In new paragraph (4), the comptroller explains how the Four-Part Test applies to software development activities. The comptroller also identifies a list of software development activities that are likely to be qualified research and a list of software development activities that are unlikely to be qualified research. The explanation and lists in this paragraph are adapted from the Internal Revenue Service's Audit Guidelines on the Application of Process of Experimentation for all Software.

Shane Frank of alliantgroup, Michael Thompson of Ryan, and Mike Williams and Alyssa Honnette of RSM suggested modifying or eliminating subsection (c)(4). The comptroller declines this suggestion. This subsection does not preclude any type of computer software from qualifying for the R&D exemption. It provides guidance regarding types of computer software development activities that are likely to qualify or unlikely to qualify, but also explicitly states that any computer software development activities that meet the requirements of the Four-Part Test qualify for the R&D exemption.

Michael Thompson of Ryan commented that subsection (c) conflicts with state law because it is not solely based on the IRC and Treasury Regulations. The comptroller declines to modify the rule in response to this comment. The applicable federal statutes and regulations are incorporated by reference into Tax Code, §151.3182, making them a part of that section. The comptroller has rulemaking authority under Tax Code, §111.002 (Comptroller's Rules; Compliance; Forfeiture) to adopt rules for the enforcement of Tax Code, §151.3182. There is no part of subsection (c) that conflicts with the applicable federal statutes or regulations, anything in subsection (c) that is not based on those statutes and regulations is intended to resolve ambiguities in them to allow the comptroller to enforce Tax Code, §151.3182.

In new subsection (d), the comptroller lists activities that do not constitute qualified research. This list is based on IRC, §41(d)(4) and Treasury Regulation, §1.41-4(c) (Excluded activities). The discussion of the funded research exclusion is also based on Treasury Regulation, §1.41-4A(d) (Qualified research for taxable years beginning before January 1, 1986). This subsection contains examples for the research after commercial production exclusion and the adaptation of existing business components exclusion.

Shane Frank of alliantgroup suggested eliminating the list of activities that are deemed to be after commercial production, found in subsection (d)(1)(B). The comptroller declines this suggestion. This list is based primarily on Treasury Regulation, §1.41-4(c)(2)(ii)(A-F). The only item that is not found in Treasury Regulation, §1.41-4(c)(2)(ii)(A-F) is the inclusion of any activities that involve the use of an item for which the taxpayer claimed the manufacturing exemption under Tax Code, §151.318. To qualify for the manufacturing exemption, items used by a manufacturer must be used in or during the actual manufacturing, processing, or fabricating of tangible personal property for ultimate sale. If a taxpayer is engaged in manufacturing, processing, or fabricating tangible personal property for ultimate sale, that tangible personal property 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.

Shane Frank of alliantgroup suggested that the examples found in subsection (d)(1)(E) are flawed. Mr. Frank provided one specific example of such a flaw: "For instance, Example 1 assumes that a newly designed belt that has never been used in an actual manufacturing process will work perfectly immediately upon integration in the taxpayer's production process. This rarely occurs." The comptroller declines to modify the rule based on this comment. The only specific issue identified relates to Example 1, an example directly based on Treasury Regulation, §1.41-4(c)(10) Example 1, which is incorporated by reference into Texas law.

Michael Thompson of Ryan suggested eliminating or modifying subsection (d)(1)(E)(iii), Example 3 (related to the Research After Commercial Production Exclusion). The comptroller declines the suggestion to eliminate this example because this example is intended to address common issues encountered in administering the R&D exemption. Mr. Thompson suggested that this example uses the term "design" in a way that conflicts with subsection (c)(1)(C)(ii) of this section and that the example does not distinguish research related to the development of a process to manufacture an item from the research related to the item itself. The example has been modified to use the term "design" consistently with subsection (c)(1)(C)(ii) of this section and to apply the example to the manufacturing process as well.

Shannon Rusing of TXOGA, Dale Craymer of TTARA, Patrick Reynolds of COST, Shane Frank of alliantgroup, and Michael Thompson of Ryan suggested eliminating or modifying subsection (d)(2)(F), Example 6 (related to the adaptation of an existing business component exclusion). The comptroller declines to eliminate this example, however, the comptroller does agree to modify the example to clarify that the research is not being excluded because the research was meant for a particular customer.

Shane Frank of alliantgroup suggested eliminating subsection (d)(2)(F)(1-3), Examples 1 through 3 (related to the adaptation of an existing business component exclusion). The comptroller declines this suggestion. These three examples are directly based on Treasury Regulation, §1.41-4(c)(10) Examples 3 through 5, which are incorporated by reference into Texas law. Mr. Frank suggested that these examples are "... especially problematic since the Treasury Department and IRS have previously instructed that the research after commercial production, adaptation, and duplication exclusions do not cover research activities that otherwise satisfy the requirements for qualified research." This statement is based on a statement in the supplementary information found in Treasury Decision 9104, 2004-1 C.B. 406, which was the treasury decision that adopted Treasury Regulation, §1.41-4. This supplementary information is not part of the text of Treasury Regulation, §1.41-4 and is not incorporated by reference into Texas law. The comptroller declines to interpret the research after commercial production, adaptation, and duplication exclusions such that they do not apply if the research activities otherwise satisfy the requirements for qualified research. The surplusage canon of statutory construction requires that statutory provisions not be read in a way that would render any word redundant. Such an interpretation would render all three of these exclusions redundant.

Michael Thompson of Ryan suggested that the comptroller should restate, verbatim, the guidance provided by the IRS in Treasury Decision 9786 (2016), which adopted Treasury Regulations regarding the Internal Use Software Exclusion. The comptroller declines this suggestion. IRC, §41(d)(4)(E) gives the IRS the authority to adopt regulations to create exceptions to the Internal Use Software Exclusion that are not found in the IRC. The comptroller does not have a similar grant of statutory authority to create exceptions to the Internal Use Software Exclusion.

At the public hearing, Dale Craymer of TTARA requested clarification of the comptroller's position with respect to the funded research exclusion. Subsection (d)(7), relating to the funded research exclusion, is based on the IRC applicable to the 2011 federal income tax year. This includes IRC, §41(d)(4)(H), Treasury Regulation, §1.41-4(c)(9), and Treasury Regulation, §1.41-4A(d). The comptroller intends subsection (d)(7) to be consistent with the text of those statutes and federal regulations. While federal court cases interpreting those statutes with respect to the federal income tax R&D credit are not binding authority for the Texas sales tax R&D exemption, they are persuasive authority and will be considered by the comptroller on a case-by-case basis.

The comptroller amends relettered subsection (e). In paragraph (5), the comptroller replaces the word "will" with the word "may" to better reflect current comptroller practice concerning cancellation of a sales and use tax registration number before claiming a franchise tax research and development credit. In paragraph (6) the comptroller explains the effective date of cancellation for a registrant whose registration number is cancelled because of a failure to file an annual information report.

The comptroller amends relettered subsection (g), related to divergent use, to explain that divergent use applies to any item that the taxpayer uses for any purpose other than for use in qualified research, whether that use occurs before, during, or after the time when the taxpayer uses the item in qualified research.

Shannon Rusing of TXOGA, Dale Craymer of TTARA, Patrick Reynolds of COST, Ronnie Berry of Celanese, Jennifer Woodard of AGC of Texas, Alyssa Honnette of RSM, and Carolyn Labatt of GSTC suggested that the amendments be applied prospectively. The comptroller disagrees that the additions or revisions in the adopted rule are retroactive changes in law. The additions or revisions are expositions of existing comptroller policy regarding Tax Code, §151.3182 (Certain Property Used in Research and Development Activities; Reporting of Estimates and Evaluation), a statute that was adopted by the Legislature in 2013, rather than changes. At the same time, these same commenters encouraged the comptroller's office to recognize Treasury Regulations that were adopted after the effective date of IRC, §41 as clarifications that should be applied retroactively to the 2011 federal income tax year, even when the IRS does not require that those regulations apply to the 2011 federal income tax year. As discussed in more detail above, with the exception of regulations that are not required to be applied to the 2011 federal income tax year, the comptroller does recognize Treasury Regulations that were adopted as clarifications. The comptroller does not view the amendments to this section any differently than the amendments to the Treasury Regulations that are applicable to the 2011 federal income tax year.

The comptroller amends relettered subsection (i) to explain that the provisions of this section, including the additions and revisions in the adopted rule, apply to the sale, storage, or use of tangible personal property occurring on or after January 1, 2014.

The amendments are adopted under Tax Code, §111.002, which provides the comptroller with the authority to prescribe, adopt, and enforce rules relating to the administration and enforcement of the provisions of Tax Code, Title 2 (State Taxation).

The amendments implement Tax Code, §151.3182.