Credit for Increasing Research Activities

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [REG-105170-97] RIN 1545-AV14

TITLE: Credit for Increasing Research Activities AGENCY: Internal
Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

SUMMARY: This document contains proposed regulations relating to the
computation of the credit under section 41(c) and the definition of
qualified research under section 41(d). The proposed regulations
reflect changes to section 41 made by the Tax Reform Act of 1986,
the Revenue Reconciliation Act of 1989, the Small Business Job
Protection Act of 1996, and the Taxpayer Relief Act of 1997. The
proposed regulations also provide certain technical amendments to
the regulations.

DATES: Written comments must be received no later than March 2,
1999.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-105170-97), room
5228, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered Monday
through Friday between the hours of 8 a.m. and 5 p.m. to:

CC:DOM:CORP:R (REG-105170-97), Courier's Desk, Internal Revenue
Service, 1111 Constitution Avenue NW., Washington, DC.

Alternatively, taxpayers may submit comments electronically via the
Internet by selecting the "Tax Regs" option of the IRS Home Page, or
by submitting comments directly to the IRS Internet site at:
http://www.irs.ustreas.gov/prod/tax_regs/comments.html.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed
regulations, Lisa J. Shuman or Leslie H. Finlow at (202)622-3120
(not a toll-free number); concerning submission of comments, the
hearing, and/or to be placed on the building access list to attend
the hearing, La Nita Van Dyke at (202)622-7190 (not a toll-free
number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed
rulemaking has been submitted to the Office of Management and Budget
for review in accordance with the Paperwork Reduction Act of 1995
(44 U.S.C. 3507(d)). Comments on the collection of information
should be sent to the Office of Management and Budget, Attn: Desk
Officer for the Department of the Treasury, Office of Information
and Regulatory Affairs, Washington, DC 20503, with copies to the
Internal Revenue Service, Attn: IRS Reports Clearance Officer,
OP:FS:FP, Washington, DC 20224. Comments on the collection of
information should be received by March 2, 1999. Comments are
specifically requested concerning:

Whether the proposed collection of information is necessary for the
proper performance of the functions of the IRS, including whether
the information will have practical utility;

The accuracy of the estimated burden associated with the proposed
collection of information (see below); How the quality, utility, and
clarity of the information to be collected may be enhanced; How the
burden of complying with the proposed collection of information may
be minimized, including through the application of automated
collection techniques or other forms of information technology; and
Estimates of capital or start-up costs and costs of operation,
maintenance, and purchase of services to provide information.

The collection of information in this proposed regulation is in
��1.41-4(a) and 1.41-8(b). The information is required by the IRS to
ensure that taxpayers have engaged in qualified research and to
ensure the proper computation of the credit for increasing research
activities under section 41. Section 1.41-4(a) defines a process of
experimentation, as required for credit eligibility, to include the
recording of the results of the experiments. This requirement
imposes no additional recordkeeping burden, because taxpayers
engaging in a bona fide process of experimentation already record
the results in any event (see discussion under Explanation of
Provisions, 3. Documentation, in this preamble).

The information required by �1.41-8 will be used to determine if the
taxpayer has elected or revoked the election to use the alternative
incremental credit allowed under section 41(c)(4).

The collection of information is mandatory. The likely respondents
are businesses or other for-profit institutions and organizations.
Responses to this collection of information are required to elect to
use and to revoke the election to use the alternative incremental
credit computation allowed under section 41(c)(4).

The reporting burden contained in �1.41-8(b)(2) (relating to the
election of the alternative incremental credit) is reflected in the
burden of Form 6765.

Estimated total annual reporting burden under �1.41-8(b)(3)
(relating to the revocation of the election to use the alternative
incremental credit): 250 hoU.S.

Estimated average annual burden hours per respondent: 50 hoU.S.

Estimated number of respondents: 5.

Estimated frequency of responses: On occasion.

An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless it displays a
valid control number assigned by the Office of Management and
Budget.

Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns
and tax return information are confidential, as required by 26
U.S.C. 6103.

Background

The research credit provisions originally appeared in section 44F of
the Internal Revenue Code of 1954 (the 1954 Code), as added to the
1954 Code by section 221 of the Economic Recovery Tax Act of 1981.
Section 471(c) of the Tax Reform Act of 1984 redesignated section
44F as section 30. Section 231 of the Tax Reform Act of 1986 (the
1986 Act) redesignated section 30 as section 41 and substantially
modified the research credit provisions. The amendments made to
section 41 by the 1986 Act primarily relate to the definition of
qualified research in section 41(d) and the computation of basic
research payments under section 41(e). The Revenue Reconciliation
Act of 1989 (the 1989 Act), the Revenue Reconciliation Act of 1993
(the 1993 Act), the Small Business Job Protection Act of 1996 (the
1996 Act), and the Taxpayer Relief Act of 1997 (the 1997 Act) also
amended the research credit provisions. These amendments primarily
relate to the trade or business requirement in section 41(b) and the
computation of the credit under sections 41(c) and 41(f).

On May 17, 1989, the IRS published in the Federal Register (54 FR
21203) final regulations under section 41. The 1989 final
regulations generally do not reflect the amendments to section 41
made by the 1986 Act, the 1989 Act, the 1993 Act, the 1996 Act, and
the 1997 Act. The amendments proposed by this document contain rules
relating primarily to the amendments to section 41(d) made by the
1986 Act. The amendments proposed by this document also contain some
rules relating to amendments to section 41 made by the 1989 Act, the
1996 Act, and the 1997 Act.

On January 2, 1997, the IRS published in the Federal Register (62 FR
81) proposed regulations (the 1997 proposed regulations) under
section 41 describing when computer software that is developed by
(or for the benefit of) a taxpayer primarily for the taxpayer's
internal use can qualify for the credit for increasing research
activities. The 1997 proposed regulations reflect a change to
section 41 made by the 1986 Act. The proposed regulations set forth
in this notice of proposed rulemaking complement but otherwise do
not affect the 1997 proposed regulations.

The Tax and Trade Relief Extension Act of 1998 extended the research
credit from June 30, 1998 through June 30, 1999. In the Conference
Report, H.R. Rep. No. 105-825, at 1547-49 (1998), the conferees
address the scope of the term qualified research, comment on an
aspect of the process of experimentation requirement, and note a
lack of clarity in the interpretation of the distinction between
internal-use software and other software.

These proposed regulations reflect the views expressed by the
conferees, as well as prior legislative history, regarding the term
qualified research and the process of experimentation. The IRS and
Treasury request comments on the distinction between internal-use
software and other software.

Explanation of Provisions

1. Qualified Research

Congress enacted the research credit to encourage business firms to
perform the research necessary to increase the innovative qualities
and efficiency of the U.S. economy. H.R. Rep. No. 99-426, at 177
(1985); S. Rep. No. 99-313, at 694 (1986). In extending the research
credit in the 1986 Act, Congress expressed concern that, in
practice, taxpayers had applied the existing definition of qualified
research too broadly and some taxpayers had claimed the credit for
virtually any expense relating to product development. H.R. Rep. No.
99-426, at 178; S. Rep. No. 99-313, at 694-95. Many taxpayers
claiming the credit were not in industries that involved high
technology or its application in developing technologically new and
improved products or methods of production. H.R. Rep. No. 99-426, at
178; S. Rep. No. 99-313, at 695.

To address these concerns, Congress narrowed the scope of the
research credit by providing in the Internal Revenue Code (Code) an
express definition of the term qualified research. In determining
eligibility for the research credit, section 41(d) requires that
qualified research activities satisfy a multi-part test. First, the
taxpayer's expenditures must be eligible to be treated as expenses
under section 174. See �1.174-2(a)(1) (defining research and
experimental expenditures).

Second, the expenditures must relate to research undertaken for the
purpose of discovering information that is both technological in
nature and the application of which is intended to be useful in
developing a new or improved business component of the taxpayer. The
proposed regulations provide that research is undertaken for the
purpose of discovering information that is technological in nature
only if the research activities are undertaken to obtain knowledge
that exceeds, expands, or refines the common knowledge of skilled
professionals in the particular field of technology or science and
the process of experimentation utilized fundamentally relies on
principles of physical or biological sciences, engineering, or
computer science.

Consistent with the requirement that the research activities be
undertaken to obtain knowledge that exceeds, expands, or refines the
common knowledge of skilled professionals in the particular field of
technology or science, the credit may be available where the
technological advance sought by the taxpayer is evolutionary, and,
in certain circumstances, where the taxpayer is not the first to
achieve the same advance. Moreover, the credit is available
regardless of whether the taxpayer succeeds or fails in achieving
the desired advance.

Third, section 41(d) requires that substantially all of the
activities of the research constitute elements of a process of
experimentation that relates to a new or improved function,
performance, reliability or quality. As noted in the previous
paragraph, the process of experimentation utilized must
fundamentally rely on principles of physical or biological sciences,
engineering, or computer science.

In developing a process of experimentation rule applicable to all
scientific disciplines, IRS personnel met with personnel from the
National Science Foundation and the National Institute of Standards
and Technology. The proposed regulation explains that a process of
experimentation is a process involving the evaluation of more than
one alternative designed to achieve a result where the means of
achieving that result are uncertain at the outset. This requires
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.

The proposed regulation does not require that the results of the
experiments be recorded in any specific manner. The results of the
experiments should be recorded in a manner that is appropriate for
the particular field of science in which the experiment is conducted
and for the type of experimentation involved. In some fields, for
example, experiments are recorded in lab books. When developing
computer software, by contrast, the experiments might be recorded in
comment lines contained in the source code.

In the 1986 Act, Congress also specified that expenditures incurred
in certain research, research-related, or non-research activities
are not eligible for the credit. The excluded activities are: post-
production activities, adaptation, duplication, surveys and studies,
research outside the United States, research in the social sciences,
funded research, and research related to certain internal-use
computer software.

Section 1.41-4 of this proposed regulation contains rules that
clarify the definition of the term qualified research and other
terms used in section 41(d). The proposed regulation also provides
rules relating to activities for which the research credit is not
allowed.

2. Application of Tests

In the legislative history to the 1986 Act, Congress stated that if
the requirements of section 41(d) are not met for an entire product,
the term business component means the most significant set of
elements of that product for which all the requirements of section
41(d) are met. The legislative history provides that this "shrinking
back" 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.

Consistent with the legislative history, �1.41-4(b) of the proposed
regulation explains that the "shrinking-back" concept is the method
for applying the tests in section 41(d) to a business component.

3. Documentation

Taxpayers must (a) record the results of their scientific
experiments (in a manner that is appropriate for the particular
field of science in which the experiment is conducted and for the
type of experiment involved) and (b) comply with the recordkeeping
requirements of section 6001 and the regulations thereunder. The
requirement that taxpayers record the results of their scientific
experiments is not intended to cause taxpayers to create records
that otherwise would not be created. Rather, the recording of
results is inherent in a process of experimentation to discover
information that is technological in nature. Limiting the
availability of the credit to taxpayers who record the results of
their scientific experiments is not intended to change taxpayer
behavior, but to identify taxpayers who engage in a bona fide
process of experimentation and thus may be eligible for the credit.

4. Election of the Alternative Incremental Credit

The notice of proposed rulemaking provides rules for electing the
alternative incremental credit, which may be elected under section
41(c)(4). Section 1.41-8 of the proposed regulation provides that
the election is made on Form 6765, "Credit for Increasing Research
Activities," and that the completed form must be attached to the
taxpayer's timely filed original return (including extensions) for
the taxable year to which the election applies.

Proposed Effective Date

In general, the regulations are proposed to be effective for
expenditures paid or incurred on or after the date final regulations
are published in the Federal Register. The regulations addressing
the base amount are proposed to be effective for taxable years
beginning on or after the date final regulations are published in
the Federal Register. The regulations providing for the election and
revocation of the alternative incremental credit are proposed to be
effective for taxable years ending on or after the date final
regulations are published in the Federal Register. No inference
should be drawn from the proposed effective date concerning the
application of section 41 to expenditures paid or incurred or the
computation of the base amount before the proposed effective date.

Special Analyses

It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in EO 12866.
Therefore, a regulatory assessment is not required.

It also has been determined that section 553(b) of the
Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to
these regulations. It is hereby certified that the collection of
information contained in these regulations will not have a
significant economic impact on a substantial number of small
entities. Accordingly, a Regulatory Flexibility Analysis under the
Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required.
This certification is based on the information that follows. The
economic impact of the collection of information contained in these
regulations on any small entity would result from the entity being
required to (1) record the results of experiments related to its
qualified research activities, (2) elect on Form 6765 to use the
alternative incremental credit if the entity desires to use that
method, and (3) obtain permission to revoke the alternative
incremental credit election, if so desired. Because taxpayers record
results in conducting their research activities in any event (see
discussion under Explanation of Provisions, 3. Documentation, in
this preamble), the economic impact of the recordkeeping requirement
in the regulation would not be significant. The economic impact of
electing the alternative incremental credit on Form 6765 also would
not be significant because the election is made on the same form and
is based on the same information that is used to claim the research
credit. Pursuant to section 7805(f), this notice of proposed
rulemaking will be submitted to the Chief Counsel for Advocacy of
the Small Business Administration for comment on its impact on small
business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments (preferably a
signed original and eight (8) copies) that are submitted timely (in
the manner described in the ADDRESSES portion of this preamble) to
the IRS. Submissions might include comments on the definition of
gross receipts, comments regarding the exclusion for post-production
activities, comments on whether and how the definition of a process
of experimentation should be refined to ensure that it is
appropriate for all scientific fields, and comments on the
interaction of the discovery requirement and the duplication
exclusion and the effect of such interaction on specific industries.
Also, submissions might include comments on clarifying the
distinction between internal-use software (i.e., software described
in section 41(d)(4)(E)) and other software. All comments will be
available for public inspection and copying.

A public hearing will be scheduled in the Internal Revenue Building,
1111 Constitution Avenue, NW., Washington, DC. The IRS recognizes
that persons outside the Washington, DC area also may wish to
testify at the public hearing through teleconferencing.

Requests to include teleconferencing sites must be received by
January 18, 1999. If the IRS receives sufficient indications of
interest to warrant teleconferencing to a particular city, and if
the IRS has teleconferencing facilities available in that city on
the date the public hearing is to be scheduled, the IRS will try to
accommodate the requests.

The IRS will publish the time and date of the public hearing and the
locations of any teleconferencing sites in an announcement in the
Federal Register. The announcement will include the date by which
persons that wish to present oral comments at the hearing must
submit requests to speak, outlines of the topics to be discussed,
and the time to be devoted to each topic.

An agenda showing the scheduling of the speakers will be prepared
after the deadline for receiving outlines has passed.

Copies of the agenda will be available free of charge at the
hearing.

Drafting Information

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

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations Accordingly, 26 CFR part 1 is
proposed to be amended as follows. (Note: The proposed amendments
complement the proposed amendments published at 62 FR 83, January 2,
1997.)

PART 1--INCOME TAXES

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

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

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

CREDITS ALLOWABLE UNDER SECTION 30 THROUGH 44B

Par. 3. Remove the undesignated centerheading immediately before
�1.41-0.

Par. 4. Section 1.41-0 is revised to read as follows:

�1.41-0 Table of contents.

This section lists the paragraphs contained in ��1.41-0 through
1.41-8.

�1.41-0 Table of contents.

�1.41-1 Credit for increasing research activities.

(a) Basic principles.

(b) Amount of credit.

(c) Introduction to regulations under section 41. �1.41-2 Qualified
research expenses.

(a) Trade or business requirements.

(1) In general.

(2) New business.

(3) Research performed for others.

(i) Taxpayer not entitled to results.

(ii) Taxpayer entitled to results.

(4) Partnerships.

(i) In general.

(ii) Special rule for certain partnerships and joint ventures.

(b) Supplies and personal property used in the conduct of qualified
research.

(1) In general.

(2) Certain utility charges.

(i) In general.

(ii) Extraordinary expenditures.

(3) Right to use personal property.

(4) Use of personal property in taxable years beginning after
December 31, 1985.

(c) Qualified services.

(1) Engaging in qualified research.

(2) Direct supervision.

(3) Direct support.

(d) Wages paid for qualified services.

(1) In general.

(2) "Substantially all." (e) Contract research expenses.

(1) In general.

(2) Performance of qualified research.

(3) "On behalf of."

(4) Prepaid amounts.

(5) Examples.

�1.41-3 Base amount for taxable years beginning on or after the date
final regulations are published in the Federal Register.

(a) and (b) [Reserved]

(c) Definition of gross receipts.

(1) In general.

(2) Amounts excluded.

(3) Foreign corporations.

(d) Consistency requirement.

(1) In general.

(2) Illustrations.

�1.41-4 Qualified research for expenditures paid or incurred on or
after the date final regulations are published in the Federal
Register.

(a) Qualified research.

(1) General rule.

(2) Requirements of section 41(d)(1).

(3) Discovering information.

(4) Technological in nature.

(5) Process of experimentation.

(6) Substantially all requirement.

(7) Use of computers and information technology.

(8) Illustrations.

(b) Application of requirements for qualified research.

(1) In general.

(2) Shrinking-back rule.

(3) Illustration.

(c) Excluded activities.

(1) In general.

(2) Research after commercial production.

(i) In general.

(ii) Certain additional activities related to the business
component.

(iii) Activities related to production process or technique.

(3) Adaptation of existing business components.

(4) Duplication of existing business component.

(5) Surveys, studies, research relating to management functions,
etc.

(6) Internal-use computer software.

(7) Activities outside the United States.

(i) In general.

(ii) Apportionment of in-house research expenses.

(iii) Apportionment of contract research expenses.

(8) Research in the social sciences, etc.

(9) Research funded by any grant, contract, or otherwise.

(10) Illustrations.

(d) Documentation.

�1.41-5 Basic research for taxable years beginning after December
31, 1986. [Reserved]

�1.41-6 Aggregation of expenditures.

(a) Controlled group of corporations; trades or businesses under
common control.

(1) In general.

(2) Definition of trade or business.

(3) Determination of common control.

(4) Examples.

(b) Minimum base period research expenses.

(c) Tax accounting periods used.

(1) In general.

(2) Special rule where timing of research is manipulated.

(d) Membership during taxable year in more than one group.

(e) Intra-group transactions.

(1) In general.

(2) In-house research expenses.

(3) Contract research expenses.

(4) Lease payments.

(5) Payment for supplies.

�1.41-7 Special rules.

(a) Allocations.

(1) Corporation making an election under subchapter S.

(i) Pass-through for taxable years beginning after December 31,
1982, in the case of an S corporation.

(ii) Pass-through, for taxable years beginning before January 1,
1983, in the case of a subchapter S corporation.

(2) Pass-through in the case of an estate or trust.

(3) Pass-through in the case of a partnership.

(i) In general.

(ii) Certain expenditures by joint ventures.

(4) Year in which taken into account.

(5) Credit allowed subject to limitation.

(b) Adjustments for certain acquisitions and dispositions-- Meaning
of terms.

(c) Special rule for pass-through of credit.

(d) Carryback and carryover of unused credits.

�1.41-8 Special rules for taxable years ending on or after the date
final regulations are published in the Federal Register.

(a) Alternative incremental credit.

(b) Election.

(1) In general.

(2) Time and manner.

(3) Revocation.

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

�1.41-1 Credit for increasing research activities.

(a) Basic principles. Section 41 provides a credit for increasing
research activities. The credit is intended to encourage business
firms to perform the technological research necessary to increase
the innovative qualities and efficiency of the U.S. economy. The
credit provides an incentive for business firms to increase their
expenditures for research to obtain new knowledge through a
scientific process of experimentation.

Consequently, the credit is not to be applied too broadly or in a
manner such that virtually any expense relating to the development
of a product is eligible for the credit, even if some portion of the
expense of developing the product does qualify for the credit.
Similarly, the credit is not available for an expenditure merely
because the expenditure may be treated as an expense under section
174. On the other hand, the credit may be available even though the
technological advance sought by the taxpayer is evolutionary, and,
in certain circumstances, even if another taxpayer has previously
achieved the same advance.

Moreover, the credit is available regardless of whether the taxpayer
succeeds or fails in achieving the desired advance. The credit is
limited to eligible expenditures paid or incurred for qualified
research, as defined in section 41(d) and �1.41-4.

(b) Amount of credit. The amount of a taxpayer's credit is
determined under section 41(a). For taxable years beginning after
June 30, 1996, and at the election of the taxpayer, the portion of
the credit determined under section 41(a)(1) may be calculated using
the alternative incremental credit set forth in section 41(c)(4).

(c) Introduction to regulations under section 41. (1) Sections
1.41-2 through 1.41-8 and 1.41-3A through 1.41-5A address only
certain provisions of section 41. The following table identifies the
provisions of section 41 that are addressed, and lists each
provision with the section of the regulations in which it is
covered.

Section of the Section of the regulation Internal Revenue Code

�1.41-2 41(b)

�1.41-3 41(c)

�1.41-4 41(d)

�1.41-5 41(e)

�1.41-6 41(f)

�1.41-7 41(f)

41(g)

�1.41-8 41(c)

�1.41-3A 41(c) (taxable years beginning before January 1, 1990)

�1.41-4A 41(d) (taxable years beginning before January 1, 1986)

�1.41-5A 41(e) (taxable years beginning before January 1, 1987)

(2) Section 1.41-3A also addresses the special rule in section
221(d)(2) of the Economic Recovery Tax Act of 1981 relating to
taxable years overlapping the effective dates of section 41. Section
41 was formerly designated sections 30 and 44F. Sections 1.41-0
through 1.41-8 and 1.41-0A through 1.41-5A refer to these sections
as section 41 for conformity purposes.

Whether section 41, former section 30, or former section 44F applies
to a particular expenditure depends upon when the expenditure was
paid or incurred.

�1.41-2 [Amended]

Par. 6. Section 1.41-2 is amended as follows:

1. The last sentence of paragraph (a)(3)(i) is amended by removing
the language "�1.41-5(d)(2)" and adding "�1.41-4A(d)(2)" in its
place.

2. The last sentence of paragraph (a)(3)(ii) is amended by removing
the language "�1.41-5(d)(3)" and adding "�1.41-4A(d)(3)" in its
place.

3. The last sentence of paragraph (a)(4)(ii)(F) is amended by
removing the language "�1.41-9(a)(3)(ii)" and adding "�1.41- 7(a)(3)
(ii)" in its place.

4. Paragraph (e)(1)(i) is amended by removing the language "�1.41-5"
and adding "�1.41-4 or 1.41-4A, whichever is applicable" in its
place.

Par. 7. An undesignated centerheading is added immediately following
�1.44B-1 to read as follows:

RESEARCH CREDIT--FOR TAXABLE YEARS BEGINNING BEFORE JANUARY 1, 1990

�1.41-3 [Redesignated as �1.41-3A]

Par. 8. Section 1.41-3 is redesignated as �1.41-3A and added under
the new undesignated centerheading "RESEARCH CREDIT-- FOR TAXABLE
YEARS BEGINNING BEFORE JANUARY 1, 1990."

Par. 9. New �1.41-3 is added to read as follows:

�1.41-3 Base amount for taxable years beginning on or after the date
final regulations are published in the Federal Register.

(a) and (b) [Reserved] (c) Definition of gross receipts--(1) In
general. For purposes of section 41, gross receipts means the total
amount, as determined under the taxpayer's method of accounting,
derived by the taxpayer from all its activities and from all sources
(e.g., revenues derived from the sale of inventory before reduction
for cost of goods sold).

(2) Amounts excluded. For purposes of this paragraph (c), gross
receipts do not include amounts representing--

(i) Returns or allowances;

(ii) Receipts from the sale or exchange of capital assets, as
defined in section 1221;

(iii) Repayments of loans or similar instruments (e.g., a repayment
of the principal amount of a loan held by a commercial lender);

(iv) Receipts from a sale or exchange not in the ordinary course of
business, such as the sale of an entire trade or business or the
sale of property used in a trade or business as defined under
section 1221(2); and

(v) Amounts received with respect to sales tax or other similar
state and local taxes if, under the applicable state or local law,
the tax is legally imposed on the purchaser of the good or service,
and the taxpayer merely collects and remits the tax to the taxing
authority.

(3) Foreign corporations. For purposes of section 41, in the case of
a foreign corporation, gross receipts include only gross receipts
that are effectively connected with the conduct of a trade or
business within the United States. See section 864(c) and applicable
regulations thereunder for the definition of effectively connected
income.

(d) Consistency requirement--(1) In general. In computing the credit
for increasing research activities for taxable years beginning after
December 31, 1989, qualified research expenses and gross receipts
taken into account in computing a taxpayer's fixed-base percentage
and a taxpayer's base amount must be determined on a basis
consistent with the definition of qualified research expenses and
gross receipts for the credit year, without regard to the law in
effect for the taxable years taken into account in computing the
fixed-base percentage or the base amount. This consistency
requirement applies even if the period for filing a claim for credit
or refund has expired for any taxable year taken into account in
computing the fixed-base percentage or the base amount.

(2) Illustrations. The following examples illustrate the application
of the consistency rule of paragraph (d)(1) of this section:

Example 1. (i) X, an accrual method taxpayer using the calendar year
as its taxable year, incurs qualified research expenses in 1990. X
wants to compute its research credit under section 41 for the tax
year ending December 31, 1990. As part of the computation, X must
determine its fixed-base percentage, which depends in part on X's
qualified research expenses incurred during the fixed-base period,
the taxable years beginning after December 31, 1983, and before
January 1, 1989.

(ii) During the fixed-base period, X reported the following amounts
as qualified research expenses on its Form 6765:

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

(iii) For the taxable years ending December 31, 1984, and December
31, 1985, X based the amounts reported as qualified research
expenses on the definition of qualified research in effect for those
taxable years. The definition of qualified research changed for
taxable years beginning after December 31, 1985. If X used the
definition of qualified research applicable to its taxable year
ending December 31, 1990, the credit year, its qualified research
expenses for the taxable years ending December 31, 1984, and
December 31, 1985, would be reduced to $ 80x and $ 100x,
respectively. Under the consistency rule in section 41(c)(5) and
paragraph (d)(1) of this section, to compute the research credit for
the tax year ending December 31, 1990, X must reduce its qualified
research expenses for 1984 and 1985 to reflect the change in the
definition of qualified research for taxable years beginning after
December 31, 1985. Thus, X's total qualified research expenses for
the fixed-base period (1984-1988) to be used in computing the fixed-
base percentage is $ 80 + 100 + 150 + 180 + 170 = $ 680x.

Example 2. The facts are the same as in Example 1, except that, in
computing its qualified research expenses for the taxable year
ending December 31, 1999, X claimed that a certain type of
expenditure incurred in 1999 was a qualified research expense. X's
claim reflected a change in X's position, because X had not
previously claimed that similar expenditures were qualified research
expenses. The consistency rule requires X to adjust its qualified
research expenses in computing the fixed-base percentage to include
any similar expenditures not treated as qualified research expenses
during the fixed-base period, regardless of whether the period for
filing a claim for credit or refund has expired for any year taken
into account in computing the fixed-base percentage.

Par. 10. Section 1.41-4 is revised to read as follows:

�1.41-4 Qualified research for expenditures paid or incurred on or
after the date final regulations are published in the Federal
Register.

(a) Qualified research--(1) General rule. Research activities
related to the development or improvement of a business component
constitute qualified research only if the research activities meet
all of the requirements of section 41(d)(1) and this section, and
are not otherwise excluded under section 41(d)(3)(B) or (4), or this
section.

(2) Requirements of section 41(d)(1). Research constitutes qualified
research only if it is research--

(i) With respect to which expenditures may be treated as expenses
under section 174, see �1.174-2;

(ii) That is undertaken for the purpose of discovering information
that is technological in nature, and the application of which is
intended to be useful in the development of a new or improved
business component of the taxpayer; and

(iii) Substantially all of the activities of which constitute
elements of a process of experimentation that relates to a new or
improved function, performance, reliability or quality.

(3) Discovering information. For purposes of section 41(d) and this
section, the term discovering information means obtaining knowledge
that exceeds, expands, or refines the common knowledge of skilled
professionals in a particular field of technology or science.

(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 physical or biological sciences,
engineering, or computer science.

(5) Process of experimentation. For purposes of section 41(d) and
this section, a process of experimentation is a process to evaluate
more than one alternative designed to achieve a result where the
means of achieving that result are uncertain at the outset. A
process of experimentation in the physical or biological sciences,
engineering, or computer science requires 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.

(6) Substantially all requirement. The substantially all requirement
of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this section is
satisfied only if 80 percent or more of the research activities,
measured on a cost or other consistently applied reasonable basis,
constitute elements of a process of experimentation for a purpose
described in section 41(d)(3). The substantially all requirement is
applied separately to each business component.

(7) Use of computers and information technology. The employment of
computers or information technology, or the reliance on principles
of computer science or information technology to store, collect,
manipulate, translate, disseminate, produce, distribute, or process
data or information, and similar uses of computers and information
technology does not itself establish that qualified research has
been undertaken.

(8) Illustrations. The following examples illustrate the application
of paragraph (a) of this section:

Example 1. (i) Facts. X undertakes to develop for sale a tool that
would improve its suite of application development products. The
desired tool would handle connectivity problems for software
application developers by providing data access via a layer of
software that is more effective than existing software at finding
data in various locations and forms within a network, translating it
if need be, and then delivering the result to whatever application
or user requested it. The means of developing such versatile
database access middleware are not in the common knowledge of
skilled professionals in the relevant technological fields. In order
to determine whether it can successfully develop the desired tool, X
develops, tests, and discards or refines various algorithms and
protocols.

(ii) Conclusion. X's activities to develop the technology to build
the new software development tool may be qualified research within
the meaning of section 41(d)(1) and paragraph (a) of this section.
In developing the technology, X undertook to obtain knowledge that
exceeds, expands, or refines the common knowledge of skilled
professionals in the relevant technological fields.

Example 2. (i) Facts. X acquired a new software environment,
including a new operating system and a new database management
system with related tools. X undertook a project to redeploy its
data processing systems to the new software environment. X
anticipated that, relative to the old system, the new system would
significantly increase the time-sharing capabilities of its computer
system. The project activities included redesign of databases and
user interfaces, and translation of code from one programming
language to another. In migrating to the new software environment, X
relied on techniques and approaches that were within the common
knowledge of skilled professionals in the relevant technological
fields.

(ii) Conclusion. X's activities to redeploy its data processing
systems to the new software environment are not qualified research
within the meaning of section 41(d)(1) and paragraph (a) of this
section. X did not undertake to obtain knowledge that exceeds,
expands, or refines the common knowledge of skilled professionals in
the relevant technological fields.

Example 3. (i) Facts. X operates a computer system that does not
recognize dates beginning in the year 2000. In order to ensure that
its computer system will not malfunction in the year 2000, X incurs
substantial costs having its employees manually search its computer
programs to find all date fields used in the programs and replace
all of the date fields with year 2000 compliant date fields.

(ii) Conclusion. Because the activities of X's employees were not
undertaken to obtain knowledge that exceeds, expands, or refines the
common knowledge of skilled professionals in the relevant
technological fields and do not involve a process of
experimentation, the activities are not qualified research within
the meaning of section 41(d)(1) and paragraph (a) of this section.

Example 4. (i) Facts. X is engaged in the business of developing and
manufacturing widgets. X wants to manufacture an improved widget
made out of a material that X has not previously used. Although X is
uncertain how to use the material to manufacture an improved widget,
the viability and means of using the material to manufacture such
widgets are within the common knowledge of skilled professionals in
the relevant technological fields.

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

Example 5. (i) Facts. X desires to build a bridge that can sustain
greater traffic flow without deterioration than can existing
bridges. The technology used to build such a bridge is not in the
common knowledge of skilled professionals in the relevant
technological fields. X eventually abandons the project after
attempts to develop the technology prove unsuccessful.

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

Example 6. (i) Facts. The facts are the same as in Example 5, except
that Y successfully builds a bridge that can sustain the greater
traffic flow. Thereafter, Z seeks to build a bridge that can also
sustain such greater traffic flow. The technology used by Y to build
its bridge is a closely guarded secret that is not known to Z and
remains beyond the common knowledge of skilled professionals in the
relevant technological fields.

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

Example 7. (i) Facts. X and other manufacturing companies have
previously designed and manufactured a particular kind of machine
using Material S. Material T is less expensive than Material S. X
wishes to design a new machine that appears and functions exactly
the same as its existing machines, but that is made of Material T
instead of Material S. The technology necessary to achieve this
objective is not within the common knowledge of skilled
professionals in the relevant technological fields.

(ii) Conclusion. X's activities to design the new machine using
Material T may be qualified research within the meaning of section
41(d)(1) and paragraph (a) of this section. In seeking to design the
machine, X undertook to obtain knowledge that exceeds, expands, or
refines the common knowledge of skilled professionals in the
relevant technological fields.

Example 8. (i) Facts. X, a tire manufacturer, seeks to build a tire
that will not deteriorate as rapidly under certain conditions of
high speed and temperature as do existing tires.

The design of such a tire is not within the common knowledge of
skilled professionals in the relevant technological fields. X
commences laboratory research on January 1. On April 1, X determines
in the laboratory that a certain combination of materials and
additives can withstand higher rotational speeds and temperatures
than the combination of materials and additives used in existing
tires. On the basis of this determination, X undertakes further
research activities to determine how to design a tire using those
materials and additives, and to determine whether such a tire
functions outside the laboratory as intended under various actual
road conditions. By September 1, but not prior to September 1, X's
research has progressed to the point where, applying X's knowledge
to date, both the viability and means of producing the desired tire
would be within the common knowledge of skilled professionals in the
relevant technological fields. However, X continues to engage in
certain research activities related to the tire after September 1,
and until the first tire rolls off the assembly line on December 1.

(ii) Conclusion. Some or all of X's research activities until
September 1 may be qualified research within the meaning of section
41(d)(1) and paragraph (a) of this section. In seeking to design the
tire, X undertook to obtain knowledge that exceeds, expands, or
refines the common knowledge of skilled professionals in the
relevant technological fields. The activities conducted after
September 1 are not qualified research within the meaning of section
41(d)(1) and paragraph (a) of this section, because those activities
were not undertaken to obtain knowledge that exceeds, expands, or
refines the common knowledge of skilled professionals in the
relevant technological fields.

(b) Application of requirements for qualified research--(1) In
general. The requirements for qualified research in section 41(d)(1)
and paragraph (a) of this section, must be applied separately to
each business component, as defined in section 41(d)(2)(B). In cases
involving development of both a product and a manufacturing or other
commercial production process for the product, research activities
relating to development of the process are not qualified research
unless the requirements of section 41(d) and this section are met
for the research activities relating to the process without taking
into account the research activities relating to development of the
product.

Similarly, research activities relating to development of the
product are not qualified research unless the requirements of
section 41(d) and this section are met for the research activities
relating to the product without taking into account the research
activities relating to development of the manufacturing or other
commercial production process.

(2) Shrinking-back rule. The requirements of section 41(d) and
paragraph (a) of this section are to be applied first at the level
of the discrete business component to be held for sale, lease or
license, or used by the taxpayer in a trade or business of the
taxpayer. If all aspects of the requirements are not met at the
first level, the requirements are to be applied at the next most
significant subset of elements of the business component. The
shrinking-back of the applicable business component continues until
a subset of elements of the business component satisfies the
requirements of section 41(d) and paragraph (a) of this section
(treating that subset of elements as a business component) or the
most basic element fails to satisfy the requirements.

(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.32 significant
subset of elements of the business component. For purposes of this
example, it is assumed that the new carburetor is the next most
significant subset of elements of the business component. The
research activities in developing the new carburetor may constitute
qualified research within the meaning of section 41(d)(1) and
paragraph (a) of this section.

(c) Excluded activities--(1) In general. Qualified research does not
include any activity described in sections 41(d)(3)(B) and (4), this
paragraph (c), and paragraph (e) of this section.

(2) Research after commercial production--(i) In general.

Activities conducted after the beginning of commercial production of
a business component are not qualified research. Activities are
conducted after the beginning of commercial production of a business
component if such activities are conducted after the component is
developed to the point where it is ready for commercial sale or use,
or meets the basic functional and economic requirements of the
taxpayer for the component's sale or use.

(ii) Certain additional activities related to the business
component. The following activities are deemed to occur after the
beginning of commercial production of a business component--

(A) Preproduction planning for a finished business component;

(B) Tooling-up for production;

(C) Trial production runs;

(D) Trouble shooting involving detecting faults in production
equipment or processes;

(E) Accumulating data relating to production processes; and

(F) Debugging or correcting flaws in a business component.

(iii) Activities related to production process or technique.

In cases involving development of both a product and a manufacturing
or other commercial production process for the product, the
exclusion described in section 41(d)(4)(A) and paragraphs (c)(2)(i)
and (ii) of this section applies separately for the activities
relating to the development of the product and the activities
relating to the development of the process. For example, even after
a product meets the taxpayer's basic functional and economic
requirements, activities relating to the development of the
manufacturing process still may constitute qualified research,
provided that the development of the process itself separately
satisfies the requirements of section 41(d) and this section, and
the activities are conducted before the process meets the taxpayer's
basic functional and economic requirements or is ready for
commercial use.

(3) Adaptation of existing business components. Activities relating
to adapting an existing business component to a particular
customer's requirement or need are not qualified research. This
exclusion does not apply merely because a business component is
intended for a specific customer.

(4) Duplication of existing business component. Activities relating
to reproducing an existing business component (in whole or in part)
from a physical examination of the business component itself or from
plans, blueprints, detailed specifications, or publicly available
information about the business component are Section 1.41-4(e),
proposed on January 2, 1997 (62 FR 83), 1 including any revisions to
that proposed rule will be incorporated as this paragraph (c)(6) in
the final rule.

not qualified research. This exclusion does not apply merely because
the taxpayer inspects an existing business component in the course
of developing its own business component.

(5) Surveys, studies, research relating to management functions,
etc. Qualified research does not include activities relating to--

(i) Efficiency surveys;

(ii) Management functions (except for the direct supervision of
qualified research as defined in �1.41-2(c)(2)) or techniques,
including such items as preparation of financial data and analysis,
development of employee training programs and management
organization plans, and management-based changes in production
processes (such as rearranging work stations on an assembly line);

(iii) Market research, testing, or development (including
advertising or promotions);

(iv) Routine data collections; or

(v) Routine or ordinary testing or inspections for quality control.

(6) Internal-use computer software. [Reserved].

(7) Activities outside the United States--(i) In general.

Research conducted outside the United States, as defined in section
7701(a)(9), does not constitute qualified research.

(ii) Apportionment of in-house research expenses.

In-house research expenses paid or incurred for qualified services
performed both in the United States and outside the United States
must be apportioned between the services performed in the United
States and the services performed outside the United States. Only
those in-house research expenses apportioned to the services
performed within 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 �1.41- 2(d)(2) applies.

(iii) Apportionment of contract research expenses. If contract
research is performed partly in the United States and partly outside
the United States, only 65 percent (or 75 percent in the case of
amounts paid to qualified research consortia) of the portion of the
contract amount that is attributable to the research activity
performed in the United States may qualify as a contract research
expense (even if 80 percent or more of the contract amount is for
research performed in the United States).

(8) Research in the social sciences, etc. Qualified research does
not include research in the social sciences (including economics,
business management, and behavioral sciences), arts, or humanities.

(9) Research funded by any grant, contract, or otherwise.

Qualified research does not include any research to the extent
funded by any grant, contract, or otherwise by another person (or
governmental entity). To determine the extent to which research is
so funded, �1.41-4A(d) applies.

(10) Illustrations. The following examples illustrate provisions
contained in paragraphs (c)(1) through (9) of this section. No
inference should be drawn from these examples concerning the
application of section 41(d)(1) and paragraph (a) of this section to
these facts:

Example 1. (i) Facts. X, a pharmaceutical company, performs
additional clinical tests on one of its products after that product
has been approved for a specific therapeutic use by the FDA and is
ready for commercial production and sale. The clinical tests study
the drug's long-term morbidity and mortality profile, and are
undertaken to develop information to use in the marketing materials
for the drug.

(ii) Conclusion. Because the additional tests are performed after
the drug is ready for commercial sale, X's activities in connection
with the tests are excluded from the definition of qualified
research under section 41(d)(4)(A) and paragraph (c)(2) of this
section.

Example 2. (i) Facts. The facts are the same as in Example 1, except
that, while studying the long-term morbidity and mortality profile
of the drug product, X discovers that the product may be useful in
treating a different medical condition.

X begins new clinical studies to establish the compound's new
potential therapeutic use.

(ii) Conclusion. Because the new clinical studies are performed to
establish a new therapeutic use of the drug product, the additional
clinical studies performed to establish the new therapeutic use are
not excluded from the definition of qualified research under section
41(d)(4)(A) and paragraph (c)(2) of this section.

Example 3. (i) Facts. X, a domestic corporation that manufactures
paper, develops and markets a new type of paper containing a
different chemical composition than the paper generally available
for commercial sale. Prior to manufacturing the paper, X conducts
preproduction planning for the finished paper product, tools up for
production, conducts trial production runs, engages in trouble
shooting involving detecting problems in production equipment,
accumulates production process data, and debugs the product.

(ii) Conclusion. X's activities of preproduction planning, tooling
up for production, trial production runs, trouble shooting,
accumulation of production process data, and product debugging do
not constitute qualified research with respect to development of the
paper product because the activities are deemed to occur after the
beginning of commercial production of the product. Whether any
activities engaged in by X to develop a process for manufacturing
the paper constitute qualified research depends on whether the
development of the process itself separately satisfies the
requirements of section 41(d) and this section, and whether the
process meets the taxpayer's basic functional and economic
requirements or is ready for commercial use.

Example 4. (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.

After entering into a contractual agreement with a customer, X
incurs expenditures in modifying the core software program to adapt
the program to the customer's requirement or need.

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

Example 5. (i) Facts. An existing gasoline additive is manufactured
by Y using three ingredients, A, B, and C. X seeks to develop and
manufacture its own gasoline additive that appears and functions in
a manner similar to Y's additive. To develop its own additive, X
first inspects the composition of Y's additive, and uses knowledge
gained from the inspection to reproduce A and B in the laboratory.
Any differences between ingredients A and B that are used in Y's
additive and those reproduced by X are insignificant and are not
material to the viability, effectiveness, or cost of A and B. X
desires to use with A and B an ingredient that has a materially
lower cost than ingredient C. Accordingly, X engages in a process of
experimentation to discover potential alternative formulations of
the additive (i.e., the development and use of various ingredients
other than C to use with A and B).

(ii) Conclusion. X's activities in analyzing and reproducing
ingredients A and B involve duplication of existing business
components and are excluded from qualified research under section
41(d)(4)(C) and paragraph (c)(4) of this section.

X's experimentation activities to discover potential alternative
formulations of the additive do not involve duplication of an
existing business component and are not excluded from qualified
research under section 41(d)(4)(C) and paragraph (c)(4) of this
section..38 Example 6. (i) Facts. X, an appliance manufacturer,
rearranges employee work stations in its manufacturing assembly line
and develops a new employee training program to train employees for
the rearranged work stations.

(ii) Conclusion. X's activities associated with rearranging the work
stations and developing a new employee training program represent
activities related to management functions or techniques and are
excluded from qualified research under section 41(d)(4)(D) and
paragraph (c)(5) of this section.

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

(ii) Conclusion. X's activities related to the new product represent
research in the social sciences, and are thus excluded from
qualified research under section 41(d)(4)(G) and paragraph (c)(7) of
this section.

(d) Documentation. See section 6001 and the regulations thereunder
for the recordkeeping requirements that must be satisfied.

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

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

�1.41-6 [Redesignated as �1.41-5 and Amended]

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

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

Par. 13. Section 1.41-7 is redesignated as �1.41-5A, and amended as
follows:

1. The section heading is amended by removing the language "January
1, 1986" and adding "January 1, 1987" in its place.

2. Paragraph (e)(2) is amended by removing the language "�1.41-5(c)"
and adding "1.41-4A(c)" in its place.

�1.41-8 [Redesignated as �1.41-6, and Amended]

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

�1.41-9 [Redesignated as �1.41-7]

Par. 15. Section 1.41-9 is redesignated as �1.41-7.

Par. 16. New �1.41-8 is added to read as follows:

�1.41-8 Special rules for taxable years ending on or after the date
final regulations are published in the Federal Register.

(a) Alternative incremental credit. At the election of the taxpayer,
the credit determined under section 41(a)(1) equals the amount
determined under section 41(c)(4).

(b) Election--(1) In general. A taxpayer may elect to apply the
provisions of the alternative incremental credit in section 41(c)(4)
for any taxable year of the taxpayer beginning after June 30, 1996.
If a taxpayer makes an election under section 41(c)(4), the election
applies to the taxable year for which made and all subsequent
taxable years.

(2) Time and manner of election. An election under section 41(c)(4)
is made by completing the portion of Form 6765, "Credit for
Increasing Research Activities," relating to the election of the
alternative incremental credit, and attaching the completed form to
the taxpayer's timely filed original return (including extensions)
for the taxable year to which the election applies.

(3) Revocation. An election under this section may not be revoked
except with the consent of the Commissioner. A taxpayer must attach
the Commissioner's consent to revoke an election under section 41(c)
(4) to the taxpayer's timely filed original return (including
extensions) for the taxable year of the revocation.

Par. 17. Section 1.41-0A is added under the new undesignated
centerheading "RESEARCH CREDIT--FOR TAXABLE YEARS BEGINNING BEFORE
JANUARY 1, 1990" to read as follows:

�1.41-0A Table of contents.

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

�1.41-0A Table of contents.

�1.41-3A Base period research expenses.

(a) Number of years in base period.

(b) New taxpayers.

(c) Definition of base period research expenses.

(d) Special rules for short taxable years.

(1) Short determination year.

(2) Short base period year.

(3) Years overlapping the effective dates of section 41 (section
44F).

(i) Determination years.

(ii) Base period years.

(4) Number of months in a short taxable year.

(e) Examples.

�1.41-4A Qualified research for taxable years beginning before
January 1, 1986.

(a) General rule.

(b) Activities outside the United States.

(1) In-house research.

(2) Contract research.

(c) Social sciences or humanities.

(d) Research funded by any grant, contract, or otherwise.

(1) In general.

(2) Research in which taxpayer retains no rights.

(3) Research in which the taxpayer retains substantial rights.

(i) In general.

(ii) Pro rata allocation.

(iii) Project-by-project determination.

(4) Independent research and development under the Federal
Acquisition Regulations System and similar provisions.

(5) Funding determinable only in subsequent taxable year.

(6) Examples.

�1.41-5A Basic research for taxable years beginning before January
1, 1987.

(a) In general.

(b) Trade or business requirement.

(c) Prepaid amounts.

(1) In general.

(2) Transfers of property.

(d) Written research agreement.

(1) In general.

(2) Agreement between a corporation and a qualified organization
after June 30, 1983.

(i) In general.

(ii) Transfers of property.

(3) Agreement between a qualified fund and a qualified educational
organization after June 30, 1983.

(e) Exclusions.

(1) Research conducted outside the United States.

(2) Research in the social sciences or humanities.

(f) Procedure for making an election to be treated as a qualified
fund.

�1.218-0 [Removed] Par. 18. Section 1.218-0 is removed.

�1.482-7 [Amended].42 Par. 19. In �1.482-7, the sixth sentence of
paragraph (h)(1) is amended by removing the language "�1.41-8(e)"
and adding "�1.41-6(e)" in its place.

Michael P. Dolan
Deputy Commissioner of Internal Revenue

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