The Comptroller of Public Accounts adopts amendments to §3.340, concerning qualified research, with changes to the proposed text as published in the April 16, 2021, issue of the Texas Register (46 TexReg 2555). The rule will be republished.

The comptroller amends this section to provide guidance regarding the research and development sales tax exemption.

Throughout the section, the comptroller adds titles to statutory citations and makes minor revisions to improve readability.

The comptroller received comments regarding the proposed amendments from: Shannon Rusing of Texas Oil & Gas Association (TXOGA); Dale Craymer of Texas Taxpayers and Research Association (TTARA); Patrick Reynolds of Council on State Taxation (COST); Shane Frank of alliantgroup, LP (alliantgroup); Michael Thompson of Ryan; Kreig Mitchell of Kreig Mitchell LLC; Ronnie Berry of Celanese Corporation (Celanese); and Jennifer Woodard of Associated General Contractors of Texas (AGC of Texas).

Ronnie Berry of Celanese and Jennifer Woodard of AGC of Texas requested a public hearing on the proposed amendments. The comptroller held the public hearing on Monday, June 28, 2021, at 9:00 a.m. in Room 170 of the Stephen F. Austin Building, Austin, Texas 78701. Benjamin Barmore of alliantgroup, Michael Thompson of Ryan, Alyssa Honnette of RSM, Dale Craymer of TTARA, Carolyn Labatt of Great South Texas Corporation (GSTC), and John Ferris of RealPage, Inc. (RealPage) testified at the hearing.

Shannon Rusing of TXOGA, Dale Craymer of TTARA, Patrick Reynolds of COST, and Shane Frank of alliantgroup each requested that the comptroller provide additional affirmative examples where a taxpayer qualified for the credit. These requests were for general examples, examples related to the Oil and Gas industry, and examples related to software development. The comptroller declines to provide additional examples in the rule because the current examples are sufficient.

Shane Frank and Benjamin Barmore of alliantgroup and Michael Thompson of Ryan commented that the proposed rule would eliminate entire industries from having any qualified research activities. The comptroller declines to modify the rule based on these comments. This is not the intent of the rule and there is no language in the rule that prevents a taxpayer from being engaged in qualified research based on the industry of the taxpayer.

The comptroller adds a new subsection (a)(1) to define the term "business component." The comptroller bases this term on Internal Revenue Code (IRC), §41(d)(2)(B) (Business component defined), with non-substantive changes. The comptroller renumbers subsequent paragraphs.

The comptroller amends the definition of "combined group" in renumbered subsection (a)(2) to remove unnecessary information and to add a cross-reference to §3.590 of this title (relating to Combined Reporting).

The comptroller adds new subsection (a)(4) to define the term "Four-Part Test." The comptroller derives this term from IRC, §41(d) (Qualified research defined) and the regulations applicable to that section.

The comptroller amends the definition of "Internal Revenue Code (IRC)" in renumbered paragraph (6) to explain that a regulation adopted after December 31, 2011 must require a taxpayer to apply that regulation to the 2011 federal income tax year to be included in this definition. The definition for IRC in Tax Code, §151.3182(a)(2) incorporates by reference Tax Code, §171.651 (Definitions). The definition of IRC in Tax Code, §171.651(1) states: "'Internal Revenue Code' means the Internal Revenue Code of 1986 in effect on December 31, 2011, excluding any changes made by federal law after that date, but including any regulations adopted under that code applicable to the tax year to which the provisions of the code in effect on that date applied."

The current version of Treasury Regulation, §1.41-4 (Qualified research for expenditures paid or incurred in taxable years ending on or after Dec. 31, 2003), adopted on November 3, 2016, is an example of a regulation that does not fully apply to the 2011 federal income tax year. With respect to its applicability, Treasury Regulation, §1.41-4(e) provides: "Other than paragraph (c)(6) of this section, this section is applicable for taxable years ending on or after December 31, 2003. Subsection (c)(6) of this section is applicable for taxable years beginning on or after October 4, 2016. For any taxable year that both ends on or after January 20, 2015 and begins before October 4, 2016, the IRS will not challenge return positions consistent with all of paragraph (c)(6) of this section or all of paragraph (c)(6) of this section as contained in the Internal Revenue Bulletin (IRB) 2015-5 (see www.irs.gov/pub/irs-irbs/irb15-05.pdf). For taxable years ending before January 20, 2015, taxpayers may choose to follow either all of §1.41-4(c)(6) as contained in 26 CFR part 1 (revised as of April 1, 2003) and IRB 2001-5 (see www.irs.gov/pub/irs-irbs/irb01-05.pdf) or all of §1.41-4(c)(6) as contained in IRB 2002-4 (see www.irs.gov/pub/irs-irbs/irb02-04.pdf)." The first sentence quoted above shows that, other than paragraph (c)(6), the current version of Treasury Regulation, §1.41-4 applies to the 2011 federal income tax year. With respect to paragraph (c)(6), the second sentence quoted above shows that the current language in Treasury Regulation, §1.41-4(c)(6) does not apply to the 2011 federal income tax year. The fourth sentence quoted above allows taxpayers to choose one of two proposed regulations described in the Internal Revenue Bulletins incorporated by reference. The proposed regulations referenced in those Internal Revenue Bulletins were not part of the Treasury Regulations in effect on December 31, 2011. Although the federal regulations allow taxpayers to choose whether they follow this prior IRS guidance, the options are not included in the term "Internal Revenue Code" because Treasury Regulation, §1.41-4(e) does not require taxpayers to follow either of those options.

Another example of a regulation that does not apply to the 2011 federal income tax year is Treasury Regulation, §1.174-2 (Definition of research and experimental expenditures), adopted July 21, 2014. With respect to its applicability, Treasury Regulation, §1.174-2(d) provides: "The eighth and ninth sentences of §1.174-2(a)(1); §1.174-2(a)(2); §1.174-2(a)(4); §1.174-2(a)(5); §1.174-2(a)(11) Example 3 through Example 10; §1.174-2(b)(4); and §1.174-2(b)(5) apply to taxable years ending on or after July 21, 2014. Taxpayers may apply the provisions enumerated in the preceding sentence to taxable years for which the limitations for assessment of tax has not expired." While the federal statute of limitations for the assessment of tax for the 2011 federal income tax year had not expired at the time this regulation was adopted, the provisions enumerated in this applicability provision are not included in the term "Internal Revenue Code" because the regulation does not require taxpayers to apply those provisions to the 2011 federal income tax year.

Shannon Rusing of TXOGA, Dale Craymer of TTARA, Patrick Reynolds of COST, Michael Thompson of Ryan, Ronnie Berry of Celanese, Jennifer Woodard of AGC of Texas, Carolyn Labatt of GSTC, and John Ferris of RealPage suggested that the Treasury Regulations that taxpayers had the option to apply to the 2011 federal income tax year, such as Treasury Regulation, §1.41-4(c)(6) and Treasury Regulation, §1.174-2, should be included in the definition of "Internal Revenue Code." For the reasons described above, the comptroller declines this suggestion.

The comptroller amends the definition of "qualified research" in renumbered paragraph (7) to explain that qualified research must be research conducted in Texas and that qualified research must satisfy the Four-Part Test. The comptroller also deletes subparagraphs (A) and (B). The information currently found in these subparagraphs is included in the expanded discussion in new subsections (c) and (d) regarding the Four-Part Test and the exclusions from qualified research.

Shane Frank of alliantgroup and Michael Thompson of Ryan commented that the redefinition of qualified research is unnecessary, will cause confusion for taxpayers, and does not conform to IRC, §41. The comptroller declines to modify the rule based on these comments. The amendments to this definition are intended to provide additional guidance to taxpayers regarding how the definition of qualified research was incorporated into Texas law. The new definition is not intended to, and does not, conflict with the IRC that was incorporated into Texas law. Any part of the rule that does not have a direct basis in federal law was included to address ambiguities that were not addressed in IRC, §41 or any applicable Treasury Regulations.

The comptroller amends subsection (b) to add paragraphs (4) through (7). The comptroller adds paragraphs (4) and (5) to explain the requirement that property must be subject to depreciation in order to be eligible for the exemption. Paragraph (4) explains that the property qualifies for the exemption even if taxpayers do not actually depreciate the property. Paragraph (5) explains that property does not qualify for the exemption if it is not subject to depreciation in the form in which it was purchased, even if it is later used to create property that is subject to depreciation. Paragraph (5) contains an example illustrating this point. The comptroller adds paragraph (6) to explain that the taxpayer has the burden of proof to establish its entitlement to the exemption by clear and convincing evidence and that qualified research activities must be supported by contemporaneous business records. The comptroller adds paragraph (7) to explain that any determination by the IRS that a taxpayer is entitled to the federal research and development credit does not bind the comptroller when determining a taxpayer's eligibility for the exemption.

Shannon Rusing of TXOGA, Dale Craymer of TTARA, Patrick Reynolds of COST, Shane Frank of alliantgroup, Ronnie Berry of Celanese, and 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 sales tax exemptions and nothing in Tax Code, §151.3182 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 sales tax exemptions and nothing in Tax Code, §151.3182 incorporates the federal documentation requirements.

The comptroller adds new subsections (c) and (d) and reletters subsequent subsections.

In new subsection (c), the comptroller discusses the application of the Four-Part Test to explain the basic requirements for research activities to be qualified research. The comptroller bases this subsection primarily on IRC, §41(d) and Treasury Regulation, §1.41-4.

In paragraph (1), the comptroller describes the four individual components of the Four-Part Test: subparagraph (A) describes the Section 174 Test; subparagraph (B) describes the Discovering Technological Information Test; subparagraph (C) describes the Business Component Test; and subparagraph (D) describes the Process of Experimentation Test. In subparagraph (D), the comptroller provides several examples illustrating the Process of Experimentation Test.

Michael Thompson of Ryan and Kreig Mitchell of Kreig Mitchell LLC suggested that services should be allowed to be business components and that subsection (c)(1)(C)(i) should be removed. The comptroller declines this suggestion. The term "business component" is defined by IRC, §41(d)(2)(B) as "any product, process, computer software, technique, formula, or invention which is to be--(i)held for sale, lease, or license, or (ii)used by the taxpayer in a trade or business of the taxpayer." Services do not fit within this definition. Concerns regarding taxpayers that provide services are addressed by this subsection by providing that a taxpayer may have qualified research activities for research related to business components that are used to provide services.

Shannon Rusing of TXOGA, Dale Craymer of TTARA, Patrick Reynolds of COST, Shane Frank of alliantgroup, Michael Thompson of Ryan, Kreig Mitchell of Kreig Mitchell LLC, Ronnie Berry of Celanese, and Jennifer Woodard of AGC of Texas suggested that designs should be allowed to be business components and that subsection (c)(1)(C)(ii) should be removed. The comptroller declines this suggestion. The term "business component" is defined by IRC, §41(d)(2)(B) as "any product, process, computer software, technique, formula, or invention which is to be--(i)held for sale, lease, or license, or (ii)used by the taxpayer in a trade or business of the taxpayer." The commenters suggested that a "design" can be produced and is included in the term "product." The surplusage canon of statutory construction requires that statutory provisions not be read in a way that would render any word redundant. An interpretation of the term "product" that is broad enough to include the term "design" would also include the terms "process," "computer software," "technique," "formula," and "invention." Such an interpretation would render all those terms redundant. The commenters also suggested that excluding a design from being a business component is inconsistent with the applicable federal law because Treasury Regulation, §1.41-4 provided that uncertainty as to the appropriate design of a business component can be a qualifying uncertainty for the Section 174 Test, the Discovering Technological Information Test, and the Process of Experimentation Test. In the phrase "appropriate design of a business component" the word design does not refer to the business component itself, it is describing a quality of the business component.

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 exemption.

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 exemption. 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, and Michael Thompson of Ryan 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 exemption. 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 exemption. 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 exemption. 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 taxpayer.

In new paragraph (3), the comptroller explains that, if the whole business component does not meet the requirements of the Four-Part Test, the taxpayer 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.