Postponed Research Credit Regulations and Discovery Test

On Dec. 27, 2000, Treasury issued final regulations (TD 8930) covering the research credit's computation under Sec. 41(c) and the definition of qualified research under Sec. 41(d). The effective date generally was to have been for expenditures paid or incurred after Jan. 2, 2001. The regulations were widely criticized by taxpayers and practitioners, because of the substantial changes made to proposed regulations. Many commentators believed Treasury should have re-issued these new regulations in proposed (rather than final) form to allow for additional public comments.

On Feb. 1, 2001, the Bush Administration indefinitely postponed these regulations' general effective date and re-opened the comment period through Apr. 2, 2001 (Notice 2001-19). While Treasury stopped short of withdrawing the regulations, it indicated that any changes would be announced as proposed regulations following a review of the final regulations, including consideration of previous and new comments. In effect, these regulations reverted to proposed regulations less than a month after they were generally effective. Nonetheless, taxpayers can rely on these regulations during this review.

Practitioners and taxpayers affected by the regulations generally applauded their withdrawal. Many commentators believed these regulations responded inadequately to problems inherent in the original proposed regulations. One of the principal points of contention between the IRS and taxpayers is the discovery test.

Discovery Test

To qualify for the credit, Sec. 41(d)(1)(B) requires that research be undertaken "for the purpose of discovering information which is technological in nature, and the application of which is intended to be useful in the development of a new or improved business component."

Under Prop. Regs. Sec. 1.41-4(a)(3), "discovering information" is defined as "obtaining knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of technology or science."

The Service and Treasury believe that discovering information is a separate statutory requirement. Taxpayers claiming the credit and their tax advisers, on the other hand, maintain that this phrase merely links the term "research" with the types of information required as the subject of the research.

Before the 1998 proposed regulations, the IRS had not published guidance on this issue. However, many taxpayers and advisers concluded that discovering information as used in Regs. Sec. 1.174-2(a)(1) was persuasive (if not determinative):

The term research or experimental expenditures, as used in section 174, means expenditures incurred in connection with the taxpayer's trade or business which represent research and development costs in the experimental or laboratory sense....Expen-ditures represent research and development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.

Eliminating uncertainty would certainly appear to be a less stringent standard than obtaining knowledge that exceeds, expands or refines the common knowledge of skilled professionals.

However, the Service and Treasury, concerned with possible credit "abuse," advanced their arguments in favor of a separate discovery requirement through the courts. In Norwest, 110 TC 454 (1998) and United Stationers, Inc., 163 F3d 440 (7th Cir. 1998), the Tax Court and the Seventh Circuit, respectively, agreed that a separate discovery test exists. Bolstered by these victories, the IRS issued the 1998 proposed regulations that contained the formal discovery test quoted above.

Taxpayers objected because the new test required those claiming the credit to prove a negative (i.e., that the knowledge sought by the research was unknown to people outside of their employment as well as their own employees). However, in Tax and Accounting Software Corp., 111 FSupp2d 1153 (DC OK 2000), the court stated "the purpose of the 'technology' requirement of 41 is to eliminate the 'soft sciences' from contention for the credit, not to focus on the word 'discovery.'"

Although Wicor, Inc., 116 FSupp2d 1028 (DC WI 2000), was decided for the Service, that case was appealable to the Seventh Circuit. Thus, it is not necessarily a separate confirmation of the IRS's position. Consequently, when the Service issued the final regulations containing the discovery test (although slightly altered from the 1998 version), taxpayers understandably felt that their concerns had been ignored.

Norwest, United Stationers and Wicor involved research expenditures for "internal use" software. Expenditures to develop internal-use software must meet three additional requirements before they are eligible for inclusion in the research credit computation: (1) the software must be innovative, (2) its development must involve significant economic risk and (3) it cannot be commercially available to the taxpayer without modifications that would meet the first two requirements. Although these additional requirements are not directly related to the discovery test, it is possible that their presence in these cases obscured the courts' analyses of the discovery issue.

In Tax and Accounting Software Corp., on the other hand, the taxpayer's expenditures were made in developing software to be sold for customers' "commercial use." The three additional requirements do not apply to commercial-use software; only the four basic tests (in Sec. 41(d)(1)) apply. Thus, the discovery test may have been more clearly considered in this case.

With the final regulations "suspended" and the comment period re-opened, taxpayers are left to interpret these conflicting signals. Is there a separate "discovery test" requiring that information exceeding, expanding or refining the common knowledge of skilled professionals be the objective of research activities? Or does a taxpayer merely have to engage in research that is technological in nature, involving the "hard sciences?" Until the current regulation project is completed, taxpayers might conclude that the latter position could be reflected in original returns. In addition, they should consider filing protective refund claims for open years, when appropriate, in the event that future regulations adopt the more favorable discovery test.

From David A. DiMuzio, J.D., LL.M., Grand Rapids, MI