| it develops
and conducts sophisticated engineering tests on several alternative
designs for a new type of belt to be used in tread cooling until it
successfully achieves a design that meets its requirements. The taxpayer
then manufactures a set of belts for its production equipment, installs
the belts, and tests the belts to make sure they were manufactured
correctly. The taxpayer's research with respect to the design of the
new belts to be used in its manufacturing of the new tire may be qualified
research under the Four-Part Test. However, the taxpayer's expenses
to implement the new belts, including the costs to manufacture, install,
and test the belts were incurred after the belts met the taxpayer's
functional and economic requirements and are excluded as research
after commercial production.
(ii) Example 2. For several years, a taxpayer has manufactured
and sold a particular kind of widget. The taxpayer initiates a new
research project to develop a new or improved widget. The taxpayer's
activities to develop a new or improved widget are not excluded from
the definition of qualified research under this paragraph. The taxpayer's
activities relating to the development of a new or improved widget
constitute a new research project to develop a new business component
and are not considered activities conducted after the beginning of
commercial production.
(iii) Example 3. For the purposes of this example,
assume that the taxpayer's development of its products and manufacturing
processes satisfies the Four-Part Test described by subsection (c)
of this section and is not otherwise excluded under this subsection.
A taxpayer is a manufacturer of integrated circuits for use in specific
applications. The taxpayer develops various integrated circuit devices
and associated manufacturing processes. The taxable entity assembles
various product configurations for testing. After an internal process
of testing, the taxpayer delivers a sample quantity of the integrated
circuit to a potential customer for further testing. At the time when
the samples are delivered to the taxpayer's potential customer, the
potential customer has not agreed to purchase any integrated circuits
from the taxpayer. This process of testing by both the taxpayer and
its potential customer continues until an acceptable product and manufacturing
process to produce the product is achieved. At that point, the taxpayer
and the potential customer enter an agreement for the delivery of
an order of the integrated circuits. In some cases, no acceptable
product or manufacturing process is achieved, and no agreement is
reached with the potential customer. Research activities occurring
prior to an agreement are not considered activities conducted after
the beginning of commercial production because the integrated circuits
were not yet ready for commercial use. Any research that occurs after
an agreement is reached are excluded as activities conducted after
the beginning of commercial production because the integrated circuits
were ready for commercial use once the product and associated manufacturing
process was accepted by the potential customer.
(2) Adaptation of existing business components. Activities
relating to adapting an existing business component to a particular
customer's requirement or need. This exclusion does not apply merely
because a business component is intended for a specific customer.
For example:
(A) Example 1. A taxpayer is a computer software development
firm and owns a general ledger accounting software core program that
it markets and licenses to customers. The taxpayer incurs expenditures
in adapting the core software program to the requirements of one of
its customers. Because the taxpayer's activities represent activities
to adapt an existing software program to a particular customer's requirement
or need, its activities are excluded from the definition of qualified
research under this paragraph.
(B) Example 2. Assume that the customer from Example
1 pays the taxpayer to adapt the core software program to the customer's
requirements. Because the taxpayer's activities are excluded from
the definition of qualified research, the customer's payments to the
taxpayer are not for qualified research and are not considered to
be contract research expenses.
(C) Example 3. Assume that the customer from Example
1 uses its own employees to adapt the core software program to its
requirements. Because the customer's employees' activities to adapt
the core software program to its requirements are excluded from the
definition of qualified research, the wages the customer paid to its
employees do not constitute in-house research expenses.
(D) Example 4. A taxpayer manufactures and sells rail
cars. Because rail cars have numerous specifications related to performance,
reliability and quality, rail car designs are subject to extensive,
complex testing in the scientific or laboratory sense. A customer
orders passenger rail cars from the taxpayer. The customer's rail
car requirements differ from those of the taxpayer's other existing
customers only in that the customer wants fewer seats in its passenger
cars and a higher quality seating material and carpet that are commercially
available. The taxpayer manufactures rail cars meeting the customer's
requirements. The rail car sold to the customer was not a new business
component, but merely an adaptation of an existing business component
that did not require a process of experimentation. Thus, the taxpayer's
activities to manufacture rail cars for the customer are excluded
from the definition of qualified research because the taxpayer's activities
represent activities to adapt an existing business component to a
particular customer's requirement or need.
(E) Example 5. A taxpayer is a manufacturer and undertakes
to create a manufacturing process for a new valve design. The taxpayer
determines that it requires a specialized type of robotic equipment
to use in the manufacturing process for its new valves. Such robotic
equipment is not commercially available. Therefore, the taxpayer purchases
existing robotic equipment for the purpose of modifying it to meet
its needs. The taxpayer's engineers identify uncertainty that is technological
in nature concerning how to modify the existing robotic equipment
to meet its needs. The taxpayer's engineers develop several alternative
designs, conduct experiments using modeling and simulation in modifying
the robotic equipment, and conduct extensive scientific and laboratory
testing of design alternatives. As a result of this process, the taxpayer'
s engineers develop a design for the robotic equipment that meets
its needs. The taxpayer constructs and installs the modified robotic
equipment on its manufacturing process. The taxpayer's research activities
to determine how to modify the robotic equipment it purchased for
its manufacturing process are not considered an adaptation of an existing
business component.
(F) Example 6. A taxpayer is an oil and gas operator
and has been engaged in horizontal drilling for the past ten years.
Recently, the taxpayer was hired by a customer to drill in a formation.
The drilling objectives included targeting an interval within that
formation for horizontal drilling. The taxpayer was uncertain about
the successful execution of the horizontal drilling because it had
not previously drilled a horizontal well in that formation. The taxpayer
was also uncertain about the economic results from the targeted interval.
The taxpayer drilled several horizontal wells before its customer
was satisfied with the economic results. The taxpayer modified its
existing horizontal drilling program based on these results. The taxpayer's
activities to identify a horizontal drilling process are excluded
from the definition of qualified research because the activities consisted
of adapting an existing business component, its existing horizontal
drilling process, and did not involve creating a new or improved business
component.
(G) Example 7. For the purposes of this example, assume
that the taxpayer's development of its products satisfies the Four-Part
Test described by subsection (c) of this section and is not otherwise
excluded under this subsection. A taxpayer is a manufacturer of rigid
plastic containers. The taxpayer contracts with major food and beverage
manufacturers to provide suitable bottle and packaging designs. The
products designed by the taxpayer may be for repeat customers and
the sizes and types of bottle may be similar to previous products.
The development of each new product, and the production process necessary
to produce the products at sufficient production volume, starts from
new concept drawings developed by engineers. The taxpayer uses a qualifying
process of experimentation to evaluate alternative concepts for the
product and production processes. The taxpayer's activities related
to both the product and the production process are not excluded from
the definition of qualified research as an adaptation of an existing
business component.
Cont'd... |
