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A Four-Part Test: Does Your Business Qualify for the Research Credit? Brought to you by The CPA Report May 2002 (SmartPros) The Internal Revenue Service has released new, controversial regulations for the research credit, a tax incentive that has played an important role in the seemingly endless array of product introductions and encouraged U.S. businesses to devote substantial resources toward research and experimentation activities. The reformed tax code for the credit was reinstated for five years, applying to research expenditures through June 30, 2004. With businesses constantly scrambling to keep pace with changes in technology and changes in global markets, more financial executives than ever before are being asked about the applicability of the research tax credit.
Since its introduction in 1981, the research credit has been modified a handful of times, and over the years many "tests," which determine whether or not a business qualifies for the credit, have been modified or eliminated. The new proposed rules includes a four-part test that businesses must pass in order to utilize the credit. This test has proven to be the biggest bone of contention between businesses and the IRS.
The first part is that the activities qualify as 'experimentation' under the tax code. This requirement, essentially, restricts experimentation to the laboratory sense of the word. The second requirement is that the activity must be technological in nature. In order to be technological in nature, it has to be a scientific project. The third requirement is that the activity must be a process of experimentation. In most situations, this means an organized system of tests where you start with a hypothesis and check out various alternatives before reaching a conclusion. The final requirement is the so-called business component test. In other words, the experimental product or process must be something that would be a useful component for some part of your business. The key focus for the newly proposed regulations is the modification and the elimination of the controversial test, known as the discovery test.
According to the tax code, qualified research must be undertaken for the purpose of discovering information which is technological in nature.
During the Clinton Administration, the IRS had proposed regulations on the research credit that allowed companies to employ existing technologies and to rely on existing scientific principles to satisfy the requirements of this ‘technological in nature’ test. In addition, there was no requirement of success in the outcome; in other words, companies could qualify for the credit even if they were unsuccessful in their research efforts.
Unfortunately, those regulations elaborated on the requirement. They stated that research is undertaken for the purpose of discovering information only when it intends to obtain knowledge that exceeds, expands, or refines the common knowledge of skilled professionals in a particular field of science or engineering.
One of the major improvements of the newly proposed regulations is the elimination of the test that exceeds, expands, or refines the common knowledge. Instead, it substitutes a definition of research found elsewhere in the tax code. This test may still rely on existing scientific principles, and the research still need not be successful to qualify for the credit.
The new test requires that research must be undertaken for the purpose of discovering information to eliminate uncertainty concerning the development or improvement of a business component.
The good news is that the regulations have eliminated the controversial test that required ‘discovery’ to take place. But, in its place, companies must now demonstrate that they are engaged in a process of experimentation that is complex, extensive, comprehensive or intricate.
But what about the requirement that research be 'technological in nature'? What happens if, for instance, the business obtains a patent for its research activities?
"Actually, there is a safe harbor provision for patents," said Richard Weiss, Executive Director of Income Taxes for Verizon. "And if you do have a patent that’s not a design patent, then you would qualify under that provision. However, you have to meet all four requirements. So even though you have a patent, and you meet the technological nature, you still have to meet the other three requirements to qualify."
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2002 SmartPros. All rights reserved.
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