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.
(G) Example 7. For the purposes of this example, assume
that the taxable entity'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 taxable entity is
a manufacturer of rigid plastic containers. The taxable entity contracts
with major food and beverage manufacturers to provide suitable bottle
and packaging designs. The products designed by the taxable entity
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 taxable entity uses a qualifying process of experimentation to
evaluate alternative concepts for the product and production processes.
The taxable entity'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.
(3) Duplication of existing business component. Any
research related to the reproduction of an existing business component,
in whole or in part, from a physical examination of the business component
itself or from plans, blueprints, detailed specifications, or publicly
available information with respect to such business component. This
exclusion does not apply merely because the taxable entity examines
an existing business component in the course of developing its own
business component.
(4) Surveys, studies, etc. Any efficiency survey; activity
relating to management function or technique; market research, testing
or development (including advertising or promotions); routine data
collection; or routine or ordinary testing or inspection for quality
control.
(5) Computer software. Any research activities with
respect to internal use software.
(A) For the purposes of this paragraph, internal use
software is computer software developed by, or for the benefit of,
the taxable entity primarily for internal use by the taxable entity.
(B) This exclusion does not apply to software used
in:
(i) an activity that constitutes qualified research,
or
(ii) a production process that meets the requirements
of the Four-Part Test.
(6) Social sciences, etc. Any research in the social
sciences, arts, or humanities.
(7) Funded research. Any research funded by any grant,
contract, or otherwise by another person or governmental entity.
(A) Research is considered funded if:
(i) the taxable entity performing the research for
another person retains no substantial rights to the results of the
research; or
(ii) the payments to the researcher are not contingent
upon the success of the research.
(B) For the purposes of determining whether a taxable
entity retains substantial rights to the results of the research:
(i) Incidental benefits to the researcher from the
performance of the research do not constitute substantial rights.
For example, increased experience in a field of research is not considered
substantial rights.
(ii) A taxable entity does not retain substantial rights
in the research it performs if the taxable entity must pay for the
right to use the results of the research.
(C) If a taxable entity performing research does not
retain substantial rights to the results of the research, the research
is considered funded regardless of whether the payments to the researcher
are contingent upon the success of the research. In this case, all
research activities are considered funded even if the researcher has
expenses that exceed the amount received by the researcher for the
research.
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