| (xxi) adapting and commercializing technology developed
by a consortium or open software group.
(d) Excluded research activities. Qualified research
does not include the activities described in this subsection.
(1) Research after commercial production. Any research
conducted after the beginning of commercial production of the business
component.
(A) Activities are conducted after the beginning of
commercial production of a business component if such activities are
conducted after the component is developed to the point where it is
ready for commercial sale or use or meets the basic functional and
economic requirements of the taxpayer for the component's sale or
use.
(B) The following activities are deemed to occur after
the beginning of commercial production of a business component:
(i) preproduction planning for a finished business
component;
(ii) tooling-up for production;
(iii) trial production runs;
(iv) troubleshooting involving detecting faults in
production equipment or processes;
(v) accumulating data relating to production processes;
(vi) debugging flaws in a business component; and
(vii) any activities that involve the use of an item
for which the taxpayer claimed the manufacturing exemption under Tax
Code, §151.318.
(C) In cases involving development of both a product
and a manufacturing or other commercial production process for the
product, the research after commercial production exclusion applies
separately for the activities relating to the development of the product
and the activities relating to the development of the process. For
example, even after a product meets the taxpayer's basic functional
and economic requirements, activities relating to the development
of the manufacturing process may still constitute qualified research,
provided that the development of the process itself separately satisfies
the requirements of this section, and the activities are conducted
before the process meets the taxpayer's basic functional and economic
requirements or is ready for commercial use.
(D) Clinical testing of a pharmaceutical product prior
to its commercial production in the United States is not treated as
occurring after the beginning of commercial production even if the
product is commercially available in other countries. Additional clinical
testing of a pharmaceutical product after a product has been approved
for a specific therapeutic use by the Food and Drug Administration
and is ready for commercial production and sale is not treated as
occurring after the beginning of commercial production if such clinical
testing is undertaken to establish new functional uses, characteristics,
indications, combinations, dosages, or delivery forms for the product.
A functional use, characteristic, indication, combination, dosage,
or delivery form shall be considered new only if such functional use,
characteristic, indication, combination, dosage, or delivery form
must be approved by the Food and Drug Administration.
(E) Examples.
(i) Example 1. A taxpayer is a tire manufacturer and
develops a new material to use in its tires. The taxpayer conducts
research to determine the changes that will be necessary for it to
modify its existing manufacturing processes to manufacture the new
tire. The taxpayer 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 taxpayer 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 taxpayer 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 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 Cont'd... |
