Credit for Increasing Research Activities

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-105170-97]

RIN 1545-AV14

Credit for Increasing Research Activities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations relating to the

computation of the credit under section 41(c) and the definition of

qualified research under section 41(d). The proposed regulations

reflect changes to section 41 made by the Tax Reform Act of 1986, the

Revenue Reconciliation Act of 1989, the Small Business Job Protection

Act of 1996, and the Taxpayer Relief Act of 1997. The proposed

regulations also provide certain technical amendments to the

regulations.

DATES: Written comments must be received no later than March 2, 1999.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-105170-97), room

5228, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC 20044. Submissions may be hand delivered Monday through

Friday between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-

105170-97), 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.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,

Lisa J. Shuman or Leslie H. Finlow at (202)622-3120 (not a toll-free

number); concerning submission of comments, the hearing, and/or to be

placed on the building access list to attend the hearing, La Nita Van

Dyke at (202)622-7190 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed

rulemaking has been submitted to the Office of Management and Budget

for review in accordance with the Paperwork Reduction Act of 1995 (44

U.S.C. 3507(d)). Comments on the collection of information should be

sent to the Office of Management and Budget, Attn: Desk Officer for the

Department of the Treasury, Office of Information and Regulatory

Affairs, Washington, DC 20503, with copies to the Internal Revenue

Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC

20224. Comments on the collection of information should be received by

March 2, 1999. Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the

proper performance of the functions of the IRS, including whether the

information will have practical utility;

The accuracy of the estimated burden associated with the proposed

collection of information (see below);

How the quality, utility, and clarity of the information to be

collected may be enhanced;

How the burden of complying with the proposed collection of

information may be minimized, including through the application of

automated collection techniques or other forms of information

technology; and

[[Page 66504]]

Estimates of capital or start-up costs and costs of operation,

maintenance, and purchase of services to provide information.

The collection of information in this proposed regulation is in

Secs. 1.41-4(a) and 1.41-8(b). The information is required by the IRS

to ensure that taxpayers have engaged in qualified research and to

ensure the proper computation of the credit for increasing research

activities under section 41. Section 1.41-4(a) defines a process of

experimentation, as required for credit eligibility, to include the

recording of the results of the experiments. This requirement imposes

no additional recordkeeping burden, because taxpayers engaging in a

bona fide process of experimentation already record the results in any

event (see discussion under Explanation of Provisions, 3.

Documentation, in this preamble). The information required by

Sec. 1.41-8 will be used to determine if the taxpayer has elected or

revoked the election to use the alternative incremental credit allowed

under section 41(c)(4). The collection of information is mandatory. The

likely respondents are businesses or other for-profit institutions and

organizations. Responses to this collection of information are required

to elect to use and to revoke the election to use the alternative

incremental credit computation allowed under section 41(c)(4).

The reporting burden contained in Sec. 1.41-8(b)(2) (relating to

the election of the alternative incremental credit) is reflected in the

burden of Form 6765.

Estimated total annual reporting burden under Sec. 1.41-8(b)(3)

(relating to the revocation of the election to use the alternative

incremental credit): 250 hours.

Estimated average annual burden hours per respondent: 50 hours.

Estimated number of respondents: 5.

Estimated frequency of responses: On occasion.

An agency may not conduct or sponsor, and a person is not required

to respond to, a collection of information unless it displays a valid

control number assigned by the Office of Management and Budget.

Books or records relating to a collection of information must be

retained as long as their contents may become material in the

administration of any internal revenue law. Generally, tax returns and

tax return information are confidential, as required by 26 U.S.C. 6103.

Background

The research credit provisions originally appeared in section 44F

of the Internal Revenue Code of 1954 (the 1954 Code), as added to the

1954 Code by section 221 of the Economic Recovery Tax Act of 1981.

Section 471(c) of the Tax Reform Act of 1984 redesignated section 44F

as section 30. Section 231 of the Tax Reform Act of 1986 (the 1986 Act)

redesignated section 30 as section 41 and substantially modified the

research credit provisions. The amendments made to section 41 by the

1986 Act primarily relate to the definition of qualified research in

section 41(d) and the computation of basic research payments under

section 41(e). The Revenue Reconciliation Act of 1989 (the 1989 Act),

the Revenue Reconciliation Act of 1993 (the 1993 Act), the Small

Business Job Protection Act of 1996 (the 1996 Act), and the Taxpayer

Relief Act of 1997 (the 1997 Act) also amended the research credit

provisions. These amendments primarily relate to the trade or business

requirement in section 41(b) and the computation of the credit under

sections 41(c) and 41(f).

On May 17, 1989, the IRS published in the Federal Register (54 FR

21203) final regulations under section 41. The 1989 final regulations

generally do not reflect the amendments to section 41 made by the 1986

Act, the 1989 Act, the 1993 Act, the 1996 Act, and the 1997 Act. The

amendments proposed by this document contain rules relating primarily

to the amendments to section 41(d) made by the 1986 Act. The amendments

proposed by this document also contain some rules relating to

amendments to section 41 made by the 1989 Act, the 1996 Act, and the

1997 Act.

On January 2, 1997, the IRS published in the Federal Register (62

FR 81) proposed regulations (the 1997 proposed regulations) under

section 41 describing when computer software that 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

1997 proposed regulations reflect a change to section 41 made by the

1986 Act. The proposed regulations set forth in this notice of proposed

rulemaking complement but otherwise do not affect the 1997 proposed

regulations.

The Tax and Trade Relief Extension Act of 1998 extended the

research credit from June 30, 1998 through June 30, 1999. In the

Conference Report, H.R. Rep. No. 105-825, at 1547-49 (1998), the

conferees address the scope of the term qualified research, comment on

an aspect of the process of experimentation requirement, and note a

lack of clarity in the interpretation of the distinction between

internal-use software and other software. These proposed regulations

reflect the views expressed by the conferees, as well as prior

legislative history, regarding the term qualified research and the

process of experimentation. The IRS and Treasury request comments on

the distinction between internal-use software and other software.

Explanation of Provisions

1. Qualified Research

Congress enacted the research credit to encourage business firms to

perform the research necessary to increase the innovative qualities and

efficiency of the U.S. economy. H.R. Rep. No. 99-426, at 177 (1985); S.

Rep. No. 99-313, at 694 (1986). In extending the research credit in the

1986 Act, Congress expressed concern that, in practice, taxpayers had

applied the existing definition of qualified research too broadly and

some taxpayers had claimed the credit for virtually any expense

relating to product development. H.R. Rep. No. 99-426, at 178; S. Rep.

No. 99-313, at 694-95. Many taxpayers claiming the credit were not in

industries that involved high technology or its application in

developing technologically new and improved products or methods of

production. H.R. Rep. No. 99-426, at 178; S. Rep. No. 99-313, at 695.

To address these concerns, Congress narrowed the scope of the

research credit by providing in the Internal Revenue Code (Code) an

express definition of the term qualified research. In determining

eligibility for the research credit, section 41(d) requires that

qualified research activities satisfy a multi-part test. First, the

taxpayer's expenditures must be eligible to be treated as expenses

under section 174. See Sec. 1.174-2(a)(1) (defining research and

experimental expenditures).

Second, the expenditures must relate to research undertaken for the

purpose of discovering information that is both technological in nature

and the application of which is intended to be useful in developing a

new or improved business component of the taxpayer. The proposed

regulations provide that research is undertaken for the purpose of

discovering information that is technological in nature only if the

research activities are undertaken to obtain knowledge that exceeds,

expands, or refines the common knowledge of skilled professionals in

the particular field of technology or

[[Page 66505]]

science and the process of experimentation utilized fundamentally

relies on principles of physical or biological sciences, engineering,

or computer science. Consistent with the requirement that the research

activities be undertaken to obtain knowledge that exceeds, expands, or

refines the common knowledge of skilled professionals in the particular

field of technology or science, the credit may be available where the

technological advance sought by the taxpayer is evolutionary, and, in

certain circumstances, where the taxpayer is not the first to achieve

the same advance. Moreover, the credit is available regardless of

whether the taxpayer succeeds or fails in achieving the desired

advance.

Third, section 41(d) requires that substantially all of the

activities of the research constitute elements of a process of

experimentation that relates to a new or improved function,

performance, reliability or quality. As noted in the previous

paragraph, the process of experimentation utilized must fundamentally

rely on principles of physical or biological sciences, engineering, or

computer science.

In developing a process of experimentation rule applicable to all

scientific disciplines, IRS personnel met with personnel from the

National Science Foundation and the National Institute of Standards and

Technology. The proposed regulation explains that a process of

experimentation is a process involving the evaluation of more than one

alternative designed to achieve a result where the means of achieving

that result are uncertain at the outset. This requires that the

taxpayer (i) develop one or more hypotheses designed to achieve the

intended result; (ii) design a scientific experiment (that, where

appropriate to the particular field of research, is intended to be

replicable with an established experimental control) to test and

analyze those hypotheses (through, for example, modeling, simulation,

or a systematic trial and error methodology); (iii) conduct the

experiment and record the results; and (iv) refine or discard the

hypotheses as part of a sequential design process to develop or improve

the business component.

The proposed regulation does not require that the results of the

experiments be recorded in any specific manner. The results of the

experiments should be recorded in a manner that is appropriate for the

particular field of science in which the experiment is conducted and

for the type of experimentation involved. In some fields, for example,

experiments are recorded in lab books. When developing computer

software, by contrast, the experiments might be recorded in comment

lines contained in the source code.

In the 1986 Act, Congress also specified that expenditures incurred

in certain research, research-related, or non-research activities are

not eligible for the credit. The excluded activities are: post-

production activities, adaptation, duplication, surveys and studies,

research outside the United States, research in the social sciences,

funded research, and research related to certain internal-use computer

software.

Section 1.41-4 of this proposed regulation contains rules that

clarify the definition of the term qualified research and other terms

used in section 41(d). The proposed regulation also provides rules

relating to activities for which the research credit is not allowed.

2. Application of Tests

In the legislative history to the 1986 Act, Congress stated that if

the requirements of section 41(d) are not met for an entire product,

the term business component means the most significant set of elements

of that product for which all the requirements of section 41(d) are

met. The legislative history provides that this ``shrinking back'' is

to continue until either a subset of elements of the product that

satisfies the requirements is reached, or the most basic element of the

product is reached and such element fails to satisfy the test.

Consistent with the legislative history, Sec. 1.41-4(b) of the

proposed regulation explains that the ``shrinking-back'' concept is the

method for applying the tests in section 41(d) to a business component.

3. Documentation

Taxpayers must (a) record the results of their scientific

experiments (in a manner that is appropriate for the particular field

of science in which the experiment is conducted and for the type of

experiment involved) and (b) comply with the recordkeeping requirements

of section 6001 and the regulations thereunder. The requirement that

taxpayers record the results of their scientific experiments is not

intended to cause taxpayers to create records that otherwise would not

be created. Rather, the recording of results is inherent in a process

of experimentation to discover information that is technological in

nature. Limiting the availability of the credit to taxpayers who record

the results of their scientific experiments is not intended to change

taxpayer behavior, but to identify taxpayers who engage in a bona fide

process of experimentation and thus may be eligible for the credit.

4. Election of the Alternative Incremental Credit

The notice of proposed rulemaking provides rules for electing the

alternative incremental credit, which may be elected under section

41(c)(4). Section 1.41-8 of the proposed regulation provides that the

election is made on Form 6765, ``Credit for Increasing Research

Activities,'' and that the completed form must be attached to the

taxpayer's timely filed original return (including extensions) for the

taxable year to which the election applies.

Proposed Effective Date

In general, the regulations are proposed to be effective for

expenditures paid or incurred on or after the date final regulations

are published in the Federal Register. The regulations addressing the

base amount are proposed to be effective for taxable years beginning on

or after the date final regulations are published in the Federal

Register. The regulations providing for the election and revocation of

the alternative incremental credit are proposed to be effective for

taxable years ending on or after the date final regulations are

published in the Federal Register. No inference should be drawn from

the proposed effective date concerning the application of section 41 to

expenditures paid or incurred or the computation of the base amount

before the proposed effective date.

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. It is hereby certified

that the collection of information contained in these regulations will

not have a significant economic impact on a substantial number of small

entities. Accordingly, a Regulatory Flexibility Analysis under the

Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. This

certification is based on the information that follows. The economic

impact of the collection of information contained in these regulations

on any small entity would result from the entity being required: to (1)

Record the results of experiments related to its qualified research

activities, (2) elect on Form 6765 to use the alternative incremental

credit if the

[[Page 66506]]

entity desires to use that method, and (3) obtain permission to revoke

the alternative incremental credit election, if so desired. Because

taxpayers record results in conducting their research activities in any

event (see discussion under Explanation of Provisions, 3.

Documentation, in this preamble), the economic impact of the

recordkeeping requirement in the regulation would not be significant.

The economic impact of electing the alternative incremental credit on

Form 6765 also would not be significant because the election is made on

the same form and is based on the same information that is used to

claim the research credit. Pursuant to section 7805(f), 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 written comments (preferably a

signed original and eight (8) copies) that are submitted timely (in the

manner described in the ADDRESSES portion of this preamble) to the IRS.

Submissions might include comments on the definition of gross receipts,

comments regarding the exclusion for post-production activities,

comments on whether and how the definition of a process of

experimentation should be refined to ensure that it is appropriate for

all scientific fields, and comments on the interaction of the discovery

requirement and the duplication exclusion and the effect of such

interaction on specific industries. Also, submissions might include

comments on clarifying the distinction between internal-use software

(i.e., software described in section 41(d)(4)(E)) and other software.

All comments will be available for public inspection and copying.

A public hearing will be scheduled in the Internal Revenue

Building, 1111 Constitution Avenue, NW., Washington, DC. The IRS

recognizes that persons outside the Washington, DC area also may wish

to testify at the public hearing through teleconferencing. Requests to

include teleconferencing sites must be received by January 16, 1999. If

the IRS receives sufficient indications of interest to warrant

teleconferencing to a particular city, and if the IRS has

teleconferencing facilities available in that city on the date the

public hearing is to be scheduled, the IRS will try to accommodate the

requests.

The IRS will publish the time and date of the public hearing and

the locations of any teleconferencing sites in an announcement in the

Federal Register. The announcement will include the date by which

persons that wish to present oral comments at the hearing must submit

requests to speak, outlines of the topics to be discussed, and the time

to be devoted to each topic.

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.

Drafting Information. The principal authors of these proposed

regulations are Lisa J. Shuman and Leslie H. Finlow of the Office of

the Assistant Chief Counsel (Passthroughs and Special Industries).

However, personnel from other offices of the IRS and the Treasury

Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows.

(Note: These proposed amendments complement the proposed

amendments published at 62 FR 83, January 2, 1997.)

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. Revise the undesignated centerheading immediately before

Sec. 1.30-1 to read as follows:

Credits Allowable Under Section 30 through 44B

Par. 3. Remove the undesignated centerheading immediately before

Sec. 1.41-0.

Par. 4. Section 1.41-0 is revised to read as follows:

Sec. 1.41-0 Table of contents.

This section lists the paragraphs contained in Secs. 1.41-0 through

1.41-8.

Sec. 1.41-0 Table of contents.

Sec. 1.41-1 Credit for increasing research activities.

(a) Basic principles.

(b) Amount of credit.

(c) Introduction to regulations under section 41.

Sec. 1.41-2 Qualified research expenses.

(a) Trade or business requirements.

(1) In general.

(2) New business.

(3) Research performed for others.

(i) Taxpayer not entitled to results.

(ii) Taxpayer entitled to results.

(4) Partnerships.

(i) In general.

(ii) Special rule for certain partnerships and joint ventures.

(b) Supplies and personal property used in the conduct of

qualified research.

(1) In general.

(2) Certain utility charges.

(i) In general.

(ii) Extraordinary expenditures.

(3) Right to use personal property.

(4) Use of personal property in taxable years beginning after

December 31, 1985.

(c) Qualified services.

(1) Engaging in qualified research.

(2) Direct supervision.

(3) Direct support.

(d) Wages paid for qualified services.

(1) In general.

(2) ``Substantially all.''

(e) Contract research expenses.

(1) In general.

(2) Performance of qualified research.

(3) ``On behalf of.''

(4) Prepaid amounts.

(5) Examples.

Sec. 1.41-3 Base amount for taxable years beginning on or after

the date final regulations are published in the Federal Register.

(a) and (b) [Reserved]

(c) Definition of gross receipts.

(1) In general.

(2) Amounts excluded.

(3) Foreign corporations.

(d) Consistency requirement.

(1) In general.

(2) Illustrations.

Sec. 1.41-4 Qualified research for expenditures paid or incurred

on or after the date final regulations are published in the Federal

Register.

(a) Qualified research.

(1) General rule.

(2) Requirements of section 41(d)(1).

(3) Discovering information.

(4) Technological in nature.

(5) Process of experimentation.

(6) Substantially all requirement.

(7) Use of computers and information technology.

(8) Illustrations.

(b) Application of requirements for qualified research.

(1) In general.

(2) Shrinking-back rule.

(3) Illustration.

(c) Excluded activities.

(1) In general.

(2) Research after commercial production.

(i) In general.

(ii) Certain additional activities related to the business

component.

(iii) Activities related to production process or technique.

(3) Adaptation of existing business components.

(4) Duplication of existing business component.

(5) Surveys, studies, research relating to management functions,

etc.

[[Page 66507]]

(6) Internal-use computer software.

(7) Activities outside the United States.

(i) In general.

(ii) Apportionment of in-house research expenses.

(iii) Apportionment of contract research expenses.

(8) Research in the social sciences, etc.

(9) Research funded by any grant, contract, or otherwise.

(10) Illustrations.

(d) Documentation.

Sec. 1.41-5 Basic research for taxable years beginning after

December 31, 1986. [Reserved]

Sec. 1.41-6 Aggregation of expenditures.

(a) Controlled group of corporations; trades or businesses under

common control.

(1) In general.

(2) Definition of trade or business.

(3) Determination of common control.

(4) Examples.

(b) Minimum base period research expenses.

(c) Tax accounting periods used.

(1) In general.

(2) Special rule where timing of research is manipulated.

(d) Membership during taxable year in more than one group.

(e) Intra-group transactions.

(1) In general.

(2) In-house research expenses.

(3) Contract research expenses.

(4) Lease payments.

(5) Payment for supplies.

Sec. 1.41-7 Special rules.

(a) Allocations.

(1) Corporation making an election under subchapter S.

(i) Pass-through for taxable years beginning after December 31,

1982, in the case of an S corporation.

(ii) Pass-through, for taxable years beginning before January 1,

1983, in the case of a subchapter S corporation.

(2) Pass-through in the case of an estate or trust.

(3) Pass-through in the case of a partnership.

(i) In general.

(ii) Certain expenditures by joint ventures.

(4) Year in which taken into account.

(5) Credit allowed subject to limitation.

(b) Adjustments for certain acquisitions and dispositions--

Meaning of terms.

(c) Special rule for pass-through of credit.

(d) Carryback and carryover of unused credits.

Sec. 1.41-8 Special rules for taxable years ending on or after the

date final regulations are published in the Federal Register.

(a) Alternative incremental credit.

(b) Election.

(1) In general.

(2) Time and manner.

(3) Revocation.

Par. 5. Section 1.41-1 is revised to read as follows:

Sec. 1.41-1 Credit for increasing research activities.

(a) Basic principles. Section 41 provides a credit for increasing

research activities. The credit is intended to encourage business firms

to perform the technological research necessary to increase the

innovative qualities and efficiency of the U.S. economy. The credit

provides an incentive for business firms to increase their expenditures

for research to obtain new knowledge through a scientific process of

experimentation. Consequently, the credit is not to be applied too

broadly or in a manner such that virtually any expense relating to the

development of a product is eligible for the credit, even if some

portion of the expense of developing the product does qualify for the

credit. Similarly, the credit is not available for an expenditure

merely because the expenditure may be treated as an expense under

section 174. On the other hand, the credit may be available even though

the technological advance sought by the taxpayer is evolutionary, and,

in certain circumstances, even if another taxpayer has previously

achieved the same advance. Moreover, the credit is available regardless

of whether the taxpayer succeeds or fails in achieving the desired

advance. The credit is limited to eligible expenditures paid or

incurred for qualified research, as defined in section 41(d) and

Sec. 1.41-4.

(b) Amount of credit. The amount of a taxpayer's credit is

determined under section 41(a). For taxable years beginning after June

30, 1996, and at the election of the taxpayer, the portion of the

credit determined under section 41(a)(1) may be calculated using the

alternative incremental credit set forth in section 41(c)(4).

(c) Introduction to regulations under section 41. (1) Sections

1.41-2 through 1.41-8 and 1.41-3A through 1.41-5A address only certain

provisions of section 41. The following table identifies the provisions

of section 41 that are addressed, and lists each provision with the

section of the regulations in which it is covered.

------------------------------------------------------------------------

Section of the Internal

Section of the regulation Revenue Code

------------------------------------------------------------------------

Sec. 1.41-2............................ 41(b)

Sec. 1.41-3............................ 41(c)

Sec. 1.41-4............................ 41(d)

Sec. 1.41-5............................ 41(e)

Sec. 1.41-6............................ 41(f)

Sec. 1.41-7............................ 41(f)

41(g)

Sec. 1.41-8............................ 41(c)

Sec. 1.41-3A........................... 41(c) (taxable years beginning

before January 1, 1990)

Sec. 1.41-4A........................... 41(d) (taxable years beginning

before January 1, 1986)

Sec. 1.41-5A........................... 41(e) (taxable years beginning

before January 1, 1987)

------------------------------------------------------------------------

(2) Section 1.41-3A also addresses the special rule in section

221(d)(2) of the Economic Recovery Tax Act of 1981 relating to taxable

years overlapping the effective dates of section 41. Section 41 was

formerly designated sections 30 and 44F. Sections 1.41-0 through 1.41-8

and 1.41-0A through 1.41-5A refer to these sections as section 41 for

conformity purposes. Whether section 41, former section 30, or former

section 44F applies to a particular expenditure depends upon when the

expenditure was paid or incurred.

Sec. 1.41-2 [Amended]

Par. 6. Section 1.41-2 is amended as follows:

1. The last sentence of paragraph (a)(3)(i) is amended by removing

the language ``Sec. 1.41-5(d)(2)'' and adding ``Sec. 1.41-4A(d)(2)'' in

its place.

2. The last sentence of paragraph (a)(3)(ii) is amended by removing

the language ``Sec. 1.41-5(d)(3)'' and adding ``Sec. 1.41-4A(d)(3)'' in

its place.

3. The last sentence of paragraph (a)(4)(ii)(F) is amended by

removing the language ``Sec. 1.41-9(a)(3)(ii)'' and adding ``Sec. 1.41-

7(a)(3)(ii)'' in its place.

4. Paragraph (e)(1)(i) is amended by removing the language

``Sec. 1.41-5'' and adding ``Sec. 1.41-4 or 1.41-4A, whichever is

applicable'' in its place.

Par. 7. An undesignated centerheading is added immediately

following Sec. 1.44B-1 to read as follows:

Research Credit--For Taxable Years Beginning Before January 1, 1990

Sec. 1.41-3 [Redesignated as Sec. 1.41-3A]

Par. 8. Section 1.41-3 is redesignated as Sec. 1.41-3A and added

under the new undesignated centerheading ``Research Credit--For Taxable

Years Beginning Before January 1, 1990.''

Par. 9. New Sec. 1.41-3 is added to read as follows:

Sec. 1.41-3 Base amount for taxable years beginning on or after the

date final regulations are published in the Federal Register.

(a) and (b) [Reserved]

(c) Definition of gross receipts--(1) In general. For purposes of

section 41, gross receipts means the total amount, as determined under

the taxpayer's method of accounting, derived by the taxpayer from all

its activities and from all sources (e.g., revenues derived from

[[Page 66508]]

the sale of inventory before reduction for cost of goods sold).

(2) Amounts excluded. For purposes of this paragraph (c), gross

receipts do not include amounts representing--

(i) Returns or allowances;

(ii) Receipts from the sale or exchange of capital assets, as

defined in section 1221;

(iii) Repayments of loans or similar instruments (e.g., a repayment

of the principal amount of a loan held by a commercial lender);

(iv) Receipts from a sale or exchange not in the ordinary course of

business, such as the sale of an entire trade or business or the sale

of property used in a trade or business as defined under section

1221(2); and

(v) Amounts received with respect to sales tax or other similar

state and local taxes if, under the applicable state or local law, the

tax is legally imposed on the purchaser of the good or service, and the

taxpayer merely collects and remits the tax to the taxing authority.

(3) Foreign corporations. For purposes of section 41, in the case

of a foreign corporation, gross receipts include only gross receipts

that are effectively connected with the conduct of a trade or business

within the United States. See section 864(c) and applicable regulations

thereunder for the definition of effectively connected income.

(d) Consistency requirement--(1) In general. In computing the

credit for increasing research activities for taxable years beginning

after December 31, 1989, qualified research expenses and gross receipts

taken into account in computing a taxpayer's fixed-base percentage and

a taxpayer's base amount must be determined on a basis consistent with

the definition of qualified research expenses and gross receipts for

the credit year, without regard to the law in effect for the taxable

years taken into account in computing the fixed-base percentage or the

base amount. This consistency requirement applies even if the period

for filing a claim for credit or refund has expired for any taxable

year taken into account in computing the fixed-base percentage or the

base amount.

(2) Illustrations. The following examples illustrate the

application of the consistency rule of paragraph (d)(1) of this

section:

Example 1. (i) X, an accrual method taxpayer using the calendar

year as its taxable year, incurs qualified research expenses in

1990. X wants to compute its research credit under section 41 for

the tax year ending December 31, 1990. As part of the computation, X

must determine its fixed-base percentage, which depends in part on

X's qualified research expenses incurred during the fixed-base

period, the taxable years beginning after December 31, 1983, and

before January 1, 1989.

(ii) During the fixed-base period, X reported the following

amounts as qualified research expenses on its Form 6765:

1984........................................................... $100x

1985........................................................... 120x

1986........................................................... 150x

1987........................................................... 180x

1988........................................................... 170x

--------

Total...................................................... $720x

(iii) For the taxable years ending December 31, 1984, and

December 31, 1985, X based the amounts reported as qualified

research expenses on the definition of qualified research in effect

for those taxable years. The definition of qualified research

changed for taxable years beginning after December 31, 1985. If X

used the definition of qualified research applicable to its taxable

year ending December 31, 1990, the credit year, its qualified

research expenses for the taxable years ending December 31, 1984,

and December 31, 1985, would be reduced to $80x and $100x,

respectively. Under the consistency rule in section 41(c)(5) and

paragraph (d)(1) of this section, to compute the research credit for

the tax year ending December 31, 1990, X must reduce its qualified

research expenses for 1984 and 1985 to reflect the change in the

definition of qualified research for taxable years beginning after

December 31, 1985. Thus, X's total qualified research expenses for

the fixed-base period (1984-1988) to be used in computing the fixed-

base percentage is $80 + 100 + 150 + 180 + 170 = $680x.

Example 2. The facts are the same as in Example 1, except that,

in computing its qualified research expenses for the taxable year

ending December 31, 1999, X claimed that a certain type of

expenditure incurred in 1999 was a qualified research expense. X's

claim reflected a change in X's position, because X had not

previously claimed that similar expenditures were qualified research

expenses. The consistency rule requires X to adjust its qualified

research expenses in computing the fixed-base percentage to include

any similar expenditures not treated as qualified research expenses

during the fixed-base period, regardless of whether the period for

filing a claim for credit or refund has expired for any year taken

into account in computing the fixed-base percentage.

Par. 10. Section 1.41-4 is revised to read as follows:

Sec. 1.41-4 Qualified research for expenditures paid or incurred on or

after the date final regulations are published in the Federal Register.

(a) Qualified research--(1) General rule. Research activities

related to the development or improvement of a business component

constitute qualified research only if the research activities meet all

of the requirements of section 41(d)(1) and this section, and are not

otherwise excluded under section 41(d)(3)(B) or (4), or this section.

(2) Requirements of section 41(d)(1). Research constitutes

qualified research only if it is research--

(i) With respect to which expenditures may be treated as expenses

under section 174, see Sec. 1.174-2;

(ii) That is undertaken for the purpose of discovering information

that is technological in nature, and the application of which is

intended to be useful in the development of a new or improved business

component of the taxpayer; and

(iii) Substantially all of the activities of which constitute

elements of a process of experimentation that relates to a new or

improved function, performance, reliability or quality.

(3) Discovering information. For purposes of section 41(d) and this

section, the term discovering information means obtaining knowledge

that exceeds, expands, or refines the common knowledge of skilled

professionals in a particular field of technology or science.

(4) Technological in nature. For purposes of section 41(d) and this

section, information is technological in nature if the process of

experimentation used to discover such information fundamentally relies

on principles of physical or biological sciences, engineering, or

computer science.

(5) Process of experimentation. For purposes of section 41(d) and

this section, a process of experimentation is a process to evaluate

more than one alternative designed to achieve a result where the means

of achieving that result are uncertain at the outset. A process of

experimentation in the physical or biological sciences, engineering, or

computer science requires that the taxpayer--

(i) Develop one or more hypotheses designed to achieve the intended

result;

(ii) Design a scientific experiment (that, where appropriate to the

particular field of research, is intended to be replicable with an

established experimental control) to test and analyze those hypotheses

(through, for example, modeling, simulation, or a systematic trial and

error methodology);

(iii) Conduct the experiment and record the results; and

(iv) Refine or discard the hypotheses as part of a sequential

design process to develop or improve the business component.

(6) Substantially all requirement. The substantially all

requirement of section 41(d)(1)(C) and paragraph (a)(2)(iii) of this

section is satisfied only if 80 percent or more of the research

activities, measured on a cost or other

[[Page 66509]]

consistently applied reasonable basis, constitute elements of a process

of experimentation for a purpose described in section 41(d)(3). The

substantially all requirement is applied separately to each business

component.

(7) Use of computers and information technology. The employment of

computers or information technology, or the reliance on principles of

computer science or information technology to store, collect,

manipulate, translate, disseminate, produce, distribute, or process

data or information, and similar uses of computers and information

technology does not itself establish that qualified research has been

undertaken.

(8) Illustrations. The following examples illustrate the

application of paragraph (a) of this section:

Example 1. (i) Facts. X undertakes to develop for sale a tool

that would improve its suite of application development products.

The desired tool would handle connectivity problems for software

application developers by providing data access via a layer of

software that is more effective than existing software at finding

data in various locations and forms within a network, translating it

if need be, and then delivering the result to whatever application

or user requested it. The means of developing such versatile

database access middleware are not in the common knowledge of

skilled professionals in the relevant technological fields. In order

to determine whether it can successfully develop the desired tool, X

develops, tests, and discards or refines various algorithms and

protocols.

(ii) Conclusion. X's activities to develop the technology to

build the new software development tool may be qualified research

within the meaning of section 41(d)(1) and paragraph (a) of this

section. In developing the technology, X undertook to obtain

knowledge that exceeds, expands, or refines the common knowledge of

skilled professionals in the relevant technological fields.

Example 2. (i) Facts. X acquired a new software environment,

including a new operating system and a new database management

system with related tools. X undertook a project to redeploy its

data processing systems to the new software environment. X

anticipated that, relative to the old system, the new system would

significantly increase the time-sharing capabilities of its computer

system. The project activities included redesign of databases and

user interfaces, and translation of code from one programming

language to another. In migrating to the new software environment, X

relied on techniques and approaches that were within the common

knowledge of skilled professionals in the relevant technological

fields.

(ii) Conclusion. X's activities to redeploy its data processing

systems to the new software environment are not qualified research

within the meaning of section 41(d)(1) and paragraph (a) of this

section. X did not undertake to obtain knowledge that exceeds,

expands, or refines the common knowledge of skilled professionals in

the relevant technological fields.

Example 3. (i) Facts. X operates a computer system that does not

recognize dates beginning in the year 2000. In order to ensure that

its computer system will not malfunction in the year 2000, X incurs

substantial costs having its employees manually search its computer

programs to find all date fields used in the programs and replace

all of the date fields with year 2000 compliant date fields.

(ii) Conclusion. Because the activities of X's employees were

not undertaken to obtain knowledge that exceeds, expands, or refines

the common knowledge of skilled professionals in the relevant

technological fields and do not involve a process of

experimentation, the activities are not qualified research within

the meaning of section 41(d)(1) and paragraph (a) of this section.

Example 4. (i) Facts. X is engaged in the business of developing

and manufacturing widgets. X wants to manufacture an improved widget

made out of a material that X has not previously used. Although X is

uncertain how to use the material to manufacture an improved widget,

the viability and means of using the material to manufacture such

widgets are within the common knowledge of skilled professionals in

the relevant technological fields.

(ii) Conclusion. Even though X's expenditures for the activities

to resolve the uncertainty in manufacturing the improved widget may

be treated as expenses for research activities under section 174 and

Sec. 1.174-2, X's activities to resolve the uncertainty in

manufacturing the improved widget are not qualified research within

the meaning of section 41(d) and paragraph (a) of this section.

Although X's activities were intended to eliminate uncertainty, the

activities were not undertaken to obtain knowledge that exceeds,

expands, or refines the common knowledge of skilled professionals in

the relevant technological fields.

Example 5. (i) Facts. X desires to build a bridge that can

sustain greater traffic flow without deterioration than can existing

bridges. The technology used to build such a bridge is not in the

common knowledge of skilled professionals in the relevant

technological fields. X eventually abandons the project after

attempts to develop the technology prove unsuccessful.

(ii) Conclusion. X's activities to develop the technology to

build the bridge may be qualified research within the meaning of

section 41(d)(1) and paragraph (a) of this section, regardless of

the fact that X did not actually succeed in developing that

technology. In seeking to develop the technology, X undertook to

obtain knowledge that exceeds, expands, or refines the common

knowledge of skilled professionals in the relevant technological

fields.

Example 6. (i) Facts. The facts are the same as in Example 5,

except that Y successfully builds a bridge that can sustain the

greater traffic flow. Thereafter, Z seeks to build a bridge that can

also sustain such greater traffic flow. The technology used by Y to

build its bridge is a closely guarded secret that is not known to Z

and remains beyond the common knowledge of skilled professionals in

the relevant technological fields.

(ii) Conclusion. Z's activities to develop the technology to

build the bridge may be qualified research within the meaning of

section 41(d)(1) and paragraph (a) of this section, even if it so

happens that the technology used by Z to build its bridge is similar

or identical to the technology used by Y. In developing the

technology, Z undertook to obtain knowledge that exceeds, expands,

or refines the common knowledge of skilled professionals in the

relevant technological fields.

Example 7. (i) Facts. X and other manufacturing companies have

previously designed and manufactured a particular kind of machine

using Material S. Material T is less expensive than Material S. X

wishes to design a new machine that appears and functions exactly

the same as its existing machines, but that is made of Material T

instead of Material S. The technology necessary to achieve this

objective is not within the common knowledge of skilled

professionals in the relevant technological fields.

(ii) Conclusion. X's activities to design the new machine using

Material T may be qualified research within the meaning of section

41(d)(1) and paragraph (a) of this section. In seeking to design the

machine, X undertook to obtain knowledge that exceeds, expands, or

refines the common knowledge of skilled professionals in the

relevant technological fields.

Example 8. (i) Facts. X, a tire manufacturer, seeks to build a

tire that will not deteriorate as rapidly under certain conditions

of high speed and temperature as do existing tires. The design of

such a tire is not within the common knowledge of skilled

professionals in the relevant technological fields. X commences

laboratory research on January 1. On April 1, X determines in the

laboratory that a certain combination of materials and additives can

withstand higher rotational speeds and temperatures than the

combination of materials and additives used in existing tires. On

the basis of this determination, X undertakes further research

activities to determine how to design a tire using those materials

and additives, and to determine whether such a tire functions

outside the laboratory as intended under various actual road

conditions. By September 1, but not prior to September 1, X's

research has progressed to the point where, applying X's knowledge

to date, both the viability and means of producing the desired tire

would be within the common knowledge of skilled professionals in the

relevant technological fields. However, X continues to engage in

certain research activities related to the tire after September 1,

and until the first tire rolls off the assembly line on December 1.

(ii) Conclusion. Some or all of X's research activities until

September 1 may be qualified research within the meaning of section

41(d)(1) and paragraph (a) of this section. In seeking to design the

tire, X undertook to obtain knowledge that exceeds, expands, or

refines the common knowledge of skilled professionals in the

relevant technological

[[Page 66510]]

fields. The activities conducted after September 1 are not qualified

research within the meaning of section 41(d)(1) and paragraph (a) of

this section, because those activities were not undertaken to obtain

knowledge that exceeds, expands, or refines the common knowledge of

skilled professionals in the relevant technological fields.

(b) Application of requirements for qualified research--(1) In

general. The requirements for qualified research in section 41(d)(1)

and paragraph (a) of this section, must be applied separately to each

business component, as defined in section 41(d)(2)(B). In cases

involving development of both a product and a manufacturing or other

commercial production process for the product, research activities

relating to development of the process are not qualified research

unless the requirements of section 41(d) and this section are met for

the research activities relating to the process without taking into

account the research activities relating to development of the product.

Similarly, research activities relating to development of the product

are not qualified research unless the requirements of section 41(d) and

this section are met for the research activities relating to the

product without taking into account the research activities relating to

development of the manufacturing or other commercial production

process.

(2) Shrinking-back rule. The requirements of section 41(d) and

paragraph (a) of this section are to be applied first at the level of

the discrete business component to be held for sale, lease or license,

or used by the taxpayer in a trade or business of the taxpayer. If all

aspects of the requirements are not met at the first level, the

requirements are to be applied at the next most significant subset of

elements of the business component. The shrinking-back of the

applicable business component continues until a subset of elements of

the business component satisfies the requirements of section 41(d) and

paragraph (a) of this section (treating that subset of elements as a

business component) or the most basic element fails to satisfy the

requirements.

(3) Illustration. The following example illustrates the application

of this paragraph (b):

Example. X, a motorcycle engine builder, develops a new

carburetor for use in a motorcycle engine. X also modifies an

existing engine design for use with the new carburetor. Under the

shrinking-back rule, the requirements of section 41(d)(1) and

paragraph (a) of this section are applied first to the engine. If

the modifications to the engine when viewed as a whole, including

the development of the new carburetor, do not satisfy the

requirements of section 41(d)(1) and paragraph (a) of this section,

those requirements are applied to the next most significant subset

of elements of the business component. For purposes of this example,

it is assumed that the new carburetor is the next most significant

subset of elements of the business component. The research

activities in developing the new carburetor may constitute qualified

research within the meaning of section 41(d)(1) and paragraph (a) of

this section.

(c) Excluded activities--(1) In general. Qualified research does

not include any activity described in sections 41(d)(3)(B) and (4),

this paragraph (c), and paragraph (e) of this section.

(2) Research after commercial production--(i) In general.

Activities conducted after the beginning of commercial production of a

business component are not qualified research. Activities are conducted

after the beginning of commercial production of a business component if

such activities are conducted after the component is developed to the

point where it is ready for commercial sale or use, or meets the basic

functional and economic requirements of the taxpayer for the

component's sale or use.

(ii) Certain additional activities related to the business

component. The following activities are deemed to occur after the

beginning of commercial production of a business component--

(A) Preproduction planning for a finished business component;

(B) Tooling-up for production;

(C) Trial production runs;

(D) Trouble shooting involving detecting faults in production

equipment or processes;

(E) Accumulating data relating to production processes; and

(F) Debugging or correcting flaws in a business component.

(iii) Activities related to production process or technique. In

cases involving development of both a product and a manufacturing or

other commercial production process for the product, the exclusion

described in section 41(d)(4)(A) and paragraphs (c)(2)(i) and (ii) of

this section applies separately for the activities relating to the

development of the product and the activities relating to the

development of the process. For example, even after a product meets the

taxpayer's basic functional and economic requirements, activities

relating to the development of the manufacturing process still may

constitute qualified research, provided that the development of the

process itself separately satisfies the requirements of section 41(d)

and this section, and the activities are conducted before the process

meets the taxpayer's basic functional and economic requirements or is

ready for commercial use.

(3) Adaptation of existing business components. Activities relating

to adapting an existing business component to a particular customer's

requirement or need are not qualified research. This exclusion does not

apply merely because a business component is intended for a specific

customer.

(4) Duplication of existing business component. Activities relating

to reproducing an existing business component (in whole or in part)

from a physical examination of the business component itself or from

plans, blueprints, detailed specifications, or publicly available

information about the business component are not qualified research.

This exclusion does not apply merely because the taxpayer inspects an

existing business component in the course of developing its own

business component.

(5) Surveys, studies, research relating to management functions,

etc. Qualified research does not include activities relating to--

(i) Efficiency surveys;

(ii) Management functions (except for the direct supervision of

qualified research as defined in Sec. 1.41-2(c)(2)) or techniques,

including such items as preparation of financial data and analysis,

development of employee training programs and management organization

plans, and management-based changes in production processes (such as

rearranging work stations on an assembly line);

(iii) Market research, testing, or development (including

advertising or promotions);

(iv) Routine data collections; or

(v) Routine or ordinary testing or inspections for quality control.

(6) Internal-use computer software. [Reserved] \1\

---------------------------------------------------------------------------

\1\ Section 1.41-4(e), proposed on January 2, 1997 (62 FR 83),

including any revisions to that proposed rule will be incorporated

as this paragraph (c)(6) in the final rule.

---------------------------------------------------------------------------

(7) Activities outside the United States--(i) In general. Research

conducted outside the United States, as defined in section 7701(a)(9),

does not constitute qualified research.

(ii) Apportionment of in-house research expenses. In-house research

expenses paid or incurred for qualified services performed both in the

United States and outside the United States must be apportioned between

the services performed in the United States and the services performed

outside the United States. Only those in-house research expenses

apportioned to the

[[Page 66511]]

services performed within the United States are eligible to be treated

as qualified research expenses, unless the in-house research expenses

are wages and the 80 percent rule of Sec. 1.41-2(d)(2) applies.

(iii) Apportionment of contract research expenses. If contract

research is performed partly in the United States and partly outside

the United States, only 65 percent (or 75 percent in the case of

amounts paid to qualified research consortia) of the portion of the

contract amount that is attributable to the research activity performed

in the United States may qualify as a contract research expense (even

if 80 percent or more of the contract amount is for research performed

in the United States).

(8) Research in the social sciences, etc. Qualified research does

not include research in the social sciences (including economics,

business management, and behavioral sciences), arts, or humanities.

(9) Research funded by any grant, contract, or otherwise. Qualified

research does not include any research to the extent funded by any

grant, contract, or otherwise by another person (or governmental

entity). To determine the extent to which research is so funded,

Sec. 1.41-4A(d) applies.

(10) Illustrations. The following examples illustrate provisions

contained in paragraphs (c)(1) through (9) of this section. No

inference should be drawn from these examples concerning the

application of section 41(d)(1) and paragraph (a) of this section to

these facts:

Example 1. (i) Facts. X, a pharmaceutical company, performs

additional clinical tests on one of its products after that product

has been approved for a specific therapeutic use by the FDA and is

ready for commercial production and sale. The clinical tests study

the drug's long-term morbidity and mortality profile, and are

undertaken to develop information to use in the marketing materials

for the drug.

(ii) Conclusion. Because the additional tests are performed

after the drug is ready for commercial sale, X's activities in

connection with the tests are excluded from the definition of

qualified research under section 41(d)(4)(A) and paragraph (c)(2) of

this section.

Example 2. (i) Facts. The facts are the same as in Example 1,

except that, while studying the long-term morbidity and mortality

profile of the drug product, X discovers that the product may be

useful in treating a different medical condition. X begins new

clinical studies to establish the compound's new potential

therapeutic use.

(ii) Conclusion. Because the new clinical studies are performed

to establish a new therapeutic use of the drug product, the

additional clinical studies performed to establish the new

therapeutic use are not excluded from the definition of qualified

research under section 41(d)(4)(A) and paragraph (c)(2) of this

section.

Example 3. (i) Facts. X, a domestic corporation that

manufactures paper, develops and markets a new type of paper

containing a different chemical composition than the paper generally

available for commercial sale. Prior to manufacturing the paper, X

conducts preproduction planning for the finished paper product,

tools up for production, conducts trial production runs, engages in

trouble shooting involving detecting problems in production

equipment, accumulates production process data, and debugs the

product.

(ii) Conclusion. X's activities of preproduction planning,

tooling up for production, trial production runs, trouble shooting,

accumulation of production process data, and product debugging do

not constitute qualified research with respect to development of the

paper product because the activities are deemed to occur after the

beginning of commercial production of the product. Whether any

activities engaged in by X to develop a process for manufacturing

the paper constitute qualified research depends on whether the

development of the process itself separately satisfies the

requirements of section 41(d) and this section, and whether the

process meets the taxpayer's basic functional and economic

requirements or is ready for commercial use.

Example 4. (i) Facts. X, a computer software development firm,

owns all substantial rights in a general ledger accounting software

core program that X markets and licenses to customers. After

entering into a contractual agreement with a customer, X incurs

expenditures in modifying the core software program to adapt the

program to the customer's requirement or need.

(ii) Conclusion. Because X's activities represent activities to

modify an existing software program to adapt the program to a

particular customer's requirement, X's activities are excluded from

the definition of qualified research under section 41(d)(4)(B) and

paragraph (c)(3) of this section.

Example 5. (i) Facts. An existing gasoline additive is

manufactured by Y using three ingredients, A, B, and C. X seeks to

develop and manufacture its own gasoline additive that appears and

functions in a manner similar to Y's additive. To develop its own

additive, X first inspects the composition of Y's additive, and uses

knowledge gained from the inspection to reproduce A and B in the

laboratory. Any differences between ingredients A and B that are

used in Y's additive and those reproduced by X are insignificant and

are not material to the viability, effectiveness, or cost of A and

B. X desires to use with A and B an ingredient that has a materially

lower cost than ingredient C. Accordingly, X engages in a process of

experimentation to discover potential alternative formulations of

the additive (i.e., the development and use of various ingredients

other than C to use with A and B).

(ii) Conclusion. X's activities in analyzing and reproducing

ingredients A and B involve duplication of existing business

components and are excluded from qualified research under section

41(d)(4)(C) and paragraph (c)(4) of this section. X's

experimentation activities to discover potential alternative

formulations of the additive do not involve duplication of an

existing business component and are not excluded from qualified

research under section 41(d)(4)(C) and paragraph (c)(4) of this

section.

Example 6. (i) Facts. X, an appliance manufacturer, rearranges

employee work stations in its manufacturing assembly line and

develops a new employee training program to train employees for the

rearranged work stations.

(ii) Conclusion. X's activities associated with rearranging the

work stations and developing a new employee training program

represent activities related to management functions or techniques

and are excluded from qualified research under section 41(d)(4)(D)

and paragraph (c)(5) of this section.

Example 7. (i) Facts. X, an insurance company, develops a new

life insurance product. In the course of developing the product, X

engages in research with respect to the effect of pricing and tax

consequences on demand for the product, the expected volatility of

interest rates, and the expected mortality rates (based on published

data and prior insurance claims).

(ii) Conclusion. X's activities related to the new product

represent research in the social sciences, and are thus excluded

from qualified research under section 41(d)(4)(G) and paragraph

(c)(7) of this section.

(d) Documentation. See section 6001 and the regulations thereunder

for the recordkeeping requirements that must be satisfied.

Sec. 1.41-5 [Redesignated as Sec. 1.41-4A, and Amended]

Par. 11. Section 1.41-5 is redesignated as Sec. 1.41-4A, and the

last sentence of paragraph (d)(1) is amended by removing the language

``Sec. 1.41-8(e)'' and adding ``Sec. 1.41-6(e)'' in its place.

Sec. 1.41-6 [Redesignated as Sec. 1.41-5 and Amended]

Par. 12. Section 1.41-6 is redesignated as Sec. 1.41-5 and the

section heading is amended by removing the language ``December 31,

1985'' and adding ``December 31, 1986'' in its place.

Sec. 1.41-7 [Redesignated as Sec. 1.41-5A, and Amended]

Par. 13. Section 1.41-7 is redesignated as Sec. 1.41-5A, and

amended as follows:

1. The section heading is amended by removing the language

``January 1, 1986'' and adding ``January 1, 1987'' in its place.

2. Paragraph (e)(2) is amended by removing the language

``Sec. 1.41-5(c)'' and adding ``1.41-4A(c)'' in its place.

[[Page 66512]]

Sec. 1.41-8 [Redesignated as Sec. 1.41-6, and Amended]

Par. 14. Section 1.41-8 is redesignated as Sec. 1.41-6, and the

last sentence of paragraph (c) is amended by removing the language

``Sec. 1.41-3, except that Sec. 1.41-3(c)(2)'' and adding ``Sec. 1.41-

3A, except that Sec. 1.41-3A(c)(2)'' in its place.

Sec. 1.41-9 [Redesignated as Sec. 1.41-7]

Par. 15. Section 1.41-9 is redesignated as Sec. 1.41-7.

Par. 16. New Sec. 1.41-8 is added to read as follows:

Sec. 1.41-8 Special rules for taxable years ending on or after the

date final regulations are published in the Federal Register.

(a) Alternative incremental credit. At the election of the

taxpayer, the credit determined under section 41(a)(1) equals the

amount determined under section 41(c)(4).

(b) Election--(1) In general. A taxpayer may elect to apply the

provisions of the alternative incremental credit in section 41(c)(4)

for any taxable year of the taxpayer beginning after June 30, 1996. If

a taxpayer makes an election under section 41(c)(4), the election

applies to the taxable year for which made and all subsequent taxable

years.

(2) Time and manner of election. An election under section 41(c)(4)

is made by completing the portion of Form 6765, ``Credit for Increasing

Research Activities,'' relating to the election of the alternative

incremental credit, and attaching the completed form to the taxpayer's

timely filed original return (including extensions) for the taxable

year to which the election applies.

(3) Revocation. An election under this section may not be revoked

except with the consent of the Commissioner. A taxpayer must attach the

Commissioner's consent to revoke an election under section 41(c)(4) to

the taxpayer's timely filed original return (including extensions) for

the taxable year of the revocation.

Par. 17. Section 1.41-0A is added under the new undesignated

centerheading ``Research Credit--For Taxable Years Beginning Before

January 1, 1990'' to read as follows:

Sec. 1.41-0A Table of contents.

This section lists the paragraphs contained in Secs. 1.41-0A, 1.41-

3A, 1.41-4A and 1.41-5A.

Sec. 1.41-0A Table of contents.

Sec. 1.41-3A Base period research expenses.

(a) Number of years in base period.

(b) New taxpayers.

(c) Definition of base period research expenses.

(d) Special rules for short taxable years.

(1) Short determination year.

(2) Short base period year.

(3) Years overlapping the effective dates of section 41 (section

44F).

(i) Determination years.

(ii) Base period years.

(4) Number of months in a short taxable year.

(e) Examples.

Sec. 1.41-4A Qualified research for taxable years beginning before

January 1, 1986.

(a) General rule.

(b) Activities outside the United States.

(1) In-house research.

(2) Contract research.

(c) Social sciences or humanities.

(d) Research funded by any grant, contract, or otherwise.

(1) In general.

(2) Research in which taxpayer retains no rights.

(3) Research in which the taxpayer retains substantial rights.

(i) In general.

(ii) Pro rata allocation.

(iii) Project-by-project determination.

(4) Independent research and development under the Federal

Acquisition Regulations System and similar provisions.

(5) Funding determinable only in subsequent taxable year.

(6) Examples.

Sec. 1.41-5A Basic research for taxable years beginning before

January 1, 1987.

(a) In general.

(b) Trade or business requirement.

(c) Prepaid amounts.

(1) In general.

(2) Transfers of property.

(d) Written research agreement.

(1) In general.

(2) Agreement between a corporation and a qualified organization

after June 30, 1983.

(i) In general.

(ii) Transfers of property.

(3) Agreement between a qualified fund and a qualified

educational organization after June 30, 1983.

(e) Exclusions.

(1) Research conducted outside the United States.

(2) Research in the social sciences or humanities.

(f) Procedure for making an election to be treated as a

qualified fund.

Sec. 1.218-0 [Removed]

Par. 18. Section 1.218-0 is removed.

Sec. 1.482-7 [Amended]

Par. 19. In Sec. 1.482-7, the sixth sentence of paragraph (h)(1) is

amended by removing the language ``Sec. 1.41-8(e)'' and adding

``Sec. 1.41-6(e)'' in its place.

Michael P. Dolan,

Deputy Commissioner of Internal Revenue.

[FR Doc. 98-31528 Filed 12-01-98; 8:45 am]

BILLING CODE 4830-01-P