshold of innovation. The facts 
and circumstances analysis takes into account only the results 
attributable to the development of the new or improved software 
independent of the effect of any modifications to related hardware or 
other software. The weight given to any fact or circumstance will 
depend on the particular case.
    (7) Effective date. This paragraph (e) is applicable for taxable 
years beginning after December 31, 1985.


Secs. 1.41-0A through 1.41-8A  [Removed]

    Par. 4. Sections 1.41-0A through 1.41-8A and the undesignated 
centerheading preceding these sections are removed.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

    Par. 5. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

    Par. 6. In Sec. 602.101, paragraph (c) is amended by removing the 
following entries from the table:


Sec. 602.101  OMB Control numbers.

* * * * *
    (c) * * *

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                                                             Current OMB
     CFR part or section where identified and described      control No.
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                  *        *        *        *        *                 
1.41-4A....................................................    1545-0074
1.41-4 (b) and (c).........................................    1545-0074
                                                                        
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Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 96-32671 Filed 12-31-96; 8:45 am]
BILLING CODE 4830-01-U