[Federal Register Volume 69, Number 1 (Friday, January 2, 2004)]
[Rules and Regulations]
[Pages 22-29]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-31818]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9104]
RIN 1545-AY82


Credit for Increasing Research Activities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the 
definition of qualified research under section 41(d) for the credit for 
increasing research activities. These final regulations reflect changes 
to section 41(d) made by the Tax Reform Act of 1986.

DATES: Effective Dates: These regulations are effective January 2, 
2004.
    Applicability Dates: For dates of applicability of these 
regulations, see Sec.  1.41-4(e) and Effective Dates under 
SUPPLEMENTARY INFORMATION.

FOR FURTHER INFORMATION CONTACT: Nicole R. Cimino at (202) 622-3120 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    On December 2, 1998, the Treasury Department and the IRS published 
in the Federal Register (63 FR 66503) a notice of proposed rulemaking 
(REG-10570-97, 1998-2 C.B. 729) under section 41 (1998 proposed 
regulations) relating to the credit for increasing research activities 
(research credit). The 1998 proposed regulations addressed, in relevant 
part, (1) the definition of qualified research under section 41(d), (2) 
the application of the exclusions from the definition of qualified 
research, and (3) the application of the shrinking-back rule. Comments 
responding to the 1998 proposed regulations were received and a public 
hearing was held on April 29, 1999.
    On January 3, 2001, the Treasury Department and the IRS published 
in the Federal Register (66 FR 280) final regulations relating, in 
relevant part, to the definition of qualified research under section 
41(d) (TD 8930). In response to taxpayer concerns regarding TD 8930, on 
January 31, 2001, the Treasury Department and the IRS published Notice 
2001-19 (2001-10 I.R.B. 784), announcing that the Treasury Department 
and the IRS would review TD 8930 and reconsider comments previously 
submitted in connection with the finalization of TD 8930. Notice 2001-
19 also provided that, upon the completion of the review, the Treasury 
Department and the IRS would announce changes to the regulations, if 
any, in the form of proposed regulations.
    On December 26, 2001, the Treasury Department and the IRS published 
in the Federal Register (66 FR 66362) a notice of proposed rulemaking 
(REG-112991-01) reflecting the Treasury Department and the IRS' review 
of TD 8930 (2001 proposed regulations). Comments responding to the 2001 
proposed regulations were received and a public hearing was held on 
March 27, 2002. After considering the comments received and the 
statements made at the public hearing, portions of the 2001 proposed 
regulations are adopted as revised by this Treasury Decision.

Explanation of Provisions

    This document amends 26 CFR part 1 to provide revised rules for the 
research credit under section 41. These final regulations generally 
retain the provisions of the 2001 proposed regulations but clarify the 
provisions relating to 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.'' These 
final regulations, however, do not contain final rules for research 
with respect to computer 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).

Process of Experimentation--In General

    The Tax Reform Act of 1986, Public Law 99-514 (100 Stat. 2085) (the 
1986 Act), which narrowed the definition of the term qualified 
research, amended the definition of qualified research by adding a 
process of experimentation requirement. Section 41(d)(1) provides

[[Page 23]]

that in order to constitute qualified research, substantially all of 
the activities of the research must constitute elements of a process of 
experimentation related to a new or improved function, performance, or 
reliability or quality. The legislative history to the 1986 Act 
explained that ``[t]he determination of whether 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.'' H.R. Conf. 
Rep. No. 99-841, at II-71 (1986). The legislative history further 
explained that the term process of experimentation means, ``a process 
involving the evaluation of more than one alternative designed to 
achieve a result where the means of achieving that result is uncertain 
at the outset.'' Id., at II-72. In addition, a process of 
experimentation may involve developing one or more hypotheses, testing 
and analyzing those hypotheses (through, for example, modeling or 
simulation), and refining or discarding the hypotheses as part of a 
sequential design process to develop the overall component. Id.
    The 1998 proposed regulations defined a process of experimentation 
as ``a process to evaluate more than one alternative designed to 
achieve a result where the means of achieving that result are uncertain 
at the outset.'' Further, the 1998 proposed regulations specified that 
a process of experimentation is a four-step process requiring that the 
taxpayer: (i) Develop one or more hypotheses designed to achieve the 
intended result; (ii) design a scientific experiment (that, where 
appropriate to the particular field of research, is intended to be 
replicable with an established experimental control) to test and 
analyze those hypotheses (through, for example, modeling, simulation, 
or a systematic trial and error methodology); (iii) conduct the 
experiment and record the results; and (iv) refine or discard the 
hypotheses as part of a sequential design process to develop or improve 
the business component. Commentators generally objected to this 
prescribed four-step test arguing that it would not be appropriate for 
evaluating the qualification of certain commercial and industrial 
research activities.
    In response to these comments, the Treasury Department and the IRS 
in TD 8930 provided that taxpayers conducting a process of 
experimentation may, but were not required to, engage in the four-step 
process described in the 1998 proposed regulations, but eliminated, for 
this purpose, the specific recordation requirement. (As an addition to 
the general recordkeeping requirement under section 6001, TD 8930 
instead included a contemporaneous documentation requirement that was 
intended to be less burdensome than the specific recordation 
requirement. The contemporaneous documentation requirement in TD 8930 
was eliminated in the 2001 proposed regulations.) Consistent with the 
legislative history, however, TD 8930 retained the underlying process 
of experimentation requirement in the 1998 proposed regulations by 
providing 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.''
    The 2001 proposed regulations further clarified the definition of a 
process of experimentation and provided, in relevant part, 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.'' More specifically, however, the general requirement was 
modified in the 2001 proposed regulations to provide, first, that ``a 
process of experimentation is a process designed to evaluate one or 
more alternatives to achieve a result.'' (Emphasis added). The 2001 
proposed regulations also provided that a process of experimentation 
may exist if a taxpayer performs research to establish the appropriate 
design of a business component even when the capability and method for 
developing or improving the business component are not uncertain. The 
2001 proposed regulations further stated that 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. 
Finally, the 2001 proposed regulations emphasized that the 
determination of whether a taxpayer has engaged in a process of 
experimentation was dependent on the facts and circumstances of the 
taxpayer's research activities and, for this purpose, contained three 
non-dispositive and non-exclusive factors that tend to indicate that a 
taxpayer has engaged in a process of experimentation.
    In response to the 2001 proposed regulations, a number of 
commentators expressed concern with the rules for the process of 
experimentation requirement, and, in particular, stated that the rules 
and terms used (including uncertainty, appropriate design, and readily 
discernible and applicable) did not provide clear guidance for the 
requirement. More specifically, commentators stated that the term 
readily discernible and applicable was highly subjective in nature, and 
thus arguably could be construed as a variant of the discovery test of 
TD 8930. In addition, one commentator expressed concern regarding the 
meaning and scope of the term uncertain and suggested adding examples 
illustrating the factors that tend to indicate that a taxpayer has 
engaged in a process of experimentation. Another commentator also noted 
that the 2001 proposed regulations appeared to allow the inclusion of 
all design costs as qualified research expenditures to the extent that 
the appropriate design of the desired result is never certain at the 
outset of the typical design process.
    The Treasury Department and the IRS continue to believe that the 
process of experimentation test requires an evaluation of the facts and 
circumstances of a taxpayer's research activities. As reflected by the 
changes made in the 2001 proposed regulations, this requirement is not 
intended to be inflexible or overly narrow. Nevertheless, the Treasury 
Department and the IRS continue to believe that the requirement in the 
2001 proposed regulations that a process of experimentation is ``a 
process designed to evaluate one or more alternatives to achieve a 
result'' (emphasis added) implies that research activities must contain 
certain core elements in order to constitute a process of 
experimentation within the meaning of section 41(d)(1)(C). These final 
regulations, therefore, make the following clarifications relating to 
the process of experimentation requirement in the 2001 proposed 
regulations.

Process of Experimentation--Requirements

    The final regulations retain, but further clarify, the requirement 
in the 2001 proposed regulations that ``a process of experimentation is 
a process designed to evaluate one or more alternatives to achieve a 
result where

[[Page 24]]

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.'' Further, the final regulations 
emphasize that the taxpayer's activities must be directed at resolving 
uncertainty regarding the taxpayer's development or improvement of a 
business component, and that the process of experimentation must 
fundamentally rely on the principles of the physical or biological 
sciences, engineering, or computer science in attempting to resolve the 
uncertainty. Although these concepts are stated explicitly in the 1986 
legislative history and are implicit in the statute, they may not have 
been given appropriate or necessary weight in prior proposed or final 
guidance on the process of experimentation requirement.
    The final regulations, therefore, set out what the Treasury 
Department and the IRS have concluded to be the core elements of a 
process of experimentation for purposes of the research credit. As 
noted above and consistent with the statute's wording which requires 
purposeful activity (i.e., ``undertaken for the purpose of discovering 
information''), a taxpayer is required to identify the uncertainty 
regarding the development or improvement of a business component that 
is the object of the taxpayer's research activities. A taxpayer is also 
required to identify one or more alternatives intended to eliminate 
that uncertainty. Additionally, a taxpayer is required to identify and 
to conduct a process of evaluating the alternatives. The final 
regulations provide that such a process may involve, for example, 
modeling, simulation, or a systematic trial and error methodology.
    The final regulations further provide that a process of 
experimentation ``must be an evaluative process and generally should be 
capable of evaluating more than one alternative.'' (Emphasis added). 
Although the identification and evaluation of more than a single 
alternative is not required to satisfy the process of experimentation 
requirement, the Treasury Department and the IRS believe that a 
taxpayer's activities, in order to qualify for the research credit, 
generally should be capable of evaluating more than one alternative 
and, in any event, must be designed to evaluate the alternative, or 
alternatives, being considered.
    The final regulations state that the mere existence of uncertainty 
regarding the development or improvement of a business component does 
not indicate that all of a taxpayer's activities undertaken to achieve 
that new or improved business component constitute a process of 
experimentation, even if the taxpayer, in fact, does achieve the new or 
improved business component. The Treasury Department and the IRS 
believe that the inclusion of a separate process of experimentation 
requirement in the statute makes this proposition clear. However, the 
Treasury Department and the IRS have included this clarification in the 
final regulations out of concern that taxpayers have not been giving 
sufficient weight to the requirement that a taxpayer engage in 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. In particular, this 
clarification is intended to indicate that merely demonstrating that 
uncertainty has been eliminated (e.g., the achievement of the 
appropriate design of a business component when such design was 
uncertain as of the beginning of a taxpayer's activities) is 
insufficient to satisfy the process of experimentation requirement. A 
taxpayer bears the burden of demonstrating that its research activities 
additionally satisfy the process of experimentation requirement.
    As noted above, all of the facts and circumstances of a taxpayer's 
research activities are taken into account to determine whether the 
taxpayer identified uncertainty concerning the development or 
improvement of a business component, identified one or more 
alternatives intended to eliminate that uncertainty, and identified and 
conducted a process of evaluating the alternatives. Although the final 
regulations set out the core elements of a process of experimentation, 
how a taxpayer's qualified research activities will reflect these core 
elements will depend on the facts and circumstances. These core 
elements will not necessarily occur in a strict, sequential order. A 
process of experimentation is an evaluative process, and as such, often 
involves refining throughout much of the process the taxpayer's 
understanding of the uncertainty the taxpayer is trying to address, 
modifying the alternatives being evaluated to eliminate that 
uncertainty, or modifying the process used to evaluate those 
alternatives.
    Accordingly, the final regulations do not provide detailed guidance 
as to how the regulatory provisions are to be applied to a given 
factual situation. Rather, the Treasury Department and the IRS have 
concluded that the application of these provisions will depend on the 
specific activities being claimed by a taxpayer as qualified research, 
the nature of the taxpayer's business and industry, and the 
uncertainties being addressed by the taxpayer's research activities. 
The Treasury Department and the IRS believe that additional, industry-
specific guidance may be appropriate and request comments on the form 
of such guidance.
    The final regulations do not include the rule contained in the 2001 
proposed regulations that a taxpayer's activities do not constitute 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. A number of commentators expressed concern that 
this rule was too vague and susceptible to conflicting interpretations. 
In light of the clarifications made in these final regulations, the 
Treasury Department and the IRS have concluded that this rule is no 
longer necessary because such activities do not constitute a process of 
experimentation under the final regulations.
    As noted above, the 2001 proposed regulations do not contain a 
specific recordkeeping requirement beyond the requirements set out in 
section 6001 and the regulations thereunder. No change regarding 
recordkeeping is being made in these final regulations. The 
clarifications being made to the process of experimentation requirement 
do not impose any recordkeeping requirement on taxpayers beyond the 
requirements set out in section 6001 and the regulations thereunder.

Process of Experimentation--Substantially all Requirement

    The 2001 proposed regulations retained the rule in TD 8930 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). This 
requirement is applied separately to each business component.
    The Treasury Department and the IRS requested comments on the 
application of the substantially all rule and, in particular, whether 
research expenses incurred for non-qualified purposes (i.e., relating 
to style, taste, cosmetic, or seasonal design factors) are includible

[[Page 25]]

in the credit computation provided that substantially all of the 
research activities constitute elements of a process of experimentation 
for a qualified purpose. After consideration of the comments received, 
the Treasury Department and the IRS have concluded that the 
substantially all requirement can be satisfied even if some portion of 
a taxpayer's activities are not for a qualified purpose.
    Accordingly, these final regulations clarify the substantially all 
rule and provide that the substantially all requirement is satisfied if 
20 percent or less of a taxpayer's research activities do not 
constitute elements of a process of experimentation for a purpose 
described in section 41(d)(3), so long as these remaining activities 
satisfy the requirements of section 41(d)(1)(A) and are not otherwise 
excluded under section 41(d)(4). Example (6) of Sec.  1.41-4(a)(8) of 
the 2001 proposed regulations has been modified to illustrate the 
application of this rule, and appears as example (4) in these final 
regulations.

Other Issues

Patent Safe Harbor
    Section 1.41-4(a)(3)(iii) of the 2001 proposed regulations 
generally provided that the issuance of certain patents 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. Some 
commentators requested that this patent safe harbor be expanded to 
cover all requirements contained in sections 41(d)(1) and (3). After 
consideration of these comments, and in light of the clarifications 
being made in these final regulations to the provisions relating to the 
process of experimentation requirement, the Treasury Department and the 
IRS continue to believe that the patent safe harbor is appropriately 
limited and, therefore, have not changed the patent safe harbor 
provision.
Shrinking-Back Rule
    Some commentators expressed concern that the language of the 
shrinking-back rule in Sec.  1.41-4(b)(2) of the 2001 proposed 
regulations implied that not all of a taxpayer's qualified research 
expenses would be eligible for the research credit as a result of the 
application of the rule. This provision has been revised in these final 
regulations to clarify that the rule is not intended to exclude 
qualified research expenses from the credit, but rather is intended to 
ensure that expenses attributable to qualified research activities are 
eligible for the research credit for purposes of section 41(d)(1).
Research After Commercial Production
    Some commentators requested additional clarification regarding the 
scope of the research after commercial production, adaptation, and 
duplication exclusions set out in section 41(d)(4)(A), (B) and (C), and 
Sec.  1.41-4(c)(2), (3) and (4) of the 2001 proposed regulations. After 
consideration of these comments, the Treasury Department and the IRS 
believe that the multitude of factual situations to which these 
exclusions might apply make it impractical to provide additional 
clarification that is both meaningful and of broad application. The 
Treasury Department and the IRS believe these three specific exclusions 
do not cover research activities that otherwise satisfy the 
requirements for qualified research. Taxpayers, however, should 
carefully review (including, as appropriate, the application of the 
shrinking-back rule) research activities that might otherwise fall 
within these exclusions to ensure that only eligible activities are 
being included in their credit computations.
    One commentator expressed concern that the language of Sec.  1.41-
4(c)(2)(iv), relating to the clinical testing of pharmaceutical 
products, could exclude from credit eligibility clinical trials 
performed under an arrangement where the Food and Drug Administration 
has granted conditional approval for a pharmaceutical product 
contingent upon the results of additional clinical trials. Another 
commentator expressed concern that the language would exclude otherwise 
qualifying activities because the research was not required to be 
approved by the Food and Drug Administration. Section 1.41-4(c)(2)(iv) 
is not a rule of exclusion. As stated above, the Treasury Department 
and the IRS believe that the research after commercial production 
exclusion (as well as the adaptation and duplication exclusions) do not 
cover research activities, including these additional clinical trials, 
so long as such trials satisfy the requirements for qualified research.

Gross Receipts

    These final regulations retain the broad definition of gross 
receipts contained in TD 8930. In response to Notice 2001-19, a number 
of commentators reiterated earlier comments that this definition was 
overly broad. As stated in the preamble to the 2001 proposed 
regulations, the Treasury Department and the IRS continue to believe 
that the definition of gross receipts should be construed broadly, and, 
accordingly, no change has been made in these final regulations to the 
definition contained in TD 8930.

Examples

    The examples in the regulations have been changed to remove 
references to ``readily discernible and applicable.'' While the 
Treasury Department and the IRS continue to believe that the activities 
in Examples 4 and 5 of Sec.  1.41-4(a)(8) of the 2001 proposed 
regulations would not qualify under the final regulations, these 
examples were removed as the only purpose of these examples was to 
illustrate the ``readily discernable and applicable'' standard. Minor 
changes to the facts in Example 4 of Sec.  1.41-4(a)(8) in the final 
regulations (Example 6 of Sec.  1.41-4(a)(8) of the 2001 proposed 
regulations) were made to illustrate more clearly the application of 
the substantially all requirement of Sec.  1.41-4(a)(6). These changes 
do not indicate that the Treasury Department and the IRS believe that 
the integration activities removed from the example, as contained in 
the 2001 proposed regulations, are or are not qualified activities 
standing alone. The determination of whether activities are qualified 
research is based on the specific facts and circumstances of those 
activities.
    Additionally, minor changes were made to the examples in Sec.  
1.41-4(c)(10) to remove references to ``readily discernable and 
applicable'' and to make some clarifications based on comments 
received. Example 1 of Sec.  1.41-4(c)(10) was modified to remove the 
conclusion regarding qualification of expenses under section 174. 
Although the Treasury Department and the IRS continue to believe that 
the conclusion in the 2001 proposed regulations is correct, the 
Treasury Department and the IRS believe that the point illustrated in 
the removed portion of the example would be more appropriately 
addressed in guidance issued under section 174, rather than in guidance 
under section 41.

Effective Date

    Notice 2001-19 stated, in relevant part, that the provisions of TD 
8930, including any changes to TD 8930, would be effective no earlier 
than the date when the completion of the Treasury Department and the 
IRS' review of TD 8930 was announced. The 2001 proposed regulations 
provided, in relevant part, that final regulations would apply to 
taxable years ending on or after December 26, 2001, the date the 
proposed regulations were published in the Federal Register.

[[Page 26]]

    Because these final regulations only clarify the provisions of the 
2001 proposed regulations, these final regulations apply to taxable 
years ending on or after December 31, 2003. For taxable years ending 
before December 31, 2003, the IRS will not challenge return positions 
that are consistent with these final regulations.

Special Analyses

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

Drafting Information

    The principal author of these regulations is Nicole R. Cimino of 
the Office of Associate Chief Counsel (Passthroughs and Special 
Industries), IRS. However, personnel from other offices of the IRS and 
the Treasury Department participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

0
Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART I--INCOME TAXES

0
Paragraph 1. The authority for part 1 continues to read in part as 
follows:

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


0
Par. 2. Section 1.41-0 is amended by revising the entry for Sec.  1.41-
4 to read as follows:
    The revision reads as follows:
Sec.  1.41-0 Table of contents.
* * * * *

Sec.  1.41-4 Qualified research for expenditures paid or incurred in 
taxable years ending on or after December 31, 2003.
    (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) Qualified purpose.
    (6) Substantially all requirement.
    (7) Use of computers and information technology.
    (8) Illustrations.
    (b) Application of requirements for qualified research.
    (1) In general.
    (2) Shrinking-back rule.
    (3) Illustration.
    (c) Excluded activities.
    (1) In general.
    (2) Research after commercial production.
    (i) In general.
    (ii) Certain additional activities related to the business 
component.
    (iii) Activities related to production process or technique.
    (iv) Clinical testing.
    (3) Adaptation of existing business components.
    (4) Duplication of existing business component.
    (5) Surveys, studies, research relating to management functions, 
etc.
    (6) Internal use software for taxable years beginning on or 
after December 31, 1985. [Reserved].
    (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.
* * * * *

0
Par. 3. Section 1.41-4 is amended as follows:
0
1. The section heading and paragraphs (a)(2)(iii), (a)(3), (a)(4), 
(a)(5), (a)(6), (a)(8), (b)(2), (b)(3), (c)(2)(iv), (c)(4), (c)(7)(ii), 
(c)(10), (d), and (e) are revised.
0
2. The heading of paragraph (c)(6) is revised and the text is removed 
and reserved.
    The revisions read as follows:


Sec.  1.41-4   Qualified research for expenditures paid or incurred in 
taxable years ending on or after December 31, 2003.

    (a) * * *
    (2) * * *
    (iii) Substantially all of the activities of which constitute 
elements of a process of experimentation that relates to a qualified 
purpose.
    (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

[[Page 27]]

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. A process of experimentation must fundamentally rely on the 
principles of the physical or biological sciences, engineering, or 
computer science and involves the identification of uncertainty 
concerning the development or improvement of a business component, the 
identification of one or more alternatives intended to eliminate that 
uncertainty, and the identification and the conduct of a process of 
evaluating the alternatives (through, for example, modeling, 
simulation, or a systematic trial and error methodology). A process of 
experimentation must be an evaluative process and generally should be 
capable of evaluating more than one alternative. 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. 
Uncertainty concerning the development or improvement of the business 
component (e.g., its appropriate design) does not establish that all 
activities undertaken to achieve that new or improved business 
component constitute a process of experimentation.
    (ii) 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.
    (6) Substantially all requirement. In order for activities to 
constitute qualified research under section 41(d)(1), substantially all 
of the activities must constitute elements of a process of 
experimentation that relates to a qualified purpose. 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 a taxpayer's 
research activities, measured on a cost or other consistently applied 
reasonable basis (and without regard to section 1.41-2(d)(2)), 
constitute elements of a process of experimentation for a purpose 
described in section 41(d)(3). Accordingly, if 80 percent (or more) of 
a taxpayer's research activities with respect to a business component 
constitute elements of a process of experimentation for a purpose 
described in section 41(d)(3), the substantially all requirement is 
satisfied even if the remaining 20 percent (or less) of a taxpayer's 
research activities with respect to the business component do not 
constitute elements of a process of experimentation for a purpose 
described in section 41(d)(3), so long as these remaining research 
activities satisfy the requirements of section 41(d)(1)(A) and are not 
otherwise excluded under section 41(d)(4). The substantially all 
requirement is applied separately to each business component.
* * * * *
    (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. The facts are the same as in Example 1, 
except that X chooses one of the green paints. X obtains samples of 
the 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. The manufacturer informs X that X must acquire a 
new nozzle that operates with the green paint X wants to use. X 
tests the nozzles 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 
are a separate business component under section 41(d)(2)(A). X's 
activities to modify its painting process 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. X did not conduct a 
process of evaluating alternatives in order to eliminate uncertainty 
regarding the modification of its painting process. Rather, the 
manufacturer of the paint machines eliminated X's uncertainty 
regarding the modification of its painting process. X's activities 
to test the nozzles to determine if the nozzles work as specified by 
the manufacturer of the paint spraying machines are in the nature of 
routine or ordinary testing or inspection for quality control.
    Example 3. (i) Facts. X is engaged in the business of 
manufacturing food products and currently manufactures a large-shred 
version of a product. X seeks to modify its current production line 
to permit it to manufacture both a large-shred version and a fine-
shred version of one of its food products. A smaller, thinner 
shredding blade capable of producing a fine-shred version of the 
food product, however, is not commercially available. Thus, X must 
develop a new shredding blade that can be fitted onto its current 
production line. X is uncertain concerning the design of the new 
shredding blade, because the material used in its existing blade 
breaks when machined into smaller, thinner blades. X engages in a 
systematic trial and error process of analyzing various blade 
designs and materials to determine whether the new shredding blade 
must be constructed of a different material from that of its 
existing shredding blade and, if so, what material will best meet 
X's functional requirements.
    (ii) Conclusion. X's activities to modify its current production 
line by developing the new shredding blade 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 evaluated alternatives to achieve a 
result where the method of achieving that result, and the 
appropriate design of that result, were uncertain as of the 
beginning of the taxpayer's research activities. X identified 
uncertainties related to the development of a business component, 
and identified alternatives intended to eliminate these 
uncertainties. Furthermore, X's process of evaluating identified 
alternatives was technological in nature, and was undertaken to 
eliminate the uncertainties.
    Example 4. (i) Facts. X is in the business of designing, 
developing and manufacturing automobiles. In response to government-
mandated fuel economy requirements, X seeks to update its current 
model vehicle and undertakes to improve aerodynamics by lowering the 
hood of its current model vehicle. X determines, however, 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's engineers are uncertain how to design a lower hood to obtain the 
increased fuel economy, while maintaining the necessary air flow 
under the hood. X designs, models, simulates, tests, refines, and 
re-tests several alternative designs for the hood and associated 
proposed modifications to both the air intake system and cooling 
system. This process enables X to eliminate the uncertainties 
related to the integrated design of the hood, air intake system, and 
cooling system, and such activities constitute eighty-five percent 
of X's total activities to update its current model vehicle. X then 
engages in additional activities that do not involve a process of 
evaluating alternatives in order to eliminate uncertainties. The 
additional activities constitute only fifteen percent of X's total 
activities to update its current model vehicle.
    (ii) Conclusion. In general, if eighty percent or more of a 
taxpayer's research activities measured on a cost or other 
consistently applied reasonable basis constitute elements of a 
process of experimentation for a qualified purpose under section 
41(d)(3)(A) and paragraph (a)(5)(ii) of this section, then

[[Page 28]]

the substantially all requirement of section 41(d)(1)(C) and 
paragraph (a)(2)(iii) of this section is satisfied. Substantially 
all of X's activities constitute elements of a process of 
experimentation because X evaluated alternatives to achieve a result 
where the method of achieving that result, and the appropriate 
design of that result, were uncertain as of the beginning of X's 
research activities. X identified uncertainties related to the 
improvement of a business component and identified alternatives 
intended to eliminate these uncertainties. Furthermore, X's process 
of evaluating the identified alternatives was technological in 
nature and was undertaken to eliminate the uncertainties. Because 
substantially all (in this example, eighty-five percent) of X's 
activities to update its current model vehicle constitute elements 
of a process of experimentation for a qualified purpose described in 
section 41(d)(3)(A), all of X's activities to update its current 
model vehicle meet the requirements of qualified research as set 
forth in paragraph (a)(2) of this section, provided that X's 
remaining activities (in this example, fifteen percent of X's total 
activities) satisfy the requirements of section 41(d)(1)(A) and are 
not otherwise excluded under section 41(d)(4).

    (b) * * *
    (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 these requirements are not met at that level, then 
they apply 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) * * *
    (2) * * *
    (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.
* * * * *
    (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.
* * * * *
    (6) Internal use software for taxable years beginning on or 
after December 31, 1985. [Reserved].
    (7) * * *
    (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.
* * * * *
    (10) Illustrations. The following examples illustrate provisions 
contained in paragraphs (c)(1) through (9) (excepting paragraphs (c)(6) 
of this section) 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 tire material retains heat for a longer period of time 
than the materials X currently uses for tires, and, as a result, the 
new tire material adheres to the manufacturing equipment during 
tread cooling. X evaluates several alternatives for processing the 
treads at cooler temperatures to address this problem, including a 
new type of belt for its manufacturing equipment to be used in tread 
cooling. Such a belt is not commercially available. Because X is 
uncertain of the belt design, X develops and conducts sophisticated 
engineering tests on several alternative designs for a new type of 
belt to be used in tread cooling until X successfully achieves a 
design that meets X's requirements. 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 new belts, 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.
    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 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

[[Page 29]]

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 manufacturers 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 existing customers only in that B 
wants fewer seats in its passenger cars and a higher quality seating 
material and carpet that are commercially available. X manufactures 
rail cars meeting B's requirements.
    (ii) Conclusion. X's activities to manufacture rail cars for B 
are excluded from the definition of qualified research. The rail car 
sold to B was not a new business component, but merely an adaptation 
of an existing business component that did not require a process of 
experimentation. 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. (i) 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. Such robotic equipment is 
not commercially available, and X, therefore, purchases the existing 
robotic equipment for the purpose of modifying it to meet its needs. 
X's engineers identify uncertainty that is technological in nature 
concerning how to modify the existing robotic equipment to meet its 
needs. X's engineers develop several alternative designs, and 
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 
needs. 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, provided that X's 
research activities satisfy the requirements of section 41(d)(1).
    Example 8. (i) Facts. An existing gasoline additive is 
manufactured by Y using three ingredients, A, B, and C. X seeks to 
develop and manufacture its own gasoline additive that appears and 
functions in a manner similar to Y's additive. To develop its own 
additive, X first inspects the composition of Y's additive, and uses 
knowledge gained from the inspection to reproduce A and B in the 
laboratory. Any differences between ingredients A and B that are 
used in Y's additive and those reproduced by X are insignificant and 
are not material to the viability, effectiveness, or cost of A and 
B. X desires to use with A and B an ingredient that has a materially 
lower cost than ingredient C. Accordingly, X engages in a process of 
experimentation to 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. (i) 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. (i) Facts. X, an insurance company, develops a new 
life insurance product. In the course of developing the product, X 
engages in research with respect to the effect of pricing and tax 
consequences on demand for the product, the expected volatility of 
interest rates, and the expected mortality rates (based on published 
data and prior insurance claims).
    (ii) Conclusion. X's activities related to the new product 
represent research in the social sciences (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. This section is applicable for taxable years 
ending on or after December 31, 2003.

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

0
Par. 4. The authority citation for part 602 continues to read in part 
as follows:

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


0
Par. 5. In Sec.  602.101, paragraph (b) is amended by removing the 
entry from the table for Sec.  1.41-4(d).

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
Pamela Olson,
Assistant Secretary of the Treasury.
[FR Doc. 03-31818 Filed 12-31-03; 8:45 am]
BILLING CODE 4830-01-P