[Federal Register Volume 66, Number 247 (Wednesday, December 26, 2001)]
[Proposed Rules]
[Pages 66362-66375]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-31007]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-112991-01]
RIN 1545-AY82


Credit for Increasing Research Activities

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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SUMMARY: This document contains proposed regulations relating to the 
computation of the research credit under section 41(c) and the 
definition of qualified research under section 41(d). In addition, this 
document contains proposed regulations describing when computer 
software that is developed by (or for the benefit of) a taxpayer 
primarily for the taxpayer's internal use is excepted from the 
internal-use software exclusion contained in section 41(d)(4)(E). These 
proposed regulations reflect changes to section 41 made by the Tax 
Reform Act of 1986, 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, and the Tax Relief 
Extension Act of 1999. This document also provides notice of a public 
hearing on these proposed regulations.

DATES: Written and electronic comments and requests to speak (with 
outlines of oral comments) at the public hearing scheduled for March 
27, 2002 must be received no later than March 6, 2002.

ADDRESSES: Send submissions to: CC:IT&A:RU (REG-112991-01), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may also be hand delivered Monday through Friday 
between the hours of 8 a.m. and 5 p.m. to: CC:IT&A:RU (REG-112991-01), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW., 
Washington, DC. Alternatively, taxpayers may submit comments 
electronically via the Internet by selecting the ``Tax Regs'' option of 
the IRS Home Page, or by submitting comments directly to the IRS 
Internet site at: http://www.irs.gov/tax_regs/reglist.html. The public 
hearing will be held in the IRS Auditorium (7th Floor), Internal 
Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Lisa J. 
Shuman, 202-622-3120; concerning submissions of comments and the 
hearing, LaNita VanDyke, 202-622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in this proposed 
regulation have been previously reviewed and approved by the Office of 
Management and Budget (OMB) in accordance with the Paperwork Reduction 
Act of 1995 (44 U.S.C. 3507(d)) and assigned OMB Control Number 1545-
1625. 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 OMB.
    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 3, 2001, Treasury and the IRS published in the Federal 
Register (66 FR 280) final regulations (TD 8930) relating to the 
computation of the credit for increasing research activities (the 
research credit) under section 41(c) and the definition of qualified 
research under section 41(d). In response to taxpayer concerns 
regarding TD 8930, on January 31, 2001, Treasury and the IRS published 
Notice 2001-19 (2001-10 I.R.B. 784), announcing that Treasury and the 
IRS would review TD 8930 and reconsider comments previously submitted 
in connection with the finalization of TD 8930. Comments were requested 
on all aspects of TD 8930 with specific comments requested on whether 
modifications should be made to the documentation requirement contained 
in Sec. 1.41-4(d).
    Notice 2001-19 also provided that, upon the completion of this 
review, Treasury and the IRS would announce changes to the regulations, 
if any, in the form of proposed regulations. Notice 2001-19 stated that 
TD 8930 would be revised so that the provisions of the regulations, 
including any changes to TD 8930, would be effective no earlier than 
the date when the completion of this review was announced, except that 
the provisions relating to internal-use computer software (including 
any revisions) generally would be applicable for taxable years 
beginning after December 31, 1985.

Explanation of Provisions

    This document amends 26 CFR part 1 to provide additional rules 
under section 41. Section 41 contains the rules for the research 
credit. After consideration of the statute and legislative history, the 
court decisions, TD 8930 and the comments previously submitted in 
connection with the finalization of TD 8930, and the comments submitted 
in response to Notice 2001-19, Treasury and the IRS have revised TD 
8930 to provide rules regarding:
    (i) The requirement in section 41(d)(1)(B)(i) that qualified 
research be ``undertaken for the purpose of discovering information 
which is technological in nature'';
    (ii) The requirement in section 41(d)(1)(C) that qualified research 
be research ``substantially all of the activities of which constitute 
elements of a process of experimentation'';
    (iii) The type of computer software constituting software ``which 
is developed by (or for the benefit of) the taxpayer primarily for 
internal use by the taxpayer'' for purposes of section 41(d)(4)(E); and
    (iv) the documentation required to substantiate the research 
credit. These and other changes to TD 8930 are discussed below.

I. Research That Is Undertaken for the Purpose of Discovering 
Information Which Is Technological in Nature

    Section 41(d)(1)(B)(i) requires that qualified research must be 
``undertaken for the purpose of discovering information which is 
technological in nature.'' TD 8930 provided that ``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

[[Page 66363]]

professionals in a particular field of science or engineering'' and 
that ``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.''
    With respect to the phrase ``undertaken for the purpose of 
discovering information,'' commentators noted that Sec. 1.174-2(a)(1) 
imposes a requirement that a taxpayer's activities must be ``intended 
to discover information'' in order to give rise to research and 
experimental expenditures under section 174, and that section 
41(d)(1)(A) incorporates this requirement because an expenditure must 
qualify under section 174 in order to give rise to the research credit. 
Commentators argued that the enactment of the section 41(d)(1)(B) 
``undertaken for the purpose of discovering information'' language 
should not necessarily be viewed as imposing a different standard than 
that imposed under section 174 because the section 174 ``intended to 
discover information'' language was promulgated in regulations after 
section 41(d)(1)(B) was enacted.
    Commentators also stated that the requirement that qualified 
research be ``undertaken for the purpose of discovering information 
which is technological in nature'' reflects Congress' concern that the 
research credit had been claimed for non-technological research. These 
commentators note that in 1984 hearings to evaluate the operation of 
the research credit prior to the changes of the Tax Reform Act of 1986, 
Public Law 99-514, 100 Stat. 2085, 2186 (the 1986 Act), members of the 
Subcommittee on Oversight of the House Committee on Ways and Means and 
Treasury officials cited research credit claims by fast food 
restaurants, fashion designers and hair stylists as examples of 
activities that should not be credit eligible. These commentators argue 
that the 1986 Act modifications to the research credit were intended to 
target research that relies upon principles of the physical or 
biological sciences, engineering, or computer science.
    Based upon their review of these comments, the statute and 
legislative history, Treasury and the IRS have determined that the 
definition of qualified research set out in TD 8930 does not fully 
address Congress' concerns regarding the importance of research 
activities to the U.S. economy. Accordingly, Treasury and the IRS have 
eliminated in these proposed regulations the requirement that qualified 
research must be undertaken to obtain knowledge that exceeds, expands, 
or refines the common knowledge of skilled professionals in a 
particular field of science or engineering. Rather, Treasury and the 
IRS believe that the requirement that qualified research be 
``undertaken for the purpose of discovering information which is 
technological in nature'' is intended to distinguish technological 
research, which may qualify for the research credit, from non-
technological research, which does not.
    When the research credit rules were amended by the 1986 Act, 
Congress explained the requirement in section 41(d)(1)(B)(i) as 
follows:

    [t]he determination of whether the research is undertaken for 
the purpose of discovering information that is technological in 
nature depends on whether the process of experimentation utilized in 
the research fundamentally relies on principles of the physical or 
biological sciences, engineering, or computer science/3/--in which 
case the information is deemed technological in nature--or on other 
principles, such as those of economics--in which case the 
information is not to be treated as technological in nature. For 
example, information relating to financial services or similar 
products (such as new types of variable annuities or legal forms) or 
advertising does not qualify as technological in nature.

H.R. Conf. Rep. No. 99-841, at II-71 (1986) (footnote omitted). This 
explanation of section 41(d)(1)(B)(i) focuses on the distinction 
between information derived from a process of experimentation that 
fundamentally relies on principles of physical or biological sciences, 
engineering or computer science, and information derived by other 
means. This and other changes to the research credit by the 1986 Act 
were driven by Congressional concerns that the research credit had been 
applied ``too broadly'' and that ``[m]any taxpayers claiming the credit 
were not in industries that involved high technology or its application 
in developing new and improved products or methods of production.'' 
H.R. Rep. No. 99-426, at 177-78; S. Rep. No. 99-313, at 694-95. The 
examples provided by Congress illustrate this point. Information 
relating to financial services, variable annuities, legal forms and 
advertising all involve information derived from non-technological 
research. This distinction between technological and non-technological 
research is further emphasized by other changes made to the definition 
of qualified research by the 1986 Act. For example, section 41(d)(4)(D) 
specifically excludes from the definition of qualified research certain 
non-technical activities including efficiency surveys, activities 
relating to management function or technique, market research testing, 
routine data collection and quality control testing. Similarly, section 
41(d)(3)(B) generally provides that if the purpose of research relates 
to style, taste, cosmetic or seasonal design factors, then that 
research cannot constitute qualified research. The 1986 Act also 
expanded the list of social science exclusions contained in section 
41(d)(4)(G).
    In contrast, the 1986 legislative history does not indicate that 
section 41(d)(1)(B)(i) was enacted to impose a scientific discovery 
requirement. The legislative history does not contain a definition of 
the term discovery. The footnote 3 referenced in the above quoted 
legislative history does state:

    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). This footnote, 
however, does not set forth a rule of general application, but instead 
merely illustrates a clear example of research satisfying the 
requirement that qualified research be technological in nature.
    For all of these reasons, Treasury and the IRS have concluded that 
there should be no ``discovery'' requirement in the research credit 
regulations separate and apart from that already required under 
Sec. 1.174-2(a)(1), which states, in part:

    Expenditures represent research and development costs in the 
experimental or laboratory sense if they are for activities intended 
to discover information that would eliminate uncertainty concerning 
the development or improvement of a product. Uncertainty exists if 
the information available to the taxpayer does not establish the 
capability or method for developing or improving the product or the 
appropriate design of the product.

Accordingly, these proposed regulations do not retain from TD 8930 the 
requirement that qualified research must be undertaken to obtain 
knowledge that exceeds, expands, or refines the common knowledge of 
skilled professionals in a particular field of science or engineering. 
Instead, the proposed regulations repeat the requirement from 
Sec. 1.174-2(a)(1) by stating that research is undertaken for the 
purpose of discovering information if it is intended to eliminate 
uncertainty concerning the development or improvement of a business 
component. Uncertainty, for purposes of this requirement, exists if the 
information

[[Page 66364]]

available to the taxpayer does not establish the capability or method 
of developing or improving the business component, or the appropriate 
design of the business component.
    These proposed regulations expand on the definition of 
technological in nature set out in TD 8930. As under TD 8930, 
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. As in TD 8930, these proposed regulations clarify the 
definition of technological in nature by stating that a taxpayer may 
employ existing technologies and may rely on existing principles of the 
physical or biological sciences, engineering, or computer science to 
satisfy this requirement.
    TD 8930 contained a patent safe harbor providing 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 (other than a patent for design issued under the provisions of 
35 U.S.C. 171) for the business component. These proposed regulations 
contain a similar rule that conforms to the underlying requirement for 
credit eligibility in section 41(d)(1)(B)(i) that research must be 
undertaken for the purpose of discovering information that is 
technological in nature. Accordingly, these proposed regulations 
provide that a taxpayer is conclusively presumed to have discovered 
information that is technological in nature that is intended to 
eliminate uncertainty concerning the development or improvement of a 
business component if that taxpayer was awarded a patent (other than a 
patent for design issued under the provisions of 35 U.S.C. 171) for the 
business component.

II. Process of Experimentation

    Together with the requirements of section 41(d)(1)(A) and (B), 
section 41(d)(1)(C) provides that qualified research means research 
substantially all of the activities of which constitute elements of a 
process of experimentation related to a new or improved function, 
performance, or reliability or quality. In TD 8930, Treasury and the 
IRS clarified how the process of experimentation required by section 
41(d)(1)(C) differs from research and development in the experimental 
or laboratory sense required by Sec. 1.174-2(a). Specifically, TD 8930 
provided that 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 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. Several commentators objected to any 
distinction regarding the design of a business component and cited 
examples from the legislative history which these commentators contend 
show that the determination of the appropriate design of a business 
component involved a process of experimentation.
    Treasury and the IRS continue to believe that the requirements for 
a process of experimentation under section 41 are more stringent than 
the requirements for research and development in the experimental or 
laboratory sense under Sec. 1.174-2(a)(1). However, Treasury and the 
IRS have determined that a process of experimentation may exist if a 
taxpayer performs research to establish the appropriate design of a 
business component when the capability and method for developing or 
improving the business component are not uncertain. As is discussed in 
more detail below, not all research to arrive at the appropriate design 
of a business component will be credit eligible.
    These proposed regulations provide that a process of 
experimentation is a process designed to evaluate one or more 
alternatives to achieve a result where the capability or the method of 
achieving that result, or the appropriate design of that result, is 
uncertain as of the beginning of the taxpayer's research activities. 
Whether a taxpayer has undertaken a process of experimentation is a 
facts and circumstances determination. The proposed regulations provide 
factors that are indicative of a process of experimentation. The 
factors listed are not exclusive, and no one factor is dispositive.
    A taxpayer's activities do not constitute elements of a process of 
experimentation where the capability and method of achieving the 
desired new or improved business component, and the appropriate design 
of the desired new or improved business component, are readily 
discernible and applicable as of the beginning of the taxpayer's 
research activities so that true experimentation in the scientific or 
laboratory sense would not have to be undertaken to test, analyze, and 
choose among viable alternatives. Similarly, a process of 
experimentation does not include merely selecting among several 
alternatives that are readily discernible and applicable. The fact that 
a taxpayer conducts only rudimentary or non-technological testing in 
order to develop or improve a business component tends to indicate that 
the appropriate design of the business component was readily 
discernible and applicable at the outset within the meaning of these 
rules.
    TD 8930 provided that the substantially all requirement of section 
41(d)(1)(C) 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. These proposed regulations retain the same 
rule. Treasury and the IRS, however, request comments on the 
application of the substantially all rule. Treasury and the IRS are 
specifically interested in comments on whether research expenses 
incurred for non-qualified purposes are includible in the credit 
computation provided that substantially all of the research expenses 
constitute elements of a process of experimentation.

III. Internal Use Software

    Section 41(d)(4)(E) provides that, except to the extent provided by 
regulations, research with respect to ``computer software which is 
developed by (or for the benefit of) the taxpayer primarily for 
internal use by the taxpayer'' (i.e., internal-use software) is 
excluded from the definition of qualified research. TD 8930 provided 
that the development of internal-use software constitutes qualified 
research only if the research satisfies both the general requirements 
for credit eligibility under section 41 (including that the research 
not be otherwise excluded) and an additional, three-part high threshold 
of innovation test. TD 8930 defined internal-use software as software 
that is to be used internally, such as software used in general and 
administrative functions of the taxpayer, or in providing noncomputer 
services. 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. 
TD 8930, however, contained an exception to this rule that provides 
that internal-use software does not include software that is designed 
to

[[Page 66365]]

provide customers with a new feature, not available from the taxpayer's 
competitors, with respect to a noncomputer service and that the 
taxpayer reasonably anticipates will give rise to increased customer 
demand for the noncomputer service.
    The high threshold of innovation test in TD 8930 generally required 
that (i) the internal-use software be innovative; (ii) the development 
of the internal-use software involve significant economic risk; and 
(iii) the internal-use software not be commercially available. The high 
threshold of innovation test, however, does not apply with respect to 
the development of software (i) for use in conducting qualified 
research; (ii) for use in a production process; (iii) for use as part 
of a package of hardware and software developed concurrently; and (iv) 
for use in providing computer services to customers. 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.
    In response to Notice 2001-19, several commentators objected to the 
internal-use software provisions of TD 8930. After reviewing the 
legislative history to the 1986 Act, the Tax and Trade Relief Extension 
Act of 1998, Public Law 105-277, 112 Stat. 2681, 2681-888 (the 1998 
Act), and the Tax Relief Extension Act of 1999, Public Law 106-170, 113 
Stat. 1860, 1919, together with the comment letters, Treasury and the 
IRS made several changes to the internal-use software rules. These 
proposed regulations clarify the definition of internal-use software 
contained in TD 8930 as well as the exceptions to this definition and 
the types of software that are not required to satisfy the high 
threshold of innovation test. These changes are discussed below.
Internal-Use Software Defined
    Under these proposed regulations, software that is developed by (or 
for the benefit of) the taxpayer primarily to be commercially sold, 
leased, licensed, or otherwise marketed, for separately stated 
consideration to unrelated third parties is not treated as internal use 
software. All other software is presumed to be developed by (or for the 
benefit of) the taxpayer primarily for the taxpayer's internal use. 
This distinction reflects the view that software that is sold, leased, 
licensed, or otherwise marketed, for separately stated consideration to 
unrelated third parties is software that is intended to be used 
primarily by the customers of the taxpayer, whereas software that does 
not satisfy this requirement is software that is intended to be used 
primarily by the taxpayer for its internal use or in connection with a 
noncomputer service provided by the taxpayer.
    These proposed regulations retain the provision in TD 8930 that 
excluded from the definition of internal-use software computer software 
and hardware developed as a single product. This rule, however, has 
been modified in response to a commentator's suggestion that some 
purchasers of combined software and hardware packages may develop their 
own computer software to operate the package or modify the imbedded 
computer software. Because the computer software is an integral part of 
the hardware, these commentators urged that the computer software/
hardware rule should be extended to these development costs. Treasury 
and the IRS agree that, provided the computer software is developed to 
be used with hardware as a single product and the activities are 
otherwise credit-eligible and not excluded under another provision 
(e.g., section 41(d)(4)(B)), the computer software/hardware rule should 
extend to these development costs. Thus, under these proposed 
regulations, internal-use software does not include a new or improved 
package of computer software and hardware developed together by the 
taxpayer as a single product (or to the costs to modify an acquired 
computer software and hardware package), of which the software is an 
integral part, that is used directly by the taxpayer in providing 
services in its trade or business to customers.
High Threshold of Innovation Test
    These proposed regulations retain the general rule contained in TD 
8930 that internal-use software must satisfy the general requirements 
for credit eligibility (and not be excluded from the definition of 
qualified research under any other exclusion) and the three-part high 
threshold of innovation test. These proposed regulations clarify the 
first prong of the three-part test by providing that internal-use 
software is innovative if the software is intended to be unique or 
novel and is intended to differ in a significant and inventive way from 
prior software implementations or methods. This change is being 
proposed pursuant to the authority provided in section 41(d)(4)(E) and 
the legislative history thereunder in order to update the definition of 
innovative contained in TD 8930. The TD 8930 definition was derived 
from the legislative history to the 1986 Act and required that the 
software be intended to result in a reduction in cost, improvement in 
speed, or other improvement, that is substantial and economically 
significant. Treasury and the IRS became concerned that the elements of 
the TD 8930 definition, while perhaps reflecting innovations in 
computer software in the mid-1980s, did not adequately reflect the 
factors that indicate that software is innovative today. The proposed 
change, therefore, is an attempt both to update the definition of 
innovative, and to provide a more flexible definition with continuing 
application. Several examples were added to these proposed regulations 
to illustrate the application of this proposed rule. The second and 
third prongs of the high threshold of innovation test (i.e., 
significant economic risk and commercial availability) remain unchanged 
from TD 8930.
Software Not Required To Satisfy the High Threshold of Innovation Test
    Like TD 8930, these proposed regulations provide that software is 
not required to satisfy the high threshold of innovation test if the 
software was developed by the taxpayer for use in an activity that 
constitutes qualified research (other than the development of the 
internal-use software itself), a production process that meets the 
requirements of section 41(d)(1), or in providing computer services to 
customers. These proposed regulations, however, eliminate the special 
rule contained in TD 8930 for software used to deliver noncomputer 
services to customers with features that are not yet offered by a 
taxpayer's competitors. Several commentators stated that this rule is 
too limited and subjective in its application to have significant value 
to taxpayers. Due to other revisions contained in these proposed 
regulations, Treasury and the IRS believe that the computer software 
targeted by this rule generally would be credit eligible without this 
rule.
    Several commentators objected to the distinction between computer 
services and noncomputer services and urged that the definition of 
internal-use software exclude any software used to deliver a service to 
customers or any software that includes an interface with customers or 
the public. An exclusion for software that includes an interface with 
customers or the public would entail substantial administrative 
difficulties and may inappropriately permit certain categories of costs 
(e.g., certain web site development costs) to constitute qualified 
research expenses without having to satisfy the high threshold of 
innovation test.

[[Page 66366]]

    With respect to software developed by a taxpayer for use in a 
production process satisfying the requirements of section 41(d)(1), 
comments from service providers urged Treasury and the IRS to give 
service providers the same benefits as manufacturing companies. 
Congress provided an explicit exclusion for software developed for use 
in a production process; however, it did not provide a similar 
exclusion for software used in the provision of noncomputer services. 
Therefore, Treasury and the IRS conclude that software used in the 
provision of noncomputer services generally should be subject to the 
internal-use software requirements.
Effective Date
    Treasury and the IRS propose the revisions to the internal-use 
software rules to be effective for taxable years beginning after 
December 31, 1985. Treasury and the IRS believe that the proposed rule 
is consistent with the legislative history and the legislative mandate 
for retroactive application of the rule. Taxpayers, however, may 
continue to rely on TD 8930 until regulations are finalized.

IV. Shrinking-Back Rule

    TD 8930 contained a special shrinking-back rule. These proposed 
regulations revise the shrinking-back rule to conform it to the rule in 
the legislative history to the 1986 Act. These proposed regulations 
also reiterate that the shrinking-back rule may not itself be applied 
as a reason to exclude research activities from credit eligibility.

V. Other Exclusions

    Several commentators raised issues concerning activities excluded 
from the definition of qualified research. In particular, the 
commentators were concerned about the research after commercial 
production exclusion. Because the rules contained in Sec. 1.41-4(c) of 
TD 8930 closely reflected the legislative history regarding post-
research activities, these proposed regulations retain the rules 
contained in TD 8930. See H.R. Conf. Rep. No. 99-841, at II-74-75. 
However, new examples are included to illustrate the application of the 
exclusions. Treasury and the IRS request comments concerning the 
application of the exclusions and the extent to which additional 
guidance concerning the exclusions may be helpful.

VI. 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).
    TD 8930 adopted a broad definition of the term gross receipts for 
purposes of computing the research credit. TD 8930 generally defined 
gross receipts as the total amount derived by a taxpayer from all 
activities and sources. In addition, because certain extraordinary 
gross receipts might not be taken into account when a business 
determines its research budget, TD 8930 provided that certain items 
(e.g., receipts from the sale or exchange of capital assets, or 
repayments of loans or similar instruments) would be excluded from the 
computation of gross receipts. Further, TD 8930 excluded from the 
definition of gross receipts any income derived 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.
    In response to Notice 2001-19, some commentators suggested that the 
definition of gross receipts created an administrative burden to the 
extent that taxpayers would be obligated to apply the definition of the 
term for the four years preceding the determination years as well as to 
the 1984 through 1988 base years.
    These proposed regulations retain the definition of gross receipts 
contained in TD 8930. Treasury and the IRS continue to believe that the 
definition of gross receipts should be construed broadly and that the 
definition of gross receipts in TD 8930 is appropriate for purposes of 
computing the research credit. Further, Treasury and the IRS believe 
that the administrative burden referred to by commentators is due to 
the incremental nature of the credit and the statutorily determined 
base years, and not to the definition of gross receipts.

VII. Recordkeeping for the Research Credit

    Under TD 8930, taxpayers were required to 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. These proposed regulations eliminate 
this recordkeeping requirement.
    Treasury and the IRS recognize that the research credit presents a 
particular burden for taxpayers because tracking eligible expenditures 
may necessitate taxpayers preparing and keeping records unlikely to be 
prepared or kept for other business purposes. The fact that the records 
are not prepared or kept for other business purposes has made 
administration of the research credit burdensome for the IRS. Moreover, 
section 41 often requires an allocation between qualifying and non-
qualifying costs that is difficult for taxpayers to make and for the 
IRS to administer.
    Nevertheless, when the research credit was extended in 1999, 
Congress made clear that the credit should not impose unreasonable 
recordkeeping requirements:

    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 
recordkeeping requirements.

H.R. Conf. Rep. No. 106-478, at 132 (1999). Treasury and the IRS have 
re-evaluated whether a research credit-specific documentation 
requirement is warranted and have concluded that the high degree of 
variability in the objectives and conduct of research activities in the 
United States compels a conclusion that taxpayers must be provided 
reasonable flexibility in the manner in which they substantiate their 
research credits. Accordingly, Treasury and the IRS have concluded that 
the failure to keep records in a particular manner (so long as such 
records are in sufficiently usable form and detail to substantiate that 
the expenditures claimed are eligible for the credit) cannot serve as a 
basis for denying the credit. Treasury and the IRS have decided that 
the rules generally applicable under section 6001 provide sufficient 
detail about required documentary substantiation for purposes of the 
research credit. Consequently, no separate research credit-specific 
documentation requirement is included in these proposed regulations.
    Section 1.6001-1 requires the keeping of records ``sufficient to 
establish the amount of * * * credits, * * * required to be shown * * 
*.'' The consequence of failing to keep sufficient records 
substantiating a claimed credit may be denial of the credit. To address 
any ongoing recordkeeping concerns regarding the research credit, 
Treasury and the IRS propose to use pre-filing

[[Page 66367]]

processes, including industry issue resolution, pre-filing agreements, 
determination letters, and record retention agreements, to provide 
certainty to taxpayers about the records that must be kept and to 
ensure the availability to the IRS of the records necessary to examine 
taxpayers' returns expeditiously. Treasury and the IRS solicit comments 
from taxpayers on establishing recordkeeping rules that will facilitate 
compliance and administration, including whether pre-filing agreements 
should extend to the qualification of particular cost centers or to the 
procedures established by the taxpayer for determining the expenditures 
qualifying for the credit. Treasury and the IRS also solicit comments 
from taxpayers on the extent to which guidelines may be developed on an 
industry-by-industry basis.

Proposed Effective Dates

    Except as specifically provided in Sec. 1.41-4(c)(6)(ix), the 
proposed amendments to Sec. 1.41-4 are proposed to apply to taxable 
years ending on or after December 26, 2001. Notwithstanding this 
prospective effective date, Treasury and the IRS believe that these 
rules prescribe the proper treatment of the expenditures they address, 
and the IRS generally will not challenge return positions consistent 
with the proposed regulations. Therefore, taxpayers may rely on these 
proposed regulations until the date final regulations under Sec. 1.41-4 
are published in the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. It also has been determined that section 533(b) of the 
Administrative Procedures Act (5 U.S.C. chapter 5) does not apply to 
these regulations, and because these regulations do not impose a 
collection of information on small entities, the Regulatory Flexibility 
Act (5 U.S.C. chapter 6) does not apply. Therefore, a Regulatory 
Flexibility Analysis is not required. Pursuant to section 7805(f) of 
the Internal Revenue Code, this notice of proposed rulemaking will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any electronic and written comments (a 
signed original and eight (8) copies) that are submitted timely to the 
IRS. The IRS and the Treasury Department specifically request comments 
on the clarity of the proposed regulations and how they may be made 
easier to understand. All comments will be available for public 
inspection and copying. All comments will be available for public 
inspection and copying.
    A public hearing has been scheduled for March 27, 2002, at 10 a.m. 
in the IRS Auditorium (7th Floor), Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC. Because of access 
restrictions, visitors will not be admitted beyond the building lobby 
more than 15 minutes before the hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons that wish to present oral comments at the hearing must 
submit (in the manner described in the ADDRESSES portion of this 
preamble) comments and an outline of the topics to be discussed and the 
time to be devoted to each topic by March 6, 2002.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

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

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

    Par. 2. Section 1.41-0 is amended as follows:
    1. Revising the section heading for 1.41-3.
    2. Revising the entries for 1.41-4.
    3. Revising the section heading for 1.41-8.


Sec. 1.41-0  Table of contents.

* * * * *


Sec. 1.41-3  Base amount for taxable years ending on or after December 
26, 2001.

* * * * *


Sec. 1.41-4  Qualified research for expenditures paid or incurred in 
taxable years ending on or after December 26, 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) Application of the discovering information requirement.
    (iii) Patent safe harbor.
    (4) Technological in nature.
    (5) Process of experimentation.
    (i) In general.
    (ii) Readily discernible capability, method and appropriate 
design.
    (iii) Qualified purpose.
    (iv) Factors tending to indicate that the taxpayer has engaged 
in a process of experimentation.
    (6) Substantially all requirement.
    (i) General rule.
    (ii) Illustrations. [Reserved]
    (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 software for taxable years beginning on or 
after December 31, 1985.
    (i) General rule.
    (ii) Requirements.
    (iii) Computer software and hardware developed as a single 
product.
    (iv) Primarily for internal use.
    (v) Software used in the provision of services.
    (A) Computer services.
    (B) Noncomputer services.
    (vi) High threshold of innovation test.
    (vii) Application of high threshold of innovation test.
    (viii) Illustrations.
    (ix) Effective date.
    (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) Recordkeeping for the research credit.
    (e) Effective dates.
* * * * *


Sec. 1.41-8  Special rules for taxable years ending on or after 
December 26, 2001.

    Par. 3. Section 1.41-3 is amended by:

[[Page 66368]]

    1. Revising the section heading.
    2. Revising paragraph (e).
    The revisions read as follows:


Sec. 1.41-3  Base amount for taxable years ending on or after December 
26, 2001.

* * * * *
    (e) Effective date. The rules of this section are applicable for 
taxable years ending on or after the date December 21, 2001.
    Par. 4. Section 1.41-4 is revised to read as follows:


Sec. 1.41-4  Qualified research for expenditures paid or incurred in 
taxable years ending on or after December 26, 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.
    (3) Undertaken for the purpose of discovering information--(i) In 
general. For purposes of section 41(d) and this section, research must 
be undertaken for the purpose of discovering information that is 
technological in nature. Research is undertaken for the purpose of 
discovering information if it is intended to eliminate uncertainty 
concerning the development or improvement of a business component. 
Uncertainty exists if the information available to the taxpayer does 
not establish the capability or method for developing or improving the 
business component, or the appropriate design of the business 
component.
    (ii) Application of the discovering information requirement. A 
determination that research is undertaken for the purpose of 
discovering information that is technological in nature does not 
require the taxpayer be seeking to obtain information that exceeds, 
expands or refines the common knowledge of skilled professionals in the 
particular field of science or engineering in which the taxpayer is 
performing the research. In addition, a determination that research is 
undertaken for the purpose of discovering information that is 
technological in nature does not require that the taxpayer succeed in 
developing a new or improved business component.
    (iii) 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 35 U.S.C. 151 
(other than a patent for design issued under the provisions of 35 
U.S.C. 171) is conclusive evidence that a taxpayer has discovered 
information that is technological in nature that is intended to 
eliminate uncertainty concerning the development or improvement of a 
business component. However, the issuance of such a patent is not a 
precondition for credit availability.
    (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. A taxpayer may employ existing technologies and may 
rely on existing principles of the physical or biological sciences, 
engineering, or computer science to satisfy this requirement.
    (5) Process of experimentation--(i) In general. For purposes of 
section 41(d) and this section, a process of experimentation is a 
process designed to evaluate one or more alternatives to achieve a 
result where the capability or the method of achieving that result, or 
the appropriate design of that result, is uncertain as of the beginning 
of the taxpayer's research activities. Thus, a taxpayer may undertake a 
process of experimentation if there is no uncertainty concerning the 
taxpayer's capability or method of achieving the desired result so long 
as the appropriate design of the desired result is uncertain as of the 
beginning of the taxpayer's research activities. However, a process of 
experimentation does not include the evaluation of alternatives to 
achieve the desired result if the capability and method of achieving 
the desired result, and the appropriate design of the desired result, 
are readily discernible and applicable as of the beginning of the 
taxpayer's research activities. A process of experimentation may 
include developing one or more hypotheses designed to achieve the 
desired result, designing and conducting an experiment to test and 
analyze those hypotheses, and refining or discarding the hypotheses as 
part of a design process to develop or improve the business component. 
For purposes of this paragraph (a)(5), factors that tend to indicate 
that the taxpayer has engaged in a process of experimentation are 
listed in paragraph (a)(5)(iv) of this section.
    (ii) Readily discernible capability, method and appropriate design. 
A taxpayer's activities do not constitute elements of a process of 
experimentation where the capability and method of achieving the 
desired new or improved business component, and the appropriate design 
of the desired new or improved business component, are readily 
discernible and applicable as of the beginning of the taxpayer's 
research activities, so that true experimentation in the scientific or 
laboratory sense would not have to be undertaken to test, analyze, and 
choose among viable alternatives. A process of experimentation does not 
include any activities to select among several alternatives that are 
readily discernible and applicable.
    (iii) Qualified purpose. For purposes of section 41(d) and this 
section, a process of experimentation is undertaken for a qualified 
purpose if it relates to a new or improved function, performance, 
reliability or quality of the business component. Research will not be 
treated as conducted for a qualified purpose if it relates to style, 
taste, cosmetic, or seasonal design factors.
    (iv) Factors tending to indicate that the taxpayer has engaged in a 
process of experimentation. For purposes of section 41(d) and this 
section, in determining whether a taxpayer has undertaken a process of 
experimentation, all facts and circumstances with respect to a 
taxpayer's research activities are taken into account. No one factor is 
dispositive in making this determination. Further, it is not intended 
that only the factors described in this paragraph are to be taken into 
account in making the determination. Thus, no inference should be drawn 
from the taxpayer's failure to satisfy any or all of the factors. Among 
the factors that tend to indicate that the taxpayer has engaged in a 
process of experimentation are--
    (A) The taxpayer tests and analyzes numerous alternative hypotheses 
to develop a new or improved business component;
    (B) The taxpayer engages in extensive, comprehensive, intricate or 
complex scientific or laboratory testing; or
    (C) The taxpayer evaluates numerous or complex specifications 
related to the

[[Page 66369]]

function, performance, reliability or quality of a new or improved 
business component.
    (6) Substantially all requirement--(i) General rule. 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.
    (ii) Illustrations. [Reserved]
    (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 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 paragraph (a)(5) of this section:

    Example 1. (i) Facts. X is engaged in the business of developing 
and manufacturing widgets. X wants to change the color of its blue 
widget to green. X obtains from various suppliers several different 
shades of green paint. X paints several sample widgets, and surveys 
X's customers to determine which shade of green X's customers 
prefer.
    (ii) Conclusion. X's activities to change the color of its blue 
widget to green are not qualified research under section 41(d)(1) 
and paragraph (a)(5) of this section because substantially all of 
X's activities are not undertaken for a qualified purpose. All of 
X's research activities are related to style, taste, cosmetic, or 
seasonal design factors.
    Example 2. (i) Facts. X is engaged in the business of 
manufacturing widgets and wants to change the color of its blue 
widget to green. X obtains samples of green paint from a supplier 
and determines that X must modify its painting process to 
accommodate the green paint because the green paint has different 
characteristics from other paints X has used. X obtains detailed 
data on the green paint from X's paint supplier. X also consults 
with the manufacturer of X's paint spraying machines and determines 
that X must acquire new nozzles that are designed to operate with 
paints similar to the green paint X wants to use. X installs the new 
nozzles on its paint spraying machines and tests the nozzles to 
ensure that to ensure that they work as specified by the 
manufacturer of the paint spraying machines.
    (ii) Conclusion. X's activities to modify its painting process 
is a separate business component under section 41(d)(2)(A). X's 
activities to modify its painting process by installing new nozzles 
on its paint spraying machines to change the color of its blue 
widget to green are not qualified research under section 41(d)(1) 
and paragraph (a)(5) of this section. The capability, method and 
appropriate design of the changes to X's painting process are 
readily discernible and applicable to X as of the beginning of X's 
activities. X's activities to test the nozzles to determine if the 
nozzles work as specified by the manufacturer of the paint spraying 
machines are not the type of testing activities that tend to 
indicate that a process of experimentation was undertaken.
    Example 3. (i) Facts. X is engaged in the business of 
manufacturing food products and currently manufactures a large-shred 
version of a product. Because X's competitors manufacture both a 
large-shred and fine-shred version of comparable food products, X 
seeks to modify its current production line to permit it to 
manufacture both a large-shred version and fine-shred version of one 
of its own food products. A shredding blade capable of producing a 
fine-shred version of the food product is not commercially 
available. Thus, X must develop a new shredding blade that can be 
fitted onto X's current production line. X must test and analyze 
numerous alternative hypotheses to determine whether a new shredding 
blade must be constructed of a different material from that of its 
existing shredding blade. In addition, X must engage in 
comprehensive and complex scientific or laboratory testing to ensure 
that its modified production process, with the newly-developed 
shredding blade, can accommodate the manufacture of both the large-
shred and fine-shred versions of X's food products.
    (ii) Conclusion. X's activities to modify its current production 
line meet the requirements of qualified research as set forth in 
paragraph (a)(2) of this section. Substantially all of X's 
activities constitute elements of a process of experimentation 
because X must evaluate more than one alternative to achieve a 
result where the method and appropriate design are uncertain as of 
the beginning of the taxpayer's research activities. X must test and 
analyze numerous alternative hypotheses and engage in comprehensive 
and complex scientific or laboratory testing to ensure that its 
modified production process, with a newly-developed shredding blade, 
can accommodate the manufacture of both the large-shred and fine-
shred versions of X's food products.
    Example 4. (i) Facts. X operates wireless networks in several 
U.S. cities. X discovers in City a service problem and collects data 
on the nature of the problem. X analyzes the data and knows, based 
on its previous experience with wireless networks in other cities, 
that the installation of a new type of gateway will eliminate the 
problem. X installs the new gateway in its City network.
    (ii) Conclusion. X's activities to determine a solution to its 
service problem are not qualified research under section 41(d)(1) 
and paragraph (a)(5) of this section. Substantially all of X's 
research activities do not constitute elements of a process of 
experimentation because the solution to the service problem is 
readily discernible and applicable by X as of the beginning of X's 
research activities.
    Example 5. (i) Facts. X is engaged in the business of 
manufacturing and selling automobiles. X incorporated into one of 
its new vehicles a new exhaust system that it designed. After X 
offered the vehicle for sale, X received complaints of a rattling 
noise that could be heard in the passenger compartment. X's 
engineers determined that the cause of the noise was the exhaust 
system coming into contact with the undercarriage of the vehicle. 
Based on previous experience with similar noise problems, X's 
engineers knew of two safe, effective, reliable solutions that would 
eliminate the noise. X's engineers selected one of the solutions 
based on cost studies that indicated it would be the less expensive 
alternative.
    (ii) Conclusion. X's activities to eliminate the rattling noise 
are not qualified research under section 41(d)(1) and paragraph 
(a)(5) of this section. Substantially all of X's research activities 
do not constitute elements of a process of experimentation because 
the solution is readily discernible and applicable to X as of the 
beginning of X's activities.
    Example 6. (i) Facts. X is in the business of designing, 
developing and manufacturing automobiles and decides to update one 
of its current model vehicles. In response to government-mandated 
fuel economy requirements, X undertakes to improve aerodynamics by 
lowering the hood of the current model vehicle. X determines that 
lowering the hood changes the air flow under the hood, which changes 
the rate at which air enters the engine through the air intake 
system, and which reduces the functionality of the cooling system. X 
designs, models, tests, refines, and re-tests proposed modifications 
to both the air intake system and cooling system until modifications 
are developed that meet X's requirements. X then integrates the 
modified air intake and cooling systems into a current model vehicle 
with a lower hood, modifying in the process the new air intake and 
cooling systems as well as the underhood wiring, brake lines and 
fuel line. X conducts extensive and complex scientific or laboratory 
testing to determine if the current model vehicle meets X's 
requirements. X conducts extensive and complex scientific or 
laboratory testing (including simulations and crash tests) to 
determine if the current model vehicle meets X's requirements.
    (ii) Conclusion. X's activities to update its vehicle meet the 
requirements of qualified research as set forth in paragraph (a)(2) 
of this section. X must test and analyze numerous alternative 
hypotheses, engage in extensive testing and analysis, and evaluate 
complex specifications related to the functionality of several of 
the vehicle's underhood systems and to the vehicle's overall 
performance. These activities indicate that X undertook a process of 
experimentation to achieve the appropriate design of the updated 
vehicle.

    (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

[[Page 66370]]

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 qualified research 
expenses are eligible for the credit. If all aspects of such 
requirements are not met at that level, the test applies at the most 
significant subset of elements of the product, process, computer 
software, technique, formula, or invention to be held for sale, lease, 
or license. This shrinking back of the product is to continue 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. This shrinking-back 
rule is applied only if a taxpayer does not satisfy the requirements of 
section 41(d)(1) and paragraph (a)(2) 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):

    Example. X, a motorcycle engine builder, develops a new 
carburetor for use in a motorcycle engine. X also modifies an 
existing engine design for use with the new carburetor. Under the 
shrinking-back rule, the requirements of section 41(d)(1) and 
paragraph (a) of this section are applied first to the engine. If 
the modifications to the engine when viewed as a whole, including 
the development of the new carburetor, do not satisfy the 
requirements of section 41(d)(1) and paragraph (a) of this section, 
those requirements are applied to the next most significant subset 
of elements of the business component. Assuming that the next most 
significant subset of elements of the engine is the carburetor, the 
research activities in developing the new carburetor may constitute 
qualified research within the meaning of section 41(d)(1) and 
paragraph (a) of this section.

    (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 is not 
treated as occurring after the beginning of commercial production if 
such clinical testing is 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 examines 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 software for taxable years beginning on or after 
the December 31, 1985--(i) General rule. Research with respect to 
computer

[[Page 66371]]

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 software satisfies the requirements of section 41(d)(1);
    (B) The software 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--
    (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 satisfies the requirements of section 41(d)(1);
    (3) The taxpayer develops the software for use in providing 
computer services to customers; or
    (4) The software satisfies the high threshold of innovation test of 
paragraph (c)(6)(vi) of this section.
    (iii) Computer software and hardware developed as a single product. 
This paragraph (c)(6) does not apply to the development costs of a new 
or improved package of computer software and hardware developed 
together by the taxpayer as a single product (or to the costs to modify 
an acquired computer software and hardware package), of which the 
software is an integral part, that is used directly by the taxpayer in 
providing services in its trade or business to customers. In these 
cases, eligibility for the research credit is to be determined by 
examining the combined software-hardware product as a single product.
    (iv) Primarily for internal use. Unless computer software is 
developed to be commercially sold, leased, licensed, or otherwise 
marketed, for separately stated consideration to unrelated third 
parties, computer software is presumed developed by (or for the benefit 
of) the taxpayer primarily for the taxpayer's internal use. For 
example, the computer software may serve general and administrative 
functions of the taxpayer, or may be used in providing a noncomputer 
service. General and administrative functions include, but are not 
limited to, functions such as payroll, bookkeeping, financial 
management, financial reporting, personnel management, sales and 
marketing, fixed asset accounting, inventory management and cost 
accounting. Computer software that is developed to be commercially 
sold, leased, licensed or otherwise marketed, for separately stated 
consideration to unrelated third parties is not developed primarily for 
the taxpayer's internal use. The requirements of this paragraph (c)(6) 
apply to computer software that is developed primarily for the 
taxpayer's internal use even though the taxpayer subsequently sells, 
leases, licenses, or otherwise markets the computer software for 
separately stated consideration to unrelated third parties.
    (v) 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.
    (vi) High threshold of innovation test. Computer software satisfies 
this paragraph (c)(6)(vi) only if the taxpayer can establish that--
    (A) The software is innovative in that the software is intended to 
be unique or novel and is intended to differ in a significant and 
inventive way from prior software implementations or methods;
    (B) The software development involves significant economic risk in 
that the taxpayer commits substantial resources to the development and 
there is 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)(v)(A) and (B) of this 
section.
    (vii) Application of high threshold of innovation test. The costs 
of developing internal use software are eligible for the research 
credit only if the software satisfies the high threshold of innovation 
test of paragraph (c)(6)(vi) of this section. This test takes into 
account only the results attributable to the development of the new or 
improved software independent of the effect of any modifications to 
related hardware or other software.
    (viii) Illustrations. The following examples illustrate provisions 
contained in this paragraph (c)(6) 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, an insurance company, has increased its 
number of insurance policies in force. In recent years, regulatory 
and financial accounting rules for computing actuarial reserves on 
these insurance policies have changed several times. In order to 
compute actuarial reserves in a more timely and cost-effective 
manner, X undertakes to create an improved reserve valuation 
software that will generate data for regulatory and financial 
accounting purposes.
    (ii) Conclusion. The improved reserve valuation software created 
by X is internal use software because the software is not developed 
to be commercially sold, leased, licensed, or otherwise marketed, 
for separately stated consideration to unrelated third parties. The 
improved reserve valuation software was developed by X to serve X's 
general and administrative functions. X's costs of developing the 
reserve valuation software are eligible for the research credit only 
if the software satisfies the high threshold of innovation test of 
paragraph (c)(6)(vi) of this section.
    Example 2. (i) Facts. Assume the same facts as in Example 1. 
Also assume that in order to create an improved reserve valuation 
software, X purchases updated hardware with a new operating system 
to build the new software system. Several other insurance companies 
using the same updated hardware and new operating system have in 
place software systems that can handle the volume of transactions 
that X seeks to handle, provide reserve computations within a 
similar time frame, and accommodate the most current regulatory and 
financial accounting requirements.
    (ii) Conclusion. X's reserve valuation software system is 
internal use software that does not satisfy the high threshold of 
innovation test of paragraph (c)(6)(vi) of this section. The 
software is not intended to be unique or novel in that it is 
intended to be merely comparable to software developed by other 
insurance companies. The software does not differ in a significant 
or inventive way from prior software implementations because X's 
reserve valuation software system was developed using the same 
technologies and methods that were employed by other insurance 
companies. Further, X's reserve valuation software is not excluded 
from the application of paragraph (c)(6) of this section by the rule 
of paragraph (c)(6)(iii) of this section.
    Example 3. (i) Facts. In 1986, X, a large regional bank with 
hundreds of branch offices, maintained separate software systems for 
each of its customer's accounts, including checking, deposit, loan, 
lease, and trust. X determined that improved customer service could 
be achieved by redesigning its disparate systems into one customer-
centric system. X also determined that commercially

[[Page 66372]]

available database management systems did not meet all of the 
critical requirements of the proposed system. Specifically, 
available relational database management systems were well suited 
for the proposed system's data modeling requirements but not the 
data integrity and transaction throughput (transactions-per-second) 
requirements. Rather than waiting several years for vendor offerings 
to mature and become viable for its purpose, X decided to embark 
upon the project utilizing older technology that satisfied the data 
integrity and transaction throughput requirements but that was 
severely challenged with respect to the data modeling capabilities. 
X commits substantial resources to this project and, because of 
technical risk, X cannot determine if it will recover its resources 
in a reasonable period. Early in the course of the project, industry 
analysts observed that the project appeared highly ambitious and 
risky. The limitations of the technology X was attempting to utilize 
required that X develop a new database architecture that could 
accommodate transaction volumes unheard-of in the industry. X was 
unable to successfully develop the system and X abandoned the 
project.
    (ii) Conclusion. X intended to develop a computer software 
system primarily for X's internal use because X did not intend to 
commercially sell, lease, license, or otherwise market the software, 
for separately stated consideration to unrelated third parties, and 
X intended to use the software in providing noncomputer services to 
its customers. X's software development activities satisfy the high 
threshold of innovation test of paragraph (c)(6)(vi) of this section 
because the system was intended to be innovative in that it was 
intended to be novel and it was intended to differ in a significant 
and inventive way from prior software implementations. In addition, 
X's development activities involved significant economic risk in 
that X committed substantial resources to the development and there 
was substantial uncertainty, because of technical risk, that such 
resources would be recovered within a reasonable period. Finally, at 
the time X undertook the development of the system, software meeting 
X's requirements was not commercially available for use by X.
    Example 4. (i) Facts. X wishes to improve upon its capabilities 
in the area of insurance fraud prevention, detection and control. X 
believes that it can exceed the capabilities of current commercial 
offerings in this area by developing and applying pattern matching 
algorithms that are not implemented in current vendor offerings. X 
has determined that many insurance fraud perpetrators can evade 
detection because its current system relies too heavily on exact 
matches and scrubbed data. Because a computer software system that 
will accomplish these objectives is not commercially available, X 
undertakes to develop and implement advanced pattern matching 
algorithms that would significantly improve upon the capabilities 
currently available from vendors. X commits substantial resources to 
the development of the software system and cannot determine, because 
of technical risk, if it will recover its investment within a 
reasonable period.
    (ii) Conclusion. X's computer software system is developed 
primarily for X's internal use because X did not intend to sell, 
lease, license or otherwise market the software, for separately 
stated consideration to unrelated third parties. X's software 
development activities satisfy the high threshold of innovation test 
of paragraph (c)(6)(vi) of this section because the software system 
is innovative in that it was intended to be novel and it was 
intended to differ in a significant and inventive way from prior 
software implementations. In addition, X's development activities 
involved significant economic risk in that X committed substantial 
resources to the development and there was substantial uncertainty, 
because of technical risk, that such resources would be recovered 
within a reasonable period. Finally, at the time X undertook the 
development of the software, software satisfying X's requirements 
was not commercially available for use by X.
    Example 5. (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. To improve customer 
service, X undertakes to develop computer software that will monitor 
the progress of the manufacture and delivery of X's widgets to 
enable X's customers to track their widget orders from origination 
to delivery, whether by air, land or ship. In addition, at the 
request of a customer, X will be able to intercept and return or 
reroute packages prior to delivery. At the time X undertakes its 
software development activities, X is uncertain whether it can 
develop the real-time communication software necessary to achieve 
its objective. None of X's competitors have a comparable tracking 
system. X commits substantial resources to the development of the 
system and, because of technical risk, X cannot determine if it will 
recover its investment within a reasonable period.
    (ii) Conclusion. X's computer software is developed primarily 
for X's internal use because the software is not developed to be 
commercially sold, leased, licensed, or otherwise marketed, for 
separately stated consideration to unrelated third parties. X's 
computer software was developed to be used by X in providing 
noncomputer services to its customers. X's software satisfies 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 a new tracking capability that is 
novel in that none of X's competitors have such a capability. 
Further, the new capability differs in a significant and inventive 
way from prior software implementations. In addition, X's 
development activities involved significant economic risk in that X 
committed substantial resources to the development and there was 
substantial uncertainty, because of technical risk, that such 
resources would be recovered within a reasonable period. Finally, at 
the time X undertook the development of the software, software 
satisfying X's requirements was not commercially available for use 
by X.
    Example 6. (i) Facts. X, a multinational chemical manufacturer 
with different business and financial systems in each of its 
divisions, undertakes a software development project aimed at 
integrating the majority of the functional areas of its major 
software systems into a single enterprise resource management system 
supporting centralized financial systems, inventory, and management 
reporting. This project involves the detailed analysis of X's (as 
well as each of X's divisions) legacy systems to understand the 
actual current business processes and data requirements. X also has 
to develop programs to fill in the gaps between the software 
features and X's system requirements. X hires Y, a systems 
consulting firm to assist with this development effort. Y has 
experience in developing similar systems. X, working jointly with Y, 
evaluates its needs, establishes goals for the new system, re-
engineers the business processes that will be made concurrently with 
the implementation of the new system, and chooses and purchases a 
software system upon which to base its enterprise-wide system.
    (ii) Conclusion. X's enterprise-wide computer software is 
developed primarily for internal use because the software is not 
developed to be commercially sold, leased, licensed, or otherwise 
marketed, for separately stated consideration to unrelated third 
parties. X's computer software was developed to be used by X to 
serve X's general and administrative functions. However, the 
development of X's enterprise management system does not satisfy the 
high threshold of innovation test of paragraph (c)(6)(vi) of this 
section because the system that X is seeking to develop is not 
intended to be unique or novel. Further, the software does not 
differ in a significant or inventive way from software implemented 
by other manufacturers.
    Example 7. (i) Facts. X, a financial services company 
specializing in commercial mortgages, decides to support its ongoing 
expansion by upgrading its information technology infrastructure. In 
order to accommodate its expanding efforts to acquire and maintain 
corporate borrowers and draw securitized loan investors, X builds a 
scalable and modular enterprise network to run its latest business 
applications, including web-based portfolio access for investors and 
staff, document imaging for customer service personnel, desktop 
access to information services for in-house securities traders and 
multimedia on-line training and corporate information delivery for 
all company personnel. As a result, X is able to access market 
information faster and function more efficiently and effectively 
than before. The new network is based on a faster local area network 
technology which is better able to meet the higher bandwidth 
requirements of X's current multimedia applications.
    (ii) Conclusion. X's software is software developed primarily 
for X's internal use because the software is not developed to be 
commercially sold, leased, licensed, or otherwise marketed, for 
separately stated consideration to unrelated third parties. X's 
software development activities do not meet the high threshold of 
innovation test of paragraph (c)(6)(vi) of this section because the 
system is not intended to be unique or

[[Page 66373]]

novel. Further, the software does not differ in a significant or 
inventive way from other existing software implementations.
    Example 8. (i) Facts. X, a corporation, undertook a software 
project to rewrite a legacy mainframe application using an object-
oriented programming language, and to move the new application off 
the mainframe to a client/server environment. Both the object-
oriented language and client/server technologies were new to X. This 
project was undertaken to develop a more maintainable application, 
and to be able to implement new features more quickly. X had to 
perform a detailed analysis of the old legacy application in order 
to determine the requirements of the rewritten application. To 
accomplish this task, X had to train the legacy mainframe 
programmers in the new object-oriented and client/server 
technologies that they would have to utilize. Several of X's 
competitors had successfully implemented similar systems using 
object-oriented programming language and client/server technologies.
    (ii) Conclusion. X's software is developed primarily for 
internal use because the software is not developed to be 
commercially sold, leased, licensed, or otherwise marketed, for 
separately stated consideration to unrelated third parties. X's 
activities to rewrite a legacy mainframe application using an 
object-oriented programming language, and to move the application 
from X's mainframe to a client/server environment do not satisfy the 
high threshold of innovation test of paragraph (c)(6)(vi) of this 
section. The software developed is not intended to be either unique 
or novel and is not intended to differ in a significant and 
inventive way from prior software implementations or methods.
    Example 9. (i) Facts. X, a retail and distribution company, 
wants to upgrade its warehouse management software. Therefore, X 
performs an analysis of the warehouse management products and 
vendors in the marketplace. X selects vendor V's software and, in 
turn, develops the software interfaces between X's legacy systems 
and V's warehouse management software in order to integrate the new 
warehouse management system with X's financial and inventory 
systems. The development of these interfaces requires a detailed 
understanding of all the input and output fields and their data 
formats, and how they map from the old system to the new system and 
vice-versa. Once X develops the interfaces, X has to perform 
extensive testing and validation work to ensure that the interfaces 
work correctly and accurately.
    (ii) Conclusion. X's software is developed primarily for 
internal use because the software is not developed to be 
commercially sold, leased, licensed, or otherwise marketed, for 
separately stated consideration to unrelated third parties. X's 
software development activities do not satisfy the high threshold of 
innovation test of paragraph (c)(6)(vi) of this section because the 
software development does not involve significant economic risk in 
that there is no substantial uncertainty, because of technical risk, 
that such resources will be recovered within a reasonable period.
    Example 10. (i) Facts. X, a credit card company, knows that its 
customers are not comfortable with purchasing products over the 
Internet because they feel the Web is not secure. X decides to build 
a payment system that provides customers with a single use, 
automatically generated, short-term time-based, transaction number. 
This single-use transaction number has a short expiration period 
that is just long enough to allow a merchant to process and fill the 
customer's order. Thus, when a customer wishes to make a purchase 
over the Internet, the customer requests X to generate automatically 
a single-use transaction number that merchant systems will accept as 
a legitimate card number. All purchases using single-use transaction 
numbers are automatically linked back to the customer's credit card 
account. X commits substantial resources to the development of the 
system and X cannot determine, because of technical risk, if it will 
recover its investment within a reasonable period. At the time of 
this project, nothing exists in the market that has these 
capabilities.
    (ii) Conclusion. X's software is developed primarily for 
internal use because the software is not developed to be 
commercially sold, leased, licensed, or otherwise marketed, for 
separately stated consideration to unrelated third parties. X's 
computer software is developed primarily for X's internal use 
because it was intended to be used by X in providing noncomputer 
services to its customers. X's software satisfies the high threshold 
of innovation test of paragraph (c)(6)(vi) of this section because 
the system is a novel way to solve the security issue of making 
purchases over the Internet. Further, because of the secure payment 
capability, the software differs in a significant and inventive way 
from prior software implementations. In addition, X's development 
activities involved significant economic risk in that X committed 
substantial resources to the development and there was substantial 
uncertainty, because of technical risk, that such resources would be 
recovered within a reasonable period. Finally, at the time X 
undertook the development of the software, software satisfying X's 
requirements was not commercially available for use by X.
    Example 11. (i) Facts. X, a corporation, wants to expand its 
internal computing power, and is aware that its PCs and workstations 
are idle at night, on the weekends, and for a significant part of 
any business day. Because the corporate computations that X needs to 
make could be done on workstations as well as PCs, X develops a 
screen-saver like application that runs on employee computers. When 
employees' computers have been idle for an amount of time set by 
each employee, the ``screen-saver'' starts to execute. However, 
instead of displaying moving lines, like the typical screen-saver, 
X's application goes back to a central server to get a new job to 
execute. This job will execute on the idle employee's computer until 
it has either finished, or the employee resumes working on his 
computer. X wants to ensure that it can manage all of the 
computation jobs distributed across its thousands of PCs and 
workstations. In addition, X wants to ensure that the additional 
load on its network caused by downloading the jobs and uploading the 
results, as well as in monitoring and managing the jobs, does not 
adversely impact the corporate computing infrastructure. At the time 
X undertook this software development project, X was uncertain, 
because of technical risk, it could develop a server application 
that could schedule and distribute the jobs across thousands of PCs 
and workstations, as well as handle all the error conditions that 
occur on a user's machine. Also, at the time X undertook this 
project, there was no commercial application available with such a 
capability.
    (ii) Conclusion. X's computer software is developed primarily 
for internal use because the software is not developed to be 
commercially sold, leased, licensed, or otherwise marketed, for 
separately stated consideration to unrelated third parties. X's 
computer software was developed to be used by X to serve X's general 
and administrative functions. X's software satisfies the high 
threshold of innovation test of paragraph (c)(6)(vi) of this section 
because making use of idle corporate computing resources through 
what is ostensibly a screen-saver, was a novel approach to solving 
X's need for more computer intensive processing time. In addition, 
X's software development involves significant economic risk in that 
there was substantial uncertainty, because of technical risk, that 
the server application that schedules and distributes the jobs 
across thousands of PCs and workstations, as well as handles all the 
error conditions that can occur on a user's machine, amounts to 
developing a new operating system with new capabilities. Finally, at 
the time X undertook the development of the software, software 
satisfying X's requirements was not commercially available for use 
by X.
    Example 12. (i) Facts. (A) X, a corporation, wants to protect 
its internal documents without building a large public key 
infrastructure. In addition, X needs to implement a new highly 
secure encryption algorithm that has a ``back-door'' such that X can 
decrypt and read any document, even when the employee is on vacation 
or leaves the company. X wants to develop a new encryption algorithm 
that is both secure, easy to use, and difficult to break. Current 
commercial encryption/decryption products are too slow for high-
level secure encryption processing. Furthermore, no commercial 
product exists that provides the capability of having a secure back-
door key to decrypt files when the owner is unavailable.
    (B) The development of the encryption/decryption software 
requires specialized knowledge of cryptography and computational 
methods. Due to the secret nature of X's work, the encryption 
algorithm has to be unbreakable, yet recoverable should the employee 
forget his key. X commits substantial resources to the development 
of the system and, because of technical risk, cannot estimate 
whether it will recover its investment within a reasonable period.
    (ii) Conclusion. X's back-door file encryption software is 
developed primarily for internal use because the software is not 
developed to be commercially sold, leased, licensed, or otherwise 
marketed, for

[[Page 66374]]

separately stated consideration to unrelated third parties. X's 
back-door file encryption software was developed to be used by X to 
serve X's general and administrative functions. X's encryption 
software satisfies 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 
encryption and back-door decryption capabilities that are unique in 
that no other product has these capabilities, which indicates the 
software encryption system differs in a significant way from prior 
software implementations. Further, the encryption and back-door 
decryption capabilities indicate that the software differs in a 
significant and inventive way from prior software implementations. 
In addition, X's development activities involved significant 
economic risk in that X committed substantial resources to the 
development and there was substantial uncertainty, because of 
technical risk, that such resources would be recovered within a 
reasonable period. Finally, at the time X undertook the development 
of the software, software satisfying X's requirements was not 
commercially available for use by X.
    Example 13. (i) Facts. X, a large regional telephone company, is 
experiencing rapidly increasing customer demand. X would like to 
determine whether evolutionary algorithms such as genetic algorithms 
may improve its ability to design cost-effective networks and extend 
existing networks. X would also like to determine whether such 
adaptive algorithms may be used to optimize the routing of call 
traffic across existing networks in order to use efficiently the 
resources available without causing congestion. X first explores the 
use of evolutionary algorithms for the call routing task, because X 
determines that this type of complex, unpredictable problem is most 
appropriate for an adaptive algorithm solution. X develops and tests 
genetic algorithms until it determines that it has developed a 
software system it can test on a pilot basis on its existing 
networks. X commits substantial resources to the project, and cannot 
predict, because of technical risk, whether it will recover its 
resources within a reasonable period. Finally, at the time X 
undertook the development of the software, software satisfying X's 
requirements was not commercially available for use by X.
    (ii) Conclusion. X's software is developed primarily for 
internal use because the software is not developed to be 
commercially sold, leased, licensed, or otherwise marketed, for 
separately stated consideration to unrelated third parties. X's 
computer software is intended to be used by X in providing 
noncomputer services to its customers. X's software satisfies the 
high threshold of innovation test of paragraph (c)(6)(vi) of this 
section because the software is intended to be novel and is intended 
to differ in a significant and inventive way from other existing 
software implementations. In addition, X's development activities 
involved significant economic risk in that X committed substantial 
resources to the development and there was substantial uncertainty, 
because of technical risk, that such resources would be recovered 
within a reasonable period. Finally, at the time X undertook the 
development of the software, software satisfying X's requirements 
was not commercially available.

    (ix) Effective date. This paragraph (c)(6) is applicable for 
taxable years beginning after December 31, 1985.
    (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 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 in the 
United States, the Commonwealth of Puerto Rico and other possessions of 
the United States and 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) (excepting (c)(6)) 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, develops a new 
material to use in its tires. X conducts research to determine the 
changes that will be necessary for X to modify its existing 
manufacturing processes to manufacture the new tire. X determines 
that the new material retains heat for a longer period of time than 
the materials X currently uses and, as a result, adheres to the 
manufacturing equipment during tread cooling. X evaluates numerous 
options for processing the treads at cooler temperatures. X designs, 
develops, and conducts sophisticated tests on the numerous options 
for a new type of belt to be used in tread cooling. X then 
manufactures a set of belts for its production equipment, installs 
the belts, and tests the belts to make sure they were manufactured 
correctly.
    (ii) Conclusion. X's research with respect to the design of the 
new belts to be used in its manufacturing of the new tire may be 
qualified research under section 41(d)(1) and paragraph (a) of this 
section. However, X's expenses to implement the design, including 
the costs to manufacture, install, and test the belts were incurred 
after the belts met the taxpayer's functional and economic 
requirements and are excluded as research after commercial 
production under section 41(d)(4)(A) and paragraph (c)(2) of this 
section. In addition, amounts expended on component materials of the 
production belts and the costs of labor or other elements involved 
in the manufacture and installation of the production belts are not 
qualified research expenses. These expenses are not for expenditures 
that may be treated as expenses under section 174 and thus are not 
qualified research under section 41(d)(1)(A) and paragraph (a)(2)(i) 
of this section. See section 174(c) and Sec. 1.174-2(b). Further, 
testing or inspection to determine whether the production belts were 
manufactured correctly is quality control testing under Sec. 1.174-
2(a)(4) and thus is not qualified research under section 41(d)(1)(A) 
and paragraph (a)(2)(i) of this section.
    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 a new or improved widget.
    (ii) Conclusion. X's activities to develop a new or improved 
widget are not excluded from the definition of qualified research 
under section 41(d)(4)(A) and paragraph (c)(2) of this section. X's 
activities relating to

[[Page 66375]]

the development of a new or improved widget constitute a new 
research project to develop a new business component. X's research 
activities relating to the development of the new or improved 
widget, a new business component, are not considered to be 
activities conducted after the beginning of commercial production 
under section 41(d)(4)(A) and paragraph (c)(2) of this section.
    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 or need, 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 are not for 
qualified research and are not considered to be 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 to adapt the 
core software program to C's requirements 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. X manufacturer and sells rail cars. 
Because rail cars have numerous specifications related to 
performance, reliability and quality, rail car designs are subject 
to extensive, complex testing in the scientific or laboratory sense. 
B orders passenger rail cars from X. B's rail car requirements 
differ from those of X's other customers in that B wants fewer seats 
in its passenger cars and a higher quality seating material and 
carpet. X manufactures rail cars meeting B's requirements. X does 
not conduct complex testing in the scientific or laboratory sense on 
the rail cars manufactured for B.
    (ii) Conclusion. X's activities to manufacture rail cars for B 
are excluded from the definition of qualified research. The rail 
cars designed for B were not subject to the type of complex testing 
that is indicative of a process of experimentation. Further, the 
rail car sold to B was not a new business component, but merely an 
adaptation of an existing business component. Thus, X's activities 
to manufacture rail cars for B are excluded from the definition of 
qualified research under section 41(d)(4)(B) and paragraph (c)(3) of 
this section because X's activities represent activities to adapt an 
existing business component to a particular customer's requirement 
or need.
    Example 7. (1) Facts. X, a manufacturer, undertakes to create a 
manufacturing process for a new valve design. X determines that it 
requires a specialized type of robotic equipment to use in the 
manufacturing process for its new valves. X is unable to locate 
robotic equipment that meets X's precise specifications, and, 
therefore, purchases the existing robotic equipment for the purpose 
of modifying it to meet its needs. X's engineers conduct experiments 
using modeling and simulation in modifying the robotic equipment and 
conduct extensive scientific and laboratory testing of design 
alternatives. As a result of this process, X's engineers develop a 
design for the robotic equipment that meets X's specifications. X 
constructs and installs the modified robotic equipment on its 
manufacturing process.
    (ii) Conclusion. X's research activities to determine how to 
modify X's robotic equipment for its manufacturing process are not 
excluded from the definition of qualified research under section 
41(d)(4)(B) and paragraph (c)(3) of this section.
    Example 8. (1) 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 develop, analyze and test potential alternative 
formulations of the additive.
    (ii) Conclusion. X's activities in analyzing and reproducing 
ingredients A and B involve duplication of existing business 
components and are excluded from the definition of qualified 
research under section 41(d)(4)(C) and paragraph (c)(4) of this 
section. X's experimentation activities to develop potential 
alternative formulations of the additive do not involve duplication 
of an existing business component and are not excluded from the 
definition of qualified research under section 41(d)(4)(C) and 
paragraph (c)(4) of this section.
    Example 9. (1) Facts. X, a manufacturing corporation, undertakes 
to restructure its manufacturing organization. X organizes a team to 
design an organizational structure that will improve X's business 
operations. The team includes X's employees as well as outside 
management consultants. The team studies current operations, 
interviews X's employees, and studies the structure of other 
manufacturing facilities to determine appropriate modifications to 
X's current business operations. The team develops a recommendation 
of proposed modifications which it presents to X's management. X's 
management approves the team's recommendation and begins to 
implement the proposed modifications.
    (ii) Conclusion. X's activities in developing and implementing 
the new management structure are excluded from the definition of 
qualified research under section 41(d)(4)(D) and paragraph (c)(5) of 
this section. Qualified research does not include activities 
relating to management functions or techniques including management 
organization plans and management-based changes in production 
processes.
    Example 10. (1) 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 (including economics and 
business management) and are thus excluded from the definition of 
qualified research under section 41(d)(4)(G) and paragraph (c)(8) of 
this section.

    (d) Recordkeeping for the research credit. A taxpayer claiming a 
credit under section 41 must retain records in sufficiently usable form 
and detail to substantiate that the expenditures claimed are eligible 
for the credit. For the rules governing record retention, see 
Sec. 1.6001-1. To facilitate compliance and administration, the IRS and 
taxpayers may agree to guidelines for the keeping of specific records 
for purposes of substantiating research credits.
    (e) Effective dates. In general, the rules of this section are 
applicable for taxable years ending on or after December 26, 2002.
    Par. 5. Section 1.41-8 is amended by:
    1. Revising the section heading.
    2. Revising paragraph (b)(4).
    The revisions read as follows:


Sec. 1.41-8  Special rules for taxable years ending on or after 
December 26, 2001.

* * * * *
    (b) * * *
    (4) Effective date. Paragraphs (b)(2) and (3) of this section are 
applicable for taxable years ending on or after December 26, 2002.

Charles O. Rossotti,
Commissioner of Internal Revenue.
[FR Doc. 01-31007 Filed 12-21-01; 8:45 am]
BILLING CODE 4830-01-P