| (ii) A process of experimentation must:
(I) be an evaluative process and generally should be
capable of evaluating more than one alternative; and
(II) fundamentally rely on the principles of the physical
or biological sciences, engineering, or computer science and involve:
(-a-) the identification of uncertainty concerning
the development or improvement of a business component;
(-b-) the identification of one or more alternatives
intended to eliminate that uncertainty; and
(-c-) the identification and the conduct of a process
of evaluating the alternatives through, for example, modeling, simulation,
or a systematic trial and error methodology.
(iii) A taxpayer may undertake a process of experimentation
if there is no uncertainty concerning the taxpayer's capability or
method of achieving the desired result so long as the appropriate
design of the desired result is uncertain as of the beginning of the
taxpayer's research activities. Uncertainty concerning the development
or improvement of the business component (e.g., its appropriate design)
does not establish that all activities undertaken to achieve that
new or improved business component constitute a process of experimentation.
(iv) The substantially all requirement of this subparagraph
is satisfied only if 80% or more of a taxpayer's research activities,
measured on a cost or other consistently applied reasonable basis
constitute elements of a process of experimentation that relates to
a new or improved function, performance, reliability, or quality.
The substantially all requirement is satisfied even if the remainder
of a taxpayer's research activities with respect to the business component
do not constitute elements of a process of experimentation that relates
to a new or improved function, performance, reliability, or quality.
(v) Non-experimental methods, such as simple trial
and error, brainstorming, or reverse engineering, are not considered
a process of experimentation.
(vi) The following are factors that may be considered
in determining whether a trial and error methodology is experimental
systematic trial and error or non-experimental simple trial and error.
Evidence provided to determine the type of trial and error is not
limited to these factors, nor is evidence of each factor required.
These factors only apply to determining whether a process of experimentation
is systematic trial and error. Systematic trial and error is not the
only qualifying process of experimentation. These factors are:
(I) whether the person conducting the trial and error
methodology stops testing alternatives once a single acceptable result
is found or continues to find multiple acceptable results for comparison;
(II) whether all the results of the trial and error
methodology are recorded for evaluation;
(III) whether there is a written procedure for conducting
the trial and error methodology; and
(IV) whether there is a written procedure for evaluating
the results of the trial and error methodology.
(vii) Examples.
(I) Example 1. A taxpayer is engaged in the business
of developing and manufacturing widgets. The taxpayer wants to change
the color of its blue widget to green. The taxpayer obtains several
different shades of green paint from various suppliers. The taxpayer
paints several sample widgets, and surveys its customers to determine
which shade of green its customers prefer. The taxpayer's activities
to change the color of its blue widget to green do not satisfy the
Process of Experimentation Test because its activities are not undertaken
for a qualified purpose. All of the taxpayer's research activities
are related to style, taste, cosmetic, or seasonal design factors.
(II) Example 2. The taxpayer in Example 1 chooses one
of the green paints. The taxpayer obtains samples of the green paint
from a supplier and determines that it must modify its painting process
to accommodate the green paint because the green paint has different
characteristics from other paints it has used. The taxpayer obtains
detailed data on the green paint from its paint supplier. The taxpayer
also consults with the manufacturer of its paint spraying machines.
The manufacturer informs the taxpayer that it must acquire new nozzles
that operate with the green paint it wants to use because the current
nozzles do not work with the green paint. The taxpayer tests the new
nozzles, using the green paint, to ensure that they work as specified
by the manufacturer of the paint spraying machines. The taxpayer's
activities to modify its painting process are not qualified research.
The taxpayer did not conduct a process of evaluating alternatives
in order to eliminate uncertainty regarding the modification of its
painting process. Rather, the manufacturer of the paint machines eliminated
the taxpayer's uncertainty regarding the modification of its painting
process. The taxpayer's activities to test the nozzles to determine
if the nozzles work as specified by the manufacturer of the paint
spraying machines are in the nature of routine or ordinary testing
or inspection for quality control.
(III) Example 3. A taxpayer is engaged in the business
of manufacturing food products and currently manufactures a large-shred
version of a product. The taxpayer seeks to modify its current production
line to permit it to manufacture both a large-shred version and a
fine-shred version of one of its food products. A smaller, thinner
shredding blade capable of producing a fine-shred version of the food
product is not commercially available. Thus, the taxpayer must develop
a new shredding blade that can be fitted onto its current production
line. The taxpayer is uncertain concerning the design of the new shredding
blade because the material used in its existing blade breaks when
machined into smaller, thinner blades. The taxpayer engages in a systematic
trial and error process of analyzing various blade designs and materials
to determine whether the new shredding blade must be constructed of
a different material from that of its existing shredding blade and,
if so, what material will best meet its functional requirements. The
taxpayer's activities to modify its current production line by developing
the new shredding blade satisfy the Process of Experimentation Test.
Substantially all of the taxpayer's activities constitute elements
of a process of experimentation because it evaluated alternatives
to achieve a result where the method of achieving that result, and
the appropriate design of that result, were uncertain as of the beginning
of the taxpayer's research activities. The taxpayer identified uncertainties
related to the development of a business component, and identified
alternatives intended to eliminate these uncertainties. Furthermore,
the taxpayer's process of evaluating identified alternatives was technological
in nature and was undertaken to eliminate the uncertainties.
(IV) Example 4. A taxpayer is in the business of designing,
developing and manufacturing automobiles. In response to government-mandated
fuel economy requirements, the taxpayer seeks to update its current
model vehicle and undertakes to improve aerodynamics by lowering the
hood of its current model vehicle. The taxpayer determines, however,
that lowering the hood changes the air flow under the hood, which
changes the rate at which air enters the engine through the air intake
system, which reduces the functionality of the cooling system. The
taxpayer's engineers are uncertain how to design a lower hood to obtain
the increased fuel economy, while maintaining the necessary air flow
under the hood. The taxpayer designs, models, simulates, tests, refines,
and re-tests several alternative designs for the hood and associated
proposed modifications to both the air intake system and cooling system.
This process enables the taxpayer to eliminate the uncertainties related
to the integrated design of the hood, air intake system, and cooling
system. Such activities constitute 85% of its total activities to
update its current model vehicle. The taxpayer then engages in additional
activities that do not involve a process of evaluating alternatives
in order to eliminate uncertainties. The additional activities constitute
only 15% of the taxpayer's total activities to update its current
model vehicle. In this case substantially all of the taxpayer's activities
constitute elements of a process of experimentation because it evaluated
alternatives to achieve a result where the method of achieving that
result, and the appropriate design of that result, were uncertain
as of the beginning of its research activities. The taxpayer identified
uncertainties related to the improvement of a business component and
identified alternatives intended to eliminate these uncertainties.
Furthermore, the taxpayer's process of evaluating the identified alternatives
was technological in nature and was undertaken to eliminate the uncertainties.
Because 85% of the taxpayer's activities to update its current model
vehicle constitute elements of a process of experimentation that relates
to a new or improved function, performance, reliability, or quality,
all of its activities satisfy the Process of Experimentation Test.
(V) Example 5. A taxpayer is in the business of providing
building and construction services, including the construction of
warehouses, strip malls, office buildings, and other commercial structures.
The taxpayer is engaged to construct a structure in a part of Texas
where foundation problems are common. The taxpayer's engineers were
uncertain how to design the structure to ensure stability of the structure's
foundation because the taxpayer had never designed a structure in
a similar location. The taxpayer's engineers used their professional
experience and various building codes to determine how to design the
foundation based on the conditions at the construction site. The engineers
chose to use piles in the foundation. The taxpayer constructed a test
pile on site to confirm whether this would work in the conditions
present on the construction site. This test pile would become part
of the foundation of the structure regardless of whether the engineers
had to redesign the additional piles required for the foundation.
The taxpayer's activities in using professional experience and business
codes to design the foundation did not meet the Process of Experimentation
Test because the activities did not resolve technological uncertainties
through an experimental process. Constructing the test pile also did
not meet the Process of Experimentation Test because it was not an
evaluative process.
(VI) Example 6. A taxpayer is in the business of providing
building and construction services, including the construction of
warehouses, strip malls, office buildings, and other commercial structures.
For one of its projects to construct an office building, the taxpayer
was uncertain how to design the layout of the electrical systems.
The taxpayer's employees held on-site meetings to discuss different
options, such as running the wire under the floor or through the ceiling,
but did not actually experiment by installing wire in different locations.
The taxpayer used computer-aided simulation and modeling to produce
the final electrical system layout. While in some cases computer-aided
simulation and modeling may be an experimental process, in this case,
it was not an experimental process because the taxpayer did not use
the computer-aided simulation and modeling to evaluate different alternatives
in a scientific manner. The taxpayer's activities did not satisfy
the Process of Experimentation Test because it did not conduct an
experimental process of evaluating alternatives to eliminate a technological
uncertainty.
(VII) Example 7. A taxpayer is an oil and gas operator
that recently acquired rights to drill in an area in which it had
not previously operated. The taxpayer decided to use horizontal drilling
in this area, but it had never drilled a horizontal well and was uncertain
how to successfully execute the horizontal drilling. At the time the
taxpayer began horizontal drilling, the technology to drill horizontal
wells was established. The taxpayer selected technology from existing
commercially available options to use in its horizontal drilling program.
The taxpayer's activities did not satisfy the Process of Experimentation
Test because evaluating commercially available options does not constitute
a process of experimentation.
(VIII) Example 8. A taxpayer is an oil and gas operator
that recently acquired rights to drill in an area in which it had
not previously operated. The taxpayer decided to use horizontal drilling
in this area. The taxpayer had drilled a horizontal well before in
a different formation and at different depths. However, it had never
drilled a horizontal well in this formation or at the required depths
and was uncertain how to successfully execute the horizontal drilling.
The taxpayer utilized its existing technology to perform its horizontal
drilling operations in this area and the existing technology was successful.
The taxpayer's activities did not satisfy the Process of Experimentation
Test because the taxpayer merely used its existing technology and
did not perform any experimentation to evaluate alternative any drilling
methods.
(IX) Example 9. A taxpayer sought to discover cancer
immunotherapies. The taxpayer was uncertain as to the appropriate
design of the proteins to be used as a drug candidate. The taxpayer
identified several alternative protein constructs and used a process
to test them. The taxpayer's process involved testing the constructs
using in vitro functional assays and binding assays, and either modifying
the designs or discarding them and repeating the previous steps. The
taxpayer took the resulting products from the in vitro testing and
tested the drug candidate in living organisms. This process evaluated
the various alternatives identified by the taxpayer. The taxpayer's
activities satisfied the Process of Experimentation Test.
Cont'd... |
