[Federal Register Volume 79, Number 139 (Monday, July 21, 2014)]
[Rules and Regulations]
[Pages 42193-42197]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2014-16956]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 9680]
RIN 1545-BE64
Research Expenditures
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations to amend the
definition of research and experimental expenditures under section 174
of the Internal Revenue Code (Code). In particular, these final
regulations provide guidance on the treatment of amounts paid or
incurred in connection with the development of tangible property,
including pilot models. The final regulations will affect taxpayers
engaged in research activities.
DATES: Effective date: These regulations are effective July 21, 2014.
Applicability date: For date of applicability see Sec. 1.174-2(d).
FOR FURTHER INFORMATION CONTACT: David McDonnell at (202) 317-4137 (not
a toll-free number).
SUPPLEMENTARY INFORMATION:
Summary of Proposed Regulations
On September 6, 2013, a notice of proposed rulemaking (REG-124148-
05) and a notice of public hearing were published in the Federal
Register (78 FR 547896). The IRS and the Treasury Department proposed
the following revisions to the current regulations:
First, to counter an interpretation that section 174 eligibility
can be reversed by a subsequent event, the proposed regulations
provided that the ultimate success, failure, sale, or other use of the
research or property resulting from research or experimentation is not
relevant to a determination of eligibility under section 174.
Second, the proposed regulations amended Sec. 1.174-2(b)(4) to
provide that the Depreciable Property Rule (the rules in Sec. 1.174-
2(b)(1) and Sec. 1.174-2(b)(4)) is an application of the general
definition of research or experimental expenditures provided for in
Sec. 1.174-2(a)(1) and should not be applied to exclude otherwise
eligible expenditures.
Third, the proposed regulations defined the term ``pilot model'' as
any representation or model of a product that is produced to evaluate
and resolve uncertainty concerning the product during the development
or improvement of the product. The term included a fully-functional
representation or model of the product or a component of a product (to
the extent the shrinking-back rule applies).
Fourth, the proposed regulations clarified the general rule that
the costs of producing a product after uncertainty concerning the
development or improvement of a product is eliminated are not eligible
under section 174 because these costs are not for research or
experimentation.
Finally, the proposed regulations provided a shrinking-back rule,
similar to the rule provided in Sec. 1.41-4(b)(2), to address
situations in which the requirements of Sec. 1.174-2(a)(1) are met
with respect to only a component part of a larger product and are not
met with respect to the overall product itself.
The proposed regulations also provided new examples applying the
foregoing provisions.
Summary of Comments and Explanation of Provisions
Several comments were received in response to the proposed
regulations. Following is a discussion of significant comments. Certain
other comments presented issues unrelated to the proposed regulations,
and they are not adopted or discussed herein.
Uncertainty
Some commentators requested a definition of ``uncertainty'' because
the examples rely on ``elimination of uncertainty'' as the point when
research activities have concluded. Section 1.174-2(a)(1) provides that
``[u]ncertainty 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.'' Because the
current regulations already provide a sufficient definition of
``uncertainty,'' and the point at which uncertainty is eliminated (that
is, information available to the taxpayer establishes the capability or
method for developing or improving the product or the appropriate
design of the product) is based on the taxpayer's facts and
circumstances, the final regulations do not provide additional guidance
with respect to the definition of ``uncertainty.''
Some commentators requested a bright-line standard, such as the
commencement of commercial production as in section 41(d)(4)(A), to
determine when uncertainty is eliminated. Section 1.174-2(a)(1) of the
proposed regulations provided that costs may be eligible under section
174 if paid or incurred after production begins but before uncertainty
concerning the development or improvement of the product is eliminated.
The point at which uncertainty is resolved is based on the taxpayer's
facts and circumstances, and therefore a bright-line standard is not
appropriate under section 174.
Some commentators requested that the regulations explicitly
incorporate the rule of application regarding the discovering
information requirement found in section 41(d)(1)(B) and Sec. 1.41-
4(a)(3)(ii) (that is, there is no requirement that the taxpayer be
seeking to obtain information that exceeds, expands, or refines the
common knowledge of skilled professionals in the particular field, and
there is no requirement that the taxpayer succeed in developing a new
or improved business component). The IRS and the Treasury Department
note that section 174 does not contain any provision defining research
or experimentation. In contrast, section 41 provides a statutory
definition for ``qualified research,'' which includes a requirement
that the research be undertaken for the purpose of discovering
information. In addition, neither the section 174 statute nor its
legislative history suggest that a taxpayer must seek information that
exceeds, expands, or refines the common knowledge of skilled
professionals in the particular field in which the taxpayer is
performing research. Section 1.174-2(a)(1) of the current regulations
simply provides that ``[e]xpenditures 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.''
Consequently, this comment is not adopted.
[[Page 42194]]
Some commentators questioned how the substantially all requirement
in section 41(d)(1)(C) and Sec. 1.41-4(a)(6) (that is, 80 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) applies to section 174. Section 174 does not
contain a similar ``substantially all'' requirement. Accordingly, the
requirement in section 41(d)(1)(C) and Sec. 1.41-4(a)(6) does not
apply to section 174.
Supplies
Some commentators requested clarification that indirect or
ancillary supplies used in research are eligible under section 174
although ineligible under section 41. Section 1.174-2(a)(1) of the
current regulations provides that the term ``research or experimental
expenditures'' ``generally includes all such costs incident to the
development or improvement of a product.'' This statement is
sufficiently broad to include indirect or ancillary supplies used in
research that otherwise satisfies the requirements of section 174.
Therefore, revisions to the proposed regulations are not needed to
respond to the commentators' concern.
Pilot Model
One commentator expressed concern regarding a proposed example
demonstrating the application of the rules in the case of multiple
pilot models. The commentator suggested that, under Example 5 of Sec.
1.174-2(a)(11) of the proposed regulations, the deductibility of
section 174 expenses for multiple pilot models is permitted only if
each pilot model is tested for a purpose that is different from any
other pilot model. The definition of pilot model contained in Sec.
1.174-2(a)(4) of the proposed regulations does not contain a
requirement that the pilot model be used to test for a discrete
purpose. A pilot model within the definition of Sec. 1.174-2(a)(4) of
the proposed regulations (including a component to the extent paragraph
(a)(5) applies) is eligible for section 174, subject to satisfaction of
the other requirements of section 174 and the regulations. The final
regulations modify Example 5 to clarify that it is not necessary for
each pilot model to be tested for a discrete purpose for the costs of
multiple pilot models to qualify as research and experimental
expenditures under section 174.
One commentator requested clarification regarding the distinction
between a section 174 eligible ``pilot model'' and a section 174
ineligible ``test bed.'' Furthermore, the commentator construed Example
2 and Example 3 of proposed regulation Sec. 1.174-2(b)(5) to state
that test beds are depreciable property excluded from section 174. As
provided in proposed regulation Sec. 1.174-2(a)(4), a pilot model
means any representation or model of a product that is produced to
evaluate and resolve uncertainty concerning the product during the
development or improvement of the product. The proposed examples
demonstrate the application of Sec. 1.174-2(b)(1), (b)(2), and (b)(4)
(that is, when expenditures for property may be research and
experimental expenditures). The facts of the proposed examples do not
demonstrate the existence of a pilot model nor do they foreclose the
possibility that a test bed may be a pilot model if it meets the
definition of a pilot model under proposed regulation Sec. 1.174-
2(a)(4). For example, if the taxpayer constructed a new test bed as a
model test bed and the new test bed was produced to evaluate and
resolve uncertainty concerning the test bed during its development or
improvement, it could be a pilot model. Because these examples were not
intended to illustrate pilot models, the final regulations do not adopt
this comment.
Shrinking-Back Rule
Some commentators expressed concern that the shrinking-back rule in
Sec. 1.174-2(a)(5) of the proposed regulations may exclude from
section 174 the cost of testing to eliminate uncertainty regarding the
integration of an experimental component with a nonexperimental
product. Section 1.174-2(a)(1) of the current regulations provides that
the term ``research or experimental expenditures'' ``generally includes
all such costs incident to the development or improvement of a
product.'' This statement is sufficiently broad to encompass the cost
of testing (other than testing specifically excluded under current
Sec. 1.174-1(a)(3) (quality control testing)) performed to eliminate
uncertainty with respect to an experimental component and costs to
resolve uncertainty regarding integration of an experimental component
with a nonexperimental product when the requirements of Sec. 1.174-
2(a)(1) are not met for the product as a whole. Therefore, revisions to
the proposed regulations are not needed to respond to the commentators'
concern.
Some commentators requested that the shrinking-back rule in Sec.
1.174-2(a)(5) of the proposed regulations be eliminated. The
commentators stated that the shrinking-back rule in Sec. 1.41-4(b)(2)
is peculiar to section 41 and serves no purpose in section 174. As with
business components under section 41, research or experimental
expenditures may relate only to one or more components of a larger
product. The shrinking-back rule in the proposed regulations was
intended to ensure that section 174 eligibility is preserved in
instances in which a basic design specification of the product may be
established, but there is uncertainty with respect to certain
components of the product, even if uncertainty arises after production
of the product has begun. Therefore, the substance of the shrinking-
back rule is retained in the final regulations. However, in response to
commentator concerns, and to avoid any unintended confusion with the
shrinking-back rule of Sec. 1.41-4(b)(2), the rule in Sec. 1.174-
2(a)(5) of the proposed regulations has been renamed. Furthermore, the
last sentence of Sec. 1.174-2(a)(5) of the proposed regulations has
been eliminated in response to commentator concerns that references to
section 41 may imply that other requirements under section 41, such as
the process of elimination requirement, apply to expenditures under
section 174.
The final regulations also modify Example 8 of the proposed
regulations and include one additional example, Example 9, to
demonstrate the application of section 174 to components of a product.
Examples
One commentator expressed concern about Example 7 of Sec. 1.174-
2(a)(11) of the proposed regulations, which described the development
of ``a new, experimental aircraft.'' The commentator believes that the
use of the words ``new'' and ``experimental'' in proposed Example 7
could be interpreted to establish a new, heightened standard for
eligibility for section 174. Section 1.174-2(a)(1) of the current
regulations provides the only qualitative criteria for eligibility for
section 174 and provides that whether expenditures qualify as research
or experimental expenditures depends on the nature of the activity to
which they relate, not the nature of the product or improvement being
developed or the level of technological advancement the product or
improvement represents. Terms used in examples do not have substantive
meaning that expand or reduce the meaning or application of terms used
in the regulations; they are simply describing the facts of the
example. Accordingly, the final regulations do not revise Example 7 to
[[Page 42195]]
remove the descriptive terms ``new'' or ``experimental.''
One commentator requested guidance revising Sec. 1.174-2(c),
regarding exploration expenditures for oil, gas, or minerals. This
comment is outside the scope of the proposed regulations which did not
propose changes to Sec. 1.174-2(c). Therefore, the requested guidance
is not adopted in the final regulations.
Effective/Applicability Date
These regulations apply to taxable years ending on or after the
date of their publication as final regulations in the Federal Register.
Taxpayers may apply the final regulations to taxable years for which
the limitations for assessment of tax has not expired.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866, as supplemented by Executive Order 13563. Therefore, a
regulatory assessment is not required. It has also been determined that
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)
does not apply to these regulations, and because the regulations do not
impose a collection of information on small entities, the Regulatory
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to
section 7805(f) of the Code, the notice of proposed rulemaking that
preceded these final regulations was submitted to the Chief Counsel for
Advocacy of the Small Business Administration for comment on its impact
on small business and no comments were received.
Drafting Information
The principal author of these regulations is David McDonnell of the
Office of Associate Chief Counsel (Passthroughs and Special
Industries). However, other personnel from the Treasury Department and
the IRS participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
0
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
0
Par. 2. Section 1.174-2 is amended:
0
1. In paragraph (a)(1), by adding a heading and by adding two sentences
at the end.
0
2. By removing paragraph (a)(7).
0
3. By redesignating paragraphs (a)(8) and (9) as paragraphs (a)(10) and
(11), respectively, and adding headings to them.
0
4. By redesignating paragraphs (a)(3) through (6) as paragraphs (a)(6)
through (9), respectively, and adding headings to them.
0
5. By redesignating paragraph (a)(2) as paragraph (a)(3) and adding a
heading to newly designated paragraph (a)(3).
0
6. By adding new paragraphs (a)(2), (4) and (5).
0
7. In newly redesignated paragraph (a)(7), by removing the language
``(a)(3)(i)'' and adding ``(a)(6)(i)'' in its place.
0
8. In newly redesignated paragraph (a)(9), by removing the language
``(a)(6)'' and adding ``(a)(9)'' in its place.
0
9. By revising newly redesignated paragraph (a)(11) introductory text.
0
10. In Example 1 in newly redesignated paragraph (a)(11) by adding a
heading.
0
11. In Example 2 in newly redesignated paragraph (a)(11) by adding a
heading, removing the language ``X'' and adding ``S'' in its place
everywhere ``X'' appears, and removing the language ``Y'' and adding
``T'' in its place everywhere ``Y'' appears.
0
12. In newly redesignated paragraph (a)(11) by adding Example 3 through
Example 10.
0
13. In paragraphs (b)(1) through (3) by adding headings.
0
14. By revising paragraph (b)(4).
0
15. By adding paragraph (b)(5).
0
16. By adding paragraph (d).
The revisions and additions read as follows:
Sec. 1.174-2 Definition of research and experimental expenditures.
(a) In general. (1) Research or experimental expenditures defined.
* * * The ultimate success, failure, sale, or use of the product is not
relevant to a determination of eligibility under section 174. Costs may
be eligible under section 174 if paid or incurred after production
begins but before uncertainty concerning the development or improvement
of the product is eliminated.
(2) Production costs. Except as provided in paragraph (a)(5) of
this section (the rule concerning the application of section 174 to
components of a product), costs paid or incurred in the production of a
product after the elimination of uncertainty concerning the development
or improvement of the product are not eligible under section 174.
(3) Product defined. * * *
(4) Pilot model defined. For purposes of this section, the term
pilot model means any representation or model of a product that is
produced to evaluate and resolve uncertainty concerning the product
during the development or improvement of the product. The term includes
a fully-functional representation or model of the product or, to the
extent paragraph (a)(5) of this section applies, a component of the
product.
(5) Application of section 174 to components of a product. If the
requirements of paragraph (a)(1) of this section are not met at the
level of a product (as defined in paragraph (a)(3) of this section),
then whether expenditures represent research and development costs is
determined at the level of the component or subcomponent of the
product. The presence of uncertainty concerning the development or
improvement of certain components of a product does not necessarily
indicate the presence of uncertainty concerning the development or
improvement of other components of the product or the product as a
whole. The rule in this paragraph (a)(5) is not itself applied as a
reason to exclude research or experimental expenditures from section
174 eligibility.
(6) Research or experimental expenditures--exclusions. * * *
(7) Quality control testing. * * *
(8) Expenditures for literary, historical, or similar research--
cross reference. * * *
(9) Research or experimental expenditures limited to reasonable
amounts. * * *
(10) Amounts paid to others for research or experimentation. * * *
(11) Examples. The following examples illustrate the application of
this paragraph (a).
Example 1. Amounts paid to others for research or
experimentation allowed as a deduction. * * *
Example 2. Amounts paid to others not allowable as a deduction.
* * *
Example 3. Pilot model. U is engaged in the manufacture and sale
of custom machines. U contracts to design and produce a machine to
meet a customer's specifications. Because U has never designed a
machine with these specifications, U is uncertain regarding the
appropriate design of the machine, and particularly whether features
desired by the customer can be designed and integrated into a
functional machine. U incurs a total of $31,000 on the project. Of
the $31,000, U incurs $10,000 of costs on materials and labor to
produce a model that is used to evaluate and resolve the uncertainty
concerning the appropriate
[[Page 42196]]
design. U also incurs $1,000 of costs using the model to test
whether certain features can be integrated into the design of the
machine. This $11,000 of costs represents research and development
costs in the experimental or laboratory sense. After uncertainty is
eliminated, U incurs $20,000 to produce the machine for sale to the
customer based on the appropriate design. The model produced and
used to evaluate and resolve uncertainty is a pilot model within the
meaning of paragraph (a)(4) of this section. Therefore, the $10,000
incurred to produce the model and the $1,000 incurred on design
testing activities qualifies as research or experimental
expenditures under section 174. However, section 174 does not apply
to the $20,000 that U incurred to produce the machine for sale to
the customer based on the appropriate design. See paragraph (a)(2)
of this section (relating to production costs).
Example 4. Product component redesign. Assume the same facts as
Example 3, except that during a quality control test of the machine,
a component of the machine fails to function due to the component's
inappropriate design. U incurs an additional $8,000 (including
design retesting) to reconfigure the component's design. The $8,000
of costs represents research and development costs in the
experimental or laboratory sense. After the elimination of
uncertainty regarding the appropriate design of the component, U
incurs an additional $2,000 on its production. The reconfigured
component produced and used to evaluate and resolve uncertainty with
respect to the component is a pilot model within the meaning of
paragraph (a)(4) of this section. Therefore, in addition to the
$11,000 of research and experimental expenditures previously
incurred, the $8,000 incurred on design activities to establish the
appropriate design of the component qualifies as research or
experimental expenditures under section 174. However, section 174
does not apply to the additional $2,000 that U incurred for the
production after the elimination of uncertainty of the re-designed
component based on the appropriate design or to the $20,000
previously incurred to produce the machine. See paragraph (a)(2) of
this section (relating to production costs).
Example 5. Multiple pilot models. V is a manufacturer that
designs a new product. V incurs $5,000 to produce a number of models
of the product that are to be used in testing the appropriate design
before the product is mass-produced for sale. The $5,000 of costs
represents research and development costs in the experimental or
laboratory sense. Multiple models are necessary to test the design
in a variety of different environments (exposure to extreme heat,
exposure to extreme cold, submersion, and vibration). In some cases,
V uses more than one model to test in a particular environment. Upon
completion of several years of testing, V enters into a contract to
sell one of the models to a customer and uses another model in its
trade or business. The remaining models were rendered inoperable as
a result of the testing process. Because V produced the models to
resolve uncertainty regarding the appropriate design of the product,
the models are pilot models under paragraph (a)(4) of this section.
Therefore, the $5,000 that V incurred in producing the models
qualifies as research or experimental expenditures under section
174. See also paragraph (a)(1) of this section (ultimate use is not
relevant).
Example 6. Development of a new component; pilot model. W wants
to improve a machine for use in its trade or business and incurs
$20,000 to develop a new component for the machine. The $20,000 is
incurred for engineering labor and materials to produce a model of
the new component that is used to eliminate uncertainty regarding
the development of the new component for the machine. The $20,000 of
costs represents research and experimental costs in the experimental
or laboratory sense. After W completes its research and
experimentation on the new component, W incurs $10,000 for materials
and labor to produce the component and incorporate it into the
machine. The model produced and used to evaluate and resolve
uncertainty with respect to the new component is a pilot model
within the meaning of paragraph (a)(4) of this section. Therefore,
the $20,000 incurred to produce the model and eliminate uncertainty
regarding the development of the new component qualifies as research
or experimental expenditures under section 174. However, section 174
does not apply to the $10,000 of production costs of the component
because those costs were not incurred for research or
experimentation. See paragraph (a)(2) of this section (relating to
production costs).
Example 7. Disposition of a pilot model. X is a manufacturer of
aircraft. X is researching and developing a new, experimental
aircraft that can take off and land vertically. To evaluate and
resolve uncertainty during the development or improvement of the
product and test the appropriate design of the experimental
aircraft, X produces a working aircraft at a cost of $5,000,000. The
$5,000,000 of costs represents research and development costs in the
experimental or laboratory sense. In a later year, X sells the
aircraft. Because X produced the aircraft to resolve uncertainty
regarding the appropriate design of the product during the
development of the experimental aircraft, the aircraft is a pilot
model under paragraph (a)(4) of this section. Therefore, the
$5,000,000 of costs that X incurred in producing the aircraft
qualifies as research or experimental expenditures under section
174. Further, it would not matter if X sold the pilot model or
incorporated it in its own business as a demonstration model. See
paragraph (a)(1) of this section (ultimate use is not relevant).
Example 8. Development of new component; pilot model. Y is a
manufacturer of aircraft engines. Y is researching and developing a
new type of compressor blade, a component of an aircraft engine, to
improve the performance of an existing aircraft engine design that Y
already manufactures and sells. To test the appropriate design of
the new compressor blade and evaluate the impact of fatigue on the
compressor blade design, Y produces and installs the compressor
blade on an aircraft engine held by Y in its inventory. The costs of
producing and installing the compressor blade component that Y
incurred represent research and development costs in the
experimental or laboratory sense. Because Y produced the compressor
blade component to resolve uncertainty regarding the appropriate
design of the component, the component is a pilot model under
paragraph (a)(4) of this section. Therefore, the costs that Y
incurred to produce and install the component qualify as research or
experimental expenditures under section 174. See paragraph (a)(5) of
this section (regarding the application of section 174 to components
of a product). However, section 174 does not apply to Y's costs of
producing the aircraft engine on which the component was installed.
See paragraph (a)(2) of this section (relating to production costs).
Example 9. Variant product. T is a fuselage manufacturer for
commercial and military aircraft. T is modifying one of its existing
fuselage products, Class 20XX-1, to enable it to carry a larger
passenger and cargo load. T modifies the Class 20XX-1 design by
extending its length by 40 feet. T incurs $1,000,000 to develop and
evaluate different designs to resolve uncertainty with respect to
the appropriate design of the new fuselage class, Class 20XX-2. The
$1,000,000 of costs represents research and development costs in the
experimental or laboratory sense. Although Class 20XX-2, is a
variant of Class 20XX-1, Class 20XX-2 is a new product because the
information available to T as a result of T's development of Class
20XX-1 does not resolve uncertainty with respect to T's development
of Class 20XX-2. Therefore, the $1,000,000 of costs that T incurred
to develop and evaluate the Class 20XX-2 qualifies as research or
experimental expenditures under section 174. Paragraph (a)(5) of
this section does not apply, as the requirements of paragraph (a)(1)
of this section are met with respect to the entire product.
Example 10. New process development. Z is a wine producer. Z is
researching and developing a new wine production process that
involves the use of a different method of crushing the wine grapes.
In order to test the effectiveness of the new method of crushing
wine grapes, Z incurs $2,000 in labor and materials to conduct the
test on this part of the new manufacturing process. The $2,000 of
costs represents research and development costs in the experimental
or laboratory sense. Therefore, the $2,000 incurred qualifies as
research or experimental expenditures under section 174 because it
is a cost incident to the development or improvement of a component
of a process.
(b) * * *
(1) Land and other property. * * *
(2) Expenditure resulting in depreciable property. * * *
(3) Amounts paid to others for research or experimentation
resulting in depreciable property. * * *
(4) Deductions limited to amounts expended for research or
experimentation. The deductions referred to in paragraphs (b)(2) and
(3) of this section for expenditures in
[[Page 42197]]
connection with the acquisition or production of depreciable property
to be used in the taxpayer's trade or business are limited to amounts
expended for research or experimentation within the meaning of section
174 and paragraph (a) of this section.
(5) Examples. The following examples illustrate the application of
paragraph (b) of this section.
Example 1. Amounts paid to others for research or
experimentation resulting in depreciable property. X is a tool
manufacturer. X has developed a new tool design, and orders a
specially-built machine from Y to produce X's new tool. The machine
is built upon X's order and at X's risk, and Y does not provide a
guarantee of economic utility. There is uncertainty regarding the
appropriate design of the machine. Under X's contract with Y, X pays
$15,000 for Y's engineering and design labor, $5,000 for materials
and supplies used to develop the appropriate design of the machine,
and $10,000 for Y's machine production materials and labor. The
$15,000 of engineering and design labor costs and the $5,000 of
materials and supplies costs represent research and development
costs in the experimental or laboratory sense. Therefore, the
$15,000 X pays Y for Y's engineering and design labor and the $5,000
for materials and supplies used to develop the appropriate design of
the machine are for research or experimentation under section 174.
However, section 174 does not apply to the $10,000 of production
costs of the machine because those costs were not incurred for
research or experimentation. See paragraph (a)(2) of this section
(relating to production costs) and paragraph (b)(4) of this section
(limiting deduction to amounts expended for research or
experimentation).
Example 2. Expenditures with respect to other property. Z is an
aircraft manufacturer. Z incurs $5,000,000 to construct a new test
bed that will be used in the development and improvement of Z's
aircraft. No portion of Z's $5,000,000 of costs to construct the new
test bed represent research and development costs in the
experimental or laboratory sense to develop or improve the test bed.
Because no portion of the costs to construct the new test bed were
incurred for research or experimentation, the $5,000,000 will be
considered an amount paid or incurred in the production of
depreciable property to be used in the taxpayer's trade or business
that are not allowable under section 174. However, the allowances
for depreciation of the test bed are considered research and
experimental expenditures of other products, for purposes of section
174, to the extent the test bed is used in connection with research
or experimentation of other products. See paragraph (b)(1) of this
section (depreciation allowances may be considered research or
experimental expenditures).
Example 3. Expenditure resulting in depreciable property. Assume
the same facts as Example 2, except that $50,000 of the costs of the
test bed relates to costs to resolve uncertainties regarding the new
test bed design. The $50,000 of costs represents research and
development costs in the experimental or laboratory sense. Because
$50,000 of Z's costs to construct the new test bed was incurred for
research and experimentation, the costs qualify as research or
experimental expenditures under section 174. Paragraph (b)(2) of
this section applies to $50,000 of Z's costs for the test bed
because they are expenditures for research or experimentation that
result in depreciable property to be used in the taxpayer's trade or
business. Z's remaining $4,950,000 of costs is not allowable under
section 174 because these costs were not incurred for research or
experimentation.
* * * * *
(d) Effective/applicability date. The eighth and ninth sentences of
Sec. 1.174-2(a)(1); Sec. 1.174-2(a)(2); Sec. 1.174-2(a)(4); Sec.
1.174-2(a)(5); Sec. 1.174-2(a)(11) Example 3 through Example 10; Sec.
1.174-2(b)(4); and Sec. 1.174-2(b)(5) apply to taxable years ending on
or after July 21, 2014. Taxpayers may apply the provisions enumerated
in the preceding sentence to taxable years for which the limitations
for assessment of tax has not expired.
John Dalrymple,
Deputy Commissioner for Services and Enforcement.
Approved: June 27, 2014.
Mark J. Mazur,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2014-16956 Filed 7-18-14; 8:45 am]
BILLING CODE 4830-01-P