(ii)A design is not a business component because a
design is not a product, process, computer software, technique, formula,
or invention. While uncertainty as to the appropriate design of a
business component is a qualifying uncertainty for the Section 174
Test and the Discovering Technological information test, the design
itself is not a business component. For example, the design of a structure
is not a business component, although the structure itself may be
a business component. Similarly, a blueprint or other plan used to
construct a structure that embodies a design is not a business component.
(D)Process of Experimentation Test. Substantially
all of the research activities must constitute elements of a process
of experimentation for a qualified purpose. A process of experimentation
is undertaken for a qualified purpose if it relates to a new or improved
function, performance, reliability, or quality of a business component.
Any research relating to style, taste, cosmetic, or seasonal design
factors does not satisfy the Process of Experimentation Test.
(i)A process of experimentation is a process designed
to evaluate one or more alternatives to achieve a result where the
capability or the method of achieving that result, or the appropriate
design of that result, is uncertain as of the beginning of the taxable
entity's research activities.
(ii)A process of experimentation must:
(I)be an evaluative process and generally should be
capable of evaluating more than one alternative; and
(II)fundamentally rely on the principles of the physical
or biological sciences, engineering, or computer science and involve:
(-a-)the identification of uncertainty concerning
the development or improvement of a business component;
(-b-)the identification of one or more alternatives
intended to eliminate that uncertainty; and
(-c-)the identification and the conduct of a process
of evaluating the alternatives through, for example, modeling, simulation,
or a systematic trial and error methodology.
(iii)A taxable entity may undertake a process of experimentation
if there is no uncertainty concerning the taxable entity's capability
or method of achieving the desired result so long as the appropriate
design of the desired result is uncertain as of the beginning of the
taxable entity's research activities. Uncertainty concerning the development
or improvement of the business component (e.g., its appropriate design)
does not establish that all activities undertaken to achieve that
new or improved business component constitute a process of experimentation.
(iv)The substantially all requirement of this subparagraph
is satisfied only if 80% or more of a taxable entity's research activities,
measured on a cost or other consistently applied reasonable basis
constitute elements of a process of experimentation that relates to
a new or improved function, performance, reliability, or quality.
The substantially all requirement is satisfied even if the remainder
of a taxable entity's research activities with respect to the business
component do not constitute elements of a process of experimentation
that relates to a new or improved function, performance, reliability,
or quality.
(v)Non-experimental methods, such as simple trial
and error, brainstorming, or reverse engineering, are not considered
a process of experimentation.
(vi)The following are factors that may be considered
in determining whether a trial and error methodology is experimental
systematic trial and error or non-experimental simple trial and error.
Evidence provided to determine the type of trial and error is not
limited to these factors, nor is evidence of each factor required.
These factors only apply to determining whether a process of experimentation
is systematic trial and error. Systematic trial and error is not the
only qualifying process of experimentation. These factors are:
(I)whether the person conducting the trial and error
methodology stops testing alternatives once a single acceptable result
is found or continues to find multiple acceptable results for comparison;
(II)whether all the results of the trial and error
methodology are recorded for evaluation;
(III)whether there is a written procedure for conducting
the trial and error methodology; and
(IV)whether there is a written procedure for evaluating
the results of the trial and error methodology.
(vii)Examples.
(I)Example 1. A taxable entity is engaged in the business
of developing and manufacturing widgets. The taxable entity wants
to change the color of its blue widget to green. The taxable entity
obtains several different shades of green paint from various suppliers.
The taxable entity paints several sample widgets, and surveys its
customers to determine which shade of green its customers prefer.
The taxable entity's activities to change the color of its blue widget
to green do not satisfy the Process of Experimentation Test because
its activities are not undertaken for a qualified purpose. All of
the taxable entity's research activities are related to style, taste,
cosmetic, or seasonal design factors.
(II)Example 2. The taxable entity in Example 1 chooses
one of the green paints. The taxable entity obtains samples of the
green paint from a supplier and determines that it must modify its
painting process to accommodate the green paint because the green
paint has different characteristics from other paints it has used.
The taxable entity obtains detailed data on the green paint from its
paint supplier. The taxable entity also consults with the manufacturer
of its paint spraying machines. The manufacturer informs the taxable
entity that it must acquire new nozzles that operate with the green
paint it wants to use because the current nozzles do not work with
the green paint. The taxable entity tests the new nozzles, using the
green paint, to ensure that they work as specified by the manufacturer
of the paint spraying machines. The taxable entity's activities to
modify its painting process are not qualified research. The taxable
entity did not conduct a process of evaluating alternatives in order
to eliminate uncertainty regarding the modification of its painting
process. Rather, the manufacturer of the paint machines eliminated
the taxable entity's uncertainty regarding the modification of its
painting process. The taxable entity's activities to test the nozzles
to determine if the nozzles work as specified by the manufacturer
of the paint spraying machines are in the nature of routine or ordinary
testing or inspection for quality control.
(III)Example 3. A taxable entity is engaged in the
business of manufacturing food products and currently manufactures
a large-shred version of a product. The taxable entity 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 taxable
entity must develop a new shredding blade that can be fitted onto
its current production line. The taxable entity 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 taxable entity 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 taxable entity's activities
to modify its current production line by developing the new shredding
blade satisfy the Process of Experimentation Test. Substantially all
of the taxable entity'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 taxable
entity's research activities. The taxable entity identified uncertainties
related to the development of a business component, and identified
alternatives intended to eliminate these uncertainties. Furthermore,
the taxable entity's process of evaluating identified alternatives
was technological in nature and was undertaken to eliminate the uncertainties.
(IV)Example 4. A taxable entity is in the business
of designing, developing and manufacturing automobiles. In response
to government-mandated fuel economy requirements, the taxable entity
seeks to update its current model vehicle and undertakes to improve
aerodynamics by lowering the hood of its current model vehicle. The
taxable entity 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 taxable entity'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 taxable entity
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
taxable entity 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 taxable entity 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 taxable entity's total activities to update its current
model vehicle. In this case substantially all of the taxable entity'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
taxable entity identified uncertainties related to the improvement
of a business component and identified alternatives intended to eliminate
these uncertainties. Furthermore, the taxable entity's process of
evaluating the identified alternatives was technological in nature
and was undertaken to eliminate the uncertainties. Because 85% of
the taxable entity'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 taxable entity is in the business
of providing building and construction services, including the construction
of warehouses, strip malls, office buildings, and other commercial
structures. The taxable entity is engaged to construct a structure
in a part of Texas where foundation problems are common. The taxable
entity's engineers were uncertain how to design the structure to ensure
stability of the structure's foundation because the taxable entity
had never designed a structure in a similar location. The taxable
entity'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 taxable entity 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
taxable entity'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 taxable entity 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 taxable entity was uncertain how to design the layout of the electrical
systems. The taxable entity'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 taxable entity 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 taxable entity did not use the computer-aided simulation and modeling
to evaluate different alternatives in a scientific manner. The taxable
entity'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 taxable entity is an oil and gas
operator that recently acquired rights to drill in an area in which
it had not previously operated. The taxable entity 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 taxable entity began horizontal drilling,
the technology to drill horizontal wells was established. The taxable
entity selected technology from existing commercially available options
to use in its horizontal drilling program. The taxable entity'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 taxable entity is an oil and gas
operator that recently acquired rights to drill in an area in which
it had not previously operated. The taxable entity decided to use
horizontal drilling in this area. The taxable entity 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 taxable entity utilized its existing
technology to perform its horizontal drilling operations in this area
and the existing technology was successful. The taxable entity's activities
did not satisfy the Process of Experimentation Test because the taxable
entity merely used its existing technology and did not perform any
experimentation to evaluate any alternative drilling methods.
(IX)Example 9. A taxable entity sought to discover
cancer immunotherapies. The taxable entity was uncertain as to the
appropriate design of the proteins to be used as a drug candidate.
The taxable entity identified several alternative protein constructs
and used a process to test them. The taxable entity'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 taxable entity 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 taxable entity. The taxable entity'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 taxable entity. 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 taxable
entity in a trade or business of the taxable entity. 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 will consider the facts and circumstances
of each activity.
(A)Application of Four-Part Test to software development
activities.
(i)A taxable entity 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 taxable entity 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
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