[Federal Register Volume 66, Number 2 (Wednesday, January 3, 2001)]
[Rules and Regulations]
[Pages 280-296]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-33170]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8930]
RINs 1545-AV14 and 1545-A051


Credit for Increasing Research Activities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the 
computation of the credit under section 41(c) and the definition of 
qualified research under section 41(d). These regulations are intended 
to provide guidance concerning the requirements necessary to qualify 
for the credit for increasing research activities, guidance in 
computing the credit for increasing research activities, and rules for 
electing and revoking the election of the alternative incremental 
credit. These regulations reflect changes to section 41 made by the Tax 
Reform Act of 1986 (the 1986 Act), the Revenue Reconciliation Act of 
1989, the Small Business Job Protection Act of 1996, the Taxpayer 
Relief Act of 1997, the Tax and Trade Relief Extension Act of 1998 (the 
1998 Act), and the Tax Relief Extension Act of 1999 (the 1999 Act). 
These regulations also provide certain technical amendments to the 
existing regulations.

DATES: Effective Dates: These regulations are effective January 3, 
2001.
    Applicability Dates: For dates of applicability of these 
regulations, see Effective Dates under SUPPLEMENTARY INFORMATION.

FOR FURTHER INFORMATION CONTACT: Lisa J. Shuman or Leslie H. Finlow at 
(202) 622-3120 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in Sec. 1.41-8(b) of this 
final rule have been reviewed and approved by the Office of Management 
and Budget in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507) under the number 1545-1625. Responses to these collections 
of information are mandatory.
    The reporting burden contained in Sec. 1.41-8(b)(2) (relating to 
the election of the alternative incremental credit) is reflected in the 
burden of Form 6765.
    Estimated average annual burden hours per respondent under 
Sec. 1.41-8(b)(3) (relating to the revocation of the election to use 
the alternative incremental credit) is 250 hours.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, W:CAR:MP:FP:S:O, 
Washington, DC 20224, and to the Office of Management and Budget, Attn: 
Desk Officer for the Department of the Treasury, Office of Information 
and Regulatory Affairs, Washington, DC 20503.
    The collections of information contained in Sec. 1.41-4(d) of this 
final rule have been reviewed and, pending receipt and evaluation of 
public comments, approved by the Office of Management and Budget (OMB) 
under 44 U.S.C. 3507 and assigned control number 1545-1625. This 
information is required to assist in the examination of the research 
credit and to ensure that the research credit is properly targeted to 
serve as an incentive to engage in qualified research. This information 
will be used to verify that the amounts treated as qualified research 
expenses were paid or incurred for activities intended to discover 
information that exceeds, expands, or refines the common knowledge of 
skilled professionals in the relevant field of science or engineering. 
This collection of information is required to obtain a benefit. The 
likely recordkeepers are businesses or other for-profit institutions.
    Estimated total annual recordkeeping burden for Sec. 1.41-4(d) is 
18,000 hours. The annual estimated burden per respondent varies from .5 
hours to 2.5 hours, depending on the circumstances, with an estimated 
average of 1.5 hours.
    The estimated number of recordkeepers is 12,000.
    Comments on the collection of information should be sent to the 
Office of Management and Budget, Attn: Desk Officer for the Department 
of the Treasury, Office of Information and Regulatory Affairs, 
Washington, DC 20503, with copies to the Internal Revenue Service, 
Attn: IRS Reports Clearance Officer, W:CAR:MP:FP:S:O,

[[Page 281]]

Washington, DC 20224. Comments on the collection of information should 
be received by March 5, 2001. Comments are specifically requested 
concerning:
    Whether the collection of information is necessary for the proper 
performance of the functions of the Internal Revenue Service, including 
whether the information will have practical utility;
    The accuracy of the estimated burden associated with the collection 
of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the collection of information may 
be minimized, including through the application of automated collection 
techniques or other forms of information technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    On January 2, 1997, the IRS and Treasury published in the Federal 
Register (62 FR 81) a notice of proposed rulemaking (REG-209494-90, 
1997-1 C.B. 723) under section 41 describing when computer software 
that 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 1997 proposed regulations). Comments 
responding to the 1997 proposed regulations were received and a public 
hearing was held on May 13, 1997.
    On December 2, 1998, the IRS and Treasury published in the Federal 
Register (63 FR 66503) a notice of proposed rulemaking (REG-105170-97, 
1998-50 I.R.B. 10) under section 41 relating to the credit for 
increasing research activities (the 1998 proposed regulations). The 
1998 proposed regulations propose rules and examples relating to (1) 
the definition of gross receipts for purposes of computing the base 
amount under section 41(c), (2) the application of the consistency rule 
in computing the base amount, (3) the definition of qualified research 
under section 41(d), (4) the application of the exclusions from the 
definition of qualified research, (5) the application of the shrinking-
back rule, and (6) the election of the alternative incremental credit. 
The 1998 proposed regulations also propose certain technical amendments 
to the existing regulations. Comments responding to the 1998 proposed 
regulations were received and a public hearing was held on April 29, 
1999.
    In the 1999 Act, Congress extended the credit for a five-year 
period. The Conference Report accompanying the 1999 Act included the 
following language addressing the proposed regulations:

    In extending the research credit, the conferees are concerned 
that the definition of qualified research be administered in a 
manner that is consistent with the intent Congress has expressed in 
enacting and extending the research credit. The conferees urge the 
Secretary to 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. The conferees further note the rapid pace of 
technological advance, especially in service-related industries, and 
urge the Secretary to consider carefully the comments he has and may 
receive in promulgating regulations in connection with what 
constitutes ``internal use'' with regard to software expenditures. 
The conferees also wish to observe that software research, that 
otherwise satisfies the requirements of section 41, which is 
undertaken to support the provision of a service, should not be 
deemed ``internal use'' solely because the business component 
involves the provision of a service.
    The conferees wish to reaffirm that qualified research is 
research undertaken for the purpose of discovering new information 
which is technological in nature. For purposes of applying this 
definition, new information is information that is new to the 
taxpayer, is not freely available to the general public, and 
otherwise satisfies the requirements of section 41. Employing 
existing technologies in a particular field or relying on existing 
principles of engineering or science is qualified research, if such 
activities are otherwise undertaken for purposes of discovering 
information and satisfy the other requirements of section 41.
    The conferees also are concerned about unnecessary and costly 
taxpayer record keeping burdens and reaffirm that eligibility for 
the credit is not intended to be contingent on meeting unreasonable 
record keeping requirements.

H.R. Conf. Rep. No. 106-478, at 132 (1999).
    After considering the comments received, the statements made at the 
public hearings, and the legislative history for the research credit, 
the proposed regulations are adopted as revised by this Treasury 
decision.

Explanation of Provisions

    This document amends 26 CFR part 1 to provide additional rules 
under section 41. Section 41 contains the rules for the credit for 
increasing research activities.

I. Basic Principles

    A number of commentators objected to the inclusion of the basic 
principles statement in Sec. 1.41-1(a) of the proposed regulations. 
They stated that the inclusion of a basic principles section was 
unusual, and that the basic principles section could be read to impose 
additional and unwarranted conditions for credit eligibility. In 
response to these comments, and because IRS and Treasury have concluded 
that the requisite principles are adequately reflected in the 
provisions of the regulations, the final regulations omit a separate 
statement of basic principles. The clarifications that the credit may 
be available where the technological advance sought is evolutionary, 
where the taxpayer is not the first to achieve the advance, and where 
the taxpayer fails to achieve the intended advance have been 
incorporated elsewhere in the regulations.

II. Gross Receipts

    When Congress revised the computation of the research credit to 
incorporate a taxpayer's gross receipts, neither the statute nor the 
legislative history defined the term gross receipts, other than to 
provide that gross receipts for any taxable year are reduced by returns 
and allowances made during the tax year, and, in the case of a foreign 
corporation, that only gross receipts effectively connected with the 
conduct of a trade or business within the United States are taken into 
account. See section 41(c)(6).
    The proposed regulations generally defined gross receipts as the 
total amount derived by a taxpayer from all activities and sources. 
However, in recognition of the fact that certain extraordinary gross 
receipts might not be taken into account when a business determines its 
research budget, the proposed regulations provided that certain 
extraordinary items (such as receipts from the sale or exchange of 
capital assets) would be excluded from the computation of gross 
receipts.
    Several commentators objected to the definition of gross receipts 
in the proposed regulations. Referring to the inclusion in a House 
Budget Report of the term sales growth as an apparent

[[Page 282]]

short-hand reference to an increase in gross receipts, some 
commentators argued that gross receipts should be limited to income 
from sales. See H.R. Rep. No. 101-247, at 1200 (1989). In determining 
its research budget, however, a business may take into account any 
expected income stream, regardless of whether or not the income is 
derived from sales or from other active business activities. Moreover, 
many businesses do not generate any income in the form of sales. 
Accordingly, the final regulations do not adopt this suggestion.
    The final regulations also do not adopt suggestions that the 
definition of gross receipts be narrowed to exclude those items not 
directly related to the conduct of the taxpayer's trade or business. As 
noted above, any expected income stream may be taken into account in 
determining a business' research budget, regardless of the source of 
the income. Moreover, IRS and Treasury believe that a subjective 
narrowing of the term gross receipts, as suggested by these 
commentators, could leave the definition of the term, and thus the 
computation of the base amount, vulnerable to manipulation.
    For example, a narrower definition allowing taxpayers to exclude 
items not derived in the ordinary course of business might prompt a 
taxpayer to assert that certain royalties received in the 1980s were 
derived in the ordinary course of business and are includable as gross 
receipts (thus decreasing the taxpayer's fixed-base percentage), but 
that certain interest income received in the years preceding the credit 
year was not derived in the ordinary course of business and was not 
includable in gross receipts (thus decreasing the base amount). Nor 
would a rule of consistency be effective in preventing such 
manipulation. While the taxpayer described above would be 
characterizing the nature of its income items as derived or not derived 
in the ordinary course of a trade or business so as to maximize the 
amount of the credit, the taxpayer would not be taking inconsistent 
positions with respect to the same items of income.
    Several commentators objected to the definition of gross receipts 
in the proposed regulations as it applies to start-up firms with pre-
operating interest income. If pre-operating interest income is treated 
as a gross receipt, many start-up firms would be precluded from using 
the start-up rules to compute their fixed-base percentages, because the 
application of the start-up rules is conditioned on a taxpayer not 
having both gross receipts and qualified research expenses in certain 
taxable years during the 1980s. Moreover, because a start-up firm whose 
only gross receipt is pre-operating interest income likely would have 
significant qualified research expenses relative to gross receipts (and 
thus a high fixed-base percentage), such a firm likely would derive 
less benefit from the credit.
    IRS and Treasury recognize that the start-up rules appear to 
contemplate that there will be years in which a taxpayer has qualified 
research expenses but no gross receipts. However, it would be difficult 
to conceive of such a year if gross receipts are defined to include 
pre-operating investment income. To address these concerns and pursuant 
to the regulatory authority of section 41(c)(3)(B)(iii), the final 
regulations exclude from the definition of gross receipts any income 
received by a taxpayer in a taxable year that precedes the first 
taxable year in which the taxpayer derives more than $25,000 in gross 
receipts other than investment income. For this purpose, investment 
income is defined as interest or distributions with respect to stock 
(other than the stock of a 20-percent owned corporation as defined in 
section 243(c)(2) of the Code).
    Some commentators suggested that the definition of gross receipts 
should be clarified to exclude certain payments made by pharmaceutical 
manufacturers to various insurers, managed care organizations and state 
governments. The final regulations do not adopt any provision 
specifically addressing such payments.

III. 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. Section 1.41-4(a)(3) of the proposed 
regulations 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.
    Commentators criticized this definition of discovering information, 
arguing that the definition imposes a discovery requirement that was 
not mandated by the statute. Commentators suggested that the phrase 
discovering information, as used in the statute, was not intended as an 
additional requirement, but was simply used as a phrase to link the 
term research with the types of information required as the subject of 
the research. Commentators argued that a taxpayer who seeks to resolve 
its own subjective uncertainty as to the information at issue is 
undertaking sufficient discovery for purposes of section 41(d).
    Consistent with the legislative history and case law as described 
below, however, IRS and Treasury continue to believe that section 41 
conditions credit eligibility on an attempt to discover information 
that goes beyond the common knowledge of skilled professionals in the 
particular field of science or engineering.
    The legislative history to the 1986 Act, which narrowed the 
definition of the term qualified research, explained that Congress had 
originally enacted the research credit to encourage business firms to 
perform the research necessary to increase the innovative qualities and 
efficiency of the U.S. economy. H.R. Rep. No. 99-426, at 177-78; S. 
Rep. No. 99-313, at 694-95. Congress was concerned 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.'' Id. In an illustration of the changes enacted, the 
legislative history explained that, under the new definition: 
``Research does not rely on the principles of computer science merely 
because a computer is employed. Research may be treated as undertaken 
to discover information that is technological in nature, however, if 
the research is intended to expand or refine existing principles of 
computer science.'' H.R. Conf. Rep. No. 99-841, at II-71 n.3 (1986) 
(emphasis added).
    Following the 1986 Act changes to the 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), and WICOR, Inc. v. United 
States, 116 F. Supp. 2d 1028 (E.D. Wis. 2000).
    In reaffirming the scope of the term qualified research, the 
Conference Report to the 1998 Act noted that:

evolutionary research activities intended to improve functionality, 
performance, reliability, or quality are eligible for the credit, as 
are research activities intended to achieve a result that has 
already been achieved by other persons but is not yet within the 
common knowledge (e.g., freely available to the general public) of 
the field (provided that the research otherwise meets

[[Page 283]]

the requirements of section 41, including not being excluded by 
subsection (d)(4)).

H.R. Conf. Rep. No. 105-825, at 1548 (1998) (emphasis added). In 
particular, it is noteworthy that the conferees clarified that the 
credit is available for research intended to achieve a result that has 
been achieved by others but is not yet within the common knowledge. The 
negative inference is that the credit is not available for research 
intended to achieve a result that has been achieved by others and is 
within the common knowledge of the field.
    The discovery requirement as set forth in the final regulations 
also is consistent with the legislative history to the 1999 Act (the 
text of which is set forth above under Background). In that legislative 
history, for example, the conferees stated that:

[e]mploying existing technologies in a particular field or relying 
on existing principles of engineering or science is qualified 
research, if such activities are otherwise undertaken for purposes 
of discovering information and satisfy the other requirements under 
section 41.

H.R. Conf. Rep. No. 106-478, at 132 (emphasis added). By referring 
separately to a requirement that the research be undertaken for 
purposes of discovering information, this legislative history again 
confirmed that the phrase ``discovering information'' is a separate 
substantive requirement and not merely a phrase used to link the term 
research with the types of information required as the subject of the 
research.
    In light of the case law and the legislative history, the final 
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. However, consistent with the legislative history to the 
1999 Act, IRS and Treasury have carefully considered comments relating 
to the ``common knowledge'' standard, and made a number of changes to 
address specific taxpayer concerns about the discovery requirement.
    In response to comments regarding the application of the discovery 
requirement, the final 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. 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 investigation 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.
    Also, in response to comments, the discovery requirement in the 
final regulations has been reworded to refer to the common knowledge of 
skilled professionals in a particular field of science or engineering 
(rather than a particular field of technology or science, as in the 
proposed regulations). As in the proposed regulations, the common 
knowledge of skilled professionals is intended to serve as an objective 
standard for the baseline knowledge that a credit-eligible taxpayer 
must seek to exceed, expand, or refine. The reference to the common 
knowledge of skilled professionals is not intended to impose 
qualification requirements on the personnel that the taxpayer uses to 
conduct qualified research.
    Several commentators raised concerns that the discovery requirement 
in the proposed regulations required that taxpayers must ``prove a 
negative;'' in response to these concerns about the potential burden 
imposed on taxpayers to demonstrate that they satisfy the discovery 
requirement, IRS and Treasury have added to the final regulations a 
rebuttable presumption. The final 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. This rebuttable presumption would arise, 
however, only if the taxpayer cooperates with reasonable requests by 
the IRS for witnesses, information, documents, meetings, and 
interviews.
    In a case where the rebuttable presumption arises, the final 
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.
    By way of further clarification, a provision has been added and 
several examples have been changed or eliminated to remove any 
implication that the underlying principles of science or engineering 
used in the research must themselves be novel. IRS and Treasury 
recognize that virtually all research utilizes existing scientific 
principles and technology. The requirement that a taxpayer seek to 
exceed, expand, or refine the common knowledge of skilled professionals 
does not mean that the tools and principles used in the attempt to 
achieve the technological advance must themselves be beyond the common 
knowledge.
    Also, in response to commentators' suggestions, the final 
regulations 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. Section 101 of title 35 of the United States Code provides 
that ``[w]hoever invents or discovers any new and useful process, 
machine, manufacture, or composition of matter, or any new and useful 
improvement thereof, may obtain a patent therefor, subject to the 
conditions and requirements of [title 35].'' Such an invention or 
discovery may be patentable if it was not previously known, used, 
patented, or described, as set forth in 35 U.S.C. 102, and the 
differences between the invention and the prior art are such that the 
invention would not have been obvious to a person having ordinary skill 
in the relevant art. See 35 U.S.C. 102.
    The final regulations contain a patent safe harbor because IRS and 
Treasury believe that information leading to a patentable invention 
constitutes information that exceeds, expands, or refines the common 
knowledge of skilled professionals in the relevant

[[Page 284]]

field. Of course, qualification under the patent safe harbor does not 
necessarily establish that the discovery requirement is satisfied with 
respect to all of the research associated with the patentable invention 
(for example, some of the research might relate to style).
    The final regulations emphasize that a patent is not a precondition 
for credit eligibility. Because not all research succeeds in achieving 
its objective and for other reasons, it is obvious that not all 
research intended to discover information that goes beyond the common 
knowledge results in a patent. Thus, the absence of a patent should 
have no bearing on credit eligibility. The factors underlying the 
denial of a patent application, on the other hand, may be relevant to 
the determination of whether the discovery requirement is satisfied.
    Because section 41(d)(3)(B) provides that the credit is not 
available for research related to style, taste, cosmetic, or seasonal 
design factors, the patent safe harbor does not include patents for 
design, as defined by 35 U.S.C. 171.
    In light of these changes, modifications have been made to several 
examples in the proposed regulations, including an example in the 
proposed regulations relating to research undertaken to develop a new 
tire. This example has been moved to the section of the final 
regulations that illustrates the exclusion for research conducted after 
the beginning of commercial production (discussed in VII. Research 
After Commercial Production of this Preamble).
    To address concerns expressed by a number of commentators that the 
common knowledge standard may be difficult for taxpayers and examiners 
to apply, and may give rise in practice to inconsistent treatment of 
similarly situated taxpayers (especially where examiners have limited 
expertise in a particular scientific field) IRS and Treasury have 
initiated measures to promote fair and consistent application of the 
discovery requirement and the other conditions for credit eligibility. 
Consistent with the suggestion of one commentator, IRS has met with 
Revenue Canada to discuss Canada's joint industry/government initiative 
to improve administration of the Canadian research credit. IRS also has 
met with various industry associations to form joint initiatives to 
devise guidelines for the administration and examination of the credit 
in particular industries. Similar efforts with respect to other 
industry groups are anticipated.

IV. Process of Experimentation

    Commentators objected to Sec. 1.41-4(a)(5) of the proposed 
regulations, which defines a process of experimentation to include a 
prescribed four-step process. Commentators argued that while the four-
step process may accurately have described the pure scientific method 
of conducting experiments, commercial and industrial practice does not 
always conform precisely to such requirements. Commentators also argued 
that the four-step process required by the proposed regulations was 
adapted from a description in the legislative history of the 1986 Act 
that was included for illustrative purposes and not as a comprehensive 
definition of the term process of experimentation. 
    In light of these comments, the final regulations provide that 
taxpayers conducting a process of experimentation may, but are not 
required to, engage in the four-step process.
    Consistent with the legislative history, the final 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 Sec. 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. See H.R. Conf. Rep. 
No. 99-841, at II-72 (``The 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.

V. Recordkeeping Requirement

    Part of the four-step process of experimentation test prescribed in 
Sec. 1.41-4(a)(5) of the proposed regulations was a requirement that 
taxpayers record the results of their experiments. Maintaining that 
this requirement was particularly burdensome, commentators argued that, 
in the industrial or commercial setting, the recording of results is 
not necessarily inherent in a bona fide process of experimentation.
    For these reasons, the final regulations do not contain a 
requirement that taxpayers record the results of their experiments. 
Moreover, reference to the recording of results has been eliminated 
from the illustrative (non-mandatory) description of a four-step 
process of experimentation.
    To assist in the examination of claims for the credit and to ensure 
that the credit is properly targeted to serve as an incentive to engage 
in qualified research, the final regulations do include a less 
burdensome contemporaneous documentation requirement. Under the final 
regulations, taxpayers must prepare and retain written documentation 
before or during the early stages of the research project that 
describes the principal questions to be answered and the information 
the taxpayer seeks to obtain that exceeds, expands, or refines the 
common knowledge of skilled professionals in the relevant field of 
science or engineering. Taxpayers also must comply with the general 
recordkeeping requirements of section 6001.
    As noted above, taxpayers may also avail themselves of a rebuttable 
presumption that they satisfy the discovery requirement if their 
contemporaneous 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.

VI. The Shrinking-Back Rule

    Under Sec. 1.41-4(b) of the proposed regulations, and consistent 
with the legislative history to the 1986 Act, if the requirements of 
section 41(d) are not met for an entire product, then the credit may be 
available with respect to the next most significant subset of elements 
of that product. 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.
    The final regulations clarify that 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. In cases where the substantially-all test is

[[Page 285]]

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. Of course, the mere fact 
that taxpayers are not required to shrink back to a smaller business 
component does not mean that all of the research expenses with respect 
to the overall credit are credit eligible. Research expenses that are 
not qualified research expenses, for example because they relate to 
style, taste, cosmetic, or seasonal design factors, remain ineligible 
for the credit.
    In response to commentators' suggestions, the final regulations 
also clarify that, if the original product is not eligible for the 
credit, the application of the shrinking-back rule may result in credit 
eligibility for multiple business components that are subsets of the 
original product. The regulations clarify that the shrinking-back rule 
may not itself be applied as a reason to exclude research activities 
from credit eligibility. Finally, an example has been added to 
illustrate these concepts.

VII. Research After Commercial Production

    Several commentators addressed the section of the proposed 
regulations providing that activities conducted after the beginning of 
commercial production of a business component are not qualified 
research. Under the proposed regulations, activities are conducted 
after the beginning of commercial production of a business component if 
such activities are conducted after the component is developed to the 
point where it is ready for commercial sale or use, or meets the basic 
functional and economic requirements of the taxpayer for the 
component's sale or use. Moreover, certain specified activities (like 
preproduction planning for a finished business component and trial 
production runs) are deemed to occur after the beginning of commercial 
production.
    Because the provisions set forth above closely reflect the 
legislative history of the post-production exclusion, these tests have 
been retained in the final regulations. See H.R. Conf. Rep. No. 841, at 
II-74-75. However, several changes have been made in response to 
commentators' concerns.
    First, a change has been made to the list of activities that are 
per se deemed to occur after the beginning of commercial production. In 
the proposed regulations, one of the items on that list was ``debugging 
or correcting flaws in a business component.'' Consistent with the 
legislative history, IRS and Treasury continue to believe that 
debugging should be conclusively presumed to occur after the beginning 
of commercial production. However, many activities conducted before the 
beginning of commercial production could be construed as the correction 
of flaws. Thus, the per se list contained in the final regulations has 
been changed to refer to debugging activities but not to the correction 
of flaws.
    Second, an example has been added to clarify that a new research 
project to improve a business component is not disqualified merely 
because the new research project commences after the commercial 
production of the unimproved business component. Other examples have 
been changed to eliminate references to and factual assertions about 
specific industries.
    Third, the final regulations incorporate provisions from the 
legislative history to the 1986 Act that clinical testing of a 
pharmaceutical product prior to its commercial production in the United 
States is not treated as occurring after the beginning of commercial 
production even if the product is commercially available in other 
countries, and that additional clinical testing of a pharmaceutical 
product after a product has been approved for a specific therapeutic 
use by the Food and Drug Administration and is ready for commercial 
production and sale are not treated as occurring after the beginning of 
commercial production if such clinical tests are undertaken to 
establish new functional uses, characteristics, indications, 
combinations, dosages, or delivery forms for the product.

VIII. Adaptation

    Several commentators suggested alternate formulations of the 
adaptation exclusion. Because such formulations effectively would 
render the adaptation exclusion inapplicable to activities that satisfy 
the other requirements for qualified research, thereby reading the 
exclusion out of the Internal Revenue Code, the final regulations do 
not adopt the suggestions.
    Two new examples clarify that the adaptation exclusion may also 
apply to contract research expenses paid by the customer to the vendor 
or to in-house research expenses incurred by the customer itself to 
adapt an existing business component to that customer's requirement or 
need.

IX. Internal-Use Software

    As noted above, the 1997 proposed regulations describe when 
software that is developed by (or for the benefit of) a taxpayer 
primarily for the taxpayer's internal use can qualify for the credit. 
The final regulations incorporate these special provisions for 
internal-use software. A number of changes have been made to the 1997 
proposed regulations to address commentator concerns, and to coordinate 
the internal-use provisions with the other provisions of the final 
regulations.
    Under the proposed regulations, research with respect to software 
developed primarily for a taxpayer's internal use is qualified research 
only if it satisfies both the general requirements for credit 
eligibility under section 41 and an additional condition for 
eligibility. Except for certain software developed for use in 
conducting qualified research or for use in a production process, and 
for certain software created as part of a package of hardware and 
software developed concurrently, the additional condition for 
eligibility is a requirement that the taxpayer satisfy a three-part 
test (requiring that the internal-use software be innovative, that its 
development involve significant economic risk, and that it not be 
commercially available).
    Most of the comments received focused on two issues--(1) the 
determination of when software is developed primarily for internal use, 
and (2) the application of the three-part test to internal-use 
software. On the first issue, several commentators urged that internal-
use software be defined to exclude any software used to deliver a 
service to customers or any software that includes an interface with 
customers or the public. After careful analysis of the legislative 
history to the 1986 Act and the 1999 Act, however, IRS and Treasury 
concluded that such a broad exclusion would be inconsistent with the 
statutory mandate, because the exclusion would extend to some software 
that Congress clearly intended to treat as internal-use software. At 
the same time, IRS and Treasury share the commentators' belief that the 
goals of the research credit may be advanced by removing additional 
conditions for credit-eligibility in the case of certain internal-use 
software used to provide new features to services offered to customers 
that are not otherwise available to them. Accordingly, as described in 
more detail below, the final regulations retain the definition of 
internal-use software contained in the proposed regulations, but 
provide a new exception (pursuant to the regulatory

[[Page 286]]

authority under section 41(d)(4)(E)) under which the development of 
certain internal-use software used to deliver noncomputer services to 
customers with features that are not yet offered by a taxpayer's 
competitors is not subject to the three-part test.
    Consistent with a statement in the Conference Report to the 1999 
Act that software research undertaken to support the provision of a 
service should not be deemed internal-use software ``solely because the 
business component involves the provision of a service,'' the final 
regulations clarify that the determination of whether software is 
internal-use software depends on the nature of the service provided by 
the taxpayer. Software that is intended to be used to provide 
noncomputer services to customers is internal-use software, while 
software that is to be used to provide computer services is not 
developed primarily for internal use. Computer services are services 
offered by a taxpayer to customers who do business with the taxpayer 
primarily for the use of the taxpayer's computer or software 
technology. Noncomputer services are services offered by a taxpayer to 
customers who do business with the taxpayer primarily to obtain a 
service other than a computer service, even if such other service is 
enabled, supported, or facilitated by computer or software technology.
    The conclusion that software used to provide noncomputer services 
is internal-use software is consistent with the legislative history to 
the 1986 Act, which defined internal-use software as software used in 
general administrative functions and software used in providing 
noncomputer services (such as accounting, consulting, or banking 
services). See H.R. Conf. Rep. No. 841, at II-73 (emphasis added).
    As noted above, the final regulations contain a new exception under 
which a taxpayer is not required to establish that internal-use 
software used to provide noncomputer services containing features or 
improvements that are not yet offered by a taxpayer's competitors 
satisfies the three-part test. Software that is intended to be used to 
provide noncomputer services is described within the exception if the 
software is designed to provide customers a new feature with respect to 
a noncomputer service; the taxpayer reasonably anticipated that 
customers would choose to obtain the noncomputer service from the 
taxpayer (rather than from the taxpayer's competitors) because of those 
features of the service that will be provided by the software; and 
those features are not available (at the time the research is 
undertaken) from any of the taxpayer's competitors.
    No inference should be drawn that software described within the 
foregoing exception is not internal-use software or that internal-use 
software not described within the exception would fail the three-part 
test. Rather, the exception reflects a determination by IRS and 
Treasury that it is appropriate to exercise the regulatory authority in 
section 41(d)(4)(E) to exempt certain internal-use software from having 
to fulfil additional conditions for credit eligibility. This exercise 
of regulatory authority is based on a determination that the 
development of software containing features or improvements that are 
not available from a taxpayer's competitors and that provide a 
demonstrable competitive advantage is more likely to increase the 
innovative qualities and efficiency of the U.S. economy (by generating 
knowledge that can be used by other service providers) than is the 
development of software used to provide noncomputer services containing 
features or improvements that are already offered by others. IRS and 
Treasury believe that drawing such a line is an appropriate way to 
administer the credit with a view to identifying and facilitating the 
credit availability for software with the greatest potential for 
benefitting the U.S. economy, an important rationale for the research 
credit.
    The final regulations also make a number of changes with respect to 
the three-part high threshold of innovation test, which continues to 
apply to certain software not described within the new exception. For 
example, commentators had questioned whether the 1997 proposed 
regulations impose a separate high threshold of innovation requirement 
that serves as an additional condition for credit eligibility, even 
where taxpayers otherwise satisfy the three-part test. The final 
regulations clarify that the three-part test is the high threshold of 
innovation test, and not a separate requirement. Similarly, 
commentators had objected to a sentence in the 1997 proposed 
regulations that could be read to suggest that certain internal-use 
software could never qualify for the credit. The final regulations 
clarify that research with respect to internal-use software that 
satisfies both the general conditions for credit eligibility and the 
three-part test is eligible for the credit.
    Consistent with the application of the discovery requirement, the 
final regulations adopt the suggestion of several commentators that the 
three-part test should be applied without regard to whether the 
taxpayer succeeds in achieving the results described in that test.
    Commentators questioned whether the ``as where'' clauses used to 
elaborate on the three requirements of the high threshold of innovation 
test in the 1997 proposed regulations were intended as mandatory 
requirements or merely as illustrations of ways in which taxpayers 
could satisfy the tests. By replacing the ``as where'' clauses with 
``in that'' clauses, the final regulations confirm that a taxpayer must 
satisfy the provisions, as elaborated. Consistent with this 
clarification, the final regulations provide that the innovative prong 
of the three-part test may be satisfied with respect to any intended 
improvement, not just reductions in cost or improvements in speed.
    Under the final regulations, all qualified research, including 
research with respect to internal-use software, must satisfy the 
discovery requirement (that is, must be intended to exceed, expand, or 
refine the common knowledge of skilled professionals in the particular 
field of science or engineering). The final regulations clarify how the 
three-part high threshold of innovation test supplements the discovery 
requirement. Specifically, the final regulations provide that several 
aspects of the three-part test (the determination of whether the 
software is intended to result in an improvement that is substantial 
and economically significant and the extent of uncertainty and 
technical risk) also must be applied with respect to the common 
knowledge of skilled professionals. In essence, the common knowledge of 
skilled professionals rather than the knowledge base of the taxpayer's 
employees is treated as the baseline with respect to which the intended 
software must satisfy the innovative prong and other prongs of the 
three-part test. Stated differently, research with respect to internal-
use software is credit eligible only if it is intended to exceed, 
expand, or refine the common knowledge of skilled professionals (as 
defined in Sec. 1.41-4(a)(3)(ii)) to a degree that is substantial and 
economically significant. See Norwest 110 T.C. at 499-500 (stating that 
``* * * the extent of the improvements required by Congress with 
respect to internal use software is much greater than that required in 
other fields'' and that ``* * * the significant economic risk test 
requires a higher threshold of technological advancement in the 
development of internal use software than in other fields'').
    Reference to the common knowledge of skilled professionals as the 
baseline is necessary to give proper meaning to

[[Page 287]]

the statutory three-part test. For example, if the innovative 
requirement was applied simply with respect to the prior state of the 
taxpayer's own business, then ordinary inventory software installed by 
a taxpayer who previously tracked its inventory manually could be 
deemed to satisfy the innovative requirement merely because the 
taxpayer had achieved a substantial and economically significant 
improvement in speed over its prior non-automated operations.
    Although the final regulations related to internal use software 
generally are effective for taxable years beginning after December 31, 
1985, the provisions relating to software developed for use in 
providing computer and noncomputer services to customers and the 
provisions clarifying the interaction of the three-part test with the 
discovery requirement, like other provisions concerning the discovery 
requirement, are effective only prospectively; however, taxpayers may 
rely on these rules for expenditures paid or incurred prior to January 
3, 2001.

X. Alternative Incremental Credit

    Certain commentators suggested that taxpayers be permitted to elect 
the alternative incremental credit on an amended return. However, IRS 
and Treasury believe that the intended incentive effects of the credit 
would not be advanced by permitting taxpayers to make retroactive 
elections to alter the computation of (and presumably increase) the 
credit for prior years. Similarly, the availability of a retroactive 
election would undermine the application of section 41(c)(4)(B). Thus, 
the final regulations retain the requirement contained in the proposed 
regulations that the election to apply the provisions of the 
alternative incremental credit must be made on the taxpayer's timely 
filed original return.

Effective Dates

    In general, the regulations are applicable for expenditures paid or 
incurred on or after January 3, 2001. However, the regulations 
addressing the base amount are applicable for taxable years beginning 
on or after January 3, 2001. The regulations addressing internal-use 
software are applicable for taxable years beginning after December 31, 
1985. However, Sec. 1.41-4(c)(6)(ii)(C)(4), Sec. 1.41-4(c)(6)(iv)(A) 
and (B), Sec. 1.41-4(c)(6)(v), the second and third sentences of 
Sec. 1.41-4(c)(6)(vii), and Sec. 1.41-4(c)(6)(viii) Example 2 are 
applicable for expenditures paid or incurred on or after January 3, 
2001. The special documentation requirements of Sec. 1.41-4(d) are 
applicable with respect to research projects that begin on or after 
March 5, 2001. The regulations providing for the election and 
revocation of the alternative incremental credit are applicable for 
taxable years ending on or after January 3, 2001. No inference should 
be drawn from the applicability date concerning the application of 
section 41 to expenditures paid or incurred or the computation of the 
base amount before the applicability date.

Special Analyses

    It has been determined that these regulations are not a significant 
regulatory action as defined in Executive Order 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.
    It is hereby certified that the collection of information contained 
in these regulations will not have a significant economic impact on a 
substantial number of small entities. This certification is based on 
the fact that the rules of this section impact only taxpayers who 
engage in qualified research. Moreover, in those instances where the 
rules of this section impact small entities, the economic impact is not 
likely to be significant because it merely requires taxpayers to (1) 
prepare (before or during the early stages of a research project) and 
retain written documentation describing the principal questions to be 
answered and the information the taxpayer seeks to obtain that 
satisfies the requirements of Sec. 1.41-4(a)(3) of these regulations; 
(2) elect on Form 6765, ``Credit for Increasing Research Activities,'' 
to use the alternative incremental credit if the entity desires to use 
that method; and (3) obtain permission to revoke the alternative 
incremental credit election, if so desired. Further, the economic 
impact of electing the alternative incremental credit on Form 6765 also 
would not be significant because the election is made on the same form 
and is based on the same information that is used to claim the research 
credit. Accordingly, a regulatory flexibility analysis under the 
Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required.
    Pursuant to section 7805(f), the notice of proposed rulemaking 
preceding these regulations was submitted to the Chief Counsel for 
Advocacy of the Small Business Administration for comment on its impact 
on small business.

Drafting Information

    The principal authors of these regulations are Lisa J. Shuman and 
Leslie H. Finlow of the Office of the Associate Chief Counsel 
(Passthroughs and Special Industries), IRS. However, personnel from 
other offices of the IRS and the Treasury Department participated in 
their development.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are 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 * * *


Sec. 1.30--  [Amended]

    Par. 2. Revise the undesignated centerheading immediately before 
Sec. 1.30-1 to read as follows:

Credits Allowable Under Sections 30 Through 44B

    Par. 3. Remove the undesignated centerheading immediately before 
Sec. 1.41-0.
    Par. 4. Section 1.41-0 is revised to read as follows:


Sec. 1.41-0  Table of contents.

    This section lists the paragraphs contained in Secs. 1.41-1 through 
1.41-8 as follows:

Sec. 1.41-1  Credit for increasing research activities.
    (a) Amount of credit.
    (b) Introduction to regulations under section 41.
Sec. 1.41-2  Qualified research expenses.
    (a) Trade or business requirement.
    (1) In general.
    (2) New business.
    (3) Research performed for others.
    (i) Taxpayer not entitled to results.
    (ii) Taxpayer entitled to results.
    (4) Partnerships.
    (i) In general.
    (ii) Special rule for certain partnerships and joint ventures.
    (b) Supplies and personal property used in the conduct of 
qualified research.
    (1) In general.
    (2) Certain utility charges.
    (i) In general.
    (ii) Extraordinary expenditures.
    (3) Right to use personal property.
    (4) Use of personal property in taxable years beginning after 
December 31, 1985.
    (c) Qualified services.
    (1) Engaging in qualified research.
    (2) Direct supervision.
    (3) Direct support.
    (d) Wages paid for qualified services.
    (1) In general.
    (2) ``Substantially all.''
    (e) Contract research expenses.

[[Page 288]]

    (1) In general.
    (2) Performance of qualified research.
    (3) ``On behalf of.''
    (4) Prepaid amounts.
    (5) Examples.
Sec. 1.41-3  Base amount for taxable years beginning on or after 
January 3, 2001.
    (a) New taxpayers.
    (b) Special rules for short taxable years.
    (1) Short credit year.
    (2) Short taxable year preceding credit year.
    (3) Short taxable year in determining fixed-base percentage.
    (c) Definition of gross receipts.
    (1) In general.
    (2) Amounts excluded.
    (3) Foreign corporations.
    (d) Consistency requirement.
    (1) In general.
    (2) Illustrations.
    (e) Effective date.
Sec. 1.41-4  Qualified research for expenditures paid or incurred on 
or after January 3, 2001.
    (a) Qualified research.
    (1) General rule.
    (2) Requirements of section 41(d)(1).
    (3) Undertaken for the purpose of discovering information.
    (i) In general.
    (ii) Common knowledge.
    (iii) Means of discovery.
    (iv) Patent safe harbor.
    (v) Rebuttable presumption.
    (4) Technological in nature.
    (5) Process of experimentation.
    (6) Substantially all requirement.
    (7) Use of computers and information technology.
    (8) Illustrations.
    (b) Application of requirements for qualified research.
    (1) In general.
    (2) Shrinking-back rule.
    (3) Illustration.
    (c) Excluded activities.
    (1) In general.
    (2) Research after commercial production.
    (i) In general.
    (ii) Certain additional activities related to the business 
component.
    (iii) Activities related to production process or technique.
    (iv) Clinical testing.
    (3) Adaptation of existing business components.
    (4) Duplication of existing business component.
    (5) Surveys, studies, research relating to management functions, 
etc.
    (6) Internal-use computer software.
    (i) General rule.
    (ii) Requirements.
    (iii) Primarily for internal use.
    (iv) Software used in the provision of services.
    (A) Computer services.
    (B) Noncomputer services.
    (v) Exception for certain software used in providing noncomputer 
services.
    (vi) High threshold of innovation test.
    (vii) Application of high threshold of innovation test.
    (viii) Illustrations.
    (ix) Effective dates.
    (7) Activities outside the United States, Puerto Rico, and other 
possessions.
    (i) In general.
    (ii) Apportionment of in-house research expenses.
    (iii) Apportionment of contract research expenses.
    (8) Research in the social sciences, etc.
    (9) Research funded by any grant, contract, or otherwise.
    (10) Illustrations.
    (d) Documentation.
    (e) Effective dates.
Sec. 1.41-5  Basic research for taxable years beginning after 
December 31, 1986. [Reserved]
Sec. 1.41-6  Aggregation of expenditures.
    (a) Controlled group of corporations; trades or businesses under 
common control.
    (1) In general.
    (2) Definition of trade or business.
    (3) Determination of common control.
    (4) Examples.
    (b) Minimum base period research expenses.
    (c) Tax accounting periods used.
    (1) In general.
    (2) Special rule where timing of research is manipulated.
    (d) Membership during taxable year in more than one group.
    (e) Intra-group transactions.
    (1) In general.
    (2) In-house research expenses.
    (3) Contract research expenses.
    (4) Lease payments.
    (5) Payment for supplies.
Sec. 1.41-7  Special rules.
    (a) Allocations.
    (1) Corporation making an election under subchapter S.
    (i) Pass-through, for taxable years beginning after December 31, 
1982, in the case of an S corporation.
    (ii) Pass-through, for taxable years beginning before January 1, 
1983, in the case of a subchapter S corporation.
    (2) Pass-through in the case of an estate or trust.
    (3) Pass-through in the case of a partnership.
    (i) In general.
    (ii) Certain expenditures by joint ventures.
    (4) Year in which taken into account.
    (5) Credit allowed subject to limitation.
    (b) Adjustments for certain acquisitions and dispositions--
Meaning of terms.
    (c) Special rule for pass-through of credit.
    (d) Carryback and carryover of unused credits.
Sec. 1.41-8  Special rules for taxable years ending on or after 
January 3, 2001.
    (a) Alternative incremental credit.
    (b) Election.
    (1) In general.
    (2) Time and manner of election.
    (3) Revocation.
    (4) Effective date.

    Par. 5. Section 1.41-1 is revised to read as follows:


Sec. 1.41-1  Credit for increasing research activities.

    (a) Amount of credit. The amount of a taxpayer's credit is 
determined under section 41(a). For taxable years beginning after June 
30, 1996, and at the election of the taxpayer, the portion of the 
credit determined under section 41(a)(1) may be calculated using the 
alternative incremental credit set forth in section 41(c)(4).
    (b) Introduction to regulations under section 41. (1) Sections 
1.41-2 through 1.41-8 and 1.41-3A through 1.41-5A address only certain 
provisions of section 41. The following table identifies the provisions 
of section 41 that are addressed, and lists each provision with the 
section of the regulations in which it is covered.

------------------------------------------------------------------------
                                               Section of the Internal
         Section of the regulation                  Revenue Code
------------------------------------------------------------------------
Sec.  1.41-2..............................  41(b).
Sec.  1.41-3..............................  41(c).
Sec.  1.41-4..............................  41(d).
Sec.  1.41-5..............................  41(e).
Sec.  1.41-6..............................  41(f).
Sec.  1.41-7..............................  41(f).
                                            41(g).
Sec.  1.41-8..............................  41(c).
Sec.  1.41-3A.............................  41(c) (taxable years
                                             beginning before January 1,
                                             1990).
Sec.  1.41-4A.............................  41(d) (taxable years
                                             beginning before January 1,
                                             1986).
Sec.  1.41-5A.............................  41(e) (taxable years
                                             beginning before January 1,
                                             1987).
------------------------------------------------------------------------

    (2) Section 1.41-3A also addresses the special rule in section 
221(d)(2) of the Economic Recovery Tax Act of 1981 relating to taxable 
years overlapping the effective dates of section 41. Section 41 was 
formerly designated as sections 30 and 44F. Sections 1.41-0 through 
1.41-8 and 1.41-0A through 1.41-5A refer to these sections as section 
41 for conformity purposes. Whether section 41, former section 30, or 
former section 44F applies to a particular expenditure depends upon 
when the expenditure was paid or incurred.


Sec. 1.41-2  [Amended]

    Par. 6. Section 1.41-2 is amended as follows:
    1. The last sentence of paragraph (a)(3)(i) is amended by removing 
the language ``Sec. 1.41-5(d)(2)'' and adding ``Sec. 1.41-4A(d)(2)'' in 
its place.
    2. The last sentence of paragraph (a)(3)(ii) is amended by removing 
the language ``Sec. 1.41-5(d)(3)'' and adding ``Sec. 1.41-4A(d)(3)'' in 
its place.
    3. The last sentence of paragraph (a)(4)(ii)(F) is amended by 
removing the language ``Sec. 1.41-9(a)(3)(ii)'' and adding ``Sec. 1.41-
7(a)(3)(ii)'' in its place.
    4. Paragraph (e)(1)(i) is amended by removing the language 
``Sec. 1.41-5'' and

[[Page 289]]

adding ``Sec. 1.41-4 or 1.41-4A, whichever is applicable'' in its 
place.


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

    Par. 6A. Sections 1.41-0A through 1.41-8A and the undesignated 
centerheading preceding these sections are removed.
    Par. 7. An undesignated centerheading is added immediately 
following Sec. 1.44B-1 to read as follows:

Research Credit--For Taxable Years Beginning Before January 1, 1990


Sec. 1.41-3  [Redesignated as Sec. 1.41-3A]

    Par. 8. Section 1.41-3 is redesignated as Sec. 1.41-3A and added 
under the new undesignated centerheading ``RESEARCH CREDIT--FOR TAXABLE 
YEARS BEGINNING BEFORE JANUARY 1, 1990.''
    Par. 9. New Sec. 1.41-3 is added to read as follows:


Sec. 1.41-3  Base amount for taxable years beginning on or after 
January 3, 2001.

    (a) New taxpayers. If, with respect to any credit year, the 
taxpayer has not been in existence for any previous taxable year, the 
average annual gross receipts of the taxpayer for the four taxable 
years preceding the credit year shall be zero. If, with respect to any 
credit year, the taxpayer has been in existence for at least one 
previous taxable year, but has not been in existence for four taxable 
years preceding the taxable year, then the average annual gross 
receipts of the taxpayer for the four taxable years preceding the 
credit year shall be the average annual gross receipts for the number 
of taxable years preceding the credit year for which the taxpayer has 
been in existence.
    (b) Special rules for short taxable years--(1) Short credit year. 
If a credit year is a short taxable year, then the base amount 
determined under section 41(c)(1) (but not section 41(c)(2)) shall be 
modified by multiplying that amount by the number of months in the 
short taxable year and dividing the result by 12.
    (2) Short taxable year preceding credit year. If one or more of the 
four taxable years preceding the credit year is a short taxable year, 
then the gross receipts for such year are deemed to be equal to the 
gross receipts actually derived in that year multiplied by 12 and 
divided by the number of months in that year.
    (3) Short taxable year in determining fixed-base percentage. No 
adjustment shall be made on account of a short taxable year to the 
computation of a taxpayer's fixed-base percentage.
    (c) Definition of gross receipts--(1) In general. For purposes of 
section 41, gross receipts means the total amount, as determined under 
the taxpayer's method of accounting, derived by the taxpayer from all 
its activities and from all sources (e.g., revenues derived from the 
sale of inventory before reduction for cost of goods sold).
    (2) Amounts excluded. For purposes of this paragraph (c), gross 
receipts do not include amounts representing--
    (i) Returns or allowances;
    (ii) Receipts from the sale or exchange of capital assets, as 
defined in section 1221;
    (iii) Repayments of loans or similar instruments (e.g., a repayment 
of the principal amount of a loan held by a commercial lender);
    (iv) Receipts from a sale or exchange not in the ordinary course of 
business, such as the sale of an entire trade or business or the sale 
of property used in a trade or business as defined under section 
1221(2);
    (v) Amounts received with respect to sales tax or other similar 
state and local taxes if, under the applicable state or local law, the 
tax is legally imposed on the purchaser of the good or service, and the 
taxpayer merely collects and remits the tax to the taxing authority; 
and
    (vi) Amounts received by a taxpayer in a taxable year that precedes 
the first taxable year in which the taxpayer derives more than $25,000 
in gross receipts other than investment income. For purposes of this 
paragraph (c)(2)(vi), investment income is interest or distributions 
with respect to stock (other than the stock of a 20-percent owned 
corporation as defined in section 243(c)(2).
    (3) Foreign corporations. For purposes of section 41, in the case 
of a foreign corporation, gross receipts include only gross receipts 
that are effectively connected with the conduct of a trade or business 
within the United States, the Commonwealth of Puerto Rico, or other 
possessions of the United States. See section 864(c) and applicable 
regulations thereunder for the definition of effectively connected 
income.
    (d) Consistency requirement--(1) In general. In computing the 
credit for increasing research activities for taxable years beginning 
after December 31, 1989, qualified research expenses and gross receipts 
taken into account in computing a taxpayer's fixed-base percentage and 
a taxpayer's base amount must be determined on a basis consistent with 
the definition of qualified research expenses and gross receipts for 
the credit year, without regard to the law in effect for the taxable 
years taken into account in computing the fixed-base percentage or the 
base amount. This consistency requirement applies even if the period 
for filing a claim for credit or refund has expired for any taxable 
year taken into account in computing the fixed-base percentage or the 
base amount.
    (2) Illustrations. The following examples illustrate the 
application of the consistency rule of paragraph (d)(1) of this 
section:

    Example 1.  (i) X, an accrual method taxpayer using the calendar 
year as its taxable year, incurs qualified research expenses in 
2001. X wants to compute its research credit under section 41 for 
the tax year ending December 31, 2001. As part of the computation, X 
must determine its fixed-base percentage, which depends in part on 
X's qualified research expenses incurred during the fixed-base 
period, the taxable years beginning after December 31, 1983, and 
before January 1, 1989.
    (ii) During the fixed-base period, X reported the following 
amounts as qualified research expenses on its Form 6765:

1984...........................................................    $100x
1985...........................................................     120x
1986...........................................................     150x
1987...........................................................     180x
1988...........................................................     170x
                                                                --------
    Total......................................................     720x
 

    (iii) For the taxable years ending December 31, 1984, and 
December 31, 1985, X based the amounts reported as qualified 
research expenses on the definition of qualified research in effect 
for those taxable years. The definition of qualified research 
changed for taxable years beginning after December 31, 1985. If X 
used the definition of qualified research applicable to its taxable 
year ending December 31, 2001, the credit year, its qualified 
research expenses for the taxable years ending December 31, 1984, 
and December 31, 1985, would be reduced to $ 80x and $ 100x, 
respectively. Under the consistency rule in section 41(c)(5) and 
paragraph (d)(1) of this section, to compute the research credit for 
the tax year ending December 31, 2001, X must reduce its qualified 
research expenses for 1984 and 1985 to reflect the change in the 
definition of qualified research for taxable years beginning after 
December 31, 1985. Thus, X's total qualified research expenses for 
the fixed-base period (1984-1988) to be used in computing the fixed-
base percentage is $80 + 100 + 150 + 180 + 170 = $680x.
    Example 2. The facts are the same as in Example 1, except that, 
in computing its qualified research expenses for the taxable year 
ending December 31, 2001, X claimed that a certain type of 
expenditure incurred in 2001 was a qualified research expense. X's 
claim reflected a change in X's position, because X had not 
previously claimed that similar expenditures were qualified research 
expenses. The consistency rule requires X to adjust its qualified 
research expenses in computing the fixed-base percentage to include 
any similar expenditures not treated as qualified research expenses 
during the fixed-base period, regardless of whether the period for 
filing a claim for credit or refund has expired for any year taken 
into account in computing the fixed-base percentage.


[[Page 290]]


    (e) Effective date. The rules in paragraphs (c) and (d) of this 
section are applicable for taxable years beginning on or after the date 
final regulations are published in the Federal Register.
    Par. 10. Section 1.41-4 is revised to read as follows:


Sec. 1.41-4  Qualified research for expenditures paid or incurred on or 
after January 3, 2001.

    (a) Qualified research--(1) General rule. Research activities 
related to the development or improvement of a business component 
constitute qualified research only if the research activities meet all 
of the requirements of section 41(d)(1) and this section, and are not 
otherwise excluded under section 41(d)(3)(B) or (d)(4), or this 
section.
    (2) Requirements of section 41(d)(1). Research constitutes 
qualified research only if it is research--
    (i) With respect to which expenditures may be treated as expenses 
under section 174, see Sec. 1.174-2;
    (ii) That is undertaken for the purpose of discovering information 
that 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; and
    (iii) Substantially all of the activities of which constitute 
elements of a process of experimentation that relates to a new or 
improved function, performance, reliability or quality.


For certain recordkeeping requirements, see paragraph (d) of this 
section.
    (3) Undertaken for the purpose of discovering information--(i) In 
general. For purposes of section 41(d) and this section, research is 
undertaken for the purpose of discovering information only if it is 
undertaken to obtain knowledge that exceeds, expands, or refines the 
common knowledge of skilled professionals in a particular field of 
science or engineering. A determination that research is undertaken for 
the purpose of discovering information does not require that the 
taxpayer succeed in obtaining the knowledge that exceeds, expands, or 
refines the common knowledge of skilled professionals in a particular 
field of science or engineering, nor does it require that the advance 
sought be more than evolutionary. However, research is not undertaken 
for the purpose of discovering information merely because an 
expenditure may be treated as an expense under section 174.
    (ii) Common knowledge. 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 is undertaken, a reasonable investigation of the 
existing level of information in the particular field of science or 
engineering. Thus, knowledge may, in certain circumstances, exceed, 
expand, or refine the common knowledge of skilled professionals in a 
particular field of science or engineering even though such knowledge 
has previously been obtained by other persons. For example, trade 
secrets generally are not within the common knowledge of skilled 
professionals in a particular field of science or engineering because 
they are not reasonably available to skilled professionals not 
employed, hired, or licensed by the owner of such trade secrets.
    (iii) Means of discovery. In seeking to obtain knowledge that 
exceeds, expands, or refines the common knowledge of skilled 
professionals in a particular field of science or engineering, a 
taxpayer may employ existing technologies in a particular field and may 
rely on existing principles of science or engineering.
    (iv) Patent safe harbor. For purposes of section 41(d) and 
paragraph (a)(3)(i) of this section, the issuance of a patent by the 
Patent and Trademark Office under the provisions of section 151 of 
title 35, United States Code (other than a patent for design issued 
under the provisions of section 171 of title 35, United States Code) is 
conclusive evidence that a taxpayer has obtained knowledge that 
exceeds, expands, or refines the common knowledge of skilled 
professionals. However, the issuance of such a patent is not a 
precondition for credit availability.
    (v) Rebuttable presumption. If a taxpayer demonstrates with 
credible evidence that research activities were undertaken to obtain 
the information described in the taxpayer's contemporaneous 
documentation required under paragraph (d)(1) of this section, 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, the research activities are presumed to satisfy 
the requirements of this paragraph (a)(3). However, the presumption 
applies only if the taxpayer cooperates with reasonable requests by the 
Commissioner for witnesses, information, documents, meetings, and 
interviews. Furthermore, the Commissioner may overcome the presumption 
in this paragraph if the Commissioner demonstrates that the information 
described in the taxpayer's documentation was within the common 
knowledge of skilled professionals (as described in paragraph 
(a)(3)(ii) of this section), or that the research activities were not 
undertaken to obtain the information described in the taxpayer's 
documentation.
    (4) Technological in nature. For purposes of section 41(d) and this 
section, information is technological in nature if the process of 
experimentation used to discover such information fundamentally relies 
on principles of the physical or biological sciences, engineering, or 
computer science.
    (5) Process of experimentation. For purposes of section 41(d) and 
this section, 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. A process of experimentation does not include the evaluation of 
alternatives to establish the appropriate design of a business 
component, if the capability and method for developing or improving the 
business component are not uncertain. A process of experimentation in 
the physical or biological sciences, engineering, or computer science 
may involve--
    (i) Developing one or more hypotheses designed to achieve the 
intended result;
    (ii) 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);
    (iii) Conducting the experiment; and
    (iv) Refining or discarding the hypotheses as part of a sequential 
design process to develop or improve the business component.
    (6) Substantially all requirement. The substantially all 
requirement of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this 
section is satisfied only if 80 percent or more of the research 
activities, measured on a cost or other consistently applied reasonable 
basis (and without regard to Sec. 1.41-2(d)(2)), constitute elements of 
a process of experimentation for a purpose described in section 
41(d)(3). The substantially all requirement is applied separately to 
each business component.
    (7) Use of computers and information technology. The employment of 
computers or information technology, or the reliance on principles of 
computer science or information technology to store, collect, 
manipulate, translate, disseminate, produce, distribute, or

[[Page 291]]

process data or information, and similar uses of computers and 
information technology does not itself establish that qualified 
research has been undertaken.
    (8) Illustrations. The following examples illustrate the 
application of this paragraph (a):

    Example 1. (i) Facts. X and other manufacturing companies have 
previously designed and manufactured a particular kind of machine 
using Material S. Material T is less expensive than Material S. X 
wishes to design a new machine that appears and functions exactly 
the same as its existing machines, but that is made of Material T 
instead of Material S. The capability and method necessary to 
achieve this objective should not have been known to skilled 
professionals had they conducted a reasonable investigation of the 
existing information in the relevant field of science or engineering 
at the time the research was undertaken.
    (ii) Conclusion. X's activities to design the new machine using 
Material T may be qualified research within the meaning of section 
41(d)(1) and this paragraph (a). In seeking to design the machine, X 
undertook to obtain knowledge that exceeds, expands, or refines the 
common knowledge of skilled professionals in the relevant field of 
science or engineering.
    Example 2. (i) Facts. X is engaged in the business of developing 
and manufacturing widgets. X wants to manufacture an improved widget 
made out of a material that X has not previously used. Although X is 
uncertain how to use the material to manufacture an improved widget, 
the capability and method of using the material to manufacture such 
widgets should have been known to skilled professionals had they 
conducted a reasonable investigation of the existing level of 
information in the particular field of science or engineering at the 
time the research was undertaken.

    (ii) Conclusion. Even though X's expenditures for the activities 
to resolve the uncertainty in manufacturing the improved widget may 
be treated as expenses for research activities under section 174 and 
Sec. 1.174-2, X's activities to resolve the uncertainty in 
manufacturing the improved widget are not qualified research within 
the meaning of section 41(d) and this paragraph (a). Although X's 
activities were intended to eliminate uncertainty, the activities 
were not undertaken to obtain knowledge that exceeds, expands, or 
refines the common knowledge of skilled professionals in the 
relevant field of science or engineering.

    Example 3.  (i) Facts. X desires to build a bridge that can 
sustain greater traffic flow without deterioration than can existing 
bridges. The capability and method used to build such a bridge 
should not have been known to skilled professionals had they 
conducted a reasonable investigation of the existing level of 
information in the particular field of science or engineering at the 
time the research was undertaken. X eventually abandons the project 
after attempts to develop the technology prove unsuccessful.

    (ii) Conclusion. X's activities to develop the technology to 
build the bridge may be qualified research within the meaning of 
section 41(d)(1) and this paragraph (a), regardless of the fact that 
X did not actually succeed in developing that technology. In seeking 
to develop the technology, X undertook to obtain knowledge that 
exceeds, expands, or refines the common knowledge of skilled 
professionals in the relevant field of science or engineering.

    Example 4.  (i) Facts. The facts are the same as in Example 3, 
except that Y successfully builds a bridge that can sustain the 
greater traffic flow. Thereafter, Z seeks to build a bridge that can 
also sustain such greater traffic flow. The method Y used to build 
its bridge is a closely guarded trade secret that is not known to Z 
and should not have been known to skilled professionals had they 
conducted a reasonable investigation of the existing level of 
information in the particular field of science or engineering at the 
time the research was undertaken.

    (ii) Conclusion. Z's activities to develop the technology to 
build the bridge may be qualified research within the meaning of 
section 41(d)(1) and this paragraph (a), even if it so happens that 
the technology Z used to build its bridge is similar or identical to 
the technology Y used. In developing the technology, Z undertook to 
obtain knowledge that exceeds, expands, or refines the common 
knowledge of skilled professionals in the relevant field of science 
or engineering.

    Example 5. (i) Facts. X, a widget manufacturer, seeks to develop 
a new widget and initiates Project A. Before or during the early 
stages of Project A, X's employees prepare contemporaneous 
documentation that describes the principal questions to be answered 
by Project A and the information that X seeks to obtain to exceed, 
expand, or refine the common knowledge of skilled professionals in 
the relevant field of science or engineering. The documentation 
includes a statement from one of X's skilled professionals setting 
forth the basis for that professional's belief that the information 
is beyond the common knowledge of skilled professionals in the 
relevant field. Upon examination by the Commissioner, X presents 
credible evidence that the research activities were undertaken to 
obtain the information described in the contemporaneous 
documentation. X cooperates with all requests by the IRS for 
witnesses, information, documents, meetings, and interviews.

    (ii) Conclusion. X's research activities with respect to Project 
A are presumed to be undertaken for the purpose of obtaining 
knowledge that exceeds, expands, or refines the common knowledge of 
skilled professionals in the relevant field of science or 
engineering. The Commissioner may overcome this presumption by 
demonstrating that the information X sought to obtain was within the 
common knowledge of skilled professionals in the relevant field of 
science or engineering (i.e., by demonstrating that, at the time 
Project A began, the information should have been known to skilled 
professionals had they performed a reasonable investigation of the 
existing level of knowledge in the relevant field).

    (b) Application of requirements for qualified research--(1) In 
general. The requirements for qualified research in section 41(d)(1) 
and paragraph (a) of this section, must be applied separately to each 
business component, as defined in section 41(d)(2)(B). In cases 
involving development of both a product and a manufacturing or other 
commercial production process for the product, research activities 
relating to development of the process are not qualified research 
unless the requirements of section 41(d) and this section are met for 
the research activities relating to the process without taking into 
account the research activities relating to development of the product. 
Similarly, research activities relating to development of the product 
are not qualified research unless the requirements of section 41(d) and 
this section are met for the research activities relating to the 
product without taking into account the research activities relating to 
development of the manufacturing or other commercial production 
process.
    (2) Shrinking-back rule. The requirements of section 41(d) and 
paragraph (a) of this section are to be applied first at the level of 
the discrete business component, that is, the product, process, 
computer software, technique, formula, or invention to be held for 
sale, lease, or license, or used by the taxpayer in a trade or business 
of the taxpayer. If the requirements for credit eligibility are met at 
that first level, then some or all of the taxpayer's research expenses 
are eligible for the credit. A special shrinking-back rule applies in 
the case where a taxpayer incurs some research expenses with respect to 
that discrete 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. In such a case, the requirements 
for the credit are to be applied at the next most significant subset of 
elements of the business component. The shrinking-back of the 
applicable business component continues until a subset or series of 
subsets of elements of the business component satisfies substantially 
all requirements of section 41(d)(1)(C) and paragraph (a)(2)(iii) of 
this section (treating that subset of elements as a business component) 
or

[[Page 292]]

the most basic element fails to satisfy the requirements. This 
shrinking-back rule is applied only if a taxpayer does not satisfy the 
requirements of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this 
section with respect to the overall business component. The shrinking-
back rule is not itself applied as a reason to exclude research 
activities from credit eligibility.
    (3) Illustration. The following example illustrates the application 
of this paragraph (b):

    (i) Facts. X, a widget manufacturer, develops a widget that is 
improved in several respects. Among the various improvements to the 
widget is an improvement to the widget's cooling mechanism. Although 
the capability and method of making the other improvements to the 
widget would have been known to skilled professionals had they 
conducted a reasonable investigation of the existing level of 
information in the particular field of science or engineering, the 
method of developing the improved cooling mechanism and of 
incorporating the improved mechanism into the widget would not have 
been known to skilled professionals had they conducted a reasonable 
investigation of the existing level of information in the particular 
field of science or engineering. Substantially all of X's research 
activities in improving the widget constitute elements of a process 
of experimentation for purposes of improving the performance of the 
widget. None of X's research activities in improving the widget are 
described in section 41(d)(4) or paragraph (c) of this section.
    (ii) Conclusion. Some, but not all, of X's research activities 
in developing the improved widget are qualified research within the 
meaning of section 41(d)(1) and paragraph (a) of this section. In 
seeking to improve the widget, some of X's activities (related to 
improving the cooling mechanism and incorporating the improved 
cooling mechanism into the widget) were undertaken to obtain 
knowledge that exceeds, expands, or refines the common knowledge of 
skilled professionals in the relevant field of science or 
engineering. However, other activities (related to the other 
improvements) were not undertaken to obtain knowledge that exceeds, 
expands, or refines the common knowledge of skilled professionals in 
the relevant field of science or engineering, and thus are not 
qualified research and are not eligible for the credit. Not all of 
X's research activities relating to the widget are eligible for the 
credit because some of the activities are not qualified research as 
defined in section 41(d) and paragraph (a) of this section, even 
though the widget qualifies as a business component with respect to 
which qualified research that satisfies the requirements of section 
41(d) and paragraph (a) of this section is undertaken.

    (c) Excluded activities--(1) In general. Qualified research does 
not include any activity described in section 41(d)(4) and paragraph 
(c) of this section.
    (2) Research after commercial production--(i) In general. 
Activities conducted after the beginning of commercial production of a 
business component are not qualified research. Activities are conducted 
after the beginning of commercial production of a business component if 
such activities are conducted after the component is developed to the 
point where it is ready for commercial sale or use, or meets the basic 
functional and economic requirements of the taxpayer for the 
component's sale or use.
    (ii) Certain additional activities related to the business 
component. The following activities are deemed to occur after the 
beginning of commercial production of a business component--
    (A) Preproduction planning for a finished business component;
    (B) Tooling-up for production;
    (C) Trial production runs;
    (D) Trouble shooting involving detecting faults in production 
equipment or processes;
    (E) Accumulating data relating to production processes; and
    (F) Debugging flaws in a business component.
    (iii) Activities related to production process or technique. In 
cases involving development of both a product and a manufacturing or 
other commercial production process for the product, the exclusion 
described in section 41(d)(4)(A) and paragraphs (c)(2)(i) and (ii) of 
this section applies separately for the activities relating to the 
development of the product and the activities relating to the 
development of the process. For example, even after a product meets the 
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 section 41(d) 
and this section, and the activities are conducted before the process 
meets the taxpayer's basic functional and economic requirements or is 
ready for commercial use.
    (iv) Clinical testing. Clinical testing of a pharmaceutical product 
prior to its commercial production in the United States is not treated 
as occurring after the beginning of commercial production even if the 
product is commercially available in other countries. Additional 
clinical testing of a pharmaceutical product after a product has been 
approved for a specific therapeutic use by the Food and Drug 
Administration and is ready for commercial production and sale are not 
treated as occurring after the beginning of commercial production if 
such clinical tests are undertaken to establish new functional uses, 
characteristics, indications, combinations, dosages, or delivery forms 
for the product. A functional use, characteristic, indication, 
combination, dosage or delivery form shall be considered new only if 
such functional use, characteristic, indication, combination, dosage or 
delivery form must be approved by the Food and Drug Administration.
    (3) Adaptation of existing business components. Activities relating 
to adapting an existing business component to a particular customer's 
requirement or need are not qualified research. This exclusion does not 
apply merely because a business component is intended for a specific 
customer.
    (4) Duplication of existing business component. Activities relating 
to reproducing 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 are not qualified research. 
This exclusion does not apply merely because the taxpayer inspects an 
existing business component in the course of developing its own 
business component.
    (5) Surveys, studies, research relating to management functions, 
etc. Qualified research does not include activities relating to--
    (i) Efficiency surveys;
    (ii) 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 (such as rearranging work 
stations on an assembly line);
    (iii) Market research, testing, or development (including 
advertising or promotions);
    (iv) Routine data collections; or
    (v) Routine or ordinary testing or inspections for quality control.
    (6) Internal-use computer software--(i) 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 (c)(6)(ii) of this section.
    (ii) Requirements. The requirements of this paragraph (c)(6)(ii) 
are--
    (A) The research satisfies the requirements of section 41(d)(1);
    (B) The research is not otherwise excluded under section 41(d)(4) 
(other than section 41(d)(4)(E)); and (C) One of the following 
conditions is met--

[[Page 293]]

    (1) The taxpayer develops the software for use in an activity that 
constitutes qualified research (other than the development of the 
internal-use software itself);
    (2) The taxpayer develops the software for use in a production 
process that meets the requirements of section 41(d)(1);
    (3) The taxpayer develops a new or improved package of computer 
software and hardware together 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) The taxpayer develops the software for use in providing 
computer services to customers; or
    (5) The software satisfies the high threshold of innovation test of 
paragraph (c)(6)(vi) of this section.
    (iii) Primarily for internal use. Software is developed primarily 
for the taxpayer's internal use if the software is to be used 
internally, for example, in general administrative functions of the 
taxpayer (such as payroll, bookkeeping, or personnel management) or in 
providing noncomputer services (such as accounting, consulting or 
banking services). If computer software is developed primarily for the 
taxpayer's internal use, the requirements of paragraph (c)(6) apply 
even though the taxpayer intends to, or subsequently does, sell, lease, 
or license the computer software.
    (iv) Software used in the provision of services--(A) Computer 
services. For purposes of this section, a computer service is a service 
offered by a taxpayer to customers who conduct business with the 
taxpayer primarily for the use of the taxpayer's computer or software 
technology. A taxpayer does not provide a computer service merely 
because customers interact with the taxpayer's software.
    (B) Noncomputer services. For purposes of this section, a 
noncomputer service is a service offered by a taxpayer to customers who 
conduct business with the taxpayer primarily to obtain a service other 
than a computer service, even if such other service is enabled, 
supported, or facilitated by computer or software technology.
    (v) Exception for certain software used in providing noncomputer 
services. The requirements of paragraph (c)(6)(ii)(C) of this section 
are deemed satisfied for research with respect to computer software if, 
at the time the research was undertaken--
    (A) The software is designed to provide customers a new feature 
with respect to a noncomputer service;
    (B) The taxpayer reasonably anticipated that customers would choose 
to obtain the noncomputer service from the taxpayer (rather than from 
the taxpayer's competitors) because of those new features provided by 
the software; and (C) Those new features were not available from any of 
the taxpayer's competitors.
    (vi) High threshold of innovation test. Computer software satisfies 
the high threshold of innovation test of this paragraph (c)(6)(vi) only 
if the taxpayer can establish that--
    (A) The software is innovative in that the software is intended to 
result in a reduction in cost, improvement in speed, or other 
improvement, that is substantial and economically significant;
    (B) The software development involves significant economic risk in 
that 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
    (C) The software is not commercially available for use by the 
taxpayer in that the software cannot be purchased, leased, or licensed 
and used for the intended purpose without modifications that would 
satisfy the requirements of paragraphs (c)(6)(vi)(A) and (B) of this 
section.
    (vii) Application of high threshold of innovation test. In 
determining if the high threshold of innovation test of paragraph 
(c)(6)(vi) of this section is satisfied, all of the facts and 
circumstances are considered. The determination of whether the software 
is intended to result in an improvement or cost reduction that is 
substantial and economically significant is based on a comparison of 
the intended result with software that is within the common knowledge 
of skilled professionals in the relevant field of science or 
engineering, see Sec. 1.41-4(a)(3)(ii). Similarly, the extent of 
uncertainty and technical risk is determined with respect to the common 
knowledge of skilled professionals in the relevant field of science or 
engineering. Further, in determining if the high threshold of 
innovation test of paragraph (c)(6)(vi) of this section is satisfied, 
the activities to develop the new or improved software are considered 
independent of the effect of any modifications to related hardware or 
other software.
    (viii) Illustrations. The following examples illustrate the 
application of this paragraph (c)(6):

    Example 1. (i) Facts. X is engaged in the business of 
manufacturing and selling widgets to wholesalers. X has experienced 
strong growth and at the same time has expanded its product 
offerings. X also has increased significantly the size of its 
business by expanding into new territories. The increase in the size 
and scope of its business has strained X's existing financial 
management systems such that management can no longer obtain timely 
comprehensive financial data. Accordingly, X undertakes the 
development of a financial management computer software system that 
is more appropriate to its newly expanded operations.
    (ii) Conclusion. X's new computer software system is developed 
by X primarily for X's internal use. X's activities to develop the 
new computer software system may be eligible for the research credit 
only if the computer software development activities satisfy the 
requirements of paragraph (c)(6)(ii) of this section.
    Example 2. (i) Facts. X is engaged in the business of designing, 
manufacturing, and selling widgets. X delivers its widgets in the 
same manner and time as its competitors. In keeping with X's 
corporate commitment to provide customers with top quality service, 
X undertakes a project to develop for X's internal use a computer 
software system to facilitate the tracking of the manufacturing and 
delivery of widgets which will enable X's customers to monitor the 
progress of their orders and know precisely when their widgets will 
be delivered. X's computer software activities include research 
activities that satisfy the discovery requirement in section 
41(d)(1) and paragraph (a)(3) of this section. At the time the 
research is undertaken, X reasonably anticipates that if it is 
successful, X will increase its market share as compared to X's 
competitors, none of which has such a tracking feature for its 
delivery system.
    (ii) Conclusion. Although X's computer software system is 
developed primarily for X's internal use, X's activities are 
excepted from the high threshold of innovation test of paragraph 
(c)(6)(vi) of this section because, at the time the research is 
undertaken, X's software is designed to provide improved tracking 
features, X reasonably anticipates that customers will purchase 
widgets from X because these improved tracking features, and because 
comparable tracking features are not available from any of X's 
competitors.

    (ix) Effective dates. This paragraph (c)(6) is applicable for 
taxable years beginning after December 31, 1985, except paragraphs 
(c)(6)(ii)(C)(4), (c)(6)(iv)(A) and (B), (c)(6)(v), the second and 
third sentences of paragraph (c)(6)(vii), and paragraph (c)(6)(viii) 
Example 2 of this section apply to expenditures paid or incurred on or 
after January 3, 2001.
    (7) Activities outside the United States, Puerto Rico, and other 
possessions--(i) In general. Research conducted outside the United 
States, as defined in section 7701(a)(9), the Commonwealth of Puerto 
Rico and

[[Page 294]]

other possessions of the United States does not constitute qualified 
research.
    (ii) Apportionment of in-house research expenses. In-house research 
expenses paid or incurred for qualified services performed both (A) in 
the United States, the Commonwealth of Puerto Rico and other 
possessions of the United States and (B) outside the United States, the 
Commonwealth of Puerto Rico and other possessions of the United States 
must be apportioned between the services performed in the United 
States, the Commonwealth of Puerto Rico and other possessions of the 
United States and the services performed outside the United States, the 
Commonwealth of Puerto Rico and other possessions of the United States. 
Only those in-house research expenses apportioned to the services 
performed within the United States, the Commonwealth of Puerto Rico and 
other possessions of the United States are eligible to be treated as 
qualified research expenses, unless the in-house research expenses are 
wages and the 80 percent rule of Sec. 1.41-2(d)(2) applies.
    (iii) Apportionment of contract research expenses. If contract 
research is performed partly in the United States, the Commonwealth of 
Puerto Rico and other possessions of the United States and partly 
outside the United States, the Commonwealth of Puerto Rico and other 
possessions of the United States, only 65 percent (or 75 percent in the 
case of amounts paid to qualified research consortia) of the portion of 
the contract amount that is attributable to the research activity 
performed in the United States, the Commonwealth of Puerto Rico and 
other possessions of the United States may qualify as a contract 
research expense (even if 80 percent or more of the contract amount is 
for research performed in the United States, the Commonwealth of Puerto 
Rico and other possessions of the United States).
    (8) Research in the social sciences, etc. Qualified research does 
not include research in the social sciences (including economics, 
business management, and behavioral sciences), arts, or humanities.
    (9) Research funded by any grant, contract, or otherwise. Qualified 
research does not include any research to the extent funded by any 
grant, contract, or otherwise by another person (or governmental 
entity). To determine the extent to which research is so funded, 
Sec. 1.41-4A(d) applies.
    (10) Illustrations. The following examples illustrate provisions 
contained in paragraphs (c)(1) through (9) of this section. No 
inference should be drawn from these examples concerning the 
application of section 41(d)(1) and paragraph (a) of this section to 
these facts. The examples are as follows:

    Example 1. (i) Facts. X, a tire manufacturer, seeks to build a 
tire that will not deteriorate as rapidly under certain conditions 
of high speed and temperature as do existing tires. X commences 
laboratory research on January 1. On April 1, X determines in the 
laboratory that a certain combination of materials and additives can 
withstand higher rotational speeds and temperatures than the 
combination of materials and additives used in existing tires. On 
the basis of this determination, X undertakes further research 
activities to determine how to design a tire using those materials 
and additives, and to determine whether such a tire functions 
outside the laboratory as intended under various actual road 
conditions. By September 1, X's research has progressed to the point 
where the new tire meets X's basic functional and economic 
requirements.
    (ii) Conclusion. Any research activities conducted by X after 
September 1 with respect to the design of the tire are not qualified 
research within the meaning of section 41(d)(1) and paragraph (a) of 
this section because they are undertaken after the beginning of 
commercial production of the tire. Whether any activities X engaged 
in to develop a process for manufacturing the new tire constitute 
qualified research depends on if the development of the process 
itself separately satisfies the requirements of section 41(d) and 
paragraph (c)(2) of this section, and also depends on if the 
activities occur before the point in time when the process meets the 
taxpayer's basic functional and economic requirements or is ready 
for commercial use.

    Example 2. (i) Facts. For several years, X has manufactured and 
sold a particular kind of widget. X initiates a new research project 
to develop an improved widget.

    (ii) Conclusion. X's activities to develop an improved widget 
are not excluded from the definition of qualified research under 
section 41(d)(4)(A) and paragraph (c)(2) of this section until the 
beginning of commercial production of the improved widget. The fact 
that X's activities relating to the improved widget are undertaken 
after the beginning of commercial production of the unimproved 
widget does not bar the activities from credit eligibility because 
those activities constitute a new research project to develop a new 
business component, an improved widget.

    Example 3. (i) Facts. X, a computer software development firm, 
owns all substantial rights in a general ledger accounting software 
core program that X markets and licenses to customers. X incurs 
expenditures in adapting the core software program to the 
requirements of C, one of X's customers.

    (ii) Conclusion. Because X's activities represent activities to 
adapt an existing software program to a particular customer's 
requirement, X's activities are excluded from the definition of 
qualified research under section 41(d)(4)(B) and paragraph (c)(3) of 
this section.

    Example 4. (i) Facts. The facts are the same as in Example 3, 
except that C pays X to adapt the core software program to C's 
requirements.

    (ii) Conclusion. Because X's activities are excluded from the 
definition of qualified research under section 41(d)(4)(B) and 
paragraph (c)(3) of this section, C's payments to X do not 
constitute contract research expenses under section 41(b)(3)(A).

    Example 5. (i) Facts. The facts are the same as in Example 3, 
except that C's own employees adapt the core software program to C's 
requirements.

    (ii) Conclusion. Because C's employees' activities are excluded 
from the definition of qualified research under section 41(d)(4)(B) 
and paragraph (c)(3) of this section, the wages C paid to its 
employees do not constitute in-house research expenses under section 
41(b)(2)(A).

    Example 6. (i) Facts. An existing gasoline additive is 
manufactured by Y using three ingredients, A, B, and C. X seeks to 
develop and manufacture its own gasoline additive that appears and 
functions in a manner similar to Y's additive. To develop its own 
additive, X first inspects the composition of Y's additive, and uses 
knowledge gained from the inspection to reproduce A and B in the 
laboratory. Any differences between ingredients A and B that are 
used in Y's additive and those reproduced by X are insignificant and 
are not material to the viability, effectiveness, or cost of A and 
B. X desires to use with A and B an ingredient that has a materially 
lower cost than ingredient C. Accordingly, X engages in a process of 
experimentation to discover potential alternative formulations of 
the additive (i.e., the development and use of various ingredients 
other than C to use with A and B).

    (ii) Conclusion. X's activities in analyzing and reproducing 
ingredients A and B involve duplication of existing business 
components and are excluded from qualified research under section 
41(d)(4)(C) and paragraph (c)(4) of this section. X's 
experimentation activities to discover potential alternative 
formulations of the additive do not involve duplication of an 
existing business component and are not excluded from qualified 
research under section 41(d)(4)(C) and paragraph (c)(4) of this 
section.

    Example 7. (i) Facts. X, an insurance company, develops a new 
life insurance product. In the course of developing the product, X 
engages in research with respect to the effect of pricing and tax 
consequences on demand for the product, the expected volatility of 
interest rates, and the expected mortality rates (based on published 
data and prior insurance claims).

    (ii) Conclusion. X's activities related to the new product 
represent research in the social sciences, and are thus excluded 
from qualified research under section 41(d)(4)(G) and paragraph 
(c)(8) of this section.

    (d) Documentation. No credit shall be allowed under section 41 with 
regard to an expenditure relating to a research project unless the 
taxpayer--
    (1) Prepares documentation before or during the early stages of the 
research

[[Page 295]]

project, that describes the principal questions to be answered and the 
information the taxpayer seeks to obtain to satisfy the requirements of 
paragraph (a)(3) of this section, and retains that documentation on 
paper or electronically in the manner prescribed in applicable 
regulations, revenue rulings, revenue procedures, or other appropriate 
guidance until such time as taxes may no longer be assessed (except 
under section 6501(c)(1), (2), or (3)) for any year in which the 
taxpayer claims to have qualified research expenditures in connection 
with the research project; and
    (2) Satisfies section 6001 and the regulations thereunder.
    (e) Effective dates. In general, the rules of this section are 
applicable for expenditures paid or incurred on or after January 3, 
2001. The rules of paragraph (d), however, apply to research projects 
that begin on or after March 5, 2001.


Sec. 1.41-5  [Redesignated as Sec. 1.41-4A, and Amended]

    Par. 11. Section 1.41-5 is redesignated as Sec. 1.41-4A, and the 
last sentence of paragraph (d)(1) is amended by removing the language 
``Sec. 1.41-8(e)'' and adding ``Sec. 1.41-6(e)'' in its place.


Sec. 1.41-6  [Redesignated as Sec. 1.41-5, and Amended]

    Par. 12. Section 1.41-6 is redesignated as Sec. 1.41-5 and the 
section heading is amended by removing the language ``December 31, 
1985'' and adding ``December 31, 1986'' in its place.


Sec. 1.41-7  [Redesignated as Sec. 1.41-5A, and Amended]

    Par. 13. Section 1.41-7 is redesignated as Sec. 1.41-5A, and 
amended as follows:
    1. The section heading is amended by removing the language 
``January 1, 1986'' and adding ``January 1, 1987'' in its place.
    2. Paragraph (e)(2) is amended by removing the language 
``Sec. 1.41-5(c)'' and adding ``1.41-4A(c)'' in its place.


Sec. 1.41-8  [Redesignated as Sec. 1.41-6, and Amended]

    Par. 14. Section 1.41-8 is redesignated as Sec. 1.41-6, and the 
last sentence of paragraph (c) is amended by removing the language 
``Sec. 1.41-3, except that Sec. 1.41-3(c)(2)'' and adding ``Sec. 1.41-
3A, except that Sec. 1.41-3A(c)(2)'' in its place.


Sec. 1.41-9  [Redesignated as Sec. 1.41-7]

    Par. 15. Section 1.41-9 is redesignated as Sec. 1.41-7.
    Par. 16. New Sec. 1.41-8 is added to read as follows:


Sec. 1.41-8  Special rules for taxable years ending on or after January 
3, 2001.

    (a) Alternative incremental credit. At the election of the 
taxpayer, the credit determined under section 41(a)(1) equals the 
amount determined under section 41(c)(4).
    (b) Election--(1) In general. A taxpayer may elect to apply the 
provisions of the alternative incremental credit in section 41(c)(4) 
for any taxable year of the taxpayer beginning after June 30, 1996. If 
a taxpayer makes an election under section 41(c)(4), the election 
applies to the taxable year for which made and all subsequent taxable 
years.
    (2) Time and manner of election. An election under section 41(c)(4) 
is made by completing the portion of Form 6765, ``Credit for Increasing 
Research Activities,'' relating to the election of the alternative 
incremental credit, and attaching the completed form to the taxpayer's 
timely filed original return (including extensions) for the taxable 
year to which the election applies.
    (3) Revocation. An election under this section may not be revoked 
except with the consent of the Commissioner. A taxpayer must attach the 
Commissioner's consent to revoke an election under section 41(c)(4) to 
the taxpayer's timely filed original return (including extensions) for 
the taxable year of the revocation.
    (4) Effective date. Paragraphs (b)(2) and (3) of this section are 
applicable for taxable years ending on or after January 3, 2001.
    Par. 17. Section 1.41-0A is added under the new undesignated 
centerheading ``RESEARCH CREDIT--FOR TAXABLE YEARS BEGINNING BEFORE 
JANUARY 1, 1990'' to read as follows:


Sec. 1.41-0A  Table of contents.

    This section lists the paragraphs contained in Secs. 1.41-0A, 1.41-
3A, 1.41-4A and 1.41-5A.

Sec. 1.41-0A  Table of contents.
Sec. 1.41-3A  Base period research expense.
    (a) Number of years in base period.
    (b) New taxpayers.
    (c) Definition of base period research expenses.
    (d) Special rules for short taxable years.
    (1) Short determination year.
    (2) Short base period year.
    (3) Years overlapping the effective dates of section 41 (section 
44F).
    (i) Determination years.
    (ii) Base period years.
    (4) Number of months in a short taxable year.
    (e) Examples.
Sec. 1.41-4A  Qualified research for taxable years beginning before 
January 1, 1986. 
    (a) General rule.
    (b) Activities outside the United States.
    (1) In-house research.
    (2) Contract research.
    (c) Social sciences or humanities.
    (d) Research funded by any grant, contract, or otherwise.
    (1) In general.
    (2) Research in which taxpayer retains no rights.
    (3) Research in which the taxpayer retains substantial rights.
    (i) In general.
    (ii) Pro rata allocation.
    (iii) Project-by-project determination.
    (4) Independent research and development under the Federal 
Acquisition Regulations System and similar provisions.
    (5) Funding determinable only in subsequent taxable year.
    (6) Examples.
Sec. 1.41-5A  Basic research for taxable years beginning before 
January 1, 1987. 
    (a) In general.
    (b) Trade or business requirement.
    (c) Prepaid amounts.
    (1) In general.
    (2) Transfers of property.
    (d) Written research agreement.
    (1) In general.
    (2) Agreement between a corporation and a qualified organization 
after June 30, 1983.
    (i) In general.
    (ii) Transfers of property.
    (3) Agreement between a qualified fund and a qualified 
educational organization after June 30, 1983.
    (e) Exclusions.
    (1) Research conducted outside the United States.
    (2) Research in the social sciences or humanities.
    (f) Procedure for making an election to be treated as a 
qualified fund.


Sec. 1.218-0  [Removed]

    Par. 18. Section 1.218-0 is removed.


Sec. 1.482-7  [Amended]

    Par. 19. In Sec. 1.482-7, the sixth sentence of paragraph (h)(1) is 
amended by removing the language ``Sec. 1.41-8(e)'' and adding 
``Sec. 1.41-6(e)'' in its place.

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

    Par. 20. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

    Par. 21. In Sec. 602.101, paragraph (b) is amended by adding an 
entry to the table in numerical order to read as follows:


Sec. 602.101  OMB Control numbers.

* * * * *
    (b) * * *

[[Page 296]]



------------------------------------------------------------------------
                                                            Current OMB
   CFR part or section where identified and described       control No.
------------------------------------------------------------------------
 
                  *        *        *        *        *
1.41-4(d)...............................................       1545-1625
 
                  *        *        *        *        *
1.41-8(b)...............................................       1545-1625
 
                  *        *        *        *        *
------------------------------------------------------------------------


Robert E. Wenzel,.
Deputy Commissioner of Internal Revenue.

    Approved: December 22, 2000.
Jonathan Talisman,
Acting Assistant Secretary of the Treasury.
[FR Doc. 00-33170 Filed 12-27-00; 12:33 pm]
BILLING CODE 4830-01-P