Shane Frank of alliantgroup, Michael Thompson of Ryan, Ronnie Berry of Celanese, Jennifer Woodard of AGC of Texas, and Mike Williams of RSM suggested eliminating subsection (c)(1)(D)(vi). The comptroller declines the suggestion to eliminate this subsection but does modify it to address these concerns. The guidance in this subsection is a non-exhaustive list of factors that the comptroller considers when determining if a trial and error experimental method is qualifying systematic trial and error or non-qualifying simple trial and error. These factors do not affect the evaluation of a process of experimentation that does not consist of trial and error. This subsection also does not require a systematic trial and error process to satisfy all the enumerated factors.

Shane Frank of alliantgroup, Michael Thompson of Ryan, and Jennifer Woodard of AGC of Texas suggested reconsidering, eliminating, or modifying subsection (c)(1)(D)(vii)(V), Example 5 (related to the Process of Experimentation Test). The comptroller declines this suggestion. This example is intended to address common issues encountered in administering the R&D credit.

Shane Frank of alliantgroup, Michael Thompson of Ryan, and Jennifer Woodard of AGC of Texas suggested reconsidering, eliminating, or modifying subsection (c)(1)(D)(vii)(VI), Example 6 (related to the Process of Experimentation Test). The comptroller declines the suggestion to eliminate this example because this example is intended to address common issues encountered in administering the R&D credit. Jennifer Woodard of AGC of Texas commented that one sentence of this example could be read such that computer-aided simulation would not qualify as a process of experimentation. That was not the intent of this example because such activities are expressly allowed by the applicable Treasury Regulations. The example has been modified to address this concern.

Dale Craymer of TTARA, Patrick Reynolds of COST, Shane Frank of alliantgroup, Michael Thompson of Ryan, and Mike Williams of RSM suggested reconsidering, eliminating, or modifying subsection (c)(1)(D)(vii)(VII), Example 7 (related to the Process of Experimentation Test). The comptroller declines this suggestion. This example is intended to address common issues encountered in administering the R&D credit. This example is also consistent with Treasury Regulation, §1.41-4(a)(8) Example 2, which provides that testing to determine if something works as specified by the manufacturer is an activity in the nature of routine or ordinary testing or inspection for quality control and is not qualified research.

Dale Craymer of TTARA, Patrick Reynolds of COST, Shane Frank of alliantgroup, and Michael Thompson of Ryan suggested reconsidering, eliminating, or modifying subsection (c)(1)(D)(vii)(VIII), Example 8 (related to the Process of Experimentation Test). The comptroller declines the suggestion to eliminate this example because this example is intended to address common issues encountered in administering the R&D credit. Dale Craymer of TTARA and Patrick Reynolds of COST suggested that this example may stand for the proposition that the Process of Experimentation Test requires evaluating multiple alternatives. That was not the intent of this example because such a requirement is not required by the IRC. The example has been modified to address this concern.

Michael Thompson of Ryan suggested eliminating or modifying subsection (c)(1)(D)(vii)(IX), Example 9 (related to the Process of Experimentation Test). The comptroller declines the suggestion to eliminate this example because this example is intended to address common issues encountered in administering the R&D credit. Mr. Thompson suggested that this example may stand for the proposition that the information discovered by a process of experimentation must be completely new to the world. That was not the intent of this example because such a requirement is not required by the IRC. The example has been modified to address this concern.

In new paragraph (2), the comptroller explains that the Four-Part Test applies separately to each business component of the taxable entity.

In new paragraph (3), the comptroller explains that, if the whole business component does not meet the requirements of the Four-Part Test, the taxable entity may then shrink back the business component to the next most significant subset of elements of the business component. This process continues until the Four-Part Test is satisfied, or the most basic element of the product fails the Four-Part Test.

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 credit. 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 credit.

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, Chapter 171, Subchapter M, making them part of that Subchapter. The comptroller has rulemaking authority under Tax Code, §171.662 (Rules) and §111.002 (Comptroller's Rules; Compliance; Forfeiture) to adopt rules for the enforcement of Tax Code, Chapter 171, Subchapter M. 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, Chapter 171, Subchapter M.

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 taxable entity 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 taxable entity 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 taxable entity 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 credit. 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. Mike Williams of RSM similarly suggested the comptroller adopt the High Threshold of Innovation Test found in those Treasury Regulations. The comptroller declines these suggestions. 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 franchise tax R&D credit, they are persuasive authority and will be considered by the comptroller on a case-by-case basis.

The comptroller amends relettered subsection (e) by moving the current language to paragraph (1) and adding two new paragraphs. The comptroller adds new paragraph (2) to explain that the taxable entity has the burden of proof to establish its entitlement to, and value of, the credit by clear and convincing evidence. In subparagraph (A), the comptroller explains that all qualified research expenses must be connected to specific qualified research activities. In subparagraph (B), the comptroller explains that all qualified research expenses must be supported by contemporaneous business records. The comptroller defines these contemporaneous business records for wages, supplies, and contract research expenses, including a non-exhaustive list of examples for each type of expense. The comptroller adds new paragraph (3) to explain that any determination by the IRS that a taxable entity is entitled to the federal research and development credit does not bind the comptroller when determining a taxable entity's eligibility for the credit.

Shannon Rusing of TXOGA, Dale Craymer of TTARA, Patrick Reynolds of COST, Shane Frank and Benjamin Barmore of alliantgroup, Ronnie Berry of Celanese, Jennifer Woodard of AGC of Texas, Alyssa Honnette of RSM, Carolyn Labatt of GSTC, and John Ferris of RealPage commented that the clear and convincing evidence standard is unnecessarily burdensome and suggested that the comptroller should apply the same burden of proof that is required for the federal income tax R&D credit. The comptroller declines this suggestion. The clear and convincing evidence standard is generally applicable to all franchise tax credits and nothing in Tax Code, Chapter 171, Subchapter M incorporates the federal burden of proof.

Shannon Rusing of TXOGA, Dale Craymer of TTARA, Patrick Reynolds of COST, Shane Frank of alliantgroup, Michael Thompson of Ryan, Ronnie Berry of Celanese, Jennifer Woodard of AGC of Texas, Alyssa Honnette of RSM, Carolyn Labatt of GSTC, and John Ferris of RealPage commented that the requirement to provide contemporaneous documentation is unnecessarily burdensome and suggested that the comptroller should require the same types of documentation that is required for the federal income tax R&D credit. The comptroller declines this suggestion. The requirement for contemporaneous documentation is generally applicable to all franchise tax credits and nothing in Tax Code, Chapter 171, Subchapter M incorporates the federal documentation requirements.

The comptroller amends relettered subsection (g)(3) to change the term "this state" to "Texas."

The comptroller amends paragraph (5) to provide additional details regarding verification of prior year QREs when those prior years are outside of the statute of limitations.

The comptroller adds paragraph (6) to explain that if a taxable entity has any QREs under a higher education contract, then all of its QREs are included in the calculation at the higher rate allowed by paragraph (3) or (4) of subsection (g). This is the case even if not all of the QREs relate to higher education contracts.

Shannon Rusing of TXOGA, Dale Craymer of TTARA, and Patrick Reynolds of COST suggested that the instructions for how combined groups should calculate their credit in proposed subsection (i) were not supported by the statute because the statute provides that the combined group is the taxable entity for the purposes of this credit. Shannon Rusing of TXOGA also suggested that the separate application of the higher education rate to different members of the combined group was similarly not supported by statute. At the public hearing held on this section, the comptroller requested comments on this issue. After careful consideration of this issue, the discussion at the public hearing, and all the comments received, the comptroller has modified subsection (i) as described below.

The comptroller restructures relettered subsection (i) into four paragraphs. The first sentence of the current subsection is now new paragraph (1). The second sentence of the current subsection is now in new paragraph (2). New paragraph (2) also explains that the total qualified research expenses of each member of the combined group shall be added together to determine the total credit claimed on the combined report. New paragraph (3) explains that a change in membership of the combined group results in a new taxable entity and the resulting combined group is not entitled to the carryforward of the credit because it is no longer the same taxable entity as the taxable entity that established the credit carryforward. New paragraph (3) also provides a list of six situations that will not be considered a change in the membership of the combined group. New paragraph (4) explains that the higher education rate described in relettered subsections (g)(3) - (4) applies to the combined group as a whole.

The comptroller amends relettered subsection (l) by adding paragraph (3) to explain that the comptroller may verify credit carryforwards by verifying the qualified research activities on which the credit that created the carryforward was based. This verification may occur even if the statute of limitations has expired for the report year on which the original credit was claimed. This verification will not result in an assessment of tax, penalty, or interest for any period for which the statute of limitation is closed, but may result in an adjustment to the credit carryforward for any periods for which the statute of limitations is open.

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, Chapter 171, Subchapter M.