[Federal Register Volume 62, Number 1 (Thursday, January 2, 1997)]
[Proposed Rules]
[Pages 81-83]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-32671]
-----------------------------------------------------------------------
DEPARTMENT OF THE TREASURY
26 CFR Parts 1 and 602
[REG-209494-90]
RIN 1545-A051
Credit for Increasing Research Activities
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
-----------------------------------------------------------------------
SUMMARY: This document contains proposed regulations under section 41
of the Internal Revenue Code of 1986 describing when computer software
which is developed by (or for the benefit of) a taxpayer primarily for
the taxpayer's internal use can qualify for the credit for increasing
research activities. The proposed regulations reflect a change to
section 41 made by the Tax Reform Act of 1986. This document also
provides notice of a public hearing on these proposed regulations.
DATES: Comments and outlines of topics to be discussed at the public
hearing scheduled for May 13, 1997 must be received by April 22, 1997.
ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-209494-90), room
5228, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered between the
hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-209494-90), Courier's
Desk, Internal Revenue Service, 1111 Constitution Avenue NW.,
Washington, DC. Alternatively, taxpayers may submit comments
electronically via the Internet by selecting the ``Tax Regs'' option of
the IRS Home Page, or by submitting comments directly to the IRS
Internet site at: http://www.irs.ustreas.gov/prod/tax__regs/
comments.html. The public hearing will be held in the auditorium,
Internal Revenue Building, 1111 Constitution Avenue, NW., Washington,
DC.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Lisa J.
Shuman or Robert B. Hanson, 202-622-3120; concerning submissions and
the hearing, Christina Vasquez, 202-622-7180 (not toll-free numbers).
[[Page 82]]
SUPPLEMENTARY INFORMATION:
Background
Section 41 of the Internal Revenue Code provides a credit against
tax for increasing research activities. Eligibility for the credit is
determined in part on the definition of qualified research under
section 41(d)(1). Section 231 of the Tax Reform Act of 1986 (the 1986
Act), 1986-3 C.B. 1, 87, established a new definition of qualified
research for purposes of the research credit. Qualified research was
narrowed to require that research be undertaken for the purpose of
discovering information that is technological in nature and the
application of which is intended to be useful in developing a new or
improved business component of the taxpayer. In addition, research is
eligible for the credit only if substantially all of the activities of
the research constitute elements of a process of experimentation for a
new or improved function, performance, or reliability or quality.
Treasury and the IRS request comments on the appropriate explanation of
the terms used in the definition of qualified research under the 1986
Act, in particular, the term process of experimentation.
Section 231 of the 1986 Act also specified that expenditures
incurred in certain research, research-related, and non-research
activities are to be excluded from eligibility for the credit without
reference to the general requirements for credit eligibility. Under
section 41(d)(4)(E) of the Code, except to the extent provided in
regulations, qualified research does not include research with respect
to computer software developed by (or for the benefit of) the taxpayer
primarily for the taxpayer's own use (internal-use software), other
than for use in (1) an activity which constitutes qualified research,
or (2) a production process whose development meets the requirements in
section 41(d)(1) for qualified research (as where the taxpayer is
developing robotics and software for the robotics for use in operating
a manufacturing process, and the taxpayer's research costs of
developing the robotics are eligible for the credit).
The legislative history indicates that Congress intended to limit
the credit for the costs of developing internal-use software to
software meeting a high threshold of innovation. In particular,
Congress intended that regulations would permit internal-use software
to qualify for the credit only if, in addition to satisfying the
general requirements for credit eligibility, the taxpayer can establish
that the following three-part test is satisfied: the software is
innovative (as where the software results in a reduction in cost, or
improvement in speed, that is substantial and economically
significant); the software development involves significant risk (as
where the taxpayer commits substantial resources to the development of
the software and there is substantial uncertainty, because of technical
risk, that such resources would not be recovered in a reasonable period
of time); and the software is not commercially available for use by the
taxpayer (as where the software cannot be purchased, leased, or
licensed and used for the intended purpose without modifications that
would satisfy the first two requirements). See H.R. Rep. No. 841, 99th
Cong., 2d Sess. II-73. Thus, Congress did not intend that the three-
part test in the legislative history would apply in lieu of the general
requirements for credit eligibility but, rather, intended that the
general requirements for credit eligibility of section 41(d) also would
have to be satisfied. See H.R. Rep. No. 841 at II-73.
The legislative history indicates, however, that Congress did not
intend the internal-use software exclusion in section 41(d)(4)(E) to
apply to research related to the development of a new or improved
package of software and hardware developed as a single product of which
the software is an integral part, and that is used directly by the
taxpayer in providing technological services to customers in its trade
or business (as where a taxpayer develops together a new or improved
high technology medical or industrial instrument containing software
that processes and displays data received by the instrument, or where a
telecommunications company develops a package of new or improved
switching equipment plus software to operate the switches). See H.R.
Rep. No. 841 at II-74.
Congress intended that regulations incorporating the three-part
test in the legislative history as an exception to the exclusion from
the definition of qualified research under section 41(d)(4)(E) would be
effective on the same date section 41(d)(4)(E) became effective. In
Notice 87-12 (1987-1 C.B. 432), the IRS stated that regulations to be
issued under section 41(d)(4)(E) would be effective for taxable years
beginning after December 31, 1985.
Explanation of Provisions
The proposed regulations follow the legislative history and provide
that internal-use software that meets the general requirements of
section 41(d), is innovative, involves significant economic risk, and
is not commercially available for use by the taxpayer is not excluded
from eligibility for the research credit under section 41(d)(4)(E).
Under the proposed regulations, this is a facts and circumstances test.
Treasury and the IRS request comments on facts and circumstances, other
than those factors enumerated in the legislative history, to be
considered in determining whether internal-use software satisfies the
three-part test.
Proposed Effective Dates
The amendments are proposed to be effective for taxable years
beginning after December 31, 1985.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in EO 12866. Therefore,
a regulatory assessment is not required. It also has been determined
that section 553(b) of the Administrative Procedure Act (5 U.S.C.
chapter 5) does not apply to these regulations, and because these
regulations do not impose a collection of information on small
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not
apply. Therefore, a Regulatory Flexibility Analysis is not required.
Pursuant to section 7805(f) of the Internal Revenue Code, this notice
of proposed rulemaking will be submitted to the Chief Counsel for
Advocacy of the Small Business Administration for comment on its impact
on small business.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any comments that are submitted timely
(in the manner described in the ADDRESSES portion of this preamble) to
the IRS. All comments will be available for public inspection and
copying.
A public hearing has been scheduled for May 13, 1997, at 10 a.m. in
the auditorium, Internal Revenue Building, 1111 Constitution Avenue,
NW., Washington, DC. Because of access restrictions, visitors will not
be admitted beyond the building lobby more than 15 minutes before the
hearing starts.
The rules of 26 CFR 601.601(a)(3) apply to the hearing.
Persons that wish to present oral comments at the hearing must
submit (in the manner described in the ADDRESSES portion of this
preamble) comments and an outline of the topics to be discussed and the
time to be devoted to each topic by April 22, 1997.
[[Page 83]]
A period of 10 minutes will be allotted to each person for making
comments.
An agenda showing the scheduling of the speakers will be prepared
after the deadline for receiving outlines has passed. Copies of the
agenda will be available free of charge at the hearing.
List of Subjects
26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 602 are proposed to be amended as
follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by adding
an entry in numerical order to read as follows:
Authority: 26 U.S.C. 7805. * * *
Section 1.41-4 also issued under 26 U.S.C. 41(d)(4)(E). * * *
Par. 2. Section 1.41-0 is amended by revising the entry for
Sec. 1.41-4 to read as follows:
Sec. 1.41-0 Table of contents.
* * * * *
Sec. 1.41-4 Qualified research for taxable years beginning after
December 31, 1985.
(a) through (d) [Reserved].
(e) Internal-use computer software.
(1) General rule.
(2) Requirements.
(3) Computer software and hardware developed as a single
product.
(4) Primarily for internal use.
(5) Special rule.
(6) Application of special rule.
(7) Effective date.
* * * * *
Par. 3. Section 1.41-4 is revised to read as follows:
Sec. 1.41-4 Qualified research for taxable years beginning after
December 31, 1985.
(a) through (d) [Reserved].
(e) Internal-use computer software--(1) General rule. Research with
respect to computer software that is developed by (or for the benefit
of) the taxpayer primarily for the taxpayer's internal use is eligible
for the research credit only if the software satisfies the requirements
of paragraph (e)(2) of this section. Generally, research with respect
to computer software is not eligible for the research credit where
software is used internally, for example, in general and administrative
functions (such as payroll, bookkeeping, or personnel management) or in
providing noncomputer services (such as accounting, consulting, or
banking services).
(2) Requirements. The requirements of this paragraph (e)(2) are--
(i) The software satisfies the requirements of section 41(d)(1);
(ii) The software is not otherwise excluded under section 41(d)(4)
(other than section 41(d)(4)(E)); and
(iii) One of the following conditions is met--
(A) The taxpayer uses the software in an activity that constitutes
qualified research (other than the development of the internal-use
software itself);
(B) The taxpayer uses the software in a production process that
meets the requirements of section 41(d)(1); or
(C) The software satisfies the special rule of paragraph (e)(5) of
this section.
(3) Computer software and hardware developed as a single product.
This paragraph (e) does not apply to the development costs of a new or
improved package of computer software and hardware developed together
by the taxpayer as a single product, of which the software is an
integral part, that is used directly by the taxpayer in providing
technological services in its trade or business to customers. In these
cases, eligibility for the research credit is to be determined by
examining the combined hardware-software product as a single product.
(4) Primarily for internal use. All relevant facts and
circumstances are to be considered in determining if computer software
is developed primarily for the taxpayer's internal use. If computer
software is developed primarily for the taxpayer's internal use, the
requirements of this paragraph (e) apply even though the taxpayer
intends to, or subsequently does, sell, lease, or license the computer
software.
(5) Special rule. Computer software satisfies the special rule of
this paragraph (e)(5) only if the taxpayer can establish that--
(i) The software is innovative (as where the software results in a
reduction in cost, or improvement in speed, that is substantial and
economically significant);
(ii) The software development involves significant economic risk
(as where the taxpayer commits substantial resources to the development
and there is a substantial uncertainty, because of technical risk, that
such resources would be recovered within a reasonable period); and
(iii) The software is not commercially available for use by the
taxpayer (as where the software cannot be purchased, leased, or
licensed and used for the intended purpose without modifications that
would satisfy the requirements of paragraphs (e)(5) (i) and (ii) of
this section).
(6) Application of special rule. In determining if the special rule
of paragraph (e)(5) of this section is satisfied all of the facts and
circumstances are considered. The special rule allows the costs of
developing internal-use software to be eligible for the research credit
only if the software meets a high threshold of innovation. The facts
and circumstances analysis takes into account only the results
attributable to the development of the new or improved software
independent of the effect of any modifications to related hardware or
other software. The weight given to any fact or circumstance will
depend on the particular case.
(7) Effective date. This paragraph (e) is applicable for taxable
years beginning after December 31, 1985.
Secs. 1.41-0A through 1.41-8A [Removed]
Par. 4. Sections 1.41-0A through 1.41-8A and the undesignated
centerheading preceding these sections are removed.
PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT
Par. 5. The authority citation for part 602 continues to read as
follows:
Authority: 26 U.S.C. 7805.
Par. 6. In Sec. 602.101, paragraph (c) is amended by removing the
following entries from the table:
Sec. 602.101 OMB Control numbers.
* * * * *
(c) * * *
------------------------------------------------------------------------
Current OMB
CFR part or section where identified and described control No.
------------------------------------------------------------------------
* * * * *
1.41-4A.................................................... 1545-0074
1.41-4 (b) and (c)......................................... 1545-0074
* * * * *
------------------------------------------------------------------------
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 96-32671 Filed 12-31-96; 8:45 am]
BILLING CODE 4830-01-U