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(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 taxable entity 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 taxable entity 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 taxable entity'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 taxable entity'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 taxable entity is a tire manufacturer
and develops a new material to use in its tires. The taxable entity
conducts research to determine the changes that will be necessary
for it to modify its existing manufacturing processes to manufacture
the new tire. The taxable entity 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 taxable entity
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 taxable entity 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 taxable entity 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
taxable entity'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 taxable entity's expenses to
implement the new belts, including the costs to manufacture, install,
and test the belts were incurred after the belts met the taxable entity's
functional and economic requirements and are excluded as research
after commercial production.
(ii)Example 2. For several years, a taxable entity
has manufactured and sold a particular kind of widget. The taxable
entity initiates a new research project to develop a new or improved
widget. The taxable entity's activities to develop a new or improved
widget are not excluded from the definition of qualified research
under this paragraph. The taxable entity'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 taxable entity'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 taxable entity is a manufacturer of integrated circuits for use
in specific applications. The taxable entity 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 taxable entity 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 taxable
entity's potential customer, the potential customer has not agreed
to purchase any integrated circuits from the taxable entity. This
process of testing by both the taxable entity and its potential customer
continues until an acceptable product and manufacturing process to
produce the product is achieved. At that point, the taxable entity
and the potential customer enter into 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 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.
A taxable entity uses software internally if the software was developed
for use in the operation of the business. Computer software that is
developed to be commercially sold, leased, licensed, or otherwise
marketed for separately stated consideration to unrelated third parties
is not internal use software.
(B)Software developed by a taxable entity primarily
for internal use by an entity that is part of an affiliated group
to which the taxable entity also belongs shall be considered internal
use software for purposes of this paragraph.
(C)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.
(D)The determination as to whether software is internal
use software depends on the facts and circumstances existing at the
beginning of the development of the software.
(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.
Cont'd...
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