[Federal Register Volume 59, Number 190 (Monday, October 3, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-24153]
[[Page Unknown]]
[Federal Register: October 3, 1994]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 8562]
RIN 1545-AM92
Research or Experimental Expenditures
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains amendments to the Income Tax
Regulations clarifying the definition of research or experimental
expenditures and providing guidance regarding the reasonableness
requirement of section 174(e), added to the Internal Revenue Code by
the Revenue Reconciliation Act of 1989. These amendments affect
taxpayers conducting research or experimentation in connection with a
trade or business.
EFFECTIVE DATE: October 3, 1994.
FOR FURTHER INFORMATION CONTACT: Lisa J. Shuman, (202) 622-3120 (not a
toll-free number).
SUPPLEMENTARY INFORMATION:
Background
Section 174 of the Internal Revenue Code (Code) provides two
alternative methods that taxpayers may use to account for research or
experimental expenditures. A taxpayer may either deduct the
expenditures in the year in which they are paid or incurred, or treat
the expenditures as deferred expenses, amortizable over a period of at
least 60 months. In 1957, the IRS adopted Sec. 1.174-2(a)(1), which
defines the term research or experimental expenditures as expenditures
which represent research and development costs in the experimental or
laboratory sense (22 FR 7901 (October 4, 1957)).
In 1993, the IRS proposed amendments to Sec. 1.174-2(a)(1) to
clarify the definition of research or experimental expenditures (58 FR
15819 (March 24, 1993)). The amendments also provide guidance regarding
section 174(e), which was added to the Code by the Revenue
Reconciliation Act of 1989. Section 174(e) provides that the accounting
rules of section 174 apply to a research or experimental expenditure
only to the extent that the amount of the expenditure is reasonable
under the circumstances.
The IRS received comments on the proposed amendments both in
writing and at a public hearing on June 18, 1993. This Treasury
decision adopts the proposed amendments with several revisions in
response to public comments.
Explanation of Provisions
A. Clarification of Uncertainty Test
As noted above, the 1957 regulations define research or
experimental expenditures as expenditures which represent research and
development costs in the experimental or laboratory sense. The proposed
amendments provide that expenditures 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.
Under the proposed amendments, the requisite uncertainty exists if the
information reasonably available to the taxpayer does not establish the
capability or method for developing or improving the product.
Several commentators expressed concern that the uncertainty test
provided in the proposed amendments could be construed to limit unduly
the definition of research or experimental expenditures. In particular,
the commentators argued that the test could exclude expenditures
incurred to determine the appropriate design of a product if the
taxpayer knows at the outset that the procedure will be successful. In
such a case, the taxpayer is not uncertain as to either its capability
to develop the product or the method by which it will develop the
product.
The Treasury Department and the IRS agree that a taxpayer's
knowledge that a product development project will be successful does
not preclude the process of determining the appropriate design of the
product from qualifying as research. The Treasury Department and the
IRS also agree that the language of the uncertainty test provided in
the proposed amendments could be construed to reach a result contrary
to that intended. The final amendments thus clarify the uncertainty
test. Under the final amendments, the requisite uncertainty exists if
the information available to the taxpayer does not establish either (i)
The capability or method for developing or improving the product, or
(ii) the appropriate design of the product.
The uncertainty test, as clarified in the final amendments,
reflects the dual purposes of section 174. Congress enacted section 174
not only to encourage research, but also to avoid the difficult tax
accounting questions that would arise regarding research expenditures
in the absence of special tax accounting rules. See H. Rep. 1337, 83d
Cong., 2d Sess. (1954), reprinted in 1954 U.S.C.C.A.N. 4017, 4053.
These difficult tax accounting questions would not be limited to cases
in which the success of a product development project is in doubt. If a
given line of inquiry proves to be unfruitful, questions could arise
regarding whether the costs involved could be deducted, or whether the
knowledge gained from the inquiry might contribute sufficiently to the
ultimate design of the product that the costs must be capitalized. In
short, the tax accounting questions that section 174 was meant to
resolve can arise whenever the taxpayer is uncertain as to the
capability or method for developing or improving the product, or the
appropriate design of the product.
The proposed amendments apply the uncertainty test with reference
to ``the information reasonably available to the taxpayer.'' The
Treasury Department and the IRS agree with the commentators that the
meaning of the phrase reasonably available is unclear. Further, the
phrase could be read to impose an unintended restriction on the
definition of research or experimental expenditures. Information could
be considered to be reasonably available to a taxpayer if the taxpayer
can obtain the information through procedures that, while not
particularly involved, are nonetheless in the nature of research
activities. To avoid the ambiguities resulting from the term
reasonably, the final amendments provide for the application of the
uncertainty test with reference to the information actually available
to the taxpayer. The removal of the term reasonably is not intended to
expand the information considered to be available to the taxpayer.
B. Validation Testing
The 1957 regulations exclude from the definition of research the
ordinary testing or inspection of materials or products for quality
control. Several commentators on the proposed amendments asked for
clarification that research includes validation testing to ensure that
a product design meets its intended objectives. In response to these
comments, the final amendments clarify that the existing exclusion for
quality control testing does not apply to testing to determine if the
design of a product is appropriate.
C. Effective Date
The final amendments retain the effective date of the proposed
amendments, and thus apply to taxable years beginning after October 3,
1994. Some commentators requested that the proposed amendments apply to
all open taxable years. Because the amendments merely clarify the
existing definition of research or experimental expenditures,
retroactive application of the amendments is unnecessary. Return
positions consistent with the amendments will be consistent with the
existing regulations and will be recognized as such by the IRS.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It has also been determined that
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)
and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to
these regulations, and, therefore, a Regulatory Flexibility Analysis is
not required. Pursuant to section 7805(f) of the Internal Revenue Code,
the notice of proposed rulemaking preceding these regulations was
submitted to the Small Business Administration for comment on their
impact on small business.
Drafting Information
The principal author of these regulations is Lisa J. Shuman of the
Office of Assistant Chief Counsel (Passthroughs and Special
Industries), IRS. However, other personnel from the IRS and Treasury
Department participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.174-2 is amended as follows:
1. Paragraph (a)(1) is revised.
2. Paragraphs (a) (2) and (3) are redesignated as paragraphs (a)
(8) and (9), respectively.
3. New paragraphs (a) (2) through (7) are added.
4. Paragraph (c) is amended by removing the reference ``sections
615'' and adding ``sections 617'' in its place.
5. The additions and revisions read as follows:
Sec. 1.174-2 Definition of research and experimental expenditures.
(a) In general. (1) 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. The term
generally includes all such costs incident to the development or
improvement of a product. The term includes the costs of obtaining a
patent, such as attorneys' fees expended in making and perfecting a
patent application. Expenditures 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. Whether expenditures
qualify as research or experimental expenditures depends on the nature
of the activity to which the expenditures relate, not the nature of the
product or improvement being developed or the level of technological
advancement the product or improvement represents.
(2) For purposes of this section, the term product includes any
pilot model, process, formula, invention, technique, patent, or similar
property, and includes products to be used by the taxpayer in its trade
or business as well as products to be held for sale, lease, or license.
(3) The term research or experimental expenditures does not include
expenditures for--
(i) The ordinary testing or inspection of materials or products for
quality control (quality control testing);
(ii) Efficiency surveys;
(iii) Management studies;
(iv) Consumer surveys;
(v) Advertising or promotions;
(vi) The acquisition of another's patent, model, production or
process; or
(vii) Research in connection with literary, historical, or similar
projects.
(4) For purposes of paragraph (a)(3)(i) of this section, testing or
inspection to determine whether particular units of materials or
products conform to specified parameters is quality control testing.
However, quality control testing does not include testing to determine
if the design of the product is appropriate.
(5) See section 263A and the regulations thereunder for cost
capitalization rules which apply to expenditures paid or incurred for
research in connection with literary, historical, or similar projects
involving the production of property, including the production of
films, sound recordings, video tapes, books, or similar properties.
(6) Section 174 applies to a research or experimental expenditure
only to the extent that the amount of the expenditure is reasonable
under the circumstances. In general, the amount of an expenditure for
research or experimental activities is reasonable if the amount would
ordinarily be paid for like activities by like enterprises under like
circumstances. Amounts supposedly paid for research that are not
reasonable under the circumstances may be characterized as disguised
dividends, gifts, loans, or similar payments. The reasonableness
requirement of this paragraph (a)(6) does not apply to the
reasonableness of the type or nature of the activities themselves.
(7) This paragraph (a) applies to taxable years beginning after
October 3, 1994.
* * * * *
Dated: September 9, 1994.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved: September 9, 1994.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 94-24153 Filed 9-30-94; 8:45 am]
BILLING CODE 4830-01-U
