| Administration.
(E) Examples.
(i) Example 1. A taxable entity is a tire manufacturer
and develops a new material to use in its tires. The taxable entity
conducts research to determine the changes that will be necessary
for it to modify its existing manufacturing processes to manufacture
the new tire. The taxable entity determines that the new tire material
retains heat for a longer period of time than the materials it currently
uses for tires, and, as a result, the new tire material adheres to
the manufacturing equipment during tread cooling. The taxable entity
evaluates several alternatives for processing the treads at cooler
temperatures to address this problem, including a new type of belt
for its manufacturing equipment to be used in tread cooling. Such
a belt is not commercially available. Because the taxable entity is
uncertain of the belt design, 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 taxable entity 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
taxable entity'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 taxable entity's expenses to
implement the new belts, including the costs to manufacture, install,
and test the belts were incurred after the belts met the taxable entity's
functional and economic requirements and are excluded as research
after commercial production.
(ii) Example 2. For several years, a taxable entity
has manufactured and sold a particular kind of widget. The taxable
entity initiates a new research project to develop a new or improved
widget. The taxable entity's activities to develop a new or improved
widget are not excluded from the definition of qualified research
under this paragraph. The taxable entity'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 taxable entity'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 taxable entity is a manufacturer of integrated circuits for use
in specific applications. The taxable entity 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 taxable entity 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 taxable
entity's potential customer, the potential customer has not agreed
to purchase any integrated circuits from the taxable entity. This
process of testing by both the taxable entity and its potential customer
continues until an acceptable product and manufacturing process to
produce the product is achieved. At that point, the taxable entity
and the potential customer enter into 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 taxable entity is a computer software
development firm and owns a general ledger accounting software core
program that it markets and licenses to customers. The taxable entity
incurs expenditures in adapting the core software program to the requirements
of one of its customers. Because the taxable entity'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 taxable entity to adapt the core software program to the
customer's requirements. Because the taxable entity's activities are
excluded from the definition of qualified research, the customer's
payments to the taxable entity 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 taxable entity 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 taxable entity. The
customer's rail car requirements differ from those of the taxable
entity'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 taxable entity 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 taxable entity's activities to manufacture
rail cars for the customer are excluded from the definition of qualified
research because the taxable entity's activities represent activities
to adapt an existing business component to a particular customer's
requirement or need.
(E) Example 5. A taxable entity is a manufacturer and
undertakes to create a manufacturing process for a new valve design.
The taxable entity 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 taxable entity purchases existing robotic equipment for the purpose
of modifying it to meet its needs. The taxable entity's engineers
identify uncertainty that is technological in nature concerning how
to modify the existing robotic equipment to meet its needs. The taxable
entity'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 taxable entity's engineers
develop a design for the robotic equipment that meets its needs. The
taxable entity constructs and installs the modified robotic equipment
on its manufacturing process. The taxable entity'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 taxable entity is an oil and gas operator
and has been engaged in horizontal drilling for the past ten years.
Recently, the taxable entity was hired by a customer to drill in a
formation. The drilling objectives included targeting an interval
within that formation for horizontal drilling. The taxable entity
was uncertain about the successful execution of the horizontal drilling
because it had not previously drilled a horizontal well in that formation.
The taxable entity was also uncertain about the economic results from
the targeted interval. The taxable entity drilled several horizontal
wells before its customer was satisfied with the economic results.
The taxable entity modified its existing horizontal drilling program
based on these results. The taxable entity'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.
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