Credit for Increasing Research Activities

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Parts 1 and 602 [TD 8930]

TITLE: Credit for Increasing Research Activities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to the
computation of the credit under section 41(c) and the definition of
qualified research under section 41(d). These regulations are
intended to provide guidance concerning the requirements necessary
to qualify for the credit for increasing research activities,
guidance in computing the credit for increasing research activities,
and rules for electing and revoking the election of the alternative
incremental credit.

These regulations reflect changes to section 41 made by the Tax
Reform Act of 1986 (the 1986 Act), the Revenue Reconciliation Act of
1989, the Small Business Job Protection Act of 1996, the Taxpayer
Relief Act of 1997, the Tax and Trade Relief Extension Act of 1998
(the 1998 Act), and the Tax Relief Extension Act of 1999 (the 1999
Act). These regulations also provide certain technical amendments to
the existing regulations.

DATES: Effective Dates: These regulations are effective January 3,
2001.

Applicability Dates: For dates of applicability of these
regulations, see Effective Dates under SUPPLEMENTARY INFORMATION.
FOR FURTHER INFORMATION CONTACT: Lisa J. Shuman or Leslie H. Finlow
at (202)622-3120 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in �1.41-8(b) of this final
rule have been reviewed and approved by the Office of Management and
Budget in accordance with the Paperwork Reduction Act of 1995 (44
U.S.C. 3507) under the number 1545-1625. Responses to these
collections of information are mandatory.

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

Estimated average annual burden hours per respondent under
�1.41-8(b)(3) (relating to the revocation of the election to use the
alternative incremental credit) is 250 hours.

Comments concerning the accuracy of this burden estimate and
suggestions for reducing this burden should be sent to the Internal
Revenue Service, Attn: IRS Reports Clearance Officer,
W:CAR:MP:FP:S:O, Washington, DC 20224, and to the Office of
Management and Budget, Attn: Desk Officer for the Department of the
Treasury, Office of Information and Regulatory Affairs, Washington,
DC 20503.

The collections of information contained in �1.41-4(d) of this final
rule have been reviewed and, pending receipt and. evaluation of
public comments, approved by the Office of Management and Budget
(OMB) under 44 U.S.C. 3507 and assigned control number 1545-1625.
This information is required to assist in the examination of the
research credit and to ensure that the research credit is properly
targeted to serve as an incentive to engage in qualified research.
This information will be used to verify that the amounts treated as
qualified research expenses were paid or incurred for activities
intended to discover information that exceeds, expands, or refines
the common knowledge of skilled professionals in the relevant field
of science or engineering. This collection of information is
required to obtain a benefit. The likely recordkeepers are
businesses or other for-profit institutions.

Estimated total annual recordkeeping burden for �1.41-4(d) is 18,000
hours. The annual estimated burden per respondent varies from .5
hours to 2.5 hours, depending on the circumstances, with an
estimated average of 1.5 hours. The estimated number of
recordkeepers is 12,000.

Comments on the collection of information should be sent to the
Office of Management and Budget, Attn: Desk Officer for the
Department of the Treasury, Office of Information and Regulatory
Affairs, Washington, DC 20503, with copies to the Internal Revenue
Service, Attn: IRS Reports Clearance Officer, W:CAR:MP:FP:S:O,
Washington, DC 20224. Comments on the collection of information
should be received by March 4, 2001.

Comments are specifically requested concerning:

Whether the collection of information is necessary for the proper
performance of the functions of the Internal Revenue Service,
including whether the information will have practical utility;

The accuracy of the estimated burden associated with the collection
of information (see below);

How the quality, utility, and clarity of the information to be
collected may be enhanced;

How the burden of complying with the collection of information may
be minimized, including through the application of automated
collection techniques or other forms of information technology; and
Estimates of capital or start-up costs and costs of operation,
maintenance, and purchase of services to provide information.

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

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

Background

On January 2, 1997, the IRS and Treasury published in the Federal
Register (62 FR 81) a notice of proposed rulemaking (REG-209494-90,
1997-1 C.B. 723) under section 41 describing when computer software
that is developed by (or for the benefit of) a taxpayer primarily
for the taxpayer's internal use can qualify for the credit for
increasing research activities (the 1997 proposed regulations).
Comments responding to the 1997 proposed regulations were received
and a public hearing was held on May 13, 1997.

On December 2, 1998, the IRS and Treasury published in the Federal
Register (63 FR 66503) a notice of proposed rulemaking
(REG-105170-97, 1998-50 I.R.B. 10) under section 41 relating to the
credit for increasing research activities (the 1998 proposed
regulations). The 1998 proposed regulations propose rules and
examples relating to (1) the definition of gross receipts for
purposes of computing the base amount under section 41(c), (2) the
application of the consistency rule in computing the base amount,
(3) the definition of qualified research under section 41(d), (4)
the application of the exclusions from the definition of qualified
research, (5) the application of the shrinking-back rule, and (6)
the election of the alternative incremental credit.

The 1998 proposed regulations also propose certain technical
amendments to the existing regulations. Comments responding to the
1998 proposed regulations were received and a public hearing was
held on April 29, 1999.

In the 1999 Act, Congress extended the credit for a five-year
period. The Conference Report accompanying the 1999 Act included the
following language addressing the proposed regulations:

In extending the research credit, the conferees are concerned that
the definition of qualified research be administered in a manner
that is consistent with the intent Congress has expressed in
enacting and extending the research credit. The conferees urge the
Secretary to consider carefully the comments he has and may receive
regarding the proposed regulations relating to the computation of
the credit under section 41(c) and the definition of qualified
research under section 41(d), particularly regarding the "common
knowledge" standard. The conferees further note the rapid pace of
technological advance, especially in service-related industries, and
urge the Secretary to consider carefully the comments he has and may
receive in promulgating regulations in connection with what
constitutes "internal use" with regard to software expenditures. The
conferees also wish to observe that software research, that
otherwise satisfies the requirements of section 41, which is
undertaken to support the provision of a service, should not be
deemed "internal use" solely because the business component involves
the provision of a service.

The conferees wish to reaffirm that qualified research is research
undertaken for the purpose of discovering new information which is
technological in nature. For purposes of applying this definition,
new information is information that is new to the taxpayer, is not
freely available to the general public, and otherwise satisfies the
requirements of section 41.

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

The conferees also are concerned about unnecessary and costly
taxpayer record keeping burdens and reaffirm that eligibility for
the credit is not intended to be contingent on meeting unreasonable
record keeping requirements.

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

Explanation of Provisions

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

I. Basic Principles

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

II. Gross Receipts

When Congress revised the computation of the research credit to
incorporate a taxpayer's gross receipts, neither the statute. nor
the legislative history defined the term gross receipts, other than
to provide that gross receipts for any taxable year are reduced by
returns and allowances made during the tax year, and, in the case of
a foreign corporation, that only gross receipts effectively
connected with the conduct of a trade or business within the United
States are taken into account. See section 41(c)(6).

The proposed regulations generally defined gross receipts as the
total amount derived by a taxpayer from all activities and sources.
However, in recognition of the fact that certain extraordinary gross
receipts might not be taken into account when a business determines
its research budget, the proposed regulations provided that certain
extraordinary items (such as receipts from the sale or exchange of
capital assets) would be excluded from the computation of gross
receipts.

Several commentators objected to the definition of gross receipts in
the proposed regulations. Referring to the inclusion in a House
Budget Report of the term sales growth as an apparent short-hand
reference to an increase in gross receipts, some commentators argued
that gross receipts should be limited to income from sales. See H.R.
Rep. No. 101-247, at 1200 (1989).

In determining its research budget, however, a business may take
into account any expected income stream, regardless of whether or
not the income is derived from sales or from other active business
activities. Moreover, many businesses do not generate. any income in
the form of sales. Accordingly, the final regulations do not adopt
this suggestion.

The final regulations also do not adopt suggestions that the
definition of gross receipts be narrowed to exclude those items not
directly related to the conduct of the taxpayer's trade or business.
As noted above, any expected income stream may be taken into account
in determining a business' research budget, regardless of the source
of the income. Moreover, IRS and Treasury believe that a subjective
narrowing of the term gross receipts, as suggested by these
commentators, could leave the definition of the term, and thus the
computation of the base amount, vulnerable to manipulation.

For example, a narrower definition allowing taxpayers to exclude
items not derived in the ordinary course of business might prompt a
taxpayer to assert that certain royalties received in the 1980s were
derived in the ordinary course of business and are includible as
gross receipts (thus decreasing the taxpayer's fixed-base
percentage), but that certain interest income received in the years
preceding the credit year was not derived in the ordinary course of
business and was not includible in gross receipts (thus decreasing
the base amount). Nor would a rule of consistency be effective in
preventing such manipulation. While the taxpayer described above
would be characterizing the nature of its income items as derived or
not derived in the ordinary course of a trade or business so as to
maximize the amount of the credit, the taxpayer would not be taking
inconsistent positions with respect to the same items of income.

Several commentators objected to the definition of gross receipts in
the proposed regulations as it applies to start-up firms with pre-
operating interest income. If pre-operating interest income is
treated as a gross receipt, many start-up firms would be precluded
from using the start-up rules to compute their fixed-base
percentages, because the application of the start-up rules is
conditioned on a taxpayer not having both gross receipts and
qualified research expenses in certain taxable years during the
1980s. Moreover, because a start-up firm whose only gross receipt is
pre-operating interest income likely would have significant
qualified research expenses relative to gross receipts (and thus a
high fixed-base percentage), such a firm likely would derive less
benefit from the credit.

IRS and Treasury recognize that the start-up rules appear to
contemplate that there will be years in which a taxpayer has
qualified research expenses but no gross receipts. However, it would
be difficult to conceive of such a year if gross receipts are
defined to include pre-operating investment income. To address these
concerns and pursuant to the regulatory authority of section 41(c)
(3)(B)(iii), the final regulations exclude from the definition of
gross receipts any income received by a taxpayer in a taxable year
that precedes the first taxable year in which the taxpayer derives
more than $25,000 in gross receipts other than investment income.
For this purpose, investment income is defined as interest or
distributions with respect to stock (other than the stock of a 20-
percent owned corporation as defined in section 243(c)(2) of the
Code).

Some commentators suggested that the definition of gross receipts
should be clarified to exclude certain payments made by
pharmaceutical manufacturers to various insurers, managed care
organizations and state governments. The final regulations do not
adopt any provision specifically addressing such payments.

III. The Discovery Requirement

To qualify for the research credit, section 41(d) requires that a
taxpayer undertake research for the purpose of discovering
information which is technological in nature, and the application of
which is intended to be useful in the development of a new or
improved business component of the taxpayer. Section 1.41-4(a)(3) of
the proposed regulations defines the phrase discovering information
as obtaining knowledge that exceeds, expands, or refines the common
knowledge of skilled professionals in a particular field of science
or engineering.

Commentators criticized this definition of discovering information,
arguing that the definition imposes a discovery requirement that was
not mandated by the statute. Commentators suggested that the phrase
discovering information, as used in the statute, was not intended as
an additional requirement, but was simply used as a phrase to link
the term research with the types of information required as the
subject of the research. Commentators argued that a taxpayer who
seeks to resolve its own. subjective uncertainty as to the
information at issue is undertaking sufficient discovery for
purposes of section 41(d).

Consistent with the legislative history and case law as described
below, however, IRS and Treasury continue to believe that section 41
conditions credit eligibility on an attempt to discover information
that goes beyond the common knowledge of skilled professionals in
the particular field of science or engineering.

The legislative history to the 1986 Act, which narrowed the
definition of the term qualified research, explained that Congress
had originally enacted the research credit to encourage business
firms to perform the research necessary to increase the innovative
qualities and efficiency of the U.S. economy. H.R. Rep. No. 99-426,
at 177-78; S. Rep. No. 99-313, at 694-95.

Congress was concerned that taxpayers had applied the original
definition of qualified research "too broadly," that some taxpayers
had claimed the credit for "virtually any expenses relating to
product development" and that many of these taxpayers were "in
industries that do not involve high technology or its application in
developing technologically new and improved products or methods of
production." Id. In an illustration of the changes enacted, the
legislative history explained that, under the new definition:
"Research does not rely on the principles of computer science merely
because a computer is employed. Research may be treated as
undertaken to discover information that is technological in nature,
however, if the. research is intended to expand or refine existing
principles of computer science." H.R. Conf. Rep. No. 99-841, at
II-71 n.3 (1986) (emphasis added).

Following the 1986 Act changes to the credit, a discovery
requirement has been applied in several recent cases. See, e.g.,
United Stationers, Inc. v. United States, 163 F.3d 440 (7th Cir.
1998), Norwest v. Commissioner, 110 T.C. 454 (1998), and WICOR, Inc.
v. United States, 116 F. Supp. 2d 1028 (E.D. Wis. 2000). In
reaffirming the scope of the term qualified research, the Conference
Report to the 1998 Act noted that:

evolutionary research activities intended to improve functionality,
performance, reliability, or quality are eligible for the credit, as
are research activities intended to achieve a result that has
already been achieved by other persons but is not yet within the
common knowledge (e.g., freely available to the general public) of
the field (provided that the research otherwise meets the
requirements of section 41, including not being excluded by
subsection (d)(4)).

H.R. Conf. Rep. No. 105-825, at 1548 (1998) (emphasis added). In
particular, it is noteworthy that the conferees clarified that the
credit is available for research intended to achieve a result that
has been achieved by others but is not yet within the common
knowledge. The negative inference is that the credit is not
available for research intended to achieve a result that has been
achieved by others and is within the common knowledge of the field.

The discovery requirement as set forth in the final regulations also
is consistent with the legislative history to the 1999 Act (the text
of which is set forth above under. Background). In that legislative
history, for example, the conferees stated that:

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

H.R. Conf. Rep. No. 106-478, at 132 (emphasis added). By referring
separately to a requirement that the research be undertaken for
purposes of discovering information, this legislative history again
confirmed that the phrase "discovering information" is a separate
substantive requirement and not merely a phrase used to link the
term research with the types of information required as the subject
of the research.

In light of the case law and the legislative history, the final
regulations retain the requirement that a taxpayer seek to discover
information that exceeds, expands, or refines the common knowledge
of skilled professionals in the particular field of science or
engineering. However, consistent with the legislative history to the
1999 Act, IRS and Treasury have carefully considered comments
relating to the "common knowledge" standard, and made a number of
changes to address specific taxpayer concerns about the discovery
requirement.

In response to comments regarding the application of the discovery
requirement, the final regulations clarify that the phrase "common
knowledge of skilled professionals in a particular field of science
or engineering" means information that should be known to skilled
professionals had they performed, before the research in question
was undertaken, a reasonable investigation of the existing level of
information in the particular field of science or engineering. Thus,
in order to satisfy the discovery requirement, research must be
undertaken for the purpose of discovering information that is beyond
the knowledge that should be known to skilled professionals had they
performed a reasonable investigation of the existing level of
knowledge in the particular field of science or engineering. There
is no requirement, however, that a taxpayer actually conduct such an
investigation in order to claim the credit. To further clarify the
application of the discovery requirement, the final regulations also
state, as an example, that trade secrets generally are not within
the common knowledge of skilled professionals because they are not
reasonably available to skilled professionals not employed, hired,
or licensed by the owner of such trade secrets.

Also, in response to comments, the discovery requirement in the
final regulations has been reworded to refer to the common knowledge
of skilled professionals in a particular field of science or
engineering (rather than a particular field of technology or
science, as in the proposed regulations). As in the proposed
regulations, the common knowledge of skilled professionals is
intended to serve as an objective standard for the baseline
knowledge that a credit-eligible taxpayer must seek to exceed,
expand, or refine. The reference to the common knowledge of skilled
professionals is not intended to impose qualification requirements
on the personnel that the taxpayer uses to conduct qualified
research.

Several commentators raised concerns that the discovery requirement
in the proposed regulations required that taxpayers must "prove a
negative;" in response to these concerns about the potential burden
imposed on taxpayers to demonstrate that they satisfy the discovery
requirement, IRS and Treasury have added to the final regulations a
rebuttable presumption. The final regulations provide that, if a
taxpayer demonstrates with credible evidence that research
activities were undertaken to obtain the information described in
documentation prepared before or during the early stages of the
research and if that documentation also sets forth the basis for the
taxpayer's belief that obtaining this information would exceed,
expand, or refine the common knowledge of skilled professionals in
the particular field of science or engineering, then the research
activities are presumed to satisfy the discovery requirement. This
rebuttable presumption would arise, however, only if the taxpayer
cooperates with reasonable requests by the IRS for witnesses,
information, documents, meetings, and interviews.

In a case where the rebuttable presumption arises, the final
regulations provide that the Commissioner may overcome this
presumption by demonstrating that the information described in the
taxpayer's documentation was within the common knowledge of skilled
professionals in the particular field of science or engineering.
That is, the Commissioner would have to demonstrate. that the
information would have been known to such skilled professionals had
they performed (before the research was undertaken) a reasonable
investigation of the existing level of information in the particular
field of science or engineering. By way of further clarification, a
provision has been added and several examples have been changed or
eliminated to remove any implication that the underlying principles
of science or engineering used in the research must themselves be
novel. IRS and Treasury recognize that virtually all research
utilizes existing scientific principles and technology. The
requirement that a taxpayer seek to exceed, expand, or refine the
common knowledge of skilled professionals does not mean that the
tools and principles used in the attempt to achieve the
technological advance must themselves be beyond the common
knowledge.

Also, in response to commentators' suggestions, the final
regulations provide that a taxpayer is conclusively presumed to have
obtained knowledge that exceeds, expands, or refines the common
knowledge of skilled professionals in the relevant field of science
or engineering, if that taxpayer was awarded a patent for the
business component. Section 101 of title 35 of the United States
Code provides that "[w]hoever invents or discovers any new and
useful process, machine, manufacture, or composition of matter, or
any new and useful improvement thereof, may obtain a patent
therefor, subject to the conditions and requirements of [title 35]."
Such an invention or discovery may be patentable if it was not
previously known, used, patented, or described, as set. forth in 35
U.S.C. 102, and the differences between the invention and the prior
art are such that the invention would not have been obvious to a
person having ordinary skill in the relevant art. See 35 U.S.C. 102.

The final regulations contain a patent safe harbor because IRS and
Treasury believe that information leading to a patentable invention
constitutes information that exceeds, expands, or refines the common
knowledge of skilled professionals in the relevant field. Of course,
qualification under the patent safe harbor does not necessarily
establish that the discovery requirement is satisfied with respect
to all of the research associated with the patentable invention (for
example, some of the research might relate to style).

The final regulations emphasize that a patent is not a precondition
for credit eligibility. Because not all research succeeds in
achieving its objective and for other reasons, it is obvious that
not all research intended to discover information that goes beyond
the common knowledge results in a patent. Thus, the absence of a
patent should have no bearing on credit eligibility. The factors
underlying the denial of a patent application, on the other hand,
may be relevant to the determination of whether the discovery
requirement is satisfied.

Because section 41(d)(3)(B) provides that the credit is not
available for research related to style, taste, cosmetic, or
seasonal design factors, the patent safe harbor does not include
patents for design, as defined by 35 U.S.C. 171.

In light of these changes, modifications have been made to several
examples in the proposed regulations, including an example in the
proposed regulations relating to research undertaken to develop a
new tire. This example has been moved to the section of the final
regulations that illustrates the exclusion for research conducted
after the beginning of commercial production (discussed in VII.
Research After Commercial Production of this Preamble).

To address concerns expressed by a number of commentators that the
common knowledge standard may be difficult for taxpayers and
examiners to apply, and may give rise in practice to inconsistent
treatment of similarly situated taxpayers (especially where
examiners have limited expertise in a particular scientific field)
IRS and Treasury have initiated measures to promote fair and
consistent application of the discovery requirement and the other
conditions for credit eligibility. Consistent with the suggestion of
one commentator, IRS has met with Revenue Canada to discuss Canada's
joint industry/government initiative to improve administration of
the Canadian research credit. IRS also has met with various industry
associations to form joint initiatives to devise guidelines for the
administration and examination of the credit in particular
industries. Similar efforts with respect to other industry groups
are anticipated.

IV. Process of Experimentation

Commentators objected to �1.41-4(a)(5) of the proposed regulations,
which defines a process of experimentation to include a prescribed
four-step process. Commentators argued that while the four-step
process may accurately have described the pure scientific method of
conducting experiments, commercial and industrial practice does not
always conform precisely to such requirements. Commentators also
argued that the four-step process required by the proposed
regulations was adapted from a description in the legislative
history of the 1986 Act that was included for illustrative purposes
and not as a comprehensive definition of the term process of
experimentation.

In light of these comments, the final regulations provide that
taxpayers conducting a process of experimentation may, but are not
required to, engage in the four-step process.

Consistent with the legislative history, the final regulations
provide further clarification on the manner in which a process of
experimentation differs from research and development in the
experimental or laboratory sense, as required by �1.174-2(a). A
process of experimentation is a process to evaluate more than one
alternative designed to achieve a result where the capability or
method of achieving that result is uncertain at the outset, but (in
contrast to expenditures that qualify under section 174) does not
include the evaluation of alternatives to establish the appropriate
design of a business component when the capability and method for
developing or improving the business component are not uncertain.
See H.R. Conf. Rep. No. 99-841, at II-72 ("The term process of
experimentation means a process involving the evaluation of more
than one alternative designed to achieve a result where the means of
achieving that result is uncertain at the outset."); United
Stationers, 163 F.3d at 446; Norwest, 110 T.C. at 496.

V. Recordkeeping Requirement

Part of the four-step process of experimentation test prescribed in
�1.41-4(a)(5) of the proposed regulations was a requirement that
taxpayers record the results of their experiments. Maintaining that
this requirement was particularly burdensome, commentators argued
that, in the industrial or commercial setting, the recording of
results is not necessarily inherent in a bona fide process of
experimentation.

For these reasons, the final regulations do not contain a
requirement that taxpayers record the results of their experiments.
Moreover, reference to the recording of results has been eliminated
from the illustrative (non-mandatory) description of a four-step
process of experimentation.

To assist in the examination of claims for the credit and to ensure
that the credit is properly targeted to serve as an incentive to
engage in qualified research, the final regulations do include a
less burdensome contemporaneous documentation requirement. Under the
final regulations, taxpayers must prepare and retain written
documentation before or during the early stages of the research
project that describes the principal questions to be answered and
the information the taxpayer seeks to obtain that exceeds, expands,
or refines the common knowledge of skilled professionals in the
relevant field of science or engineering. Taxpayers also must comply
with the general recordkeeping requirements of section 6001.

As noted above, taxpayers may also avail themselves of a rebuttable
presumption that they satisfy the discovery requirement if their
contemporaneous documentation also sets forth the basis for the
taxpayer's belief that obtaining this information would exceed,
expand, or refine the common knowledge of skilled professionals in
the particular field of science or engineering.

VI. The Shrinking-back Rule

Under �1.41-4(b) of the proposed regulations, and consistent with
the legislative history to the 1986 Act, if the requirements of
section 41(d) are not met for an entire product, then the credit may
be available with respect to the next most significant subset of
elements of that product. This shrinking back continues until either
a subset of elements of the product that satisfies the requirements
is reached, or the most basic element of the product is reached and
such element fails to satisfy the test.

The final regulations clarify that this shrinking-back rule applies
only if the taxpayer incurs some research expenses with respect to
the overall business component that would constitute qualified
research expenses with respect to that business.

component but for the fact that less than substantially all of the
research activities with respect to that component constitute
elements of a process of experimentation that relates to a new or
improved function, performance, reliability or quality. In cases
where the substantially-all test is satisfied with respect to the
overall business component, those research expenses with respect to
the overall business component that are qualified research expenses
are credit eligible, and there is no need for a taxpayer to shrink
back to apply the tests with respect to subsets of elements of the
business component. Of course, the mere fact that taxpayers are not
required to shrink back to a smaller business component does not
mean that all of the research expenses with respect to the overall
credit are credit eligible.

Research expenses that are not qualified research expenses, for
example because they relate to style, taste, cosmetic, or seasonal
design factors, remain ineligible for the credit.

In response to commentators' suggestions, the final regulations also
clarify that, if the original product is not eligible for the
credit, the application of the shrinking-back rule may result in
credit eligibility for multiple business components that are subsets
of the original product. The regulations clarify that the shrinking-
back rule may not itself be applied as a reason to exclude research
activities from credit eligibility. Finally, an example has been
added to illustrate these concepts.

VII. Research After Commercial Production. Several commentators
addressed the section of the proposed regulations providing that
activities conducted after the beginning of commercial production of
a business component are not qualified research. Under the proposed
regulations, activities are conducted after the beginning of
commercial production of a business component if such activities are
conducted after the component is developed to the point where it is
ready for commercial sale or use, or meets the basic functional and
economic requirements of the taxpayer for the component's sale or
use. Moreover, certain specified activities (like preproduction
planning for a finished business component and trial production
runs) are deemed to occur after the beginning of commercial
production.

Because the provisions set forth above closely reflect the
legislative history of the post-production exclusion, these tests
have been retained in the final regulations. See H.R. Conf. Rep. No.
841, at II-74-75. However, several changes have been made in
response to commentators' concerns.

First, a change has been made to the list of activities that are per
se deemed to occur after the beginning of commercial production. In
the proposed regulations, one of the items on that list was
"debugging or correcting flaws in a business component." Consistent
with the legislative history, IRS and Treasury continue to believe
that debugging should be conclusively presumed to occur after the
beginning of commercial production. However, many activities
conducted before the beginning of commercial production could be
construed as the correction of flaws. Thus, the per se list
contained in the final regulations has been changed to refer to
debugging activities but not to the correction of flaws.

Second, an example has been added to clarify that a new research
project to improve a business component is not disqualified merely
because the new research project commences after the commercial
production of the unimproved business component. Other examples have
been changed to eliminate references to and factual assertions about
specific industries.

Third, the final regulations incorporate provisions from the
legislative history to the 1986 Act that clinical testing of a
pharmaceutical product prior to its commercial production in the
United States is not treated as occurring after the beginning of
commercial production even if the product is commercially available
in other countries, and that additional clinical testing of a
pharmaceutical product after a product has been approved for a
specific therapeutic use by the Food and Drug Administration and is
ready for commercial production and sale are not treated as
occurring after the beginning of commercial production if such
clinical tests are undertaken to establish new functional uses,
characteristics, indications, combinations, dosages, or delivery
forms for the product.

VIII. Adaptation

Several commentators suggested alternate formulations of the
adaptation exclusion. Because such formulations effectively would
render the adaptation exclusion inapplicable to activities that
satisfy the other requirements for qualified research, thereby
reading the exclusion out of the Internal Revenue Code, the final
regulations do not adopt the suggestions.

Two new examples clarify that the adaptation exclusion may also
apply to contract research expenses paid by the customer to the
vendor or to in-house research expenses incurred by the customer
itself to adapt an existing business component to that customer's
requirement or need.

IX. Internal-use Software

As noted above, the 1997 proposed regulations describe when software
that is developed by (or for the benefit of) a taxpayer primarily
for the taxpayer's internal use can qualify for the credit. The
final regulations incorporate these special provisions for internal-
use software. A number of changes have been made to the 1997
proposed regulations to address commentator concerns, and to
coordinate the internal-use provisions with the other provisions of
the final regulations.

Under the proposed regulations, research with respect to software
developed primarily for a taxpayer's internal use is qualified
research only if it satisfies both the general requirements for
credit eligibility under section 41 and an additional condition for
eligibility. Except for certain software developed for use in
conducting qualified research or for use in a production process,
and for certain software created as part of a package of hardware
and software developed concurrently, the additional condition for
eligibility is a requirement that the taxpayer satisfy a three-part
test (requiring that the internal-use software be innovative, that
its development involve significant economic risk, and that it not
be commercially available).

Most of the comments received focused on two issues -- (1) the
determination of when software is developed primarily for internal
use, and (2) the application of the three-part test to internal-use
software. On the first issue, several commentators urged that
internal-use software be defined to exclude any software used to
deliver a service to customers or any software that includes an
interface with customers or the public. After careful analysis of
the legislative history to the 1986 Act and the 1999 Act, however,
IRS and Treasury concluded that such a broad exclusion would be
inconsistent with the statutory mandate, because the exclusion would
extend to some software that Congress clearly intended to treat as
internal-use software. At the same time, IRS and Treasury share the
commentators' belief that the goals of the research credit may be
advanced by removing additional conditions for credit-eligibility in
the case of certain internal-use software used to provide new
features to services offered to customers that are not otherwise
available to them. Accordingly, as described in more detail below,
the final regulations retain the definition of internal-use software
contained in the proposed regulations, but provide a new exception
(pursuant to the regulatory authority under section. 41(d)(4)(E))
under which the development of certain internal-use software used to
deliver noncomputer services to customers with features that are not
yet offered by a taxpayer's competitors is not subject to the three-
part test.

Consistent with a statement in the Conference Report to the 1999 Act
that software research undertaken to support the provision of a
service should not be deemed internal-use software "solely because
the business component involves the provision of a service," the
final regulations clarify that the determination of whether software
is internal-use software depends on the nature of the service
provided by the taxpayer. Software that is intended to be used to
provide noncomputer services to customers is internal-use software,
while software that is to be used to provide computer services is
not developed primarily for internal use. Computer services are
services offered by a taxpayer to customers who do business with the
taxpayer primarily for the use of the taxpayer's computer or
software technology. Noncomputer services are services offered by a
taxpayer to customers who do business with the taxpayer primarily to
obtain a service other than a computer service, even if such other
service is enabled, supported, or facilitated by computer or
software technology. The conclusion that software used to provide
noncomputer services is internal-use software is consistent with the
legislative history to the 1986 Act, which defined internal-use
software as software used in general administrative functions and
software used in providing noncomputer services (such as accounting,
consulting, or banking services). See H.R. Conf. Rep. No. 841, at
II-73 (emphasis added).

As noted above, the final regulations contain a new exception under
which a taxpayer is not required to establish that internal-use
software used to provide noncomputer services containing features or
improvements that are not yet offered by a taxpayer's competitors
satisfies the three-part test. Software that is intended to be used
to provide noncomputer services is described within the exception if
the software is designed to provide customers a new feature with
respect to a noncomputer service; the taxpayer reasonably
anticipated that customers would choose to obtain the noncomputer
service from the taxpayer (rather than from the taxpayer's
competitors) because of those features of the service that will be
provided by the software; and those features are not available (at
the time the research is undertaken) from any of the taxpayer's
competitors.

No inference should be drawn that software described within the
foregoing exception is not internal-use software or that internal-
use software not described within the exception would fail the
three-part test. Rather, the exception reflects a determination by
IRS and Treasury that it is appropriate to exercise the regulatory
authority in section 41(d)(4)(E) to exempt certain internal-use
software from having to fulfil additional conditions for credit
eligibility. This exercise of regulatory authority is based on a
determination that the development of software containing features
or improvements that are not available from a taxpayer's competitors
and that provide a demonstrable competitive advantage is more likely
to increase the innovative qualities and efficiency of the U.S.
economy (by generating knowledge that can be used by other service
providers) than is the development of software used to provide
noncomputer services containing features or improvements that are
already offered by others. IRS and Treasury believe that drawing
such a line is an appropriate way to administer the credit with a
view to identifying and facilitating the credit availability for
software with the greatest potential for benefitting the U.S.
economy, an important rationale for the research credit.

The final regulations also make a number of changes with respect to
the three-part high threshold of innovation test, which continues to
apply to certain software not described within the new exception.
For example, commentators had questioned whether the 1997 proposed
regulations impose a separate high threshold of innovation
requirement that serves as an additional condition for credit
eligibility, even where taxpayers otherwise satisfy the three-part
test. The final regulations clarify that the three-part test is the
high threshold of innovation test, and not a separate requirement.
Similarly, commentators had objected to a sentence in the 1997
proposed regulations that could be read to suggest that certain
internal-use software could never qualify for the credit. The final
regulations clarify that research with respect to internal-use
software that satisfies both the general conditions for credit
eligibility and the three-part test is eligible for the credit.

Consistent with the application of the discovery requirement, the
final regulations adopt the suggestion of several commentators that
the three-part test should be applied without regard to whether the
taxpayer succeeds in achieving the results described in that test.

Commentators questioned whether the "as where" clauses used to
elaborate on the three requirements of the high threshold of
innovation test in the 1997 proposed regulations were intended as
mandatory requirements or merely as illustrations of ways in which
taxpayers could satisfy the tests. By replacing the "as where"
clauses with "in that" clauses, the final regulations confirm that a
taxpayer must satisfy the provisions, as elaborated. Consistent with
this clarification, the final regulations provide that the
innovative prong of the three-part test may be satisfied with
respect to any intended improvement, not just reductions in cost or
improvements in speed.

Under the final regulations, all qualified research, including
research with respect to internal-use software, must satisfy the
discovery requirement (that is, must be intended to exceed, expand,
or refine the common knowledge of skilled professionals in the
particular field of science or engineering). The final regulations
clarify how the three-part high threshold of innovation test
supplements the discovery requirement.

Specifically, the final regulations provide that several aspects. of
the three-part test (the determination of whether the software is
intended to result in an improvement that is substantial and
economically significant and the extent of uncertainty and technical
risk) also must be applied with respect to the common knowledge of
skilled professionals. In essence, the common knowledge of skilled
professionals rather than the knowledge base of the taxpayer's
employees is treated as the baseline with respect to which the
intended software must satisfy the innovative prong and other prongs
of the three-part test. Stated differently, research with respect to
internal-use software is credit eligible only if it is intended to
exceed, expand, or refine the common knowledge of skilled
professionals (as defined in �1.41-4(a)(3)(ii)) to a degree that is
substantial and economically significant. See Norwest 110 T.C. at
499-500 (stating that "...the extent of the improvements required by
Congress with respect to internal use software is much greater than
that required in other fields" and that "...the significant economic
risk test requires a higher threshold of technological advancement
in the development of internal use software than in other fields").

Reference to the common knowledge of skilled professionals as the
baseline is necessary to give proper meaning to the statutory three-
part test. For example, if the innovative requirement was applied
simply with respect to the prior state of the taxpayer's own
business, then ordinary inventory software installed by a taxpayer
who previously tracked its inventory. manually could be deemed to
satisfy the innovative requirement merely because the taxpayer had
achieved a substantial and economically significant improvement in
speed over its prior non-automated operations.

Although the final regulations related to internal use software
generally are effective for taxable years beginning after December
31, 1985, the provisions relating to software developed for use in
providing computer and noncomputer services to customers and the
provisions clarifying the interaction of the three-part test with
the discovery requirement, like other provisions concerning the
discovery requirement, are effective only prospectively; however,
taxpayers may rely on these rules for expenditures paid or incurred
prior to January 3, 2001.

X. Alternative Incremental Credit

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

Effective Dates

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

Special Analyses

It has been determined that these regulations are not a significant
regulatory action as defined in Executive Order 12866. Therefore, a
regulatory assessment is not required. It also has been determined
that section 553(b) of the Administrative Procedure Act (5 U.S.C.
chapter 5) does not apply to these regulations.

It is hereby certified that the collection of information contained
in these regulations will not have a significant economic impact on
a substantial number of small entities. This certification is based
on the fact that the rules of this section impact only taxpayers who
engage in qualified research.

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

Drafting Information

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

Adoption of Amendments to the Regulations

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

PART 1--INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * * Par. 2. Revise the undesignated
centerheading immediately before �1.30-1 to read as follows:

CREDITS ALLOWABLE UNDER SECTIONS 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 ��1.41-1
through 1.41-8 as follows: �1.41-1 Credit for increasing research
activities.

(a) Amount of credit.

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

(a) Trade or business requirement.

(1) In general.

(2) New business.

(3) Research performed for others.

(i) Taxpayer not entitled to results.

(ii) Taxpayer entitled to results.

(4) Partnerships.

(i) In general.

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

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

(1) In general.

(2) Certain utility charges.

(i) In general.

(ii) Extraordinary expenditures.

(3) Right to use personal property.

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

(c) Qualified services.

(1) Engaging in qualified research.

(2) Direct supervision.

(3) Direct support.

(d) Wages paid for qualified services.

(1) In general.

(2) "Substantially all."

(e) Contract research expenses.

(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 January 3, 2001.

(a) New taxpayers.

(b) Special rules for short taxable years.

(1) Short credit year.

(2) Short taxable year preceding credit year.

(3) Short taxable year in determining fixed-base percentage.

(c) Definition of gross receipts.

(1) In general.

(2) Amounts excluded.

(3) Foreign corporations.

(d) Consistency requirement.

(1) In general.

(2) Illustrations.

(e) Effective date. �1.41-4 Qualified research for expenditures paid
or incurred on or after January 3, 2001.

(a) Qualified research.

(1) General rule.

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

(3) Undertaken for the purpose of discovering information.

(i) In general.

(ii) Common knowledge.

(iii) Means of discovery.

(iv) Patent safe harbor.

(v) Rebuttable presumption.

(4) Technological in nature.

(5) Process of experimentation.

(6) Substantially all requirement.

(7) Use of computers and information technology.

(8) Illustrations.

(b) Application of requirements for qualified research.

(1) In general.

(2) Shrinking-back rule.

(3) Illustration.

(c) Excluded activities.

(1) In general.

(2) Research after commercial production.

(i) In general.

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

(iii) Activities related to production process or technique.

(iv) Clinical testing.

(3) Adaptation of existing business components.

(4) Duplication of existing business component.

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

(6) Internal-use computer software.

(i) General rule.

(ii) Requirements.

(iii) Primarily for internal use.

(iv) Software used in the provision of services.

(A) Computer services.

(B) Noncomputer services.

(v) Exception for certain software used in providing noncomputer
services.

(vi) High threshold of innovation test.

(vii) Application of high threshold of innovation test.

(viii) Illustrations.

(ix) Effective dates.

(7) Activities outside the United States, Puerto Rico, and other
possessions.

(i) In general.

(ii) Apportionment of in-house research expenses.

(iii) Apportionment of contract research expenses.

(8) Research in the social sciences, etc.

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

(10) Illustrations.

(d) Documentation.

(e) Effective dates. �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 January 3, 2001.

(a) Alternative incremental credit.

(b) Election.

(1) In general.

(2) Time and manner of election.

(3) Revocation.

(4) Effective date.

Par. 5. Section 1.41-1 is revised to read as follows: �1.41-1 Credit
for increasing research activities. (a) Amount of credit. The amount
of a taxpayer's credit is determined under section 41(a). For
taxable years beginning after June 30, 1996, and at the election of
the taxpayer, the portion of the credit determined under section
41(a)(1) may be calculated using the alternative incremental credit
set forth in section 41(c)(4).

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

Section of the 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).41 �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 as sections 30 and 44F. Sections 1.41-0
through 1.41-8 and 1.41-0A through 1.41-5A refer to these sections
as section 41 for conformity purposes. Whether section 41, former
section 30, or former section 44F applies to a particular
expenditure depends upon when the expenditure was paid or incurred.
�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.

��1.41-0A through 1.41-8A [Removed] Par. 6A. Sections 1.41-0A
through 1.41-8A and the undesignated centerheading preceding these
sections are removed. Par. 7. An undesignated centerheading is added
immediately following �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 January 3, 2001.

(a) New taxpayers. If, with respect to any credit year, the taxpayer
has not been in existence for any previous taxable year, the average
annual gross receipts of the taxpayer for the four taxable years
preceding the credit year shall be zero. If, with respect to any
credit year, the taxpayer has been in existence for at least one
previous taxable year, but has not been in existence for four
taxable years preceding the taxable year, then the average annual
gross receipts of the taxpayer for the four taxable years preceding
the credit year shall be the average. annual gross receipts for the
number of taxable years preceding the credit year for which the
taxpayer has been in existence.

(b) Special rules for short taxable years--(1) Short credit year. If
a credit year is a short taxable year, then the base amount
determined under section 41(c)(1) (but not section 41(c)(2)) shall
be modified by multiplying that amount by the number of months in
the short taxable year and dividing the result by 12.

(2) Short taxable year preceding credit year. If one or more of the
four taxable years preceding the credit year is a short taxable
year, then the gross receipts for such year are deemed to be equal
to the gross receipts actually derived in that year multiplied by 12
and divided by the number of months in that year.

(3) Short taxable year in determining fixed-base percentage. No
adjustment shall be made on account of a short taxable year to the
computation of a taxpayer's fixed-base percentage.

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

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

(i) Returns or allowances;

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

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

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

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

(vi) Amounts received by a taxpayer in a taxable year that precedes
the first taxable year in which the taxpayer derives more than
$25,000 in gross receipts other than investment income. For purposes
of this paragraph (c)(2)(vi), investment income is interest or
distributions with respect to stock (other than the stock of a 20-
percent owned corporation as defined in section 243(c)(2).

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

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

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

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

(ii) During the fixed-base period, X reported the following amounts
as qualified research expenses on its Form 6765:
1984..................$ 100x
1985.................. 120x
1986.................. 150x.46
1987.................. 180x
1988.................. 170x
Total.................$ 720x

(iii) For the taxable years ending December 31, 1984, and December
31, 1985, X based the amounts reported as qualified research
expenses on the definition of qualified research in effect for those
taxable years. The definition of qualified research changed for
taxable years beginning after December 31, 1985. If X used the
definition of qualified research applicable to its taxable year
ending December 31, 2001, the credit year, its qualified research
expenses for the taxable years ending December 31, 1984, and
December 31, 1985, would be reduced to $ 80x and $ 100x,
respectively. Under the consistency rule in section 41(c)(5) and
paragraph (d)(1) of this section, to compute the research credit for
the tax year ending December 31, 2001, X must reduce its qualified
research expenses for 1984 and 1985 to reflect the change in the
definition of qualified research for taxable years beginning after
December 31, 1985. Thus, X's total qualified research expenses for
the fixed-base period (1984-1988) to be used in computing the fixed-
base percentage is

$ 80 + 100 + 150 + 180 + 170 = $ 680x.

Example 2. The facts are the same as in Example 1, except that, in
computing its qualified research expenses for the taxable year
ending December 31, 2001, X claimed that a certain type of
expenditure incurred in 2001 was a qualified research expense. X's
claim reflected a change in X's position, because X had not
previously claimed that similar expenditures were qualified research
expenses. The consistency rule requires X to adjust its qualified
research expenses in computing the fixed-base percentage to include
any similar expenditures not treated as qualified research expenses
during the fixed-base period, regardless of whether the period for
filing a claim for credit or refund has expired for any year taken
into account in computing the fixed-base percentage.

(e) Effective date. The rules in paragraphs (c) and (d) of this
section are applicable for taxable years beginning on or after the
date final regulations are published in the Federal Register.

Par. 10. Section 1.41-4 is revised to read as follows: �1.41-4
Qualified research for expenditures paid or incurred on or after
January 3, 2001.

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

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

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

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

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

For certain recordkeeping requirements, see paragraph (d) of this
section.

(3) Undertaken for the purpose of discovering information--(i) In
general. For purposes of section 41(d) and this section, research is
undertaken for the purpose of discovering information only if it is
undertaken to obtain knowledge that exceeds, expands, or refines the
common knowledge of skilled professionals in a particular field of
science or engineering. A determination that research is undertaken
for the purpose of discovering information does not require that the
taxpayer succeed in obtaining the knowledge that exceeds, expands,
or refines the common knowledge of skilled professionals in a
particular field of science or engineering, nor does it require that
the advance sought be more than evolutionary.

However, research is not undertaken for the purpose of discovering
information merely because an expenditure may be treated as an
expense under section 174.

(ii) Common knowledge. Common knowledge of skilled professionals in
a particular field of science or engineering means information that
should be known to skilled professionals had they performed, before
the research in question is undertaken, a reasonable investigation
of the existing level of information in the particular field of
science or engineering. Thus, knowledge may, in certain
circumstances, exceed, expand, or refine the common knowledge of
skilled professionals in a particular field of science or
engineering even though such knowledge has previously been obtained
by other persons. For example, trade secrets generally are not
within the common knowledge of skilled professionals in a particular
field of science or engineering because they are not reasonably
available to skilled professionals not employed, hired, or licensed
by the owner of such trade secrets.

(iii) Means of discovery. In seeking to obtain knowledge that
exceeds, expands, or refines the common knowledge of skilled.
professionals in a particular field of science or engineering, a
taxpayer may employ existing technologies in a particular field and
may rely on existing principles of science or engineering.

(iv) Patent safe harbor. For purposes of section 41(d) and paragraph
(a)(3)(i) of this section, the issuance of a patent by the Patent
and Trademark Office under the provisions of section 151 of title
35, United States Code (other than a patent for design issued under
the provisions of section 171 of title 35, United States Code) is
conclusive evidence that a taxpayer has obtained knowledge that
exceeds, expands, or refines the common knowledge of skilled
professionals. However, the issuance of such a patent is not a
precondition for credit availability.

(v) Rebuttable presumption. If a taxpayer demonstrates with credible
evidence that research activities were undertaken to obtain the
information described in the taxpayer's contemporaneous
documentation required under paragraph (d)(1) of this section, and
if that documentation also sets forth the basis for the taxpayer's
belief that obtaining this information would exceed, expand, or
refine the common knowledge of skilled professionals in the
particular field of science or engineering, the research activities
are presumed to satisfy the requirements of this paragraph (a)(3).
However, the presumption applies only if the taxpayer cooperates
with reasonable requests by the Commissioner for witnesses,
information, documents, meetings, and interviews. Furthermore, the
Commissioner may overcome the presumption in this paragraph if the
Commissioner demonstrates.

that the information described in the taxpayer's documentation was
within the common knowledge of skilled professionals (as described
in paragraph (a)(3)(ii) of this section), or that the research
activities were not undertaken to obtain the information described
in the taxpayer's documentation.

(4) Technological in nature. For purposes of section 41(d) and this
section, information is technological in nature if the process of
experimentation used to discover such information fundamentally
relies on principles of the physical or biological sciences,
engineering, or computer science.

(5) Process of experimentation. For purposes of section 41(d) and
this section, a process of experimentation is a process to evaluate
more than one alternative designed to achieve a result where the
capability or method of achieving that result is uncertain at the
outset. A process of experimentation does not include the evaluation
of alternatives to establish the appropriate design of a business
component, if the capability and method for developing or improving
the business component are not uncertain. A process of
experimentation in the physical or biological sciences, engineering,
or computer science may involve--

(i) Developing one or more hypotheses designed to achieve the
intended result;

(ii) Designing an experiment (that, where appropriate to the
particular field of research, is intended to be replicable with an
established experimental control) to test and analyze those
hypotheses (through, for example, modeling, simulation, or a
systematic trial and error methodology);

(iii) Conducting the experiment; and

(iv) Refining or discarding the hypotheses as part of a sequential
design process to develop or improve the business component.

(6) Substantially all requirement. The substantially all requirement
of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this section is
satisfied only if 80 percent or more of the research activities,
measured on a cost or other consistently applied reasonable basis
(and without regard to �1.41-2(d)(2)), constitute elements of a
process of experimentation for a purpose described in section 41(d)
(3). The substantially all requirement is applied separately to each
business component.

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

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

Example 1. (i) Facts. X and other manufacturing companies have
previously designed and manufactured a particular kind of machine
using Material S. Material T is less expensive than Material S. X
wishes to design a new machine that appears and functions exactly
the same as its existing machines, but that is made of Material T
instead of Material S. The capability and method necessary to
achieve this objective should not have been known to skilled
professionals had they conducted a reasonable investigation of the
existing information in the relevant field of science or engineering
at the time the research was undertaken.

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

Example 2. (i) Facts. X is engaged in the business of developing and
manufacturing widgets. X wants to manufacture an improved widget
made out of a material that X has not previously used. Although X is
uncertain how to use the material to manufacture an improved widget,
the capability and method of using the material to manufacture such
widgets should have been known to skilled professionals had they
conducted a reasonable investigation of the existing level of
information in the particular field of science or engineering at the
time the research was undertaken.

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

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

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

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

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

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

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

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

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

(2) Shrinking-back rule. The requirements of section 41(d) and
paragraph (a) of this section are to be applied first at the level
of the discrete business component, that is, the product, process,
computer software, technique, formula, or invention to be held for
sale, lease, or license, or used by the taxpayer in a trade or
business of the taxpayer. If the requirements for credit eligibility
are met at that first level, then some or all of the taxpayer's
research expenses are eligible for the credit.

A special shrinking-back rule applies in the case where a taxpayer
incurs some research expenses with respect to that discrete business
component that would constitute qualified research expenses with
respect to that business component but for the fact that less than
substantially all of the research activities with respect to that
component constitute elements of a process of experimentation that
relates to a new or improved function, performance, reliability or
quality. In such a case, the requirements for the credit are to be
applied at the next most significant subset of elements of the
business component.

The shrinking-back of the applicable business component continues
until a subset or series of subsets of elements of the business
component satisfies the substantially all requirement of section
41(d)(1)(C) and paragraph (a)(2)(iii) of this section (treating that
subset of elements as a business component) or the most basic
element fails to satisfy the requirements. This shrinking-back rule
is applied only if a taxpayer does not satisfy the requirements of
section 41(d)(1)(C) and paragraph (a)(2)(iii) of this section with
respect to the overall business component. The shrinking-back rule
is not itself applied as a reason to exclude research activities
from credit eligibility.

(3) Illustration. The following example illustrates the application
of this paragraph (b):

(i) Facts. X, a widget manufacturer, develops a widget that is
improved in several respects. Among the various improvements to the
widget is an improvement to the widget's cooling.56 mechanism.
Although the capability and method of making the other improvements
to the widget would have been known to skilled professionals had
they conducted a reasonable investigation of the existing level of
information in the particular field of science or engineering, the
method of developing the improved cooling mechanism and of
incorporating the improved mechanism into the widget would not have
been known to skilled professionals had they conducted a reasonable
investigation of the existing level of information in the particular
field of science or engineering. Substantially all of X's research
activities in improving the widget constitute elements of a process
of experimentation for purposes of improving the performance of the
widget. None of X's research activities in improving the widget are
described in section 41(d)(4) or paragraph (c) of this section.

(ii) Conclusion. Some, but not all, of X's research activities in
developing the improved widget are qualified research within the
meaning of section 41(d)(1) and paragraph (a) of this section. In
seeking to improve the widget, some of X's activities (related to
improving the cooling mechanism and incorporating the improved
cooling mechanism into the widget) were undertaken to obtain
knowledge that exceeds, expands, or refines the common knowledge of
skilled professionals in the relevant field of science or
engineering. However, other activities (related to the other
improvements) were not undertaken to obtain knowledge that exceeds,
expands, or refines the common knowledge of skilled professionals in
the relevant field of science or engineering, and thus are not
qualified research and are not eligible for the credit. Not all of
X's research activities relating to the widget are eligible for the
credit because some of the activities are not qualified research as
defined in section 41(d) and paragraph (a) of this section, even
though the widget qualifies as a business component with respect to
which qualified research that satisfies the requirements of section
41(d) and paragraph (a) of this section is undertaken.

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

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

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

(A) Preproduction planning for a finished business component;

(B) Tooling-up for production;

(C) Trial production runs;

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

(E) Accumulating data relating to production processes; and

(F) Debugging flaws in a business component.

(iii) Activities related to production process or technique.

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

(iv) Clinical testing. Clinical testing of a pharmaceutical product
prior to its commercial production in the United States is not
treated as occurring after the beginning of commercial production
even if the product is commercially available in other countries.
Additional clinical testing of a pharmaceutical product after a
product has been approved for a specific therapeutic use by the Food
and Drug Administration and is ready for commercial production and
sale are not treated as occurring after the beginning of commercial
production if such clinical tests are undertaken to establish new
functional uses, characteristics, indications, combinations,
dosages, or delivery forms for the product. A functional use,
characteristic, indication, combination, dosage or delivery form
shall be considered new only if such functional use, characteristic,
indication, combination, dosage or delivery form must be approved by
the Food and Drug Administration.

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

(4) Duplication of existing business component. Activities relating
to reproducing an existing business component (in whole or in part)
from a physical examination of the business component itself or from
plans, blueprints, detailed specifications, or publicly available
information about the business component are not qualified research.
This exclusion does not apply merely because the taxpayer inspects
an existing business component in the course of developing its own
business component.

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

(i) Efficiency surveys;

(ii) Management functions or techniques, including such items as
preparation of financial data and analysis, development of employee
training programs and management organization plans, and management-
based changes in production processes (such as rearranging work
stations on an assembly line);

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

(iv) Routine data collections; or

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

(6) Internal-use computer software--(i) General rule. Research with
respect to computer software that is developed by (or for the
benefit of) the taxpayer primarily for the taxpayer's internal use
is eligible for the research credit only if the software satisfies
the requirements of paragraph (c)(6)(ii) of this section.

(ii) Requirements. The requirements of this paragraph

(c)(6)(ii) are--

(A) The research satisfies the requirements of section 41(d)(1);

(B) The research is not otherwise excluded under section 41(d)(4)
(other than section 41(d)(4)(E)); and

(C) One of the following conditions is met--

(1) The taxpayer develops the software for use in an activity that
constitutes qualified research (other than the development of the
internal-use software itself);

(2) The taxpayer develops the software for use in a production
process that meets the requirements of section 41(d)(1);

(3) The taxpayer develops a new or improved package of computer
software and hardware together as a single product, of which the
software is an integral part, that is used directly by the taxpayer
in providing technological services in its trade or business to
customers. In these cases, eligibility for the research credit is to
be determined by examining the combined hardware-software product as
a single product;

(4) The taxpayer develops the software for use in providing computer
services to customers; or

(5) The software satisfies the high threshold of innovation test of
paragraph (c)(6)(vi) of this section.

(iii) Primarily for internal use. Software is developed primarily
for the taxpayer's internal use if the software is to be used
internally, for example, in general administrative functions of the
taxpayer (such as payroll, bookkeeping, or personnel management) or
in providing noncomputer services (such as accounting, consulting or
banking services). If computer software is developed primarily for
the taxpayer's internal use, the requirements of paragraph (c)(6)
apply even though the taxpayer intends to, or subsequently does,
sell, lease, or license the computer software.

(iv) Software used in the provision of services--(A) Computer
services. For purposes of this section, a computer service is a
service offered by a taxpayer to customers who conduct business with
the taxpayer primarily for the use of the taxpayer's computer or
software technology. A taxpayer does not provide a computer service
merely because customers interact with the taxpayer's software.

(B) Noncomputer services. For purposes of this section, a
noncomputer service is a service offered by a taxpayer to customers
who conduct business with the taxpayer primarily to obtain a service
other than a computer service, even if such other service is
enabled, supported, or facilitated by computer or software
technology.

(v) Exception for certain software used in providing noncomputer
services. The requirements of paragraph (c)(6)(ii)(C) of this
section are deemed satisfied for research. with respect to computer
software if, at the time the research was undertaken--

(A) The software is designed to provide customers a new feature with
respect to a noncomputer service;

(B) The taxpayer reasonably anticipated that customers would choose
to obtain the noncomputer service from the taxpayer (rather than
from the taxpayer's competitors) because of those new features
provided by the software; and

(C) Those new features were not available from any of the taxpayer's
competitors.

(vi) High threshold of innovation test. Computer software satisfies
the high threshold of innovation test of this paragraph (c)(6)(vi)
only if the taxpayer can establish that--

(A) The software is innovative in that the software is intended to
result in a reduction in cost, improvement in speed, or other
improvement, that is substantial and economically significant;

(B) The software development involves significant economic risk in
that the taxpayer commits substantial resources to the development
and there is a substantial uncertainty, because of technical risk,
that such resources would be recovered within a reasonable period;
and

(C) The software is not commercially available for use by the
taxpayer in that the software cannot be purchased, leased, or
licensed and used for the intended purpose without modifications.
that would satisfy the requirements of paragraphs (c)(6)(vi)(A) and
(B) of this section.

(vii) Application of high threshold of innovation test. In
determining if the high threshold of innovation test of paragraph
(c)(6)(vi) of this section is satisfied, all of the facts and
circumstances are considered. The determination of whether the
software is intended to result in an improvement or cost reduction
that is substantial and economically significant is based on a
comparison of the intended result with software that is within the
common knowledge of skilled professionals in the relevant field of
science or engineering, see �1.41-4(a)(3)(ii).

Similarly, the extent of uncertainty and technical risk is
determined with respect to the common knowledge of skilled
professionals in the relevant field of science or engineering.
Further, in determining if the high threshold of innovation test of
paragraph (c)(6)(vi) of this section is satisfied, the activities to
develop the new or improved software are considered independent of
the effect of any modifications to related hardware or other
software.

(viii) Illustrations. The following examples illustrate the
application of this paragraph (c)(6):

Example 1. (i) Facts. X is engaged in the business of manufacturing
and selling widgets to wholesalers. X has experienced strong growth
and at the same time has expanded its product offerings. X also has
increased significantly the size of its business by expanding into
new territories. The increase in the size and scope of its business
has strained X's existing financial management systems such that
management can no longer obtain timely comprehensive financial data.
Accordingly, X undertakes the development of a financial management
computer software system that is more appropriate to its newly
expanded operations.

(ii) Conclusion. X's new computer software system is developed by X
primarily for X's internal use. X's activities to develop the new
computer software system may be eligible for the research credit
only if the computer software development activities satisfy the
requirements of paragraph (c)(6)(ii) of this section.

Example 2. (i) Facts. X is engaged in the business of designing,
manufacturing, and selling widgets. X delivers its widgets in the
same manner and time as its competitors. In keeping with X's
corporate commitment to provide customers with top quality service,
X undertakes a project to develop for X's internal use a computer
software system to facilitate the tracking of the manufacturing and
delivery of widgets which will enable X's customers to monitor the
progress of their orders and know precisely when their widgets will
be delivered. X's computer software activities include research
activities that satisfy the discovery requirement in section 41(d)
(1) and paragraph (a)(3) of this section. At the time the research
is undertaken, X reasonably anticipates that if it is successful, X
will increase its market share as compared to X's competitors, none
of which has such a tracking feature for its delivery system.

(ii) Conclusion. Although X's computer software system is developed
primarily for X's internal use, X's activities are excepted from the
high threshold of innovation test of paragraph (c)(6)(vi) of this
section because, at the time the research is undertaken, X's
software is designed to provide improved tracking features, X
reasonably anticipates that customers will purchase widgets from X
because these improved tracking features, and because comparable
tracking features are not available from any of X's competitors.

(ix) Effective dates. This paragraph (c)(6) is applicable for
taxable years beginning after December 31, 1985, except paragraphs
(c)(6)(ii)(C)(4), (c)(6)(iv)(A) and (B), (c)(6)(v), the second and
third sentences of paragraph (c)(6)(vii), and paragraph (c)(6)(viii)
Example 2 of this section apply to expenditures paid or incurred on
or after January 3, 2001.

(7) Activities outside the United States, Puerto Rico, and other
possessions--(i) In general. Research conducted outside the United
States, as defined in section 7701(a)(9), the Commonwealth of Puerto
Rico and other possessions of the United States does not constitute
qualified research.

(ii) Apportionment of in-house research expenses. In-house research
expenses paid or incurred for qualified services performed both (A)
in the United States, the Commonwealth of Puerto Rico and other
possessions of the United States and (B) outside the United States,
the Commonwealth of Puerto Rico and other possessions of the United
States must be apportioned between the services performed in the
United States, the Commonwealth of Puerto Rico and other possessions
of the United States and the services performed outside the United
States, the Commonwealth of Puerto Rico and other possessions of the
United States. Only those in-house research expenses apportioned to
the services performed within the United States, the Commonwealth of
Puerto Rico and other possessions of the United States are eligible
to be treated as qualified research expenses, unless the in-house
research expenses are wages and the 80 percent rule of �1.41-2(d)(2)
applies.

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

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

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

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

Example 1. (i) Facts. X, a tire manufacturer, seeks to build a tire
that will not deteriorate as rapidly under certain conditions of
high speed and temperature as do existing tires. X commences
laboratory research on January 1. On April 1, X determines in the
laboratory that a certain combination of materials and additives can
withstand higher rotational speeds and temperatures than the
combination of materials and additives. used in existing tires. On
the basis of this determination, X undertakes further research
activities to determine how to design a tire using those materials
and additives, and to determine whether such a tire functions
outside the laboratory as intended under various actual road
conditions. By September 1, X's research has progressed to the point
where the new tire meets X's basic functional and economic
requirements.

(ii) Conclusion. Any research activities conducted by X after
September 1 with respect to the design of the tire are not qualified
research within the meaning of section 41(d)(1) and paragraph (a) of
this section because they are undertaken after the beginning of
commercial production of the tire. Whether any activities X engaged
in to develop a process for manufacturing the new tire constitute
qualified research depends on if the development of the process
itself separately satisfies the requirements of section 41(d) and
paragraph (c)(2) of this section, and also depends on if the
activities occur before the point in time when the process meets the
taxpayer's basic functional and economic requirements or is ready
for commercial use.

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

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

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

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

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

(ii) Conclusion. Because X's activities are excluded from the
definition of qualified research under section 41(d)(4)(B) and
paragraph (c)(3) of this section, C's payments to X do not
constitute contract research expenses under section 41(b)(3)(A).
Example 5. (i) Facts. The facts are the same as in Example 3, except
that C's own employees adapt the core software program to C's
requirements.

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

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

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

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

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

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

(d) Documentation. No credit shall be allowed under section 41 with
regard to an expenditure relating to a research project unless the
taxpayer--

(1) Prepares documentation before or during the early stages of the
research project, that describes the principal questions to be
answered and the information the taxpayer seeks to obtain to satisfy
the requirements of paragraph (a)(3) of this section, and retains
that documentation on paper or electronically in the manner
prescribed in applicable regulations, revenue rulings, revenue
procedures, or other appropriate guidance until such time as taxes
may no longer be assessed (except under section 6501(c)(1), (2), or
(3)) for any year in which the taxpayer claims to have qualified
research expenditures in connection with the research project; and

(2) Satisfies section 6001 and the regulations thereunder.

(e) Effective dates. In general, the rules of this section are
applicable for expenditures paid or incurred on or after January 3,
2001. The rules of paragraph (d), however, apply to research
projects that begin on or after March 4, 2001.

�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 January
3, 2001.

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

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

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

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

(4) Effective date. Paragraphs (b)(2) and (3) of this section are
applicable for taxable years ending on or after January 3, 2001.

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

�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 expense.

(a) Number of years in base period.

(b) New taxpayers.

(c) Definition of base period research expenses.

(d) Special rules for short taxable years.

(1) Short determination year.

(2) Short base period year.

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

(i) Determination years.

(ii) Base period years.

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

(e) Examples. �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].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.

PART 602-OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT. Par.
20. The authority citation for part 602 continues to read as
follows:

Authority: 26 U.S.C. 7805.

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

* * * * *

(b) * * *

CFR part or section where Current OMB identified and described
control No.

* * * * *

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