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New rules recently released by the Internal Revenue Service are designed to make it easier to claim a tax credit for certain technological innovation costs incurred in developing or improving a product or process. The IRS has struggled in its attempts to provide guidance on the types of research activities eligible for the tax credit. In 2001, the IRS issued regulations, which were replaced with new proposed regulations in response to taxpayer reaction. On Dec. 31, 2003, the IRS issued final regulations. THE CREDIT GENERALLY The tax credit for “qualified research” was first enacted in 1981 as a temporary measure, and has been renewed ten times. Although the current extension expires June 30, 2004, Congress almost certainly will enact another extension this year. Under the law, a taxpayer may claim a credit for a portion of its qualified research expenditures, based on a complex formula. The credit allowable in a given year is designed to encourage taxpayers to undertake more research than they had in the past. Generally, the credit is 20 percent of the amount by which qualified research expenses exceed a certain “base amount” of expenditures, which is determined under special rules that depend on when the taxpayer initially had gross receipts and qualified research expenses. Qualifying expenditures include wages to certain employees engaging in or supervising research and certain amounts paid for supplies. General overhead expenses, such as utilities, cannot be allocated to qualified research. The credit is generally available only in limited circumstances for start-up businesses or existing businesses entering a new, unrelated business. LEGAL REQUIREMENTS Expenditures may qualify for the research credit only if they are incurred in the taxpayer’s trade or business and meet the following general criteria: (1) The purpose of the research must be to discover information that is “technological” in nature; (2) The information obtained from the research must be intended to be useful in the development of a “new or improved product, process, computer software, technique, formula, or invention, which is held for sale, lease, license, or used in a trade or business of the taxpayer” (these are known as “business components” in the regulations, but we will refer to them as “innovations,” “products,” or processes”); (3) The purpose of the research must relate to a new or improved function, performance, or reliability or quality of the innovation (as opposed to style, taste, or cosmetic factors); and (4) “Substantially all” of the research activities must be elements of a “process of experimentation.” In other words, the availability of the credit is dependent on what the innovation is and how the innovation was made. The criteria are separately applied to each product or process. For example, any plant process, machinery, or technique for commercial production is treated separately from the product being produced. ‘TECHNOLOGICAL’ IN NATURE To qualify for the credit, it is not enough that the results of the research are intended to lead to an innovation. The information discovered from the research must be “technological.” The regulations provide that information is “technological” if the process of experimentation used to discover the information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science. Issuance of a patent is conclusive evidence that the information discovered is technological in nature. In patent law, an innovation is patentable if it is useful, new, and nonobvious. The tax regulations, as a general matter, are similar to the patent rules in that the innovation clearly needs to be new and useful. In addition, the capability, method, or appropriate design of the innovation must be uncertain as of the beginning of the taxpayer’s research activities. The “uncertainty” rule appears to be akin to the “non-obvious” rule for patent eligibility. This requirement that the innovation merely be “technological” is new. Under the prior rule, taxpayers were presumed to satisfy this requirement by showing credible, contemporaneous evidence that the research would exceed, expand, or refine the common knowledge of skilled professionals. The new rule, requiring merely that the information be technological in nature, should provide more certainty for taxpayers that they are eligible for the credit even if the research does not result in a patent. ‘PROCESS OF EXPERIMENTATION’ To qualify for the credit, “substantially all” of the expenditures for a particular innovation must be part of a “process of experimentation.” To satisfy that requirement, a process must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer science and must identify (1) uncertainty concerning the capability or method of achieving a result or concerning the appropriate design of a result, (2) one or more alternatives intended to eliminate that uncertainty, and (3) a process of evaluating the alternatives (such as modeling, simulation, or systematic trial and error methodology). The regulations incorporate several changes to the “process of experimentation” rule: (1) no longer must the capability, method, or design of the new or improved product or process be “readily discernible” and “applicable” at the start of the research; (2) the capability and method of achieving the result no longer must be uncertain at the outset of the research, as long as the design of the result is uncertain; (3) the “process” no longer must evaluate more than one alternative (although it should permit evaluation of more than one); and (4) the “process” is no longer required to comply with particular enumerated procedural requirements as long as it identifies an uncertainty, at least one alternative, and a process to evaluate alternatives (formerly, taxpayers had to develop hypotheses, design an experiment, conduct an experiment, and refine or discard hypotheses in order to have a “process of experimentation”). For “substantially all” of the research activity to constitute a process of experimentation, at least 80 percent of the research activities (measured on a cost or other reasonable basis) must constitute elements of a process of experimentation for a functional (rather than cosmetic) purpose. The new final regulations clarify that if this 80 percent requirement is satisfied, the remaining research activities with respect to the innovation in question need not constitute a process of experimentation for a functional purpose, as long as these remaining activities generally constitute research in the experimental or laboratory sense and are not otherwise ineligible for the credit (see below). Notably, this means that the remaining research activities can be for nonfunctional purposes, such as style, taste, or cosmetic factors. Eligibility for the credit is first tested at the level of the product or process held for sale. If the research expenditures related to that business component do not qualify (because the “substantially all” test is not satisfied), then the next most significant subset of the business component is tested, and so on until either the “substantially all” test is satisfied or the most basic subset fails. An example released by the IRS illustrates how this so-called “shrinking back” rule operates. If a taxpayer redesigns a kitchen toaster with a new heating element and a new high-tech appearance, the product held for sale (the toaster) might not satisfy the “substantially all” test. However, the next subset of the product (the new heating element) might satisfy the test. RESEARCH ACTIVITIES INELIGIBLE FOR THE CREDIT Expenditures incurred for the following activities are ineligible for credit regardless of whether the criteria discussed above are otherwise satisfied: (1) research after the beginning of commercial production; (2) research relating to the adaptation of an existing product or process to a particular customer’s requirements; (3) research related to reproducing an existing product or process from a physical examination of an item itself or from plans, blueprints, detailed specifications, or publicly available information; (4) surveys or studies relating to efficiency, management, marketing, routine data collection, or routine or ordinary testing for quality control; (5) research conducted outside of the United States or one of its possessions; (6) research in the arts, humanities, or social sciences (including economics, business management, and behavioral sciences); (7) research to the extent funded by any grant, contract, or otherwise; and (8) research resulting in certain internal-use software. The IRS did not finalize its proposed rules for internal-use software and has asked for comments regarding how “internal-use software” should be defined. Brian A. Silikovitz, a tax attorney, and Michael B. Johannesen, a registered patent attorney, are counsel to Lowenstein Sandler (www.lowenstein.com) of Roseland, N.J. They are members of the firm’s Tech Group. If you are interested in submitting an article to law.com, please click here for our submission guidelines.

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