-
INCOME TAX
T.D. 8930, page 433.Final regulations under section 41 of the
Code relate to thecomputation of the credit for increasing research
activitiesand the definition of qualified research. These
regulationsprovide guidance concerning the requirements to qualify
forthe credit and rules for electing and revoking the election
ofthe alternative incremental credit.
Rev. Rul. 2001–5, page 451.LIFO; price indexes; department
stores. The November2000 Bureau of Labor Statistics price indexes
are acceptedfor use by department stores employing the retail
inventoryand last-in, first-out inventory methods for valuing
inventoriesfor tax years ended on, or with reference to, November
30,2000.
REG–106542–98, page 473.Proposed regulations relate to an
election under section 645of the Code to have certain revocable
trusts treated andtaxed as part of an estate. A public hearing is
scheduled forFebruary 21, 2001.
Notice 2001–10, page 459.Split-dollar insurance arrangements.
This notice clari-fies prior rulings issued by the IRS regarding
the taxation ofsplit-dollar arrangements, provides taxpayers with
interimguidance on the tax treatment of split-dollar
arrangementspending publication of further guidance, and requests
tax-
payer comments on the interim guidance and a number ofunresolved
issues. Rev. Rul 55–747 revoked. Rev. Ruls.64–328 and 66–110
modified.
Notice 2001–11, page 464.This notice provides additional
guidance to financial institu-tions located in U.S. possessions in
relation to the section1441 nonresident alien withholding
regulations that werepublished as T.D. 8734 (1997-2 C.B. 109) and
T.D. 8881(2000–23 I.R.B. 1158). Those regulations will apply to
cer-tain payments of income to foreign persons after December31,
2000.
EXEMPT ORGANIZATIONS
Rev. Proc. 2001–15, page 465.This procedure provides a modified
and supplemented list ofIndian tribal governments that are to be
treated similarly tostates for specified purposes under the
Internal RevenueCode. Rev. Procs. 83–87 and 92–19 superseded.
ESTATE TAX
T.D. 8912, page 452.Final regulations under section 2601 of the
Code relate tothe retention of a trust’s exempt status for
generation-skip-ping transfer tax purposes in the case of
modifications, etc.,to a trust.
Internal Revenue
bbuulllleettiinnBulletin No. 2001–5
January 29, 2001
HIGHLIGHTSOF THIS ISSUEThese synopses are intended only as aids
to the reader inidentifying the subject matter covered. They may
not berelied upon as authoritative interpretations.
Department of the TreasuryInternal Revenue Service
Actions Relating to Court Decisions is on the page following the
Introduction.Finding Lists begin on page ii.Announcements of
Disbarments and Suspensions begin on page 482.
-
January 29, 2001 2001–5 I.R.B.
The Internal Revenue Bulletin is the authoritative instrumentof
the Commissioner of Internal Revenue for announcing offi-cial
rulings and procedures of the Internal Revenue Serviceand for
publishing Treasury Decisions, Executive Orders, TaxConventions,
legislation, court decisions, and other items ofgeneral interest.
It is published weekly and may be obtainedfrom the Superintendent
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It is the policy of the Service to publish in the Bulletin all
sub-stantive rulings necessary to promote a uniform applicationof
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Revenue rulings represent the conclusions of the Service onthe
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Rulings and procedures reported in the Bulletin do not havethe
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rulings, and proce-
dures must be considered, and Service personnel and oth-ers
concerned are cautioned against reaching the sameconclusions in
other cases unless the facts and circum-stances are substantially
the same.
The Bulletin is divided into four parts as follows:
Part I.—1986 Code.This part includes rulings and decisions based
on provisionsof the Internal Revenue Code of 1986.
Part II.—Treaties and Tax Legislation.This part is divided into
two subparts as follows: Subpart A,Tax Conventions, and Subpart B,
Legislation and RelatedCommittee Reports.
Part III.—Administrative, Procedural, and Miscellaneous.To the
extent practicable, pertinent cross references tothese subjects are
contained in the other Parts and Sub-parts. Also included in this
part are Bank Secrecy Act Ad-ministrative Rulings. Bank Secrecy Act
Administrative Rul-ings are issued by the Department of the
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Part IV.—Items of General Interest.This part includes notices of
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The first Bulletin for each month includes a cumulative indexfor
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indexes are cumulated on a semiannualbasis, and are published in
the first Bulletin of the succeed-ing semiannual period,
respectively.
The IRS Mission
Provide America’s taxpayers top quality service by help-ing them
understand and meet their tax responsibilities
and by applying the tax law with integrity and fairness
toall.
Introduction
The contents of this publication are not copyrighted and may be
reprinted freely. A citation of the Internal Revenue Bulletin as
the source would be appropriate.
For sale by the Superintendent of Documents, U.S. Government
Printing Office, Washington, DC 20402.
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2001–5 I.R.B. January 29, 2001
It is the policy of the Internal RevenueService to announce at
an early datewhether it will follow the holdings in cer-tain cases.
An Action on Decision is thedocument making such an announcement.An
Action on Decision will be issued atthe discretion of the Service
only on un-appealed issues decided adverse to thegovernment.
Generally, an Action on De-cision is issued where its guidance
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Actions on Decisions shall be reliedupon within the Service only
as conclu-sions applying the law to the facts in theparticular case
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Decision to similarcases where the facts are different. More-over,
the recommendation in the Actionon Decision may be superseded by
newlegislation, regulations, rulings, cases, orActions on
Decisions.
Prior to 1991, the Service published ac-quiescence or
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TheService has expanded its acquiescenceprogram to include other
civil tax caseswhere guidance is determined to be help-ful.
Accordingly, the Service now may ac-quiesce or nonacquiesce in the
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The recommendation in every Actionon Decision will be summarized
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for the last half of the year.
The Commissioner ACQUIESCES inthe following decision:
Security State Bank v. Commissioner,1
214 F.3d 1254 (10th Cir. 2000),aff’g 111 T.C. 210 (1998)
Actions Relating to Decisions of the Tax Court
1 Acquiescence as to whether a cash method bank that makes
short-term loans in the ordinary course of its business is subject
to accrual of the stated interest on thoseloans under section
1281(a)(2) or, in the alternative, under section 1281(a)(1).
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Section 41.—Credit forIncreasing Research Activities
26 CFR 1.41–1: Credit for increasing researchactivities.
T.D. 8930
DEPARTMENT OF THE TREASURYInternal Revenue Service 26 CFR Parts
1 and 602
Credit for Increasing ResearchActivities
AGENCY: Internal Revenue Service(IRS), Treasury.
ACTION: Final regulations.
SUMMARY: This document containsfinal regulations relating to the
computa-tion of the credit under section 41(c) andthe definition of
qualified research undersection 41(d). These regulations
areintended to provide guidance concerningthe requirements
necessary to qualify forthe credit for increasing research
activi-ties, guidance in computing the credit forincreasing
research activities, and rulesfor electing and revoking the
election ofthe alternative incremental credit. Theseregulations
reflect changes to section 41made by the Tax Reform Act of 1986
(the1986 Act), the Revenue ReconciliationAct of 1989, the Small
Business JobProtection Act of 1996, the TaxpayerRelief Act of 1997,
the Tax and TradeRelief Extension Act of 1998 (the 1998Act), and
the Tax Relief Extension Act of1999 (the 1999 Act). These
regulationsalso provide certain technical amend-ments to the
existing regulations.
DATES: Effective Dates: These regula-tions are effective January
3, 2001.
Applicability Dates: For dates ofapplicability of these
regulations, seeEffective Dates under SUPPLEMEN-TARY INFORMATION.
FOR FUR-THER 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 containedin §1.41–8(b) of this
final rule have been
reviewed and approved by the Office ofManagement and Budget in
accordancewith the Paperwork Reduction Act of1995 (44 U.S.C. 3507)
under the number1545–1625. Responses to these collec-tions of
information are mandatory.
The reporting burden contained in§1.41–8(b)(2) (relating to the
election ofthe alternative incremental credit) isreflected in the
burden of Form 6765.
Estimated average annual burden hoursper respondent under
§1.41–8(b)(3) (relatingto the revocation of the election to use
thealternative incremental credit) is 250 hours.
Comments concerning the accuracy ofthis burden estimate and
suggestions forreducing this burden should be sent to theInternal
Revenue Service, Attn: IRSReports Clearance Officer,
W:CAR:MP:FP:S:O, Washington, DC 20224, andto the Office of
Management andBudget, Attn: Desk Officer for theDepartment of the
Treasury, Office ofInformation and Regulatory Affairs,Washington,
DC 20503.
The collections of information containedin §1.41–4(d) of this
final rule have beenreviewed and, pending receipt and evalua-tion
of public comments, approved by theOffice of Management and Budget
(OMB)under 44 U.S.C. 3507 and assigned controlnumber 1545–1625.
This information isrequired to assist in the examination of
theresearch credit and to ensure that theresearch credit is
properly targeted to serveas an incentive to engage in
qualifiedresearch. This information will be used toverify that the
amounts treated as qualifiedresearch expenses were paid or incurred
foractivities intended to discover informationthat exceeds,
expands, or refines the com-mon knowledge of skilled professionals
inthe relevant field of science or engineering.This collection of
information is requiredto obtain a benefit. The likely
recordkeep-ers are businesses or other for-profit
insti-tutions.
Estimated total annual recordkeepingburden for §1.41–4(d) is
18,000 hours.The annual estimated burden per respon-dent varies
from .5 hours to 2.5 hours,depending on the circumstances, with
anestimated average of 1.5 hours.
The estimated number of recordkeepersis 12,000.
Comments on the collection of infor-
mation should be sent to the Office ofManagement and Budget,
Attn: DeskOfficer for the Department of theTreasury, Office of
Information andRegulatory Affairs, Washington, DC20503, with copies
to the InternalRevenue Service, Attn: IRS ReportsClearance Officer,
W:CAR:MP:FP:S:O,Washington, DC 20224. Comments onthe collection of
information should bereceived by March 4, 2001. Commentsare
specifically requested concerning:
Whether the collection of informationis necessary for the proper
performance ofthe functions of the Internal RevenueService,
including whether the informa-tion will have practical utility;
The accuracy of the estimated burdenassociated with the
collection of informa-tion (see below);
How the quality, utility, and clarity ofthe information to be
collected may beenhanced;
How the burden of complying with thecollection of information
may be mini-mized, including through the application ofautomated
collection techniques or otherforms of information technology;
and
Estimates of capital or start-up costs andcosts of operation,
maintenance, and pur-chase 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
dis-plays a valid control number assigned bythe Office of
Management and Budget.
Books or records relating to a collec-tion of information must
be retained aslong as their contents may become mater-ial in the
administration of any internalrevenue law. Generally, tax returns
andtax return information are confidential, asrequired by 26 U.S.C.
6103.
Background
On January 2, 1997, the IRS andTreasury published in the
FederalRegister (62 F.R. 81) a notice of proposedrulemaking
(REG–209494–90, 1997–1C.B. 723) under section 41 describingwhen
computer software that is developedby (or for the benefit of) a
taxpayer primar-ily for the taxpayer’s internal use can qual-ify
for the credit for increasing researchactivities (the 1997 proposed
regulations).Comments responding to the 1997 pro-
2001–5 I.R.B. 433 January 29, 2001
Part I. Rulings and Decisions Under the Internal Revenue Code of
1986
-
January 29, 2001 434 2001–5 I.R.B.
posed regulations were received and a pub-lic hearing was held
on May 13, 1997.
On December 2, 1998, the IRS andTreasury published in the
Federal Register(63 F.R. 66503) a notice of proposed rule-making
(REG–105170–97, 1998–2 C.B.729) under section 41 relating to the
creditfor increasing research activities (the 1998proposed
regulations). The 1998 proposedregulations propose rules and
examplesrelating to (1) the definition of gross receiptsfor
purposes of computing the base amountunder section 41(c), (2) the
application of theconsistency rule in computing the baseamount, (3)
the definition of qualifiedresearch under section 41(d), (4) the
applica-tion of the exclusions from the definition ofqualified
research, (5) the application of theshrinking-back rule, and (6)
the election ofthe alternative incremental credit. The 1998proposed
regulations also propose certaintechnical amendments to the
existing regula-tions. Comments responding to the 1998proposed
regulations were received and apublic hearing was held on April 29,
1999.
In the 1999 Act, Congress extended thecredit for a five-year
period. TheConference Report accompanying the1999 Act included the
following languageaddressing the proposed regulations:
In extending the researchcredit, the conferees are con-cerned
that the definition ofqualified research be adminis-tered in a
manner that is con-sistent with the intent Congresshas expressed in
enacting andextending the research credit.The conferees urge
theSecretary to consider carefullythe comments he has and
mayreceive regarding the proposedregulations relating to the
com-putation of the credit undersection 41(c) and the definitionof
qualified research under sec-tion 41(d), particularly regard-ing
the “common knowledge”standard. The conferees fur-ther note the
rapid pace oftechnological advance, espe-cially in service-related
indus-tries, and urge the Secretary toconsider carefully the
com-ments he has and may receivein promulgating regulations
inconnection with what consti-tutes “internal use” with regard
to software expenditures. Theconferees also wish to observethat
software research, that oth-erwise satisfies the require-ments of
section 41, which isundertaken to support the pro-vision of a
service, should notbe deemed “internal use” sole-ly because the
business com-ponent involves the provisionof a service.
The conferees wish to reaf-firm that qualified research
isresearch undertaken for thepurpose of discovering newinformation
which is techno-logical in nature. For purposesof applying this
definition, newinformation is information thatis new to the
taxpayer, is notfreely available to the generalpublic, and
otherwise satisfiesthe requirements of section 41.Employing
existing technolo-gies in a particular field or rely-ing on
existing principles ofengineering or science is quali-fied
research, if such activitiesare otherwise undertaken forpurposes of
discovering infor-mation and satisfy the otherrequirements of
section 41.
The conferees also are con-cerned about unnecessary andcostly
taxpayer record keepingburdens and reaffirm that eligi-bility for
the credit is notintended to be contingent onmeeting unreasonable
recordkeeping requirements.
H.R. Conf. Rep. No. 106–478, at 132(1999).
After considering the commentsreceived, the statements made at
the pub-lic hearings, and the legislative history forthe research
credit, the proposed regula-tions are adopted as revised by
thisTreasury decision.
Explanation of Provisions
This document amends 26 CFR part 1to provide additional rules
under section41. Section 41 contains the rules for thecredit for
increasing research activities.
I. Basic Principles
A number of commentators objectedto the inclusion of the basic
principles
statement in §1.41–1(a) of the proposedregulations. They stated
that the inclu-sion of a basic principles section wasunusual, and
that the basic principlessection could be read to impose
addi-tional and unwarranted conditions forcredit eligibility. In
response to thesecomments, and because IRS andTreasury have
concluded that the requi-site principles are adequately reflectedin
the provisions of the regulations, thefinal regulations omit a
separate state-ment of basic principles. The clarifica-tions that
the credit may be availablewhere the technological advance soughtis
evolutionary, where the taxpayer isnot the first to achieve the
advance, andwhere the taxpayer fails to achieve theintended advance
have been incorporat-ed elsewhere in the regulations.
II. Gross Receipts
When Congress revised the computa-tion of the research credit to
incorporate ataxpayer’s gross receipts, neither thestatute nor the
legislative history definedthe term gross receipts, other than to
pro-vide that gross receipts for any taxableyear are reduced by
returns andallowances made during the tax year, and,in the case of
a foreign corporation, thatonly gross receipts effectively
connectedwith the conduct of a trade or businesswithin the United
States are taken intoaccount. See section 41(c)(6).
The proposed regulations generallydefined gross receipts as the
total amountderived by a taxpayer from all activitiesand sources.
However, in recognition ofthe fact that certain extraordinary
grossreceipts might not be taken into accountwhen a business
determines its researchbudget, the proposed regulations
providedthat certain extraordinary items (such asreceipts from the
sale or exchange of cap-ital assets) would be excluded from
thecomputation of gross receipts.
Several commentators objected to thedefinition of gross receipts
in the pro-posed regulations. Referring to theinclusion in a House
Budget Report ofthe term sales growth as an apparentshort-hand
reference to an increase ingross receipts, some commentatorsargued
that gross receipts should be lim-ited to income from sales. See
H.R. Rep.No. 101–247, at 1200 (1989). In deter-mining its research
budget, however, a
-
business may take into account anyexpected income stream,
regardless ofwhether or not the income is derivedfrom sales or from
other active businessactivities. Moreover, many businessesdo not
generate any income in the formof sales. Accordingly, the final
regula-tions do not adopt this suggestion.
The final regulations also do not adoptsuggestions that the
definition of grossreceipts be narrowed to exclude thoseitems not
directly related to the conduct ofthe taxpayer’s trade or business.
As notedabove, any expected income stream maybe taken into account
in determining abusiness’ research budget, regardless ofthe source
of the income. Moreover, IRSand Treasury believe that a subjective
nar-rowing of the term gross receipts, as sug-gested by these
commentators, couldleave the definition of the term, and thusthe
computation of the base amount, vul-nerable to manipulation.
For example, a narrower definitionallowing taxpayers to exclude
items notderived in the ordinary course of businessmight prompt a
taxpayer to assert that cer-tain royalties received in the 1980s
werederived in the ordinary course of businessand are includible as
gross receipts (thusdecreasing the taxpayer’s fixed-base
per-centage), but that certain interest incomereceived in the years
preceding the credityear was not derived in the ordinarycourse of
business and was not includiblein gross receipts (thus decreasing
the baseamount). Nor would a rule of consistencybe effective in
preventing such manipula-tion. While the taxpayer described
abovewould be characterizing the nature of itsincome items as
derived or not derived inthe ordinary course of a trade or
businessso as to maximize the amount of the cred-it, the taxpayer
would not be taking incon-sistent positions with respect to the
sameitems of income.
Several commentators objected to thedefinition of gross receipts
in the pro-posed regulations as it applies to start-upfirms with
pre-operating interest income.If pre-operating interest income is
treatedas a gross receipt, many start-up firmswould be precluded
from using the start-up rules to compute their fixed-base
per-centages, because the application of thestart-up rules is
conditioned on a taxpayernot having both gross receipts and
quali-fied research expenses in certain taxable
years during the 1980s. Moreover,because a start-up firm whose
only grossreceipt is pre-operating interest incomelikely would have
significant qualifiedresearch expenses relative to grossreceipts
(and thus a high fixed-base per-centage), such a firm likely would
deriveless benefit from the credit.
IRS and Treasury recognize that thestart-up rules appear to
contemplate thatthere will be years in which a taxpayer
hasqualified research expenses but no grossreceipts. However, it
would be difficult toconceive of such a year if gross receipts
aredefined to include pre-operating investmentincome. To address
these concerns and pur-suant to the regulatory authority of
section41(c)(3)(B)(iii), the final regulationsexclude from the
definition of gross receiptsany income received by a taxpayer in a
tax-able year that precedes the first taxable yearin which the
taxpayer derives more than$25,000 in gross receipts other than
invest-ment income. For this purpose, investmentincome is defined
as interest or distributionswith respect to stock (other than the
stock ofa 20-percent owned corporation as definedin section
243(c)(2) of the Code).
Some commentators suggested that thedefinition of gross receipts
should be clar-ified to exclude certain payments made
bypharmaceutical manufacturers to variousinsurers, managed care
organizations andstate governments. The final regulationsdo not
adopt any provision specificallyaddressing such payments.
III. The Discovery Requirement
To qualify for the research credit, sec-tion 41(d) requires that
a taxpayer under-take research for the purpose of discover-ing
information which is technological innature, and the application of
which isintended to be useful in the developmentof a new or
improved business componentof the taxpayer. Section 1.41–4(a)(3)
ofthe proposed regulations defines thephrase discovering
information as obtain-ing knowledge that exceeds, expands,
orrefines the common knowledge of skilledprofessionals in a
particular field of sci-ence or engineering.
Commentators criticized this definitionof discovering
information, arguing thatthe definition imposes a discovery
require-ment that was not mandated by the statute.Commentators
suggested that the phrasediscovering information, as used in
the
statute, was not intended as an additionalrequirement, but was
simply used as aphrase to link the term research with thetypes of
information required as the subjectof the research. Commentators
argued thata taxpayer who seeks to resolve its ownsubjective
uncertainty as to the informationat issue is undertaking sufficient
discoveryfor purposes of section 41(d).
Consistent with the legislative historyand case law as described
below, however,IRS and Treasury continue to believe thatsection 41
conditions credit eligibility onan attempt to discover information
thatgoes beyond the common knowledge ofskilled professionals in the
particular fieldof science or engineering.
The legislative history to the 1986 Act,which narrowed the
definition of the termqualified research, explained that
Congresshad originally enacted the research credit toencourage
business firms to perform theresearch necessary to increase the
innova-tive qualities and efficiency of the U.S.economy. H.R. Rep.
No. 99–426, at177–78; S. Rep. No. 99–313, at 694–95.Congress was
concerned that taxpayers hadapplied the original definition of
qualifiedresearch “too broadly,” that some taxpayershad claimed the
credit for “virtually anyexpenses relating to product
development”and that many of these taxpayers were “inindustries
that do not involve high technol-ogy or its application in
developing techno-logically new and improved products ormethods of
production.” Id. In an illustra-tion of the changes enacted, the
legislativehistory explained that, under the new defin-ition:
“Research does not rely on the prin-ciples of computer science
merely becausea computer is employed. Research may betreated as
undertaken to discover informa-tion that is technological in
nature, howev-er, if the research is intended to expand orrefine
existing principles of computer sci-ence.” H.R. Conf. Rep. No.
99–841, atII–71 n.3 (1986) (emphasis added).
Following the 1986 Act changes to thecredit, a discovery
requirement has beenapplied 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), andWICOR,
Inc. v. United States, 116 F.Supp. 2d 1028 (E.D. Wis. 2000).
In reaffirming the scope of the termqualified research, the
Conference Reportto the 1998 Act noted that:
2001–5 I.R.B. 435 January 29, 2001
-
evolutionary research activi-ties intended to improve
func-tionality, performance, relia-bility, or quality are
eligiblefor the credit, as are researchactivities intended to
achievea result that has already beenachieved by other persons
butis not yet within the commonknowledge (e.g., freely avail-able
to the general public) ofthe field (provided that theresearch
otherwise meets therequirements of section 41,including not being
excludedby subsection (d)(4)).
H.R. Conf. Rep. No. 105–825, at 1548(1998) (emphasis added). In
particular, itis noteworthy that the conferees clarifiedthat the
credit is available for researchintended to achieve a result that
has beenachieved by others but is not yet withinthe common
knowledge. The negativeinference is that the credit is not
availablefor research intended to achieve a resultthat has been
achieved by others and iswithin the common knowledge of
thefield.
The discovery requirement as set forthin the final regulations
also is consistentwith the legislative history to the 1999 Act(the
text of which is set forth above underBackground). In that
legislative history,for example, the conferees stated that:
[e]mploying existing tech-nologies in a particular fieldor
relying on existing princi-ples of engineering or scienceis
qualified research, if suchactivities are otherwise under-taken for
purposes of discov-ering information and satisfythe other
requirements undersection 41.
H.R. Conf. Rep. No. 106–478, at 132(emphasis added). By
referring separate-ly to a requirement that the research
beundertaken for purposes of discoveringinformation, this
legislative history againconfirmed that the phrase
“discoveringinformation” is a separate substantiverequirement and
not merely a phrase usedto link the term research with the types
ofinformation required as the subject of theresearch.
In light of the case law and the legisla-tive history, the final
regulations retain therequirement that a taxpayer seek to dis-
cover information that exceeds, expands,or refines the common
knowledge ofskilled professionals in the particular fieldof science
or engineering. However, con-sistent with the legislative history
to the1999 Act, IRS and Treasury have careful-ly considered
comments relating to the“common knowledge” standard, andmade a
number of changes to address spe-cific taxpayer concerns about the
discov-ery requirement.
In response to comments regarding theapplication of the
discovery requirement,the final regulations clarify that the
phrase“common knowledge of skilled profes-sionals in a particular
field of science orengineering” means information thatshould be
known to skilled professionalshad they performed, before the
research inquestion was undertaken, a reasonableinvestigation of
the existing level of infor-mation in the particular field of
science orengineering. Thus, in order to satisfy thediscovery
requirement, research must beundertaken for the purpose of
discoveringinformation that is beyond the knowledgethat should be
known to skilled profes-sionals had they performed a
reasonableinvestigation of the existing level ofknowledge in the
particular field of sci-ence or engineering. There is no
require-ment, however, that a taxpayer actuallyconduct such an
investigation in order toclaim the credit. To further clarify
theapplication of the discovery requirement,the final regulations
also state, as anexample, that trade secrets generally arenot
within the common knowledge ofskilled professionals because they
are notreasonably available to skilled profession-als not employed,
hired, or licensed by theowner of such trade secrets.
Also, in response to comments, the dis-covery requirement in the
final regula-tions has been reworded to refer to thecommon
knowledge of skilled profession-als in a particular field of
science or engi-neering (rather than a particular field
oftechnology or science, as in the proposedregulations). As in the
proposed regula-tions, the common knowledge of skilledprofessionals
is intended to serve as anobjective standard for the baseline
knowl-edge that a credit-eligible taxpayer mustseek to exceed,
expand, or refine. The ref-erence to the common knowledge ofskilled
professionals is not intended toimpose qualification requirements
on the
personnel that the taxpayer uses to con-duct qualified
research.
Several commentators raised concernsthat the discovery
requirement in the pro-posed regulations required that
taxpayersmust “prove a negative;” in response tothese concerns
about the potential burdenimposed on taxpayers to demonstrate
thatthey satisfy the discovery requirement,IRS and Treasury have
added to the finalregulations a rebuttable presumption. Thefinal
regulations provide that, if a taxpay-er demonstrates with credible
evidencethat research activities were undertaken toobtain the
information described in docu-mentation prepared before or during
theearly stages of the research and if thatdocumentation also sets
forth the basis forthe taxpayer’s belief that obtaining
thisinformation would exceed, expand, orrefine the common knowledge
of skilledprofessionals in the particular field of sci-ence or
engineering, then the researchactivities are presumed to satisfy
the dis-covery requirement. This rebuttable pre-sumption would
arise, however, only ifthe taxpayer cooperates with
reasonablerequests by the IRS for witnesses, infor-mation,
documents, meetings, and inter-views.
In a case where the rebuttable presump-tion arises, the final
regulations providethat the Commissioner may overcome
thispresumption by demonstrating that theinformation described in
the taxpayer’sdocumentation was within the commonknowledge of
skilled professionals in theparticular field of science or
engineering.That is, the Commissioner would have todemonstrate that
the information wouldhave been known to such skilled profes-sionals
had they performed (before theresearch was undertaken) a
reasonableinvestigation of the existing level of infor-mation in
the particular field of science orengineering.
By way of further clarification, a provi-sion has been added and
several exampleshave been changed or eliminated toremove any
implication that the underly-ing principles of science or
engineeringused in the research must themselves benovel. IRS and
Treasury recognize thatvirtually all research utilizes existing
sci-entific principles and technology. Therequirement that a
taxpayer seek toexceed, expand, or refine the commonknowledge of
skilled professionals does
January 29, 2001 436 2001–5 I.R.B.
-
not mean that the tools and principlesused in the attempt to
achieve the techno-logical advance must themselves bebeyond the
common knowledge.
Also, in response to commentators’suggestions, the final
regulations providethat a taxpayer is conclusively presumedto have
obtained knowledge that exceeds,expands, or refines the common
knowl-edge of skilled professionals in the rele-vant field of
science or engineering, if thattaxpayer was awarded a patent for
thebusiness component. Section 101 of title35 of the United States
Code provides that“[w]hoever invents or discovers any newand useful
process, machine, manufac-ture, or composition of matter, or any
newand useful improvement thereof, mayobtain a patent therefor,
subject to theconditions and requirements of [title 35].”Such an
invention or discovery may bepatentable if it was not previously
known,used, patented, or described, as set forth in35 U.S.C. 102,
and the differencesbetween the invention and the prior art aresuch
that the invention would not havebeen obvious to a person having
ordinaryskill in the relevant art. See 35 U.S.C.102.
The final regulations contain a patentsafe harbor because IRS
and Treasurybelieve that information leading to apatentable
invention constitutes informa-tion that exceeds, expands, or
refines thecommon knowledge of skilled profession-als in the
relevant field. Of course, quali-fication under the patent safe
harbor doesnot necessarily establish that the discov-ery
requirement is satisfied with respect toall of the research
associated with thepatentable invention (for example, someof the
research might relate to style).
The final regulations emphasize that apatent is not a
precondition for credit eli-gibility. Because not all research
suc-ceeds in achieving its objective and forother reasons, it is
obvious that not allresearch intended to discover informationthat
goes beyond the common knowledgeresults in a patent. Thus, the
absence of apatent should have no bearing on crediteligibility. The
factors underlying thedenial of a patent application, on the
otherhand, may be relevant to the determina-tion of whether the
discovery requirementis satisfied.
Because section 41(d)(3)(B) providesthat the credit is not
available for research
related to style, taste, cosmetic, or season-al design factors,
the patent safe harbordoes not include patents for design,
asdefined by 35 U.S.C. 171.
In light of these changes, modificationshave been made to
several examples in theproposed regulations, including an exam-ple
in the proposed regulations relating toresearch undertaken to
develop a new tire.This example has been moved to the sec-tion of
the final regulations that illustratesthe exclusion for research
conducted afterthe beginning of commercial production(discussed in
VII. Research AfterCommercial Production of this Preamble).
To address concerns expressed by anumber of commentators that
the commonknowledge standard may be difficult fortaxpayers and
examiners to apply, and maygive rise in practice to inconsistent
treat-ment of similarly situated taxpayers (espe-cially where
examiners have limitedexpertise in a particular scientific
field)IRS and Treasury have initiated measuresto promote fair and
consistent applicationof the discovery requirement and the
otherconditions for credit eligibility. Consistentwith the
suggestion of one commentator,IRS has met with Revenue Canada to
dis-cuss Canada’s joint industry/governmentinitiative to improve
administration of theCanadian research credit. IRS also hasmet with
various industry associations toform joint initiatives to devise
guidelinesfor the administration and examination ofthe credit in
particular industries. Similarefforts with respect to other
industrygroups are anticipated.
IV. Process of Experimentation
Commentators objected to §1.41–4(a)(5)of the proposed
regulations, which defines aprocess of experimentation to include a
pre-scribed four-step process. Commentatorsargued that while the
four-step process mayaccurately have described the pure scientif-ic
method of conducting experiments, com-mercial and industrial
practice does notalways conform precisely to such require-ments.
Commentators also argued that thefour-step process required by the
proposedregulations was adapted from a descriptionin the
legislative history of the 1986 Act thatwas included for
illustrative purposes andnot as a comprehensive definition of
theterm process of experimentation.
In light of these comments, the finalregulations provide that
taxpayers con-
ducting 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 clari-fication on the manner in which a processof
experimentation differs from researchand development in the
experimental orlaboratory sense, as required by§1.174–2(a). A
process of experimenta-tion is a process to evaluate more than
onealternative designed to achieve a resultwhere the capability or
method of achiev-ing that result is uncertain at the outset,but (in
contrast to expenditures that quali-fy under section 174) does not
include theevaluation of alternatives to establish theappropriate
design of a business compo-nent when the capability and method
fordeveloping or improving the businesscomponent are not uncertain.
See H.R.Conf. Rep. No. 99–841, at II–72 (“Theterm process of
experimentation means aprocess involving the evaluation of morethan
one alternative designed to achieve aresult where the means of
achieving thatresult is uncertain at the outset.”);
UnitedStationers, 163 F.3d at 446; Norwest, 110T.C. at 496.
V. Recordkeeping Requirement
Part of the four-step process of experi-mentation test
prescribed in §1.41–4(a)(5)of the proposed regulations was a
require-ment that taxpayers record the results oftheir experiments.
Maintaining that thisrequirement was particularly
burdensome,commentators argued that, in the industri-al or
commercial setting, the recording ofresults is not necessarily
inherent in abona fide process of experimentation.
For these reasons, the final regulationsdo not contain a
requirement that taxpay-ers record the results of their
experiments.Moreover, reference to the recording ofresults has been
eliminated from the illus-trative (non-mandatory) description of
afour-step process of experimentation.
To assist in the examination of claimsfor the credit and to
ensure that the creditis properly targeted to serve as an
incen-tive to engage in qualified research, thefinal regulations do
include a less burden-some contemporaneous
documentationrequirement. Under the final regulations,taxpayers
must prepare and retain writtendocumentation before or during the
earlystages of the research project that
2001–5 I.R.B. 437 January 29, 2001
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January 29, 2001 438 2001–5 I.R.B.
describes the principal questions to beanswered and the
information the taxpay-er seeks to obtain that exceeds, expands,or
refines the common knowledge ofskilled professionals in the
relevant fieldof science or engineering. Taxpayers alsomust comply
with the general recordkeep-ing requirements of section 6001.
As noted above, taxpayers may alsoavail themselves of a
rebuttable presump-tion that they satisfy the discoveryrequirement
if their contemporaneousdocumentation also sets forth the basis
forthe taxpayer’s belief that obtaining thisinformation would
exceed, expand, orrefine the common knowledge of
skilledprofessionals in the particular field of sci-ence or
engineering.
VI. The Shrinking-back Rule
Under §1.41–4(b) of the proposed regu-lations, and consistent
with the legislativehistory to the 1986 Act, if the requirementsof
section 41(d) are not met for an entireproduct, then the credit may
be availablewith respect to the next most significantsubset of
elements of that product. Thisshrinking back continues until either
a sub-set of elements of the product that satisfiesthe requirements
is reached, or the mostbasic element of the product is reached
andsuch element fails to satisfy the test.
The final regulations clarify that thisshrinking-back rule
applies only if the tax-payer incurs some research expenses
withrespect to the overall business componentthat would constitute
qualified researchexpenses with respect to that business com-ponent
but for the fact that less than sub-stantially all of the research
activities withrespect to that component constitute ele-ments of a
process of experimentation thatrelates to a new or improved
function, per-formance, reliability or quality. In caseswhere the
substantially-all test is satisfiedwith respect to the overall
business compo-nent, those research expenses with respectto the
overall business component that arequalified research expenses are
credit eligi-ble, and there is no need for a taxpayer toshrink back
to apply the tests with respectto subsets of elements of the
business com-ponent. Of course, the mere fact that tax-payers are
not required to shrink back to asmaller business component does not
meanthat all of the research expenses withrespect to the overall
credit are credit eligi-ble. Research expenses that are not
quali-
fied research expenses, for examplebecause they relate to style,
taste, cosmetic,or seasonal design factors, remain ineligiblefor
the credit.
In response to commentators’ sugges-tions, the final regulations
also clarify that,if the original product is not eligible for
thecredit, the application of the shrinking-backrule may result in
credit eligibility for mul-tiple business components that are
subsetsof the original product. The regulationsclarify that the
shrinking-back rule may notitself be applied as a reason to
excluderesearch activities from credit eligibility.Finally, an
example has been added to illus-trate these concepts.
VII. Research After CommercialProduction
Several commentators addressed the sec-tion of the proposed
regulations providingthat activities conducted after the
beginningof commercial production of a businesscomponent are not
qualified research.Under the proposed regulations, activitiesare
conducted after the beginning of com-mercial production of a
business compo-nent if such activities are conducted afterthe
component is developed to the pointwhere it is ready for commercial
sale oruse, or meets the basic functional and eco-nomic
requirements of the taxpayer for thecomponent’s sale or use.
Moreover, certainspecified activities (like preproductionplanning
for a finished business componentand trial production runs) are
deemed tooccur after the beginning of commercialproduction.
Because the provisions set forth aboveclosely reflect the
legislative history of thepost-production exclusion, these tests
havebeen retained in the final regulations. SeeH.R. Conf. Rep. No.
841, at II–74–75.However, several changes have been madein response
to commentators’ concerns.
First, a change has been made to the listof activities that are
per se deemed to occurafter the beginning of commercial
produc-tion. In the proposed regulations, one of theitems on that
list was “debugging or cor-recting flaws in a business
component.”Consistent with the legislative history, IRSand Treasury
continue to believe thatdebugging should be conclusively pre-sumed
to occur after the beginning of com-mercial production. However,
many activi-ties conducted before the beginning ofcommercial
production could be construed
as the correction of flaws. Thus, the per selist contained in
the final regulations hasbeen changed to refer to debugging
activi-ties but not to the correction of flaws.
Second, an example has been added toclarify that a new research
project toimprove a business component is not dis-qualified merely
because the new researchproject commences after the
commercialproduction of the unimproved businesscomponent. Other
examples have beenchanged to eliminate references to and fac-tual
assertions about specific industries.
Third, the final regulations incorporateprovisions from the
legislative history to the1986 Act that clinical testing of a
pharma-ceutical product prior to its commercialproduction in the
United States is not treat-ed as occurring after the beginning of
com-mercial production even if the product iscommercially available
in other countries,and that additional clinical testing of a
phar-maceutical product after a product has beenapproved for a
specific therapeutic use bythe Food and Drug Administration and
isready for commercial production and saleare not treated as
occurring after the begin-ning of commercial production if such
clin-ical tests are undertaken to establish newfunctional uses,
characteristics, indications,combinations, dosages, or delivery
formsfor the product.
VIII. Adaptation
Several commentators suggested alter-nate formulations of the
adaptation exclu-sion. Because such formulations effective-ly would
render the adaptation exclusioninapplicable to activities that
satisfy theother requirements for qualified research,thereby
reading the exclusion out of theInternal Revenue Code, the final
regula-tions do not adopt the suggestions.
Two new examples clarify that the adap-tation exclusion may also
apply to contractresearch expenses paid by the customer tothe
vendor or to in-house research expensesincurred by the customer
itself to adapt anexisting business component to that cus-tomer’s
requirement or need.
IX. Internal-use Software
As noted above, the 1997 proposed regu-lations describe when
software that isdeveloped by (or for the benefit of) a tax-payer
primarily for the taxpayer’s internaluse can qualify for the
credit. The final reg-ulations incorporate these special provi-
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2001–5 I.R.B. 439 January 29, 2001
sions for internal-use software. A numberof changes have been
made to the 1997proposed regulations to address commenta-tor
concerns, and to coordinate the internal-use provisions with the
other provisions ofthe final regulations.
Under the proposed regulations, researchwith respect to software
developed primar-ily for a taxpayer’s internal use is
qualifiedresearch only if it satisfies both the generalrequirements
for credit eligibility undersection 41 and an additional condition
foreligibility. Except for certain softwaredeveloped for use in
conducting qualifiedresearch or for use in a production process,and
for certain software created as part of apackage of hardware and
software devel-oped concurrently, the additional conditionfor
eligibility is a requirement that the tax-payer satisfy a
three-part test (requiring thatthe internal-use software be
innovative, thatits development involve significant eco-nomic risk,
and that it not be commerciallyavailable).
Most of the comments received focusedon two issues — (1) the
determination ofwhen software is developed primarily forinternal
use, and (2) the application of thethree-part test to internal-use
software. Onthe first issue, several commentators urgedthat
internal-use software be defined toexclude any software used to
deliver a ser-vice to customers or any software thatincludes an
interface with customers or thepublic. After careful analysis of
the leg-islative history to the 1986 Act and the1999 Act, however,
IRS and Treasury con-cluded that such a broad exclusion wouldbe
inconsistent with the statutory mandate,because the exclusion would
extend tosome software that Congress clearlyintended to treat as
internal-use software.At the same time, IRS and Treasury sharethe
commentators’ belief that the goals ofthe research credit may be
advanced byremoving additional conditions for credit-eligibility in
the case of certain internal-usesoftware used to provide new
features toservices offered to customers that are nototherwise
available to them. Accordingly,as described in more detail below,
the finalregulations retain the definition of internal-use software
contained in the proposed reg-ulations, but provide a new exception
(pur-suant to the regulatory authority undersection 41(d)(4)(E))
under which the devel-opment of certain internal-use softwareused
to deliver noncomputer services to
customers with features that are not yetoffered by a taxpayer’s
competitors is notsubject to the three-part test.
Consistent with a statement in theConference Report to the 1999
Act thatsoftware research undertaken to support theprovision of a
service should not bedeemed internal-use software “solelybecause
the business component involvesthe provision of a service,” the
final regula-tions clarify that the determination ofwhether
software is internal-use softwaredepends on the nature of the
service pro-vided by the taxpayer. Software that isintended to be
used to provide noncomput-er services to customers is internal-use
soft-ware, while software that is to be used toprovide computer
services is not developedprimarily for internal use. Computer
ser-vices are services offered by a taxpayer tocustomers who do
business with the tax-payer primarily for the use of the
taxpayer’scomputer or software technology.Noncomputer services are
services offeredby a taxpayer to customers who do businesswith the
taxpayer primarily to obtain a ser-vice other than a computer
service, even ifsuch other service is enabled, supported,
orfacilitated by computer or software tech-nology.
The conclusion that software used toprovide noncomputer services
is internal-use software is consistent with the legisla-tive
history to the 1986 Act, which definedinternal-use software as
software used ingeneral administrative functions and soft-ware used
in providing noncomputer ser-vices (such as accounting, consulting,
orbanking services). See H.R. Conf. Rep.No. 841, at II–73 (emphasis
added).
As noted above, the final regulationscontain a new exception
under which a tax-payer is not required to establish that
inter-nal-use software used to provide noncom-puter services
containing features orimprovements that are not yet offered by
ataxpayer’s competitors satisfies the three-part test. Software
that is intended to beused to provide noncomputer services
isdescribed within the exception if the soft-ware is designed to
provide customers anew feature with respect to a
noncomputerservice; the taxpayer reasonably anticipat-ed that
customers would choose to obtainthe noncomputer service from the
taxpayer(rather than from the taxpayer’s competi-tors) because of
those features of the ser-vice that will be provided by the
software;
and those features are not available (at thetime the research is
undertaken) from anyof the taxpayer’s competitors.
No inference should be drawn that soft-ware described within the
foregoing excep-tion is not internal-use software or
thatinternal-use software not described withinthe exception would
fail the three-part test.Rather, the exception reflects a
determina-tion by IRS and Treasury that it is appro-priate to
exercise the regulatory authority insection 41(d)(4)(E) to exempt
certain inter-nal-use software from having to fulfil addi-tional
conditions for credit eligibility. Thisexercise of regulatory
authority is based ona determination that the development
ofsoftware containing features or improve-ments that are not
available from a taxpay-er’s competitors and that provide a
demon-strable competitive advantage is morelikely to increase the
innovative qualitiesand efficiency of the U.S. economy
(bygenerating knowledge that can be used byother service providers)
than is the devel-opment of software used to provide non-computer
services containing features orimprovements that are already
offered byothers. IRS and Treasury believe thatdrawing such a line
is an appropriate way toadminister the credit with a view to
identi-fying and facilitating the credit availabilityfor software
with the greatest potential forbenefitting the U.S. economy, an
importantrationale for the research credit.
The final regulations also make a num-ber of changes with
respect to the three-part high threshold of innovation test,which
continues to apply to certain soft-ware not described within the
new excep-tion. For example, commentators hadquestioned whether the
1997 proposedregulations impose a separate high thresh-old of
innovation requirement that servesas an additional condition for
credit eligi-bility, even where taxpayers otherwisesatisfy the
three-part test. The final regu-lations clarify that the three-part
test is thehigh threshold of innovation test, and nota separate
requirement. Similarly, com-mentators had objected to a sentence
inthe 1997 proposed regulations that couldbe read to suggest that
certain internal-usesoftware could never qualify for the cred-it.
The final regulations clarify thatresearch with respect to
internal-use soft-ware that satisfies both the general condi-tions
for credit eligibility and the three-part test is eligible for the
credit.
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January 29, 2001 440 2001–5 I.R.B.
Consistent with the application of thediscovery requirement, the
final regulationsadopt the suggestion of several commenta-tors that
the three-part test should beapplied without regard to whether the
tax-payer succeeds in achieving the resultsdescribed in that
test.
Commentators questioned whether the“as where” clauses used to
elaborate on thethree requirements of the high threshold
ofinnovation test in the 1997 proposed regula-tions were intended
as mandatory require-ments or merely as illustrations of ways
inwhich taxpayers could satisfy the tests. Byreplacing the “as
where” clauses with “inthat” clauses, the final regulations
confirmthat a taxpayer must satisfy the provisions,as elaborated.
Consistent with this clarifi-cation, the final regulations provide
that theinnovative prong of the three-part test maybe satisfied
with respect to any intendedimprovement, not just reductions in
cost orimprovements in speed.
Under the final regulations, all qualifiedresearch, including
research with respect tointernal-use software, must satisfy the
dis-covery requirement (that is, must be intend-ed to exceed,
expand, or refine the commonknowledge of skilled professionals in
theparticular field of science or engineering).The final
regulations clarify how the three-part high threshold of innovation
test sup-plements the discovery requirement.Specifically, the final
regulations providethat several aspects of the three-part test(the
determination of whether the softwareis intended to result in an
improvement thatis substantial and economically significantand the
extent of uncertainty and technicalrisk) also must be applied with
respect tothe common knowledge of skilled profes-sionals. In
essence, the common knowl-edge of skilled professionals rather than
theknowledge base of the taxpayer’s employ-ees is treated as the
baseline with respect towhich the intended software must satisfythe
innovative prong and other prongs ofthe three-part test. Stated
differently,research with respect to internal-use soft-ware is
credit eligible only if it is intendedto exceed, expand, or refine
the commonknowledge of skilled professionals (asdefined in
§1.41–4(a)(3)(ii)) to a degreethat is substantial and economically
signifi-cant. See Norwest 110 T.C. at 499–500(stating that “...the
extent of the improve-ments required by Congress with respect
tointernal use software is much greater than
that required in other fields” and that “...thesignificant
economic risk test requires ahigher threshold of technological
advance-ment in the development of internal usesoftware than in
other fields”).
Reference to the common knowledge ofskilled professionals as the
baseline is nec-essary to give proper meaning to the statu-tory
three-part test. For example, if theinnovative requirement was
applied simplywith respect to the prior state of the taxpay-er’s
own business, then ordinary inventorysoftware installed by a
taxpayer who previ-ously tracked its inventory manually couldbe
deemed to satisfy the innovative require-ment merely because the
taxpayer hadachieved a substantial and economicallysignificant
improvement in speed over itsprior non-automated operations.
Although the final regulations related tointernal use software
generally are effectivefor taxable years beginning after
December31, 1985, the provisions relating to softwaredeveloped for
use in providing computerand noncomputer services to customers
andthe provisions clarifying the interaction ofthe three-part test
with the discoveryrequirement, like other provisions concern-ing
the discovery requirement, are effectiveonly prospectively;
however, taxpayers mayrely on these rules for expenditures paid
orincurred prior to January 3, 2001.
X. Alternative Incremental Credit
Certain commentators suggested thattaxpayers be permitted to
elect the alter-native incremental credit on an amendedreturn.
However, IRS and Treasurybelieve that the intended incentive
effectsof the credit would not be advanced bypermitting taxpayers
to make retroactiveelections to alter the computation of
(andpresumably increase) the credit for prioryears. Similarly, the
availability of aretroactive election would undermine
theapplication of section 41(c)(4)(B). Thus,the final regulations
retain the require-ment contained in the proposed regula-tions that
the election to apply the provi-sions of the alternative
incremental creditmust be made on the taxpayer’s timelyfiled
original return.
Effective Dates
In general, the regulations are applica-ble for expenditures
paid or incurred on orafter January 3, 2001. However, the regu-
lations addressing the base amount areapplicable for taxable
years beginning onor after January 3, 2001. The
regulationsaddressing internal-use software areapplicable for
taxable years beginningafter December 31, 1985. However,§ 1 . 4 1 –
4 ( c ) ( 6 ) ( i i ) ( C ) ( 4 ) ,§1.41–4(c)(6)(iv)(A) and
(B),§1.41–4(c)(6)(v), the second and thirdsentences of
§1.41–4(c)(6)(vii), and§1.41–4(c)(6)(viii) Example 2 are
applic-able for expenditures paid or incurred onor after January 3,
2001. The special doc-umentation requirements of §1.41–4(d)are
applicable with respect to researchprojects that begin on or after
March 4,2001. The regulations providing for theelection and
revocation of the alternativeincremental credit are applicable for
tax-able years ending on or after January 3,2001. No inference
should be drawn fromthe applicability date concerning
theapplication of section 41 to expenditurespaid or incurred or the
computation of thebase amount before the applicability date.
Special Analyses
It has been determined that these regu-lations are not a
significant regulatoryaction as defined in Executive Order12866.
Therefore, a regulatory assess-ment is not required. It also has
beendetermined that section 553(b) of theAdministrative Procedure
Act (5 U.S.C.chapter 5) does not apply to these regula-tions.
It is hereby certified that the collectionof information
contained in these regula-tions will not have a significant
economicimpact on a substantial number of smallentities. This
certification is based on thefact that the rules of this section
impactonly taxpayers who engage in qualifiedresearch. Moreover, in
those instanceswhere the rules of this section impact
smallentities, the economic impact is not likelyto be significant
because it merely requirestaxpayers to (1) prepare (before or
duringthe early stages of a research project) andretain written
documentation describingthe principal questions to be answered
andthe information the taxpayer seeks toobtain that satisfies the
requirements of§1.41–4(a)(3) of these regulations; (2) electon Form
6765, “Credit for IncreasingResearch Activities,” to use the
alternativeincremental credit if the entity desires touse that
method; and (3) obtain permission
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2001–5 I.R.B. 441 January 29, 2001
to revoke the alternative incremental creditelection, if so
desired. Further, the eco-nomic impact of electing the
alternativeincremental credit on Form 6765 alsowould not be
significant because the elec-tion is made on the same form and is
basedon the same information that is used toclaim the research
credit. Accordingly, aregulatory flexibility analysis under
theRegulatory Flexibility Act (5 U.S.C. chap-ter 6) is not
required.
Pursuant to section 7805(f), the noticeof proposed rulemaking
preceding theseregulations was submitted to the ChiefCounsel for
Advocacy of the SmallBusiness Administration for comment onits
impact on small business.
Drafting Information
The principal authors of these regula-tions are Lisa J. Shuman
and Leslie H.Finlow of the Office of the AssociateChief Counsel
(Passthroughs and SpecialIndustries), IRS. However, personnelfrom
other offices of the IRS and theTreasury Department participated in
theirdevelopment.
Adoption of Amendments to theRegulations
Accordingly, 26 CFR parts 1 and 602are amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation forpart 1 continues to read
in part as follows:
Authority: 26 U.S.C. 7805 * * *Par. 2. Revise the undesignated
center-
heading immediately before §1.30–1 toread as follows:
CREDITS ALLOWABLE UNDERSECTIONS 30 THROUGH 44B
Par. 3. Remove the undesignated cen-terheading immediately
before §1.41–0.
Par. 4. Section 1.41–0 is revised to readas follows:
§1.41–0 Table of contents.
This section lists the paragraphs con-tained in
§§1.41–1 through 1.41–8 as follows:
§1.41–1 Credit for increasing researchactivities.
(a) Amount of credit.
(b) Introduction to regulations under sec-tion 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
partnershipsand joint ventures.(b) Supplies and personal property
used inthe 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
taxableyears 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 yearsbeginning 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 credityear.(3)
Short taxable year in determiningfixed-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 forexpenditures paid or incurred on
or afterJanuary 3, 2001.
(a) Qualified research. (1) General rule.(2) Requirements of
section 41(d)(1).(3) Undertaken for the purpose of discov-ering
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
informationtechnology.(8) Illustrations.(b) Application of
requirements for quali-fied 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 tothe business
component.(iii) Activities related to productionprocess or
technique.(iv) Clinical testing.(3) Adaptation of existing business
com-ponents.(4) Duplication of existing business com-ponent.(5)
Surveys, studies, research relating tomanagement functions, etc.
(6) Internal-use computer software.(i) General rule.(ii)
Requirements.(iii) Primarily for internal use. (iv) Software used
in the provision of ser-vices.(A) Computer services.(B) Noncomputer
services. (v) Exception for certain software used inproviding
noncomputer services.(vi) High threshold of innovation test.(vii)
Application of high threshold ofinnovation 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 researchexpenses. (iii)
Apportionment of contract researchexpenses.
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January 29, 2001 442 2001–5 I.R.B.
(8) Research in the social sciences, etc.(9) Research funded by
any grant, con-tract, or otherwise.(10) Illustrations. (d)
Documentation.(e) Effective dates.
§1.41–5 Basic research for taxable yearsbeginning after December
31, 1986.[Reserved]
§1.41–6 Aggregation of expenditures.
(a) Controlled group of corporations;trades or businesses under
common con-trol.(1) In general.(2) Definition of trade or
business.(3) Determination of common control.(4) Examples.(b)
Minimum base period researchexpenses.(c) Tax accounting periods
used.(1) In general.(2) Special rule where timing of researchis
manipulated.(d) Membership during taxable year inmore 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
undersubchapter S.(i) Pass-through, for taxable years begin-ning
after December 31, 1982, in the caseof an S corporation.(ii)
Pass-through, for taxable years begin-ning before January 1, 1983,
in the case ofa subchapter S corporation.(2) Pass-through in the
case of an estate ortrust.(3) Pass-through in the case of a
partner-ship.(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 acquisitionsand
dispositions—Meaning of terms.(c) Special rule for pass-through of
credit.(d) Carryback and carryover of unusedcredits.
§1.41–8 Special rules for taxable yearsending 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 readas follows:
§1.41–1 Credit for increasing researchactivities.
(a) Amount of credit. The amount of ataxpayer’s credit is
determined under sec-tion 41(a). For taxable years beginningafter
June 30, 1996, and at the election ofthe taxpayer, the portion of
the creditdetermined under section 41(a)(1) may becalculated using
the alternative incremen-tal credit set forth in section
41(c)(4).
(b) Introduction to regulations undersection 41. (1) Sections
1.41–2 through1.41–8 and 1.41–3A through 1.41–5Aaddress only
certain provisions of section41. The following table identifies the
pro-visions of section 41 that are addressed,and lists each
provision with the sectionof the regulations in which it is
covered.
Section of the Section of theregulation Internal Revenue
Code
§1.41–2 41(b)
§1.41–3 41(c)
§1.41–4 41(d)
§1.41–5 41(e)
§1.41–6 41(f)
§1.41–7 41(f)41(g)
§1.41–8 41(c)
§1.41–3A 41(c) (taxable years beginning before January 1,
1990)
§1.41–4A 41(d) (taxable years beginning before January 1,
1986)
§1.41–5A 41(e) (taxable years beginning before January 1,
1987)
(2) Section 1.41–3A also addresses thespecial rule in section
221(d)(2) of theEconomic Recovery Tax Act of 1981relating to
taxable years overlapping theeffective dates of section 41. Section
41was formerly designated as sections 30
and 44F. Sections 1.41–0 through 1.41–8and 1.41–0A through
1.41–5A refer tothese sections as section 41 for conformi-ty
purposes. Whether section 41, formersection 30, or former section
44F appliesto a particular expenditure depends upon
when the expenditure was paid orincurred.
§1.41-2 [Amended]
Par. 6. Section 1.41-2 is amended asfollows:
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2001–5 I.R.B. 443 January 29, 2001
1. The last sentence of paragraph(a)(3)(i) is amended by
removing the lan-guage “§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 lan-guage “§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 thelanguage “§1.41–9(a)(3)(ii)” and
adding“§1.41–7(a)(3)(ii)” in its place.
4. Paragraph (e)(1)(i) is amended byremoving the language
“§1.41–5” andadding “§1.41–4 or 1.41–4A, whicheveris applicable” in
its place.
§§1.41–0A through 1.41–8A[Removed]
Par. 6A. Sections 1.41–0A through1.41–8A and the undesignated
center-heading preceding these sections areremoved.
Par. 7. An undesignated centerheadingis added immediately
following §1.44B–1to read as follows:
RESEARCH CREDIT—FORTAXABLE 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 undes-ignated centerheading “RESEARCHCREDIT—FOR
TAXABLE YEARSBEGINNING BEFORE JANUARY 1,1990.”
Par. 9. New §1.41–3 is added to read asfollows:
§1.41–3 Base amount for taxable yearsbeginning on or after
January 3, 2001.
(a) New taxpayers. If, with respect toany credit year, the
taxpayer has not beenin existence for any previous taxable year,the
average annual gross receipts of thetaxpayer for the four taxable
years pre-ceding the credit year shall be zero. If,with respect to
any credit year, the tax-payer has been in existence for at least
oneprevious taxable year, but has not been inexistence for four
taxable years precedingthe taxable year, then the average
annualgross receipts of the taxpayer for the fourtaxable years
preceding the credit yearshall be the average annual gross
receipts
for the number of taxable years precedingthe credit year for
which the taxpayer hasbeen in existence.
(b) Special rules for short taxableyears—(1) Short credit year.
If a credityear is a short taxable year, then the baseamount
determined under section 41(c)(1)(but not section 41(c)(2)) shall
be modi-fied by multiplying that amount by thenumber of months in
the short taxableyear and dividing the result by 12.
(2) Short taxable year preceding credityear. If one or more of
the four taxableyears preceding the credit year is a shorttaxable
year, then the gross receipts forsuch year are deemed to be equal
to thegross receipts actually derived in that yearmultiplied by 12
and divided by the num-ber of months in that year.
(3) Short taxable year in determiningfixed-base percentage. No
adjustmentshall be made on account of a short tax-able year to the
computation of a taxpay-er’s fixed-base percentage.
(c) Definition of gross receipts—(1) Ingeneral. For purposes of
section 41, grossreceipts means the total amount, as deter-mined
under the taxpayer’s method ofaccounting, derived by the taxpayer
fromall its activities and from all sources (e.g.,revenues derived
from the sale of inventorybefore reduction for cost of goods
sold).
(2) Amounts excluded. For purposes ofthis paragraph (c), gross
receipts do notinclude amounts representing—
(i) Returns or allowances;(ii) Receipts from the sale or
exchange
of capital assets, as defined in section1221;
(iii) Repayments of loans or similarinstruments (e.g., a
repayment of the prin-cipal amount of a loan held by a commer-cial
lender);
(iv) Receipts from a sale or exchangenot in the ordinary course
of business,such as the sale of an entire trade or busi-ness or the
sale of property used in a tradeor business as defined under
section1221(2);
(v) Amounts received with respect tosales tax or other similar
state and localtaxes if, under the applicable state or locallaw,
the tax is legally imposed on the pur-chaser of the good or
service, and the tax-payer merely collects and remits the tax tothe
taxing authority; and
(vi) Amounts received by a taxpayer ina taxable year that
precedes the first tax-
able year in which the taxpayer derivesmore than $25,000 in
gross receipts otherthan investment income. For purposes ofthis
paragraph (c)(2)(vi), investmentincome is interest or distributions
withrespect to stock (other than the stock of a20-percent owned
corporation as definedin section 243(c)(2).
(3) Foreign corporations. For purposesof section 41, in the case
of a foreign cor-poration, gross receipts include only
grossreceipts that are effectively connectedwith the conduct of a
trade or businesswithin the United States, theCommonwealth of
Puerto Rico, or otherpossessions of the United States. See sec-tion
864(c) and applicable regulationsthereunder for the definition of
effectivelyconnected income.
(d) Consistency requirement—(1) Ingeneral. In computing the
credit forincreasing research activities for taxableyears beginning
after December 31, 1989,qualified research expenses and
grossreceipts taken into account in computing ataxpayer’s
fixed-base percentage and ataxpayer’s base amount must be
deter-mined on a basis consistent with the defi-nition of qualified
research expenses andgross receipts for the credit year,
withoutregard to the law in effect for the taxableyears taken into
account in computing thefixed-base percentage or the base
amount.This consistency requirement applies evenif the period for
filing a claim for credit orrefund has expired for any taxable
yeartaken into account in computing the fixed-base percentage or
the base amount.
(2) Illustrations. The following exam-ples illustrate the
application of the con-sistency rule of paragraph (d)(1) of
thissection:
Example 1. (i) X, an accrual method taxpayerusing the calendar
year as its taxable year, incursqualified research expenses in
2001. X wants tocompute its research credit under section 41 for
thetax year ending December 31, 2001. As part of thecomputation, X
must determine its fixed-base per-centage, which depends in part on
X’s qualifiedresearch expenses incurred during the
fixed-baseperiod, the taxable years beginning after December31,
1983, and before January 1, 1989.
(ii) During the fixed-base period, X reported thefollowing
amounts as qualified research expenses onits Form 6765:
1984 . . . . . . . . . . . . . . . . . . . . . . .$ 100x1985 . .
. . . . . . . . . . . . . . . . . . . . . . 120x1986 . . . . . . .
. . . . . . . . . . . . . . . . . 150x1987 . . . . . . . . . . . .
. . . . . . . . . . . . 180x1988 . . . . . . . . . . . . . . . . .
. . . . . . . 170xTotal . . . . . . . . . . . . . . . . . . . . . .
.$ 720x
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January 29, 2001 444 2001–5 I.R.B.
(iii) For the taxable years ending December 31,1984, and
December 31, 1985, X based the amountsreported as qualified
research expenses on the defini-tion of qualified research in
effect for those taxableyears. The definition of qualified research
changed fortaxable years beginning after December 31, 1985. If
Xused the definition of qualified research applicable toits taxable
year ending December 31, 2001, the credityear, its qualified
research expenses for the taxableyears ending December 31, 1984,
and December 31,1985, would be reduced to $ 80x and $ 100x,
respec-tively. Under the consistency rule in section 41(c)(5)and
paragraph (d)(1) of this section, to compute theresearch credit for
the tax year ending December 31,2001, X must reduce its qualified
research expensesfor 1984 and 1985 to reflect the change in the
defini-tion of qualified research for taxable years beginningafter
December 31, 1985. Thus, X’s total qualifiedresearch expenses for
the fixed-base period (1984-1988) to be used in computing the
fixed-base percent-age is $ 80 + 100 + 150 + 180 + 170 = $
680x.
Example 2. The facts are the same as in Example1, except that,
in computing its qualified researchexpenses for the taxable year
ending December 31,2001, X claimed that a certain type of
expenditureincurred in 2001 was a qualified research expense.X’s
claim reflected a change in X’s position, becauseX had not
previously claimed that similar expendi-tures were qualified
research expenses. The consis-tency rule requires X to adjust its
qualified researchexpenses in computing the fixed-base percentage
toinclude any similar expenditures not treated as qual-ified
research expenses during the fixed-base period,regardless of
whether the period for filing a claim forcredit or refund has
expired for any year taken intoaccount in computing the fixed-base
percentage.
(e) Effective date. The rules in para-graphs (c) and (d) of this
section areapplicable for taxable years beginning onor after the
date final regulations are pub-lished in the Federal Register.
Par. 10. Section 1.41-4 is revised toread as follows:
§1.41-4 Qualified research forexpenditures paid or incurred on
or afterJanuary 3, 2001.
(a) Qualified research—(1) General rule.Research activities
related to the develop-ment or improvement of a business compo-nent
constitute qualified research only if theresearch activities meet
all of the require-ments of section 41(d)(1) and this section,and
are not otherwise excluded under section41(d)(3)(B) or (d)(4), or
this section.
(2) Requirements of section 41(d)(1).Research constitutes
qualified researchonly if it is research—
(i) With respect to which expendituresmay be treated as expenses
under section174, see §1.174-2;
(ii) That is undertaken for the purposeof discovering
information that is techno-logical in nature, and the application
of
which is intended to be useful in thedevelopment of a new or
improved busi-ness component of the taxpayer; and
(iii) Substantially all of the activities ofwhich constitute
elements of a process ofexperimentation that relates to a new
orimproved function, performance, reliabil-ity or quality.
For certain recordkeeping require-ments, see paragraph (d) of
this section.
(3) Undertaken for the purpose of dis-covering information—(i)
In general. Forpurposes of section 41(d) and this section,research
is undertaken for the purpose ofdiscovering information only if it
isundertaken to obtain knowledge thatexceeds, expands, or refines
the commonknowledge of skilled professionals in aparticular field
of science or engineering.A determination that research is
undertak-en for the purpose of discovering informa-tion does not
require that the taxpayersucceed in obtaining the knowledge
thatexceeds, expands, or refines the commonknowledge of skilled
professionals in aparticular field of science or engineering,nor
does it require that the advance soughtbe more than evolutionary.
However,research is not undertaken for the purposeof discovering
information merelybecause an expenditure may be treated asan
expense under section 174.
(ii) Common knowledge. Commonknowledge of skilled professionals
in aparticular field of science or engineeringmeans information
that should be knownto skilled professionals had they per-formed,
before the research in question isundertaken, a reasonable
investigation ofthe existing level of information in theparticular
field of science or engineering.Thus, knowledge may, in certain
circum-stances, exceed, expand, or refine thecommon knowledge of
skilled profession-als in a particular field of science or
engi-neering even though such knowledge haspreviously been obtained
by other per-sons. For example, trade secrets general-ly are not
within the common knowledgeof skilled professionals in a
particularfield of science or engineering becausethey are not
reasonably available toskilled professionals not employed, hired,or
licensed by the owner of such tradesecrets.
(iii) Means of discovery. In seeking toobtain knowledge that
exceeds, expands,or refines the common knowledge of
skilled professionals in a particular fieldof science or
engineering, a taxpayer mayemploy existing technologies in a
particu-lar field and may rely on existing princi-ples of science
or engineering.
(iv) Patent safe harbor. For purposesof section 41(d) and
paragraph (a)(3)(i) ofthis section, the issuance of a patent by
thePatent and Trademark Office under theprovisions of section 151
of title 35,United States Code (other than a patentfor design
issued under the provisions ofsection 171 of title 35, United
StatesCode) is conclusive evidence that a tax-payer has obtained
knowledge thatexceeds, expands, or refines the commonknowledge of
skilled professionals.However, the issuance of such a patent isnot
a precondition for credit availability.
(v) Rebuttable presumption. If a tax-payer demonstrates with
credible evidencethat research activities were undertaken toobtain
the information described in thetaxpayer’s contemporaneous
documenta-tion required under paragraph (d)(1) ofthis section, and
if that documentation alsosets forth the basis for the taxpayer’s
beliefthat obtaining this information wouldexceed, expand, or
refine the commonknowledge of skilled professionals in
theparticular field of science or engineering,the research
activities are presumed to sat-isfy the requirements of this
paragraph(a)(3). However, the presumption appliesonly if the
taxpayer cooperates with rea-sonable requests by the Commissioner
forwitnesses, information, documents, meet-ings, and interviews.
Furthermore, theCommissioner may overcome the pre-sumption in this
paragraph if theCommissioner demonstrates that the infor-mation
described in the taxpayer’s docu-mentation was within the common
knowl-edge of skilled professionals (as describedin paragraph
(a)(3)(ii) of this section), orthat the research activities were
not under-taken to obtain the information describedin the
taxpayer’s documentation.
(4) Technological in nature. For pur-poses of section 41(d) and
this section,information is technological in nature ifthe process
of experimentation used todiscover such information
fundamentallyrelies on principles of the physical or bio-logical
sciences, engineering, or computerscience.
(5) Process of experimentation. Forpurposes of section 41(d) and
this section,
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2001–5 I.R.B. 445 January 29, 2001
a process of experimentation is a processto evaluate more than
one alternativedesigned to achieve a result where thecapability or
method of achieving thatresult is uncertain at the outset. A
processof experimentation does not include theevaluation of
alternatives to establish theappropriate design of a business
compo-nent, if the capability and method fordeveloping or improving
the businesscomponent are not uncertain. A processof
experimentation in the physical or bio-logical sciences,
engineering, or computerscience may involve—
(i) Developing one or more hypothesesdesigned to achieve the
intended result;
(ii) Designing an experiment (that,where appropriate to the
particular field ofresearch, is intended to be replicable withan
established experimental control) totest and analyze those
hypotheses(through, for example, modeling, simula-tion, or a
systematic trial and errormethodology);
(iii) Conducting the experiment; and (iv) Refining or discarding
the hypotheses
as part of a sequential design process todevelop or improve the
business component.
(6) Substantially all requirement. Thesubstantially all
requirement of section41(d)(1)(C) and paragraph (a)(2)(iii) of
thissection is satisfied only if 80 percent ormore of the research
activities, measuredon a cost or other consistently applied
rea-sonable basis (and without regard to §1.41-2(d)(2)), constitute
elements of a process ofexperimentation for a purpose described
insection 41(d)(3). The substantially allrequirement is applied
separately to eachbusiness component.
(7) Use of computers and informationtechnology. The employment
of comput-ers or information technology, or thereliance on
principles of computer scienceor information technology to store,
col-lect, manipulate, translate, disseminate,produce, distribute,
or process data orinformation, and similar uses of comput-ers and
information technology does notitself establish that qualified
research hasbeen undertaken.
(8) Illustrations. The following exam-ples illustrate the
application of this para-graph (a):
Example 1. (i) Facts. X and other ma