| (A) Section 174 Test. Expenditures related to the research
must be eligible to be treated as expenses under IRC, §174 (Research
and experimental expenditures).
(i) Expenditures are eligible to be treated as expenses
under IRC, §174, if the expenditures are incurred in connection
with the taxable entity's trade or business and represent a research
and development cost in the experimental or laboratory sense. Expenditures
represent research and development costs in the experimental or laboratory
sense if they are for activities intended to discover information
that would eliminate uncertainty concerning the development or improvement
of a product. Uncertainty exists if the information available to the
taxable entity does not establish the capability or method for developing
or improving the product or the appropriate design of the product.
(ii) For the purposes of this test, the term "product"
includes any pilot model, process, formula, invention, technique,
patent, or similar property, and includes products to be used by the
taxable entity in its trade or business as well as products to be
held for sale, lease, or license.
(iii) Expenditures for the following are not eligible
to be treated as expenses under IRC, §174:
(I) land;
(II) depreciable property;
(III) the ordinary testing or inspection of materials
or products for quality control;
(IV) efficiency surveys;
(V) management studies;
(VI) consumer surveys;
(VII) advertising or promotions;
(VIII) the acquisition of another's patent, model,
production, or process; or
(IX) research in connection with literary, historical,
or similar projects.
(B) Discovering Technological Information Test. The
research must be undertaken for the purpose of discovering information
that is technological in nature.
(i) Research is undertaken for the purpose of discovering
technological information if it is intended to eliminate uncertainty
concerning the development or improvement of a business component.
Uncertainty exists if the information available to the taxable entity
does not establish the capability or method for developing or improving
the business component, or the appropriate design of the business
component.
(ii) In order to satisfy the requirement that the research
is technological in nature, the process of experimentation used to
discover information must fundamentally rely on principles of the
physical or biological sciences, engineering, or computer science.
A taxable entity may employ existing technologies and may rely on
existing principles of the physical or biological sciences, engineering,
or computer science to satisfy this requirement.
(iii) A determination that research is undertaken for
the purpose of discovering information that is technological in nature
does not require that the taxable entity:
(I) seek to obtain information that exceeds, expands,
or refines the common knowledge of skilled professionals in the particular
field of science or engineering in which the taxable entity is performing
the research; or
(II) succeed in developing a new or improved business
component.
(C) Business Component Test. The application of the
technological information for which the research is undertaken must
be intended to be useful in the development of a new or improved business
component of the taxable entity, which may include any product, process,
computer software, technique, formula, or invention that is to be
held for sale, lease, or license, or used by the taxable entity in
a trade or business of the taxable entity.
(i) If a taxable entity provides a service to a customer,
the service provided to that customer is not a business component
because a service is not a product, process, computer software, technique,
formula, or invention. However, a product, process, computer software,
technique, formula, or invention used by a taxable entity to provide
services to its customers may be a business component.
(ii) A design is not a business component because a
design is not a product, process, computer software, technique, formula,
or invention. While uncertainty as to the appropriate design of a
business component is a qualifying uncertainty for the Section 174
Test and the Discovering Technological information test, the design
itself is not a business component. For example, the design of a structure
is not a business component, although the structure itself may be
a business component. Similarly, a blueprint or other plan used to
construct a structure that embodies a design is not a business component.
(D) Process of Experimentation Test. Substantially
all of the research activities must constitute elements of a process
of experimentation for a qualified purpose. A process of experimentation
is undertaken for a qualified purpose if it relates to a new or improved
function, performance, reliability, or quality of a business component.
Any research relating to style, taste, cosmetic, or seasonal design
factors does not satisfy the Process of Experimentation Test.
(i) A process of experimentation is a process designed
to evaluate one or more alternatives to achieve a result where the
capability or the method of achieving that result, or the appropriate
design of that result, is uncertain as of the beginning of the taxable
entity's research activities.
(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 taxable entity may undertake a process of experimentation
if there is no uncertainty concerning the taxable entity'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
taxable entity'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 taxable entity'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 taxable entity'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 taxable entity is engaged in the business
of developing and manufacturing widgets. The taxable entity wants
to change the color of its blue widget to green. The taxable entity
obtains several different shades of green paint from various suppliers.
The taxable entity paints several sample widgets, and surveys its
customers to determine which shade of green its customers prefer.
The taxable entity's activities to change the color of its blue widget
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