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(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.
(2)Application of the Four-Part Test to business components.
The Four-Part Test is applied separately to each business component
of the taxpayer. Any plant process, machinery, or technique for commercial
production of a business component is treated as a separate business
component from the business component being produced.
(3)Shrink-back rule. The Four-Part Test is first applied
at the level of the discrete business component used by the taxpayer
in a trade or business of the taxpayer. If the requirements of the
Four-Part Test are not met at that level, then they are applied at
the next most significant subset of elements of the business component.
This shrinking back of the product continues until either a subset
of elements of the product that satisfies the requirements of the
Four-Part Test is reached, or the most basic element of the product
is reached and such element fails to satisfy any part of the Four-Part
Test.
(4)Software development as qualified research. In
determining if software development activities constitute qualified
research, the comptroller shall consider the facts and circumstances
of each activity.
(A)Application of Four-Part Test to software development
activities.
(i)A taxpayer must prove that a software development
activity is qualified research and meets all the requirements of the
Four-Part Test under paragraph (1) of this subsection, even if the
activity is likely to qualify as described in subparagraph (B) of
this paragraph.
(ii)A taxpayer may prove that a software development
activity described as unlikely to qualify in subparagraph (C) of this
paragraph, is qualified research by providing evidence that the activity
meets all the requirements of the Four-Part Test under paragraph (1)
of this subsection.
(B)Software development activities likely to qualify.
Types of activities likely to qualify include, but are not limited
to:
(i)developing the initial release of an application
software product that includes new constructs, such as new architectures,
new algorithms, or new database management techniques;
(ii)developing system software, such as operating
systems and compilers;
(iii)developing specialized technologies, such as
image processing, artificial intelligence, or speech recognition;
and
(iv)developing software as part of a hardware product
where the software interacts directly with that hardware in order
to make the hardware/software package function as a unit.
(C)Software development activities unlikely to qualify.
Types of activities unlikely to qualify include, but are not limited
to:
(i)maintaining existing software applications or products;
(ii)configuring purchased software applications;
(iii)reverse engineering of existing applications;
(iv)performing studies, or similar activities, to
select vendor products;
(v)detecting flaws and bugs directed toward the verification
and validation that the software was programmed as intended and works
correctly;
(vi)modifying an existing software business component
to make use of new or existing standards or devices, or to be compliant
with another vendor's product or platform;
(vii)developing a business component that is substantially
similar in technology, functionality, and features to the capabilities
already in existence at other companies;
(viii)upgrading to newer versions of hardware or software
or installing vendor-fix releases;
(ix)re-hosting or porting an application to a new
hardware such as from mainframe to PC, or software platform, such
as Windows to UNIX, or rewriting an existing application in a new
language, such as rewriting a COBOL mainframe application in C++;
(x)writing hardware device drivers to support new
hardware, such as disks, scanners, printers, or modems;
(xi)performing data quality, data cleansing, and data
consistency activities, such as designing and implementing software
to validate data fields, clean data fields, or make the data fields
consistent across databases and applications;
(xii)bundling existing individual software products
into product suites, such as combining existing word processor, spreadsheet,
and slide presentation software applications into a single suite;
(xiii)expanding product lines by purchasing other
products;
(xiv)developing interfaces between different software
applications;
(xv)developing vendor product extensions;
(xvi)designing graphic user interfaces;
(xvii)developing functional enhancements to existing
software applications/products;
(xviii)developing software as an embedded application,
such as in cell phones, automobiles, and airplanes;
(xix)developing software utility programs, such as
debuggers, backup systems, performance analyzers, and data recovery;
(xx)changing from a product based on one technology
to a product based on a different or newer technology; and
(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 process of experimentation. Thus, the taxpayer's
activities to manufacture rail cars for the customer are excluded
from the definition of qualified research because the taxpayer's activities
represent activities to adapt an existing business component to a
particular customer's requirement or need.
(E)Example 5. A taxpayer is a manufacturer and undertakes
to create a manufacturing process for a new valve design. The taxpayer
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 taxpayer purchases
existing robotic equipment for the purpose of modifying it to meet
its needs. The taxpayer's engineers identify uncertainty that is technological
in nature concerning how to modify the existing robotic equipment
to meet its needs. The taxpayer'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 taxpayer'
s engineers develop a design for the robotic equipment that meets
its needs. The taxpayer constructs and installs the modified robotic
equipment on its manufacturing process. The taxpayer'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 taxpayer is an oil and gas operator
and has been engaged in horizontal drilling for the past ten years.
Recently, the taxpayer was hired by a customer to drill in a formation.
The drilling objectives included targeting an interval within that
formation for horizontal drilling. The taxpayer was uncertain about
the successful execution of the horizontal drilling because it had
not previously drilled a horizontal well in that formation. The taxpayer
was also uncertain about the economic results from the targeted interval.
The taxpayer drilled several horizontal wells before its customer
was satisfied with the economic results. The taxpayer modified its
existing horizontal drilling program based on these results. The taxpayer'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 taxpayer'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 taxpayer is a manufacturer of rigid
plastic containers. The taxpayer contracts with major food and beverage
manufacturers to provide suitable bottle and packaging designs. The
products designed by the taxpayer 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 taxpayer uses a qualifying
process of experimentation to evaluate alternative concepts for the
product and production processes. The taxpayer'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 taxpayer examines an existing
business component in the course of developing its own business component.
Cont'd...
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