| REG-209494-90 |
April 07, 1998 |
Credit for Increasing Research Activities
DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Parts 1 and 602 [REG-209494-90] RIN
1545-A051
TITLE: Credit for Increasing Research Activities
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
SUMMARY: This document contains proposed regulations under section
41 of the Internal Revenue Code of 1986 describing when computer
software which 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 proposed regulations
reflect a change to section 41 made by the Tax Reform Act of 1986.
This document also provides notice of a public hearing on these
proposed regulations.
DATES: Comments and outlines of topics to be discussed at the
public hearing scheduled for May 13, 1997 must be received by April
22, 1997.
ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-209494- 90),
room 5228, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered between the
hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-209494-90),
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue
NW., Washington, DC. Alternatively, taxpayers may submit comments
electronically via the Internet by selecting the "Tax Regs" option
of the IRS Home Page, or by submitting comments directly to the IRS
Internet site at:
http://www.irs.ustreas.gov/prod/tax_regs/comments.html. The public
hearing will be held in the auditorium, Internal Revenue Building,
1111 Constitution Avenue, NW., Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Lisa
J. Shuman or Robert B. Hanson, 202-622-3120; concerning submissions
and the hearing, Christina Vasquez, 202-622-7180 (not toll-free
numbers).
SUPPLEMENTARY INFORMATION:
Background
Section 41 of the Internal Revenue Code provides a credit
against tax for increasing research activities.
Eligibility for the credit is determined in part on the definition
of qualified research under section 41(d)(1).
Section 231 of the Tax Reform Act of 1986 (the 1986 Act), 1986-3
C.B. 1, 87, established a new definition of qualified research for
purposes of the research credit. Qualified research was narrowed to
require that research be undertaken for the purpose of discovering
information that is technological in nature and the application of
which is intended to be useful in developing a new or improved
business component of the taxpayer. In addition, research is
eligible for the credit only if substantially all of the activities
of the research constitute elements of a process of experimentation
for a new or improved function, performance, or reliability or
quality. Treasury and the IRS request comments on the appropriate
explanation of the terms used in the definition of qualified
research under the 1986 Act, in particular, the term process of
experimentation.
Section 231 of the 1986 Act also specified that expenditures
incurred in certain research, research-related, and non-research
activities are to be excluded from eligibility for the credit
without reference to the general requirements for credit
eligibility. Under section 41(d)(4)(E) of the Code, except to the
extent provided in regulations, qualified research does not include
research with respect to computer software developed by (or for the
benefit of) the taxpayer primarily for the taxpayer's own use
(internal-use software), other than for use in (1) an activity which
constitutes qualified research, or (2) a production process whose
development meets the requirements in section 41(d)(1) for qualified
research (as where the taxpayer is developing robotics and software
for the robotics for use in operating a manufacturing process, and
the taxpayer's research costs of developing the robotics are
eligible for the credit).
The legislative history indicates that Congress intended to
limit the credit for the costs of developing internal-use software
to software meeting a high threshold of innovation. In particular,
Congress intended that regulations would permit internal-use
software to qualify for the credit only if, in addition to
satisfying the general requirements for credit eligibility, the
taxpayer can establish that the following three-part test is
satisfied: the software is innovative (as where the software
results in a reduction in cost, or improvement in speed, that is
substantial and economically significant); the software development
involves significant risk (as where the taxpayer commits substantial
resources to the development of the software and there is
substantial uncertainty, because of technical risk, that such
resources would not be recovered in a reasonable period of time);
and the software is not commercially available for use by the
taxpayer (as where the software cannot be purchased, leased, or
licensed and used for the intended purpose without modifications
that would satisfy the first two requirements). See H.R. Rep. No.
841, 99th Cong., 2d Sess.
II-73. Thus, Congress did not intend that the three-part test in
the legislative history would apply in lieu of the general
requirements for credit eligibility but, rather, intended that the
general requirements for credit eligibility of section 41(d) also
would have to be satisfied. See H.R. Rep. No. 841 at II-73.
The legislative history indicates, however, that Congress did
not intend the internal-use software exclusion in section 41(d)(4)
(E) to apply to research related to the development of a new or
improved package of software and hardware developed as a single
product of which the software is an integral part, and that is used
directly by the taxpayer in providing technological services to
customers in its trade or business (as where a taxpayer develops
together a new or improved high technology medical or industrial
instrument containing software that processes and displays data
received by the instrument, or where a telecommunications company
develops a package of new or improved switching equipment plus
software to operate the switches). See H.R. Rep. No. 841 at II-74.
Congress intended that regulations incorporating the three-part
test in the legislative history as an exception to the exclusion
from the definition of qualified research under section 41(d)(4)(E)
would be effective on the same date section 41(d)(4)(E) became
effective. In Notice 87-12 (1987-1 C.B. 432), the IRS stated that
regulations to be issued under section 41(d)(4)(E) would be
effective for taxable years beginning after December 31, 1985.
Explanation of provisions
The proposed regulations follow the legislative history and
provide that internal-use software that meets the general
requirements of section 41(d), is innovative, involves significant
economic risk, and is not commercially available for use by the
taxpayer is not excluded from eligibility for the research credit
under section 41(d)(4)(E). Under the proposed regulations, this is
a facts and circumstances test. Treasury and the IRS request
comments on facts and circumstances, other than those factors
enumerated in the legislative history, to be considered in
determining whether internal-use software satisfies the three-part
test.
Proposed effective dates
The amendments are proposed to be effective for taxable years
beginning after December 31, 1985.
Special Analyses
It has been determined that this notice of proposed rulemaking
is not a significant regulatory action as defined in EO 12866.
Therefore, a regulatory assessment is not required. It also has
been determined that section 553(b) of the Administrative Procedure
Act (5 U.S.C. chapter 5) does not apply to these regulations, and
because these regulations do not impose a collection of information
on small entities, the Regulatory Flexibility Act (5 U.S.C.
chapter 6) does not apply. Therefore, a Regulatory Flexibility
Analysis is not required. Pursuant to section 7805(f) of the
Internal Revenue Code, this notice of proposed rulemaking will be
submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its impact on small business.
Comments and Public Hearing
Before these proposed regulations are adopted as final
regulations, consideration will be given to any comments that are
submitted timely (in the manner described in the ADDRESSES portion
of this preamble) to the IRS. All comments will be available for
public inspection and copying.
A public hearing has been scheduled for May 13, 1997, at 10
a.m. in the auditorium, Internal Revenue Building, 1111 Constitution
Avenue, NW., Washington, DC. Because of access restrictions,
visitors will not be admitted beyond the building lobby more than 15
minutes before the hearing starts.
The rules of 26 CFR 601.601(a)(3) apply to the hearing.
Persons that wish to present oral comments at the hearing must
submit (in the manner described in the ADDRESSES portion of this
preamble) comments and an outline of the topics to be discussed and
the time to be devoted to each topic by April 22, 1997.
A period of 10 minutes will be allotted to each person for
making comments.
An agenda showing the scheduling of the speakers will be
prepared after the deadline for receiving outlines has passed.
Copies of the agenda will be available free of charge at the
hearing.
List of Subjects
26 CFR Part 1 Income taxes, Reporting and recordkeeping
requirements.
26 CFR Part 602 Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations Accordingly, 26 CFR parts 1
and 602 are proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by
adding an entry in numerical order to read as follows:
Authority: 26 U.S.C. 7805. * * * Section 1.41-4 also issued
under 26 U.S.C. 41(d)(4)(E).
* * * Par. 2. Section 1.41-0 is amended by revising the entry for
1.41-4 to read as follows:
1.41-0 Table of contents.
* * * * *
1.41-4 Qualified research for taxable years beginning after
December 31, 1985.
(a) through (d) [Reserved].
(e) Internal-use computer software.
(1) General rule.
(2) Requirements.
(3) Computer software and hardware developed as a single product.
(4) Primarily for internal use.
(5) Special rule.
(6) Application of special rule.
(7) Effective date.
* * * * *
Par. 3. Section 1.41-4 is revised to read as follows:
1.41-4 Qualified research for taxable years beginning after
December 31, 1985.
(a) through (d) [Reserved].
(e) Internal-use computer software--(1) 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 (e)(2) of this
section. Generally, research with respect to computer software is
not eligible for the research credit where software is used
internally, for example, in general and administrative functions
(such as payroll, bookkeeping, or personnel management) or in
providing noncomputer services (such as accounting, consulting, or
banking services).
(2) Requirements. The requirements of this paragraph (e)(2)
are--
(i) The software satisfies the requirements of section 41(d)
(1);
(ii) The software is not otherwise excluded under section
41(d)(4) (other than section 41(d)(4)(E)); and
(iii) One of the following conditions is met--
(A) The taxpayer uses the software in an activity that
constitutes qualified research (other than the development of the
internal-use software itself);
(B) The taxpayer uses the software in a production process that
meets the requirements of section 41(d)(1); or
(C) The software satisfies the special rule of paragraph (e)
(5) of this section.
(3) Computer software and hardware developed as a single
product. This paragraph (e) does not apply to the development costs
of a new or improved package of computer software and hardware
developed together by the taxpayer as a single product, 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) Primarily for internal use. All relevant facts and
circumstances are to be considered in determining if computer
software is developed primarily for the taxpayer's internal use. If
computer software is developed primarily for the taxpayer's internal
use, the requirements of this paragraph (e) apply even though the
taxpayer intends to, or subsequently does, sell, lease, or license
the computer software.
(5) Special rule. Computer software satisfies the special rule
of this paragraph (e)(5) only if the taxpayer can establish that--
(i) The software is innovative (as where the software results
in a reduction in cost, or improvement in speed, that is substantial
and economically significant);
(ii) The software development involves significant economic
risk (as where 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
(iii) The software is not commercially available for use by
the taxpayer (as where the software cannot be purchased, leased, or
licensed and used for the intended purpose without modifications
that would satisfy the requirements of paragraphs (e)(5)(i) and (ii)
of this section).
(6) Application of special rule. In determining if the
special rule of paragraph (e)(5) of this section is satisfied all of
the facts and circumstances are considered.
The special rule allows the costs of developing internal-use
software to be eligible for the research credit only if the software
meets a high threshold of innovation. The facts and circumstances
analysis takes into account only the results attributable to the
development of the new or improved software independent of the
effect of any modifications to related hardware or other software.
The weight given to any fact or circumstance will depend on the
particular case.
(7) Effective date. This paragraph (e) is applicable for
taxable years beginning after December 31, 1985.
1.41-0A through 1.41-8A [Removed] Par. 4. Sections 1.41-0A
through 1.41-8A and the undesignated centerheading preceding
these sections are removed.
PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT
Par. 5. The authority citation for part 602 continues to read
as follows:
Authority: 26 U.S.C. 7805.
Par. 6. In 602.101, paragraph (c) is amended by removing the
following entries from the table:
602.101 OMB Control numbers.
* * * * *
(c) * * *
CFR part or section where Current OMB identified and
described control No.
* * * * *
1.41-4A...................................1545-0074
1.41-4(b) and (c).........................1545-0074
* * * * *
Commissioner of Internal Revenue
Margaret Milner Richardson
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